AL Economics Notes (Ver 3) by A Karim Lakhani

Distributed by A. KARIM LAKHANI (0333- TUTOR 4U) (0333- 888 67 48) (www.tutor4u.com.
pk)
Microeconomics Notes
Central Problem of Economics
Central Problem of Economics - SCARCITY
 Definition: Limited resources available are unable to satisfy the unlimited human wants
 Resources - Land, Labour, Capital, Entrepreneurship.
 Unlimited wants - Desire for ever higher levels of consumption.
o When old wants are satisfied, new wants are created.
doing so, the three basic questions that arise are:

N I
Resources have to be allocated to promote the two main microeconomic aims: Efficiency and Equity. In
A
1. What and how much to produce
2. How to produce
3. For whom to produce
K
Productive Efficiency: Absence of waste in the production process
H
L A
 PPC: All points on the PPC are productive efficient. Points inside the PPC are inefficient,
representing either unemployment or underemployment.
 LRAC: All points on the LRAC curve are productive efficient.
I M
Allocative Efficiency: Maximum welfare for society
R
 PPC: Only one point is allocatively efficient.
 Also achieved when P = MC or SMB = SMC.
K A
 Allocative inefficiency results in deadweight loss, since society values additional/previous units of a
good more/less than it costs to produce them. (standard explanation for deadweight loss; try to
.
refer to areas for benefit, cost and deadweight loss in graph)
A
The Production Possibility Curve (PPC) shows all the different maximum attainable combinations of goods
or services that can be produced in an economy, when all the available resources are used fully and
efficiently, at a given state of technology.
 Scarcity: Points outside the PPC such as U currently cannot be attained, even if desired by society.
o Even if growth occurs so such points are now inside PPC, new wants U1 will be created
 Choice: Society must choose a single point within the PPC to produce at, e.g. between A, B, C.
 Opportunity cost: Downward slope of the PPC.
 Law of Increasing Opportunity Cost: Concave Good Y
shape of the PPC. As more of one good is
● U1
produced, more and more of the other good ● ● U
must be sacrificed. A
o Due to resources not being equally suited
for the production of all goods ●
 Economic/Potential growth: Outward shift of C B
●
PPC boundary.
 Actual growth: Outward shift of point of
production inside PPC. Good X
1
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Demand & Supply

[ Demand/Supply refers to the quantity of a good or service that consumers/producers are willing and
able to buy/offer for sale at each possible price during a given period of time, ceteris paribus. ]
When a question asks for how a market has changed, it’s asking for how/how much demand and supply
have changed and their resulting effect on equilibrium price and quantity. Define all terms in terms of these
four basic concepts, e.g. Revenue/Expenditure is Price x Quantity, Profit is Revenue - Cost.
Make sure to cover all four aspects, and include elasticity concepts to boost your explanations!
I
Determinants of demand
Population: Changes in population size or composition affects size of market

Expectations of future incomes and prices
Tastes and preferences: Affected by advertising (Price elasticity) A N
Income: Normal vs. Inferior goods (Income elasticity) K H
Related goods’ prices: Complements vs. substitutes vs. derived demand (Cross elasticity)
Determinants of Supply
Related goods’ prices: Competitive vs. Joint Supply L A

Expectations of future prices
I M
R
Cost of Production: Taxes, Wages, Inputs, Technology.
A
. K Elasticity
[ Price elasticity of demand/supply measures the responsiveness of quantity demanded/supplied of a
A good to changes in its own price, ceteris paribus.
Income/Cross elasticity of demand measures the responsiveness of demand of a good to changes in

income of consumers/price of another good, ceteris paribus. ]
State their formulae:

% change in qty demanded / qty supplied / demand (of good X)
[ PED / PES / YED / CED = ]
% change in price/income/price of good Y
Price Elastic Supply Price Inelastic Supply

When demand increases: When demand increases:
Characteristics Price ↑ slightly, but output ↑ more than Price ↑ signiﬁcantly, but output ↑ less
proportionately. than proportionately.
Number of firms Many firms Few firms (Monopoly)
Availability of variable inputs, like labour
Spare capacity Scarce resources available
and raw materials
Non-capital intensive, with factors easily Capital intensive, with specialised
Factor Mobility
shifted in from other processes machinery and labour required
Long vs. Short run In the long run, fixed costs become variable with enough time to build up machinery
(Evaluation) and train labour; hence supply becomes more price elastic.
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Price Elastic Demand Price Inelastic Demand
Characteristics Gentle demand curve Steep demand curve
Substitutes Large amount of close substitutes Little substitutes

Proportion of
Costs high proportion of income Costs low proportion
income
Addiction Non-addictive goods Addictive goods
 Firms: Lower prices to increase
Application revenue  Firms: Jack up prices!
(Price, Taxes)  Govt: Levy taxes to decrease  Govt: Levy taxes for tax revenue
Effect on Tax /
Subsidy Incidence
consumption
N I
Producers pay greater share of taxes, but Consumers pay greater share of taxes,
also receive higher share of subsidies. but also receive higher share of subsidies.
Positively Income Elastic A

(General rule for tax incidence: The party with a more price elastic curve pays less.)
H
Positively Income Inelastic Negative Income
K
(PED > 1) (0 < PED < 1) Elasticity (PED < 0)
A
Normal good
Nature of good Inferior good
L
Luxury Necessity
People keep wanting more of People are quickly satisfied
Rate of
that good even when they when they consume more Unknown
IM
satisfaction
consume more of it of the good (e.g. food)
Increase production of luxury Increase production
R
Application
goods during boom - Do nothing - of lower-grade goods
(Output)
A
(NOT raise prices!) during recession
. K
Positively Cross Elastic
(CED > 1)
Positively Cross Inelastic
(0 < CED < 1)
Negative Cross Elasticity
Characteristics
Application
(Response to
A Goods are substitutes.
Magnitude of CED depends on how close they are.
1. Slash prices as well, when competitors lower prices

Goods are complements
Joint promotions
2. Differentiate product
other firms)
Universal Micro Evaluations
 Ceteris paribus: Most concepts assume ceteris paribus condition. In reality, this rarely holds true as
several factors may be changing simultaneously.
 Imperfect competition: Again, most concepts assume perfect competition. In reality, perfect
competition rarely exists, possibly due to imperfect information or barriers to entry and exit.
 Time horizon: Concepts may only hold true in the short term. In the long run, prices may fall and
demand for a good may get more price elastic due to more competitors entering the market, or a
trend might die out for example.
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Price Controls
Price Floor
Aims
 Achieve equity by protecting the welfare of certain groups (e.g. workers)
 Create a consistent surplus so stocks will be accumulated (e.g. to prepare for future shortages)
Problems
 Allocatively inefficient (deadweight loss of ABC, same as price ceiling on next page)
 Distorts price signals, creating illusion of a lucrative market
o Producers become complacent
o May attract new producers, creating excessive surpluses
N I
 Stock storage = Waste of money
Example: Minimum Wage

H A
 However, after a minimum wage P1 is imposed,
A K
 The labour market is initially at equilibrium with a wage of P and a quantity of Q jobs available.
L
 The number of job seekers increase to Q1 but the quantity of workers demanded by firms drops to
Q2, resulting in a surplus of (Q1 – Q2).
 (Q – Q2) jobs are lost.
I M
 Only a quantity Q2 of workers enjoy the higher wages.
R
Wage
SS
P1
K A A
A . P
C
B
DD
Quantity of
Q2 Q Q1 workers
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Price Ceiling
Aims
 Achieve equity by keeping prices of a good affordable to the majority
 Stabilise prices (e.g. during war)
 Prevent suppliers from exploiting the market by raising prices
Problems
 Allocatively inefficient (deadweight loss of ABC, same as price floor)
 Distorts price signals, making them no longer a way to allocate scarce resources
 Emergence of the black market
Example: Rent Controls

 The market is initially at equilibrium at price P and quantity Q.
N I
A
 However, after a maximum price P1 is imposed,
 A shortage of (Q1 – Q2) arises.
higher price of P2.
K H
 A black market may be created, where goods bought at the controlled price of P1 are sold at a
A
Price
SS
L
IM
P2 A
P B
P1
AR C
DD
. K Quantity
A
Q2 Q Q1 of rentals
Alternative mechanisms for resource allocation: Balloting, Rationing.
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Correcting Market Failure

Market failure occurs when the free market fails to achieve the microeconomic aims of efficiency (!) and
equity (probably not tested).
Issue Cause Policy Evaluation

A public good is: Direct provision of public goods,  Difficult to determine the exact
e.g. street lighting, national quantity of a public good to provide
 Non-excludable: Impossible
defence.  Increases burden on taxpayers
or prohibitively expensive to
exclude non-payers from
I
consuming a good.
(Complete market failure)
o No one will pay for what
N
he can get for free (free-
rider problem)
Public Goods
o Absence of price signal, so

producers will not supply
the good => Good must be
H A
K
provided by government.
 Non-rivalrous: Benefits
enjoyed from a good are not
depleted by additional users.
o MC = 0, so P = MC = 0, i.e. L A
I M
good must be provided for
free.
R
Externalities are costs or Tax Pros
benefits from production or The government can impose a  Still allows market to operate
K A
consumption experienced by
society, but not by producers
or consumers themselves.
tax equal to the EMC, so the
externality is internalised.
 Ensures firms/consumers bear the
full cost of their actions
.
Cost/Benefit  Provides incentive for firms to find
SMC = PMC
ways to reduce EMC
A
+ tax
Explaining negative  Generates tax revenue
externalities: [vice versa for SS = PMC
positive] Cons
(Partial market failure)
1. An individual/firm, in  Difficult to measure and quantify

deciding whether to (do PMB = SMB
EMC in monetary terms to
Externalities
something), only considers determine size of taxes

Qty
his Private Marginal Cost QSE Q  Unfeasible to have one-size-fits-all
(PMC), which include tax, as EMC may vary between
(examples). various parties
2. However, there is also an  If demand is price inelastic, taxes may
External Marginal Cost not cause quantity demanded to fall
(EMC), which includes significantly
(examples).
3. Since the individual only
considers his PMC and not
the EMC, he equates PMC =
PMB in equilibrium,
consuming quantity Q of
(good); however, social
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efficiency requires SMC = Subsidy Pros

SMB, with the socially The government can impose a  Still allows market to operate
efficient output actually at subsidy equal to the EMB.  Ensures society receives full benefits
QSE. of consumption
Cost/Benefit
4. Hence, there is over - SS = PMC  Increases both consumer and
consumption/production of producer surplus, so everyone
= SMC
(Q – QSE) units of (good) in PMC1 = PMC - benefits
equilibrium, which incur a subsidy
social cost of ABQQSE that SMB = PMB + Cons
exceeds the social benefit EMB  Difficult to measure and quantify
they give, ACQQSE. This DD = PMB EMB in monetary terms to
I
results in a deadweight loss determine size of subsidies
Qty
of area ABC. Q QSE  May breed inefficiency as firms lack
N
Cost/Benefit incentive to find lowest cost of
A
SMC = PMC production
B
+ EMC  Increases burden on taxpayers
H
A SS = PMC Marketable Permits Pros
(Cap and Trade)  Internalises EMC by establishing a

C
K market for it
Externalities
A
DD = PMB The government estimates the  Provides incentive for firms to find
= SMB socially efficient output, then ways to reduce EMC
QSE Q Qty of (good)
consumed / L
decides on the number of
marketable permits to issue. Cons
M
Each permit allows firms to  Difficult to measure EMC in
I
produced
produce a certain amount of determining the number of permits
NOTE: Demerit and merit good negative externalities, and firms to be released
R
need not necessarily have can buy and sell the permits with  May hence also be difficult to enforce
negative and positive
A
prices determined by market the limit as specified by permits
externalities, only that the forces.  Difficult to withdraw permits once
K
government deems them to be they are owned by firms
.
so and will hence intervene!
(Possible link to government Regulation / Ban Pros
A
failure)  Regulation: Impose legislation  Easy to understand and enforce
to regulate behaviour that have  Can be implemented quickly
EMC/EMB (e.g. restricting
production) Cons
 Total ban: Only beneficial if the  Do not allow market to operate
welfare loss from it (area  Legal restrictions are blunt weapons
between SMB and SMC) is less – firms may adhere to the letter but
than the deadweight loss under not the spirit of the law. They have
the free market (area ABC). no incentive to lower EMC beyond
the legal requirement.
 High investigative and legal costs
required for enforcement and
prosecution
 Consumers may not know, or  Education, campaigns or  Difficult and takes time to change
Imperfect Information
simply ignore the full costs/ advertisements mindsets

benefits to themselves  Require firms to make  Increases burden on taxpayers to
 Inaccurate or misleading information available by law fund such schemes
information
(For graph: Instead of SMC vs.

PMC, it will now be PMCactual vs.
PMCperceived ; same for PMB.)
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Issue Cause Policy Evaluation

Inefficiency arises in imperfect 1. Prohibiting formation of
markets, esp. monopolies: monopolies (e.g. antitrust
laws)
1. Allocative Inefficiency since 2. Prohibiting monopolistic
P > MC, resulting in a behaviour such as predatory 3. Significant barriers to entry may still
deadweight loss of ABC since pricing (Singapore exist, such as established firms’
society values additional units Competitive Commission does reputation.
of the good at ABQEQ, more this) 4. Natural monopolies will make
than the cost to produce them, 3. Lowering barriers to entry to economic losses at P=MC, hence it
CBQEQ. create a contestable market needs to be coupled with a two-part
I
Revenue/Cost (e.g. through deregulation) tariff on consumers to make up for
4. Setting price at P=MC, so their losses:
N
MC
AC allocative efficiency is  Fixed minimum charge to cover
A
A achieved and supernormal firm’s fixed costs
P
Imperfect Competition
B profits are lowered  Further charge that varies with
H
AR 5. Setting price at P=AC, so only quantity
C
normal profits are earned  BUT fixed cost may deter
Q QE
MR
Output
A K
6. Imposing a lump-sum tax
 Adds to firm’s fixed costs,
so AC rises
potential users from using the
service.
However, this may be tolerated

if the monopoly: unchanged
L
 Price and output 5-7. Allocative efficiency still not
achieved
M
 Is a natural monopoly, where  Firm loses profits to  BUT equity achieved, as firm’s
the market size allows for
only one firm to operate at
the MES; or
R I government as tax revenue
7. Imposing a specific tax
 Adds to firm’s variable cost
profits are reduced.
A
 Is able to reap substantial o Both MC and AC rise
economies of scale or achieve  Price increases, output
dynamic efficiency, and hence
.
perform better than a
perfectly competitive firm. K decreases
 Tax burden borne by both
A
firm and consumers
2. X-Inefficiency as firm has no

incentive to lower costs due to
lack of competitive pressures.
On the whole, the role of the government is to achieve all six economic goals, namely:
 Micro: Efficiency and Equity, by correcting market failure (as above)
 Macro: Growth, Full employment, Low inflation and a Healthy BOP (discussed in next chapter)
Hence, when “government” is mentioned in micro questions, you should immediately think of the types of
market failures above.
However, government failure (applicable to all solution above!) may actually worsen allocative efficiency
instead, due to:
 Politicians motivated by self interests instead of society’s interests
 Electoral pressures overshadow societal welfare, e.g. unpopular taxes are avoided
 Imperfect information: Government may not know the full costs/benefits of policies, the exact
monetary value of externalities, or level of demand for a public good
 Costs of administration and enforcement might outweigh the social benefits from policies
 Time lags due to bureaucracy and inefficiency may cause policies to be ineffective or too late
 Overdependence on government intervention, resulting in a vicious cycle of intervention
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Cost Theory
Internal Economies of Scale [ Falling unit costs of production when a firm increases output. ]
Financial Economies:
 A large firm has higher sales volume and more assets to offer as collateral, and is hence deemed to
be more credit-worthy compared to a small firm, so banks will be more willing to offer loans
 Lower interest rates when borrowing large amounts
 Large firms can also raise interest-free funds by issuing shares to the public
Marketing Economies:


Bulk purchase of inputs means lower prices and higher quality
N I
Bulk distribution of products through large modes of transport means lower per unit delivery cost
 High output also means lower per unit advertising costs
Administrative Economies:
H A
K
 Lower per unit admin costs, as admin costs will not rise much with output
A
 Decentralised decision making increases efficiency, and avoids distortions and delays otherwise
present in information transfer

L
Large firms able to offer higher pay to keep the best staff
Risk-bearing Economies:

I M
Able to predict demand more accurately due to greater market share
R
 Diversification to reduce risk
Technical Economies:

K A
Specialisation through division of labour
.
 Lower per unit fixed costs of machinery
 More resources available for R&D
A
External Economies of Scale [ Falling unit costs of production when whole industry grows. ]
Economies of Concentration: When firms carrying out similar activities are concentrated in an area
 Training schools may be set up to meet the industry’s growing demand for labour, providing a
ready pool of skilled workers
 Better infrastructure may also be set up to meet the industry’s needs, lowering operating costs
I
Economies of nformation: Firms can share cost of R&D
Economies of Disintegration: Specialisation through division of production processes among firms
Internal Diseconomies of Scale [ Rising unit costs of production when a firm increases output. ]
Management Difficulties
 Difficult to coordinate between various departments due to communication breakdowns, resulting
in inefficiency
 Long chains of authority may lead to time lags in decision implementation
 Extensive red tape results in large firms responding more slowly to changes in market conditions
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Strained Relationships
 Difficult to ensure welfare of all workers, especially those at the lower end of the hierarchy,
resulting in low morale and loyalty and an overall fall in productivity.
External Diseconomies of Scale [ Rising unit costs of production when whole industry grows. ]
Higher Input Prices

 Increased demand for factors of production results in higher input prices, especially if supply of the
inputs is limited and price-inelastic.
 Trade unions of larger firms tend to be more powerful, securing higher wages.
Increased Strain on Infrastructure
N I
 Concentration and expansion of firms may result in congestion, overcrowding and pollution.
Small vs. Large Firms

H A
A K
When considering the pros and cons of mergers and large monopolies on society, consider the effects on:
 Firms: Revenue and cost advantages (the 3 marked pts below) & Efficiencies (see table on next page)
 Consumers: Price, Output, Quality and Variety
L
 Mergers may also result in rationalisation, through which productive efficiency is increased but at
M
the cost of retrenchment.
1. Niche Market:
R I
Revenue Factors Cost Factors
1. Limited economies of scale due to low
A
 Specialised products that will lose their appeal if
K
fixed costs involved
Small Firms
mass-produced, e.g. customised jewellery  MES at low output

 Services that require individual attention 2. Faster response to economic downturns
A .
2. Subcontracting for large firms, providing them
with infrastructural support
3. Products where variety is preferred
1. High pricing power due to large market share  1. Presence of substantial economies of
 Demand curve more price inelastic scale, from high start-up costs and capital
 Able to employ strategies like predatory intensive production 
Large Firms
pricing  MES at high output

2. Able to conduct non-price competition by 2. Significant barriers to entry
investing supernormal profits in R&D and
advertising (Dynamic Efficiency) 
 Builds up brand image and customer loyalty,
making demand even more price inelastic
Small firms can actually coexist with large firms if:

 Presence of niche market allows for small firms to survive amidst competition from large firms
 Vertical disintegration results in large firms subcontracting to small firms
 No substantial cost advantages for being large: LRAC has a gently falling portion over a large output,
or is saucer-shaped (flat base)
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Market Structures
* Defining characteristic
Perfect Monopolistic
Oligopoly Monopoly
Competition Competition
 Many buyers Many firms with A few dominant firms Only one producer
and sellers insignificant market share *Mutual
 Perfect each. interdependence:
information  Prevents collusion Each firm’s decisions
Number of
 Independence of firms: will also affect rival
Firms firms, hence rival
Firms’ decisions will
Characteristics
not affect others consciousness

significantly needed in deciding
I
market strategy.
Homogenous, *Product differentiation No specific type – Unique, no close
N
perfect  May be real: e.g. can be homogenous substitutes
Type of
substitutes with Personalised service; or differentiated.
A
Product no variety.  Or imaginary: e.g.
H
Branding
Barriers to None None High *High
K
Entry
Allocative
(P = MC)
Yes
No – Only L A
No. (But not as bad as
monopoly, due to more
price-elastic DD curve)
Not much, since
No
Yes – To gain a
No
Yes.
M
normal profits supernormal profits competitive edge,
run.
R I
earned in long earned in short run from
innovation will not be
sustained anyway due to
even if only
temporary.
Evaluation:
 May lack incentive
to innovate due to
A
Dynamic freedom of entry for new lack of competitive
(Investing firms. pressures
K
supernormal (X-inefficiency)
profits in R&D) Evaluation: Small-scale
.
 No guarantee that
innovation will still occur R&D will produce
A
to differentiate products, results
since rivals may not copy
Efficiencies
all innovations due to

imperfect information.
X-Efficiency Yes Yes Yes No, since lack of
(Minimising competitive
cost due to pressures may result
competitive in complacency.
pressures)
Productive
Yes to all!
(Firm produces
(However, X-inefficiency will result in productive inefficiency.)
on LRAC)
Minimum Will always Excess Capacity Can possibly produce at MES if the minimum
Efficient Scale produce at Theorem: Each firm point of LRAC happens to coincide with the
(When MES. serves too small a market profit-maximising output, i.e. it intersects the
economies of to be able to fully exploit point where MC=MR.
scale have been economies of scale, so (This can happen because monopolies can
fully exploited, resources can be used maintain supernormal profits in the long run
i.e. min. pt. of more efficiently if output and so LRAC can lie anywhere, while monop.
LRAC) was raised to MES. comp. firms can only earn normal profits.)
 Wider consumer choice Equilibrium price can be lower and output
Remarks  Creates jobs in higher than if there were many firms, if
(Other merits) advertising sector substantial economies of scale are reaped
such that MC falls significantly.
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Oligopoly: Models
1. Kinked Demand Curve Theory Revenue/Cost
 No collusion
MC
 Homogenous product
 Rival firms will match price decreases but
P
not price increases
Merits: Explains price rigidity

A
 No change in price and output for minor AR
I
shifts in MC within the discontinuous
B
region AB
 Change in output but not price for
moderate shifts in demand
A N MR
Output
H
Criticisms: Q
 Does not explain how eqm price/output were obtained in the first place
K
 Firms may match price increases if there is a rise in costs or demand across entire industry
A
L
2. Non-price competition
 Product Development and Innovation: Firms may try to maintain profits through developing new
products that will give a competitive edge (even if only temporary)
I M
 Marketing, Advertising and Promotions: To give consumers a perception of product differentiation
R
3. Price Wars
K A
Usually a last resort, as they are costly to wage and hence unsustainable. However, predatory pricing may
be used to eliminate new competitors or gain market share.
5. Collusion
A .
4. Cooperation – E.g. joint ventures, when R&D costs are high but the pace of technical changes is rapid
 Explicit: Cartel – E.g. OPEC

 Tacit: Price Leadership Theory – Firms follow pricing policy of a recognised leader
 Works best with:
o Small number of participants sharing strong trust
o Similar costs of production among participants
o Clear leader
o Policing of agreement
o Stable market conditions, with no danger of new entrants
o No intervention from government
6. Contestable Market: Government regulation to make market more like monopolistic competition
 No barriers to entry/exit – Creates threat of potential entrants making a hit-and-run, by entering
the market for a short while for quick supernormal profits
o All firms subject to same government regulations and control regardless of size
o Regulation to prevent predatory pricing by incumbent firms to deter entrants
 Hence firms will behave as if under strong competition and be unable to set prices above AC
without attracting new entrants, thus earning only normal profits in the long run.
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Price Discrimination
[ Price discrimination occurs when a firm charges different prices for the same product when they are not
a result of cost differences. (NOT price differentiation: Price difference due to differences in cost) ]
When asked if something is a case of price discrimination, evaluate how much it satisfies the conditions for
price discrimination, as below:
Conditions:
1. Some degree of monopoly power
2. Segregation of market into separate and identifiable groups, with no seepage between groups (i.e.
I
consumers cannot buy in the lower-priced market and sell in the higher-priced one)
N
3. Different price elasticities of demand among groups
4. Product is homogenous, with all units giving equal benefits to consumers and having equal costs to
Types:
the producer (as implied in the definition)
H A
A K
1. First Degree Price Discrimination: Each unit sold at the maximum price buyers are willing to pay.
 DD = AR curve also becomes MR curve since additional revenue from each unit sold is equal to the
L
full price consumers are willing to pay, hence firm earns profits of area under DD curve.
2. Second Degree (Block pricing): Charging higher prices for initial units and lower prices thereafter, to sell
off surplus capacity.
I M
R
3. Third Degree: Charging different prices in different markets.
Benefits:
K
 Extra profits for firmA
P=MC
.
 Allocative efficiency is achieved in 1st degree, since profit-maximising output is increased to where
A
 Possibility of supply even when AC lies above AR, due to extra profit generated to cover costs
o 3rd degree also makes it possible to supply a more price elastic market, so consumers who
are less willing to buy the good can buy it at a lower price
 Can result in positive externalities if merit goods involved (e.g. medical services)
Disadvantages:
 Loss of consumer welfare, as consumer surplus is lost to firm as profits
o Complete reduction of consumer surplus in 1st degree
o Hence, not equitable.
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Alternative Theories
The Traditional Theory of firms assumes that firms will always aim to maximise profits, producing where
MC=MR. In reality, this is not the case, due to:
 Imperfect information, resulting in an inability to maximise profits; or
 Firms having other aims besides profit maximisation.
1. Lack of Information towards MC: Firms usually only consider explicit costs since they are easier to
compute, but economic cost consists of both explicit and implicit costs => True MC unknown.
2. Lack of Information towards MR: Difficult to determine demand curves and hence MR

be inaccurate or become outdated very quickly.
N I
Even if firms conduct market research to determine the price elasticity of demand, such data may
Not ceteris paribus: Demand curve does not remain static, and may change due to other
A
o
factors affecting demand (i.e. PETRI)
aims, such as:
K H
3. Divorce of Ownership and Control: Owners want to maximise profits but managers may have other
A
 Maximising their own self-interests, in terms of one’s salary and fringe benefits

L
Increasing the number of subordinates under one’s control
 The power to dictate how company funds are used
Since these often depend on sales revenue or size of the company, managers may aim for revenue
I M
maximisation or growth maximisation instead (see below)
4. Revenue Maximisation: Firms themselves may choose to maximise sales revenue instead by producing
institutions.
AR
up to the point where MR = 0, in order to boost the firm’s reputation among consumers and financial
K
5. Growth Maximisation: Firms may want to maximise growth to gain market share and hence produce at
.
AR = AC, the maximum possible output that will still not incur economic losses.
A
 BUT firms still need to satisfy the demands of their shareholders (owners), i.e. be profit satisficing,
and may hence impose a minimum profit constraint.
 Evaluation: Revenue and growth maximisation may just be short-term goals, and serve as a means
to the end of profit maximisation in the long run.
6. Organisational Slack (X-inefficiency): Occurs when the firm uses more input than in necessary for a
certain output, hence making AC and MC higher than necessary. May occur due to:
 Lack of competitive pressures
 Imperfect knowledge of the lowest costs or wages needed
 Unwillingness to take the risk of investments
 Trade unions’ demands for higher wages
7. Other Goals: Consumer/Worker cooperatives, Corporate Social Responsibility (i.e. charity work),
environmental beliefs etc.
 Behavioural Theories: Firm will aim to satisfice the minimum demands of the various interest
groups it deals with, e.g. the government, shareholders, workers, consumers and environmentalists
o Firm will try to reach a compromise with all groups, but hence be unable to maximise anything
 Evaluation: Large firms listed on stock exchanges and which are vulnerable to takeovers often still
focus on profit maximisation as one of their top priorities.
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Macroeconomics Notes
Macroeconomic Goals
Economic Growth
Economic growth indicates an increase in both a
country’s output capacity and real output, so
more goods and services are available for Growth involving restructuring may
cause structural unemployment.
I
consumption, which increases the standard of
living of residents, creates jobs and increases tax
N
revenue. Potential growth also helps to prevent Growth reduces Full Employment
cyclical
demand-pull inflation. Low unemployment means human capital
A
unemployment;
Shown by outward shift in boundary and point of high employment is maximised, fuelling growth. It also
H
production in PPC, or an increase in NI due to ensures the provides greater tax revenue and social
AD↑ or AS↑. economy is
stability.
K
producing near
its full potential.
A
Potential growth
L
(increasing AS)
ensures domestic Growth will raise incomes and
demand can be met, cause M to grow faster than
hence preventing X; fixing BOP deficits through
M
expenditure reducing Improving
I
Low predictable demand-pull
policies effectively trade balance
inflation rates boost inflation.
means slowing creates jobs in
R
investors’ Improving BOP by the export
this growth.
confidence and devaluing currency sector.
A
encourage savings, a (expenditure
key source of funds switching policy)
K
for investment, will boost X and I,
hence fuelling creating growth.
.
investment.
A
Low Inflation
Stable prices help to improve BOP and
Lower inflation rates
than other countries
Balance of Payments Equilibrium
An imbalance in trade and capital flows would
affect national income and the exchange rate.
ensure exports remain  Trade deficits deplete a country’s reserves and
provide economic certainty, encouraging price-competitive.
investment. Maintaining the internal value may have to be financed by borrowing from
of money also encourages savings since abroad. This outflow of currency results in a
Expenditure reducing weakened exchange rate. Investor confidence
people are less worried about the value of
policies (reducing AD)
their money, providing additional funds for may also fall.
will reduce demand-pull
investment and growth. inflation.  Trade surpluses may cause a protectionist
Cost-push inflation is always bad, whereas Expenditure switching backlash from trade partners. The high
policies (devaluing demand for exports may also cause demand-
mild demand-pull inflation stimulates
currency) will cause
growth and employment. pull inflation.
imported inflation.
 FDI outflows will take away jobs.
IN EFFECT: BOP + low inflation VS growth + employment
 ECONOMIC GROWTH creates more jobs, but may cause demand-pull inflation and trade deficits.
 Increasing EMPLOYMENT will increase output and growth, but create demand-pull inflation.
 INFLATION can be fixed through reducing AD, in the process also solving BOP DEFICITS, but this would
slow down growth and cause unemployment.
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(AE=Y) and (AD/AS) Frameworks
AE=Y AD / AS
Aggregate Expenditure is the total planned Aggregate Demand/Supply is the total demand/
expenditure on goods and services in an economy. supply of goods and services in an economy at
any given time.
Use the AE=Y framework to explain the effect of
changes to C G I X M on national income and Use the AD-AS framework to explain how both the
employment ONLY, without considering effects on price level AND national income/employment can
I
price level. be adjusted to achieve the macroeconomic goals.
N
∆ Price Level
Also used to show multiplier, k = ∆ (= ). AS1
A
AS2
AE
Y = AE
AE inflation
P2
K H
A
Inflationary AEFE P1
Gap AD2
L
Deflationary AE unemployment
Gap
AD1
IM
Real National
Income
Y1 Y2
R
[An outward shift in AD greater than that of AS increases NI
Y
YFE and employment, but causes mild demand-pull inflation.]
K A Circular Flow of Income
A .
This came out in the 2009 ‘A’s, so it likely won’t be tested again anytime soon. Good for your understanding
though, plus... it actually makes sense!
Households
Income Savings Taxes M

(Factors of C
(Goods) Banks Govt External
Production)
I G X
↖
Tourism falls under X -
Firms an export of services!
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Shifting Aggregate Demand/Supply 101

AD/AS can be manipulated to achieve ALL macroeconomic goals!
(The other method, exchange rates, can be used for imported inflation and BOP, though it affects AD too.)
Increasing AD/AE: growth, employment, inflation, worsens BOP
Taxes -- C, I
FISCAL POLICY
 Since consumption is given by C = a + bY: ↓ direct taxes => ↑ disposable income Y => ↑induced
consumption bY => ↑ C
 Tax rebates for firms will increase their profits and the expected rate of return on investments => ↑ I
I
(as per the MEI)
Evaluation:
A N
1. MPC: If Marginal Propensity to Consume (MPC) is low, reducing taxes may have little effect on
H
consumption, as consumers will just save the extra income.
2. Consumer/Investor Confidence: (“animal spirits”, or lack thereof)
A K
 Consumers do not only base their consumption on current income levels but also on future
expected income, so tax cuts may not stimulate consumption much if they view it as only a
L
temporary measure.
 Private investment also depends on business expectations, so tax cuts may not stimulate
M
investment much if investor confidence is low.
Government Expenditure -- G
R I
The government may inject increased government expenditure into a weak economy, in order to trigger off
A
a stream of induced spending via the multiplier effect which will jump-start the economy (“Pump-priming”)
. K
Evaluation: “Crowding-out Effect” / Public Sector Borrowing Requirement (PBSR)
To fund increased spending, the government will need to:
A
 Increase taxes: But this reduces disposable income and profits of consumers and firms => ↓ C, I
 Borrow from financial institutions: But ↑ demand for loans => ↑ interest rate => ↓ I
 Print money: But this creates inflation.
BUT fiscal policy can still be effective if ↑ AD due to G outweighs ↓C, I.
Also NOT applicable to SG, as the govt draws any extra funds required for G from our accumulated reserves,
and not through public borrowing.
Monetary Policy involves the manipulation of:

MONETARY POLICY
1. Monetary Supply – Amount of currency in circulation and cash reserves of commercial banks
2. Interest Rates – If domestic consumption and investment make up a large portion of AD
3. Exchange Rates – For price stability.
Interest and Exchange Rates are interlinked: Lowering IR would cause the outflow of hot money, causing ER
to depreciate; while lowering ER brings in hot money as investors expect it to rise back in future, hence
providing more funds for investments and lowering IR.
Exam questions usually won’t ask you to explain how the Central Bank manipulates the interest rate, so you
probably don’t even need to bother with the Liquidity Preference and Loanable Funds theories; just know
how interest rates affect the economy.
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Interest Rate -- C, I
With lower interest rates:
MONETARY POLICY
 Decreased opportunity cost of consumption => ↑ C
 The cost of borrowing for firms is reduced, hence increasing their expected rate of return on
investments and giving them incentive to increase their level of investment (as per the MEI curve)
 Domestic currency will depreciate due to the outflow of hot money, as people will withdraw money
from that country and save it in banks of other countries that offer higher rates => ↑ X-M
Evaluation:
1. Interest Elasticity of Money Demand: If the bulk of the money in the economy consists of speculative
I
funds, a large decrease in money supply will be needed to decrease interest rates.
2. Interest Elasticity of C & I: If C and I are interest-inelastic and are more dependent on confidence levels,
A N
bleak expectations of future incomes may mean C, I do not rise much despite low interest rates.
(vice versa: “irrational exuberance” despite high interest rates in contractionary MP)
H
3. Liquidity Trap: If interest rates are already at the perceived lowest possible rate, increasing money
supply will not decrease it any further, since investors expect it to rise in future and would rather hold
on to cash to exchange for bonds when that happens.
A K
4. For SG: Open Market Operations are ineffective due to our inactive secondary bond market.
Exchange Rate -- X-M, I

If a country depreciates the domestic exchange rate: L
* Managed Float Exchange Rate is SG’s main tool! (see last page)
M
 Exports become cheaper and imports more expensive, and if the Marshall-Lerner condition holds (i.e.
R I
PEDX + PEDM > 1), export revenue will rise while import expenditure falls => X-M ↑
o BUT for SG: Due to the high import content of our exports, they will actually become less
A
competitive due to imported inflation
NOTE: Invoke the M-L condition only in explaining how exchange rate affects trade, as it is the only factor
. K
that affects demand for both X and M. Otherwise, just say “import/export demand is price elastic” (or not).
 Attracts FDI due to the lower costs of operation, and also short-term investments (“hot money”) since
A
people expect the currency to appreciate => I ↑
(Such capital inflows may actually cause the exchange rate to rise back to equilibrium.)
o Evaluation: Unstable exchange rates may actually discourage long-term investment.
 Also helps to remedy BOP deficits – see Expenditure Switching Policies
Trading Partners’ Incomes -- X

An increase in trading partners’ incomes will lead to an increase in their demand for a country’s exports,
provided that this demand is income elastic.
Expected Future Incomes -- C

In an economic boom, consumers will expect future incomes to rise and will hence increase current
consumption. MPC [vice versa for recession]
Savings -- C, I
 A high MPS actually reduces C and the multiplier, resulting in a fall in AD and hence national
income. (Savings will hence ironically fall – Paradox of Thrift)
o Saving may hence hurt economic recovery from recessions
 BUT if people save during economic booms, it provides funds for investment in capital goods,
allowing for future potential growth in the economy.
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Multiplier Effect
Full explanation needed only if the focus of the question is specifically on fiscal/monetary policy, or how NI
rises from injections. Otherwise, just state the two lines below:
[ The actual increase in national income will be greater than the increase in autonomous expenditure (i.e.
components OTHER than C), due to the multiplier effect. ]
Stage 1: If the government decides to inject $100m into the construction of new highways…
Stage 2: This amount will be received as income by contractors and construction workers. Given that the
MPC is 0.6, they will then spend $60m on consumption of clothes for example, with the remaining
$40m leaking out as savings, taxes and imports.
N I
Stage 3: This spending will in turn raise the income of shop owners by $60m, who will again spend $36m of
it on other goods, with the remaining $24m leaking out as saving, taxes and imports.
H A
As a result, national income will rise with the increase in consumption at every successive stage, resulting in
an overall increase of ($250m) that is far greater than the initial injection of ($100m in government
expenditure), as per the formula ∆Y = ∆G / (1 – MPC).
[Reverse multiplier effect happens as well!]
A K
Evaluation:
L
 Enough excess capacity needs to be present for the full multiplier effect to occur. If the economy is
M
already producing at full employment, increasing AD will only create inflationary pressures.
R I
 Multiplier effect is very low in countries with low MPC such as Singapore (multiplier = 0.54):
o Our import spending is double our GDP due to our lack of natural resources, resulting in a high
A
import leakage (MPM)
o Significant proportion of Singaporeans’ wealth is “locked up” in the CPF, a form of mandatory
. K
savings, resulting in a high MPS
o Hence, fiscal and monetary policy less effective due to low multiplier.
A
Increasing Short-Run AS (i.e. outward shift): growth, employment, reduce inflation, improves BOP
SRAS may fall due to supply shocks (e.g. natural disasters) or cost-push inflation - refer to Inflation section.
To increase ONLY SRAS, cost of production needs to be brought down:
 Wage-push inflation can be corrected by a prices and incomes policy, in which a price ceiling or even a
wage freeze is imposed onto wages. Governments can also clamp down on trade unions.
o Evaluation: Distorts market forces in the labour market, and may result in a confrontation with
trade unions. Powerful trade unions may also make negotiations difficult.
 Imported inflation can be corrected by appreciating domestic currency, hence making imports
relatively cheaper.
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Increasing both Short-Run and Long-Run AS: growth, employment, reduce inflation, improves BOP
(Basically, improving the quantity and quality of resources.)
Increase capital stock - Investments also increase AS!

 Attract FDI from overseas to establish new industries
SUPPLY-SIDE POLICY
 Investments in capital: R&D investments, and purchasing capital like machinery
o Reduces the cost of production in the short run
o Increases the productive capacity of the economy
To encourage R&D, the government can:

 Implement strong patent laws
 Provide subsidies and tax treats for firms engaging in R&D
N I
 Build industrial parks, to bring R&D personnel from different firms closer together and hence
encourage cooperation.
H A
K
Increase productivity of workforce
Quality of human capital can be increased through re-training => Increases both potential and real output
of firms.
Increase size of workforce

L A
M
The labour force can be expanded through:
R I
 Reducing structural and frictional unemployment - refer to Unemployment section.
 Arrival of migrant workers with the intention of settling permanently
 Increased female participation in the workforce
A
 Increasing future population size by raising fertility rates (e.g. through baby bonus)
K
.
All this increases SRAS by depressing wages, and also increases LRAS by increasing the country’s potential
output.
Evaluation:
A
 Foreign workers may face resentment from locals who believe that they are stealing their jobs
o May affect social stability
 Cheap foreign labour may give firms less incentive to upgrade from labour-intensive to capital-intensive
methods of production, slowing down the restructuring of the economy.
 BUT the influx of foreign workers may serve as an incentive for locals to go for upgrading, to improve
their competitiveness in the job market.
Tax rate
 Income effect (Productivity ↑): With higher taxes, people can afford less, so they work more so that
they do not have to cut their consumption as much.
 Substitution effect (Productivity ↓): People are discouraged from working as much since the
opportunity cost of leisure – i.e. the wages they could have earned – is now lower.
Both points can be used as evaluation for each other in deciding whether taxes will increase or decrease AS.
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When evaluating the economic effects of events:

1. Explain the effects on AD/AS and the 4 macroeconomic goals
2. Raise other miscellaneous effects (e.g. increase in oil prices encourages R&D on substitutes)
3. Evaluate the overall effect with relation to the 4 goals
Economic Growth
[ Economic growth consists of both actual and potential growth, which are the annual percentage
increase in national output and output capacity respectively. ]
I
Policies
N
 Actual Growth: Expansionary fiscal and monetary policies (anything that increases AD)
 Potential Growth: Supply side policies (anything that increases AS)
Benefits vs. Costs
H A
 Increased SOL: An increase in real GDP per capita indicates increased consumption levels
created when old ones are met
A K
 BUT higher consumption may not necessarily lead to higher utility, as new wants are
L
 Unemployment: Actual growth (increase in AD) and diversification reduces cyclical unemployment,
while potential growth (increase in AS) may be due to a reduction of structural unemployment
M
 BUT if growth is from restructuring and the creation of new industries, structural
I
unemployment may result.
 Demand-Pull Inflation: If economy is already producing near full employment, any increases in AD
AR
unmatched by similar increases in AS will result in firms competing for the limited resources
available as the economy is already experiencing supply bottlenecks, so prices of inputs and
K
ultimately that of products are pushed up.
 Balance of Payments: Increased incomes will result in imports growing faster than exports
A .
assuming import demand is income elastic, hence worsening trade balance and BOP.
 Equity: Increased tax revenues collected from the rich through a progressive tax system can be
redistributed to the poor
 BUT if growth is enjoyed mainly by the rich elite and the government fails to help the poor,
wealth may not trickle down to them, hence worsening income inequality
 Externalities to environment: People feel they can afford to care more about the environment,
and become less concerned about their private consumption
 BUT higher consumption levels may still lead to pollution, waste and a depletion of natural
resources.
 Opportunity cost of current consumption: To achieve future potential growth, a country must
sacrifice production of consumption goods for that of capital goods (Use PPC to illustrate trade off)
Evaluation of Goal: Economic growth is the most important goal in SG, since in the process of achieving
growth, we can achieve the other goals as well.
 Cyclical and structural unemployment is reduced through actual and potential growth respectively.
 Our exchange rate centred monetary policy and supply-side policies, aimed at achieving growth,
also help to achieve low inflation.
 The exchange rate centred monetary policy also helps us achieve a healthy BOP in the process.
 However, if there are other more urgent economic problems (e.g. high inflation) at hand, we may
need to temporarily focus on them instead of economic growth.
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Unemployment
[ Unemployment refers to the number of people of working age who are without work, but willing and
able to take up employment. ]
Causes
Cyclical unemployment
 Labour is a derived demand: A lack of AD during downswings of the business cycle also reduces
demand for labour
 Greatest concern in Singapore, due to our export-oriented growth model
Structural unemployment
N I
o Economy closely linked to the global business cycle => highly susceptible to global downturns
A
 Occurs when changes in technology/industries change the set of skills needed by workers, so
workers without these skills become unemployed
K H
 Prevalent in SG, as we are shifting towards a knowledge-based economy
o Manufacturing sector contracting due to other countries like China gaining a comparative
A
advantage in low-skilled labour
L
o Education levels among the older generation are low
Frictional unemployment
M
 Due to imperfect information, as time is needed to match people to the right jobs
R I
 Less of a concern as it is part of the natural rate of unemployment
Seasonal unemployment: Self-explanatory.
Costs

K A
Loss of production: Unemployment implies that the economy is producing inside the PPC, hence
 .
representing a loss in potential national income and SOL.
A
Loss of human capital: Prolonged unemployment may cause people to lose their skills and
knowledge, reducing their productivity even if they are re-hired and hence also reducing the
country’s potential output
 Welfare of unemployed:
o The unemployed lose their financial security and face low material well-being
o Loss of self-esteem and morale, affecting mental health
 Financial cost to government:
o Loss of tax revenue, since the unemployed do not pay income tax
o Increased spending on welfare payments and benefits
 Social stability: Unemployment is linked to increased crime and violence.
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Policies
Cyclical unemployment (Basically, increase AD)

 Fiscal Policy: Used in SG with supply-side policies to ensure long-term growth
 Monetary Policy: Not effective in SG, as domestic demand constitutes very little of our AD
 Exchange Rate: Devalue currency to make exports more price competitive, increasing employment
in export sector
o Evaluation: If imports are price inelastic (M-L condition not satisfied), import expenditure
will rise and worsen the BOP
I
Structural unemployment (Supply-side policies)
 The government can steer the education system towards nurturing a workforce with the relevant
skills needed in the economy
A N
 Provide training grants and subsidies for the retraining of unemployed workers
o E.g. SPUR scheme: Provides subsidies for companies to retrain their workers and redeploys
Evaluation:
retrenched workers to new jobs.
K H
A
 Increased government spending required for subsidies
 Older workers may put up great resistance to retraining
L
 Illiterate people will find it difficult to get new skills.
M
Frictional unemployment
I
More job fairs and better job information services to remedy imperfect information in job market.
R
Evaluation of Goal:
K A
.
 Reducing cyclical through expansionary fiscal policy will result in demand-pull inflation.
 However, achieving high employment is still more important than keeping prices stable. If consumers
 A
have at least a stable income from a job to fall back on, they will be less affected by higher prices.
That said, we achieve low unemployment through economic growth, hence actual growth (to prevent
cyclical via diversification) and potential growth (to prevent structural via supply side policies) remain
SG’s most important macroeconomic goal.
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Inflation
[ Inflation is a sustained increase in the general price level. ]
Causes
Demand-pull inflation
 Increase in AD: When unmatched by an increase in AS, especially if the economy is already producing
near full employment.
 Increase in monetary supply: When banks hand out loans too freely or the government prints too much
money such that people have more money to increase their consumption, hence increasing AD.
Cost-Push Inflation (Basically factors that shift SRAS with fancy names)

N I
Wage-push inflation: If trade unions push up wages without a corresponding increase in labour

productivity.
H A
Imported inflation: Due to inflation in other countries, or a weakening of domestic currency.
K
o Prices of imported goods and services rise (Direct effect)
o Prices of locally produced goods that use imported factors of production rise (Indirect effect)

o
L
as a result of our lack of natural resources.
A
Main cause of inflation in Singapore, due to the high import content of our goods and services
Tax-push inflation: Indirect taxes increase costs of production for firms, with some tax burden passed
M
to consumers.
R I
Wage-Price Spiral: A rise in prices due to continual shifts in AD and SRAS.
from AS to AS1
K A
1. Trade unions demand higher wages, decreasing AS Price Level
.
2. Firms respond to the rising cost of production by
cutting back on the workers they hire. Real national
A
income and employment levels fall from Y to Y1.
3. To prevent a rise in unemployment, the
government boosts AD from AD to AD1. Output and
P2
P1 AD1
employment return to their initial levels at Y,
P
however price levels will rise even further from P1 AS1 AD
to P2.
4. Trade unions will again demand higher wages to Real National
AS Income
offset the rising costs of living... vicious cycle occurs.
Y1 Y
Effects
 Mild demand-pull inflation increases firms’ profits, stimulating investment and growth
 Low inflation encourages investment:
o Encourages savings, a key source of funds for investment, as people are confident the real
value of their money will not fall
o Low cost-push inflation also makes investors more confident of returns
o BUT even if inflation is high, as long as it is not unexpected, investors’ confidence will not
be affected much
 Unemployment: Demand-pull increases employment if economy is not already at full employment;
Cost-push always causes unemployment.
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 BOP: If we have lower inflation than other countries, our exports become more competitive while
imports are relatively more expensive, therefore trade balance and BOP improves. Exchange rate
also appreciates.
 Inflation also results in income redistribution:
o Winners: Variable income earners, Debtors, Firms (firms win in demand-pull, but will lose
as well if cost-push)
o Losers: Fixed income earners, Creditors, Consumers (consumers always lose, since their
purchasing power always falls during inflation)
Policies

 Cost-push inflation: Supply-side policy
N I
Demand-pull inflation: Contractionary fiscal and monetary policy, Supply-side policy
A
 Imported inflation: Exchange rate policy
K
Balance of Payments H
L A
[ The Balance of Payments records all economic transactions between the residents of a country and the
rest of the world during a specified period, usually one year. ]
M
The two most/only important categories of BOP are: the Current Account which shows trade balances, and
I
the Financial Account which shows investment flows.
AR
BOP will naturally return to equilibrium through exchange rates and national income. E.g. If BOP deficit:
 Domestic exchange rate depreciates => exports become more price-competitive
 (X-M) ↓ => national income ↓ => import spending falls
K
Therefore, trade deficit eliminated! [vice versa for BOP surpluses]
.
A
However, persistent BOP deficits may still occur in one country due to:
1. Fixed exchange rate regime
2. Higher inflation rates than other countries – Exports become less competitive
3. Higher growth than other countries – Imports will grow faster than exports with rising income
4. Long-term structural changes – Trade restrictions, Emergence of new substitutes and rivals
Consequences of BOP Deficits
Technically, BOP surpluses are bad as well since they may result in demand-pull inflation (due to high I and
X-M) and also indicate a deficit in another country, which may hence adopt protectionist measures.
However, it seems exam questions are only concerned with deficits, since they are much more harmful.
 Current Account (Trade) deficit:

o X-M ↓ => AD ↓
o External debt incurred through borrowing from other nations
o Evaluation: Not a problem if deficit is short-term, as a result of country buying capital goods to
increase export production.
 Financial Account (Investment) deficit: Outflow of FDI towards countries with lower labour costs or
better opportunities will cause employment to fall
 Overall: Deficits draws down on government reserves, which may thus affect investor confidence.
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 BOP is closely linked to the equilibrium exchange rate

o Demand for a country’s currency is affected by Price of S$ in US$
changes in its exports or capital inflows into the SS
country; while supply is affected by changes in its
imports or the capital outflows from the country.
o Hence, BOP surpluses (more money going into the P
country) always result in an appreciation of the
exchange rate, while deficits (money going out)
result in depreciation. DD
o Fluctuations in the exchange rate will subsequently Quantity
affect AD and imported inflation.
Policies to Correct Deficits

N I of S$
 Reduce incomes to reduce demand for imports
H A
1. Expenditure Reducing Policies – i.e. contractionary fiscal and monetary policies
K
o Producers will turn to overseas markets => Exports increase as well
 Raise interest rates to draw in hot money
L A
 Reduces inflation as well, but at expense of economic growth
o Exports become more price competitive => X ↑ (this may slightly offset the fall in AD)
M
2. Expenditure Switching Policies – i.e. protectionism or lowering exchange rate


R I
Protectionism to restrict imports: Refer to Protectionism and its evaluations.
Devaluation of domestic currency: Exports get cheaper while imports get more expensive, and
Evaluation:
K A
assuming the Marshall-Lerner condition holds this will improve trade balance.
.
 May be ineffective if export and import demand is price inelastic (i.e. M-L condition does
A
not hold)
 Trading partners may retaliate by devaluing their currencies
 Spare resources must be available to meet the increase in demand for exports
 May result in imported inflation Surplus
 J-Curve Effect: Current account may actually worsen
in short-run after devaluation with a reduction in
Balance of Trade
export revenue and an increase in import

expenditure, as it takes time for consumers to adjust
Time after
to price changes
devaluation
 SG: Export competitiveness will actually worsen due
to the high import content of our exports, hence Deficit
BOP will worsen.
3. Supply-side Policies – To increase output and quality of exports and hence their competitiveness.
** MOST EFFECTIVE but takes time to work!
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Taxation
Direct taxes: Taxes on the income and capital owned by individuals or firms, e.g. income tax. Tax burden
cannot be shifted.
Indirect taxes: Taxes on goods and services, e.g. GST, customs duties. Tax burden is shared between seller
and buyer, with the party that has a more price elastic curve bearing less of the burden.
 Specific tax: Fixed tax per unit of good, regardless of price. Supply curve shifts up evenly.
 Ad valorem tax: Tax is a fixed proportion of the price of good. Supply curve shifts up, but also
becomes steeper.
Effects (Fiscal Policy, Market Failure, Equity)
1. Redistributes Income
N I
A
Progressive taxes: Help to distribute income more equally, as they take into account one’s ability to pay. As
one’s income increases, the proportion of it paid in taxes increases.
 Direct taxes are usually progressive, e.g. income tax
K H
 Indirect taxes may be progressive, if they are levied on luxury goods
A
 Tax revenue can be used to help the poor through subsidies and welfare benefits, e.g. Workfare
L
Regressive taxes: Less equitable. As one’s income increases, the proportion of it paid in taxes decreases.
 Lump-sum taxes are regressive
 Indirect taxes like GST are also regressive, as the poor bear a heavier burden since they tend to
I M
spend a larger proportion of their income on necessities.
R
2. Corrects Negative Externalities
A
If there are negative externalities involved in the consumption or production of a good, taxes can help to
change consumption patterns or encourage producers to switch to other methods of production.
. K
Evaluation: Taxes distort the price mechanism and hence affect the allocation of resources.
3. Influences Productivity
A
Depending on the income and substitution effect, a rise an taxes will either cause people to work more to
make up for the fall in income or discourage them from working since they earn less for the same amount
of work, hence affecting productivity and the AS curve.
4. Reduces Consumption and Savings

 Direct taxes reduce disposable income, which will cause consumption to fall to an extent that
depends on the MPC
o Evaluation: If people are already enjoying a high SOL and are able to save a lot, they may
resist a reduction in their consumption by simply saving less instead (MPS falls)
 Progressive taxes also reduces how much people are able to save
 Indirect taxes reduces consumption to an extent that depends on the PED
5. Reduces Investment – The reason why SG has been shifting from direct taxes (personal, corporate tax)
towards indirect taxes (GST). Due to taxes:
 Savings ↓: Reduces funds available for investment.
 Expected rate of return ↓: Reduces firms’ incentive to invest, as per the MEI.
 Supernormal profits ↓: Reduces firms’ ability to invest. (Dynamic efficiency reduced)
o Evaluation: Not a problem if government reallocates tax revenue into R&D (SG does this)
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Standard of Living & Reliability of GDP

[ The standard of living is the quality of life enjoyed by people, and includes material and non-material
well-being. ]
GDP / GNP: Total market value of all final goods and services produced within the geographical boundaries
of a country / produced by productive factors owned by residents of a country during a specified period.
How GDP/employment figures relate to SoL:
 High GDP, low unemployment => high overall per capita income levels => increased availability and
I
accessibility of material goods and services, so people can enjoy more of them => high standard of
living [vice versa for negative NI figures]

 GDP statistics might also be unreliable.
A N
BUT such figures do not indicate non-material goods and services available

K H
Disproving GDP figures: (mostly applicable to both comparisons over time AND between countries)
Changes in price level: Nominal GDP is misleading as it may rise due to a rise in prices (inflation)
A
but not output
L
o Real GDP more accurate since it accounts for price differences, so any rise must be from a
rise in output.
M
 Changes in population: Even if absolute GDP grows, if population grows faster than it, then GDP
I
per capita will actually fall.

R
Changes in exchange rate: Since GDP figures are converted to US$ for international comparison,
they will be affected by fluctuations in the exchange rate, especially that due to governmental
K A
manipulation or capital flows
o GDP per capita adjusted for Purchasing Power Parity (PPP) more accurate, as it reflects
.
actual purchasing power of residents
 GDP Composition
A
o GDP includes both consumption and investment goods but current living standards depend
only on consumption goods.
o Large proportion of GDP may actually be spent on goods which do not directly improve the
welfare of the people (e.g. defence), rather than goods like infrastructure.
 GDP Distribution: Most of national income may be concentrated within the rich elite
o Gini coefficient more reliable - measures inequality of income
 Reliability of Data: Firms and individuals might under-report their incomes in order to evade
income taxes.
 Non-monetised sector: Services that do not pass through a market are not counted in the GDP
o E.g. Charity work or Barter trade, especially in developing countries
 Intangibles: Externalities are unpriced by the price mechanism, hence not captured by GDP figures.
o Factories might add to GDP, but create pollution
o More jobs need not mean improved SOL, since people might be subjected to long working
hours accompanied by stress from the workplace
Evaluation: Composite indicators provide more accurate reflection of standards of living, e.g. Physical
Quality of Life Index which measures life expectancy, infant mortality rate and literacy rate.
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International Trade
[ Free trade is a policy of imposing no artificial restrictions on the movements of goods and services
between countries. ]
The pattern of trade describes who trades what, and is based on the theory of comparative advantage.
Illustration of the Law of Comparative Advantage
A country is said to have comparative advantage in the production of a good if she can produce the good
at a lower opportunity cost than another country; the Law of Comparative Advantage states that trade
I
can benefit all countries if they specialise in the production of goods where they have the lowest
N
opportunity cost.
A
Assumptions Limitations (when applying to real life)
H
Constant opportunity costs of production => Law of Increasing Opportunity Cost: Countries will
Straight-line PPC lose their comparative advantage as they specialise
K
further, since the resources in the economy are not
This implies perfect factor mobility within each perfectly homogenous. Hence, complete
country, i.e. resources can be easily transferred
from the production of one good to another
L A
specialisation not possible.
Lack of Factor Mobility: Factors of production may
not be quickly or efficiently moved into other uses
M
Factor immobility between different countries, i.e.
I
each country can only use her own resources
No transport costs nor trade restrictions, so full  Transport costs may be very high in
AR
benefits of specialisation and trade can be felt international trade, making it cheaper to
produce goods domestically than import them
 Protectionism: Free trade does not always exist,
K
and countries may want to protect certain
.
industries even if they do not have a
comparative advantage in them
A Product differentiation: Countries may produce

similar goods but differentiate them enough such
that countries producing similar goods will still
import those goods. (Intra-industry trade)
We assume that two countries devote exactly half their resources to the production of each of two goods,
with output as shown in the table and indicated on their PPC curves:
Wheat
Production before specialisation: 30
Wheat Cloth 20 Wheat Cloth

China 15 30 15 China 15 30
PPC of
USA 10 5 USA 10 5 China
10
PPC of
USA
1. Explaining comparative advantage: Cloth
5 10 30 60
 China has a comparative advantage in cloth, since her opportunity cost of 1 cloth is 0.5 wheat, lower
than that of USA, which is 2 wheat.
 Similarly, USA has a comparative advantage in wheat, since her opportunity cost of producing 1 wheat
is 0.5 cloth, lower than that of China, which is 2 cloth.
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2. Hence, both countries should specialise completely in its area of comparative advantage, so China and
USA produce 60 cloth and 20 wheat respectively.
3. Setting Terms of Trade (TOT):

 For each unit of cloth, China will not accept less than 0.5 units of wheat, and USA will not pay more
than 2 units of wheat. Therefore, the TOT for cloth is: 0.5 wheat < 1 cloth < 2 wheat.
 Similarly, for each unit of wheat, USA will not accept less than 0.5 units of cloth, and China will not pay
more than 2 units of cloth. Therefore, the TOT for wheat is: 0.5 cloth < 1 wheat < 2 cloth.
 Assume that the TOT is set at 1 wheat for 1 cloth, so the Consumption Possibility Curve for each
country is equal to this TOT.
4. Both countries now trade 15 cloth and 15 wheat.

Wheat Wheat
N I
60 20
H A
30
PPC CPC
10
A K PPC
CPC
L
15 5
China USA
Cloth Cloth
60
M
30 45 5 10 15 20
R I
5. Explaining benefits from trade:
 China can now consume 15 wheat and 45 cloth, 15 more cloth than before specialisation. Hence,
specialisation and trade has allowed her to enjoy a higher level of consumption and standard of living.
K A
 Similarly, USA can now consume at a point outside her PPC that was previously unattainable. She has
also gained from specialisation and trade.
A .
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Benefits of Trade (and by extension, Free Trade and Globalisation)
In effect, larger markets for both producers and consumers.
1. Firms: Higher revenues through exports

a. Promotes entrepreneurship, with the incentive of increased revenue from new markets
b. (X-M) increases, AD increases via multiplier effect => Improved BOP, Economic growth
2. Firms: Lower costs
a. Economies of scale reaped from increased output for the international market, esp. if fixed costs
are high (high MES) but the domestic market is small
I
b. Factor Price Equalisation: Prices of inputs in different countries are brought closer together
 Firms can import inputs from the cheapest markets worldwide, since their supply is now
perfectly price elastic
3. Consumers: Increased competition from foreign firms
a. Prevention of monopolies
A N
K H
b. Promotes X-efficiency among firms => Lower prices, higher quality products
4. Consumers: Greater amount and variety of goods and services available
Can consume outside of PPC => Increased SOL, reduced scarcity
5. Overall: Efficient allocation of world resources
L A
By the Law of Comparative Advantage, if all country specialise in area of CA and trade, everyone
gains from higher world output and consumption, given favourable Terms of Trade (TOT) for all
OVERALL:
I M
R
 PPC shifts outwards (due to increased efficiency and lower costs), CPC shifts outside PPC,
Consumption point shifts outside PPC => Increased SOL, reduced scarcity
K A
 AD rises (from X), AS rises => Improved BOP, ECONOMIC GROWTH!
Protectionism (and why it fails)
A .
Arguments for Protectionism
Improve BOP (Expenditure-switching policy)
Evaluation
(see overall evaluations for protectionism below!)
 Protectionism is a “beggar-thy-neighbour” policy:
Restriction of imports to curb excessive import Trade partners’ incomes reduced
expenditure over export revenue => they import less (if demand is income elastic)
Reduce Cyclical Unemployment => export revenue falls
 Importing foreign goods may mean creating jobs => BOP worsens, AD ↓
for foreign markets that would otherwise go to  At best a stop-gap measure, as this will cause
domestic labour, in effect “exporting jobs”. retaliation from trade partners in the form of
 Protectionism will divert demand from foreign protectionism
goods to domestically-produced goods, protecting  Should opt for supply side or expenditure-
employment in those industries. reducing policies instead (see BOP policies)
 For unemployment: If it is the result of a
recession, domestic recovery may eventually be
delayed since it can no longer be triggered by
multiplier effects from exports.
Reduce Structural Unemployment May actually hinder the restructuring of the
Allow declining industries to decline slowly, to economy, by preventing it from growing through
prevent sudden structural unemployment by the development of new sectors
providing some buffer time for workers to be
retrained and seek other jobs.
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Protection of infant industries  Difficult to determine which industries have that

 Infant industries have potential comparative potential CA
advantage  Difficult to determine when to withdraw
 Need to be protected from foreign competition in protection
the early stages, to give them time to develop and  May breed inefficiency and complacency
reap economies of scale
Competition from Countries with Cheap Labour Hurts wages of workers in poor countries by curbing
Protect domestic industries from cheap goods external demand, and not allowing factor prices to
coming from countries with the “unfair” advantage equalise across countries.
of lower wages
 Also prevents the loss of jobs in affected
industries
Protection against Dumping
 Predatory dumping: Foreign firms sell goods in a
N I
Domestic producers may falsely accuse foreign firms
of “dumping” when they cannot match their lower
A
market at a price below marginal cost, to destroy prices, which may actually be so due to them being
local competition. more efficient.
 The firm becomes a monopoly in that market, and
can charge consumers higher prices.
Improve TOT
K H
Only works if a country can dictate world prices
Restrict imports, so foreign firms lower prices and
the country gains from higher TOT.
Protection of strategic industries
L A
(monopsonistic power), not if it is a price taker.
(See below for evaluations that apply to all points.)
M
To remain self-sufficient especially for times for war,
I
even if country has no CA in those industries.
Protection against harmful goods
AR
Political objectives – e.g. embargoes
Trade Diversion (applies ONLY to FTAs)
K
 Members of an FTA may import goods from other
members instead of more efficient producers
tariffs.
.
elsewhere in the world, simply due to the lack of
A
 Just a diversion from an external source to a new
source within the FTA, so little gains from trade
may be made.
Overall arguments against protectionism:

 Goes against the Law of Comparative Advantage – Loss of CA in one sector should drive a country
to source for new areas of CA
 Country forgoes gains from trade from purchasing more efficiently produced foreign goods
 Resources tied up in protected industries cannot be used for other more efficient industries
o Misallocation of resources
 Perpetuates domestic inefficiency
 Consumers ultimately suffer from having to pay higher prices.
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Protectionism, in the form of tariffs:
Price
Sd (domestic supply)
I
P2 Sw + tariff
C
N
A B (tax revenue) D
P1 Sw (world supply)
H A Dd (domestic demand)
Quantity
QS QS ’ QD ’
A K QD
Tariffs or quotas can be set to reduce imports from (QD - QS) to (QD’ - QS’), but at the cost of a deadweight
L
loss to society equal to the loss in consumer surplus not transferred to other sectors, shown by areas B + D.
 A + B + C + D: Total loss in consumer surplus
I M
 A: Increased producer surplus for domestic producers (Redistribution Effect)
 B: Deadweight loss from the extra cost incurred by domestic producers to produce (QS’ - QS),
AR
which could have been imported at P1 instead. (Protective Effect)
 C: Tax revenue collected by government (Revenue Effect)
 D: Deadweight loss due to under-consumption. (Consumption Effect)
Tariffs vs. Quotas
. K



A Tariff
Still allows market to operate
Provides tax revenue
Effectiveness depends on price elasticity of



More restrictive
Quota
No revenue to government
Foreign producers may gain by raising prices
demand
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doing so, the three basic questions that arise are:

Demand & Supply

Population: Changes in population size or composition affects size of market

Related goods’ prices: Competitive vs. Joint Supply L A

A good to changes in its own price, ceteris paribus.

Income/Cross elasticity of demand measures the responsiveness of demand of a good to changes in

State their formulae:

Price Elastic Supply Price Inelastic Supply

Price Elastic Demand Price Inelastic Demand

Characteristics Gentle demand curve Steep demand curve

Substitutes Large amount of close substitutes Little substitutes

Positively Income Elastic A

1. Slash prices as well, when competitors lower prices

Universal Micro Evaluations

Example: Minimum Wage

Example: Rent Controls

higher price of P2.

Alternative mechanisms for resource allocation: Balloting, Rationing.

Correcting Market Failure

Issue Cause Policy Evaluation

o No one will pay for what

o Absence of price signal, so

1. An individual/firm, in  Difficult to measure and quantify

something), only considers determine size of taxes

efficiency requires SMC = Subsidy Pros

(Cap and Trade)  Internalises EMC by establishing a

simply ignore the full costs/ advertisements mindsets

(For graph: Instead of SMC vs.

Issue Cause Policy Evaluation

B profits are lowered  Further charge that varies with

However, this may be tolerated

2. X-Inefficiency as firm has no

Economies of Disintegration: Specialisation through division of production processes among firms

Higher Input Prices

Increased Strain on Infrastructure

Small vs. Large Firms

mass-produced, e.g. customised jewellery  MES at low output

pricing  MES at high output

Small firms can actually coexist with large firms if:

not affect others consciousness

all innovations due to

Merits: Explains price rigidity

 Explicit: Cartel – E.g. OPEC

aims, such as:

(AE=Y) and (AD/AS) Frameworks

K A Circular Flow of Income

Income Savings Taxes M

Shifting Aggregate Demand/Supply 101

Increasing AD/AE: growth, employment, inflation, worsens BOP

Monetary Policy involves the manipulation of:

Exchange Rate -- X-M, I

Trading Partners’ Incomes -- X

Expected Future Incomes -- C

[Reverse multiplier effect happens as well!]

To increase ONLY SRAS, cost of production needs to be brought down:

(Basically, improving the quantity and quality of resources.)

Increase capital stock - Investments also increase AS!

To encourage R&D, the government can:

Increase size of workforce