FP0002 Economics PDF

International Foundation Programme
Economics
James Abdey
FP0002
2019
This guide was prepared for the University of London by:
J.S. Abdey, The London School of Economics and Political Science
This is one of a series of subject guides published by the University. We regret that due to pressure
of work the author is unable to enter into any correspondence relating to, or arising from, the
guide. If you have any comments on this subject guide, favourable or unfavourable, please use
the online form found on the virtual learning environment.
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ECONOMICS i
Contents
Introduction to the course 1
Unit 1: The nature and scope of economics

Introduction to Unit 1 10
Section 1.1: The basic economic problem, opportunity cost
and economic systems 12
Section 1.2: Production possibility frontiers 18
Concluding comments 26
Unit 2: Microeconomics I: markets and the consumer

Section 2.1: Demand, supply and price determination 30
Section 2.2: Elasticities 46
Section 2.3: Consumer and producer surplus, tax and
social welfare 58
Section 2.4: Consumer choice 69
Unit 3: Microeconomics II: firms and production

Section 3.1: Production 86
Section 3.2: Market structure 97
Section 3.3: Market failure and externalities 108
Section 3.4: Labour markets 122
Unit 4: Macroeconomics I: closed economy

Section 4.1: Introduction to macroeconomics and
national income accounting 134
Section 4.2: Aggregate demand and aggregate supply 142
Section 4.3: Unemployment 153

Contents ii
Section 4.4: Inflation 162

Section 4.5: Monetary policy and fiscal policy 171
Unit 5: Macroeconomics II: open economy

Section 5.1: International trade 186
Section 5.2: Balance of payments and exchange rates 193
Section 5.3: Measures of economic development 202
Unit 6: Global financial crisis

Section 6.1: Contributory factors leading to the global
financial crisis 213
Section 6.2: Consequences of the crisis and possible cures 223
Appendix A: Economic history 231
Glossary 235
1
Introduction to the course
Introduction to the course
Route map to the guide 2
Interrelated courses 3
Syllabus 3
Aims of the course 5
Learning outcomes for the course 5
Microeconomics vs. Macroeconomics 6
Overview of learning resources 7
Examination advice 8

Route map to the guide

Welcome to the world of economics! Although the discipline of economics is often referred to
as the ‘dismal science’, in reality it offers a fascinating window into the behaviour and decision-
making of ‘agents’ (people) in the global economy. For economics, at its heart, is the study of
people – the aim of all social sciences.
Decisions ranging from oil production in the Gulf (whether to increase or decrease production?),
manufacturing your product in Europe or Asia (where to produce?), to central banks across the
world setting interest rates (should interest rates be changed?), even commercial spaceflight (to
boldly go, or not?) all reduce to economic decision-making. As economists, we seek to analyse,
understand and explain human behaviour in the economic sphere.
When studying this course, it is important to appreciate that the real world is highly complex
- a web of ‘interdependencies’ between a large number of variables. In our attempt to analyse,
understand and explain economic behaviour, it will be necessary for us to simplify the real
world using models. Always keep in mind that a model is a ‘deliberate simplification of reality’,
where a good model retains the most important features of the real world, while ignoring factors
which (we think) do not matter.
Ultimately, we face a trade-off. The benefit of a model is that we simplify the complex real
world. The cost of a model is that the consequence of this simplification of reality is a departure
from reality, and so the analysis of the effects of an economic policy, say, in a model may deviate
from what would actually happen in practice.
To assist our model-building, we will often make simplifying assumptions. Of course, we must
be aware that assumptions can be wrong, running the risk that the conclusions drawn from our
model are invalid. However, such assumptions are necessary (and inevitable) as we analyse the
real world which is far too complex to be considered in its entirety. For the most part, we will
often assume people are rational decision-makers. However, people do not always behave
rationally!
Maps are a great example of widely-used models. Metro systems across the world have
maps allowing people to navigate the network with relative ease. The world-famous London
Underground map is an excellent example of a model used for getting from point A to point B.
You can view the map here http://content.tfl.gov.uk/standard-tube-map.pdf.
The London Underground Map is ‘schematic’ and represents only the most important pieces of
information needed for reaching your intended destination:
distinct names and colours to distinguish each line
the order of stations on each line
the interchange stations between lines.
However, less important details are ignored, such as:
the depth of each tunnel
the exact distance between stations
the non-linear nature of the tunnels under the ground.
An engineer would likely need to know these ‘less important details’, but for a tourist visiting
London such information is not essential and the schematic map is very much fit-for-purpose.
However, as mentioned above, a model means a departure from reality, hence some caution
should always be exercised when using a model. Supporting a belief entirely based on a model
might be misleading.
For example, take a look at this geographically accurate map of the London Underground
where the lines are simply overlaid onto a regular city map https://www.telegraph.co.uk/travel/
destinations/europe/united-kingdom/england/london/articles/Accurate-distance-London-
tube-map/. In contrast to the schematic map, we can see that this one accurately represents the
precise geographic locations of stations. If you were to follow the schematic map outright, you
could end up taking a longer route.
The route from Holborn to Temple appears quite far away on the schematic map, requiring at
least two trains and lines to get there. When in fact, geographically, they are only around ten
minutes apart by foot.
Also, even line names can be a model. Most notably, the Circle line (in yellow) is clearly not a true
circle. Does it matter? Well, the Circle line forms a loop and it is an easy name to remember, so
arguably here the simplification of the name outweighs the slight depature in reality from a true
circle!
Our key takeaway is that models inevitably involve trade-offs. As we further simplify reality (a
benefit), we further depart from reality (a cost). In order to determine whether or not a model is
‘good’, we must decide whether the benefit justifies the cost. Resolving this cost-benefit trade-off
is subjective – further adding to life’s complexities!
Interrelated courses
As you embark on the International Foundation Programme it is important to appreciate the
links across courses. Indeed, as you recognise the connections between disciplines there
will be economies of scale in your studies, allowing you to obtain a deeper understanding of
content and become more efficient at studying!
For example, economists are keen consumers of economic statistics – data on variables
of interest (such as the price of crude oil, the level of unemployment and foreign exchange
rates). Of course, when analysing data we need to apply data visualisation and descriptive
statistics as covered in Units 12 and 13 of FP0001 Mathematics and Statistics. Also, when
interested in exploring the relationship between variables, such as price and quantity when
modelling demand and supply, we use algebra to form mathematical equations (as seen in Unit
2 of FP0001 Mathematics and Statistics).
Assuming rational behaviour, a firm makes a decision on its level of production in order to
maximise profits and differential calculus can solve such an ‘unconstrained optimisation problem’
(as seen in Unit 7). Whereas in your mathematics course you focus on the mathematics of
calculus, the economic interpretation of such results is of importance in your study of economics.
Government intervention in markets, as well as the tax-and-spend decisions of government
(known as fiscal policy) are clearly political decisions with links to FP0004 Politics, while
FP0003 International Relations can be useful when understanding the challenges when
forming international agreements such as trade blocs.
Syllabus
The course is divided into six units, each of them further divided into two to five smaller sections.
You should be aware, however, that they are not mutually exclusive, that is the sections do not
cover completely separate issues, and you will soon start to find links between them. The best
way to study is to work through the subject guide starting with Unit 1, as each subsequent unit
builds on everything else covered before.

This unit introduces the central economic concepts of scarcity and choice, including the extent
of government involvement in economic decisions. By the end of this unit, you should be able
to consider different mechanisms by which society determines what, how and for whom to
produce.

This unit explores the determination of market prices and quantities and the behaviour of
consumers. By the end of this unit, you should be able to apply analytical tools to model
microeconomic problems related to consumers.
Unit 3: Microeconomics II: firms and production

This unit explores the behaviour of firms when deciding on the level of production, different
types of market structure and labour markets. By the end of this unit, you should be able to apply
analytical tools to model microeconomic problems related to firms.
Unit 4: Macroeconomics I: closed economy

This unit models the national economy as a system featuring feedback mechanisms. Core
variables of unemployment and inflation are introduced along with the tools of monetary policy
and fiscal policy. By the end of this unit, you should be able to conduct macroeconomic analysis
for a closed economy, including the impact of monetary and fiscal policies.

This unit considers trade with the rest of the world. Balance of payments and exchange rates
are introduced, concluding with measures of economic development. By the end of this unit,
you should be able to discuss the international economy and appraise different measures of
economic development.
Unit 6: Global financial crisis

This unit examines the major economic event of modern times – the global financial crisis of
2008. By the end of this unit, you should be able to outline events which contributed to the
global financial crisis and critique different economic policy responses.
Week Unit Section

1: The nature and scope of Introduction to the course
1 economics
1.1: The basic economic problem, opportunity
cost and economic systems
2 1.2: Production possibility frontiers
3 2: Microeconomics I: markets and 2.1: Demand, supply and price determination
the consumer
4 2.2: Elasticities
2.3: Consumer and producer surplus, tax and
5
social welfare
6 2.4: Consumer choice
7 3: Microeconomics II: firms and 3.1: Production
production
8 3.2: Market structure
9 3.3: Market failure and externalities
10 3.4: Labour markets
Week Unit Section

4: Macroeconomics I: closed 4.1: Introduction to macroeconomics and
11
economy national income accounting
12 4.2: Aggregate demand and aggregate supply
13 4.3: Unemployment
14 4.4: Inflation
15 4.5: Monetary policy and fiscal policy
16 5: Macroeconomics II: open 5.1: International trade
economy
17 5.2: Balance of payments and exchange rates
18 5.3: Measures of economic development
6: Global financial crisis 6.1: Contributory factors leading to the global
19
financial crisis
6.2: Consequences of the crisis and economic
20
responses
You should be aware, however, that the above topics are not mutually exclusive, that is the
sections do not cover separate issues and you will soon start to find links between them, as well
as links to other disciplines. The best way to study is to work through the subject guide in order,
as each subsequent topic builds on everything else covered before in a cumulative way.
Aims of the course

The major aims of the course are to:
introduce you to a range of key issues and questions at the centre of the study of economics
appreciate how economics contributes to the understanding of the wider economic and
social environment
develop an understanding of current economic affairs and the role of institutions which affect
everyday life
provide tools which support you in the critical evaluation of economic models and methods
of inquiry
interpret appropriate data from a range of different sources and understand the relationship
between data, decisions of economic agents and policy formation.
Learning outcomes for the course

At the end of the course, and having completed the background reading and activities, you
should be able to:
demonstrate familiarity with key economic concepts
use a range of simple microeconomic and macroeconomic models to analyse the relationship
between economic variables
provide reasons for, and explain the implications of, market failure and the impact and
effectiveness of government policies
contrast and assess different approaches to the same economic problem
interpret data presented in different formats, carry out simple calculations and construct
diagrams
compare measures of economic development

provide an economic critique of the global financial crisis.
Microeconomics vs. Macroeconomics

Before we embark on our first unit looking at the nature and scope of economics, let us spend a
few moments considering the differences between microeconomics and macroeconomics –
which comprise the core of this course (Units 2 to 5).
Microeconomics
Microeconomics is concerned with modelling the behaviour of individual consumers and
firms. Consumers decide what quantity to buy of different goods and services based on a
variety of factors such as price, income, tastes and preferences. Firms produce the goods and
services which consumers buy and can be assumed to be profit-maximising, i.e. firms decide
on their output subject to the price, for example, the revenue they receive per unit, as well as
their cost of production, with profits being the difference between revenues and costs.
Demand and supply curves can be used to illustrate the relationship between price and
quantity from the consumer’s and firm’s perspectives, respectively. Equilibrium is achieved
when demand equals supply. Throughout the microeconomics units you will see several links
to the mathematics part of FP0001 Mathematics and Statistics, and these connections will
be emphasised in this subject guide. This is because economic relationships can be modelled
mathematically as well as graphically.
The price which a firm receives per unit of output sold will depend on the market structure, i.e.
how many firms operate in a particular market. At one extreme there is a pure monopoly (only
one firm in the market), while at the other extreme there is perfect competition (in principle an
infinite number of firms). The type of market structure affects the influence the firm has over the
price and hence revenues.
Market failure sometimes occurs whereby the price mechanism fails to allocate resources
efficiently. In such circumstances there is a possible role for government intervention to
achieve a socially-acceptable allocation. We will look at reasons for market failure and examples
of how and when governments should intervene.
Other topics which you will meet in microeconomics include elasticities (the sensitivity of demand
to changes in a variable), consumer and producer surplus, tax, social welfare and labour markets.
Macroeconomics
Macroeconomics considers an economy at the aggregate level, sacrificing analysis of individual
consumers and firms for an economy as a whole. The concepts of demand and supply met
in microeconomics will be extended to aggregate demand and aggregate supply when
summed over all individual units. When you hear economic stories in the news, these usually
concern macroeconomic variables such as economic growth, unemployment and inflation – all
of which will be discussed in this course.
Given the prevalence of macroeconomics in the news, you will no doubt see several time series
graphs of macroeconomic data. When you do, relate these to the data exploration units (Units 12
and 13) of FP0001 Mathematics and Statistics.
The primary macroeconomic policy tools are monetary policy (the setting of interest rates
by central banks) to combat inflation (among possible other objectives) and fiscal policy
(the tax-and-spend decisions of governments). A graphical treatment will allow us to consider
how different policy mixes, for example, an expansionary monetary policy combined with a
contractionary fiscal policy, can affect the economy.
Modern economies trade with each other, and we will explore the international economy
through a study of exchange rates (the price of one currency in terms of another) and the
impact these have on the balance of payments (which compares the value of imports and
exports), as well as international trade in general.
Finally, we will look at different measures of economic development. While economic
development may seem desirable, how do we quantify this? A purely monetary measure may be
misleading, so different measures will be introduced enabling you to critique each one.
Overview of learning resources
Economics in the News

Economics is all around us in the media. Every day there are stories in the news about topics in
this subject guide which are going on in the real world in the present. ‘Economics in the News’ is
available on the Virtual Learning Environment (VLE) and consists of weekly news articles covering
a broad cross-section of microeconomic and macroeconomic news stories. Each post links to a
real news article, complemented with several key takeaways which cross-reference back to this
subject guide. A summary discussion point concludes, which you are encouraged to use for the
basis of an in-class discussion with your peers.
Make every effort to keep up-to-date with current affairs both in your home country as well as
internationally. Over time, as your knowledge of economic concepts deepens, increasingly you
will be able to ‘read between the lines’ of any economics-themed story and be able to provide
your own economic critique of it!
Background reading
The subject guide gives you a comprehensive commentary on the issues discussed and will help
you to understand the main ideas – you should always refer to it first as the subject guide
represents the definitive examinable content.
Once you have read the subject guide, you may wish to deepen your knowledge by reading
relevant sections from the following textbooks:
• Anderton, A. and D. Gray (Ed) Economics. (Lancashire: Anderton Press, 2015) 6th edition
[ISBN 9780993133107].
• Gillespie, A. AS & A Level Economics through diagrams. (Oxford: Oxford University Press, 2009)
3rd edition [ISBN 9780199180899].
Further reading
The following texts, although not compulsory, can help you gain more knowledge of economics
as a whole. If you have time, you may want to read some of the following:
• Davies, H. The financial crisis - who is to blame? (Cambridge: Polity Press, 2010) [ISBN
9780745651644].
• Frank, R.H. The economic naturalist: why economics explains almost everything. (New York: Virgin
Books, 2008) [ISBN 9780753513385].
• Harford, T. The undercover economist. (London: Abacus, 2007) [ISBN 9780349119854].
• Jevons, M. The fatal equilibrium. (New York: Penguin Random House, 1986) [ISBN
9780345331588].
• Klein, G. and Y. Bauman The cartoon introduction to economics, Volume I: Microeconomics. (New
York: Hill and Wang, 2010) [ISBN 9780809094813].
• Klein, G. and Y. Bauman The cartoon introduction to economics, Volume II: Macroeconomics.
(New York: Hill and Wang, 2012) [ISBN 9780809033614].

• Krugman, P. End this depression now! (New York: W.W. Norton & Company, 2013) [ISBN
9780393345087].
• Levitt S.D. and S.J. Dubner Freakonomics: A rogue economist explores the hidden side of
everything. (London: Penguin Random House, 2007) [ISBN 9780141019017].
• Levitt S.D. and S.J. Dubner Superfreakonomics: Global cooling, patriotic prostitutes and why
suicide bombers should buy life insurance. (London: Penguin Random House, 2010) [ISBN
9780141030708].
• Sloman, J. and D. Garratt Essentials of economics. (Harlow: Pearson Prentice Hall, 2016) 7th
edition [ISBN 9781292082240].
Useful web links

In addition, you could also benefit from the following web links:
www.anforme.co.uk – provider of online educational resources
www.bankofengland.co.uk – central bank of the United Kingdom
www.bbc.co.uk/news – BBC news website
www.bized.co.uk – provider of online educational resources
www.economist.com – weekly newspaper with economic and socially liberal views
www.edexcel.org.uk – education and examination board
www.guardian.co.uk – left-of-centre newspaper
www.oecd.org – Organisation for Economic Co-operation and Development
www.philipallan.co.uk – publisher and conference provider
www.statisticsauthority.gov.uk – United Kingdom Statistics Authority
www.telegraph.co.uk – right-of-centre newspaper
www.treasury.gov.uk – HM Treasury
www.tutor2u.net – provider of online educational resources.
Accessing the Student Portal and virtual learning environment

To manage all of your student administrative processes you will need to log in to the Student
Portal via: my.london.ac.uk You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave on your application form. You
have probably already logged in to the Student Portal in order to register. As soon as you register,
you will automatically be granted access to the VLE, Online Library and fully functional University
of London email account. If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page. In order to access your learning materials for each course,
you can click on the VLE tab within the Student Portal or login to the VLE directly via: https://ifp.
elearning.london.ac.uk/
Examination advice
Important: the information and advice given in the following section are based on the
examination structure used at the time this subject guide was written. We strongly advise you to
check both the current Regulations for relevant information about the examination and the VLE
where you should be advised of any forthcoming changes. You should also carefully check the
rubric/instructions on the paper you actually sit and follow those instructions.
You may think it is too early to think about your examination, but you could not be further from
the truth! The year will pass quickly, and without even realising it you will soon be only a few
weeks away from your final assessment - a two-hour unseen written examination.
The examination will seek to test the following specific areas and skills:
1. subject knowledge applied to short qualitative and quantitative questions
2. ability to respond and apply economic knowledge/theory to data provided, i.e. ‘stimulus
response’
3. ability to consider at length a particular area of economics and then to write an answer in a
coherent and structured way. This answer must include knowledge, analysis and judgements
based on an objective review of the evidence presented. It must clearly consider different
perspectives.
Economics cannot be learned by heart through memorisation. It must be understood and
this is a gradual process taking both time and effort. Here are a few useful study tips to help you
prepare for the final examination.
Be systematic – do not leave all the work until the last moment. It is impossible to squeeze
the whole course into one month before the examination. Neither is it possible to do well by
learning only selected topics. Remember that all topics are interrelated.
The examination consists of questions of similar difficulty to activities in this subject guide
and on the VLE, testing your knowledge of the course material, your analytical skills and your
ability to apply tools learned in the course to real-life situations. Therefore, the best way is to
regularly complete the activities. You will not learn simply by accessing the answers before
you try the questions on your own!
Graphs are essential – the best way to learn is to draw them several times. When drawing
a graph, make sure you explain what it is showing. Label the axes and key points of your
diagram, such as any points of intersection of curves, as well as any shifts of curves.
Mind maps and revision sheets – after each topic create a mind map or a revision sheet
which highlights the most important ideas that you have learned so far. Do not rewrite the
whole book because a summary should be short and informative. Doing this will save you a
lot of time when revising for the final examination.
Glossary – definitions in economics are very important. You may want to learn some of these
by heart, but it is always more useful to try to explain the concepts using your own words. As
there are many new terms to learn, you are advised to review the glossary at the end of the
subject guide.
Last, but not least, here is a little secret about economics – it’s not all that complicated. It’s
really all about us and our behaviour. With this subject guide, you will very soon discover how
exciting and universal it is.
Good luck!
James Abdey
10
Introduction to Unit 1
Overview of the unit 11
Aims 11
Learning outcomes 11
Background reading 11
Further reading 11

Unit 1: The nature and scope of economics 11
Overview of the unit

This first unit begins with an introduction to economics by considering the basic economic
problem (how to satisfy unlimited wants when faced with scarce resources) which leads to
the fundamental concept of an opportunity cost (what must be sacrificed to gain more of
something). We consider different types of economic systems and outline their key features. Our
first economic model (the production possibility frontier) provides a visual representation of
the productive potential of an economy. As with all models, we are interested in analysing the
model when something changes.
Week Unit Section
1 1: The nature and scope of 1.1: The basic economic problem, opportunity
economics cost and economic systems
2 1.2: Production possibility frontiers
Aims
This unit aims to:
introduce you to the concepts of the basic economic problem and opportunity cost
provide you with a general overview of different economic systems
provide you with tools which support the critical evaluation of the productive capacity of a
given economy.
Learning outcomes
By the end of this unit, and having completed the background reading and activities, you should
be able to:
define the concepts of the basic economic problem, scarcity, efficiency, opportunity cost and
specialisation
explain the main features of different economic systems
explain what is meant by the production possibility frontier and analyse its position and
shape.
Background reading
[ISBN 9780993133107].
Please read the following units from Anderton (2015):
• Unit 3, pp. 12–16
• Unit 4, pp. 17–21
• Unit 5, pp. 22–25
• Unit 6, pp. 26–31.
Further reading
• Frank, R.H. The economic naturalist: why economics explains almost everything. (London: Virgin
Books, 2008)
• Introduction.
Section 1.1: The basic economic problem,

opportunity cost and economic systems
Introduction 13
Opportunity cost 14
Division of labour as an example of specialisation 15
Different economic systems 16

Unit 1: The nature and scope of economics • Section 1.1: The basic economic 13
problem, opportunity cost and economic systems
Introduction
Think of Planet Earth, home to around seven billion people, as the provider of resources for
the population such as food and shelter. Ideally, we would wish to allocate resources such that
everyone’s wants, or demands, are satisfied. Of course, the planet has finite resources while our
individual wants can be infinite. Therefore, we need to make choices and decide how to allocate
scarce resources between competing uses in the best possible way. This notion is referred to as
the basic economic problem.
Due to the scarcity of resources, it is impossible to meet the demands of all of us as individuals
and collectively – we cannot completely reconcile limited resources with our infinite wants.
Hence economics looks at what, how and for whom society produces goods and services.
Scarcity itself can be thought of as having to distribute a fixed stock of resources to best meet
our insatiable wants. However, what are these ‘resources’?
Formally, we view these economic resources as factors of production – the means for
producing the goods and services which people demand. We consider the four factors of
production, known as CELL for short:
Capital – human-made assets, such as machinery or buildings.
Entrepreneurship – the ability and originality to combine all factors of production to make
profits. ‘Confidence’ is sometimes also considered as part of entrepreneurship.
Land – all naturally-occurring resources, such as soil, air, water, minerals, flora and fauna.
Labour – people who provide physical and intellectual skills (human capital).
Some resources are renewable (they can be replaced), while others are not. Almost all resources,
however, are limited (at least in the short term) – there is a finite amount of water, oil, land, coal,
and so on, which is why economists say that these resources are scarce. For example, if you want
to buy a car, you can only purchase the one which you can afford. If the latest high-performance
car is beyond your budget, you cannot have it. If a government wants to build a new hospital,
it needs resources. If there is not enough money to fund it, no hospitals can be built. All goods
which are scarce are called economic goods. However, not all resources are limited. Take air as
an example. There is more air than anyone could ever need. All such goods which are (effectively)
infinite are called free goods. Although, you may argue that clean, breathable air is in short
supply in some of the world’s most polluted cities, as well as underwater!
DISCUSSION POINT 1.1

‘Economics is the study of how people eliminate scarcity.’ Do you agree or disagree?
Why?
ACTIVITY 1.1
Explain the difference between human needs and wants.
ACTIVITY 1.2
If we would all like more money, why does the government not print a lot more? Could it
not thereby solve the problem of scarcity instantly?
Opportunity cost
Economists think about ‘costs’ in a slightly different way to most people. They use the term
opportunity cost to represent the cost of the best alternative forgone. It is a cost associated
with engaging in a certain activity evaluated as the value of the best alternative you must give
up pursuing it.
Every day we face the same problem – what to do with our time. An hour has only 60 minutes; a
day has only 24 hours. The average life expectancy of a person born today is around 79 years (of
course, there are significant regional variations, as well as sex differences). Time is one of the most
valued of all scarce resources. Each of us needs to decide what to do with the finite amount of
time we have, to decide between leisure and study or work. Parents must decide how much time
to devote to their work and how much time they spend with their children. Every extra hour at
work means one less hour with family. Finding the right ‘work-life balance’ is difficult as it means
deciding which aspects of your life should be prioritised – what is most important in your life?
As you consider your university options you will face opportunity costs. You can only enrol in
one degree programme at one institution. You cannot take multiple degrees at the same time
(dual degree programmes aside!), so you must decide which discipline to study and where to
study. Some career destinations may require a certain type of degree. For example, if you want
to become a doctor you will need to study medicine, whereas if you aspire to be an economist
then an economics degree would be appropriate. Therefore, pursuing a BSc in Economics would
typically prevent you from becoming a doctor – there is an opportunity cost from specialising in
a particular discipline.
Admittedly, some professions may have a degree as an entry requirement, but are not specific
about the subject area. Therefore, any degree in a broad class of subjects may be sufficient.
However, employers may place different weights on the degree-awarding institution. For
example, an internationally-recognised degree from the University of London (regardless of
subject) would be deemed of higher quality than degrees awarded by many other universities.
As such, the university you choose to study at has an opportunity cost in terms of the best
alternative university forgone!
DISCUSSION POINT 1.2

Discuss the opportunity cost of studying the International Foundation Programme (IFP).
What factors would make the opportunity cost of pursuing the IFP relatively high?
Is the cost of food included in the opportunity cost?
What impact would it have on the calculation of opportunity costs if you really disliked
the nature of the work in the best alternative job available to you?
Suppose now you have graduated from the IFP and you are an undergraduate student. Is
the opportunity cost to you (as an individual) of attending university different from the
opportunity cost to society as a whole? Are the benefits of higher education for society
different from those for you?
Division of labour as an example of specialisation

Specialisation occurs when a country, firm or individual focuses on the production of a limited
range of goods or services. Specialisation can occur for a number of reasons. For example, almost
30 per cent of all potatoes produced in the United States are grown in the relatively small state
of Idaho due to the particularly favourable combination of climate, soil and geography. Another
reason for specialisation is when a ‘critical mass’ of expertise, money and talent is concentrated in
a single location. For example, such a critical mass can be found in Silicon Valley, California, where
there is a high concentration of high-tech firms, also Bangalore in India.
One of the forms of specialisation is the division of labour which is a major source of growth.
Production is broken down into a series of tasks which are conducted by individual workers – an
idea famously, and successfully, implemented by Henry Ford, by the time of his death one of the
wealthiest and most famous men of his day. Many people believe he invented the automobile,
and others think he was the first to come up with the idea of an assembly line. The truth is he did
neither. So, what was his success?
Ford’s dream was to build fast, reliable cars as quickly and cheaply as possible so that everyone,
including the working class, could afford to own one. After a series of failures, in 1903 Ford
finally founded his own motor company. It was not until 1908, however, that he came up with
the idea of the ‘Model T’ (often referred to as the ‘Tin Lizzie’) – a car which revolutionised the US
automobile market. The car was simple to operate, powerful, sturdy, easy to repair and could
carry the whole family. More importantly, it was much cheaper than options offered by Ford’s
competitors.
In the beginning Ford produced one vehicle at a time, but soon the demand for cars greatly
exceeded supply (known as excess demand). Ford realised that a more efficient process of
production was needed. In 1913, the Ford Motor Company established what was, at the time,
regarded as the largest moving assembly line. All pieces were produced according to strict
rules so that they were virtually the same and would fit with any other. Assembly of the Model
T was broken down into smaller tasks. Each worker was trained to specialise in only a few steps
in the chain. Thanks to this division of labour, Model T production was faster, cheaper and more
efficient. The assembly time of a single car was cut down to just 93 minutes!
As great as the idea of an assembly line sounds, it also had some inevitable drawbacks. Since
the tasks were mindless, repetitive and required almost no skill, workers were easily bored and
discouraged. Yet, again, it was Ford who quickly realised the need to invest in human capital.
Since most of the workers employed in the factory were immigrants, the vast majority of them
could not communicate in English. He opened a dedicated school for them, established a hospital
at the factory and doubled their wages to give incentives and boost morale. Although many
commentators predicted bankruptcy, Ford managed to double Model T production in each of the
next three years. Henry Ford and his ‘Tin Lizzie’ changed the automobile industry forever.
The next great advance in mass production techniques took place in the 1970s in Japan – the
Toyota production system. Toyota saw their workers as assets and encouraged them to come
up with new ideas and methods to improve production. Above all, the company wanted to
concentrate on quality. They believed that no car should leave an assembly line unless it was free
from any fault. The traditional friction between management (whose objective was to maximise
production) and workers (who were bored and not motivated) was replaced by cooperation and
mutual respect. This system has now been exported and adopted by firms in many industries
worldwide.
Over time you will increasingly appreciate that when analysing a topic (be it economic, political,
or otherwise) there are often advantages and disadvantages. As you continue your study of the
social sciences, it is important when forming opinions and judgements on something that you
consider both sides of the argument. Indeed, we have already considered the benefit and cost of
working with models (simplicity versus departure from reality). Here, we consider the advantages
and disadvantages of the division of labour.
The advantages of the division of labour are that:
a person who spends time focused on one task quickly becomes highly-skilled
no time is wasted in moving from one job to another
capital equipment (such as machinery) can be used continuously in production
less time is required to train workers for specific tasks, as they only need to focus on one task
at a time
there is more choice of jobs for workers and they can specialise in tasks to which they are best
suited (in other words, if you are not good at something, you can focus on something else).
These benefits lead to a higher output per worker (a type of mean, or average) and help to
reduce the cost of single-unit production. Overall, the standards of living within the population
increase.
There are, however, also some drawbacks.
Disadvantages of the division of labour are that:
repetition of the same, easy tasks often creates monotony and boredom for the workers
in a large plant, where workers focus only on their own task, there might be a widespread
feeling of alienation due to the lack of interaction between workers
breaking down production into different tasks makes it easier to replace skilled workers with
machines, leading to structural unemployment
specialisation creates interdependence in production – if one group of workers goes on strike,
it could halt production across the whole industry.
ACTIVITY 1.3
Describe any three innovations which you would implement to minimise the
disadvantages of the division of labour.
Different economic systems

So far, we have established that the central economic problem of scarcity arises from infinite
wants and finite resources. All societies have to deal with this issue; they differ, however, in
the approaches which they adopt. The main difference comes from the degree of economic
intervention and control over resources. We therefore distinguish between:
free-market economies
centrally-planned economies
mixed economies.
In a free-market (or capitalist) economy, resources are privately-owned and therefore
decentralised – decisions about what to produce, and in which quantities, are decided by the
forces of demand and supply. The price mechanism ensures that prices adjust to achieve
equilibrium (i.e. when demand equals supply) and hence determines how much of a good will
be produced and sold in the market. Government intervention is minimal, and such minimised
intervention can be observed in countries such as Singapore. Advocates of the free-market
system argue that it achieves the most efficient allocation of scarce resources due to individuals
pursuing their own self-interest which is meant to be optimal for society overall. Critics argue
that market failure can sometimes occur, leading to third-party effects such as pollution
(an example of an externality which will be discussed in Section 3.3) for which government
intervention is required.
In a centrally-planned economy, the central authority, i.e. the government, decides which
goods are to be produced. Such decisions were taken in the former Soviet Union in the 1930s, for
example, and were carefully described in so-called ‘Five-Year Plans’. Each plan dealt with virtually
all aspects of development (such as the use of natural resources, production of consumer goods
and education) with the aim of creating an advanced industrial economy. The growth of the
economy was visibly boosted under Stalin, but at the cost of severe human suffering. Not only
is it impossible for one person to be able to determine the right amount of output, but the
whole process of gathering data is costly, time-consuming and liable to error. Most 21st-century
economists agree that, unless there is a sound reason to believe that the solution offered by the
market is not the best from society’s point of view, for example when there is monopolistic
pricing and supernormal profits (which will be discussed briefly later in the course), price and
quantity decisions should be left to demand and supply forces.
In practice the majority of developed countries (such as France and Germany) can be classified as
mixed economies, as their governments intervene to improve efficiency, correct market failures
(for example, in the education or health sectors) or provide public goods, such as defence. In all
systems, however, production decisions do not come without a cost.
Unit 2 will begin by introducing the price mechanism as the means to resolve differences in
demand and supply. While the price mechanism is central to the capitalist system, Section
2.3 will examine the impact of taxation (where governments raise revenue for spending and/
or redistributing to combat income or wealth inequality) and Section 3.3 will look at market
failure including examples of government intervention to correct this, as can be seen in mixed
economies.
ACTIVITY 1.4
Rank the following economies from the most centrally-controlled to the least centrally-
controlled:
Australia
Japan
North Korea
Singapore
United Kingdom.
Section 1.2: Production possibility

frontiers
Introduction 19
Inefficient production 21
Economic growth and the PPF 22
Shapes of PPFs 24
A reminder of your learning outcomes 26

Unit 1: The nature and scope of economics • Section 1.2: Production possibility 19
frontiers
Introduction
One of the main objectives for governments is the sustained economic growth of their
country – the long-term expansion of the productive potential of the economy. This, however, is
not easy to achieve because of the issues discussed in the previous section (for example, scarce
resources and the need to choose between them, as well as the associated opportunity costs).
The following question naturally arises – is there any way to represent the productive potential
of the economy? The answer is ‘yes’, with a production possibility frontier (PPF). This is our
first example of an economic model, i.e. a simplified way of representing a real-world economic
phenomenon.
A PPF shows all the possible combinations of two or more goods or services which can be
produced in an economy if all the available resources are fully and efficiently used with the best
available technology. Therefore, if an economy is fully utilising its resources, it is producing on
the frontier. Throughout this course, we will keep the analysis rather simple – from now on we
will consider only two goods. However, the model and its conclusions can easily be extended
to include more goods and services. It is possible to consider two goods as one specific good
(such as coffee) and ‘everything else’. Note that although this is an extreme simplification (given
the vast number of available goods and services), it still allows us to analyse the specific good in
detail, so serves us well as a model (we gain simplicity without departing from reality too much).
Figure 1.1 is a typical PPF showing the possible combinations of the two goods, A and B,
which can be produced by an economy. All points on and below the PPF are feasible points
of production, with the points on the frontier itself representing the full and efficient use of
resources.
Figure 1.1: A simple production possibility frontier for an economy producing two
goods, A and B.
Imagine that the economy can produce only food and shelter and that all raw resources (the
CELL factors of production - capital, entrepreneurship, land and labour) are needed to produce
both. If all resources are devoted to the production of food, then there are no resources available
to build shelter. This situation is represented in Figure 1.2 as point Q0 (with no shelter), where
Q stands for ‘quantity’ (note the same notation used in Unit 2 of FP0001 Mathematics and
Statistics).
Alternatively, if all resources are used to build shelter, then there would be no resources available
to grow food. This situation is represented by point Q1 (with no food). If resources were divided
frontiers
between the two - a mixture of food and shelter - then a range of combinations of the two
goods is available. Consider point X. Here the economy is producing Q2 of food and Q3 of shelter.
However, point Y (Q4 of food and Q5 of shelter) is also possible. Similarly, there are other points on
the frontier representing different combinations of food and shelter which the economy could
potentially produce. The set of all points for which all resources are fully utilised is the curve itself,
known as the PPF.
Any combination of outputs represented by a point on the frontier is said to be productively
efficient, since no resources are wasted. The only way of producing more food is by producing
less shelter; the only way to build more shelter is by reducing the production of food. Therefore,
the PPF (or more precisely, its slope) also illustrates the concept of opportunity cost. This is
calculated by finding out how many units of shelter must be sacrificed to obtain one more unit
of food. For example, in Figure 1.2 the opportunity cost of moving from X to Y, and so producing
Q4 rather than Q2 units of food, is by giving up Q3 – Q5 units of shelter.
Figure 1.2: Opportunity cost of moving from point X to point Y, sacrificing shelter for
more food.
So far, we have established that a PPF represents all combinations of goods which can be
produced when all resources are used efficiently, but exactly which combination should the
economy choose? How do we decide?
In a free-market economy, forces of demand and supply ensure that the correct
equilibrium is reached (the concept of equilibrium is formally discussed later in the course).
Suppose that there is a sudden increase in the need for shelter. To meet the increased demand,
the economy will need to build more houses. As a result, this sector would need more resources
and the price paid for those resources would increase. Therefore, suppliers would be willing
to sell their goods to house builders rather than to food producers because they would get
more money for the same products from house builders. As a result, resources would be shifted
away from food production and towards the construction of shelter. The very same market
forces which trigger an increase in demand for one product will also ensure that the necessary
resources for production are available.
For example, by the late 1970s Kodak (founded in 1888) products accounted for approximately
90 per cent of the US traditional film and camera market. However, the 21st century presented
a great challenge for the company. The sales of traditional photography devices started to
decline as the market for new digital photography grew rapidly. As a result, Kodak had to
frontiers
transfer all of its resources to digital-oriented production; otherwise it would not have been able
to keep up with market demand.
Inefficient production
The ideal situation of productive efficiency is, unfortunately, rarely achieved in practice. This is
because the curve is only a hypothetical concept and so can only be estimated. For example,
some resources which may be needed may not yet be known, or the cost of accessing others
might be too high. Therefore, even the best economies are very often producing inefficiently.
This can be represented graphically as a point within the PPF, such as point W in Figure 1.3.
Figure 1.3: Points W and S, where W is inefficient and S is not feasible. Production at
W is inefficient due to some unused resources and the possibility of increasing output
without any opportunity cost. Production at point S is not feasible due to the lack of
available resources.
In this example, the production of one or both goods can be increased without the need to
sacrifice production of the other. There is no opportunity cost involved, as there are still some
spare resources which can be used, i.e. there is slack in the economy since it is not producing at
full capacity. What about point S? Since it lies outside the PPF, even though it would be desirable,
it is not feasible as there are not enough resources and technology to be able to produce at that
point.
Another reason for an economy not to produce at the frontier is time trade-offs. For example,
you could put money into a bank account now and go on holiday with the money next year or,
alternatively, you could spend the money now on new clothes. In a similar manner, we can use
all of our available resources now or, alternatively, save some of them for future generations. By
sacrificing some of our current consumption, we increase consumption for future generations.
So, let us summarise what we have learned so far:
a PPF represents all the different combinations of goods (and/or services) which can be
produced within the economy if all resources are used efficiently
only one point on the curve can be produced – which demonstrates the need for choice
if all resources are fully utilised, to produce more of one good some quantity of other goods
must be sacrificed – therefore, the slope of a PPF represents the opportunity cost
frontiers
production of all goods is not always achievable. All points outside a PPF are points the
economy would want to achieve but cannot reach due to resource scarcity
all points within a PPF are feasible, but not desirable, as there are some spare resources which
are not fully utilised. There is no opportunity cost of expanding production from any point
within a PPF
some economies may choose to produce within a PPF because of time trade-offs.
Economic growth and the PPF

Once the frontier is reached, expansion is the only way to increase production. Expansion
can be achieved by either inventing new resources and/or new technologies. Such growth is
represented by an outward shift of a PPF. Possible reasons for such increases include:
increased training of employees making them more productive – fewer resources are needed
to produce the same quantity of output, so some of the workforce can be shifted to the
production of other goods
a greater increase in capital or the discovery of new resources
an increase in population – more labour means greater human capital
an improvement in technology, new discoveries, specialisation or the division of labour.
To put these factors into context, let us use the earlier example of food and shelter. Here are a
few scenarios and their corresponding graphs.
Scenario A: The entire workforce is required to attend special training before being employed
and during the training they acquire all of the skills necessary for their work. Evidence suggests
that this increases efficiency of an average worker by 30 per cent. This is depicted in Figure 1.4
where there is an outward shift of the original PPF as the productive capacity of the economy has
increased.
Figure 1.4: Scenario A showing an increase in the productive capacity of the economy.
Scenario B: At a recent international summit it was agreed that Country 1 should get its fertile
land back from Country 2. So, from Country 1’s perspective, it gains more land on which to
cultivate food and/or build shelter. Given it is fertile land, it would be better suited to producing
food rather than shelter. So, although the PPF would shift outward, it would expand further in the
direction of food, as indicated in Figure 1.5.
frontiers
Figure 1.5: Scenario B showing a country gaining more fertile land which is better-
suited to food production rather than building shelter.
Scenario C: Following the opening of a country’s frontiers and market liberalisation (freer
markets), the net outflow of people aged between 20 and 45 doubled. People in this age group
are likely to be some of the most productive in the economy. Therefore, the productive capacity
would decrease significantly due to the net emigration of this age group. Given building shelter
is likely to be more labour-intensive than food production, there would be a greater effect on
shelter capacity than on food production. Therefore the PPF would shift inwards, as shown in
Figure 1.6.
Figure 1.6: Scenario C showing how emigration of the prime workforce reduces
the productive capacity of the economy, with labour-intensive shelter being more
severely affected.
Scenario D: A new, faster and cheaper way of building houses has been discovered by a team
of researchers. This is effectively a new technological discovery, and hence the PPF expands
frontiers
outward although food production techniques are unchanged so if the economy only produced
food there would be no change to the total amount of food produced. The PPF expansion would
be as shown in Figure 1.7.
Figure 1.7: Scenario D showing how technological advances in house building

increase the capacity of the economy to build more shelter for any particular level of
food production.
Note that the shift of a PPF does not have to be parallel as a new technology can benefit some
goods more than others. Even if increased productivity affects only one of the goods, production
of all goods can increase. This is because resources saved on production of one good can be
transferred to the production of all other goods. For example, if fewer people are required to
produce food, those people could be used to build more shelter.
Shapes of PPFs
The most common shape of a PPF is the one we have drawn so far – concave to the origin
(curved like a circle). This is because we assume that the opportunity cost is not the same along
the curve due to diminishing marginal returns (that is, the more resources you use, the less
productive one extra unit becomes). However, this shape is not the only one which can exist.
Suppose you can read twenty pages of a history book per hour or forty pages of a Harry Potter
book per hour. If your reading speed does not change with time (suppose you do not become
tired), then no matter how long you read, the opportunity cost of reading one more page of the
history book is to give up two pages of Harry Potter. The situation described here represents a
constant opportunity cost. Therefore, the relevant PPF would be a (downward-sloping) straight
line, as shown in Figure 1.8. (You will cover straight lines mathematically in Unit 2 of FP0001
Mathematics and Statistics.)
frontiers
Figure 1.8: Production possibility frontier representing a constant opportunity cost

(i.e. a straight line) where the cost of obtaining one more unit of one good is fixed in
terms of the other good, regardless of level.
In real life, things are often much more complicated than the examples given above.
Nevertheless, the idea of the PPF helps us to illustrate and understand general principles. As
previously discussed, a model is not reality, but a good model allows us to represent the main
features of reality, which the above PPFs achieve.
ACTIVITY 1.5
Suppose a country can produce combinations of cars and boats each day. Making full
use of the available factors of production (CELL) the country can produce the following
possible combinations of each:
Cars (quantity) 0 60 110 150 180 200

Boats (quantity) 50 40 30 20 10 0
a. Draw the production possibility frontier for this country with cars on the vertical axis
and boats on the horizontal axis.
b. Are the following combinations of cars and boats feasible for this country? Explain
why in each case.
i. 150 cars and 20 boats
ii. 50 cars and 30 boats
iii. 190 cars and 15 boats.
c. Determine the opportunity cost, in terms of cars, of producing 10 additional boats
when the country is currently producing:
i. 180 cars and 10 boats
ii. 150 cars and 20 boats
iii. 110 cars and 30 boats
iv. 60 cars and 40 boats.
d. Suppose now that advances in technology allow three times as many cars to be
produced and twice as many boats for any specific amount of resources. Assume
that the available factors of production are unchanged. Determine the new possible
production combinations and draw the new production possibility frontier.
Concluding comments
This introductory unit has outlined the basic economic problem of how to reconcile unlimited
wants with finite resources. The concept of an opportunity cost was defined, with a brief
discussion of the different types of economic systems along with their main characteristics.
Our first graphical economic model, the production possibility frontier, enabled us to show
opportunity costs visually as the slope of the frontier. Shifts of the PPF under different scenarios
allowed us to demonstrate a fundamental idea of economic analysis, i.e. what happens when
something changes.
For interested students, you may wish to read Appendix A which provides a summary of
economic history, including some of the main historical figures who have contributed to the
development of modern economics. Although this material is non-examinable, it is always
beneficial to understand what came before, ahead of studying current developments.
A reminder of your learning outcomes

Having completed this unit and the background reading and activities, you should be able to:
define the concepts of the basic economic problem, scarcity, efficiency, opportunity cost and
specialisation
explain the main features of different economic systems
explain what is meant by the production possibility frontier and analyse its position and
shape.
Unit 2: Microeconomics I: markets and the consumer 27
Aims 28
References cited 29


Microeconomics explores the behaviour of consumers and firms and the determination of
market prices and quantities. Over the next eight weeks you will cover several aspects of
microeconomic theory as well as real-world examples to help you relate key terms and concepts
to everyday life. We begin by exploring markets and the consumer, moving on to firms and
production in the following unit.
Week Unit Section

3 2: Microeconomics I: markets and 2.1: Demand, supply and price determination
4 the consumer 2.2: Elasticities
5 2.3: Consumer and producer surplus, tax and
social welfare
6 2.4: Consumer choice
Section 2.1 describes the individual human objectives and motivation behind demand and
supply curves, and seeks to explain their shape, slope and how interaction between the two
forces should result in a stable equilibrium price and quantity. Section 2.2 deals with elasticities
and their importance in determining the response to changes in the demand and supply
environment. Section 2.3 explains the benefits which can accrue to the consumer and to the
producer and investigates the effect of outside action and ‘interferences’. Section 2.4 discusses
the consumer choice problem of maximising utility subject to a budget constraint, an example
of constrained optimisation.
Aims
This unit aims to:
introduce you to the demand and supply model
introduce you to the concepts of elasticities and their real-life applications
provide tools which support you in the critical evaluation of the impact of taxes on the
consumer, producer and social welfare
explain the consumer choice problem.
Learning outcomes
By the end of this unit, having completed the background readings and activities, you should be
able to:
define the concepts of demand and supply and list their determinants
distinguish between movements along, and shifts of, curves in relation to demand and supply
explain how the price mechanism helps to allocate scarce resources
define price elasticity of demand, price elasticity of supply, income elasticity and cross-price
elasticity and explain their importance for making decisions
identify consumer and producer surplus
explain how taxes influence social welfare
model the consumer choice problem.
Background reading
Anderton, A. and D. Gray (Ed) Economics. (Lancashire: Anderton Press, 2015) 6th edition
[ISBN 9780993133107].
Section 2.1 – Units 8 (pp. 36–43), 11 (pp. 61–68) and 12 (pp. 69–75)
Section 2.2 – Units 9 (pp. 44–53) and 10 (pp. 54–68)
Section 2.3 – Unit 14 (pp. 81–86)
Section 2.4 – Unit 15 (pp. 87–90).
References cited
Arnold, R.A. Economics (Mason, USA: Cengage Learning, 2008) 9th edition, p.64
Free exchange, ‘As price goes up, so does demand: Are the Giffen goods of legend real?’ (July
2007) www.economist.com/free-exchange/2007/07/18/as-price-goes-up-so-does-demand
(last accessed 31/08/2018)
Section 2.1: Demand, supply and price

determination
Introduction 31
Demand and its determinants 31
What influences the amount people want to buy of a 32

certain good?
What influences the amount of a certain good which 37

firms want to supply?
Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, 31
supply and price determination
Introduction
Broadly speaking, a market is a ‘place’ where buyers and sellers ‘meet’ to exchange goods and
services. Some markets, like flower stalls and grocery shops, are limited to a specific time and
location. They require buyers and sellers to meet physically. Others, such as Alibaba, Amazon or
eBay, are online and global. In the latter kind of market, buyers and sellers seldom actually meet.
In all cases, however, for trade to be successful both sides need to agree the price at which the
goods and services should be exchanged. How can we model this behaviour in economics? Well,
this introduces the ideas of demand and supply.
Demand and its determinants

Demand is the relationship between price and quantity which tells us how many units of a certain
good consumers are willing to purchase at every possible price. You need to be careful here because
‘wanting to have’ and ‘willing to buy’ are not necessarily the same thing. Most sports fans would want
to have a ticket for at least one match involving their favourite player or team, but not all of them are
willing, or able, to pay the asking price. Remember that demand includes only those who would buy
the ticket at the price, should they have the opportunity to do so.
Quantity demanded, on the other hand, is the single value which tells us how many units of goods
and services consumers want to buy at a specific price. You should not confuse the two as they
are not the same thing! Figure 2.1 shows a simple demand ‘curve’ (which here is a line!). Note that
demand is the whole line. An example of quantity demanded is six units at a price of £10 per unit.
Appreciate that it is simpler to express demand graphically as a line rather than as a curve,
although in practice the real world is typically non-linear. However, remember our desire
to simplify reality as much as possible while retaining the main characteristics of reality.
Mathematically, it is easier to work with linear functions instead of non-linear functions. In Unit
2 of FP0001 Mathematics and Statistics you cover linear equations so to demonstrate the
connection with this course, we will represent demand curves as lines!
Figure 2.1: A simple demand ‘curve’ (which is actually a line).
With respect to Figure 2.1, let p denote price (on the y-axis) and q denote quantity (on the x-axis).
The inverse demand function is when we represent price as a function of quantity, whereas
the demand function is when we represent quantity as a function of price. Suppose in Figure
2.1 the y-intercept was at £20 (i.e. when q = 0), then the inverse demand function would be:
10
p = 20 – q
6
and the demand function would be:
6
q = 12 – p.
10
This ensures that these pass through the points (0, 20) and (6, 10). Of course, in reality demand
for a good will not follow such a linear equation exactly. However, as an approximating model it
offers a sufficiently simplified way of thinking about demand. Strictly speaking, a demand ’curve’
should be precisely that, i.e. a curve, although linear demand equations (as above) are simpler
for us to deal with unlike non-linear demand equations. As usual, we face the familiar trade-off
between our preference for simplicity and our desire for a realistic model!
What influences the amount people want to buy of a certain good?

The following are the most common determinants of demand.
Price of the product

The law of demand pinpoints a negative (downward) relationship between quantity demanded
and price, as shown in Figure 2.1. This means that people buy more of a good when its
price decreases and buy less when its price increases. As a result, demand for most goods is
downward-sloping. These goods are known as ordinary goods, which includes normal and
inferior goods. Normal goods are all goods for which demand increases when income
increases and falls when income decreases. Cars and holidays are examples of normal goods –
we buy more cars and holidays as our income grows. Inferior goods, on the other hand, are
characterised by decreased demand when income rises, and increased demand when income
falls. Examples of inferior goods include inexpensive foods such as frozen or ready-made meals
– as people’s incomes increase, they can afford to replace inferior goods with better-quality (and
hence more expensive) substitutes.
There are, however, a few exceptions to the law of demand. Unlike normal and inferior goods, the
demand curve for ‘luxury goods’ and ‘Giffen goods’ is upward-sloping.
Luxury goods, such as branded clothes, bags or cars, are often bought by people to signal their
wealth and social position. Therefore, the more they cost, the more they are valued. These can be
considered as ‘status symbols’ and are an example of conspicuous consumption – if people are
seen displaying such goods on their person then others assume they are wealthy.
Giffen goods are often regarded as unusual – the law of demand fails because people
paradoxically consume more of such goods as their prices increase. Many textbooks use the
infamous nineteenth century Irish potato famine as an example. In this instance, potatoes were an
important part of the Irish diet and when the price rose, people had to spend more of their money
on them. As a result, people could no longer afford to buy meat, which meant that they needed
to consume even more potatoes to survive – they were still cheaper than other goods, despite the
increase in price. In this example, ‘Ireland was experiencing a potato famine at the time and the
rising potato price was caused by a supply shortage, making it highly unlikely that people were
able to consume more of them’ – potatoes had become scarcer (The Economist, 2007).
Price of complements (goods which are consumed together) and substitutes

(replacements)
Tennis balls and tennis rackets are complements – if the price of tennis rackets goes up, fewer
people will be able to afford them. As a result of this, fewer people will play tennis and would not
need as many tennis balls as before and, therefore, the demand for tennis balls will fall (Arnold,
2008, p.64). This is shown in Figure 2.2 – when the price of a good increases, the demand curve
for complementary goods shifts to the left.
Figure 2.2: Impact of the change in price of tennis rackets on the demand for tennis
balls. The demand curve for tennis balls shifts to the left from D to D’.
Buses and private cars are substitutes – if the price of maintaining a car increased, fewer people
would be able to afford to drive one. They would, therefore, need to find a cheaper alternative
method of transport and so the demand for buses, for example, would go up. This is shown in Figure
2.3 – when the price of a good increases, the demand curve for substitute goods shifts to the right.
Figure 2.3: Impact of the change in the price of private cars on the demand for public
transport.
The demand curve for public transport shifts to the right from D to D’.
Income
The amount of money you earn determines what you can afford and in which quantities. If
you start earning more money, you can afford a better car and your demand for better cars will
increase. You can also afford better quality food and, therefore, instead of consuming cheap fast
food, for example, you may decide to switch to organic meat and vegetables (which are usually
more expensive). As a result, your demand for fast food will decrease.
The goods for which demand goes up as income increases remember are called normal goods.
Inferior goods, on the other hand, are goods for which demand decreases when income
increases. This is shown in Figure 2.4 – when income increases, the demand curve shifts to the
right for normal goods and shifts to the left for inferior goods.
Figure 2.4: Impact of an increase in income on the demand for normal and inferior
goods. When income increases the demand curve for normal goods shifts to the right
(from D to D’), while for inferior goods it shifts to the left (again, from D to D’).
Wealth
Wealth, or your net worth, means the difference between the value of everything you own (for
example, cars, houses and shares in companies, i.e. assets) and the value of everything you owe
(for example, mortgages, credit card debt and other loans, i.e. liabilities). The higher the value of
your wealth (i.e. the richer you are), the higher your credit rating is (ceteris paribus1) which means
that banks are more likely to give you a loan (or allow you to borrow more). Therefore, even if
you do not have enough liquid funds now to buy something (perhaps your wealth is tied up in
long-term investments), you can borrow money and pay it back later – therefore your spending
decisions are more flexible.
1
Latin term for ‘other things equal’. This means that other things which could change are, for the moment, assumed not
to. The term allows us to isolate the relationship between two economic variables controlling for all other variables.
For example, the demand curve represents the effect of a price change on the quantity demanded assuming all other
determinants of demand (such as income, tastes or preferences) remain unchanged. Beware, though, that in the real
world other things are rarely equal -– when one variable changes there is usually a change in at least one other variable!
Nevertheless, when conducting economic analysis ‘ceteris paribus’ is a very convenient way of investigating the effect of one
variable on another without the complexity of worrying about other variables.
Note wealth is different from income. Wealth is a stock variable, i.e. wealth is fixed at a particular
point in time, while income is a flow variable considered over a period of time, such as annual
income. Of course, changes to your net, i.e. after-tax, income may change your wealth.
Tastes, preferences, advertising

People are easily influenced by current trends and celebrity endorsements, therefore their
demand for goods changes with them. Product placements in television shows, movies and
video games can affect demand – people see the products and may be persuaded to buy them!
Expectations of future price increases

If people expect prices of goods to increase (known as inflation, covered in Section 4.4), they
sometimes buy them now for consumption later and, therefore, save money.
Climate
Some goods (such as ice-cream and winter coats) are only needed in certain weather conditions.
For example, winter coats are usually bought during cold winter months rather than in the
middle of a hot summer.
Population
Total market demand for goods increases with a higher number of people (for example, due to
a higher birth rate, or immigration) – there might be only one pharmacy in a small village, but
there would be many more in a larger city where there is a larger population and, therefore, more
demand for pharmaceutical goods and services.
Demographics
Young people and old people have completely different needs. Therefore, we observe more bars
and nightclubs in cities mainly inhabited by students than in areas comprised mainly of pensioners.
Shifts versus movements along the demand curve

Demand is not constant over time. It varies as its determinants change. For example, if the price
of a good decreases, ceteris paribus people would be able to afford more units and the quantity
demanded would increase. This would result in a movement along the demand curve. When
any other factor changes, such as preferences, income or population, the whole demand curve
shifts. For example, if there are more children born in a town, the demand for toys would increase
(in other words, the quantity demanded at every single price increases) and so the demand
curve would shift to the right. Figure 2.5 illustrates the distinction between movements along a
demand curve and a shift of the demand curve.
Figure 2.5: The difference between movements along the demand curve and a shift
of the demand curve. A price change leads to a movement along the demand curve,
while a change in any of the other determinants of demand leads to a shift of the
demand curve (here, from D to D’).
Supply and its determinants

Supply is the relationship between price and quantity which tells us how many units of a
certain good firms are willing to sell at every possible price. As with demand, it is important to
distinguish between supply and the quantity supplied. Quantity supplied, similar to quantity
demanded, is the single value which tells us how many units of goods or services firms want to
sell at a specific price. Figure 2.6 shows a simple supply ‘curve’ (which, again, we depict as a line
for mathematical simplicity). Note that supply is the whole line. An example of quantity supplied
is twenty units at a price of £80 per unit.
Figure 2.6: A simple supply ‘curve’ (which is actually a line).

The inverse supply function is when we represent price as a function of quantity, whereas the
supply function is when we represent quantity as a function of price. Suppose in Figure 2.6 the
y-intercept was at £0 (i.e. when q = 0), then the inverse supply function would be:
p = 4q
and the supply function would be:
1
q= p.
4
This ensures that these pass through the points (0, 0) and (20, 80). As with demand, in reality
supply of a good will not follow such a linear equation exactly. However, as an approximating
model it offers a simplified way of thinking about supply.
Note how (inverse) demand functions are usually downward-sloping as represented by a
negative slope coefficient, while (inverse) supply functions are upward-sloping as represented
by a positive slope coefficient. Consumers demand more of a product as its price decreases;
producers are willing to supply more of a product as its price increases.
What influences the amount of a certain good which firms want

to supply?
The following are the most common determinants of supply:
Price of the product

The law of supply states that there is a positive (upward) relationship between price and quantity
supplied. This means that firms supply more goods when the price increases and fewer goods
when the price decreases. As a result, the supply curve is upward-sloping. With a higher price,
firms receive greater revenue per unit of product sold.
Technology
The better the technology available to firms, the more efficient is the process of production.
Fewer resources are used up per item, which results in a lower per-unit cost and the ability to
supply more at the same price.
Weather conditions
Production of some goods, agricultural ones in particular, greatly depends on weather
conditions. For example, in years of drought or excessive flooding, food harvests are limited.
During good years, on the other hand, farmers enjoy bumper crops.
Cost of inputs
The amount of goods which suppliers are willing to offer at any given price depends first and
foremost on their costs of production. These costs, in turn, mainly depend on the cost of inputs –
labour, capital and raw materials. If the cost of any of these inputs increases, then the cost of the
whole production process will increase, and therefore fewer goods would be offered at the old price.
Access to raw materials

Some raw materials, such as diamonds and amber, are very rare. The more limited they are, the
higher their cost.
Regulations
The supply of certain goods or services may be regulated by government or other institutions.
Common examples include goods, such as electricity, and services, such as rented
accommodation. Governments may also implement some import quantity quotas.
Number of firms in the industry

The more firms there are which can supply a certain product to the market, the greater the total
quantity supplied of that product at any given price will be. With an increased number of firms,
the supply schedule shifts to the right, as shown in Figure 2.7.
(Note: supply can be defined for an individual firm, for a few firms, or for the whole market.
Market supply is the summation of individual supplies.)
Figure 2.7: A shift of the supply curve caused by new firms entering the market. More
firms means more total production and an outward shift of the supply curve, from S to
S’.
Taxes and subsidies

Most countries impose taxes (compulsory payments collected by the government) on at least
some goods and services. Relatively fewer countries, however, offer subsidies (monetary benefits
given by the government). Nevertheless, both taxes and subsidies effectively change the costs
of production faced by firms – taxes increase costs while subsidies lower costs. For example,
a higher tax on alcohol would limit the amount supplied at a given price, while agricultural
subsidies would lower the price of certain foodstuffs.
Shifts versus movements along the supply curve

Supply, like demand, is not constant over time. It varies as its determinants change. For example,
if the price of a good increases, ceteris paribus firms would be willing to offer more units and the
quantity supplied would increase. This would result in a movement along the supply curve. When
any other factor changes, such as technology, weather conditions or the cost of inputs, the whole
supply curve shifts. For example, if the price of labour decreases, textile factories are able to employ
more workers and the amount of clothes produced increases (in other words, the quantity supplied
at every single price increases – the supply curve shifts to the right). Figure 2.8 illustrates the
distinction between movements along a supply curve and a shift of the supply curve.
Figure 2.8: The difference between movements along the supply curve and a shift of
the supply curve. A price change leads to a movement along the supply curve, while a
change in any of the other determinants of supply leads to a shift of the supply curve,
such as from S to S’.
ACTIVITY 2.1
By referring to the above determinants of supply, explain how:
a. the supply of coffee beans could decrease
b. the supply of commercial flights could increase.
ACTIVITY 2.2
Consider the market for fossil fuels (oil, coal and gas). For each case below, explain
whether there is a movement along the supply curve (including the direction of the
movement) or a shift of the supply curve (to the left or right).
a. The government imposes a pollution tax on the use of fossil fuels.
b. New oil, coal and gas fields are discovered.
c. Consumers becoming more environmentally conscious.
d. The price of energy increases.
e. Prolonged very cold weather.
Determining equilibrium
Let us recall what we have learned so far:
A market is a place (either physical or virtual) where buyers and sellers meet to exchange
goods and services.
Demand is the relationship between price and quantity which tells how many units of a
certain good consumers are willing to buy at every possible price.
Supply is the relationship between price and quantity which tells us how many units of a
certain good firms are willing to produce at every possible price.
Movements along the curves are caused by price changes, while changes of other demand or
supply determinants result in shifts of the curves.
It is no secret that sellers and buyers often have different valuations of various goods and services
which they either own or want to own. So, what determines the actual price and amount of
goods traded in the market? It is the price mechanism – the ‘invisible hand’ which responds to
changes in demand and/or supply of a certain good or service to maintain the balance in the
market. The price mechanism has three main functions:
rationing – it allocates scarce resources to those who are willing to pay the most for them
signalling – changing prices indicate changes in market conditions (demand and/or supply)
incentivising – changing prices give incentives to sellers to either increase or decrease their
production.
In short, the price mechanism is responsible for maintaining equilibrium in different markets.
Equilibrium is when the demand for a certain good is exactly the same as the supply of that
good, i.e. where the demand and supply curves intersect.
Section 2.3.3 of FP0001 Mathematics and Statistics shows the application of simultaneous
equations to demand and supply analysis in economics. Figure 2.9 illustrates, graphically, the
determination of the equilibrium point as the intersection of the demand and supply curves (or
rather lines!).
p
equilibrium point S
O q
Figure 2.9: Determining the equilibrium point, as shown in Section 2.3.3 of FP0001
Mathematics and Statistics.
ACTIVITY 2.3
Assume that the equations for demand and supply of a specific good are:
qD = 100 – 3p and qS = 4 + 5p.
Calculate the equilibrium price and quantity.
In other words, when in equilibrium, economists would say that the ‘market clears’. There is
neither excess demand nor excess supply. Existence of either excess demand or excess supply is
referred to as disequilibrium – a situation where the quantity demanded is different from the
quantity supplied so the market cannot clear.
Excess demand happens when, at the given price, people are willing to buy more goods than
producers are willing to offer. In this case, the price will continue to rise until equilibrium is
reached. Excess supply, on the other hand, is a situation when, at the given price, firms are
offering more goods than consumers are willing to buy. In this case, the price will fall until the
market clears again. These cases are illustrated in Figure 2.10.
Figure 2.10: Two cases of disequilibrium in a market: excess demand (demand exceeds
supply) when the price is below the market equilibrium, and excess supply (supply
exceeds demand) when the price is above the market equilibrium.
Price adjustments: worked examples

Example 2.1: Taxi services
The taxi industry is initially in equilibrium at price p0 and quantity q0 in Figure 2.11, i.e. the
intersection of the demand curve, D, and supply curve, S. Suppose that the price of petrol
decreases. In this case, taxi companies incur lower costs per kilometre travelled. As a result, they
are able to offer cheaper prices for their services. We can illustrate this situation as an overall shift
of the supply curve to the right, from S to S’.
However, at the old equilibrium price, p0, there is an excess supply of taxi services. Therefore,
the price will fall, increasing quantity demanded and decreasing quantity supplied (here we
have movement along the demand curve) until the new equilibrium is reached at price p1 and
quantity q1, i.e. the intersection of the (original) demand curve, D, and the new supply curve, S’.
The equilibrium price has dropped while the equilibrium quantity has increased.
Figure 2.11: Impact of lower petrol prices on the taxi market. The supply curve shifts
from S to S’, ultimately leading to a new equilibrium with a lower price and a higher
quantity.
Example 2.2: Olive oil

Suppose the olive oil industry is originally in equilibrium with price p0 and quantity q0 in Figure
2.12, i.e. the intersection of the demand curve, D, and supply curve, S. However, the government
now decides to launch a campaign promoting a better and healthier lifestyle. As a result,
demand for olive oil greatly increases. This situation can be illustrated by a shift of the demand
curve to the right from D to D’. At the old price, however, there is excess demand and firms
cannot supply as much as consumers would want to buy. Therefore, the price starts increasing,
reducing the quantity demanded and increasing the quantity supplied. The price keeps rising
until the new equilibrium is reached at price p1 and quantity q1, i.e. the intersection of the
new demand curve, D’, and the (original) supply curve, S. Both the equilibrium price and the
equilibrium quantity have increased. These changes are shown in Figure 2.12.
Figure 2.12: Impact of a government health campaign on the olive oil market. The
demand curve shifts from D to D’, ultimately leading to a new equilibrium with a
higher price and a higher quantity.
In real life, markets are rarely in equilibrium and so prices are constantly adjusting due to excess
demand and excess supply.
Price controls
In certain cases, governments may want to intervene in markets to control prices. They usually do
this by setting either the minimum price or maximum price which can be charged for particular
goods.
A minimum price, also known as a price floor, is the legally-established threshold value below
which the market price cannot fall. It will, however, only have an impact on the market, when the
minimum price is set above the equilibrium price (otherwise the market price would settle at
the equilibrium price, which would be above the price floor). As a result, excess supply would be
created. A well-known example of a price floor is the minimum wage, which will be considered
in Section 3.4 in the context of labour markets.
A maximum price, also known as a price ceiling, is the legally-established threshold value
above which the market price cannot rise. It will, however, only have an impact on the market
when the maximum price is set below the current equilibrium price (otherwise the market price
would settle at the equilibrium price, which would be below the price ceiling). As a result, excess
demand would be created.
A well-known example of this is rent control, as illustrated in Figure 2.13. Suppose the
government imposes a maximum price pmax which can be charged for apartments, that is
(significantly) below the current equilibrium price p*. The government’s objective is to increase
the affordability of accommodation. The number of people willing to rent an apartment
increases while the amount of apartments offered decreases. As a result, there are plenty of
people willing to pay but are still unable to rent an apartment.
Without a price ceiling, the ‘invisible hand’ would tend to raise the price to p*, therefore reducing
demand and increasing supply.
Figure 2.13: Excess demand as a result of rent control. The price ceiling of pmax is below
the market equilibrium, p*, creating excess demand.
A similar situation to the one described above happened in New York when soldiers returned
home at the end of World War II. Another example of a maximum price would be the Sri Lankan
government’s introduction, in 2008, of price restrictions after the price of rice significantly increased.
Interrelationships between markets

Frequently, changes in one market will cause changes in other markets. Therefore, economists
say that markets are interrelated. Consider the following example.
Suppose that, in a year, the harvesting of olives was extremely bad. The immediate consequence
of this would be a much higher price of olives due to the limited supply. This is illustrated in
Figure 2.14, with the supply curve shifting to the left from S to S’. However, the price of olive oil
and other cooking oils would also be affected.
Figure 2.14: Impact of a bad olive harvest on the olive market. The supply curve shifts
from S to S’.
Olive oil, as its name suggests, is a product mainly made from olives. Therefore, olives are inputs
in olive oil production. With a bad harvest, the price of olives increases, meaning that a core input
for the olive oil producers is more expensive and harder to obtain (as there was a bad harvest,
olives become scarcer). Therefore, the supply curve of olive oil shifts to the left. As a result, olive
oil gets more expensive and fewer units are supplied, as shown in Figure 2.15 where the supply
curve of olive oil shifts from S to S’, resulting in a change in equilibrium price (from p0 to p1) and
equilibrium quantity (from q0 to q1).
Figure 2.15: Impact of a decrease in the availability of olives on the olive oil market.
The increase in the cost of production of olive oil shifts the supply curve from S to S’,
resulting in a new equilibrium with a higher price and lower quantity.
Other cooking oils are close substitutes for olive oil – i.e. sunflower oil performs a very similar
function to olive oil, and so it can easily act as a substitute. As the price of olive oil increased
significantly, some consumers will no longer be able to afford olive oil so they will switch to
cheaper substitutes (note that we assume that olive oil is more expensive than other cooking
oils, which is quite a realistic assumption). In this case, more consumers will demand other
cooking oils, so the demand curve for these substitute oils will shift to the right. As a result,
both the equilibrium price and quantity of other cooking oils will increase, as shown in Figure
2.16 where the demand curve of other cooking oils shifts from D to D’, resulting in a change in
equilibrium price (from p0 to p1) and equilibrium quantity (from q0 to q1).
Figure 2.16: Impact of an increase in the price of olive oil on the market for other
cooking oils. The demand curve for these substitute goods shifts from D to D’,
resulting in a new equilibrium with a higher price and a higher quantity.
Recall the earlier remark that rarely in life are ‘other things equal’ (ceteris paribus). Indeed, the
interrelationships between markets show how a change in one market can have knock-on
consequences for equilibrium price and quantity in other markets. These small examples help to
illustrate the complexity of the real world in which prices are constantly adjusting due to excess
demand and excess supply.
ACTIVITY 2.4
Assuming the market is initially in equilibrium, how will the following changes affect the
market price of petrol-powered cars? Support your answers in each case using a suitable
diagram.
a. The price of electric-powered cars decreases.
b. The price of petrol decreases.
c. Public transport becomes unreliable due to strike action by trade unions.
d. Raw materials to produce petrol-powered cars become more expensive.
Section 2.2: Elasticities
Introduction 47
Elasticity along a demand curve 51
Determinants of price elasticities 52
Price elasticity of demand and supply: 53

short run vs. long run
Why are elasticities so important? 54

Unit 2: Microeconomics I: markets and the consumer • Section 2.2: Elasticities 47
Introduction
Elasticity is the responsiveness of one variable to changes in a different variable. In economics
we distinguish between price elasticity of demand, price elasticity of supply, income
elasticity of demand and cross-price elasticity of demand.
The value of the elasticity, in absolute terms, varies between zero and infinity. The sign of the
elasticity depends on the directions in which the two variables are moving. If both of them move
in the same direction, the elasticity is positive. If they move in opposite directions, however, the
sign of the elasticity is negative. The sign only shows the direction of the movement, it does not
show the actual elasticity.
Definitions
Let us explain the concept of elasticities further using price elasticity of demand. The price
elasticity of demand (PED) is the responsiveness of quantity demanded to changes in the price
of a good.
The PED for normal and inferior goods would be negative because when the price increases, the
quantity demanded decreases. Therefore, the two variables move in opposite directions.
The PED for Giffen goods (these are goods where people consume more as the price increases),
on the other hand, would be positive because when the price of Giffen goods increases, the
quantity demanded increases as well. The two variables move in the same direction.
We define the PED as follows, where P denotes price and Qd denotes quantity demanded:
percentage change in quantity demanded ∆Qd /Qd = ∆Qd . P .

PED =
percentage change in price ∆P/P ∆P Qd
Note that the triangle symbol (the Greek capital letter ‘delta’) in the above formula denotes
‘change’. The demand for goods is said to be elastic if the percentage change in quantity
demanded is greater than the percentage change in the price. In this case the PED (ignoring the
sign, i.e. in absolute terms) is greater than 1. A 1 per cent increase in price leads to a reduction in
quantity demanded of more than 1 per cent.
The demand for goods is said to be inelastic if the percentage change in quantity demanded
is less than the percentage change in the price. In this case the PED (again, in absolute terms) is
less than 1. A 1 per cent increase in price leads to a reduction in quantity demanded of less than
1 per cent.
The demand for goods is said to be unitary elastic if the percentage change in quantity
demanded is equal to the percentage change in price. In this case the PED (again, in absolute
terms) is equal to 1. Therefore a 1 per cent increase in price leads to a reduction in quantity
demanded of 1 per cent (the effects offset each other).
When (very) small changes in price bring about (very) large changes in quantity demanded we
say that demand is almost perfectly (or infinitely) elastic (the PED, in absolute terms, is almost
infinite). When quantity demanded does not respond at all to changes in price, we say that
demand is perfectly inelastic (the PED is 0). These cases are shown in Figures 2.17 and 2.18,
respectively.
Figure 2.17: Perfect elasticity (or infinite elasticity) occurs when consumers demand
an unlimited quantity at a particular price. The demand curve is horizontal.
Figure 2.18: Perfect inelasticity (or zero elasticity) occurs when there is complete price
unresponsiveness, i.e. quantity demanded is fixed regardless of price. The demand
curve is vertical.
The same rules and nomenclature apply to other types of elasticities.

The price elasticity of supply (PES) is the responsiveness of quantity supplied to the changes
in the price of a good, defined as:
percentage change in quantity supplied ∆Qs /Qs ∆Qs . P

PES = percentage change in price = .
∆P/P ∆P Qs
Usually, price elasticities of supply are positive as higher prices incentivise producers to supply
larger quantities.
The income elasticity of demand (YED) is the responsiveness of demand, D, to changes in
income, Y, defined as:
percentage change in demand ∆D/D ∆D
YED = percentage change in income = ∆Y/Y = ∆Y .Y .
D
Note that, as is common practice in economic formulae, the letter Y is used to refer to income.
Normal goods have positive YEDs because demand for them increases when income increases.
For example, people tend to spend more money on holidays abroad when their salaries (i.e.
incomes) increase. Inferior goods, on the other hand, have negative YEDs – when incomes rise,
people demand less fast food, for example, because they switch to healthier, more expensive
options which they can now afford.
The cross-price elasticity of demand (XED) is the responsiveness of quantity demanded for
one good to changes in the price of another, defined as (for goods A and B):
percentage change in demand for good A ∆QA /QA ∆Qd PB

XED = = = . .
percentage change in price of good B ∆PB /PB ∆PB QA
Substitute goods are characterised by positive XEDs (remember, a substitute good is a good
which can be used in place of another). Private and public transport, for example, can be
regarded as (imperfect) substitutes. When the price of cars goes up, people still need to travel
so they would be looking for cheaper alternatives. As a result, the demand for public transport
would increase. Figure 2.19 shows the relationship between the price of cars and the quantity
demanded of public transport. As substitutes, the XED is positive.
Figure 2.19: When the price of cars increases, the quantity of public transport
demanded also increases. The cross-price elasticity of demand is positive.
Complementary goods, on the other hand, are characterised by negative XEDs (remember,
complements are goods which are consumed together).
As mentioned before, tennis rackets and tennis balls are complements. When the price of tennis
rackets increases, fewer people would play tennis and so they would require fewer tennis balls.
Therefore, the demand for tennis balls would decrease. Figure 2.20 shows the relationship
between the price of tennis rackets and the quantity demanded of tennis balls. As complements,
the XED is negative.
Figure 2.20: When the price of tennis rackets increases, the quantity of tennis balls
demanded decreases. The cross-price elasticity of demand is negative.
Empirical example
Due to an increase in air passenger tax, a small low-cost airline had to raise their one-way ticket
prices from £50 to £57. It was observed that the number of customers travelling on that route
decreased from 1.2 million to 0.95 million.
What is the price elasticity of demand of the flight services offered by this airline?
Step-by-step approach
The price has increased by £7, which is equivalent to a 14 per cent increase ((£57– £50)/£50 ×
100%).
The quantity demanded has fallen by 0.25 million which is equivalent to a 20.8 per cent
decrease in the number of passengers ((0.95 million – 1.2 million)/1.2 million × 100%). We now
calculate the PED:
percentage change in quantity demanded –20.8%
PED = = = –1.49.
percentage change in price 14%
Therefore, the PED = –1.49. Do not forget about the sign! The PED is negative here as flights are
normal goods (although as this is for a low-cost airline, i.e. a budget airline, this might in fact be
an inferior good – see below). This means that a 1 per cent increase in price coincides with a 1.49
per cent decrease in quantity demanded.
Is this demand elastic or inelastic? Why?

Since the PED is greater than 1 (in absolute terms) this suggests that demand is elastic – people
reduce the number of flights they make proportionately more than the increase in price. Why?
People usually use low-cost airlines for leisure travelling purposes, such as holidays or visiting
friends (rather than for business) so they pay more attention to the cost of the journey than
people travelling for work reasons (who must travel, and usually use scheduled airlines anyway,
which are more expensive).
Suppose that, a year later, there was no tax increase so prices stayed at £57 for a one-way ticket.
However, the airline noticed that the number of people travelling with them had now increased
to 1.1 million. The airline suspected that it was caused by the national average 12 per cent
increase in salaries (incomes). Calculate the income elasticity of demand for the services offered
by this airline. Are the changes elastic or inelastic?
Step-by-step approach
The number of passengers increased by 0.15 million which is equivalent to a 16 per cent increase
((1.1 million - 0.95 million)/0.95 million x 100%). Income has increased by an average of 12 per
cent. We now calculate the YED:
percentage change in demand 16%
YED = = = 1.33.
percentage change in income 12%
Since 1.33 is greater than 1, we have elastic changes in demand. A 1 per cent increase in income
is associated with a 1.33 per cent increase in demand.
So, are flights a normal or inferior good? Based on the above calculation, since the income
elasticity of demand is positive for airline tickets, which means that the number of tickets bought
increases with income, we conclude this is a normal (rather than an inferior) good.
Elasticity along a demand curve

Note that elasticity varies along any straight line demand curve, ranging from zero (perfectly
inelastic) at the intersection with the horizontal axis, to infinity (perfectly elastic) at the
intersection with the vertical axis. At the midpoint of the straight line demand curve we reach
the unitary elastic point. Above the midpoint elasticity is greater than one (therefore, firms should
lower the price to increase revenue), while below the midpoint demand is inelastic (therefore,
firms should raise the price to increase revenue). Elasticity along a straight line demand curve is
illustrated in Figure 2.21.
Figure 2.21: Elasticity along a straight line demand curve.
Example 2.3
We can see how the price elasticity of demand changes as we move along the demand curve
(which, for simplicity, we assume is linear). Consider the demand schedule in the first two
columns of the table below. As we proceed from one row to the next, the percentage change in
quantity demanded and price, respectively, are calculated. The ratio of these percentage changes
is then the price elasticity of demand, which is then classified as being either ‘elastic’ or ‘inelastic’.
Quantity Percentage Percentage Price elasticity

Price, P Classification
demanded, Qd change in Qd change in P of demand
1 10 – – – –
2 9 100.00% –10.00% –10.00 Elastic
3 8 50.00% –11.11% –4.50 Elastic
4 7 33.33% –12.50% –2.67 Elastic
5 6 25.00% –14.29% –1.75 Elastic
6 5 20.00% –16.67% –1.20 Elastic
7 4 16.67% –20.00% –0.83 Inelastic
8 3 14.29% –25.00% –0.57 Inelastic
9 2 12.50% –33.33% –0.38 Inelastic
10 1 11.11% –50.00% –0.22 Inelastic
The price elasticity of demand changes quite dramatically, from –10.00 to –0.22. This means that
for very high prices, such as between 10 and 9, a 1 per cent decrease in price will lead to a 10
per cent increase in the quantity demanded. At the other extreme, at relatively low prices, from
2 to 1, a 1 per cent decrease in price will lead to only a 0.22 per cent increase in the quantity
demanded. Therefore, here elasticity falls as the price falls.
Determinants of price elasticities

So far, we have established how elasticities represent degrees of responsiveness to changes in
price. However, what determines the actual elasticity? We consider PED and PES.
Determinants of the PED:

availability of close substitutes – the more substitutes there are, the more choice for
customers who can switch to other similar options relatively easily when the price of a given
good increases
time horizon (short run vs. long run) – immediately after a price increase, people may still
buy the original good but, with time, they will find cheaper alternatives and switch to them
percentage of income spent on those goods – if the goods people are buying constitute
only a small proportion of their income, they are not that concerned with price changes;
however, when most of their income is spent on a certain type of good (for example,
housing) they tend to be very sensitive to any price changes
type of goods (such as habit-forming, necessities, luxury goods) – the more used to a certain
good/brand people become, the more difficult it is for them to switch to other options
(people develop an inertia to switch)
brand image – people are willing to pay more for goods which have an established
reputation, i.e. branded goods carry a price premium which is why firms try so hard to build a
strong and recognisable brand image!
Determinants of the PES:

number of suppliers – the more suppliers there are in the market, the tougher the
competition is between them and the more elastic the supply
time horizon (short run vs. long run) – the longer the time period, the easier it is for firms to
adjust to market changes
ease of storing extra units – if firms can store the goods they produce as inventory then
they would be more flexible in responding to market changes
productive capacity – the greater the spare capacity, the easier it is for firms to increase
production, so supply becomes more flexible
length of production period – the quicker the production process, the easier it becomes to
respond to price changes
perishability of the product – some foods are very hard to store (in terms of staying fresh,
like fruit, vegetables and flowers), and so their supply tends to be more inelastic.
Price elasticity of demand and supply: short run vs. long run
Over time price elasticities can change. As such it is possible to consider how the PED and PES
change between the short run and the long run as time allows for an adjustment to elasticities.
We begin with PED. The longer the time period allowed for adjustment, the greater the PED.
Consider Figure 2.22. We begin in an equilibrium situation with market price Pe and quantity
demanded Qe. Suppose the price increases to P1. In the short run, demand decreases to Q1. Over
time, which allows consumers to adjust (perhaps discovering substitute goods), the demand curve
rotates around the original equilibrium point, initially from D1 to D2, and then in the long run all the
way to D3. Note how the demand curve gets flatter over time, reflecting the greater PED.
Figure 2.22: Short-run and long-run price elasticity of demand.

We now consider PES. The longer the time period allowed for adjustment, the greater the PES.
Consider Figure 2.23. We begin with price Pe and quantity supplied Qe. Initially, assume that
suppliers are unable to alter production in the very short run, even when there is a price increase
– therefore, the initial supply curve is vertical. Following a price increase to P1, over time the
supply curve adjusts by rotating around the original equilibrium point, moving from S1 to S2, and
finally to S3 in the long run. The quantity supplied has now increased.
Figure 2.23: Short-run and long-run price elasticity of supply.
Why are elasticities so important?

Elasticities are widely used by firms when determining their optimal pricing strategies. By
knowing how people will react to price changes, they can predict (and, therefore, maximise) their
future profits. Firms also use estimates of cross-price elasticities to find out the extent of other
firms’ behaviour which will influence their products. For example, if company A’s close competitor
drastically decreases its prices, company A will most probably also have to cut its own prices,
otherwise it may risk losing many customers. Moreover, by knowing income elasticity of demand,
firms can adjust their output decisions to current and expected economic growth rates, and
hence income growth rates.
Governments also use elasticities, for example, to estimate the impact of taxes on both market
prices and consumers’ spending decisions. Governments will aim to maximise their revenue by
taxing products whose sales at the higher taxed rate will fall by a smaller percentage than the
percentage rise in price (i.e. goods with inelastic demand). In other words, governments will tax
products where they assume that the taxpayer will reduce purchases by less than the tax, for
example tobacco, alcohol or petrol. Consumers will (reluctantly) tolerate the tax and continue to
buy at only slightly reduced levels. There would be no point in a government taxing a product
with a highly-elastic demand. People would simply cut back drastically on their purchases and
the tax would not generate much revenue.
Relationship between elasticity and total revenues

We have seen that for linear demand curves elasticity falls as the price falls. Consequently, the
type of demand (elastic or inelastic) changes along the (linear) demand curve. Here we examine
the impact on the total revenue of the firm, which is simply price multiplied by quantity,
i.e. P x Qd .
Quantity Total revenue, Price elasticity of

Price, P Classification
demanded, Qd P x Qd demand
1 10 10 – –
2 9 18 –10.00 Elastic
3 8 24 –4.50 Elastic
4 7 28 –2.67 Elastic
5 6 30 –1.75 Elastic
6 5 30 –1.20 Elastic
7 4 28 –0.83 Inelastic
10 1 10 –0.22 Inelastic
We see that in the elastic range of the demand curve total revenue increases when price
decreases (consumers increase demand by a greater percentage than the percentage reduction
in price), whereas in the inelastic range of the demand curve total revenue increases when price
increases (consumers decrease demand by a smaller percentage than the percentage increase in
price). Figure 2.24 shows the relationship between price elasticity of demand and total revenue.
Figure 2.24: The relationship between price elasticity of demand and total revenue.
When demand is elastic, total revenue can be increased by reducing price; when
demand is inelastic, total revenue can be increased by increasing price. At a point
where demand is unit elastic, total revenue does not change with a change in price, as
the effect on total revenue due to the price change is exactly offset by the change in
quantity demanded.
For unitary elastic demand the effects of price and demand changes exactly offset each other,
resulting in no change to total revenue. Constant price elasticity of demand corresponds to a
demand curve which actually curves in such a way that the PED remains constant. An example is
shown in Figure 2.25. For example, at points A and B we have that the total revenue is the same,
i.e. P1Q1 = P2Q2 = 32.
Figure 2.25: Here the demand curve is structured in such a way that total revenue
remains constant regardless of price. This is a situation of unit elasticity everywhere.
We can summarise the relationship between price changes, PED and total revenue as follows:
Figure 2.26: The effect of price elasticity of demand on total revenue when
prices change.
So, there is also a close relationship between price elasticity of demand and firms’ revenues. The
total amount that people spend is exactly the same as the total sales revenue that firms receive.
As a result, the formula for price elasticity of demand could be stated in terms of percentage
changes in firms’ sales revenue rather than in terms of percentage changes in demand.
ACTIVITY 2.5
Write out the table below and complete the empty cells by reporting the different types
of elasticities numerically and commenting on the nature of the demand and supply
curves (i.e. horizontal, vertical, upward-sloping or downward-sloping).
Elasticity in Corresponding Corresponding
absolute terms demand curve supply curve
Perfectly inelastic
Inelastic <1 Downward-sloping Upward-sloping
Unitary elastic
Elastic >1
Perfectly elastic
ACTIVITY 2.6
A bus operator knows the following elasticities of demand: (i) PED = –1.2; (ii) XED with
respect to train fares = 2.1; and (iii) YED = –0.5.
The bus operator is contemplating shutting down a loss-making service between two
cities (which are already connected by rail). Discuss how the demand elasticities could
help the bus operator make a decision on the future of the bus route.
Are there any other factors which could help management make a decision? (Think
about the options available to the bus operator, i.e. increase or decrease price, and how
this would affect demand.)
ACTIVITY 2.7
The Organisation of Petroleum Exporting Countries (OPEC) is a group of major oil-
producing countries who collectively decide on each member’s supply of oil to the
market. How does the price elasticity of demand affect OPEC’s decision to affect the price
of oil through its supply decision?
ACTIVITY 2.8
Explain why we would expect the price elasticity of demand and the price elasticity of
supply to change in the long run.
58
Section 2.3: Consumer and producer

surplus, tax and social welfare
Introduction 59
Consumer surplus and producer surplus 59
Taxes 62
Deadweight loss 66
So why do governments impose taxes? 68

Unit 2: Microeconomics I: markets and the consumer • Section 2.3: Consumer 59
and producer surplus, tax and social welfare
Introduction
Having introduced the concepts of demand and supply in Section 2.1, we now examine social
welfare by considering the surpluses which accrue to consumers and producers. The role
of government has been briefly mentioned previously, although in this section we formally
introduce the role of taxation (levied by governments), the different types of taxation, as well as
the impact taxation has on social welfare.
Consumer surplus and producer surplus

Social welfare (also known as the economic surplus) is the total (combined) welfare of
consumers, producers and government.
Consumer surplus is the welfare gain to consumers resulting from the fact that some
consumers pay less for the good than their maximum willingness to pay, i.e. their maximum
valuation of the good. Remember that a demand curve shows how many units of a certain
good consumers are willing to purchase at every possible price, therefore the demand curve
reflects consumers’ maximum valuations.
Graphically, Figure 2.27 depicts a (linear) demand curve. If the market price is P, then the
consumer surplus is given by the area below the demand curve and above the market price paid,
i.e. the red shaded area. By paying a price below their valuation, the consumer gains additional
satisfaction, or utility, as they end up spending less money on the good than they would have
been prepared to pay.
Consumer surplus is maximised when free-market forces of demand and supply are allowed to
‘battle it out’ in a setting of perfect competition (perfect competition is a type of market structure
which will be discussed in Section 3.2). For this section we will assume a perfectly competitive
market, while in Section 3.2 we will re-visit consumer surplus when the market is not perfectly
competitive.
Figure 2.27: The red shaded area represents consumer surplus for market equilibrium
price P. At the equilibrium price the consumer satisfaction (or utility) from
consumption of the marginal unit of the good is equal to the price P. All previous units
resulted in utility greater than the price P, reflecting that consumers would have been
willing to pay more for these units of the product than the actual market equilibrium
price.
As you may already have realised, consumer surplus varies with the price. When the price goes
up, the consumer surplus decreases; when the price decreases the consumer surplus increases
(as consumers, paying less for something makes us happy; paying more for something makes us
unhappy!).
Figure 2.28 assumes that the supply curve shifts from S to S1, leading to an increase in the market
price from P to P’. Assuming no change in the demand curve, this new market equilibrium price is
higher, which inevitably reduces the area below the demand curve and above the (now higher)
price, and so there is a reduction in the consumer surplus.
The grey shaded area represents the loss of consumer surplus as a result of the supply curve shift.
Remember the determinants of supply in Section 2.1 which offer possible explanations for the
supply curve shift seen in Figure 2.28 (for example, weather conditions, cost of inputs and access
to raw materials).
Figure 2.28: A reduction in consumer surplus caused by an upward shift in the supply
curve, which increases the market price.
Producer surplus is the welfare gain to firms resulting from the fact that the price they receive
for their product is higher than the minimum price at which they are willing to supply the
product. The welfare gain is the extra earnings obtained by the producer. Remember that a
supply curve tells us how many units of a certain good firms are willing to sell at every possible
price, therefore the supply curve reflects the minimum price at which firms are willing to supply
their goods or services.
Graphically, Figure 2.29 depicts a (linear) supply curve. If the market price is P, then the producer
surplus is given by the area above the supply curve and below the market price received, i.e.
the green shaded area. At any point along the supply curve segment from the origin to point E,
producers are willing to supply the particular quantity and receive a price P which is above the
price at which they are willing to sell.
In practice, firms are not identical and vary in terms of how efficient they are at supplying a good.
At a given market price which just sufficiently incentivises the least efficient producer to supply
the good, it must mean that all other active producers are more efficient and hence they earn
more in terms of producer surplus.
Figure 2.29: The green shaded area represents producer surplus for market price P.
Producer surplus, as with consumer surplus, also varies with price changes. It increases when the
price increases and decreases when the price falls. Consumer and producer surpluses vary with
the price changes in opposite directions to each other – consumers prefer lower prices, while
producers prefer higher prices. Both of them, however, are affected by taxes.
Figure 2.30 assumes that the demand curve shifts from D to D1, leading to a decrease in the
market price from P to P’. Assuming no change in the supply curve, this new market equilibrium
price is lower, which inevitably reduces the area above the supply curve and below the (now
lower) price and so there is a reduction in the producer surplus.
The grey shaded area represents the loss of producer surplus as a result of the demand curve
shift. Remember the determinants of demand in Section 2.1 which offer possible explanations
for the demand cure shift seen in Figure 2.30 (for example, income, tastes, preferences and
demographics).
Figure 2.30: A reduction in producer surplus caused by an inward shift in the demand
curve, which decreases the market price.
Taxes
A tax is a compulsory payment, or levy, charged by a government and imposed either on firms
or consumers. Taxes are levied by governments to raise revenue for spending on public services
such as education, healthcare and defence (overall spending is called government spending)
as well as redistributing income to combat inequality.
We can be taxed directly and indirectly. Direct taxes are applied to the income and wealth
earned by households and firms. Examples of direct taxes are income taxes, corporation taxes
and wealth taxes. Direct taxes are progressive, which means that the amount of tax paid
depends on the level of income, or wealth, of the taxpayer. Direct taxes are paid straight to the
government by a person or institution on whom the tax was imposed.
Indirect taxes, on the other hand, are usually levied on goods and services which we consume.
Examples of indirect taxes are excise taxes and value added tax (VAT). Indirect taxes can either
be charged as a fixed amount per unit sold (known as specific taxes) or as a percentage of the
price of the good (known as ad valorem taxes). An example of a specific tax is an excise tax.
Value added tax (VAT) on clothes and computer programmes is an example of an ad valorem tax.
Indirect taxes are regressive, which means that the same (fixed) amount of tax is paid
independent of the income or wealth of the taxpayer. Therefore, such taxes are regressive in the
sense that a fixed amount of tax is a less significant proportion of the income or wealth of higher
income or wealthier taxpayers, with the impact of the tax disproportionately hurting those on
lower incomes or the less wealthy.
How do taxes affect our demand and supply model?

Income taxes shift the demand curve inward, as shown in Figure 2.31. Recall that income is one
of the determinants of demand (Section 2.1), and so think of the imposition of an income tax
as reducing a consumer’s income. Economists often refer to after-tax income as disposable
income, i.e. the amount of current income available to spend or save (likely a mixture of
spending and saving) after the payment of personal income taxes.
Figure 2.31: Impact of income tax on the demand curve. Higher income taxes shift the
demand curve inward.
When combined with a supply curve, as shown in Figure 2.32, it is seen that the inward shift
of the demand curve results in a new equilibrium at a lower price (P1 to P2), but with a lower
quantity demanded (Q1 to Q2).
Figure 2.32: The impact of income tax on equilibrium price and quantity.
In contrast, indirect taxes affect the supply curve. Specific taxes (also called unit taxes) cause a parallel
shift upward in the curve (shown in the first graph of Figure 2.33), while ad valorem taxes cause a
pivotal rotation (shown in the second graph of Figure 2.33).
Figure 2.33: Impact of specific and ad valorem taxes on the supply curve. Specific taxes
cause a parallel shift upward of the supply curve, while ad valorem taxes cause a pivotal
rotation of the supply curve.
When combined with demand curves, as shown in Figure 2.34, it is seen that for both specific and ad
valorem taxes the shift upward of the supply curve results in a new equilibrium at a higher price (P1 to
P2) and a lower quantity demanded (Q1 to Q2).
Figure 2.34: The impact of specific and ad valorem taxes on equilibrium price and
quantity.
Tax incidence – the effect of taxes on social welfare

The imposition of taxes inevitably affects both consumers and producers (through their
respective surpluses) in a negative manner because it impacts the price paid by consumers and
received by producers. The decreased surpluses can be seen in Figure 2.35.
Figure 2.35: Changes to consumer surplus (CS) and producer surplus (PS) resulting
from the imposition of tax.
In Figure 2.35, before the tax was imposed the total consumer surplus consisted of the orange
and pink areas, while the total producer surplus was equal to the sum of the two blue areas. After
the tax (the height of the arrow in the figure) has been imposed, both consumer and producer
surpluses decrease. The new consumer surplus is only the orange triangle, while the new producer
surplus is now equal to the dark blue area only, as indicated. The effect of the imposition of the tax
has been to make both consumers and producers worse off in a welfare sense.
The amount of tax paid by each party is called the tax incidence. Tax incidence is a term used
to describe the division of the tax burden between consumers and producers. In the case of
income tax, it is the consumer (the individual taxpayer) who fully bears the tax – we saw above
how this affected the demand curve. Indirect taxes affect the supply curve and our discussion
below focuses on specific taxes, i.e. parallel shifts of the supply curve.
Figure 2.36 illustrates a situation where the imposition of a specific tax is borne equally by
consumers and producers. The total tax revenue received by the government is the sum of the
pink and blue areas, where the equal size of the pink and blue areas shows the equal division of
the tax by consumers and producers. Clearly, we would not expect such an equal distribution of
tax liabilities across both groups in all situations.
Figure 2.36: Consumers and producers bearing equal amounts of a specific tax.
Tax incidence depends mainly on two things:
1. price elasticities
2. time horizon.
The more inelastic demand is, the steeper the demand curve, and hence the lower the
responsiveness from consumers will be to price changes so producers can place more of the tax
burden on them. Therefore, with a rather inelastic demand, most of the tax is paid by consumers.
However, elasticity increases with time. So once consumers start finding cheaper alternatives,
their demand becomes more elastic as they identify substitutes to which they can switch in the
longer run. As a result, most of the tax burden is subsequently borne by producers. Therefore, in
the short run most of the tax is paid by consumers, while in the long run producers suffer more.
As demand becomes more elastic over time, the slope of the demand curve becomes flatter,
therefore affecting the tax burden placed on consumers and producers.
Figure 2.37 considers the case of elastic demand. The imposition of a specific tax (of amount
denoted by the distance BE1) shifts the supply curve from S to S’. The equilibrium price increases
from P to P1, with a corresponding decrease in the equilibrium quantity from Q to Q1. Due to the
elastic demand, a small percentage increase in price is met with a larger percentage decrease in
quantity demanded (as shown by the fact that P1 – P < Q – Q1), i.e. a small price increase results
in a very large decrease in quantity sold. Overall, this will impact firms’ profitability due to a much
lower level of sales and as a result lower profits (despite the higher price).
Figure 2.37: Tax incidence when demand is elastic. A small increase in price following
the imposition of a specific tax leads to a large reduction in quantity demanded due
to elastic demand being price sensitive.
Figure 2.38 considers the case of inelastic demand (note the steeper slope of the demand curve).
Again, the imposition of a specific tax (of amount denoted by the distance BE1) shifts the supply
curve from S to S’. Here the price increase is large, but the decrease in the quantity sold is very
small (as shown by the fact that P1 – P > Q – Q1). Consumers bear most of the tax in the form of
a high price. The fact that demand is inelastic means the producer can transfer most of the tax
burden on to the consumer as demand is price insensitive.
In Figures 2.37 and 2.38, the distance CE1 is the tax borne by the consumer, and BC is the tax
borne by the producer. See how the relative burden changes with the price elasticity of demand.
Figure 2.38: Tax incidence when demand is inelastic. A large increase in price
following the imposition of a specific tax leads to a small reduction in quantity
demanded due to inelastic demand being price insensitive.
Deadweight loss
No tax comes without a cost to society, which economists call a deadweight loss. The
deadweight loss from a tax is the extent to which its impact is reduced due to side-effects.
For example, an increase in income tax provides a disincentive to work (the government takes
a greater share of your income) resulting in workers reducing their working hours, or even
withdrawing from the labour market entirely. This reduces the total tax receipts received by the
government.
In terms of consumer and producer surplus, the deadweight loss is the reduction in these
surpluses when the quantity of the product sold is less than the optimum efficient level which
would occur under perfect competition without the tax.
Deadweight loss is a cost to society resulting from the loss of economic efficiency. This can be
represented as a part of consumer surplus and a part of producer surplus which is now lost, as
illustrated in Figure 2.39. Note the shaded areas represent only the deadweight loss, not the
total reduction in consumer surplus and producer surplus. The deadweight loss is the total
(combined) reduction in consumer and producer surpluses minus the total tax raised (the total
tax revenue shown in Figure 2.36). This difference is the overall cost to society and hence is the
deadweight loss.
Figure 2.39: The deadweight loss (DWL) resulting from the imposition of a tax.
Figure 2.40 shows demand and supply curves with equilibrium price P and quantity Q. The total
consumer surplus is the red area, i.e. the triangle ABP, while the producer surplus is the green
area, i.e. the triangle cornered at the origin and AP. In the event that a tax of CD was imposed, this
would restrict quantity to Q1, resulting in the price paid by the consumer increasing to P1, with
consumer surplus reduced by the amount ACE. Meanwhile producers receive the price P2, with
producer surplus reduced by the amount ADE.
Figure 2.40: The deadweight loss with the tax of amount CD.
So why do governments impose taxes?

Taxes create government revenue (the revenue which a government receives from imposing
specific taxes is calculated by multiplying the unit tax and the quantity sold). Taxes are used to
correct market failure (covered in Section 3.3) and are used to limit the consumption of demerit
goods such as alcohol, drugs and cigarettes.
Taxes, and consequent government expenditure on welfare, can be used to establish a more
equitable society by reducing the differences between the rich and the poor. There will always
be a trade-off between efficiency and equity. The economic theory of a perfect market defines
maximum efficiency but, in real life, governments intervene to redistribute wealth by taxation,
despite the welfare losses described above.
ACTIVITY 2.9
Find examples of direct, indirect, income, specific and ad valorem taxes in your country
by creating and completing a table like the one shown below.
Tax type Example(s)

Direct
Indirect
Income
Specific
Ad valorem
ACTIVITY 2.10
In the absence of taxes, how does the price elasticity of demand affect the level of
consumer surplus? Also, how does the price elasticity of supply affect the level of
producer surplus?
ACTIVITY 2.11
Analyse how price elasticity of supply influences tax incidence.
ACTIVITY 2.12
‘Imposing specific taxes is fair’. Do you agree?
Section 2.4: Consumer choice
Introduction 70
Utility 70
Indifference curves 71
Utility functions for perfect substitutes 74
Utility functions for perfect complements 74
Utility functions for other types of goods 76
Budget constraint 77
Sensitivity of the budget constraint to changes in 78

income and prices
Combining indifference curves and the budget constraint 79
Conclusion 80

choice
Introduction
In Section 2.3 (Consumer and producer surplus, tax and social welfare) we introduced the
concept of utility as a form of ‘customer satisfaction’ when consumers realise a consumer surplus,
paying a price which is less than their maximum willingness to pay. Here, we formally model the
utility which consumers derive from their consumption of bundles of goods and services.
The topic of consumer choice focuses on the decisions consumers make when choosing
between different consumption bundles. We frame this as a utility maximisation problem
such that consumers seek to achieve maximum utility (satisfaction) while simultaneously being
constrained by their budget.
Utility
We formally define utility as the satisfaction (or pleasure) which a consumer obtains from the
consumption of a good or service. Utility is an abstract or subjective concept and as such there
are no units of measurement associated with utility (we could think of units of utility as ‘utils’, but
this is purely a theoretical measure).
In Section 1.2 (Production possibility frontiers), we considered a simplified world in which there
are only two goods. Although we noted this was an extreme simplification of reality (for example,
think about the amount of choice you face in a supermarket) we said it was possible to view
the two goods as one specific good (such as coffee) and ‘everything else’. Here, we assume a
consumer is choosing between just two goods, X and Y. The actual quantity consumed of each
good will be denoted by lower case letters, i.e. x and y, respectively.
A utility function is a (mathematical) function which returns the total utility a consumer derives
from consuming x units of good X, and y units of good Y. We represent this as:
u(x, y).
For example, suppose the utility function for a consumer was of the mathematical form:
u(x, y) = x + y.
In this case the total amount of utility the consumer obtains from consuming two units of X
(i.e. x = 2) and three units of Y (i.e. y = 3) would be:
u(2, 3) = 2 + 3 = 5.
Therefore, the utility from consuming six units of X (i.e. x = 6) and four units of Y (i.e. y = 4) would
be:
u(6, 4) = 6 + 4 = 10.
However, how should we view ‘5’ units of utility versus ‘10’ units of utility, given that utility is
subjective? Since there are no observable units of measurement associated with utility, it is not
possible to come up with an absolute measure of utility, but it is sensible to consider ordinal
utility.
This means that we can assign a rank-order to different consumption bundles such that it is
possible to say whether a consumer prefers one bundle to another. Higher values of utility
indicate strictly-preferred consumption bundles. A utility function assigns numbers to different
possible consumption bundles such that more-preferred bundles are assigned larger utility
values.
choice
Therefore, the magnitude of utility is only important as far as the ranks of different consumption
bundles are concerned. The size of the utility difference between any two consumption bundles
does not matter, which is why we refer to this as ordinal utility.
Suppose we let consumption bundle A be two units of X and three units of Y, while we let
consumption bundle B be six units of X and four units of Y. The respective utilities of bundles A
and B, calculated above, can then be expressed as:
uA(2, 3) = 5 and uB(6, 4) = 10.

Since 5 < 10, this consumer achieves a higher level of utility from bundle B compared to bundle
A, and hence prefers bundle B to bundle A. As we are working with ordinal utility, the fact that
10 is twice as large as 5 does not necessarily mean that bundle B is preferred twice as much as
bundle A. The ordinal nature of utility simply means that because 10 is greater than 5, bundle
B is preferred by the consumer – the size of the difference in utility (here 10 – 5 = 5) is of no
relevance.
Indifference curves
We have seen that we can determine a consumer’s preference for one consumption bundle over
another by comparing the utility values. In the example above, bundle B was preferred to bundle
A because:
uA(2, 3) < uB (6, 4).

Let us now consider a third bundle, C, which consists of four units of X and one unit of Y (i.e. x = 4
and y = 1). Therefore, we have:
uC(4, 1) = 4 + 1 = 5.
Bundles A and C both result in a utility level of 5, and so this consumer is indifferent between
these two bundles as the consumer is equally satisfied consuming either bundle (with both
strictly less preferred than bundle B due to its higher utility level of 10).
In fact, we can consider other bundles which also result in a utility level of 5. Assuming only
non-negative integer quantities of goods X and Y can be consumed, then for the utility function
u(x, y) = x + y we can obtain the following set of bundles with the same utility level of 5:
Quantity of good X Quantity of good Y Utility of the bundle (x, y)

0 5 0+5 =5
1 4 1+4=5
2 3 2+3=5
3 2 3+2=5
4 1 4+1=5
5 0 5+0=5
So a consumer with utility function u(x, y) = x + y is equally satisfied with any of these six bundles
(0, 5), (1, 4), (2, 3), (3, 2), (4, 1) and (5, 0), as they all result in a utility level of 5.
We now plot these bundles in Figure 2.41.
choice
Figure 2.41: A plot of all non-negative integer consumption bundles resulting in a

utility level of 5, when u(x, y) = x + y.
Suppose we now allow for non-negative fractional amounts of X and Y to be consumed. This
now opens up a continuum of possible consumption bundles where each yields a utility level of
5. Note we impose the constraint that the consumption levels must be non-negative, as it is not
possible to consume a negative amount of a good!
Mathematically, suppose we fix the utility level to be the constant value of 5. For the utility
function u(x, y) = x + y, then we have:
x+y=5
which we can rearrange to give:
y = 5 – x.
From FP0001 Mathematics and Statistics, you should recognise this as the mathematical
equation of a line, with a y-intercept of 5, and a slope of –1. This line is plotted in Figure 2.42 to
depict an example of an indifference curve (which here is a line, rather than a curve!).
Figure 2.42: An indifference curve such that all consumption bundles on the line
provide the consumer with the same level of utility. Here u(x, y) = x + y = 5 at every
point on the line.
choice
An indifference curve shows alternative combinations of two products where every

consumption bundle on the curve provides the consumer with the same level of utility and
therefore, the consumer is indifferent between all of the bundles on the curve.
Now, rather than letting utility be 5, let us set it to some arbitrary fixed constant k. We then have:
x+y=k
which we can rearrange to give:
y = k – x.
This is the mathematical equation of a line with a y-intercept of k, and a slope of –1. For different
values of k, we can draw multiple indifference curves which, for this utility function, will be
parallel lines.
Remember that utility is ordinal, so the higher the value of k, the consumption bundles along
an indifference curve will be strictly preferred to the bundles of any indifference curve below it.
However, we cannot say by how much these bundles are preferred.
Figure 2.43 shows indifference curves for a consumer with utility function u(x, y) = x + y = k, for k
= 1, 3, 5, 7 and 9.
Figure 2.43: Indifference curves for u(x, y) = x + y = k, for k = 1, 3, 5, 7 and 9.
So far we have only considered indifference ‘curves’ which are straight lines. This is due to the
linear utility function of u(x, y) = x + y = k. As you might expect, other forms of utility functions are
possible, including non-linear functions. For example, consider the utility function:
u(x, y) = xy.
For a given level of utility k, we can solve for y as a function of x:
k
xy = k ⇔ y =x.
Figure 2.44 sketches indifference curves for this utility function for the values k = 1, 2 and 3. Note
that since 1 < 2 < 3, the consumer strictly prefers being on higher indifference curves, i.e. utility
increases when we travel in a north-easterly direction away from the origin.
choice
Figure 2.44: Indifference curves where k = xy, for different values of k.
Utility functions for perfect substitutes

What determines the mathematical form of the utility function? For example, when should we
use u(x, y) = x + y instead of u(x, y) = xy?
The answers depends on what type of goods X and Y are. Suppose the goods are perfect
substitutes. An example might be a striped pen, X, and a spotted pen, Y.
For practical purposes there is no real difference between these two pens (assuming you are
indifferent between the two designs), such that you could easily substitute one for the other.
Suppose all that mattered to you was the total number of pens, rather than their types. As these
are perfect substitutes we may assign the utility function:
u(x, y) = x + y.
This leads to utility being constant along indifference curves (as seen in Figure 2.43) and it assigns
a higher utility level to more-preferred bundles. For example, a total of 10 pens makes you
happier than only 5 pens (regardless of their design).
As we have ordinal utility, this is not the only possible utility function for perfect substitutes. In
general, perfect substitutes are represented by utility functions of the form:
u(x, y) = ax + by
where a and b are some positive constants which measure the value of goods X and Y to the
consumer. Note that all indifference curves based on such a utility function will have a slope of
–a/b.
Utility functions for perfect complements

Perfect complements are goods which are consumed in fixed proportions. A classic example
is left shoes and right shoes. We consume these in pairs, i.e. each left shoe is worn with a
corresponding right shoe. In this example, it seems reasonable to treat the number of pairs of
shoes as the utility function, with more pairs of shoes giving the consumer a higher level of
utility. Note that the number of complete pairs of shoes at your disposal is given by the minimum
number of left and right shoes.
choice
Let the number of left shoes be denoted by X, and the number of right shoes be denoted by Y.
We use the “min” function to form the utility function, such that:
u(x, y) = min {x, y}.

For example, suppose you had 5 left shoes and 5 right shoes. You have five complete pairs of
shoes, so your utility would be min (5, 5) = 5. However, suppose you received an additional right
shoe (without another left shoe), such that x = 5 and y = 6. As you still only have five complete
pairs of shoes, your total utility is unchanged. The extra right shoe is useless on its own so gives
you no additional utility since min (5, 6) = 5, i.e. 5 is the smaller (minimum) value of 5 and 6.
For any situation of perfect complements in which X and Y are consumed together on a one-to-
one basis (as with left and right shoes), the indifference curves are L-shaped, with the kink along
the 45-degree line from the origin, as shown in Figure 2.45.
Figure 2.45: L-shaped indifference curves for perfect complements which are
consumed in fixed proportions of one-to-one. Higher indifference curves correspond
to higher utility levels.
How do we deal with cases when the two goods are consumed in fixed proportions other than
one-to-one?
Suppose you drink coffee with sugar, and that you use two teaspoons of sugar with every cup of
coffee (by the way, I do not endorse such excessive sugar consumption!).
Let X denote the number of cups of coffee, and let Y denote the number of teaspoons of sugar.
Given our preference for two teaspoons of sugar per cup of coffee, we have the utility function of:
u(x, y) = min {x, y/2}.

The appearance of ‘y/2’ might seem surprising. However, with a little thought, this can be
explained. In the event that the number of cups of coffee is greater than half the number of
teaspoons of sugar, then it will be impossible to add two teaspoons of sugar to each cup of
coffee. We will only be able to make y/2 sweetened cups of coffee. For example, if we had 5 cups
of coffee and 8 teaspoons of sugar, since 5 > 8/2 = 4, then we can only make four cups of coffee
each with two teaspoons of sugar; the fifth cup of coffee can have no sugar and hence gives us
no utility as we always consume coffee with sugar.
As we are dealing with ordinal utility, we can transform the utility function to preserve the same
preference ordering. Here, a natural choice is to multiply by 2 to eliminate the fraction, leading to:
choice
u(x, y) = min {2x, y}.

Figure 2.46 shows indifference curve for our coffee-sugar example. Note that as these goods are
perfect complements the indifference curves continue to be L-shaped, although now the kinks
are no longer along the 45-degree line from the origin.
Figure 2.46: L-shaped shaped indifference curves for perfect complements which are
consumed in fixed proportions of two-to-one. Higher indifference curves correspond
to higher utility levels.
In general, a utility function to describe preferences for perfect complements is of the form:
u(x, y) = min {ax, by}

where a and b are positive constants indicating the proportions in which the goods are
consumed.
Utility functions for other types of goods

Perfect substitutes and perfect complements are clearly special cases of X and Y. The indifference
curves for these are downward-sloping straight lines (as shown in Figure 2.42) and L-shaped
curves (as shown in Figure 2.45), respectively.
A common depiction of indifference curves is as shown in Figure 2.44, i.e. genuine ‘curves’. Figure
2.44 was constructed assuming:
u(x, y) = xy.
This is a special case of what is known as a Cobb-Douglas utility function (named after the
economists Charles Cobb and Paul Douglas). The general form of the Cobb-Douglas utility
function is:
u(x, y) = xayb
where a and b are positive constants, this describes the preferences of the consumer. The
indifference curves shown in Figure 2.44 have a = b = 1.
Indifference curves can take other forms, although we will not consider these in this course. If you
study economics at undergraduate level, you will almost certainly meet these other forms then.
choice
Budget constraint
So far, we have looked at modelling the utility, i.e. satisfaction, which the consumer derives from
consuming the bundle (x, y). We now turn our attention to the consumer’s budget.
Goods are rarely free, so let us denote the prices of goods X and Y by pX and pY, respectively,
where clearly pX > 0 and pY > 0. Therefore, the consumer’s total expenditure when consuming x
units of X and y units of Y is:
pX x + pY y
that is, price times quantity for each good.
Suppose the consumer has an income of M. Assuming no access to savings or borrowing, the
consumer cannot spend more than his or her income. As such the consumer faces a constraint
in that total expenditure on X and Y must be no greater than income. This is known as a budget
constraint. Mathematically, this is:
pX x + pY y ≤ M.
For simplicity, we will assume the consumer spends all of his or her income on goods X and Y,
without any saving, i.e. the full income M is spent. This makes the constraint binding, such that:
pX x + pY y = M.
We now rearrange this equation to solve for y as a function of x. In doing so, we obtain:
M p
y = p – pX x .
Y Y
This is a linear equation relating y and x, with a y-intercept of M/pY and a slope of -pX/pY.
We can draw this as shown in Figure 2.47. Note the y-intercept corresponds to all income spent
on good Y, hence the consumer can afford M/pY units of Y only. Similarly, if the consumer spends
all the income on good X, then the consumer can afford M/pX units of X only. This means that the
budget constraint has an x-intercept of M/pX.
Figure 2.47: The linear budget constraint of pXx + pYy = M. The shaded area represents
all affordable (i.e. feasible) consumption bundles for the consumer when faced with
prices pX and pY with income M. Any point on the budget constraint itself represents all
income spent on some combination of the two goods.
choice
Sensitivity of the budget constraint to changes in income and

prices
Suppose the consumer’s income increases from M to M’. Ceteris paribus (other things equal, i.e.
keeping prices fixed), the consumer can now afford a larger set of consumption bundles.
Graphically, this corresponds to the budget constraint shifting outward with new axis intercepts
of M’/pY > M/pY and M’/pX > M/pX, as shown in Figure 2.48.
Figure 2.48: An increase in a consumer’s income from M to M’ shifts the budget

constraint outward, increasing the affordable set of consumption bundles. The
affordable set is given by all points on or below the (new) budget constraint.
Returning to the original income M, an increase in the price of good X, i.e. pX, means X is now
more expensive, which makes the consumer worse off. A change in pX affects the slope and also
the x-intercept of the budget constraint. An increase in pX pivots the budget constraint inward as
shown in Figure 2.49. Note that the y-intercept is unaffected as this is M/pY, and we are assuming
M and pY are unchanged.
Figure 2.49: An increase in pX pivots the budget constraint inward about the
y-intercept, reducing the affordable set of consumption bundles. The affordable set is
given by all points on or below the (new) budget constraint.
choice
Returning to the original income M and original pX, a decrease in the price of good Y, i.e. pY,
means Y is now less expensive, which makes the consumer better off. A change in pY affects the
slope and y-intercept of the budget constraint. A decrease in pY pivots the budget constraint
outward as shown in Figure 2.50. Note that the x-intercept is unaffected as this is M/pX, and we
are assuming M and pX are unchanged.
Figure 2.50: A decrease in pY pivots the budget constraint outward about the
x-intercept, increasing the affordable set of consumption bundles. The affordable set
is given by all points on or below the (new) budget constraint.
Combining indifference curves and the budget constraint

We conclude this section with a graphical depiction of a constrained optimisation problem.
Having considered indifference curves and budget constraints separately, we now bring these
together to solve the standard consumer choice problem.
The consumer’s objective is to maximise utility subject to the budget constraint. This means the
consumer is trying to reach the highest possible level of utility (i.e. reach the highest possible
indifference curve, where higher indifference curves represent higher levels of utility), while not
exceeding the budget constraint.
Figure 2.51 combines indifference curves with a budget constraint. Remember that the
consumer wishes to be on the highest possible indifference curve (IC). Here IC3 is preferable
to IC2, which in turn is preferable to IC1. However, the consumer cannot exceed the budget
constraint, so must consume a bundle within the affordable set (the shaded area).
We see that point A is the optimal solution. This point is the consumption bundle (x*, y*) and
is the highest level of utility which can be reached. Point B is preferred, but unaffordable as the
indifference curve IC3 lies above the budget constraint. Point C is affordable (being within the
affordable set), but is less preferred than point A.
choice
Figure 2.51: The standard consumer choice problem of utility maximisation subject to
a budget constraint. The consumer wants to be on the highest affordable indifference
curve, when faced with income M and prices pX and pY. Here point A is the optimal
point resulting in the optimal consumption bundle (x*, y*).
At undergraduate level you would consider this exercise for different types of indifference curves
(such as for perfect substitutes, perfect complements and other types of preferences) while
changing any of M, pX and pY. In this course, we will only consider the basic problem for generic
indifference ‘curves’ and the initial budget constraint as depicted in Figure 2.51, just to give you a
sense of what constrained optimisation problems look like. You will likely meet these problems
both graphically and mathematically in the future.
Conclusion
We have modelled the consumer choice problem of utility maximisation subject to a budget
constraint.
Consumers gain utility from their consumption, where utility is the pleasure or satisfaction they
experience. As such, economists think of consumers as utility maximisers. An indifference
curve depicts consumption bundles which result in the same level of utility and hence
consumers are indifferent between them. The exact shape of indifference curves depends on the
consumer’s tastes and preferences (which vary from individual to individual).
Thinking back to the basic economic problem of resolving our unlimited wants with scarce
resources, here the scarce ‘resource’ is income. When faced with a fixed income and prices,
consumers have a budget constraint, such that they are unable to spend beyond this. The
affordable set of bundles are all those on or below the budget constraint.
Combining indifference curves and the budget constraint on a single diagram, the consumer
faces a constrained optimisation problem – to maximise utility (by being on the highest possible
indifference curve) subject to the budget constraint.
Next time you are out shopping and deciding what to buy, remember you are choosing to buy
items to make you as happy as possible but you cannot spend more than your budget. Therefore,
this economic model is a deliberate simplification of our own real-world behaviour!
choice
ACTIVITY 2.13
Suppose you consider goods X and Y to be perfect substitutes, although you get twice as
much utility from good X as you do from good Y.
a. Write down a suitable utility function to represent your preferences.
b. Draw some examples of indifference curves for the utility function in part a.
ACTIVITY 2.14
Suppose you consider goods X and Y to be perfect complements, although you consume
X and Y in the fixed proportions of three-to-one, i.e. you consume three units of X with
every one unit of Y.
a. Write down a suitable utility function to represent your preferences.
b. Draw some examples of indifference curves for the utility function in part a.
ACTIVITY 2.15
a. Explain why a consumer would prefer to be on a higher indifference curve rather than
a lower one.
b. Is it possible to state how much more preferred consumptions bundles on the higher
indifference curve are to those on the lower indifference curve? Explain your answer.
ACTIVITY 2.16
Show on a diagram how the budget constraint changes when:
a. income decreases
b. the price of good X decreases
c. the price of good Y increases.
ACTIVITY 2.17
Consider Figure 2.51.
a. What would need to change in order for the consumer to end up consuming at
point B?
b. What would need to change in order for the consumer to end up consuming at
point C?
82
Concluding comments
This unit forms the basis of the study of microeconomics. It introduced demand and supply,
along with their respective determinants, and price determination in equilibrium when demand
equals supply. Different types of elasticities were defined, including how to calculate and
interpret them. Determinants of price elasticities, as well as short-run and long-run effects, were
examined. Social welfare, with specific reference to consumer and producer surplus, and the
different types of taxation were modelled, including the deadweight loss to society. Finally, the
consumer choice problem of utility maximisation subject to a budget constraint was analysed.

Having completed this unit, and the background readings and activities, you should be able to:
define the concepts of demand and supply and list their determinants
distinguish between movements along, and shifts of, curves in relation to demand and supply
explain how the price mechanism helps to allocate scarce resources
define price elasticity of demand, price elasticity of supply, income elasticity and cross-price
elasticity and explain their importance for making decisions
identify consumer and producer surplus
explain how taxes influence social welfare
model the consumer choice problem.
Unit 3: Microeconomics II: firms and production 83
Aims 84


Now that you have considered the behaviour of the consumer, our discussion of
microeconomics moves on to firms and production.
How do firms decide how much to produce?
This will depend on several factors such as technology, production costs and the extent of
market competition. We will explore these factors, which includes an examination of different
types of market structure.
Markets sometimes ‘fail’, for which a case could be made for government intervention to correct
instances of market failure. Central to this discussion are externalities – third-party effects. We
will examine both positive and negative externalities. Finally, we explore demand and supply in
labour markets.
Week Unit Section
7 3: Microeconomics II: firms and 3.1: Production
8 production 3.2: Market structure
9 3.3: Market failure and externalities
10 3.4: Labour markets
Section 3.1 models the production decision of firms assuming firms seek to maximise profits.
This involves the maximisation of revenues and minimisation of costs. Section 3.2 presents
a spectrum of different types of market structure, ranging from a pure monopoly to perfect
competition. We look at the characteristics, and consequences, of these different structures.
Section 3.3 explains what market failure is and highlights the differences between private and
social costs and benefits, as well as illustrating how governments may seek to intervene in the
market with the objective of optimising welfare. Section 3.4 concludes the microeconomics part
of the course by looking at labour markets, including an explanation of the backward-bending
labour supply curve.
Aims
This unit aims to introduce you to:
the production decisions of firms
different types of market structure
market failure and its causes
inefficiencies resulting from externalities
government interventions which aim to reduce market failure
features of labour markets.
Learning outcomes
be able to:
define the production problem of firms
explain the different types of market structure
define the concept of market failure and explain how it arises
define externalities and give real-life examples
define costs (social, private and external) and benefits (social, private and external)
explain how governments can intervene to correct market failures

explain what impacts demand and supply in labour markets.
Background reading
[ISBN 9780993133107].
• Section 3.1 – Units 45 (pp. 265–268) and 48 (pp. 283–288)
• Section 3.2 – Unit 49 (pp. 289–295)
• Section 3.3 – Units 60 (pp. 367–376) and 61 (pp. 377–389)
• Section 3.4 – Units 63 (pp. 395–399), 64 (pp. 400–411) and 65 (pp. 412–424).
Section 3.1: Production
Introduction 87
Profit maximisation 87
Technology 88
Examples of technology 89
Cost functions 92
Sensitivity of isocost lines to changes in input costs 93
Combining isocost lines and the production function 94
Conclusion 95
Unit 3: Microeconomics II: firms and production • Section 3.1: Production 87
Introduction
Production uses the same tools as consumer choice, so having studied Section 2.4 of Unit 2, this
material should seem somewhat familiar. Actually, production is simpler than consumer choice
as we consider the output of a firm (which is observable) instead of utility (which is not).
We initially consider the profit maximisation problem of firms, cross-referencing with your
FP0001 Mathematics and Statistics course. A discussion of technology follows, which
determines how a firm can convert inputs (factors of production) into outputs. This gives rise
to ‘isoquants’ which are very similar to indifference curves. We then explore cost functions,
leading to the cost minimisation problem of the firm, namely deciding the most cost-efficient
way of producing an amount of output, which takes into account the cost of each input and the
available technology.
Profit maximisation
Section 7.2.4 of FP0001 Mathematics and Statistics considers an economic application of
optimisation, namely profit maximisation, when a firm wants to determine the level of
production which maximises its profit.
Assuming the firm produces only one product, the quantity it produces is denoted by q. We
define profits as the difference between revenues and costs, i.e.
profits = revenues – costs.
In mathematical notation, we have:
π = profits
R = revenues
C = costs.
However, each of these variables will depend on the level of q. As such, each variable is a
function of q, giving rise to the concepts of a profit function, a revenue function, and a cost
function, where:
π(q) = profit function
R(q) = revenue function
C(q) = cost function.
Therefore, the profit function is defined as:
π(q) = R(q) − C(q).

This is the firm will seek to maximise profits as profits are desirable!
Exploring the revenue function in more detail, assuming perfect competition (formally
introduced in Section 3.2) then the firm is considered to be a price-taker, i.e. the firm’s level
of production has no impact on the market price because it is viewed as being such a small
proportion of the total market that its level of output has negligible impact on the market supply
of the good, and hence does not affect the market price.
Let the market price be p. Under perfect competition, a firm’s total revenue is simply price
multiplied by the quantity it produces, so we have as the revenue function:
R(q) − pq.
As a result, the profit function is:
π(q) = pq − C(q).
This is for a perfectly competitive firm.

However, when the firm is a pure monopoly (this type of firm will also be formally introduced
in Section 3.2), it is the only firm in the market (so the firm is the market), and its output directly
affects the market price as the demand curve captures the price consumers are willing to pay for
each level of output, i.e. we have:
p = pD(q).
Unlike a perfectly competitive firm, a pure monopoly is a price-setter, or price-maker, such that
price is no longer a fixed constant. As a result, the revenue function becomes:
R(q) = qpD(q).
This then leads to a profit function of:
π(q) = qpD(q) − C(q)

as shown in Section 7.2.4. This profit function is then maximised using differential calculus to
determine the profit-maximising level of output.
Technology
In practice, the output of a firm requires factors of production. In Section 1.1 we identified
these by CELL (capital, entrepreneurship, land and labour). Here, our focus will be on the amount
of input(s) rather than the type of input(s).
All firms face technological constraints, in that ‘nature’ restricts how factor inputs can be
combined to produce a desired output through the available technology.
A production set shows all possible combinations of inputs and outputs which are
technologically feasible. Since factor inputs typically cost the firm money, any firm will want to
produce the maximum output for a particular level of input. As such, a firm will produce at the
boundary of the production set.
A production function (similar to a production possibility frontier) is the function which
describes this boundary. Assuming an output amount of q, and an input amount of x, then
mathematically the production function could be represented as:
q = f (x).
This represents the maximum amount of output, q, for a particular amount of input, x.
Figure 3.1 shows an example of a production set, where the boundary of the set (the production
function) shows that output, q, is an increasing function of an input, x (more of the input is
required to produce more of the output).
Figure 3.1: A production set showing possible amounts of output which can be
produced with a given amount of input. The production function is the boundary of
this set.
The production function depicted in Figure 3.1 assumed only a single input, x. Of course, we can
extend production analysis to more than one input. Suppose there are two inputs. We could
denote the amounts of these two inputs by x1 and x2. Mathematically, the production function is
then:
q = f (x1, x2).
This represents the maximum amount of output, q, for x1 units of input 1 and x2 units of input 2.
With two inputs, it is straightforward to model production relationships using isoquants. An
isoquant is the set of all possible combinations of inputs 1 and 2 which are (just) sufficient to
produce a particular amount of output, q. The prefix ‘iso’ means ‘same’, so all points along an
isoquant result in the same quantity being produced.
Isoquants are similar to indifference curves (along an isoquant there is the same quantity
of output; along an indifference curve there is the same level of utility). However, there is a
crucial difference. Output is actually observed and quantifiable, and is subject to the available
technology. In contrast, utility is an arbitrary value with only ordinal properties.
Examples of technology
In Section 2.4 we examined consumer preferences for perfect substitutes and perfect
complements. We adopt a similar approach here when considering different types of
technologies.
We begin with perfect substitutes. Suppose you can use pens and/or pencils to write your
homework. Let x1 denote the number of pens, and x2 the number of pencils. As far as writing
instruments are concerned, in practice these are perfect substitutes such that the total amount
of homework produced is determined only by the total number of pens and pencils combined.
Here, the production function can be expressed as:
q = f (x1, x2) = x1 + x2.

The isoquants look identical to the indifference curves for perfect substitutes seen in Section 2.4.
Figure 3.2 displays isoquants for the case of perfect substitutes.
In general, production functions for perfect substitutes take the form:
q = f (x1, x2) = ax1 + bx2.

In this case a and b are non-negative constants. For such technologies, one unit of output can be
produced using 1/a units of input 1, or using 1/b units of input 2, or any combination of x1 and x2
such that ax1 + bx2 = 1.
This means one factor input can be substituted for the other at a constant rate, hence why they
are perfect substitutes!
Figure 3.2: Isoquants when the factor inputs x1 and x2 are perfect substitutes. Higher
isoquants represent greater levels of output.
Now suppose the two factor inputs are people and machines, such that to produce output we
need to combine people and machines in fixed proportions, for example one person operates
one machine.
If there are more people than machines, then the extra people contribute nothing to production,
similarly if there are more machines than people, then the extra machines contribute nothing
to production. So, the total amount of output which can be produced is the minimum of the
number of people and machines. The production function is therefore:
q = f (x1, x2) = min {x1, x2}.

Figure 3.3 displays isoquants for the case of fixed proportion inputs. Note that these are L-shaped
just as indifference curves are for perfect complements.
Figure 3.3: Isoquants when the factor inputs x1 and x2 are used in fixed proportions.
Higher isoquants represent greater levels of output.
In general, production functions for inputs used in fixed proportions take the form:
q = f (x1, x2) = min {ax1, bx2}

where a and b are non-negative constants. For such technologies, one unit of output can be
produced using 1/a units of input 1 and 1/b units of input 2. Another way of thinking about
it is that q units of output can be produced using q/a units of input 1 and q/b units of input 2.
Additional units of either input (on their own) cannot be used to boost output.
Cobb-Douglas production functions are also possible and mathematically these have the
general form of:
q = f (x1, x2) = Ax1axb2 .

Unlike indifference curves where utility was ordinal, here the values of the parameters A, a and
b matter. The parameter A can be thought of as representing the scale of production, i.e. the
amount of output if one unit of each input was used, because:
q = f (1, 1) = A × 1a × 1b = A.
The parameters a and b measure the responsiveness of output to changes in the inputs.
Isoquants for Cobb-Douglas production functions resemble the smooth curves seen for Cobb-
Douglas indifference curves. An example is shown in Figure 3.4.
Figure 3.4: Isoquants for a Cobb-Douglas production function. Higher isoquants

represent greater levels of output.
Cost functions
Earlier, when defining the profit function, we saw that the cost function was one component of this.
In the real world, factor inputs are not free (for example, labour and machinery both cost money),
so we need to model the total cost of production, which we do using cost functions.
We continue to assume two factor inputs. Suppose the cost (or price) of one unit of input 1 is w1,
and the cost (or price) of one unit of input 2 is w2, where clearly w1 > 0 and w2 > 0. The choice of
the letter ‘w’ can be explained by it representing the ‘wage’ of each input.
Mathematically, the firm’s total cost of production, c, when using x1 units of input 1 and x2 units of
input 2 is:
c = w1x1 + w2x2
i.e. unit cost times quantity for each input. Note the similarity to the consumer’s total expenditure
seen in Section 2.4.
We now rearrange this equation to express x2 as a function of x1. Doing so, we obtain:
c w1
x2 =
w2
– x
w2 1
which notice is a linear equation relating x2 and x1, with an x2-intercept of c/w2 (here the y-axis
variable is x2) and a slope of -w1/w2. We can draw this as shown in Figure 3.5. At any point along
this line, the value of c is the same, so we call this line an isocost line, remembering that
the prefix ‘iso’ means ‘same’ so all points along an isocost line result in the same total cost of
production.
Note the x2-intercept corresponds to the total cost of production when only input 2 is used (i.e.
when x1 = 0). Similarly, the x1-intercept corresponds to the total cost of production when only
input 1 is used (i.e. when x2 = 0).
Figure 3.5: The linear isocost line of c = w1x1 + w2x2. Any point on the isocost line leads
to the same total cost of production, c, when the unit cost of input 1 is w1 and the unit
cost of input 2 is w2.
Sensitivity of isocost lines to changes in input costs

The unit costs of w1 and w2 clearly impact the total cost of production, c.
Suppose the cost of input 1, i.e. w1, increases to w1’. This means input 1 is now more expensive,
which makes the firm worse off (it costs more to use the same amount, x1, of input 1). Suppose
the firm has a fixed production budget of c, and so ceteris paribus (other things equal) an increase
in w1 pivots the isocost line inward as shown in Figure 3.6. Note that the x2-intercept is unaffected
as this is c/w2, and we are assuming c and w2 are unaffected (there is a fixed production budget
of c, and w2 does not change). The new x1-intercept is c/w1’ and represents the amount of input 1
used when x2 = 0.
Figure 3.6: An increase in w1 pivots the isocost line inward about the x2-intercept,
reducing the amount of input 1 which can be used in the production process when
there is a fixed production budget of c.
Returning to the original w1, and still assuming a fixed production budget of c, a decrease in the
cost of input 2, i.e. w2, now means factor 2 is less expensive which makes the firm better off (it
costs less to use the same amount, x2, of input 2).
A decrease in w2 pivots the isocost line outward as shown in Figure 3.7. Note that the x1-intercept
is unaffected as this is c/w1, and we are assuming c and w1 are unaffected (there is a fixed
production budget of c, and w1 does not change). The new x2-intercept is c/w2’ and represents
the amount of input 2 used when x1 = 0.
Figure 3.7: A decrease in w2 pivots the isocost line outward about the x1-intercept,
increasing the amount of input 2 which can be used in the production process when
there is a fixed production budget of c.
Combining isocost lines and the production function

We conclude this section with a graphical depiction of another constrained optimisation
problem (in Section 2.4 our goal was to maximise utility subject to a budget constraint).
Having considered isoquants and isocost lines separately, we now bring these together to solve
the standard producer choice problem.
The producer’s objective is to minimise cost when producing q units of output subject to the
production function. This means the producer is trying to produce q units of output at minimum
total cost (i.e. reach the lowest possible isocost line, where lower isocost lines represent lower
total costs of production), while being constrained by the available technology (as represented
by the production function).
Figure 3.8 combines isocost lines with a production function. Remember that the producer
wishes to be on the lowest possible isocost line (cost minimisation is necessary for profit
maximisation).
We see that the optimal solution is the input combination (x1*, x2*), i.e. using x1* units of input 1
and x2* units of input 2 will minimise the total cost of production of producing q when faced
with the isoquant shown (which reflects the available technology, i.e. the combinations of inputs
1 and 2 required to produce q units of output).
Figure 3.8: The standard producer choice problem of cost minimisation to produce
q units of output subject to the production function. The producer wants to be on
the lowest possible isocost line, when faced with factor input prices w1 and w2, and
technology represented by the production function q = f(x1, x2).
At undergraduate level you would consider this exercise for different types of isoquants
(such as for perfect substitutes, fixed proportions and other types of production functions)
while changing w1 and w2. In this course, we will only consider the basic problem for generic
isoquants and isocost lines as depicted in Figure 3.8, just to give you a sense of what constrained
optimisation problems in production can look like. You will likely meet these problems both
graphically and mathematically in the future.
Conclusion
We have modelled the producer choice problem of cost minimisation subject to a production
function.
Producers have to pay production costs to make output, where they are constrained by the
technology which is available. A production function models how technology converts inputs
into outputs. As such, economists think of producers as cost minimisers. An isoquant depicts
input combinations which result in the same level of output. The exact shape of isoquants
depends on the type of technology.
Combining isocost lines and an isoquant (for producing q units of output) on a single diagram,
the producer faces a constrained optimisation problem - to minimise the cost of producing q (by
being on the lowest possible isocost line) subject to the production function.
ACTIVITY 3.1
Suppose inputs 1 and 2 are perfect substitutes, although two units of input 1 are
required to produce a unit of output, while only one unit of input 2 is required.
a. Write down a suitable production function for this technology.
b. Draw some examples of isoquants for the production function in part a.
ACTIVITY 3.2
Suppose inputs 1 and 2 are used in fixed proportions in a production process. Three units
of input 1 are needed with each unit of input 2 to produce one unit of output.
a. Write down a suitable production function for this technology.
b. Draw some examples of isoquants for the production function in part a.
ACTIVITY 3.3
Explain why a producer would prefer to be on a lower isocost line rather than a higher
one.
ACTIVITY 3.4
Show on a diagram how the isocost line changes when:
a. the cost of input 1 decreases
b. the cost of input 2 increases.
ACTIVITY 3.5
Technology changes over time. In the long run, how would you expect isoquants to
change?
Section 3.2: Market structure
Introduction 98
Market structure spectrum 98
Herfindahl index 103
Lorenz curve 104
Gini coefficient 104
Barriers to entry 104
Barriers to exit 105
Product differentiation 106
Conclusion 106
Unit 3: Microeconomics II: firms and production • Section 3.2: Market 98
structure
Introduction
Market structure refers to how a market is organised. In this section we focus on examining
the main characteristics of different types of market structure, as well as the degree of seller
concentration, including ways to quantify the amount of concentration. A discussion of barriers
to entry and exit follows, as the absence or presence of these can affect the level of increase or
decrease in competition levels.
Market structure spectrum

We can plot the different types of market structure on a spectrum, as shown in Figure 3.9.
The spectrum spans from perfect competition, through monopolistic competition, to
oligopoly, ending with monopoly.
Figure 3.9: The market structure spectrum spanning from perfect competition (the
most competitive) to monopoly (the least competitive). As the market structure
approaches monopoly, the degree of market concentration increases.
The characteristics of each type of market structure are now discussed, followed by examples of
concentration measures.
Perfect competition
In this extreme form of market structure, there are many buyers alongside many firms (sellers),
with each firm acting independently, producing a homogeneous product such that the
production decisions of a single firm are so negligible that there is no impact on the market
price. As mentioned in Section 3.1, such firms are price-takers and can take as given the market
price of p, determined through aggregate market demand and supply.
Due to the homogeneity of the product, consumers regard the output of each firm as being
identical such that there is no practical difference between the output of different firms. As
such, there is no product differentiation (discussed later in this section). There is free entry
and exit from the market, and so no barriers to entry or exit exist (also covered later in this
section). Finally, it is assumed that buyers and sellers in the market have perfect knowledge of
products and prices.
With a homogeneous product, the cross-price elasticities are infinite whereby no seller is able
to increase their sale price above p without losing all customers, as all customers would switch
to the lower price set by all other sellers of this identical product. Therefore, under perfect
competition, the demand curve faced by a single firm is just a horizontal line at the market
price, p, as shown in Figure 3.10.
Perfect competition results in the most efficient form of market organisation where these
assumed identical firms earn normal profits. A normal profit is a profit which is just sufficient to
allow a firm to continue to supply its output. It represents the opportunity cost of the resources
of a firm’s owner.
structure
Figure 3.10: The demand curve of a perfectly competitive firm, producing a

homogeneous product with free entry and exit when there is perfect knowledge of
buyers and sellers. Such firms are price-takers, setting the price at p, which is when
demand and supply are in equilibrium in the market.
Monopolistic competition
A monopolistically-competitive market is similar to perfect competition (many buyers,
and many firms with free entry and exit) but there is now product differentiation where
consumers are able to distinguish between competing products produced by competitor firms.
We assume each such firm faces identical demand and cost functions, with profit maximisation
being the objective. Unlike in perfect competition, firms which are monopolistically competitive
face a downward-sloping demand curve, as shown in Figure 3.11. Consumer demand for a
differentiated product increases as its price decreases. Note that in this type of market structure,
competitors will produce distinct, but close substitutes and so the cross-price elasticities of
demand ensure that the demand curve for any such firm will be fairly elastic, i.e. quite flat.
The production of differentiated products typically leads to such firms having different cost
functions which, in the short run, can lead to supernormal profits. A supernormal profit is the
sum of normal profit and economic profit, where economic profit is the excess profit above the
opportunity costs of the firm’s owners (i.e. the excess over normal profit). We have:
supernormal profit = normal profit + economic profit.
However, in the long run the presence of supernormal profits attracts new entrants to the
market (remember there is free entry under monopolistic competition) which competes away
any economic profits. In effect, the demand curves of the incumbent firms are shifted down,
resulting in a lower quantity demanded for each price level.
Relative to perfect competition, monopolistic competition tends to be less efficient in that the
market consists of lower output levels at higher prices than would be achieved under perfect
competition.
structure
Figure 3.11: The demand curve of a monopolistically-competitive firm, with free entry
and exit, producing a (slightly) differentiated product from its competitors. Quantity
demanded increases from q1 to q2 as price decreases from p1 to p2. The presence of
competition causes demand to be quite elastic as consumers can easily switch to close
substitutes.
Oligopoly
Oligopoly is a type of market structure where there are many buyers, but only a few firms, i.e.
a few dominant firms serve the needs of many consumers. Products are perceived by consumers
to be either homogeneous or differentiated, with the latter more likely, resulting in downward-
sloping demand curves for each differentiated product.
Due to the dominance of the small number of firms in the market, it is difficult for other firms
to enter the market. These are known as barriers to entry, and an in-depth discussion of such
barriers follows later in this section.
When deciding on their own price and output decisions, oligopolistic firms must take into
account the likely responses of their competitors. As such, price and quantity decisions are
strategic decisions, since the actions of one firm are likely to affect the actions of others. For
example, a price cut by one oligopolist might result in other competitors responding with their
own price cuts (i.e. a price war erupts) which leads to all firms earning lower profits. Because
of this, an oligopoly would generally not be a suitable market structure for price competition,
instead each oligopolist would attempt to engage in price-coordination activities. Such
coordination could result in the formation of cartels where firms collude to keep prices high,
allowing them to earn supernormal profits.
Monopoly
A monopoly is a type of market structure in which there is one firm and many buyers.
This means a single supplier serves the needs of lots of buyers, who we think of as behaving
independently. Under pure monopoly, there are no close substitute products for the
monopolist’s product, resulting in a zero cross-price elasticity of demand. The barriers to entry
into the market are so high that it is impossible for new entrants to try and compete against the
monopolist, i.e. there is an effective blockade on market entry.
As seen in Section 3.1 (as well as in FP0001 Mathematics and Statistics), monopolists are
price-setters, or price-makers, as they have full power to set the market price as their firm’s
output represents the entire market supply. Monopolists face downward-sloping demand
curves, with the production and sale of additional units of output (and hence increased market
supply) forcing down the market price at which all its units of output must be sold. We have seen
structure
previously that the demand curve captures the price consumers are willing to pay for each level
of output, which is why for a monopolist price is a function of quantity, i.e. we have:
p = pD(q)
with p a decreasing function of q.
When a monopolist solves its profit-maximisation problem, it can be shown (precise details are
beyond the scope of the course) that in equilibrium the price-quantity point is at a higher price
and lower quantity than would be achieved under perfect competition, resulting in supernormal
profits for the monopolist. The blockade of entry to the market by the very high barriers to entry
means that such supernormal profits can be sustained in the long run, until such time when
consumer demand significantly changes and/or supply conditions are significantly affected.
Concentration measures
Many concentration measures exist, each with the objective of quantifying the size distribution
of firms in an industry.
At the broadest level, we could consider aggregate concentration measures which focus
on the contribution to total activity by the largest firms in the market. For example, the share of
manufactured output produced by the largest 100 firms. In practice we have a choice of criteria
for what is observed - such as sales, number of employees or market share – which inevitably
would result in slightly different concentration measurements. Nevertheless, these provide a
big picture view of concentration, and can be monitored over time to detect any changes in
concentration.
However, if we want to be more precise then we will need to move away from aggregate
concentration measures. Instead we choose to focus on measures of seller concentration.
The concentration ratio captures the extent of seller concentration in a particular market. It
shows the percentage of market sales due to the largest n firms. Plotted on a graph, the number
of firms cumulated down from the largest is on the x-axis, and the cumulative percentage of
market sales is on the y-axis.
A steep curve or line indicates that just a few dominant firms have captured the market, while
a flatter curve or line reflects a low level of concentration with no single firm being particularly
dominant.
Figure 3.12 shows an example with concentration ratios plotted for two markets, A and B, where
market A is highly concentrated, while market B has a much lower level of concentration.
structure
Figure 3.12: A graphical depiction of concentration ratios. Here market A is more

concentrated with 80 per cent of the market served by just four firms, while market B
has a much lower level of concentration with only 20 per cent of the market served by
seven firms.
A drawback of the concentration ratio is that it only shows the seller concentration at a single
point along the cumulative concentration curve which makes it hard to directly compare curves
for different markets. For example, in Figure 3.13 we draw different conclusions about the level
of concentration in a market depending on whether we use a three-firm or five-firm ratio. The
Herfindahl index (discussed below) avoids this problem by using the quantity and market shares
of all firms in a market. The value of the index can then be used for direct comparisons across
markets.
Figure 3.13: Cumulative concentration curves depicting the cumulative market

share served by cumulative numbers of firms (from the largest). Using a three-firm
ratio, market A is more concentrated, while under a five-firm ratio market B is more
concentrated.
structure
Herfindahl index
The Herfindahl index is a measure of the extent of seller concentration in a market. The index
considers the size of firms relative to the industry output. It is calculated by adding up the
squared market shares of all firms in the industry. Mathematically:
N
H = ∑ S i2
i=1
where:
Si is the market share of firm i, expressed as a proportion
N is the number of firms in the market
H is the value of the Herfindahl index.
For example, suppose a market had the following market shares distributed across six firms:
Firm number 1 2 3 4 5 6
Market share (in %) 50 20 10 10 5 5
The Herfindahl index is then calculated to be:
6
H = ∑ S i2 = (0.5) 2 + (0.2) 2 + (0.1) 2 + (0.1) 2 + (0.05) 2 + (0.05) 2 = 0.315.
i=1
It is important to remember that the market shares must be expressed as a proportion, for
example 50 per cent = 0.5.
The range of possible values of the index spans from 1/N to 1. It is equal to 1/N when all N firms
are of the same size, hence the value of the index is the reciprocal of N. For example, with 10
firms each with 10% market share, then the index is 1/10 = 0.1 (or, using the formula, 10 x (0.1)2
= 0.1). Clearly, as N → ∞, then H → 0. For H = 1, there must be a monopoly, i.e. a single firm with
100 per cent market share.
Since we have defined the Herfindahl index as a measure of seller concentration, we should think
about what the value of H tells us about the level of competition. Clearly, the least competitive
situation of a monopoly (when H = 1) demonstrates that the larger the value of the index, the
more concentrated the market, and so the less competitive the market is.
As rules-of-thumb, we can classify a market as follows:
a highly competitive market if H < 0.01
a competitive market if H < 0.15
a moderately concentrated market for 0.15 ≤ H ≤ 0.25
a highly concentrated market (i.e. an oligopoly) for H > 0.25
a pure monopoly for H = 1.
In our earlier numerical example, H = 0.315 indicating a highly concentrated market showing
characteristics of an oligopoly. This is evident due to one dominant firm having 50 per cent
market share, and there being only six firms.
So far, we have considered absolute concentration ratios, taking into account the absolute
number of firms. Here, we look at relative concentration measures, which instead look at
inequalities with respect to the proportion (or percentage) of firms which account for a particular
share of a market.
structure
Lorenz curve
The Lorenz curve is a relative concentration measure. Figure 3.14 shows an example. The x-axis
represents the cumulative percentage of firms, from the largest to the smallest firms and the
y-axis represents the cumulative percentage share of market size. Perfect equality of firm shares
corresponds to the 45-degree line, with greater deviations of the Lorenz curve (above) this line
reflecting greater levels of inequality, i.e. greater levels of seller concentration. This is because the
x-axis shows cumulative percentages from the largest firms, so defined this way the Lorenz curve
cannot be below the 45-degree line. In Figure 3.14 we see that under equality 50 per cent of
firms would account for 50 per cent of sales, but in the market depicted the largest 25 per cent of
firms account for 50 per cent of sales and so sellers are more concentrated.
Figure 3.14: A Lorenz curve depicting the cumulative share of market size accounted
by cumulative percentages of firms (from the largest). Perfect equality would result in
the 45-degree line, with greater seller concentrations leading to steeper Lorenz curves
above this.
Gini coefficient
Visual inspection of a Lorenz curve is helpful to assess the extent of seller concentration.
However, a quantified measure of inequality would be even more useful. For this, we could
compute the Gini coefficient. This takes values between 0 and 1. It is calculated as the area
below the Lorenz curve and above the 45-degree line, i.e. the shaded blue area shown in Figure
3.14, divided by the area above the 45-degree line.
So, if there is perfect equality, the Gini coefficient is 0 (as the shaded area would be zero), while
complete inequality would result in a Gini coefficient of 1.
Barriers to entry
Incumbent firms dislike facing competition as they are self-interested in maintaining any
supernormal profits. Therefore, incumbents are keen to prevent new firms entering their market.
Barriers to entry are obstacles which make it difficult for potential new firms to get a foothold
in the market. We list some of the main barriers to entry which exist when there is a lack of
competition.
structure
Lower production costs for incumbent firms

Due to their large market shares, incumbent firms tend to benefit from large economies of scale
from the production and distribution of their product. New entrants do not have the experience
necessary to achieve such cost-efficient production so would struggle to compete against
incumbents. Consequently, they are put off entering the market.
Consumer preferences for existing brands

Some consumers are brand loyal and so are reluctant to switch to a new product.
Their preference for a ‘tried-and-tested’ product dominates any urge to experiment by
switching to a (close) substitute. In particular, incumbent firms invest heavily in product
differentiation to distinguish their product from any competitors in an attempt to lock-
in consumers to their brand. If consumers are unwilling to switch to a new firm’s product
in sufficient numbers, then a potential entrant would be unable to build a sufficient
market share and, therefore, choose not to enter the market at all.
Control of factor inputs and/or technology
Incumbents may have full or partial control of factor inputs, such as essential raw materials,
without which production of a close substitute product would be extremely difficult. In addition,
incumbents may have taken out patents on essential production techniques (i.e. product-specific
technologies) which prevent new entrants using them (or meaning they would need to invest
heavily to develop their own equivalent technology). Such controls and patent protections
contribute to higher production costs if a new firm entered the market, so act as barriers to entry.
Significant initial capital expenditure

The mere act of entering a new market inevitably requires some initial set-up
expenditure on capital (such as buildings and machinery). Such up-front fixed costs of
entry might make it too expensive for a new firm to enter the market.
The overall effect of limiting the number of firms in a market is that the incumbents are
able to earn supernormal profits. As such, incumbents are incentivised to restrict how
much competition they face. While the above barriers to entry would almost certainly
put off small firms with limited financial backing, large firms, such as conglomerates
(who operate in multiple industries) may have sufficient money to overcome all barriers
to entry. Indeed, such firms may then be able to innovate new technologies and
ultimately develop a competitive advantage over long-standing incumbents.
Barriers to exit
We now briefly turn to barriers to exit. Just as potential entrants may struggle to enter a
market, it is possible that existing firms may struggle to exit even if faced with falling sales and
profitability if the costs of exit exceed the costs of continuing to trade. We list some of the main
barriers to exit which can exist.
Ownership of high-cost special-purpose assets

If specialist machinery was purchased to produce the firm’s output at a sufficiently high cost and
this machinery could not be redeployed to produce something different or be sold at a high
enough price, then the firm may decide to continue in the market to avoid incurring a loss on its
capital expenditure. If the assets are only leased (rather than owned) then this is less of a barrier
as any costs would be limited to those associated with ending the rental contract.
Redundancy costs
Exiting the market would likely result in laying off staff who usually have to be compensated with
a severance payment known as a redundancy payment. The larger the workforce, the greater
the total cost of redundancy and so this may prohibit the exit of the firm altogether.
structure
Terminating other contractual obligations

In addition to any redundancy payments to employees, exiting the market may also involve
terminating various types of contracts, such as the lease of a building, or penalty clauses in
contracts with suppliers of raw materials. The greater the sum of such payments, the greater the
disincentive to exit.
Product differentiation
It was mentioned previously that firms invest in product differentiation in an attempt to
demonstrate a sufficient distinction between their product and a non-perfect substitute of a
competitor. This concept is worthy of a special mention.
Product differentiation can be thought of as a type of non-price competition. The product
concerned may be differentiated either in terms of demand-side or supply-side ways.
Demand-side differences are conveyed through advertising, which seeks to promote the relative
benefits of a product over those of any competitor by emphasising differences in product
characteristics (whether real or imaginary). Indeed, brand image can play a very powerful
role in this respect. Branded products often command a price premium over non-branded
substitutes (for example, branded cereals in supermarkets tend to be much more expensive
than a supermarket’s own-branded cereal). By cultivating a powerful brand image a firm hopes
to sustain and grow its customer base, especially in an oligopolistic market setting. Any price
premium contributes to the firm earning supernormal profits.
Supply-side differences tend to refer to actual differences in product characteristics which might
cover areas such as quality, design, style, performance or packaging.
Conclusion
This section has presented a spectrum of different types of market structure, classifying different
ways in which markets can be organised. We have considered the characteristics of perfect
competition, monopolistic competition, oligopoly and monopoly.
Various measures of concentration were introduced, each aimed at determining the type of
market structure present in an industry. In particular, the Herfindahl index, Lorenz curve and Gini
coefficient were offered as ways of assessing the level of seller concentration.
Just because a type of market structure may be in place, it is possible for this to change over
time. How likely this is will depend on the extent of barriers to entry and exit. The ease with
which a firm can decide to enter or exit a market will have a major impact on the level of
competition.
The amount of competition in a market can have consequences for society. A market dominated
by a small number of ‘big players’ could potentially stifle innovation. Indeed, there is a possible
role for government intervention over monitoring mergers and takeovers within a sector.
On the one hand it could be argued that when companies merge (or one takes over another)
this creates synergies which benefit innovation and hence consumers. However, from a
different perspective it could be argued that a competitor is being absorbed – a competitor
who potentially may have unleashed their own innovations, disrupting the sector which could
ultimately threaten the other incumbents.
structure
ACTIVITY 3.6
Compare and contrast the main characteristics of perfect competition, monopolistic
competition, oligopoly and monopoly.
ACTIVITY 3.7
Which is the best form of market structure from the perspective of:
a. the producer?
b. the consumer?
ACTIVITY 3.8
Calculate the Herfindahl index for the following market and interpret its value.
Firm number 1 2 3 4 5 6 7 8
Market share (in %) 28 21 17 14 9 5 4 2
Also, for this market, plot the:
a. cumulative concentration curve
b. Lorenz curve.
ACTIVITY 3.9
Find examples of different types of market structure in your country. Can you explain
why a particular industry has its level of competition? (You may discuss barriers to entry
and exit in your answer.)
ACTIVITY 3.10
Under oligopoly, it was stated that firms may undertake price-coordination activities
which could lead to the formation of a cartel and possible price collusion. The
Organisation of Petroleum Exporting Countries (OPEC, www.opec.org) is an organisation
of countries which account for about 45 per cent of the global oil market.
OPEC members regularly meet to discuss output decisions (i.e. how much oil to produce)
conscious that the quantity supplied to the market will impact prices.
Research examples of OPEC output decisions, including the reasons behind why the
particular output decisions were made.
Section 3.3: Market failure and externalities
Introduction 109
Market failure 109
Merit and demerit goods 110
Economic analysis of externalities 111
Markets with negative externalities 112
Markets with positive externalities 113
Government intervention 114
Subsidies 117
Congestion charges 117
Tradable pollution permits 118
Regulation and legislation 118
Government provision through buffer stock schemes 119
Desirability of government intervention 120
Conclusion 120
Unit 3: Microeconomics II: firms and production • Section 3.3: Market failure and 109
externalities
Introduction
In Section 2.1 we discussed how the price mechanism allocates scarce resources through
the forces of demand and supply to reach market equilibrium. However, out of all the
possibilities, is the obtained allocation the best one? Often, the answer is no. The price
mechanism sometimes fails to allocate resources efficiently. Such a situation is called
market failure.
Externalities are third-party effects (delivered and received outside the market)
caused by decisions or actions made by someone else. These can be positive (i.e. ‘good’
externalities) or negative (i.e. ‘bad’ externalities). Having analysed externalities, we will also
consider a role for government intervention to promote positive externalities and reduce
negative externalities through taxation and subsidies, as well as other intervention tools.
Market failure
Market failure occurs when the market fails to achieve an optimal allocation of resources. There
are numerous sources of market failure, which we now review.
Monopoly and other forms of market dominance

Markets are rarely (if ever) perfectly competitive. Most firms enjoy at least some degree of
market power. The fewer firms there are in a market, the greater the market power each of them
possesses. Recall the market structure spectrum in Section 3.2 which demonstrated how the
level of competition and concentration varied across the spectrum.
In the absence of competition (i.e. under monopoly and oligopoly), prices are higher than those
needed for a firm to break even. This increases profits made by such firms but decreases general
efficiency - prices charged by firms no longer reflect the true costs of production. Moreover, there
are some unhappy customers who are willing and able to pay more than it costs to produce a
good, but who still cannot buy it as prices charged by firms operating in imperfectly competitive
markets are just too high. As a result, market failure occurs.
The power of monopolists and oligopolists to earn supernormal profits and their distortion of
the perfect market is enormously inefficient. Employees of the monopoly and the firm’s owners
may benefit, but society suffers a severe welfare loss. This is one of the main reasons why
governments also intervene in the market. Anti-monopoly legislation and taxation are used by all
governments in mixed economies.
Externalities
Externalities are defined as the extra, or external, costs or benefits delivered outside the market
to a third party resulting from a decision made by someone else. For example, if your classmates
regularly consume a balanced diet, they are less likely to get ill. This is their private benefit.
However, their actions also affect you - since people around you are healthier, that means you
are less likely to catch infections from them. As a result, you benefit from actions taken by your
friends, i.e. there is an external benefit. Economists call this a positive externality. Private and
external benefits combined together are referred to as social benefits.
On the other hand, when somebody smokes, they risk their own health. This is their private cost
of smoking. However, when they smoke around you, they expose you to the consequences of
passive smoking, which is an external cost. Subsequent lung problems are examples of negative
externalities. Private and external costs combined together are referred to as social costs.
To summarise:
social benefits = private benefits + external benefits
externalities
and:
social costs = private costs + external costs.
Externalities can also be categorised as either production or consumption externalities,
depending on their source. Production externalities occur when the spill-over (third-party)
effects result from the physical production of a good. Examples include factory pollution and
environmental damage caused by carbon dioxide emissions. Consumption externalities,
on the other hand, occur as a direct result of product consumption. For example, by using
deodorant, people are making it easier and nicer for others to be around them!
Public goods
Most goods, such as cars, clothes, food and so on, are called private goods. This is because they
are both rivalrous and excludable. Rivalry means that one person’s consumption reduces the
amount of the good available to others. For example, if I consume a bar of chocolate, there will
be less available for you. Excludability, on the other hand, means that some people may not be
allowed to benefit from a certain good, for example if they are not willing or able to pay for it.
On the other hand, public goods (such as national defence or street lighting) are said to be both
non-rivalrous and non-excludable. They are said to be non-rivalrous because the amount
consumed by one person does not limit the quantity available for others. For example, if a
country is protected by its armed forces, the amount of protection available to you is not usually
affected by the fluctuations in the size of the population. Public goods are also non-excludable
because it is also impossible to prevent anyone from enjoying the public good once it has been
provided. If there is a street light installed on a London street, anyone travelling through the city
can benefit from it.
The consequence of the non-rivalry and non-excludability of public goods is the ‘free-rider’
problem. Even those who are not willing or able to pay for the good can still enjoy it without
any limits. Therefore, if such goods were to be provided by private companies, no-one would
be willing to pay for the provision of the good. In such cases, no profits can be made and so
no private company would be willing to provide the good. The problem of a missing market
would arise. In graphical terms, there would be no intersection of the market demand and supply
curves.
Some goods, such as libraries, are classified as quasi-public goods because they exhibit mixed
characteristics of both private and public goods - they are either non-rivalrous but excludable, or
non-excludable but rivalrous. For example, radio and TV broadcasting can be classified as quasi-
public goods as they are non-rivalrous - the amount of programmes or stations available to you
is not affected by the size of the audience; but at the same time it is excludable – it is possible
to prevent someone from enjoying the broadcast if the person is not willing to pay for the
television licence. Sea fishing, on the other hand, is said to be rivalrous (especially when stocks
are overfished) but non-excludable. Since the amount of fish in the sea is limited in a given time
period, if I catch all of them, there will be none left for you. However, I cannot prevent you going
fishing!
Merit and demerit goods

It is a common belief that people should know best what is good for them and what is not. Some
argue, however, that this is not always the case, especially when it comes to the consumption of
merit and demerit goods.
Merit goods are goods which are better for people than they think. Benefits could be
underestimated, for example, due to time lags. Costs are observed immediately, while positive
effects may only be visible in a few years’ time. As people find it difficult to make well-informed,
externalities
rational decisions, merit goods are usually under-provided by the free-market mechanism. In
addition, merit goods can also benefit others. Education, for example, not only helps you find a
better job in the future, but it indirectly contributes to the growth of the country. This is because
the better educated you are, the more efficient you become as a worker (remember why you are
studying the IFP!).
Demerit goods are goods with under-estimated or ignored harmful effects, for example
cigarettes, drugs and alcohol. Not only do they have a negative effect on people who consume
them in excessive amounts, but they can also harm others, for example, through passive
smoking.
Under-consumption of merit goods and over-consumption of demerit goods can, therefore, be
explained in two ways, in terms of the:
imperfect information problem (people not fully appreciating what is good for them and
what is not)
consumption externalities (third-party effects) generated by their consumption decisions.
Economic analysis of externalities

Now that we know what externalities are, we need to find out why and how they cause market
failure. Market outcomes are only efficient when prices accurately reflect the costs and benefits
to society of a certain economic activity. Instead of using total costs and benefits, economists
often switch to marginal costs and marginal benefits.
Marginal cost is the cost of one extra unit produced. For example, if the production of three
copies of a book costs £20 while the production of four copies of the book costs £23, the
marginal cost of the fourth book is £3. This is because increasing production by one unit (from
three copies to four), the total cost increases by £3 (from £20 to £23). Marginal cost usually falls
with the first few units produced (due to increased efficiency) but then tends to increase with the
production of more goods. This is because, with increased output, more factors of production are
needed, and they become more expensive when demand for them increases.
Marginal benefit is the benefit of one extra unit consumed. For example, if you derive 50 units
of utility from 10 candles and 54 units of utility from 11 candles, then the marginal benefit in
terms of utility of the 11th candle is 4. This is because by consuming one more candle your utility
increases by 4 more than when you consumed only 10 candles. Marginal benefit, here marginal
utility, decreases when consumption increases. This is due to diminishing returns - every extra
unit consumed makes you less happy than the one before because some of your needs were
already satisfied and therefore you gain less extra utility from an additional candle.
Figure 3.15 shows, in the absence of externalities, marginal cost at different levels of output,
which is the same as the supply curve. Likewise, the marginal benefit curve is the same as the
demand curve. Market equilibrium occurs when the demand curve intersects the supply curve,
or, equivalently, when the marginal benefit curve intersects the marginal cost curve. In the
absence of externalities, the marginal benefit is equal to the marginal private benefit, similarly the
marginal cost is equal to the marginal private cost.
externalities
Figure 3.15: Marginal benefit (MB) and marginal cost (MC) curves which coincide with
demand and supply curves, respectively, in the absence of externalities.
We now verify how the existence of externalities results in the condition for the efficient
outcome not being satisfied, i.e. the market outcome when prices do not accurately reflect costs
and benefits to society.
Markets with negative externalities

Consider production of a car. How many cars people demand is determined by the benefits
of owning one. If you have a car, you can enjoy faster, safer and more reliable means of travel.
Your demand for the car is the same as your marginal private benefit. There are no positive
externalities from having a car, therefore the marginal private benefits and marginal social
benefits are the same. You (or your family and friends) are the only one(s) who enjoy it.
The number of cars which sellers are willing to supply is determined by their costs of production:
cost of labour, operating assembly line, wheels, engine etc. This is represented by their supply
curve (or marginal private cost curve). Therefore, as long as customers are willing to pay more for
one extra car than it costs to produce it, that extra car would be supplied. Equilibrium quantity is
therefore the one where marginal benefit equals marginal private cost.
However, is the private cost the only cost of this production process? Cars produce pollution
after all. Such external costs are not included in the price of the car, but they are part of the social
costs. Therefore, the marginal social cost is higher than the marginal private cost, as shown in
Figure 3.16. Consequently, from society’s point of view, the current price, p0, is too low and the
number of cars produced, q0, is too high.
externalities
Figure 3.16: Market with negative externalities. Here marginal private benefits are
the same as marginal social benefits, so we simply show the marginal benefit (MB)
curve, while the supply curve is the marginal private cost (MPC) curve, producing an
equilibrium quantity-price point of (q0, p0). Negative externalities mean the marginal
social cost (MSC) is higher than the MPC, for example due to pollution, which should
result in a lower quantity-higher price point of (q1, p1).
The over-production of cars results in a welfare loss to society (the pink triangle). It can only
be eliminated when price is increased and quantity decreased to the socially optimal levels.
Market equilibrium at q0 and p0 reflects the situation of the marginal benefit being equal to
the marginal private cost. However, when marginal social costs are considered, the equilibrium
should be established at q1 and p1 by an increase in price and a decrease in quantity demanded.
A welfare loss to society exists because the marginal social cost at the level of production q0 is
greater than the private equilibrium situation.
Markets with positive externalities

Consider the provision of higher education. The number of different degrees universities are
willing to supply depends on the costs associated with the number of lecturers employed,
buildings maintained, and electricity supplied etc. All these constitute private costs. Since there
are no negative externalities of providing higher education degrees, social costs and private
costs are the same. How about benefits? Private benefits to students include better employment
prospects, higher wages and their own personal enjoyment of their broadened horizons.
However, there are also some external benefits. A better-educated workforce is believed to have
greater efficiency and higher human capital resulting in new discoveries and increased growth.
Consequently, from society’s point of view, the benefits of higher education are greater than
from an individual’s point of view. Therefore, society would want to see a greater amount of
higher education consumed. This can be seen in Figure 3.17.
The under-consumption of higher education results in a welfare loss to society (the green
triangle). Society can increase its welfare by the size of the green triangle if the quantity
consumed is increased to the socially optimal level, q1, which also coincides with a higher price.
externalities
Figure 3.17: Market with positive externalities. Here marginal private costs are the
same as marginal social costs, so we simply show the marginal cost (MC) curve,
while the demand curve is the marginal private benefit (MPB) curve, producing an
equilibrium quantity-price point of (q0, p0). Positive externalities mean the marginal
social benefit (MSB) is higher than the MPB, for example due to a better-educated
workforce, which should result in a higher quantity-higher price point of (q1, p1).
Let us summarise everything we have observed about externalities so far:

externalities are third-party effects resulting from decisions or actions made by someone else.
They are delivered and received outside the market
harmful effects are called negative externalities, whereas beneficial effects are called positive
externalities
both positive and negative externalities can be identified as consumption or production
externalities, depending on their source
negative externalities give rise to an inefficient allocation of resources because external costs
are not included in the free-market equilibrium. From society’s point of view, goods are over-
produced and prices charged are too low
positive externalities give rise to an inefficient allocation of resources because external
benefits are not included in the free-market equilibrium. From society’s point of view, goods
are under-consumed and under-priced.
Government intervention
Markets can fail and they often do. Demerit goods are over-provided; merit goods are under-
consumed; while markets for some public goods are missing. Government intervention is one
way of trying to solve these problems. We consider a few of the most commonly-used means of
government intervention, including an examination of some advantages and disadvantages of
each.
Taxation
Indirect taxes (introduced in Section 2.3) are mostly used to correct market failure resulting from:
negative externalities
demerit goods.
externalities
In the case of negative externalities, inefficiency is caused by the fact that marginal social costs
are higher than the marginal private costs of production (MSC > MPC). Imposing tax on such
goods increases private costs and reduces supply making marginal social costs and marginal
private costs with tax approximately the same (MSC ≈ MPC + tax). In order to fully eliminate the
welfare loss caused by negative externalities, the tax should be exactly equal to the size of the
externality (see Figure 3.18).
Figure 3.18: Taxation to combat negative externalities. A tax equal in size to the red
arrow fully eliminates a negative externality by ensuring the marginal social cost is
fully taken into account.
Market failure in the case of demerit goods is caused by the over-consumption of harmful
substances. In order to make them less attractive to consumers, governments tax the goods
which significantly increase their prices. The effectiveness of such a policy greatly depends on the
price elasticity of demand.
If consumers are insensitive to price changes (such as heavy smokers), the imposed tax has to be
very large in order to have at least some effect. If buyers are price sensitive (such as occasional
smokers), then a smaller tax would likely be sufficient to significantly reduce the quantity of
cigarettes bought (see Figure 3.19).
externalities
Figure 3.19: Taxation to combat the over-consumption of demerit goods. A unit tax
shifts the supply curve up from S to “S with T”, resulting in a reduction in equilibrium
quantity from q0 to q1 and an increase in equilibrium price from p0 to p1. The
effectiveness of such a unit tax depends on the price elasticity of demand. Inelastic
demand, such as for heavy smokers, means a steep demand curve so a large increase
in price (due to a large unit tax) only reduces consumption by a small amount. Less
inelastic demand, such as for occasional smokers, means a flatter demand curve
so a smaller increase in price (due to a smaller unit tax) can reduce consumption
dramatically.
Direct taxes (especially income taxes) provide funding which is used for the provision of public
goods such as new roads or street lighting. Direct taxes also help to correct the problem of
inequality. Excessive income is collected from the rich and given to those in need in the form of
social benefits (unemployment benefits, jobseekers’ allowances, child benefits, housing benefits
etc.).
Advantages of taxes for correcting market failure:

taxes create revenue for the government which can be used to further improve efficiency, as
well as to provide public goods
negative externalities are internalised because those who cause them pay for them (this is
often referred to as the ‘polluter pays’ principle)
increased costs of production should result in higher prices being charged and, therefore,
an immediate reduction of the quantity consumed of demerit goods and those resulting in
negative externalities.
Disadvantages of taxes for correcting market failure:

it is very hard to put a monetary value on some harmful effects (such as noise or pollution)
and so setting the correct tax amount to fully internalise the externality is very challenging
increased taxes add to production costs and may reduce firms’ competitiveness when faced
with imported goods from countries where taxes are not imposed
when demand is price inelastic, even high taxes may not significantly reduce the amount
consumed
black markets might be created to avoid paying the tax.
externalities
Subsidies
Subsidies are provided by governments in order to increase the consumption of merit goods
and goods whose consumption generates positive externalities which benefit other people.
By subsidising the costs of production, governments help in lowering the prices of goods for
consumers which results in an increase in the quantity demanded. This is achieved because the
subsidy shifts the supply curve to the right as shown in Figure 3.20. After the subsidy is applied,
the quantity demanded increases from q1 to q2, while the market price falls from p1 to p2. The
amount of the subsidy is given by p0 – p2.
Figure 3.20: A subsidy shifts the supply curve to the right, here from S to
“S with subsidy”. The demand curve is the marginal private benefit (MPB)
curve. Initially the good has a price of p1 and a quantity demanded of q1. After
the subsidy is introduced, the price falls to p2 and the quantity demanded
increases to q2. The amount of the subsidy is p0 - p2.
Advantage of subsidies
subsidies lower the market price and therefore help to internalise external benefits
producers may be incentivised to produce more products with positive externalities.
Disadvantage of subsidies
there is an opportunity cost involved with every pound or dollar spent on subsidising certain
goods as the money could have been used more beneficially for other purposes
prolonged subsidies might limit firms’ incentives to find better and more efficient means of
production.
Congestion charges
Congestion charges are applied to roads which tend to be over-used and so result in negative
externalities, such as increased traffic and pollution. The use of these roads is only allowed after
a certain toll is paid. Because extra payments increase the costs of travelling by other private
means of transportation, some people switch to cheaper substitutes (i.e. public transport) and
congestion is effectively reduced. Such solutions have been successfully implemented in London
and Singapore, for example.
externalities
Advantages of congestion:
congestion charges effectively reduce the amount of traffic
traffic is easy to monitor and can be changed by modifying the size of the toll.
Disadvantages of congestion:
monitoring systems are costly
people living within the congestion charge zone may feel that it is unfair that they have to
pay the charges
it may be difficult to put an exact monetary value on the harmful effects caused by road
traffic.
Tradable pollution permits

Many factories pollute the environment by emitting harmful gases (such as carbon dioxide,
CO2, and sulphur dioxide, SO2). These harmful effects are, however, not included in the costs
of production and, therefore, too many units are supplied. In order to correct this situation,
governments may internalise these negative externalities by charging firms for their rights
to pollute. Each company must buy special pollution permits which are licences given by
governments allowing pollution at a certain level. Because the supply of pollution permits is
limited, the amount of gases emitted is under strict control. A good example of government
regulation and permits involves the control of gas flaring from North Sea oil production
platforms in the UK.
Advantages of tradable pollution permits:

the missing market for pollution is created
pollution permits can be reduced over time, therefore reducing the target level of total
pollution
pollution permits can be a source of income for governments if permits are sold rather than
given out for free
high prices of pollution permits give firms incentives to invest in better, cleaner technologies,
which in the long run might be cheaper than buying the permits every year.
Disadvantages of tradable pollution permits:

if too many permits are issued, the resulting reduction in pollution would be very limited (if
any)
if too few permits are issued, firms may become uncompetitive or stop production altogether,
i.e. they exit the market, reducing the amount of competition and increasing the seller
concentration
monitoring pollution is very costly and challenging
it is hard to put monetary values on the costs of pollution.
Regulation and legislation

Regulation is one of the most easily implemented solutions. Regulation involves the control
of economic activities by the government or some other regulatory body. Once written down
and passed as a law, regulation must be obeyed under a threat of punishment. Examples of
regulations used worldwide include age restrictions on purchasing cigarettes and alcohol,
minimum school-leaving ages and compulsory car insurance.
externalities
Advantages of regulation and legislation:

regulations are clear and direct
when mergers or takeovers require regulatory approval, this can be withheld if the proposed
merger or takeover is considered detrimental to market competitiveness
legislation sends a clear signal that the activity is wrong or undesirable.
Disadvantages of regulation and legislation:

enforcement costs can be very high if every company/shop/institution is to be carefully
controlled
possibility of under- or over-regulation due to imperfect information
some regulations (such as banning harmful goods) may result in black markets
danger of regulatory capture – the situation when the regulatory agency, which was created
in order to act in the public interest, instead acts to benefit only a specific interest group, usually
the one dominating that specific market.
regulations can act as a barrier to entry, protecting already existing monopolies.
Government provision through buffer stock schemes

Prices of primary agricultural goods can be very volatile and therefore cause a lot of uncertainty
to both consumers and producers. To limit price changes, the government may operate special
buffer stocks where goods are bought to be stored if the year is particularly good (when there
is a surplus) and sold when the harvest is bad and there is a shortage of that commodity. See
Figure 3.21 which considers the provision of coffee beans.
Figure 3.21: The supply curves S1 and S2 represent the supply of coffee beans at the
end of two different seasons – bad and good, respectively.
externalities
Note that at any given time, supply is perfectly inelastic since farmers cannot change the
quantity supplied to the market after a harvest has been collected. Suppose the government
wants to keep price fluctuations within a certain band: namely, below Pmax and above Pmin.
Suppose now that in a particular year there is a bumper harvest and, therefore, the supply in that
year can be represented by the S2 curve. Without any intervention, the coffee bean price would
quickly drop below Pmin. To avoid such a situation, the government could buy Y - X of the coffee
beans and place in storage to increase the market price to Pmin.
Desirability of government intervention

We have seen how the government can intervene, but is government intervention always
successful? The answer is no.
Sometimes, government intervention to correct market failure may not work. This could be
caused by the following reasons:
inadequate information – to set a successful policy one needs to rely on perfect information
and precise data
administrative failings – imposition of any control or regulation could provide a loophole for
evasion, for example investment banks can ask their employees to sign a contract stating
that maximum working time does not apply to them (labour markets are discussed next in
Section 3.4)
unintended effects – growth of a black market and cash-only transactions to evade tax
political conflicts – some influential groups can persuade politicians or governments to
change their decisions; there could also be a lot of pressure from media, lobbyists and others
or simply politicians may not be able to reach a consensus.
Conclusion
This section has introduced the concept of market failure and shown examples of how it can
arise, with a particular emphasis on positive and negative externalities. The welfare losses
generated by externalities have been illustrated graphically by considering how social benefits
and costs exceed private benefits and costs.
We have also seen how governments can intervene in an effort to correct market failure, using
a variety of tools such as taxation, subsidies, congestion charges, tradable pollution permits,
regulation and legislation.
ACTIVITY 3.11
Explain whether each of the following goods are private, public or quasi-public:
parks
the Internet
beaches
refuse collection
footpaths
art galleries
food.
externalities
ACTIVITY 3.12
What is the difference between public goods and merit goods?
Using defence and education as examples, discuss the economic arguments regarding
the provision of public goods and merit goods.
ACTIVITY 3.13
Give three examples, other than those mentioned in this section, of goods/actions with
positive externalities and three examples of goods/actions with negative externalities.
Clearly distinguish between the private and external costs and benefits.
ACTIVITY 3.14
In what sense can the market system ‘fail’?
To what extent could an argument be made to justify public sector (i.e. government)
provision of goods and services?
ACTIVITY 3.15
Using Figure 3.21, analyse how the government can intervene in the coffee bean market
in order to stabilise the price after bad weather impacts on the following harvest if a buffer
stock scheme was in place.
Section 3.4: Labour markets
Introduction 123
Wage rate 123
Labour demand and labour supply 123
Determinants of labour demand and supply 124
Minimum wage legislation 127
Asymmetric and imperfect information 128
Conclusion 129

Unit 3: Microeconomics II: firms and production • Section 3.4: Labour markets 123
Introduction
We conclude the microeconomics part of the course by taking a look at labour markets.
Up to this point, we have considered demand and supply for tangible goods and services. We
now consider demand and supply in the context of the labour market. Here, the ‘service’ is labour
which is supplied by a worker and demanded by an employer.
A labour market is a ‘factor of production’ market providing a means to exchange work for wages.
While labour is a factor of production, its characteristics are quite distinct from other factors
such as capital. The rate at which workers produce output will depend on how efficiently firms
organise work tasks, as well as the motivation of workers themselves (see the division of labour
covered in Section 1.1).
This section will begin by defining the wage rate, then consider demand and supply curves in
the labour market, including some determinants of labour demand and supply. An argument for
a ‘backward-bending’ labour supply curve will be put forward. Government intervention in the
labour market through a minimum wage will be discussed, along with some information issues
which can affect the labour market.
Wage rate
Labour can be thought of as the human capital supplied to the market by willing workers and
the demand for labour comes from firms which need workers to produce goods according to
their production functions.
In the labour market, employers ‘buy’ labour from workers (who can be thought of as ‘selling’ their
labour). Prices have been introduced as the mechanism by which imbalances between demand
and supply have been resolved. Here, the price is the wage of the worker per unit of labour
(which might be in units of hours, for example), which we call the wage rate. So the wage rate is
the price of labour.
Labour demand and labour supply

The demand curve for labour is downward-sloping, as higher wage rates mean higher labour
costs, so firms demand less labour as the wage rate (the price of labour) increases. The supply
curve for labour is (typically) upward-sloping as workers are prepared to supply more of their
labour to the market as a unit of their labour earns them more money as the wage rate increases.
Figure 3.22 shows labour demand and supply curves. In a competitive labour market, the
equilibrium wage rate is achieved when demand equals supply, i.e. at the intersection of the
labour demand and supply curves. In Figure 3.22 the equilibrium wage rate is we, and equilibrium
quantity of labour is Qe.
Figure 3.22: Labour demand and supply curves which, in a competitive labour market,
determine the equilibrium wage rate, we, at the intersection of the curves, leading to
the equilibrium quantity of labour Qe.
Determinants of labour demand and supply

Note that there are several determinants of labour demand and supply, and changes in any of
these will shift the respective curve. Determinants of labour demand include:
demand for the goods and services produced by workers
total wages costs relative to total production costs
the extent to which capital can substitute labour in the production process.
Determinants of labour supply include:
population size
school-leaving age
retirement age
labour mobility
skills and training
income tax rates
barriers to entry for some professions (such as needing certain qualifications)
influence of trade unions as ‘monopoly sellers’ of labour.
Labour is largely immobile because people are often unwilling to leave their families and home
countries. This is partially due to strong cultural and language differences. Workers can also
often find it extremely difficult to move across occupations and into different fields of work. If a
mathematics teacher is made redundant, they may experience difficulties finding a new job if the
only available vacancies are for nurses. The skills and qualifications of the teacher cannot be easily
transferred and applied to a nurse’s role.
Labour is not unique, after all people pursue many different professions with some better-paid
than others. As such, we should not necessarily think of the labour market as a homogeneous
market of identical workers, rather it is a combination of several individual labour markets for
each profession where each profession may have its own specific characteristics – for example, in
terms of barriers to entry.
Consider the labour market for high-skilled surgeons (requiring extensive study and training at
medical school) versus the labour market for low-skilled office cleaners (requiring little-to-no
training). While both professions have labour demand and supply curves, these will be very
different, as shown in Figure 3.23.
Surgeons are highly-skilled which means the supply of surgeons is very limited (you cannot train
to be a surgeon overnight), leading to a steep labour supply curve spanning low quantities of
labour. Demand for surgeons is high – you may need surgery to save your life. As a result, the
equilibrium wage rate is at a high wage rate of ws.
Office cleaners fulfil an essential task, however there is a much greater supply of office cleaners
compared to surgeons (the barriers to entry are far lower – no need for medical school, for
example). Although there is demand for office cleaners, this is quite low relative to the supply. As
such, the equilibrium wage rate is at the much lower wage rate of wo.
The difference in wage rates for surgeons and office cleaners, ws - wo, is the wage differential.
Indeed, as IFP students you are studying now to progress to undergraduate study to obtain a
degree (and perhaps a postgraduate degree after that), presumably with the ultimate objective
of securing a highly-skilled, well-paid job. Think back to your discussion of the opportunity costs
of studying the IFP back in Section 1.1!
Figure 3.23: Labour markets and wage rate determination for surgeons and office
cleaners.
Backward-bending labour supply curve

Of course, from the worker’s perspective there is an opportunity cost of working, i.e. the leisure
time foregone. The longer you spend working, the less free time you have to pursue leisure
activities. Therefore, an argument can be made that labour supply curves are backward-bending
as a consequence of income and substitution effects.
Figure 3.24 shows an example of a backward-bending labour supply curve. The theory claims
that when the wage rate is low, increases in the wage rate incentivise workers to increase their
supply of labour as the opportunity cost of leisure time increases. However, every extra hour
worked means an hour less of leisure (and we gain utility from leisure, so each hour of leisure
is valuable to us). Therefore, it is assumed there comes a point when the wage rate equals the
worker’s valuation of a unit of leisure time, so higher wage rates do not change the number of
hours worked. Beyond this, at very high wage rates workers reduce their supply of labour as they
substitute leisure for work and can afford to do so given the very high wage rate.
Figure 3.24: A backward-bending labour supply curve. As the wage rate increases
(from initially low levels) workers increase their supply of labour, but gradually work
becomes so well-paid that utility-maximising workers begin to substitute leisure for
work.
With only 24 hours in a day, a worker must choose the right balance between work and leisure
(what to do with our time was cited as an example when the concept of opportunity cost was
introduced in Section 1.1). An hour of work is paid at the wage rate, while an hour of leisure is
unpaid.
As the wage rate increases, the opportunity cost of an extra hour of leisure increases, i.e. leisure
becomes relatively more expensive, and so there is a substitution effect away from (the more
expensive) leisure to work.
As the wage rate increases, the hours worked at the previous wage rate are now paid at a
higher rate, which creates an income effect. This income effect makes leisure more affordable.
Assuming leisure is a normal good (defined in Section 2.1), then as income increases we demand
more leisure.
As a result, there are two competing effects as the wage rate rises. The backward-bending labour
supply curve assumes that for low wage rates the substitution effect dominates the income
effect as the wage rate rises. At some point, at a higher wage rate, the income and substitution
effects cancel each other out resulting in no change to the total hours worked. Beyond this, at
very high wage rates, the income effect dominates the substitution effect, resulting in the labour
supply curve becoming backward-bending, as shown in Figure 3.25.
Figure 3.25: A backward-bending labour supply curve in terms of income and

substitution effects, showing the relative dominance of these two effects at different
points on the curve.
Minimum wage legislation

In Section 2.1 price controls were introduced as a mechanism through which governments could
intervene in markets to control prices. There we saw the example of rent control to illustrate a
price ceiling.
Governments can intervene in labour markets. In this section we consider a price floor, using
the well-known example of a minimum wage. This is illustrated in Figure 3.26.
When a government introduces a minimum wage at pmin, which is above the pre-existing
equilibrium wage rate p*, workers are paid more. However, firms will no longer be willing to
employ as many workers as before and, therefore, some would have to be fired.
Additionally, there would be other previously-unemployed people who would be willing to work
at the new higher wage rate, but there would be no work for them. As a result, excess supply
and therefore unemployment, would be created.
So, is a minimum wage a good idea? Well, it depends on whether you are a winner or a loser after
its introduction! Workers who keep their jobs are better off, as they now receive pmin - p* more per
unit of labour worked - these are the winners. However, if you are one of those fired due to the
excess supply created by the minimum wage you are definitely worse off – these are the losers
from a minimum wage. In truth, it is all about perspective!
Figure 3.26: When a government implements minimum wage legislation, it sets a

price floor on the wage rate. Here, let pmin denote the minimum wage, which is above
the market-clearing wage rate of p*. At the wage rate of pmin excess supply of labour is
created.
Asymmetric and imperfect information

In practice, knowledge and information are unevenly distributed. Workers know more about their
skills and work ethics than their employers do. Patients know more about their vulnerability and
the strength of their immune systems than their insurance companies do. Lenders do not know
how likely a borrower is to repay a loan.
In some situations, parties may want to signal their characteristics or learn more about others.
Therefore, we have job interviews, education certificates, health checks and so on. Without
reliable information, employers, consumers and producers may make decisions which lead to
suboptimal outcomes.
You may buy a second-hand car which turns out to be defective or unreliable. Or you may end
up employing unqualified workers by taking false resumes at face value. In general, job markets,
second-hand goods markets, insurance markets and even dating websites are all examples of
markets with the highest degree of asymmetric information. Some parties know more than
others, and therefore well-informed decisions are not possible.
Asymmetric information is when a party involved in a transaction has more information than
the other party. The main solutions are signalling and/or screening to reduce (if not entirely
eliminate) the information asymmetry. One could argue that the role of education is for students
to signal their ability to employers in order to get a job which requires skills which match their
ability.
A related, but distinct, concept is that of imperfect information, which occurs when a decision-
maker has incomplete, inaccurate, uncertain or misinterpreted information leading them to
potentially make an incorrect choice.
Examples include:
inaccurate information from misleading advertising
uncertainty about the costs and benefits which may not be realised until after a decision has
been made
not fully understanding the private and social costs of going to university.
In practice, labour markets tend to be imperfect due to the costs of collecting information on
(potential) workers. The fact that workers are not homogeneous also makes it difficult to assess
the relative skill sets and abilities of individual workers.
Conclusion
Labour is a special factor of production requiring a separate analysis of the labour market. We
model workers as selling their labour at a given wage rate to firms who buy the labour to allow
production. The forces of demand and supply, in a competitive labour market, determine the
equilibrium wage rate and quantity of labour. Profession-specific characteristics result in different
equilibrium points across different professions, with higher-skilled professions realising higher
wage rates. We have also seen how income and substitution effects can result in a backward-
bending labour supply curve as workers attempt to resolve the trade-off between work and
leisure, taking into account the wage rate.
Government intervention in the labour market through minimum wage legislation was analysed.
When a minimum wage is set above the market-clearing equilibrium, an excess supply of labour
results which leads to unemployment. Only workers who keep their jobs are better off. Note that
unemployment will be discussed in detail in Section 4.3.
The section concluded with a brief discussion of asymmetric and imperfect information, which
represent challenges for employers as they can never be certain about the quality of job
applicants, making optimal hiring of workers difficult.
ACTIVITY 3.16
For each of the determinants of labour demand and supply, determine how the
respective labour demand and supply curves would shift.
ACTIVITY 3.17
Explain why the world’s top footballers earn such high salaries.
ACTIVITY 3.18
Suppose a government wanted to introduce a minimum wage. Discuss its effectiveness if:
a. the minimum wage was set below the market equilibrium wage rate
b. the minimum wage was set at the market equilibrium wage rate
c. the minimum wage was set slightly above the market equilibrium wage rate
d. the minimum wage was set far above the market equilibrium wage rate.
ACTIVITY 3.19
Why could it be argued that education helps people to obtain jobs which are suitable
given their skills?
Concluding comments
This unit concludes our study of microeconomics. We began with the production decisions of
firms, noting similarities with the consumer choice problem in Section 2.4. Different types of
market structure were presented, ranging from perfect competition to monopoly, with their
distinct characteristics discussed. Left to their own devices, markets do not always achieve the
‘best’ outcome, and we describe such cases as instances of market failure. Consumption and
production externalities resulted in free-market outcomes which did not fully internalise all
benefits and costs. In response, a case was made for government intervention to correct market
failure, using various tools including taxation and subsidies, with associated advantages and
disadvantages. Finally, the labour market was analysed, noting that labour is a special factor of
production. Workers have to resolve the trade-off between work and leisure, while governments
may be tempted to intervene by setting minimum wages.
Unit 4 transitions us from the microeconomic world to the macroeconomic, by looking at
important economic issues at an aggregate level. Enjoy!

define the production problem of firms
explain the different types of market structure
define the concept of market failure and explain how it arises
define externalities and give real-life examples
define costs (social, private and external) and benefits (social, private and external)
explain how governments can intervene to correct market failures
explain what impacts demand and supply in labour markets.
Unit 4: Macroeconomics I: closed economy 131
Aims 132


So far in this course, we have discussed market dynamics within one industry or firm only.
From now on, we will focus on the performance of the economy as a whole. The first question
we need to ask ourselves is: how do we know whether or not an economy is doing well?
Unfortunately, there is no simple answer to this question or a concise definition of ‘doing well’;
however, most governments try to control economic growth, unemployment and inflation.
In Units 2 and 3, we used the demand and supply model to demonstrate changes in a particular
industry, such as textiles and oil. However, to deal with the behaviour of the economy as a whole,
we now need to consider aggregates. Therefore, instead of a single price, consider the price
level (the weighted average of prices of the whole spectrum of goods and services consumed
by a given country). We will also consider total output, rather than the quantity produced of a
single good.
The following sections will cover national income accounting, aggregate demand and aggregate
supply, unemployment, inflation, monetary policy and fiscal policy.
Week Unit Section
11 4: Macroeconomics I: closed 4.1: Introduction to macroeconomics and national
economy income accounting
12 4.2: Aggregate demand and aggregate supply
13 4.3: Unemployment
14 4.4: Inflation
15 4.5: Monetary policy and fiscal policy
Section 4.1 provides an introduction to macroeconomics using the circular flow of income.
An analysis of the composition of gross domestic product (GDP) is presented, along with a
discussion of economic growth. Section 4.2 extends the microeconomic analysis of demand
and supply to the macroeconomic level through aggregate demand and aggregate supply.
Determinants of these are identified and shifts versus movements along the resultant curves
are examined. Section 4.3 defines unemployment and examines the different types of
unemployment, along with the costs and possible remedies associated with unemployment.
Section 4.4 considers inflation, distinguishing between its different types, its costs and its
remedies. Finally, Section 4.5 explains the features of, and differences between, monetary and
fiscal policies, noting their effects when applied in expansionary and contractionary manners.
Aims
This unit aims to:
introduce you to the main macroeconomic objectives of national governments
provide tools which support you in the critical evaluation of the costs and benefits of
economic growth
introduce you to the aggregate demand and aggregate supply models
explain the different types of unemployment, costs and remedies
explain the different types of inflation, costs and remedies
introduce you to the mechanics of monetary policy and fiscal policy, including their effects on
important macroeconomic variables.
Learning outcomes
be able to:
explain the macroeconomic objectives of national governments
explain the circular flow of income and how to determine the total amount of economic
activity
define the concepts of economic growth, unemployment and inflation
describe the different types of unemployment, their costs and possible remedies
explain the relationship between unemployment and economic growth
describe the different types of inflation, their costs and possible remedies
explain the phenomenon of stagflation
describe how monetary policy works from expansionary and contractionary perspectives
describe how fiscal policy works from expansionary and contractionary perspectives
outline the similarities and differences between monetary and fiscal policies.
Background reading
Anderton, A. and D. Gray (Ed) Economics. (Lancashire: Anderton Press, 2015) 6th edition
[ISBN 9780993133107].
Section 4.2 – Unit 38 (pp. 213–220)
Section 4.3 – Unit 39 (pp. 221–228)
Section 4.4 – Unit 41 (pp. 234–243)
Section 4.5 – Unit 42 (pp. 244–249).
Section 4.1: Introduction to

macroeconomics and national income
accounting
Introduction 135
Circular flow of income 135
Composition of gross domestic product (GDP) 137
Economic growth 138
Conclusion 140
Unit 4: Macroeconomics I: closed economy • Section 4.1: Introduction to 135
macroeconomics and national income accounting
Introduction
Macroeconomics concerns the study of a national economy, requiring us to consider totals or
aggregates. Governments (and others) are interested in knowing the amount of economic
activity taking place, so we begin our study of macroeconomics by looking at how to measure
economic activity over a period of time, typically a year. This is achieved using national income
accounting.
Ahead of this, though, we need to consider the macroeconomic variables of ‘total output’ and
‘total expenditure’ and how they link together using the circular flow of income.
Circular flow of income

Factors of production allow firms to produce various goods and services, or ‘output’. When
aggregated across all firms in an economy, we obtain the total output. Ultimately, this output is
purchased by households and the amount spent is the total expenditure. So, we can think of
the economy as a system where there is a relationship between firms and households.
More specifically, economists talk about a ‘flow’ of goods and services from firms to households,
and a ‘flow’ of payments from households to firms for these goods and services. Ideally we
would like to measure these flows.
Figure 4.1 shows the circular flow of income model of an economy which forms the basis for
all models of the macro-economy and for understanding how national income, output and
expenditure change over time. The circular flow diagram shows the fundamental, mutually
beneficial economic relationships between firms and households. For this example, we have
disregarded the effect of foreign trade for the sake of simplicity (the open economy will be
discussed in Unit 5).
Figure 4.1: The circular flow of income.
Households provide the demand for goods and services through their spending. They also
provide the four factors of production (CELL: capital, entrepreneurship, land and labour) which
firms need, and for which they pay incomes to households. Firms respond to that demand and
provision by supplying goods and services.
The outer (dashed) loop in Figure 4.1 depicts the supply of the factors of production by
households (in particular labour supply, as discussed in Section 3.4) to firms, from which the
firms use their production functions to turn these factors into goods (and services) which
are consumed by households. The inner loop shows the financial flows between firms and
households. In return for supplying factors, firms pay incomes to households. These incomes
provide the budgets to allow households to undertake spending (i.e. the payment of the goods,
and services, which they consume). While obviously a much-simplified model of reality, this
circular flow model is sufficiently realistic because production requires factor inputs so firms can
make the output which households want to buy.
At this point, it is worth considering the different types of ‘incomes’ which firms pay households.
The type of income will depend on the factor of production being bought. We consider each
factor of CELL in turn:
Capital – firms often borrow money to buy capital (machinery) for which they pay interest.
Entrepreneurship – entrepreneurs receive the profits (if any) which the firms make.
Land – firms pay rents for the use of land.
Labour – firms pay wages for labour.
Household incomes are derived from four main sources: interest, profits, rents and wages. You
might think that ‘profits’ are not really a form of household income; however, if there was no
expectation of profits, entrepreneurs would not be prepared to undertake the risks which are
associated with production, so profit is the reward for being exposed to such risks.
Figure 4.1 also shows two leakages from the system: savings (S) and taxes (T). The more
households save, the less they can spend, which causes a reduction in spending. Governments
can cause further household spending reductions by imposing taxes.
Finally, there are also two injections into the system: investment (I) and funds (F). Investment is
when firms invest in new machinery and other assets. Governments inject funds by spending on
welfare and infrastructure.
An economy is in equilibrium when injections and leakages are equal; that is, when:
I + F = S + T.
Any increases to, or reductions of, any of these elements will result in an increase or decrease of
overall economic activity.
The above description has been deliberately simplified and does not explain the effect of a
great number of influences (depreciation of assets, transfers, double-counting, speed of flow
and size of flow, second-hand goods and other influences). It does, however, give an invaluable
description of how a mixed economy works.
The circular flow of income illustrates the relationship between a country’s income, expenditure
and output such that we could determine the total amount of economic activity, for example
per year, in any one of three equivalent ways:
1. summing the value of all incomes received in a year
2. summing the value of all spending which occurred in a year
3. summing the value of all goods and services produced in a year.
In theory, each approach should result in the same total:
total income ≡ total expenditure ≡ total output.

Note the use of the symbol ‘≡’ rather than ‘=’, as these are identities. In mathematics, an
identity is a special kind of mathematical formula which allows us to rewrite one mathematical
expression in another way (as explained in Unit 1 of FP0001 Mathematics and Statistics). The
three-bar identity sign ‘≡’ is used to show that the variables either side are equal by definition.
Composition of gross domestic product (GDP)

Gross domestic product (GDP) is the total monetary value of all final goods and services an
economy produces in a year. In this course, we will focus on the total expenditure approach to
measuring total economic activity (i.e. total GDP). We will denote GDP by the symbol Y, which is a
popular form of notation by economists to denote national income.
We proceed by determining a decomposition of GDP by the different components of spending
in an economy. The determinants of demand will vary across consumers, firms and the
government, so it makes sense to divide aggregate production (GDP) according to the different
purchasers of goods and services. The components are:
consumption
investment
government spending
net exports.
Consumption
Consumption, C, is the first component of GDP and represents the spending by consumers on
goods and services (for example food, clothes, cars and holidays). Consumption is by far the
largest component of GDP, representing about 60–70 per cent of total spending in an economy.
Investment
Investment, I, represents the capital expenditure by firms on physical assets, for example on
machinery and equipment. Investment was shown in Figure 4.1 as an injection into the circular
flow of income.
Government spending
Government spending, G, represents the total spending by the government on goods and
services, for example education, healthcare, defence and infrastructure. In national income
accounting, transfer payments (such as unemployment benefits) are not included in G because
these payments do not lead to any production, rather these are just transfers of funds from the
government to recipient households.
Net exports
Although the open economy will not be considered until Unit 5, for completeness of our
decomposition of GDP we include trade now. Net exports, NX, is the difference between exports,
X, and imports, M, such that NX = X - M. Exports are the purchases of domestic output by
foreigners, while imports are the purchases of foreign output by domestic consumers. When X =
M an economy is said to operate a trade balance, when X > M the economy is said to operate a
trade surplus, and when X < M the economy is said to operate a trade deficit.
Combining GDP components

Putting all these GDP components, we have:
Y ≡ C + I + G + NX.
This is where NX = X – M. Note this is an identity as it is true by definition. For the rest of this unit
we will assume the economy is ‘closed’ (i.e. it does not trade with the rest of the world). While
all modern economies trade with the rest of the world (admittedly to varying degrees, such as
the very open Singapore, to the much less open North Korea), ignoring net exports for the time
being makes our lives simpler. Therefore, we proceed to set X = 0 and M = 0, such that NX = 0.
Under this assumption, GDP then reduces to:
Y ≡ C + I + G.
Other things equal, an increase in any one of these components will increase GDP, and a
decrease in any component will decrease GDP. Next we consider economic growth (i.e. when
GDP increases).
Economic growth
Economic growth can be defined in the following two ways:
as an increase in the real income or the gross domestic product (GDP) of an economy –
known as the actual economic growth
as an increase in the productive capacity of the economy – known as the potential
economic growth.
What determines if growth is actual or potential?

One of the key factors is the time horizon. In the short run, we usually observe actual economic
growth whereas it takes considerably longer to observe potential economic growth. For example,
it takes much longer to invent and implement new, more efficient production technologies.
As mentioned, actual economic growth is concerned with a country’s GDP. Gross national
product (GNP), on the other hand, is GDP plus the net property income from abroad – income
earned abroad by domestic residents less the income earned by foreigners in the domestic
economy. For example, the GNP of the UK would be the value of goods and services produced
within the country, plus any other money earned by UK citizens living abroad, less income
earned in the UK by non-UK residents. Profits earned in the UK and ‘exported’ by foreign
manufacturers would be a good example of this effect.
Economists are often interested in the economic growth differences between various parts of
the world. In order to be able to compare GDP values across countries, the following adjustments
have to be made.
Population sizes differ greatly between countries. The population of China is over 1.35 billion,
whereas in Lithuania it is around 3 million. What really determines the quality of life is not the
output of the economy as a whole, but rather the output per person. Therefore, instead of talking
about GDP, economists usually consider GDP per capita (literally GDP per head), which is GDP
divided by the size of the population. This is effectively an average, as you learn about in FP0001
Mathematics and Statistics.
The GDP of a specific country is usually expressed in nominal terms; however, most countries
have different currencies. Therefore, in order to be able to compare values across countries, the
same currency, usually US dollars, needs to be used.
It is also important how values are converted. Ten dollars in the USA and 10 dollars in Namibia,
say, have completely different spending power. In order to adjust for such differences,
economists use the purchasing power parity (PPP) exchange rates, which aim to equalise the
real purchasing power between various currencies. Recent surveys by The Economist refer to the
‘Big Mac’ index. The cost of a McDonald’s Big Mac in various countries reflects the comparative
purchasing power of each currency. Using this index, at the time of writing, Switzerland has the
most overvalued currency while Egypt has the most undervalued.
Suppose we expressed GDP at PPP values and then divided this by the population size. Is this
enough to conclude that economic growth had occurred? The answer is no. As you might have
already realised, the value of goods and services can increase either due to its increased nominal
value or because of the greater amount of the quantities produced. Nominal growth means
that the value of goods and services produced within the economy increased, but that could be
caused by either increased production or simply by higher prices, in other words the effect of
inflation.
It has been observed that the cost of a Mars chocolate bar has closely mirrored the level of
inflation in the UK for the past five decades. (Inflation will be covered in Section 4.4.) We are more
concerned, however, with the increase in the quantity of goods produced. Therefore, whenever
we talk about growth, we mean real growth – an increase in the productive capacity of the
economy.
Graphically, growth can be represented by using PPFs, as shown in Figure 4.2. Potential growth
is the outward shift of the PPF. Actual growth happens when the economy moves to a higher
output of at least some of the goods.
Figure 4.2: Potential economic growth can be depicted as an outward shift of a

production possibility frontier (PPF), here from PPF1 to PPF2 for an economy with
agricultural and manufactured goods.
Why is economic growth desirable?

Economic growth brings about many benefits, including the following:
More consumption possibilities – if the quantity of goods produced increases, consumers
have more choice.
Increased standards of living – when incomes increase, people can afford more and better
quality goods. In addition, the more people earn, the more is collected through taxation and
so the more money government has to invest in education, infrastructure and other public
services.
Increased life expectancy – when incomes increase, people can afford better living conditions,
healthcare and medicine.
Improved diet and healthcare – instead of consuming basic foods, people can afford higher
quality produce and have a more varied diet. Farmers can use better and more ecological
means of production, while people can be referred to nutritionists in order to help them
improve their eating habits.
More money spent on research and development leads to the invention of new technologies
which improve the standard of living, for example washing machines or dishwashers.
Better ways of redistributing income from rich to poor – this reduces inequality as more
money is collected through taxation which can be used to fund benefit schemes.
Unfortunately, economic growth also has some negative side effects:
Inflation – when people earn more, their demand for goods and services increases. If this
increased demand cannot be accompanied by an increase in the amount of goods produced,
it will inevitably lead to higher prices and, therefore, inflation.
The possible depletion of non-renewable natural resources.
Increase in pollution and noise, and a general detrimental effect on the environment.
Deforestation – increased economic growth requires more land and so factories are built in
previously unoccupied territories (for example, rainforests). This has a negative impact on
fauna and flora and the natural habitat of many species.
An increase in inequality – technical progress may only benefit some groups (such as the
skilled labour force) and may leave others jobless (by replacing the unskilled labour force with
machines as a result of job automation).
Conclusion
We have now begun our study of macroeconomics (i.e. moving on from analysing a single
consumer or firm to an economy at the aggregate level). The circular flow of income was
introduced as a simple way to represent the flow of money, goods and services between firms
and households, and included important injections and leakages.
It was noted that the total value of economic activity per year, GDP, could be measured in one
of three equivalent ways: total income, total expenditure and total output by definition all
measure the value of GDP. This section focused on the expenditure approach and showed the
decomposition of GDP into consumption, investment, government spending and (for an open
economy) net exports.
Finally, economic growth was considered, distinguishing between actual and potential economic
growth. The benefits and side effects of economic growth were also itemised.
ACTIVITY 4.1
What is the difference between government spending and transfer payments?
ACTIVITY 4.2
In the circular flow of income, why are savings and taxes called leakages, and investment
and funds called injections?
ACTIVITY 4.3
For a closed economy, draw a PPF showing the effect of a drop in consumer confidence
which leads to a fall in consumption (assume there is no change to investment or
government spending).
ACTIVITY 4.4
Conduct research to identify countries with the highest and lowest economic growth
rates. Are they suffering from any of the harmful effects listed above?
ACTIVITY 4.5
Look up The Economist’s Big Mac index and find out how it works. See if you can find your
home country’s currency and check whether it appears to be overvalued or undervalued,
according to the Big Mac index.
Section 4.2: Aggregate demand and

aggregate supply
Introduction 143
Aggregate demand 143
Aggregate supply 145
Combining aggregate demand and aggregate supply 146
Equilibrium changes due to curve shifts 149
Conclusion 151
Unit 4: Macroeconomics I: closed economy • Section 4.2: Aggregate demand 143
and aggregate supply
Introduction
Section 4.1 explained how national income could be determined by summing any of total
income, spending or production. Here we work with aggregate demand (the sum of all planned
expenditure) and aggregate supply (the sum of all goods and services produced), which allow
us to examine demand and supply at a national level. As we now consider multiple goods and
services, it is no longer appropriate to speak about a price, so instead we refer to the price level,
which is the general level of prices in the economy. This section also explores the determinants
of aggregate demand and aggregate supply, changes in which result in shifts of the respective
curve. Equilibrium changes are also discussed.
Aggregate demand
Aggregate demand is the relationship between total output and the price level, which shows
planned expenditure (in nominal terms) on final goods and services at all possible price levels.
Figure 4.3 shows an example of an aggregate demand curve (here represented as a line). Like
demand curves in microeconomics, it is downward-sloping (i.e. the lower the price level, the
greater the planned total expenditure).
Figure 4.3: The aggregate demand curve.
In a closed economy, aggregate demand consists of consumption, investment and government

spending (as discussed in Section 4.1, where we considered the total expenditure approach for
measuring GDP). Of these components, consumption tends to be fairly stable over time, whereas
investment by firms tends to be more volatile (fluctuating a lot) and so it has a greater impact on
changes in aggregate demand over time.
Consumption
Consumption is the amount of goods and services purchased by households. It depends on the
following variables:
Income – the more you earn, the more you can spend.
Transfer payments (such as unemployment benefits) received from the government.
Marginal propensity to consume – the proportion of income that a person spends on

consumption. Most people do not spend everything they earn as some of their income is
usually saved. Generally, the rich spend a lower proportion of their disposable income than
the poor because they have more disposable income than is needed to buy essential goods
(such as food) so richer households have greater choice in whether to spend or save their
disposable income once essential purchases have been made.
Taxes – the greater the amount of income, Y, which is paid as an income tax, T, the less is left
to spend by the household. After-tax income is referred to as disposable income, denoted
Yd, where:
Yd ≡ Y – T
where note, again, we have an identity as this is true by definition.
We can mathematically relate consumption, C, and disposable income, Yd, through a simple
consumption function. It is reasonable to suppose a linear relationship of the form:
C = c0 + c1Yd
where c1 is the marginal propensity to consume, or mpc, with c1 > 0 (and 0 < c1 ≤ 1 if we
assume consumers cannot spend beyond their disposable income, i.e. they cannot borrow or
run down savings). For completeness, the y-intercept is c0 and some economists refer to this
as autonomous consumption (i.e. the level of consumption when Yd = 0). Note even if our
disposable income is zero, we still need to consume the basics to survive, such as food, so c0 > 0.
Figure 4.4 shows an example of a consumption function, which note is simply a linear function
as seen in Unit 2 of FP0001 Mathematics and Statistics, albeit one with a macroeconomic
application.
Figure 4.4: A (linear) consumption function relating consumption, C, to disposable

income, Yd.
Here the slope is c1, which is the marginal propensity to consume, and the y-intercept is c0, which
is autonomous consumption.
This means that for every one-unit increase in disposable income, consumers spend a proportion
c1 of this. For example, if c1 = 0.8 then 80 per cent of each extra unit of disposable income is spent
(meaning the other 20 per cent is saved). In fact, 1 – c1 is the marginal propensity to save.
So, assuming that 0 < c1 < 1 (i.e. c1 is strictly less than 1), consumption increases as disposable
income increases, but less than one-for-one as there is some saving.
Investment
Some level of investment by firms is independent of market conditions (which is more due to
tastes and preferences). However, most investment decisions largely depend on interest rates
– the cost of borrowing money. Investment is negatively related to the level of interest rates.
This is because the increase in the capital stock has to be financed, and most firms borrow from
banks to finance their investment. If interest rates are too high, firms are less likely to borrow as
borrowing is expensive. This is because of the opportunity cost of money. When interest rates are
low, on the other hand, it is relatively cheap to take out a loan. So demand for loans (and hence
the level of investment by firms) increases when interest rates decrease.
Government spending
In mixed economies, governments play an important role. They often spend money collected
from taxation on healthcare, infrastructure (for example, roads and bridges), schools and
public services (for example, the police, armed forces and fire-fighters) etc. This is referred to as
government spending. For the time being, we will assume it to be a lump sum – just a number
decided by the government.
Government spending does not have to be equal to the amount of revenue collected from taxes.
The difference between government spending and tax revenue is known as the budget (or fiscal)
deficit or surplus. If a government spends more than it collects in taxes then it runs a budget
deficit. When government spending in a particular year is less than tax revenue, the government
saves money by creating a budget surplus. A balanced budget results when government
spending equals government revenue.
Although the government can deliberately choose to vary its level of spending so that it runs
a budget deficit or surplus, neither policy should be used for too long. Too large a surplus
might put economic growth at risk as the income created by the economy is not fully invested.
Running a continuous budget deficit, on the other hand, greatly increases the national debt
and the economy might not be able to pay it all back (an important issue related to the global
financial crisis, covered in Unit 6).
Aggregate supply
Aggregate supply is the total amount of all goods and services produced within the economy.
It tells us the amount that firms are willing to produce at all possible price levels. Figure 4.5 shows
an example of an aggregate supply curve (here represented as a line). Like supply curves in
microeconomics, it is upward-sloping (i.e. the higher the price level, the greater the total amount
of goods supplied).
Figure 4.5: The aggregate supply curve.

Aggregate supply is influenced by the following factors:

Price of materials, including imported ones – the more expensive the production inputs,
the higher the minimum price that firms have to charge in order to break even.
Wages of workers – the higher the cost of the labour force, the more expensive production
becomes, so firms need to charge higher prices for their products to cover their costs.
Amount of available capital – if firms do not have access to capital, they do not have the
means of production and therefore their output is limited.
Level of technology – the better the technology, the more efficient (and cheaper) the
production process.
Size of the available labour force – if there are plenty of workers with a wide range of
skills from which firms can choose, the chance of finding properly qualified and cheaper
employees is higher.
Existence of worker incentives – if workers have good morale, they will work more
efficiently.
Quality of human capital – the better the education and skills of the labour force, the
higher the quality of the products produced by them
Existence of market rigidities – more obstacles in the market lead to a more difficult and
expensive production process.
Combining aggregate demand and aggregate supply

We have already seen how to illustrate aggregate demand and aggregate supply using simple
diagrams in Figures 4.3 and 4.5. To illustrate the equilibrium output and price level within the
economy, we need to put the two curves together. The economy will only be in equilibrium
when the level of aggregate demand is equal to the level of aggregate supply.
Figure 4.6 combines the aggregate demand and aggregate supply curves, showing the
equilibrium output level, Y*, and equilibrium price level, P*, at the intersection of the two curves.
Figure 4.6: Equilibrium is achieved at the intersection of the aggregate demand (AD)
and aggregate supply (AS) curves, resulting in equilibrium output Y* and equilibrium
price level P*.
Equilibrium adjustments
Sometimes in the short run, one of the aggregates, either demand or supply, is greater than
the other. This situation, however, cannot be sustained in the long run. As a result, one of two
adjustment processes will need to occur.
Price adjustment – the price level within the economy will change until equilibrium is
reached. When aggregate demand is greater than aggregate supply, the price level is more
likely to increase in order to eliminate the excess aggregate demand. When aggregate supply
is greater than aggregate demand, the price level will fall to encourage consumers to buy
more goods and services.
Quantity adjustment – the amount of goods and services produced within the economy
may also change. When consumers demand more than current production levels, suppliers
may decide to increase their production in order to meet the excess aggregate demand. As
a result, output will increase. However, when too much is supplied, firms may decide to cut
their production levels back.
Often, both of the adjustment processes happen at the same time. There is, however, a word
of caution. There is a limit to how much output can increase – this is called the maximum
productive capacity – beyond which, the economy cannot grow unless new technologies or
new resources are found. An example of an aggregate supply curve demonstrating this feature
is shown in Figure 4.7, such that the vertical segment is at the point of the maximum productive
capacity.
Figure 4.7: An aggregate supply curve showing the maximum productive capacity of
an economy (i.e. the maximum level of output which can be produced employing the
technology and resources that are available).
The situation when aggregate demand and aggregate supply are not the same is referred to
as disequilibrium. In the short run, aggregate supply tends to change with changes in the level
of demand for goods and services, although in practice the exact equilibrium may not be
achieved. This may be because, for example, in the short run firms may produce more output
than demanded, with the ‘excess’ stored as inventory (i.e. unsold stocks in warehouses to be
sold in the future when demand picks up). However, we would not expect to observe a large
difference between aggregate demand and aggregate supply for too long so we can suppose
equilibrium (or a point close to it) is quickly reached.
Shifts versus movements along curves

Changes to the price level result in movements along the aggregate demand and aggregate
supply curves. Changes to all other determinants will cause a shift of the relevant curve. A
shift of one curve results in movement along the other curve until the new equilibrium point is
reached.
Aggregate demand can shift either to the left or to the right. Anything which increases the level
of planned expenditure (for example, lower taxes or higher government spending) will cause a
rightward shift. Anything that lowers the amount of planned expenditure (for example, higher
taxes or lower government spending) will result in a leftward shift.
We have seen previously that aggregate demand (in a closed economy) is given by:
C + I + G.
An increase in any of these components corresponds to a rightward shift, while a reduction
corresponds to a leftward shift. Figure 4.8 shows an example of a rightward shift caused, for
example, by lower taxes, which increases consumers’ disposable incomes, and hence aggregate
consumption, C, increases.
Figure 4.8: Increase in aggregate demand caused by lower taxes, which increases
disposable incomes and hence increases aggregate consumption.
Note the same rightward shift could have been obtained in other ways, for example:
a reduction in interest rates reduces the cost of borrowing leading to an increase in
investment, I
an increase in government spending, G.
Aggregate supply can either shift left or right caused by changes in the costs of production, or
due to changes in the maximum productive capacity.
Figure 4.9 shows a leftward shift in the aggregate supply curve which would result if workers’
wages increase. Higher wages increase the firms’ costs of production, hence firms are less willing
to supply goods and services so they produce a lower level of output for each price level.
Figure 4.9: Shift of aggregate supply caused by an increase in wages which increases
firms’ costs of production.
When new technology is introduced, however, more can be produced at every possible price
level and, therefore, the aggregate supply curve would shift to the right.
Equilibrium changes due to curve shifts

We conclude this section with an examination of how a shift in either curve impacts the
equilibrium output and price level. Remember, a shift of one curve results in movement along
the other curve until the new equilibrium point is reached.
Figure 4.10 shows a rightward shift in the aggregate demand curve, which was previously
discussed in the context of Figure 4.8 where it was attributed to lower taxes, ultimately resulting
in an increase in aggregate consumption. In Figure 4.10, the economy is initially in equilibrium
at point A with output and price level of (Y1, P1). Aggregate demand then shifts to the right from
AD1 to AD2. Firms now respond to this increase in demand by increasing output (they could
also run down any inventory stocks), which is shown as a movement along the AS curve that
continues until the economy reaches a new equilibrium at point B with output and price level of
(Y2, P2). Note that ultimately the economy has grown, since Y1 < Y2, although the price level has
increased, since we observe P1 < P2.
Figure 4.10: A rightward shift of the aggregate demand curve moves the economy
from the old equilibrium of (Y1, P1) to the new equilibrium of (Y2, P2).
Figure 4.11 shows a leftward shift in the aggregate supply curve, which was previously
discussed in the context of Figure 4.9, where it was attributed to an increase in wages which
increased firms’ costs of production. In Figure 4.11, the economy is initially in equilibrium at
point A with output and price level of (Y1, P1). Aggregate supply then shifts to the left from AS1
to AS2. Consumers (households, firms and the government collectively) now respond to this
by decreasing their total demand, which is shown as a movement along the AD curve that
continues until the economy reaches a new equilibrium at point B with output and price level
of (Y2, P2). Note that ultimately the economy has shrunk, since Y1 > Y2, and the price level has
increased, since we observe P1 < P2.
Figure 4.11: A leftward shift of the aggregate supply curve moves the economy from
the old equilibrium of (Y1, P1) to the new equilibrium of (Y2, P2).
Finally, Figure 4.12 shows simultaneous equal rightward shifts of both aggregate demand and
aggregate supply curves such that the increase in production exactly meets the increase in
demand, resulting in a higher level of equilibrium output, since Y1 < Y2, and no change to the
price level, since we observe P1 = P2. Such a situation could occur due to, for example, an increase
in any aggregate demand component (i.e. consumption, investment or government spending)
which was exactly served by an increase in aggregate production.
Figure 4.12: Simultaneous, and equal, rightward shifts of the aggregate demand
and supply curves move the economy from the old equilibrium of (Y1, P1) to the new
equilibrium of (Y2, P2), resulting in increased output but no change in the price level.
Conclusion
Aggregating demand and supply over all purchasers and suppliers of goods and services
in an economy, we obtain the aggregate demand and aggregate supply curves. We have
considered their respective determinants, for which a change in any of these results in a shift
of the respective curve. The economy is in equilibrium when the curves intersect, and we have
examined how the equilibrium output and price level change when there is a shift of either of
the curves.
ACTIVITY 4.6
Distinguish between a movement along the aggregate demand curve and a shift of the
aggregate demand curve. Repeat for the aggregate supply curve.
ACTIVITY 4.7
Explain, using diagrams, the likely effect of the following on the aggregate demand
curve:
a. an increase in the marginal propensity to consume
b. an increase in taxes
c. a decrease in interest rates.
ACTIVITY 4.8
Explain, using diagrams, the likely effect of the following on the aggregate supply curve:
a. an increase in the number of young people going to university
b. an increase in trade union membership
c. advances in computing power.
ACTIVITY 4.9
Explain, using a diagram, how the equilibrium output and price level would change
when:
a. the aggregate demand curve shifts to the left (with no shift in the aggregate supply
curve)
b. the aggregate supply curve shifts to the right (with no shift in the aggregate demand
curve).
Section 4.3: Unemployment
Introduction 154
Defining and measuring unemployment 154
Types of unemployment and their causes 155
Costs of unemployment 156
Remedies for unemployment 157
Unemployment and GDP 159
Conclusion 160
Unit 4: Macroeconomics I: closed economy • Section 4.3: Unemployment 154
Introduction
Unemployment occurs when labour is not fully utilised, resulting in an economy producing
at an aggregate output level below its potential. Governments are keen to reduce the level of
unemployment, and may even desire full employment, through the use of macroeconomic
policy. Full employment means everyone has a job who wants a job at the market wage rate.
Unemployment matters as the unemployment rate signals whether an economy is operating
at, above or below its normal level and it also has significant social consequences. In this section
we begin by defining unemployment and how to measure it, followed by an examination of the
different types of unemployment. Costs, both economic and social, of unemployment are briefly
considered, along with possible remedies aimed at reducing unemployment. We conclude with
a discussion about the relationship between unemployment and GDP, known as Okun’s law.
Defining and measuring unemployment

Unemployment can broadly be defined as the number of people who are currently not
employed but who are actively seeking work and are able to start work immediately. The
unemployment rate, u, is the ratio of the number of unemployed persons, U, to the size of the
labour force, L:
U
u=
L
where the labour force is defined as the sum of the number of employed persons, E, and those
unemployed, such that:
L = E + U.
The most common factors associated with unemployment include people who:
want to work, but are unable to find a job
are working, but are unable to find a job for as many hours as they want to work
have difficulties finding work to match their skills.
There is no standard way of measuring the rate of unemployment. The two most common ways
are the claimant count and the International Labour Organisation (ILO) unemployment
survey.
In the UK, the claimant count is the number of people who are officially registered and able to
work but who currently cannot find a job and are, therefore, claiming unemployment benefits.
However, the claimant count is likely to underestimate the level of unemployment if the level
of unemployment benefits is restricted in some way; for example, if a benefit claimant had
exhausted their benefit entitlements, they would have no reason to stay registered as being
unemployed. While there may be some fraudulent claims, these are likely to be smaller in
number than those who do not bother to register, leading to a net underestimate of the true
level of unemployment.
The ILO unemployment rate, on the other hand, is based on a quarterly survey of approximately
40,000 households, equating to around 80,000 adults. Respondents are classified as being
employed if they have a job at the time of the survey; those who state that they have been
actively seeking a job in the last four weeks, but are not currently in work, are considered to be
unemployed.
The problem with the two unemployment measures is that neither is perfect, most notably as
the following types of people are not included:
those who choose to undertake studies to avoid being unemployed

part-time workers who wish to work full-time
those who work in the unofficial black economy (also known as the underground economy)
discouraged workers who leave the labour force.
Collectively, the above is known as hidden unemployment. Therefore, true unemployment is
usually much higher than the one estimated by the available data.
Note that in the ILO survey, only those ‘actively seeking a job’ are classified as being unemployed.
Clearly, some households will have individuals who are not looking for a job, and these
individuals are classified as not being in the labour force.
During periods of high unemployment (such as in the aftermath of the global financial crisis,
discussed in Unit 6), some people without jobs simply give up looking for work and are
considered as being outside the labour force. Such individuals are known as discouraged
workers. Another way of thinking about this is that a higher unemployment rate, u, results in a
lower participation rate, where:
labour force .
participation rate =
total population of working age
Types of unemployment and their causes
Unemployment is a general term used to describe a situation when people who are willing and
able to work cannot find a job. It can, however, be divided into different types depending on
causal factors. We now itemise the different types of unemployment.
Cyclical (demand-deficient) unemployment

Cyclical (demand-deficient) unemployment is caused by the variable business cycle (also
referred to as the economic cycle). This type of unemployment can be illustrated graphically
through shifting aggregate demand curves.
In Figure 4.13, it is assumed that a reduction in aggregation consumption, investment and/or
government spending leads to a leftward shift of the aggregate demand curve, resulting in
output reducing from Y1 to Y2. A lower level of output means a lower level of labour employed,
since less output needs to be produced – there is lower employment and hence higher
unemployment.
Figure 4.13: A leftward shift of the aggregate demand curve moves the economy
from the old equilibrium of (Y1, P1) to the new equilibrium of (Y2, P2), resulting in lower
employment (i.e. higher unemployment).
Structural unemployment
Structural unemployment is caused by changes in the structure of an economy. An example
would be a transition between sectors, such as an economy moving from agricultural production
toward industrial output. The only way to reduce structural unemployment is to affect the
economic causal structures. One remedy is to relax labour market rigidities, such as having no
minimum wage, lower levels of job protection and weaker trade unions to reduce collective
wage-bargaining power, allowing firms to be able to hire and fire employees more easily.
Globalisation is an important cause of structural unemployment.
Frictional unemployment
Frictional unemployment occurs when people are in-between jobs; in other words, they are
temporarily unemployed while they undertake a job search or take a break between leaving one
job and starting another (this type of unemployment always exists, hence strictly speaking full
employment – everyone has a job who wants a job at the market wage rate – is not achievable
in practice). Improving the information flow of job vacancies to those searching for new positions
can reduce frictional unemployment. With vacancies increasingly being advertised online,
through job websites, searching for jobs is now far easier than in the pre-internet era.
Seasonal unemployment
Seasonal unemployment occurs when people are unemployed because of the season, for
example fruit pickers and temporary workers in tourism are only employed in the summer. Of
course, such employment opportunities may appeal to some people, such as students looking
for temporary work during the summer holidays.
Regional (geographical) unemployment

Regional (geographical) unemployment is associated with a particular region of a country.
For example, manufacturing may be confined to certain regions of a country and if production
was moved overseas (perhaps due to lower labour costs in other countries) then regional
unemployment would result due to the loss of manufacturing jobs in the geographical area
where manufacturing occurred.
Voluntary unemployment
Voluntary unemployment is the term used to describe unemployment due to people
choosing not to work (i.e. unemployment which is left once an economy achieves full
employment). Frictional unemployment (defined above) forms part of voluntary unemployment,
but the latter also includes people who simply do not want to work. Such individuals may not be
motivated to work due to the attraction of generous unemployment benefits, or perhaps high
income-tax rates provide a disincentive to work.
Costs of unemployment
Governments are concerned with high levels of unemployment because persistent and high levels
of people without a job can have serious economic and social consequences. There can be a:
loss of output forever
loss of individual self-esteem
strain on the whole family of unemployed people
deterioration of skills if the period of unemployment lasts for too long (i.e. an erosion of
human capital)
higher level of depression, increased alcohol consumption, higher crime rates and other
social factors.
Governments also care about being re-elected, so if there are too many unemployed people
(who are voters!), a government is likely to become unpopular and hence less likely to win the
next election.
As well as the impact on the individual, the direct effects of unemployment on government
are two-fold: higher expenditure on welfare payments to the unemployed and their families,
coupled with a reduction in revenue from income tax and indirect taxes. Note how tax revenues
are affected in two ways:
fewer people in work reduces aggregate labour income and so less income tax is raised
higher unemployment suppresses aggregate output so fewer goods and services are sold,
causing a reduction in receipts of indirect taxes (typically, it is the unemployed who spend
less).
The higher level of expenditure on unemployment benefits comes at an opportunity cost for
the government, as the money could have been spent on alternative, more productive, activities
such as infrastructure spending, rather than simply redistributing income. An opportunity cost
also arises from the lost output which could have been produced had unemployed people been
in work.
Unemployed people in receipt of welfare payments may end up becoming dependent on
this ‘income’ and become deterred from seeking employment. They become stuck in an
unemployment trap (or poverty trap). Welfare-to-work schemes operate by making
the receipt of welfare payments conditional on recipients actively looking for work by way of
incentive – for example, reducing or stopping payment of unemployment benefits after a certain
period of time.
Remember though that not all unemployment is ‘bad’, as frictional unemployment tends to be
temporary and short-lived. However, some groups of society can be disproportionately affected
by unemployment (in particular young people, unskilled workers and ethnic minorities) who
may face discrimination when trying to find work. Youth unemployment was especially acute
following the global financial crisis, for example.
Remedies for unemployment

Is there a way out of unemployment? Due to the high costs of unemployment, governments
seek different ways to minimise its rate. The most common include demand-side policies and
supply-side policies.
Demand-side policies
Demand-side policies relate to direct intervention by the government. Stimulating economic
growth, by generating more aggregate demand, can reduce cyclical unemployment. Figure
4.14 (in fact, the same as Figure 4.10 in Section 4.2) shows a boost to aggregate demand via a
rightward shift caused by increased government spending. Output increases from Y1 to Y2, which
means more labour is required by firms to meet this higher level of production. Consequently,
employment increases and (cyclical) unemployment decreases.
Increased government spending is an example of an expansionary fiscal policy, which will be
discussed in Section 4.5 when monetary policy and fiscal policy are introduced.
Figure 4.14: A rightward shift of the aggregate demand curve (due to demand-
side policies, i.e. higher government spending) moves the economy from the
old equilibrium of (Y1, P1) to the new equilibrium of (Y2, P2), resulting in higher
employment (i.e. lower unemployment).
Supply-side policies
Supply-side policies attempt to boost economic growth by making markets work more
efficiently and more freely. Proponents argue that only using demand-side policies merely leads
to inflation (a higher price level) as seen in Figure 4.14 where P1 < P2. Inflation will be covered in
Section 4.4.
Examples of supply-side policies include:
increased training of workers to make them more productive
investment in new technologies to increase productivity
a reduction in unemployment benefits and/or cutting income tax rates (incentivising work, by
making it more financially attractive to work than to be unemployed)
deregulating labour markets
better advertising of job vacancies
wage negotiations with trade unions.
All of these can be represented diagrammatically as a shift in the aggregate supply curve, as
shown in Figure 4.15. Such a shift leads to higher equilibrium output, Y1 < Y2, and note in passing
that the price level is also reduced since P1 > P2.
Figure 4.15: A rightward shift of the aggregate supply curve (due to supply-
side policies) moves the economy from the old equilibrium of (Y1, P1) to the new
equilibrium of (Y2, P2), resulting in higher employment (i.e. lower unemployment).
Unemployment and GDP

Most countries exhibit a relationship between unemployment and GDP growth. Okun’s law
(named after the economist Arthur Okun who first identified this link through his empirical
research in the 1960s) describes the relationship between the GDP growth rate and the
unemployment rate, specifically:
high GDP growth leads to high employment growth (as firms hire more workers to produce
more output), and hence a lower unemployment rate
low GDP growth leads to a higher unemployment rate (as firms hire fewer workers to produce
less output).
Empirically, during Okun’s study of the US economy he found that:
annual GDP growth of 3 per cent equates to no change in the unemployment rate
annual GDP growth above 3 per cent results in a decrease in the unemployment rate by
approximately half of the difference between the GDP growth rate and 3 per cent
annual GDP growth below 3 per cent results in an increase in the unemployment rate by
approximately half of the difference between the GDP growth rate and 3 per cent.
Although this is not an exact empirical rule, it serves sufficiently well as a rule-of-thumb.
Mathematically, we have:
ut − ut−1 = −0.5 (gyt − 3%)

where:
ut is the unemployment rate in period t
ut – 1 is the unemployment rate in period t – 1
gyt is the GDP growth rate in period t.
For example, if the GDP growth rate is gyt = 4 per cent, then the unemployment rate decreases by
0.5 per cent because:
ut − ut−1 = −0.5(4% − 3%) = − 0.5%

and if the GDP growth rate is gyt = 1%, then the unemployment rate increases by 1 per cent
because:
ut − ut−1 = −0.5(1% − 3%) = 1%

as can be seen in Figure 4.16, which shows the negative linear relationship between the change
in the unemployment rate and the GDP growth rate (both in percentage terms).
Figure 4.16: Okun’s law as represented by a negative linear relationship between the
unemployment rate (in %) and the GDP growth rate (in %).
Conclusion
We have defined unemployment and discussed how it can be measured (albeit imperfectly
measured). The different types of unemployment, and their causes, were described and we
noted that not all unemployment is necessarily bad, as frictional unemployment is reasonable
for people in-between jobs. Some of the economic and social costs of unemployment were
covered, as well as possible remedies through the use of demand-side and supply-side policies.
Both types of policy can lead to increased equilibrium output, and the section concluded with
Okun’s law, which models the relationship between changes in the unemployment rate and
changes in the GDP growth rate.
ACTIVITY 4.10
Do you expect the figures given by the two unemployment measures (the claimant
count and the ILO survey) to be the same? Explain your answer.
ACTIVITY 4.11
What kind of unemployment are the following likely to endure?
a. A highly-skilled secretary in London seeking to change to a new post.
b. A furniture salesperson made redundant because of a recession.
c. A coal miner dismissed when power generators switched from coal-burning fuel to
gas.
d. A farm worker unemployed because of a poor potato harvest.
ACTIVITY 4.12
What are the differences between demand-side policies and supply-side policies when
used to reduce unemployment?
ACTIVITY 4.13
a. According to Okun’s law, what would be the change in the unemployment rate if the
GDP growth rate was 2.5 per cent?
b. According to Okun’s law, if the unemployment rate decreased by 1 per cent, what
would have been the change in the GDP growth rate?
ACTIVITY 4.14
Look up the current unemployment rate in your country of residence, and research how
the figure is calculated. How has the unemployment rate changed in recent years, and
can you explain these changes?
Section 4.4: Inflation
Introduction 163
Defining and measuring inflation 163
How is inflation measured? 163
Types of inflation and their causes 164
Costs of inflation 167
Remedies for inflation 168
Inflation and unemployment 168
Conclusion 169
Unit 4: Macroeconomics I: closed economy • Section 4.4: Inflation 163
Introduction
Inflation is an important macroeconomic variable which deals with rising prices. When prices rise,
the purchasing power of a unit of the currency (such as a pound or dollar) is eroded. This section
begins by defining inflation and how to measure it, followed by an examination of the different
types of inflation and their causes. Costs of inflation are briefly considered, along with possible
remedies aimed at reducing inflation. We conclude with a discussion about the joint occurrence
of inflation and unemployment, known as ‘stagflation’.
Defining and measuring inflation

Inflation is the sustained overall increase in the price level – conversely, the overall reduction in
the value of money. The inflation rate is the rate at which the price level increases, defined as:
Pt – Pt –1
t =
Pt –1
where:
πt is the inflation rate in period t
Pt is the price level in period t
Pt – 1 is the price level in period t – 1.
Inflation most severely impacts those earning a fixed income, like pensioners who cannot
negotiate an increase in income, unlike employed workers who can, especially when they have a
powerful trade union behind them.
There are two key requirements for inflation to exist. The increase in the price level must be:
continuous (not just an individual unique event)
general (the price of the goods which people buy most often).
So, if only the price of butter increases but everything else stays the same, do we consider that to
be inflation? No, this could just be a temporary price fluctuation and relates to only one product.
How is inflation measured?

Measuring inflation requires computing, and then comparing, price levels between different time
periods, as shown in the equation above, typically over a year to give the annual inflation rate. To
measure price levels, researchers use the following steps:
identify a ‘representative’ consumer and find out what they spend their money on
write down the exact names of the products and their brands
ensure that you include durables, for example cars, computers, mobile phones and any
frequent payments, such as electricity bills or rent. All of them will create a representative
consumer’s ‘basket’ of goods and services
recall the prices of all of the goods within the basket and weight them according to their
importance and frequency of purchase.
The index of weighted prices is known as the consumer price index (CPI). Every month, prices
of goods within the basket are recorded and the CPI is calculated. People, of course, change their
buying habits; there are new trends, new brands and new goods (for example, we spend more
today on smartphones and less on video cassettes than previous generations did as a result of
technological innovation). Therefore, the basket is reviewed on a regular basis to reflect such
changes. The level of inflation is the percentage change of the CPI values over a certain time
horizon, usually a month or a year.
Another way of measuring inflation is to use the retail price index (RPI). How does it
differ from the CPI? The CPI conforms more closely to European standards and methods of
calculation. It excludes payments on housing costs and mortgage repayments, which usually
form a large proportion of a household’s monthly expenditure. The RPI conforms to the
international harmonised index of consumer prices. This is the index most commonly used
by governments to calculate increases in pensions and welfare payments to ensure that they
are inflation-proofed. It is also used by the Bank of England to target inflation. The RPI though
has been termed ‘flawed and outdated’. We will not enter into a discussion of the finer statistical
points of these indices – at this level, it is simply enough for you to know of their existence.
Types of inflation and their causes

Inflation can either be anticipated (expected) or unanticipated (unexpected). When people
know that prices are going to increase, they can better optimise their money holdings. If
inflation comes as a surprise, however, they do not have such an option. Inflation also varies in its
intensity. We distinguish between the following types of inflation:
Creeping inflation is when prices increase gradually and slowly, up to five per cent – in the
UK, the Bank of England has an annual target inflation rate of two per cent.
Strato-inflation is a moderate increase in the price level, around 10 to 20 per cent, generally
experienced in developing economies such as Brazil or India.
Hyperinflation is an extremely large and accelerating increase in the price level caused
by a major disruption to an economy, for example a war or an economic depression.
Hyperinflation leads to a severe loss of confidence in a country’s currency, leading people
to look for an alternative form of money which will be a better store of value, such as other
currencies or even commodities like gold. Hyperinflation is enormously costly as it wipes
out the welfare gains from having money – it must be avoided at all costs as an economy
suffering from hyperinflation is at risk of collapse! The most dramatic historical example of
hyperinflation was in Hungary after World War II, when inflation was recorded at 4.19 x 1016
per cent per month in July 1946, which equated to prices doubling every 15 hours!
We have already established that inflation is a result of an increasing price level. However, what
causes prices of so many goods to increase at the same time?
We distinguish between demand-pull inflation and cost-push inflation.
Demand-pull inflation
Demand-pull inflation is attributable to excess demand when an economy is operating at the full
employment level of national output and so aggregate demand exceeds the supply potential of
an economy. The excess demand effectively ‘pulls up’ prices of output.
Figure 4.17 shows an example of demand-pull inflation. Initially, the economy is at point A
where the economy is producing at its maximum productive capacity. When aggregate demand
increases, from AD1 to AD2, aggregate supply cannot increase any further, resulting in inflation as
the economy reaches point B with the price level increasing from P1 to P2 as the excess demand
bids up the prices of output, leading to an increase in the overall price level, with no additional
output produced. Therefore, real output remains the same, but the nominal value of output is
inflated. The overall increase in the price level (i.e. P2 - P1) is called the inflationary gap.
Figure 4.17: Demand-pull inflation occurs when aggregate demand increases while
the economy is already operating at its maximum productive capacity. The economy
shifts from point A to point B, with a higher price level, since P1 < P2, but unchanged
total output, since Y1 = Y2. Real output remains the same, but the nominal value of
output is inflated.
Cost-push inflation
Cost-push inflation occurs when there is an increase in the cost of factor inputs, in particular the
cost of raw materials, energy and wages. These higher costs effectively ‘push up’ prices.
Raw materials and energy could increase in price due to increased demand and/or global
shortages. In cases of oligopoly (see Section 3.2), cartels could collude to sustain high prices,
such as OPEC members agreeing to restrict their oil production, therefore curtailing global oil
supply and keeping the oil price high.
In an open economy (considered in Unit 5), a depreciation of a country’s exchange rate makes
the cost of imported factors of production more expensive, contributing to higher production
costs overall.
When wages rise faster than the productivity of workers, this can also contribute to cost-push
inflation. This is possible, for example:
if the unemployment rate is low, the limited supply of potential hires are in a strong
bargaining position to demand a high wage as they face little competition for jobs
powerful trade unions could negotiate higher wages for their members in collective wage
bargaining.
The overall impact of an increase in the cost of factor inputs is a leftward shift of the aggregate
supply curve, as shown in Figure 4.18. Cost-push inflation results in the price level increasing
from P1 to P2.
Figure 4.18: Cost-push inflation results when factor input costs increase, leading to a
leftward shift of the aggregate supply curve from AS1 to AS2, causing the price level to
rise, since P1 < P2, as the economy moves from point A to point B.
Where possible, producers want to pass on these higher costs to consumers instead of having to
absorb the higher production costs themselves. This passing on of costs results in the cost-push
inflation. As seen in Section 2.2, the ability of a firm to increase the price of its good or service
depends on the consumer’s price elasticity of demand. At the aggregate level, the slope of the
aggregate demand curve determines the magnitude of the cost-push inflation.
Figure 4.19 considers the same shift in aggregate supply but assumes overall consumers have
more inelastic demand, resulting in greater cost-push inflation since P2 - P1 is greater in Figure
4.19 than in Figure 4.18.
Figure 4.19: Cost-push inflation when consumers collectively have more inelastic
demand for goods and services, resulting in greater cost-push inflation than shown in
Figure 4.18.
Other causes of inflation include:

too much money in the economy – it is naive to assume that simply printing more money will make a
country richer, as printing more money (an increase in the money supply) simply leads to an increase
in inflation
innovation – when new products are launched, they are initially at a high price, but over time
competition acts to bring down prices as a result of imitation and wider availability of the new
products.
Costs of inflation
Low increases in price levels are harmless. They are actually needed to keep spending stimulated.
If prices were decreasing, people would refrain from consumption as they would be expecting prices
to fall even further, and so would be waiting for a better deal, hence delaying their consumption. Many
economists argue that a moderate rate of inflation is actually built into the capitalist system.
Too high an increase in the price level, on the other hand, can be very dangerous. An economy could,
for example, become less competitive in the world market; the cost of its exports would rise, making
them relatively more expensive, leading to a fall in export revenues. Imports become cheaper. Its overall
international trade competitiveness would decline.
Inflation redistributes income away from those on fixed incomes as their wealth is held in fixed-rate
bonds and savings accounts and so they suffer a relative loss. Lending and borrowing are also affected –
lenders lose out, while borrowers gain since their nominal debts are inflated away.
Inflation rewards the owners of real estate with increases in the value of property, possibly at the expense
of saving being diverted away from industry investment in the circular flow of income. If property prices
rise too much, making them unaffordable for young people, this could ultimately lead to social unrest.
Uncertainty over the rate of inflation could lead to difficulties for firms predicting their future income.
This could, in turn, lead to them cancelling or postponing decisions on investment (with an adverse
effect on employment). Governments and local authorities face similar problems. This makes planning
more difficult, uncertain and costly. If people fear inflation, they may be more risk-averse in their decision-
making as they take fewer risks to minimise the probability of being negatively affected by a price shock.
If inflation was perfectly predictable, people could factor in higher (known) prices to their decision-
making when planning. However, inflation is unpredictable, with higher rates of inflation increasing the
uncertainty in predicting its future value, resulting in a loss of confidence in the currency (as mentioned
when we discussed hyperinflation).
There are also less serious effects, such as:
increased accountancy charges for firms
the need to change labelling and prices, known as ‘menu costs’; just as a restaurant must print a new
menu when it changes prices, shops must do the same, potentially resulting in ‘sticky prices’ as firms
are reluctant to continually change prices due to the forces of demand and supply (although online
retailers can change prices on screen almost immediately at negligible cost)
the tendency for all consumers to ‘shop around’, therefore wasting time and money. This is known as
‘shoe leather costs’ due to the shoe leather used up in walking from shop to shop (again, the rise of
e-commerce and online shopping has reduced actual shoe leather costs!).
Most economists agree that a healthy level of inflation should be targeted between two and three per
cent a year. As noted, the Bank of England has an annual inflation target of two per cent which it uses to
guide monetary policy (covered in Section 4.5).
Remedies for inflation

Once inflation reaches too high a level, as it sometimes does, the following measures can be
used to decrease it.
Demand-pull inflation can be tackled using demand-side policies such as reducing government
spending (shifting the aggregate demand curve leftward, as shown in Figure 4.20). This achieves
a reduction in the price level, since P1 > P2, although ceteris paribus (i.e. other things being equal)
this leads to a higher level of unemployment due to the reduction in output, since Y1 > Y2.
Figure 4.20: A demand-side policy of reducing aggregate demand shifts the

aggregate demand curve leftward, resulting in a lower price level, since P1 > P2, but
higher unemployment, since Y1 > Y2.
Another demand-side policy is to reduce the amount of money in circulation, i.e. reducing the
money supply.
For cost-push inflation, there is little a government can do other than find cheaper substitutes
for imported goods (when raw materials and/or energy are imported), or hold negotiations
with trade unions to curb their demands for wage increases above the rate of inflation (however
unlikely this may seem).
Inflation and unemployment

Can we have both high levels of inflation and high unemployment? The answer is yes. This can
be caused by what is termed a supply-side shock – ‘stagflation’, a term derived from the words
‘stagnation’ and ‘inflation’.
Stagflation results when there is a depressed level of real output (caused by a fall in aggregate
demand) and rising factor input costs (leading to cost-push inflation), although stagflation tends
to be the result of cost-push inflation as the instigator.
Figure 4.21 recycles Figure 4.18, although here we explicitly consider the stagflation problem.
Historically, stagflation affected many countries during the 1970s as a result of the oil price crises
of 1973 and 1979, when OPEC caused large oil price increases, resulting in cost-push inflation.
This combined with a depressed economy in oil-consuming nations led to a stagnant economy,
leading to lower consumption and employment, hence higher unemployment.
The resulting rise in costs to suppliers (the leftward shift of the supply curve) increases prices and
reduces the quantity demanded. The downward pressure can be so great as to drastically reduce
the requirement for labour, as shown in Figure 4.21. Therefore, the country experiences inflation
and unemployment simultaneously – the worst of both worlds!
Figure 4.21: Stagflation caused by a leftward shift of the aggregate supply curve moves
the economy from the old equilibrium of (Y1, P1) to the new equilibrium of (Y2, P2),
resulting in stagnation (unemployment), since Y1 > Y2, and inflation, since P1 < P2.
Conclusion
We have defined inflation and discussed how it can be measured, by way of the consumer price
index and retail price index, noting their differences. The different types of inflation, and their
causes, were described, distinguishing between demand-pull and cost-push inflation. Some of
the costs of inflation were covered, as well as possible remedies (mainly due to demand-side
policies). The twin economic problems of inflation and unemployment concluded with an
examination of the phenomenon of stagflation when an economy simultaneously experiences
stagnation and inflation.
ACTIVITY 4.15
Do you expect the figures given by the two inflation measures (the consumer price index
and the retail price index) to be the same? Explain your answer.
ACTIVITY 4.16
Look up cases of some of the highest inflation rates in history and research what caused
these hyperinflation episodes.
ACTIVITY 4.17
What are the differences between demand-pull inflation and cost-push inflation?
ACTIVITY 4.18
Look up the current inflation rate in your country of residence, and research how the
figure is calculated. How has the inflation rate changed in recent years, and can you
explain these changes?
ACTIVITY 4.19
‘Inflation is more serious than unemployment.’ Do you agree? Justify your answer with
the use of examples.
Section 4.5: Monetary policy and fiscal

policy
Introduction 172
Monetary policy 172
Monetary policy types 173
Fiscal policy 176
Monetary policy versus fiscal policy 178
Preview of the global financial crisis 180
Conclusion 180

Unit 4: Macroeconomics I: closed economy • Section 4.5: Monetary policy and 172
fiscal policy
Introduction
Demand-side policies were mentioned in Sections 4.3 and 4.4 as possible remedies for
unemployment and inflation, respectively. In this section, we focus on two very important
macroeconomic policies in detail. Demand-side policies, as the name suggests, are the actions
of a government which affect the levels of aggregate demand. The two main policies are known
as monetary policy and fiscal policy.
In this section, we consider how each policy works in practice, distinguishing between
‘loose’ versions of each (known as an expansionary policy) and ‘tight’ versions (known as a
contractionary policy). The macroeconomic effects of each policy type are shown, as well as an
appraisal of the relative features of each policy path.
Monetary policy
Monetary policy is conducted by a central bank. In many countries the central bank acts
independently of the government, therefore making apolitical decisions. A central bank is the
major monetary and financial regulatory authority within a country. Central banks set interest
rates (the cost of borrowing) and are responsible for supervising the financial system, acting as
the ‘lender of last resort’ when commercial banks become insolvent (i.e. when banks are unable
to access funds from the capital markets). Examples of central banks include the Bank of England
in the UK, the Federal Reserve (the Fed) in the US, and the European Central Bank (ECB) in the
Eurozone (countries which form a monetary union through their common use of the euro
currency).
Broadly speaking, monetary policy involves controlling the money supply, which in turn affects
demand, allowing central banks to manage aggregate demand. The money supply can be
defined as the total amount of money in circulation in an economy. The money supply can be
controlled in the following ways.
Changing the short-term nominal interest rate, known as the discount rate. This is the
interest rate which a central bank charges when lending to other banks. This is the primary
monetary policy tool in most countries.
Open-market operations, recently termed quantitative easing, whereby the central
bank buys and sells ‘securities’ in the open market. These securities are usually government
bonds (effectively government debt, whereby the government borrows by issuing and selling
interest-bearing bonds) but can also be commercial securities. Buying securities allows the
central bank to increase the money supply (it pays for the securities with money, so injects
money directly into the economy); selling securities allows the central bank to remove money
from circulation (purchasers of the securities pay with money, so money is withdrawn from
the economy). During periods of zero or near-zero interest rates, cutting interest rates is no
longer possible so central banks resort to open-market operations (quantitative easing has
been used extensively following the global financial crisis, as discussed in Unit 6).
Changing reserve requirements, where reserve requirements are regulations which
govern the minimum amount of capital a commercial bank must keep as liquid assets (such
as cash) to meet the expected demand of withdrawals by depositors. This approach is the
only one which is regulatory in nature, since it corresponds to a ‘capital adequacy’ rule to
which commercial banks must adhere.
Measuring the money supply is challenging, as many methods exist which reflect the different
liquidities different types of money possess. Banknotes and coins (i.e. cash) are fully liquid,
while some forms of bank deposits can only be withdrawn after a period of notice. Avoiding
technicalities, we distinguish between:
fiscal policy
narrow money – assets which are fully liquid, primarily used for spending
broad money – narrow money plus less liquid assets, primarily used for spending and as a
store of value.
We define the money supply schedule as the relationship between the quantity of money
in the economy and the (short-term) nominal interest rate. Figure 4.22 shows an example of
a money supply schedule, MS, which note is just a vertical line because the money supply is
fixed (constant) for all nominal interest rates. Also shown in Figure 4.22 is the money demand
schedule, MD, which shows a negative relationship between the demand for money and
nominal interest rates – lower nominal interest rates mean borrowing is cheaper, so demand for
money increases. In equilibrium money demand equals money supply, resulting in the nominal
interest rate of i.
Figure 4.22: The money supply, MS, and money demand, MD, schedules relate the
quantity of money and nominal interest rates. As the money supply is fixed, MS is a
vertical line. As nominal interest rates reflect the cost of borrowing, money demand
increases when nominal interest rates fall, causing MD to be downward-sloping. The
equilibrium nominal interest rate, i, occurs when MD = MS.
Monetary policy types

Monetary policy can be expansionary or contractionary. We now consider both types in the
context of interest rates, the price level, national output (GDP) and unemployment.
Expansionary monetary policy

An expansionary monetary policy can be achieved directly by increasing the money supply,
which in turn reduces the nominal interest rate (since money is now less scarce, so its price – the
nominal interest rate – decreases) via a rightward shift of the money supply schedule, as shown
in the left panel of Figure 4.23. In turn, this increases aggregate demand as the interest rate-
sensitive components of GDP (investment, and also consumption) respond to the lower interest
rate leading to a rightward shift of the aggregate demand curve, which results in a higher
price level (i.e. inflation), but also economic growth due to higher national output (and lower
unemployment), as shown in the right panel of Figure 4.23.
So, in summary, an expansionary monetary policy leads to:
fiscal policy
a lower nominal interest rate

a higher price level
higher GDP
lower unemployment.
Figure 4.23: Expansionary monetary policy caused by an increase in the money supply
(MS1 to MS2), leading to a lower nominal interest rate, since i1 > i2, shown in the left
panel. The lower interest rate stimulates investment and consumption, causing a
rightward shift in aggregate demand (AD1 to AD2), leading to a higher price level, since
P1 < P2, but increased GDP, since Y1 < Y2, and lower unemployment, shown in the right
panel.
Contractionary monetary policy

A contractionary monetary policy can be achieved directly by decreasing the money supply,
which in turn increases the nominal interest rate (since money is now scarcer, so its price – the
nominal interest rate – increases) via a leftward shift of the money supply schedule, as shown
in the left panel of Figure 4.24. In turn, this decreases aggregate demand as the interest rate-
sensitive components of GDP (investment, and also consumption) respond to the higher interest
rate, leading to a leftward shift of the aggregate demand curve, which results in a lower price
level and also lower national output (and higher unemployment), as shown in the right panel of
Figure 4.24.
So, in summary, a contractionary monetary policy leads to:
a higher nominal interest rate
a lower price level
lower GDP
higher unemployment.
fiscal policy
Figure 4.24: Contractionary monetary policy caused by a decrease in the money

supply (MS1 to MS2), leading to a higher nominal interest rate, since i1 < i2, shown in the
left panel. The higher interest rate suppresses investment and consumption causing
a leftward shift in aggregate demand (AD1 to AD2), leading to a lower price level, since
P1 > P2 and decreased GDP, since Y1 > Y2, also higher unemployment, shown in the
right panel.
Expansionary or contractionary monetary policy?

We have seen that the macroeconomic outcomes (in terms of interest rates, price level, GDP and
unemployment) differ depending on whether monetary policy is expansionary or contractionary.
So when would a central bank choose one policy path over another?
This will depend on the current state of the economy. If the central bank felt the economy
was sluggish and hence in need of a boost, expansionary monetary policy would be followed.
Lowering the nominal interest rate through increasing the money supply stimulates interest
rate-sensitive components of spending (investment and consumption), resulting in economic
growth. Also, if inflation was below the central bank’s target inflation rate, expansionary monetary
policy achieves a higher price level.
In contrast, if the central bank felt the economy was overheating (for example, due to demand-
pull inflation), it would undertake contractionary monetary policy to cool the economy and
slow it down. By restricting the money supply, and raising the nominal interest rate, aggregate
demand eases (due to lower investment and consumption), reducing economic output and
taming inflation.
Note how monetary policy plays an important role in controlling the level of inflation.
Economists refer to it as the monetary transmission mechanism. The central bank sets the
nominal interest rate for a period of time. This rate, in turn, affects the interest rates of mortgages
and bank lending. Asset prices and the currency exchange rate can also be affected. Such
changes will, therefore, influence firms and individuals in terms of their investment decisions
(higher interest rates tend to encourage saving; lower rates tend to encourage investment). This
has a knock-on effect on the demand for labour, and hence wage rates. Therefore, the central
bank seeks to influence economic activity and the level of inflation and/or unemployment.
While monetary policy seems like a perfect way to achieve the desired level of inflation and
unemployment, be aware that in practice it is extremely difficult to accurately determine the
timing of these flows. As with many things in life (including fiscal policy), timing is crucial!
fiscal policy
Fiscal policy
Fiscal policy is conducted by the government. It forms the tax-and-spending decisions of the
government and is the government’s primary instrument for managing aggregate demand
(whereas the nominal interest rate is the primary instrument of a central bank to manage
aggregate demand using monetary policy).
Governments can control domestic economies via their revenues and levels of government
spending. Revenues mostly come from collecting taxes, but also from dividends and rents.
Governments then decide how much to spend on health, education, transport, defence and
other areas of government spending.
The mechanism by which government spending has an impact on the economy is known as the
multiplier (i.e. how an increase in government spending can produce an even greater increase
in national income).
Suppose a government spends £100 million on building new roads. This money will go to
architects, builders and resource providers responsible for the project. Some of the money will
be paid by workers as their income tax, some will be saved, but the rest will be spent. Suppose,
for the simplicity of the argument, that £70 million is spent by workers on goods, including food.
This £70 million would then go to shop owners and farmers who will pay some income tax, save
some of the money, but spend the rest. This story would go on and on.
Therefore, the initial spending of £100 million will result in a much higher additional income of
the economy (£100 million to workers + £70 million to shop owners and food producers, and so
on). The more ‘re-spent’, as opposed to paid as a tax or saved, the higher the final increase in total
income. The total effect of this cascade of spending is termed the multiplier. The calculation
and accuracy of this multiplier is crucial in estimating the effectiveness of fiscal policy. The
multiplier has been (not very accurately) calculated as being somewhere between 1 and 2.
The effectiveness of fiscal policy depends, therefore, on the level of consumer responsiveness.
There are, however, some possible problems with fiscal policy:
time lags – it takes time for the policy to have an impact on the economy
information issues – the government may underestimate or overestimate the amount of
government spending needed.
Fiscal policy types

As with monetary policy, fiscal policy can be expansionary or contractionary. We now
consider both types in the context of the price level, national output (GDP) and unemployment.
Expansionary fiscal policy

An expansionary fiscal policy is achieved by increasing government spending (one of the
components of GDP), which in turn increases aggregate demand, leading to a rightward shift
of the aggregate demand curve which results in a higher price level (i.e. inflation), but also
economic growth due to higher national output, and hence lower unemployment, as shown in
Figure 4.25.
So, in summary, an expansionary fiscal policy leads to:
a higher price level
higher GDP
lower unemployment.
fiscal policy
Figure 4.25: Expansionary fiscal policy (that is, increased government spending)
causing a rightward shift in aggregate demand (AD1 to AD2), leading to a higher price
level, since P1 < P2, but increased GDP, since Y1 < Y2, and hence lower unemployment.
Contractionary fiscal policy

A contractionary fiscal policy is achieved by decreasing government spending (one of the
components of GDP), which in turn decreases aggregate demand, leading to a leftward shift
of the aggregate demand curve which results in a lower price level and reduced output with
increased unemployment, as shown in Figure 4.26.
So, in summary, a contractionary fiscal policy leads to:
a lower price level
lower GDP
higher unemployment.
Figure 4.26: Contractionary fiscal policy (that is, decreased government spending)
causing a leftward shift in aggregate demand (AD1 to AD2), leading to a lower price
level, since P1 > P2 and reduced GDP, since Y1 > Y2, and hence higher unemployment.
fiscal policy
Expansionary or contractionary fiscal policy?

We have seen that the macroeconomic outcomes (in terms of the price level, GDP and
unemployment) differ depending on whether fiscal policy is expansionary or contractionary. So
when would a government choose one policy path over another?
If a government felt the economy needed a boost, then it would embark on expansionary fiscal
policy. Note that governments make political decisions (trying to win enough votes to win the
next election); they may be tempted to loosen the government purse strings to create economic
growth and lower unemployment to increase their popularity with voters, and by doing so
increase the probability of winning the election and staying in power.
A contractionary fiscal policy produces the politically-undesirable outcomes of lower output and
higher unemployment, but could help to lower inflation. If the government was benevolent and
felt the economy was overheating, it may not be too concerned with the impact on output and
unemployment. Also, if the government could not afford high levels of spending, it may decide
to tighten its fiscal policy.
So we see that fiscal policy can be used to keep levels of inflation and unemployment under
control. We need to be careful, however, as there are some trade-offs when trying to control
both at the same time. Countries should also be careful in their use of fiscal policies as excessive
spending beyond the amount collected from taxes will greatly increase the level of national
debt. Following the global financial crisis, many European economies are suffering from this very
problem, as will be seen in Unit 6.
Another difficulty is the timing of the multiplier effect. Fiscal policy can take a long period
of time to fully work its way through the economy, by which time there may be unintended
consequences with respect to inflation and economic growth. As with monetary policy, timing is
crucial!
Monetary policy versus fiscal policy

You may think there is little to choose between using monetary policy or fiscal policy, since both
affect the aggregate demand curve (shifting it to the right for expansionary (loose) policy paths,
and to the left for contractionary (tight) policy paths), resulting in the same directional change in
price level, GDP and unemployment.
While there are some similarities of outcome, there are also some important differences which
we now consider, initially summarised in Table 4.1.
fiscal policy
Monetary policy Fiscal policy

Policy type Expansionary Contractionary Expansionary Contractionary
Lower nominal Higher nominal Cut taxes and/ Increase taxes
Policy interest rate, interest rate, or increase and/or decrease
instrument increased money reduced money government government
supply supply spending spending
Lowers cost Raises cost of
of borrowing, borrowing, Increases the Decreases the
Direct effect
including including budget deficit budget deficit
mortgages mortgages
Current taxpayers
and recipients
Winners Borrowers Savers Future taxpayers
of government
spending
Current taxpayers
and recipients
Losers Savers Borrowers Future taxpayers
of government
spending
Lower income Higher income
Supply-side taxes act as taxes act as
Limited impact
impact incentives to disincentives to
work work
Apolitical if central bank is
Politics Highly political
independent
Ineffective if
Always possible
Liquidity trap nominal interest Advisable in Advisable if
to increase
and national rates at zero/close cases of severe national debt is
nominal interest
debt issues to zero – no room recession unsustainable
rates
to cut rates
Exchange rate Exchange rate

depreciation, appreciation,
makes exports makes exports
Exchange rate No effect on exchange rate
more competitive less competitive
and imports more and imports
expensive cheaper
Table 4.1: Differences between monetary policy and fiscal policy.
The policy instruments have already been discussed. With regards to direct effects, monetary
policy primarily impacts the nominal interest rate, directly affecting borrowers and savers.
Borrowers benefit from lower interest rates (expansionary monetary policy), while savers benefit
from higher interest rates (contractionary monetary policy).
In contrast, tax-and-spending decisions directly affect taxpayers and those who receive
government spending (typically producers). Note we distinguish between current and future
taxpayers. When government spending exceeds tax revenues, dividends and rents, the
government runs a budget deficit (as explained in Section 4.2), adding to the national debt (the
stock of total amount of outstanding government borrowing). This national debt needs servicing
fiscal policy
(at the very least interest payments, if not capital repayment in full) and the liability will fall on
future taxpayers (i.e. future generations), whose welfare the present-day government should
care about; although they may not in practice as they may only care about winning the next
election!
Only fiscal policy has a significant impact on the supply side, as changes to taxation levels impact
the incentives to work (as mentioned in the supply-side policies discussion in Section 4.3).
Politics is at the heart of fiscal policy decision-making, whereas independent central banks, like
the Bank of England, operate separately from the government and hence are not particularly
concerned with the opinion of voters. Governments are electorally motivated to act in the short
run, and so may care less about future taxpayers, making it tempting to undertake expansionary
fiscal policy for short-term electoral gain. In contrast, central banks can afford to take a more
long-term view when setting policy.
When interest rates are at or near zero, expansionary monetary policy becomes redundant (or
instead, an expansion of open-market operations – quantitative easing – could occur, but this
risks generating inflationary pressures), in which case, the economy falls into a liquidity trap,
and so an expansionary fiscal policy may be necessary instead. Indeed, some governments
responded in this way to the global financial crisis covered in Unit 6.
Finally, we consider exchange rate implications of monetary policy (there are no effects
stemming from fiscal policy). While the open economy is discussed in Unit 5, for completeness
we briefly note now the relationship between interest rates and exchange rates. Savers benefit
from higher interest rates, so when higher interest rates occur as a result of contractionary
monetary policy foreigners can earn a higher return on their capital so buy the domestic
currency. The increased demand for the domestic currency leads to an appreciation of the
exchange rate. Conversely, lower interest rates reduce foreigner demand for domestic currency,
causing a depreciation. Linked to the exchange rate is the competitiveness of exports, and the
cost of imports, as indicated in Table 4.1.
Preview of the global financial crisis

In the immediate aftermath of the global financial crisis (see Unit 6), there was fierce debate
about the correct macroeconomic response of governments. The dramatic fall in aggregate
demand prompted Keynesian-influenced economists (see Appendix A) to promote equally
dramatic government interventions, primarily through fiscal stimuli, to offset the collapse in
aggregate demand immediately following the crash and prevent a new global depression, as
well as to counteract the severe loss of consumer and business confidence.
Friedman (again, see Appendix A) advocates would instead have recommended minimal
government intervention, provided central banks acted to inject sufficient reserves into the
banking system to avoid a reduction in the money supply.
The lack of consensus among the world’s economists and government economic advisers has
meant fierce debate between politicians about how best to combat the global financial crisis,
demonstrating the challenges in choosing between different types of monetary and fiscal
policies.
Conclusion
This section has looked in detail at the two main macroeconomic policies. Starting with
monetary policy, we have seen how central banks control the money supply, as well as the
macroeconomic impact of expansionary and contractionary policy paths, including conditions
favouring either loose or tight policy.
fiscal policy
Fiscal policy was then considered, including a brief discussion of the multiplier effect, which
amplifies the impact of an increase in government spending as it works its way through the
economy. The macroeconomic impact of expansionary and contractionary policy paths,
including conditions favouring either loose or tight policy, were discussed.
We concluded with a comparison of monetary policy and fiscal policy, taking into account the
policy instruments, direct effects, winners and losers, supply-side effects, politics, liquidity trap
and national debt issues, plus the exchange rate.
ACTIVITY 4.20
In your own words, explain how a central bank controls the money supply.
ACTIVITY 4.21
Explain the difference between an expansionary monetary policy and a contractionary
monetary policy.
ACTIVITY 4.22
Explain the difference between an expansionary fiscal policy and a contractionary fiscal
policy.
ACTIVITY 4.23
‘Monetary policy and fiscal policy are equally effective.’ Do you agree? Justify your
answer.
ACTIVITY 4.24
Suppose an economy was running an unsustainable budget deficit which was
concerning policymakers. Explain, using an appropriate diagram, how a contractionary
fiscal policy, combined with an expansionary monetary policy, could prevent an
economy entering a recession (defined as two consecutive quarters of negative
economic growth).
(Note such a policy mix was used by then US President Bill Clinton and then Fed
chairman Alan Greenspan with great success in the US during the 1990s.)
Concluding comments
This unit has started our study of macroeconomics. We began by studying the circular flow
of income, which links households and firms in an economy. The tools of national income
accounting were outlined, showing how we could determine the total amount of economic
activity using either total income, total expenditure or total production. GDP was decomposed
into the components of consumption, investment, government spending, and (for an open
economy) net exports. Changes to any of these components affect GDP.
Aggregate demand and aggregate supply were introduced as macroeconomic versions of
single-good demand and supply. However, rather than a single-good price, we now consider the
price level, i.e. the general level of prices in the economy.
The key macroeconomic variables of unemployment and inflation were defined, distinguishing
their different types, costs and possible remedies. The unit concluded with an examination of
monetary policy and fiscal policy, how they function and impact the economy, including a
discussion of their similarities and differences.
Next up is Unit 5 which moves us from a closed economy to an open economy which trades
with the rest of the world!

explain the macroeconomic objectives of national governments
explain the circular flow of income and how to determine the total amount of economic
activity
define the concepts of economic growth, unemployment and inflation
describe the different types of unemployment, their costs and possible remedies
explain the relationship between unemployment and economic growth
describe the different types of inflation, their costs and possible remedies
explain the phenomenon of stagflation
describe how monetary policy works from expansionary and contractionary perspectives
describe how fiscal policy works from expansionary and contractionary perspectives
outline the similarities and differences between monetary and fiscal policies.
183
Aims 184

Unit 5: Macroeconomics II: open economy 184

Our macroeconomic analysis so far has been confined to closed economies, which are
economies detached from the outside world. Clearly, we live in a highly globalised world with
much interaction between countries. This unit considers the international economy by providing
an overview of international trade, the balance of payments and exchange rates.
Why do countries engage in trade with each other? Trade occurs due to countries possessing
a comparative advantage in the production of some goods, i.e. there are different opportunity
costs of production. We will see this phenomenon through some simple numerical examples.
The balance of payments is a statement detailing a country’s trade and financial transactions
with the rest of the world. We will consider its two components - the current account and the
capital account - followed by a discussion of exchange rates (the price of one currency in terms
of another) including an examination of different exchange rate regimes.
The unit concludes with an examination of different measures of economic development which
allow us to compare the extent of economic development across countries. Three important
measures will be introduced - the Human Development Index, the Human Poverty Index and the
Gini coefficient.
Week Unit Section

16 5: Macroeconomics II: open 5.1: International trade
17 economy 5.2: Balance of payments and exchange rates
18 5.3: Measures of economic development
Section 5.1 begins with the benefits and costs of globalisation before explaining why
international trade occurs by considering absolute advantage and comparative advantage (with
the latter being responsible for creating incentives to trade). Section 5.2 explains the balance
of payments before proceeding to exchange rates. There are two main exchange rate regimes
(fixed and floating) and the differences between these are discussed. In a floating exchange rate
regime, a country can operate an independent monetary policy which itself has implications for
the exchange rate - this relationship between exchange rates and monetary policy is explored.
Section 5.3 concludes the macroeconomic part of the course by analysing three different
measures of economic development.
Aims
This unit aims to:
outline the benefits and costs of globalisation
explain why international trade occurs
explain the balance of payments
compare different exchange rate regimes and how exchange rates are determined under a
floating regime
compare different measures of economic development.
Learning outcomes
By the end of this unit, having completed the background readings and activities, you should be
able to:
define globalisation
explain the difference between absolute advantage and comparative advantage
show how international trade is beneficial as a consequence of comparative advantage
outline the components of the balance of payments and how deficits and surpluses are
reconciled
explain the features of fixed and floating exchange rate regimes
explain the relationship between exchange rates and monetary policy under a floating
regime
explain the determination of the Human Development Index, Human Poverty Index and Gini
coefficient.
Background reading
Anderton, A. and D. Gray (Ed) Economics. (Lancashire: Anderon Press, 2015) 6th edition [ISBN
9780993133107].
Section 5.3 – Unit 90 (pp. 615–620).
Section 5.1: International trade
Introduction 187
Globalisation 187
Benefits of globalisation 187
Costs of globalisation 187
International trade 188
Absolute advantage and comparative advantage 188
Trade blocs 191
Conclusion 192
Unit 5: Macroeconomics II: open economy • Section 5.1 International trade 187
Introduction
We begin our look at open economy macroeconomics with a discussion of globalisation,
including its benefits and costs. We then explain how international trade stems from different
endowments of factors of production, before using some simple empirical examples to illustrate
the concepts of absolute advantage and comparative advantage. This section concludes
with a discussion of trade blocs.
Globalisation
Globalisation refers to the increasingly integrated nature of national economies into a single
international market. Economic integration comprises four main parts:
free trade of goods and services across borders
free movement of labour
free movement of financial capital
free exchange of technology and intellectual capital.
Of course, many protectionist barriers to the above still exist, such as tariffs (a tax on imported
goods levied by the government of the importing country), so we do not live in an entirely
globalised world. However, according to the World Trade Organization (WTO), global exports
as a percentage of global GDP (gross domestic product) have leapt from around 5 per cent in
1950 to around 30 per cent today. The WTO is the governing body of international trade and is
responsible for setting the rules of global trade which its member countries must follow, enforces
those rules, and punishes members who break the rules.
Arguably, the driving force behind globalisation has been multinational companies which have
lobbied national governments to expand into national markets that were previously heavily
protected from international competition.
Benefits of globalisation
Globalisation has the following benefits:
Free trade between countries should eliminate tariffs and subsidies between countries,
promote economic growth, reduce unemployment and result in lower prices for consumers.
Less-developed countries benefit from foreign direct investment (FDI) and can increase their
productive capacity by using imported technology.
Workers who are able to be flexible can emigrate to ensure they can maximise their earnings.
Further gains from specialisation are possible due to greater production economies of scale.
Increased competition means that domestic monopolies face competition from foreign firms,
to the benefit of consumers.
Costs of globalisation
Inevitably, globalisation also has associated costs, which include the following:
Jobs may move to developing countries with lower wage rates leading to increased
unemployment in developed countries, or these workers have to accept lower wages to
compete against workers in developing countries.
Dependence on other countries for essential goods and services can prove problematic in the
event of a deterioration of relations between countries or if there are supply chain problems.
Close integration of economies increases the risk of contagion – economic problems in one
country can be quickly transmitted to other countries (which was seen in the global financial
crisis of 2007–08 – see Unit 6).
Potentially greater inequality can result if the gains from globalisation are concentrated
among the top income groups only.
If countries compete to make their exports more competitive through currency devaluations,
a ‘race to the bottom’ can occur.
International trade
International trade is the exchange of goods and services between countries through exports
and imports and occurs for several reasons. Countries differ in terms of their endowments of
factors of production. For example, oil-rich Gulf states are endowed with significant oil reserves,
Russia has the world’s largest gas reserves; in contrast, Japan and Singapore have almost no
natural resources. Labour force skills vary, with developed economies typically having a greater
proportion of highly-skilled and well-educated workers.
As a consequence of different factor endowments, the cost of production of goods and services
also differs widely. Therefore, there are gains to be realised from specialisation which we will
consider in the next section.
Although classes of products, such as cars and televisions, are fairly homogeneous in terms of their
primary functions (any car can transport you from point A to point B), typically there is product
differentiation across manufacturers. For example, two rival car manufacturers will produce slightly
different cars in terms of size, fuel efficiency, design etc. This leads to increased consumer choice.
We considered such product differentiation in Section 3.2 under monopolistic competition.
Note that international trade is not just restricted to tangible goods (i.e. something you can
touch), but also includes services, which are classified as being intangible (i.e. something you
cannot touch). Common examples of services that can be traded include financial services
(banking), advertising and even distance education. Collectively, trade in services is called
invisible trade due to its intangible characteristics.
Politics also influences international trade. Countries may sign free-trade agreements, either
bilaterally (between two countries) or as trading blocs, such as the European Union. Political barriers
to free trade also exist, such as trade embargoes – most notably the US embargo with Cuba.
So just why is international trade so beneficial? To answer that question requires an
understanding of the theory of comparative advantage, which we discuss next.
Absolute advantage and comparative advantage

If two countries possess the same resource input(s), absolute advantage is the ability of one of
those countries to produce more output of a good or service than the other country.
Consider two countries, A and B, which are each capable of producing two goods, X and Y.
Country A has sufficient resources to produce either 100X or 100Y, while country B can produce
either 150X or 120Y with the same resources. Clearly, country B is absolutely more efficient than
country A because it is able to produce more of both goods.
At first sight, we might think that there would be no trade between these two countries.
However, being the best at something does not necessarily mean producing this item is the
best use of scarce economic resources. Whether or not international trade is beneficial is
determined on comparative advantage, not absolute advantage. Comparative advantage
occurs because the marginal opportunity costs of one good in terms of the other differ between
countries. (This principle can also be extended to firms and individuals.)
Country B could benefit from specialising in producing good X, since its advantage in the
production of X is greater. That is, country B is able to produce X at a lower factor cost than
country A. The opportunity cost for country B of producing an extra unit of X is only 0.8Y. In
contrast, for country A, the opportunity cost of producing an extra unit of X is 1Y.
Country A could benefit from specialising in producing good Y, since its advantage in the
production of Y is greater. That is, country A is able to produce Y at a lower factor cost than
country B. The opportunity cost for country A of producing an extra unit of Y is only 1X. In
contrast, for country B, the opportunity cost of producing an extra unit of Y is 1.25X.
So, both countries benefit in terms of their economic welfare from specialisation in the sole
production of the good for which they possess a comparative advantage and then trading with
each other.
The above example is summarised in Table 5.1 which shows the opportunity cost ratios.
Country Possible output of good Opportunity cost ratio
X Y X:Y
A 100 100 1:1
B 150 120 1:0.8 (or 1.25:1)
Table 5.1: Opportunity cost ratios showing that country A has a comparative
advantage in the production of Y, while country B has a comparative advantage in the
production of X.
This simple example assumes that factor endowments and, therefore, comparative advantages
remain fixed. Of course, this may not be the case in practice. For example, government intervention
may promote the redirection of resources to politically appealing alternative uses. Movements in
international capital and adopting new technologies may also affect comparative advantage.
Also, producing goods and services for which it has a comparative advantage will increase a
country’s GDP. This will allow it to spend more on infrastructure and education (thereby ‘upskilling’
its workforce) which, subsequently, may give it a comparative advantage in other areas.
Whether or not trade actually takes place between countries will depend on the terms of
trade, that is, the ratio of export prices relative to import prices. Terms of trade is expressed as an
index because it is based on the weighted average price of exports and the weighted average
price of imports reflecting not just one, but thousands of different export and import prices. It is
calculated as follows:
weighted index of average export prices .
terms of trade = 100 ×
weighted index of average import prices
Example 5.1
Two countries, A and B, each have 100,000 workers. Each country can produce two goods:
smartphones and computers. Country A has superior technology and is therefore more efficient
in the production of both products. Two workers are needed to produce a smartphone, and
eight workers are needed to produce a computer. In contrast, in country B it takes 10 workers to
produce a smartphone, and 100 workers to produce a computer.
Suppose the countries do not engage in trade with each other. In this scenario, in each country
50,000 workers (half the workforce) are employed in each of the smartphone and computer
industries. Therefore, country A produces 50,000/2 = 25,000 smartphones and 50,000/8 = 6,250
computers. Meanwhile, country B produces 50,000/10 = 5,000 smartphones and 50,000/100 =
500 computers. Total output across the two countries is 25,000 + 5,000 = 30,000 smartphones
and 6,250 + 500 = 6,750 computers.
Then both countries decide to specialise. While country A has an absolute advantage in the
production of both goods (due to its superior technology), it has a comparative advantage in
manufacturing computers. Suppose 55 per cent of the workforce (i.e. 55,000 workers) produce
computers, with the remaining 45 per cent are employed in the smartphone sector.
Now, country A produces 45,000/2 = 22,500 smartphones and 55,000/8 = 6,875 computers.
Meanwhile, country B decides to only produce smartphones, with a total production of
100,000/10 = 10,000 smartphones. Total output across the two countries is now 22,500 + 10,000
= 32,500 smartphones and 6,875 + 0 = 6,875 computers. Therefore, total output has increased
because of specialisation. These results are summarised in Table 5.2.
Country (each Workers per Workers Smartphone Computer Smartphone Computer
with 100,000 smartphone per production production production production
workers) computer without without with with
specialisation specialisation specialisation specialisation
A 2 8 25,000 6,250 22,500 6,875
B 10 100 5,000 500 10,000 0
Total 30,000 6,750 32,500 6,875

production:
Table 5.2: Production levels of smartphones and computers without specialisation,
with the workforces split equally between industries, and with specialisation.
If the countries are prepared to trade at the right price, then they can both consume more
smartphones and computers, and hence both be better off.
In order to determine the price, we first note that neither country will import a product that it
is capable of making more cheaply itself. Country A will want at least 8/2 = 4 smartphones per
computer, while country B would be prepared to pay no more than 100/10 = 10 smartphones
per computer (the countries’ respective opportunity cost ratios). Therefore, a price of between 4
and 10 smartphones per computer would induce trade.
Suppose the terms of trade are such that the ‘exchange rate’ is 6 smartphones per computer,
resulting in country B selling 3,600 smartphones in exchange for 600 computers.
Country A now has 22,500 + 3,600 = 26,100 smartphones available for consumers, and 6,875
– 600 = 6,275 computers. Country B now has 10,000 – 3,600 = 6,400 smartphones available for
consumers, and 0 + 600 = 600 computers. Both countries are now better off than they were
before they started specialising and trading. This is summarised in Table 5.3.
Country Number of Number of Gains Number of Number of Gains
smartphones smartphones from computers computers with from
without with trade without specialisation trade
specialisation specialisation specialisation and trade
and trade and trade and trade
A 25,000 26,100 1,100 6,250 6,275 25
B 5,000 6,400 1,400 500 600 100
Total 30,000 32,500 2,500 6,750 6,875 125

available for
consumers:
Table 5.3: Numbers of smartphones and computers without specialisation and trade,
and with specialisation and trade, showing the gains from trade for both countries.
So we see clear gains from specialisation and trade, with an additional 2,500 smartphones
produced (1,100 for country A; 1,400 for country B) and an additional 125 computers produced
(25 for country A; 100 for country B). Therefore, consumption levels of both goods are higher in
both countries, making everyone better off.
Trade blocs
So far we have not mentioned international institutions. Here we consider the establishment of
free trade areas through trade blocs. Despite globalisation, many countries establish trade
blocs with their geographical neighbours. Perhaps this is unsurprising, since once tariffs have
been removed, shipping costs of goods between trading partners become more important.
Therefore, the closer the geographical proximity of countries, the lower shipping costs are.
Numerous regional trade agreements exist. Among the more well-known are the European
Union (EU), the North American Free Trade Agreement (NAFTA) covering Canada, Mexico and
the USA, and Mercosur in South America. In May 2014 a political and economic union between
Belarus, Kazakhstan and Russia was established, which is known as the Eurasian Economic Union
(EEU). We will take a closer look at just the first of these, the EU.
The EU, which is its present name, originally consisted of Belgium, France, Italy, Luxembourg,
The Netherlands and West Germany. It was set up in the 1950s with the objective of establishing
freer trade among those countries and a unified trade policy with the rest of the world. Since its
formation, numerous other countries have joined, most notably the UK in 1973 (although the
UK recently voted in a referendum in 2016 to leave the EU). In recent years, there has been a
significant expansion of the EU which now includes several eastern European countries after they
made the transition from communist to market-based economies.
From an economic perspective, the EU promotes trade between its members by removing
trade barriers and creating a harmonised regulatory environment. The idea is that costs can be
reduced by providing incentives to specialise and by increasing competition.
A major milestone of the EU was the creation of a common currency – the euro – which came
into existence in electronic form in 1999 and in physical form (i.e. banknotes and coins) in 2002.
Note that not all EU members have adopted the euro; at the time of writing 19 members of
the EU use the euro as their currency. The other countries are expected to join when they meet
the euro convergence criteria. (Denmark has a special opt-out that allows it to be exempt from
joining, unless it wants to, as did the UK before it voted to leave the EU.)
A full exploration of the costs and benefits of the euro is a course in itself! For our purposes, we
will briefly mention one of each:
A cost is that Eurozone members having lost their own independent monetary policy, since
there is a pan-Eurozone monetary policy with a single nominal interest rate set by the European
Central Bank (ECB). Given that the economies of Eurozone countries are quite diverse (for
example, the distribution between agriculture and manufacturing), it is impossible to set an
interest rate that is optimal for all members. Therefore, monetary policy ends up being too loose
for some countries and too tight for others.
A key benefit is the elimination of exchange rate effects on transaction costs as all trade
between Eurozone countries is denominated in the same currency.
In addition to economic union, there are many who see the EU as an attempt to foster political
union through tax harmonisation and pan-European legislation. In FP0002 Economics, we will
not explicitly study the politics of the EU, but it is nevertheless important to appreciate that the
EU is a mix of economic and political decision-making. Indeed, in the wake of the recent global
financial crisis (discussed in Unit 6) there has been a significant rise in anti-EU sentiment across
the continent, and going forward, country membership of the Eurozone – and even of the EU
itself – is not assured. Indeed, the UK’s decision to leave the EU following the 2016 referendum
will be a major test of how the EU will function after the UK’s departure in 2019.
Conclusion
This section introduced you to open economy macroeconomics, recognising that countries
are not self-sufficient as they trade with others. Having defined globalisation and considered its
benefits and costs, international trade was seen as the result of different factor endowments.
Comparative advantage, rather than absolute advantage, determines whether trade takes place.
This is so when the marginal opportunity costs of one good in terms of another differ between
countries. Simple empirical examples showed you how to calculate opportunity cost ratios, as
well as how countries can obtain gains from specialisation and trade.
The section concluded with a discussion of trade blocs, with a focus on the European Union.
ACTIVITY 5.1
Suppose country A can produce either 80 units of X or 100 units of Y, and country B can
produce either 90 units of X or 125 units of Y with the same resource inputs. What are the
comparative advantages and opportunity cost ratios?
ACTIVITY 5.2
Consider again the empirical example of smartphones and computers for countries A
and B, in particular Tables 5.1 to 5.3. Suppose that the terms of trade were such that the
‘exchange rate’ is 7 smartphones per computer.
At this exchange rate, explain why trade would occur, and show how both countries
could be better off by engaging in specialisation and trade.
Would trade occur if the exchange rate was 3 smartphones per computer? Explain your
answer.
ACTIVITY 5.3
Explore the European Central Bank (ECB) website at: www.ecb.europa.eu
Focus in particular on the section covering monetary policy. Read about the process
followed by the ECB for making monetary policy decisions and the ‘instruments’ that are
available to the ECB.
Section 5.2: Balance of payments and

exchange rates
Introduction 194
Balance of payments 194
Exchange rates 195
Exchange rates and trade 196
Exchange rates and monetary policy 199
Conclusion 200
Unit 5: Macroeconomics II: open economy • Section 5.2: Balance of payments 194
and exchange rates
Introduction
Goods produced within an economy are not only consumed by the domestic population, some
of them are also sold abroad. Similarly, consumers do not only rely on domestic production, they
also purchase goods produced in other countries. French wine is consumed in Germany, for
example, and German beer, likewise, is consumed in France.
In this section, we introduce the balance of payments as a statement of a country’s transactions
with the rest of the world; we explain the different components of the balance of payments as
well as how a country settles any imbalances. Exchange rates are also discussed. We will consider
the two different types of exchange rate regimes that can exist, the impact the exchange rate
can have on trade and the relationship between exchange rates and monetary policy.
Balance of payments
Effectively the balance of payments is a statement detailing a country’s trade and financial
transactions with the rest of the world – that is, it is a record of all money that moves in and out
of a country. The balance of payments is calculated as the difference between the sum of all
the money flowing into a country from abroad and the sum of all the money flowing out of the
country. The balance of payments is typically formed of two parts – the current account (the
profit/loss from day-to-day transactions) and the capital account (capital flows related to capital
items in the form of assets, such as firms purchasing machinery).
The current account has the following components:
transactions involving ‘visible’ (tangible) goods, such as raw materials, fuel and manufactured
products – that is, the value of physical exports minus imports
transactions involving ‘invisibles’ (intangibles), such as services, tourism, insurance, advertising
and investment income (dividends and interest)
private money transfers, such as remittances sent home to support family members by
expatriate workers abroad
official transfer payments in the form of international aid.
The difference in value of exports and imports is known as the trade balance.
The capital account has the following components:
short-run capital flows that result from currency speculation, for example, such as betting on
exchange rate movements, as well as profiting from different national interest rates
long-run capital flows, for example, investments in foreign companies and any resulting
capital gains from closing out these investments.
Collectively, the balance of payments shows whether a country’s net position is in deficit
or surplus. The foreign exchange reserves of a country are used to settle any balance of
payments deficit. Most countries’ reserves are in the form of dominant currencies such as US
dollars and the euro.
When the balance of payments is in deficit, this is met by either borrowing or running down
the country’s foreign exchange reserves.
When the balance of payments is in surplus, borrowing can be repaid or the country adds to
its foreign exchange reserves.
Too large an imbalance in the economy is risky. Over-reliance on imports from another country,
for example, is potentially dangerous as one country is unlikely to be able to supply goods to,
and keep up with the demand of, the rest of the world.
and exchange rates
The balance of payments on the current account is affected by the index of the terms of trade
(defined in Section 5.1) through the price elasticities of demand for exports and imports.
Consider exports. If exports are price elastic then an increase (decrease) in the price leads to
a greater proportionate decrease (increase) in export volumes. Since the total value of exports
is the average price multiplied by volume, a price increase (decrease) will lead to a decrease
(increase) in the total value of exports. Ceteris paribus, this will improve (deteriorate) the terms
of trade (through the change in the numerator), but would deteriorate (improve) the current
account balance. For price inelastic exports, the opposite occurs.
Exchange rates
An exchange rate is the price of one currency in terms of another currency. The foreign
exchange market facilitates the exchange of currencies. A currency appreciates when it gains
value against another currency, while it depreciates when it loses value.
Governments experiment with different exchange rate regimes, as there is a choice between a
fixed exchange rate and a floating exchange rate.
Fixed exchange rate

Under a fixed exchange rate, the domestic currency is assigned a fixed value with respect to
other currencies, known as a peg. The central bank then intervenes in the foreign exchange
market by buying or selling the domestic currency, as appropriate, to maintain the exchange rate
peg using its foreign exchange reserves.
When the domestic currency is pegged, an extreme balance of payments deficit or surplus could
lead the government to change the peg to a more suitable level. This can be achieved through a
devaluation (decreasing the value of the domestic currency) or a revaluation (increasing the
value of the domestic currency), as appropriate.
A key benefit of a fixed exchange rate is the certainty it provides, especially to businesses who
trade internationally. Exports, imports and foreign investment are much less risky when the
exchange rate is known, as exchange rate fluctuations do not need to be taken into account in
decision-making. This allows firms to be more confident when making their export, import and
investment decisions.
On the other hand, devaluations are undesirable for the government politically as they signal
a struggling economy. As this alarms voters, governments may be reluctant to adjust the peg
even when it is necessary. However, arguably a more important disadvantage is the loss of an
independent monetary policy, since the central bank has to directly intervene to maintain
and defend the peg.
An example of a fixed exchange rate is the UK from 1949 (after the Second World War) to 1971
when the UK government committed to fix the value of £1 at USD 2.80. Whenever strong
demand for the pound occurred, it appreciated. In order to maintain the fixed exchange rate,
the central bank would then intervene by selling pounds (to offset the strong demand) to buy
US dollars. Conversely, a weak demand for pounds would result in its depreciation, to which the
central bank would respond by selling US dollars to buy pounds (strengthening demand for the
pound). After 1971, the pound became a floating currency against the US dollar and this remains
the case today. (In the early 1990s the pound briefly belonged to the European Exchange Rate
Mechanism (ERM), but exited in 1992.)
Floating exchange rate

Under a floating exchange rate, the market forces of demand and supply are free to determine
an equilibrium in the exchange rate. In Section 2.1, we saw how the price mechanism resolves
differences in the demand and supply of a good or service. Here the ‘goods’ are different
and exchange rates
currencies, with the exchange rate being the price of a currency (expressed in terms of another
currency).
When the exchange rate is free to float, the central bank does not need to intervene in the
foreign exchange market to maintain a peg. As such, the country has full control over its
monetary policy and can adjust the nominal interest rate when necessary (as discussed in
Section 4.5). While businesses do not have the certainty provided by a fixed exchange rate, they
can ‘hedge’ against exchange rate fluctuations. This involves the futures market which is beyond
the scope of this course.
However, as the exchange rate is determined by the forces of demand and supply, it can be
susceptible to large capital movements into or out of the country creating economic instability,
which will be discussed in the section ‘Exchange rates and monetary policy’.
For the remainder of this section, we will focus on floating exchange rates only.
Exchange rates and trade

Under a floating regime, the equilibrium exchange rate is determined when demand for the
currency equals its supply (i.e. when there is equilibrium). Figure 5.1 shows an example of the
equilibrium pound/dollar exchange rate, e, when demand equals supply at Q pounds.
Figure 5.1: Demand and supply determining the equilibrium exchange rate, e, under a
floating exchange rate regime for the $/£ exchange rate.
Trade determinant of demand

Demand for a country’s exports is the trade determinant of demand for the domestic currency.
When a country sells exports to foreign buyers (who are importing to their countries), prices are
charged in the domestic currency. Hence these buyers must buy the domestic currency to pay
for the exports, creating demand for the domestic currency.
Changes in demand for exports will shift the demand curve, and so the equilibrium exchange
rate adjusts. For example, Figure 5.2 shows the demand curve shifting to the right, from D1 to D2,
caused by an increased demand for exports. Here, an appreciation of the pound occurs from e1
to e2.
and exchange rates
Figure 5.2: An appreciation of the pound (versus the dollar) from e1 to e2 caused by
increased demand for the domestic currency as a result of increased demand for
exports which are paid for in the domestic currency.
Similarly, Figure 5.3 shows a depreciation in the pound, from e1 to e2, due to a leftward shift of the
demand curve, because of reduced demand for a country’s exports. (This can occur, for example,
if the importing economies are suffering from poor economic conditions, as a result of which
they purchase less from abroad.)
Figure 5.3: A depreciation of the pound (versus the dollar) from e1 to e2 caused by
decreased demand for the domestic currency as a result of decreased demand for
exports which are paid for in the domestic currency.
Trade determinant of supply

Supply is determined by the domestic demand for imported goods. Goods which are traded
internationally are always sold in the currency of the country of production (i.e. the local
currency), since the producers of goods must pay for their domestic production costs in their
local currency. If the UK wants to import more goods from the USA, for example, then it would
need to buy dollars to do so. Buying these dollars requires that pounds be supplied (sold).
Figure 5.4 shows a shift to the right of the currency supply curve, from S1 to S2, which would
occur when there is increased domestic demand for imported goods, leading to an increase in
and exchange rates
the supply of the domestic currency in order to purchase the imports in the local currency of the
producers of the imported goods. The increased supply results in a depreciation of the exchange
rate, from e1 to e2.
Figure 5.4: A depreciation of the pound (versus the dollar) from e1 to e2 caused by
increased (domestic) demand for imports.
So far we have considered exports and imports separately. We now look at how the exchange
rate can affect the trade balance (the difference in value between exports and imports). When
export revenue equals import spending, there is trade balance. Figure 5.5 shows this at exchange
rate e*.
Figure 5.5: A trade balance occurs when export revenue equals import spending,
which here is at the exchange rate e*, with Q* pounds. At the higher exchange rate
of e, import spending, QM, exceeds export revenue, QX, resulting in a trade deficit of
QM – QX.
Now suppose the exchange rate was higher at e (following an appreciation), which means the
domestic currency is more valuable. As such, imports are cheaper since these are paid for in a
foreign currency (i.e. the local currency of the producers) resulting in greater import spending.
However, the country will lose export competitiveness as its exports are now more expensive for
foreigners to buy. As such, export revenue falls and a trade deficit occurs.
and exchange rates
Exchange rates and monetary policy

When trade patterns shift, the (floating) exchange rate adjusts to ensure the balance of payments
returns to equilibrium. However, the relationship between the exchange rate and trade is two-
directional. Exchange rate changes may be due not to different trade patterns, but to large
international movements of capital as the result of currency speculation.
We previously noted how, in a floating exchange rate regime, a country has an independent
monetary policy as the central bank does not need to defend a fixed exchange rate peg.
In Section 4.5 where we covered monetary policy, we saw how the (domestic) nominal interest
rate could be adjusted. An expansionary monetary policy meant a reduction in the nominal
interest rate, while a contractionary monetary policy resulted in an increase. Here, we consider
how the domestic nominal interest rate affects capital flows into and out of a country by
currency speculators. Such capital flows are known as hot money, due to the high velocity such
capital flows can have. This can potentially create volatility and instability in exchange rates and
for the domestic economy.
Suppose a country experiences large capital inflows (perhaps due to an increase in domestic
interest rates). The capital inflows shift the demand curve for the domestic currency to the right
(just as in Figure 5.2). Ceteris paribus, the exchange rate will appreciate. As a result, producers
in the domestic economy lose competitiveness as the goods that they export become more
expensive for foreigners to buy, and imports of substitute goods become cheaper. Therefore, a
balance of trade deficit results. So we can see how a tight monetary policy (raising interest rates)
cools an economy down through increasing the cost of borrowing (consumers and firms spend
less), reducing exports (lower injections to the economy) and increasing imports (representing
leakages from the economy). Overall, this would lead the economy to contract.
In practice, different countries will have different nominal interest rates, resulting in interest rate
differentials, known as arbitrage opportunities. Speculative investors chase the greatest
return by looking for the highest available interest rates. Therefore, ceteris paribus, we note the
following impact domestic monetary policy can have on hot money capital flows:
An expansionary monetary policy leads to a decrease in the domestic nominal interest rate
(see Figure 4.23 in Section 4.5), meaning a lower return on capital relative to other countries.
Currency speculators then sell the domestic currency (leading to its depreciation) to buy
other currency with higher interest rate yields.
A contractionary monetary policy leads to an increase in the domestic nominal interest
rate (see Figure 4.24 in Section 4.5), meaning a higher return on capital relative to other
countries. Currency speculators then buy the domestic currency (leading to its appreciation)
thereby benefiting from the higher interest rate yield.
In the era of globalisation, the free movement of financial capital can result in potentially very large
amounts of hot money moving in and out of different currencies – and hence countries. For large
changes in domestic nominal interest rates, in particular, rapid capital flows can have destabilising
effects on an economy by making it very difficult to maintain a balance of payments equilibrium.
The subsequent exchange rate volatility can be damaging for businesses (and tourists!). If this
becomes extreme, a government may choose to impose capital controls to restrict the amount
of hot money that can flow into and out of a country, thereby limiting the negative effects.
Since the exchange rate determines the price of traded goods, we should consider price
elasticities to determine the likely impact of a change in an exchange rate. As we know,
elasticities may be rigid in the short run, but tend to be more flexible in the long run. You are
likely to study such elasticity effects in future courses.
and exchange rates
Conclusion
Section 5.1 explained how countries can benefit from international trade through the concept
of comparative advantage. In this section we introduced the balance of payments, which is a
recorded statement of a country’s trade and financial dealings with the rest of the world, formed
of the current account and the capital account.
Exchange rates (the price of one currency in terms of another) can be determined through
fixed or floating exchange rate regimes, with implications for business decision-making under
uncertain conditions and the independence of a country’s monetary policy. Trade determinants
of demand and supply (in the form of export demand and import demand) were examined,
along with an examination of trade balance. We concluded this section with a discussion of
speculative capital flows, in the form of hot money, showing how exchange rates and monetary
policy are related.
ACTIVITY 5.4
Research the balance of payments for your home country. How does this compare with
the UK?
Details of the UK’s balance of payments can be found at:
www.ons.gov.uk/economy/nationalaccounts/balanceofpayments
ACTIVITY 5.5
Does your home country have a fixed or floating exchange rate regime at the moment?
Has this always been the case?
(Note: In practice some countries may operate a ‘managed’ exchange rate regime
whereby the currency is part fixed and part floating.)
ACTIVITY 5.6
Assuming a floating exchange rate, explore the impact on the equilibrium domestic
exchange rate in the following scenarios. Illustrate your findings with a suitable diagram.
a. Economic growth in foreign countries.
b. A recession in the domestic economy.
ACTIVITY 5.7
Consider Figure 5.5. If the exchange rate depreciated (i.e. was below e*), explain what
happens to the trade balance.
ACTIVITY 5.8
Show, using a suitable diagram, the impact on the exchange rate, due to hot money, if
the central bank pursues a contractionary monetary policy.
and exchange rates
ACTIVITY 5.9
Does your country belong to a trade bloc? If so, research the origins of the trade bloc
and what benefits your country has gained from being a member. If not, choose another
country that does belong to a trade bloc, research its origins and the benefits that
country has gained.
202
Section 5.3: Measures of economic

development
Introduction 203
Economic development 203
The Human Development Index (HDI) 204
The Human Poverty Index (HPI) or Multidimensional 205

Poverty Index (MPI)
Gini coefficient 205
Why are some countries poor and others rich? 206
Conclusion 209

Unit 5: Macroeconomics II: open economy • Section 5.3 Measures of economic 203
development
Introduction
Open economy macroeconomics is chiefly concerned with international trade, balance of
payments and exchange rates, which we have looked at so far in this unit. We conclude Unit 5 by
comparing economic development across countries at the global level. While economic growth
(i.e. GDP growth) is a simple metric, it fails to fully capture the welfare actually experienced by
people within a country.
In this section we review some common measures of economic development, outlining how
they are constructed, before concluding with an overview of why some countries are poor, while
others are rich.
Economic development
How do we define ‘economic development’? If we look up the term in a dictionary, we find that
‘to develop’ is to become more complete and/or advanced. Using this definition, we conclude
that economic development is an improvement in economic conditions which leads to higher
standards of living and a better quality of life for people.
Unfortunately, both ‘quality of life’ and ‘standards of living’ are subjective, rather than objective,
values. Therefore, economic development is a normative concept (in other words, it relates to
a rank). Economies are usually classified as being either developed or developing based on
some commonly accepted and recognised indicators of economic development.
The development economist Michael Todaro argues that the following three variables provide
the meaning of development:
sustenance – the ability to meet basic needs (food, health and shelter)
self-esteem
freedom of action and expression.
According to this view, we can see that there are two parts to development: material
(sustenance) and non-material (self-esteem and freedom).
The first and most commonly quoted indicator of economic development is the level of
economic growth (discussed in Section 4.1). As you know, economic growth is an increase in the
productive capacity of an economy. Increased growth means:
higher incomes for workers, who can increase their utility by consuming more and better
quality goods
higher taxes collected by the government, allowing for increased government spending on
public goods and services, such as infrastructure and education (which itself could increase
the productive capacity of the economy further).
Such investments improve people’s quality of life. However, economic growth only measures a
general increase in output and income levels, even if we make the following adjustments:
express GDP in per capita terms, rather than GDP of the country as a whole
use purchasing power parity (PPP) to adjust for the costs of living in the country
use real GDP (inflation adjusted) rather than nominal GDP figures.
Unfortunately, these measurements of growth say absolutely nothing about the distribution of
income, and so we cannot draw any conclusions about inequality or poverty levels purely from
the data on economic growth. In other words, increased economic growth does not guarantee
decreased poverty levels.
There are many factors, other than economic growth, which determine the level of economic
development, such as:
development
access to clean water

birth and mortality rates
education
freedom of choice
infrastructure
literacy rates
self-esteem.
Combining all of these (and possibly others) into a single measure of economic development
would be very complicated and impossible to measure accurately. There are, however, two
relatively simple indices which are used worldwide: the Human Development Index (HDI) and
the Human Poverty Index (HPI), recently superseded by the Multidimensional Poverty Index
(MPI), which are maintained by the United Nations Development Programme (UNDP). We also
consider another measure of economic development, the Gini coefficient.
The Human Development Index (HDI)

The HDI consists of the average of the following three indicators:
standard of living (measured by GDP per capita in PPP terms)
life expectancy at birth
adult literacy.
This index can take any value between 0 and 1, where a value close to 0 indicates extremely
bad conditions and a value close to 1 indicates a near-perfect situation. Using HDI as a measure
of economic development has obvious benefits as it incorporates more than one indicator (as
mentioned above).
Consider the following examples which illustrate how misleading it could be to use GDP alone to
measure economic development. HDI figures are sourced from UNDP; life expectancy figures are
sourced from Trading Economics (an online platform providing historical economic data: https://
tradingeconomics.com/).
South Africa, which ranks relatively well when it comes to economic growth, still suffers from
a low life expectancy of about 64 years, according to the World Health Organization (WHO),
largely due to high levels of HIV/AIDS and other infectious diseases. Therefore, as of 2018, its
HDI is only 0.666 and, as a result, it ranks lower than Colombia (HDI = 0.727), despite these
countries having similar GDP per capita.
Cuba has a lower GDP per capita but a much higher HDI of 0.775 than South Africa, due to
the government’s prioritisation of education (adult literacy is 99.7 per cent) and because life
expectancy is around 80.
HDI allows countries to be ranked, and hence compared. Data needed to compute an HDI index
are collected by all countries, so almost all of them are included in the ranking. It is often the
case that developed countries top the ranking while developing countries are near the bottom.
What is interesting, however, is the fact that countries with very similar levels of GDP can have
completely different HDI levels, as exemplified above.
Unfortunately, as you might expect, HDI as an indicator of economic development also has some
disadvantages, which include:
problems of data accuracy, especially with some low-income countries
different measuring techniques, and so the validity of the comparisons between countries
could be undermined
development
the one-third weighting looks very arbitrary (Should the three components have equal
weight? Why these three particular measures? Why only three? Why not more?)
an increase in GDP has a disproportionately different impact on the standard of living in
developing countries than in developed countries, yet the current structure of HDI would
count them as equivalent
HDI is an average, so if a country is very diverse with a lot of inequality, then the HDI does not
accurately represent the situation of all who live in that country.
To summarise, HDI as an economic development indicator goes beyond simple GDP growth
measures, but it still has disadvantages. However, without HDI we would probably be left with
only GDP measures, which do not necessarily indicate real economic development. Only three
indicators have been included and only data for these three areas are collected. Even if the
inclusion of other variables is desirable, it would be very difficult to measure due to a lack of
reliable data. Other indicators might partially overlap with the three already included and so may
distort the picture.
The Human Poverty Index (HPI) or Multidimensional Poverty

Index (MPI)
Economic development can also be measured by finding out how well a country is doing at
achieving poverty reduction. This is the role of the HPI. As with HDI, it consists of three parts,
namely:
the probability at birth of a life expectancy of less than 40 years
the percentage of illiterate adults (reflecting knowledge exclusion)
the percentage of people without a sufficient standard of living as reflected by an
unweighted average of no access to clean water and children who are underweight.
Through a computational formula (we omit the details here), these three indicators give rise to
the HPI which, like HDI, yields a value between 0 and 1. The better the conditions of living within
a country, the closer the HPI is to 0. For example, as of 2008 Sweden had an HPI of 0.063 while for
Italy it was 0.298.
Why do we need HPI if we already have HDI? While HDI focuses on countries with the highest
growth and newest technology, HPI focuses on those worse off, rather than those doing well.
Gini coefficient
The Gini coefficient was introduced in Section 3.2 as a quantified measure of inequality in the
context of market structure. Here, we consider the Gini coefficient, G, as a measure of economic
development that reflects the extent of the inequality of income distribution within a country.
As with HDI and HPI, G varies between 0 and 1, ranging from perfect equality (every household
has the same income) to complete inequality (all income is accrued by a single household),
respectively.
Graphically, the Gini coefficient is determined by comparing the cumulative percentage of
income on the vertical axis with the cumulative percentage of population on the horizontal axis.
Figure 5.6 shows the Gini coefficient for different levels of inequality. It is calculated as the area
above the Lorenz curve and below the 45-degree line (i.e. the shaded pink area) divided by the
area below the 45-degree line. (Note here the Lorenz curve is drawn below the 45-degree line,
unlike in Figure 3.14 where it was drawn above.)
development
Figure 5.6: Gini coefficients for varying degrees of inequality, calculated as A/(A+B).
Under perfect equality, A = 0, hence G = 0; under complete inequality, B = 0, hence G = 1.
As examples, according to the World Bank, the most unequal country according to the Gini
coefficient is South Africa (G = 0.634), while the most equal countries are Iceland and Ukraine
(G = 0.256 and 0.255, respectively).
Why are some countries poor and others rich?

While measures of economic development consider quality of life within countries, it is also of
interest to consider wealth across countries. We conclude this section with a discussion of why
some countries are poor, while others are rich.
Everyone would surely like to know how to become rich. Unfortunately, as yet, no-one has found
a foolproof way of doing so! If they had, we would not now be asking ‘why are some countries
poor and others rich?’
In the Middle Ages, there was no significant and practical difference between countries which
are now labelled as being ‘developed’ or ‘developing’. Today, the difference between the two
is striking. Large parts of Africa, for example, rely on income from the primary sector (mainly
development
agricultural production), mortality rates are extremely high and diseases spread quickly, while
Europe has developed very differently. We will now discuss, albeit briefly, some factors that are
said to have an impact on the wealth of nations.
History
There is a belief that rich countries are rich because they exploited the natural resources of
poorer countries. Colonialism is the most obvious example of this. Conversely, some argue that
many former colonies benefited from access to an imperial market, investment in human and
economic capital, and the creation of successful institutions. (Note here we are focusing purely
on economic aspects, rather than the human rights of colonised peoples.)
Political regimes
A country’s government and political regime can have a major impact on the welfare and
prosperity of its people. For example, the Republic of Korea (commonly known as South Korea)
and the Democratic People’s Republic of Korea (North Korea) experience the same climate
and are populated by people from the same culture. North Korea, however, is controlled by a
communist regime with no free elections, state policies that have resulted in famine and poverty,
and an overinflated military budget. The state also invests in many prestige projects (for example,
the development of nuclear weapons) which are enormously expensive and give little return to
the average citizen. In contrast, South Korea has enjoyed overseas investment and trade, and is
one of the most successful of the ‘Asian Tiger’ economies (which refers to the economies of Hong
Kong, Singapore, South Korea and Taiwan, which all experienced significant economic growth
in the latter part of the 20th century). Regular and free elections are held and there is a sound
welfare state. South Korea boasts one of the fastest and best-distributed broadband systems in
the world – an example of foresight and investment for the future development of a ‘knowledge
economy’.
Venezuela has the largest proven oil reserves in the world (see ‘Natural resources’ below), yet
gross economic mismanagement by the government has resulted in hyperinflation and a dire
economic situation.
Institutions
One of the most important state institutions is that of the rule of law. Confidence in the
protection of property (both physical and intellectual) is essential if entrepreneurs are to invest in
new business ventures. An effective and flexible financial sector is also very important to ensure
the smooth flow of credit, as is a flexible labour market. For example, the UK benefits from a
relative lack of ‘red tape’; in other words, there is relatively little bureaucracy and paperwork, and
the legal system works smoothly and quickly.
The eradication of corruption in national institutions has been set as an objective for both
the Indian and Chinese economies. This target was specifically mentioned by Xi Jinping, the
president of China, in a March 2013 speech to the ruling Politburo Standing Committee.
Natural resources
Natural resources are important, but optional, factors for the wealth of a country. Perhaps the
best example is the spectacular success of Singapore. Good government, sound institutions
and high-quality education have created wealth, despite the city-state’s almost complete lack of
natural resources. Perhaps the best example to provide a contrast is the Democratic Republic of
Congo, where there are abundant natural resources, but where the population at large has seen
very little benefit.
A country’s level of oil production is – again – not a guarantee of success. The contrast between
two important oil-producing countries provides evidence of this. Nigeria produces and exports
over two million barrels of oil per day, yet the standard of living for most of its population is
development
almost at poverty levels. Norway produces a similar amount of oil and gas, but the average
Norwegian enjoys the benefits of a welfare state and an even distribution of income. Even
controlling for the difference in total populations, the contrast is significant. Indeed, just as for oil
production, an abundance of oil reserves is also not a guarantee of wealth, as seen in the case of
Venezuela.
The discovery of natural resources, and the wealth it creates, can be channelled into the hands of
a few corrupt politicians and bureaucrats, thereby denying the general population any material
benefit.
Human capital
Human capital investment in the education and training of any population is essential to
economic development. A well-educated and trained worker is more productive than their
uneducated counterparts, to say nothing of the social and intellectual development of the
individual. Much early work in this field was done by the welfare economist Arthur Pigou.
Climate and topography

Some countries have to spend a large amount of their resources tackling the extremes of
temperature or other weather-related problems. Mountains, deserts and floods also bring
hazards, destruction and expense.
A country’s actual location can also be significant. Many argue that one reason for the success
of London’s ‘Square Mile’ financial district is that it is in the best time zone. London can
communicate with Asian and American centres of industry in the same day – one going to sleep
as the other wakes up.
Access to the sea

Geographic location, access to river and sea lanes as well as to natural harbours are also very
important. Again, we could cite the example of Singapore which is adjacent to the Straits of
Malacca, one of the busiest shipping lanes in the world. Hong Kong has one of the best natural
harbours in the world and a population of over a billion people on its doorstep.
Land-locked countries can also experience difficulties if access to the sea is blocked by
neighbouring countries. However, Switzerland is land-locked but lies at the centre of one of the
most prosperous regions of the world.
Culture
Some observers have noted that successful economies have a culture which celebrates wealth
creation and risk-taking (most notably the US), whereas cultures where the attitude of the people
is to leave things to fate tend to be less successful.
Summary
The success, or otherwise, of a country depends on a combination of the positive and negative
effects of those factors listed above. There is no prescribed combination and the effects can
change over time. We may not be able to answer conclusively ‘Why are some countries poor and
others rich?’ but at least we can now understand the central influences.
development
Conclusion
Economic development is a normative concept with no single best way to measure it. In this
section we have outlined the limitations of GDP growth, followed by an examination of the
Human Development Index, Human Poverty Index and Gini coefficient as attempts to quantify
the level of economic welfare within a country as well as income inequality.
In practice the world is a very unequal place. At the international level, we considered why some
countries are poor while others are rich and we identified numerous factors which contribute to
the wealth of nations.
ACTIVITY 5.10
The debate about which is the best indicator of economic development continues. Compare
and contrast HDI, HPI and the Gini coefficient as measures of economic development. Which,
if any, is the best, and why?
ACTIVITY 5.11
Research the HDI, HPI and Gini coefficient values for your home country and any other
countries that interest you. Can you explain their respective levels of wealth or poverty?
HDI values can be obtained from: http://hdr.undp.org/en/countries
HPI values can be obtained from: http://hdr.undp.org/en/content/multidimensional-poverty-
index
Gini coefficient values can be obtained from: www.indexmundi.com/facts/indicators/SI.POV.
GINI/rankings
ACTIVITY 5.12
Research examples of neighbouring countries with very different levels of economic
development. Why are their economic performances so different?
ACTIVITY 5.13
Research examples of countries that have greatly benefited from the endowment of
abundant natural resources. Explain how these countries have benefited.
ACTIVITY 5.14
Identify which factors have contributed to the current economic standing of your own
country.
210
Concluding comments
This unit concludes our study of macroeconomics. We began with a description of globalisation
alongside some of its benefits and costs. International trade was shown to be a result of
comparative advantage, i.e. the different opportunity costs of production across countries. Even
when a country possesses an absolute advantage in the production of all goods, it will not
possess a comparative advantage for all goods, hence higher total production can be achieved
through specialisation.
The balance of payments was defined, followed by an examination of exchange rates. The
differences between fixed and floating exchange rate regimes were outlined and, for the latter,
the relationship with monetary policy was discussed.
The unit concluded with three popular measures of economic development - the Human
Development Index, the Human Poverty Index and the Gini coefficient. Each of these attempts to
better capture the well-being of people than simple GDP growth rates.
Next up is Unit 6 which looks at the global financial crisis of 2008.

define globalisation
explain the difference between absolute advantage and comparative advantage
show how international trade is beneficial as a consequence of comparative advantage
outline the components of the balance of payments and how deficits and surpluses are
reconciled
explain the features of fixed and floating exchange rate regimes
explain the relationship between exchange rates and monetary policy under a floating
regime
explain the determination of the Human Development Index, Human Poverty Index and Gini
coefficient.
Unit 6: Global financial crisis 211
Aims 212
References cited 212


Unit 6 considers the recent (and ongoing) global financial crisis. Section 6.1 plots the origins and
development of the crisis, highlighting how quickly and easily problems can be exported in our
modern global economy, while also considering possible factors which contributed to the crisis
in the first place. Section 6.2 describes the consequences and economic responses to the crisis.
Week Unit Section

19 6: Global financial crisis 6.1: Contributory factors leading to the global
financial crisis
20 6.2: Consequences of the crisis and economic
responses
Aims
This unit aims to:
provide a general overview of the causes and consequences of the global financial crisis
discuss some economic responses to the crisis.
Learning outcomes
By the end of this unit, and having completed the activities, you should be able to:
outline events which resulted in the global financial crisis
explain the consequences of the crisis for both developed and developing countries
state different economic responses to the crisis.
References cited
Argersinger, Matthew J. and Erin M. Whitaker, U.S. International Transactions: Fourth Quarter
of 2006 (Survey of Current Business, 2007) https://apps.bea.gov/scb/pdf/2007/04%20
April/0407_ita_q.pdf pp.13-21.
Davies, H. The financial crisis: who is to blame? (Cambridge: Polity Press, 2010) [ISBN
9780745651644].
Ferguson, C. Inside job: the financiers who pulled off the heist of the century. (Oxford: Oneworld,
2012) [ISBN 9781851689156].
Section 6.1: Contributory factors

leading to the global financial crisis
Introduction 214
Anatomy of the financial crisis 214
Stage 1: Build up and irrational exuberance 216
Stage 2: Collapse 219
Stage 3: Credit crunch and economic recession 221
Conclusion 222
Unit 6: Global financial crisis • Section 6.1: Contributory factors leading to the 214
global financial crisis
Introduction
A financial crisis, broadly speaking, is a major disruption to the financial markets which results
in the significant fall of asset prices. One of the most infamous examples of 20th-century crises
is the Great Depression of the 1930s. In 1929, there was a stock market crash on Wall Street,
leading to mass unemployment and an economic depression which lasted several years.
A more recent example is the global financial crisis, the origins of which date back to 2007 (some
may argue even earlier) – the most destructive economic event in the last 80 years. We will
conclude with an exploratory look into the causes of the crisis and its consequences – which will
be affecting economies for many years to come!
The forces of globalisation have greatly increased the level of interdependence between
the world’s economies such that ‘shocks’ in one part of the global economic system are quickly
transmitted more widely. This can be thought of as contagion, whereby economic problems are
spread across borders – ‘when America sneezes, the world catches a cold’ is a phrase which nicely
illustrates this point! The idea being that a bad economic event in the US (a sneeze) leads to a
more severe problem for the global economy (a cold). The world’s economies are now so closely
connected that it is nearly impossible for one economy to be completely immune to a crisis
occurring in another economy. The amount of economic integration across countries is expected
to increase further in the years ahead.
As a consequence of this interdependence, the global economic and financial system is
incredibly complex with countless relationships between variables. We should perhaps not be
surprised to discover that there is a great deal of endogeneity between economic variables as
their interactions mean changes in one variable will lead to changes in another variable, which
may well feed back into further changes in the original variable. For example, suppose a fall in
consumer confidence leads to less consumer spending (i.e. less consumption), which reduces
economic growth and therefore reduces households’ incomes too, leading to a further fall in
consumer confidence, and so even less consumer spending. Trying to distinguish cause from
effect becomes very challenging!
In Units 19 and 20 of FP0001 Mathematics and Statistics, you learn about linear regression,
which attempts to model the causal linear relationship between a dependent variable and an
independent variable. Endogeneity, roughly, is an extension of this idea to a system of equations
in which dependent and independent variables can swap roles in other equations within the
system.
Anatomy of the financial crisis

Although we recognise the inevitable complexities associated with the financial crisis, in order
to make some sense of things, a degree of simplification is required. Remember, a model is a
deliberate simplification of reality which retains the most important features of the real world but
ignores some less important details such that it provides a reasonable representation of the real-
world problem under consideration.
We will break the crisis down into three sequential stages as follows.
1. Build up and irrational exuberance.
2. Collapse.
3. Credit crunch and economic recession.
These stages are depicted in a time order sense in Figure 6.1 with respect to GDP.
GDP 2. Collapse
3. Credit crunch and

1. Build up and economic recession
irrational exuberance
Time
Figure 6.1: The stages of the financial crisis in terms of GDP for countries adversely
affected.
In Stage 1 (build up and irrational exuberance), asset prices such as those of stocks and houses,
rose considerably. Figure 6.2 shows the US house price index for 1990–2007, up to the point
where house prices started to collapse.
S&P/Case-Shiller US National Home Price Index
180
160
Index January 2000 = 100
140
120
100
80
60
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Figure 6.2: US house prices, using the S&P/Case-Shiller price index, for the period
January 1987 to March 2007. Source: Federal Reserve Bank of St Louis, https://fred.
stlouisfed.org/
However, did this house price growth justify the simultaneous boom in stock markets? This
could be seen as a wealth effect where people feel richer (you feel wealthier if your house
increases in value, even though you cannot spend this ‘money’), making people feel positive
about the economy, leading to a bull run in stock markets.
Also, some countries experienced widening trade deficits (that is, countries importing more
than they export), but since global trade is zero sum (i.e. all exported goods must be imported by
someone), this necessarily means there were widening trade surpluses elsewhere in the world.
In addition to trade deficits, many governments also ran budget deficits, so they were already
spending more than their tax revenues, with the difference financed by government borrowing,
therefore increasing national debts. Finally, focusing again on asset prices, houses (real estate)
are a type of asset and the house price boom was in part fuelled by subprime mortgage
loans (made to borrowers with poor credit histories). Keen to obtain keys to a new home, many
subprime borrowers took out mortgages – who wouldn’t in that situation?
In Stages 2 and 3 (collapse, credit crunch and economic recession), many economies
experienced a collapse in house prices due to defaults on mortgages (in particular subprime
mortgages) as borrowers struggled to meet the mortgage repayments. There were also many
financial ‘derivative’ products whose valuations were tied to the performance of mortgage
loans (i.e. their values were derived from the performance of these mortgages). As a result, the
housing market in this complex puzzle began to collapse.
Economic recessions followed and there were inevitable spill-over effects transmitted globally –
for example, to countries which had acquired large trade surpluses, such as China and South East
Asian economies.
We now consider these stages in greater detail.
Stage 1: Build up and irrational exuberance

The US trade deficit increased sharply between 2000 and 2006–07, from around $300 billion to
around $800 billion, on an annualised basis. US GDP in 2006 was $13.4 trillion, so the trade deficit
represented about six per cent of GDP, which is in fact a large proportion. Figure 6.3 shows data
for the US trade deficit for the period 2000–10.
US Trade Balance - Goods and Services

-25K
-30K
Trade balance (in millions of dollars)
-35K
-40K
-45K
-50K
-55K
-60K
-65K
-70K
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Figure 6.3: US trade balance for the period January 2000 to December 2010. Source:
Federal Reserve Bank of St Louis, https://fred.stlouisfed.org/
Of course, by their nature, trade deficits are offset by trade surpluses elsewhere. As the world’s
largest economy, the magnitude of the US trade deficit suggests that global trade imbalances
played a contributory role in the financial crisis.
However, why did the US trade deficit increase so sharply? We can explain this by the abundance
of cheap credit to which the US (and other developed economies) had access. Cheap credit
means low interest rates (which represent the cost of borrowing), and so lenders were all too
eager to advance loans to borrowers who, under ‘normal’ interest rate levels, would usually have
their loan applications rejected. In particular, there was a dramatic expansion in subprime
lending, i.e. to subprime borrowers with credit scores below prime borrowers (who typically
have a lower risk of default).
However, why was so much cheap credit available? This can be attributable to the strong
demand from foreigners (for example China, the oil-producing Gulf states and South East Asian
economies) for US financial assets (for example, shares). It was these capital inflows (foreign
money entering the US economy) which provided the funding for imports by US consumers and
firms, which led to the widening US trade deficit. There was a circular flow of money.
The source of the foreign capital could be traced back to the savings glut by Asian and other
emerging economies. For example, as China’s trade surplus with the US grew (mirroring the US
trade deficit), China did not permit its exchange rate to appreciate against the US dollar. By
keeping its currency cheap, this stimulated exports to the US and decreased domestic Chinese
consumption (since imported goods became increasingly expensive).
Reduced domestic consumption means increased savings, which were then channelled abroad
to buy US (and other) financial securities. Why not invest in domestic financial markets (i.e. the
emerging markets’ own capital markets)? Perhaps this might be because the capital markets of
emerging economies are less well-developed and hence less trusted by investors compared
to the more established and trusted capital markets of developed economies. After all, people
always have trust in the US dollar.
We can now start to appreciate the interdependence between many economic variables in
this discussion. However, if we are interested in the causes of the crisis, is it easy to establish
causality? That is, although we may observe correlated variables, how justified are we in
claiming that one factor caused another?
Consider the variables mentioned above. A possible narrative for the root cause of global trade
imbalances is the excessive debt-financed spending by US consumers and firms, increasing the
US trade deficit, leading to substantial capital inflows from abroad. This ‘explanation’ apportions
the blame to US consumers and firms.
DEBT → TRADE DEFICIT → CAPITAL INFLOWS
However, one could instead put forward a case that it was the abundance of cheap credit which
drove US consumers and firms to indulge in a debt-fuelled spending spree. In addition to the
widening trade deficit, the tidal wave of cheap credit could plausibly have fuelled a sharp rise in
asset prices, such as real estate and financial securities.
DEBT
→
CHEAP CREDIT
→
RISE IN ASSET PRICES
So, conclusively identifying the true causal factor seems difficult, perhaps impossible! However,
economic data clearly show that strong demand for Western assets contributed to the build
up to the crisis. According to the US Bureau of Economic Analysis, US capital inflows actually
exceeded the trade deficit by about $1 trillion in 2006 and 2007 (https://www.bea.gov/scb/
pdf/2007/04%20April/0407_ita_q.pdf ). So, clearly, this surplus was used by US investors to buy
up foreign assets.
We have previously introduced the term balance of payments. In short, any trade deficit (when
imports exceed exports) on the current account must be financed by a surplus on the capital
account (i.e. a net inflow of foreign capital).
Alternatively, we can say that the trade balance (exports minus imports) equals net lending
(aggregate saving minus aggregate borrowing). Therefore, the US trade deficit meant foreign
capital inflows which were the source of credit to firms and households. Given the substantial
amount of foreign capital, this excess supply of credit resulted in a drop in the price of credit (i.e.
interest rates fell) as banks competed with each other to advance loans to borrowers. This fall in the
cost of borrowing made credit ‘cheap’. Much of this credit found its way into inflating asset prices
(especially real estate). Mortgage applications had very high probabilities of being approved!
At this point, it is important not to ignore US monetary policy which, arguably, also contributed
to low interest rates. Following the dot.com bust in 2000 and the aftermath of 9/11, monetary
policy was kept very loose (i.e. low interest rates, to keep the cost of borrowing low) to help
boost economic growth through increased domestic consumption, and investment by firms.
Some argue that the Federal Reserve (known as ‘the Fed’) kept rates too low for too long,
exacerbating the problem of cheap credit.
Continuing with the first stage of the crisis, we now turn to the irrational exuberance which was
created by over-confidence in the strength of developed economies. Specifically, in the build up
to the crisis, there was a continuous period of economic growth. As we know, economic growth
is associated with increased incomes. Also, there was a dramatic increase in asset prices – notably
house prices and stock markets.
It is questionable whether such asset price inflation was justified, instead we could attribute it
to ‘irrational exuberance’ (the phrase used by Alan Greenspan, then-chairman of the Fed) on the
part of market participants who held overly optimistic expectations about the true future value
of houses (based on housing demand) and corporate profitability (based on market valuations
of firms, as signalled by their share prices). Although such optimism was misplaced, at the time
this led to a wealth effect, whereby asset owners, seeing the increased value of their assets, felt
richer and therefore boosted their consumption of goods and services accordingly.
You may have come across the term ‘asset price bubble’ in the media in recent years. It could
be argued that the asset price inflation was not due to overly optimistic expectations about
the intrinsic value of housing and companies; rather it was due to a speculative bubble. Such
bubbles occur when investors are willing to buy assets if they believe the assets will increase in
value, allowing them to sell them in the future for an anticipated profit.
Even if all market participants believe the asset is overpriced, as long as they think they can sell
it on for a higher price in the near-future, this would serve to drive demand for assets, therefore
increasing asset prices further. Of course, bubbles cannot expand indefinitely, and so there would
come a point when the bubble bursts. Needless to say, if investors knew with certainty when the
bubble would burst, they would trade accordingly. Clearly, no one has perfect foresight so there
would be a degree of luck in terms of who is left holding the assets when the bubble bursts!
Another potential explanation for the increase in asset prices is financial innovation. So-called
securitised mortgages were financial assets formed by packaging up various mortgage
loans into financial securities which were (incorrectly!) thought to be as safe as relatively riskless
government bonds (issued by governments to finance budget deficits).
Why did investors think securitised mortgages were as safe as government debt? Well, credit
rating agencies invariably attached AAA credit ratings (the highest rating) to these assets
which, unknown at the time, under-priced the risk of these assets. Indeed, the debt created from
subprime lending was often combined with other assets to create so-called collateralised
debt obligations (CDOs) which are structured asset-backed financial products. These CDOs
were used to create financial derivatives which, due to the abundant cheap credit, were in great
demand. Due to the complexity of CDOs, we will not consider these financial instruments any
further in this course. Suffice to say, CDOs represent an example of the ‘exotic’ types of financial
products which have been invented in recent years.
Stage 2: Collapse
Early 2007 saw the collapse of the house price bubble. The trigger for this was the replacement
of exuberance (which built up the bubble) by caution. This involved investors undoing their
positions by selling assets (and repaying debt, if the original purchase was financed by borrowing
– known as deleveraging). Consequently, as investors started wanting to sell their assets, this
created an excess supply in the market which meant a fall in asset prices. Figure 6.4 shows data
demonstrating the collapse in US house prices.
S&P/Case-Shiller US National Home Price Index
185
180
175
Index January 2000 = 100
170
165
160
155
150
145
140
2000 2008 2009 2010 2011
Figure 6.4: US house prices, using the S&P/Case-Shiller price index, for the period
January 2007 to December 2010. Source: Federal Reserve Bank of St Louis,
https://fred.stlouisfed.org
As the reversal of a speculative bubble, the mechanics of the process which created the bubble
now go in reverse. With the expectation of asset prices being lower in the near-future, asset-
holders rush to sell their assets today (to secure a higher price than if they wait to sell in the
future). This becomes self-fulfilling and leads to dramatic price reductions.
The decline in house prices preceded a substantial systematic fall in the prices of numerous other
assets. This is attributed to the interdependencies across many asset-backed securities.
From peak to trough, the US house price index fell some 30 per cent. From our earlier work on
the determinants of demand and supply (Section 2.1), a fall in price could come about because
of a fall in demand or an increase in supply. Any expansion in the supply of new housing stock
in the US (through new builds) would not account for such a sharp decline in house prices,
therefore the decline was demand-determined.
As the crisis hit, the equity ratios of banks shrank dramatically. A bank’s equity is its buffer to
cover unexpected losses which could occur. From an accounting perspective, equity is calculated
as the difference between total assets and total liabilities. Many of the banks’ assets were in the
form of mortgages and mortgage-backed securities. As borrowers began to default on their
mortgages (either due to being unable to make mortgage repayments or realising that the value
of their home was less than the outstanding mortgage on it due to the fall in house prices – a
phenomenon known as negative equity), some of the outstanding mortgages would not be
repaid. This reduced the total value of the banks’ assets (with little or no change in their liabilities),
which meant a reduction in their equity.
However, equity by itself is not fully representative of a bank’s financial health. Instead, we need
to account for the size of the bank giving rise to equity ratios. These are defined as:
Equity Net assets Total assets - Total liabilities

Equity ratio = = = .
Total assets Total assets Total assets
Why do equity ratios matter? When a saver deposits money at a bank, the bank only retains a
fraction of the deposit, and uses the rest to create interest-bearing assets, such as loans. Although
the depositor has the right to withdraw their money without notice (unless there are withdrawal
restrictions on the account, such as term deposit accounts), the bank does not expect all depositors
to withdraw their money at the same time. Therefore, banks engage in fractional reserve
banking, which means they keep only a fraction of deposits in liquid form (such as cash) on hand
to meet the expected demand for withdrawals. As the equity ratio deteriorates, there is a greater
risk that a bank is unable to meet depositors’ demands for withdrawal of their money.
So far, our narrative of the crisis has been restricted to the financial sector (‘Wall Street’) with little
observable direct impact on the real economy (‘Main Street’). However, the collapse in equity
ratios had the following effect.
Depositors were fearful that banks were not financially sound and so were reluctant to make
new deposits (or withdrew existing deposits) and interbank lending also dried up as banks
were unwilling to lend to each other (again, fearful about the solvency of other banks). This
prevented new lending to firms and households, meaning willing borrowers were unable to
access credit and so had to cut back on investment spending (by firms) and consumer spending
(by households), which generated a recession. Figure 6.5 shows the cost of interbank borrowing
in the UK over the period 2007–09. This refers to the ‘London Inter-bank Offered Rate’ (LIBOR),
which is the average interest rate for banks to borrow from each other in the short term, and the
Bank of England (BoE) base rate (i.e. the UK’s central bank-set interest rate). The cost of interbank
borrowing is the difference in these rates.
Difference between LIBOR and Bank of England Base Rate

1.8
1.6
1.4
1.2
Difference in %
1.0
0.8
0.6
0.4
0.2
0.0
1 Dec 06 1 Apr 07 1 Aug 07 1 Dec 07 1 Dec 08 1 Aug 08 1 Dec 08 1 Apr 09 1 Aug 09 1 Dec 09
Figure 6.5: Cost of interbank borrowing (LIBOR – BoE rate) for the period 2007–09.
Source: Federal Reserve Bank of St Louis, https://fred.stlouisfed.org and Bank of
England, www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate
Stage 3: Credit crunch and economic recession

As the collapse unfolded, the credit risk of banks increased sharply, such that banks were
unwilling to lend to each other (for fear of the borrowing banks defaulting). Indeed, we can think
of this as an example of asymmetric information between the banks – each bank knew the
extent of losses on its own assets, but did not know the losses incurred by competitor banks.
The increased credit risk was reflected in higher interest rates on interbank lending, as shown in
Figure 6.5. In ‘normal’ times, LIBOR tracks the Bank of England base rate very closely, with historically
only a small difference between the two, reflecting the perceived low risk of one bank lending
to another bank. The difference between the LIBOR rate and the base rate shown in Figure 6.5 is
the risk premium which a lending bank receives to reflect the greater risk of lending to another
bank.1 The rise in interbank interest rates meant a far greater risk premium associated with interbank
lending, resulting in a contraction in the supply of interbank credit as banks undertook a ‘flight to
safety’ by preferring to deposit funds with the central bank instead with a near-zero risk of default.
The steep rise in the cost of interbank lending dramatically cut the amount of interbank lending
(as the price went up, the quantity demanded reduced), giving rise to the term credit crunch
(i.e. a severe contraction in the amount of available credit).
The contraction of interbank lending acted as a transmission mechanism to the real economy,
as the seized-up interbank lending market restricted the supply of credit to borrowers in the real
economy (i.e. firms and households).
In an effort to unblock the frozen market for interbank loans to get it operating effectively again,
monetary authorities quickly intervened by offering emergency loans to banks allowing them
to make their balance sheets more robust. Such central bank assurances reduced the risk
premium, quickly returning interbank rates to levels closer to the base rate.
The credit crunch then resulted in sharp economic contractions in many countries around the
world – i.e. it resulted in an economic recession (formally defined as two consecutive quarters of
negative economic growth). Figure 6.6 shows the extent of the economic recession in the US by
reporting US GDP growth over the period 2006–10.
The worst-affected economies, for example Greece, are embarking on a long road to economic
recovery. So the reduction in credit decreased aggregate demand, ultimately resulting in the
worst recession since the Great Depression of the 1930s.
1
The base rate can be thought of as the interest rate banks receive for depositing funds with the Bank of England – this
is effectively riskless, since the Bank of England is highly unlikely to go bankrupt since it has the legal status of being
able to print money to repay depositors.
US Real GDP Growth Rate

4
Percentage change from the quarter one year earlier
-1
-2
-3
-4
2005 Q1 2005 Q3 2006 01 2006 Q3 2007 Q1 2007 Q3 2008 Q1 2008 Q3 2009 Q1 2009 Q3 2010 Q1 2010 Q3 2011 Q1
Figure 6.6: US real GDP growth rate, for the period Q1 2005 to Q4 2010. Source:
Federal Reserve Bank of St Louis, https://fred.stlouisfed.org
Conclusion
In this section, a simplified narrative of the complex global financial crisis has been presented.
Due to the interdependencies and complexities of the global financial and economic system, in
reality the true nature of the relationships between financial and economic variables is still largely
unknown.
Researchers continue to try to ‘understand’ the origin of the crisis and which factors caused
changes in other factors. Nevertheless, this section should make you appreciate that it is
too simplistic and naive to pin the blame of the crisis on a single group (such as bankers,
governments or consumers). In truth, many groups jointly contributed to the crisis, although
there is an ongoing debate about the importance of the role each of these played.
ACTIVITY 6.1
In your own words, write a 500-word summary of the stages of the global financial crisis.
Section 6.2: Consequences of the crisis and

possible cures
Introduction 224
Consequences of the crisis 224
Bank bailouts and national debt 224
National and international reactions to ‘cure’ the 226

problems of the crisis
Conclusion 229

Unit 6: Global financial crisis • Section 6.2: Consequences of the crisis and 224
possible cures
Introduction
Initially harmless, at least from the global perspective, the 2008 financial crisis originated in
the US real estate market. However, because of the closely interdependent (and virtually
unregulated) financial markets, it quickly spread to Europe and other parts of the world. It
was not long before it managed to affect the real economy, causing spectacular reductions in
economic growth rates. The situation has already improved, but the economic and social costs of
the crisis will be felt long after the crisis is over.
In this final section, we consider some of the key consequences of the crisis, as well as different
economic cures which have been proposed.
Consequences of the crisis

The consequences of the crisis, direct and indirect, are numerous.
Bank insolvencies
Because of the crisis, assets held by banks in the form of mortgage loans no longer generated
the cash flows which were expected, and so these assets reduced in value. Subprime loans
(later referred to as ‘toxic assets’) spread to many financial institutions worldwide. The collapse
and bankruptcy of the investment bank Lehman Brothers in 2008 triggered the largest ‘crisis of
confidence’ and trust in the financial markets ever seen.
Banks became unwilling to continue lending money to each other, which resulted in a drastic
reduction in interbank lending. Raising capital for investment became extremely difficult as
sometimes banks refused even to continue already ongoing lending to businesses (i.e. there was
a credit crunch). This resulted in a significant decline in the levels of investment and production
which, in turn, decreased the output of many economies.
Unemployment and loss of homes

Global unemployment is estimated to have increased by 15 million (Davies, 2010). As mentioned
in Section 4.3, unemployment is truly damaging for anyone affected by it. However, long-term
unemployment is even worse. It really does break morale. Human capital deteriorates as acquired
skills worsen due to skills not being used. There is an increased lack of self-confidence among
those unemployed. There is also a fear of having homes repossessed due to a failure to make
mortgage repayments through a lack of income (even if in receipt of unemployment benefits,
such government transfers are typically insufficient to cover mortgage repayments). As a result,
many become homeless by having their homes repossessed (known as foreclosure in the
US); families break down and those affected have higher risks of suffering from mental health
problems.
Bank bailouts and national debt

The US and other developed countries have spent billions of dollars in bank bailouts and
increased fiscal spending to cushion the speed at which economies have been contracting.
The money obviously had to come from somewhere! Usually government expenditure would
come from taxation. However, the large sums involved were often debt-financed, resulting in
governments increasing their national debt. Since the crisis broke, debt-to-GDP ratios have
increased sharply in countries heavily exposed to the effects of the crisis, in particular many
Eurozone countries. Figure 6.7 illustrates how government gross debt levels have changed since
the crisis broke for selected Eurozone countries.
possible cures
Eurozone
France
Germany
Greece
150
Ireland
General government gross debt (% of GDP)
Italy
Portugal
Spain
100
50
2004 2006 2008 2010 2012 2014

Year
Figure 6.7: General government gross debt of selected Eurozone countries. Source:
http://ec.europa.eu/eurostat/tgm/table.do?tab=table&init=1&language=en&pcode=t
eina225&plugin=1
Does this matter? Well, the national debt has to be serviced (i.e. paying interest as well as making
capital repayments) and much of this is likely to fall on future generations. Many would argue
that it is inherently unfair to ask future generations to pay for the profligacy of the current
generation. Such ‘intergenerational shifting’ of the costs of the crisis raises questions of fairness
because it will be future generations who will be required to pay higher taxes and enjoy lower
levels of government spending as the national debt is repaid.
Opportunity cost of bailouts

We must also consider the opportunity cost of the bank bailout funds. This (borrowed) money
could have been spent elsewhere, for example on healthcare or infrastructure improvements,
which, from society’s point of view, are more important.
The level of education and job opportunities are sharply decreasing. As Ferguson (2012), states:
… with the exception of wealthy families, children today are now less educated
than their parents, and will earn less money than their parents. Even worse, the
opportunities and lives of young people are increasingly determined by how
wealthy their parents are, not by their own abilities or efforts.
Ferguson (2012) pp.8-9.
Nothing can be done about it if governments keep restricting funding for developing education,
as that money will go to repaying the national debt rather than investing in human capital. It is
unsurprising that riots broke out in many European cities.
Eurozone economies
European countries which have been most affected by the economic crisis are collectively
known as the ‘PIIGS’ countries (Portugal, Ireland, Italy, Greece and Spain). The unemployment
rate in Greece and Spain rose to close to 25 per cent, meaning that one in four people who
are willing and able to work does not have a job. These countries may have to deal with such
problems largely on their own because other nations are no longer able to participate in foreign
possible cures
aid schemes. Much depends on the attitude of other Eurozone countries, such as Germany,
which acts as a creditor.
Loss of competitiveness
Another consequence of the crisis is the overall decline in the competitiveness of developed
countries. In the era of globalisation, a country must have superior knowledge and technology in
order to continue growing (i.e. a comparative advantage). Otherwise, most businesses would be
based in countries where the costs of labour are simply much lower, such as China or India.
Effects in Africa
Not all economies were affected in the same manner, or to the same extent, but the degree of
contagion was spectacular. Even African banks, which did not have any significant exposure
to subprime mortgages, were affected by the situation. This is because in some countries, for
example Zambia, Chad, Lesotho and Botswana, the level of foreign bank ownership is quite high.
Additionally, the financial crisis also had a negative impact on the African terms of trade. The
prices of commodity products, as well as the volume of exports, sharply decreased and, as a
consequence, it reduced the income of African exporters. It was estimated that within one
month in 2008, for example, Burundi coffee earnings fell by as much as 36 per cent! However, the
consequences are more far-reaching than decreased export revenues. Without export revenues,
governments are neither able to cushion the negative effects of the crisis, nor are they able to
import goods necessary for domestic production.
We now proceed to explore some of the remedies introduced around the world to ‘cure’ the
problems created by the crisis.
National and international reactions to ‘cure’ the problems of the

crisis
Austerity – cutting government spending

The initial, and widespread, reaction of governments was to introduce austerity. By reducing
government spending, and imposing cuts and freezes on public sector jobs, wages and
pensions, it was hoped that the national debt-to-GDP ratio would be reduced. This was done to
reassure the money markets (which would allow potential further borrowing at attractive rates)
and to protect a country’s credit rating. The UK was rated AAA (the most secure) by Moody’s (a
credit rating agency) but it was downgraded to AA1 (a lower level than AAA) in February 2013
after financial markets expressed doubts about the UK’s creditworthiness.
Governments are, however, on a tightrope as they try to maintain a balance between austerity
and growth. Cutting public spending has had the effect of increasing unemployment. This, in
turn, has resulted in increased welfare payments (unemployment benefits) and a reduction in the
tax base as fewer workers are able to find jobs.
The best way to ensure increased tax revenue is to generate growth, but how to do that at the
same time as implementing austerity is a question with which governments are continuing to
wrestle.
Targeted infrastructure investment

One possible method of achieving growth is by direct government spending on infrastructure
projects. This has the multiple benefits of reducing unemployment, raising tax revenue (via the
spending multiplier) and creating better roads, broadband networks, hospitals etc.
The strong argument for such a policy is that borrowing has never been cheaper, but great care
would be required to avoid the charge of abandoning the restriction on government spending.
The key point is that such investment would indeed be ‘targeted’ and be productive investment.
possible cures
Quantitative easing (QE)

The complete mechanism of quantitative easing is beyond the scope of this course, although
you will come across it later if you study economics at undergraduate level. The media have
termed it ‘printing money’, but this is not quite correct. Quantitative easing does have the
effect of increasing the balances of liquid assets in commercial banks. The hope is that this will
encourage lending, but the danger is that it may have the effect of leading to inflation in the
long run.
In short, quantitative easing is a process which injects money into the economy with the
objective of boosting economic activity. When interest rates are at or near zero, a central bank
has no or little scope to reduce interest rates further. Instead, a central bank can create money
electronically and use this to purchase financial assets – usually government bonds, although
other financial assets may be purchased. This cash injection reduces the cost of borrowing and
increases asset prices (due to the increased demand for financial assets created by the central
bank) with the net result of stimulating economic growth. Quantitative easing may be reversed
by the central bank selling the financial assets that it purchased which consequently reduces the
money supply in the economy and cools economic activity.
Interest rates
Low interest rates encourage investment. In the UK, the Bank of England aggressively cut interest
rates in response to the crisis. Figure 6.8 shows the Bank of England’s base rate for the period
2000–17.
UK base interest rates
6
5
UK base interest rates (%)
4
3
2
1
2000 2005 2010 2015

Year
Figure 6.8: UK base interest rates, 2000–17. Source: Bank of England,

www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate
As can be clearly seen, prior to the crisis, the base rate was in the range of four to six per cent. By
March 2009, the base rate stood at an historic low of 0.5 per cent. Following the UK’s decision to
leave the European Union in the Brexit referendum vote (held in June 2016), the base rate was
cut even further, to just 0.25 per cent in August 2016.
The European Central Bank took a similar approach to monetary policy, as did the Fed, while
Japan set rates at 0.1 per cent.
possible cures
Even at these historically low interest rates, investment in new business projects is still stalled.
Why? The answer is a lack of confidence among business investors, who see little prospect of the
possibility of profitable investment. In fact, in order to boost confidence, the Bank of England has
experimented (with varying degrees of success) with a policy known as ‘forward guidance’. The idea
is to signal that interest rates would remain low at least until certain trigger points are reached.
If businesses expect interest rates to remain low, they would have increased confidence to invest
than had they (rightly or wrongly) believed rates (and hence the cost of borrowing) would rise.
Bank lending
A further problem is that banks have been reluctant to lend to prospective investors despite
pressure from the government. This is an understandable (if unfortunate) reaction, because they
got their fingers burnt by reckless lending in the past! They also need to repair and restructure
their balance sheets, by building up (or retaining) liquid assets to counter the impact of toxic assets
incurred in the past. By building up their liquid assets, banks would improve their equity ratios.
Bank regulation
It is recognised that there needs to be better regulation of banking practices following the
mistakes and malpractice of the past – never again must banks be in the situation of being ‘too
big to fail’ and, therefore, requiring massive public bailouts.
Such regulation is fairly easily achieved at a national level, but solid international agreement
on best practice is difficult, and a long way off as there would need to be consensus on the
regulation which should be implemented. There has been much talk of separating the ‘good’
banks from the ‘bad’ banks (i.e. separating the risk-taking investment activities from day-to-day
retail banking).
Bank’s capital requirements (i.e. their equity) represent the capital buffer to offer protection
to financial institutions to cover potential future losses. Regulators set minimum capital
requirements to ensure that depositors, and other creditors, can be repaid.
The Basel Committee on Banking Supervision in 1998 (known as the Basel Accord, or ‘Basel I’)
required banks to hold eight per cent of their assets as (liquid) capital; a higher percentage if
riskier portfolios of assets were held. This capital was comprised as follows:
Tier 1 capital – shareholder equity
Tier 2 capital – subordinated debt and hybrid debt-equity instruments.
Weaknesses in Basel I came to light shortly afterwards. This led to discussions on the successor
to Basel I, called Basel II, to introduce greater flexibility by permitting banks to use their own
in-house risk models to determine the appropriate capital requirement, while keeping the total
capital buffer unchanged. Although many countries had adopted Basel II prior to the crisis,
significantly the US had not.
Some commentators lay the blame for the crisis at the regulators for failing to ensure the
banking sector was adequately capitalised. Indeed, when the crisis broke, the top 50 banks in
the world held an average of just four per cent capital, clearly providing an insufficient buffer –
especially when taking into account the over-valuation of mortgage-backed securities and other
financial derivatives. Therefore, increasing capital adequacy requirements is a possible cure.
Boost international trade

US/EU bilateral talks started in July 2013 with the aim of cutting existing tariffs and restrictive
practices, boosting trade between the US and Europe by an estimated $100 billion per year. This
would be the largest such agreement ever negotiated. Such an increase would have the effect
of stimulating both economies, without causing concern in the money markets. The policies
described (fiscal and monetary) were discussed in Unit 4.
possible cures
Conclusion
It can be seen from the above discussion that governments have competing, and sometimes
impossible, objectives. It can also be concluded that there are quite a few difficult questions, and
no easy answers!
Nevertheless, it can be argued that the above measures have had some success, although
recovery is patchy and slow. Some countries (for example Canada, Australia, Singapore and
Germany) have weathered the crisis relatively well.
The consequences of the crisis will be felt in many countries for years to come, so be sure to keep
an eye on Economics in the News for any developments!
ACTIVITY 6.2
Research and tabulate the current debt-to-GDP ratios for the leading global economies. (You
may, if you wish, illustrate your findings using Excel spreadsheets.)
You might find www.tradingeconomics.com a valuable source of data.
ACTIVITY 6.3
Conduct research to identify those countries most, and least, affected by the crisis. Why has
this been so?
ACTIVITY 6.4
In the aftermath of the crisis, discuss whether the UK economy has moved closer to
becoming a free-market economy. (You may need to conduct some research to investigate
this.)
Concluding comments
In this unit, we have identified the probable causes and effects of the recent global financial
crisis. We have also discussed some of the proposed cures.
The causes were the unbridled greed of individuals and institutions, coupled with the failure of
regulation, both at national and international levels, for example within the US and the Eurozone.
Governments allowed reckless loans and investments to be traded globally.
The effects have been mass unemployment and reductions in the provision of welfare for
millions of people. Austerity is the order of the day in most countries of the world, and the costs
will be borne by future generations.
We should note that not all economies have been affected to the same extent. Greece has
suffered badly, whereas Canada, Australia and the Gulf states have fared relatively well.
We should all be careful to learn from the lessons of history. The Great Depression of the 1930s
was tackled by Roosevelt’s ‘New Deal’, but many argue that it was preparation for joining the
Second World War that actually pulled the US economy out of recession. There is no real sign of a
repeat of this experience, but we must ensure that our present situation cannot lead to a similar
result.
The cures have been two-fold. The first is essentially printing money, called ‘quantitative easing’,
to allow banks to lend in a controlled fashion and to rebuild their balance sheets after the effects
of holding toxic assets. This could be termed a monetarist approach. Second, there has also
been a call for ‘smart investment’ in infrastructure projects to stimulate growth in the depressed
economies suffering a ‘double-dip’ recession. These investments could be termed Keynesian.

Having completed this unit, and the activities, you should be able to:
outline events which resulted in the global financial crisis
explain the consequences of the crisis for both developed and developing countries
state different economic responses to the crisis.

Appendix A: Economic history
This appendix contains non-examinable material, but you are encouraged to read it to gain some
deeper background to various aspects of economics. You will become a better-rounded economist as a
result!
Economic history
It is almost impossible to fully understand current developments in economics without an
understanding of the past. As such, here we take a brief journey back in time to note important
historical periods of economics which, for simplicity, are subdivided into ‘Ancient’, ‘Classical’ and
‘Modern’. During this brief historical tour, some important influential figures in the history of economics
are introduced to give you some background perspective of the discipline.
Ancient
Origins of economic thought can be traced back to Ancient Greece in the third century BC from the
writings of two eminent philosophers – Plato and Aristotle. Plato was a multi-talented student of
Socrates (a Classical Greek philosopher who formalised the concepts which are known today as the
‘scientific method’, i.e. the setting and testing of hypotheses using experiments) who founded the first
higher education institution in the Western world, the Academy in Athens. Plato was also the most
influential author of the era. In one of his works, Republic, he attempted to describe the necessary
conditions for the ideal state to exist. He was mainly concerned with the efficient organisation of
society which requires people to focus on activities for which they are most suited. In other words, Plato
was the first to describe the need for, and the benefits of, the division of labour. Although he recognised
the importance of trade, his views were rather socialist in nature. Goods could be bought and sold, for
example, but he believed that property should be divided equally between all members of society.
Aristotle (Plato’s student) strongly disagreed with this view. According to him, private ownership was a
much better concept than the idea of common value. He argued that goods are better cared for when
property rights are clearly assigned and owners of assets should be able to profit from their wealth.
Aristotle also widely discussed the origins and superiority of money as opposed to the old system of
barter.
Thomas Aquinas was a Catholic priest who lived in the 13th century. His main contribution to the
history of economic thought is his long discussion on the ‘just price’. According to St. Thomas, a fair
price should be a common valuation and reflect the costs of production (especially those of labour).
The ideas expressed by him come close to what is now called perfect competition. St. Bernardino of
Siena, and other subsequent scholars, focused on the exchange of goods and contracts which should
be made between parties. According to St. Bernardino, value (and hence price) should be determined
by the object’s:
usefulness
scarcity
desirability.

Classical
Sir William Petty, the 17th century founder of systematic statistics (also called political
arithmetic) is also of interest. Petty travelled across the United Kingdom collecting data on
regional mortality rates, soil conditions and other economic indicators. It is thanks to him
recording this information that we know so much about the standards of living at that time.
His most noteworthy achievement is his superior insight into taxes and the need for common
contributions to secure funds for public spending.
Richard Cantillon was an Irish banker who believed that the existence of banks not only made
money circulate around the economy faster, but also rationalised and formalised it. He was the
first to discuss the mechanism of market prices which adjust with fluctuations in the demand for,
and supply of, goods and services.
The discipline of systematic economics – that is, the economics we study now – emerged
in the 18th century. Our discussion starts with classical economics and its most prominent
representative, Adam Smith.
Smith is often referred to as ‘the father of free-market economics’. Born in 1723, the Scottish
philosopher is best-remembered for the idea of the ‘invisible hand’ – where the interaction of
supply and demand would bring about equilibrium price and quantity, without the intervention
of any individual trader – mentioned in his most famous work, An Inquiry into the Nature and
Causes of the Wealth of Nations (1776). Interestingly, Smith would not have recognised the word
‘economics’ as used today; rather his study would have been described as ‘political economy’,
reflecting the idea that political and social factors also contribute to material welfare.
He argues that rational, self-interested homo economicus and tough competition result in more
economic prosperity than when there is external intervention or regulation. It is, therefore, the
forces of demand and supply which guide the actions of individuals. If every individual is allowed
to follow his or her own self-interest, the interest of society as a whole is maximised. This is
sometimes referred to by using the French phrase ‘laissez-faire’, which we can think of as non-
intervention (a rough translation is ‘let it be’ or ‘leave it alone’). An important part of Smith’s work
is a discussion of the division of labour which inevitably gives rise to economic growth.
Another figure worth mentioning is Thomas Malthus, the co-founder of the famous Political
Economy Club in London. He was not the first person to write about the issue of increasing
population size, but he was the one with the most original views:
‘The power of population [to increase] is indefinitely greater than the power in the earth to
produce substance for man’ (Malthus, An Essay on the Principle of Population, 1798).
He was concerned that there would come a time when there would be insufficient resources to
feed all humans because population increases geometrically while food increases arithmetically.
Malthus claimed that to avoid such a scenario the population size must be kept under strict
control. Interestingly, Malthus’ theories convinced Charles Darwin of the correctness of the
fundamental law of evolution.
Malthus’ contemporary was another great economist, David Ricardo, who is best-known for his
law of comparative advantage. Ricardo proved that countries are better off if they specialise in
the production of goods which they can produce with the lowest opportunity cost (discussed in
Section 5.1, which examines international trade). Countries can then trade goods across borders,
creating a win-win situation. Ricardo was one of the first economists to include complicated
mathematical calculations in his publications.
The development of economic thought in the 17th and 18th centuries mirrors the evolution
of trade and the expansion of European empires (sometimes referred to as mercantilism). By
the 19th century, with the advent of the Industrial Revolution, we see a change of focus toward
capitalism, the role of the state and labour movements.
Modern
The end of the19th century and the early years of the 20th century, saw the collapse of Tsarist
Russia. This overthrow was inspired by the writings of Karl Marx and implemented by Vladimir
Lenin. The revolution had been brought to a head by the disruption and losses of the First World
War. Marx argued for the dictatorship of the proletariat (i.e. that the factors of production should
be brought under workers’ control, the profit motive should be abolished and that economic
decisions on what to produce, for whom it should be produced and how it should be produced
should be decided by a central planning state authority). Communism was established in Russia
after a bloody civil war and was exported worldwide following the Second World War.
The Chinese Communist revolution established a new regime in 1948, and Chairman Mao
Zedong applied socialist solutions to the country’s problems (known as the Cultural Revolution).
These ‘solutions’ were applied stringently and harshly, causing widespread disruption, death
and famine. Today’s China has adopted many free-market economy features (with spectacular
success), while it is a state dominated by one political party and run by the Politburo (a
committee of 25 leaders who meet frequently to guide and control policy).
In this overview of historical figures in economics, we must not forget John Maynard Keynes
whose ideas were in complete opposition to those of Adam Smith. Keynes believed that
government intervention in the form of fiscal policy (tax-and-spend decisions, explained in
Section 4.5) and direct investment must be used to control the economy. In Keynes’ mind,
the so-called ‘invisible hand’ advocated by Smith was not enough to control booms and
busts of economic cycles. He was mostly concerned with the negative effects of prolonged
unemployment (because he experienced the Great Depression of the 1930s) and much less
with the costs of inflation. Keynes’ views are respected and there are many examples of his
recommendations being followed by policymakers to this day.
J.K. Galbraith, a 20th century Canadian economist, who worked for most of his life in the
US, was a great advocate and populariser of Keynesian principles. Galbraith was also a prolific
author and teacher. One of his most widely-read books, The Affluent Society (1958), portrays
modern economies as being influenced by big business, large labour unions and interventionist
government.
Using the same concepts and language as Keynes, but opposed to his conclusions, was
the American economist Milton Friedman. In the 1960s, he proposed an alternative
macroeconomic policy known as monetarism. Friedman believed that the government’s main
responsibility is to control the amount of money in circulation. If too much money is pumped
into the economy, it will inevitably cause inflation (discussed in Section 4.4) which could have
devastating consequences. Friedman also suggested that people base their spending decisions
not on their current income, but rather on their expected lifetime wealth – known as the
‘permanent income hypothesis’.
We should also mention the rise of Islamic economics in the 20th century – well documented
by Timur Kuran in Islam and Mammon (2005). The basic premise is that Western capitalism has
failed and that Islam offers the remedy. Such ideas have been heavily backed by Saudi Arabia
and other oil-rich Gulf states. Islamic economics bans the imposition of interest on loans, seeks to
redistribute wealth more fairly through Zakāt taxation, and promotes a superior business ethic.
Schools of economic thought

Having introduced some of the key historical figures in economics, we conclude with a
discussion of some of the main ‘schools’ of economic thought, to which some of the figures
mentioned above are associated. A ‘school’ does not necessarily refer to a single educational
institution, but rather a set of beliefs held by a group of like-minded economists. Indeed, in our
discussion of key influential figures in economics we have seen that differences of opinion have
sometimes been considerable. We now briefly consider some of the major schools of economic
thought.
Classical school
Adam Smith, Robert Malthus and David Ricardo, among others, are linked with the Classical
school – often held to be the first school of economic thought. The belief system of classical
economists was that markets are most effective when free of government intervention. The
laissez-faire view advocated that the price mechanism should be used to allocate resources
efficiently to foster economic development. Economic value was based on scarcity and
production costs. Self-adjustment mechanisms were assumed to always result in an economy
achieving full employment. This period of economic thought continued to about 1870.
Neoclassical school
The Neoclassical school superseded classical economics. In short, it involved a change in
emphasis from the classical preoccupation with the source of wealth and its division to the
ideas which govern the optimal allocation of scarce resources to particular wants. The doctrine
is scientific in nature making use of assumptions and hypotheses to model the behaviour of
consumers and firms. Neoclassical economists assume that consumers and firms are both
rational with consumers seeking to maximise utility (as explained in Section 2.4), while firms look
to maximise profits (as explained in Section 3.1). The Neoclassical school is also responsible for
developing the use of ‘marginal analysis’ – the examination of the effects when an economic
variable is changed by one unit. Much of microeconomics was developed by the Neoclassical
economist Alfred Marshall.
Keynesian economics
This school of economic thought is named, unsurprisingly, after John Maynard Keynes.
Keynesian economists are sceptical of the ability of free markets to achieve full employment.
Instead, Keynesians advocate state intervention through the use of macroeconomic policy, in
particular fiscal policy (discussed in Section 4.5). Since the 1920s, the Keynesian and Neoclassical
schools were deeply opposed to each other and such conflicts stimulated much economic
debate which continues today as governments across the world sought to remedy the adverse
effects of the 2008 global financial crisis (discussed in Unit 6).
Glossary 235
Glossary
A
Absolute advantage: The ability of a country to produce more output of a good or service than
another country when two countries possess the same resource input(s).
Ad valorem tax: An indirect tax which is charged as a percentage of the price of the good.
Aggregate demand: The relationship between total output and the price level, which shows
planned expenditure (in nominal terms) on final goods and services at all possible price levels.
Aggregate supply: The total amount of all goods and services produced within the economy. It
tells us the amount that firms are willing to produce at all possible price levels.
Appreciation: The increase in the value of a domestic currency in terms of other currencies.
Asymmetric information: When a party involved in a transaction has more information than
the other party.
Austerity: Reducing government spending, and imposing cuts and freezes on public sector
jobs, wages and pensions in the hope of reducing national debt-to-GDP ratios.
Autonomous consumption: The level of consumption when disposable income is zero.
B
Balance of payments: A statement detailing a country’s trade and financial transactions with
the rest of the world – that is, it is a record of all money that moves in and out of a country.
Balance sheet: An accounting statement of a firm’s assets and liabilities on the last day of a
trading period.
Balanced budget: When government spending equals government revenue.
Barriers to entry: Obstacles which make it difficult for potential new firms to get a foothold in
the market.
Barriers to exit: Obstacles which make it difficult for existing firms to exit the market.
Basic economic problem: How to allocate scarce resources between competing uses in the
best possible way.
Broad money: Narrow money plus fewer liquid assets, primarily used for spending and as a
store of value.
Budget constraint: The consumer faces a constraint in that total expenditure on X and Y must
be no greater than income.
Budget (or fiscal) deficit: When a government spends more than it collects in taxes.
Budget (or fiscal) surplus: When a government spends less than it collects in taxes.
Buffer stock: Goods are bought (by the government) to be stored if the year is particularly
good (when there is a surplus) and sold when the harvest is bad and there is a shortage of that
commodity.

Glossary 236
C
Capital: Human-made assets, such as machinery or buildings.
Capital account: A component of the balance of payments. Capital flows related to capital
items in the form of assets, such as firms purchasing machinery.
Capital controls: Government restricting the amount of hot money that can flow into and out
of a country.
Central bank: The major monetary and financial regulatory authority within a country.
Centrally-planned economy: The central authority, i.e. the government, decides which goods
are to be produced.
Ceteris paribus: Latin term for ‘other things equal’. This means that other things which could
change are, for the moment, assumed not to. The term allows us to isolate the relationship
between two economic variables controlling for all other variables.
Cheap credit: The lending of money at low interest rates.
Circular flow of income: This shows the fundamental, mutually-beneficial economic
relationships between firms and households.
Claimant count: In the UK, the number of people who are officially registered and able to work
but who currently cannot find a job and are, therefore, claiming unemployment benefits.
Collateralised debt obligations (CDOs): Structured asset-backed financial products.
Comparative advantage: This occurs because the marginal opportunity costs of one good in
terms of the other differ between countries.
Complements: Two goods are considered to be complements if a change in the price of one
causes an opposite shift in the demand for the other.
Concentration measure: A measure to quantify the size distribution of firms in an industry.
Concentration ratio: This captures the extent of seller concentration in a particular market. It
shows the percentage of market sales due to the largest n firms.
Congestion charge: Applied to roads which tend to be over-used and so result in negative
externalities, such as increased traffic and pollution.
Consumer choice: Decisions consumers make when choosing between different consumption
bundles.
Consumer price index (CPI): An index of weighted prices for a representative basket of goods.
It excludes payments on housing costs and mortgage payments.
Consumer surplus: The welfare gain to consumers resulting from the fact that some consumers
pay less for the good than their maximum willingness to pay, i.e. their maximum valuation of the
good.
Consumption: The spending by consumers on goods and services.
Consumption externality: An externality which occurs as a direct result of product
consumption.
Consumption function: The mathematical relationship between consumption and disposable
income.
Contagion: A situation where economic problems in one country can be quickly transmitted to
other countries.
Contractionary (tight) fiscal policy: Decreasing government spending.
Contractionary (tight) monetary policy: Decreasing the money supply.
Glossary 237
Cost-push inflation: Inflation which occurs when there is an increase in the cost of factor
inputs, in particular the cost of raw materials, energy and wages. These higher costs effectively
‘push up’ prices.
Credit crunch: A severe contraction in the amount of available credit.
Credit rating agencies: Companies which assign credit ratings to debt.
Creditor: A lender who is owed money.
Creeping inflation: When prices increase gradually and slowly, up to five per cent.
Cross-price elasticity of demand (XED): The responsiveness of quantity demanded for one
good to changes in the price of another.
Current account: A component of the balance of payments. The profit/loss from day-to-day
transactions involving ‘visible’ (tangible) goods, ‘invisibles’ (intangibles), private money transfers
and official transfer payments in the form of international aid.
Cyclical (demand-deficient) unemployment: Unemployment caused by the variable
business cycle (also referred to as the economic cycle).
D
Deadweight loss: The cost to society resulting from the loss of economic efficiency. The
deadweight loss is the total (combined) reduction in consumer and producer surpluses minus
the total tax raised.
Debt-to-GDP ratio: The ratio of outstanding national debt to GDP.
Default: When a borrower is unable to repay a loan.
Deleveraging: The selling of assets whose original purchase was financed by borrowing.
Demand: The relationship between price and quantity which tells us how many units of a
certain good consumers are willing to purchase at every possible price.
Demand function: Demand when we represent quantity as a function of price.
Demand-pull inflation: Inflation attributable to excess demand when an economy is operating
at the full employment level of national output and so aggregate demand exceeds the supply
potential of an economy. The excess demand effectively ‘pulls up’ prices of output.
Demand-side policies: Direct (fiscal and monetary) intervention by the government which
affects the level of aggregate demand.
Demerit goods: Goods with under-estimated or ignored harmful effects, for example cigarettes,
drugs and alcohol. Not only do they have a negative effect on people who consume them in
excessive amounts, but they can also harm others, for example, through passive smoking.
Depreciation: The decrease in the value of a domestic currency in terms of other currencies.
Determinants of demand: Factors which determine demand, such as price of the product,
price of complements (goods which are consumed together) and substitutes (replacements),
income, wealth, tastes, preferences, advertising, expectations of future price increases, climate,
population and demographics.
Determinants of supply: Factors which determine supply, such as price of the product,
technology, weather conditions, cost of inputs, access to raw materials, regulations, number of
firms in the industry, taxes and subsidies.
Determinants of the price elasticity of demand (PED): Factors which determine the PED,
such as availability of close substitutes, time horizon (short run vs. long run), percentage of
income spent on those goods, type of goods and brand image.
Glossary 238
Determinants of the price elasticity of supply (PES): Factors which determine the PES,
such as number of suppliers, time horizon (short run vs. long run), ease of storing extra units,
productive capacity, length of production period and perishability of the product.
Devaluation: Decreasing the value of the domestic currency under a fixed exchange rate
regime.
Direct tax: A tax applied to the income and wealth earned by households and firms. Direct taxes
are paid straight to the government by a person or institution on whom the tax was imposed.
Discouraged workers: People without jobs who simply give up looking for work and are hence
considered as being outside the labour force.
Disequilibrium: A situation where the quantity demanded is different from the quantity
supplied so the market cannot clear. In the aggregate setting, the economy will be in
disequilibrium when the level of aggregate demand is not equal to the level of aggregate supply.
Disposable income: The amount of current income available to spend or save (likely a mixture
of spending and saving) after the payment of personal income taxes.
Division of labour: Production is broken down into a series of tasks which are conducted by
individual workers.
E
Economic good: All goods which are scarce.
Economic growth: Defined in one of two ways: (i) as an increase in the real income or the gross
domestic product (GDP) of an economy - known as the actual economic growth, or (ii) as an
increase in the productive capacity of the economy - known as the potential economic growth.
Elasticity: The responsiveness of one variable to changes in a different variable. The value
of the elasticity, in absolute terms, varies between zero and infinity. The sign of the elasticity
depends on the directions in which the two variables are moving. If both of them move in the
same direction, elasticity is positive. If they move in opposite directions, however, the sign of the
elasticity is negative. The sign only shows the direction of the movement, it does not show the
actual elasticity.
Endogeneity: Interactions between economic variables which mean changes in one variable
will lead to changes in another variable, which may well feed back into further changes in the
original variable.
Entrepreneurship: The ability and originality to combine all factors of production to make
profits. ‘Confidence’ is sometimes also considered as part of entrepreneurship.
Equilibrium: When the demand for a certain good is exactly the same as the supply of that
good, i.e. where the demand and supply curves intersect.
Equity: A bank’s buffer to cover unexpected losses which could occur. From an accounting
perspective, equity is calculated as the difference between total assets and total liabilities.
Equity ratio: The ratio of a bank’s equity to its total assets.
Euro: The official currency of the Eurozone.
Excess demand: At the given price, people are willing to buy more goods than producers are
willing to offer. In this case, the price will continue to rise until equilibrium is reached.
Excess supply: At the given price, firms are offering more goods than consumers are willing to
buy. In this case, the price will fall until the market clears again.
Exchange rate: The price of one currency in terms of another currency.
Expansionary (loose) fiscal policy: Increasing government spending.
Glossary 239
Expansionary (loose) monetary policy: Increasing the money supply.

Exports: The purchases of domestic output by foreigners.
Externalities: Third-party effects (delivered and received outside the market) caused by
decisions or actions made by someone else. These can be positive or negative.
F
Factors of production: The means for producing the goods and services which people
demand. There are four factors of production - capital, entrepreneurship, land and labour –
collectively known as CELL.
Financial crisis: A major disruption to the financial markets which results in the significant fall of
asset prices.
Fiscal policy: A tool of macroeconomic policy which involves the tax-and-spending decisions of
the government and is the government’s primary instrument for managing aggregate demand.
Fixed exchange rate: The domestic currency is assigned a fixed value with respect to other
currencies, known as a peg.
Floating exchange rate: The market forces of demand and supply are free to determine an
equilibrium in the exchange rate.
Flow variable: A variable which is considered over a period of time, such as annual income.
Foreign exchange reserves: Used to settle any balance of payments deficit.
Fractional reserve banking: A system of banking whereby banks keep only a fraction of
deposits in liquid form (such as cash) on hand to meet the expected demand for withdrawals.
Free good: Any good which is available in an (effectively) infinite quantity.
Free-market (or capitalist) economy: Resources are privately owned and, therefore,
decentralised. Decisions about what to produce and in which quantities, are decided by the
forces of demand and supply.
Free-rider problem: A problem associated with public goods in which individuals presume
that others will pay for the public goods, so that individually they can escape paying for their
production without a reduction in production occurring.
Frictional unemployment: Unemployment which occurs when people are in-between jobs. In
other words, they are temporarily unemployed while they undertake a job search or take a break
between leaving one job and starting another.
G
GDP per capita: GDP (see below) divided by the size of the population.
Giffen good: A good for which demand increases as its price increases.
Gini coefficient: A measure of economic development that reflects the extent of the inequality
of income distribution within a country.
Globalisation: The increasingly integrated nature of national economies into a single
international market.
Government spending: The total spending by the government on goods and services. In
national income accounting, transfer payments (such as unemployment benefits) are not
included because these payments do not lead to any production, rather these are just transfers
of funds from the government to recipient households.
Gross domestic product (GDP): The total monetary value of all final goods and services an
economy produces in a year.
Glossary 240
Gross national product (GNP): GDP plus the net property income from abroad - income
earned abroad by domestic residents less the income earned by foreigners in the domestic
economy.
H
Herfindahl index: A measure of the extent of seller concentration in a market. The index
considers the size of firms relative to the industry output. It is calculated by adding up the
squared market shares of all firms in the industry.
Hidden unemployment: Official unemployment statistics are not 100 per cent accurate since
people may be incorrectly included or excluded.
Hot money: Capital flows into and out of a country by currency speculators.
Human Development Index (HDI): An index of economic development consisting of the
average of three indicators: standard of living (measured by GDP per capita in PPP terms), life
expectancy at birth and adult literacy.
Human Poverty Index (HPI): Recently superseded by the Multidimensional Poverty Index, HPI
is an alternative index of economic development focusing on quantifying how well a country is
doing at achieving poverty reduction. HPI consists of the probability at birth of a life expectancy
of less than 40 years, the percentage of illiterate adults (reflecting knowledge exclusion) and
the percentage of people without a sufficient standard of living as reflected by an unweighted
average of no access to clean water and children who are underweight.
Hyperinflation: An extremely large and accelerating increase in the price level caused by a
major disruption to an economy, for example a war or an economic depression.
I
Identity: A special kind of mathematical formula which allows us to rewrite one mathematical
expression in another way.
Imperfect information: This occurs when a decision-maker has incomplete, inaccurate,
uncertain or misinterpreted information leading them to potentially make an incorrect choice.
Imports: The purchases of foreign output by domestic consumers.
Income elasticity of demand (YED): The responsiveness of demand to changes in income.
Indifference curve: This shows alternative combinations of two products where every
consumption bundle on the curve provides the consumer with the same level of utility and
therefore, the consumer is indifferent between all of the bundles on the curve.
Indirect tax: A tax which is usually levied on goods and services which we consume.
Inferior good: A good characterised by decreased demand when income rises, and increased
demand when income falls.
Inflation: The sustained overall increase in the price level – conversely, the overall reduction in
the value of money.
Inflation rate: The rate at which the price level increases.
Interbank lending: Lending between banks (i.e. from one bank to another bank).
Interdependence: The situation where a number of countries are so closely linked by trade and
financial relationships that they depend on each other economically.
Interest rate differentials: Arbitrage opportunities which arise due to different countries
having different nominal interest rates.
Interest rates: The cost of borrowing money.
Glossary 241
International Labour Organisation (ILO) unemployment survey: An unemployment rate

based on a quarterly survey of approximately 40,000 households, equating to around 80,000
adults.
International trade: The exchange of goods and services between countries through exports
and imports.
Inverse demand function: Demand when we represent price as a function of quantity.
Inverse supply function: Supply when we represent price as a function of quantity.
Investment: The capital expenditure by firms on physical assets.
Invisible trade: Trade in services, due to its intangible characteristics.
Isocost line: All points along an isocost line result in the same total cost of production.
Isoquant: The set of all possible combinations of inputs 1 and 2 which are (just) sufficient to
produce a particular amount of output, q.
J
Job automation: The labour market is transformed with many repetitive tasks currently
undertaken by low-skilled workers being replaced by machines.
L
Labour: People who provide physical and intellectual skills (human capital).
Labour force: The sum of the number of employed persons and those unemployed.
Labour market: A factor of production market providing a means to exchange work for wages.
Land: All naturally-occurring resources, such as soil, air, water, minerals, flora and fauna.
Lorenz curve: A relative concentration measure.
Luxury good: A good with an upward-sloping demand curve, often bought by people to signal
their wealth and social position. Such goods can be considered as ‘status symbols’ and are an
example of conspicuous consumption.
M
Marginal benefit: The benefit of one extra unit consumed.
Marginal cost: The cost of one extra unit produced.
Marginal propensity to consume: The proportion of income that a person spends on
consumption.
Market: A place (either physical or virtual) where buyers and sellers meet to exchange goods
and services.
Market failure: The market fails to achieve an optimal allocation of resources.
Market power: The ability of a firm to set a price for its product above that determined in a
perfectly-competitive market environment.
Market structure: How a market is organised.
Merit goods: Goods which are better for people than they think. Benefits could be
underestimated, for example, due to time lags. Costs are observed immediately, while positive
effects may only be visible in a few years’ time. As people find it difficult to make well-informed,
rational decisions, merit goods are usually under-provided by the free-market mechanism.
Missing market: A situation when no private company would be willing to provide a (public)
good as no profits could be made. In graphical terms, there would be no intersection of the
market demand and supply curves.
Glossary 242
Mixed economy: Governments intervene to improve efficiency, correct market failures or

provide public goods.
Model: A deliberate simplification of reality. A good model retains the most important features
of the real world, while ignoring factors which (we think) do not matter.
Monetary policy: A tool of macroeconomic policy which involves controlling the money
supply, which in turn affects demand, allowing central banks to manage aggregate demand.
Monetary transmission mechanism: The central bank sets the nominal interest rate for a
period of time. This rate, in turn, affects the interest rates of mortgages and bank lending. Asset
prices and the currency exchange rate can also be affected.
Money supply: The total amount of money in circulation in an economy.
Monopolistic competition: A form of market structure similar to perfect competition (many
buyers, and many firms with free entry and exit) but there is now product differentiation where
consumers are able to distinguish between competing products produced by competitor firms.
Monopoly: A type of market structure in which there is one firm and many buyers. This means a
single supplier serves the needs of lots of buyers, who we think of as behaving independently.
Multiplier: The mechanism by which government spending has an impact on the economy,
i.e. how an increase in government spending can produce an even greater increase in national
income.
N
Narrow money: Assets which are fully liquid, primarily used for spending.
National debt: The total outstanding government debt of a country.
National income accounting: A way to measure economic activity over a period of time,
typically a year.
Negative equity: The situation when the fall in the value of a house means the house is worth
less than the outstanding mortgage secured against it.
Negative externality: An externality where one person suffers from actions taken by
somebody else. Negative externalities give rise to an inefficient allocation of resources because
external costs are not included in the free-market equilibrium. From society’s point of view,
goods are over-produced and prices charged are too low.
Nominal interest rate: The interest rate which a central bank charges when lending to other
banks. This is the primary monetary policy tool in most countries.
Normal good: A good for which demand increases when income increases and falls when
income decreases.
Normal profit: A profit which is just sufficient to allow a firm to continue to supply its output. It
represents the opportunity cost of the resources of a firm’s owner.
O
Okun’s law: The relationship between the GDP growth rate and the unemployment rate.
Oligopoly: A type of market structure where there are many buyers, but only a few firms, i.e. a
few dominant firms serve the needs of many consumers.
Open-market operations: The central bank buys and sells securities in the open market. These
securities are usually government bonds but can also be commercial securities.
Opportunity cost: The cost of the best alternative foregone. It is a cost associated with
engaging in a certain activity evaluated as the value of the best alternative you must give up
pursuing it.
Glossary 243
Ordinary good: A good for which demand is downward-sloping (i.e. people buy more of a
good when its price decreases and buy less when its price increases).
P
Participation rate: The labour force divided by the total population of working age.
Perfect competition: An extreme form of market structure where there are many buyers
alongside many firms (sellers), with each firm acting independently, producing a homogeneous
product such that the production decisions of a single firm are so negligible that there is no
impact on the market price.
Perfect complements: Goods which are consumed in fixed proportions.
Perfect substitutes: Goods which can perfectly substitute for each other.
Positive externality: An externality where one person benefits from actions taken by
somebody else. Positive externalities give rise to an inefficient allocation of resources because
external benefits are not included in the free-market equilibrium. From society’s point of view,
goods are under-consumed.
Price adjustment: The price level within the economy changes until equilibrium is reached.
Price ceiling: A maximum price is the legally-established threshold value above which the
market price cannot rise.
Price elasticity of demand (PED): The responsiveness of quantity demanded to changes in the
price of a good.
Price elasticity of supply (PES): The responsiveness of quantity supplied to the changes in the
price of a good.
Price floor: A minimum price is the legally established threshold value below which the market
price cannot fall.
Price level: The weighted average of prices of the whole spectrum of goods and services
consumed by a given country.
Price mechanism: The ‘invisible hand’ which responds to changes in demand and/or supply of a
certain good or service in order to maintain the balance in the market. The price mechanism has
three main functions: rationing, signalling and incentivising.
Price-taker: A perfectly-competitive firm which can take as given the market price of p,
determined through aggregate market demand and supply.
Private goods: Goods which are both rivalrous and excludable.
Producer choice problem: The producer problem of cost minimisation to produce q units of
output subject to the production function.
Producer surplus: The welfare gain to firms resulting from the fact that the price they receive
for their product is higher than the minimum price at which they are willing to supply the
product.
Product differentiation: A type of non-price competition. The product concerned may be
differentiated either in terms of demand-side or supply-side ways.
Production externality: An externality which occurs when the spill-over (third-party) effects
result from the physical production of a good.
Production function: The function which describes the boundary of a production set.
Production possibility frontier (PPF): A PPF shows all the possible combinations of two or
more goods or services which can be produced in an economy if all the available resources are
fully and efficiently used with the best available technology.
Glossary 244
Production set: A set which shows all possible combinations of inputs and outputs which are
technologically feasible.
Profit: The difference between revenues and costs.
Profit maximisation: When a firm wants to determine the level of production which maximises
its profit.
Public goods: Goods which are non-rivalrous and non-excludable.
Purchasing power parity (PPP): PPP exchange rates aim to equalise the real purchasing power
between various currencies.
Pure monopoly: Monopoly when there are no close substitute products for the monopolist’s
product, resulting in a zero cross-price elasticity of demand.
Q
Quantitative easing: A process which injects money into the economy with the objective
of boosting economic activity. A central bank creates money electronically and uses this to
purchase financial assets – usually government bonds, although other financial assets may be
purchased. This cash injection reduces the cost of borrowing and increases asset prices with the
net result of stimulating economic growth.
Quantity adjustment: The amount of goods and services produced within the economy
changes until equilibrium is reached.
Quantity demanded: The single value which tells us how many units of goods and services
consumers want to buy at a specific price.
Quantity supplied: The single value which tells us how many units of goods or services firms
want to sell at a specific price.
Quasi-public goods: Goods which exhibit mixed characteristics of both private and public
goods - they are either non-rivalrous but excludable, or non-excludable but rivalrous.
R
Regional (geographical) unemployment: Unemployment associated with a particular region
of a country.
Regulation: The control of economic activities by the government or some other regulatory
body.
Repossession: In relation to property, the situation when a lending financial institution takes
possession of the property used as collateral (security) against a mortgage loan when the
borrower defaults.
Reserve requirement: Regulations which govern the minimum amount of capital a
commercial bank must keep as liquid assets (such as cash) to meet the expected demand of
withdrawals by depositors.
Retail price index (RPI): A statistical measure of a weighted average of prices of a specified set
of goods and services purchased by representative families.
Revaluation: Increasing the value of the domestic currency under a fixed exchange rate regime.
Risk premium: In terms of interbank lending, the additional cost of borrowing above the central
bank base rate reflecting the greater risk of one bank lending to another bank.
S
Scarcity: The existence of a finite amount of resources.
Seasonal unemployment: Unemployment which occurs when people are unemployed
because of the season, for example fruit pickers and temporary workers in tourism are only
employed in the summer.
Glossary 245
Securitised mortgages: Financial assets formed by packaging up various mortgage loans into
financial securities.
Social benefits: Private and external benefits combined together.
Social costs: Private and external costs combined together.
Social welfare: Also known as the economic surplus, social welfare is the total (combined)
welfare of consumers, producers and government.
Specialisation: A country, firm or individual focuses on the production of a limited range of
goods or services.
Specific tax: An indirect tax which is charged as a fixed amount per unit sold.
Speculative bubble: Such bubbles occur when investors are willing to buy assets if they believe
the assets will increase in value, allowing them to sell them in the future for an anticipated profit.
Stagflation: This occurs when there is a depressed level of real output (caused by a fall in
aggregate demand) and rising factor input costs (leading to cost-push inflation).
Stock variable: A variable which is fixed at a particular point in time, such as wealth.
Strato-inflation: A moderate increase in the price level, around 10 to 20 per cent, generally
experienced in developing economies such as Brazil or India.
Structural unemployment: Unemployment caused by changes in the structure of an
economy.
Subprime mortgage loans: Mortgage loans made to borrowers with poor credit histories.
Subsidy: A monetary benefit provided by governments in order to increase the consumption of
merit goods and goods whose consumption generates positive externalities which benefit other
people.
Substitutes: Two goods are considered to be substitutes when a change in the price of one
causes a shift in demand for the other in the same direction as the price change.
Supernormal profit: The sum of normal profit and economic profit, where economic profit is
the excess profit above the opportunity costs of the firm’s owners (i.e. the excess over normal
profit).
Supply: The relationship between price and quantity which tells us how many units of a certain
good firms are willing to sell at every possible price.
Supply function: Supply when we represent quantity as a function of price.
Supply-side policies: Attempts to boost economic growth by making markets work more
efficiently and more freely.
T
Tariff: A tax on imported goods levied by the government of the importing country.
Tax: A compulsory payment, or levy, charged by a government and imposed either on firms or
consumers.
Tax incidence: The amount of tax paid by each party. Tax incidence is a term used to describe
the division of the tax burden between consumers and producers.
Terms of trade: The ratio of export prices relative to import prices. Terms of trade is expressed as
an index because it is based on the weighted average price of exports and the weighted average
price of imports reflecting not just one, but thousands of different export and import prices.
Tradable pollution permit: Licences given by governments allowing pollution at a certain
level.
Glossary 246
Trade balance: The difference in value of exports and imports.

Trade bloc: A free trade area established through an intergovernmental agreement.
Trade deficit: When the value of imports exceeds the value of exports.
Trade surplus: When the value of exports exceeds the value of imports.
Transfer payments: Monetary payments made by the government to individuals for which no
goods or services are concurrently rendered, such as unemployment benefits.
U
Unemployment: The number of people who are currently not employed but who are actively
seeking work and are able to start work immediately.
Unemployment rate: The ratio of the number of unemployed persons to the size of the labour
force.
Unemployment (poverty) trap: Unemployed people in receipt of welfare payments end up
becoming dependent on this ‘income’ and become deterred from seeking employment.
Utility: The satisfaction (or pleasure) which a consumer obtains from the consumption of a good
or service.
Utility function: A (mathematical) function which returns the total utility a consumer derives
from consuming x units of good X, and y units of good Y.
Utility maximisation problem: Consumers seek to achieve maximum utility (satisfaction)
while simultaneously being constrained by their budget.
V
Voluntary unemployment: Unemployment due to people choosing not to work (i.e.
unemployment which is left once an economy achieves full employment).
W
Wage differential: The difference between wage rates of different professions.
Wage rate: The price of labour.
Wealth: The difference between the value of everything you own (i.e. assets) and the value of
everything you owe (i.e. liabilities).
Wealth effect: When asset prices rise, asset owners feel richer and hence boost their
consumption of goods and services accordingly.
Welfare-to-work scheme: A scheme to make the receipt of welfare payments conditional on
recipients actively looking for work by way of incentive.

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International Foundation Programme

 J.S. Abdey, The London School of Economics and Political Science

Published by: University of London

Introduction to the course 1

Unit 1: The nature and scope of economics

Unit 2: Microeconomics I: markets and the consumer

Unit 3: Microeconomics II: firms and production

Unit 4: Macroeconomics I: closed economy

© University of London 2019

Section 4.4: Inflation 162

Unit 5: Macroeconomics II: open economy

Unit 6: Global financial crisis

Introduction to the course

Route map to the guide 2

Aims of the course 5

Learning outcomes for the course 5

Microeconomics vs. Macroeconomics 6

Overview of learning resources 7

© University of London 2019

Route map to the guide

Unit 1: The nature and scope of economics

Unit 2: Microeconomics I: markets and the consumer

Unit 3: Microeconomics II: firms and production

Unit 4: Macroeconomics I: closed economy

Unit 5: Macroeconomics II: open economy

Unit 6: Global financial crisis

Week Unit Section

Week Unit Section

Aims of the course

Learning outcomes for the course

 compare measures of economic development

Microeconomics vs. Macroeconomics

Overview of learning resources

Economics in the News

(New York: Hill and Wang, 2012) [ISBN 9780809033614].

Useful web links

Accessing the Student Portal and virtual learning environment

Overview of the unit 11

© University of London 2019

Overview of the unit

Section 1.1: The basic economic problem,

Division of labour as an example of specialisation 15

Different economic systems 16

DISCUSSION POINT 1.1

DISCUSSION POINT 1.2

Division of labour as an example of specialisation

Different economic systems

Section 1.2: Production possibility

Economic growth and the PPF 22

A reminder of your learning outcomes 26

Economic growth and the PPF

Figure 1.7: Scenario D showing how technological advances in house building

Figure 1.8: Production possibility frontier representing a constant opportunity cost

Cars (quantity) 0 60 110 150 180 200

A reminder of your learning outcomes

J.S. Abdey, The London School of Economics and Political Science

compare measures of economic development