OXFORD IB STUDY GUIDES

2020 edition

Economics
FO R T H E IB D IPLO M A

Constantine Ziogas
Marily Apostolakou
 2020 edition

Economics
F OR T H E I B D I P LOM A

Constantine Ziogas
Marily Apostolakou

3
 Acknowledgements

3
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Contents
Unit 1: Introduction to economics Unit 4: The global economy
1.1 What is economics? 2 4.1 Benefits of international trade 145
1.2 How do economists approach the world? 7 4.2 Types of trade protection 149
4.3 Arguments for and
Unit 2: Microeconomics against trade control and protection 156
2.1 Markets – demand 10 4.4 Economic integration 159
2.2 Markets -supply 13 4.5 Exchange rates 164
2.3 Competitive market equilibrium 16 4.6 Balance of payments 177
2.4 Critique of the maximizing behaviour of 4.7 Sustainable development 187
consumers and producers (HL) 22 4.8 Measuring development 188
2.5 Elasticities of demand 25 4.9 Barriers to economic
2.6 Elasticity of supply 33 growth and/or economic development 191
2.7 Role of governments in microeconomies 36 4.10 Economic growth and/or economic
development strategies 197
2.8 Market failure—externalities and
common pool or common access resources 43
Glossary of key terms:
2.9 Market failure – public goods 54 www.oxfordsecondary.com/9781382009423
2.10 Market failure –
asymmetric information (HL) 55
2.11 Market failure – market power (HL) 56

Unit 3: Macroeconomics
3.1 Measuring economic
activity and illustrating its variations 71
3.2 Variations in economic activity—
aggregate demand and aggregate supply 75
3.3 Macroeconomic objectives 84
3.4 Economics of inequality and poverty 105
3.5 Demand management
(demand-side policies): monetary policy 114
3.6 Demand management
(demand-side policies): fiscal policy 124
3.7 Supply-side policies 132
3.8 Macroeconomic policies—
strengths, limitations and conflicts 139
 1.1 What is economics?

Economics as a social science

The social nature of economics economics, inequity is often interpreted to refer to inequality,
Social sciences are academic disciplines that systematically which may apply to how income or wealth is distributed in a
study human behaviour from different perspectives and society. Promoting equity is a significant issue for societies.
include psychology, anthropology, political science and The extent to which markets or governments should, or
others. Economics is one of the social sciences as it is are able to, create greater equity or less inequality in an
concerned with human actions and social relationships economy is an area of much debate.
while deploying the social scientific method, which refers Economic well-being
to the collection and analysis of data and the formulation Economic well-being relates to the living standards enjoyed
of testable and falsifiable hypotheses about social by the members of an economy and includes the dimensions:
phenomena.
• security in terms of income, wealth, employment and
Microeconomics and macroeconomics shelter
Economics is divided into two main branches • the ability to meet basic needs (food, housing, health care,
microeconomics and macroeconomics —“micro” and “macro” transportation, education, childcare, clothing)
are Greek words meaning small and large respectively. • the ability to make economic choices and feel a sense of
• Microeconomics is concerned with the individual parts security and personal fulfillment with personal finances
of the economy; it deals with individual units within the and employment
economy such as firms, consumers or markets. • the ability to maintain all the above over time.
• Macroeconomics is concerned with the economy as a Sustainability
whole; it deals with aggregates such as the overall level of Sustainability refers to the ability of the present generation
unemployment, total output of an economy and its growth to meet its needs without compromising the ability of future
through time and the average price level. generations to meet their own needs. It relates to the idea
that current generations should be good stewards of the
The nine central concepts environment.
The nine key concepts that are central to economics and that
we will be discussing throughout this book are as follows. Change
The economic world is not static; it continuously changes.
Scarcity
In terms of economic theory, economics focuses not on the
Scarcity is fundamental to economics, as it is the problem level of a certain economic variable but on the change in
all societies face. It refers to the excess of human wants over that variable from one situation to another. With respect to
what can actually be produced to fulfill these wants. Human the study of real-world phenomena, it is always subject to
wants are unlimited. In contrast, the resources available to continuous change at institutional, structural, technological,
fulfill these wants are limited. economic and social levels.
Choice Interdependence
Since resources are scarce, not all wants can be satisfied. Economic agents such as consumers, producers, governments
Choices must therefore be made. Societies have to choose and nations interact with each other. Any action of any
between which goods or services to produce and how much economic agent will impact other agents, indicating that
of each they want. Economics is thus also concerned with all economic agents are interdependent. The intended and
choices over competing alternatives together with their unintended consequences of these interdependencies must
current and future consequences. therefore be considered.
Efficiency Intervention
Scarce resources must be used in the best possible way to Intervention refers to government involvement in the
produce the combinations of goods and services that are workings of markets despite markets being considered as
optimum for society. This is known as allocative efficiency. At the best mechanism to organize economic activity. Markets
the same time, it is important to use resources in a way that often do fail, creating room for government intervention.
ensures minimum waste. This is known as technical efficiency. Note that not only is the extent of government intervention
Equity a contentious subject of debate but also there is no
Equity refers to the idea of fairness. Fairness is an elusive guarantee that the outcome of any intervention will improve
concept, as it means different things to different people. In market outcomes.

2
The problem of scarcity and choice

UNIT 1: INTRODUCTION TO ECONOMICS

Scarcity and resource allocation. The fact that virgin forests are
Scarcity is the fundamental problem that all societies disappearing (being cut down for timber or firewood) or
face. It refers to the excess of human wants over what can that fish stocks in many parts of the world are severely
actually be produced to fulfill these wants. Human wants depleted or that the atmosphere is becoming so polluted
are unlimited, as individuals typically prefer to have more demonstrates the current impact of human activities on the
and better goods and more services. Yet, it is not possible environment. Such activities pose a threat to sustainability,
to produce all of the goods and services to satisfy all wants. as resources will not be available for others to use in the
This is due to the fact that resources are limited. future. Given that resources are also scarce it is of great
importance to use them in a sustainable manner. The goal
Resources (factors of production) should be preserving and even increasing or improving the
Resources refer to whatever is used to produce goods and available stock of natural resources.
services and are also known as factors of production. There
are four factors of production, as defined below. Opportunity cost
• Land and raw materials are inputs into production The cost of choice
provided by nature, for example agricultural and non- Every choice involves sacrifice. For example, choosing to
agricultural land, forests, pastures, mineral deposits, oil, produce corn using the available land implies that some
natural gas, lakes and rivers. The world’s land area and raw other agricultural product, for example wheat, has been
materials are limited. Some resources, such as oil and coal sacrificed. This alternative foregone is the opportunity cost
deposits, are non-renewable: if they are used now, they will of that choice. The opportunity cost of choosing any activity
not be available in the future. Other resources, for example is thus the value of the next best alternative sacrificed. If
forests (timber) and the stock of fish, are renewable. resources were unlimited, no sacrifices would be necessary,
• Labour is the human input, both physical and mental, and the opportunity cost of producing any good or service
into production. The labour force is, at any point in time, would be zero.
limited both in number and in skills. The total number of Economic goods versus free goods
people available for work is referred to as the labour force
Economic goods are goods and services that require scarce
or working population.
resources to be sacrificed in order for them to be produced.
• Capital includes manufactured resources; in other words, In contrast to economic goods, free goods have a
produced means of production. The world has a limited zero opportunity cost of production, as there were no scarce
stock of capital (a limited supply of factories, machines, resources sacrificed in their production. There are very few
tools and other equipment). Note that the meaning of real-world examples, perhaps seawater and air. Note that
capital in economics is different from that used in ordinary goods available at a zero price are not free in the economist’s
speech where people refer to capital as money. sense if scarce resources have been used up to produce them.
• Entrepreneurship is the willingness and ability that some
individuals have to take risks and to manage the other The basic economic questions
three factors of production. Entrepreneurship is related Scarcity forces every economy to answer three fundamental
but not identical to management. When a new venture questions, independently of their level of economic
is being considered, risks exist. They involve the unknown development or the economic system adopted.
future. Someone must assess these risks and make
1. What to produce? Choices must be made in all economies
judgments about whether or not to undertake them. The
about which goods will be produced and in what quantities.
people who do so are called entrepreneurs.
2. How to produce? All economies must make choices on
Choice how to use their resources in order to produce goods and
Scarcity has an important consequence. Scarcity necessitates services. Should a good be produced using more labour
choice. Societies must choose between which goods or and less capital (machines) or perhaps rely more on
services to produce and how much of each they want given capital and less on labour?
the available resources. For example, society cannot enjoy all
3. For whom? All economies must make choices about how the
the books and all the tables it wants because the number
goods and services produced are to be distributed among
of trees required to produce these two goods is limited. It
the population. Should all enjoy education and health
somehow has to decide how many books and how many
services? Should all enjoy the same amount of all goods?
tables it wants to produce. If there were no scarcity, no
choices would have to be made.
Means of answering the economic questions
The problem of scarcity has a second important consequence.
Since resources are scarce, it is important to produce the
Markets versus government intervention
combination of goods and services that society values the A market should be thought of as a mechanism that can
most and also to avoid wasting any scarce resources. provide answers to the three fundamental questions. For
example, the market can determine:
Scarcity and sustainability
• whether this good or that good will be produced and in
The concept of sustainability is closely related to the
what quantities
environmental effects of current patterns of production

3
 • which production technology a firm should use to produce Economic systems: free market economy,
a good or a service command economy, mixed economy
• how much income the owner of each factor of production The market mechanism and government intervention explained
will earn. above are two ways through which the basic economic questions
Yet, there is no guarantee that the market outcome is the best can be answered. We can in turn distinguish between the types of
outcome from society’s point of view. Sometimes the market organization of each economy. There are two extreme cases: the
as a mechanism succeeds and results in the best possible free-market economy and the command economy.
answers for society to these questions. Many other times, the In the free-market economy, markets through the interaction
market as a mechanism fails. For example, markets may lead of households and firms answer the three fundamental
to too much pollution, or not enough libraries; they may lead to questions. Households decide what goods to consume. Firms
unacceptably high rates of unemployment, or to inadequate decide what goods to produce and what resources to use.
health care for lower income households; they may lead to Then markets ensure that these decisions are coordinated.
excessively risky lending practices by financial institutions, In the command economy, the state owns all capital
or to not enough basic scientific research. When the market and land. This means that the state answers the three
fails it automatically creates a role for the government fundamental questions.
to step in and attempt to correct the market failure. The
purpose of government intervention is thus to help markets Between these extremes are mixed economies. In a mixed
function better. However, there is no a priori guarantee that economy the answers to the three fundamental questions are
the answers governments provide are necessarily better, as given partly by the market and partly by the state. In practice
government failure is also possible. all economies are mixed; yet, the roles and importance of the
state and of markets can differ substantially.

The production possibilities curve (PPC) model

The production possibilities curve (PPC), also referred to Choice, opportunity cost and scarcity
as the production possibilities frontier (PPF), is the first The PPC also illustrates choice and opportunity cost. As
economic model we will study. Figure 1.1.1 shows, if the economy chooses to produce more
Assumptions of the model of good X it will have to sacrifice the production of some of
good Y. This is shown by moving along the PPC from point C
The production possibilities curve (PPC) provides a visual to point D. This sacrifice of good Y is the opportunity cost
account of an economy at a point in time. It refers to a of producing the additional amount of X. Specifically, we
country with a fixed amount of resources and some level realize that the opportunity cost of producing an additional
of technology producing only two goods or services. It is 100 units of good X (400 units instead of 300 units) is
unrealistic but still, as you will see, powerful enough to the 40 units of good Y (160 instead of 200) that must
illustrate a number of key concepts. be foregone.
Figure 1.1.1 will help you to visualize a PPC. Assume that an It is because of scarcity that the PPC is negatively sloped:
economy devotes all of its resources to the production of two to produce more of X, less of Y can be produced as scarce
goods: X and Y (X and Y can be any goods or services such resources will need to be diverted from the production of Y
as wheat and cotton, or health care and national defence). to the production of X. If scarcity were not the case, then the
Good Y A idea of a PPC would make no sense as any combination of
the two goods could be produced.
Increasing opportunity costs
200 C
The PPC also illustrates the phenomenon of increasing
160 D
opportunity costs. The opportunity cost of producing more
and more units of good X is ever-increasing quantities of
100 E
good Y sacrificed. As already mentioned, when moving from
point C to point D the opportunity cost of producing an
additional 100 units of good X is the 40 units of good Y
that must be foregone. Now consider moving from point D
to point E. The opportunity cost of producing an additional
B 100 units of good X (500 units instead of 400 units) is the
0 300 400 500 Good X 60 units of good Y (100 instead of 160) that are sacrificed.
Producing these additional 100 units of good X is now
Figure 1.1.1 The PPC
costlier as 60 units instead of 40 units of good Y have been
The PPC shows for each amount of one good produced, the sacrificed. This means that an economy producing more and
maximum amount of the other good that can be produced more of one good is forced to sacrifice increasing amounts of
given its resources and its technology. For instance, if the other good.
300 units of good X are produced then this economy can The reason for this is that resources tend to be specialized. As
produce at the most 200 units of good X if it fully uses all of the economy concentrates more and more of its production on
its resources with its technology.

4
 one good, it must start using resources that are less and less The movement from point A to point B depicts economic growth

UNIT 1: INTRODUCTION TO ECONOMICS

suitable for its production (that is, resources that would have as this movement illustrates an increase in the economy’s actual
been more appropriate to produce the other good). The PPC output. Point B reflects production of more of good X and more
is concave (bowed-in towards the origin) rather than being a of good Y compared to point A (as X2 > X1 and Y2 > Y1). This
negatively sloped straight line exactly because opportunity increase in actual output represents economic growth.
cost increases as more and more of X is produced. Potential growth
Actual growth Economic growth can also be illustrated through an outward
What if the economy is operating inside the PPC producing shift of the PPC, as shown in Figure 1.1.3.
a combination like point A shown in Figure 1.1.2? Then
Good Y
the available resources are not being fully utilized; for
example there is unemployment. Point A is therefore an H
inefficient production combination. Lower unemployment
in the country and, more generally, more efficient use of
F
existing resources will allow the economy to move to another
combination towards the northeast, closer to the curve itself.

Good Y

Y2 B 0 F’ H’ Good X
Figure 1.1.3 Potential growth
A The production possibilities of this economy have expanded
Y1
and the PPC has shifted from FF’ to HH’. Given that each
point represents a specific combination of output, it should
be clear that this economy is now in a position to produce
and enjoy combinations of good X and of good Y that
0 X1 X2 Good X were previously unattainable. Such a shift is possible if
Figure 1.1.2 Actual growth the quantity or quality of available resources increases or
improves and/or if the available technology advances.

Modelling the economy

The circular flow of income model Income: rent, wages, interest and profit
The circular flow model is a simplified representation of how (factor payments)
the basic decision-making units of an economy (households, Factors of production
firms, the government and, in an open economy, the foreign (land, labour, capital, entrepreneurship)
sector) interact.
At first, consider an economy with only households and
firms. Households own all factors of production, which they
offer to firms. In exchange for the factors of production, Households Firms
firms make payments to households in the form of rents
(for land), wages (for labour), interest (for capital) and
profits (for entrepreneurship). The sum of these payments Goods and services
makes up national income. Firms use the factors of
production to produce goods and services, which they offer
Spending on goods and services
to households, and so households make expenditures on
the goods and services produced by firms.
Figure 1.1.4 Transactions: real flows and monetary flows
In this basic view of the economy there are transactions
that take place by two kinds of flows: real flows of factors The monetary flows described above must be equal as it is
of production and goods or services in one direction, and initially assumed that there is no “tomorrow” so all income
monetary flows of factor payments (income) and spending generated must be spent. The income that flows from firms
on goods or services in the opposite direction. The real to households, as payments made for the use of the factors
flows are shown in grey and the monetary flows in blue in of production, must be equal to the spending by households
Figure 1.1.4. that flows back to firms as payment for the goods and
services produced. This is the circular flow of income.

5
 If there is a “next period” then part of the income generated and the government spend on domestic output but also
may be saved—a leakage from this circular flow—while it is not foreigners. These expenditures foreigners make on domestic
only households that spend on domestic output but also firms output constitute the export revenues (X) of the economy
that spend on capital goods (that is, investment spending and they are an injection to its circular flow. On the other
occurs). This latter expenditure is an injection to the circular hand, part of the income generated in this economy may
flow. Where did this injection come from? The answer is that now be spent on foreign output. This spending represents
banks or financial intermediaries attract savings and then our imports (M) and is a leakage to the circular flow. The
lend firms the funds they need to finance their investments. equilibrium condition becomes:
It follows that the flow in this system will neither increase (I + G + X) = (S + T + M)
nor decrease if injections are equal to leakages. In this
simplified version of an economy, without government Recap
and without a foreign sector, the equilibrium condition for
national income (Y) is: Leakages and injections
I=S • Leakages are defined as income not spent on
domestic goods and services.
If a government is added then part of the income generated
in this economy may not be spent because it leaks out of • Injections can be thought of as expenditures on domestic
the circular flow of income in the form of taxes (T). On the goods and services not originating from households.
other hand, injections into the circular flow will also include • If injections into the circular flow are equal to
government expenditures (G) on domestically produced leakages from the circular flow then the level of
output. Domestic output in this model can be bought national income will not change.
by households and firms as well as the government. The • If injections are larger than leakages then national
equilibrium condition therefore becomes: income will tend to increase.
(I + G) = (S + T) • If injections are smaller than leakages national
Lastly, if we make this model more realistic and add a income will tend to decrease.
foreign sector then we have one more source of expenditures
on domestic output, namely the expenditures foreigners A simplified representation of the circular flow is shown in
make on it. Now, not only do domestic households, firms Figure 1.1.5.

Income

Households Firms

Household spending
on domestic output

Savings Taxes Imports Exports Government Investment

spending

Leakages Injections
Figure 1.1.5 The circular flow of income

6
 1.2 How do economists approach the world?

UNIT 1: INTRODUCTION TO ECONOMICS

Economic methodology
Economists frequently distinguish between “positive” and also be represented with diagrams and with simple or
“normative” economics. advanced mathematics. The aim is to draw conclusions
from the constructed models.
The role of positive economics • The ceteris paribus assumption: an important part of many
Positive economics is concerned with the development and models is the assumption of ceteris paribus, a Latin phrase
testing of positive statements about the world that are that means “other things equal” or “all else constant”. In
objective and verifiable. A positive statement is a statement order to focus on the possible relationship between two
of fact. It can be proven right or wrong. “Unemployment economic variables, in economics it is often assumed that
is rising” and “Inflation will be over 6% by next year” are no other variables change. Of course, in the real world,
examples of positive statements. many things are usually changing at the same time.
• The use of logic: positive economic thinking relies on the • Refutation: theories and models can be judged according
use of logic. Economists use careful reasoning in order to to how successful they are in explaining and predicting.
draw out potential implications for economic behaviour. If the data and the empirical evidence do not support
Very often, economic reasoning is expressed through a hypothesis then it must be rejected or modified. This
mathematical models. process is referred to as refutation.
• The use of hypotheses: economists make general hypotheses
about the causes of economic phenomena—for example, that The role of normative economics
consumer demand will rise when consumer incomes rise. Normative economics relate to opinions or points of view.
These hypotheses are typically based on observations. A normative statement is a value judgment: a statement
• Empirical evidence: once a hypothesis has been about what ought to be, about whether something is good
formulated it can then be tested against empirical or bad, desirable or undesirable. “It is right to tax the rich
evidence. Empirical evidence refers to the collection of more than the poor” and “The government ought to reduce
real-world observations and numerical data. inflation” are examples of normative statements. They
cannot be accepted or rejected by a simple appeal to the
Consider the following example of how the above can be
facts as positive economic statements and theories can. If
applied to an economic issue.
a statement or a theory cannot be tested and refuted or
• We have the following information about the world: accepted then it is a normative statement or theory.
supermarkets are selling more organic apples than
• Value judgments in policy-making: it is important to
before—and we want to know why this is the case.
realize that economists practising positive economics do,
• Next we state a hypothesis: the volume of organic apples however, make value judgments. Any analysis involves
that a supermarket will sell rises if the price at which they an element of subjectivity. First, even what to analyse
are sold is reduced. and how to analyse it often depend upon the subjective
• Then we test our hypothesis by looking for evidence to views of the analyst regarding what is, and what is not,
support the link between volume of sales at different important. In addition, economists can contribute to
prices in different countries and for different time periods. questions of policy based on their value judgments; that is,
• If the evidence supports the hypothesis we accept it, and they can advise policymakers of which policies to pursue
move on to more refined hypotheses, such as those relating depending on the issues faced. For example, economists
to how big the response by consumers is to price changes. may suggest that a policy of increasing government
• If the evidence does not support the hypothesis, we reject expenditure will reduce unemployment.
it and then modify it. • The meaning of equity and equality: equitable does not
This process of trial and error gradually leads to a theory mean equal. It means fair—but fairness means different
that fits well with experience. things to different people. Equity is therefore a normative
concept. The ideas of equality and equity often arise in
• The use of theories: economists formulate theories to relation to the distribution of income. Equality in the
explain how the economic world works. A theory is a well- distribution of income is where each individual in the
substantiated explanation of an aspect of the economic economy receives the same share of income. Equity is
world that can incorporate hypotheses and evidence. It where income is distributed in a way that is considered
should be noted that a theory can never be as complex to be fair or just. The problem with this, however, is that
and rich as the reality it seeks to explain, so theory is people have different notions of fairness. For example,
about simplification. a rich person may well favour a much higher degree of
• The use of models: theories give rise to models, which inequality than a poor person. As a result, both terms
are analytical tools used to illustrate theories and to are often being used interchangeably, and equity in the
show simplified relationships between various economic distribution of income is often interpreted as less inequality
variables. Most models can be described, but they can in the share of income received by members of society.

7
 Economic thought
Economic ideas have originated way back in time, and are increased emphasis was put on consumption rather than
known to have been important topics in ancient Greece production only, with the introduction of the concept of
and the Middle East. In fact, the word economy can be utility as a measure of individual satisfaction from the
traced back to the Greek word oikonomia (= οικονομία), consumption of goods or services. Below is an outline of a
which in turn is composed of two words: oikos, which is few of the main contributors of the Classical school.
usually translated as household; and nemein, which is best Alfred Marshall (1842–1924) is renowned for developing
translated as management and dispensation. Thus, the the framework of demand and supply. Marshall focused
cursory story usually goes, the term oikonomia referred to on the study of a competitive market and illustrated with
household management and while this was in some loose the help of price-quantity diagrams that the intersection of
way linked to the idea of budgeting, it has little or no supply and demand identifies equilibrium where the market
relevance to contemporary economics. clears. The equilibrium approach is known as the “scissors”
Still, scholars in the Antiquity and the Middle Ages thought analysis where demand and supply resemble the two blades
a great deal about trade, money, prices and interest rates, of a pair of scissors.
but an autonomous discipline only developed toward the William Stanley Jevons (1835–1882) advanced the so-called
late 17th to early 18th centuries. Despite the interest of the marginal revolution. He distinguished between total utility
early literature, a detailed account of it would be beyond and marginal utility—namely, the change in the level of
the scope of this section. Instead the review of economic utility that results from a given increase in the quantity of
thought will start from the late 18th century. Focus will be the good. Marginal utility was thought to diminish with the
on Adam Smith (1723–1790), who is widely regarded as one quantity consumed. The importance of thinking in terms
founder of the discipline; the remainder of this section will of marginal changes rather than total proved so useful to
outline the development of economic thought in the 19th, account for utility and demand that it was subsequently
20th and into the 21st centuries. extended to supply with the concepts of marginal
productivity and marginal cost of production.
18th century Jean-Baptiste Say (1767–1832) is best known for Say’s Law
that in its simplest formulation states that supply creates its
In his 1776 Wealth of Nations, Adam Smith laid the own demand. There are several interpretations of this law.
foundations of what would become basic principles of Nevertheless, Say wrote: “it is production which opens a
economists’ understanding of individual behaviour, the demand for products ... . Thus the mere circumstance of the
market mechanism and the role of markets in relation to creation of one product immediately opens a vent for other
governments. products”. In other words, Say claimed that production is
Smith was the first to characterize individual economic the source of demand. One’s ability to demand goods and
behaviour explicitly as self-interested behaviour, admitting services derives from the income generated by one’s own
that it is people’s desire for a gain that explains work, acts of production. Wealth is created by production not by
production and ultimately the existence of an economic consumption.
system: “It is not from the benevolence of the butcher, the The Marxist critique was influenced by classical authors but
brewer, or the baker that we expect our dinner, but from at the same time critical of them, Karl Marx (1818–1883)
their regard to their own interest”. highlighted the conflict between labour and capital, and
His work also contributed to shaping economists’ view of the historical tendencies that brought about the modern
the market as a mechanism that ensures that individual economic system but that would also generate tensions
decisions are consistent with one another and lead to an that eventually would bring about its collapse. His
orderly result. Adam Smith’s “invisible hand” has often been work was the most widely adhered-to critique of market
recognized as an effective representation of this mechanism. economics during much of the 19th and 20th centuries.
This is also known as the laissez-faire approach that relates Marx’s Das Kapital (also known as Capital), published
to the idea that markets should be allowed to operate freely. in 1867, attracted many followers in economics and also
While acknowledging the merits of the market, Smith did inspired political action directed at radical social, economic
not deny the need for a solid government. In particular, he and political change.
insisted that governments should ensure the basic conditions
that allow markets to function properly. 20th century

19th century In the aftermath of the Great Depression, macroeconomics

also entered the scene bringing along the Keynesian
Adam Smith’s work stimulated much reflection that shaped “revolution”. John Maynard Keynes (1883–1946) is
economic thinking of the 19th century. Economists of this perhaps the most influential economist of the 20th
time period are often referred to as “classical” economists. century. He changed the relationship between government
Early 19th century classical economists were mainly and the economy and stressed the need for government
interested in production and supply as well as in the intervention and stabilization policies. Keynes “General
relationship between wages and profits, while they placed Theory” was published in 1936. In the Keynesian
relatively less emphasis on consumption and demand. From framework no endogenous forces exist that restore full
the second half of the 19th century onwards, however, employment. Instead of believing in “supply creating its

8
own demand” (Say’s law), Keynes turned things inside out,
21st century

UNIT 1: INTRODUCTION TO ECONOMICS

postulating that it is effective demand that determines
the equilibrium level of real output in an economy. If, for
whatever reason, aggregate demand proves insufficient One branch of economics that has seen considerable growth
to establish full employment then a market economy will in recent years is behavioural economics. Behavioural
suffer a system-wide failure, as it will be unable on its own economists have challenged the conventional rational
to restore full employment conditions. As such, there is an decision-making approach and have studied the effects of
active role for the government. Through fiscal policy the psychological, cognitive, emotional, cultural and social factors
government can stabilize the economy and achieve full on the economic decisions of individuals and businesses.
employment. Keynesian interventionist ideas reigned until Behavioural economic analysis extends the traditional model
the mid 1970s but for many they have been resurrected in an attempt to provide a better, more realistic explanation
in the 2008–09 global financial crisis and again in 2020 in of human decision-making. Some researchers, for example,
the Covid-19 crisis. have focused on how happiness and individual satisfaction,
as well as prosocial and cooperative attitudes, may be
In the 1970s, monetarism and the monetarist counter-
important determinants of individual behaviour that were not
revolution emerged at the University of Chicago with
fully accounted for in the standard economic model.
Nobel Prize Laureate Milton Friedman (1912–2006)
being the most widely known advocate of monetarist In addition, over recent years sustainability has emerged
ideas. Friedman strongly opposed many of the policy as an important concept due to the growing awareness
proposals by the Keynesian economists. He argued for regarding the interdependencies that exist between the
deregulation in most areas of the economy, calling for economy, society and the environment. In fact, sustainable
a return to the free market. The idea behind this view development requires a balance between the economic,
is that the government creates more problems than it social and environmental dimensions. For this reason the
solves. Monetarism spread widely in the early 1980s idea of moving towards a circular economy has emerged.
and had a strong influence on policy-making. Keynesian In a circular economy goods and services are designed in a
ideas did not completely vacate the scene, though: many way that allows them to be reused, either in the biological or
became convinced that government policies can still have technical cycles. Products are manufactured in a way so they
a temporary effect and that the Keynesian framework of can be disassembled and materials can either be broken
analysis applies in the short run, while the monetarist down by nature or returned to production. The goal is to
framework applies in the long run. throw nothing away and to reduce the need for purchasing
new commodities, while production and transportation
should be best achieved with renewable energy.

9
 2.1 Markets—demand
The interaction of consumers and producers determines the in market prices. These changes set off a chain of events
market price of each product. Markets are institutions that leading to more or less of the good being produced and
permit the interaction between buyers and sellers. They consequently to a new allocation of scarce resources. To
determine which goods and services will be produced in analyse how product markets function we need to examine
an economy and so how scarce resources will be allocated. first the behaviour of consumers and then the behaviour of
Changes in market conditions therefore result in changes producers.

Definition of demand
The demand for a good is an analytical way of summarizing the behaviour of buyers in a market. Specifically, demand can be
defined as the relationship between various possible prices of a good and the corresponding quantities that consumers are
willing and able to purchase per time period, ceteris paribus.

The law of demand

The relationship between price and quantity per period of relationship between price and quantity demanded is
time is inverse (negative), meaning that if the price increases referred to as the law of demand. The law of demand states
then quantity demanded will decrease as consumers will that if the price of a good rises then quantity demanded per
be willing and able to buy less per period. This inverse period will fall, ceteris paribus.

HL
Behind the law of demand Utility refers to the satisfaction one gains by consuming
a good or a service. The typical consumer has a fixed
The substitution and income effects
amount of income and he or she faces a fixed set
The law of demand holds because of the substitution and of prices. We assume that consumers allocate their
income effect. expenditures among all the goods and services that they
• The substitution effect: if the price of a good rises, the might buy so as to gain the greatest possible utility. This
good will now cost more than alternative or substitute means that the goal of typical consumers is to maximize
goods. That is to say, all other goods automatically their utility subject to their budget constraint (that is,
become relatively cheaper and so people will tend to income).
switch to these substitutes. This explains why following an We will now examine the relationship between utility
increase in price, quantity demanded decreases. and the quantity consumed for an individual consumer.
• The income effect: if the price of a good rises, consumers Marginal utility is defined as the additional satisfaction
feel poorer; they will not be able to afford to buy so derived from consuming an additional unit of a good.
much of the good with their income. That is to say, the The idea is simple. As one consumes additional units of a
purchasing power of their income (their “real income”) good per period (that is, per hour, per day, per week and
falls and so people will tend to buy less of that good. so on), the additional satisfaction enjoyed decreases. If
Again, this explains why following an increase in price, this is the case, then individuals will be willing to pay less
quantity demanded decreases. and less to buy more and more units of a good per period
The law of diminishing marginal utility of time.
Another explanation behind the law of demand rests on
the law of diminishing marginal utility.

10
The demand curve

UNIT 2: MICROECONOMICS
The demand curve illustrates the relationship between In Figure 2.1.1, if the price per unit is P1 then consumers
the price of a good and the quantity of the good will be willing and able to buy Q1 units per period, ceteris
demanded over a time period. Price is measured on the paribus. If the price increases to P2 then consumers will be
vertical axis; quantity demanded is measured on the willing and able to buy Q2 units per period, ceteris paribus.
horizontal axis. Given that the relationship between price
Price per
and quantity demanded is inverse (law of demand) the
unit (P)
demand curve is downward sloping from left to right: it
has a negative slope.
A demand curve can be for an individual consumer or P2
more usually for the whole market. The market demand
derives from adding up at each price the quantities
demanded by all consumers in a market. For example, P1
at the price of $2.00, consumer A is willing and able
to buy three cappuccinos per week while consumer B is
willing and able to buy five cappuccinos per week. If the
market consists of these two consumers then at the price D
of $2.00, market demand is eight cappuccinos per week. 0 Q2 Q1 Quantity per
Diagrammatically the market demand curve is derived by
period (Q)
the horizontal summation of the individual demand curves.
Figure 2.1.1 A typical market demand curve

Non-price determinants of demand (“shift” factors)

The non-price determinants of demand are the factors other For some goods, typically lower quality goods, an increase in
than the good’s own price that can affect demand. They are income will lead to a decrease in demand and a shift of the
the factors that are assumed to be constant under the ceteris demand curve to the left as consumers may switch to other,
paribus assumption. If any of the non-price determinants higher quality products. This is the case of inferior goods.
of demand changes, the demand curve shifts. Particularly, The demand for inferior goods decreases when incomes
if a change in one of the determinants of demand causes increase and the demand curve shifts to the left from D1 to
demand to increase then the demand curve shifts to the D2, as shown in Figure 2.1.2b.
right. This means that at each price more quantity of the The same good may behave as a normal good in one society
good (or service) is demanded. Or, if a change in one of the or market and as an inferior good in another. For example,
determinants of demand causes demand to decrease then in a country with a generally low-income population, an
the demand curve shifts to the left. This implies that at each increase in income may lead to an increase in the demand
price less quantity of the good (or service) is demanded. for used cars, whereas in another country where people have
The non-price determinants of demand include the following. higher incomes, a further increase in income levels may lead
Income to a decrease in the demand for used cars.
Changes in consumers’ income may affect demand. Price of related goods
As income rises, demand for most goods will rise. Such Substitute goods: two goods are considered substitutes if
goods are called normal goods. Therefore, an increase in they are in competitive consumption and consumers typically
income will lead to an increase in the demand for a normal buy one or the other as the goods satisfy the same need or
good and the demand curve will shift to the right from D1 want. Examples include Pepsi and Coca-Cola, coffee and tea,
to D2 as shown in Figure 2.1.2a. pizza and burgers. For instance, the demand for Coca-Cola is
(a) Normal good (b) Inferior good
Price per Price per
unit (P) unit (P)

D2 D1
D1 D2
0 Quantity per 0 Quantity per
period (Q) period (Q)
Figure 2.1.2 The effect of an increase in income on the demand for a normal and an inferior good

11
 expected to increase if a supermarket increases the price of Price per
Pepsi. More generally, if good X and good Y are considered unit (P)
as substitutes then an increase in the price of good Y will
lead to an increase in the demand for X. Demand for X will
shift to the right from D1 to D2, as shown in Figure 2.1.3.
Price per
unit (P)

D1
D2
0 Quantity per
period (Q)
Figure 2.1.4 The effect of an increase in the price of a complement
For example, the heavy promotion of adopting a healthy
D2
D1 eating behaviour has increased the popularity of certain
0 Quantity per products such as kale and quinoa that are deemed to be of
period (Q) high nutritional value. The demand for such products will
Figure 2.1.3 The effect of an increase in the price of a substitute increase and the demand curve will shift to the right.
Complement goods: two goods are considered complements Expectations of future price changes
if they are consumed together (“jointly consumed”), such as If people expect that the price of a good is going to rise in the
peanut butter and jelly or coffee and sugar. For instance, if future, they are likely to buy more now before its price goes up.
the price of coffee increases then the demand for sugar This will lead to an increase in demand and a rightward shift
may decrease. More generally, if goods X and Y are of the demand curve. In the same way, if consumers anticipate
considered as complements then an increase in the that the price of a product will fall in the future, they are likely
price of good Y will lead to a decrease in the demand for to withhold their purchases now to take advantage of the
good X. Demand for X will shift to the left from D1 to D2, lower future price. Thus, the demand for the product will now
as shown in Figure 2.1.4. decrease and the demand curve will shift to the left.
Tastes and preferences Number of consumers
The more desirable people find a good, the more they will As the number of consumers in a market (or the size of a
demand it. Tastes are affected by advertising, by fashion, by market) increases, demand for most products will tend to rise
observing other consumers, or by considerations of health. and vice versa.

Recap
Non-price determinants of demand (shift factors)
Income • An increase in consumers’ income will lead to an increase in demand for a normal good and to
a rightward shift of the demand curve. However, an increase in consumers’ income will lead to a
decrease in demand for an inferior good and to a leftward shift of the demand curve.
Prices of related • If goods X and Y are substitutes, an increase in the price of good Y will lead to an increase in
goods demand for X and the demand curve will shift to the right.
• If goods X and Y are complements, an increase in the price of Y will lead to a decrease in
demand for X and the demand curve will shift to the left.
Tastes and • If a good appears more attractive to consumers as a result of advertising, fashion, trends or health
preferences considerations, then demand for that good will increase and the demand curve will shift to the right.
Expectations of • If the price of a product is expected to rise in the future, then its demand will now increase
future price changes and the demand curve will shift to the right. Or, if the price is expected to fall in the future,
then its demand will now decrease and the demand curve will shift to the left.
Number of • If the number of consumers in a market increases, demand will increase and the demand curve
consumers will shift to the right, and vice versa.

Movements along and shifts of the demand curve

A shift in the demand curve occurs when a determinant demand whereas the rise in quantity demanded that follows
other than the price of the good changes; we then say that a price decrease is also known as an “extension” of demand.
a change in demand has occurred. A movement along the
demand curve occurs when there is a change in the price Movement along the demand curve:
of the good; we then say there is a change in quantity when the price of the good changes
demanded. Given an increase in price, the decrease in Shift of the demand curve: when any of the
quantity demanded is also known as a “contraction” in non-price determinants of demand changes
12
 2.2 Markets—supply

UNIT 2: MICROECONOMICS
Definition of supply
The concept of supply is merely a way to summarize analytically the behaviour of firms. It is defined as the relationship between
various possible prices and the corresponding quantities that firms are willing to offer per time period, ceteris paribus.

The law of supply

The relationship between price and quantity supplied per period is direct (positive), meaning that if the price increases then
quantity supplied will also increase, as producers will be willing to offer more per period. This positive relationship between price
and quantity supplied is referred to as the law of supply. The law of supply states that if the price rises then the quantity of a
good supplied per period will increase, ceteris paribus.

HL
Behind the law of supply in costs because of a change in output. Due to diminishing
The producer is assumed to seek to maximize profits. Assuming returns, the marginal cost may fall initially as there are
that a firm has fixed productive capacity, producing ever- increasing marginal returns but eventually, when diminishing
increasing quantities of a good becomes more and more difficult returns set in, the costs will start to rise. If an additional unit
(that is, more and more costly). This is the result of the law of of labour leads to less and less additional output, then to
diminishing marginal returns and increasing marginal costs. achieve equal additional units of output, more and more units
of labour will be required. It follows that the additional cost
More specifically, the law of diminishing marginal returns (the marginal cost) of additional units will be increasing.
states that as more and more units of a variable factor (usually
labour) are used with a fixed factor (usually capital), there is It should now be clear that if the additional cost of producing
a point beyond which total product will continue to rise, but more and more units is increasing, then a firm will be willing
at a decreasing rate, or equivalently, that marginal product to offer more and more units only at a higher and higher price.
will start to decline. Marginal cost is the extra (additional) Thus more units will be offered per period only at a higher price,
cost resulting from an increase in output; it is thus the change which reflects the direct relationship of the law of supply.

The supply curve

The supply curve is a graph that shows the relationship between increased to P2 per unit then producers will be willing to
the price of a good and the quantity of the good supplied over offer Q2 units per period.
a given period of time. The price is measured on the vertical
Price per
axis; quantity supplied is measured on the horizontal axis. Given
unit (P)
the direct relationship between price and quantity supplied S
(the law of supply), the supply curve is upward sloping: it has a
positive slope and can be drawn as shown in Figure 2.2.1.
A supply curve may be an individual firm’s supply curve or a P2
market supply curve (that is, the supply curve of the whole
industry). As with the market demand, the market supply P1
derives from adding up the quantities supplied at each price
by all producers. So, if a market consists of 100 identical
firms and each is willing to offer 200 units per month at the
price of $5.00, then the market supply will be 20,000 units
per month priced at $5.00 per unit.
0 Q1 Q2 Quantity per
In Figure 2.2.1, if the price is P1 then producers will be period (Q)
willing to offer Q1 units per period, whereas if the price
Figure 2.2.1 A typical market supply curve

Non-price determinants of supply (“shift” factors)

The non-price determinants of supply are the factors other than supply curve shifts to the right. This means that at each price
the good’s own price that can affect supply. They are the factors more quantity of the good (or service) is supplied. Or, if a change
that are assumed to be constant under the ceteris paribus in one of the determinants of supply causes supply to decrease
assumption. If any of the non-price determinants of supply then the supply curve shifts to the left. This implies that at each
changes, the supply curve shifts. Particularly, if a change in one price less quantity of the good (or service) is supplied.
of the determinants of supply causes supply to increase then the

13
 (a) (b)
Price per Price per
unit (P) S2 unit (P) S2
S1 S1

P P2

P1

0 Q2 Q1 Quantity per 0 Q Quantity per

period (Q) period (Q)
Figure 2.2.2 The effect on supply of an increase in wages paid
The non-price determinants of supply include the following. Goods in competitive supply: a change in the price of a
Changes in costs of factors of production good in competitive supply will also have an effect. Other
goods are likely to become more profitable if their prices
If input prices increase (for example, if the wages paid to labour
rise. For example, consider a farmer with a fixed amount of
increase or the price of a raw material used in the production
land using it to produce carrots and potatoes. If the price
of the good increases) then, ceteris paribus, supply is expected
of carrots goes up, farmers may decide to reduce potato
to decrease. So, the supply curve is expected to shift to the left.
production in order to produce more carrots. The supply of
At each price, firms will be willing to offer less, or they will be
potatoes will decrease and the supply curve will shift to the
willing to offer each unit at a higher price than before.
left from S1 to S2, as shown in Figure 2.2.4.
Figure 2.2.2 shows the effect of an increase in the wages
paid. Assume that the original supply curve is S1. Look at Price per
unit (P) S2
Figure 2.2.2a—before an increase in wages paid, firms were S1
willing to offer Q1 units per period at price P. If wages paid
increase then production costs will rise, so firms will be willing
to offer only Q2 units per period at price P. The same holds at
each price so supply decreases, shifting to the left to S2. Now
refer to Figure 2.2.2b—before an increase in wages, firms were
willing to offer Q units at price P1. After wages increase, firms
will be willing to offer Q units only at the higher price P2. The
same holds for all units so supply decreases, shifting left to S2.
Prices of related goods
Goods in joint supply: sometimes when one good is produced, 0 Quantity per
another good is also produced at the same time. These are period (Q)
said to be goods in joint supply. A farm that is producing
lambs is also producing wool. If the price of lamb meat Figure 2.2.4 The effect of an increase in the price of a good in competitive
supply
increases in the market, lamb farmers will have an incentive to
increase the quantity supplied of lambs, but at the same time Indirect taxes and subsidies
the supply of wool will increase and its supply curve will shift Changes in government policy, such as indirect taxes and
to the right from S1 to S2, as shown in Figure 2.2.3. subsidies, affect costs of production. Indirect taxes and subsidies
Price per affect the cost of producing an extra unit of a good. An indirect
unit (P) S1
tax is a payment to the government by firms per unit of output
S2
produced, whereas a subsidy is a payment to firms by the
government per unit of output produced. An indirect tax will
increase production costs and lead to a decrease in supply and
a shift of the supply curve to the left, whereas a subsidy will
decrease production costs and lead to an increase in supply and
a shift of the supply curve to the right.
Expectations of future price changes
If the price of the product is expected to rise, producers may
temporarily reduce supply now. They are likely to build up
their stocks and only release them on to the market when
0 Quantity per
the price rises in the future. At the same time they may
period (Q)
install new machines or take on more labour, so that they
Figure 2.2.3 The effect of an increase in the price of a jointly supplied good can be ready to supply more when the price has risen.

14
 Changes in technology Number of firms

UNIT 2: MICROECONOMICS
Improved technology allows firms to offer more units of the Changes in the size of the market (the number of firms)
good at the same price, increasing supply and shifting the affect supply. As more firms join a market, for example,
supply curve to the right. Improved technology decreases supply will tend to increase, shifting the supply curve to
the cost of producing each additional unit of the good. the right, since at each price more units will be offered.

Recap
Non-price determinants of supply (shift factors)
Changes in costs of factors • An increase in the costs of factors of production (such as wages, raw material prices)
of production will lead to a decrease in supply and to leftward shift of the supply curve.
Prices of related goods • If goods X and Y are in joint supply, an increase in the price of good Y will lead to
an increase in the supply of good X and to a rightward shift of the supply curve.
• If goods X and Y are in competitive supply, an increase in the price of good Y will
lead to a decrease in the supply of good X and to a leftward shift of the supply
curve.
Indirect taxes and subsidies • An indirect tax will increase costs of production, leading to a decrease in supply and
to a leftward shift of the supply curve.
• A subsidy will decrease costs of production, leading to an increase in supply and to
rightward shift of the supply curve.
Expectations of future price • If the price of the product is expected to rise, producers may reduce supply now and
changes the supply curve will shift to the left.
Changes in technology • Improved technology will lead to an increase in supply, shifting the supply curve to
the right.
Number of firms • If more firms enter a market, supply will increase, shifting the supply curve to
the right.

Movements along and shifts of the supply curve

The principle here is the same with demand curves. The Movement along the supply curve:
effect of a change in price is illustrated by a movement when the price of the good changes
along the supply curve. If any other determinant of supply Shift of the supply curve: when any of the
changes (such as costs of production, number of producers) non-price determinants of supply changes
the whole supply curve will shift. A rightward shift illustrates
an increase in supply. A leftward shift illustrates a decrease
in supply.

15
 2.3 Competitive market equilibrium
Market equilibrium
The price at which a good will be sold in a competitive other words, at P2 producers are willing and able to offer
market will be determined by the interaction between a greater quantity of the good compared to the quantity
consumers and producers (that is, by the interaction of consumers are willing and able to buy. There is excess
demand and supply). supply or, a surplus equal to line distance (hf). If at P2 more
Consider the market demand and supply shown in Figure 2.3.1. quantity is supplied than is demanded then the price cannot
What will be the price that will prevail in the market? remain at that level; it will tend to decrease. The effect of
excess supply (or, of a surplus) is to create a tendency for
Price per the price to decrease (that is, to drive the price downwards).
unit (P) S
Again, since there is a tendency for the price to change, P2
excess cannot be the price that will prevail in the market.
supply In fact, there is only one price from which there is no tendency
P2 to move away—the price where quantity demanded per period
h f
equals quantity supplied, namely P. At P there is neither excess
P e demand nor excess supply so the market “clears”. Thus, P is
the price that will prevail in the market and it is called the
excess
j demand v equilibrium price. The corresponding quantity Q is called the
P1 equilibrium quantity. The equilibrium price and quantity are
found at the point where the demand curve intersects the
D supply curve—at point e, which is the market equilibrium.
0 QS1 QD2 Q QS2 QD1 Q/period If Qd > Qs there is excess demand ➞
Figure 2.3.1 The determination of equilibrium price in a competitive market the price rises ➞ not equilibrium
If the price per unit is at P1, then quantity demanded per If Qs > Qd there is excess supply ➞
period exceeds quantity supplied as QD1 > QS1. In other the price falls ➞ not equilibrium
words, at P1 consumers are willing and able to purchase
If Qd = Qs the market clears ➞ no tendency
a greater quantity of the good compared to the quantity
for the price to change ➞ equilibrium
producers are willing and able to offer. There is excess
demand or, a shortage equal to line distance (jv). If at P1
more quantity is demanded than is supplied then the price Info
cannot remain at that level; it will tend to increase. The When a market is in equilibrium, quantity demanded
effect of excess demand (or, of a shortage) is to create a equals quantity supplied, and there is no tendency for
tendency for the price to increase (that is, to drive the price the price to change. Market equilibrium is determined
upwards). Since there is a tendency for the price to change, at the intersection of the demand and the supply curve.
P1 cannot be the price that will prevail in the market. The price in market equilibrium is the equilibrium price,
Symmetrically, if the price per unit is at P2, then quantity and the quantity is the equilibrium quantity.
supplied exceeds quantity demanded as QS2 > QD2. In

Changes in market equilibrium

Market equilibrium will remain unchanged only so long as increase in the demand for chocolate bars, assuming
the demand and supply remain unchanged. If either demand that chocolate bars are a normal good. The demand
or supply changes, a new equilibrium will be formed. curve shifts to the right from D1 to D2. At the original
equilibrium price P1, there is excess demand equal to
A change in demand line distance (hk), as quantity demanded exceeds
If one of the determinants of demand changes, then demand quantity supplied. This exerts an upward pressure on the
will either increase or decrease and in turn the demand price. As the price increases, there is a movement along
curve will shift either to the right or to the left. the supply curve from h to g, and along the new demand
Figure 2.3.2a shows the case where demand for chocolate curve (D2) from k to g. At g, the excess demand has been
bars has increased. Initially, the market is at equilibrium eliminated and the new equilibrium is established at a
point h where the equilibrium price is P1 and equilibrium higher price P2 and a higher quantity Q2 (given by the
quantity is Q1. A rise in consumer incomes leads to an intersection of D2 with S).

16
 (a) Increase in demand (b) Decrease in demand

UNIT 2: MICROECONOMICS
P/unit P/unit
S S

g h
k
P2 P1
h k g
P1 P2

D2
D1
D1 D2
0 Q1 Q2 Q/period 0 Q2 Q1 Q/period
Figure 2.3.2 The effect of a change in demand on market equilibrium
Figure 2.3.2b shows the case where demand for chocolate A decrease in supply is shown in Figure 2.3.3b say, due to
bars has decreased. Initially, the market is at equilibrium an elimination of farm subsidies. The initial equilibrium is
point h where the equilibrium price is P1 and equilibrium at point j where equilibrium price and quantity are P1 and
quantity is Q1. A decrease in the price of a substitute good, Q1. The decrease in supply is shown by a leftward shift of
such as cereal bars, has decreased demand for chocolate the supply curve from S1 to S2. At the initial price P1, there
bars. There is a leftward shift in the demand curve from D1 is excess demand, equal to line distance (kj). This causes an
to D2. At the original equilibrium price P1, there is excess upward pressure on price, which begins to increase, causing
supply equal to line distance (hk), as quantity supplied a movement along the demand curve from j to h and along
exceeds quantity demanded. This exerts a downward the new supply curve (S2) from k to h. Equilibrium is reached
pressure on price. As the price falls, there is a movement at h, where the excess demand has been eliminated, and
along the supply curve from h to g, and along the new there is a higher equilibrium price P2 and lower quantity Q2.
demand curve (D2) from k to g. At g, the excess supply has
been eliminated and the new equilibrium is established A shift in one curve leads to a movement along the
at a lower price P2, and a lower quantity Q2 (given by the other curve to the new intersection point.
intersection of D2 with S). • A shift in the demand curve leads to a movement
along the supply curve to the new intersection point.
A change in supply
• A shift in the supply curve leads to a movement along
Similarly, if one of the non-price determinants of supply the demand curve to the new intersection point.
changes, then supply will either increase or decrease and in
turn the supply curve will shift either to the right or to the left.
In Figure 2.3.3a the initial equilibrium for wheat is at j where Both demand and supply change
equilibrium price and quantity are P1 and Q1. An increase in Sometimes a number of determinants might change, causing
supply, say, due to an improvement in agricultural technology, both demand and supply to change. This might lead to a shift in
shifts the supply curve from S1 to S2. At the original equilibrium both curves. When this happens, equilibrium simply moves from
price P1, there is excess supply equal to line distance (jk), since the point where the old curves intersected to the point where
quantity supplied exceeds quantity demanded. Therefore, price the new ones intersect. In such cases, the effect on equilibrium
begins to fall, and there results a movement along the demand price and equilibrium quantity depends on how much demand
curve from j to h and along the new supply curve (S2) from k to and how much supply have changed. This can be determined
h. At h, excess supply has been eliminated and there is a lower diagrammatically according to which of the two shifts is larger.
equilibrium price, P2, but a higher equilibrium quantity, Q2
(given by the intersection of S2 and D).

(a) Increase in supply (b) Decrease in supply

P/unit P/unit S2
S1 S1
S2
h
j P2
k j
P1 k
h P1
P2

D D
0 Q1 Q2 Q/period 0 Q2 Q1 Q/period
Figure 2.3.3 The effect of a change in supply on market equilibrium

17
 The role of the price mechanism
The operation of the price mechanism, also known as the demand for kale has increased. It also creates the incentive
invisible hand (a phrase introduced by Adam Smith), allows for producers to offer more kale to the market, as it is now
markets to reach equilibrium automatically. More specifically, more profitable for them. So, as the price increases, there is an
in a competitive market, where there are very many firms “extension” along the supply curve—from h to f. At the same
producing the same product, a change in the demand or the time, some consumers will be cutting back on their purchases
supply of a product leads to a change in its price. This change of kale or even dropping out of the market. The increase in
in price acts as a signal and also creates incentives, leading price also leads to a decrease in quantity demanded. There is a
to either more or less of the good produced and thus a change “contraction” along the new demand curve—from f to j. As long
in the allocation of scarce resources. as excess demand exists in the market for kale, its price will
Consider the case where demand for a product has increased. continue to rise. A new equilibrium is reached at j when the
For example, the spreading of the health benefits and price of kale reaches P2 and the equilibrium quantity Q2. What
nutritional value of kale (a green leafy vegetable) has led effectively is happening is that the higher price of the good is
to an increase in the demand for kale in the market. This is signalling that consumers are willing to see resources diverted
shown in Figure 2.3.4. from other uses. This is just what producers do: they divert
P/unit resources (such as land, labour and capital) from uses and
S allocate them in the production of kale. A resource reallocation
takes place only as a result of the change in the price of kale.
j More generally, a rise in the demand for a good raises its price
P2 and profitability. Firms respond by increasing the amount
h
P1 f of the good offered. To do so, they divert resources from
goods with lower prices to goods that have become more
profitable. Therefore, society’s scarce resources are reallocated.
D2 Symmetrically, a fall in demand is signalled by a fall in price.
D1 This then acts as an incentive for producers to decrease the
0 Q1 Q2 Q/period amount of the good they offer to the market. The goods are now
Figure 2.3.4 Increase in demand: the market for kale less profitable to produce. Resources will again be reallocated.
Initially the market is in equilibrium at h whereby the price of As such, producers and consumers acting in their own self-
kale is at P1 per unit and quantity is at Q1 per time period interest and responding only to changes in relative prices
with some scarce resources of land, labour and capital allocated adjust their behaviour and are responsible for the new
to the production of the good. The increase in demand for outcome. It is as if an invisible hand guides their behaviour.
kale is illustrated by a rightward shift of the demand curve We have seen that prices have a signalling and incentive role
from D1 to D2. At P1, there is now excess demand for kale in a market. They also have a rationing function. If a market
equal to the line distance (hf) that puts an upward pressure is free, meaning that there is no government intervention,
on the price of kale. The increase in the price of kale emits then whoever is willing and able to pay the market-
information and thus acts as a signal to producers of kale that determined price will end up with the good.

Recap
The functions of the price mechanism
The signalling function Changes in price act as signals, communicating information to market participants.
The incentive function Changes in price create incentives, motivating market participants to respond to
the information.
The rationing function The market-determined price will guarantee that the buyers who are willing and
able to pay that price are the ones who will end up with the good.
The operation of the price mechanism moves markets to equilibrium and determines the allocation of scarce
resources between competing uses.

Market efficiency
Consumer surplus is 15 cents. The consumer surplus from consuming both units
You may be willing to pay $1.00 for a cold soft drink at the is therefore equal to 40 cents. You were willing to pay at the
beach but you find that the price is only 75 cents. You buy the most $1.90 for the two units (as much as they were worth to
drink (as it is worth more to you than the price you have to you) and you ended up paying only $1.50.
pay). We say that you enjoyed a consumer surplus of 25 cents. More generally, the consumer surplus refers to the difference
For the sake of the argument, assume that a second unit is between how much consumers are willing at the most to pay
worth 90 cents to you. You would also buy this second unit and how much they actually pay.
as it is worth more to you than the market price you have to For each Q in a demand diagram, the vertical distance to the
pay. The consumer surplus you enjoyed from the second unit curve illustrates how much that specific unit is worth, at the

18
most, to consumers. Unit Q in Figure 2.3.5 is worth P dollars additional cost of producing that extra unit. A firm would

UNIT 2: MICROECONOMICS
(or distance QH) to consumers as they would be willing to never accept anything less to be willing to offer an extra
pay P dollars at the most to buy it, not a cent more. If the unit. The minimum it would accept is the cost of producing
price was even slightly higher (say, at the level of the grey it. Later you will realize that the supply curve is nothing but
dotted line), then they would not have been willing to buy the marginal cost (MC) curve of the firm.
that last unit Q. Equivalently, unit Q’ is worth P’ to consumers
(or distance Q’F) as that is the most they would be willing P/unit S, MC
to pay to acquire it. The vertical distance to a demand curve F
P’
measures the marginal benefit (MB) enjoyed from that unit.
H
P
P/unit F

H 0 Q Q’ Q /period
P
Figure 2.3.6 Producer surplus

F So, for a firm to be willing to offer unit Q in Figure 2.3.6, the

P’
lowest price required is P dollars (or distance QH), not a cent
D, MB less. If the price was even slightly less (say at the level of the
0 Q Q’ Q/period grey dotted line), then the firm would not have been willing to
Figure 2.3.5 Consumer surplus
offer that last unit Q. It would be willing to offer fewer units per
period but not unit Q. Equivalently, for the firm to be willing to
If it happens that the price in the market is P dollars then offer unit Q’ the least payment required is P’ (or distance Q’F).
consumers will buy all units up until (at the limit) unit Q, as
each of these units is worth more to them than the market price If it so happens that the market price is P dollars per unit,
would require them to pay. They would not buy any units past then firms will be willing to offer per period all units up until
unit Q. For example, they would not buy unit Q’ as it is worth and including unit Q. They would not be willing to offer unit
P’ dollars (or distance Q’F) to them (this is as much as they Q’ as they would require more (P’ or distance Q’F) than they
would be willing to pay for it at the most) and the price (what would get from the market. It follows that the minimum firms
they would be forced to pay) is higher, at P dollars. It follows would require to be willing to offer Q units is area (0QHJ),
that Q units are worth area (0QHF) to consumers as that is the which is the sum of all vertical distances up until unit Q. Given
amount they would have been willing to pay to enjoy all these a market price of P dollars per unit, firms will actually earn
units, which is the sum of all vertical distances up until unit Q. area (0QHP) by selling Q units or the price per unit (P) times
Given a market price of P dollars, they will end up paying area the quantity offered (Q). So, producer surplus is area (JHP), the
(0QHP) to enjoy Q units, or the price per unit times the quantity difference between area (0QHP) and area (0QHJ).
consumed. Consumer surplus is therefore area (PHF), the
On a diagram, producer surplus is the area above the
difference between area (0QHF) and area (0QHP).
supply curve and below the price line for the units of
On a diagram, consumer surplus is the area below the the good produced and sold.
demand curve and above the price line for the units of
the good consumed.
Social or community surplus
Social or community surplus is defined as the sum of the
Producer surplus consumer surplus and the producer surplus. It is a measure
A firm may be willing to offer a unit of a good for $2.00. If the of welfare.
market price is $3.00 then the firm will certainly decide to offer
P/unit
that unit. We say that the firm enjoys a producer surplus equal h S
to $1.00. Assume that the firm would have been willing to offer
the next unit if the price was at least $2.20. Since the market
price is $3.00 the firm would also offer this unit, enjoying from
it a producer surplus of 80 cents. The producer surplus it enjoyed
from offering both these units is $1.80. It required at least $4.20 P e
to be willing to offer these units but it earned $6.00.
More generally, the producer surplus refers to the difference
between the minimum producers (firms) would be willing
to receive to offer some amount of the good and what they
actually receive from offering this amount. f D
For each Q in a supply diagram, the vertical distance to the 0 Q Q/period
curve illustrates the minimum a firm requires to be willing Figure 2.3.7 Social surplus
to offer that specific unit. This would be nothing but the

19
 In Figure 2.3.7, given a market price P and an equilibrium P/unit S, MC
quantity Q, consumer surplus is equal to area (heP) while
$18.00
producer surplus is area (Pef). Given the definition of social
surplus it follows that it is equal to area (feh). $14.00 A
F
J
P
Recap H
$8.00 B
Consumer the difference between how
surplus: much consumers are willing at $6.00
the most to pay and how much
they actually pay D, MB
Producer surplus: the difference between the 0 Q’ Q’’ Q Q’’’ Q/period
minimum producers (firms) Figure 2.3.8 Allocative efficiency
would be willing to receive to In Figure 2.3.8, the optimal amount of the good from
offer some amount of the good society’s point of view is Q units. Society would like to enjoy
and what they actually receive all units up until and including unit Q. For the last unit Q
from offering this amount produced, P = MC, or, more generally, marginal benefit (MB)
Social surplus: the sum of consumer and is equal to marginal cost (MC).
producer surplus It is easy to understand why. Referring to Figure 2.3.8,
society would want unit Q’ to be produced as it is worth
$18.00 to consumers, which is more than the $6.00 it would
Allocative efficiency cost firms to produce. We could say that if the market did
indeed produce that unit, society would gain a surplus of
Assume two goods: apples and oranges, and one resource,
$12.00 from unit Q’. Similarly for unit Q’’, as it is worth more
land. Determine some allocation of land, which, in turn,
($14.00) than it would cost to produce ($8.00); society
determines some amount of apples and some amount of
would gain a surplus of $6.00 from unit Q’’. The same
oranges being produced. The question that arises is: should
argument holds up until and including unit Q which is worth
one more unit (a kilogram, a ton) of apples be produced?
to consumers as much as it would cost to produce it; that is,
Consequently, should more land go to the production of
P (= MB) = MC.
apples? The answer will be yes if the following applies.
The one more unit of apples is valued more by society What about unit Q’’’? Society would not want that unit
(measured by how much society would be willing to pay, produced as this would mean that scarce resources would
the vertical distance up from that quantity (Q) towards not be properly used. Why? It is because that unit is worth
the demand curve) than what it costs society to produce to consumers less than it would cost to produce it. If unit
it; that is, more than the value of sacrificed oranges Q’’’ were produced, society would have lost surplus from its
(measured by the vertical distance up from that Q towards production equal to FH. It would have lost surplus equal to
the supply curve). area (JHF) from the production of all units QQ’’’.
Thus, more should be produced as long as the extra benefit What if only Q’’ units were produced and for some reason
to society from the increased production exceeds the extra units Q’’Q were not produced and enjoyed by society? Then
cost it entails that reflects the value of the alternatives society would have lost the surplus represented by the area
sacrificed. Output is optimal from society’s point of view (ABJ) as all units up until unit Q are worth more than they
when for the last unit, price (= MB) is equal to marginal would have cost to produce. If, by producing either less
cost. Note that in a free competitive market, market forces or more than Q units, a portion of social surplus is lost, it
themselves will lead to the optimal amount of each good follows that by producing exactly Q units per period, social
being produced and consumed and thus to an optimal surplus is maximized.
resource allocation from society’s point of view. Social
surplus (the sum of the consumer and producer surplus) is If, for the last unit produced, P (= MB) = MC, then
maximized. Allocative efficiency is achieved. allocative efficiency is achieved and social surplus is
maximized.

20
 HL

UNIT 2: MICROECONOMICS
Calculating consumer and producer surplus Identify the equilibrium price and quantity
You may be asked to calculate the consumer and producer In this case the equilibrium price is sol 5 and the equilibrium
surplus from a diagram. The following exercise will take you quantity is 4,000 kilos.
through the process. Calculate the consumer surplus
Consider Figure 2.3.9, which depicts the market for quinoa The consumer surplus is the area of the triangle below
in Peru. the demand curve and above the price line. The area of a
The price per kilo of quinoa is in sol (the Peruvian currency)
triangle is base × height . In this case the base is 4,000 kilos
and the quantity is in thousands of kilos. 2
P S and the height is sol 4. Thus:
9 4,000 × 4 = sol 8,000
8 2
7 Calculate the producer surplus
6 The producer surplus is the area of the triangle above the
supply curve and below the price line. The area of a triangle
5
base × height
4 is . In this case the base is 4,000 kilos and
2
3 the height is sol 4. Thus:
2 4,000 × 4 = sol 8,000
1 2
D In this case consumer and producer surplus are the same
0
0 1 2 3 4 5 6 7 8 9 Q(’000s) amount, but this may not necessarily be the case.

Figure 2.3.9 The market for quinoa in Peru

21
 2.4 Critique of the maximizing behaviour of
consumers and producers (HL)
HL
Rational consumer choice Utility maximization
When analysing consumer behaviour, economists work The goal of the rational consumer is to maximize utility while
with a model of rational consumer choice. The assumptions satisfying the budget constraint. That is, each consumer will
underlying rational consumer choice are explained here. choose the basket of goods and services that allows him or
Consumers decide upon the purchase of different baskets of her to reach the highest utility (satisfaction) while being on
goods and services based on their preferences. their budget (income). This is the consumer’s optimal choice.
• Preferences are considered complete: that is, the consumer Perfect information
is able to rank any two baskets of goods and services. For
Consumers have perfect information. That is to say there is
example, the consumer can state whether he or she prefers
full awareness by consumers about alternative products and
basket A to basket B or prefers basket B to basket A.
prices, which reduces uncertainty surrounding choices.
• Preferences are transitive, meaning that the consumer
According to standard economic theory, rational consumers,
makes choices that are consistent with each other. For
based on their preferences and while using all available
instance, if a consumer prefers basket A to basket B and
information, will reach a consumption choice that maximizes
basket B to basket E, then it is expected that the consumer
utility while allowing them to live within their budget
prefers basket A to basket E.
constraints. This choice is the optimal choice and this
• More is better; having more of a good is better for the behaviour has been a result of pure self-interest.
consumer.

Behavioural economics HL
Prominent behavioural economist Richard Thaler has defined showed that participants with higher-ending telephone
behavioural economics as “economics with strong injections digits valued all the houses more highly. Anchoring works
of good psychology and other social sciences” (Thaler 2015). similarly in practice. For example, the first house shown to
Behavioural economics argues that people are not the an individual by a real estate agent serves as an anchor
rational decision-makers assumed by standard economic and influences perceptions of houses presented next (as
theory. There are many deviations from the predictions of the relatively cheap or expensive). This of course is known and
standard model, indicating that consumer behaviour is much exploited by businesses.
more complex than the model supposes. • Framing refers to how options and opportunities are
presented to people, which can significantly influence
Biases their choices. Of particular importance is whether people
Behavioural economics using psychological experimentation are presented with a negative or positive frame. Consider
has identified a range of biases that affect individuals’ the following two options: (a) “If you get the flu vaccine,
decision-making, leading to choices that are not optimal. you will be less likely to get the flu” and (b) “If you do
Some of the more common biases include the rules of not get the flu vaccine, you are more likely to get the flu”.
thumb, anchoring, framing and availability. Both statements contain the same information but they
• The rules of thumb (also known as heuristics) refer to have been framed differently. People are most likely to
decision-making shortcuts, which enable individuals to prefer the option that is presented in a positive way. As
make quick decisions. Rules of thumb are usually a result another example, think of two fast food chains presenting
of common sense, practice and experience. For example, their new burger. One uses the label “91% fat free” and
a rule of thumb—often used automatically—is recognition. the other uses the label “9% fat”. Individuals will tend to
Recognition of a hotel brand involves choosing the hotel prefer the first as it frames the burger as healthier despite
with the most recognizable name. Applying such rules the fact that both burgers contain the same amount of fat.
helps to simplify economic decision-making. Nevertheless, • Availability relates information that is most recently
they can also result in poor decisions, which could available and on which people place most importance. For
have been improved if more effort had been devoted to instance, people make judgments about the likelihood of
considering the alternatives available. an event based on how easily an example, instance or case
• Anchoring takes place when people rely on a piece of comes to mind, which can then lead to erroneous decisions.
information that is not necessarily relevant as a reference It has been found that there is an increased purchase of
point when making a decision. For instance, in one earthquake insurance immediately after a major earthquake,
experiment participants were asked to write down the despite the fact that the likelihood of recurrence in the near
last three digits of their phone number multiplied by one future is low. Similarly, individuals with a greater ability to
thousand (for example, 576 = 576,000). They were then recall antidepressant advertising were found to consider that
asked to estimate the prices of different houses. Results depression is more prevalent compared to individuals with a

22
 lower recall. Or, for example, investors may judge the quality time on their smartphone but they spend too much time on

UNIT 2: MICROECONOMICS
of an investment based on information that was recently in their smartphone then they are showing signs of bounded
the news, ignoring other relevant facts. self-control. This can result in making choices that they prefer
Besides biases that influence consumers’ decision-making, not to make or decisions that they soon regret.
behavioural economists have also challenged the rational
consumer choice on other grounds, as outlined below.
Bounded selfishness
As mentioned above, the rational consumer is a maximizer
Bounded rationality driven by self-interest. The rational consumer therefore
Herbert Simon pioneered the idea of bounded rationality to behaves selfishly. However, many people in many
highlight the barriers to optimal consumer decision-making. circumstances engage in non-selfish behaviour to contribute
More specifically, bounded rationality refers to the idea to the public even if their personal welfare is reduced.
that people make choices with the restricted information,
time constraints and cognitive limitations that they face.
Imperfect information
Cognitive limitation does not mean that individuals are Rational consumer choice is based on the assumption
somehow inferior, but that even the “smartest” cannot that consumers have perfect information. Yet, in practice
necessarily make fast and accurate assessments of the consumers cannot have access to full and perfect
costs and benefits of all individual decisions. Instead of information—so their choices are not fully informed and
considering all possible options, people limit their attention therefore cannot be optimal.
to a more-or-less subjective subset of possibilities. As a result,
people may not make the optimal choice but they at least Overall, behavioural economists do not deny that rational
make a choice that will move them towards their goal. consumer choice plays a part in people’s decision-making,
but they believe that the standard model provides an
Bounded self-control incomplete picture of the factors that influence the choices
Sometimes individuals make choices that do not maximize people make. Behavioural economic analysis extends the
their utility due to lack of self-control. If people prefer not traditional model in an attempt to provide a better, more
to smoke but they smoke, if they prefer not to eat junk food realistic explanation of human decision-making.
but they eat junk food, if they prefer not to spend too much

Behavioural economics in action HL

People’s choices often end up being inconsistent with their • Restricted choice: the way in which the options are
preferences. Too often, individuals are unable to appreciate categorized and presented to the decision-maker can
what is in their own best interest. This provides the also be used by the choice architect to influence people’s
opportunity for positive intervention in the decision-making choices. Consumers can find it increasingly difficult to
process to motivate people to make choices in the individual’s make decisions when the number of options is large.
best interest. Specific aspects of this are explored below. Therefore, restricting the number of available choices may
be more likely to cause consumers to make a decision
Choice architecture resulting in a better outcome. For example, in the case of
How a particular choice is presented—the choice pensions, offering people a vast number of options can
architecture—can have a significant effect on the choice result in a low take-up rate and inappropriate decisions
made. The choice architect is the individual or organization being made. Restricted choice may therefore be better.
that is responsible for organizing the context in which • Mandated choice: this is a variation of default choice; it
people make decisions and that necessarily knows more is where people are required by law to make a decision.
about what is the consumer’s best interest. Choice For example, when people apply for important national
architecture can offer three types of choices. documents, such as a passport or driving licence, they
• Default choice: this is the option that a consumer could be required to choose whether or not they are
“selects” if he or she does nothing. Default choices are willing to donate their organs when they die.
therefore made automatically. The nature of the default
option strongly affects consumer behaviour. To encourage Nudge theory
a particular behaviour that is welfare improving, the choice Another way to influence people’s choices is through
architect can set the desired outcome as the default nudges. A nudge helps people make better choices for
choice. For example, if society would benefit from higher themselves without restricting their freedom of choice. An
rates of organ donation, then the default choice can be expert can nudge people’s choices in the direction the expert
set to everybody’s organs being donated upon death. An considers to be correct. According to Richard Thaler, “small
individual may still choose to opt out of organ donation and apparently insignificant details can have major impacts
but that would not be the default. Similarly, to encourage on people’s behaviour” (Thaler 2015).
pension scheme enrollment, workers are automatically Nudging can be used to tackle the growing obesity problem.
signed up for pensions. This is the default choice. A worker For example, sellers of goods and services can be nudged
can still opt out but that would not be the default.

23
 to display products or lists of products (for example, on a in the UK to aid with tax collection. Letters that included
menu) in a manner that induces people to buy healthier phrases such as “9 out of 10 people in your area are up to
foods. This could simply be putting fruit and vegetables in date with tax payments” were sent to those in arrears on
grocery stories at eye level. Nudging can also be used to their taxes. Tax payments from people that received the
induce environmentally friendlier behaviour. For instance, in letters went up 15%.
some places bins provided for recycled material are twice or Critics of the use of choice architecture and nudges claim
even three times bigger than bins for other waste. Having that they interfere with an individual’s freedom to choose.
less room for general waste nudges people to recycle more. However, if people are always influenced by the context in
Similarly, nudging can be used to reduce food waste. An which decisions are made, complete freedom of choice is not
experiment carried out by Green Nudge—a social enterprise really feasible. Perhaps to prevent people from being misled
with an environmental focus—showed that by reducing some intervention is required. With proper regulations it is
plate sizes in hotel restaurants by 2 inches, they were able more likely, but not necessary, that the choices people make
to reduce food waste by as much as 22% while guest are better choices.
satisfaction stayed the same. Lastly, nudging was used

Business objectives HL
Standard economic theory assumes that the goal of a enable the firm to raise prices and enjoy more profit in the
rational producer is to maximize profits: that is, to produce long term. Also, increasing market share may force rivals
that level of output that maximizes the difference between out of business, which reduces competition and increases
its total revenue and total cost (see section 2.11). However, dominance in the market.
a firm may choose to pursue a range of other goals instead
of maximizing its profits. These include the following. Satisficing
The term satisficing was introduced by Herbert Simon
Corporate social responsibility and derives from “satisfy” and “suffice”. It describes when,
Firms may depart from a strict free-market, profit-maximizing because of conflicting objectives of the various stakeholders
mode of operation and may pursue objectives that are in within a firm as well as informational limitations, a firm does
line with the interests of the wider community in which not aim at maximizing profits or revenues. Instead it only
they operate, both the local and global communities. This strives to achieve at least some pre-determined minimum
involves avoidance of activities such as pollution, the use level of profits or revenues. This means that firms aim to
of child labour or dangerous working conditions, all of achieve a satisfactory outcome.
which may create a negative image with consumers. Overall,
corporate social responsibility involves ethical ways of doing Growth
business and a sense of obligation to satisfy long-term goals Firms may also wish to maximize growth (that is, the
that include goals encompassing positive impact on the volume of output sold subject to non-negative profits).
lives of the workforce and their families as well as of society By maximizing growth the firm may be able to lower unit
at large. costs. A larger firm is also in a better position to diversify
into different markets as well as into different products.
Market share The consequence of such diversification is an overall
Market share is the percentage of total sales (by value) or lowering of associated risks. The condition to maximize
total output that a business has in a specified market. Firms the volume of output without incurring losses is that at the
often seek to increase their market share. This occurs since chosen level of output the average revenue earned should
increased market share can increase market power and may equal the average costs incurred (see section 2.11).

24
 2.5 Elasticities of demand

UNIT 2: MICROECONOMICS
Price elasticity of demand (PED)
Price elasticity of demand (PED) measures the responsiveness P/unit
of quantity demanded to a change in price.
The following formula is used to calculate PED:
Q2 − Q1
%∆Qd Q1 Q2 − Q1 P1 P2
PED = = = ×
%∆P P2 − P1 P2 − P1 Q1
P1
P1
Price and quantity demanded have an inverse relationship
that reflects the law of demand. Therefore, since PED is
the ratio of change of two variables—price and quantity
demanded, that move in opposite directions—PED is always
a negative number. However, the minus sign can be ignored D
and PED is usually treated as a positive number. Note though 0 Q2 Q1 Q/period
that the minus sign should not be ignored in calculations. Figure 2.5.2 Price inelastic demand

Degrees of PED As shown in Figure 2.5.2, when demand is price inelastic, a

change in price (from P1 to P2) leads to a proportionately
A. Demand is price elastic if PED > 1; that is, the percentage smaller change in quantity demanded (from Q1 to Q2). This
change in quantity demanded is larger than the percentage means that demand in this range is relatively unresponsive
change in price. to price changes.
P/unit
Tip: to draw a price inelastic demand curve make sure
you draw the demand curve quite steep and also far from
the origin.

P2
P1 Note that even along a linear (that is, a constant slope)
D demand curve, PED is not constant, but continuously
changes. (See the HL section on page 26.)

C. Demand is unit elastic if PED = 1; that is, the percentage

change in quantity demanded is equal to the percentage
0 Q2 Q1 Q /period change in price.
Figure 2.5.1 Price elastic demand D. Demand is perfectly elastic if PED → ∞; that is, a small
As shown in Figure 2.5.1, when demand is price elastic, a change change in price leads to an infinitely large change in
in price (from P1 to P2) leads to a proportionately greater quantity demanded.
change in quantity demanded (from Q1 to Q2). This means that E. Demand is perfectly inelastic if PED = 0; that is, a change
demand in this range is relatively responsive to price changes. in price has no effect on quantity demanded.
The following is shown in Figure 2.5.3.
Tip: to draw a price elastic demand curve make sure you • A demand curve of zero elasticity is a straight vertical line.
draw the demand curve quite flat and also far from the
origin. • A demand curve of infinite elasticity is a straight
horizontal line.
B. Demand is price inelastic if 0 < PED < 1: that is, the • A demand curve of unitary elasticity is a rectangular
percentage change in quantity demanded is smaller than hyperbola, so that the demand curve does not touch the axes.
the percentage change in price.
Note that the three cases above are exceptions and PED
is constant throughout the length of the curve.

25
 P/unit P/unit P/unit
D

PED = 0
PED –> ∞
P D
PED = 1

0 Q Q /period 0 Q/period 0 Q /period

Figure 2.5.3 Constant PED throughout the length of the curve

Recap
Price elasticity of demand (PED)
If, PED > 1 demand is price elastic so, %ΔQd > %ΔP Draw the curve flat but far from the
origin
If, 0 < PED < 1 demand is price inelastic so, %ΔQd < %ΔP Draw the curve steep but far from the
origin
If, PED = 1 demand is unit elastic so, %ΔQd = %ΔP Draw a curve that never touches either
axis
If, PED → ∞ demand is perfectly elastic so, consumers will buy Draw parallel to the Q-axis
any amount at some price
If, PED = 0 demand is perfectly inelastic so, when P changes, Draw vertical to the Q-axis
Qd doesn’t

HL
Changing PED along a straight-line a good is already quite expensive then a relatively greater
downward sloping demand curve response will be caused if it becomes more expensive or
slightly cheaper. In contrast, if a good is already cheap
Along any straight-line demand curve, PED continuously varies.
then a relatively smaller responsiveness will be induced if it
PED can be calculated as: becomes a bit more expensive or a bit cheaper.
ΔQ P1 Figure 2.5.4 shows how PED varies from infinity to zero
×
ΔP Q1 along a negatively sloped demand curve.
It follows that PED is the product of the slope of the demand
function Q = f(P) or the inverse of the slope of the demand P/unit PED –> ∞
ΔQ
curve ( )ΔP
multiplied by the original price over quantity A
PED > 1
P1
ratio( )Q1
.
The slope of a straight-line demand curve is constant but PED = 1
P1
the ratio ( )
Q1
continuously varies as we move along the P
M
demand curve.
0 < PED < 1
Hence, PED is not represented by the slope of the demand
curve. Whereas the slope is constant for a linear demand
curve, PED varies throughout its range. PED = 10
D
Demand is price elastic at high prices and low quantities, 0 Q B Q /period
and price inelastic at low prices and large quantities. This
is because as a result of the law of demand, when price Figure 2.5.4 The range of PED values
P1
increases, quantity demanded decreases so the ratio
Q1
is ( ) Refer to Figure 2.5.4.
greater at higher prices and so is PED. • As point A is approached, PED tends to infinity, while at
From a less technical viewpoint, demand is price elastic point B we see that PED is zero.
at high prices and price inelastic at low prices because • At the midpoint M of a linear demand curve, PED is
consumers will be more responsive to any price change when equal to 1.
the price is already high than when it is low. For instance, if

26
• Within line segment AM, corresponding to prices higher than Since PED varies along a demand curve how is it that we can

UNIT 2: MICROECONOMICS
P within the segment AP, demand is price elastic (PED > 1). draw a price elastic or a price inelastic demand curve? Hint:
• Within line segment MB, corresponding to prices lower think of why in the tips above it is advised that to do so one
than P within the segment PB, demand is price inelastic must draw the curves far from the origin.
(0 < PED < 1).

Determinants of PED make adjustments and use coal or cooking gas instead of
the fuel oil with its higher price.
The number and closeness of available substitutes
The more substitutes there are for a good, and the closer they
are, the more price elastic demand is expected to be. If the Recap
price of a good with many and close substitutes rises, people Determinants of PED
will easily switch to these alternatives and so there will be a
The determinants of PED are:
relatively large drop in quantity demanded. On the contrary,
if a good has few if any close substitutes, then an increase • the number and closeness of available substitutes
in price will bring about a relatively small drop in quantity • the nature of the good: for example, whether the
demanded. Note that this also depends on how broadly good is a necessity or addictive
or narrowly the good is defined (for example “soft drinks” • the proportion of income spent on the good
versus “Fanta”). The broader the definition, the fewer the
• the time period involved.
available substitutes and so the more price inelastic demand
is expected to be. Beer is not a close substitute for soft drinks
whereas Sprite is a much closer substitute for Fanta. PED and total revenue
The nature of the good Total revenue (TR) is the product of price times quantity bought.
• If a good is a necessity, quantity demanded is less TR (Q) = P × Q
responsive to a change in its price and demand is Revenues are not the same as profits, which are defined as
expected to be more price inelastic. Food products can be the difference between the revenues collected and the costs
considered necessities; as such quantity demanded is not of production. Knowledge of the PED for a product allows
very responsive to price changes. a firm to predict the effect that a price change will have on
• If a good is addictive, such as cigarettes and alcoholic its revenues.
drinks, it is more difficult to reduce consumption following Case 1: The price increases
an increase in price. Therefore, demand is expected to be
more price inelastic. When the price of a good increases, quantity demanded is
expected to decrease because of the law of demand. What
The proportion of income spent on the good will happen to a firm’s revenues following the increase in
If a small proportion of income is spent on a good then a price? The answer depends on PED.
change in price will not affect consumers’ spending behaviour. • If demand is price elastic (PED > 1), a 10% increase in
If, for example, the price of lettuce increases by 10% the typical price results in a larger than 10% decrease in quantity
consumer will decrease quantity demanded by much less demanded. The effect on total revenue of the decrease
than 10%. This is because the person’s monthly expenditure in quantity demanded is larger than the effect of the
on lettuce is a small proportion of his or her income. On the increase in price; therefore, total revenue falls.
contrary, the higher the proportion of income that is spent on
• If demand is price inelastic (0 < PED < 1), a 10% price
a good, the more price elastic demand is expected to be. For
increase leads to a smaller than 10% decrease in quantity
example, demand for laptops or cars for the typical consumer
demanded. The effect on total revenue of the increase in
is more price elastic. In contrast, demand for fresh milk for an
price is larger than the effect of the decrease in quantity
unemployed mother or a pensioner will be more price elastic
demanded; therefore, total revenue rises.
because their monthly expenditure on fresh milk represents a
greater proportion of their low monthly income. • If demand is unit elastic (PED = 1), a 10% increase in
price produces a 10% decrease in quantity demanded. The
The time period involved effect on total revenue of the increase in price is matched
It is difficult for consumers to change patterns of by the decrease in quantity demanded; therefore, total
consumption immediately. It takes time to find suitable revenue remains unchanged.
substitutes and to cut back consumption of a good following
an increase in price. Over a short period of time demand is
Case 2: The price decreases
more price inelastic but it becomes more price elastic as time When the price of a good decreases, quantity demanded
goes on, as consumers are able to make adjustments and is expected to increase because of the law of demand.
find substitutes, reducing consumption further. The longer The effect of the price decrease on a firm’s revenue again
the time period after a price change, the more price elastic depends on PED.
demand is likely to be. For instance, if the price of fuel oil • If demand is price elastic (PED > 1), a 10% price
rises, it may be difficult to use substitute fuels, such as coal fall results in a larger than 10% increase in quantity
or cooking gas. Given sufficient time, though, people will demanded. The effect on total revenue of the increase

27
 in quantity demanded is larger than the effect of the
decrease in price; therefore, total revenue increases. Recap
• If demand is price inelastic (0 < PED < 1), a 10% price If price changes and PED > 1
fall results in a smaller than 10% increase in quantity When demand is price elastic, quantity demanded changes
demanded. The effect on total revenue of the decrease in proportionately more than price and total revenue changes
price is larger than the effect of the increase in quantity in the same direction as quantity demanded.
demanded; therefore, total revenue falls.
• If P rises, Q falls proportionately more; therefore TR falls.
• If demand is unit elastic (PED = 1), a 10% increase in
• If P falls, Q rises proportionately more; therefore TR rises.
price produces a 10% decrease in quantity demanded. The
effect on total revenue of the decrease in price is matched If price changes and 0 < PED < 1
by the increase in quantity demanded; therefore, total When demand is price inelastic, quantity demanded
revenue remains unchanged. changes proportionately less than price. Thus, the change
in price has a bigger effect on total revenue than does the
P/unit (a) change in quantity demanded and total revenue changes
in the same direction as price.
• If P rises, Q falls proportionately less; therefore TR rises.
b • If P falls, Q rises proportionately less; therefore TR falls.
P2
C a
P1 The overall relationship between PED and total revenue
D is also shown in Figure 2.5.6, which shows the typical, linear,
negatively sloped demand curve. At zero quantity (point at
A B the origin), TR is zero and at a zero price (H) TR is also zero.
As price decreases (thinking of walking down the price axis)
from F to P, quantity demanded increases from 0 to Q. Since
demand for that price range is price elastic, the resulting
0 Q2 Q1 Q /period
increase in quantity demanded is proportionately greater,
so TR rises. Skipping the midpoint price P, if price continues
P/unit (b) to decrease past P all the way down to zero, quantity
demanded increases from Q to H. Since demand is now price
inelastic, the resulting increase in quantity demanded is
proportionately smaller, so TR decreases. Having established
that TR rises all the way to midpoint Q and then, right
P2 b after Q, TR decreases, it necessarily follows that at Q it is
C at a maximum. So, right below the midpoint of the linear
P1 a demand curve where PED = 1, TR is maximized.

P/unit
A B F PED –> ∞

D PED > 1
0 Q2 Q1 Q/period
Figure 2.5.5 PED and total revenue between two points
P PED = 1
Figure 2.5.5 shows the effect of an increase in price on
total revenue. Total revenue is given by the area derived by
multiplying price times quantity. In Figure 2.5.5a demand 0 < PED < 1
is price elastic between the two points.
At the original price and quantity, P1 and Q1, total PED = 0
revenue is given by the sum of areas A and B. When D
price increases to P2 and quantity decreases to Q2, total 0 Q H Q/period
revenue is given by the sum of areas A and C. Area B is TR
lost while area C is gained. Since the revenue lost (B) is
larger than the revenue gained (C), total revenue falls. In
Figure 2.5.5b, demand is price inelastic between the two
points. Following the price increase, the revenue gained
(area C) is larger than the revenue lost (area B) and so
total revenue increases.
TR
0 Q Q/period
Figure 2.5.6 PED and the shape of the TR curve

28
Importance of PED for firms and of consumption following the tax. The lower the PED, the

UNIT 2: MICROECONOMICS
government decision-making greater the tax revenues to be collected. This is because
the higher price resulting from the tax produces a smaller
Importance of PED for firms decrease in quantity demanded when demand is price
• PED permits a firm to predict the direction of change in its inelastic than when demand is price elastic. Tax revenues
revenues given a price change. For example, a firm wishing collected will be greater. This explains why governments
to increase its revenues will lower the price of a good if seeking to maximize tax revenue collection impose indirect
demand for it is thought to be price elastic and it will taxation on, for example, fuel.
increase the price if its demand is price inelastic. Consider • Governments interested in curtailing the consumption of
the case of a hairdresser. If she is thinking of increasing the certain goods often referred to as demerit goods, such as
price she charges for a haircut, her revenues will increase tobacco and alcohol, also need to have knowledge of PED.
if the demand for her services is price inelastic. Her clients Tobacco is addictive so demand is quite price inelastic.
must consider her services desirable and different from other This means that if the goal is to decrease smoking, a very
hairdressers in the area. Quantity of haircuts demanded high tax will be needed so that the monthly expenditure
will then decrease (because of the law of demand) but will on cigarettes becomes a prohibitively large proportion
decrease proportionately less so that her weekly revenues of the typical consumer’s monthly income. PED will help
will rise. If her services are considered very similar to those in determining how high the indirect tax needs to be to
offered by other hairdressers in the neighbourhood then curtail consumption by some specific target percentage.
demand for her services will be price elastic. If she increases
the price she charges for a haircut demand will fall
Recap
proportionately more as many of her clients will switch to
competitors and her weekly revenues will decrease. Importance of PED
• PED also helps firms determine the extent to which they PED is important for firms because:
can shift an indirect tax (a tax on goods and services) on • it allows them to predict the direction of change of
to the consumer. Ceteris paribus, the more price inelastic their revenues given a price change
the demand faced is, the greater the proportion of the tax
• it helps them to determine the extent to which they
that can be shifted on to the consumer in the form of a
can shift an indirect tax on to the consumer.
higher price. The idea is intuitively simple. If demand is
price inelastic it implies that consumers have few if any PED is important for governments because:
close substitutes to switch to so the increase in price will • it helps governments interested in increasing their
have a relatively small impact on quantity demanded. tax revenues to decide on which goods to impose an
Importance of PED for governments indirect tax
• Governments looking into raising tax revenues must • it allows governments to estimate the size of the
consider the PED of the goods to be taxed. Tax revenues necessary tax required to decrease consumption of
collected equal the tax imposed per unit times the level demerit goods, such as cigarettes or alcoholic drinks.

HL
PED for primary commodities versus are often a big proportion of income for many consumers,
manufactured products though. That may also explain why their demand is typically
more price elastic.
Primary commodities are goods derived directly from the use of
Therefore, given a price change, quantity demanded is
the factor of production land and include both agricultural and
generally more responsive in the case of manufactured
non-agricultural products. Agricultural products include food
products than for primary commodities.
(corn, wheat, potatoes) as well as other, non-food commodities
such as cotton. Non-agricultural commodities include products P/unit
of extraction such as minerals (copper, tin, cerium), oil and coal.
The PED for primary products is typically lower than the PED
for manufactured goods. For instance, the demand for most
food products is price inelastic because they are necessities and
do not have close substitutes. The same is true for the majority
of primary commodities. Consider lanthanum, a rare earth
P1
mineral necessary in the production of the batteries needed
for hybrid cars. Given the lack of substitutes, even if the price
of lanthanum increases, manufacturers of batteries for hybrid
cars will not have much of a choice and so they will be less D manufactured
responsive to the price increase. By contrast, the demand for
D primary
manufactured products tends to be more price elastic, because
these products usually do have substitutes as a result of the 0 Q1 Q/period
extensive product differentiation. If someone is considering Figure 2.5.7 Primary commodities versus manufactured products
a BMW she may also consider a Mercedes. If someone is For small changes around P1, demand for manufactured
planning on buying a new Dell laptop he will probably also products is more price elastic compared to demand for
consider an HP or a Mac. Expenditures on manufactured goods primary products.
29
 Calculating PED 4,000 − 12,000
1. Assume that price falls by 6% leading to an increase in 12,000
PED = = (if GDC is allowed then EXE)
quantity demanded of 9%. What is the PED? 9−3
To calculate PED enter the percentage changes into the 3
formula with their sign: –8,000 3
× PED = −0.33 (or, 0.33).
%∆Qd 6 12,000
PED =
%∆P Demand is therefore price inelastic.
9% 3. Assume that PED is –0.74 and price increases by 12%.
PED = PED = −1.5 (or, 1.5).
–6% Calculate the change in quantity demanded.
Demand is therefore price elastic.
Again, the PED formula can be used to calculate the change
2. Assume that the price increases from $3 to $9,
in quantity demanded:
causing quantity demanded to fall from 12,000 units %∆Qd
to 4,000 units. What is the PED? PED =
%∆P
To calculate PED enter the above values into the formula: ∆Q%
–0.74 = %∆Q = –0.74 × 12% = –8.88%
Q2 − Q1 12%
%∆Qd Q1 Q2 − Q1 P1 Remember the minus sign for PED in this case. Since the price
PED = = = × has increased it follows that quantity demanded will change
%∆P P2 − P1 P2 − P1 Q1
in the opposite direction because of the law of demand.
P1
Income elasticity of demand (YED)
Income elasticity of demand (YED) measures the responsiveness staple goods) are usually income inelastic. For example,
of demand to a change in income. YED provides information on demand for many food products is income inelastic.
the direction of change of demand given a change in income Demand for milk or rice or chocolate will not increase
and on the size of demand curve shifts. much following an increase in income in a market where
The formula used to calculate YED is the following: consumers earn at least an average level of income.
∆Q • If YED = 0 then demand for the good is not affected by a
%∆Qd Q1 ∆Q Y1 Q2 − Q1 Y1 change in income. Income may increase or decrease but
YED = = = × = ×
%∆Y ∆Y ∆Y Q1 Y2 − Y1 Q1 demand for the good remains the same.
Y1 • If YED = 1 then the percentage change in income is
Since YED is the ratio of the percentage changes in demand equal to the percentage change in quantity demanded: a
and income levels, it follows that if both changes are positive 5% increase in income leads to a 5% increase in quantity
(plus sign) or if both are negative (minus sign) then YED is a demanded, for example.
positive number. For example, if an increase in income leads YED values can be graphically represented by an Engel
to more of a good being demanded or a drop in income curve, which is just a graph with income on the vertical axis
leads to less being demanded, then YED is a positive number. and quantity demanded on the horizontal axis. If the curve
If one change is positive (plus sign) and the other is negative is positively sloped then YED is positive and the good is
(minus sign), then YED is a negative number. For example, normal. If the slope is negative then YED is negative and the
if an increase in income leads to a decrease in quantity good is inferior. If the curve is vertical then YED is zero. All
demanded, or a decrease in income leads to an increase three cases are shown in Figure 2.5.8.
in quantity demanded, then YED is a negative number.
Income (Y)
We can distinguish between normal and inferior goods
Negative slope
based on whether YED is positive or negative.
YED < 0
• If YED > 0 the good is a normal good since demand increases Inferior good
(decreases) as consumer income increases (decreases): both
income and demand change in the same direction.
• If YED < 0 the good is an inferior good since demand decreases
(increases) as consumer income increases (decreases): income Y2
and demand change in opposite directions.
Focusing on normal goods, we can state the following.
YED = 0
• If YED > 1 then the percentage change in quantity (income rises but
demanded is greater than the percentage change in Qd stays the same)
income. We say that demand is income elastic, as a
rise in income leads to a faster rise (a proportionately
greater increase) in demand. Luxury goods, as well as Y1
most services, are usually considered income elastic. For
example, demand for plastic surgery, spa therapy or haute
Positive slope
couture clothing is income elastic in many markets. YED > 0
• If 0 < YED < 1 then the percentage change in quantity Normal good
demanded is smaller than the percentage change in
income. We say that demand is income inelastic as a rise
0 Quantity demanded (Yd)
in income leads to a slower rise (a proportionately smaller
increase) in demand. Basic goods (everyday goods or Figure 2.5.8 YED represented by an Engel curve

30
Consider Jane and her demand for white bread. If her • YED equal to 1, draw any straight line Engel curve that

UNIT 2: MICROECONOMICS
income is initially very low and then it increases up to goes through the origin.
Y1, the quantity demanded of white bread by Jane will The proof requires manipulating the formula using simple
increase. YED is thus positive up to income Y1. As her algebra, which is beyond our scope here. These cases are
income increases more and up until income level Y2, she shown in Figure 2.5.9.
will not consume more white bread as she already consumes
a sufficient amount per week. If her income now rises past Normal goods (YED > 0)
Y2, then she may consider switching away from white bread 0 < YED < 1 YED > 1
and start consuming more nutritious and expensive whole Income inelastic demand Income elastic demand
wheat bread. Past Y2, YED is thus negative and white bread
becomes for Jane an inferior product. Typically: Typically:
It is possible to illustrate the cases of products with income farm products; food; most services; expensive
elastic and income inelastic demand as well as the case basic day-to-day goods; (luxury) goods
where YED = 1. To illustrate a product with: necessities (nail salons, cruises,
• income elastic demand, draw a straight line Engel curve (rice, spaghetti sauce, plastic surgery cars,
that cuts the vertical axis canned tuna, pencils, erasers, dishwashers, iPhones,
haircuts, napkins) sail boats)
• income inelastic demand, draw a straight line Engel curve
that cuts the horizontal axis Inferior goods (YED < 0)
Typically: used cars, lower quality clothing, lower quality food

Y Y Y

YED > 1 0 < YED < 1 YED = 1

0 Qd 0 Qd 0 Qd
Figure 2.5.9 More cases of YED represented by Engel curves

HL
Importance of YED goods with income inelastic demand such as food and fuel
faced a smaller decline in their sales compared to furniture
Importance of YED for firms
retailers, foreign travel agencies or high-end restaurants.
Firms would like to know whether demand for their product
is highly income elastic or moderately income inelastic Importance of YED for the economy
to help them better plan their investments. In periods of Economies have three sectors: the primary sector, the
economic growth, incomes in the country increase. As manufacturing sector and the services sector. As an economy
incomes increase, markets for goods with high YED will grows and incomes rise over the long term, the relative size
expand more compared to markets for goods with low YED. of the three sectors can change. Many agricultural products
Hence, if an economy is growing and incomes are increasing have a low YED once a certain threshold level of income is
fast, then firms producing highly income elastic products reached. Any further increases in income are mostly spent
may have to invest now in expanding their capacity to be on products from the manufacturing sector, for example
able to meet the increased demand. cars, appliances and furniture, which carry a higher YED.
Conversely, farmers growing, say, potatoes (that have a low Luxury items and services are considered to have an even
YED), may think of switching to kiwi fruit or to agro-tourism, higher YED so once households have attained a certain
which have a higher YED. Over the long term, farmers standard of living, further increases in discretionary income
producing agricultural products with a low YED will witness are spent mostly on vacations, spa treatments, expensive
a slower increase of their income relative to the rest of the clothing and expensive cars. In this way the relative size of
population, widening income inequality. the primary sector and later of manufacturing shrinks while
that of services expands. In the UK both the agricultural
Now consider what happens if an economy is in a recession. and the manufacturing sectors have been in relative decline
Incomes will decline. As a result, goods and services with since the 1960s. According to the UK Office for National
high YED will face a large drop in their sales, products with Statistics (ONS), currently the services sector is the largest
low YED can avoid large declines in their sales, while inferior sector in the UK, accounting for more than 75% of GDP.
goods will experience increases in sales. For example, as a Manufacturing and production contribute less than 21% of
result of the 2009 eurozone crisis incomes decreased, with GDP, and agriculture contributes less than 0.60%.
different effects on firms in various markets. Firms offering

31
 Calculating YED 2. Assume annual per capita income levels in Shanghai
1. Suppose that an increase in national income of 2.4% increase from Rmb 55,000 to Rmb 61,600 leading to an
leads to a 4.75% fall in bus journeys. Calculate the YED increase in the number of manicure appointments from
for bus journeys. 350,000 to 413,000. Calculate the YED for manicure
%∆Qd treatments.
YED =
%∆Y Enter the above values into the formula:
Enter the percentage changes into the formula remembering %∆Qd Q2 − Q1 Y1
the signs: YED = = ×
%∆Y Y2 − Y1 Q1
–4.75% 413,000 – 350,000 55,000
YED = YED = −1.98. YED =
+2.4% × YED = 1.5
61,600 – 55,000 350,000
Note that here the negative sign must be kept. It informs us Demand for this service in Shanghai is income elastic.
that bus journeys in this economy are inferior products.

32
 2.6 Elasticity of supply

UNIT 2: MICROECONOMICS
Price elasticity of supply (PES)
Price elasticity of supply (PES) measures the responsiveness B. Supply is price inelastic if 0 < PES < 1; that is, the
of quantity supplied to a change in price. percentage change in quantity supplied is smaller than
The following formula is used to calculate PES: the percentage change in price.
Q2 − Q1 S
P/unit
%∆Qs Q1 Q2 − Q1 P1
PES = = = ×
%∆P P2 − P1 P2 − P1 Q1
P1
Price and quantity supplied have a positive relationship that P2
reflects the law of supply. If price increases then quantity
supplied increases and vice versa. Therefore, since PES is the ratio
of change of two variables—price and quantity supplied, that P1
move in the same direction—PES is always a positive number.

Degrees of PES
PES ranges in value from zero to infinity.
A. Supply is price elastic if PES > 1; that is, the percentage
change in quantity supplied is larger than the percentage 0 Q1 Q2 Q/period
change in price.
Figure 2.6.2 Price inelastic supply
P/unit
As shown in Figure 2.6.2, when supply is price inelastic, a
S change in price (from P1 to P2) leads to a proportionately
smaller change in quantity supplied (from Q1 to Q2). This
P2 means that supply in this range is relatively unresponsive to
price changes.
P1
A price inelastic supply curve must cut the horizontal axis.

C. Supply is unit elastic if PES = 1; that is, the percentage

change in quantity supplied is equal to the percentage
change in price.
D. Supply is perfectly elastic if PES -> ∞; that is, a small
0 Q1 Q2 Q/period change in price leads to an infinitely large change in
Figure 2.6.1 Price elastic supply quantity supplied.
As shown in Figure 2.6.1, when supply is price elastic, a change E. Supply is perfectly inelastic if PES = 0; that is, a change
in price (from P1 to P2) leads to a proportionately greater in price leads to no change in quantity supplied.
change in quantity supplied (from Q1 to Q2). This means that The following is shown in Figure 2.6.3.
supply in this range is relatively responsive to price changes.
• A supply curve of unitary elasticity passes through the origin.
A price elastic supply curve must cut the vertical axis. • A supply curve of infinite elasticity is a straight horizontal line.
• A supply curve of zero elasticity is a straight vertical line.

P/unit P/unit P/unit S

S
S1

S2 P S
PES –> ∞ PES = 0

PES = 1

0 Qs 0 Qs 0 Q Qs
Figure 2.6.3 Constant PES throughout the length of the curve

33
 Recap
Price elasticity of supply (PES)
If, PES > 1 supply is price elastic so, %ΔQs > %ΔP The curve must “cut” the vertical axis
If, 0 < PES < 1 supply is price inelastic so, %ΔQs < %ΔP The curve must “cut” the horizontal axis
If, PES = 1 supply is unit elastic so, %ΔQs = %ΔP The curve must go through the origin (any slope)
If, PES → ∞ supply is perfectly so, a small change in price Draw the curve parallel to the Q-axis
elastic leads to an infinitely large
change in quantity supplied.
Effectively, it shows that the
firm is willing to offer any
amount at the current price.
If, PES = 0 supply is perfectly so, when price changes, Draw the curve vertical to the Q-axis
inelastic quantity supplied does not.

Determinants of PES inelastic (0 < PES < 1). Producers can only marginally respond
The time period involved to changes in price. If demand increases there will be both an
increase in quantity supplied and an increase in price, yet the
Time in economics is distinguished into the momentary run,
effect on price will be proportionately greater.
the short run and the long run.
P/unit
P/unit S

S
P2
P2 P1

P1
D2 D2
D1
D1
0 Q1 Q2 Q/period
0 Q Q/period
Figure 2.6.6 PES in the long run
Figure 2.6.4 PES in the momentary run
In the long run, all factors of production are considered
In the momentary run (market period) all factors of production
variable by the firm; all adjustments are possible. The firm can
are considered fixed; firms can thus make no adjustments. As a
change both capital and labour (that is, it can change its scale
result, supply is perfectly inelastic (PES = 0). Producers cannot
of operations). As a result, supply is price elastic (PES > 1).
respond to any change in price. If demand increases, quantity
Producers can fully respond to changes in price and the firm is
supplied remains the same and only price increases.
able to increase in size. If demand increases there will be both
S an increase in quantity supplied and an increase in price, yet
P/unit
the effect on quantity supplied will be proportionately greater.
Therefore, over time, supply tends to become more price
elastic as firms can make more and more adjustments.
S1 S2
P2 P/unit
S3
P1
S4

D2 P S5
D1
0 Q1 Q2 Q/period
Figure 2.6.5 PES in the short run
In the short run, at least one factor of production is considered
fixed. For example, the capital employed by the firm is fixed but
0 Q Qs
it can change the number of workers or the hours they work.
Figure 2.6.7 PES over time
Thus, some adjustments are possible. As a result, supply is price

34
The mobility of factors of production usually characterized by long time lags. For instance, grapes

UNIT 2: MICROECONOMICS
The mobility of labour is relevant. If, for example, labour is and apples are agricultural products. It takes a long time
occupationally or geographically immobile then it will be more for farmers to plant seedlings and for the crops to mature
difficult to meet an increase in the demand for a product than and be harvested. This means that an increase in price can
if labour is mobile between occupations or between regions. only bring about a very insignificant output response. The
same applies to the oil and the copper industries, which
The extent to which spare (excess) capacity exists are extractive industries. It takes a long time to bring new
When a firm is operating at full capacity, it is very difficult copper mines into production and it takes a long time to
to increase output. Supply is price inelastic. A firm is able find and bring a new oil field into production. Supply is
though to increase output if it does have available spare therefore price inelastic.
capacity. For example, a factory that has machines that
The speed by which costs rise as output increases
are idle will easily be able to increase output if there is an
increase in price. The greater the extent of spare capacity The higher the additional (marginal) costs of producing
available, the more responsive quantity supplied will be to additional output, the more difficult it will be for firms to
an increase in price. Supply is more price elastic. increase output following an increase in price, so the more
price inelastic supply will be. For example, heavy mining
The need for skilled as opposed to unskilled labour equipment used in the extraction industry is extremely
In an economy there are more unskilled than skilled workers. expensive. For a mining company it is very difficult to
It is easier for firms that use unskilled labour to find and hire expand output given the additional cost of acquiring such
more workers in order to increase output. Supply of the product equipment.
is more price elastic. When specialized labour is needed, a firm
may not be able to find and employ more labour as quickly so
supply is more price inelastic. For example, it will be easier for Recap
a food delivery firm to hire more workers than it will be for a Determinants of PES
mental institution to find more doctors; the former does not PES is determined by:
require specialized labour, in contrast to the latter.
• the time period
The ability to store the product
• the mobility of factors of production
Quantity supplied can easily be increased when the firm is
• the extent to which spare (excess) capacity exists
able to hold stocks of the product. Goods can be released
onto the market very quickly; therefore supply is more price • the need for skilled as opposed to unskilled labour
elastic. For example, firms can maintain stocks of plastic • the ability to store the product
flowers but not of fresh flowers. • the time lags that characterize the production process
The time lags that characterize the production • the speed by which costs rise as output increases.
process
The longer the time lags, the longer it takes for producers
to respond to price increases. Primary sector products are

HL
PES for primary commodities versus products as opposed to manufactured goods. In the case
manufactured products of agriculture, farmers need at least a planting season to
be able to respond to higher prices. In the case of other
Overall, primary commodities usually have a lower PES
primary products, such as oil, natural gas and minerals, time
compared to manufactured products. This is due to the
is needed to make the necessary investments for extraction
long time lags that characterize the production of primary
and to begin production.

Calculating PES PES for foot massage services Singapore is 2, which means
1. Calculate the PES for foot massage services in Singapore that supply is price elastic.
if the number of appointments offered per week 2. If PES for wax candles is estimated at 1.4 and there is an
increases from 2,140 to 2,568 when the market price 8% increase in price, calculate the response in quantity
increases from S$50 to S$55 per appointment. supplied.
Enter the values into the formula: Enter the values into the formula:
%∆Qs
Q2 − Q1 PES =
%∆P
%∆Qs Q1 Q2 − Q1 P1 ∆Qs%
PES = = = × 1.4 = ∆Q = 11.20%.
%∆P P2 − P1 P2 − P1 Q1 8%
P1 Quantity supplied for wax candles will increase by 11.20%.
2,568 – 2,140 50
PES = × PES = 2
55 – 50 2,140

35
 2.7 Role of governments in microeconomics

Government intervention in markets

Governments intervene in markets for various reasons, which St
include to: P/unit
• support certain producers, usually farmers
S
• support low income households ensuring that basic goods
and services services, such as food and housing, are Pc a
affordable
1 2 3
• influence the level of output in a market P e
4 5 6
• influence the level of consumption of the good or service
Pp b
• correct market failures (that is, cases where market forces
fail to reach the socially efficient outcome)
• promote equity.
D
Indirect taxation
0 Q’ Q Q/period
What are indirect taxes?
Indirect taxes are taxes on goods or services, or on Figure 2.7.1 Impact of an indirect tax: market for sugar-sweetened
beverages
expenditures. They are distinguished into unit (specific)
taxes and ad valorem taxes. Unit taxes are a fixed “dollar” The indirect tax will shift the supply curve vertically upwards
amount per unit of the good (for example, $4.00 per pack of by the amount of the tax to St. As a result, the market price
cigarettes). Ad valorem taxes are a percentage on the price consumers pay increases to Pc and the equilibrium quantity
of a good (for example, the 15% GST in New Zealand). decreases to Q'. Producers now earn per beverage Pp, which
is the price consumers pay minus the tax (ab).
Why do governments impose indirect taxes?
The tax revenues the government collects are equal to the
Indirect taxes are imposed to:
tax per unit (ab) times the new equilibrium quantity Q'. This
• collect tax revenues needed to finance government is area (PpbaPc) or area (1 + 2 + 4 + 5).
expenditures
The proportion of the tax paid by consumers is equal to
• decrease the consumption of demerit goods such as PPc
tobacco, alcohol and sugar that harm not only the (PcPp ) .
individual consumer but also society at large It is referred to as the incidence of the tax to consumers.
• decrease production processes that generate pollution, or It follows that the incidence of the tax to producers is
PPp
decrease the use of fossil fuels
(PcPp ) .
• decrease imports in certain industries and thus help
Note that the above analysis is the same if the tax is an ad
domestic producers and workers.
valorem tax (except that St is steeper than S).
Analysing indirect taxes using a diagram Consequences for stakeholders
An indirect tax is considered an additional cost of production • Consumers are worse off as they pay a higher price
and, as a result, it decreases supply, shifting the supply (Pc > P) and enjoy less of the good (Q' < Q). Consumer
curve left or, better yet, vertically upwards by the amount surplus decreases by area (1 + 2 + 3). Of course, if the
of the tax. If the tax is a specific tax the shift is parallel to product taxed is a demerit good then, at least in the long
the original supply curve. If the tax is an ad valorem tax, the term, the lower level of consumption and the resulting
new supply curve is steeper because the “dollar” amount of health benefits make them better off, despite the higher
the tax, and so the vertical distance between the two supply price. Note that indirect taxes are considered unfair as
curves, is bigger at higher prices. they are regressive with respect to consumers’ income.
Impact on market outcomes If two individuals purchase the same good, the “dollar”
In the market for sugar-sweetened beverages, shown in amount of the tax is the same for both, but it represents a
Figure 2.7.1, demand D and supply S lead to a market price higher proportion of the income of the poorer individual.
P and an equilibrium quantity Q. This explains why basic goods (basic food products or
heating oil) in many countries are typically not subject to
tax (see Chapter 3, section 3.4).

36
• Producers are worse off as they earn less per unit Why do government grant subsidies to firms?

UNIT 2: MICROECONOMICS
(Pp < P) and sell fewer units (Q' < Q). The revenues they • To increase revenues of particular producers: typically
collect decrease from area (0QeP) to area (0Q'bPp). Producer these are farmers, as demand for most farm products
surplus decreases by area (4 + 5 + 6). Since less of the good is income inelastic. As an economy grows and average
will be produced and sold, workers may be laid off so they incomes increase, farmers’ incomes grow more slowly. By
will be adversely affected. Also, if the good taxed is used as increasing farmers’ income, rural–urban income inequality
an input for the production of other goods then production decreases and so does rural–urban migration. Agricultural
costs will increase, forcing firms to raise price and suffer a subsidies are also considered to promote food self-
decrease in their sales and in employment levels. sufficiency. In addition, they decrease the price of food,
• The government collects tax revenues equal to which is very important for low income households and
area (1 + 2 + 4 + 5) that may be spent on infrastructure, improves nutrition among the poor.
education, health care services and so on, so this cannot • To decrease the price of certain goods or services so
be considered a loss to society. that they become more affordable to low income
• Consumers and producers together lose surplus equal to households. Beyond basic food products, gasoline, public
area (1 + 2 + 3 + 4 + 5 + 6) but since the government transportation and rent are also sometimes subsidized.
collects tax revenues equal to area (1 + 2 + 4 + 5), • To help certain industries grow: for example, subsidies are
the resulting welfare loss is equal to area (3 + 6). This granted to promote the adoption of green technologies
represents net value lost by society from units Q'Q not (solar, wind, hydro and geothermal) by firms. Subsidies
being produced as a result of the indirect tax, even though to the solar panel industry in the USA, China and other
they should have been from society’s point of view. countries are responsible for its growth over the past years.
• Note though that there is no welfare loss if the indirect Aircraft manufacturers, such as Airbus, have been accused
tax was imposed on demerit goods or on industries that of receiving government subsidies.
generate pollution because a lower level of production and • To increase consumption of merit goods such as education
consumption in both cases is considered socially optimal. and health care services: consumption of these services
What does the incidence of an indirect tax not only benefits the individual consumer but also society
depend on? at large.
An indirect tax typically burdens both consumers and producers. • To protect domestic firms from import penetration, or
This may sound counterintuitive but often producers are forced to assist them in increasing export competitiveness,
to lower the pre-tax price charged in order to avoid a significant governments may grant subsidies.
loss of sales as a result of the tax. In general, the incidence of Analysing subsidies using a diagram
an indirect tax depends on both PED and PES. If demand is
A subsidy decreases production costs of firms and, as a
more price inelastic than supply, then the incidence is greater
result, increases supply. This shifts the supply curve to the
on consumers as they pay a greater proportion of the tax. If
right or, better yet, vertically downwards by the amount of
supply is more price inelastic than demand, then the incidence
the subsidy. The shift is parallel to the original supply curve.
on producers is greater. The following relationship applies,
which is very helpful in determining tax incidence: Impact on market outcomes
% of tax incidence on consumers PES In the market for rice shown in Figure 2.7.2, demand D and
= supply S lead to a market price P and an equilibrium quantity Q.
% of tax incidence on producers PED
The sum of the two percentages is of course 100% since P/unit S
if, for example, the incidence on consumers is 80%, then Ss
the incidence on producers must be 20%. Inspecting this
relationship, it becomes clear that firms will be able to shift Pp a
onto consumers 100% of an indirect tax if either demand is 1 2
perfectly price inelastic (vertical) or supply is perfectly elastic P e 6
(horizontal). If it happens that PES = PED then an indirect 3 4 5
tax will be split 50%–50%. Carefully constructed diagrams Pc b
will illustrate the above.

Subsidies
What are subsidies? D
A subsidy is a payment by the government to firms that aims
to decrease their production costs and so price and to increase 0 Q Q’ Q/period
production and consumption of the good. For example, in Figure 2.7.2 Impact of a subsidy: market for rice
Malaysia since 1980, rice farmers receive a pre-determined
The rice subsidy will shift the supply curve vertically downwards
amount of Malaysian ringgit for each ton of rice harvested.
by the amount of the subsidy to Ss. As a result, the market price
In 2018 governments around the world were paying an
consumers pay for rice decreases to Pc and the equilibrium
estimated US$35 billion in subsidies to their fishing fleets
quantity produced and consumed increases to Q'. Rice
(mostly on fuel subsidies) to decrease their cost of inputs.

37
 producers now earn per unit of rice sold Pp which is the price have to tax more now, borrow more now and tax later
buyers pay plus the subsidy (ab) paid by the government. or cut back now on another government programme.
The cost of the subsidy to the government is equal to the Financing a subsidy therefore involves an opportunity cost
subsidy paid per unit (ab) times the new equilibrium quantity for society.
Q'. This is area (PcbaPp) or area (1 + 2 + 3 + 4 + 5 + 6). • Since a subsidy makes both consumers and producers better
Consequences for stakeholders off and together they enjoy an increase in surplus equal
to area (1 + 2 + 3 + 4 + 5) it seems that social welfare
• Consumers are better off as they pay a lower price (Pc < P)
increases and so resource allocation improves. This is
and enjoy more of the good (Q' > Q). Consumer surplus
typically not the case. In addition, we have to consider the
also increases by area (3 + 4 + 5).
cost of the subsidy to the government, which is equal to
• Producers are also better off as they earn more per unit area (1 + 2 + 3 + 4 + 5 + 6), and thus greater. A welfare
(Pp > P) and sell more units (Q' > Q). Revenues collected loss equal to area (6) results, which represents net value lost
increase from area (0QeP) to area (0Q'aPp). Producer by society from units QQ' now being produced even though,
surplus increases by area (1 + 2). Since more of the good from society’s point of view, they should not have been.
is produced and sold, more workers will be employed.
• Note though that there is no welfare loss involved if the
Also, if the subsidized product is used as an input for the
subsidy was granted to increase consumption of merit
production of other goods then production costs would
goods or use of pollution-abating technologies. More
decrease permitting producers also to lower price and
generally, the welfare effects of a subsidy have to be
increase output and employment levels.
judged by weighing the expected benefits for society of
• The government must finance the cost of this subsidy, the policy subsidized against its cost (that is, the value of
which is equal to area (1 + 2 + 3 + 4 + 5 + 6), so it will what society will have to sacrifice to finance it).

Recap
Impact of indirect taxes and subsidies on stakeholders
Impact of an indirect tax on stakeholders Impact of a subsidy on stakeholders
• Consumers pay a higher price and enjoy less of the • Consumers pay a lower price and enjoy more of the
good. good.
• Consumer surplus decreases. • Consumer surplus increases.
• Firms earn less per unit and sell fewer units so • Firms earn more per unit and sell more units so
revenues collected decrease. revenues collected increase.
• Producer surplus decreases. • Producer surplus increases.
• Government collects tax revenues that may be spent • The government must finance the cost of the subsidy
on infrastructure, education, health care and so on. so it may have to increase taxation now, borrow now
• A welfare loss results unless the good taxed is a and tax later or cut back on another government
demerit good or its production generates pollution. programme.
• A welfare loss results unless the subsidized good is
a merit good or its production generates significant
benefits for society.

Policymakers’ perspective to impose a high tax if the goal is truly to curtail

consumption and not just to raise tax revenue.
Imposing indirect taxes is necessary for the reasons
However, high taxation raises the possibility of
explained above but their regressive nature must always be
smuggling and of parallel markets arising as there is
recognized by policymakers. They may be easier to collect
room for making a profit. Whether such phenomena are
than income taxes but by disproportionately hurting the
observed is a function of the size of the penalties and
poor they may lead to increased income inequality.
the degree to which the laws are enforced. In the case of
Indirect taxes must definitely be considered as a tool polluting activities such as driving, flying or production
to decrease polluting production processes as well as processes that use fossil fuels as energy, a government
the consumption of tobacco, alcohol and even perhaps must be prepared to face popular resentment if it
sugar-sweetened beverages. Governments, in the case of decides to impose indirect taxes to curb their use.
tobacco, alcohol and other goods that are addictive in Few want to pay more for driving or flying or for their
nature and so rather price inelastic, must be prepared monthly electricity bill.

38
 UNIT 2: MICROECONOMICS
Subsidies benefit both consumers and producers so are of political pressure. However, if they manage to
far easier for a government to grant instead of imposing slow down rural–urban migration and permit the
taxes. There are several valid reasons, all based on sound government to build in the meantime more schools,
economics, for the granting of a subsidy but subsidies hospitals, roads and other infrastructure then society at
are often also captured by special interest groups that large may benefit in ways not initially realized. On the
represent powerful industries and confer benefits only to other hand, if a government decides to subsidize the
their members. domestic fishing industry in order to feed its population
Whether a subsidy is granted or not should depend on and to ensure jobs for workers in coastal regions then,
weighing all the benefits and all the costs for society. from a national perspective, these subsidies may perhaps
Sometimes it is difficult for us to judge whether a be sensible. If the framework of analysis is global,
subsidy is necessary because we may not have all the though, fishing subsidies are harmful and should stop
necessary information, especially if the benefits are because they deplete world fisheries and the resulting
mostly realized in the long term. For example, farm global social costs exceed any national social benefits.
subsidies are typically considered wasteful and a result

Often, governments consider the market-determined price of P/unit

a product unsatisfactory: that is, either too high or too low. z S

In these cases, the government intervenes and sets the price

of the good either below or above the market price.
1 2 e
Price ceilings (maximum prices) Pe
4
3
What are price ceilings (maximum prices)? P’
a b Maximum price
5
A price ceiling (maximum price) is a form of price control
that a government can impose in a market if it considers the h D
market-determined price is too high. Price ceilings act as the 0 Qs Qe Qd Q/period
highest possible price that can be charged for a good and
Figure 2.7.3 The impact of imposing a price ceiling: rent control
so they are set below the market equilibrium price. In this
way the government restricts the price to the desired level Consequences of rent controls
and therefore protects consumers, especially low income Rent controls render housing more affordable and may
households, against prohibitively high prices. thus prevent the displacement of low income residents
Why do governments impose price ceilings and decrease the prevalence of homelessness. However,
(maximum prices)? the resulting shortage means that not all tenants who are
willing and able to pay P’ will find rental housing units.
Price ceilings can be imposed on basic goods, usually on
This creates further problems.
food products, such as milk or bread, but also on gasoline
and heating fuel. For instance, up until the late 1980s the • Non-price rationing mechanisms: once a shortage
French government had set a price ceiling in the market for arises the price is no longer able to perform its rationing
the baguette, which did not allow bakeries to sell baguettes function and alternative rationing mechanisms are
above the legal maximum price. In many cities around the developed.
world, authorities have also imposed rent controls in the rental ° Allocation may be on a “first come, first served” basis.
housing market. Rent controls are examples of price ceilings This may lead to real estate agencies adopting waiting
that prevent landlords from renting their properties above the lists for tenants wanting to secure rented housing.
legal maximum rent. For example, in the USA in 2019 Oregon  
° Landlords may decide, according to their own
and California approved statewide rent controls, and New York preferences, to whom they will rent their property
strengthened its existing rent regulations. Price ceilings (for example, to households without a pet or
therefore aim to make certain basic goods and services without young children). There is also a high risk of
cheaper and so more affordable to low income consumers. discrimination based on ethnic background or religion.
Analysing the impact of rent controls • Emergence of parallel markets: landlords may demand
using a diagram “under-the-table” payments in addition to the legal
In the rental housing market in Portland, Oregon, USA, maximum rent, or demand high deposits paid in advance.
shown in Figure 2.7.1, the equilibrium rental price is Pe and The result is that higher income individuals will manage to
Qe is the equilibrium quantity. The rent control (P’) is set get rented housing and not the poor, who are the people
below the market determined rental price (Pe) and acts as intended to benefit from rent controls.
the maximum rental price landlords can legally charge. At P’ • In the long-term additional problems may arise.
the housing units now offered by landlords are fewer than
° Quality of housing may worsen, as landlords who are
the housing units tenants are willing and able to rent (that now earning less will not have the incentive to restore
is, Qs < Qd). A shortage of housing units results, equal to the or maintain their rental units properly.
line distance (QsQd or ab).

39
 ° The number of rental housing units available may Imposing a price ceiling in the market for
further shrink, making shortages more severe, as a basic good
landlords may switch the use of their properties. For A price ceiling in the market for a basic food product or in
example, landlords may switch to short-term rentals the market for fuel can be analysed in the same way with
through Airbnb or other similar platforms. rent controls. Using Figure 2.7.1, the price ceiling would be
Welfare effects: Who gains and who loses set at P', below the market determined price (Pe) and would
be the maximum price sellers could legally charge. As a
Before the imposition of the rent control the consumer result, the quantity of the good demanded would exceed the
surplus is equal to area (1 + 2) and the producer surplus is quantity of the good supplied (Qd > Qs) and so a shortage
equal to area (3 + 4 + 5). Social surplus is therefore equal of the good equal to line distance (QsQd or ab) would result.
to area (1 + 2 + 3 + 4 + 5). When the rent control, P', is Similar consequences will apply.
imposed the quantity of rental units is now only Qs. The
Price ceilings on basic products, such as bread, make these
result is as follows.
staples cheaper and more affordable for low income groups.
• The consumer surplus is equal to area (1 + 3). Some tenants However, the price P' cannot perform its rationing function
lucky enough to find housing at the lower rent are better anymore since individuals may be willing and able to pay
off—but these are not necessarily the poorer households. the price but it is not certain that they will end up with the
Some tenants are worse off. These are tenants who would good, as a shortage exists.
have been able to find housing if the market was free but
• Rationing can be on the basis of “first come, first served”,
now, as a result of the shortage, are unable to. Tenants who
which may lead to queues developing outside grocery
are discriminated against or who end up paying significantly
stores, bakeries and gas stations as people rush to buy the
more because of the shortage are also worse off.
good before there is none left.
• The producer surplus shrinks to area 5. Landlords are
• Firms may decide which customers should be allowed to
worse off, unless they rent at an illegal higher rate where
buy goods; they may prefer to sell to regular customers,
of course they run the risk of being caught. Often, many
attractive customers or important customers.
are forced to leave the market (for example, by selling
their property) or they may be forced to witness a long- • There may be random allocation of supplies by ballot.
term deterioration of the value of their property if they • The government may adopt a system of rationing: people
cannot afford maintenance. could be issued with a set number of coupons for each
• Social surplus after the rent control is equal to area item. For example, this may take place in wartime.
(1 + 2 + 5). This means that social surplus decreased by area • It is likely that illegal markets will develop where some
(4 + 5), which represents the welfare loss to society; now there sellers will sell at prices above the legal maximum,
is allocative inefficiency in the market for rented housing. depending on the willingness to pay and, of course, the
income of buyers.
Policymakers' perspective • Quality may worsen as producers may use lower quality
inputs in an attempt to increase their profit margin. For
Rent controls have many negative side effects. instance, bakers may use lower quality flour.
However, the rising rents in many cities around the
world may make it necessary to impose rent controls. • If other non-price-controlled goods may be produced with
A major factor responsible for the rising rents has the same inputs, then the quantity offered may further
been gentrification. Gentrification is a process of shrink, making shortages more severe. For example, bakers
reviving deteriorated urban neighbourhoods, usually may choose to sell cookies instead of bread.
as a result of an influx of more, typically affluent, Price floors (minimum prices)
residents. Demand for housing then increases. House
prices and rents surge and as this process continues, What are price floors (minimum prices)?
lower income households are often displaced. In A price floor (minimum price) is a form of price control that
fact, in many major cities there is an increase in a government can impose in a market if it considers the
homelessness. Homelessness is a phenomenon that market determined price is too low. Price floors act as the
not only impacts negatively on the destitute but also lowest possible price that can be charged for a good and are
on society at large. Therefore, some form of perhaps set above the market equilibrium price. The government’s
temporary rent controls may feature in a policy goal is to protect certain groups of producers.
package that aims to eradicate this phenomenon. Why do governments impose price floors
However, care has to be taken to ensure that there (minimum prices)?
are incentives for the supply of housing to increase in
the long term. For example, perhaps the rent controls Governments impose price floors in order to prevent the
should not apply to newer housing units but only to market price from falling below a certain level. Price floors
units that are older. are typically encountered in agricultural product markets.
In India the government has set a price floor on several
agricultural products including wheat, soybeans, paddy and
cotton. The reasons behind agricultural price floors may
include the following.

40
• Fluctuations of prices and so fluctuation in farmers’ Impact on stakeholders: Who gains and

UNIT 2: MICROECONOMICS
incomes can be a problem. The supply of agricultural who loses
products is affected by weather conditions; for instance, • Producers and more specifically farmers are better off
droughts or floods can reduce supply. Changes in supply as their incomes are stabilized and increased. In fact,
result in price volatility that leads to unstable incomes for producers’ revenue increases from area (PeQe0) to area
farmers. (P'bQs0). The producer surplus increases from areas
• The agricultural sector’s share of national income (4 + 5) to areas (2 + 3 + 4 + 5 + 6).
may be decreasing. As economies grow, the demand • Buyers pay more than they would otherwise and enjoy
for agricultural products grows but more slowly, less of the good. Consumers are therefore worse off.
as the income elasticity of demand for most farm The consumer surplus decreases from areas (1 + 2 + 3)
products is rather low. Therefore, over time, farmers’ to area (1). If the price-controlled product is used as an
incomes decrease relatively to incomes earned in the input in manufacturing, then production costs for these
manufacturing and service sectors. manufacturing firms will be higher. This may lead to
• The government could be aiming to protect employment higher prices in their goods. For example, a minimum price
in rural areas. Price floors support agricultural production on corn in Mexico may lead to a higher price for tortillas.
and this may prevent local farmers from moving into • The government is forced to spend heavily to purchase the
the cities (urbanization). With a price floor imposed, surplus. Specifically, the government must spend
employment in rural areas will be preserved and cities (P' × ab); that is, the product of the promised price floor
will experience less pressure on their infrastructure (roads, times the amount of the surplus that is equal to area
sewage, transport systems, schools and so on). (QdabQs). This implies that there is an opportunity cost
Analysing the impact of a price floor using involved as financing this government expenditure will
a diagram require imposing new taxes now, or borrowing more
In the market for soybeans in India, shown in Figure 2.7.2, now and imposing higher taxes later or cutting back
the market determined price is Pe and respective quantity is expenditures on some other government project (for
Qe. The price floor (P') is set above the equilibrium price (Pe). example, not building some schools).
At P', producers offer Qs units of the good while consumers • The shaded area represents the welfare loss to society
are willing and able to purchase Qd units. A surplus equal to caused by the overproduction of the good and in turn the
line distance QdQs or ab results. In order for the price floor misallocation of resources; too much land is allocated to
to be maintained (not to collapse), the Indian government the production of one particular farm product. There is
must buy the surplus at the promised price (that is, at P'). allocative inefficiency.
This artificially increases demand to D + government purchases.

P/unit Policymakers’ perspective

z S Despite the inefficiency, the waste and the additional
1 a b Minimum price
government expenditures required by such a policy, it
P’ is not safe to argue that such policies should never be
2 3 6 implemented. Policymakers must weigh the costs of
Pe e a minimum price policy with the expected benefits. If
5
4 D + government the expected benefits for society are greater than the
purchases expected costs then such a policy should be adopted.
For example, if by imposing a minimum price, farmers’
h D incomes remain at an acceptable level and as a result
0 Qd Qe Qs Q /period a rural–urban wave of migration slows down then, at
least temporarily, it may prove beneficial to society
Figure 2.7.4 The impact of imposing a price floor at large. Also, such support may be necessary as a
What does the government do with the surplus? means to alleviate rural poverty, which may also be
The government may: important for maintaining a country’s social fabric.
• store the surplus and release the stock into the market in
a subsequent period to avoid the price rising too much Imposing a price floor in the labour market
if there is a crop failure—but storage involves additional Price floors are also found in labour markets in the form of
costs for the government a minimum wage. In Luxembourg the minimum wage in
• destroy the surplus, which has been the case in many 2020 is at 11.97€ per hour, in Greece at 3.94€ per hour and
countries and which is simply a terrible waste in Brazil at about $1.80 per hour. The reason for setting a
• sell the surplus abroad in other markets usually at a price minimum wage is to guarantee a socially acceptable level
below average cost (a practice known as dumping), which of income to unskilled workers. In Figure 2.7.3, the vertical
may disrupt trade relations, as local farmers will suffer axis measures the money wage rate (W) per worker and the
from the lower price. horizontal axis depicts the number of workers (L).

41
 Wage S(L) only L1 workers. The excess supply (surplus) of labour L1L2
rate (W) (or hf) represents unemployment.
h f Minimum
W’
wage A minimum wage policy will benefit some workers:
those who will end up with a job at W' instead of We. It
will typically, but not necessarily, create unemployment
We
(L1L2) though, and will especially hurt the workers who
would have had a job without this policy but are now left
without one, namely individuals L1Le. It may not increase
D(L)
unemployment if firms are able to keep money wages
below the competitive level.
0 L1 Le L2 Number of
workers (L)
Policymakers’ perspective
Figure 2.7.5 Minimum wage policy
If the minimum wage is not exorbitantly high then
Firms demand labour to produce the goods and services they unemployment may not necessarily increase. Empirical
produce. It is negatively sloped, as at higher wage rates firms evidence has shown that increases, modest at least,
will try to substitute capital for labour. Workers offer their in the minimum wage have not resulted in higher
labour services to the labour market. The supply of labour is unemployment. One reason for this outcome is that
upward sloping as at higher wage rates the opportunity cost the increase in costs caused by the minimum wage
of leisure increases (it becomes more expensive for someone is small relative to most firms' overall costs and
to be outside the labour market) so more individuals will only modest relative to the wages paid to low wage
substitute work for leisure. workers. On top, evidence suggests that employment
If the labour market is competitive then the equilibrium increases faster when there is an increase in the
wage rate will be at We with Le individuals employed. If the minimum wage. Increased pay adds money to
government now considers that the market determined wage workers’ income and allows them to buy more goods
rate (We) is too low and decides to set a minimum wage and services, creating higher demand, which in turn
at W', then firms at W' will want to hire fewer individuals requires hiring more workers. Hence, the minimum
than the number of individuals willing to offer their labour wage may have little or no discernible effect on the
services. At the higher wage rate W' that the government employment prospects of low wage workers.
sets, L2 individuals are looking for a job while firms will hire

Recap
Price ceilings (maximum prices) Price floors (minimum prices)
Aim to protect vulnerable consumers Aim to protect vulnerable producers,
typically farmers
Price is set below market-determined price Price is set above market-determined price
Results in • a shortage Results in • a surplus
• non-price rationing mechanisms • the government being forced
• the emergence of parallel markets to buy the resulting surplus
• worse quality and wider • burdening taxpayers by
shortages in the long term the cost of the policy or
in sacrifice of some other
government project
Impact on some are better off, others are Impact on they are worse off
consumers worse off consumers
Impact on sellers they are worse off Impact on sellers they are better off
Impact on welfare inefficiency and welfare loss Impact on welfare inefficiency and welfare loss
Examples rent controls, food price controls Examples agricultural price supports,
minimum wage

42
 2.8 Market failure—externalities and

UNIT 2: MICROECONOMICS
common pool or common access resources
Free markets: successes and failures
The fundamental economic problem that all societies face achieved, as just the right amount of the good from society’s
is scarcity: limited resources versus unlimited wants. This point of view is produced and consumed, scarce resources
necessitates choices about which goods to produce and in are optimally allocated and social surplus is maximized.
what quantities. How will scarce resources be allocated? In the real world however the necessary conditions to arrive
In a market economy, the answer is given by the market at the socially efficient outcome are seldom present. Markets
mechanism. The interaction of demand and supply, with often do not work to the best interest of society and lead
consumers aiming to maximize utility and firms trying to to either too much or too little of the good produced and
maximize profits, determines how much of each good will be consumed. When this happens, resources are misallocated,
produced and consumed. If markets are free and competitive social surplus is not maximum and so the market fails. One
then the outcome is socially efficient. Allocative efficiency is such circumstance is the case of externalities.

Externalities
An externality is present if an economic activity (production production process. This means that they include not just
or consumption) imposes costs on, or creates benefits for, the labour and other resources that are sacrificed, the
third parties for which they do not get compensated, or do costs of which are taken into consideration by the firm,
not pay for, respectively. Equivalently, an externality exists but also include any external costs that are not taken into
whenever there is a divergence between private and social consideration by firms in the form of, say, pollution. In this
costs of production or between private and social benefits case the MSC of production exceed the MPC and should
of consumption. Externalities are also referred to as spillover be drawn above the MPC (the supply) curve. This would be
effects. the case with a negative production externality. If, though,
An externality leads to a market failure as either more or less a production process creates benefits for a third party (say,
than the socially optimal amount is produced or consumed. another firm or the whole economy) then the MSC curve lies
Market forces alone fail to lead to an efficient resource below the MPC (the supply) curve as there is an external
allocation. production benefit involved in the process.
Externalities may arise in the production process, where they Marginal private benefits (MPB)
are known as production externalities, or in the consumption Marginal private benefits are defined as the additional
process, in which case they are known as consumption benefits individuals enjoy from the consumption of an
externalities. If they impose costs on third parties they additional unit of a good. The willingness of consumers to
are considered negative externalities. In contrast, if they pay for an additional unit is determined by the additional
generate benefits they are considered positive externalities. benefits enjoyed from consuming that additional unit. The
demand curve always thus reflects the MPB enjoyed from
Externalities consuming additional units of a good.
Marginal social benefits (MSB)
Production Consumption These are the benefits that society enjoys from each
additional unit consumed. Marginal social benefits include
the private benefits enjoyed by the individual consumers
Negative Positive Negative Positive
but in addition any benefits third parties may enjoy as a
result (external benefits). It follows that the MSB curve lies
Relevant terms and definitions above the MPB (the demand) curve. If, though, individuals’
Marginal private costs (MPC) consumption imposes a cost on others then the MSC curve
will lie below the MPB (the demand) curve, as there is an
Marginal private costs are defined as the additional costs
external cost of consumption generated by the process.
a firm incurs from producing an additional unit of a good.
They include wages, costs of raw materials and other costs The Four Types of Externalities and
that a firm takes into consideration in its decision-making
regarding production. It follows that the supply curve always
Their Impact
reflects the MPC of a firm. A. Negative Production Externality
Marginal social costs (MSC) Heavy industry and power-plants in many countries use
fossil fuels (coal, oil, natural gas) in their production
These are defined as the costs of producing an additional
process. But the burning of fossil fuels releases several
unit of a good that are borne by society. They reflect the
greenhouse gases that contribute to global warming
value of all resources that are sacrificed in the specific

43
 and climate change and lead to rising sea waters, B. Negative Consumption Externality
extreme weather conditions (droughts and wildfires, When people consume alcohol there is always the risk of
floods, hurricanes), crop failures, health problems, the increased violence, of drunk driving, of lower productivity
extinction of species and other costs. Demand, which at work and other negative effects. These are all external
always reflects the marginal private benefit of buyers, is costs of drinking. The supply of alcohol always reflects the
identical to marginal social benefits as no external effects MPC of liquor producers. The MPC are identical to the MSC
in consumption are assumed. Supply reflects the marginal as no external effects in the production process itself are
private costs of such firms (that is, the costs they pay, such assumed. Demand for alcohol reflects the MPB of those who
as for wages, energy and materials). Since the production consume the product. Since consumption of alcohol often
process entails external costs in the form of pollution, it creates external costs, it follows that the social benefits of
follows that society sacrifices more than such firms take alcohol consumption are lower than the private benefits
into consideration. Society sacrifices environmental assets that individuals enjoy when deciding whether to consume
because of the pollution. The marginal social costs are alcohol or not. The MSB of alcoholic beverages are therefore
therefore bigger than the marginal private costs by the less by the amount of the external costs created given by
amount of the external costs created given by the vertical the vertical distance (ab) in the figure below and so the MSB
distance (ab) in the figure below and so the MSC curve lies curve lies below the D, MPB curve.
above the S, MPC curve.
P/unit
S, MPC = MSC
Tip
There is no shift involved as the two curves, MPC and welfare
MSC, reflect different information. loss
f
Pm external cost
MSC e of alcohol
P/unit a MSB = MSC a consumption
f S, MSC h
external D, MPB
e
MSB = MSC cost of
pollution b
b MSB
Pm h 0 Qs* Qm Q/period
welfare
The market for alcoholic drinks: a case of negative consumption externality
loss
Focusing on the figure above, the supply curve of alcohol
reflects the MPC as well as the MSC of producing alcohol
D, MPB = MSB since no externality is assumed in the production of alcohol.
The market equilibrium is determined at the intersection
0 Qs* Qm Q/period
of the market demand and the market supply so Qm units
Market for steel: a case of negative production externality of alcohol will be produced and consumed at a market
determined price Pm.
Focusing on the figure above, the demand curve reflects
both the MPB and the MSB since no externality is assumed The socially optimal level of alcohol consumption and
in consumption. The market outcome is determined at the production though is less at Qs*. Why at Qs*? Because
intersection of market demand and market supply leading to for the last unit Qs*, the MSB is equal to the MSC. Note
Qm units of steel produced at a market price of Pm. that for all units up to Qs*, the additional benefits society
enjoys (MSB) from alcohol consumption exceed the
The socially optimal level of output though is less at Qs*.
additional costs society incurs (MSC), so all these units
Why at Qs*? Because for the last unit Qs*, the MSB is
should be produced and consumed. On the other hand,
equal to the MSC. Note that for all units up to Qs*, the
past unit Qs*, the marginal costs incurred by society (MSC)
additional benefits society enjoys (MSB) from the steel
are greater than the marginal benefits enjoyed by society
produced exceed the additional costs society incurs (MSC),
(MSB). It follows that units Qs*Qm should not have been
so all these units should be produced. On the other hand,
consumed from society’s point of view, but they are. There is
past unit Qs*, the marginal costs incurred by society (MSC)
overconsumption and overprovision of alcohol, which is the
are greater than the marginal benefits enjoyed by society
market failure in this case. The shaded area (efh) represents
(MSB). It follows that units Qs*Qm should not have been
the welfare loss as a result of the market failure. This welfare
produced from society’s point of view, but they are. There is
loss reflects the net ‘dollar’ value lost by society from the
overproduction of steel, which is the market failure in this
consumption of units Qs*Qm. The market fails. Market forces
case. The shaded area (efh) represents the welfare loss as
lead to too much alcohol consumed at too low a price.
a result of the market failure. This welfare loss reflects the
net ‘dollar’ value lost by society from the production of units
Qs*Qm. The market fails. Market forces lead to too much
steel produced at too low of a price.

44
 determined at the intersection of market demand and

UNIT 2: MICROECONOMICS
Demerit goods market supply so that Qm apples will be produced at a
Demerit goods are a special class of goods that are market price of Pm.
defined as goods that governments would like to The socially optimal level of apple production though is
limit consumption of because individuals may not be more at Qs*. Why at Qs*? Because for the last unit Qs*,
aware of the costs arising from the consumption of the MSB is equal to the MSC. For all units past unit Qm up
such goods. This is a result of myopic behaviour and until and including unit Qs*, the marginal benefits enjoyed
so the state takes a paternalistic role. Alternatively, by society exceed the marginal costs incurred by society,
demerit goods can be defined in terms of externalities so units QmQs* should have been produced from society’s
generated. If the consumption of a good creates very point of view but they are not. The market leads to an
significant negative externalities, then the product underproduction of apples, which is the market failure in
is referred to as a demerit good. Alcoholic drinks, this case. The shaded area (efh) represents the welfare loss
tobacco products and even sugary drinks can all be as a result of the market failure. This welfare loss reflects
considered good examples since individual consumers the net ‘dollar’ value lost by society from units Qm Qs* not
do not take into consideration the costs that arise being produced by the market even though they should
from consuming such products while significant have been from society’s point of view. The market fails.
external costs arise. Analysis of demerit goods can Market forces lead to fewer apples being produced than the
thus be conducted within the negative consumption socially optimal.
externality framework. A most significant example of positive production
externalities relates to the production of infrastructure.
C. Positive Production Externality Infrastructure investments, like the construction of a road
The production of certain goods may generate positive network or of an airport, generate massive benefits not
externalities. The classic example of such a case was given only for the users of the road network or the airport but
by James Meade in his 1952 paper ‘External Economies and for all society, as infrastructure permits faster growth. This
Diseconomies in a Competitive Situation’. Imagine a region explains why it is the state that typically finances such
containing some apple orchards and some beekeeping. The investments. Firms in the private sector would not be able
beekeepers benefit from the apple farmers’ trees as their to charge for all the benefits generated and thus less than
bees feed on the apple blossom. But the apple farmers are the socially optimal level of infrastructure investment would
not rewarded for the benefit they provide to the beekeepers. result. The significance of infrastructure becomes painfully
Demand, which always reflects the MPB is identical to clear when examining many developing countries where
MSB as no external effects in the consumption of apples it is either insufficient or crumbling. Another significant
are assumed. Supply of apples reflects the MPC of apple example of positive production externalities relates to R&D
farmers. Yet, given the external benefits that arise from activities. When the outcome of a successful R&D project is
the production of apples, the social costs of apple growing such that it cannot be patented by a firm then the private
are lower than the private costs. Thus, the MSC of apple sector will not be willing to get involved. Thus, R&D in
production are less than the MPC incurred by apple farmers basic science is also typically undertaken in state research
by the amount of the external benefit, illustrated by the agencies and universities or by government funded
vertical distance (ab) in the figure below. The MSC curve research institutions.
thus lies below the S, MPC curve. D. Positive Consumption Externality
P/unit S, MPC If a student visits a doctor and gets vaccinated against
a
the flu it is not only the student who benefits but also her
MSC classmates, teachers and others. Individuals wearing a
mask during the covid-19 pandemic did not only protect
e external themselves but also others. Focusing on vaccines, the
Pm supply of vaccines always reflects the MPC of producers of
b benefit of
production vaccines (pharmaceutical corporations). They are identical
MSB = MSC h to MSC as no external effects in the production process
welfare of vaccines are assumed. Demand for vaccines reflects the
f loss MPB of those who are vaccinated. Since their vaccination
creates external benefits to others in the form of a lower
D, MPB = MSB probability that those others will get sick, it follows that
the social benefits of vaccine consumption are greater than
0 Qm Qs* Q/period the private benefits that individuals take into account in
Market for apples: a case of positive production externality deciding whether to have a vaccination or not. The MSB
of vaccines are therefore greater than the MPB by the
Focusing on the figure above, the demand curve amount of the external benefit created given by the vertical
reflects both the MPB and the MSB since no externality distance (ab) in the figure below and so the MSB curve lies
is assumed in consumption. The market outcome is above the D, MPB curve.

45
 P/unit S, MPC = MSC Summary Table

h Demand Supply
welfare
loss Demand always reflects the Supply always reflects the
e MPB enjoyed by consumers: MPC paid by firms: when
MSB = MSC external when drawing the demand drawing the supply curve
a benefits of curve instead of simply instead of simply labelling it
Pm f consumption labelling it D, label it ‘D, MPB’. S, label it ‘S, MPC’.
If there is no externality If there is no externality in
in consumption then the production then the costs
MSB benefits enjoyed by society imposed on society are not
b are not any different from any different from the costs
D, MPB
the benefits enjoyed by the paid by the firms producing
0 Qm Qs* Q/period individuals consuming the the good, so label the
Market for vaccines: a case of positive consumption externality good, so label the demand supply curve ‘S, MPC=MSC’.
Focusing on the figure above, the supply curve reflects the curve ‘D, MPB=MSB’.
MPC as well as the MSC of producing vaccines since no If, though, there is an If, though, there is an
externality is assumed in the production process. The market externality in consumption externality in production
equilibrium is determined at the intersection of the market then one of two cases then one of two cases
demand and the market supply so that Qm vaccines will be applies: applies:
produced and consumed at a market price Pm. i. If there is an external cost i. If there is an external
The socially optimal level of consumption though is more in the consumption of cost in the production
at Qs*. Why at Qs*? Because for the last unit Qs*, the the good then the MSB of a good then the MSC
MSB is equal to the MSC. Units QmQs* should have been curve lies below the D, curve lies above the S,
consumed from society’s point of view but they are not. For MPB curve (negative MPC curve (negative
all units past unit Qm up until and including unit Qs*, the consumption externality). production externality).
marginal benefits enjoyed by society exceed the marginal External costs arise in External costs arise in
costs incurred by society. The market therefore leads to an the market for alcoholic production processes
underconsumption of vaccines, which is the market failure in drinks, tobacco and sugar- that use fossil fuels and
this case. The shaded area (efh) represents the welfare loss sweetened beverages. pollute.
as a result of the market failure. This welfare loss reflects ii. If there is an external ii. If there is an external
the net ‘dollar’ value lost by society from units Qm Qs* not benefit in the benefit in the production
being consumed even though they should have been from consumption of the of a good then the MSC
society’s point of view. The market fails. Market forces lead good then the MSB curve lies below the S,
to fewer vaccines being consumed than the socially optimal. curve lies above the D, MPC curve (positive
MPB curve (positive production externality).
Merit goods consumption externality). External benefits arise
Merit goods are a special class of goods that are External benefits arise in the production of
defined as goods that the government would like in the market for flu infrastructure and of
all members of society to consume in adequate vaccinations and more basic science R&D.
quantities independently of their income or even generally in health care
their preferences. Individuals may not be aware of the and education services.
benefits arising from the consumption of such goods
because of myopic behaviour. This is why education is
compulsory in many countries up to at least a certain
level. Note the paternalistic role of the state in this
case. Alternatively, merit goods can be defined in terms
of externalities generated. If the consumption of a
good creates very significant positive externalities then
it is referred to as a merit good. Education and health
care are prime examples. Analysis of merit goods can
thus be conducted within the positive consumption
externality framework.

46
Government intervention in response to externalities

UNIT 2: MICROECONOMICS
Dealing with Negative Production Nevertheless, determining the appropriate tax on every
Externalities individual product that causes environmental damage can
be a difficult task. Estimating the tax amount in monetary
– Indirect (Pigovian) taxes terms requires research and analysis. If the production
The pioneering work recommending government intervention of some goods causes relatively minimal environmental
in the case of polluting firms is attributed to Cambridge damages, then the small amount of taxes collected may
economist A.C. Pigou (1920) when he proposed the not be worth the costs of estimating the correct amount
imposition of an indirect tax equal to the size of the external of tax. Also, there are administrative costs involved in
cost generated by the firm. The indirect tax would in principle imposing and collecting the tax. If a product does not
internalize the externality in the sense that it would force cause much environmental damage, then these costs
the firm to take it into consideration. The tax would raise the might outweigh the revenues collected. In addition,
firm’s production costs (MPC) to the level of the social costs even if the tax leads to the optimal rate of output Qs*,
(MSC) associated with the production process. This would the size of the total level of pollution generated by the
induce the firm to limit output to the socially optimal level. activity (which is equal to the area between the MSC and
The principle underlying this solution is referred to as the the MPC curves for output up to Qs*) is dependent on
‘polluter pays principle’ and all taxes that force polluters to the PED for the good. If demand is very price inelastic,
pay for the pollution they generate are referred to as Pigovian the total pollution generated may be still unacceptably
taxes. The figure below illustrates the effect of imposing a high given all other pollution-generating activities in the
Pigovian tax on polluting firms in the steel industry. economy. Moreover, the demand for any good reflects the
St = (MPC + tax) preferences only of the present generation and ignores
P/unit future generations, which will be hardest hit by polluting
f
S, MPC activities. Another issue is that the effects of polluting
activities extend beyond national borders but Pigovian
taxation does not.
P* Therefore, instead of imposing Pigovian taxes on final consumer
products, economists generally recommend applying Pigovian
h taxes as far upstream in the production process as possible. An
Pm upstream tax is imposed at the level of raw production inputs.
This is the case of carbon taxes analysed below.
– Carbon taxes
A carbon tax is a Pigovian tax levied on carbon-based fossil
fuels in proportion to the amount of carbon dioxide emitted
D, MPB = MSB during production and use. Such a tax raises the price of
carbon-based energy sources such as oil, coal and natural
Qs* Qm Q/period
gas and so provides incentives to users to conserve energy
Market for steel: effect of a Pigovian tax as it would reduce their tax burden. At the same time, users
The government estimates the size of the pollution (external) thus are induced to switch to sources of energy that produce
costs that firms create and imposes an indirect tax equal to lower carbon emissions and are thus taxed at lower rates. As
that amount which is given by the vertical distance (fh) in the a result, the external costs of production decrease and the
figure above. Steel manufacturers now have to pay the tax in socially optimal level of output increases. The figure below
addition to their manufacturing costs. Thus, the new supply illustrates the effect of the imposition of a carbon tax in the
curve with the tax has shifted to the level of the MSC curve. electricity industry.
The market will adjust to the Pigovian tax by moving to a new P/unit
equilibrium, with a higher price of P* for steel and a lower MSC 1
quantity Qs*. The tax has resulted in the optimal level of steel MSC 2
production. In other words, steel is produced only to the point S, MPC
where the marginal social benefits are equal to the marginal
social costs. Also, note that even though the tax was levied on MSB = MSC1
producers, a portion of the tax is passed on to buyers in the MSB = MSC2
form of a price increase for steel (from Pm to P*). This causes
Pm
buyers to cut back their purchases from Qm to Qs*.
A gasoline tax is an example of a Pigovian tax. It raises the
driver's cost to cover the negative externalities created by
driving automobiles. In the United States, the federal gas D, MPB = MSB
tax was $0.183 per gallon in 2019.The average state gas tax
was $0.2868 per gallon. The revenue goes into the federal 0 Q*s1 Q*s2 Qm Q/period
Highway Trust Fund to pay for roadway maintenance. Other Market for electricity: effect of a carbon tax
examples of Pigovian taxes on products include the tax often
imposed on pesticides and on chemical fertilizers.

47
 The external costs of production decrease as a result of saved permits have an incentive to lower their level of
the lower use of carbon-based fuels and so the MSC curve pollution; on the other hand, firms that find it cheaper to
shifts from MSC1 to MSC2. The fall in external costs allows buy additional permits in the open market than to lower
the socially optimal level of output to increase from Q*s1 their level of pollution have an incentive to buy permits.
to Q*s2 which is closer to the market outcome Qm. The Thus, a new allocation of permits results but pollution will
decreased vertical distance between MPC and MSC2 implies have decreased by those firms that can do it cost effectively
that the size of the required carbon tax on the cleaner (lower i.e. with the least cost.
carbon content) fuel is lower. In 2005, the EU launched the European Union Emissions
A carbon tax has been in place since 2008 in British Trading Scheme (EU ETS), which operates in 31 countries
Columbia, Canada. The tax is equal to 30 Canadian dollars and is the largest emissions trading system in the world. It
per ton of carbon dioxide and affects an estimated 77% limits emissions from more than 11,000 heavy energy-using
of British Columbia’s total greenhouse gas emissions. All installations (power stations and industrial plants) as well
revenue generated through this carbon tax programme is as airlines operating between these countries, and it covers
returned to British Columbians through rebates or cuts in around 45 percent of the EU’s greenhouse gas emissions.
other taxes. After four years in effect, British Columbia’s per Emissions in the EU were reduced by 22% between 1990
capita consumption of fuels subject to the tax was found to and 2015 and according to the European Environment
have declined by 19% compared to the rest of Canada. Agency (EEA) the decrease was mostly driven by emissions
Governments however may be reluctant to set carbon taxes reductions in power generation.
high enough as they hurt businesses. In addition, in many Although tradable permits in theory bring pollution down
cases the carbon tax placed on power-generating firms has to the desired level, they may under certain circumstances
led to higher energy bills for households which increase the actually lead to an increase in the level of emissions. If costs
cost of living and hurt even more lower income families. of reducing emissions fall drastically for some firms (those
Yet, in Canada to help protect low-income households using newer technology), the permit price will fall, allowing
from the resulting higher prices, the government through plants with older technology to cheaply purchase more
the Low Income Climate Action Tax Credit programme permits and actually increase emissions. Surprisingly, better
provides residents with lump sum tax credits. The carbon tax pollution control technology can lead to more pollution by
revenue collected is often divided equally among the whole some firms. Nevertheless, this can be avoided by reducing
population so lower income households receive rebates in the total number of permits issued.
excess of the carbon taxes they had paid. Also, governments – Direct regulation
can redirect the revenue from carbon taxes to lower other Governments can also address the issue of negative
taxes. A carbon tax can be matched, for example, with a cut production externalities by resorting to direct regulation.
in income or social security taxes. In addition, the higher Governments can directly regulate the level of output of
cost of energy may also create a powerful incentive for polluting firms, the prices they charge, where they may or
energy-saving technological innovations and stimulate new may not locate as well as the type of machines, filters and
markets. fuel they can use.
– Tradable pollution permits (‘cap and trade’ For example, the International Maritime Organization (IMO)
schemes) has recently decreased substantially the limit for sulphur in
Besides taxation another government response involves fuel oil on board ships. This regulation will result in a more
tradable pollution permits also known as cap and trade than 75% decrease in sulphur oxide emissions from ships and
schemes, whereby each emitting firm is allocated a specific will thus have major health and environmental benefits for the
permissible level of greenhouse gas emissions. More world, especially for people living close to ports and coasts.
specifically, the government sets the desired national goal of Regulations are usually easier to design and implement
emissions and issues the permits accordingly. For example, compared to Pigovian taxation or tradable permits. In many
if greenhouse gas emissions for a particular country are cases they are considered a realistic, certain and cost-effective
currently 40 million tons and the policy goal is to reduce solution. Still, monitoring adherence by the authorities
this by 10 percent (4 million tons), then permits would be requires allocating a significant amount of resources that
issued to emit only 36 million tons. The cap (and, hence, range from manpower to specialized instruments.
the number of permits) is reduced over time so that total
– Increasing awareness and education
emissions will fall. The permits can initially be allocated for
free on the basis of past emissions or can be auctioned to This is a different set of solutions whereby the government
the highest bidders. Firms are then able to trade permits attempts to change the preferences and practices of
freely among them in the open market. The price of a permit consumers and of firms by increasing their awareness of the
is determined through market demand and supply forces as external costs of certain activities they undertake. By making
a simple demand for permits and (vertical) supply of permits school children aware of the benefits of recycling today the
diagram can illustrate. government aims at creating citizens who will make better
choices about such issues in future. When polluting firms are
Firms that can lower their pollution and save permits at a
exposed, the bad publicity they receive may force them to
cost that is less than what they can earn by selling their
alter their practices.

48
 The specific tax fh will decrease supply to St. As a result, the

UNIT 2: MICROECONOMICS
Policymakers’ perspective market price of sugary drinks will increase to P*. The higher
price will lead to a decrease in the quantity consumed to
The most appropriate pollution control policy depends Qs*, the socially optimal level of consumption.
upon the circumstances. While economists generally
Several issues arise with such a solution. Again, the
prefer market-based solutions such as Pigovian taxation
optimal tax is difficult to determine. Let’s take the
and tradable permits there are situations when these
examples of drinking and smoking. Alcohol and tobacco
policies might not be the best choice especially if
are addictive, so demand is quite price inelastic. This
pollution is localized and not dispersed.
means that if the goal is to curtail smoking then a very
With direct regulation and tradable permits, the high tax on cigarettes will be needed. The reason is
government can set a cap on total emissions. With that with a very high tax, the monthly expenditure on
taxation, the resulting pollution level will be unknown cigarettes will represent a large proportion of the monthly
in advance as it depends on how firms and even final income for many households thus deterring consumption.
consumers will adjust their behavior to the resulting Remember that price elasticity of demand also depends
increased prices. Thus, if the policy objective is to keep on the proportion of income spent on the good. The
pollution levels below a predetermined level with impact of even a high tax on higher income individuals
certainty, regulations or a ‘cap and trade’ scheme may will be minimal but studies point that the prevalence of
be the best options. On the other hand, if encouraging smoking decreases with higher levels of income and the
innovation in cleaner technologies is the objective, a level of education.
Pigovian tax may be preferable. Still, enacting pollution
On the other hand, in the case of alcohol, a tax aiming
taxes can be politically difficult as new taxes are typically
at decreasing heavy drinking is considered rather
unpopular. In theory, a pollution tax can be revenue-
ineffective. The reason is that there are very many
neutral if the revenues from the tax are offset by lowering
different types (whisky, vodka, wine, white cider etc.) and
other taxes—but this may or may not occur in practice.
for each type there are very many different brands and
Tradable permit systems on the other hand tend to be
qualities that differ dramatically in price. Thus, if, say,
more politically popular, especially if firms believe they
20% tax is imposed on alcoholic drinks then a ‘chain
can lobby policymakers to receive free permits.
of substitutions’ may start with many poorer addicted
individuals just switching to lower priced and lower
Dealing with Negative Consumption quality alcoholic substitutes so that overall consumption
Externalities (Demerit Goods) decreases very little.
Many consumers may also seek to buy the good in a
– Indirect taxation
black market where no tax is paid to the government.
In the case of a negative consumption externality the goal Consumption may therefore not decrease as expected
is to reduce the consumption of the good generating the and, even worse, health-related problems may result if
external costs. Indirect taxes are one option. In most countries the products are of a lower or dubious quality while the
around the world there are taxes on tobacco products. government earns less in tax revenue. Tax hikes on tobacco
Recently, taxes have also been placed on sugary drinks and products that successive governments in Greece have
perhaps a tax on red meat may soon follow. More specifically, implemented have contributed to a loss of tax revenues as
a sugar tax is in place in the UK since 2018. Officially called many smokers switched to parallel markets.
the Soft Drinks Industry Levy (SDIL), the tax puts a charge of
Lastly, keep in mind that indirect taxes are regressive. Thus,
24p on drinks containing 8g of sugar per 100ml and 18p a
low-income consumers will be burdened proportionately more.
litre on those with 5–8g of sugar per 100ml.
An indirect tax equal to the external costs of consumption will – Legislation and regulation
decrease supply and so increase the price of the good. The Often governments regulate consumption of demerit
higher price will induce a lower level of consumption. If the size goods and the behaviour of those who consume them.
of the tax is correct, the socially optimal level of consumption This may involve a ban just like has happened with
may be achieved. The figure below illustrates the case. smoking which has been banned from public spaces
in many countries. Or, it may involve legal age limits
P/unit St
whereby a minimum age at which a person can legally
consume a good is set.
f S, MPC = MSC
Another approach to reduce consumption of
P*
certain demerit goods is packaging warnings where
manufacturers are forced by law to include health
Pm warnings on their products. This has been applied to
both tobacco products and alcoholic beverages. Recently,
MSB = MSC h packaging requirements for tobacco products have
increased. Australia was the first country to introduce
D, MPB the plain packaging law, which refers to packaging
MSB that requires the removal of all branding, allowing
Qs* Qm Q/period
Market for sugary beverages: the impact of an indirect tax

49
 manufacturers to print only the brand name in a
standardized font in addition to the health warnings. All Policymakers’ perspective
these laws and regulations aim to reduce demand and
shift it closer to MSB. Decreasing negative consumption externalities related
to drinking or smoking is a complex issue that requires
– Minimum unit price a multidimensional response. No single policy initiative
In the case of alcohol, a price floor may also be used to is considered sufficient to reduce consumption of these
decrease consumption. Given that there are many types of goods. Any success that has been achieved cannot be
alcohol and very many different brands, the minimum price attributed to any one policy.
imposed is analytically different from a minimum price on a Higher prices, either as a result of indirect taxes or as a
farm product like corn and thus a simple demand and supply result of some form of minimum price, are credited with
diagram cannot be used. significant success and policymakers agree that price
More specifically, the Scottish government was first to signals are important to lower alcohol and tobacco use.
set a minimum price on a ‘unit of alcohol’ at 50p. The Of course, higher prices are more effective in decreasing
unit of alcohol was defined as 10ml of pure alcohol. For the consumption of lower income households which
each alcoholic beverage, the number of units of alcohol seems unfair but at the same time it is the poor who are
contained is determined and thus the minimum price at often more at risk especially from heavy drinking, so if the
which it can be sold is the number of units contained policy is successful then, in the long term, they will reap
times 50p. This means that stronger alcoholic drinks that the benefits of better health.
contain more units of alcohol become more expensive Regulations, being direct, have a more certain effect
and since a ‘chain of substitutions’ cannot occur, their than higher prices which are favored in several settings.
consumption will decrease. Heavy drinkers will be forced Banning tobacco use in public places to protect the
to quit or to switch to alcoholic drinks with less alcohol health of non-smokers and prohibiting the sale of tobacco
content that will be cheaper. Studies published in the BMJ and alcohol to minors are more successful policy choices
have found that introduction of minimum unit pricing than taxation, since higher prices would not necessarily
appears to have been successful in reducing consumption be sufficient to protect non-smokers or minors. It is thus
of alcohol in Scotland especially in lower income generally agreed that a wide range of interventions
households and the purchase of cheap, high-strength is required. Higher prices, regulations and nudges are
alcohol. all important and should be used in a complementary
– Increasing awareness and education fashion. Increasing public awareness, especially of the
Governments use advertising to increase awareness about young, is also very crucial in this effort. Ignorance about
the risks of smoking and drinking.The goal is to inform the the ill effects of smoking, drinking and even of excessive
public of the health-related costs of smoking and drinking. sugar consumption would make it much more difficult for
However, given the nature of goods like cigarettes and policymakers to curtail consumption of demerit goods.
alcohol or even sugary drinks, those already addicted may Of course, increased information alone about the risks of
not be incentivized to reduce their consumption. Still, it may consuming such goods without higher prices, regulations
be that persuasion will actually prevent the young from or nudges would prove insufficient.
taking up such habits. The effectiveness of advertising and
persuasion can only be seen in the long term and must
Dealing with Positive Production Externalities
be complementary to other price-related policies and also
regulations. – Granting a subsidy
– Nudges Granting a subsidy will decrease the costs of production
associated with the activity generating the externality
‘Nudges’ to reduce smoking and alcohol consumption are
and will thus decrease price and induce a greater level of
also used as a complementary strategy to pricing policies.
output. Using the James Meade apple farmer and beekeeper
Plain packaging mentioned earlier as well as visual display
example presented earlier, the subsidy will lower production
bans (placing tobacco products far from the checkout area
costs for the apple farmer and if the subsidy is equal to the
of the store) are gaining in popularity. Removing information
external benefit of production then the MPC will become
on cigarette packs regarding the amount of tar, nicotine and
equal to MSC so that the level of apple production will reach
carbon monoxide in a brand may nudge smokers towards
the socially optimal level.
considering all tobacco products equally dangerous and
threatening. The problem once again is that it is difficult to estimate
properly the size of the external benefits generated and
Framing a message sent to drinkers by telling them how
so the correct size of the subsidy. Therefore, the subsidy
their drinking ranks compared to others (‘You are in the top
may not be enough to correct market failure and ensure
10% of heaviest drinkers’) has been shown to lead to more
allocative efficiency or indeed the subsidy might lead to
individuals asking for help. Or, the default size for a draught
overproduction of the good. Also, a subsidy is associated
beer in British pubs can change to a half pint instead of a
with opportunity cost. The funds spent on the subsidy could
pint thus requiring customers to ask for a pint.
have been used for spending in other areas such as public
health or public education.

50
– Direct provision Again, estimating the proper size of the subsidy is not an

UNIT 2: MICROECONOMICS
The government may itself provide the good that generates easy task. Also, there is an opportunity cost associated
positive externalities associated with its production. For with subsidies. The cost of the subsidy must be somehow
example, the government typically funds infrastructure financed. Either taxes must increase now, or the government
investments such as the construction of airports, power and must borrow now and tax later or some other government
communication grids, sewerage, sanitation and wastewater project must be scratched. All these options involve an
facilities etc. opportunity cost so that the additional benefits accruing
to society from any such subsidy must be weighed against
It also engages directly (through public universities or
these costs.
research institutes) or indirectly (through providing research
grants and other funding) with research and development – Legislation
(R&D) activities that advance scientific knowledge. Governments may also try to increase consumption of goods
Note that both the granting of subsidies and direct provision with positive externalities through legislation. For example,
require funding. Financing thus requires higher taxes many countries have legislation that makes education
now, or borrowing now and higher taxes later and has an compulsory up to a certain level. Similarly, in many countries
opportunity cost. there are laws that require children to be vaccinated against
certain types of disease.
Dealing with Positive Consumption – Direct provision
Externalities (Merit Goods) When a government considers that the external benefits are
– Granting a subsidy very significant to the economy and that any positive price
The government can grant a subsidy equal to the size of the may be prohibitively high for some, very poor, members
external benefit created. The subsidy would lower production of society it often directly provides the good or the service
costs and increase supply leading to a lower price and a free at point of delivery. In many countries this is the case
higher level of consumption which in principle would be with state education, or with national health-care systems
equal to the socially optimal level, as illustrated in the and public hospitals. Direct provision is of course costly and
figure below. creates a significant burden on the government’s budget.
The state must run schools and hospitals equipped with
P/unit trained professionals, or purchase and distribute vaccinations
S, MPC = MSC
for free. All these government expenditures eventually are
paid by taxpayers.
Ss
f – Increasing awareness and education
MSB = MSC
Governments also resort to advertising the benefits from
Pm the consumption and use of such goods in an attempt to
increase their demand to the level of the MSB curve. Many
countries, for example, have campaigns and programmes
P* h that try to increase enrolment in schools and in colleges.
Increased awareness about the benefits of education may
convince parents in many countries to ensure that their
MSB
children are not only enrolled but also attend school and
D, MPB may convince high school graduates to attend or not to drop
Qm Qs* Q/period out from college. Campaigns to increase awareness about
the benefits of covid-19 vaccinations are also organized in
Market for flu vaccinations: the impact of a subsidy
many countries.
The subsidy increases supply of the good (for example
vaccinations) to Ss. The market price will consequently drop to
P*. Consumers at the lower price P* will be willing to consume
Qs* which is equal to the socially optimal level of consumption.

Dealing with...
Negative production Negative consumption Positive production Positive consumption
externalities externalities externalities externalities
• Indirect taxes (Pigovian taxes) • Indirect taxes • Subsidies • Subsidies
• Carbon taxes • Legislation and • Direct provision • Legislation
• Tradable pollution permits regulation • Direct provision
(“cap and trade” schemes) • Increasing awareness • Increasing awareness
• Direct regulation and education and education
• Increasing awareness and • Nudges
education

51
 Common pool or common access resources
Common pool or common access resources are resources P/unit MSC
that are not owned by anyone but are available for anyone
f
to use without payment. Examples include fisheries, forests,
wildlife, irrigation systems (groundwater), hunting grounds, welfare S, MPC
pastures and lakes. Note that since the atmosphere has been loss
e
used as a ‘sink’ of many anthropogenic pollutants it is also MSB = MSC
considered a common resource. These are all renewable
resources in the sense that they can replenish themselves
unless they are overused by humans. Pm h
Technically speaking, a common resource is a non-
excludable good because people cannot easily be excluded
from using it. The other characteristic of a common resource
is that it is a rival good, meaning that its use by one person
diminishes the quantity or quality of the resource available to D, MPB = MSB
others. That is to say that one individual’s use subtracts from Qs* Qm Q/period
the benefits available to others using the resource and for this
reason the rivalrous characteristic of common pool resources is The fishing firm will choose to fish Qm units where the MPB
also referred to as subtractability. of fishing an additional unit are equal to the MPC of the
activity. The optimal level of fishing though is less at Qs*,
Consider the open seas an example of a common pool where MSB is equal to MSC of the activity. More fishing than
resource. Fishing vessels can catch as many fish as they are the socially optimal level takes place.
able to as no one can be excluded from fishing in these
waters. But if one vessel catches a ton of fish there will be The depletion or degradation of common pool resources
one ton less available for all other vessels to catch. One poses a threat to sustainability, as overexploitation implies
person’s use of a common resource subtracts from the that the resource will not be available for others to use in
amount available for all others. This implies that others the future.
will have to fish longer and harder to catch the same Responses to the threat to sustainability
amount of fish.
common pool resources face
The result is an overuse of common pool resources. Assume
(note that given that the atmosphere is a common
a pasture open to all (“the commons”) with the adjacent
pool resource all the responses to negative production
land owned by a number of herdsmen. Each herdsman has
externalities explained earlier also apply here)
the incentive to have more and more of his cattle graze on
the commons because he enjoys the full benefits of this as – Regulation by the government
his animals are fed. However, the costs are shared by all. (“top-down” approach)
As a result, there will be overgrazing and the commons will In certain cases, regulation by governments may prove
be destroyed. This is also why fish stocks in many parts of effective. Setting fishing quotas is an example. Fishing
the world are severely depleted or why many forests are quotas are catch limits (usually expressed in tonnes) that are
disappearing. According to the UN’s Food and Agriculture set for most commercial fish stocks. The EU has set fishing
Organization the percentage of the world’s assessed fish quotas for the managing of fisheries and for preventing
stocks that are overexploited or fully exploited is 87% while depletion of fish stocks. But, even with fishing quotas,
1.3 million square kilometers of forest have disappeared there may still be issues. For instance, a shipping company
between 1990 and 2016. A resource that is non-excludable of a certain nationality is only subject to its national
and subtractable is usually overused and this is referred to as government’s fishing quota. Yet, if its fleet is flagged under
the “Tragedy of the Commons”, a term introduced by Garrett a different country it is no longer subject to the quota.
Hardin in his 1968 SCIENCE paper. Other regulations may involve restrictions regarding hunting
Analytically, the effect of such behaviour may be illustrated seasons, issuing licenses or permits for particular activities
through a negative externalities diagram, as in the figure (such as hunting or fishing), the establishment of protected
below, which illustrates the decisions of a fishing firm. areas for endangered ecosystems as well as emission
What is important to notice in the diagram is that the standards. Nevertheless, such regulations may often involve
MSC of fishing exceed the MPC the fishing firm takes into significant costs of monitoring to detect possible violations.
consideration. The activity imposes costs on all other fishing – International agreements
boats as they are forced to fish harder and for longer. It also
Regulations are typically imposed by national governments.
imposes costs on future generations as unsustainable fishing
However, the overuse of common access resources often
practices risk depleting fisheries around the world. However,
has international consequences, in which case international
these are costs external to a fishing firm’s decisions. The
cooperation of governments is necessary. For instance, much
MSC curve is drawn steeper to illustrate that the external
of the open water of the oceans is a common-pool resource
costs increase as the volume of fishing increases and the
to governments as well as to individual fishermen. No single
fishery is depleted.

52
body can exercise control over it. As long as that continues in Economics 2009). The idea is that, under certain

UNIT 2: MICROECONOMICS
to be the case, the corrective action will be difficult to conditions, a group of users of a common pool resource
implement. In recognition of this fact, there is now an can and has devised frameworks of use that effectively
evolving law of the sea defined by international treaties. regulate access to the resource and balance resource use
The global scope of many common pool resources, therefore, and resource renewal.
requires new and reformed institutions that can manage More specifically, if users can engage in face-to-face
common pool resources at an international level. bargaining and have autonomy to change their rules,
The Paris Agreement on Climate Change was adopted by 197 they may well attempt to organize themselves. For the
countries in Paris on 12 December 2015. Its goal is to reduce self-organized management of the common resource to be
global greenhouse gas emissions and to ensure that the feasible it must be that:
global temperature increase in this century is below 2 degrees • The resource is not at a point of deterioration such that
Celsius above pre-industrial levels and hopefully even below it is useless to organize or so overutilized that little
1.5 degrees. It is worth noting that the Paris Agreement does advantage results from organizing.
not guarantee these outcomes, but it requires signatories
• Reliable and valid information about the general
to commit to reduce emissions through plans for climate
condition of the resource is available at reasonable costs.
action referred to as nationally determined contributions
(NDCs). It represents a step toward realization, on the part • Users are dependent on the resource for a major portion of
of the signatory countries, that there was a common interest their livelihood.
in combatting climate change. Even though the US had • Users have a shared image of the resource and how their
withdrawn in June 2017 under President Trump, it rejoined actions affect each other and the resource.
under President Biden and the Paris Agreement will enter • Users trust each other to keep promises and relate to one
into force for the US on 19 February 2021. This is important another with reciprocity.
as even though the US represents just over 4 percent of the Many scholars conclude that only very small groups can
world’s population, it emits almost a third of the excess carbon organize themselves effectively because they presume that
dioxide in the atmosphere. By rejoining, countries producing size is related to the uniformity of a group, which is needed
two-thirds of all global carbon pollution will have committed to initiate and sustain self-governance. For example, if
to net-zero emissions, up from just half without the US. groups from diverse cultural backgrounds share access to
Prior to the Paris Agreement there were a few noteworthy a forest, the key question affecting the likelihood of self-
efforts concerning climate change. The 1992 Rio Earth Summit organized solutions is whether the views of the multiple
led to a first “Framework Convention” and in 1997 the Kyoto groups concerning the structure of the forest, interpretation
Protocol was signed but overall these were not successful. of rules, trust and reciprocity differ or are similar.
– Education Overall, for users to contemplate changing the framework
Educating, especially the young, on the importance of of use, they have to conclude that the expected benefits
adopting environmentally conscious behaviour may have from an institutional change will exceed the immediate
considerable long-term significance. and long-term expected costs. Whether the self-governed
management succeeds over the long term depends on
– Collective self-governance (‘bottom-up’
whether the institutions the users develop have clearly
approach) defined boundaries, involve collective-choice arrangements
A different approach is the self-governance of the and include monitoring and conflict-resolution
commons as proposed by Elinor Ostrom (Nobel Prize mechanisms.

53
 2.9 Market failure—public goods
Public goods
A good is considered a public good if it is characterized by of it available for others to listen to. Interestingly, off-the-
the following two properties. air television and radio broadcasting, despite their public
• It is non-excludable. This means that if the good becomes good features, are produced and offered by private, for-profit
available to even one consumer it automatically becomes companies. This is possible because broadcasters are not
available to all. No one can be excluded from consuming it. selling the programmes but the advertising time, which is
both excludable and rival.
• Consumption of the good is non-rival. This means that
each individual’s consumption of the good does not
decrease the amount available for all others. Recap
Non-excludability leads to individuals hiding their true
preferences and behaving as free-riders because they know
Public goods
that they can enjoy the good without having to pay for it once Public goods are:
it becomes available for others. Non-rivalry in consumption • non-excludable: if the good becomes available
implies that the marginal cost of an extra user is zero. to even one consumer it automatically becomes
The externality aspect of public goods becomes apparent available to all.
by realizing that if someone provides or maintains a public • non-rival: each individual’s consumption of the good
good, even at a cost, he or she cannot prevent others from does not decrease the amount available for all others.
enjoying the benefits. So, if the private benefits of providing • Examples of public goods are traffic lights, peace and
a public good are small compared to the social benefits and national security.
the private costs are larger than the private benefits, then
• Public goods are a case of market failure because
the good will not be supplied at all.
private profit-oriented firms will not have the
More generally, public goods are a case of market failure incentive to produce and offer such goods and
because private profit-oriented firms will not have the services through the market.
incentive to produce and offer such goods and services
through the market. The market mechanism fails. Even
though there may be sufficient demand for such a good, it Government intervention in response to
will not be offered. public goods
Few examples of pure public goods exist. National defence, The government must provide public goods, using tax
traffic lights and lighthouses are examples. Once national revenue. Note, though, that the government is not
defence is provided to one citizen it is impossible to stop necessarily producing the public goods. For instance,
others from enjoying the benefits of national security. Also, traffic lights or military aircraft are not produced by the
if one citizen enjoys the benefits, this does not diminish the government but by private firms who are contracted by the
amount available for others to enjoy. Similarly, if a traffic state. However, the following points should be considered.
light is placed at an intersection it automatically becomes
• There are opportunity costs associated with such
available to all drivers. No driver can be excluded from the
expenditures on public goods, as these expenditures must
benefits. In addition, the use of the traffic light by one driver
be financed either by higher taxes now or by borrowing
does not diminish the benefits available for other drivers.
now and imposing higher taxes later—or by cutting other
Or, if a lighthouse is built and maintained, no ship can be
government expenditures such as on health care or
excluded from its benefits. In addition, if the lighthouse
education.
benefits one ship, the same amount of benefit is available
to all other ships. Peace and security of a community is a • Evaluating the benefits and costs is not easy and often
somewhat different example but satisfies both criteria of a open to debate. For example, should the local government
public good. For example, if it is peaceful and secure for one of a town install traffic lights? If so, should there be traffic
citizen in a community then, probably, the same applies to lights at all intersections? How many traffic lights should
others. Also, if that citizen benefits from peace and security be installed? The local government should conduct a
there is no less benefit available for others. cost-benefit analysis but there is unfortunately room for
corruption as some individuals may use the power of their
A different example of a pure public good is radio and off-
office for their own private benefit. The result could be
the-air television broadcasting. Both public good properties
that we end up with more traffic lights or military aircraft
are satisfied. A radio broadcast is normally available to
than necessary. This could imply much less allocated on
any household with a receiver (a private, separate good).
health care and education.
Also, if one person listens to a programme there is no less

54
 2.10 Market failure—asymmetric

UNIT 2: MICROECONOMICS
information (HL)
HL
Asymmetric information occurs in a market when one party allocated efficiently and the market fails. There are two
in the transaction has access to more or better information distinct problems that asymmetric information can lead to:
than the other party. In such situations resources are not adverse selection and moral hazard.

Adverse selection HL
Adverse selection relates to limitations on information and • Something similar happens in the market for health
occurs when one party knows more about the product being insurance. A health insurance company cannot determine
sold than the other party. the health status of its potential customers. Individuals in
• Consider the used car market. Sellers have more good health know that they are less likely to incur medical
information about the condition of their cars than expenses. As a result, they are discouraged from buying
potential buyers. Due to asymmetric information, buyers the company’s insurance plan as they find it expensive.
are willing to offer an “average” price based on the used This leaves the health insurance company with exactly
cars offered. However, sellers of better than average cars the customers it does not want: people with a higher risk
withdraw from the market. This results in a decrease in the of needing medical care. In response, the firm will raise
average quality of cars, as there are fewer good cars now premiums, trying to compensate for the payouts to its
being sold. The price buyers are willing to offer decreases, less healthy customers. This will also drive away more of
leading to a greater number of better than average cars the remaining healthier customers. Again, the market for
withdrawn. The market thins out and may collapse. health insurance becomes thin and possibly collapses.

Moral hazard HL
Another problem of asymmetric information is moral hazard. they will not bear the cost of any damage they might cause.
Moral hazard occurs when individuals have the incentive to Similarly, doctors with malpractice insurance may put less
alter their behaviour after a contract has been signed, while effort into avoiding malpractice because they know that the
someone else bears the cost. This can occur because they insurer will cover the costs. In both examples, this happens
have better information regarding their behaviour compared because individuals on one side of the contract have more
to the other party, while the other party in the contract information about their own actions than the insurers, while
cannot easily monitor their behaviour. For example, buyers of their behaviour cannot be easily monitored.
car insurance may become less careful while driving, because

Responses to asymmetric information HL

Government responses car dealers often offer warranties—promises to repair any
• Governments can legislate minimum quality and safety problems with the cars they sell that arise within a given
standards and can regulate firms’ behaviour in order to amount of time. This is not just a way of insuring their
minimize information-related market failures. However, customers against possible expenses; it is a way of reliably
legislation and regulation are arduous, bureaucratic showing that they are selling good quality cars.
procedures. Also, regulatory and quality control activities • Screening takes place when individuals try to
have very large opportunity costs and may impose large infer additional information from other observable
costs on firms, especially if these activities are excessive. characteristics. If you apply to purchase health insurance,
• Governments may also choose to provide information to you will find that the insurance company will demand
consumers that will protect buyers in their purchasing documentation of your health status in an attempt to
decisions. However, when the government directly supplies “screen out” sicker applicants—customers they will refuse
information, there are difficulties with respect to the to insure or will insure only at very high premiums. Auto
collection and sharing of all the necessary information insurance also provides a very good example. Insurance
and possibly to its accuracy. company staff may not know whether you are a careful
driver, but they have statistical data on the accident rates
Private responses of people who resemble your profile—and they use those
• Signalling takes place when the party with superior data in setting premiums. In some cases, this may be
information conveys information that will make them seem quite unfair. However, nobody can deny that the insurance
credible to the other party. For instance, reputable used- companies are right on average.

55
 2.11 Market failure—market power (HL)
Focusing on firms HL
Profits Paying the market wage rate is necessary to secure the scarce
Economic profits, typically denoted with the Greek letter π, factor of production labour and is, of course, an element of
are equal to the difference between the total revenues (TR) economic costs. Normal profits are the necessary minimum
collected from selling Q units of a good minus the total return to secure the scarce factor of entrepreneurship. Since
economic costs (TC) incurred in producing these Q units, or: wages paid to labour are an element of economic costs,
normal profit is also an element of economic cost. Economic
π(Q) = TR(Q) − TC(Q) profits thus differ from accounting profits in that they include
Revenues the value of all resources sacrificed in the production process.
Total revenues or sales revenues (TR) collected from selling Average costs
Q units are defined as the product of the price (P) per unit Average costs (AC) are defined as costs per unit of output
charged times the number of units sold, or: produced. This is total costs (TC) divided by the number of
TR(Q) = P × Q units (Q) so:
Average revenue TC
AC =
Q
Average revenue (AR) is revenue per unit sold, so:
TR Profit maximization
AR = We typically assume in economics that firms aim to maximize
Q
Since TR = P × Q, it follows that average revenue is always profits even though, as we have seen, there may be other
equal to the price charged by the firm. objectives. The question that a firm must answer is how
much output to produce to achieve its profit-maximization
TR P × Q goal. To answer this question, we must first introduce and
AR = = =P
Q Q explain the terms marginal cost and marginal revenue.
Note that since the demand curve a firm faces shows at each
output level Q the price at which it will be absorbed and Marginal cost (and the law of diminishing
since average revenue is always equal to price, it follows that marginal returns)
the demand curve that a firm faces is also its AR curve. Marginal cost (MC) is defined as the additional cost of
Economic costs producing an additional unit of a good. More generally, it is
the change in total cost (TC) following a change in output:
The concept of economic costs is tricky. Since resources
are scarce, in economics we care about the value of all TC
MC =
resources sacrificed in the production process, whether an Q
explicit payment is made or not. Economic costs are thus This is the slope of the total cost function. Typically,
distinguished into explicit and implicit costs. Explicit costs marginal costs initially decrease and then, after some point,
refer to “out-of-pocket” costs a firm has, for example when they start to increase. This behaviour is the result of the law
it has to pay a supplier. Implicit costs include, for example, of diminishing returns.
the value of firm-owned resources. No payment is made for,
In the short run, when at least one factor of production
say, premises owned by a firm, but they are “sacrificed” as no
is considered fixed (typically, capital; think of the firm’s
other firm can use them. Or, consider an entrepreneur also
premises) it is initially easy to increase output because
working in her firm. We must include the wages she would
there is a lot of opportunity for labour specialization. The
have earned had she been working for another firm.
additional output produced from an additional worker rises.
Normal profit This implies that the additional cost of an additional unit of
output produced (the MC) decreases.
Economic costs include something more. Remember that
entrepreneurship is also a scarce factor. The entrepreneurial After some point, though, there is less and less room for
capital that an entrepreneur invests in a certain line of specialization and the additional output from an additional
business cannot at the same time also be invested elsewhere. worker employed starts to decrease. This is when diminishing
Economic costs thus also include the minimum return the marginal returns set in. Total output continues to rise as workers
entrepreneur requires to remain in a line of business. This are added to the production process but at a diminishing rate.
minimum return is known as normal profit. It is equal to It follows that the additional cost (the MC) of an additional unit
what could have been earned if this entrepreneurial capital of output produced will at that point start to rise. The behaviour
was invested in the next best alternative with the same risk. just described for the MC gives rise to the “Nike-swoosh” shape
If this return is not earned, then the firm is not viable—in the of the MC curve shown in Figure 2.11.1. At output level q1, the
same way that if a firm is not prepared to pay workers the law of diminishing marginal returns begins to take effect and
market rate then they will not be willing to work for that firm. MC starts to rise.

56
 UNIT 2: MICROECONOMICS
MC P, MR
F
MC

m (ped = 1)

Q1 Q
D, AR
Figure 2.11.1 The MC curve
0 Q H
Marginal revenue
Q/period
Marginal revenue (MR) is the additional revenue collected from MR
selling an additional unit of a good. More generally, it is the
Figure 2.11.3 The MR curve if the firm is a price maker
change in total revenues (TR) following a change in output:
sloped demand curve will have a marginal revenue curve
TR
MR = with double the slope of the demand curve.
Q
Note that since marginal revenue has double the slope of
There are two cases.
the demand curve it cuts the midpoint Q of line segment
Case 1 (0H). Right above output Q, where MR is equal to zero,
In this case, the firm is very small compared to the size of the the PED of the demand curve is 1 because point m is the
market in which it operates and produces a good identical to midpoint of line segment (FH). Remember that as price
what the other firms in this market offer (the good is known decreases, if demand is price inelastic, then total revenues
as homogeneous). This firm must accept the market price. decrease, so that marginal revenue must be negative.
It is a price taker. In this case marginal revenue is constant,
as shown in Figure 2.11.2. The additional revenue collected Rule for profit maximization
from selling one more unit will always be equal to the price To maximize profits, a firm must choose a level of output
prevailing in the market. Q for which:
MR = MC
P, MR
Very often, students incorrectly infer from the above
condition that the level of profits enjoyed by a firm at that
level of output is zero. It will become clear that if MR = MC
then we know that profits are maximum but these maximum
profits can be: positive, in which case we say that the firm
enjoys abnormal (or supernormal) profits; zero (in which case
we say that the firm enjoys just normal profits, the minimum
MR return required by the entrepreneur to remain in that line of
P business); or even negative (in which case the firm is making
economic losses and is not even earning normal profits).
To understand the above, consider a firm producing pencils.
Assume that currently it is producing 5 pencils per period (say,
per hour) and is making profits equal to $18.00. If the
Q
additional revenue it can collect by producing and offering a
Figure 2.11.2 The MR curve if the firm is a price taker 6th pencil is $3.00 (so MR = $3.00) and the additional cost
Case 2 of producing it is equal to $1.00 (so MC = $1.00), should
it produce it? What will its profits be if instead of 5 pencils
In this case (shown in Figure 2.11.3), the firm faces a
per period, it is producing 6 pencils per period? Profits would
negatively sloped demand curve and so it can choose the
increase and equal $20.00. What if for an additional pencil (the
price at which it wishes to sell its product. It is a price maker.
7th), MR is equal to $3.00 and MC is equal to $2.00? Should
If it wishes to sell more units per period, it must lower the
the firm be increasing output to 7 pencils per period? Yes, as by
price. However, this lower price will apply to all units sold
increasing output to 7 pencils, it would further increase profits
per period, not just the additional (last) unit. Marginal
to $21.00. Pushing this logic further, it should be clear that as
revenue collected will thus be less than the new lower price
long as MR exceeds MC then it pays a firm to increase output
charged for the firm’s output. A firm that faces a negatively
per period because by doing so, its profits will be increasing.

57
 if MR > MC, keep on increasing output … • The type of the product offered in the market. The
… until, for the last unit produced, MR = MC product offered can be differentiated or homogeneous.
A product is differentiated if it differs across firms in
At that level of output at which MR = MC,
terms of characteristics, quality or even just packaging.
profits will be maximum
Examples include nearly everything: laptops, cars,
So: What if the firm was producing 5 pencils per period and hair salon services, banking services, mobile phone
was making losses equal to, say, $30.00? Assume that again, service providers or plain vanilla ice cream sold
the additional revenue it can collect by producing and offering in supermarkets. A product offered in a market is
a 6th pencil is $3.00 (so MR = $3.00) and the additional cost homogeneous if it is considered identical across firms in
of producing it is equal to $1.00 (so MC = $1.00). Should the the eyes of consumers. If it is branded, like the vanilla
firm produce the 6th pencil? What will its profits be if instead ice cream or the bottled water offered by different firms
of 5 pencils per period, the firm was producing 6 pencils per in supermarkets, it is not considered homogeneous. Very
period? Losses would decrease to $28.00. What if for one few products can be considered being homogeneous,
more (an additional) pencil (the 7th), MR is equal to $3.00 as all firms have the incentive to somehow differentiate
and MC is equal to $2.00. Should the firm be producing what they offer from what other firms in the same
and selling 7 pencils per period? Yes, as by increasing output market offer. By differentiation firms can increase
to 7 pencils, the firm would be further decreasing losses. price without risk of losing all customers or sales. So,
Pushing this logic further, it should be clear that as long as what are examples of homogeneous products? One is
MR exceeds MC then it pays this loss-making firm to increase copper offered by different mining companies in the
output per period because by doing so, its losses will be world to manufacturers. Another is the wheat that
decreasing. So, for this firm: food companies, such as Kellogg’s or Nestlé, buy from
if MR > MC, keep on increasing output … farmers around the world. Examples are found in the
primary sector as commodities are considered “gifts
… until, for the last unit produced, MR = MC
of nature”.
At that level of output at which MR = MC,
• Whether or not barriers exist preventing entry of other
losses will be minimum
firms into the market. A barrier is anything that deters
Summing up, if a firm is producing a level of output for entry into a market. There are different types of barriers,
which MR = MC for the last unit produced, then it is either which will be discussed later.
making maximum profits or minimum losses. To determine
whether these are positive, zero or negative profits, we need
to compare average revenue (AR) and average cost (AC).
Recap
• If AR > AC then profits are positive (abnormal or
supernormal). Characteristics used to distinguish
market structures
• If AR = AC then profits are zero (the firm is just making
normal profits). The three characteristics are:
• If AR < AC then the firm is making losses (negative • the number of firms in the market—it can be very
profits). many, few or one
• the type of product offered—it can be homogenous or
Market structures differentiated
In economics, there are four types of market structure. The • the entry conditions—barriers may or may not exist.
distinction is based on the following three characteristics.
• The number of firms in the market. There can be very On the basis of the above, four market structures are
many firms, few firms or just one firm in the market. distinguished in economics.

Perfect Monopoly Monopolistic Oligopoly

competition competition
Number of firms Very many One Very many Few
Type of product Homogeneous (Unique) Differentiated Either homogeneous or
differentiated
Entry conditions No barriers exist Barriers do exist No barriers exist Barriers do exist
(and perfect information)
(and perfect factor mobility)

58
“Structure—Conduct—Performance” and market power

UNIT 2: MICROECONOMICS
The characteristics or structure of each of the different
types of market determine to a large extent their market Policymakers’ perspective
behaviour. Their market behaviour, in turn, affects their
performance. Performance refers to the degree to which firms In most countries, specialized offices exist that monitor
in each market structure achieve relevant societal goals. In market and firm behaviour. Examples include the
a market economy, these goals refer to producing the level Directorate-General for Competition in the European
of output that is optimal from society’s point of view and Union, the Antitrust Division of the Department of Justice
charging the lowest possible prices. in the USA, the Competition and Markets Authority in
the UK and the Competition Commission of India.
Another most important performance outcome is the
extent to which firms innovate. Innovations refer to new The degree of market power that a firm possesses is
products and new production processes and are considered extremely important for policymakers who focus on
a most desirable market outcome in a vibrant and dynamic the way different markets operate. We will later see
economy. that if in a market the degree of market power is very
high, policymakers, and specifically the competition
These goals are closely related to the degree of market
authorities, may have sufficient reason to intervene.
power firms have. Market power refers to the ability of a
They definitely have reason to intervene if policymakers
firm to influence price and is prevalent in most real-world
suspect abuse of market power. The goal of competition
markets. We will see that even though lack of any market
authorities is to ensure that consumers have access to
power is desirable, it is, on the other hand, usually necessary
goods and services at the most competitive prices and
for firms to innovate.
that firms have the incentive to innovate.

Perfect competition
A market is considered perfectly competitive if the following without pushing down the price, what incentive is there for it
applies. to lower the price? There is no incentive.
• The market includes very many firms. The perfectly competitive firm is thus a price-taker. It faces
• The product is homogeneous. a horizontal, perfectly elastic demand curve at the market
determined price which is also its average revenue (AR)
• There are no entry barriers.
curve and also its marginal revenue (MR) curve. In perfect
• In addition, perfect information and perfect factor mobility competition, the additional revenue (MR) the typical firm
are assumed. collects from selling an additional unit is equal to the
market-determined price.
Perfectly competitive firms are price-takers
The above assumptions imply that such firms are price- Short-run equilibrium for the perfectly
takers. This means that each firm must accept the market competitive firm
determined price. Why? A firm cannot charge a higher price
Think of the quinoa market, a good example of a perfectly
because there are very many other firms in the market,
competitive market. Let’s give a name to the typical quinoa firm
all producing the identical product. Buyers in the market
we are focusing on. Let’s call it Felipe. Figure 2.11.4b shows the
are aware of this as a result of also assuming perfect
quinoa market and Figure 2.11.4a shows Felipe’s firm.
information. Why not sell at a lower price? A firm has no
incentive to do so. Why not? The firm is so small compared Market demand and market supply for quinoa determine
to the whole market that it can sell all it wants at the going the equilibrium market price P. Note that the scale of
market price. If a firm is so small that it can sell more output the horizontal axis differs. It is thousands of kilos for the

(a) Typical quinoa firm: Felipe (b) Quinoa market

P/kg MC P/kg D

ATC
b
P P
π>0 D, AR, MR
C a

0 q* q /period 0 Q Q /period
(kgs) (thousands of kgs)
Figure 2.11.4 Perfect competition: short-run equilibrium—case with abnormal (or supernormal) profits

59
 market (Figure 2.11.4b) but only kilos for the typical firm (a) Typical quinoa firm: Felipe
(Figure 2.11.4a). Felipe, as explained above, will have to accept P/kg P/kg
the market determined price P. He thus faces a perfectly elastic MC
(horizontal demand) at P as he knows that consumers will buy AC
any amount he offers (remember it is very small compared to
the market) at that price P. Demand always reflects his average
revenue and here it also reflects his marginal revenue. f
P' P'
D, AR, MR
Profit maximization for the typical
perfectly competitive firm
Focusing on Figure 2.11.4, to maximize profits, Felipe will
choose to offer q* units of quinoa, as at q*, MR = MC. To
determine whether these maximum profits are positive, zero
or negative, we have to compare the firm’s AR with its ATC. 0 q' q /period 0
(kgs)
Note that the ATC curve in Figure 2.11.4a is U-shaped and
that the MC on its way (a)upTypical
cuts thequinoa firm:
ATC curve at Felipe
its minimum. (b) Quinoa market
This isP/kg
the result of a strict relationship between marginal P/kg
costs and average costs, which is explained in the MC box below. S’, MC
AC
Info
Relationship between marginal
f costs
P'
and average costs P'
D, AR, MR
Consider a classroom with any number of students in
it. Assume that the school nurse walks in and takes
their temperature. Their average temperature is 36.6°. D
If one more student (marginal) now walks in and her
temperature is 37.2° what will happen to the average
0 of the class? The answer
temperature q' is that it willq rise.
/period 0 Q' Q/period
What if her temperature was 36.1°? Then the average(kgs) (thousands of kgs)
temperature of the class would decrease. Figure 2.11.5 Perfect competition: long-run equilibrium

Generalizing, we can write that: market supply will increase and the supply curve will
If Marginal > Average → Average increases start shifting to the right. Excess supply will start pushing
If Marginal < Average → Average decreases the quinoa market price down. Entry will stop when
abnormal (or supernormal) profits are competed away and
Focusing on the MC and AC curves this implies that if
driven down to zero (that is, to normal). If profits earned
average cost is decreasing then marginal cost must lie
are normal, the quinoa firms are making the minimum
below (that is, be less than) average cost. If average cost
return they require to remain in the quinoa market. There
is increasing then marginal cost must lie above (that
will be no incentive for more firms to enter and also no
is, be greater than) average cost. It follows that where
reason for existing firms to exit. Each firm is achieving its
average cost is at a minimum (as it is U-shaped) marginal
profit-maximizing goal (MR = MC) and no entry or exit
cost must be equal to average costs.
takes place (as AR = AC). This is referred to as long-run
equilibrium. So, the condition for long-run equilibrium is
Unit costs (ATC) when Felipe is producing q* units are equal
that at the chosen output Q': P (= AR) = MR = MC = AC.
to segment (q*a) or (0C). Since price (= AR) is greater than
This position is shown in Figure 2.11.5.
average total cost, this firm is making positive economic
profits equal to segment (CP) per unit. Multiplying by Figure 2.11.5 depicts long-run equilibrium in a perfectly
the number of units (0q*) Felipe sells which are equal to competitive market. In Figure 2.11.5a, the typical firm,
segment (Ca), we arrive at the size of the positive economic Felipe, is achieving its goal to maximize profits as at Q':
(abnormal or supernormal) profits Felipe is earning, which MR = MC. In addition, there is no reason for new firms to
are equal to the rectangular area (CabP). enter or for any of the existing firms to exit as the typical
firm is earning at Q' zero economic profits; that is, it is
From short-run to long-run earning normal profits, as much as these entrepreneurs
If the typical firm in a market is making positive economic could earn in the next best alternative with the same risk.
profits, it is earning more than normal profits (more than At Q', AR = AC = (0P').
what entrepreneurs could earn in the next best alternative If the typical firm was making losses in the short run, it
with the same risk). There is an incentive for more firms means that it would not be earning normal profits, the
or entrepreneurs to enter. There are no barriers in perfect minimum it required. This case is illustrated in Figure 2.11.6.
competition, so new firms will start entering the quinoa Firms in this case have the incentive to exit this market
market. As the number of firms in the market increases, and switch to their next best alternative with the same

60
 (a) Typical quinoa firm: Felipe (b) Quinoa market

UNIT 2: MICROECONOMICS
P/kg P/kg
MC
ATC S

g
C
π<0
P P
h D, AR, MR

0 q q /period 0 Q Q /period
(kgs) (thousands of kgs)
Figure 2.11.6 Perfect competition: short-run equilibrium—case with losses
risk. Remember, we also assume perfect factor mobility. stop when the typical firm is earning just normal profits
As the least efficient firms exit, the market supply will (that is, zero economic profits).
shift left and the market price would start rising. Exit will

Efficiency issues in perfect competition: Allocative efficiency

If markets are perfectly competitive then market forces alone, whatever is sacrificed) are indeed produced, up until and
without the need of the state, will lead to just the right including that unit for which P = MC. Focusing on the
amount of the good being produced from society’s point of typical firm, we realize that at Q': P = MC and focusing on
view. Scarce resources will be optimally allocated (appointed the market, at Q': P = MC. Remember that for each level of
to their best possible use) and social welfare, the sum of the output how much it is worth to consumers is measured by
consumer surplus and the producer surplus will be maximized. their willingness to pay, P.
Why is this the case? It is because for the last unit produced, Since in perfectly competitive markets all units for which
both in the market and by the firm, P = MC. This means that P > MC are produced up until and including that unit for
all units of the good that are worth to consumers more than which P = MC, allocative efficiency is achieved and the price
the additional cost of producing each (that is, the value of charged to consumers is the lowest it can be.

Policymakers’ perspective
Perfect competition does not exist in real-world that allocative efficiency is achieved. In addition, since in the
markets. Few markets can be perhaps considered good long run the typical firm is forced to produce with minimum
approximations of perfect competition. In many markets, average cost, it is also technically efficient. This means that
few large firms dominate. Market power is often present the “how” question is also answered in the best possible way,
that usually leads to higher prices for consumers and less as no scarce resources are wasted.
than the socially optimal level of output enjoyed. Real- Perfectly competitive markets thus lead to the optimal output
world markets often fail as they are allocatively inefficient. at the lowest possible price. Policymakers use this market
So, why is perfect competition considered important? The structure as a measuring rod against which actual market
reason is that it manages to answer in the best possible way performance is judged. Thus, when in real-world markets
the first fundamental question of economics, the “what” prices charged by firms are significantly higher than the
question. It guarantees that just the right amount of a good marginal cost of production it means that consumers enjoy
is produced from society’s point of view: that is, it guarantees less and pay more. Policymakers may decide to intervene.

Recap
Two benefits of perfect competition
Perfectly competitive firms have no market power.
• Firms cannot charge more than the competitive equilibrium price (P).
• Consumers enjoy the good at the lowest price possible.
Allocative efficiency is achieved.
• At the competitive equilibrium output (Q): MB = MC
• Just the right amount of the good is produced; resources are allocated in the best way and social surplus is maximized.

61
 Monopoly
A monopoly is a market where the following conditions apply. incurred when producing Qm units which is equal to
• There is only one firm producing a good or one firm segment (QmA) or (0C). Since in this case average revenue
dominating the market. For example, Google’s parent exceeds average cost, this monopoly firm is earning profits
company, Alphabet, controls 92.5% of the world search per unit equal to segment (PmC). Multiplying this by the
engine market, with Bing controlling 2.5%. number of units (0Qm) or segment (CA), we arrive at the
size of the positive economic profits this monopoly firm is
• The product is considered unique.
earning, which is equal to the rectangular area (CABPm).
• There are high entry barriers. These economic profits are positive, so the monopoly firm
is earning abnormal (or supernormal) profits. Consequently,
Monopoly firms are price-makers
other firms or entrepreneurs would like to enter this market.
Assuming there is only one firm in the market, it becomes clear However, in monopoly we assume that barriers to entry
that the monopoly firm faces the negatively sloped market exist and so entry cannot take place. It follows that these
demand curve. The monopoly firm can choose the price it abnormal (or supernormal) profits will persist in the long
wishes to charge and in this sense such firms are price-makers or run and that Figure 2.11.7 shows both the short-run and
price-setters. Monopoly firms thus have market power. Market the long-run equilibrium position of the monopoly firm.
power is also often referred to as monopoly power.
P/unit MC
Keep in mind that a monopoly is still constrained by the
demand curve it faces so it cannot choose both the output
it wishes to sell per period and the price it wishes to charge. B
(AR =) Pm
If it decides to choose the output rate it wishes to sell per
period then it is the market that will determine the price at AC
which it will be absorbed; if it decides the price it wishes F
to charge then the market will determine the quantity that A
will be absorbed at that price. Figure 2.11.7 shows the (AC =) C
equilibrium position of a profit-maximizing monopoly firm.
To maximize profits the monopoly firm will choose that
level of output Q for which MR is equal to MC. This is the H
case at output level Qm. To determine the price at which
the market will absorb this output per period we need to D, AR
draw a vertical line up from Qm to meet the demand curve.
This price is Pm. To determine now the level of profits (or, 0 Qm Qsoc Q /period
losses) we need to compare price (Pm), which is also the MR
average revenue earned by the firm, with the unit costs Figure 2.11.7 Equilibrium in a monopoly

Efficiency issues and the monopoly firm

A monopoly firm is allocatively inefficient. Referring to Figure monopoly firm are the same as those that perfectly
2.11.7, at the chosen profit-maximizing level of output Qm, competitive firms faced. The MC curve thus remains the same.
price (P) exceeds marginal cost (MC). Specifically, price is This is a rather restrictive assumption and will be relaxed later
equal to segment (QmB) while marginal cost is equal to when we will examine the possible benefits of larger size.
segment (QmH). Society would have wanted more units of this
good produced. Society would have wanted all units up until Comparing perfect competition with
unit Qsoc, as Qsoc price, which measures the willingness to monopoly: Same cost conditions
pay, is equal to MC (since at that level of output the AR curve P/unit S, MC
intersects the MC curve). Since the monopoly firm does not
produce units (QmQsoc), a welfare loss results equal to area 1 2
(HBF). The welfare loss reflects net value lost by society from Pm
3 4 5
units (QmQsoc) not being produced by the monopoly firm Pc
78
even though they should have been produced from society’s
point of view. A monopoly firm is also not forced to produce 6
with minimum average cost, as perfectly competitive firms are,
so it is also technically inefficient.
It is instructive to make a direct comparison of a perfectly
competitive market and a monopoly market. In Figure 2.11.8,
a perfectly competitive market is shown. The interaction
of market demand and market supply (which also reflects D
marginal cost) leads to an equilibrium price Pc and an
equilibrium quantity Qc. Assume now that this market
is somehow monopolized. In addition, assume that the 0 Qm Qc Q/period
technology used, and the cost conditions faced by the MR
Figure 2.11.8 A perfectly competitive market

62
 The profit-maximizing monopoly firm will choose to produce • A welfare loss results equal to area (5 + 8) since monopoly

UNIT 2: MICROECONOMICS
Qm units where MR = MC. The price that will be charged restricts output and units that should have been produced
will be Pm. It is clear that the monopoly firm restricts output from society’s point of view are not produced.
to raise price. Monopoly produces and offers less than the • Area (3 + 4) represents a transfer of income from
competitive market (Qm < Qc) and charges a higher price consumers to the monopoly as it used to be part of
(Pm > Pc). In addition, whereas the competitive outcome is the consumer surplus but is now appropriated by
allocatively efficient (as at Qc, P = MC), the monopolist is the monopoly firm. If in an economy market power
allocatively inefficient (since at Qm, P > MC). is increasing in more and more industries, income
A welfare analysis is revealing. distribution will become more unequal because firms
• The consumer surplus is the area below the demand curve, with market power can charge consumers a higher price.
above the price paid for the units actually consumed. This is one of the reasons that income inequality in many
economies has been increasing in the past 20 years or so.
• The producer surplus is the area below the price earned,
above the supply curve (or the MC curve for the monopoly Note that price is set by the monopolist above marginal
as MC reflects the minimum the firm requires to offer each cost. The ability of a firm to set price above marginal cost
additional unit) for the units actually sold (which in the is the formal definition of monopoly power. The degree
case of monopoly are up to Qm). of monopoly power is measured by the Lerner Index of
Monopoly Power defined as the difference between price
• The social surplus is the sum of the consumer and
and marginal cost expressed as a proportion of price:
producer surplus.
Perfect competition ( P − MC
P )
Consumer surplus Area (1 + 2 + 3 + 4 + 5) Monopoly power and market power can be used
Producer surplus Area (6 + 7 + 8) interchangeably. If a firm is a perfectly competitive firm,
then the Lerner Index of Monopoly Power measurement
Social surplus Area (1 + 2 + 3 + 4 + 5 + 6 + 7 + 8)
is zero, as price is equal to marginal cost. The firm has no
Monopoly monopoly power (no market power) as it cannot influence
Consumer surplus Area (1 + 2) price. However, a monopoly can set price. It does have
Producer surplus Area (3 + 4 + 6 + 7) market power, and the degree of monopoly power it has
depends on how much higher than marginal cost it can
Social surplus Area (1 + 2 + 3 + 4 + 6 + 7) set its price. This of course depends on the number and
The above analysis reveals the following. closeness of available substitutes to consumers. The fewer
• Consumers are worse off as they lose area (3 + 4 + 5). the available substitutes, the greater the ability to raise
• The firm is better off as it loses area (8) but it gains price above marginal cost and the greater the degree of
area (3 + 4). monopoly or market power the firm possesses.

Monopoly firms: A report card

Monopoly firms or, more generally, firms that dominate in their Sometimes the existence of monopoly firms or, more generally,
market have significant market power, so they are typically not large firms that dominate a market may benefit society. It will be
considered desirable from society’s point of view. explained later why under certain conditions having only one firm
There are quite a few reasons for this. Their market power in a market may even be preferable. This is the case of a natural
permits them to restrict output below the competitive level. monopoly where having two firms splitting the market would
Consumers then enjoy less of the good. Restricting output result in an unnecessary waste of resources; the price natural
allows these firms to charge a higher price. This hurts monopolies can charge consumers is typically regulated by the
consumers, especially lower income households, since it state. It will also be explained that large firms may often be able
decreases their purchasing power. Consumer surplus shrinks to produce at a lower average cost (this is known as benefiting
and part of this surplus is transferred to the monopoly firm. from economies of scale) allowing them to decrease the price they
This transfer of income that is accomplished through the charge. Also, because of entry barriers such firms may maintain in
higher prices charged by firms with significant monopoly power the long run any supernormal profits earned. They thus have the
increases income inequality. necessary resources to invest in research and development, which
leads to innovations that benefit society.

Policymakers’ perspective
Keep in mind that it is the existence of barriers to entry referred to as “entrenched” monopoly positions, while
that permit a firm to maintain abnormal (or supernormal) others may eventually be overcome by entrepreneurs who
profits in the long run and keep price significantly higher develop a new product or a new competing technology.
than the competitive level. The extent to which barriers Entrenched monopoly positions are typically a result
prove successful in protecting a monopoly position in the of state-created barriers but in the recent past, even in
real world depends on the type of barriers that exist in any the absence of state-created barriers, there are some
particular market. Some barriers may lead to what are questionable tactics by firms that have been very successful
in fending off potential competition in their markets.

63
 Entry barriers
What is an entry barrier? has established itself as the centre of e-commerce by providing
An entry barrier can be anything that deters entry of new the infrastructure that other rival businesses crucially rely on
firms into a market. Barriers can be distinguished into three to exist. An example of this is when Amazon delisted a French
types. They are: publisher’s books from its website for a while. Such behaviour
is considered by several legal experts to constitute abuse of
• state-created barriers market power and we will examine it again later.
• firm-created barriers
• natural barriers. Natural barriers
Economies of scale and the case of the
State-created barriers natural monopoly
State-created barriers include patents, licenses and trade barriers.
The production technology for some goods or services
Patents are granted by governments to firms that introduce requires huge set-up costs. Examples include laying out a
a new product or a new technology. A patent permits railway network, a water distribution network or a power
the owner to produce the good or to use the technology grid to deliver electricity. Such infrastructure costs imply
exclusively for 20 years. This creates a monopoly in order to that the average cost of one large firm supplying the whole
protect the incentive to invest in research and development market is much lower than the average cost that each of two
(R&D) and to generate innovations. Pharmaceutical firms supplying the same market would have. Significant
corporations apply for and are granted patents for new economies of scale are present.
drugs they develop. Patents are obviously necessary, but the
particulars of the law may prove counterproductive. Economies of scale are defined as decreases in average costs
that are a result of a firm’s larger size. They refer to the long
Licenses are exclusive permits that governments issue to one run when firms can change all factors and so can change
or few firms for a variety of reasons. Licenses are granted to their scale (size) of operations. Firms of larger size may enjoy
radio and television stations in order to allocate bandwidth. a cost advantage for many other reasons. They may be able
Medical doctors and lawyers are also licensed to protect the to buy their inputs in bulk, extracting lower prices from
public from unqualified individuals. Of course, to the extent their suppliers. They may be able to borrow from banks at
that medical associations also restrict entry into the field of better terms (lower interest rates) by being considered more
medicine they also are responsible for maintaining higher creditworthy and less risky. Indivisibilities of certain types
fees, in other words to exert some degree of monopoly power. of capital equipment or of certain technologies imply that
Trade barriers will be examined in detail in section 4.2. They they can be adopted only by very large firms. An example is
include taxes on imports (tariffs), quantitative restrictions on the assembly line in car manufacturing. Indivisibilities also
imports (quotas) and other policies that limit competition explain why production processes such as those involved in
from abroad. They aim at protecting domestic firms and their electricity, water and natural gas distribution, or a railway or
workers but they do lead to higher prices for buyers. subway network, require firms that are very large in size and
can spread these huge set-up costs across a huge scale of
Firm-created barriers output, resulting in lower average costs.
Firms also try to prevent entry of new firms into their market. A natural monopoly may emerge if, given market size, only
Restricting competition will lead to higher prices and will permit one firm can profitably exist. Two firms splitting the market
these firms to maintain abnormal (or supernormal) profits. would both be unprofitable. Figure 2.11.9 shows this.
These firms may maintain excess productive capacity so that a
potential entrant is aware that the incumbent firm can easily Assume that the profit-maximizing level of output is at Q*.
increase output and drive the price down to unprofitable levels. (Note: the profit-maximizing level of output is where MR and MC
They may engage in excessive advertising and create a distinct intersect. This is not shown, to avoid cluttering Figure 2.11.9).
brand name, or they may extensively differentiate their product P/unit
and offer very many different varieties to make it more difficult
for others to find a niche and enter the market. They may even
set price only slightly above average cost so that the potential losses when two
entrant knows that if it decides to enter, price will be depressed firms are splitting
to unprofitable levels as a result of the additional supply the market
entering in the market. profits when one
C' f firm is serving the
In the recent past another old questionable tactic has
market
resurfaced. Large firms with very significant market power h b
have been buying out competitors or any start-ups that may P
threaten their dominance. For example, Oracle acquired
a LAC
PeopleSoft, Siebel, BEA, Sun Microsystems and more than C
60 other firms. Google “vacuumed-up” more than 100
companies including YouTube and DoubleClick. Facebook
even managed to block multi-homing of all social media D, AR
applications under one host. It has since also acquired 0 Q*/2 Q* Q/period
Instagram and WhatsApp, cementing its dominance in social
media. Amazon has acquired more than 100 companies and Figure 2.11.9 The case of a natural monopoly

64
 The price at which this market will absorb Q* units is this market, together with the huge economies of scale

UNIT 2: MICROECONOMICS
P. Average costs for this firm are equal to (0C). It thus present, permit only one firm to profitably operate. This
makes abnormal (or supernormal) profits equal to area is a natural monopoly. Natural monopolies are usually
(CabP). If now two firms were to split this market, each regulated by the government. Prices charged are set
Q* below the profit maximizing level to ensure affordability.
producing ( )
2
units, then together they would still be
Note that a natural barrier leading to monopoly is also
producing Q* units and the market price would still be exclusive ownership of a vital natural resource that prevents
P (remember the good is homogeneous). Now, though, others from offering the good or the service. For example, if
these smaller in size firms will not be able to enjoy one person owns all the land surrounding a pristine beach in
the cost savings that the single large firm enjoyed. Mykonos, then only he or she decides who can buy land in
Average cost for each would be (0C') and thus each order to build a resort hotel there.
would make losses equal to area (PhfC'). The size of

Oligopoly
An oligopoly has the following characteristics. share and their profits at the expense of rivals, but at the
• It is a market in which only a few firms operate. risk of starting a price war which could prove catastrophic
for all firms involved. By colluding they decrease uncertainty
• The firms produce either a homogeneous product (such
and maximize joint profits as if they were a monopoly, but
as steel, cement, oil or copper) or a differentiated product
at the risk of getting caught and facing the consequences
(such as cars, laptops or mobile phones, or products
of the law, namely fines and even imprisonment. This
offered by the banking or insurance industries, or providers
dilemma and much more can be clearly visualized through
of mobile phone services).
the “Prisoner’s dilemma”.
• High barriers to entry exist, which explains why there are
only a few firms. Barriers are the same as those that give rise The “Prisoner’s dilemma”
to monopolies (for example, economies of scale that permit A branch of mathematics known as game theory is widely
only a few firms to operate profitably, licenses, creation of used to analyse oligopolistic set-ups. We will examine
brand names, limit pricing and product proliferation). the simplest form of a game, known as the “Prisoner’s
As a result of only a few firms operating in the market dilemma”. Through this game we will clearly understand
these firms are interdependent. Interdependence exists in a interdependence in such markets, why a price war may be
market if the outcome of any action of one firm depends on initiated, why such firms have an incentive to collude and
the reaction of its rival or rivals. We can say that a market is also why there is sometimes cheating involved.
oligopolistic if the firms in the market are interdependent. We assume two firms, A and B, each with two possible
strategies. Each can either maintain price high or it can
Concentration ratios
cut price. Figure 2.11.10 shows their “pay-off matrix”. Each
To determine the extent of concentration in a market a number is the profit each firm will earn from each strategy
concentration ratio (CR) is used that measures the proportion adopted, given the strategy its rival will adopt. Firms are
of total sales accounted for by the “n” largest firms in a market. aware of the pay-offs, but initially we assume that there is no
For example, the four-firm concentration ratio (CR4) is given by: communication between the two firms.
Sales of largest 4 firms in the market
×100 Firm A
Total market sales Maintain high price Cut price
Researchers often calculate a series of concentration ratios
Maintain high price

for a market, for example the CR4, the CR8 and the CR20, $210 million $250 million
in order to provide a more comprehensive picture of the
degree of concentration. The higher the concentration ratio
of a market, the more oligopolistic it is, as it indicates that
few firms dominate. In the USA, the CR4 in the dry cat food
industry is 97%, the CR3 in the car rental industry is 50%
$210 million $35 million
Firm B

and the CR2 in smartphone operating systems is 99%. Not

only is a series of concentration ratios useful to derive safer $35 million $70 million
conclusions about the degree of concentration in a market,
but historical data are also necessary to determine whether
Cut price

there is a trend towards more or less concentration.

To collude or to compete?
Interdependence in oligopolistic markets is responsible $250 million $70 million
for this dilemma that oligopolistic firms face. Through
competition these firms may increase their own market Figure 2.11.10 Pay-off matrix

65
 Policymakers’ perspective all belong to one or two companies, giving just the
illusion of fierce competition. As we shall see next,
Defining the relevant market is very difficult. Markets
even if we do not have a monopoly but an oligopoly
are not defined only by the product being produced and
with say, five or six producers, these companies may
sold but also by geography and location. There may
have secret agreements and behave as if they were
be very many fuel stations in a country but if there is
a monopoly.
only one outlet in some remote area, then this one is
a local monopoly; if there are only three fuel stations Regarding concentration ratios, they do not provide us with
then these three are a local oligopoly. The same applies any information concerning the underlying size distribution
to private hospitals in many countries. There may be of the firms in the market. The same five-firm concentration
very many hospitals in the USA but in certain areas ratio may result in a market where one firm has 80% of the
there may only be two, in which case this would be a market and the remaining four only have 5% each, but it
local oligopoly. Or, to make matters worse, these two may also result in a market where each of the five firms has
hospitals may both be owned by the same corporation. roughly 20% of the market. Lastly, concentration ratios do
Also, in many markets there may be a vast array of not take into consideration competition from imports which
similar products available to consumers, but they may may greatly affect pricing behaviour of domestic firms.

Interdependence Collusive oligopoly

Interdependence is clear. Assume that firm A chooses to Collusion exists when two or more firms agree to fix or to
maintain a high price. It does not know the outcome—whether raise price in order to restrict competition. The agreement
it will earn $210 million or $35million—because it depends can be written, verbal or inferred from conduct. When firms
on the reaction of its rival firm B; namely, whether firm B will collude, they collectively behave as if they were a monopoly.
also maintain a high price or whether firm B will cut its price. Collusion can be formal—in which case a cartel is formed—or
tacit, where the agreement is informal. When a tacit collusive
Risk of a price war agreement is uncovered by the competition authorities, it is
We can see why without some kind of coordination there referred to as a cartel by the press. Collusive agreements are in
is risk of a price war occurring. Consider firm A. It realizes general illegal. The best known formal collusive agreement is
that if firm B maintains a high price it will earn more by OPEC, the Organization of Petroleum Exporting Countries. This
cutting price ($250 million) than by maintaining price ($210 is an international exporting cartel of 14 countries.
million). Firm A also realizes that if firm B cuts price, firm A In collusive oligopoly, member firms behave as if they were a
will again earn more by cutting price ($70 million instead of monopoly. Their aim is to maximize joint profits. This is shown
$35 million). So, no matter what firm B chooses to do, firm in Figure 2.11.11, which can be used to represent an oil cartel.
A will cut price. The same logic applies to firm B thinking
about its best strategy given firm A’s action. It follows that Collusive oligopoly acting as a monopoly
both firms under this set-up will choose to cut price, each
P/unit
earning $70 million.

Incentive to collude MC
The set-up above assumes no communication and can be
Pk b
called a “one-shot” game. In the real world, there is repeated
AC
or, more precisely, continuous interaction between firms in Joint profits
a market. It would become evident to both firms that if they
were to make an agreement and coordinate price changes, C a
they would both be better off: each would earn $210 million.
Less uncertainty and the possibility of greater profits makes
collusion very tempting for firms in oligopolistic markets.

Risk of cheating
D, AR
The structure of the pay-off matrix in Figure 2.11.10 may
also explain why firms sometimes do not abide by the terms 0 Qt MR Q /period
of the collusive agreement made. Firm A realizes that if,
following the agreement with firm B to maintain a high Figure 2.11.11 Collusive oligopoly: an oil cartel
price, it alone decided to cut price it would earn even higher In order to maximize joint profits, the total output all cartel
profits ($250 million) while its rival would have earned members together must sell is at Qt where MR = MC. If the
only $35 million. In such a case, both firms would return members adhere to the agreement, then the cartel price
to cutting price so only under very particular circumstances will be Pk. Joint profits will then be equal to area (CabPk).
would this incentive to cheat materialize. If the pay-off of Members will have to agree on their quotas—the quantity
$35 million was instead a loss of $20 million, then cheating each member will produce and sell.
may have been a much more tempting strategy to pursue.

66
 In the case of OPEC, member countries negotiate and agree wars may deliberately start when circumstances are such

UNIT 2: MICROECONOMICS
on how much oil each will sell in the market to achieve a that a firm confidently expects to gain market share at the
certain price for oil. Despite the formal structure of OPEC, for expense of rivals by cutting price. An example is T-Mobile,
the following reasons the organization’s goal is difficult to which initiated a price cut to attract more subscribers and
achieve. was considered the winner in a relatively recent mobile
• Price still also depends on demand conditions. telecoms price war in the USA. Often such firms have a
“deep pocket”, meaning that they can sustain losses for
• There are quite a few large oil producers who are not
a while.
members (such as the USA, Canada and Russia).
Since starting a price war is typically not in the interest of
• For various reasons, members do not abide by the rules.
most oligopolistic firms, it follows that such firms usually
In other collusive cases, executives of companies secretly adopt non-price competition as a strategy to increase sales,
agree to fix price and then each firm sells as much as it can even if a price agreement has been made. Fear of triggering
at that price. Secret agreements often take place in cafés, a price war as well as collusive agreements result in prices
restaurants or hotels. It has been reported that executives of being “sticky” in oligopolistic markets. Even if production
a yogurt cartel met at a Parisian café “Au chien qui fume” costs decrease, firms do not decrease price.
while executives of a car parts cartel met in Tokyo at “Café
Non-price competition can take many forms. Perhaps the
Renoir”.
single most important method of non-price competition is
Note that oligopolistic firms face a negatively sloped heavy advertising and creation of brand names (an example
demand curve and, independently of whether or not is the soft drinks industry). Firms also compete by:
collusion is present, allocative efficiency cannot be achieved.
• developing and marketing new products (smartphones
Output is less than the socially optimal level because:
and cars)
• profit maximization requires MR = MC
• continuously differentiating their products (breakfast cereals)
• P > MR because demand is negatively sloped; so P > MC,
• offering volume discounts (for shampoos, conditioners and
while allocative efficiency requires that P = MC.
detergents)
Non-collusive oligopoly • providing customers with after-sale service (customer plans
If oligopolistic firms decide to compete by cutting price in the car industry)
there is a very significant chance that they will become • offering lengthy guarantees (for electronics products)
involved in a price war. A price war refers to a situation • offering gifts and coupons (in newspapers and
where a firm attempts to gain market share at the expense supermarkets)
of its rivals by cutting price, triggering retaliation and
• organizing competitions (as radio stations often do).
further price cuts. Usually, all firms end-up worse off, as
shown in the “Prisoner’s dilemma” earlier. Rarely, price

Policymakers’ perspective approach marginal cost and thus the extent

of allocative inefficiency will be diminished. Also,
Oligopolistic firms face a negatively sloped demand
as we shall see later, if these oligopolistic firms are
curve and thus charge a price higher than marginal cost
large they may enjoy other benefits, such as those
so they are allocatively inefficient. If in an oligopolistic
resulting from economies of scale. The issue of efficiency
market firms collude then price may even be as high
in such markets is thus rather complicated.
as if the market was a monopoly. But we must bear
in mind that if there is a price war then price may

Monopolistic competition
A market is considered monopolistically competitive if the monopoly) power. However, that market power is small. This
following applies. is because there are very many firms in each market and
• It has very many firms. consumers thus face many close substitutes. A restaurant
can raise the price of the pasta dish it offers, but not too
• The firms produce differentiated products.
much as there are many other restaurants around that offer
• There are no entry barriers. the same or similar pasta dishes. The same issue affects fuel
Typical examples of monopolistic competition include hair stations and hair salons.
salons, restaurants, bars, opticians or fuel stations. Since
each firm is producing a differentiated product, it faces Monopolistic competition: Short-run
a negatively sloped demand curve. If it raises price it will equilibrium
lose some, but not all, of its customers. It follows that Figure 2.11.12 shows the short-run equilibrium position of a
monopolistically competitive firms have some market (or monopolistically competitive firm.

67
 P/unit MC
P/unit
P B MC

AC
AC
F
C A (AC = AR) = P

H D, AR

0 Q Q /period
D, AR MR
0 Q Qsoc Q /period Figure 2.11.13 Monopolistic competition: long-run equilibrium
MR
Efficiency issues in monopolistic
Figure 2.11.12 Monopolistic competition: short-run equilibrium
competition
Assuming that it aims at maximizing profits it will choose
Monopolistically competitive firms are allocatively inefficient.
to produce and offer Q units per period, where MR = MC,
They produce less output than the socially optimal level
and sell at price P. It will be thus earning abnormal (or
because at the chosen level of output, P > MC. Remember,
supernormal) profits equal to area (CABP).
they face a negatively sloped demand curve and so have
Since firms in this market are earning abnormal (or some degree of market (or monopoly) power. However, the
supernormal) profits other entrepreneurs will have the degree of monopoly power they possess is quite limited.
incentive to enter this market. Why? It is because firms They cannot charge a price that is significantly higher than
in this market are earning more than normal profits, marginal cost. Consumers have very many close substitutes
which means more than what they could have been to choose from. For example, if the price of a popular meal
earning in the next best alternative with the same risk. rises too much in a restaurant in town, people can easily
More firms will enter the market as there are no barriers switch to another restaurant. The degree of allocative
in monopolistic competition. As they enter, the demand inefficiency in monopolistically competitive markets is
that each firm faces “shrinks and tilts”. It decreases and usually rather small. In addition, demand faced may not
the demand curve shifts left. This is because at each be horizontal, but since the existence of very many close
price they will be selling less because of their diminishing substitutes makes it quite flat, such firms will produce with
market share. Demand also becomes flatter, meaning more an average cost only slightly above the minimum. This may
price elastic. Why? It is because consumers will be facing also be the result of their constant attempt to differentiate
even more and even closer substitutes. This process of their product even more. So, even the extent of technical
entry will stop when firms in this market are earning zero inefficiency will be small.
economic profits (that is, normal profits). If entrepreneurs
Most importantly, monopolistically competitive markets
earn in this market as much as they could earn in the
present consumers with great variety and this is a highly
next best alternative with the same risk, then there will
valued characteristic of this market structure. There are
be no reason for more firms to enter or for any of the
restaurants and hair salons, for example, that cater to every
incumbent firms to exit. Long-run equilibrium will have
taste and if there is a niche, an entrepreneur will soon enter
been reached. Figure 2.11.13 shows long-run equilibrium
the market to satisfy it.
in a monopolistically competitive market.

Monopolistic competition: Policymakers’ perspective

Long-run equilibrium Monopolistic competition is allocatively and
Entry of new firms and the existence of even more and even technically inefficient but the extent of these
closer substitutes for consumers have shifted the demand inefficiencies is very small compared to monopoly
curve to the left for each firm and made it quite price elastic or oligopoly. The market power and resulting
and flat. It can never be horizontal because products are pricing power of monopolistically competitive
differentiated. Profit-maximizing monopolistically competitive firms are minimal. These firms offer tremendous
firms will choose Q units, where MR = MC, and sell at variety to consumers. The fact that there are many
price P. Economic profits are zero as at Q, AR = AC. The monopolistically competitive firms implies that for any
demand curve has shifted left until it became tangent to the such market there will probably be a firm located near
U-shaped AC curve. Since firms are earning normal profits, consumers, which is also an advantage.
this represents long-run equilibrium in the market.

68
Advantages of large firms

UNIT 2: MICROECONOMICS
Firms that are large in size and have significant market Large firms in monopoly or oligopolistic markets are in
or monopoly power have certain advantages when position to maintain abnormal (supernormal) profits in
compared with the small firms in perfect and monopolistic the long run. This enables them to invest in research and
competition. development (R&D) activities which is of tremendous
Being large in size allows firms to benefit from economies importance because R&D leads to innovations.
of scale. These firms can often produce at a lower average Innovations refer to new products and new production
cost compared to smaller firms. This allows larger firms processes. There is no question that consumers have
to set a price lower than the price found in a perfectly benefited from striking innovations. The question that
competitive market and to offer an even greater quantity. remains is what market characteristics make innovations
Of course, there is no guarantee that the cost savings more likely to result.
resulting from economies of scale will be passed on to Lastly, there is the Schumpeterian argument in favour
consumers in the form of lower prices. The extent to which of large firms with monopoly power that can maintain
this will be the case depends on the actual and potential abnormal (supernormal) profits in the long run. Schumpeter,
competition these firms face. Entrenched monopoly an Austrian economist at Harvard University, held that in
positions or successful collusive agreements that are the absence of entrenched monopoly power, large firms are
maintained for long and are not exposed may not lead to not only able to innovate but are forced continuously to
the lowest prices that competition guarantees. innovate to avoid being swept away by the “perennial gale
of creative destruction”.

Abuse of monopoly power

Monopoly power may be necessary to permit a firm to to higher prices for final consumers but it has caused
grow and to invest in R&D and innovate but there are competing producers to suffer and may have decreased the
many instances where a firm’s dominant position has led rate of innovation.
to abuse of such a position. A dominant position does not When firms collude and behave as if they were a monopoly,
in itself constitute a reason for governments or competition pricing abuses result that harm consumers (who are forced
authorities to intervene. However, abuse may be present to pay higher prices). The European Commission has
if it is suspected that a firm is acting with the intention to fined members of many cartels in a vast area of markets
eliminate competitors or to prevent entry of new firms. Tech including canned vegetables, electronics products, car safety
giants such as Google, Facebook, Apple, Intel and Amazon, equipment, apple sauce, beer, vehicle sales and many others.
among others, have been suspected of abusing their market In all cases of collusion, the resulting market power led to
power. They have been accused of acting in precisely the much higher prices paid and less choice for consumers. In
manner described above. They have restricted competition in the market for pharmaceuticals there is a lot of discussion on
their markets by aggressively buying out their competitors. how some firms have managed effectively to extend patents
The USA Justice Department has complained that some on drugs to more than 40 years instead of the 20-year
hi-tech companies have reached agreements that deprived current limit. Some drugs companies have also been accused
engineers and scientists working for them of seeking better of “paying for delaying” tactics, where they pay firms to
job opportunities elsewhere. Some have used their extensive delay entry into a market after a patent has expired. Such
legal resources to suppress competition by restricting access abuse of monopoly power has led to exorbitant prices for
to their platforms to rival firms. This may not directly lead drugs, harming consumers and taxpayers.

69
 Policymakers’ perspective
The typical set of available responses in the policymakers’ example, the EU competition commission recently blocked
toolkit includes, among other tools: the merger between the German firm Siemens and French
• imposing heavy fines firm Alstom, Europe’s largest suppliers in the rail market.
The reason was that the merger would have “harmed
• prohibiting mergers
competition in markets for railway signaling systems and
• prohibiting acquisitions very high-speed trains”. The proposed merger “would
• forcing firms to sell off parts have led to higher prices, less choice and less innovation”,
• imposing a maximum price. according to EU Competition Commissioner M Vestager.
It is important to stress that in the case of enforcing There was another side to the argument, though. It
competition the USA and the European perspective relates to the discussion of what constitutes the relevant
diverge. The USA has shifted its focus exclusively towards market. According to this perspective, the real markets for
consumer welfare so that a major guiding principle is these European manufacturers are outside Europe where
whether the final consumer is harmed from higher prices they would have to compete for international contracts
or not. The 2020 Economic Report to the President with CRCC, a huge Chinese competitor, as well as with
claimed that rising concentration is driven by economies other Japanese and South Korean companies. There was
of scale that decrease prices for consumers and that need, according to this side, for a “European champion”
successful firms tend to grow, so it is important that that could better compete in international markets. It was
competition authorities do not punish firms for their not an easy question to decide.
success. Or, if policymakers set price ceilings or other restrictions
Others, including the Europeans, have in addition focused on, for example, pharmaceutical corporations, there is
on: the rights of excluded competitors; the impact of firm a risk that it would decrease their incentive to innovate
practices on workers; whether certain large firms have too and spend billions to find new life-saving drugs. These are
much buying power, forcing down prices and suffocating questions that are not easily settled.
suppliers; and the possible negative impact of rising In general, it is not easy to decide whether there is abuse
concentration on the rate of innovation. of market power and what kind of response is optimal for
The job of the policymaker is not easy. It is a balancing society. The particulars of each case matter a lot.
act often with many conflicting considerations. For

70
 3.1 Measuring economic activity and

UNIT 3: MACROECONOMICS
illustrating its variations
Measuring economic activity involves measuring an a point in time or over some period if we do not know how
economy’s national income or total output and is referred total output and income have behaved. If performance has
to as national income accounting. been judged unsatisfactory, policymakers will need to devise
We cannot evaluate the performance of an economy: that is, and implement policies to improve its performance and also
determine whether an economy is doing better or worse this to judge the effectiveness of their policy choices later.
year compared with last year or five years ago, if there is no National income accounting therefore helps in assessing
measurement of economic activity. We cannot compare the economic performance through time, across countries, as
performance of one economy against other economies at well as in devising and evaluating policies.

How is economic activity measured?

Gross domestic product (GDP) such as agriculture, manufacturing, transport, banking
GDP is the most often used measure of economic activity and so on.
and it is defined as the value of all final goods and services GDP = sector 1 + sector 2 + sector 3 + … + sector n
produced within an economy over a period of time, usually • The expenditure approach measures the total amount
a year or a quarter. spent on domestically produced final goods and services.
Let’s add some points to explain this definition. Total spending includes:
• The “value” of a good or a service is simply its quantity − consumption spending (C) : spending by households
produced multiplied by its price. − investment spending (I) : spending by firms
• Goods can either be “final” or intermediate. Only final − government spending (G)
goods and services are included in GDP. Intermediate − net exports (X – M): spending by foreigners on
goods, which are inputs to the production of final goods domestic goods and services (that is, exports) minus
and services, are excluded to avoid double counting. domestic spending on foreign goods and services
For example, steel is an input to the production of cars (that is, imports).
and so it is an intermediate good while cars are the final
good. Steel is thus already included in GDP as part GDP = C + I + G + (X – M)
of cars. Considering it separately would only lead to • The income approach adds up all the income generated
counting it twice. in the production process and by the factors of production
• In some cases a good can be both final and intermediate. in the economy.
For instance, flour produced by McDougall’s flour mill GDP = rents + wages + interest + profits
is final when bought by individual consumers at the The three methods described above are equivalent
supermarket but also intermediate when bought by and with some minor adjustments all three approaches
Warburtons bakery to produce bread. This shows that, yield the same result. The idea rests on the circular
instead of trying to work out which goods are final, the flow of income, which was presented in section 1.1
“value added” contributed by each firm in the country can (see page 5).
be counted. The value added is defined as the difference The circular flow model shows that the value of
between the total revenues collected by each firm and the output produced is equal to the expenditures made to
cost of raw materials, services and components the firm purchase that output, which is equal to the total income
purchased to produce the good or service. generated in producing that output. That is to say, in an
• “Within an economy” means that the goods and economy the value of goods and services produced is
services are produced within the physical borders of equal to the expenditures made to purchase these goods
the country. and services. These expenditures did not disappear but
• Also, measurement of the GDP of an economy does not they ended up in the pockets of all those who were
include transactions involving used goods, financial responsible for the production of these goods and
transactions or transfer payments, as these do not services as income. For example, if in an economy only
represent contributions to current production of goods 100 haircuts were produced in 2020 valued at $1000.00
and services. (value of output), then $1000.00 was spent by all those
There are three conceptually equivalent methods to calculate who got their hair cut (expenditures on this output) and
GDP. Government statisticians use all three methods. this $1000.00 was collected by all those responsible for
the production of these haircuts (income generated by the
• The output approach adds up the value of all the final production of this output).
goods and services produced by each economic sector,

71
 Gross national income (GNI) a measure of output after having isolated (or, adjusted for)
As explained above, the income approach of calculating GDP the effect of inflation. Real GDP figures reflect the volume of
is to add up all the income earned by factors of production production, not the value. The same applies to real GNI.
from firms operating within the economy—but consider two Define the GDP deflator as the ratio of nominal GDP to real
questions. What happens when profits are paid to foreigners GDP of a year times 100:
nominal GDP
who own stocks in domestic firms? Where do the profits earned GDP deflator = × 100
real GDP
by domestic companies operating overseas fit in? The answer is
that they go into GNI but not GDP, where GNI is given by: By manipulating the above we arrive at:
GNI = GDP + factor income from abroad − factor income nominal GDP
Real GDP = × 100
sent abroad GDP deflator
GNI thus includes factor income earned abroad by a country’s The GDP deflator is a comprehensive price index that
residents, such as the profits of Microsoft’s European measures the average level of prices of all goods and
operations that accrue to Microsoft’s US shareholders and the services included in the GDP of a country.
wages of US consultants who work temporarily in East Asia. Real GDP or real GNI must be used when making
However, it excludes factor income earned by foreigners, such comparisons over time, as it is important to isolate the effect
as profits paid to Chinese investors who own US stocks and of changing price levels.
payments to Venezuelan workers temporarily in the USA.
In practice, it does not make much difference which measure
Per capita figures
is used for large economies like that of the USA, as the flows By dividing GDP or GNI by the population of a country we
of net factor income to other countries are small. For smaller arrive at per capita GDP and per capita GNI respectively. Per
countries, however, GDP and GNI can diverge significantly. For capita figures provide an indication of average or per person
example, much of Ireland’s industry is owned by US corporations output or income in the economy. Per capita income figures
and their profits must be deducted from Ireland’s GDP. can be used as a measure of the standard of living in a
country as they provide a very rough indication of the access
Nominal versus real values to goods and services that the population of a country has.
Nominal GDP is the value of output of a certain period Real GDP/GNI per capita at purchasing power
valued using the prices that prevailed at that period. parity (PPP)
Nominal GDP or nominal GNI for, say, 2020 are expressed in
To have a basis of comparison across countries we need to
terms of current prices, the prices prevailing in 2020.
convert each country’s per capita income figure to a common
Now consider the following. If GDP was $10 million in currency, which is typically the US dollar. Yet, prices of goods
2017 and 10% more in 2018 (that is, $11 million) we and services can vary significantly across countries. A haircut in
cannot know whether the higher figure was due to an Lagos is much cheaper than a haircut in New York. Cost of living
increase in output produced. If prices had increased by 10% differences must be considered in the conversion of per capita
then output produced was the same. To measure actual income to US dollars. Therefore, instead of the market exchange
changes in output, we need real GDP or real GNI. rate we use “purchasing power parity” (PPP) dollars. These are
More specifically, real GDP is a measure of output of a certain dollars of equal purchasing power: that is, they buy the same
year (say, year “t”) valued at the prices prevailing at some basket of goods and services that the national currency buys. As
reference period (known as the base period or base year). So, such, PPP dollars incorporate cost of living differences and make
the output of each good in year “t” is multiplied by its price cross-country comparisons more meaningful.
that prevailed in the base year chosen. Real GDP is therefore

What do all these national income statistics tell us?

National income statistics can: • help policymakers devise and evaluate appropriate policies
• provide a measure of the size of the economy • be used to make cross-country comparisons
• be used to assess the performance of an economy over time • be used as a measure of the standard of living in a country.

Using GDP or GNI statistics to measure economic well-being

Bear in mind that if any such attempt is made it is better to divided by the population to adjust for the size of the country.
use GNI rather than GDP figures, as GNI focuses on incomes Also, if comparisons are made through time, then real and not
earned by the nationals of a country while GDP focuses on nominal figures must be used to adjust for changing prices.
output produced inside the country. Such a figure must be

72
The major argument in favour of using per capita income as a Better Life Index (BLI)

UNIT 3: MACROECONOMICS
measure of living standards is that if it is higher it implies that The Better Life Index (BLI) has been developed by the
people command more output on average, and access to more Organization for Economic Cooperation and Development
output is considered better than access to less output. (OECD) and is designed to produce an overall well-being
However, this per capita statistic suffers from major index. The BLI includes 11 topics that reflect what the OECD
deficiencies and should be employed with extra care. The has identified as essential to well-being in terms of material
following is a list of the associated problems. living conditions and quality of life. The topics include:
• As an average, a per capita statistic provides no information • housing • education • life satisfaction
about the distribution of income in a country. Per capita • income • environment • safety
income of a country may be high because people in the top
1% earn extraordinarily high incomes but the bottom 99% • jobs • civic engagement • work and life
earn very little. For example, the USA and Denmark have • community • health balance.
both high per capita income levels but income inequality in Each of the 11 topics of the index is based on one to
the USA is much higher and so we cannot claim that living four indicators that are averaged with equal weights.
standards in these two countries are the same. For example, the Jobs topic is based on four separate
• Per capita income rises when production levels rise but measures: the employment rate, personal earnings, the
it may be rising at a huge cost to the environment. long-term unemployment rate and job security. The
Any damaging effect of increased production on the BLI can then be used to assess well-being within countries
environment is ignored. If per capita incomes double and across countries. For instance, the USA, despite having
over a decade but at a cost of epic pollution and a high per capita GDP (much higher compared to the
environmental degradation, is it safe to conclude that OECD average), ranks below average in terms of work
living standards have also doubled? For instance, in and life balance because it is faced with significant income
India per capita incomes have grown dramatically but inequality. In contrast, Colombia has a relatively low per
at the same time in 2020 India was home to “21 of the capita GDP (significantly lower than the OECD average),
world’s 30 most polluted cities” (CNN 2020). Green GDP but ranks above average in health status as well as
is an attempt to correct this problem as it factors in the environmental quality, which are important dimensions
detrimental effect of production on the environment. of well-being.
Green GDP is estimated by subtracting from GDP the cost
of natural resource and environmental depletion. Happiness Index
• Per capita income statistics fail to include the value of leisure. The Happiness Index has been developed by the United
Leisure is a most important dimension of the well-being of Nations Sustainable Development Solutions Network and is
people, but its importance is not accounted for. Per capita published annually in the World Happiness Report, a survey
income levels may be the same in two countries, but it makes of the state of global happiness that ranks 156 countries by
a difference whether people work 60 or 35 hours per week. how happy their citizens perceive themselves to be. To estimate
the Happiness Index the “Cantril Ladder” is used, where the
• Living standards are not only affected by current income sample population is asked to rank their satisfaction with
but also by the stock of wealth of the population. The respect to their present living conditions from 0–10 (where
house or the car a family owns provides services that 10 represents the best possible life and living conditions and
significantly contribute to their well-being. 0 presents the worst possible life and living conditions). The
• The level of public health care and public education available Happiness Index is then calculated by averaging the answers
to citizens may differ between two countries with the same to this Cantril Ladder to a single number. According to the
per capita income greatly affecting living standards. High Happiness Index of 2018, the happiest countries in the world
quality health care and education services available free are: Finland (7.63), Norway (7.59) and Denmark (7.56) whereas
at point of delivery permit families to spend more on other the unhappiest countries in the world are: Burundi (2.91),
goods and services. Central African Republic (3.08) and South Sudan (3.25).
• Some expenditures may be recorded as positive contributions
to economic activity and so to income although they have Happy Planet Index (HPI)
been made to counteract activities that have caused harm. The Happy Planet Index (HPI) has been developed by the
For example, the expenditures for cleaning up the oil spill in New Economics Foundation of London and is designed to
the Gulf of Mexico were an addition to the US GDP with no assess whether a country is able to promote the well-being
adjustment made for the environmental catastrophe. of its residents. It is made up of the three variables of:
• Per capita statistics fail to reveal the composition of • average life expectancy
output. Two economies with equal per capita income • average subjective well-being
levels may differ with respect to economic well-being • ecological footprint (the impact of a person or community
because of different output mix. A country that devotes on the environment, expressed as the amount of land
a large proportion of its GDP to, say, defence, sacrifices required to sustain their use of natural resources).
resources that could otherwise have been used in the
production of pro-development goods. Surprisingly, the top five countries in the Happy Planet Index
ranking have GDP per capita levels below $10,000. Costa Rica is
For all these reasons, alternative measures to assess well- on the top of the ranking, with Costa Ricans having a significantly
being have been developed. higher well-being than the residents of many rich nations.

73
 The business cycle 1. Calculate nominal GDP from the expenditure approach.
The real GDP of a country does not increase continuously over Nominal GDP can be calculated from expenditure data using
time. Typically, periods during which the economy expands are the relationship:
followed by periods during which the economy contracts. The nominal GDP = C + I + G + (X – M)
business cycle, shown in Figure 3.1.1, refers to these short-term So: nominal GDP = 35.86 + 6.52 + 22.82 + (8.6 – 9.8) =
fluctuations of an economy’s real GDP over time. $64.0 billion
2. Calculate nominal GNI for Lalaland.
Real
GDP To calculate Lalaland’s GNI we need to add net factor
peak long-term (or property) income from abroad to its GDP figure. This is
peak trendline equal to income earned abroad ($1.1 billion) minus income
paid abroad ($1.3 billion):
n
co

sio
n

1.1 – 1.3 = −$0.2 billion.

tra

n
pa
cti

It follows that in 2015 Lalaland’s GNI was

ex
o n

64.1 – 0.2 = $63.8 billion.

trough
The following table shows additional data for Lalaland.
Year Nominal GDP GDP deflator Population
($ billion) (million)
0 t1 t2 t3 Time 2016 308.12 98.9 13.27
Figure 3.1.1 The business cycle 2017 321.99 100 13.34
2018 332.65 102.2 13.47
Between time t1 and t2 the economy is contracting
(contraction phase) since real GDP is decreasing. We say that 3. Calculate the level of real GDP for Lalaland for 2016 to
it is in recession (technically, an economy is in recession if real 2018.
GDP decreases for at least two consecutive quarters). At t1
To calculate real GDP from nominal GDP data we need to
it was at a peak and just about to enter recession. The major
divide the nominal GDP data by the GDP deflator that year
characteristic of a recession is rising unemployment. At t2 it
and multiply your result by 100.
is at a trough and just about to enter recovery–expansion.
Between time t2 and t3 the economy is growing (expansion 308.12
2016: real GDP = × 100 = $311.55 billion
phase) since real GDP is increasing. However, if the expansion 98.9
is too rapid it may give rise to inflationary pressures. 321.99
2017: real GDP = × 100 = $321.99 billion
This economy is also growing over the long term as the 100
trendline is upward sloping. The trend line is the average 332.65
annual long-term growth of the economy. 2018: real GDP = × 100 = $325.49 billion
102.2
An economy is growing when real GDP is increasing, and
4. Calculate the real GDP per capita for Lalaland for 2016
it is contracting when real GDP is decreasing. The growth
to 2018.
rate of an economy is the percentage change of real GDP
between two years. If the percentage change in real GDP To calculate real GDP per capita we must divide real GDP by
is positive, then real GDP is increasing, suggesting that the population of the country.
the economy is growing. However, if the growth rate is
negative, then real GDP is decreasing, and the economy
2016: real GDP per capita = x 311.55 × 109
13.27 × 106 c = $23,478
is in recession. Note that if the growth rate is positive but
real GDP per capita = x
13.34 × 10 c
decreasing (from, say, 2.1% to 0.8%) real GDP continues to 321.99 × 109
2017: 6
= $24,137
increase but at a slower rate. It is not in recession.

real GDP per capita = x

13.47 × 10 c
Calculations 325.49 × 10 9
2018: 6
= $24,164
The following data refer to Lalaland in 2015.
Variable Amount ($ billion)
Consumption expenditures (C) 35.86
Investment expenditures (I) 6.52
Government expenditures (G) 22.82
Export revenues (X) 8.6
Import expenditures (M) 9.8
Factor income earned abroad 1.1
Factor income paid abroad 1.3

74
 3.2 Variations in economic activity—aggregate

UNIT 3: MACROECONOMICS
demand and aggregate supply
Aggregate demand
Aggregate demand refers to the total planned spending on If people feel poorer they tend to spend less; consumer
domestic goods and services at different average price levels expenditures fall (C). Thus, if the average price level rises
per period of time. then spending on domestic goods and services falls,
Spending on domestic goods and services can originate leading to a downward sloping AD curve.
from households, firms, the government and foreigners. This • The trade effect: if the average price level increases then
means that aggregate demand (AD) includes consumption exports become less competitive abroad while imports
expenditures (C), investment expenditures (I), government seem more attractive at home, so net exports (NX), a
expenditures (G) and exports (X). However, since some of component of aggregate demand, decrease. Thus, if the
the expenditures that households, firms and the government average price level rises then net exports fall, leading to a
make are on foreign goods, we must subtract imports (M). downward-sloping AD curve.
AD = C + I + G + (X – M) • The interest rate effect: if the average price level increases,
If this looks familiar, it is because GDP measured by the then people need to hold more money to buy the same
expenditure approach is the same sum—but GDP and goods and services. The demand for holding money (cash
aggregate demand are not at all the same concepts. GDP and cheque accounts) increases. If the supply of money
is actual output produced, say $5.15 trillion in Japan in by the central bank is constant then the “price” of money,
2019, whereas aggregate demand shows the planned level which is the interest rate, rises. Higher interest rates decrease
of spending at different price levels in a country. So GDP is a consumption (C) and investment (I) expenditures as people
number whereas aggregate demand is a function. and firms will borrow less from banks to buy durables
and capital equipment. So, if the average price level rises
In Figure 3.2.1, aggregate demand is illustrated by the AD
then consumption and investment decrease, leading to a
curve. On the horizontal axis is real output and on the vertical
downward-sloping AD curve.
axis is the average price level (APL), an index of the average of
the prices of all final goods and services in the economy. As in all diagrams, the function will not shift when a variable
on either of the axes changes. So, if there is a change in the
Average price average price level there will be no shift in the AD curve but
level (APL) only a movement along it.
Aggregate demand will shift only if a determinant induces a
change in any of its components. An increase in aggregate
APL2 demand means that there is a shift of the AD curve to the
right from AD1 to AD2. A decrease in aggregate demand
means that the AD curve shifts to the left from AD1 to AD3.
APL1 These effects are shown in Figure 3.2.2.

Average price
level (APL)
AD
0 Yr2 Yr1 Real output
(Yr)
Figure 3.2.1 The AD curve

So, if the average price level is at APL1 then planned level

of spending on domestic output is at Yr1. If the average price
level is at APL2 then planned level of spending on domestic AD2
AD1
output is at Yr2.
AD3
The AD curve is downward sloping but not for the same 0 Real output
reasons that the demand for a single good is downward (Yr)
sloping, as on the vertical axis we have the average price of
all goods and not the price of a single good. The AD curve Figure 3.2.2 Shifts of the AD curve
is negatively sloped because of the wealth effect, the trade
effect and the interest rate effect. Determinants of aggregate demand
• The wealth effect: if the average price level increases then components
the real value of the money that people have in their Consumption expenditures (C) are defined as spending by
pockets or in bank accounts, as well as the real value of households on durables and non-durables and services and
other financial assets they own such as bonds, decreases. depend on the following.

75
 • Interest rates: the interest rate is the cost of borrowing leading to an increase in aggregate demand and a
or the reward for saving money over a period of time rightward shift of the AD curve.
expressed as a percentage. Households borrow to finance Investment expenditures (I) are defined as spending by
the purchase of durables, such as cars and appliances, and firms on capital goods (such as machines, tools, equipment
of houses. An increase in interest rates makes borrowing and factories) per period of time. Investment increases the
more expensive, resulting in less borrowing and so less stock of capital of an economy. Investment is important
consumer spending, decreasing aggregate demand and both because of its influence on aggregate demand but also
shifting the AD curve to the left. In addition, higher because of its influence on aggregate supply and so the rate
interest rates make saving more attractive. If people of long-term economic growth. Investment spending depends
tend to save more then it automatically implies that they on the following.
will tend to spend less. The reverse applies following a
• Interest rates: if interest rates increase then borrowing to
decrease in interest rates. Lower interest rates reduce the
finance the purchase of capital goods such as machines,
cost of borrowing while rendering saving less attractive
tools, equipment and factories will become more
and can lead to an increase in spending, boosting
expensive so firms will find that fewer possible investment
aggregate demand and shifting the AD curve to the right.
projects are now profitable. Even if a firm uses its own
• Consumer confidence: this is a measure of how optimistic funds to finance an investment project, the opportunity
households are and how secure they feel about the future. cost of using these funds instead of keeping them in
Households feeling secure and confident about their banks or as bonds increases. Investment expenditures by
future will tend to spend more. A stable and growing businesses are therefore expected to decrease, shifting the
economy with low inflation and unemployment will boost AD curve to the left. Decreases in interest rates have the
consumer confidence and favourably affect household opposite effect. Borrowing costs for firms fall leading to an
spending, shifting the AD curve to the right. On the other increase in investment spending and aggregate demand
hand, uncertainty over future job prospects and insecurity shifting the AD curve to the right.
about one’s future income adversely affect present
• Business confidence: this refers to how businesses feel
consumption. Spending on durable goods, such as cars
about their future sales and about the economy. Economic
and appliances, as well as on housing, is greatly affected
and political stability are necessary for a positive business
by consumer moods.
climate to evolve and so for more investments to take
• Household wealth: wealth refers to the value of what place. If firms are optimistic, they are more likely to
households own, such as stocks, bonds, deposits or real invest and expand, aggregate demand will increase and
estate, minus what they owe. An increase in household the AD curve will shift to the right. Business pessimism,
wealth, for example due to a rise in property prices, leads though, results in a decrease in investment spending
to more spending, which increases aggregate demand, and a decrease in aggregate demand, so the AD curve
shifting the AD curve to the right. In contrast, if stock shifts to the left. Keynes considered the behaviour of
prices fall, wealth decreases and so will consumption. entrepreneurs with respect to investment decisions
Aggregate demand will decrease and the AD curve will similar to that of a herd (imitation) and, in his opinion,
shift to the left. the observed instability of investment was due to these
• Personal income taxes: these determine the level of “animal spirits”. Expectations can be greatly changed
disposable income, which is the income left after taxes by many unpredictable factors, leading to swings in the
are paid. If the government raises personal income taxes, prevailing business climate and so to changes in the level
disposable income falls, spending drops with aggregate of investment spending.
demand decreasing and the AD curve shifting to the left. • Technology: industries where technology improves fast
On the contrary, a reduction in personal income taxes will will witness more investments, thus causing increases in
lead to an increase in disposable income. Consumption aggregate demand and a rightward shift in the AD curve.
will thus increase and so will aggregate demand.
• Business taxes: these affect firms’ profits. A decrease in
• Household indebtedness: this refers to how much money business taxes increases the profitability of investment
households owe from taking out loans or from using projects. More investment projects will be approved so
credit cards. If they owe a lot, they will cut back on their investment spending will tend to increase. Aggregate
spending, as they will first try to decrease their debt. demand will increase and the AD curve will shift to
Aggregate demand will decrease and the AD curve will the right. An increase in business taxes may result in
shift left. decreased investment and a leftward shift of the
• Expectations of future price level: if households expect AD curve.
the average price level to decrease (deflationary • Corporate indebtedness: if firms have high levels of debt
expectations) they may delay purchases since they come due to past borrowing, they will be hesitant to take out
to expect further price decreases. As a result, aggregate more loans and make more investments as they will first
demand decreases and the AD curve shifts to the left. try to decrease debt. Hence, aggregate demand decreases
On the contrary, if consumers expect prices to increase and the AD curve shifts to the left.
(inflationary expectations) they may increase spending,

76
Government expenditures (G) are in many economies a increase, increasing aggregate demand and shifting the

UNIT 3: MACROECONOMICS
large proportion of total expenditures on goods and services. AD curve to the right. An increase in the exchange rate
Government spending is categorized as: (appreciation) will have the opposite effect; net exports
• current spending on goods and services decrease, shifting the AD curve to the left.
• capital (public investments) spending, which refers to • Trade policies: these refer to restrictions to international trade
spending on roads, ports, telecommunications, schools such as tariffs or quotas often imposed by governments
and other infrastructure (see section 4.2). If the government of one country imposes
restrictions on the imports of another country, then imports
• transfer payments, which refer to pensions and
will fall and so net exports will rise, increasing aggregate
unemployment benefits; note that transfer payments
demand and shifting the AD curve to the right. For example,
are not included in national income since they do not
the US administration’s decision to impose tariffs on Chinese
represent rewards to current productive effort.
steel and aluminum is expected to reduce imports and in turn
Governments spend to ensure that adequate amounts of increase net exports and aggregate demand. Relaxing trade
public and merit goods and services are available, such as restrictions can have the reverse effect. Reducing tariffs or
national defence, education and health care. They spend to quotas can lead to an increase in imports and so to a fall in
regulate markets in their attempt to guarantee product safety, net exports, which will decrease aggregate demand, shifting
environmental standards, competitive conditions and so on. the AD curve to the left.
They may also spend to redistribute income so that a socially
acceptable minimum is guaranteed for all. Such spending,
for example, includes funding state pensions, unemployment Recap
benefits, subsidies and disability benefits. Lastly, governments Aggregate demand
spend to affect aggregate demand. An increase or decrease
Movements along the AD curve are caused by
in government expenditures will cause aggregate demand to
changes in the average price level that lead to:
increase or decrease, with the AD curve shifting to the right
or to the left. This is part of what is known as fiscal policy • the wealth effect
(explained in section 3.6). We may therefore conclude that • the trade effect
economic and political priorities affect the level of government • the interest rate effect.
spending. For instance, it may be a political priority to equip
Shifts in aggregate demand are caused by:
all public schools with smartboards and each student with a
tablet, while it may be an economic priority that taxes on higher changes in consumption expenditures (C) resulting
incomes must increase to decrease widening income inequality. from changes in
Net exports (X – M) are defined as the difference between • interest rates
spending by foreigners on domestic output minus domestic • consumer confidence
spending on foreign output or, more simply, as the difference • household wealth
between export revenues and import expenditures per period
• personal income taxes
of time. They depend on the following.
• household indebtedness
• Income of trading partners: if income of our trading
partners increases, their level of spending will increase. • expectations on future price level
Part of their increased spending will be on imports, which changes in investment expenditures (I) resulting
are our exports. Thus, the exports of an economy will tend from changes in
to increase if the income of its trading partners increases, • interest rates
increasing aggregate demand and shifting the AD curve • business confidence
to the right. For example, if the USA grows and income
of Americans rises they will buy more Mexican goods • technology
so Mexico’s exports will increase and so will Mexico’s • business taxes
aggregate demand: the AD curve will shift to the right. • corporate indebtedness
If, however, the income of our trading partners decreases, changes in government expenditures (G) resulting
say, as a result of a recession, then our exports will tend to from changes in
decrease, leading to a decrease in aggregate demand and
• economic priorities
a leftward shift in the AD curve.
• political priorities
• Exchange rates: an exchange rate is the price of a
country’s currency expressed in terms of another country’s changes in net exports (X – M) resulting from
currency. For example if €1.00 = USD1.13 it means that changes in
the price of one euro expressed in terms of US dollars is • income of trading partners
1.13. If the exchange rate depreciates (so, in this example, • exchange rates
if €1.00 now is equal to USD1.05) then EU exports
• trade policies.
become cheaper and more competitive abroad (in the
USA) while imports (from the USA) become pricier and less
attractive domestically (in the EU). As a result, net exports

77
 Aggregate supply
Aggregate supply is defined as the planned level of output and the average price level is on the vertical axis. This is
domestic firms are willing to offer at different average price shown in Figure 3.2.3.
levels per period time. Note that aggregate supply is not the
same as real GDP. Aggregate supply shows how much output Average price
domestic firms are planning to offer at different average level (APL) SRAS
price levels. The shape of the AS curve is rather controversial
in macroeconomics as it reflects the different assumptions
used by different schools of thought. We will initially discuss
aggregate supply under the Monetarist /New Classical
APL2
model and, then, we will present aggregate supply under the
Keynesian model.
APL1
Aggregate supply under the Monetarist/
New Classical school
Monetarists (and New Classical economists) make a
0 Yr1 Yr2 Real output
distinction between the short run and the long run. As
a result, there is a short-run aggregate supply (SRAS) and a (Yr)
long-run aggregate supply (LRAS).
Figure 3.2.3 The SRAS curve
Short-run aggregate supply
If the average price level rises from AP1L to APL2 while
Within the aggregate supply framework, the short run is the
money wages remain fixed, then the real wage decreases and
period during which money wages are fixed and unable to
firms enjoy greater profitability, which induces them to offer
adjust to changes in the average price level. The money wage
more output: Yr2 instead of Yr1.
is basically what is written on a pay slip (that is, the “dollars”
earned per time period). Changes and thus shifts in short-run aggregate supply are
mainly caused by changes in production costs. Note that
On the other hand, the real wage is what you can buy
these would have to be changes in costs of production that
with your money wage, or the purchasing power of your
will simultaneously affect most firms in the economy, not
money wage. The real wage is thus:
only firms of a particular market. Thus short-run aggregate
Wm
Wr = supply will increase or decrease and thus the SRAS curve will
APL shift in the following cases.
For example, if the Edgar’s money wage is $60 per day and • Money wages change: money wages can change if, for
the price of a small carton of fruit juice is $2.00 then his real example, there is a change in the minimum wage. So,
wage can be thought of as being 30 small cartons of juice if money wages increase, firms’ costs of production rise,
per day. If Edgar continues to earn $60 but the price of a fruit resulting in a decrease in short-run aggregate supply and a
juice rises to $4.00 per small carton, his real wage decreases leftward shift in the SRAS curve. In contrast, if money wages
to 15 of these cartons of juice per day. Of course, instead of decrease, for example because a government weakens the
using the price of one good, we use the average price level to power of labour unions, short-run aggregate supply increases
determine whether the real wage increased or decreased. and the SRAS curve shifts to the right.
Money wages are usually determined by labour contracts. • Energy prices change: changes in the price of oil affect
This means that if the price level in the economy changes, short-run aggregate supply in the same way as changes in
as long as contracts are in effect, money wages will not wages. An increase in the price of oil decreases short-run
adjust to match the change in the price level. There is also a aggregate supply and shifts the SRAS curve to the left; a
second explanation based on the idea that workers are slow decrease increases short-run aggregate supply and shifts
to adjust their expectations of inflation (of a rising average the SRAS curve to the right.
price level) and only after some time do they realize that
rising prices have affected their purchasing power. • Indirect taxes or subsidies change: indirect taxes, such as
sales taxes, affect costs of production. Therefore, higher
The reason money wages are closely related to aggregate taxes increase production costs and so decrease short-run
supply is that they account for the largest part of firms’ aggregate supply and shift the SRAS curve to the left.
production costs. As long as money wages remain fixed, if Lower taxes on the other hand, lower production costs.
the average price level changes only the real wage will be For example, if the VAT in Greece decreases from 24% to
affected and so workers, in real terms, will either become 10%, firms will face lower costs of production leading to
“cheaper” or “pricier” to firms, inducing an output response. an increase in short-run aggregate supply and to a shift
More specifically, if the average price level increases, then of the SRAS curve to the right. Subsidies also affect firms’
the real wage decreases and in turn firms will be willing to production costs. An increase in government subsidies
offer more output. On the contrary, if the average price level will reduce costs of production and so increase short-run
decreases, then the real wage increases and in turn firms will aggregate supply, which will shift the SRAS curve to the
be willing to offer less output. The SRAS curve is therefore right. A decrease in government subsidies, on the
upward sloping, where real output is on the horizontal axis

78
 other hand, will raise production costs for firms, causing a potential level of real output, Yp, since in the long run an

UNIT 3: MACROECONOMICS
decrease in short-run aggregate supply and a leftward shift economy produces whatever its resources and technology
of the SRAS curve. allow it to produce. Output is at its potential or natural
An increase in short-run aggregate supply means that there is level, which is considered the economy’s full employment
a shift of the SRAS curve to the right, shown in Figure 3.2.4 level of output.
as a shift from SRAS1 to SRAS2. A decrease in short-run Note that even though at this level of potential output we
aggregate supply means that the SRAS curve shifts to the say that there is full employment, it should not be taken
left from SRAS1 to SRAS3. to mean that there is no unemployment in the economy.
At the potential level of real output there is some
Average price SRAS3 unemployment, which is referred to by the Monetarists
level (APL) SRAS1 as natural (or normal) unemployment, and is the
SRAS2 unemployment that exists when the labour market is in
equilibrium (see section 3.3).
If long-run aggregate supply increases and the LRAS curve
shifts to the right then this implies that the potential level of
output has increased, meaning that the economy’s productive
capacity has increased. This is shown in Figure 3.2.6.

Average price
level (APL)
LRAS LRAS’
0 Real output
(Yr)

Figure 3.2.4 Shifts in the SRAS curve

Long-run aggregate supply

In the long run, money wages are assumed by the
Monetarist/New Classical school to be flexible and fully
adjusting to changes in the average price level. So, if the
price level rises by 2.4% then money wages will also increase 0 Yp Yp’ Real output
by 2.4%. It follows that the real wage is constant. As such,
(Yr)
firms no longer respond to changes in the price level by
changing their level of output. Figure 3.2.6 The LRAS curve shifting to the right
Long-run aggregate supply is therefore drawn as a vertical
(the LRAS curve) to show that changes in the average price An increase in long-run aggregate supply can be a result of
level do not affect real output. The reason is that in the the following.
long run money wages fully adjust and thus the real wage • The quantity of factors of production increases. An
and firms’ profitability do not change to induce an output increase in the quantity of labour due to immigration
response. This is shown in Figure 3.2.5. means that the economy is capable of producing more real
output and so the LRAS curve shifts to the right.
Average price • The quality of factors of production improves. Greater
level (APL) levels of education and skills improve the quality of labour.
LRAS Workers become more productive and the LRAS curve
shifts to the right.
• There are improvements in technology. Technological
innovation can lead to improved machines and equipment,
which will be able to produce more output, and so the
LRAS curve will shift to the right.
• Efficiency increases. When an economy makes better use of
its resources, it can as a result produce a greater quantity
of output. Therefore, the LRAS curve shifts to the right.
0 Yp Real output • There are institutional changes. Improvements in the
(Yr) institutional framework increase the economy’s productive
capacity. Reducing the amount of bureaucracy facilitates
Figure 3.2.5 The LRAS curve economic activity and can increase the output produced;
the LRAS curve will shift to the right.
More specifically, according to the Monetarist/New
Classical school, the LRAS curve is vertical at the economy’s

79
 Recap
Monetarist/New Classical aggregate supply
Short-run aggregate supply (SRAS) Long-run aggregate supply (LRAS)
Money wages are assumed fixed. Money wages are assumed flexible.
The SRAS curve is upward sloping: The LRAS curve is vertical at the potential level of output:
• if average price level (APL) increases, the real wage • changes in average price level (APL) do not affect real
drops, so firms offer more output output because the real wage is not affected.
• if APL decreases, the real wage increases, so firms Shifts of the LRAS curve can occur due to:
offer less output. • an increase in the quantity of factors of production
Shifts of the SRAS curve can occur due to: • an improvement in the quality of factors of production
• changes in money wages • improvements in technology
• changes in energy prices • increases in efficiency
• changes in indirect taxes or subsidies. • institutional changes.

Aggregate supply under the Keynesian school below the full employment level of real output denoted with
In the Keynesian school there is no distinction between the Yf. Such an economy operates presumably in deep recession
short run and the long run and so there is only one AS curve, or depression-like conditions. Unemployment is very high and
which has three sections, as shown Figure 3.2.7. there is a lot of spare or unused capacity.
Section III is vertical at the full employment level of
Average price
output Yf. This full employment level of output is typically
level (APL) AS considered within the extreme Keynesian framework of
III analysis as a “wall”, implying that there is no unemployment
in the economy. Real output cannot increase beyond Yf.
Section II illustrates an upward sloping AS curve. It depends
II on the realization that an economy consists of many different
sectors and industries that employ differing types of resources,
I which do not reach full employment conditions together. Some
industries may reach full employment earlier than others. This
situation is referred to as bottlenecks in production: spare
capacity in some industries may coexist with full employment
0 Yf Real output in others. Real output may continue to rise but as a result of
(Yr) the capacity constraints in some industries, wages and, more
generally, production costs may also be rising and so will prices.
Figure 3.2.7 The Keynesian AS curve
Note that, strictly speaking, it is a mistake to refer to long-run
Section I is horizontal, implying that higher levels of output Keynesian aggregate supply as Keynes was not interested in
can and will be produced without the average price level the long run in his analysis of the workings of an economy. We
rising. The explanation lies with the realization that the real will thus make the distinction between short-run and long-run
output levels corresponding to this region are significantly aggregate supply only for the Monetarist/New Classical model.

Macroeconomic equilibrium
Equilibrium in the Monetarist/New APL
Classical model SRAS
Short-run equilibrium
Macroeconomic equilibrium in the short run exists at
that level of real output at which aggregate demand
is equal to short-run aggregate supply, as shown in APL
Figure 3.2.8.

AD

0 Yr Yr
Figure 3.2.8 Short-run macroeconomic equilibrium

80
The equilibrium level of real output Yr is determined at the output as a result of money wages being flexible and fully

UNIT 3: MACROECONOMICS
intersection of AD with SRAS. The average price level of the adjusting to any change in the APL. Figure 3.2.11 shows this.
economy is also determined at level APL.
APL SRAS
Any shift in aggregate demand will induce a change in the LRAS
equilibrium average price and output levels in the same
direction as the change in aggregate demand. For example, SRAS’
if aggregate demand increases, say, as a result of lower APL1 A1
interest rates, then the AD curve will shift to the right from
AD1 to AD2. This will lead in the short run to higher real APL2 A2
output Yr2 as well as to a higher average price level at APL2,
as shown in Figure 3.2.9. APL’ A3
AD1
APL
SRAS
AD2

APL2 Yr2 Yp Yr
APL1 (NRU)
Figure 3.2.11 Returning to full employment following a decrease in
aggregate demand

AD2 Assume an economy in equilibrium at point A1 where real

output is at its potential level Yp, unemployment is at its
AD1 natural or, normal rate (NRU) and the average price level
0 Yr1 Yr2 Yr is at APL1.
Figure 3.2.9 A shift in the AD curve Now assume that business and consumer confidence in the
economy decrease, leading to a decrease in consumption
Shifts in short-run aggregate supply will induce changes in
and investment expenditures. Aggregate demand decreases,
the average price level and of equilibrium output that are
with the AD curve shifting to the left from AD1 to AD2. The
in the opposite direction. For example, if oil prices increase
average price level drops from APL1 to APL2 and, since in
then, since production costs will rise, short-run aggregate
the short run money wages are assumed fixed, the real wage
supply will decrease, with the SRAS curve shifting to the left
increases and thus profitability for firms decreases so that
from SRAS1 to SRAS2 in Figure 3.2.10. There will be a higher
real output falls to Yr2. There is a movement in the short run
average price level, APL2, accompanied by lower equilibrium
along the SRAS curve from point A1 to point A2.
real output Yr2.
Short-run equilibrium is at point A2 at the intersection of
APL SRAS2 AD2 with the SRAS curve. Real output is below its potential
(full employment) level and so unemployment rises above
SRAS1 its natural rate (NRU). The economy is characterized by
a deflationary (recessionary) gap equal to the difference
APL2 between the potential level of output and the lower
APL1 equilibrium level of output Yr2Yp.

A deflationary gap (also referred to as a recessionary

gap) exists when equilibrium real output is below the
potential (full employment) level of output.
AD
0 Yr2 Yr1 Yr In the long run, however, according to Monetarists, money
Figure 3.2.10 A shift in the SRAS curve wages are flexible, which means that money wages will
decrease to match the decrease in the price level. Remember
Long-run equilibrium that money wages is a shift factor for short-run aggregate
In the long-run, equilibrium will necessarily be at the supply. For this reason, short-run aggregate supply increases and
economy’s potential or full employment level of output, as the SRAS curve shifts to the right to SRAS’. Since the adjustment
any deviation from the potential level of output can only exist of money wages is assumed full, the real wage returns to
in the short run because money wages are assumed fixed. its original level. Also, since the real wage is unchanged,
Deviations of short-run equilibrium from the potential level of unemployment must return to its natural rate (NRU) and
output will be temporary and the economy will always return consequently real output back to its potential level Yp. The
in the long-run to its potential or full employment level of economy has therefore moved automatically at point A3.

81
 According to Monetarists, an economy will bounce back APL
(that is, the deflationary/recessionary gap will close), only LRAS SRAS’
through the adjustment of money wages. There is no need
for the government to intervene. The question is, of course,
APL’ A3 SRAS
how fast the economy will return to full employment. It is
not specified and thus the “long run” may prove too long a
period, especially for the unemployed. APL2 A2
Something similar happens if there is an increase in APL1
aggregate demand. This is shown in Figure 3.2.12. AD2
A1
Assume an economy in equilibrium at point A1 where real
output is at its potential level Yp, unemployment is at its
natural or normal rate (NRU) and the APL is at APL1. AD1
Now assume that a reduction in interest rates leads to an
increase in aggregate demand, which shifts the AD curve to the Yp Yr2 Yr
right from AD1 to AD2. The price level rises from APL1 to APL2 (NRU) (U<NRU)
and since in the short run money wages are assumed fixed, the Figure 3.2.12 Returning to full employment following an increase in
real wage decreases and thus profitability for firms increases so aggregate demand
that real output rises to Yr2. There is a movement in the short
run along the SRAS curve from A1 to A2. According to Monetarists, an inflationary gap will close only
Short-run equilibrium is at A2 at the intersection of AD2 with through market adjustments, namely the increase in money
SRAS. Real output is above its potential (full employment) wages. There is no need for government intervention.
level and so unemployment falls below its natural rate (NRU).
The economy is characterized by an inflationary gap equal to
Equilibrium in the Keynesian model
the difference between the potential level of output and the The major difference between the Monetarist/New Classical
greater equilibrium level of output YpYr2. model described above and the Keynesian model is that
the latter is not equipped with an automatic adjustment
mechanism. Within the Keynesian framework an economy
An inflationary gap exists when equilibrium real
may find itself stuck at an equilibrium level of real output
output is greater than potential (full employment)
with less than full employment. No endogenous forces exist
output.
that will restore full employment.
More specifically, money wages are assumed “sticky
However, in the long-run, money wages are assumed flexible downwards” (money wages may increase but they do
and they will fully adjust, matching the increase in the not easily adjust downwards). It follows that within the
average price level. Short-run aggregate supply decreases, Keynesian model, aggregate demand is the driving force
shifting the SRAS curve to the left to SRAS'. Since the behind the equilibrium level of economic activity. Instead
adjustment of money wages is assumed full, the real wage of believing in “supply creating its own demand” (Say’s law
returns to its original level. Also, since the real wage is from the Classical school of thought, which included the
unchanged, unemployment must return to its natural rate intellectual fathers of monetarism and the New Classical
(NRU) and consequently real output back to its potential school), Keynes turned things inside out, postulating that
level Yp. The economy has therefore moved automatically at
point A3.

Recap
Adjustments in the Monetarist/New Classical model
The case of a deflationary gap The case of an inflationary gap
• A decrease in aggregate demand in the short run will • An increase in aggregate demand in the short run will
lead to a decrease in the average price level. Since lead to an increase in the average price level. Since
money wages are assumed fixed, the real wage will money wages are assumed fixed, the real wage will
increase, inducing firms to reduce output. decrease, inducing firms to increase output.
• A deflationary gap will arise since the equilibrium level • An inflationary gap will arise since the equilibrium
of real output will fall below the potential output level. level of real output will exceed the potential output
• In the long run, money wages are flexible and will level.
adjust and decrease to match the decrease in the • In the long run, money wages are flexible and will
average price level. The real wage will be restored and adjust and increase to match the increase in the
so will the potential level of output. average price level. The real wage will be restored and
• There is no need for government intervention. so will the potential level of output.
• There is no need for government intervention.

82
it is “effective demand” (which we call aggregate demand) curve to the right from AD1 to AD2. Equilibrium real output

UNIT 3: MACROECONOMICS
that determines the equilibrium level of real output in an will remain at Yf (remember the “wall”). The APL will though
economy. If, for whatever reason, aggregate demand proves rise from APL1 to APL2.
insufficient to establish full employment then a market Vertical distance ab can be referred to as the inflationary
economy will suffer a system-wide failure, as it will be unable gap. Unlike the Monetarist/New Classical model, the gap
on its own (that is, without the help of the government) to is now on the vertical axis as in the strict interpretation
restore full employment conditions. of the Keynesian model, full employment refers to zero
Consider the economy shown in Figure 3.2.13, initially unemployment.
operating at full employment. A collapse in business and
consumer confidence causes a decrease in aggregate APL AS
demand, and the AD curve shifts to the left from AD1
to AD2. Equilibrium real output Yr2 is below the full APL2 b
employment level of output Yf. Thus, there is a deflationary
(recessionary) gap equal to Yr2Yf.
APL1 a
APL AS AD2

AD1

Yf Yr
Figure 3.2.14 The inflationary gap within the Keynesian diagram

AD1 Note that the idea of the natural rate of unemployment can
still be incorporated in the Keynesian model. The way to do
AD2
it is to define as the full employment level of output some
Yr2 Yf Yr level of real output to the left of where the vertical section
Figure 3.2.13 The deflationary (recessionary) gap within the Keynesian of the AS curve would intersect the horizontal axis. This is
diagram shown in Figure 3.2.15.
APL AS
As mentioned above, according to the Keynesian school,
money wages are “sticky downwards”. There is no automatic
adjustment mechanism to push the economy back to the
full employment level of output. Therefore, an economy may
remain stuck in a deflationary/recessionary gap; that is,
at a level of real output that is below the full employment
level. The government must therefore intervene in order to
increase aggregate demand and restore full employment.
This can be achieved either through expansionary fiscal
policy or loose monetary policy (see sections 3.6 and 3.8).
AD1
An inflationary gap is more cumbersome to illustrate within
a Keynesian diagram, as Keynesian analysis was originally AD
not interested in investigating inflationary conditions.
In any case, if aggregate demand increases within the 0 Yfe Y1 Yr
vertical section of a Keynesian AS curve (section III) then an Figure 3.2.15 An alternative on the Keynesian inflationary gap
inflationary gap is said to be created.
The increase of aggregate demand to AD1 creates an
Figure 3.2.14 shows an economy at the full employment of
inflationary gap equal to distance YfeY1 on the horizontal
output Yf. A rise in business and consumer confidence now
axis.
causes aggregate demand to increase and thus shift the AD

83
 3.3 Macroeconomic objectives

Economic growth
Meaning of the term The most important factors that may lead to short-term
Economic growth refers to an increase in the size of an economic growth include the following.
economy over time: it is defined as an increase of real GDP • Improved consumer and business confidence leading to
through time. increased spending by households (C) and firms (I) may
Measuring economic growth increase economic growth in the short term.
The growth rate is the percentage change in real GDP • Short-term growth may result from a decrease in interest
between two periods. The periods are usually two years but rates as lower interest rates decrease the cost of borrowing
they could be two quarters. So, for example, the growth rate for households and firms, who may borrow more to buy
for an economy in, say, 2020 (compared to 2019) would be: or build houses, to buy consumer durables or to buy
machines or build factories. Lower interest rates may also
rGDP20 − rGDP19
Growth2019→2020 = × 100 lead to a depreciation of the exchange rate which makes
rGDP19 exports cheaper and more competitive, and imports pricier
Using actual data to calculate the US growth rate in 2019: and less attractive, so that net exports, another component
of aggregate demand, increase.
real GDP in 2019 = $19,220 billion
• An increase in government expenditures (G) which, being
real GDP in 2018 = $ 18,783 billion. a component, would directly increase aggregate demand.
19220 −18783 • A decrease in (direct) taxation would increase disposable
Growth in 2019 = × 100 = 2.33% income, which could lead to an increase in consumption
18783
expenditures (C). Note that an increase in government
This means that the US economy grew in 2019 by 2.33%. expenditures and a decrease in direct taxes are referred to
If the growth rate figure for a country in 2019 was −2.5% as expansionary fiscal policy.
it would mean that this economy’s real GDP decreased • A depreciation of the exchange rate, faster growth of
between 2018 and 2019, so this economy was in recession. our trading partners and a decrease in the degree of
If the growth rate for another economy in 2018 was 3.45% protection domestic firms face can all lead to an increase
and then one year later it was at 2.85% this lower growth in net exports and thus growth.
rate does not mean that real GDP decreased or that the
economy is in recession. Since the growth rate is still Illustrating short-term growth
positive, the economy continued to grow in 2019, but at a To show short-term growth you can use a Keynesian or a
slower rate. Monetarist/New Classical diagram where the AD curve
Growth rates can also be calculated using per capita real shifts to the right, leading to an increase in real output
GDP figures. and thus economic growth. The effect of such an increase
in aggregate demand on real GDP depends on the size of
Growth over the short term the increase in aggregate demand but also on the original
This refers to growth that is a result of greater use of existing equilibrium level of real output.
resources. Potential (or full employment) output is not In the Keynesian model, the increase in aggregate demand
affected. could prove ineffective in generating growth if the economy
Growth over the short term is a result of aggregate demand was operating close to its potential (full employment) as
increasing as an increase in aggregate demand will lead to the rise in aggregate demand would mostly lead to a rise in
an increase in real GDP (assuming the economy is not at its prices with only a small, if any, increase in real GDP.
potential, or full employment, output). In the Monetarist/New Classical model (Figure 3.3.1b), an
Aggregate demand can increase, shift to the right and increase in aggregate demand would prove ineffective if the
lead to growth for a variety of reasons. Technically, any economy was operating past potential real output. The original
factor that increases any component of aggregate demand equilibrium level of real output must lie to the left of potential
will shift it to the right and increase real output. Remember output to illustrate any growth in real GDP that is not temporary.
that aggregate demand includes consumption (C), The Keynesian diagram (Figure 3.3.1a) should be used to
investment (I) and government (G) expenditures as well as show that an increase in aggregate demand may not lead to
net exports (NX). any increase in the average price level.

84
 Growth over the long term

UNIT 3: MACROECONOMICS
(a) Keynesian model
APL Growth over the long term is a result of more or better
AS
resources becoming available and/or of improved
technology. Any factor that will increase potential (full
employment) output implies growth over the long term.
The following are some of the most important factors.
• An increase in the size of the labour force. The number
AD2 of workers available for work may increase for a variety
AD1 of reasons. For example, an increase in population,
Y1 Y2 Real output an influx of migrant workers, or an increase in the
(Yr) participation rate of some population group (for
(b) Monetarist/New Classical model example, of women) will increase the size of the labour
APL force.
LRAS
SRAS • An increase in the stock of human capital. Past
investments in education and health care will increase
labour productivity.
• An increase in the stock of physical capital. If there are
more machines and more factories, then the productive
AD2
capacity of the economy increases, leading to long-
AD1 term growth. Note that more and better infrastructure
Y1 Y2 Yp Real output becoming available is a most significant contributing
(Yr) factor for a country to achieve and sustain economic
growth over the long term.
Figure 3.3.1 Growth in the short term through a shift right of aggregate
demand (AD) • Historically, the main drivers of long-term economic growth
In Figure 3.3.1a and 3.3.1b, aggregate demand shifts to the are technological advances. Advances in technology
right from AD1 to AD2 leading to an increase in real output in agriculture, industry and health services have been
from Y1 to Y2 and thus to short-term growth. responsible for dramatic increases in potential output for
all economies in the past two centuries.
You can also illustrate short-term growth using a production
possibilities curve (PPC) diagram. Think of an economy • Advances in information and communication technologies
initially located at a point inside the PPC and then are considered to further increase potential output.
moving towards the northeast, closer to the boundary. • An improved institutional framework (the rules and
Such a movement would indicate more being produced regulations within which economic activity takes place)
of both goods. Total output would be greater and since may also help achieve growth in the long term. Less
the production possibilities boundary will not have shifted bureaucracy, a more flexible labour market and more
outwards, this growth would be the result of greater use competition in the product markets can also shift long-
of existing resources and not of more resources or better run aggregate supply (LRAS) to the right and lead to an
technology becoming available. In Figure 3.3.2, the economy increase in potential output.
was initially producing X1 units of good X and Z1 units of
Illustrating long-term growth
good Z (combination F). Greater use of existing resources
permits it now to produce combination H with X2 units of Long-term growth can be illustrated through a shift to the
good X and Z2 units of good Z. Since more of both goods right of the Keynesian AS curve or the Monetarist/New
are produced while the production possibilities remain the Classical LRAS curve so that full employment real output
same (AB), actual growth has been achieved. (potential output) increases (see Figure 3.3.3).
Growth in the long term can also be illustrated using
Good Z a production possibilities curve (PPC) diagram. Since
A growth in the long term requires more or better resources,
or better technology, a diagram where the PPC shifts
outwards can be used to illustrate economic growth over
the long term.
Z2 H The PPC for the economy shown in Figure 3.3.4 was initially
AB. As a result of more or better resources and/or better
Z1 F technology, the production possibilities of this economy
expanded, and it is now able to produce combinations of
goods that initially were not feasible. Its PPC has shifted out
B to FH. This illustrates growth in the long term.
X1 X2 Good X
Figure 3.3.2 Growth in the short term through an outward shift of the PPC

85
 (a) Keynesian model Good X
AS AS’ F
APL
A

B H Good Z
Yfe Yfe’ Yr Figure 3.3.4 Growth in the long term using the PPC model

Note that certain factors that lead to an increase and shift

(b) Monetarist/New Classical model to the right of aggregate demand and thus to an increase
LRAS LRAS’ in equilibrium real output (short-term economic growth)
APL may also to an increase and shift to the right of long-run
aggregate supply and lead to an increase in potential output
(long-term growth).
For example, an increase in government spending on
infrastructure or on education and health care will increase
aggregate demand, increasing equilibrium real output—but
it will also increase long-run aggregate supply and thus
potential output. Or, higher level of private investment
spending now will increase aggregate demand and thus
equilibrium real output but the increase in the stock of
Yp Yp’ Yr capital (more machines and factories available) in the
economy will also increase its potential level of output as
Figure 3.3.3 Growth in the long term using the AD/AS models
long-run aggregate supply will also shift to the right. In
other words, increased private or public investment spending
increases aggregate demand and thus real output but also
increases the productive capacity of the economy and thus
long-run aggregate supply and potential output.

Consequences of economic growth

Impact of economic growth on automatically the average income of its customers increases
living standards to several billion dollars. But have any of non-Bezos customers
become any richer? Economic growth accompanied by increased
Economic growth is defined as an increase through time of an
income inequality is fragile and not desirable because the living
economy’s total output (real GDP). Given that the value of an
standards of ordinary people do not improve. This is one reason
economy’s total output is the flip-side of the income generated
why we need to re-evaluate laudatory headlines about the rate
in the production process (in other words, the country’s national
of economic growth of any country.
income) it follows that if an economy is growing faster than
its population, then income per person (referred to as per Also, to the extent that economic growth negatively impacts
capita income) is rising. Higher per capita income levels permit the environment in which people live, it is highly controversial
individuals greater access to goods and services, so in this to accept that economic growth necessarily improves living
sense living standards improve. This explains why the release of standards. If the means with which economic growth is being
growth statistics make headlines in most countries. achieved are responsible for the extreme weather conditions
experienced in many parts of the world that have resulted in
Unfortunately, economic growth may not imply improved living
floods, droughts, fires, rising sea levels and crop failures, then
standards for the population. The reason is that there is no
it cannot be argued that this type of growth has improved
guarantee that the fruits of growth are shared by all. They may
living standards for the affected people.
accrue only to the wealthiest. For growth to lead to improved
living standards it must be inclusive. Per capita income figures Economic growth may not improve living standards if it is
are just an average and this average provides no information jobless. It will be jobless if it is a result of adopting labour-
about the underlying distribution of income. As a famous Nobel saving technologies. Widespread adoption of technologies
Prize economist explained, if Jeff Bezos walks into a bar then

86
relying on robotics, automation and artificial intelligence Government could adopt and enforce stricter environmental

UNIT 3: MACROECONOMICS
further increase the risk of jobless growth in the near future. regulations. Policies that force polluting industries to
It must be noted that living standards also depend on internalize the external costs they generate are necessary.
very many other factors that are not captured by economic These include imposing carbon taxes which incentivize firms
growth and rising per capita incomes. The idea of improved to adopt cleaner technologies, and the broader adoption of
living standards is closely related to the idea of human cap and trade schemes so that pollution decreases more by
development, which is discussed later in this book. Even those firms that can do it effectively (with the least cost).
Simon Kuznets (the creator of national income and product Investments in green technologies and subsidies to firms
accounts for which he earned the Nobel Prize in 1971) noted that adopt clean technologies are also necessary.
that increase in per capita income (that is, growth) is an Lastly, parties to the Paris Agreement must ensure that their
imperfect measure of living standards. Nationally Determined Contributions (NDCs) are met. NDCs
include the goals and the means each of the signatory
Impact of economic growth on countries commits itself to adopt in order to meet the goals
the environment of the Paris Agreement. It has become clear that these NDCs
The relationship between economic growth and the should successively become more ambitious when they are
environment is not simple. Economic growth may have both a reviewed every five years.
positive and a negative impact on the environment. It may have
a positive impact because richer countries have more resources
Impact of economic growth on the
at their disposal to deal with environmental issues, they rely distribution of income
more on the production of services and on information intensive Economic growth may both decrease and increase income
industries and they have tougher environmental regulations. inequality. It may decrease income inequality because of
It was believed that the relationship between environmental the “fiscal dividend” that the government collects through
degradation and growth exhibited an inverted U-shape. As growth. Growth implies higher incomes, which lead to more
countries grew and per capita incomes increased, pollution income and expenditure taxes collected. Higher tax revenues
would initially rise and then, after some critical level of allow governments to adopt policies that alleviate poverty.
per capita income, it would decrease. This relationship is For example, more can be spent to create or improve a social
referred to as the environmental Kuznets curve (EKC). If such safety net. The government can set up or improve a pension
a relationship was generally true, then economic growth system to increase the disposable incomes of older people.
would lead to eventual environmental improvement. Several Higher tax revenues enable the government to establish
considered the EKC as a justification for adopting a “business or to increase unemployment benefits and to pay cash
as usual” approach to the issue of sustainability. More recent transfers to the disabled and the destitute. Such short-term
research has shown that even if such a relationship is true, it programmes decrease income inequality.
applies only to certain types of pollutants typically associated Growth also allows a government to embark on longer-
with “local externalities” (such as indoor household pollution term programmes that lift people out of poverty and
from cooking using polluting open fires). Also, if the EKC was decrease income inequality. Growth over the long term
more generally true for some advanced economies, it may enables governments to invest in policies to increase
have been the result of the effect of international trade on the agricultural productivity and to improve sanitation and
distribution of polluting industries across countries so that the basic infrastructure, especially in rural areas of the country.
adverse global environmental impact is not reduced. It allows higher investment in education and health care
The EKC does not seem to apply to what are known programmes that favour the poor by improving their access
as “dispersed externalities”, such as carbon emissions. to these services, thus increasing their human capital. Their
Economic growth is a result of increased levels of production, resulting increased productivity increases their income-
but increased production has predominantly relied on the earning capacity and so decreases income inequality.
use of fossil fuels or on the use and depletion of common However, income inequality has increased in many growing
access resources. Growth that neglects the impact on the economies. Leading experts on the issue have documented
environment is not sustainable. Economic growth that comes that in the past three decades, income inequality within
at the expense of pollution and environmental degradation countries has risen dramatically as they have grown. The
has an adverse impact on the living standards of the present fiscal dividend that has resulted from growth may allow, but
and future generations. Such economic growth has been does not force, governments to adopt policies that decrease
labelled by the UNDP as “futureless”. It is not sustainable income inequality. There is no guarantee that market forces
and, if unchecked, it is thus undesirable. alone will ensure that the benefits of growth are fairly
Is it possible for economic growth to be sustainable? The distributed.
optimistic answer is yes. Perhaps the first step in this direction Growth may be driven by only a handful of industries or it
is for governments to stop subsidizing use of fossil fuels may be concentrated in certain regions of a country (often
and other unsustainable economic activities. For example, the coastal regions). It may rely only on certain skills, often
many governments around the world continue to subsidize of the more educated. This is referred to as the “skill-biased
their fishing industry heavily, which of course accelerates the technological progress” where the wages of the highly skilled
depletion of fish stocks. workers have been rising much faster than the wages of the
less skilled, widening income inequality.

87
 Another contributing factor is that in some countries there affect the level of disposable income in a country. Disposable
has been a very significant increase in corporate concentration income is defined as factor income plus transfers (such as
and monopoly power. This is responsible for a transfer of benefits and pensions) minus income taxes. According to the
income away from consumers to a few firms. Firms with high Luxemburg Income Study Center (LIS) the USA has the highest
monopoly power can charge consumers more for products and inequality among advanced economies when considering
services and pay their workers less. Research shows that this disposable income. This may be the result of the belief that
rise in corporate power is more pronounced in the USA than in high income taxes decrease incentives to work and to invest,
Europe, even though it has been rising in most countries. while generous welfare payments disincentivize recipients to
Rising income inequality may also be the result of increased increase their income earning potential, thus slowing down
trade liberalization and globalization. Many workers in growth of the economy. However, research has shown that
industries where import penetration has been high have lost northern European countries with more progressive income
their jobs. Even though, as it will become clear, the gains of taxes and more generous payments have not, over the long
the winners from free trade are greater than the losses of the term, grown more slowly.
losers, there have been few, if any, government programmes More generally, even the International Monetary Fund (IMF)
in most countries to compensate displaced workers for their is now re-evaluating growth resulting from market-based
losses. Workers in import-competing industries lose their supply-side policies that many countries of the world have
income and face dislocation, whereas workers in booming implemented since the 1980s. These policies, which will
export-oriented industries maintain or increase their income. be explained later, decrease the role of the government
Tax and transfer systems may also be responsible. In many and increase the role of unregulated markets. They aim at
countries, taxation has become much less progressive accelerating growth, but they do not pay attention to the
since the 1980s, while at the same time transfer payments distribution of the growth that results. As this growth is
decreased both in size and in scope. Tax and transfer systems not inclusive, income inequality is increased.

Recap • education and health care for the poor

to increase their human capital, productivity
How growth may affect income inequality
and income-earning capacity.
The resulting higher tax revenues permit the government Growth may increase income inequality:
to create or improve a social safety net by spending
more on: • if it relies only on certain skills, the highly educated or
is concentrated in certain areas, often coastal regions
• pension schemes to support older people
• if market concentration is rising, as it permits firms to
• unemployment benefits charge higher prices and pay lower wages
• other cash transfers, to support other groups of people • as a result of trade liberalization that displaced many
who are deprived and in need. workers without any compensation or retraining
The resulting higher tax revenues permit the government provided
to invest more in: • as a result of income taxes becoming less progressive
• improving policies that increase agricultural and transfer payments decreasing in size and scope
productivity that raise rural incomes • as a result of market-based supply-side policies
• infrastructure projects that improve sanitation, implemented since the 1980s that decreased the role
electrification, transport and telecommunications and of the state and of labour unions.
so improve the lives and prospects of the poor

Policymakers’ perspective that make the headlines must be carefully evaluated.

If these higher levels of income are enjoyed only by
Growth is an important economic objective for any
the top 1% or the top 10% of the population, then there
economy. It permits the government to make or increase
may be less to applaud. If the rising levels of output and
investments in infrastructure, in human capital and in
incomes come at a high environmental cost, then there
R&D. Such investments lay the foundation for further
may be less to cheer about. Growth must be inclusive
growth. In addition, higher growth rates imply that
and sustainable. Otherwise it may prove fragile.
incomes are rising faster. However, faster growth rates

88
Low unemployment

UNIT 3: MACROECONOMICS
Meaning and measurement differences among regions within countries. Therefore, it is
An individual is considered unemployed if he or she is important to examine disaggregated unemployment data to
actively looking for a job but cannot find one. get a clearer picture of the labour market of a country.
The unemployment rate is the ratio of the number of Lastly, of significant importance is the long-term
unemployed over the size of the labour force (also referred unemployment rate of a country, which is defined as the
to as the workforce) times 100. The labour force includes the ratio of those unemployed for 12 months or more as a
employed and the unemployed. proportion of the labour force.
Number of unemployed
Unemployment rate = × 100
Labour force Recap
Note that the labour force or the workforce is not the same as Limitations of the official
the population of working age, which includes everyone typically unemployment statistic
aged between 15 and 64, even if they are not looking for a job.
• It may underestimate true unemployment because
Difficulties of measuring unemployment of hidden unemployment that includes discouraged
workers, involuntary part-timers and individuals
The above formula seems straightforward but there are
being employed below their capacity.
many difficulties in arriving at an accurate estimate of the
unemployment rate of a country. The official statistic may • It may underestimate true unemployment because of
underestimate or overestimate true unemployment. individuals concealing their employment status to avoid
paying income taxes or because their work is illegal.
The official unemployment statistic may underestimate true
unemployment for the following reasons. • It is just an average for the economy, so it may
conceal differences between regions, gender,
• The population includes discouraged workers. These are
ethnicities and age groups.
individuals who would like to work and would happily
accept a job offer but who have stopped actively searching
for one because they have remained unemployed for too Causes of unemployment
long and their past search effort was unsuccessful. Since
Not all unemployment is the same. Individuals who are
they are demonstrating no effort in seeking employment,
unemployed are unemployed for different reasons. This
they are not considered unemployed and they are not
is very important because the policies used to decrease
included in the official unemployment statistic.
unemployment differ depending on the cause. Policies that
• Some individuals are underemployed. They are involuntary may be effective to decrease one type of unemployment may
part-time workers who do have a job so they are considered be ineffective to deal with another type.
employed but they are working fewer hours per week than
Unemployment is categorized into four types: seasonal, frictional,
desired. Underemployed individuals also include workers
cyclical and structural. The first two are relatively insignificant
who do not fully utilize their skills or experience so they
and they are typically low. Cyclical and structural unemployment
may be overqualified for the job they hold.
are much more serious. These are examined separately below.
The term hidden or disguised unemployment is often used to
Seasonal unemployment
refer to underemployed individuals and to discouraged workers.
Seasonal unemployment is a result of unavoidable and
The official unemployment rate may overstate true
predictable variations in the demand and supply of labour.
unemployment because of the following.
Weather patterns mean that construction workers are often
• Some individuals may intentionally conceal their true laid off for several weeks in the winter months in places
employment status, either fearing loss of transfer where freezing temperatures and ice may prevent their work
payments such as unemployment benefits that are granted and will increase the risk of work-related accidents. In many
only to the unemployed, or to avoid paying income taxes. areas farm workers are unemployed for some periods of
• Some individuals are employed in illegal activities and time relating to work schedules for different crops. Another
report that they are unemployed. seasonal variation is the surge in labour supply every year in
The official unemployment statistic is also nothing more June in the USA, and other countries, as many college and
than an average for the whole country so it does not reveal secondary school graduates start looking for a job but only
disparities between: gradually find employment.
• different regions of the country This type of unemployment is expected and there is not
• female and male unemployment rates much governments can do about it. Monthly unemployment
statistics are corrected by statisticians (seasonally adjusted)
• different ethnic or religious groups though, so that policymakers can determine true changes in
• different age groups. unemployment, not those due to seasonal factors.
Youth unemployment refers to unemployment among Frictional unemployment
workers aged between 15 and 24 and it is typically
Frictional unemployment refers to people who are between
the unemployment category with the highest rate.
jobs as it takes time to match a job-seeker with an available
Unemployment is also usually higher for women and for
job vacancy. This unemployment is of a short-term nature and
minorities. Studies show that there are often significant
is also largely unavoidable in an economy since people

89
 will always voluntarily switch jobs, searching for better Average price AS
ones, or choosing to relocate. Faster and better information level (APL)
related to the labour market will decrease but not eliminate
frictional unemployment. Governments can minimize frictional
unemployment by ensuring that job vacancies as well as the
profiles of those available for work become known wider and
faster. The internet has considerably helped as vacancies and
availabilities can be posted and matched in real time. AD
Cyclical (demand deficient) unemployment
AD’
This type of unemployment is directly related to the business
cycle. Higher unemployment will necessarily accompany a
recession because of the lower level of economic activity. 0 Y’ Yf Real output
Assume that aggregate demand decreases for some reason. (Yr)
This could be the result of a decrease in consumer or
Figure 3.3.5 Illustrating cyclical unemployment (Keynesian model)
business confidence levels. Or it could be the result of lower
exports because of lower incomes abroad. The resulting Structural unemployment
decrease in economic activity forces some businesses to Structural unemployment is the unemployment that remains
shrink and others to shut down. way past economic recovery. The causes of structural
As production levels fall, demand for labour will decrease. unemployment may be summarized by two words: mismatch
However, money wages do not easily decrease for many and rigidities. Mismatch describes the situation where job
reasons, for example because of contracts. They are “sticky vacancies exist but the skills of the unemployed are not the
downwards”. Firms will need to fire workers. The resulting skills that employers demand.
unemployment is cyclical unemployment. It is a result of the New technologies render certain jobs obsolete while at
downturn of the business cycle. the same time creating new job opportunities. Artificial
Cyclical unemployment can be illustrated using a intelligence will be responsible for many losing their jobs.
Keynesian diagram (see Figure 3.3.5). Initially the economy Driverless trucks are already used in some countries, slowly
is assumed to be at its full employment level of real output making truck drivers unemployed.
Yf. Aggregate demand decreases from AD to AD’. As a Loss of export markets to more competitive, lower cost, foreign
result, real output decreases below full employment to firms may also lead to job losses in a country. Very many
Y’ and a deflationary gap forms equal to Y’Yf. This lower industrial jobs were lost in the USA and in other countries due
level of economic activity leads to cyclical unemployment to lower cost imports. Job vacancies may be plenty in exporting
as workers are laid off by firms that are shrinking or and other industries but those unemployed due to import
forced to exit the market. Again, the greater the size of competition often lack the necessary skills to be offered a job.
the deflationary gap, the greater the size of the resulting Figures 3.3.6a and 3.3.6b illustrate this case. They show
cyclical unemployment. structural unemployment as a result of a fall in demand in
It should be clear that in order for policymakers to decrease a particular industry: ship repair.
cyclical unemployment they should try to decrease the size Assume the market for shipyard repairs in Greece. As a result of
of the deflationary gap by increasing aggregate demand more efficient and cheaper ship repair services offered in Korea,
and thus economic activity. The expansionary demand-side China and other countries, demand for ship repair services in
policies that may be used to increase aggregate demand will Greek shipyards dramatically decreased and thus demand for the
be explained and evaluated later. highly specialized labour working in this industry also decreased.
In Figure 3.3.6a demand for ship repair services in Greece
decreased, from D to D’. As a result, far fewer ship repair services

(a) (b)
Price/unit S Money S
wage (W)

P a b
W1

P’ W2

D
D1(L)
D’ D2(L)
0 Q’ Q Quantity of L2 L1 Labour
services (L)
Figure 3.3.6a Market for ship repair services Figure 3.3.6b Labour market for ship repair services workers

90
were produced: Q’ instead of Q per year, and at a much lower Other labour market rigidities leading to structural

UNIT 3: MACROECONOMICS
price. Shipyards in Greece were thus forced to fire very many unemployment include the following.
highly specialized and highly paid workers. Unemployment in • High non-wage labour costs that burden businesses: these
towns where shipyards were the biggest employer reached 90%. refer to national insurance contributions (for pensions and
In Figure 3.3.6b, the labour market for these highly specialized health care benefits) that employers pay for their workers.
workers is shown where demand for their services decreased Higher labour costs imply fewer workers hired.
from D1(L) to D2(L). If money wages are “sticky downwards” • High money wages achieved by powerful labour unions for
and remain at W1, then structural unemployment equal to their members: again, this implies higher production costs for
(ab) will result. Even if money wages do decrease to W2, you businesses and fewer workers hired. Union members (“insiders”)
will note that only L2 workers would be employed in these benefit at the expense of “outsiders” who do not get hired.
shipyards. This implies that L1L2 highly specialized shipyard
• Laws that guarantee job security aiming at protecting workers:
workers were laid off. Some may have accepted lower paying
if it becomes difficult and more costly for firms to fire workers
jobs elsewhere, perhaps as gas attendants, but the vast
then they may become more reluctant to hire workers.
majority remains structurally unemployed. It should be realized
from Figure 3.3.6b that the number of employed workers is • High unemployment benefits: these may decrease the
lower and the resulting unemployment higher if money wages incentive of the unemployed to accept a job offer.
in such industries are indeed “sticky downwards” and remain To decrease structural unemployment, governments offer
at, or below but close to, W1. training and retraining programmes or they may subsidize
The mismatch can also be geographic, with the unemployed or grant tax breaks to firms that hire and retrain long-term
clustered in one region of the country while job vacancies unemployed individuals. Governments may also provide
exist elsewhere. Newer research reveals that geographical low-cost loans to individuals enrolling in skill-creating
mobility of labour is much lower than previously thought as courses or who are willing to relocate to areas with better
the unemployed, especially older individuals, are reluctant to job prospects. To force the unemployed to faster accept a job
move because of family ties, home ownership and the often offer, governments may also decrease the size of, and limit
high cost of moving. the duration of, unemployment benefits. These policies are
referred to as labour market related supply-side policies and
Structural unemployment may also be a result of labour
will be discussed in section 3.7.
market rigidities. These refer to labour market related laws and
regulations that do not permit the labour market to adjust to
changing labour demand and labour supply conditions. Recap
Minimum wage laws are examples of labour market rigidities. Types and causes of unemployment
If money wages are set above the market equilibrium level, The four types of unemployment and their causes are:
then firms will be willing to hire fewer workers while more
• seasonal—a result of seasonal variations in the
individuals will be offering their labour services.
demand or the supply of labour
Money • frictional—a result of people between jobs
wage (W) S(L)
• cyclical—a result of recession as firms will be forced
a b to shed labour
W’
Minimum wage • structural—a result of a mismatch between skills the
We unemployed have and skills that firms demand,
or a result of labour market rigidities.

The natural rate of unemployment (NRU)

The idea of the natural rate of unemployment (NRU)
was introduced earlier (see section 3.2, page 81). Some
D(L)
unemployment is unavoidable in any economy. There will always
0 be people who are out of work because of seasonal factors
L1 L L2 Labour
or because they are between jobs. Given that any economy is
(L)
always in a constant state of change, some people will be also
Figure 3.3.7 Structural unemployment as a result of minimum wage laws
unemployed because of advances in technology or changes
In Figure 3.3.7, at the minimum wage rate W’, excess supply of in global competitive advantage. Some will be unemployed
labour results equal to L2 – L1 or line segment (ab). It should because the labour market cannot always adjust fast enough
be noted though that many empirical studies have shown to changing labour market conditions. What has just been
that reasonable minimum wage laws have not led to higher described amounts to seasonal, frictional and structural
unemployment. One explanation could be that wages paid by unemployment. So, we can state that natural unemployment
many employers were originally below the competitive level comprises seasonal, frictional and structural unemployment.
or that employers do not object to a reasonable increase in Figure 3.3.8 can be used to illustrate the NRU. It shows a labour
the wage rate paid because it may elicit greater effort from market in equilibrium. The vertical axis is the real wage rate (Wr)
workers and decrease turnover, which is costly. and the horizontal is the number of workers (L). The labour

91
 demand (LD) curve shows how many workers firms are willing to that could have been produced are not produced. Remember
hire at different levels of the real wage. At a higher real wage, that resources are limited. It becomes clear what a complete
firms will try to employ fewer workers. The LF (labour force) waste unemployment represents. Higher unemployment
curve shows the number of individuals willing to join the labour is associated with a loss in real GDP as the economy is
force at each level of real wage. As the real wage increases, operating inside its production possibilities curve.
the opportunity cost of leisure increases so more people will • Rising unemployment decreases the tax revenues the
substitute work for leisure and thus join the labour market. government collects. The unemployed lose their incomes
The AJ (accept jobs) curve shows at each real wage rate, the so they do not pay income taxes. They may collect
number of individuals in the labour force who, given the level unemployment benefits, but these are lower than their
of unemployment benefits, will accept a job offer. As the real income, so they spend less. The government thus collects
wage rises compared to the level of unemployment benefits, the less in both direct and indirect taxes. At the same time,
probability of one accepting a job offer increases. Therefore, the government expenditures rise, as a result of:
horizontal difference between the AJ and the LF curves becomes
− unemployment benefits that most governments pay the
smaller. Equilibrium in the labour market is at Wre where the
unemployed for some period of time
number of individuals that firms are willing to hire is equal to
the number of individuals who are willing to accept a job offer − funding more training programmes that are
(Le). The unemployment that continues to exist when the labour implemented to help retrain unemployed workers
market is in equilibrium is the equilibrium or NRU. It is equal to − additional expenditures to remedy social costs that
distance (ab). often arise as a result of unemployment.
Real wage AJ LF • Perhaps the most significant economic costs arise when
(Wr) unemployment is high and prolonged. High and prolonged
unemployment increases income inequality in the country as
the unemployed lose their income while others maintain theirs.
Many people may slip into poverty, especially the less educated,
because even if they manage to find a job later it is often a
a
Wre b low pay, part-time, insecure job. Rising income inequality is
responsible for many economic, social and political problems.
• High and prolonged unemployment may force many,
especially the younger and the better educated, to try
to find a job abroad. In this way, emigration shrinks the
economy’s human capital. A country is often deprived
LD
of its best and brightest members of its labour force.
Le Labour The lower human capital decreases labour productivity,
(L) compromising future growth prospects. Growth may as a
Figure 3.3.8 The NRU
result be lower for many years to come.
Personal costs of unemployment
Figure 3.3.8 implies that those included in the natural rate are
voluntarily unemployed. This may be true for some workers. • The single biggest cost for people losing their job is lost
For example, certain high paid workers who lost their jobs income. Even if they receive unemployment benefits, these
because of foreign competition may simply reject offers to will be less than what they earned while working—and
work as gas attendants or farm workers. On the other hand, the benefits will be temporary. Suddenly the set of goods
it is also unfair to label all unemployed at the natural rate as and services these people can access becomes smaller. The
voluntarily unemployed, as many can simply not find a job that unemployed may even lose their house if they are unable
will permit them and their families to afford a relatively decent keep up with their monthly mortgage payments to the
standard of living. This figure is still very useful as it does show bank. Some end up homeless.
that the NRU is equilibrium unemployment and it also permits • In some countries matters become much worse because
discussion on the extent to which some of the unemployed here individuals losing their job may also lose their health
may be considered voluntarily unemployed. It also shows that if, insurance. If there is no national health-care service that
for example, policymakers decrease unemployment benefits, the covers all individuals independently of their employment
AJ curve will shift right and so the NRU will decrease. status this may prove disastrous for the unemployed.
• Long-term unemployed people also lose their skills. This
Costs of unemployment decreases their job prospects when competing against
One of the most significant goals of macroeconomic policy is others with up-to-date skills.
achieving and maintaining high levels of employment in the • In addition, an employer offering a job may prefer to hire
economy. This implies that unemployment should be kept a person currently working elsewhere rather than someone
low. The reason is that unemployment imposes many costs who is unemployed. This is because the employer cannot
on the economy, on the individual and on society, especially be sure why the unemployed person lost his or her job or
if it is high and prolonged. is no longer working.
Economic costs of unemployment • Long-term unemployed individuals often suffer family
• Perhaps the most important economic cost of unemployment breakdown, accumulation of debt, alcohol or drug abuse, loss
in a country is the “lost output forever”. Goods and services of self-esteem or depression. Some may even commit suicide.

92
 Studies have shown that a 1% increase in the unemployment

UNIT 3: MACROECONOMICS
rate is associated with a rise in suicides between 0.8% and Policymakers’ perspective
1.3% among people under the age of 65.
Achieving and maintaining high levels of employment
Social costs is one of the most significant macroeconomic goals.
Unemployment also burdens society with very significant Unemployment is a terrible waste and it imposes many
costs in both the short term and the long term. costs on the economy, on individuals and on society.
• Society may experience a higher incidence of crime and Economic costs are more pronounced if unemployment
violence and other negative externalities resulting from is high and prolonged. It is the resulting increase in
increased drug and alcohol abuse. Unemployment, if income inequality and the erosion of the stock of
high and prolonged, imposes costs on businesses, law human capital that are the most significant economic
enforcement and the judicial system, and health care. costs of unemployment. The loss of tax revenues is
of secondary importance because governments can
• Matters become much worse if unemployment is
typically borrow any shortfall in funds while any
regionally concentrated. If the major employer in an
increase in government expenditures is also
area is forced out of business, populations of whole towns
relatively small.
may suffer. Recent research finds that even if economic
conditions are terrible, contrary to what was believed, The personal costs are of obvious importance to the
people find it very difficult to move elsewhere with better unemployed individuals, especially if unemployment
jobs and financial prospects. The opioid crisis in many benefits are low and paid for a short period of time
towns in the USA points to this conclusion. Society suffers and their health insurance is lost.
in the long term from the breakdown that follows. It has also become clear that policymakers should be
• Problems also become more pronounced and difficult very mindful of areas suffering a persistently very high
if unemployment is concentrated in certain age groups rate of unemployment. Social costs rapidly escalate
such as the young. High youth unemployment may be in such communities and in the long term may even
responsible for a lost generation of productive workers transform into serious political costs.
who without some assistance from the state to improve Policymakers must ensure that the appropriate polices
their condition may also become a burden over the long are chosen to tackle unemployment. No policies
term as they will never be able to land jobs with a secure are adopted for seasonal unemployment. Reducing
and promising future. With insecure, part-time, low paying frictional unemployment requires better and faster
jobs they may never be able to save enough for retirement transmission of labour market information. Dealing
and this will create further social problems in the future. with cyclical unemployment is straightforward as the
• Over the long term, society may suffer from political costs. policy goal is to increase aggregate demand. Later
Long-term unemployment concentrated in areas and age it will become clear that different levels of cyclical
groups may create heightened levels of discontent that may unemployment may require different policy approaches
erode the social fabric and even risk democratic institutions. in achieving this. Decreasing structural unemployment
that is a result of a mismatch of skills requires that
retraining of workers is somehow achieved. Policies
Recap necessary for dealing with structural unemployment
Costs of unemployment that is a result of rigidities may seem straightforward,
The economic costs are: but their implementation and their possible long-term
side effects often render them difficult to pursue in
• lost output
practice. This will also be explained later.
• lower tax revenues and higher government
expenditures Policymakers should be aware that measuring the
• rising income inequality size of unemployment is not as easy as it seems. First,
• erosion of human capital. it is just an estimate. In addition, individuals may
misrepresent their true employment status. Also, many
The personal costs include: previously discouraged workers may be re-entering
• loss of income and, in some countries, of health the labour force and finding a job if aggregate
insurance demand is rising and the economy is growing fast. The
• erosion of skills unemployment rate may therefore be decreasing below
• family breakdown what was considered the NRU without any pressure on
• debt accumulation wages or on prices to increase, complicating the job of
• alcohol and drug abuse the policymakers. Lastly, differences between regions
• deterioration of mental health. or groups may necessitate a policy response even if
overall unemployment is low.
The social costs are:
• higher rates of violence and crime
• the social costs of drug and alcohol abuse
• longer-term social and political problems.

93
 Inflation
Inflation is defined as a sustained increase in the average that year. It follows that the price index for the base year
price level. The inflation rate is the percentage change will be equal to 100. By expressing a variable as an index
in the average price level between two periods. So, if the number, we get rid of its units of measurement, which makes
inflation rate in India in 2016 was 4.94% it means that comparisons through time a lot easier.
prices in India, on the average, increased in 2016 by 4.94% Once the CPI is available, calculating the inflation rate is
compared to 2015. easy. It will be the percentage change in the CPI between
One year later, in 2017, the inflation rate in India was two years. So, the inflation rate for 2019 will be:
recorded at 2.49%. What does this mean? It means that
CPI19 − CPI18
prices in India, on the average, continued to rise but at Inflation rate 2019 = ×100
a slower rate, compared to 2016. This is referred to as CPI18
disinflation. It follows that disinflation exists when the Note that in this IB course we simplify matters by using the
inflation rate decreases so that the average price level is still quantities purchased of each good as weights. We multiply
increasing but at a slower rate. the price of each product by the number of units bought
In Switzerland the inflation rate for 2016 was recorded at by the typical consumer. The worked example on page 99
–0.43%. What does this mean? The negative inflation rate illustrates the process.
in 2016 means that the average price level in Switzerland Limitations of the CPI in measuring inflation
decreased compared to 2015. This describes deflation.
Measuring the rate of inflation using a consumer price index
Deflation exists if prices in an economy, on average, are
(CPI) may not be accurate. There are a few problems that we
decreasing or, more formally, deflation refers to a sustained
need to be aware of.
decrease in the average price level.
• As already explained, the CPI is the average of the prices
Measuring inflation of the goods and services that the “typical” consumer
The average price level that is used to measure the inflation purchases. This “typical” consumer is no actual individual.
rate is the Consumer Price Index (CPI). The CPI is the weighted Instead, this fictitious individual is both a bit old and a
average of the prices of all the goods and services the typical bit young, rich and poor, lives in a city but also in the
consumer in a country buys per period. Statisticians determine countryside and is a man and a woman. Since different
the basket of goods and services that the typical household groups of people buy different baskets of goods and
buys through household surveys conducted every few years. services, the actual buying patterns and so the cost of living
This basket is fixed for a few years. By keeping the goods and of any specific group, say of young urban professionals
services included the same, the changes in the cost of buying with an average income, is not measured. This makes
the basket can be recorded. it problematical to use the published inflation rate to
determine, for example, by how much a government should
This average is “weighted”, which means that not all prices
increase pensions, because older people consume more
included in the basket are of the same significance when
health-care services and perhaps less entertainment than
deriving the average. Is the significance for consumers the
others and it could very well be that the cost of purchasing
same when rents increase by 10% and when the price of
their basket of goods and services has increased by a lot
chocolate-chip ice cream increases by 10%? The impact on
more than other groups’ baskets.
households of a 10% increase in rents is of much greater
significance than a 10% increase in the price of ice cream. • Some products may become more expensive, but their
To account for differences in the significance of goods quality may have improved so much that they are
and services in the budget of consumers, the price of each effectively cheaper for the buyer. Think of car tyres. A new
product is multiplied by the proportion of total expenditures set may be 10% more expensive but it may last 50% more
the typical consumer makes on each product. Goods for miles. Quality improvements are often not sufficiently
which the typical consumer devotes a bigger proportion of accounted for, so published inflation may overestimate
his or her total spending will thus “weigh” more (that is, true inflation. This is referred to as the “quality bias”.
“count” more) in the derivation of the average. • New products enter our lives almost daily but are included
So, the CPI would be: in the CPI only after a long delay. For example, many
consumers in Greece subscribe to Netflix and to Spotify
w1P1 + w2P2 + w3P3 + … + wnPn, where the w’s are the
but neither service is yet included in Greece’s CPI. This is
expenditure on good i referred to as the “new product bias”.
weights and wi =
total expenditures • More and more people now buy more and more goods
The cost of purchasing this basket is recorded and then online where prices are usually lower than prices in “brick
expressed as an index number. What does this mean? It and mortar” stores. Many consumers buy electronics,
means that, using statistical criteria, some year is chosen books, clothing and groceries online. If the statistical
to be the “base” (or reference) year and all other years are agency of a country sends its employees every month to
then expressed as a percentage of the cost of the basket collect prices mostly from physical stores and not so much

94
 from online retailers then the published inflation rate will they can only save in simple bank accounts. The interest

UNIT 3: MACROECONOMICS
again tend to overestimate true inflation. This is referred rate paid on such savings accounts is usually not only low
to as the “new retail outlet bias”. but also less than the rate of inflation. The real interest
• The “substitution bias” results from the fact that the rate, defined as the interest rate minus the rate of inflation,
weights are fixed for some time. If a good becomes more is thus negative. For example, if the interest rate paid on
expensive then consumers will tend to switch to cheaper a savings account is 3% per year but prices are rising at
substitutes. The significance of this good for the typical 5% per year then the saver loses money as the real rate of
consumers will thus diminish. However, if its weight in interest is –2%. In a year’s time $100.00 will buy roughly
the calculation of the CPI remains fixed, this now lower only as much as $98.00 can buy now. On the other hand,
significance will not be reflected. This means that inflation higher income households can protect themselves against
will be overestimated. inflation by borrowing from banks and purchasing assets
such as houses or land, or art or gold, the price of which
is expected to increase faster than inflation. In this way,
Recap inflation may redistribute national income away from the
Limitations of the CPI in measuring poor to the rich, widening income inequality.
inflation • If actual inflation proves higher than anticipated inflation
• The average refers to the buying patterns of the then borrowers will gain income at the expense of lenders.
typical consumer, a fictitious person. The money they will be paying back to lenders will be
• Improved quality of more expensive products may worth less than what had been expected when the loan
not be sufficiently accounted for. was agreed. Banks, in an attempt to protect against the
possibility of inflation proving higher than expected, may
• New products that consumers buy are included in
charge even higher interest rates. This though decreases
the CPI only after a significant time lag.
borrowing and spending, and aggregate demand, which
• Lower prices from new retail outlets such as also slows down economic growth.
e-shops are not adequately sampled.
• Inflation hurts the exports of a country. They become more
• Weights are fixed so if a good becomes pricier expensive and therefore less competitive in foreign markets.
even though its significance for consumers Inflation also makes imports more attractive to domestic
decreases, its weight does not. buyers so import expenditures rise. Decreasing export
revenues and increasing import expenditures decrease
aggregate demand and widen a trade deficit. This may exert
Costs of a high inflation rate pressure on the currency to depreciate and lead to more
Maintaining price stability is a most significant goal for inflation, as will be explained in sections 3.5 and 4.5.
policymakers because, as will be explained, a high rate of
• Inflation is “noise”. It distorts the signalling power of
inflation creates many problems for an economy.
relative price changes that is responsible for resource
• Inflation increases the uncertainty that businesses face. This allocation in a market economy. If the price of quinoa
makes it even more difficult for firms to judge whether an rises, this sends a signal to producers that people want
investment project will be profitable and worth undertaking more quinoa. If all prices are rising as a result of inflation,
or not. How fast will wages and other production costs though, the price signal is not clear anymore and
increase? At what price will it be possible to sell the good producers cannot be sure that consumers actually demand
produced two or three years into the future? How fast will more quinoa. Misallocation of resources is the result.
prices of substitutes and complements rise? How much will
• Inflation may induce people to save less. They may choose
interest rates increase? Increased uncertainty discourages
to buy durables now before these become even more
investment spending. Long-term economic growth and so
expensive, spending more and saving less. Saving may
employment generation will be slower.
also decrease because during inflationary periods the real
• The purchasing power (real income) of those earning fixed interest rate is often negative. Savings in a bank account
money incomes decreases. Individuals with fixed money will be worth less and less.
incomes include wage earners as well as pensioners.
However, inflation does have some benefits.
This is not the case though for those individuals who
can adjust their earnings as prices increase. These • Mild inflation slowly reduces the real wage and so the
groups include professionals such as lawyers, architects, real cost of labour to firms. This is especially important for
consultants and others. Entrepreneurs who can raise their firms since money wages do not easily adjust downward.
prices faster than inflation also gain. Income inequality Lower production costs induce firms to produce more.
thus widens. • Inflation also reduces the real value of debt. Households,
• Low income families cannot easily borrow from banks. In firms and the government own less in real terms if there is
addition, if their income permits them to make any savings, some inflation in the economy.

95
 chasing after too few goods”. Monetarists consider
Recap that “inflation is always and everywhere a monetary
phenomenon”. If the central bank increases the money
Costs of a high inflation rate supply too fast and thus too much money is pumped
• Uncertainty increases, decreasing investment and into an economy, then this excess liquidity will be spent.
slowing down growth. Inflation could follow. Many consider that this is a serious
• The purchasing power of wage earners and risk of quantitative easing, which will explained later.
pensioners decreases, increasing income inequality. • Households and firms can be overly optimistic, resulting
• Income inequality widens as the rich can protect in excessive spending in the expectation that good
themselves against inflation whereas the poor times will persist. Since consumption and investment are
cannot. components of aggregate demand, aggregate demand
will be increasing and the AD curve will be shifting to the
• If inflation is unanticipated then lenders lose;
right, potentially proving inflationary.
banks may charge higher interest rates on loans
they make, slowing down growth. • A sudden surge in exports may also prove inflationary, if
the economy is operating near full employment.
• Exports are hurt and imports rise, decreasing
aggregate demand and widening a trade deficit, • Inflationary expectations are considered a most important
which may lead to currency depreciation. driving force of inflation. If businesses expect prices to rise,
then they will their set prices higher, creating or increasing
• Price mechanism is distorted, leading to
inflation as a result. Also, households expecting prices to rise
misallocation of resources and inefficiency.
may prefer to spend more now, before prices rise even further,
• Saving may decrease as people may choose to which will lead to higher aggregate demand and higher
spend more now and because the real rate of inflation. This explains why it is important that policymakers
interest may be negative. are credible that price stability will be maintained.
Average AS
Causes of inflation price level
(APL)
Analytically, it is easy to understand why inflation may occur
by examining a simple AD/AS diagram. Any factor that
persistently increases aggregate demand or that leads to an
adverse shift to the left of AS curve may lead to an increasing APL2
price level (that is, to inflationary pressures). The former is APL1
referred to as demand-pull inflation and the latter is referred
to as cost-push inflation, even though once an inflationary
process begins it is difficult or even meaningless to distinguish AD2
between the two. AD1
Demand-pull inflation Y1 Y2 Yfe
Any factor increasing any component of aggregate demand Real output (Yr)
may potentially initiate inflationary pressures. Of course, the
Figure 3.3.9 Demand-pull inflation
risk of inflation increases the closer to full employment an
economy is operating. The smaller the size of the deflationary In Figure 3.3.9, a simple AD/AD is used to illustrate demand-
gap in the economy, the greater the chance that an increase in pull inflation. Aggregate demand increases, perhaps as a
aggregate demand will lead to an increase in the average price result of excessively optimistic households and firms. The
level. Unfortunately, it cannot be easily ascertained whether the AD curve shifts to the right from AD1 to AD2. As a result,
economy is about to reach its potential level of real output. the average price level rises from APL1 to APL2. It should be
clear from Figure 3.3.9 that the same increase in aggregate
The most common causes of demand-pull inflation include the
demand will prove more inflationary the closer to potential
following.
output the economy is operating. Unfortunately, policymakers
• Profligate government spending. Profligate is the word are never sure in advance how close to full employment
used to describe excessive spending by a government. an economy is and this creates significant policy response
Politicians historically have often increased spending to problems. Policymakers closely examine economic data that
maximize their re-election chances, as even a temporary may signal inflationary pressures and lead them to take action
boost of economic activity and a resulting decrease but there is a lot of uncertainty that makes their job difficult.
in unemployment will serve this purpose. Government
It is perhaps worth noting that the Monetarist/New Classical
expenditures (G) are a component of aggregate demand,
diagram is strictly speaking ill equipped to illustrate demand-
so if G rises, then aggregate demand will increase and
pull inflation. Since the short-run aggregate supply (SRAS)
the AD curve will shift to the right, potentially, but not
curve is upward sloping, it shows that demand-pull inflation
necessarily, proving inflationary.
results whenever aggregate demand is increasing even if
• According to the Monetarist School, and quoting Milton the economy is operating way below its potential and is
Friedman, inflation results when “too much money is suffering from a large deflationary gap, which is misleading.

96
 • Another significant reason that may increase production

UNIT 3: MACROECONOMICS
Recap costs and lead to cost-push inflationary pressures is a
depreciation of the exchange rate. The reason is that
Causes of demand-pull inflation a depreciation increases the domestic price of imports.
Demand-pull inflation is caused by: If the country imports a lot of raw materials and
• profligate government spending intermediate products, then production costs for many
firms will increase. There is more on depreciation of the
• “too much money chasing after too few goods”
exchange rate in section 4.5.
• overly optimistic households and firms
Average SRAS2
• a sudden surge in exports price level SRAS1
• inflationary expectations. (APL)

Cost-push inflation APL2

This is the result of a decrease in aggregate supply. This APL1
shifts the AS curve to the left and leads to an increase in
the average price level as well as to a lower level of real
output. Aggregate supply may decrease, and the AS curve
shift to the left, for a variety of reasons.
• Historically, the most common reason for cost-push AD
inflation has been a sustained and significant increase Y2 Y1 Real output
in the price of oil. Oil is still the predominant form (Yr)
of energy and it is also used as an input in many Figure 3.3.10 Cost-push inflation
production processes e.g. in the plastics industry. If the Figure 3.3.10 shows cost-push inflation. A sustained
price of oil increases, production costs for many firms will increase in the price of oil has increased production costs
increase. Aggregate supply will decrease (the AS curve for most firms. As a result, aggregate supply decreases and
will shift left), leading to rising prices but also to slower the AS curve shifts left from SRAS1 TO SRAS2. The average
growth (or even a decrease in real GDP) and rising price level increases from APL1 to APL2. Real output also
unemployment. decreases from Y1 to Y2 even though it is more likely
• More generally, production costs may increase because that growth will just slow down, but that would be more
other commodity prices rise. Commodities are primary difficult to show on this diagram.
products that are used as inputs in manufacturing.
Crop failures increase the price of agricultural products
and this may increase the cost of food production. Recap
Disruptions in extraction industries may also lead to Causes of cost-push inflation
higher prices of metals and minerals. Cost-push inflation is caused by:
• Powerful labour unions in many countries have been • a sustained and significant increase in the price
successful in increasing money wages for their members of oil
and thus production costs for firms, especially in the
• other commodity prices rising
past. More generally, keep in mind that the standard way
policymakers assess the risks of rising inflationary pressures • money wages rising
has been to monitor closely the state of the labour market • depreciation of the exchange rate as prices of
and whether money wages are rising. Even if inflationary imported inputs rise.
pressures originate from rising aggregate demand, these
pressures will show up as rising money wages in the labour
market and will be an early signal of inflation.

Deflation
Deflation is a sustained decrease in the average price Causes of deflation
level. If the inflation rate is negative it means that the Typically, deflation results from a prolonged decrease in
average price level has decreased and thus there is aggregate demand. If aggregate demand in an economy
deflation. is decreasing so that inflation is very low (say, at 0.6%)
So, if the CPI in 2019 was 145.65 and in 2020 it was and growth is also very low (say, at 0.4%) then a further
142.95 then the rate of inflation in 2020 was −1.85%. decrease in aggregate demand could easily result in
There was deflation in 2020 as prices decreased compared negative growth and deflation. Figure 3.3.11 shows
to 2019. deflation resulting from a decrease in aggregate demand.

97
 Average • Low confidence levels and increased uncertainty may
AS also induce households to defer consumption and deter
price level
(APL) firms to make investments.
• The biggest risk of deflation is that the economy may
APL1 enter a deflationary spiral. A vicious cycle may start,
where deflation creates more deflation.
APL2 • Resources are misallocated as prices lose their signalling
power and incentives are distorted. It becomes difficult for
producers to determine whether demand for their product is
falling when there is a general tendency for prices to fall.
AD2 AD1
• If an economy becomes caught in a deflationary spiral,
policymakers may not have many policy options available.
Y2 Y1 Real output Monetary policy may be ineffective as interest rates
(Yr)
are probably already very close to zero. A “zero lower
Figure 3.3.11 Deflation: aggregate demand decreasing and the AD curve bound” (ZLB) on interest rates was considered a limit
shifting left
for using monetary policy to help an economy grow and
The decrease in aggregate demand from AD1 to AD2 was exit deflation. More recently though, negative interest
responsible for a decrease in real GDP from Y1 to Y1 and rates policies (discussed later) are being considered and
for the average price level decreasing from APL1 to APL2. have even been employed by some central banks. Using
It is feared by many that Covid-19 will result not only in expansionary fiscal policy by increasing government
severe economic contraction but perhaps even deflation as expenditures is also not always an option as many
a result of the dramatic decrease in aggregate demand. economies face debt constraints and are fearful of raising
Technically, deflation may also result from aggregate supply the debt to GDP ratio by too much.
increasing. Since a falling average price level is in this case
accompanied by an increase in real output, this is sometimes
Recap
referred to as “good deflation”, which is considered rather
misleading. Deflation, as will be explained below, if it Consequences of deflation
becomes expected, is very difficult to reverse. • Consumers postpone purchases of durables, further
decreasing aggregate demand.
Recap • Firms’ revenues and profits are reduced, leading to
Causes of deflation redundancies and bankruptcies.
• Since aggregate demand is falling, real GDP is
Deflation is caused by:
decreasing and unemployment is rising.
• sustained decrease in aggregate demand
• Real debt levels rise so there is less borrowing and
• an increase in aggregate supply. spending, which further decreases aggregate demand.
• There is increased risk of a banking crisis because
Costs of deflation banks accumulate bad loans.
• Deflation induces consumers to delay purchases of • The low level of confidence decreases spending and
durables since they come to expect further price decreases. so decreases aggregate demand.
Why buy a smartphone now, if you can buy it later at a • There is a risk of a deflationary spiral as deflation
lower price? As a result, aggregate demand decreases even brings about more deflation.
more, pushing the average price level even lower. • There is resource misallocation and inefficiency.
• Deflation decreases firms’ revenues, reducing profit margins • The policy options available are very limited.
and forcing them to cut costs. Wages fall and workers are
made redundant. Some firms may go bankrupt.
• Since deflation is a result of a persistent fall in aggregate Relative costs of unemployment versus
demand, it is not only the average price level that falls inflation
but also real output. Deflation is accompanied by higher Which is worse—inflation or unemployment? The simple
levels of unemployment. answer is that it depends.
• What households and businesses owe to banks increases It depends on who you are. Much of the income earned by
in real terms. Households become hesitant to borrow wealthy households is in the form of interest payments from
and spend; indebted firms are also hesitant to make fixed income assets they own, such as bonds. Inflation erodes
investments. Aggregate demand decreases even more. the real value of the income earned from bonds. If a wealthy
• Since the real value of outstanding debt increases, some household earns $1 million per year from interest payments,
households and some firms may not be able to service their inflation slowly decreases the real value of this $1 million.
loans. Banks may thus start to accumulate non-performing On the other hand, the primary concern for workers is keeping
(“bad” loans). The risk of a banking crisis increases. their job. Inflation for workers is of lesser importance. Losing

98
 their job and the wage they earn (often even their health Whether inflation or unemployment is more costly to

UNIT 3: MACROECONOMICS
insurance) is much more costly, even if inflation shrinks their the economy also depends on the particulars. High and
real wage. The threat of unemployment represents to them a prolonged unemployment can destroy the social fabric of
much greater cost than inflation does. the economy as poverty increases and income inequality
Whether inflation or unemployment is more costly also widens. In addition, if the youngest and the brightest
depends on one’s ideological leanings. Monetarists such members of the country’s labour emigrate, then the future
as Milton Friedman considered inflation as the true enemy growth of the country is compromised. In this sense, high
of an economy for many reasons. Inflation distorts the unemployment may be considered costlier than inflation.
workings of markets and of the price mechanism and The opposing view is that accelerating inflation is also
leads to inefficient allocation of resources. It increases very costly and dangerous, especially for countries that
uncertainty for businesses, decreasing investment rely on export-led growth. Runaway inflation severely
spending. On the other hand, if price stability is achieved damages savings and has led in many instances to
and maintained, the economy can theoretically grow faster social unrest.
and, in the long term, even more jobs will be created.

Policymakers’ perspective notably the USA, money wages were not rising and
neither was inflation accelerating. So, if policymakers
One of the biggest problems that policymakers face is to
had decided to adopt too soon the policies that would
determine early when a growing economy enjoying lower
slow down growth then many workers who did find jobs
and lower unemployment is about to experience rising
would have remained unemployed.
inflation. As long as an economy is growing, incomes are
rising, and more jobs are created. To the extent that this There are many explanations for the persistently low
growth is inclusive and sustainable it is, of course, much growth in wages and in prices but one that should be
desired. However, if the potential level of real output easily understood is that many discouraged workers
is being approached then there is a risk of inflation (known as “workers on the sidelines”) were joining
accelerating. It is thus important for policymakers to try the labour force again, encouraged by the sustained
to slow down growth to avoid the inflation rate increasing expansion. If more workers join the labour force and
above their target, which is usually set at 2%. accept jobs there is no reason for wages to start rising
and subsequently for prices to increase.
Policymakers therefore closely monitor the labour market.
If they see that the unemployment rate is decreasing The opposite side of the above is the problem faced
and approaching historically low levels, they realize that when policymakers try to decrease inflation. Some of the
money wages and subsequently inflation will soon start to measurement problems discussed earlier may lead to an
increase. At that point they will want to try to slow down overestimation of inflation. A positive inflation rate may
the expansion. be officially recorded, but in reality the average price level
may have already started to decrease. This explains why
The problem lately faced by policymakers was that despite
the target rate of inflation is never 0%.
unemployment decreasing fast in several countries,

Worked example
Calculating a weighted price index and the
rate of inflation from a set of data
You may be asked to calculate from a set of data a weighted Assume that in Laylaland, the basket of goods the typical
price index (HL) and then use the price index to calculate consumer purchases includes only five products, A, B, C, D
inflation rates (SL and HL). This exercise takes you through and E. The table below includes the quantities bought of
the process. each by the typical consumer per period and their prices in
dollars for the years 2017 to 2020.

Product Quantities Price per unit in Price per unit in Price per unit in Price per unit in
bought 2017 ($) 2018 ($) 2019 ($) 2020 ($)
per period
A 5 2.15 2.25 2.30 2.30
B 8 1.20 1.25 1.30 1.28
C 2 3.40 3.50 3.55 3.45
D 10 1.10 1.25 1.30 1.20
E 8 0.80 0.90 0.95 1.00

99
 In order to calculate a weighted price index (HL) for each
of the four years we first will have to calculate the cost of
CPI for 2019 = ( 49.60
44.55 )
×100 = 111.335578 or 111.34
this basket of goods in each of these years. For each year we 48.64
multiply the quantity bought of each good (the “weight”) by ( )
CPI for 2020 = 44.55 ×100 = 109.1806958 or 109.18
its price. We then add the expenditures together to arrive at
the cost of the basket in each year, as follows. Now the inflation rates can be calculated (SL and HL).
For 2017: (5 × 2.15) + (8 × 1.20) + (2 × 3.40) + (10 × 1.10) + The inflation rate for each year will be the percentage
(8 × 0.80) = $44.55 change in the CPI between two years.
For 2018: (5 × 2.25) + (8 × 1.25) + (2 × 3.50) + (10 × 1.25) +
(8 × 0.90) = $47.95
Inflation rate for 2018 = ( 107.63100− 100) × 100 = 7.63%
For 2019: (5 × 2.30) + (8 × 1.30) + (2 × 3.55) + (10 × 1.30) +
(8 × 0.95) = $49.60
Inflation rate for 2019 = ( 111.34107.63
− 107.63
) × 100 = 3.45%
For 2020: (5 × 2.30) + (8 × 1.28) + (2 × 3.45) + (10 × 1.20) + (note that if you had not rounded off the CPI figures this
(8 × 1.00) = $48.64 would be 3.44%; the IBO has accepted both in all past
One of the years will be the base year. Assume that the base exams)
year is 2017. To derive the price index for each year we have
to divide the cost of the basket in each year by the cost of Inflation rate for 2020 = ( 109.18 − 111.34
111.34
) × 100 = −1.94%
the basket in the base year (in this case 2017) and multiply We realize that since the rate of inflation in 2019 was lower
the result by 100. (Remember the two decimal places in than 2018 there was disinflation. This means that prices
economics calculations.) in 2019 continued to rise but at a slower rate compared
44.55
CPI for 2017 = (44.55 ) × 100 = 100
to 2018. It should also be realized that in 2020 there was
deflation because the rate of inflation was negative. Prices in
47.95
CPI for 2018 = ( 44.55 ) × 100 = 107.6318743 or 107.63 2020 decreased by 1.94% compared to 2019.
All of the results of our calculations are included in the
following table.

2017 2018 2019 2020

Cost of basket 44.55 47.95 49.60 48.64
Weighted price index (CPI) 100 107.63 111.34 109.18
base year: 2017
Annual inflation rate 7.63% 3.44% −1.94%

The government (national) debt

Meaning of the term Why is the national debt expressed as a
At the simplest level the term government (national) debt percentage of GDP?
refers to what a government owes. Governments’ expenditures The reason is very simple: the size of a country’s debt must be
must be financed. This is the reason governments impose scaled for the size of its economy. The same dollar amount of
taxes. They need to raise money to finance these expenditures. debt has different implications for a small economy compared
However, governments often spend more than they collect to a large economy. The size of an economy is measured by its
in taxes. A budget deficit then results. The way to finance GDP. Dividing debt by GDP provides us with a more accurate
this deficit spending is by borrowing. A government typically picture of the size of the debt. Greece’s debt in 2018 was
borrows by issuing and selling bonds. In contrast, if a around $375 billion. This number by itself conveys very little
government collects more than it spends then it is running information—but if expressed as a percentage of the size of the
a budget surplus. In this sense the government debt is the Greek economy in 2018, it amounted to about 172% of the
sum of all past budget deficits minus any repayments made country’s GDP. The same level of debt for the UK, a much bigger
through budget surpluses. economy, would amount only to around 13% of that country’s
What is a bond? A bond as a promissory note: it promises to pay GDP. The implications are significant. The same debt implies a
the holder of this note a specific payment at a specific future much higher debt burden for Greece than for a larger economy.
date. Bonds used to be “official” pieces of paper but now they debt
It should also be clear that the ratio of could increase
are mostly electronic records. They are also referred to as IOUs GDP
for the obvious reason. Governments sell these promissory notes not only because the size of the country’s debt is increasing
at a price that is lower than the amount each note promises to but also because its GDP is decreasing as a result of recession.
pay the holder in the future. This makes the bond attractive to If GDP decreases faster than the size of the country’s debt
buy because the owner earns interest. Effectively, when people decreases, then the debt to GDP ratio will be increasing. More
buy government bonds they lend to the government. A bond debt
generally, the ratio will increase if the size of the debt
that has not been paid off is an outstanding bond. It follows GDP
that the government (national) debt is equal to the total value rises relatively faster than GDP.
of all outstanding government bonds.

100
Why is the debt to GDP ratio of importance? The reason is that achieve a “primary budget” surplus, which refers to tax

UNIT 3: MACROECONOMICS
it is a measure of how easily an economy is able to pay off its revenues exceeding government expenditures excluding
debt. A high debt to GDP ratio could imply that the economy’s debt servicing costs, so that debt is slowly reduced. Efforts
output and income may not be sufficiently high to pay off its to reduce budget deficits by decreasing government
debts, forcing investors to demand higher interest rates. expenditures and increasing taxes are referred to as
austerity policies.
Costs of a high national debt Spending cuts can be painful as they often include reductions
Cost of debt servicing in pensions and unemployment benefits that hurt vulnerable
Debt servicing (that is, paying back the principal and the population groups. The wages of public sector employees are
interest) carries a high opportunity cost. Governments facing also decreased. Infrastructure investments may also be scrapped
a very high debt–to–GDP ratio must devote a share of their and repairs of existing infrastructure may be postponed,
expenditures on debt servicing. negatively impacting the economy’s potential output.
Rising debt-servicing costs will squeeze a government’s Increasing taxation is painful especially if the government
ability to undertake discretionary spending. Resources that decides to increase indirect taxes because indirect taxes are
could have been invested on infrastructure, education and regressive in nature and affect lower income households
health care will have to be diverted to servicing the debt and disproportionately more than those on higher incomes.
poorer households will suffer the most. Such policies, which are considered necessary when debt
The cost may also deny the country the ability to adopt is growing at unsustainable rates, clearly impose a lot of
expansionary fiscal policy (explained in section 3.5) if there is a hardship on the population of a country, especially the poor.
sudden and severe recession. The government will not be able to It is worth noting that austerity policies typically lead to a
borrow in order to finance the necessary increase in government decrease in economic activity and in national income which
expenditures. Lenders (that is, buyers of government bonds) will will, at least in the short term, further increase the debt to
not be willing to lend unless interest rates paid rise sufficiently to GDP ratio, even if the absolute level of debt decreases.
compensate for the increased risk they face.
When is debt sustainable?
Governments may choose to service debt held by domestic
residents by issuing new money. This is referred to as This is not an easy question to answer. An increase in
“monetizing” the debt. This will though increase the risk of government debt may increase welfare if it increases the
inflation and of a subsequent depreciation of the currency. growth rate of the economy. However, higher debt levels lead
A depreciating currency, as will be explained in sections 3.5 to higher risks. In addition, there may be a certain threshold
and 4.5, will increase the cost of repaying any debt held by level of debt beyond which further accumulation of debt
foreigners and thus denominated in dollars and may further decreases growth and may even lead to financial collapse or
increase inflation. default. Examples show great variation: Japan can sustain
debt levels above 200% of GDP without any pressure on
Credit ratings interest rates whereas Ukraine defaulted on debt roughly
The term credit ratings refers to a grade assigned by certain equal to 30% of its GDP. The literature shows how difficult
agencies, such as Moody’s or Standard and Poor’s, on the it is to determine when a country’s debt to GDP ratio signals
borrowing risks a prospective issuer of debt (for example, of heightened economic risks and there are a few indicators
a bond) presents to lenders. The highest rating assigned by that help.
Moody’s is “Aaa” and is for bonds judged to be of the highest The relationship between interest rates and growth rate of the
quality issued by governments presenting the lowest risk to country is important. It reveals how fast the country’s income
creditors. A rating of “B” is for bonds considered speculative and debt repayment ability is rising compared to how fast its
and subject to high credit risk. A “C” is the lowest grade, and debt obligations are rising.
is assigned to bonds typically in default, where the prospect of
The condition of the “primary budget” balance is also
recovering the principal or interest is low.
important. If debt is rising and a government fails to improve
As the debt to GDP ratio of a country increases, there is its primary balance, then future debt problems become
greater risk that a credit agency will downgrade the country’s more likely. Similarly, it makes a difference whether debt
bonds. Investors will lose confidence in the government’s is used by the government to finance productive capital
ability to pay back borrowed funds and will demand expenditures that will permit faster future growth or mostly
higher interest rates on the debt. The higher interest rate current expenditures that do not add to the stock of the
governments are forced to pay is referred to as a “risk nation’s capital. Debt that accumulates as a result of budget
premium” and it may lead to a feedback loop: higher risk deficits from tax cuts is also risky since the literature shows
premiums lead to higher debt, which may lead to even higher that corporate tax cuts lead to small, if any, additional private
risk premiums and increase the risk of default. The economy investment.
becomes trapped in a debt crisis.
Lastly, explosive debt problems are less likely if most of a
Impact on future taxation and government country’s national debt is held by domestic investors, as in
spending the case of Japan, and denominated in its domestic currency.
If the debt to GDP ratio is high, governments will be forced Countries heavily depending on external borrowing in foreign
to cut spending and raise tax revenues. They will need to currency face greater debt-related risks.

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 Policymakers’ perspective However, if unchecked, then a high and rising
debt–to–GDP ratio may become unsustainable. It
Historically, it has become painfully clear to a number
may lead to a debt crisis that will require very painful
of countries that the debt–to–GDP ratio is an economic
adjustments for the population of the country and it may
variable requiring very close monitoring. Debt financing
also jeopardize the country’s growth prospects for a
of increased government expenditures may help a country
long time.
recover from a recession (as will be explained later) and
grow and it will be necessary if a country suddenly faces
a natural disaster.

HL
The Phillips curve Why the Phillips curve is compatible with
Trade-off between unemployment and shifts in aggregate demand
inflation (a)
The original Phillips curve Average AS
price level
Since the early 1960s and until the mid-1970s economists (APL)
relied on an empirical result that Alban W Phillips,
a New Zealand economist at the London School of APL2
Economics, published in 1958. His work, the Phillips
curve, became one of the most famous relationships in APL1
macroeconomics.
APL3
His original statistical work examined UK data on the
annual percentage change in money wages and the annual AD2
unemployment rate over a period of 96 years (from 1861
AD1
to 1957). He found that the percentage changes in money AD3
wages and the unemployment rate were inversely related.
Y3 Y1 Y2 Real output
• If unemployment was low (which implied a “tight” labour (Yr)
market) then money wages increased a lot because
employers were forced to offer higher wages to find
workers. (b)
Inflation
• If unemployment was high (a “slack” labour market), then rate (π)
money wages would increase but only by a little, or could
even decrease because firms could find and hire additional
workers without having to offer more than last year’s π2 A2
prevailing money wage.
Moving from wage inflation to price inflation was the A1
π1
next step. Since wages typically form a big proportion
of production costs and since firms in the real world
often set prices by adding a percentage mark-up on A3 Phillips
π3
their average cost, it seemed sensible to expect that curve
decreasing unemployment would lead to an increase
in the average price level. The empirical results showed
U2 U1 U3 Unemployment
that there was indeed a trade-off between the inflation
rate (U)
rate and the unemployment rate of an economy. When
the unemployment rate decreases, inflation increases as Figure 3.3.12 The effect on the Phillips curve of shifts in aggregate demand
businesses compete for fewer workers and this drives up Focusing on Figure 3.3.12a, assume the economy at equilibrium
wages, which leads to an increase in prices. with real output Y1 and the average price level at APL1.
This inverse relationship is referred to as the Phillips curve Now look at Figure 3.3.12b. There is some inflation in this
and it is compatible with our simple AD/AS model. economy equal to π1 and some unemployment equal to U1,
shown at point A1. Let aggregate demand increase to AD2.
Equilibrium real output will increase to Y2. The higher level of
economic activity will decrease unemployment to U2. The

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average price level rises though, so inflation is now higher at

UNIT 3: MACROECONOMICS
LRPC
π2. We have moved from point A1 to point A2. Following the Inflation
increase in aggregate demand, unemployment has decreased rate (π)
from U1 to U2, while inflation has increased to π2. If 7% A7
A6
aggregate demand had instead decreased from AD1 to AD3,
real output would have decreased from Y1 to Y3. The lower A5
level of economic activity will increase unemployment from 4%
A4
U1 to U3. The decrease in the average price level implies that
inflation decreases from π1 to π3. We have moved from point A3 SRPC (4%)
2%
A1 to point A3 on Figure 3.3.12b. Following the decrease in A2
AD, unemployment increased and inflation decreased. This A1
1% SRPC (2%)
inverse relationship between unemployment and inflation is SRPC (1%)
exactly what the Phillips curve described so Figure 3.3.12b is
the original curve resulting from the work of AW Phillips. U’ NRU Unemployment
If this inverse relationship between inflation and (3.5%) (4.5%) rate (U)
unemployment was stable, then governments could perhaps Figure 3.3.13 The long-run Phillips curve
exploit it. The Phillips curve was considered for many years
as presenting policymakers with a “menu of choices” inviting Figure 3.3.13 shows an economy initially at point A1 with
them to intervene. It seemed policymakers could achieve a unemployment at the natural rate of unemployment, the
lower unemployment rate but at the cost of higher inflation, example used being 4.5%, and inflation for some time now
or they could achieve lower inflation but at the cost of equal to 1%. Workers expect 1% inflation next year.
higher unemployment. The issue was for the government Assume now that the government attempts to decrease
to determine the politically desired combination of the two unemployment below the 4.5% natural rate to 3.5%
variables and then by manipulating aggregate demand (by by increasing aggregate demand (using expansionary
using demand-side policies), policymakers could achieve it. policies). It is essentially trying to expand real GDP beyond
For many years, policymakers in many countries were its potential level Yp. As a result of the higher aggregate
trying to achieve whichever combination of inflation and demand, inflation will now accelerate to 2%. Since in the
unemployment the government considered most desirable. short run money wages are assumed fixed, the real wage
In the 1970s, not only did this stable relationship between rate will decrease, and firms will want to produce more
inflation and unemployment break down but also Milton output so they will hire more workers. Unemployment
Friedman, the most prominent Monetarist economist, decreases to 3.5% and the economy has moved on Figure
showed that in the long run there is no such trade-off 3.3.13 to point A2 along the short-run Phillips curve SRPC
between inflation and unemployment. (1%) that reflects workers expecting 1% inflation. This
movement along a negatively sloped short-run Phillips curve
In the long run, policymakers cannot decrease unemployment
is only the result of workers being temporarily fooled. They
below what Friedman called the natural rate by pursuing
expected inflation at 1% but it increased to 2%. Workers
policies that aimed to increase aggregate demand. He
are slow to realize that inflation is higher than they had
showed that any such attempt could only temporarily lower
expected and that consequently their real wage is lower. If
unemployment at the cost of higher inflation. In the short run,
we refer back to the Monetarist AD/SRAS diagram we have
an inverse relationship between inflation and unemployment
moved along the economy’s SRAS curve: at a higher average
did exist, but in the long run unemployment would return to
price level, real output is greater and so unemployment is
its natural rate. According to Friedman, the long-run Phillips
lower.
curve is vertical at the natural rate of unemployment, which is
also the equilibrium rate of unemployment. In the long run, though, workers’ expectations about inflation
will adjust. They realize that inflation is now higher (at 2%) and
The logic of the vertical long-run Phillips curve will demand higher money wages. Since in the long run money
The distinction between a short-run Phillips curve (SRPC) and wages are assumed flexible, they will start to increase. As
a long-run Phillips curve (LRPC) was introduced by Milton money wages increase, the SRAS curve in the Monetarist AD/
Friedman and, independently, by another economist, Ed SRAS diagram will start to decrease and shift to the left. Firms
Phelps. Their theory became known as the Phelps-Friedman will be firing workers. Since money wages are assumed to adjust
critique or the expectations-augmented Phillips curve. fully to changes in the average price level, the real wage will
According to this theory, any short run trade-off between return back to its original equilibrium level. We say that in the
inflation and unemployment was only the result of workers long run the real wage is “restored”. Unemployment will return
suffering from money illusion. Specifically, workers expect next to its equilibrium natural rate at 4.5% (see Figure 3.3.13).
year’s inflation rate to be the same as previous inflation rates Real output will thus also return to its potential level Yp. The
(referred to as backward-looking or adaptive expectations). economy is at point A3 in Figure 3.3.13. Workers’ expectations
Workers are slow to realize that inflation is increasing when have adjusted and they expect inflation at 2%. The short-run
the government uses (expansionary) policies to increase Phillips curve has shifted to the right to SRPC (2%) because
aggregate demand. workers now expect higher 2% inflation.

103
 If the government insists on trying to decrease unemployment potential level Yp. The short-run Phillips curve will have shifted
below its natural 4.5% rate by increasing aggregate demand, to SRPC (4%) as workers’ expectations have adjusted and they
it would need to engineer even higher inflation so that now expect 4% inflation next period.
workers would again be temporarily fooled and accept job It follows that in the long run, when expectations have
offers without realizing immediately that their real wage has adjusted so that the money wage has increased and the real
decreased. In Figure 3.3.13, inflation would have to rise to wage has been restored, the Phillips curve will be vertical
4% for unemployment to drop again to 3.5% (point A4). at the NRU. There is no trade-off in the long run between
The movement from point A3 to point A4 along the SRPC unemployment and inflation.
(2%) was because workers were fooled again. They expected
This analysis is symmetric to the earlier analysis of why any
inflation 2% but inflation increased to 4%.
inflationary gap will automatically close according to the
In the long run, since money wages are assumed flexible, Monetarist model. Remember, the long-run aggregate supply
they will adjust and increase so that the real wage is restored. (LRAS) is vertical at the potential level of real output (Yp)
The economy would move to point A5 on SRPC (4%) with where unemployment is at its equilibrium natural rate.
unemployment back at its 4.5% natural rate and output at its

Recap • The problem is that policymakers do not know for

sure what the NRU of the country is equal to.
The short-run and the long-run Phillips curve
• The NRU is not the same across time or for all
• In the short run there is a trade-off between countries.
unemployment and inflation.
• It follows that policymakers run the risk of slowing down
• In the long run, there is no trade-off. growth fearing that the NRU has been reached when
• In the long run there is only one rate of unemployment, unemployment could decrease even more and thousands
the natural rate of unemployment (NRU). more workers could have found a job. In contrast, they
• Any attempt to lower unemployment below the NRU may not apply the brakes soon enough to slow down
by increasing aggregate demand will be futile and only growth and, as a result, allow inflation to rise.
lead to inflation.

Policymakers’ perspective or in inflation. The unemployment rate had decreased

below 4% to a historic 3.5% low, which was significantly
The policy implication of this analysis is clear.
below what was believed to be the NRU for the USA.
Governments should not adopt policies to increase
Still, inflation did not rise. Many questioned whether the
aggregate demand in order to increase real output above
inverse Phillips curve relationship still holds. Articles were
its potential level and to decrease unemployment below
written wondering whether the Phillips curve was dead or
its natural rate. Any attempt to do this will increase
flattening or, perhaps, just “hibernating”. One explanation
inflation and in the long run prove futile.
of the observed phenomenon is that it is impossible to
Practically, this means that policymakers must keep know precisely how much unemployment is structural and
monitoring how much unemployment is decreasing how much is cyclical. Since structural unemployment—the
and whether it is approaching what is considered the dominant type of unemployment in the NRU—can change
country’s natural rate. If unemployment is decreasing through time, the NRU is not constant either. The NRU is
fast to very low levels, policymakers may suggest that it not a fixed percentage through time or across countries.
is probably time to slow down growth. They will fear that In addition, as we have mentioned earlier, discouraged
higher inflation is just around the corner. The idea of a workers rejoining the labour market and finding a job may
negatively sloped short-run Phillips curve relationship is also obscure the issue as this causes the unemployment
responsible for this fear. rate to decrease without wages or prices rising. Lastly,
In the USA, though, during the last decade something it could be the result of expectations of future inflation
strange was going on. The country had been experiencing remaining very low so that workers do not demand higher
falling unemployment since the end of the 2008−09 wages and firms do not start asking for higher prices.
global financial crisis without an increase in money wages

104
 3.4 Economics of inequality and poverty

UNIT 3: MACROECONOMICS
Equality versus equity
The ideas of equality and equity often arise in relation to the on the desirability of greater income equality for its own
distribution of income. Equity means fairness, which is not the sake or on what constitutes a fair distribution of income.
same as equality. Different societies have different perceptions Nonetheless, equity is typically interpreted as less inequality in
of what is equitable. Although there is a consensus that the share of income received by members of society.
extreme inequality is unfair, there is little general agreement

Economic inequality
The meaning of economic inequality
The Organisation for Economic Co-operation and
Economic inequality relates to the unequal distribution of
Development (OECD) is an intergovernmental economic
income and of wealth.
organization with 37 member countries. The OECD
Income and wealth are often used interchangeably but works to shape policies that foster prosperity, equality,
they are not the same. A pensioner living in a house valued opportunity and well-being for all.
at $500,000 might be considered wealthy, but if her
pension pays her just $100 a week, most would consider
inequality is twice the level of income inequality on average.
her as having a low income. This is why it is important to
This is important because wealth can itself generate income
understand the difference between income and wealth.
and so as wealth inequality widens, it fuels income inequality.
Household income is generated from the payments received
Wealth inequality is highest in the USA where households in
per period of time from the use of factors of production that
the top 10% in terms of their wealth own 80% of total wealth
include rent, wages, interest and profit. Wealth consists of
and those in the bottom 40% own just over 2% of total wealth.
what households own—the value of their assets at some point
The next two countries on the scale of high wealth inequality
in time—minus what they owe (that is, their debt). Assets
are the Netherlands and Denmark. Wealth inequality is lowest
include bank deposits, shares, bonds, houses, cars and boats.
in Japan, Poland, Greece and Belgium where households in the
Households can use wealth to consume more than their
top 10% own a little over 40% of total wealth.
income, or may consume less than their income and add to
their wealth. Given that wealth is accumulated over time it is Interestingly though, countries with high wealth inequality,
typically higher on average than income. For instance, in 2016, such as the Netherlands and Denmark, where households
the average household income in OECD countries was $25,908 in the bottom 60% owe more than they own, are countries
a year but average household net wealth was $67,139. with a very equitable income distribution. Also, households
with low net wealth are not necessarily “poor” in terms of
Wealth is distributed more unequally than income, that is to
their income and some may own substantial wealth but
say inequalities in wealth tend to be more prominent than
combined with high levels of debt.
income inequalities. In fact, across the OECD countries, wealth

Measuring economic inequality

The income distribution in an economy can be represented Population is represented on the horizontal axis of the graph,
graphically using a Lorenz curve. in cumulative percentages, from the lowest to the highest
income households. On the vertical axis, the percentage
National income (cumulatively ranked)

100% of national income received by each percentage of the

population is represented. So, the poorest 20% of people
receives only 7% of national income, the poorest 40% of
the population receives 15% of national income while the
richest 20% receives 45% of national income.
55% The diagonal line is the line of perfect income equality, where
B the “poorest” 20% earns 20% of income and the “poorest”
A 40% earns 40% of national income. As we move further to the
right of the diagonal, the distribution of income becomes more
and more unequal. So, more income inequality is shown by a
15% shift of the Lorenz curve further to the right of the diagonal and
7% less income inequality by a move towards the diagonal.
0% The degree of income inequality can be measured through
20% 40% 80% 100%
Population (cumulatively ranked) the Gini coefficient. The Gini coefficient is defined as the
Figure 3.4.1 The Lorenz curve

105
 ratio of the area between the Lorenz curve and the diagonal Real world Gini coefficient values are between 0.25 and
over the area of the half-square. 0.60. The lowest values are recorded in Northern
Area (A) European countries such as Sweden, Norway, Denmark
Gini coefficient = and Austria, while the highest values are to be found in
Area (A + B)
Lesotho, South Africa and Latin America. The USA has the
It can vary from 0 to 1, where 0 represents a society where higher income inequality of advanced nations as according
everyone has the same income and, therefore, there is no to recent data (2018) the Gini coefficient has increased
inequality. At the other end of the scale, 1 represents a from 0.40 to 0.48, while China is reaching a Gini
society where only one person has all the income and so coefficient of 0.50.
there is maximum inequality.
HL
Constructing a Lorenz curve from income curve (see Figure 3.4.2). Then the lowest 40% receives
quintile data 11.6% (= 3.2% + 8.4%), which is the second point on
the Lorenz curve. Adding the third quintile leads to 60%
The income distribution for an economy by quintile
of households receiving 25.9% (= 11.6% + 14.3%) of
appears in Table 3.4.1.
total income and to the third point on the Lorenz curve.
Year Lowest Second Third Fourth Highest Adding the fourth quintile leads to a total income share
20% 20% 20% 20% 20% of 48.9% (= 25.9% + 23.0%) and to the fourth point.
2018 3.2 8.4 14.3 23.0 51.1 The last point on the curve derives from adding the fifth
quintile (that is, 48.9% + 51.1% = 100%).
Table 3.4.1
Each column shows what share of the total income 100% 100%
is earned by each quintile in the year 2018. The first
quintile is the lowest 20% ,the second quintile is the next
lowest and so on. 80%
Given that a Lorenz curve shows cumulative shares of
income received, to plot the curve we begin with the 60%
lowest quintile and mark a point to show the percentage 48.90%
of total income those households received. We then add
40%
the next quintile and its cumulative share and mark a
point to show the share of the lowest 40% of households.
Then, we add the third quintile, and then the fourth. 20% 25.90%
Since the share of income received by all the quintiles will
3.20% 11.60%
be 100%, the last point on the curve always shows that
100% of households receive 100% of the income. 0%
20% 40% 60% 80% 100%
Using the data above, the lowest 20% receives 3.2% of Figure 3.4.2
total income, which will be the first point on the Lorenz

Meaning of poverty Both absolute and relative poverty relate to people’s income
Poverty refers to the inability to cover minimal consumption and material conditions. Poverty has more dimensions,
needs. There is a distinction between absolute and relative though: it can be thought of in terms of possessing the
poverty, as follows. basics of life, such as shelter or nutritious food; having
access to services that improve people’s lives, such as
• Absolute poverty refers to the case where a household education and health care; being free of the threat of
does not have sufficient income to meet basic needs. violence; and being able to contribute to decisions that will
Absolute poverty is often discussed in terms of an income shape the future of someone’s community. The impact of
below which people cannot afford a basic basket of goods these dimensions of poverty is increasingly recognized.
and services.
• Relative poverty compares the income of households in Measuring poverty
a society with the median national income. The more Poverty should be measured in order to provide estimates
unequal the distribution of income within the total of the magnitude of the problem, and raise its visibility
population, the more significant is the degree of relative (that is, to keep poor people on the policy agenda). Also,
poverty. The idea behind relative poverty is that people poverty measures are needed to target appropriate policy
may still be poor, even if they can afford basic necessities, interventions.
when they cannot afford the typical lifestyle in their Poverty is usually measured in terms of income.
society—relative poverty gauges where people stand
compared to everyone else in their society. To measure absolute poverty, a minimum income level called
the “poverty line” is identified. That is the basic minimum

106
that families need in order to get by. Once the poverty line is Difficulties in measuring poverty

UNIT 3: MACROECONOMICS
defined, the amount of poverty can be measured by taking Measuring poverty accurately is important in assessing the
the percentage of the population, who earn an income scale of poverty, formulating policies and evaluating their
below the poverty line. These poverty lines can be set both effectiveness. However, measurement is not a simple task.
at a national and an international level. The World Bank sets
• Issues arise from the very first step, which is defining what
the international poverty line at periodic intervals. It was first
is meant by the term poverty. There are differences in the
set in 1990 at $1.00 a day. Some years ago, it was revised
perceptions of those who define and measure poverty. As
to $1.25 and, in 2015, it was revised again—to $1.90 per
such, poverty can be difficult to measure because of the
day. At that time, households living on less than $1.90 a day
difficulty in agreeing a definition.
were in absolute poverty. Note that these thresholds are not
actually in “real” US dollars but rather in purchasing power • Household surveys are currently the source of most
parity (PPP) dollars in order to take account of differing cost poverty-related data. However, in many countries the
of living between countries. surveys are conducted on an irregular basis. Even if
countries have a regular household survey in place, the
Relative poverty can be measured by specifying a
data provided by the survey may be insufficient.
percentage of the median income, usually set at 50%.
Households earning less than 50% of the median income • In addition, household poverty surveys frequently omit
will be considered relatively poor. More specifically, from the sampling people who may be likely to be poor
statisticians examine the full range of incomes in a but who do not live in households. This includes a range
country—from lowest to highest—and identify the point that of people such as the homeless, drug users, sex workers
separates the top half of earners from the bottom half. This and street children, who all face acute deprivations but
is the median income. The poverty line is then calculated at who are still not represented in the surveys and in turn in
50% of the median income. For instance, say the median poverty statistics.
annual household income in an economy is $20,000. • There are also limits to the disaggregation of data in
Taking 50% of this, we have $10,000. Any household with relation to gender, disability and age. More disaggregated
an annual income that falls below $10,000 is considered poverty data would enable a better understanding of
poor in relative terms. poverty and its impact on different groups of people,
The measures of absolute and relative poverty described above including women for example.
provide poverty estimates on the basis of income. Yet, as • There is evidence to suggest that the poverty lines
already explained, poverty is a phenomenon that can neither underestimate the actual severity and intensity of poverty,
be described in a single word nor accurately be captured by a as poverty lines tend to provide no more than arbitrary
single indicator. For this reason the Multidimensional Poverty cut-off points that have no specific relevance to the lives of
Index (MPI)—a composite indicator—has been constructed. the poor. Poverty lines often produce an overly simplistic
Oxford Poverty & Human Development Initiative (OPHI) as portrait of poor people’s lives.
well as the United Nations Development Programme (UNDP) Minimum income standards can be misleading and can
developed this index in 2010 in order to determine poverty create a sense that people living in poverty have a reliable,
beyond measures that are based solely on income. It covers albeit very small, income. However, in reality, incomes can be
over 100 developing countries and helps to determine the unpredictable and sporadic. Farmers, for instance, may earn
most vulnerable people among the poor in different societies all their money just once or twice a year after harvest time.
around the globe.
The MPI captures the acute deprivations that each person Recap
faces with respect to education, health and living standards.
Difficulties in measuring poverty
These three dimensions are assessed by ten indicators,
which are: There are difficulties in:
• child mortality • sanitation • defining poverty
• nutrition • drinking water • having insufficient and irregular household surveys
to collect poverty data
• years of schooling • electricity
• sampling; people in acute poverty may be omitted
• school attendance • housing
• having limited disaggregation of data
• cooking fuel • assets.
• relying on poverty lines, which may underestimate
If individuals are deprived in three or more of these ten
the severity of poverty
indicators, the index identifies them as “MPI poor”, and the
intensity of their poverty is measured by the percentage of • relying on minimum income standards, which can
deprivations they are experiencing. be misleading.
According to the MPI, at least 1.57 billion people are living
in multidimensional poverty, representing deprivations in Causes of economic inequality and poverty
health, education and their standard of living. This is much There is a whole range of factors—economic, social and the
higher than the roughly 800 million people worldwide role of the state—driving economic inequality and poverty.
estimated to be living in absolute poverty. Examples are explored below.

107
 Inequality of opportunity Over the years, the proportion of workers who have mid-
This occurs when people living in the same society do not level skills has declined. Between 1995 and 2010, the share
have access to the same opportunities. Parental background fell from 53% to 41% of the workforce in OECD countries.
is the key circumstance influencing inequality of opportunity, However, the share of people working at the two ends of
followed by gender and place of birth. Inequality of the skills spectrum, high skilled workers such as designers
opportunity is strongly correlated with income inequality. and lower skilled workers such as drivers, has increased. This
trend is likely to increase income inequality.
Countries with high levels of inequality of opportunity
tend to have high levels of income inequality. The reason is Discrimination
that people’s circumstances at birth such as their parental Discrimination against gender, race, religion or any other
background, the place where they were born, their ethnicity factor plays an important role in perpetuating inequality.
or their gender determine to a large degree the educational Groups of the population facing discrimination may have
qualifications they obtain, the type of job they get and, greater difficulty in finding a job and may receive lower
ultimately, their level of income. earnings than workers who are not discriminated against.
For example, due to the Covid-19 lockdown in 2020 and In the case of gender discrimination, for example, evidence
schools switching to remote learning strategies, children suggests that women are generally at higher risk of poverty
have not had the same opportunities within and across than men as they are less likely to be in paid employment,
countries. In some cases, distance-learning programmes they tend to have lower pensions, they are more involved
were launched within a few days of schools closing but in in unpaid caring responsibilities and when they are in work
other cases it took much longer. At the same time, wealthier they are frequently paid less for the same job. Similarly, in
households were able to seek distance-learning opportunities cases of racial discrimination, members of minority ethnic
at higher rates than poorer households. Overall, because of groups and immigrants may have less chance to access
these disruptions current students stand to lose $10 trillion employment and may end up earning less than other
in earnings over their working life. Yet, as a result of the workers, often without social security or insurance.
disparities in opportunities the learning loss will not be Unequal status and power
uniformly distributed; the income level of the parents and
the place where these children were born will determine how Inequality can also arise when there are disparities in
much this may set them back over their lifetime. market power and social power. Significant market power
concentrated in the hands of a few firms may lead to
Remarkably, there are no cases where a country with high economic inequality. More specifically, in some countries there
levels of inequality of opportunity enjoys moderate or low has been a very significant increase in corporate concentration
levels of income inequality. In contrast, there are a few and monopoly power. This leads to a transfer of income away
rare instances where inequality of opportunity is relatively from consumers to a few firms, as they can charge consumers
low, but income inequality is still high. This suggests that more for what they sell and pay their workers less. At the same
inequality of opportunity is an important determinant of time, certain powerful social groups may be granted exclusive
income inequality but not the only one. privileges and preferences, which could boost their income
Different levels of resource ownership and wealth, widening inequality.
Income depends on the payments households receive by Government tax and benefits policies
offering the factors of production they own. Remember that Governments can mitigate inequality through public
factor payments take the form of rents (for land), wages (for policy—primarily taxes and payments such as public retirement
labour), interest (for capital) and profits (for entrepreneurship). benefits or unemployment benefits. Typically higher-income
A highly unequal ownership of the factors of production individuals tend to pay proportionately more in taxes than their
would lead to a highly unequal income distribution. lower income counterparts; while lower income individuals
Over the past few decades there is increasing evidence tend to receive more support from the state. Combined, these
that the share of national income going to capital and systems of taxes and benefits can narrow income disparities.
entrepreneurship is rising and that the share going to labour However, many countries have now seen an increase in income
is falling. This decline in labour’s share of income is fuelling inequality, indicating gaps in existing tax-and-transfer systems
inequality. For instance, a report by the International Labour to counteract rising inequality. Particularly, in some advanced
Organisation on G20 countries suggests that a 1% decrease economies the tax rate on high incomes has declined. Across
in labour’s share of income increases inequality in income OECD countries, the average top tax rate fell from 66% in
by 0.1% to 0.2%. 1981 to 41% in 2008. High earners have benefited from
Different levels of human capital other changes in tax regimes, too. Tax on property and on
Human capital refers to the skills, education and experience inheritances has tended to fall, allowing high earners to build
embodied in the labour force. Some workers are able to up wealth. At the same time, transfer payments have decreased
receive higher wages because of special skills and education both in size and in scope; the welfare state is shrinking. As a
or experience, while others who are less skilled, educated result, economic inequality has been rising.
or experienced may receive extremely low wages. At the See page 110 for a more detailed explanation of the role of
same time, lower wage jobs are often associated with poorer taxation.
working conditions and less stability.

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Globalization and technological change Inequality lowers growth by depriving the ability of lower

UNIT 3: MACROECONOMICS
The world economy has become increasingly integrated and income households to access health care and education and
interconnected. All of the flows that constitute globalization to accumulate human capital. For instance, it can lead to
can have some impact on inequality, but perhaps the most underinvestment in education with poor children ending up
important one is technology. Technological change affects in lower quality schools and less able to go to college. As a
the job market, devaluing and revaluing skills and, of course, result, labour productivity will be lower than it would have
creating whole new skills and jobs—think of app developers and been if it were not for inequality. Lower labour productivity
social media strategists. People with the devalued skills suffer then leads to slower economic growth.
from a decline in wages while those with the revalued or new With high inequality, the overall rate of savings in the
skills see their earnings rise, potentially widening inequality—so economy tends to be lower, because the highest rate
the relationship between skills and technology can be regarded of savings is usually found among the middle classes,
as an important factor behind rising income inequality. which are usually “squeezed” by inequality. High income
Increased international trade as a result of globalization has individuals typically spend much of their incomes on
also impacted income inequality. Many workers in industries imported luxury goods, jewellery, expensive houses
where import penetration has been high become redundant. and foreign travel, or they seek havens abroad for their
As such, workers in import-competing industries lose their savings in what is known as capital flight. Therefore,
income and face dislocation whereas workers in booming when savings are low, the level of investment is low. As
export-oriented industries maintain or increase their income, a result, productive resources do not increase or improve,
widening the income gap. withholding economic growth.
Market-based supply side policies High levels of inequality have also been linked to rent
seeking, defined as “efforts that people take to get a larger
The basic principle of market-based supply-side policies is to share of the pie rather than to increase the size of the
have less government and more free and unfettered markets pie”. Wealthy individuals may use their ability to, say, fund
in order to achieve long-term growth. Based on this principle political parties to influence policies in a way that benefits
many countries have reformed the rules covering products, them. When resources are allocated to such rent-seeking
services and employment, and so market forces are generally behaviours, they are diverted from productive purposes that
allowed freer rein. However, this has also tended to widen could have led to faster growth.
inequality.
The higher the inequality is, the smaller the fraction of the
Deregulation and privatization have increased monopoly population that qualifies for a loan or other credit. When
power and concentration in many countries, which has led to low income individuals cannot borrow money, they may
higher prices and to a transfer of income from consumers to not be able to educate their children sufficiently or start
businesses. The increased labour market flexibility resulting and expand a business. The result of these factors can be a
from lower minimum wages, lower labour union power, slower growth.
lower employment protection laws and lower unemployment
benefits is responsible for the shrinking share of wages in In addition, according to several researchers, growth tends to
national income. Lastly, the benefits of tax cuts have accrued be more fragile when inequality is high. That is to say that
mostly to the wealthiest. it is how the benefits from growth are distributed that will
ultimately determine whether the growth will last. If growth
is non-inclusive and its benefits remain with the wealthiest
Recap because of economic inequality, then growth will be less
Causes of inequality and poverty resilient. This implies that in an unequal society policies that
would help deal with an adverse economic shock will not
Inequality and poverty can arise from:
gain enough support since the long-term benefits will not be
• inequality of opportunity uniformly shared.
• different levels of resource ownership Lastly, a growing gap between rich and poor may also
• different levels of human capital impede growth, because it may create political and social
• discrimination (gender, race, others) instability, which, in turn, may deter investment. Social
• unequal status and power divisions fuelled by inequality may also make it more
difficult for governments to find the necessary consensus in
• government tax and benefits policies society to meet economic and financial crises.
• globalization and technological change
Impact on standards of living
• market-based supply-side policies. and social stability
High and sustained levels of inequality can have a harsh
Impact of income and wealth inequality effect on societies, making them worse places in which to
Impact on economic growth live. Such inequality will result in large social costs.
There is rising evidence—from the OECD, IMF and others— Inequality can reduce people’s well-being by fuelling crime:
that inequality can have a negative impact on economic disadvantaged people are more likely to commit and to be
growth and that this impact can be substantial. Particularly, victims of crimes.
in OECD countries, the rising inequality over the past couple Inequality may also damage trust. In particular, citizens can
of decades is estimated to have cut GDP by around 8.5%. lose confidence in institutions, eroding social cohesion.

109
 Even worse, high inequality makes weak institutions very inequality also strengthens the political power of the
difficult to improve, because the powerful few are likely rich and hence their bargaining power. Usually, this
to view themselves as worse off from a socially efficient power will be used to encourage outcomes favourable to
reform, and so they have the incentive and the means the rich.
to resist it. In cases of extreme inequality, upheavals and civil
High inequality may also lead those on low incomes to support conflict may result that can cost lives and set back any
populist policies that can prove to be damaging. Moreover, high progress.

Recap
Impact of inequality
Impact on economic growth includes: Impact on standards of living and social
stability includes:
low levels of human capital → low labour productivity higher criminality
→ slower growth
lower savings → lower investment → slower growth damaged trust and social cohesion
inequality encourages rent-seeking behaviours → diverting increasing support of populist policies
resources from productive purposes
lack of access to credit → lower investment → slower increasing power of the rich
growth
inequality creates instability → discouraging fuelling conflicts and upheavals.
investment → limiting growth
high inequality → non-inclusive growth → fragile
growth.

The role of taxation To understand the difference between progressive,

proportional and regressive taxation consider two individuals,
Taxes are distinguished into direct and indirect.
Alex and Bill, whose yearly earnings are different.
• Direct taxes are directly paid to tax authorities by
• If Alex earns $10,000 and pays $2,000 in income tax
taxpayers and include:
while Bill earns $20,000 and pays $5,000 then the tax
− personal income taxes: paid based on all forms of system is progressive. Bill pays a larger proportion of his
income such as wages, rental income, interest income income in tax compared to Alex (25% > 20%).
and dividends
• If Bill pays $4,000 in income tax then the tax system is
− corporate income taxes: taxes on the profits of a proportional. Both Alex and Bill pay the same proportion
corporation of their income in tax (20%).
− wealth taxes: taxes imposed on the ownership of assets; • If Bill pays $3,000 then the tax system is regressive. Bill
they include property taxes and inheritance taxes. pays a smaller proportion of his income in tax compared
• Indirect taxes are taxes imposed on goods and services to Alex (15% < 20%).
or on expenditures. They are called indirect because Note that in all three cases Bill pays more. The key is whether
consumers are paying them indirectly through the sellers Bill pays proportionately more or not.
of the good or service being purchased.
Income taxes are never regressive; however, indirect taxes are.
Progressive, proportional and regressive taxes The following example shows why this is.
Taxes can be progressive, proportional or regressive Assume that the VAT is 20% and both Alex and Bill have
depending on the relationship between income and the paid $400 in tax for a $2,000 laptop. As a proportion of his
percentage of income paid as tax. lower income, Alex is paying more; he is paying:
• A tax is progressive if higher income individuals pay 400
proportionately more so that as income increases the or 4%
10,000
percentage of income paid as taxes also increases. whereas Bill is paying:
• A tax is proportional if higher income individuals pay 400
proportionately the same so that as income increases the or 2%
20,000
percentage of income paid as taxes remains constant.
Both individuals have paid the same “dollar” amount of VAT.
• A tax is regressive if higher income individuals pay Yet, since they do not have the same level of income, the
proportionately less so that as income increases the amount of tax paid is a greater percentage of income for the
percentage of income paid as taxes decreases. poorer individual.

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 UNIT 3: MACROECONOMICS
HL
Calculating the total tax paid may be income, profits, wealth or spending. The MTR
Table 3.4.2 shows how much income tax Greek is additional tax paid as a result of additional income
individuals were asked to pay, as of 2019. earned: that is, the tax paid on the last “dollar” earned.
Table 3.4.3 shows the two rates.
Income (€) Tax rate (%)
Average tax rate (ATR) Marginal tax rate (MTR)
(0–20,000) 22
T ΔT
(20,001–30,000) 29 ATR = MTR =
Y ΔY
(30,001–40,000) 37
Table 3.4.3
40,001 and above 45
Let us turn again to the case of Nikos and Sofia.
Table 3.4.2 As shown, Nikos earns €35,000 per year and pays
Nikos earns €35,000 per year. How much tax does €9,150 in tax:
he have to pay? Most will answer €12.950 (35,000 × €9,150
ATR = = 0.26 = 26%
0.37) and they are wrong. The calculation is a bit more €35,000
complicated. For the last euro earned Nikos paid 37% in tax, which is
the MTR.
Using the information in Table 3.4.2, the tax paid for the
first €20,000 earned will be 22%; for the next €10,000 it Sofia earns €70,000 per year and pays €24,500 in tax:
will be 29%; and for the next €5,000 Nikos earns he will €24,500
ATR = = 0.35 = 35%
be taxed 37%. So: €70,000
(0.22 × €20,000) + (0.29 × €10,000) + (0.37 × For the last euro earned Sofia paid 45% in tax, which is
€5,000) = the MTR.
€4,400 + €2,900 + €1,850 = €9,150 ATR MTR
The total tax paid by Nikos on the €35,000 he earns Nikos (income = €35,000) 26% 37%
is €9,150.
Sofia (income = €70,000) 35% 45%
Now consider Sofia, who earns €70,000 per year (so
Table 3.4.4
double the amount Nikos earns). To calculate how much
tax she has to pay the same steps will be followed. What can be inferred from this case is that as income
rises the ATR also rises, while the MTR is greater than
Using the information in Table 3.4.2, the tax paid for the
the ATR for both individuals (see Table 3.4.4). The tax
first €20,000 earned will be 22%; for the next €10,000 it
system in this case is progressive, with Sofia paying
will be 29%; for the next €10,000 it will be 37%; and for
proportionately more than Niko.
the €30,000 that Sofia has above €40,000 she will be
taxed 45%. So: In a proportional tax system the ATR remains constant
as income rises so the MTR is equal to the ATR. In a
(0.22 × €20,000) + (0.29 × €10,000) +
regressive tax system the ATR decreases as income rises
(0.37 × €10,000) + (0.45 × €30,000) =
so the MTR is less than the ATR.
€4,400 + €2,900 + €3,700 + €13,500 = €24,500
The total tax paid by Sofia on the €70,000 she earns Recap
is €24,500.
Effect of tax systems on ATR and MTR
Average and marginal tax rates • If the tax system is progressive then as income rises
To explain the difference between progressive, the ATR rises and MTR > ATR.
proportional and regressive taxes further we need to • If the tax system is proportional then ATR remains
define the average tax rate (ATR) and the marginal tax constant as income rises and MTR = ATR.
rate (MTR).
• If the tax system is regressive then ATR decreases as
The ATR is the proportion of income paid in taxes; that is, income rises and MTR < ATR.
the ratio of the tax collected over income. More generally
it is the tax paid as a proportion of the tax base, which

111
 In Figure 3.4.3 the horizontal axis measures the tax base There may also be scope to raise taxation of residential
(say, income) and the vertical the amount of tax paid. A property in particular, which is relatively lightly taxed in
proportional tax system is illustrated by any straight line many countries. However, while the better off tend to own
through the origin. In a progressive tax system the slope of the most expensive residential property, there are many
the line is increasing while in a regressive tax system the middle-class owners too. Nevertheless, many existing
slope of the line is decreasing. property taxes tend to be regressive (that is, they take
proportionally more of the income of poorer households).
Tax paid Reform that would make property taxes more progressive will
Progressive
make the burden of the tax fall most heavily on the upper-
income groups, rendering the taxes fairer and less distortive.
Proportional Lastly, reducing reliance on indirect taxes can also help
towards reducing inequality and poverty. Indirect taxes are
regressive with respect to income given that they fall on the
consumption of goods and services that make up a larger
Regressive
share of the budgets of poorer households than of wealthier
households. Hence, greater reliance on indirect taxes may
make the tax system more regressive. On the other hand,
indirect taxes such as VAT may be the only way to finance
Tax base (income) government spending. However, as some countries lack the
capacity to make transfer payments to households, there
Figure 3.4.3 Progressive, proportional and regressive taxation
may be a case for differentiating VAT rates to tax necessities
How can taxation reduce poverty, income and at a lower rate, if at all.
wealth inequalities?
Taxation can play a major role in making the after-tax Recap
income distribution less unequal. In addition, taxation is Taxation as a tool to reduce inequality
crucial for raising revenues to finance public expenditure on and poverty
transfer payments, health care and education that tend to • Progressive income taxes can redistribute income
favour low-income households. more equally.
Progressive taxation of income is one of the main ways for • A wealth tax can be used to redistribute wealth
governments to redistribute incomes. Progressive income taxes more equally.
will require those on higher incomes to pay a larger proportion
of their total income in taxes compared to those on lower • Property taxes if increased and made more
incomes. Increasing the progressivity of the income tax system progressive can improve inequality.
can lead to a less unequal after-tax distribution of income. This • Less reliance on indirect taxes can promote equity.
can be achieved by raising marginal tax rates on high earners.
However, higher marginal tax rates may encourage the Further policies to reduce poverty, income and
development of selective tax reliefs, which can distort wealth inequality
investment decisions. Also, they may lead to extensive Besides taxation, a government may also resort to the use of
tax avoidance through the exploitation of legal tax and other policies. These include the following.
accounting loopholes, with those on higher incomes ending
• Policies to reduce inequalities of opportunities—
up paying fewer taxes.
investment in human capital. Reducing inequalities
Perhaps an appropriate approach would be to reduce tax- of opportunities implies ensuring individuals’ own
induced distortions, including closing loopholes, and to achieve background or circumstances—such as gender, ethnicity or
greater equity through other types of taxation and tax reforms. parental status—are not allowed to limit the educational
Key economists, such as Emmanuel Saez and Thomas qualifications they can obtain, the type of job they can get
Piketty, have been documenting a massive rise in economic and, in turn, their level of income. This can be achieved
inequality in the USA that has been fuelled by tax cuts through improving the quality and access to education
initiated after 1980 and which culminated after the recent and health services for lower income groups. A healthier
2018 tax cut. Their estimates show that the top tenth of population with better education, training and skills will
1% of Americans held 19.3% of all wealth in 2018. That increase labour productivity and the income-earning
was triple their share from four decades earlier. On these capacity of the deprived, so they decrease income and
grounds, key economists are proposing a wealth tax as a wealth inequality.
way to reduce economic inequality by forcing the richest • Transfer payments. These usually include pensions,
Americans to pay taxes on everything they own and unemployment and disability benefits as well as child and
diverting that money to public services such as improved other allowances. These payments are made to the most
health care and education for all. The wealth tax may thus vulnerable groups of the population using a part of the
serve as another way of using taxation towards narrowing tax revenue collected from the working population, so they
economic inequality. decrease income inequality.

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 It is important to note that there is a risk that the enough to take care of the individual’s basic needs but

UNIT 3: MACROECONOMICS
beneficiaries of such payments become overly dependent not enough to provide a lot of add-ons. However, the
on them—but that may only necessitate that their design UBI can be a huge draw on a government’s funds, which
improves. For example, conditional cash transfers in Brazil could prevent its other priorities, such as infrastructure
have reduced the Gini coefficient from 0.62 to 0.49. These refurbishment or the building of hospitals or affordable
cash transfers are part of the Bolsa Familia programme housing. In June 2016 Switzerland’s voters rejected such
that was initiated many years ago whereby a cash transfer a plan.
is provided to poor mothers (as it has been shown that • Minimum wage policy. The government can set or
mothers are more likely than fathers to spend on the increase the minimum wage in order to support the
welfare of their children) under three conditions: their incomes of low skilled workers. The result is that the
children have to attend school regularly, they have to be minimum wage policy will benefit those workers, who
taken for regular medical check-ups and the mother has to will end up with a job at a higher wage. It may create
attend neighbourhood nutrition and health classes. This unemployment. However, as mentioned in sections 2.7
programme managed to decrease the intergenerational and 3.3, research has shown that reasonable increases in
transfer of poverty. the minimum wage have not led to higher unemployment
• Targeted spending on goods and services. The and may even prompt greater effort on the part of workers.
government can subsidize or directly provide services such
as education and health care, and infrastructure in order Policymakers’ perspective
to make them available to the most deprived groups.
Examples include public health projects in rural villages Widening income inequality is the defining challenge
and urban fringe areas, school lunches and pre-school of our time. There is no “one-size-fits-all” approach to
nutritional supplementation programmes, and the tackling inequality. The nature of appropriate policies
provision of clean water and electrification to remote depends on the underlying drivers and country-specific
rural areas. policy and institutional settings. Still, when using
policy to address income inequality, a number of areas
Often it is not sufficient that education is free of charge;
stand out. Education and skills are key—policymakers
poor rural families may need to keep their children at
must ensure that as many people as possible enjoy
home to help in generating income so a cash subsidy may
access to high quality opportunities to learn. The same
be necessary to induce them to send children to school;
applies to health care, where again policymakers must
or it may not be sufficient to offer free vaccinations for
ensure that as many people as possible have access to
children in remote villages. Esther Duflo (Nobel Prize,
high quality services. The role of taxes and transfers
2019) showed that the likelihood of mothers in Udaipur,
in redistributing income and wealth must also be
India bringing their children to be vaccinated in a free
considered. Increasing the progressivity of income
immunization camp increased by six times if a 1 kilogram
taxes, reducing reliance on indirect taxes, decreasing
bag of lentils was also offered.
loopholes from which higher income individuals mostly
• Universal basic income (UBI). The UBI is a model for benefit, taxation of wealth and of property all seem to
providing all citizens of a country or a geographic area be potentially under consideration. Therefore, policy
with a given sum of money, regardless of their income, should perhaps focus on reforms to increase human
wealth or employment status. In its most common form, capital, coupled with reforming tax systems and on
identical periodic payments are made to all individuals, widening a well-designed social safety net.
which are funded through the taxes paid by those with
higher incomes. The amount of money paid should be

113
 3.5 Demand management (demand-side
policies): monetary policy
Money, banking and monetary policy
In order to achieve policy objectives, policymakers use They include monetary policy and fiscal policy. Monetary policy
monetary, fiscal and supply-side policies. In this unit, is conducted by the central bank of the country and involves
each type of policy will be explained, their strengths and changes in the money supply or interest rates. Fiscal policy is
limitations will be examined and their effectiveness in conducted by the government and involves changes in the level
achieving satisfactory growth, low unemployment, price of government expenditures and/or taxes.
stability and other objectives will be evaluated. Supply-side policies aim at increasing aggregate supply. They
Figure 3.5.1 provides a “bird’s eye view“ of macroeconomic focus on the production side of the economy. They are often
policies. distinguished into market-based supply-side policies and
Demand-side policies aim at affecting aggregate demand. They interventionist policies. Fiscal and monetary policy may try to
are also referred to as short-run stabilization policies as they increase, but sometimes also to decrease, aggregate demand.
aim at stabilizing aggregate demand, and so the economy. Supply-side policies aim only to increase aggregate supply.

Macroeconomic
policies

Demand-side Supply-side
policies policies

Fiscal policy Monetary policy

Changes in G Changes in r Market-based Interventionist
and/or T (or, Ms)

Figure 3.5.1 Macroeconomic policies

HL
Money she knows that everyone else in the eurozone must also
Money is defined as anything generally acceptable as a accept the euro when she wants to buy something.
means of payment. If nothing serves this function, then So, what is generally acceptable as a means of payment?
it is a barter economy, where goods are exchanged for What is considered “money”? One can of course make a
goods. Barter requires double coincidence of wants: if Joey payment with notes and coins, so cash is definitely money.
wants to buy something that Jason is selling, Jason must Payments can also be made by writing a cheque or by using
want to buy something that Joey has and is willing to sell; your debit card linked to your bank account, so demand
otherwise the transaction will not take place. Individuals will deposits (or cheque deposits or sight deposits) are also
therefore prefer to avoid specialization in order to minimize considered money. This means that the money supply of
dependency on exchange. Introducing money permits an economy must include currency in circulation and also
specialization to take place and specialization expands demand deposits. This is a narrow definition of money.
dramatically the production possibilities of an economy. However, it is now extremely easy to transfer funds from
In the past, various commodities had been generally any savings account to a demand account. As a result,
accepted as a means of payment. For example, cattle, even though one cannot make a payment with a savings
shells, salt and, of course, gold and silver coins were all account, a broader definition of money includes what
used as money. Money had an intrinsic value. It had value are often referred to as “near monies”. Near monies are
independently of its value as a means of payment. At a later assets that can be quickly converted into cash or demand
date, paper money was introduced that was backed by a deposits. For our purposes we will consider as the money
commodity. This meant that one could always convert this supply the currency in circulation and demand deposits.
paper money into something of value, such as gold or silver. The functions of money
Nowadays, money is “flat money”. It has no intrinsic value,
What functions does money perform?
nor does it represent a claim on something else of value. It
is backed by absolutely nothing. Flat money is considered • Money is of course a “medium of exchange” as it is
money as a result of government decree. An Italian woman acceptable, by definition, as a means of payment in all
will accept a euro as a payment in the eurozone because market transactions.

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 UNIT 3: MACROECONOMICS
• Money is a “unit of account”. It is a yardstick used to amount of money withdrawn. Most transactions (in terms
express prices and so measure and compare values of of value) involve the transfer of funds, the electronic
goods and services. crediting of one account and the debiting of another
• Money is a “store of value”. It can be used to hold bank account. A commercial bank will thus only be
purchasing power and wealth over time. This is the first required to keep a fraction of the deposits it holds in the
function of money that high inflation destroys. form of liquid assets, which can either be cash in its vault
or deposits it holds at the central bank (as these can be
• Money is also a “standard of deferred payment”. Money
converted into cash immediately).
links the past, the present and the future as it allows
intertemporal contracts, which is just a way of saying The currency held by commercial banks in their vaults
that it permits people and firms to borrow and lend. plus the deposits they keep at the central bank are
referred to as bank reserves. The central bank determines
The banking system of a country the fraction of bank deposits that must be held as
The banking system of a country comprises a central bank reserves by commercial banks and which cannot be lent
and commercial banks. out. This is referred to as the reserve requirement ratio (rr).
Excess reserves are the amount of reserves available for
The functions of a central bank lending after required reserves are satisfied.
• A central bank is the sole note-issuing authority of a
The process of money creation by
country. Keep in mind though that the supply of notes
is a small percentage of the money supply, which commercial banks
includes not just currency in circulation but mostly Let’s assume in the following example that the central
deposits that banks hold. bank has set rr equal to 10%, or 0.10. What happens
• It is the central bank that issues new government bonds, when Avinash decides to deposit $1,000 that he held
collects the proceeds and is also responsible for paying in cash in the First National Bank? The money supply
back bondholders when bonds mature. (currency in circulation plus demand deposits) has not
changed because there will be $1,000 less of currency in
• The central bank conducts monetary policy by circulation but $1,000 more in bank deposits.
influencing interest rates and bank lending practices. It
is in charge of achieving and maintaining price stability, Now though, First National Bank has $1,000 more in
one of the most important macroeconomic goals. reserves. If the required reserve ratio is 10% it only needs
to hold $100 in reserves (0.1 × 1000). The remaining
• One of the central bank’s responsibilities is exchange $900 are “excess reserves”. First National Bank can lend
rate policy, which influences the competitiveness of a the $900 to Bob who uses the funds to pay for a new
country’s exports and the attractiveness of imports. laptop. The seller of the laptop, Laptops R Us, will deposit
• The way in which commercial banks operate and the $900 to the Second National Bank.
behave is regulated and supervised by the central The money supply has now increased. It is equal to the
bank. Most importantly, the central bank makes sure initial $1,000 that Avinash had as cash and was then
that banks, in their quest for profits, do not engage converted into the demand deposit he has plus the $900
in excessively risky lending as this could prove demand deposit of Laptops R Us in the Second National
catastrophic for the whole banking system. Bank, or $1,900.
• The central bank is what is known as the “lender of last The Second National Bank now has $900 additional
resort”. Commercial banks must always have enough reserves. It will keep $90 as required reserves (0.10 × 900)
cash in their vaults to meet their cash obligations to and will lend the remaining excess reserves of $810 to
depositors. The central bank is always ready to provide Carla, who will use the proceeds of the loan to buy a new
commercial banks with any required cash liquidity in cellphone from Best Cellphones. Then Best Cellphones will
case of a sudden emergency, to avoid a banking crisis. deposit the $810 to the Third National Bank. The money
Commercial banks and the fractional supply is now the initial $1,000 in Avinash’s account
reserve system plus the $1,810 in the accounts of Laptops R Us and
Commercial banks are financial institutions that bring Best Cellphones. The Third National Bank now has $810
borrowers and lenders together. They collect deposits, of additional reserves of which 10% or $81 are required
for which they pay interest, and then use these to make reserves and the remaining $729 are excess reserves. It
loans, for which they charge interest. Their profitability can now lend out $729 to Daniel, who will use the loan
thus largely depends on the difference between these two to buy a Nakamura mountain bicycle from CrimsonBikes.
interest rates. CrimsonBikes will deposit the money in the Fourth National
Bank, and the process will continue until no more lending
It is not necessary for a bank to keep in its vaults all of
can take place out of Avinash’s original $1,000 deposit.
the funds deposited in it because it is highly unlikely that
all depositors will want cash and withdraw all of their Commercial banks can thus lend and create money by the
funds at the same time. On any day the amount of new “stroke of a pen” or nowadays by the click of a mouse.
deposits made will on average be roughly equal to the Money is created when one bank’s loan becomes another

115
 bank’s deposit and that bank uses most of this deposit to The demand for money
make another loan. Table 3.5.1 shows the process. The term demand for money seems strange as most people
Deposit 10% required Loans issued would claim that the demand for money is infinite. Think of
Reserve ratio having $100 million of your own. Will you choose to hold
this $100 million of your wealth as money stashed in your
$1,000 $100 $900
basement? In one year, you will still have $100 million. This
$900 $90 $810 would also be the case if you had your $100 million in a
$810 $81 $729 demand deposit (a cheque account or sight deposit) where
$729 $72.90 $656.10 in a year your balance will still be $100 million (as no, or
extremely low, interest is paid on such deposits). If, though,
$656.10 $65.61 $590.49
instead you had bought a government bond then in a year’s
… … … time you would have earned interest on your bond and your
Total deposits Total required Total loans $100 million would have grown.
reserves issued The term demand for money now has meaning. You
$10,000 $1,000 $9,000 demand money because you must be liquid enough to
make transactions as you cannot go to the supermarket
Table 3.5.1 The money creation process
to buy groceries with a government bond. This is often
You may have noticed that, for simplicity, we are assuming referred to as the transactions motive for holding money.
the following. The higher the nominal income in a country, the more
money will be demanded for transaction purposes. So,
• All currency is deposited in banks. The public holds no
demand for money for transactions will increase if real
currency.
GDP increases but also if the average price level increases.
• Banks lend out all of their excess reserves.
However, there is an opportunity cost involved if you
If a bigger part of a loan is kept in cash and not choose to hold money. You sacrifice the interest that you
deposited, or if banks decide to keep and not lend out all could have earned if instead you had chosen to hold a
of their excess reserves, then the expansion of the money bond. There is a trade-off between the convenience of
supply will be smaller. holding money that earns no interest, and sacrificing this
The central bank can inject easily into the economy “fresh” convenience but earning interest. If Sammy is keeping
reserves with tools we will examine later. If the required funds in a demand deposit to take advantage of the
reserve ratio is rr then simple mathematics reveals how convenience offered, he is foregoing the interest he would
much the money supply can increase from a $1,000 of have earned by placing his funds in an interest-earning
“fresh” reserves (so ΔR = +1000) entering the economy. asset such as a bond. It follows that the demand for
Note that Ms below denotes the money supply and D money decreases if interest rates increase.
denotes deposits while the Greek letter Δ denotes change, Figure 3.5.2 shows what the above suggests—that the
which in this case is an increase. demand for money is negatively sloped if drawn against the
interest rate (r) and that this money demand function will
ΔMs = ΔD = 1000 + 900 + 810 + 729 + …
shift to the right if nominal income (money GDP) increases as
ΔMs = ΔD = ΔR + (1 − rr) ΔR + (1 − rr)2 ΔR + (1 − rr)3 ΔR + at each interest rate people will want to hold more money.
(1 − rr)4 ΔR + …
Interest
ΔMs = ΔD = ΔR × [1 + (1 − rr) + (1 − rr) + (1 − rr) + …]
2 3 rate (r)

ΔMs = ΔD = ΔR ×
1
1 − (1 − rr) xc
= ΔR ×
1
rr
r2
So, if the rr is 10% then an increase by $1,000 in the banking
reserves (the ΔR above) can increase demand deposits and the
money supply by $10,000. The money multiplier m is equal to
the inverse of the required reserve ratio rr. r1
It follows that a fractional reserve banking system
permits the money supply to grow many times more
M’d
than the reserves in the banking system. This is the Md (when Y’>Y>)
result of loans converted into deposits which allow more
lending to take place and thus more deposits to be M2 M1 M’2 Quantity of
generated, and so on. It should also be clear that the money (M)
central bank can affect the money supply by increasing Figure 3.5.2 The demand for money
or decreasing the amount of reserves commercial banks
have available. Given a level of nominal income (Y), demand for money is
Md. If interest rates increase from r1 to r2 then demand

116
 UNIT 3: MACROECONOMICS
for money will decrease from M1 to M2 as the opportunity Determination of interest rates by the
cost of holding on to money balances is higher. There is a central bank
movement along the money demand function Md. The equilibrium interest rate is determined in the money
Now, if the average price level increases or real GDP market by the interaction of the money demand curve and
increases then money income will increase from Y to Y’. At the money supply.
each level of interest rates, people will now need to hold
more money for transactions. So, at r2, demand for money Interest Ms
will be M’2, greater than M2. The money demand function rate (r)
has increased and shifted to the right from Md to M’d.

The supply of money r2

The supply of money is affected and determined by the
central bank. We have established that if the central r(e)
bank somehow changes bank reserves then the money
supply will change. Even though commercial banks can
also affect the money supply by altering how much they r1
will choose to lend out after they satisfy the reserve
requirement set by the central bank, we will choose for Md
simplicity to consider the supply of money as determined
only by the central bank and draw it vertical at some M Quantity of money (M)
quantity of money (M) on the horizontal axis. This is Figure 3.5.4 Equilibrium interest rate determination by the central bank
shown in Figure 3.5.3.
Assume that the central bank has set the money supply at
Interest Ms Ms in order to achieve an equilibrium interest rate r(e). If
rate (r) the interest rate though is for some reason at r1, then the
quantity of money demanded is greater than the quantity
supplied. The public will try to switch from holding interest-
bearing assets such as bonds into holding more money.
As a result of the excess demand for money, the interest
rate will increase to r(e) where the quantity of money
demanded is equal to the quantity of money supplied by
the central bank.
If the interest rate is at r2 then the quantity of money
supplied by the central bank will exceed the quantity
demanded at that interest rate. The public wants to
M Quantity of money (M) hold more bonds and less money. The excess supply of
money will decrease the interest rate to r(e) where money
Figure 3.5.3 The supply of money demanded is equal to money supplied.

Monetary policy though a number of prominent economists consider that a

Monetary policy, as explained earlier, is a demand-side slightly higher rate would for several reasons be preferable.
policy that is conducted by the central bank of a country. Inflation close to 0% is not desired because, as explained
For example, in India it is conducted by the Central Bank earlier, the CPI tends to overestimate increases in the
of India, in China by the People’s Bank of China, in Egypt cost of living so there is a chance that if the measured
by the Central Bank of Egypt, in New Zealand by the inflation rate is close to zero, the economy may already
Reserve Bank of New Zealand, in the USA by the Federal be experiencing deflation. In addition, it is argued that a
Reserve Bank, in the UK by the Bank of England and in slightly higher than 2% inflation target gives central banks
the eurozone by the European Central Bank. Most central greater ability in a recession to decrease unemployment
banks are independent of the government, but their degree by cutting interest rates. Independently of the target rate
of independence varies. Monetary policy refers to changes of inflation set, a central bank must also ensure that it is
in the money supply, and so interest rates, in order to affect stable through time.
aggregate demand. • Many central banks have an explicit dual mandate not
only to achieve and maintain price stability but also to
Goals of monetary policy
pursue “maximum employment”. More generally, signs of
• The single most important goal of monetary policy is to a recession and of a possible increase in unemployment
achieve and maintain price stability. A low and reasonably instantly trigger a response by central banks. The possible
stable rate of inflation is necessary to avoid the adverse trade-off between inflation and unemployment makes it
consequences explained earlier. Most central banks define difficult to achieve both goals. Central banks thus
price stability as inflation “below but close to 2%”, even

117
 face a delicate balancing act. This is why it is argued thus more competitive. This may be necessary if a country
that a slightly higher inflation rate target would help in is to restore external balance as export revenues will tend
achieving both goals. to increase.
• Monetary policy is used to minimize fluctuations in the
business cycle. It has several advantages that permit Recap
central banks to act as “first responders” to any imminent
Goals of monetary policy
risk of recession or to any inflationary pressures.
The goals of monetary policy are to:
• Monetary policy, if successful, promotes a stable and
less uncertain macroeconomic environment. If a low and • achieve and maintain price stability
stable rate of inflation is achieved and maintained, then • achieve high levels of employment
the rate of investment spending in the economy will be • stabilize economic activity
higher. Higher long-term growth and so faster job creation
• promote a stable economic environment favourable
will follow.
to investment
• Monetary policy influences the exchange rate of a
• influence the exchange rate and achieve external
currency. For example, a decrease in interest rates will (for
balance.
reasons that will be explained) lead to depreciation of
the currency, which will make exports cheaper abroad and

HL
Tools of monetary policy Open market operations
The central bank can change the money supply and affect Open market operations refer to the purchase or sales of
the interest rate using the following tools. outstanding short-term government bonds (bonds that
The required reserve ratio (rr) mature in less than a year) from banks. The purchase
of short-term government bonds increases the money
As explained earlier, in a fractional reserve banking supply, and the sale of government bonds decreases the
system the commercial banks are required to hold money supply. Assume that the central bank decides
reserves in the form of cash in their vaults or as deposits to purchase $500 million of short-term government
with the central bank. The minimum percentage of their bonds from commercial banks. The central bank will
demand (and other) deposits that they must keep as pay commercial banks for these bonds by crediting the
reserves is set by the central bank and is the required reserves that commercial banks maintain at the central
reserve ratio. Commercial banks can only lend out any bank. Commercial banks will thus be able to increase
excess reserves. If the central bank decreases the required their lending. The money supply will increase. If the
reserve ratio then banks will have more excess reserves central bank wishes to decrease the money supply, it will
available and will be able to lend out more, so the money sell short-term government bonds it owns to commercials
supply will increase. The money supply curve in Figure banks. As a result, bank reserves with the central bank
3.5.3 will shift to the right. If the central bank increases will fall, forcing banks to reduce their loans, and this
the required reserve ratio then commercial banks will be leads to a decrease in the money supply. Note that open
able to lend out less so the money supply will decrease, market operations are the principal tool of monetary
and the money supply curve will shift to the left. Central policy that central banks use.
banks rarely use the required reserve ratio as it would
abruptly affect the profitability of commercial banks. Quantitative easing
The discount rate Lately, there is an additional tool that central banks in
many countries have been using. Since the 2008–09
The discount rate is a special interest rate on loans that the global financial crisis many central banks, including
central bank makes to commercial banks. It is also referred the US Federal Reserve, the Bank of England, the
to as the refinancing rate or base rate. If a commercial European Central Bank, the Bank of Japan and others,
bank is short of required reserves, it can always borrow were forced to resort to a new unconventional type of
from the central bank. If the discount rate is lowered open market operations that is known as quantitative
commercial banks can, if necessary, obtain additional easing.
reserves by borrowing from the central bank. With
additional reserves commercial banks can lend more, so the Short-term interest rates were in many countries down to
money supply increases. An increase in the discount rate zero and central banks were faced with the zero lower
discourages commercial banks from obtaining additional bound (ZLB) problem. They could not decrease interest
reserves through borrowing from the central bank. So, the rates (much) below zero as people always have the option
central bank may raise the discount rate when it wants to of holding cash. Further monetary easing thus became
restrict the money supply. The discount rate is not often difficult.
used as a tool of monetary policy but in times of financial Central banks responded by conducting large-scale
emergencies this special interest rate has been lowered to purchases of a wide variety of longer-term assets that
ease pressure on banks with bad loans. banks held that included long-term (5-year or 10-year)

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 UNIT 3: MACROECONOMICS
government bonds, mortgage loans owned by banks system. Banks found themselves with a flood of
as well as a variety of other financial assets. The aim non-interest earning reserves, forcing them to lend
was to pump huge amounts of money into the banking more aggressively.

Recap
Tools of monetary policy
Tools of monetary policy include:
• changes in the required reserve ratio (the proportion of deposits that cannot be lent out)
• changes in the discount rate (the interest rate central banks charge commercial banks in need of reserves)
• open market operations (purchases or sales of short-term government bonds that alter the reserves banks have)
• quantitative easing: purchases of long-term bonds and other assets by the central bank.
To increase money supply the central bank can:
• decrease the required reserve ratio
• decrease the discount rate
• buy short-term government bonds from commercial banks
• resort to QE which involves buying a wide array of many other longer-term financial assets from banks.
To decrease money supply, the central bank can:
• increase the required reserve ratio
• increase the discount rate
• sell short-term government bonds to commercial banks.

How does the central bank change Interest

Ms1 Ms2
interest rates? rate (r)
If the goal of the central bank is to increase aggregate
demand to fight off an imminent recession and a rise in
unemployment, then expansionary (also referred to as easy r1
or loose) monetary policy will be pursued. The central bank
will decrease interest rates.
r2
If the goal of the central bank is to decrease aggregate
demand (or, better yet, to slow down its increase) in order
to fight off inflationary pressures, then contractionary (also
referred to as “tight”) monetary policy will be pursued. The Md
central bank will increase interest rates.
Figures 3.5.5 and 3.5.6 show how a central bank uses M1 M2 Quantity of money (M)
changes in the money supply to change the interest rate and Figure 3.5.5 Decreasing the equilibrium interest rate by increasing the
thus achieve its goals. money supply
Assume that the central bank wishes to lower interest
rates from r1 to r2. In other words, assume that it has What if instead the central bank decided to pursue
decided to pursue expansionary (that is, easier or looser) contractionary (tighter) monetary policy and thus wanted
monetary policy. It will use its tools to increase the money to increase the interest rate? It will use its tools to decrease
supply from Ms1 to Ms2. It may decrease the required the money supply. It may increase the required reserve
reserve ratio rr or perhaps decrease the discount rate. Most ratio or increase the discount rate. Most probably though it
probably though it will conduct open market purchases of will conduct open market sales of outstanding (short-term)
outstanding (short-term) government bonds. Bank reserves government bonds. Bank reserves will decrease so that the
will increase so that the money supply will increase to money supply decreases from Ms1 to Ms2 in Figure 3.5.6. At
Ms2. At the original equilibrium interest rate r1, the supply the original equilibrium interest rate r1 the public will want
of money exceeds the demand for money. There is excess to hold more money. The excess demand for money will
supply of money in the money market, which will lower the increase the interest rate to r2.
interest rate to r2.

119
 Ms2 Ms1 • Even if a firm uses its past profits to finance the purchase
Interest of capital goods and does not need to borrow from banks,
rate (r) if interest rates decrease then the opportunity cost of
using these funds decreases, which will tend to increase
investment spending.
r2
Lower interest rates can also increase net exports (NX), as
follows.
• A decrease in a country’s interest rates implies a lower
r1
rate of return for financial investors who own bonds or
have deposits in that country’s currency. They will want
to switch to financial assets of other countries where
interest rates are higher. They will sell the currency to buy
Md currencies of other countries. The increased supply of that
M2 M1 Quantity of money (M) country’s currency in the foreign exchange market will
decrease its value. However, depreciation of a currency
Figure 3.5.6 Increasing the equilibrium interest rate by decreasing the
makes exports cheaper abroad and thus more competitive.
money supply
Exports will tend to increase and so aggregate demand
will shift to the right. The impact of a change in interest
Effect of expansionary monetary policy on rates and thus of the exchange rate on net exports is very
aggregate demand important and will be fully explained later.
What if an economy’s growth is slowing down and It follows that expansionary monetary policy will tend to
policymakers fear a recession, or an economy is already increase consumption and investment expenditures as well
experiencing recession? The central bank may use as net exports, leading to an increase in aggregate demand.
expansionary monetary policy, also referred to as “loose”
In the Keynesian AD/AS diagram shown as Figure 3.5.7 an
or “easy” monetary policy, aiming at increasing aggregate
economy, as a result of a decrease in aggregate demand, is
demand and thus closing a recessionary (or, deflationary)
experiencing a recessionary (or deflationary) gap equal to
gap. The central bank will decrease interest rates by
Y’Yf. Aggregate demand has decreased, and equilibrium real
increasing the money supply, typically through open market
GDP is at Y’, way below the full employment level Yf. The
purchases of bonds. The resulting lower interest rate will
economy is in recession and unemployment (cyclical) has
increase consumption and investment expenditures as well
increased.
as net exports. If C and I and NX increase, then AD will
increase. AS
Lower interest rates will tend to increase consumption APL
expenditures (C) for the following reasons.
• Lower interest rates decrease the cost of borrowing
for households. Households borrow from banks to buy
consumer durables such as cars and appliances but
most importantly to buy a house. Borrowing will tend to
increase and so household expenditures on durables and
on houses are expected to increase. Aggregate demand
will increase and shift to the right. The impact of lower
AD
interest rates on the housing market is considered the
most significant route through which looser monetary
policy increases aggregate demand. AD’
• Lower interest rates decrease the incentive for households Y’ Yf Yr
to save. If households save less, it means that they spend Figure 3.5.7 Impact on aggregate demand of expansionary monetary policy
more. Consumption expenditures rise and aggregate
demand increases and shifts to the right. This route is The central bank, using its monetary policy tools, increases
empirically rather insignificant. the money supply and decreases interest rates. Aggregate
Lower interest rates also increase investment expenditures (I) demand increases for the reasons explained above and
of firms for the following reasons. shifts to the right from AD’ to AD. The recessionary (or
deflationary) gap is closed. The economy grew as real GDP
• Typically, firms borrow to build new factories or to buy
increased from Y’ to Yf and cyclical unemployment also
machines, tools and equipment. The cost of borrowing
decreased.
for firms will be lower so more investment projects will be
considered profitable. Investment spending is expected You should notice that as aggregate demand increases and
to increase and since investment expenditures are a the economy is approaching the full employment level of
component of aggregate demand, aggregate demand real output Yf, there may be pressure on the average price
increases and shifts to the right. level to increase. The degree of any inflationary pressures
depends on the shape of the aggregate supply curve.

120
A Monetarist/New Classical diagram can be used to show It follows that contractionary (tighter) monetary policy will tend

UNIT 3: MACROECONOMICS
how expansionary monetary policy can increase aggregate to decrease consumption and investment expenditures as well
demand and restore output back to its potential level and as net exports, leading to a decrease in aggregate demand.
decrease unemployment back to the natural rate. In the Monetarist/New Classical AS/SRAS/LRAS diagram
shown in Figure 3.5.8, an economy is experiencing an
Effect of contractionary monetary policy on inflationary gap equal to YpY’ as a result of an increase in
aggregate demand aggregate demand from AD to AD’.
What if an economy is experiencing inflationary pressures
as a result of aggregate demand increasing too fast so LRAS
APL
that an inflationary gap arises? Policymakers will try to
decrease inflation and restore price stability. They may use SRAS
contractionary monetary policy, also referred to as tight
monetary policy, aiming at decreasing aggregate demand
or slowing down its increase. The central bank will increase APL’
interest rates by decreasing the money supply, typically APL
through open market sales of bonds. The resulting higher
interest rate will decrease consumption and investment
expenditures as well as net exports. If C and I and NX AD’
decrease then AD will decrease.
Higher interest rates will tend to decrease consumption AD
expenditures (C) for the following reasons.
• Higher interest rates increase the cost of borrowing Yp Y’ Yr
(NRU)
for households so borrowing will tend to decrease and
household expenditures on durables and on houses are Figure 3.5.8 Impact on aggregate demand of contractionary monetary policy
expected to decrease. Aggregate demand will decrease
Real GDP has increased above its potential level Yp and the
and shift to the left. The impact of higher interest rates
average price level is rising from APL to APL’. The central
on the housing market is considered the most significant
bank, using its tools, decreases the money supply and
route through which tighter monetary policy decreases
increases interest rates. Aggregate demand decreases for the
aggregate demand.
reasons explained earlier and shifts to the left from AD’ to
• Higher interest rates increase the incentive for households AD. The inflationary gap is closed.
to save. If households save more, it means that they will
A Keynesian AD/AS diagram can also be used to illustrate
spend less. Consumption expenditures fall and aggregate
that tighter monetary policy will decrease aggregate demand
demand decreases and shifts to the left.
and manage to eliminate inflationary pressures. However,
Higher interest rates also decrease investment expenditures (I) both the Keynesian and the Monetarist diagrams must be
of firms for the following reasons. interpreted loosely as the vertical axis denotes the average
• The cost of borrowing for firms increases so fewer investment price level. The decrease in aggregate demand is not aimed
projects will be considered profitable. Investment spending at creating deflation but at lowering inflation.
is expected to decrease and since investment expenditures
are a component of aggregate demand, aggregate demand Recap
decreases and shifts to the left.
Expansionary and contractionary
• Even if a firm uses its past profits to finance the purchase
monetary policy
of capital goods and does not need to borrow from banks,
if interest rates increase then the opportunity cost of • Expansionary monetary policy (easy; loose)
using these funds increases, which will tend to decrease Ms↑ → r↓ → C↑ and I↑ and NX↑ → AD↑
investment spending. • Contractionary monetary policy (tight)
Higher interest rates can also decrease net exports (NX) as Ms ↓ → r↑ → C↓ and I↓ and NX↓ → AD↓
follows.
• An increase in a country’s interest rates implies a higher
rate of return for financial investors who own bonds or The real interest rate
have deposits in that country’s currency. They will want The interest rates that banks quote for different types of deposits
to buy that currency to buy bonds or make deposits in or for different types of loans are referred to as nominal interest
that country’s currency. The increased demand for that rates. For example, if on a savings account the bank advertises a
country’s currency in the foreign exchange market will 4% annual interest rate, that is the nominal interest rate of the
increase its value. However, appreciation of a currency deposit. It means that if you deposit $200 you will get back in
makes exports more expensive abroad and thus less a year $208. If, though, inflation during that same year was at
competitive. Exports will tend to decrease and so 4%, it means that the $208 that you will get back in a year will
aggregate demand will shift to the left. be able to buy the same amount of goods and services as the
$200 could buy when you deposited the money. You received
nothing extra. The real interest rate was 0%.

121
 The real interest rate is more generally the nominal interest that the inflation rate is negative 1.50%. The real
rate minus the (expected) rate of inflation: interest rate is:
rr = rn − p̂ 0.50 − (−1.50) = +2.00%.
where rr is the real interest rate, rn is the nominal interest So, very low nominal interest rates in a deflationary
rate and p̂ is the (expected) rate of inflation. world that try to induce more borrowing and spending by
For our purposes we can simplify and remember that: households and firms lead to a higher real interest rate paid.
This decreases the incentive to borrow and spend. Monetary
real interest rate = (nominal interest rate − inflation rate)
policy is ineffective if there is deflation in an economy.
So, if nominal interest rate on a savings account is 2.25%
Remember: if there is inflation in an economy then the
annually, and inflation is 1.5% then the real rate of interest is
real interest rate is lower than the nominal interest rate
0.75%. If inflation was higher at 3.20% then the real interest
and may even be negative. This benefits borrowers and
rate would be −0.95%. In other words, you get less back in a
penalizes savers. In contrast, if there is deflation in an
year in real terms than what you had deposited. You will be able
economy then real interest rates are higher than nominal
to buy fewer goods than what you were able to buy last year.
interest rates, which rewards saving and penalizes
Now let the nominal interest rate on a car loan be at 0.50%. borrowing. Think whether this holds if nominal interest
Further assume that there is deflation in the economy, so rates could be negative.

Effectiveness of monetary policy

Advantages − The administrative or implementation lag. This is the
Monetary policy is the main choice for stabilizing an time it takes policymakers to decide on the appropriate
economy. It is considered the “first responder” when either a policy response. This is much shorter for monetary policy.
recessionary gap or an inflationary gap arises. Fiscal policy A central bank can decide much faster on a change in
is also a demand-side policy and has been used to stabilize interest rates. It takes a lot longer for a government to
economic activity but certain advantages that characterize change government expenditures and/or taxes as any
monetary policy render it the preferred tool for policymakers. change will also have to be approved by a long legislative
Strengths of monetary policy include the following. political process, which can last months.
• It is flexible. Monetary policy can respond quickly − The impact or execution lag. This is somewhat shorter
to changing economic conditions. Monetary policy for monetary policy as some borrowing and spending
committees meet very often to decide on interest rate decisions may change fast. Still, it may take months for an
policy. Most central banks meet between six to eight times interest rate change to have full impact on the economy.
per year and they may even hold emergency meetings. Overall, monetary policy faces shorter time lags and it
• It is incremental. A central bank can increase or decrease is thus less likely to destabilize the economy. This is an
interest rates in a series of steps by 0.25% at a time. So, additional extremely important argument in favour of
credit conditions can be tightened or loosened gradually. using monetary policy as the preferred policy response for
short run stabilization.
• It is reversible. If it becomes clear to the central bank that
interest rates increased or decreased more than necessary, Disadvantages
it can easily reverse course. Monetary policy faces certain significant constraints.
• Central banks are typically independent from the • Monetary policy may be very effective in reducing inflation
government. This insulates them from political pressure but is less effective in fighting a recession. Lower interest
in their monetary policy decision-making. In several cases rates affect spending by households and firms indirectly.
though, politicians have tried to force central bankers to The cost of borrowing decreases and this should induce
decrease interest rates at levels too low to be consistent households and firms to borrow more and so spend more.
with stable inflation in order to maximize their re-election What if consumer and business confidence is very low
chances. In 2018 President Trump openly criticized the though? What if the recession is deep and people and
US Central Bank for raising interest rates and later for not firms feel pessimistic, insecure and uncertain about their
cutting rates more quickly. The degree of independence of financial future? There is no guarantee they will decide
central banks varies across countries. that now is the right time to buy a house or a new car, if
• Monetary policy, just like fiscal policy, is characterized by they fear losing their job. It is also unlikely that a firm will
time lags. Time lags weaken the effectiveness of demand- decide to expand during a severe downturn. In addition,
side policies. Time lags can be distinguished into these banks may be reluctant to lend money, fearing that the
three types. loans they make will not be paid back. Monetary policy is
− The detection or recognition lag. This is the time it takes like a string: you can pull it but you cannot push it.
for policymakers to realize that there is an economic • There is limited scope of reducing interest rates to help an
problem they should deal with. It takes time to collect economy avoid or exit a recession or deflation when they
and process data. This lag is the same for both monetary are already close to zero. This problem of monetary policy
policy and fiscal policy. is referred to as the zero lower bound (ZLB) constraint.

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 UNIT 3: MACROECONOMICS
Recap
Advantages and disadvantages of monetary policy
Advantages Disadvantages
• Monetary policy is flexible. • If confidence levels are low, monetary policy may prove
• It is incremental. ineffective.
• It is reversible. • When nominal interest rates are close to zero there is
not much room to lower them more (the ZLB problem).
• It is independent (typically) of the government.
• It has shorter time lags than fiscal policy.

Are negative interest rates possible? Policymakers’ perspective

Negative interest rates imply that depositors would pay The advantages of monetary policy have made it the
to hold money in bank accounts, which is unlikely as preferred policy choice to help stabilize an economy.
they could just withdraw their funds and keep the cash. Inflationary pressures are dealt with by the central
Even though the idea is strange, negative interest rates bank, notching up interest rates to reduce consumer
have lately been used. How did we get here? and business spending. Recessions have led to
To fight the 2008–09 global financial crisis, central central banks decreasing interest rates to encourage
banks decreased interest rates close to zero. Low borrowing and spending and stimulate the economy.
borrowing and spending continued, though, and However, the extremely low interest rates prevailing
growth was still weak with inflation below the 2% in many economies since the 2008–09 global
target. This persistently low growth is referred to as financial crisis have left little room for central banks
secular stagnation, a term introduced by Harvard to conduct expansionary monetary policy and fight a
economist Lawrence Summers. Central banks have severe recession or deflation. Negative interest rates
responded with quantitative easing, which was and discussion of the necessary legal and regulatory
explained earlier. However, some also began to changes now seem to be the issues for policymakers
introduce negative interest rates on any excess in an attempt to circumvent the zero lower bound
reserves that commercial banks held with accounts at (ZLB) problem they face.
the central bank. The goal was to prevent banks for
hoarding the cash inflows from the quantitative easing
programmes and to encourage banks to lend more
aggressively. Denmark’s Central Bank and the ECB were
first, followed by the Swiss, the Swedish and Hungary’s
central banks. Slightly negative interest rates were also
introduced on certain accounts by some commercial
banks and there were no widespread withdrawals,
probably because the convenience and safety of a
bank account outweighed the cost of paying instead or
earning interest.
To move from mildly negative interest rates to
“unconstrained negative interest rate policy” is not an
easy task and it is also risky. It would require phasing
out large denomination notes as well as changes in
the legal, regulatory and tax framework. In a country
suffering from deflation, though, it could provide the
monetary stimulus required.

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 3.6 Demand management
(demand-side policies): fiscal policy
Fiscal policy
Fiscal policy is also a demand-side policy. It refers to changes from a recession it means that more jobs are created, so
in the level of government expenditures (G) and/or in (direct) more people are employed.
taxes (T) in order to affect aggregate demand and so real • Fiscal policy can also be used to decrease inflation.
output (growth), the level of employment and inflation. Remember though that achieving and maintaining price
stability is the responsibility of the central bank so tighter
Government expenditures monetary policy is typically the preferred policy choice.
• Capital expenditures—which is really another name for However, policymakers will also use fiscal policy if inflation
public investments—include spending on infrastructure is the result of profligate government spending.
such as harbours, roads and highways, airports,
• Faster long-term growth may also result if fiscal policy is
telecommunication networks, electricity grids, water and
“prudent” which really means that large deficits are avoided,
sanitation networks, schools and hospitals.
and the national debt does not increase to unsustainable
• Current expenditures—these include salaries of public sector levels. Why? Businesses feel less uncertain about the future so
employees but also expenditures on public school and they are more willing to invest. They are less fearful of a need
hospital supplies as well as subsidies. Interest payments in the future to raise taxes or of interest rates rising (this is the
made to owners of government debt are also included. “crowding out” idea, explained in the HL section on page 126).
• Transfer payments—these include pensions, unemployment • Fiscal policy may also reduce the short-term fluctuations of
benefits and other cash transfers. Note that these the business cycle. Automatic stabilizers (a type of fiscal
expenditures are not included in GDP as they do not policy explained in the HL section on page 126), are built-
represent a contribution to current production. in fiscal characteristics that most economies have. These
stabilizers help to protect an economy from short-term
Government revenues fluctuations in the business cycle.
Government revenues are mostly from taxes, direct and indirect.
• If the government expenditures are capital expenditures
Revenues also include one-off receipts from the sale of state-
(that is, public investments) that increase or improve the
owned assets (for example, firms, ports and airports) to the
available infrastructure, not only will aggregate demand
private sector (privatizations) as well as any profits collected
and so real GDP increase in the short term but long-term
from the goods and services that state-owned enterprises sell.
growth will also accelerate. It is claimed that lower income
Terminology and corporate taxes increase the incentive to work and to
If government expenditures (G) exceed tax revenues (T) in any invest and so they may also accelerate growth, but there is
given year, then the government is running a budget deficit. scant evidence to support this claim.
If tax revenues (T) exceed government spending (G) in any • Fiscal policy can also be used to narrow income inequality
given year, then the government is running a budget surplus. in a country through cash transfers and more progressive
If government expenditures (G) are equal to tax revenues (T) taxation in the short term and through investments in
then the budget is balanced. education and health in the long term.
A budget deficit needs to be financed. The government finances • Fiscal policy can also be used to decrease trade imbalances.
a budget deficit by borrowing. It issues bonds that it sells to
the general public. If you buy a government bond you are Recap
effectively lending money to the government. The government Goals of fiscal policy
will pay you at a specified future date the principal plus interest.
In this way, a budget deficit adds to the public debt whereas a Fiscal policy can:
budget surplus decreases the public debt. • lift an economy from recession
• lower (cyclical) unemployment
Goals of fiscal policy
• decrease inflation
• Fiscal policy is considered a Keynesian-inspired demand
management policy. It is the name of John Maynard Keynes • promote a stable macroeconomic environment that
that is associated with the idea of government intervention accelerates growth
using fiscal tools; that is, government expenditures and taxes • reduce business cycle fluctuations
to help an economy restore full employment. It follows that • decrease income inequality
perhaps the single most important goal of fiscal policy is • decrease trade imbalances.
to lift an economy from recession, especially a deep one.
Fiscal policy is then the preferred policy choice to close
a large recessionary or deflationary gap because of the Fiscal policy in action
ineffectiveness of monetary policy in such a situation. The government can increase government expenditures
• Fiscal policy is also adopted to decrease cyclical and/or decrease taxes to increase aggregate demand. It
unemployment. If fiscal policy manages to lift an economy

124
can also decrease government expenditures and/or increase We should note a few things here. As it should be clear from

UNIT 3: MACROECONOMICS
taxes to decrease aggregate demand. These decisions Figure 3.6.1, the increase in aggregate demand resulting
describe what is referred to as “discretionary” fiscal policy. It from expansionary fiscal policy may also result to an increase
is at the discretion of the government to decide how much to in the average price level or, in other words, may lead to
spend and/or to tax. The government “does” something. We some inflation. This risk is lower if the economy is operating
will examine first how this kind of discretionary fiscal policy on the horizontal section of the Keynesian AS curve. Any
works and then (HL) we will also examine fiscal policy that increase in aggregate demand will prove less inflationary if
could be described as “on automatic pilot” as it is conducted there is still spare capacity in the economy.
through the use of automatic stabilizers. Also, expansionary fiscal policy may actually aim at generating
some inflation. This could be the case if the economy is on the
Expansionary fiscal policy verge of or already suffers from deflation. Given that monetary
Expansionary fiscal policy increases aggregate demand and policy is ineffective if interest rates are very low and an even
shifts the AD curve to the right, as in Figure 3.6.1. The goal greater policy problem exists if there is deflation, expansionary
is to lift an economy from recession. By increasing aggregate fiscal has been used by policymakers to achieve higher inflation.
demand, expansionary fiscal policy closes a deflationary
A Monetarist/New Classical AD/SRAS/LRAS diagram can
(recessionary) gap. The government will increase government
also be used to show how a deflationary gap could be closed
expenditures (G) and/or decrease taxes (T).
even though, if we rely on the extreme interpretation of the
If government expenditures (G) increase, then aggregate Monetarist/New Classical school, there is really no need for
demand will directly increase as government expenditures policymakers to intervene to close a deflationary gap. Market
(G) are a component of aggregate demand. Interestingly, the forces alone in the long run, namely the assumed decrease
resulting increase in real GDP will be greater than the increase of money wages, guarantee that the economy will return to
in government expenditures. Why? It is due to the work of the its potential output.
multiplier effect (HL), explained on page 126.
If taxes (T) decrease, then disposable incomes (Yd) of Contractionary fiscal policy
households increase. Remember that disposable income Contractionary fiscal policy decreases aggregate demand
is defined as income minus direct taxes plus transfer and shifts the AD curve to the left as in Figure 3.6.2. The
payments. With higher disposable incomes, people will tend goal is to decrease inflationary pressures and close an
to spend more, increasing consumption expenditures (C) inflationary gap.
and thus aggregate demand. Also, if corporate taxes The government will decrease government expenditures (G)
decrease then the resulting higher profitability that firms and/or increase taxes (T). If government expenditures (G)
will enjoy may lead to an increase in investment spending decrease, then aggregate demand will directly decrease
(I) which also increases aggregate demand as I is also a as government expenditures (G) are a component of
component. Note that we are referring here to changes in aggregate demand.
direct taxation.
If taxes (T) increase, then the disposable income (Yd) of
AS households decreases. With lower disposable incomes, people
APL will tend to spend less, decreasing consumption expenditures
AD2 (C) and so aggregate demand. Also, if corporate taxes increase
then the resulting lower profitability that firms will experience
AD1 may lead to a decrease in investment spending (I) which also
decreases aggregate demand.
LRAS
APL

SRAS

APL1
Y1 Yf Real output (Yr)
APL2
Figure 3.6.1 Expansionary fiscal policy closing a deflationary gap using a
Keynesian diagram
AD1
In the Keynesian diagram shown in Figure 3.6.1 aggregate
demand increases from AD1 to AD2 because government AD2
expenditures increased and/or because direct taxes Yp Y1 Real output (Yr)
decreased. As a result of aggregate demand increasing,
equilibrium real output (Yr) increases from Y1 towards the Figure 3.6.2 Contractionary fiscal policy closing an inflationary gap using a
potential (full employment) level of real output Yf (or Yp). Monetarist diagram
The deflationary gap decreases and may even close.
In the Monetarist /New Classical diagram Figure 3.6.2,
Unemployment (cyclical) in the economy also decreases.
(note that a Keynesian diagram could also be used), an

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 inflationary gap equal to (YpY1) exists. Contractionary and accelerate growth. This idea became is referred to as
fiscal policy will decrease aggregate demand from AD1 to “expansionary fiscal contraction” but most economist criticize it,
AD2 because government expenditures decreased and/ claiming that the alleged “confidence fairy” doesn’t exist.
or because direct taxes increased. As a result of aggregate It is perhaps necessary to make two more points.
demand decreasing, the average price level decreases from Contractionary fiscal policies, whenever applied, rarely
APL1 to APL2 and the inflationary gap (YpY1) closes or include a tax increase. The reason is that politicians are
at least decreases. Within this Monetarist/New Classical worried that a tax rise will decrease their re-election chances.
framework, unemployment increases and returns to its More generally, changing taxes is not considered prudent
natural rate. Within a broader analytical framework, because firms and households require a degree of certainty
contractionary fiscal that decreases aggregate demand to regarding their future tax obligations.
relieve an economy from inflationary pressures leads to an
increase in cyclical unemployment.
However, both the Keynesian and the Monetarist diagrams Recap
must be interpreted slightly loosely as the vertical axis denotes Expansionary and contractionary
the average price level but the resulting decrease in aggregate fiscal policy
demand does not create deflation, it lowers inflation. Only a
Expansionary fiscal policy:
severe decrease in government spending (G) and an increase
in taxes could lead to deflation. This was the case when G↑ → AD↑
Greece agreed with its creditors to implement austerity, which T↓ → Yd↑→ C↑ → AD↑
simply means to cut spending and to increase taxes, during its Contractionary fiscal policy:
debt crisis. An interesting twist to contractionary fiscal policy
G↓ → AD↓
was proposed by a few economists and is worth mentioning.
They argued that decreasing government spending (but not T↑ → Yd↓→ C↓ → AD↓
increasing taxes) and trying to control widening budget deficits
will increase business confidence, so it will foster investment

HL
The Keynesian multiplier bottles, and other unemployed workers to dig the bottles
The term multiplier was introduced by JM Keynes and his up. National income has directly increased by $100 million,
student RF Kahn. It is often referred to as the Keynesian the income that these workers earned for the service they
multiplier and it helps explain why expansionary fiscal produced. Spending by the government is income for the
policy in the form of increased government expenditures workers. Economic activity will not stop there, though. There
(G) is considered a very powerful tool to lift an economy is a 2nd and a 3rd and an nth round that follow. Why?
out of a deep recession. The Keynesian multiplier states These workers will spend part of this additional income on
that an increase in government expenditures G will lead to domestic goods and services that others produce, and the
a greater increase in national income Y: process will continue. Note that the additional spending
in each round creates additional demand, which leads
ΔY > ΔG to additional output (GDP) produced. If, for example,
where ΔY is the resulting change in national income and all workers hired by the government spend part of the
ΔG is the change in government expenditures. This means additional income earned on domestically produced milk
that the change in national income Y will be “k” times the and all milk producers spend part of the additional income
change in government expenditures, or: they earned on haircuts, then the economy’s income will
ΔY = kΔG where k is the multiplier. have increased and in addition more milk and more haircuts
So, if for example the government decides to increase will have been produced. Remember that income and
government expenditures by $100 million and national production are identically equal.
income increases by $240 million then the multiplier, The size of the multiplier depends on the proportion of
namely k, would be equal to 2.4: the additional income earned that is spent on domestic
240 = 2.4 × 100 goods and services. The additional spending on domestic
goods and services resulting from additional income
Why is that the case? The idea of the multiplier rests
earned has a name—it is called marginal propensity to
on the fact that one person’s spending is automatically
consume (MPC).
someone else’s additional income, which in turn leads to ΔCd
additional spending that generates additional income MPC =
ΔY
and so on. Economic activity takes place in successive If for example, you spend $100 on a haircut and the
“rounds”, as clearly illustrated by the circular flow model hairdresser spends $80 of these dollars on domestically
(see section 1.1, page 5). produced cheese, then the MPC is:
An example will help to clarify the point. Assume that the +80
government decides to increase expenditures by $100 = 0.8
+100
million and hires unemployed workers to dig holes and bury

126
 UNIT 3: MACROECONOMICS
If, though, 80 additional dollars were spent on domestic as a result of the multiplier. Interestingly, the IMF, one
goods and services, where did the remaining $20 go? It of Greece’s creditors, had underestimated the size of the
is useful to remind ourselves again of the circular flow. Greek expenditure multiplier, so the ensuing recession
We have defined withdrawals (leakages) as income not proved much deeper than expected. The IMF’s chief
spent on domestic goods and services. It follows that part economist at the time, Olivier Blanchard, acknowledged
of these $20 (say $8) were saved, part was paid to the the error and published a revised estimate.
government as taxes (say $7) and part was spent but on • Any change in any injection will initiate a multiplier
foreign goods and services; that is, on imports (say $5). process. In other words, GDP will change more not
These are the withdrawals, namely savings (S), taxes (T) only if government expenditures (G) change, but also if
and import expenditures (M). investment expenditures (I) or exports (X) change. Again,
Some definitions of terms used below are: this can be easily visualized using the circular flow of
• the marginal propensity to save (MPS)—the additional income illustration. Remember that injections, which
savings from additional income earned are considered autonomous expenditures as they do not
depend on domestic income, include G, but also I and X.
• the marginal propensity to tax (MPT, also referred to as
the marginal rate of tax)—the additional taxes paid from • The formulas to remember for simple exercises related
additional income earned to the multiplier are these two:
• the marginal propensity to import (MPM)—the (a) ΔY = kΔJ, where J symbolizes injections
additional spending on imports from additional income. and can be G or I or X
Using these definitions and the numbers in the example (this relationship has three elements, ΔY, k and ΔJ, so if
above: any two are given, you can solve for the third)
ΔS +8 1 1
MPS = = = 0.08 (b) k = or
ΔY +100 MPW (1 – MPCd)
ΔT +7 (here, each relationship has two elements so if either is
MPT = = = 0.07
ΔY +100 given, you can solve for the other).
ΔM +5
MPM = = = 0.05 • If in an exercise there is no government or, if it is referred
ΔY +100 to as a “closed” economy, it means that this economy has
It can be shown (see “Optional material”, page 131) that no taxes and/or no imports as withdrawals so its multiplier
the multiplier k is equal to: will be greater (the denominator, MPW, will be smaller).
1 1 To illustrate the multiplier, it is probably preferable to choose
k= or
(MPS + MPT + MPM) MPW a Keynesian AS curve as the idea of the multiplier effect
1 is indeed Keynesian. It is also preferable to assume an
which is equal to
(1 – MPCd) economy in equilibrium at a level of income (of GDP) way
where MPW is the marginal propensity to withdraw, which below the full employment level (at Y1 in Figure 3.6.3) so
is equal to the sum of the MPS, the MPT and the MPM. that there is a sizable deflationary gap (equal to Y1Yf). To
MPW is also found by subtracting from each additional illustrate the increase in government spending reflecting
dollar earned all that is spent on domestic goods and the expansionary fiscal policy chosen to close this gap, draw
services; that is, MPW = (1 – MPCd). a new aggregate demand curve (AD2) somewhat to the
right of the initial one and then, to illustrate the idea of the
It should be realized that the multiplier k is greater:
multiplier, draw a third AD3 even further to the right at AD3.
(a) the greater the MPCd and (b) the smaller the marginal
propensity to withdraw. AS
APL
This makes sense if you check the circular flow: an increase
in government expenditures will go around the circular flow
of income many times (as your spending is someone else’s
income) but each time a fraction of the income generated AD1 AD2 AD3
leaks out of the flow because some will be saved, paid in
taxes or spent but on imports. The size of the increase in +∆G 'K'
national income that will result is greater, the bigger the
part that is spent on domestic output or, equivalently, the
smaller the part that is withdrawn.
There are a few points to keep in mind.
• The multiplier also works in reverse: if the government
expenditures decrease, then national income (GDP)
Y1 Y2 Y3 Yf Yr
will decrease by more. This was the case in Greece a (real GDP)
number of years ago when it agreed to cut government
expenditures (G) drastically in order to receive the Figure 3.6.3 The multiplier effect following an increase in government
necessary bailout loans. Greece’s GDP decreased by more expenditures (G)

127
 Expansionary fiscal policy, namely the increase in If an economy is entering recession, economic activity starts to
government expenditures by ΔG, managed to decrease decrease as some firms shrink in size while others shut down.
the recessionary (deflationary) gap from Y1Yf to Y3Yf, People will be made redundant. Automatic stabilizers decrease
approaching full employment real GDP at Yf. the financial pain to households because they will owe less
A 2020 paper by C Bayer and others estimated that in taxes and they will be eligible to collect unemployment
following the massive March 2020 $2 trillion US stimulus benefits. All this is accomplished automatically, without the
response to the Covid-19 pandemic, the multiplier could need for the government to design and enact new laws. Their
be as high as 2. Following the 2009 Obama Stimulus incomes (that is, wage earnings) may drop to zero as they lose
Plan, which increased government expenditures in their jobs but their disposable incomes (Yd) do not, because
the USA by $787 billion to lift the US economy from unemployment benefits automatically start and their tax
recession, Christina Romer, then Chair the Council of burden will also be lower. Automatic stabilizers do not only
Economic Advisers, estimated the US multiplier at 1.6, help households in distress but also the economy as they
which meant that the US real GDP was expected to stimulate aggregate demand when the economy is in great
increase as a result by roughly $1.26 trillion. The size of need for a boost. Consumption expenditures will decrease
the Keynesian multiplier depends on certain characteristics by less due to the effect on disposable income of automatic
of an economy, for example on the degree of openness to stabilizers and so will aggregate demand. The downturn will
international trade or on the debt–GDP ratio. In a more not be as severe. It will be milder.
“open” economy imports, a withdrawal, will be greater. In contrast, if the economy and incomes are growing too
Characteristics vary across countries and through time, fast and there is increased risk of overheating and inflation,
making it difficult to estimate the expenditure multiplier. disposable incomes will rise but at a slower rate than
incomes because of income taxes being progressive and thus
Recap rising faster than incomes. So, consumption expenditures will
increase but at a slower rate and so will aggregate demand.
Keynesian multiplier The boom will be milder. Inflationary pressures will decrease.
• A change in any injection (G, I or X) will lead to Automatic stabilizers smoothen the ups and downs of the
a greater change in national income (GDP). business cycle without requiring legislative action. They are
• This is because one’s spending is someone else’s especially useful in a recession as they respond quickly.
income, which leads to more spending and more Beyond responding quickly, automatic stabilizers also
income generation. have a sizable impact on the economy. For example, the
• The size of the multiplier effect depends on the Obama Stimulus package was enacted in February 2019,
proportion of any additional income spent on five quarters after the start of the US recession—but by
domestic output. Or, equivalently, it depends on that time, spending by automatic stabilizers had already
the proportion saved, paid in taxes or spent but grown to almost 2% of the US potential GDP.
on imports. Recently, several economists are proposing to increase the
1 size and scope of automatic stabilizers. For example, they
• Since the multiplier is equal to it follows
MPW propose offering lump-sum payments to households when
that the smaller the withdrawals in an economy, unemployment increases by more than 0.5% compared to
the greater the multiplier. last year’s low or introducing “shovel ready” local projects
such as construction of additional schools that would
What are automatic stabilizers? automatically happen at the start of a recession without
As explained earlier, discretionary fiscal policy involves the need for action by the government.
the deliberate change by the government of government
expenditures and/or of taxes. However, politicians may not Recap
move quickly enough to cut taxes or increase expenditures Automatic stabilizers
to mitigate the effects of a recession. Fortunately, most
economies are equipped with automatic stabilizers. • Automatic stabilizers, which exist in most
Automatic stabilizers are institutional features built into the economies, are institutionally built-in characteristics
budget of a country, such as the existence of unemployment that mitigate the short-term fluctuations of GDP.
benefits and of progressive income taxes, that reduce the • Automatic stabilizers include unemployment
ups and downs of the business cycle automatically. benefits and progressive taxes.
• As soon as an economy enters recession, tax burdens
A tax is a progressive tax if higher incomes not only decrease and unemployment benefits are claimed.
pay more but pay proportionately more, so that as
• Without any need for the government to act,
income rises, progressive taxes rise faster. For example,
disposable incomes and consumption decrease
if Brody earns $10,000 per year and pays $2,000 in
by less and the downturn is milder.
income tax while Carrie earns $20,000 per year and
pays $5,000 then Brody pays 20% of his income in • If an economy is growing too fast, progressive
taxes but Carrie pays 25% of her income in taxes. (For income taxes guarantee that disposable incomes
a full explanation see section 3.4, page 105.) and spending rise slower.

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 UNIT 3: MACROECONOMICS
crowded-out by the increased interest rates resulting from
• Without any need for the government to act, increased government spending. If the goal increasing
aggregate demand rises slower; this slows down government expenditures (G) was intended to increase
growth and reduces the risk of inflationary pressures. aggregate demand then, since private investment (I) may
decrease, aggregate demand will not increase as much as
expected or even at all. This is shown in Figure 3.6.4b.
What is the “crowding-out” effect?
The increase in government spending would increase
If the government increases government expenditures (G) aggregate demand from AD1 to AD2 in the absence of
it will need to somehow finance these expenditures. It crowding out. If, though, the increased borrowing needs
could increase taxes but if the goal is to increase aggregate of the government increase interest rates then investment
demand that would defeat the purpose. Instead, it will prefer spending, also a component of aggregate demand, will
to resort to “deficit spending” and borrow the money from decrease. The result is that aggregate demand may not
anyone willing to lend it. The government will turn to the increase as much as expected, all the way to AD2, but
loanable funds market, the market where those who want only to AD3. Real GDP will perhaps rise, but only to Y2.
to borrow money (firms and households) and those who Expansionary fiscal policy is not as effective as expected
are willing to lend money (the savers) get together. Their to close a recessionary (deflationary) gap, as private
interaction determines the interest rate for loanable funds. investment spending was crowded out.
In Figure 3.6.4a, demand for loanable funds D(LF)1 is As you might have guessed, this is a major criticism of
downward sloping because at lower interest rates more Monetarists against the effectiveness of Keynesian-inspired
investment projects will be profitable so firms will want expansionary fiscal policy and deficit spending. It makes
to borrow more. Supply of loanable funds S(LF) is upward sense, but only if the economy is booming and approaching
sloping because higher interest rates make saving and full employment. In such a case the government will be
lending more attractive. The interest rate at which the competing with private firms for funds, which could drive up
demand for loanable funds D(LF)1 is equal to the supply of interest rates. What if the economy is in a deep recession? In
loanable funds S(LF) in Figure 3.6.4a is the interest rate in this case crowding out is unlikely as business confidence will
the loanable funds market. This is at r1. be low and firms will not be willing to invest.
Assume now that the government decides to employ Whether crowding out occurs or not crucially depends on the
expansionary fiscal policy in order to increase aggregate size of the deflationary gap. The risk is smaller, the deeper
demand and that it increases government expenditures. the recession. Also, in a deep recession it is expansionary
As explained above, the government will need to finance fiscal policy in the form of increased government spending
these expenditures and will enter the loanable funds that can help an economy grow again.
market to borrow the necessary funds. As shown in Figure
3.6.4a, the demand for loanable funds will increase and
shift to the right from D(LF)1 to D(LF)2. The interest rate Recap
on loanable funds will increase from r1 to r2. Crowding out
The resulting higher borrowing cost will dissuade many If G↑→ DLF↑→ r↑→ I↓ → AD↓
firms from borrowing to finance their own investment (I)
plans. Private investment will decrease. It will have been
(a)
(b)
S(LF)
Interest APL AS
rate (r)

r2
AD1 AD3 AD2
r1

D(LF)2
D(LF)1
F1 F2 Loanable Y1 Y3 Y2 Yf Real
funds output
Figure 3.6.4a Crowding out: the loanable funds market Figure 3.6.4b Crowding out: the impact on the economy

129
 Effectiveness of fiscal policy
Advantages economy indicate the need for contractionary fiscal policy,
• Perhaps the biggest advantage of expansionary fiscal it is not often adopted because cutting expenditures
policy in the form of increased government expenditures and raising taxes do not appeal much to the median
is that it is direct. Government spending is a component voter. In contrast to monetary policy, fiscal policy is not
of aggregate demand. If it increases, aggregate demand independent of the political agenda of the ruling party.
will automatically increase. This is especially important Fiscal policy therefore has an “expansionary bias”.
in a deep recession when easy monetary policy may be • On the other hand, in many parliamentary democracies,
ineffective as confidence levels are low but also because opposition politicians often try to stall expansionary fiscal
of the zero lower bound (ZLB) constraint explained in policy even if it is direly needed. Typically, opposition
section 3.5, page 110. politicians claim that increasing government expenditures
• (HL) An increase in government expenditures will lead will increase the national debt to unsustainable levels
to an even greater increase in aggregate demand and (the country will “become like Greece” was the typical
in economic activity (that is, on GDP) because of the argument). Other opposition claims are that increasing
operation of the multiplier effect. government expenditures will lead to rampant inflation
or that it will lead to increased interest rates. The result is
• Fiscal policy can be targeted. Increased government that discretionary fiscal policy is often caught in endless
spending can target specific sectors of the economy, such debates and this explains why there are many economists
as specific needs in infrastructure, R&D, the development who argue in favour of an increased role for automatic
of green technologies, education or health care. It can also stabilizers.
target specific regions of a country that are growing much
slower than average or are in decline. • Fiscal policy is also characterized by very long time-
lags. Time lags, as explained earlier (page 122), also
• Tax cuts can also target the poor, who are not only in characterize monetary policy but the administrative lag
greater need for a boost in their disposable incomes in fiscal policy is much longer. Not only will opposition
during an economic crisis but who are also more likely politicians question the need for expansionary fiscal
to spend the resulting additional income than are higher policy and stress its potential risks but even if there is
income households, significantly increasing aggregate agreement for a stimulus plan it can get stuck in further
demand. In addition, tax cuts for the poor can help to political debates about, for example, how much to
decrease income inequality. increase expenditures, which expenditures to increase
• An increase in government (capital) expenditures, such and which taxes to decrease and by how much. Long time
as on infrastructure, R&D, education and health care will lags may destabilize the economy instead of stabilizing
also in the long term increase potential output, shifting it. For example, if the government decides to increase
aggregate supply to the right the long run. government spending in order to deal with a recession
• If an economy can issue its own currency and if most of and close a deflationary gap, an inflationary gap may
its debt is domestically owned, then fiscal policy can be result if exports unexpectedly rise before the full impact of
scaled up significantly. The response to the Covid-19 crisis the fiscal stimulus.
in early 2020 clearly showed this. Advanced economies • Expansionary fiscal policy may prove inflationary if the
increased government spending by June 2020 by more economy is already operating close to full employment or
than $7.6 trillion, representing roughly 11% of the 2019 if time lags prove longer than expected.
world GDP. In the USA alone, a $2 trillion package had • (HL) Expansionary fiscal policy may lead to private
been enacted by March 2020 and an additional investment being crowded out if the economy is close to
$2 trillion package was being discussed at the time full employment.
of writing.
• If it succeeds in raising incomes in the economy,
• (HL) A huge advantage to economies entering a downturn expansionary fiscal policy may widen a trade deficit
is the existence of automatic stabilizers. Automatic because higher incomes lead to more imports.
stabilizers do not require legislative action by the
government so they are able to respond quickly to an • Expansionary fiscal policy increases the national debt and
economic downturn. under certain conditions this may prove unsustainable.
• Expansionary fiscal policy that relies on tax cuts may not
Disadvantages prove effective if the tax cuts are mostly geared to higher
• Discretionary fiscal policy is the responsibility of incomes because those with higher incomes have a lower
politicians. This presents some issues. Politicians aiming propensity to consume. More generally, tax cuts may not
to maximize their re-election chances often push before lead to increased spending if consumer and business
elections for sizable increases in government spending confidence is very low.
as well as for tax cuts. Even if the fundamentals of the

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 UNIT 3: MACROECONOMICS
Recap
Advantages and disadvantages of fiscal policy
Advantages Disadvantages
• Fiscal policy affects aggregate demand directly. • Politicians are responsible for fiscal policy.
• Fiscal policy can be targeted. • Fiscal policy is characterized by long time lags.
• Certain expenditures may also increase potential output. • It may lead to unsustainable debt.
• Under certain conditions fiscal policy can be scaled up • It may lead to inflation.
significantly. • It may widen a trade deficit.
• (HL) The multiplier renders fiscal policy powerful to • Tax cuts may not induce more spending.
fight a recession.
• (HL) Fiscal policy may crowd out private investment.
• (HL) Automatic stabilizers can be quick and sizable.

Policymakers’ perspective directed to improve the plight of the poor. Monetary

policy, and specifically quantitative easing, is considered
It should be stressed that the role of fiscal policy in
to have widened income inequality because much of the
economic stabilization is becoming more important.
additional funding that central banks have pumped into
Many policymakers are afraid that economies are
economies has been fuelling stock market booms.
ill-prepared to fight off a downturn. Monetary policy
alone may not be able to mitigate recessions as a result However, policymakers must be mindful of the risks
of the zero lower bound (ZLB) constraint it faces with associated with the expansionary bias of discretionary
nominal interest rates. Research has shown that central fiscal policies. The national debt may increase to
banks typically decrease nominal interest rates by three unsustainable deficits and debt levels. Discretionary fiscal
to five percentage points in response to contractions. policy may also prove inflationary or it may crowd out
In recent years this is not possible in many countries private investment. Of course, with real interest rates so
because nominal interest rates are already below 5%. low, debt is not very costly.
On the other hand, the long time lags that characterize Policymakers are aware though that the need for
expansionary discretionary fiscal policy may be a problem discretionary fiscal policy is the greatest when an
and may even worsen macroeconomic fluctuations. This is economy experiences extraordinary shocks not as a
why policymakers are seriously considering relying more result of cyclical economic conditions but as a result of
on automatic stabilizers. exceptional circumstances. Its potency in such conditions
Policymakers consider fiscal policy better equipped than was manifested at the outset of the Covid-19 crisis, as we
monetary policy to prevent rising income inequality. saw with the example given earlier, when governments
Spending can be targeted towards regions and industries implemented extraordinary emergency fiscal measures to
that are suffering more than others and tax cuts can be support economies.

Optional material example, if I earned from the government £100 pounds

Algebraically the following holds: for fixing a window in a government building and my MPC
is 0.8 then I will spend £80 pounds, say on luxury cakes
(1) ΔY = ΔG + bΔG + b2ΔG + b3ΔG + b4ΔG + … → that the baker Roxanne across the street baked. Now,
(2) ΔY = (1 + b + b2 + b3 + b4 + …) ΔG → income has increased by 180 and represents the service
(3) ΔY = x c1
1−b
ΔG → (window fixing) and the good (cakes) produced up to this
point. If Roxanne in turn spends 0.8 of her extra income
(4) ΔY = k ΔG, on say, cheddar cheese that Bob produces, then his income
where k is the multiplier will have increased by £64 pounds (this the third term,
b2ΔG) representing the extra cheddar produced. Up to this
Since b is the marginal propensity to consume (MPC)
point, national income has increased by 100 + 80 + 64 or,
domestic goods and services the multiplier k can be
generalizing, by ΔG + bΔG + b2ΔG. Bob will then spend a
rewritten as:
1 portion b of his extra income b2ΔG or, b3ΔG on some other
k=
(1 − MPC) goods, and so on.
In (1) the change in income ΔY is equal to the initial In (2) the term ΔG is factored out and it should be realized
change in government spending (ΔG) which workers earned that inside the parentheses we have the sum of infinite
and is the direct, first-round effect and the first term in the terms of a geometric progression that converges
equation. The second term (bΔG) is the proportion b of this 1
income that was spent on other domestic goods by these (as 0 < b < 1) to .
(1 − b)
workers and which is income to others in the economy. For

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 3.7 Supply-side policies
Supply-side policies focus on the production side of the Supply-side policies may be distinguished into market-based
economy. They attempt to enhance the institutional framework policies and interventionist policies. In the former, the role of
within which economic activity takes place, to increase the the government shrinks while the role of free markets expands.
quantity and improve the quality of the available factors of In the latter, the government takes on an active role in trying
production as well as to improve incentives. The goal is to to influence the productive capacity of the economy.
increase potential output shifting the long-run aggregate
supply (LRAS) curve to the right.

Goals of supply-side policies

• The primary goal of supply-side policies is to expand the labour market more flexible, permitting firms to hire more
productive capacity of the economy and accelerate long- workers. Profitability also increases, which is also hoped to
term growth. increase investment spending.
• Supply-side policies aim to increase the degree of • Supply-side policies aim to improve firms’ incentives to
competition in product markets. More competition leads to invest in new capacity and new innovative technologies.
lower prices, higher levels of output and improved efficiency. • Supply-side policies aim to help reduce the risk of inflation, thus
• Supply-side policies aim to reduce wage and non-wage improving the international competitiveness of domestic firms.
labour costs for firms. Lower labour costs render the

Market-based policies
Market-based supply-side policies were championed for many their monopoly power. In the USA, intervention by antitrust
years as the prime engine for economies to achieve long- authorities is only expected if firms’ behaviour harms the
term growth. The theory was that a shrunken government consumer (for example, only if it leads to higher prices). So, for
stimulates private investment and so stimulates growth. years the staggering growth of Amazon, Google and Facebook
After the 2008–09 global financial crisis, these policies have did not prompt any action in the USA despite the enormous
come under greater scrutiny, forcing even the IMF, an ardent market power these firms amassed. Only recently has there
early advocate of such policies, to recognize that the growth been some debate over the economic and even political risks
that resulted from adopting some of these policies proved of such market power; in September 2020 some US states
fragile and not sustainable. started investigations of these large tech companies. It is
Market-based supply-side policies can be distinguished also worth noting here that globalization has made it more
into product market related policies, labour market related difficult for policymakers to decide whether a large in size
policies and incentive-related policies. firm that results from a merger or an acquisition will abuse its
monopoly power because the relevant market may now extend
Product market related policies way beyond national borders.
Anti-monopoly regulation Deregulation
Monopoly power leads to higher prices, lower output, Regulations are rules, restrictions and laws imposed by
slower rates of innovation and increased income inequality. governments that aim to modify the behaviour of firms and
Governments try to limit monopoly power by establishing the operation of markets. Of course, markets could not function
competition commissions and passing antitrust laws. effectively without numerous regulations. The challenge
Competition commissions have been vigilant in detecting is to devise regulations that improve the functioning of
collusive agreements and other anti-competitive practices markets. Often, regulations have been introduced as a result
and have also blocked certain mergers and acquisitions. The of political pressure by special interest groups that aim to
interpretation, though, of what kind of behaviour should shield specific industries from competition or ensure that they
be regulated differs over time and between countries. For enjoy preferential treatment in the form of guaranteed prices,
example, since the 1980s the USA has taken a much more subsidies and so on. A different set of regulations, such as
permissive pro-business hands-off approach compared to environmental or health and safety regulations, aim to promote
the EU and other countries. The EU tries to prevent mergers social objectives when free markets fail to deliver.
and acquisitions that would allow a firm to grow excessively Deregulation refers to the process of dismantling or relaxing
and strengthen its monopoly position. It has blocked inappropriate rules, restrictions and laws in the operation
several mega-mergers such as the one between German of firms or markets. Many industries in many countries
Siemens and French Alstom in the railway equipment and including the airline industry, trucking, banking, electricity,
infrastructure market. It has also imposed significant fines on communications and others have been, in the past 40 years,
tech giants such as Google and Facebook for abusing

132
deregulated. For example, in Greece the trucking industry has • many regulatory health and safety barriers (that

UNIT 3: MACROECONOMICS
recently been deregulated. Special licenses were required to purportedly protect consumers but in reality often only
start and operate a trucking firm to transport goods. For very protect domestic firms from foreign competition).
many years the government succumbed to special interests If trade is liberalized, then domestic firms with monopoly
and issued no new licences. The result was that a scarce power immediately face competition from foreign producers.
licence could only be secured for more than €300,000, To survive, they have to cut costs, to lower prices and to
increasing the cost of transporting everything in the country. invest in innovation, stimulating growth. Trade liberalization
The OECD identified 555 regulatory restrictions in Greece has lately been accused of displacing domestic labour as
that were considered to harm competition. Deregulation it has, in some cases, forced many smaller domestic firms
thus benefits competition and consumers if entry barriers to shut down and exit the market. As a result, some world
are removed and prices are determined by market forces. markets are now dominated by a few large firms with very
Deregulation also decreases the costs that burden firms. More significant market power. Prices are higher than the expected
competition, greater levels of efficiency, and fewer costly competitive ideal and income inequality has increased.
rules and restrictions to comply with effectively shift both
the SRAS and the LRAS curves to the right. Of course, not all Labour market related policies
deregulation has been successful. The deregulation of the Reducing the power of labour unions
US financial and banking industry has been considered by
Labour unions have historically been successful in achieving
several economists as the root cause of the 2008–09 global
higher money wages for their members. This implies higher
financial crisis. The deregulation of electricity companies in
wage costs, so higher production costs for firms. By reducing
California has also been severely criticized as suppliers were
labour unions’ power, money wages and production costs
accused of deliberately limiting capacity, building investments
decrease, permitting firms to reduce prices, expand output and
to restrict supply artificially and steeply increase prices
hire more labour. Low labour union power in a country may also
charged to consumers. The rolling back or elimination of many
attract more inflows of foreign direct investment (FDI). On the
environmental regulations in the USA under President Trump
other hand, it is argued that labour unions are necessary for
is considered by many to have increased the risks of global
several reasons. They ensure that safety and other regulations
warming and climate change.
in the workplace are enforced; they protect workers from sexual
Privatization and other types of harassment by some employers as well as
Privatization refers to the transfer of state-owned assets, against unlawful firing; and, if labour unions are abolished, the
usually enterprises, to the private sector. Many firms in share of wages in national income decreases.
many countries up until the 1980s were nationalized. Since Decreasing or even abolishing the
then extensive privatization has taken place. Examples of
minimum wage
privatized firms include utilities (water, electricity), telecoms,
railways, steel, coal, airlines, airports, harbours, gas, oil and A high minimum wage increases the cost of hiring so demand
others. The logic is simple. Private owners of firms aim to for labour shrinks and unemployment rises. A lower or no
make profits so they have the incentive to operate more minimum wage decreases production costs and induces
efficiently by cutting costs and to try harder to meet the lower prices, an increase in output and perhaps more
needs of consumers. Privately owned firms are also more investment. On the other hand, several studies have shown
likely to introduce new technologies. Critics claim that often that reasonable increases in the minimum wage have not led
a private monopoly simply replaced a state monopoly; to higher unemployment and have even contributed to higher
that privatized firms led to higher prices and reduced labour productivity as a result of greater job satisfaction.
employment as they often fired workers in their attempt Reducing non-wage labour costs
to cut costs; or that the services provided were of inferior Non-wage labour costs typically include employer
quality. The evidence from the privatization experience contributions to national insurance and pension schemes
of many countries does not suggest that state-owned for their employees. By decreasing these, production costs
enterprises are necessarily inefficient or that privatized firms decrease, permitting firms to reduce prices and increase
are necessarily more efficient. Performance of privatized firms output. On the other hand, workers’ disposable income
has been mixed. Much depends on the specifics of each case. decreases, which may prove devastating for unskilled labour,
Trade liberalization especially if minimum wage laws are also abolished.
A very fast way to unleash the power of markets and to Decreasing unemployment benefits
increase competition and efficiency, forcing domestic firms to If a government offers high unemployment benefits compared
cut costs and improve quality, is through trade liberalization. to the average wage earned this reduces the incentive of an
The term refers to the elimination of policies that protect unemployed individual to accept a job offer. If the replacement
domestic firms from foreign competition. Such policies include: ratio, the ratio of unemployment benefits to wage earned,
• tariffs (which are nothing but taxes on imports) is high, the probability of accepting the first job offer made
• quotas (which are restrictions on the volume of imports available is low. Decreasing the size, but also the duration
allowed into the country) of unemployment benefits paid, increases the probability of
unemployed individuals accepting a job offer, decreasing
• subsidies (that artificially lower production costs and
unemployment and increasing aggregate supply. However,
render domestic firms more competitive)
workers may be forced to accept jobs that underutilize their
skills, which will damage economic efficiency.

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 Incentive-related policies economic growth, but they do increase income inequality,
Tax cuts are closely associated with a group of 1980s as it is the wealthy who mostly own such assets and so they
economists known as “supply-siders”. They believed that benefit disproportionately.
high tax rates on personal income and on corporate profits
discourage hard work and investments by individuals and Recap
firms respectively. Market-based supply-side policies
Cutting personal income taxes Product market related policies include:
Reducing personal income tax rates is expected to increase • increasing competition in product markets that
labour supply. As a result of lower personal income tax rates, would lower prices, increase output and spur
more individuals may decide to join the labour force; the innovation
unemployed may be less willing to remain unemployed given
• deregulation to open-up markets and decrease
a job offer; and workers may be incentivized to work longer
production costs for firms
hours. The increase in the factor of production labour will
increase the economy’s potential output, shifting the LRAS • privatization as the profit motive increases
curve to the right. On the other hand, the higher disposable efficiency
income that results from a tax cut may induce workers to • trade liberalization to expose domestic firms to
choose more leisure and less work so that the labour supply foreign competition.
does not increase. Labour market related policies include decreasing:
Cutting business taxes and the capital gains tax • the power of labour unions, to decrease the ability
Tax cuts on corporate profits increase profitability of of labour to raise wages
investments. More investments are expected and this will mean • the minimum wage (or even abolishing it), to
faster growth. The expected higher rate of investment in the decrease wage costs for firms
country will increase potential output and shift the LRAS curve
• non-wage labour costs to firms, to lower the cost of
to the right. However, the empirical evidence on corporate tax
labour
cuts suggests that in most, if not all, cases investment spending
did not in fact increase following a cut in corporate taxation. • unemployment benefits, to induce unemployed
workers to accept sooner job offers.
Capital gains are the profits an individual earns from selling
an asset at a higher price than it was purchased. It typically Incentive-related policies include decreasing:
applies to the sale of stocks, bonds and real estate. By • personal income taxes, to increase the incentive
cutting capital gains tax, investments in stocks, bonds and to work
real estate are encouraged. It is argued that a lower capital • business and capital gains tax, to increase the
gains tax will have a large beneficial effect on output, incentive to invest.
growth and entrepreneurial activity. Many empirical studies
conclude, however, that such cuts do not significantly boost

Interventionist supply-side policies

These policies include increased government spending on investments in education in East Asia increased the quantity
education and health care, on infrastructure and on research of education. The quality also improved and the gap
and development (R&D), as well as a separate class of between male and female enrollments closed very quickly.
policies referred to as “industrial policies”. These investments have paid off dramatically. The high
returns of education are also evident in the Scandinavian
Increasing public investments in education, countries where public spending on education are among
training and health care the highest in the world. Note also the value of various
The goal of such public investments is to increase the stock retraining programmes offered directly or indirectly by
of human capital of the economy. Human capital refers to governments and of lifelong learning programmes in
the education, training, skills and experience embodied decreasing structural unemployment.
in the labour force of a country. It is an intangible asset Public investments in health care also increase and improve
that increases labour productivity, employability and the stock of human capital of a nation. Better health-care
innovation. services and greater access to them also generate significant
Improving the quality of available education and training private and external benefits. Workers who are skilled and
and ensuring greater access to these improved services, healthy are more productive, and a more productive labour
especially access for the poor, has been documented to force accelerates growth.
significantly increase labour productivity and so potential
output and growth. Education generates not only significant
Public investment in infrastructure
private benefits for the educated but also very sizable Infrastructure is defined as physical capital, typically
external benefits for the economy as a whole. Massive financed by the state, that decreases the overall cost of

134
economic activity as it generates massive external benefits. for the productive capacity of an economy to increase. This

UNIT 3: MACROECONOMICS
A better road and rail network in a country does not group of policymakers considers market forces necessary
constrain firms to local inputs and local markets. It decreases but often inadequate to guide financial capital and
the cost of accessing from more distant locations the inputs investments to their most productive uses and so believe
that exactly meet their specifications. It helps them to that government is necessary to do the job and “pick
employ specialized labour based further from the firm. Most winners”. These are industries and firms that are thought to
importantly, a better transportation network permits firms to be crucial for long-term growth. Direct or indirect subsidies,
sell in more markets. Harbours and airports allow a country’s subsidized low interest loans, tax cuts and tax allowances,
firms to engage in international trade. Water, sanitation and joint public-private research programmes and protection from
sewerage networks improve water quality and the level of foreign competition are some of the measures employed.
health enjoyed by the population, increasing productivity. Typical examples of industries that have received or are
Power grids and telecommunication networks are crucial for receiving preferential treatment include the cement and
an economy’s growth. Electrification facilitates learning. It steel industries (as construction is considered an engine
permits access to information. Electrification also permits of growth for many economies), artificial intelligence and
refrigeration; the use of many time-saving appliances; it telecommunications, such as 5G technology (since in high-
supplies lighting that, for example, increases the degree tech it is often “winner takes all”). A more specific example
of safety enjoyed in towns and in driving; it permits the of successful industrial policy is the case of Hyundai in
operation of clinics and very many businesses that need South Korea where the government in the 1960s financed
uninterrupted power. A telecommunications network is its expansion into the shipbuilding industry only for South
crucial for all, but especially for businesses, as it enables Korea to become one of the world’s leading shipbuilders.
instantaneous access to necessary information related to Korea more generally successfully subsidized bank credit
their activities. Poor or crumbling infrastructure is considered and rationed it to sectors and firms that invested in strategic
a major obstacle to growth. Conversely, expanding and industries. Also, China’s manufacturing strength is not only
improved infrastructure raises potential output, shifting the the result of unconstrained market forces but also of active
LRAS curve to the right. government guidance.
It must also be acknowledged that despite the widespread
Public investment in research and use of industrial policies many have been regarded as
development (R&D) outright wasteful. Such waste is usually the result of political
Technological developments matter. Improvements in capture. The term refers to the case when industrial policies
technology are the most significant determinant of long- are captured by powerful business groups, closely linked to
term growth. Governments, in their attempt to increase the ruling party, who manage to tailor these policies to serve
the productive capacity of the economy, fund research and their own narrow business interests instead of the country’s
development (R&D) projects. Public provision of basic R&D is long-term goals.
also responsible for significant spillover benefits that a private
firm would never be able to capture. This means that there Recap
is justification for an active role of the state. Markets alone
would lead to fewer R&D projects being undertaken, which Interventionist supply-side policies
implies a slower rate of technological progress. Governments These policies increase:
also provide incentives to private firms to invest R&D in the • public investment in infrastructure as infrastructure
form of subsidies, tax allowances and patents granted for new decreases the overall cost of economic activity
products and new processes developed. Labour productivity
• public investment in education and health care
does not only depend on the level of human capital of
as the increased human capital increases labour
the labour force but also on the quality and the level of
productivity
technology of the physical capital that workers use. It follows
that a faster rate of technological advancement will increase • public investment in R&D as labour productivity
labour productivity and so increase aggregate supply, shifting also depends on the technology embodied in the
an economy's LRAS curve to the right. economy’s stock of capital
• economic growth—industrial policies are used in
Industrial policies certain industries that are crucial for growth and may
Industrial policies are a separate category of supply-side benefit from preferential treatment by the state.
policies. Since they are highly interventionist, pro-market
economists and politicians, who often overstate what
markets alone can achieve and are critical of almost any Analysing the expected impact of supply-side
public action, consider them counterproductive. However, policies using a diagram
industrial policies have been adopted by most, if not all, The impact of successful supply-side policies, whether market-
economies at various degrees. They are still employed based or interventionist, can be illustrated using either
around the world, although few governments admit this. a Monetarist /New Classical diagram (Figure 3.7.1) or a
Industrial policies are championed by policymakers who Keynesian diagram (Figure 3.7.2). In either case, you must
consider government intervention and guidance necessary

135
 shift the LRAS and the Keynesian AS curves to the right to Any impact on aggregate demand will of course be in the
show that potential (full employment) real output increases, short term whereas any impact on potential output and
from Yp to Y’p in the Monetarist /New Classical diagram aggregate supply will be in the long term. All interventionist
and from Yf to Y’f in the Keynesian diagram. In the supply-side policies that call for public investments in
Monetarist /New Classical diagram you could also shift the infrastructure, health care, education and R&D activities also
SRAS to the right to show the impact of lower production increase aggregate demand in the short term as these public
costs resulting from deregulation, increased labour market investments require increased government expenditures. In
flexibility and so on, but it is not necessary. addition, the tax cuts that aim at improving the incentive to
work and to invest increase aggregate demand. If personal
APL LRAS1 LRAS2 income taxes decrease, then households immediately
SRAS1 enjoy higher disposable incomes, leading to an increase in
consumption expenditures and thus an increase aggregate
SRAS2
demand, so the AD curve shifts right. Corporate tax cuts
may also increase aggregate demand if they manage to
increase investment expenditures, a component of aggregate
APL demand. In the long term, when the stock of capital of the
economy increases, then the LRAS curve will also shift right.

Supply-side effects of fiscal and

AD2
monetary policies
AD1 Fiscal policy is a demand-side policy, but an increase
in certain government expenditures will also produce
Yp Y’p rGDP a supply-side effect in the long term. In a recession, a
government may decide to increase spending in order
Figure 3.7.1 Impact of supply-side policies: Monetarist/New Classical to increase aggregate demand. If this spending is on
diagram infrastructure, health care, education and R&D, not only
will aggregate demand increase, but in the long term,
APL AS AS’ aggregate supply and potential output will also increase.
In fact, during a deep recession when interest rates are
low, increased spending on expanding or improving
infrastructure is often undertaken, as borrowing to finance
these expenditures will be cheap. More jobs are created,
economic activity picks up and in the long term the
productive capacity of the economy also expands.
If a corporate tax cut succeeds in increasing investment
spending, aggregate demand will increase in the short term,
but since it leads to an increase in the stock of capital of
the economy, aggregate supply will also increase in the
long term. A cut in personal income taxes will increase
AD1 AD2
disposable income so, it is hoped, there will be an increase
Yf Y’f rGDP (Yr) in consumption and aggregate demand in the short term. If,
though, it increases the incentive to work, then the labour
Figure 3.7.2 Impact of supply-side policies: Keynesian diagram supply will increase and so, in the long term, aggregate
supply will also increase.
You could also include an increase in aggregate demand
from AD1 to AD2. In such a case, you can illustrate that Lastly, if fiscal policy is prudent (meaning that budget
supply-side policies, by successfully increasing the productive deficits are low and the level of national debt is considered
capacity of the economy, decrease inflationary pressures sustainable), then businesses will feel less uncertain about
that any increase in aggregate demand would exert. In both the future. They will not fear a sudden acceleration of
diagrams above, the increase in aggregate demand did not inflation or a sudden increase in interest rates. They will be
result in any upward pressure on the average price level more willing to invest, which positively affects aggregate
because successful supply-side policies had managed to shift demand in the short term, but also the productive capacity
the AS curve to the right. of the economy (that is, aggregate supply) in the long
term. Also, if monetary policy is successful in maintaining
Demand-side effects of supply-side low and stable inflation, then the associated lower
policies economic uncertainty that firms enjoy may encourage more
investment, positively affecting aggregate demand, and, in
Supply-side policies do not only have an impact on
the long term, also aggregate supply.
aggregate supply. Many also increase aggregate demand.

136
Effectiveness of supply-side policies

UNIT 3: MACROECONOMICS
Strengths of market-based sustainable. The reason for this is that these policies
supply-side policies are considered an important contributing factor for the
observed increase in income inequality. Monopoly power
• A major advantage of market-based supply-side policies
and concentration has increased in many domestic and
is that resource allocation will theoretically be improved.
world markets as a result of deregulation, privatizations
Less interference by the state will permit prices to emit the
and the belief that markets should be unrestricted. Higher
correct signals to producers and consumers; if deregulation
concentration in markets has led to higher prices and so
opens up markets to greater competition and/or lowers
to a transfer of income from consumers to businesses. The
production costs, then prices charged will decrease and
benefits of tax cuts have accrued mostly to the wealthiest.
closer reflect marginal costs of production. Privatized firms
The increased labour market flexibility resulting from lower
will typically waste fewer scarce resources. Labour will
minimum wages, lower labour union power, lower job
become cheaper relative to capital, permitting firms to
security and lower unemployment benefits is responsible
choose the optimal combination of capital and labour for
for the shrinking share of wages in national income. It is
their production process.
now accepted by many policymakers that it is not just the
• Market-based supply-side policies aim to decrease the size of the pie that matters but also its distribution.
involvement of the government and increase the role
• Market-based supply-side policies also suffer from very long
of markets. As these policies do not rely on increased
time lags. The impact on the real economy of deregulating
government spending, they do not burden the expenditure
markets or any efficiency gains from privatizing a firm may
side of the government’s budget. In addition, tax cuts,
take years to materialize. Any beneficial consequences
according at least to their ardent supporters, “pay
resulting from rendering the labour market of a country
for themselves”. By this they mean that as tax cuts
more flexible also take time.
theoretically stimulate more work and more investments,
tax revenues will be higher despite the lower tax rates. • Not only is the impact of any successful market-based
Empirically though, this has not been the case. supply-side policy felt long after it is implemented but
vested interests in many countries have often managed
Strengths of interventionist to stall or even block efforts to privatize, to deregulate,
supply-side policies to liberalize trade or to render the labour market more
flexible. Politicians who are always apprehensive of the
• Interventionist supply-side policies directly target areas
possible political cost of any game-changing decisions
that are considered instrumental for accelerating long-
and who often rely on the support of large businesses
term growth of nations. Public investments in education
or powerful professional associations (such as those of
and health care, if properly designed and implemented,
lawyers, accountants, tax consultants, engineers and
will increase the stock of human capital of the economy.
architects) have in several countries proved to be unwilling
Quality education and health-care services accessed by all,
to push hard for such structural reforms. Organized
especially the poor, increase labour productivity and the
labour has also fought and often succeeded in stalling
income-earning capacity of all, permitting faster growth
or blocking labour market reforms that would hurt their
but also a more equitable income distribution. More and
interests. Market-based supply-side policies are very long-
better infrastructure directly increases the productive
term policies not only because once implemented it takes
capacity of an economy and indirectly permits business
time for them to have an impact on the economy but
to grow faster. Over the very long term, growth has mostly
also because vested interests in many countries stall their
been the result of better technology so the importance of
implementation.
public investment in R&D and government efforts to foster
private investment in R&D cannot be overstated. As an • Regulations, as explained earlier, also include
example, the development of the internet was a product of environment-related rules aimed at promoting social
publicly funded research by the US Defense department. objectives when free markets fail to deliver. It has also
been explained that such rules increase the cost of
Drawbacks of market-based doing business for firms. It follows that rolling back or
supply-side policies eliminating these rules will decrease production costs
for firms, leading to higher levels of output and lower
• Perhaps the biggest drawback of market-based supply-
prices. This may sound good, but there may be significant
side policies is that they have led to increased income
drawbacks involved, which, if taken into consideration,
inequality. Even the IMF, which for decades championed
render deregulation in such circumstances undesirable. For
deregulation, reducing barriers to entry in product
example, recent deregulation initiatives taken in the USA
markets, privatization, trade liberalization and increased
to relax or eliminate environmental rules may negatively
labour market flexibility, has questions about these
impact the environment in the future. In March 2020,
policies. The IMF has acknowledged that despite empirical
the US revised standards for average fuel economy in
evidence that the policies have indeed been successful in
cars and for carbon dioxide emissions, making them less
accelerating economic growth, it now questions whether
strict, so less costly, for US car manufacturers. The new less
they alone can achieve “sustained” growth. There is
stringent rules will lead though to roughly an additional
now mounting evidence that the growth resulting from
2.0 billion barrels of fuel consumed and 900 more million
market-based supply-side policies proved fragile and not

137
 metric tons of carbon dioxide emitted, compared to earlier now, since interest rates in many countries are at
standards. Many other examples of similar deregulation historically low levels.
initiatives have been passed in other countries.
• Supply-side policies suffer from very long time lags.
Drawbacks of interventionist Interventionist supply-side policies may have a short-term
supply-side policies impact on aggregate demand, reflecting the increase in
government expenditures, but any impact on supply will
• A major issue with interventionist supply-side policies
take a very long time to manifest itself.
is that they need to be financed. The monetary cost of
revamping or expanding the infrastructure of a country is − Infrastructure takes a very long time to build and
a huge government expenditure. Even modest attempts to complete.
finance increased education, health-care services and R&D − Public investment in education that permits access to
efforts need money. It follows that to fund improvement or schools to all children takes even longer to show results.
expansion of infrastructure the government would have to − Technological breakthroughs are uncertain and also
increase taxes or resort to increased borrowing. Increased take a long time to achieve.
taxes are, in general, not politically popular, even if the
− The benefits of improved health for the population are
increased taxes are taxes that aim to decrease the use of
also manifested in the long term.
fossil fuels. Typically, governments resort to borrowing.
In order to minimize the cost of borrowing, interest rates − Industrial policies are also, by definition, very long-term
must be very low. This is why many economists are urging policies as their goal is to influence the structure of
governments to improve or expand infrastructure, as well markets and of the economy.
as to embark on human capital augmenting investments

Recap
Effectiveness of market-based supply-side policies
Strengths of market-based supply-side policies are that Drawbacks of market-based supply-side policies are
they involve: that they involve:
• improved resource allocation • increased income inequality
• minimal burden on the government’s budget. • very long time lags
• vested interests that may stall or even block their
implementation
• deregulation of environmental rules that may worsen
pollution and accelerate climate change.
Effectiveness of interventionist supply-side policies
Strengths of interventionist supply-side policies are that Drawbacks of interventionist supply-side policies are
they are targeted to: that they involve:
• factors critical for accelerating growth (infrastructure, • costly financing, adding to the national debt
human capital, R&D) • very long time lags.
• industries considered critical to drive growth.

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 3.8 Macroeconomic policies—strengths,

UNIT 3: MACROECONOMICS
limitations and conflicts
Macroeconomic objectives
The toolbox that policymakers can use in order to manage has certain advantages and certain disadvantages. Often
the economy and achieve their macroeconomic objectives though, to achieve one goal, another goal may be sacrificed.
includes fiscal policy, monetary policy and supply-side In this section we examine these issues.
policies. Depending on the issue faced, each of these policies

Growth
Fiscal policy HL
• Since an increase in government expenditures (G) and/or
a decrease in (direct) taxes (T) will increase aggregate In addition, an increase in government expenditures
demand, it follows that expansionary fiscal policy can will lead to a greater increase in aggregate demand
promote growth. Remember that an economy is growing if and thus in real GDP because of the multiplier. In
real GDP is increasing. other words, expansionary fiscal policy in the form of
• Since fiscal policy is characterized by long time lags, increased government expenditures may prove to be
expansionary fiscal policy is typically not used if an a very potent tool.
economy is on the verge of entering recession (in other
words, if growth is decreasing and close to 0%) or is − Increased government expenditures can be targeted to
already experiencing a mild recession. Any increase in specific geographical areas of the country suffering the
government spending will take a long time to have an most or towards sectors of the economy that are hit the
effect. It may destabilize the economy and risk creating hardest by the crisis.
an inflationary gap if, by the time of impact, it has − By increasing and expanding unemployment benefits,
already entered the recovery phase. Governments also fiscal policy can minimize the hardship felt by the
avoid making frequent changes in their tax system as this vulnerable who lose their jobs. The poor typically spend
creates uncertainty to households and businesses. a large proportion of any additional income leading to
a significant increase in aggregate demand.
HL
• In contrast, in a deep recession a tax cut, even if
Automatic stabilizers may have disadvantages implemented, will probably not achieve much. The reason
but if they are significant in size, they may prove is that households will prefer to save instead of spending
very helpful to rekindle growth in a weakening the resulting increase in their disposable income. Consumer
economy. Since the increase in government confidence in a deep recession is low and workers fear that
expenditures and the decrease in personal taxes they may lose their job. Also, the theoretically presumed
are applied automatically, time lags are much increase in labour supply and so in aggregate supply has
shorter, increasing their effectiveness. This is why had only very weak empirical support.
policymakers are considering increasing the size • Increased government spending on infrastructure,
and scope of automatic stabilizers, especially since education, health care and R&D will, as explained,
the effectiveness of easier monetary policy is now not only increase aggregate demand (so that real GDP
debatable because of the zero lower bound (ZLB) increases) but will also increase potential output, over the
problem explained earlier (see section 3.5, page 114). long term shifting the AS curve to the right. The economy
will not only achieve actual growth in the short term but
• If an economy is in a deep recession or, if there is also higher potential growth in the long term.
significant risk of entering a deep recession (as was the • Prudent fiscal policy implies that budget deficits are kept
case when Covid-19 forced lockdowns in many countries) low and that the government (national) debt is considered
then expansionary fiscal policy in the form of increased sustainable. If fiscal policy is considered prudent then
government expenditures is for many reasons the policy entrepreneurs will consider the risk of sudden inflation
of choice. or of a sudden increase in interest rates low, leading to a
− First, increasing government expenditures is direct. If higher rate of investment and faster long-term growth.
government expenditures increase, then automatically, • Increased government expenditures to achieve or
aggregate demand increases: government expenditures accelerate growth require financing. There are three
(G) is a component of aggregate demand (AD). The choices. The government can increase taxes (direct
increase in aggregate demand leads to an increase in and/or indirect) now, it can borrow now and tax later
economic activity and thus of real GDP.

139
 or it can lower spending elsewhere. Increasing taxes • If the central bank of a country is successful in achieving
and cutting back on other government projects are low and stable inflation over long periods of time, then
both politically unpopular choices—so, usually such the resulting decrease in business uncertainty may induce
government expenditures are financed by borrowing. a higher rate of investment and faster long-term growth.
Borrowing, though, increases the budget deficit and adds
to the national debt. It is therefore preferable to initiate Supply-side policies
such public investments when interest rates are low and • Supply-side policies aim at expanding the productive
inflation is below the target 2% rate. The resulting faster capacity of an economy. As such they are the principal tool
growth will lead to increased tax revenues which may be policymakers employ to achieve or accelerate long-term
sufficient to pay off the increased level of debt. growth.
Monetary policy • The significance of public investments in infrastructure,
education, health care and R&D is enormous, as
• Since a decrease in interest rates will increase aggregate
the experience of all countries has demonstrated.
demand and thus real GDP, it follows that easy monetary
Interventionist supply-side policies can and have helped
policy can promote growth.
nations achieve and also accelerate growth.
• Monetary policy has several advantages over fiscal
• Despite their role in achieving and accelerating growth, it
policy as a short-run stabilization tool. Monetary policy
must be noted that not all such expenditures are effective.
is flexible, incremental, reversible and it has shorter time
Many infrastructure projects in developing and advanced
lags compared to fiscal policy. It follows that if growth
nations proved wasteful. The returns to investments in
is weakening and there is risk of entering recession or
education and health care that were not correctly targeted
if an economy has already entered a mild recession,
may also prove meagre. Building a bridge to nowhere or
policymakers will usually prefer to use easier monetary
a school without teachers or students will not help a
policy. It is said that monetary policy is the “first
country grow.
responder”. Lower interest rates in such a case will induce
more borrowing and more spending by households and • Industrial policies have also been successful in many
perhaps by firms while the weakening (depreciation) of cases in transforming economies and setting them on a
the currency will render exports cheaper and thus more successful growth path. China is the best example. The
competitive abroad and imports pricier and less attractive perceived economic threat from China perhaps
domestically. As consumer expenditures, investment also explains recent discussions for a new industrial
expenditures and net exports will all tend to increase, policy in the USA and in Europe. Still, success of
aggregate demand will also increase, lifting the economy industrial polices is not guaranteed. In many countries,
from recession. special interests have been able to secure preferential
treatment by government officials that did not lead to
• If interest rates are very close to zero, there is little room
economy-wide benefits but only to higher guaranteed
for central banks to decrease them. Thus, the ability of
profits for the protected industry and a waste of
monetary policy to fight a recession and stimulate growth
government funds.
is limited. Central banks will lack the ammunition needed
to stimulate economic activity. • Market-based supply-side policies were considered for
many decades as the winning recipe to boost economic
• In a deep recession with cyclical unemployment rising
growth over the long term. The idea was that decreasing
and firms shutting down, even if the central bank has
the role of the government and unleashing market forces
room to cut the interest rate significantly, it is unlikely
guaranteed growth. Recent empirical work has questioned
that such a decrease will be able to induce more spending
the effectiveness of such policies as it has been pointed
by households and firms. Low levels of confidence will
out that any resulting growth was not inclusive, so it was
discourage increased borrowing and spending. In a deep
fragile. In economies with widening income inequality,
recession, policymakers are therefore more likely to resort
there is less support by the poor for the, often painful,
to expansionary fiscal policy in the form of increased
policies necessary to fight-off unfavourable economic
government spending to encourage growth than to looser
setbacks because they fear that they will not enjoy any
monetary policy or even a tax cut.
of the benefits.
• Very low interest rates (the zero-lower bound or ZLB
problem) have forced several central banks to adopt Key issues
massive quantitative easing programmes to support To accelerate long-term growth, interventionist and market-
bank lending and to boost the economy. Some have even based supply-side policies are the primary policy choice. Each
pushed short-term interest rates slightly below zero to set has its advantages and disadvantages. On the other
provide a further boost to growth. The consensus on the hand, to increase real GDP over the short term, expansionary
effectiveness of such policies to stimulate growth is mixed. demand-side policies are employed. Easy monetary policy
Significantly negative interest rates are also difficult for is usually adopted to avoid a recession. Expansionary fiscal
central banks to implement since earning zero interest by policy in the form of increased government spending is
holding cash is preferable for savers to earning negative advised if the economy is stuck in a deep recession when
rates. confidence levels are very low.

140
Price stability

UNIT 3: MACROECONOMICS
Fiscal policy This is not true. First, the distinction between demand-
• To decrease inflation, contractionary demand-side policies pull and cost-push inflation is often vague. If money
are needed. Contractionary fiscal policy involves a wages are rising, is it demand-pull or cost-push inflation?
decrease in government expenditures and/or an increase For analytical purposes it may be important to make the
in (direct) taxes. Contractionary fiscal policy will therefore distinction but for policy purposes it is typically not that
decrease aggregate demand and it could decrease significant. No matter what the fundamental cause of any
inflation. In most real-world cases though, policymakers inflationary pressures arising in an economy, policymakers
avoid using contractionary fiscal policy to fight inflation. always respond with tighter monetary policy.
One reason is that the responsibility for price stability lies Interventionist supply-side policies are not appropriate
with central banks, which are in charge of monetary policy. because the necessary increase in government
In addition, monetary policy has significant advantages expenditures and resulting increase in aggregate demand
compared to fiscal policy. It is flexible, incremental, would only add to inflationary pressures. Market-based
reversible and has shorter time lags. supply-side policies are also never considered as it
• However, if inflation is the result of past profligate has been established that they are usually difficult to
government spending then policymakers will complement implement because of vested interests and they also have
tighter monetary policy with contractionary fiscal policy. very long time lags. By the time they manage to increase
The result will be decreased government expenditures and, the productive capacity of the economy, inflation will
perhaps, increased taxes, dealing with the fundamental have risen massively and inflationary expectations will
cause of the inflationary pressures. be entrenched in the decisions of both workers and firms,
creating further inflationary pressures.
• Remember that if an economy is approaching its
potential (full employment) level of real output, then Supply-side policies can help keep inflation stable over
expansionary fiscal policy risks proving inflationary so it the long term only in the sense that if they are successful
should be avoided. The problem is that it is not always and manage to shift the LRAS curve to the right then the
easy for policymakers to know whether the economy is economy can withstand increases in aggregate demand
approaching its potential level of real output. They cannot without any upward pressure on prices (see section 3.7,
be sure how low unemployment can decrease as the Figures 3.7.1 and 3.7.2).
natural rate of unemployment (NRU) is not fixed through • Monetary policy is considered ineffective to deal with
time. So, there is risk that expansionary fiscal policy will deflation. The reason is that if there is risk of deflation in
generate inflation. an economy, interest rates are already very low, close to
• In an economy suffering from deflation policymakers have zero. In this case, monetary policy faces the zero lower
resorted to expansionary fiscal policy increasing, often bound (ZLB) constraint. Nominal interest rates cannot be
dramatically, government expenditures to boost aggregate negative. Many central banks have adopted quantitative
demand and help the economy exit the deflationary spiral. easing programmes with mixed success. A few have even
A good example is Japan. Remember that if an economy is experimented with mildly negative interest rates. The need
suffering from deflation, then interest rates are very close to implement significantly negative interest rates may
to zero so there is not much room for the central bank to soon become clear in many economies.
decrease interest rates further. Supply-side policies
Monetary policy • One of the goals of supply-side policies is to help reduce
• If inflationary pressures are building up in an economy, the risk of inflation, thus improving the international
tighter monetary policy is the “first responder”. When competitiveness of domestic firms. This should not
an economy is overheating and policymakers fear that be misinterpreted. It does not mean that supply-side
inflation is an approaching threat, or if an economy is polices are appropriate to fight inflationary pressures.
already suffering from inflation, then policymakers always Even if there is cost-push inflation, policymakers will still
resort to tighter monetary policy and increase interest employ tighter monetary policy to get inflation under
rates. There are many reasons for this. First, it is the control because supply-side policies are characterized
central bank that is responsible for price stability, and by very long time lags. Inflationary expectations cannot
central banks are in charge of monetary policy. Central become entrenched because if workers and firms expect
bank committees meet often to decide on the appropriate that inflation will continue in the next period they will
level of interest rates, usually every few weeks. They can demand higher wages and prices now, further increasing
increase interest rates by 0.25% at a time so that any inflationary pressures.
change in monetary policy is gradual. If necessary, they • On the other hand, successful supply-side policies that
can reverse their decision in the next meeting. They do not render product markets more competitive, labour markets
fear the political cost of slowing down the economy. Lastly, more flexible and increase the productive capacity of
the associated time lags are shorter. the economy help in reducing the risk of inflation. Of
• What if inflation is not demand-pull but cost-push course, this helps domestic firms maintain or improve their
inflation? Many erroneously claim that in such a case international competitiveness.
supply-side policies are necessary as a policy response.

141
 Key issues side policies are only useful over the long term to help an
Policymakers always use tight monetary policy to economy maintain price stability if aggregate demand is
decrease inflation or to cool off an overheating economy. increasing and to help domestic firms maintain or improve
Contractionary fiscal policy is adopted if inflation is the their international competitiveness.
result of past excessive government spending. Supply-

Low unemployment
The decision on which policy is appropriate to decrease • To decrease structural unemployment policymakers must
unemployment depends on the type of unemployment the try to equip the unemployed with the skills that firms
policymaker faces. demand. The government:
− can and should provide lifelong training and retraining
Fiscal policy opportunities to labour
• Expansionary fiscal policy is the best policy to use if
− could provide incentives to firms to hire and train long-
unemployment is cyclical and the recession faced is deep.
term unemployed individuals
Cyclical unemployment is the result of aggregate demand
decreasing. It follows that expansionary demand-side − could provide subsidized loans so that the unemployed,
policies are needed that will manage to increase aggregate especially if young, can afford to enroll in training
demand so that the resulting higher level of economic seminars that would equip them with the skills
activity induces firms to expand and hire more labour. employers demand
Demand-side policies include both easy monetary policy − could also provide subsidized loans so that the
and expansionary fiscal policy. In a deep recession, though, unemployed can afford to relocate to areas with jobs
expansionary monetary policy may be ineffective. Low that require the skills they possess.
business and consumer confidence may discourage firms Most of these initiatives are costly to the state but if
and households from borrowing more and spending more. properly designed their expected private and social
Also, the zero lower bound (ZLB) constraint applies: if benefits exceed the financing costs.
interest rates are already very low and close to zero, there • If structural unemployment is the result of labour market
is little room, if any, for the central bank to decrease the rigidities, then market-based supply-side policies that aim
cost of borrowing. On the other hand, expansionary fiscal to decrease or eliminate these rigidities are appropriate.
policy in the form of increased government expenditures is A flexible labour market is one that adjusts easily to
effective as it is direct. If government expenditures increase, changing labour market conditions. Typical supply-side
aggregate demand will increase. The operation of the policies to decrease structural unemployment resulting
multiplier effect (HL) can boost the increase in aggregate from a rigid labour market include decreasing:
demand even more. − the minimum wage (or even eliminating it)
• Since structural unemployment is not the result of − non-wage labour costs, such as national insurance
insufficient aggregate demand, fiscal policy is not relevant. contributions that employers pay for their workers
Monetary policy − the degree of job security that workers enjoy
• If unemployment is cyclical policymakers can use loose − the power of labour unions.
monetary policy, decreasing interest rates so that All these policies aim to decrease labour costs for firms
households and firms borrow more and spend more. If so that they have an incentive to hire more workers and
the recession is mild and cyclical unemployment is slowly produce more. In addition, in some countries, governments
rising then expansionary monetary policy is preferable. The have decreased unemployment benefits so that the
reasons are clear. Fiscal policy has longer time lags, which unemployed are forced to accept a job offer. However, all
may destabilize the economy whereas monetary policy is of these policies have suppressed wages and decreased
flexible, incremental and reversible. the disposable income of labour, so they have contributed
• Since structural unemployment is not the result of to the observed rising income inequality in many
insufficient aggregate demand, monetary policy is countries.
not relevant. • Note that if these policies are successful in decreasing
structural unemployment, they also lower the natural rate
Supply-side policies of unemployment (NRU) as structural unemployment is
• Supply-side policies are required if unemployment is the the most significant type of unemployment included in the
result of a mismatch between the skills of the unemployed NRU.
and the skills that firms demand, or if it is the result of • What about seasonal unemployment? It may come as a
labour market rigidities. Structural unemployment is the surprise, but governments do virtually nothing to decrease
unemployment that persists way past recovery—so it is not seasonal unemployment. The construction worker who
a result of insufficient aggregate demand. Policies aiming is out of work because of freezing temperatures may
to increase aggregate demand are not appropriate to deal only wait for a week or so for temperatures to rise while
with structural unemployment

142
 collecting unemployment benefits. The farm workers gym as a trainer for the rest of the year, so this is hardly a

UNIT 3: MACROECONOMICS
in rural areas who are out of work because the farm case of seasonal unemployment.
is between crops just wait for the next crop and in the • What about frictional unemployment? This type of
meantime collect unemployment benefits. If every June unemployment is the result of people constantly trying to
unemployment statistics surge in many countries because find a better job or to live in a better place. So, the only
of high school and college graduations, there is clearly thing that can be done is to ensure that more and better
not much for a government to do. The only thing that labour market related information is quickly accessible to
governments do for seasonal unemployment is to adjust labour market participants. Government internet sites with
monthly unemployment statistics seasonally. As for the listings of vacancies and of availabilities are extremely
snow ski instructor, for example, he or she is usually a useful in reducing frictional unemployment and so is
water ski instructor during the summer and works at a LinkedIn and other such specialized sites.

Potential conflict between macroeconomic objectives

Low unemployment and low inflation curve begins to slope upwards as a result of “bottlenecks”
It should be easy to realize that if policymakers increase arising in the economy. As explained in section 3.2, as
aggregate demand though expansionary fiscal and/or aggregate demand rises not all sectors and industries reach
easy monetary policies to try to achieve lower full employment simultaneously. Capacity constraints (the
unemployment, then there is risk of higher inflation. If they “bottlenecks”) are responsible for any inflationary pressures
try to lower inflation through tight monetary policy and/ showing up in an economy as it grows.
or contractionary fiscal policy, then there is risk of (cyclical) The closer an economy is operating to potential
unemployment increasing. It seems difficult to achieve (full employment) output, the more inflationary any
low unemployment and low inflation. There seems to be a further economic growth will prove. Again, the problem for
conflict in achieving both policy objectives. policymakers is that they do not know in advance whether
Assuming that an economy is facing an upward sloping any further growth will lead to an acceleration of inflation.
Monetarist SRAS curve or that it is operating in the middle How much can they encourage growth and decrease
upward sloping section of a Keynesian AS curve. It becomes unemployment before there is pressure on wages and on
apparent that an increase in aggregate demand as a result prices to rise?
of expansionary policies will increase economic activity (real Once again, the problem policymakers face is that
GDP) and decrease unemployment but it will also increase the country’s NRU can only be estimated with limited
prices (that is, it will generate inflation). This conflict is confidence. Since it may have decreased, they cannot know
reflected in the (short-run) Phillips curve (HL). beforehand what its level is. Only after inflation has started
Is this conflict unavoidable? The recent path of several to accelerate will they know that they had pushed growth
economies following the 2008–09 global financial crisis too far and decreased unemployment below its natural rate.
suggests that it is not. At this time, unemployment in On the other hand, if policymakers prematurely tighten
many countries had been decreasing, often at historically monetary policy to avoid the possibility of inflation
low levels, without inflation accelerating. In the USA accelerating, they may succeed in keeping inflation very low
unemployment had fallen below 4%, which is lower (perhaps even lower than the common 2% target) but they
than what economists considered the natural rate of will have inadvertently condemned very many individuals to
unemployment (NRU) for the country without any increase remain unemployed for longer. It may have been the case
in wages or inflation. There are several explanations for that the economy could have continued to grow so that they
this (see section 3.3, page 84). In any case though, the also found a job without inflation rising.
consensus is that typically there is an inverse relationship The role of successful supply-side polices should be noted.
between inflation and unemployment. Whenever an Successful supply-side policies permit an economy to grow
economy is expanding and unemployment decreases below without experiencing inflationary pressures. If the productive
the NRU, inflation will accelerate. Some research examining capacity of an economy is increasing and its LRAS curve is
historical data suggests though that for inflation to start shifting to the right, then increases in aggregate demand
to accelerate unemployment must fall more than one will not lead to a rising price level.
percentage point below the country’s NRU. The issue Lastly, it is worth noting that inflation has not been a
becomes more complicated once it is realized that the NRU serious issue for most economies for more than a decade.
is not constant and may decrease. Policymakers therefore For example, since 2000, the inflation rate in the USA has
remain vigilant. never been higher than 4%. Very many countries are even
struggling to increase inflation to meet the common 2%
High economic growth and low inflation
target. The world is more concerned with the risk of deflation
Perhaps the easiest way to illustrate the possible conflict and of very slow long-term growth.
between achieving higher growth and maintaining low
inflation is to use a Keynesian AS curve. The Keynesian AS

143
 High economic growth and environmental High economic growth and equity
sustainability in income distribution
Economic growth can have both positive and negative Economic growth can both improve and worsen income
effects on the environment. distribution.
The possible benefits can be understood through the Growth can alleviate income inequality as it permits a
environmental Kuznets curve (see section 3.3, page 87). The redistribution of income from the wealthy to the poor.
basic idea is that as countries grow and per capita incomes Redistribution can be direct, through governments
increase, pollution initially rises and then, after some critical establishing or improving and expanding a social welfare net
level of per capita income, it decreases. This implies that such as pensions and unemployment benefits, but it can also
economic growth can eventually lead to environmental be indirect, through spending on programmes to alleviate
improvement and thereby become sustainable. poverty. These programmes may seek to increase agricultural
The issue is that economic growth not only requires the use productivity. They may also improve sanitation and basic
of natural resources and the depletion of common access infrastructure, as well as health and education facilities that
resources but also leads to more emissions and wastes increase human capital and labour productivity.
that may exceed the Earth’s carrying capacity. Growth may However, economic growth often leads to higher income
therefore be unsustainable. The environmental Kuznets inequality. In fact, income inequality has been increasing
curve provides an optimistic view but it may only hold for in many growing economies. This is because there is
local externalities and not for many dispersed externalities no guarantee that the benefits of growth will be fairly
such as carbon emissions. Nevertheless, a reduction in the distributed. If growth is driven by only a handful of
production of pollution-intensive goods and a turn towards industries, if it is concentrated in certain regions, if it relies
less pollution-intensive production technologies may allow only on certain skills or if it is jobless, then many will be left
for more sustainable growth. out and inequality in the country may widen.
In addition, to avoid “futureless” growth, governments Lastly, if growth is non-inclusive and its benefits remain with
should stop subsidizing use of fossil fuels or activities such the wealthiest then growth will be less resilient. This means
as fishing that deplete common pool resources that it is how the benefits from growth are distributed that
(see section 2.8). Governments should also adopt and will ultimately determine whether the growth will last. In
enforce stricter environmental regulations. Carbon taxes an unequal society necessary policies to revive the economy
as well as the broader adoption of cap and trade schemes may not gain enough support since the long-term benefits
may also help towards more sustainable economic will not be uniformly shared.
growth. Lastly, investments in green technologies are also
necessary, together with subsidies to firms that adopt clean
technologies.

144
 4.1 Benefits of international trade

UNIT 4: THE GLOBAL ECONOMY

International trade refers to the buying and selling of imports over GDP, world trade has increased from about
goods and services across borders. The goods and services a 27% in 1970 to about 60% in 2018. Perhaps the most
country sells to other countries are referred to as exports (X). important reason for this growth is that restrictions to the
The the goods and services a country buys from other free flow of goods and services between countries (free
countries are referred to as imports (M). The importance trade) have decreased dramatically. What are the possible
of trade in the world has grown dramatically over the past benefits for countries engaging in free trade?
decades. Examining the ratio of the sum of exports and

Benefits of free trade

• Free trade permits specialization. The scarce resources
of a country will specialize in the production of a Recap
range of goods and services, leading to higher levels
of output and higher possible levels of consumption. A Benefits of free trade
country engaging in international trade can consume Free trade:
combinations of goods and services outside its production • permits specialization of resources increasing output
possibilities curve (PPC). and levels of consumption
• Free trade and specialization improve the allocation of • improves the allocation of resources
scarce resources within an economy and in the world. • increases competition, lowering domestic monopoly
• Free trade automatically decreases any monopoly power power
that domestic firms may possess. All the benefits of • leads to lower prices and improved quality
increased competition will follow.
• forces firms to cut waste and become more efficient
— More competition leads to lower prices for buyers and • may induce domestic firms to grow and achieve
improved product quality. economies of scale
— Increased competition as a result of free trade leads to • permits domestic firms to import capital goods that
greater efficiency in the use of resources as firms will meet exactly their specifications
be forced to cut costs. Firms cannot afford to waste
• presents consumers with greater variety
resources.
• permits technology and ideas to spread faster
— Firms will also be forced to innovate to withstand
competition from imports or to penetrate foreign • permits countries to acquire natural resources they
markets and export more. are not endowed with.
Most importantly, free trade stimulates faster growth.
• Free trade allows firms to grow in size since the market in
which they sell their products expands. This allows firms
exporting from small countries with small markets to Exports, imports and the welfare increase
benefit from economies of scale.
resulting from free trade
• Free trade allows firms to import and use capital
Figures 4.1.1a to 4.4.1c illustrate the quantity of exports, the
goods (machinery, equipment, tools and intermediate
quantity of imports and the increased welfare that results from
products) that meet much more closely their exact
free trade. We assume the market for corn, a homogeneous
specifications. This further increases their productivity
product sold in perfectly competitive markets. We further assume
and profitability.
that the country is “small”. In the context of international trade,
• Consumers enjoy a greater variety of goods and services to “small” means that the country can buy or sell as much of the
choose from due to free trade. product as it wants without the world price changing.
• Free trade enables faster transfer and diffusion of Price/unit Sd
technology across borders as technology is embodied in
traded capital goods.
• Natural resources are not distributed equally across countries.
Free trade allows countries to import and use natural Pd
resources, such as oil, that they may not have.
• The benefits of specialization and of more competition,
the faster diffusion of technology, the possibility of
economies of scale and the increased exports a country D
enjoys all allow faster growth. This is why trade is
Q Quantity/
referred to as an engine of economic growth. period
Figure 4.1.1a Closed economy—no trade; “autarky” case

145
 Price/unit Sd In Figure 4.1.1b we assume that the country is now an
open economy and that the price of corn in the world
market is higher at Pw. At the world price Pw domestic
Sw
Pw corn producers can sell as much as they want without
A B C affecting it (remember this is a “small” country). They face
Pd
the world price Pw at which they will be willing to offer
Q2 units. At that price, though, domestic consumers will
only be willing to buy Q1 units of corn. Domestic corn
producers will sell Q1 units in the domestic market and
D the remaining Q1Q2 units in the world market. Exports
are equal to Q1Q2.
Q1 Q2 Quantity/
period In this case, where the world price is higher than the
domestic price resulting in exports, consumer surplus
Figure 4.1.1b Open economy—Pw > Pd: country exports corn decreases by area (A + B) and producer surplus increases
by area (A + B + C). A welfare gain thus results equal to
Sd area (C). Producers could in principle fully compensate
Price/unit
consumers for their loss of income and still be better off.
Free trade has increased social welfare but not everyone is
a winner.
In Figure 4.1.1c we assume that the country is again an
Pd open economy but that the price of corn in the world
A B Sw market is lower at Pw. Domestic consumers can buy as
Pw
much corn as they want at that price without affecting it
(remember, this is a “small” country). At price Pw they will
D be willing to buy Q4 units while domestic corn producers
will only be willing to offer Q3 units of corn. Units Q3Q4
0 Q3 Q4 Quantity/ will thus be purchased from abroad and reflect imports
period of corn.
Figure 4.1.1c Open economy—Pw < Pd: country imports corn In this case where the world price is lower than the domestic
price resulting in imports, consumer surplus increases by
Figure 4.1.1a illustrates the closed economy case when there area (A + B) and producer surplus decreases by area (A). A
are no imports or exports of corn. This is also referred to as welfare gain thus results equal to area (B). Consumers could
the “autarky” case. Domestic demand and domestic supply in principle fully compensate domestic producers for their
of corn will lead to an equilibrium price of Pd per unit and loss of profits and still be better off. Free trade increases
an equilibrium quantity of Q units per period. social welfare but not everyone is a winner.

Absolute and comparative advantage; specialization HL

Absolute and comparative advantage possibilities of two countries, called Red and Green,
Free trade generates many benefits for an economy. It also each producing two goods, apples and bananas. We are
increases social welfare even though not all parties involved assuming that both countries have the same amount of
are better off. The next step is to determine which goods labour and of capital or, to simplify matters, each country
should a country specialize in and export, and which goods has just one unit of labour. The numbers are the maximum
should it import. We consider a world with two countries amount of each good that each country can produce if it
each producing two goods. uses all of its resources in the production of that good.

Absolute advantage: Adam Smith Country Red Country Green

The first explanation relies on Adam Smith’s theory of Apple production: 30 10
absolute advantage. A country has an absolute advantage maximum
in the production of a good if compared to its trading
partner, it can produce more units with the same resources Banana 10 20
or, equivalently, if it can produce a unit of the good production:
using fewer resources. A country should specialize in and maximum
export that good in which it has an absolute advantage. Table 4.1.1
Table 4.1.1 and Figure 4.1.2 show the production

146
 Apples Comparative advantage: David Ricardo

UNIT 4: THE GLOBAL ECONOMY

30 In 1817 David Ricardo showed that even in the case shown
in Table 4.1.3 there is still room for mutually beneficial
25 specialization and exchange. He showed that what matters is
comparative and not absolute advantage. Relative, and not
20
Red absolute, cost of production is important. This means that we
15 should look at the opportunity cost of producing each good for
each country. A country has a comparative advantage in the
10 production of a good that it can produce at a lower opportunity
cost than its trading partner. Table 4.1.3 focuses on which
5 Green country sacrifices fewer bananas to produce an apple and which
country sacrifices fewer apples to produce a banana.
0 5 10 15 20 Focusing on
Bananas Focusing on Red It follows that:
Green
Figure 4.1.2
Red can produce Green can produce Green can
It should be clear from Table 4.1.1 that Red has the absolute either 40 apples either 60 apples produce a banana
advantage in apples, as with the same resources (say, one or 20 bananas. or 90 bananas. at a lower
unit of labour) it can produce 30 apples whereas Green can If it produces If it produces opportunity cost:
produce only 10 apples. Green has the absolute advantage 20 bananas it 90 bananas it it needs to
in bananas as it can produce 20 bananas while Red can only will sacrifice will sacrifice sacrifice ½ of an
produce 10 bananas. So, Red can produce apples absolutely 40 apples: 60 apples: apple whereas
cheaper and should specialize in and export apples whereas opportunity cost opportunity cost Red must sacrifice
Green should specialize in and export bananas. of 20 bananas = of 90 bananas = 2 apples.
What if one of the countries has the absolute advantage 40 apples 60 apples. Green has a
in the production of both goods? What if the production Dividing by 20: Dividing by 90: comparative
possibilities are as in Table 4.1.2 and Figure 4.1.3? advantage
opportunity cost opportunity cost
As shown in Figure 4.1.3, in this case Green (with the same in producing
of 1 banana = of 1 banana =
bananas: it should
Country Red Country Green 2 apples ½ of an apple
specialize in and
Apple production: 40 60 export bananas.
maximum Red can Green can Red can produce
Banana production: 20 90 produce either produce either an apple at a lower
maximum 40 apples or 60 apples or opportunity cost: it
Table 4.1.2
20 bananas. 90 bananas. needs to sacrifice
If it produces If it produces ½ of a banana
40 apples it 60 apples it whereas Green
Bananas
will sacrifice will sacrifice must sacrifice
100 1.5 bananas.
20 bananas: 90 bananas:
90 Red has a
Green consumes 20 apples opportunity cost opportunity cost
80 and 70 bananas comparative
of 40 apples = of 60 apples =
70 20 bananas. 90 bananas. advantage in
60 apple production:
Dividing by 40: Dividing by 60:
50 it should
opportunity cost opportunity cost
40 specialize in and
Red consumes of 1 apple = ½ of of 1 apple =
export apples.
30 20 apples and 20 a banana 1.5 bananas
20 bananas
10 Table 4.1.3

0 10 20 30 40 50 60 We have established which country should produce apples

Figure 4.1.3 Apples and which should produce bananas. How can they now
trade and increase their consumption bundles?
resources) can produce both more apples than Red (60 Green, which will specialize in bananas, sacrifices two-
versus 40) and more bananas (90 versus 20). Green has thirds of an apple to produce one banana so it will be
the absolute advantage in the production of both goods. willing to sell (export) one banana if it earns more than the
So according to Adam Smith, there is no room for mutually opportunity cost to produce it (that is, more than two-thirds
beneficial specialization and exchange. of an apple). Red will be willing to buy (import) one banana

147
 if it can pay less than two apples, which is the opportunity Limitations of the model
cost Red experiences of producing one banana. Despite the model of comparative advantage being helpful
A mutually beneficial exchange can occur if they trade one in determining which goods a country should export and
banana for one apple. which goods it should import, it does not fully explain
Green will sell (export) one banana to buy (import) one apple. actual trade flows. The limitations arise from the underlying
Note that looking at it the other way around leads to the assumptions of the model.
same conclusion: Red will be willing to sell (export) one • The theory of comparative advantage assumes that goods
apple if it earns more than half of a banana, which is the are homogeneous. This may be the case for agricultural
opportunity cost of producing it. So, earning one banana for goods, but it is definitely not the case for services or for
one apple is acceptable. Green will be willing to buy (import) manufactured goods. For example, both Italy and Germany
an apple if pays less than the opportunity cost to produce produce, export and import cars because cars are highly
one, which is one and a half bananas. differentiated products.
Red will sell (export) one apple to buy one banana. • It is assumed that opportunity costs are constant so
If these two countries trade they will be able to consume that no matter how much of a good is produced the
combinations of the two goods that are outside their additional cost of producing one more unit remains the
production possibilities. For example, Red can sell (export) same and thus the PPCs are linear. In the real world,
20 apples for 20 bananas. It could therefore consume 20 though, there are often economies of scale as increased
apples and 20 bananas. levels of production are commonly associated with lower
average costs.
Green can sell (export) 20 bananas for 20 apples. It could
therefore consume 70 bananas and 20 apples. Both • It is assumed that factors of production are perfectly
countries can consume outside their PPCs. mobile, easily switching from producing one good to
producing another other. Is labour both geographically
Note that there is room for mutually beneficial specialization and occupationally mobile, though? A worker may not
and exchange only if the PPCs of the two countries are have the necessary skills to switch jobs or may not be able
parallel because in this case the opportunity costs are to move location.
the same.
• It is assumed that there are no transportation costs which,
Sources of comparative advantage despite these often being very low because of container
Ultimately, comparative advantage depends on differences shipping, may sometimes impede trade.
in factor endowments and in technology. • It is assumed that there are no trade barriers, but there are
• Differences in the quantity and quality of factor plenty of barriers that restrict trade flows in the world.
endowments result from differences in the stock of natural Complete specialization is risky
capital and its productivity, differences in the stock of
human capital and its productivity and differences in the It should be noted that complete specialization in one good
stock of physical capital and its productivity. or service, or in a narrow range is very risky according to a
strict interpretation of the theory of comparative advantage.
• Differences in technology are manifested indirectly as If a country has a significant comparative advantage in
technology is embodied in the physical capital available tourism it should not specialize only in exporting tourism
and affects the productivity of human capital. services because if something went wrong, its economy would
In addition: be devastated. Export revenues would collapse, decreasing
• Actual trade flows can also be affected by movements aggregate demand and real GDP. This was painfully realized
in the exchange rate. For example, a stronger currency after the outbreak of Covid-19 in countries relying almost
increases the foreign price of an exported good and may exclusively on tourism. A country must try to diversify,
result in shrinking export markets. specializing in and exporting a wide range of products. By
• Changes in relative inflation rates also affect trade flows. doing so it minimizes risks. This is especially true for certain
Higher inflation in a country worsens the international developing nations that often specialize in and export a
competitiveness of the goods and services it exports as narrow range of mostly primary products.
they become relatively more expensive over time.
Comparative advantage is a dynamic
• Many countries also pay export subsidies to lower the cost
concept
of producing a good or a service artificially and therefore
increase its competitiveness abroad. It should also be noted that comparative advantage is a
dynamic concept as it can and does change over time.
• Lastly, non-price factors can lead to the creation or the
Governments invest in education, raising labour productivity.
loss of comparative advantage and of international
They may also import technology by attracting foreign
competitiveness. These factors include product design,
direct investment (FDI) in high-tech sectors. In addition, they
reliability or quality of after-sales support. For example,
may pursue a variety of industrial policies in the hope of
exports of German capital goods are not significantly
creating a comparative advantage over the very long term,
affected by an appreciating euro because of their good
as many countries have. For example, South Korea’s exports
reputation in foreign markets.
of electronic and integrated circuits, as well as of cargo
ships and cars, are to a large degree a result of successful
industrial policies.

148
 4.2 Types of trade protection

UNIT 4: THE GLOBAL ECONOMY

Despite the many benefits derived from free trade, many of trade protection. The most common forms are tariffs,
countries restrict trade flows and employ various degrees quotas, subsidies and administrative barriers.

Tariffs
Analysis of a tariff Given the new price P’ established in the domestic market,
A tariff is defined as a tax imposed on imports aimed domestic production will rise to Q3 units of corn per period
at restricting their flow into the country and protecting while domestic consumption drops to Q4 units of corn per
domestic producers. It has been the most common form of period. The volume of imports shrinks to Q4 – Q3 = Q3Q4 of
protection. It may be specific or ad valorem. For example, corn units per period. In addition:
in May 2019 the USA imposed 25% on about $250 billion • total revenues collected by domestic corn farmers =
of Chinese products. A tariff will tend to raise the domestic P’ × Q3 = area (H + F + 2 + 1)
price and domestic production of the good while lowering • total expenditures on corn by domestic consumers =
the amounts consumed and imported. P’ × Q4 = area (H + F + J + 3 + 2 + 1); note that whether
Figure 4.2.1 refers to the market for corn in some country. they increased or decreased depends on the price elasticity
Let the world price of corn be at Pw. Assuming free trade, of demand (PED).
the world price will prevail in the domestic market in a small • import expenditures = Pw × Q3Q4 = area (J) as the tariff
country. Remember that, in this context, “small” means that “t” per unit is collected by the domestic government so
the country can buy or sell as much of the product as it foreigners (exporters) still earn Pw dollars per unit of corn
wants without the world price changing. • tariff revenues collected by the government = “t” × Q3Q4
or, P’Pw × Q3Q4 = area (3).
P/unit Sd
A welfare analysis reveals the following.
• Consumer surplus decreases by area (1 + 2 + 3 + 4) as
a result of the higher price paid and the lower quantity
enjoyed. Domestic buyers of corn are clearly worse off.
• Producer surplus increases by area (1) as domestic
(Pw+t) = P' S'w
producers sell more corn and earn a higher price
1 2 3 4 = tariff 't'
Pw Sw (remember that the tariff is collected from the imported
units of corn).
H F J G D • Area (3) is collected by the government and may be spent
Q1 Q3 Q4 Q2 Q /period on schools, health care or infrastructure so it is money
put back into the economy and it cannot be considered a
Figure 4.2.1 Effects of a tariff on the market for corn
welfare loss.
• It follows that a tariff leads to a welfare loss equal to
With the price at Pw, domestic firms will offer Q1 units of area (2) and area (4).
corn per period while domestic consumption will be Q2 units
Area (2) is referred to as production inefficiency because
of corn per period. The difference Q2 – Q1 = Q1Q2 is the
it costs more to produce units Q1Q3 domestically than it
quantity (volume) of corn imported. In addition:
would have cost the country to import these units at the
• total revenues collected by domestic corn farmers = world price Pw. Analytically, the cost of producing Q1Q3
Pw × Q1 = area (H) units domestically is area (F + 2), the area under the supply
• total expenditures on corn by domestic consumers = curve, as the supply curve is also the marginal cost of
Pw × Q2 = area (H + F + J + G) producing a good. The cost of importing these units is only
• import expenditures = Pw × Q1Q2 = area (F + J + G). area (F), the product of units Q1Q3 times the world price
Assume now that the government in order to protect Pw at which they could have been bought under free trade.
domestic corn producers imposes a tariff equal to “t” dollars Area (2) therefore represents net value lost by society from
per unit of corn. The tariff will raise the domestic price to units Q1Q3 being domestically produced even though they
P’ = (Pw + t). The tariff “t” is thus equal to P’Pw dollars per should have been imported instead.
unit on Figure 4.2.1. The world price Pw is not affected if, as Area (4) is referred to as consumption inefficiency because
a result of the tariff, the country demands less corn because units Q4Q2 are now, as a result of the tariff, not being
the country is small—its production and consumption consumed by domestic consumers even though these units
decisions are insignificant and do not affect the world price. are valued by consumers more than what it would have

149
 cost to import them. Analytically, units Q4Q2 are worth
to consumers area (G + 4), which is the area under the Recap
demand curve, and is the sum of how much consumers Effects of tariffs
would have been willing to pay to consume these units. It
would have cost to import and enjoy these units only area A tariff:
(G), the product of units Q4Q2 times the world price Pw • increases the domestic price of the protected good
at which they could have been bought under free trade. • increases domestic production of the good
Area (4) therefore represents net value lost by society from • decreases consumption of the good
units Q4Q2 not being consumed even though they should
have been. • decreases the volume of imports
• decreases consumer surplus
• increases producer surplus
• creates tariff revenues equal to area (3) on Figure 4.2.1.
• leads to production inefficiency and resource
misallocation
• leads to consumption inefficiency
• is responsible for a welfare loss.

Quotas
Analysis of a quota The supply of corn in the domestic market is now restricted.
A quota is a quantitative restriction on the volume of imports. At the world price Pw, domestic farmers are still willing to
For example, in 2018 the USA imposed a quota on Korean offer Q1 units of corn but only ab units are allowed to be
steel imports equal to 2.68 million tons per year, which imported as a result of the quota. So, at Pw, there is an
meant that the USA restricted annual steel imports of steel excess demand for corn equal to bf. Total quantity supplied
from Korea to that specific amount. This was a 21% decrease by both domestic and foreign producers is equal to line
from the 2017 volume of imports. Figure 4.2.2 shows the segment Pwb while quantity demanded is line segment Pwf.
effect of such a quota, using corn as an example. There is pressure for the domestic price of corn to rise.
Sd What is the effective supply of corn in this market? At each
P/unit price, it will be equal to whatever domestic producers are
S' = (Sd + quota)
willing to offer plus the fixed quota amount of corn ab. We
a
Quota b therefore draw from point b a line parallel and to the right
= (ab) of Sd at S’ so that the horizontal rightward shift is equal at
all prices to distance ab. Note that supply of corn in this
P' market has decreased from Sw to S’. The world supply Sw
1 2 3 4 pivoted to S’.
Pw Sw
a b f
The new equilibrium price of corn in the domestic market
H F J G D will be at P’ where demand D intersects the effective corn
Q1 Q3 Q4 Q2 Q /period supply S’. At that price, domestic farmers are willing to offer
Q3 units of corn and buyers are willing to purchase Q4
Figure 4.2.2 Effects of a quota on the market for corn
units of corn. The difference Q4–Q3 = Q3Q4 is the quantity
In Figure 4.2.2, the world price for corn is at Pw. At price Pw, of imports which is, of course, equal to the amount of the
domestic farmers are willing to offer Q1 units of corn per imposed quota ab.
period while domestic consumption will be Q2 units. The Before the quota was imposed:
volume of corn imports will be Q2 – Q1 = Q1Q2 = af units of • total revenues collected by domestic corn farmers =
corn per period. Pw × Q1 = area (H)
The government now decides to limit the quantity of corn • total expenditures on corn by domestic consumers =
imports from af to only ab units per period. No more than ab Pw × Q2 = area (H + F + J + G)
units of imported corn may enter the domestic market. How
• import expenditures = Pw × Q1Q2 = area (F + J + G).
much corn is supplied in this market?
After the quota was imposed:
Before the quota was imposed, at the world price Pw, the
supply of corn faced by domestic buyers was infinitely elastic • total revenues collected by domestic corn farmers =
at Sw. At that price, foreign producers would offer as much P’ × Q3 = area (H + F + 2 + 1)
corn as domestic consumers demanded. Therefore, at the • total expenditures on corn by domestic consumers =
world price Pw, given the demand for corn D, Q1 units of P’ × Q4 = area (H + F + J + 3 + 2 + 1); note that whether
corn were offered by domestic farmers and Q1Q2 units were they have increased or decreased depends on the price
offered by foreign exporters. elasticity of demand (PED).

150
 A welfare analysis reveals the following points. they usually collect these rents. If the foreign exporting

UNIT 4: THE GLOBAL ECONOMY

• Consumer surplus decreases by area (1 + 2 + 3 + 4) as firms collect the quota rent, then their export revenues
a result of the higher price paid and the lower quantity (and equivalently, the import expenditures of the importing
enjoyed. Domestic buyers of corn are clearly worse off. country) are bigger than if an equivalent tariff had been
imposed. Their export revenues may even be greater than
• Producer surplus increases by area (1) as domestic
they would have been under free trade. With free trade their
producers sell more corn and earn a higher price.
export revenues (and, import expenditures) were equal to
• Area (3), the shaded area is known as ”quota rents” area (F + J + G)—whereas with a quota appropriated by
and represents money typically earned by the foreign the foreign exporter they are equal to area (J + 3), which
exporting firms that can now export the product at a could be greater. This possibility minimizes the probability of
higher price as a result of the restricted supply. The money retaliation.
represented by shaded area (3) may also go to foreign
governments. The money that area (3) represents is rarely
received by the domestic government. This would be the Recap
case only if the domestic government auctioned off the Effects of quotas
quota licences. Note that the term rents in economics
A quota:
refers to income earned as a result of some favourable
policy decision. • increases the domestic price of the protected good
• The effects of a quota are the same as those of an • increases domestic production of the good
”equivalent” tariff (that is, a tariff that would also raise • decreases consumption of the good
the domestic price to P’) with one exception: the tariff • decreases the volume of imports
revenues area (3) now represents quota rents that are
• decreases consumer surplus
usually collected by foreigners, so they represent an
additional welfare loss. • increases producer surplus
• It follows that a quota typically leads to a greater • creates “quota rents”, which are usually collected by
welfare loss equal to area (2), which reflects the foreigners
resulting production inefficiency explained earlier, • leads to production inefficiency and resource
plus area (4), which reflects the resulting consumption misallocation
inefficiency also explained earlier, plus area (3), the • leads to consumption inefficiency
quota rents. • is responsible for a welfare loss greater than that of
The existence of quota rents helps explain why quotas are an equivalent tariff (assuming that the quota rents
often imposed instead of tariffs even though the associated are collected by foreigners).
welfare loss is usually bigger. Foreigners are better off as

Subsidies
Analysis of production subsidies and of
P/unit g Sd
export subsidies Ss
A production subsidy is a per unit payment by the
government on all units of the good produced by a firm. An j
export subsidy is a per unit payment by the government only
on the units exported by a firm. In both analyses we keep Pp n
the assumption that the country is small in the context of F H
economics. Pw Sw
m
Production subsidy A B C D
A production subsidy is a per unit payment by the Q1 Q3 Q2 Q/
government to firms on all units of output produced, which period
leads to a decrease in their production costs. The lower
Figure 4.2.3 Effects of a production subsidy on the market for corn
production cost permits firms to produce more at each
price so that imports of the good decrease. The effects of a In Figure 4.2.3 the world price of corn is at Pw. At that price
production subsidy are illustrated in Figure 4.2.3. domestic farmers are willing to offer Q1 units of corn per
period while domestic consumption of corn will be at Q2

151
 units per period. The quantity of corn imported, if trade is
free, will thus be equal to Q2 – Q1 = Q1Q2 units of corn per Recap
period. In addition:
Effects of production subsidies
• total revenues collected by domestic producers =
Pw × Q1 = area (A) A production subsidy:
• total expenditures by domestic consumers = Pw × Q2 = • does not affect the domestic price of the protected
area (A + B + C) good
• import expenditures = Pw × Q1Q2 = area (B + C). • does not affect consumption of the good
If the government now grants a production subsidy equal to • does not affect consumer surplus
jg dollars per unit of output, then the decrease in production • increases domestic production of the good
costs will increase supply and shift the supply curve to the • increases producers’ revenues
right or, better yet, vertically downwards by the amount • increases producer surplus
of the subsidy jg to Ss. Remember the supply curve is the
• decreases the volume of imports
marginal cost (MC) curve so marginal cost decreases by jg
dollars. • decreases import expenditures (and thus export
revenues foreigners collect)
The world price will not be affected (given a small country
case). At the world price Pw domestic firms will be willing • leads to increased government spending and
to offer Q3 units per period because of their now lower financing, and imposes an opportunity cost
production costs. Now, though, per unit sold they earn • leads to production inefficiency and resource
Pp, which is equal to what consumers pay (Pw) plus the misallocation
subsidy mn paid by the government. Consumption remains • is responsible for a welfare loss.
unchanged at Q2. It follows that the quantity (volume) of
imports decreased from Q1Q2 to Q3Q2. In addition: export the good than to sell it in the domestic market. The
• total revenues collected by domestic producers increase to government’s goal is to stimulate exports. Technically, export
Pw × Q3 = area (A + B + H + F). subsidies are illegal under World Trade Organization (WTO)
• total expenditures by domestic consumers remain the rules but they are still granted by many countries in different
same equal to area (A + B + C) since the price paid and forms. (See section 4.4, page 162 for information on the WTO.)
the quantity consumed do not change The effects of an export subsidy are illustrated in Figure 4.2.4.
• import expenditures decrease to Pw × Q3Q2 = area (C); The world price is assumed at Pw so that quantity demanded
(remember that import expenditures are equal to the is equal to Q1 units of corn per period while firms offer Q2
export revenues foreigners collect). units per period. Units Q1Q2 are thus exported.
A welfare analysis reveals the following. If a subsidy is paid to domestic firms equal to hj for each unit
they export, then the domestic price of corn will increase to P’.
• Consumer surplus remains the same as consumers pay the
This is because firms earn P’ by selling abroad so they will not
same price and consume the same quantity.
• Producer surplus increases by area (F) because the price Sd
earned per unit by producers Pp is equal to the world price P/unit
P' h r
Pw plus the subsidy mn paid by the government, which is
equal to jg, the vertical distance between the two supply A B C F
Pw Sw
curves. j g z w
• The cost of the subsidy to the government is equal to the
subsidy per unit mn times the quantity produced Q3 or,
area (F + H). This cost must somehow be financed. It can
be financed by higher taxes now, by increased borrowing
now and higher taxes later or by cutting back on some D
other government expenditure. An opportunity cost is 0 Q3 Q1 Q2 Q4 Q/period
therefore involved.
Figure 4.2.4 Effects of an export subsidy on the market for corn
• It follows that a production subsidy leads to a welfare
loss equal to area (H). This represents the production be willing to sell any quantity domestically unless they also
inefficiency because units Q1Q3 are now produced earn P’ in the home market. The difference P’—Pw is equal to
domestically even though it would have been cheaper to the export subsidy paid hj. At P’, domestic consumption will
import them. decrease to Q3 while firms will offer Q4 units. The quantity of
corn exports increases from Q1Q2 (= gz) to Q3Q4 (= jw) units
Export subsidy per period. In addition:
An export subsidy is a per unit payment by the government
• total revenues collected by domestic producers increase
to firms based only on the units of output exported. This
from area (0Q2zPw) to area (0Q4rP’)
payment means that a firm will find it more profitable to

152
 • total expenditures by domestic consumers change from

UNIT 4: THE GLOBAL ECONOMY

area (0Q1gPw) to area (0Q3hP’); whether they have Recap
increased or decreased depends on PED
Effects of export subsidies
• export revenues increase from area (Q1Q2zg) to area
(Q3Q4rh). An export subsidy:
A welfare analysis reveals the following. • increases the domestic price of the good
• Consumer surplus decreases by area (A + B) as a result • decreases consumption of the good
of the higher price paid and the lower quantity enjoyed. • decreases consumer surplus
Domestic buyers of corn are clearly worse off. • increases domestic production of the good
• Producer surplus increases by area (A + B + C) as • increases the revenues of domestic firms
producers sell a greater quantity and earn a higher price. • increases the quantity of exports
• The cost to the government of the export subsidy is equal • increases producer surplus
to the subsidy per unit hj times the volume of exports
jw (= Q3Q4), or area (B + C + F); the government must • leads to increased government spending and
finance this cost by increasing taxes now, by borrowing financing as it imposes an opportunity cost
now and increasing taxes later or by cutting back on some • leads to production inefficiency and resource
other government project. misallocation
• There is therefore a welfare loss equal to area (B + F). • leads to consumption inefficiency
This becomes clear since the gains were equal to • is responsible for a welfare loss.
areas (A + B + C) while the losses were equal to areas (A + B)
plus areas (B + C + F). Areas (A), (C) and one of the two
(B) areas cancel out, leaving areas (B + F) as the welfare loss.

Administrative trade barriers

Administrative trade barriers are also referred to as with only a few officers who were ordered to fully inspect
regulatory or legal barriers and are a common form of trade each and every truck. You can imagine the delays that this
protection. Standards are set that imports must satisfy seemingly innocent requirement created and that resulted in
otherwise they are prohibited. These may be health-related effectively reducing the volume of imports entering France.
standards, environmental standards or safety standards. Calculations
For example, the EU and the UK do not permit imports of
1. Tariff exercise
chlorine-washed chicken and hormone-treated beef from
the USA. The USA maintains that these restrictions aim Assume that a tariff is imposed on some good X. Answer the
at blocking US exports of chicken and beef. Countries set following questions using the information in Figure 4.2.5.
environmental regulations such as specified emissions
standards for car imports to protect the domestic population P/unit S
and combat climate change but some so-called “green (euros)
regulations” may be used only to impede imports. Safety
standards are set to protect consumers, for example
regulations concerning automobile or electrical equipment,
or chemicals or children’s products. Some standards, 4400 S'
though, may be set just to make it more costly for foreign 1 2 3 4
4000 Sw
exporting firms to comply and so they amount to disguised
protectionism. The issue is to ensure that the standards are A B C
set to protect domestic consumers and are not just an excuse D
for protecting domestic producers. 0 18 32 51 75 Q/period
In addition to such standards, the importing country may (thousand
of units)
add more “red tape“ to the necessary bureaucracy involved
Figure 4.2.5 Tariff diagram: small country case
when importing a good. The country may increase the typical
paperwork required for exporters to complete or it may
lengthen the valuation, inspection and customs clearance a. What is the size of the tariff imposed?
processes. Perhaps the most absurd example of such b. Calculate the pre-tariff volume of imports.
administrative barriers is a very old one related to the city of c. Calculate the import expenditures (or the export revenues
Poitiers in France. The French government had ordered that of the foreign firms) under free trade.
all Japanese video imports were to be inspected and pass
d. Calculate the revenues earned by domestic producers
customs at Poitiers instead of at a major harbour or airport.
under free trade.
Poitiers is located inland, is far from ports and was staffed

153
 e. Calculate consumer expenditures on the good under free k. Calculate the resulting increase in the producer surplus.
trade. l. What is the resulting production inefficiency equal to?
f. Calculate the post-tariff volume of imports and their m. Calculate the resulting consumption inefficiency.
change.
3. Production subsidy exercise
g. Calculate import expenditures after the tariff was imposed
and the change that occurred as a result of the tariff. Assume that a subsidy is granted to the producers of
some good X. Answer the following questions using the
h. How much did consumers spend on the good after the
information in Figure 4.2.7.
tariff was imposed?
i. The money spent by consumers after the tariff was P/unit
imposed was collected by foreign exporters, domestic (dollars) s
producers and the government. Calculate how much each s'
group collected.
j. What is the resulting production inefficiency equal to?
k. Calculate the resulting consumption inefficiency. h
165
l. Calculate the resulting decrease in the consumer surplus.
1 2 g
2. Quota exercise 150 Sw
j f
Assume that a quota is imposed on imports of some good X.
Answer the following questions using the information in
Figure 4.2.6. D
0 250 450 1000 Q/year
P/unit Sd (thousand of units)
(euros)
S'=(Sd+Quota) Figure 4.2.7 Production subsidy diagram: small country case

a b a. What is the size of the subsidy granted (on a per unit basis)?
b. Calculate the annual import expenditures (or export
revenues of the foreign firms) under free trade.
7500 c. Calculate the annual revenues earned by domestic
1 2 3 Sw producers under free trade.
6000 4
d. Calculate annual consumer expenditures on the good
A B C under free trade.
D e. Calculate the annual change in the volume of imports as
0 450 700 1400 1750 Q /month a result of the subsidy.
Figure 4.2.6 Quota diagram: small country case f. Calculate annual import expenditures after the subsidy
was granted and the change that occurred as a result of
a. What is the size of the quota imposed? the subsidy.
b. Calculate the import expenditures (or export revenues of g. How much did consumers annually spend on the good
the foreign firms) under free trade. after the subsidy was granted?
c. Calculate the revenues earned by domestic producers h. Calculate the annual total revenues domestic firms
under free trade. collected after the subsidy was granted.
d. Calculate consumer expenditures on the good under free i. Calculate the annual cost of the subsidy to the
trade. government.
e. Calculate the change in the volume of imports as a result j. Calculate the change in the consumer surplus.
of the quota. k. Calculate the resulting increase in the producer surplus.
f. Calculate import expenditures after the quota was l. What is the resulting production inefficiency equal to?
imposed and the change that occurred as a result of the
m. Calculate the resulting consumption inefficiency.
quota.
g. How much did consumers spend on the good after the 4. Export subsidy exercise
quota was imposed? Assume that a subsidy is granted to the producers of some
h. What can you infer about the price elasticity of demand good X on each unit of X exported. Answer the following
(PED) for the good given the price change in the market? questions using the information in Figure 4.2.8.
i. Calculate the size of the quota rents. Who earns these a. What is the size of the subsidy granted (on a per unit basis)?
rents? b. Calculate the annual export revenues that domestic
j. Calculate the resulting decrease in the consumer surplus. producers earned before the export subsidy was granted.

154
 d. Calculate annual consumer expenditures on the good

UNIT 4: THE GLOBAL ECONOMY

S
P/unit before the export subsidy was granted.
(dollars)
e. Calculate the annual change in the volume of exports as
7.00 a result of the export subsidy.
f. Calculate annual export revenues after the export subsidy
5.00 Sw
was granted as well as the change in export revenues
earned as a result of the export subsidy.
g. How much did consumers annually spend on the good
after the export subsidy was granted?
h. Calculate the annual total revenues domestic firms
collected after the export subsidy was granted.
D i. Calculate the annual cost of the export subsidy to the
14 21 30 38 Q/year government.
(thousand of units)
j. Calculate the change in the consumer surplus.
Figure 4.2.8 Export subsidy diagram k. Calculate the resulting increase in the producer surplus.
l. What is the resulting production inefficiency equal to?
c. Calculate the total annual revenues earned by domestic
m. Calculate the resulting consumption inefficiency.
producers before the export subsidy was granted.

155
 4.3 Arguments for and against trade
control and protection
If the benefits from free trade are so many and—as shown in a specific area of the country. Clearly, each of these firms
in Figures 4.1.1a to 4.1.1c (section 4.1—net welfare of the has a big financial incentive to lobby the government and
country increases, why do so many countries restrict imports demand protection. Politicians are likely to succumb to these
employing various degrees of protection? Why is “managed” pressures because of the very visible political cost of firms
trade so common? shrinking or shutting down in an area and the consequent
The simple answer is that not all the parties involved gain increase in unemployment.
from free trade. There are groups that are worse off. Free Managed trade may also aim to increase exports. Even
trade creates winners and losers. When the losses of the though consumers as a whole may be worse off when the
losers from free trade are significant then they may try to government pursues policies that aim to promote exports
pressure the government for protection. This is often the case artificially, the loss of income suffered from each consumer
when free trade increases import penetration in a market. is small while the benefits enjoyed by each of the fewer
Focusing on Figure 4.1.1c (page 146) it is realized that exporting firms are large. This explains why governments are
the increase in consumer surplus resulting from free trade often active in promoting, directly or indirectly, their export-
and cheaper imports exceeds the decrease in the producer oriented firms.
surplus that import-competing firms suffer. If there are only Below we examine the most common arguments used in
few affected producers then each one suffers a significant favour of protection. They are divided into non-economic
loss of revenues and profits and may also be forced to arguments and economic arguments.
dismiss workers. In addition, these firms may be concentrated

Arguments in favour of protection

Common non-economic arguments These claims must be carefully evaluated. First, higher
• Governments often erect trade barriers to ensure that in domestic wages do not necessarily imply higher labour
case of a conflict a country is self-sufficient in the production costs for firms because labour productivity is important.
of crucial goods for strategic reasons. The weapons and If domestic wages are higher because of higher labour
aerospace industries as well as the food industry are often productivity, then labour costs may be even lower than
classified as being of such strategic importance. The validity abroad and therefore there is no reason to fear imports.
of this argument is doubtful, at least for countries belonging If the higher domestic wages are not a reflection of higher
in wide strategic and/or political alliances. labour productivity, then the domestic industry has a
• Trade barriers are employed to restrict imports of drugs comparative disadvantage. Theory suggests that labour
and other harmful substances. Trade barriers are also used and other resources should be channelled to other, more
to pressurize and weaken politically unfriendly countries efficient uses. Workers and owners of capital, and perhaps
and in these cases are referred to as embargoes. whole regions, will face real adjustment costs and, of course,
will resist these changes. They will try to blame foreigners
• Some countries resort to protection to preserve a way of for their plight and will demand protection.
life or their cultural identity as part of a broader social
strategy. For example, the television stations in many Instead of protection, which will reduce the incentive to
countries restrict the number of broadcast hours of foreign restructure and adjust, other policies could be adopted to
language films and programmes. smoothen the adjustment, especially for displaced workers.
Note that in many cases shifting resources from one use
• Trade barriers also exist to ensure that certain minimum to another may be almost impossible without significant
safety and health standards are met. The goal is purportedly government assistance, which itself is costly to implement.
to protect the public but often such standards are a pretence In such cases, trade liberalization should proceed gradually.
through which domestic producers are protected. Also, if employment in a whole region relies on the
Common economic arguments in favour distressed industry with few or no employment alternatives
for the local population, then the trade liberalization process
of protection must be gradual to give sufficient time for owners of capital
• A most common argument in favour of restricting trade is to and workers to adjust. Recent research has found that
protect domestic jobs. Many claim that free trade decreases people do not move easily to another location even if they
employment as cheaper and higher quality foreign products have no job. Financial incentives do not matter as much as
flood the domestic market, forcing domestic firms to shut economists had thought, according to Esther Duflo (Nobel
down. Cheap foreign labour is typically blamed for the Prize, 2019). This significantly complicates the issue.
resulting higher rates of unemployment.

156
• Another common argument in favour of protection is to

UNIT 4: THE GLOBAL ECONOMY

its government may impose a tariff, referred to as
improve a trade deficit. A trade deficit exists if the value “anti-dumping duty”, to minimize the injury.
of imports of goods and services is greater than export The WTO launches an investigation to determine the extent
revenues. The idea is that protection will render imports of any dumping taking place. It is not always easy to
more expensive and less attractive. Spending on imports determine the “normal price” of the good as the price may
will then decrease, shrinking and correcting the trade vary depending on the region at which the good is sold,
imbalance. the buyers of the good or the time period during which
There are several potential problems with this argument. dumping was allegedly taking place. As anti-dumping
First, it invites retaliation from trading partners as any duties are automatically imposed when dumping is
improvement in a country’s trade balance comes at their suspected and the investigation is lengthy, many industries
expense. Second, restricting foreign products into the make an accusation of dumping when imports flood their
country will decrease foreign incomes and consequently domestic market to gain time until a verdict is reached
their ability to buy the country’s exports. Third, and most in order to restructure and (they hope) to become more
importantly, such a policy does not treat the fundamental efficient.
cause of a widening trade deficit problem. The ballooning • Tariffs provide a government with revenues. Tax systems
trade deficit may be the result of domestic products in certain developing countries are ineffective, making it
being expensive and therefore uncompetitive: domestic difficult for their governments to collect sufficient revenue
goods and services may be unable to penetrate foreign to finance pro-development activities. Since points of entry
markets (so that exports decrease) and they are also not into a country are few, taxing imports may be a last resort to
the preferred choice for domestic households who find it collect revenue, which cannot be given up. If this is the case
cheaper to buy imported products instead (so that imports then trade liberalization must be gradual to ensure that the
rise). High inflation, rigid labour markets that result in provision of basic government services is not interrupted.
high labour costs, uncompetitive domestic markets, as
• Protection may be necessary when a developing country
well as poor quality, lack of reliability, delivery issues, poor
is trying to diversify its production and export base.
design or poor marketing may be the real reasons behind
Diversification refers to the process of increasing the
a growing trade deficit. In these cases, protection will not
variety of goods and services produced and exported in
prove helpful and possibly may prove detrimental as it will
order to decrease risks (see section 4.10, page 198). Many
delay the adoption of appropriate remedial policies.
developing countries still produce and export a limited
• Governments may decide to erect import barriers to assist range of products according to the principle of comparative
the growth of certain industries in their initial stages advantage (an HL concept). If these countries are to
of development. The idea is that once these industries decrease risks, they need to develop, through appropriate
acquire the necessary know-how and lower their unit costs investments, a comparative advantage in new areas. Also,
by achieving economies of scale, they will be able to meet in the meantime they need to keep out imports from more
international competition. At that point, theory dictates, efficient foreign producers. This is accomplished through
protection should be removed. This is the well-known protection of the new industries being established. It is
“infant industry” argument and is essentially a form of again a form of necessary industrial policy.
industrial policy.
This argument also needs to be carefully evaluated. Recap
It is indeed theoretically sensible, and the policy has
been adopted by all developed economies in the past Non-economic arguments in favour
including the USA, as well as by all Asian export achievers of protection
in varying degrees. However, it also suffers from the These include arguments that protection is needed to:
previously discussed drawbacks of industrial policies. How • ensure self-sufficiency in certain crucial industries
does a government pick a “winner”? It may be difficult to such as weapons or food
determine which industry qualifies for such treatment. If
• block imports of drugs and illegal substances
a mistake is made, will it be possible for the government
to reverse its course and withdraw its support? Removing • protect a way of life (cultural issues)
the protection could be fiercely resisted by the industry • protect the health and safety of the population.
stakeholders. If protectionism is not lifted as theory Economic arguments in favour of protection
dictates, then we have the case of the “perpetual infant”.
These include arguments that protection is needed to:
There is an inherent risk of making the industry over-reliant
on state support, sluggish and inefficient. • protect jobs from foreign competition
• The World Trade Organization (WTO) permits a country to • correct a trade deficit
impose tariffs (taxes on imports) on a good if dumping • protect against possible dumping
is suspected. Dumping is said to exist if a firm is selling • enhance government revenues
abroad at a price below the normal price it sells at in its
• protect infant industries
own country, or below average cost. Often this could be
because exporters are subsidized directly or indirectly by • help a developing country diversify its produce and
their government. The injured firm may file a complaint export base.
with the WTO (see section 4.4, page 162) and

157
 Arguments against protection
• Protection breeds inefficiency as domestic firms are exposed to
less competition and are faced with captive domestic markets. beneficial to economies. However, surveys suggest that
Less competition implies greater domestic monopoly power. only about one-third of the general public have a similar
• Greater monopoly power for domestic firms implies higher positive opinion on free, for reasons explained earlier. The
prices for buyers. Higher prices decrease consumer surplus and benefits from trade, even though greater in size, are not
lower the purchasing power for households. Their ability to as visible to the layperson as the costs. Most people can
express demand for all other goods and services in the economy identify a firm or an industry that has shrunk or shut down
is therefore constrained. This could have negative effects on because of free trade and may even know someone who
overall output and employment levels. Unfortunately, these has lost his or her job in such circumstances. Most of us,
effects are not conspicuous and may be ignored by politicians. though, are not aware how much cheaper our clothes,
appliances or cars are because of free trade.
• Higher prices for domestic firms that import intermediate
products (inputs in their own production process) imply The conclusion that free trade leads to a net welfare gain
higher production costs, so higher prices for these firms. rests on one crucial assumption, namely that winners fully
Aggregate supply may decrease, and cost-push inflationary compensate losers. This compensation can be accomplished
pressures may even arise. through targeted government policies. Governments can
help displaced workers to retrain and move to industries
• If these domestic firms happen to be export-oriented
and areas with plentiful jobs. Governments can help
their competitiveness in international markets will be
owners of capital to start new businesses that can compete
eroded, hurting their sales and adversely affecting overall
more effectively in world markets. Too often though,
employment levels in the economy. Protectionism usually
losers, especially labour, have been neglected and this
destroys more jobs than it preserves or create.
compensation has never materialized. This may help
• Protectionism may induce retaliation (“tit for tat”) by foreign explain why, in the past few years, protection has increased
governments. If the trade frictions escalate then a trade war and why there has been a backlash against globalization.
may result, in the long term hurting all parties involved.
The best example of this new and dangerous trend is clear
• Consumers and firms are faced with limited options to in the tariffs imposed by the USA on many goods ranging
choose from. The reduction in variety is a cost since buyers from solar panels and washing machines to steel and
(consumers as well as firms) have to settle for their second- aluminum. These tariffs have led to retaliatory tariffs by the
best or third-best choice. Utility decreases for households USA’s trading partners. Studies have found the following.
while competitiveness decreases for firms.
• US companies, as a result of the recent tariffs, lost
• Domestic firms will not be exposed to the technological more than $1.7 trillion in the price of their stocks
advancements embodied in imported machinery (capital goods). (www.nber.org).
• Overall, US employment decreased by almost
Recap 300 000 jobs (www.brookings.edu).
Arguments against protectionism • These retaliatory tariffs by USA’s trading partners
• It breeds inefficiency as a result of less competition were costing US exporters approximately $2.6 billion
and greater monopoly power, leading to waste and per month in lost exports (www.princeton.edu).
misallocation of resources. In addition, as our earlier tariff analysis suggests,
• It leads to higher prices for consumers decreasing their American consumers and firms have borne almost
purchasing power and their ability to express demand entirely the cost of the tariffs imposed.
for other products. Slower growth in the USA, China and other major
economies will decrease demand for commodities,
• It limits choice for consumers and for firms as variety
affecting commodity exporters in Africa, South America
decreases.
and Australia. It will also slow down exports of all goods
• It increases the production costs of firms importing and services from the rest of the world with potentially
intermediate goods (inputs), forcing them to increase devastating consequences for their economies.
their prices. The Covid-19 pandemic has only made these matters
• It may also reduce export competitiveness of domestic worse, especially for developing countries. The response
firms relying on more expensive imported inputs. of the advanced economies is crucial. Most policymakers,
• It deprives domestic firms of taking advantage of the including world organizations such as the IMF and the
technological progress embodied in imported capital goods World Bank, agree that perhaps the only solution is the
• It increases the possibility of retaliation by trading partners. return to free trade—accompanied this time with policies
that compensate the vulnerable in each economy.

References
Policymakers’ perspective www.brookings.edu/podcast-episode/how-have-trumps-
Free trade versus trade protection trade-wars-affected-rust-belt-jobs/
Just a few years ago there would have been no dilemma. www.nber.org/system/files/working_papers/w27114/
Free trade has been responsible for much of the growth and w27114.pdf; page 33
rising incomes most countries have witnessed over the last www.princeton.edu/~reddings/papers/CEPR-DP13564.
few decades. Almost all economists agree that free trade is pdf; page 15

158
 4.4 Economic integration

UNIT 4: THE GLOBAL ECONOMY

Globalization implies greater interconnectedness of countries Trade liberalization, defined as a process of reducing or
in the world. This greater interconnectedness is also even eliminating trade barriers, may be achieved through
expressed in the area of international trade. Economies have preferential trade agreements or, multilaterally through
become more open, meaning that the size of exports and the World Trade Organization (WTO) which currently
imports as a proportion of GDP has been increasing. The has 164 member countries representing roughly 98% of
volume and value of annual trade flows has been rising in world trade.
the past decades as a result of trade liberalization.

Preferential trade agreements

Preferential trade agreements are agreements between two agreement (a regional trading bloc). If it is between many
or more countries to eliminate trade barriers between them countries that may not be in the same region it is referred
on a narrow or wider range of goods and services. to as a plurilateral agreement (but this distinction is not
If the agreement is between two countries it is referred necessary here). Lastly, if it is between all countries who
to as a bilateral agreement. If it is between many, usually are members of the WTO it is referred to as a multilateral
neighbouring countries, it is referred to as a regional agreement.

Trading blocs
Regional trading blocs or agreements tax and government spending policies. They share common
According to the WTO, in 2020 there were 320 regional regulatory policies (on, say, competition issues or bank
trade agreements in force up from 294 in 2019. There has supervision), as well as other policies such as on climate,
been a proliferation of regional trading blocs because such the environment, health, security, justice and migration.
agreements are faster to achieve and because of growing Members of a monetary union adopt, in addition, a common
demand for deeper integration between countries. currency and share a common central bank.

Types of trading bloc Examples of regional trading blocs

• Free trade area (FTA): this is formed when a group of • Free Trade Area (FTA). The prime example is the USMCA,
countries agrees to phase out or eliminate trade barriers the United States–Mexico–Canada Agreement, which
between them while each maintains its own tariff (trade came into force on 1 July 2020. It is referred to as
barriers) toward non-members. Free trade areas require the new NAFTA (the 1994 North American Free Trade
“rules of origin” to prevent non-members shipping goods Agreement) as it incorporates some minor changes. For
into the area through the country with the lowest external example, the USMCA changed the “country of origin”
tariff. For example, it may be required that at least 80% of rule for automobiles so that 75% of components, up from
the components of a laptop are manufactured within the 62.5%, must be manufactured inside the area; it also
group to qualify for 0% tariff. stipulates somewhat greater protection of workers, so in
factories making cars, workers must earn at least $16 an
• Customs union: an FTA may evolve into a customs union hour by 2023; US farmers have greater access to Canada’s
if, in addition, members agree to a common external tariff dairy market; it strengthens intellectual property rights,
or, more generally, to a common trade policy toward non- extending copyright protection of an author’s work by
members. 20 years, for example.
• Common market: a customs union may evolve into a Other examples include:
common market if, in addition, to the free flow of goods
and services within the bloc there is also free flow of: — the US–Israel FTA, which entered into force in 1985
— capital (cross-border investments within the bloc) — the ASEAN Free Trade Area, established by the original
ASEAN 6 (Brunei Darussalam, Indonesia, Malaysia, the
— labour (no work permits are required for a citizen of any Philippines, Singapore and Thailand) in 1992 and by
member country to work in any other member country). 1999 had added Cambodia, Laos, Myanmar and
The highest form of integration is for the bloc to evolve into Viet Nam.
an economic and monetary union. Members of an economic • Customs union. The Southern African Customs Union
union harmonize certain economic policies, particularly (SACU) which includes Botswana, Lesotho, Namibia,
macroeconomic and regulatory policies. They coordinate

159
 South Africa and Eswatini was established in 1910. It is central, the European Central Bank, and the euro as their
the world’s oldest Customs union. common currency.
The EU was initially a customs union when in July 1968
the six member countries of the European Economic Recap
Community (EEC)—Belgium, Germany, France, Italy,
How trading blocs are formed
Luxembourg and the Netherlands—eliminated all customs
duties between them and adopted a common external • A free trade area is formed if members eliminate
tariff. or agree to phase out trade barriers between them,
but each member country maintains its trade policy
• Common market. The Southern Common Market
towards non-members.
(MERCOSUR) was initially established by Argentina,
Brazil, Paraguay and Uruguay, and subsequently joined as • A customs union is formed if free trade area
associate members by Bolivia, Chile, Colombia, Ecuador, members agree to adopt a common trade policy
Guyana, Peru and Surinam. Venezuela’s membership was towards non-members.
suspended in 2016. • A common market is formed if members of a customs
The Common Market for Eastern and Southern Africa union additionally agree to permit the free flow of
(COMESA) has included 21 African states since July 2018. capital and labour.
The European Customs Union was transformed into a • An economic union is formed if members of a
common market in 1993 when adopting the four freedoms common market additionally harmonize certain
of movement of goods, services, people and money. macroeconomic and regulatory policies.
• Economic and monetary union. The European Union now • A monetary union is formed if members of an
has 27 member countries. Currently, 19 of these member economic union agree to adopt a common currency
states have joined in a monetary union with a common and to establish a common central bank.

Advantages and disadvantages of trading blocs

The big question is whether preferential trade agreements agreement but, at the same time, non-members of most
are a “stumbling block” or a “building block” to multilateral agreements, the significance of evaluating the role of trading
trade liberalization through the WTO. Since almost all WTO blocs becomes apparent.
members are also members of at least one preferential trade

HL
Static effects non-member to the artificially cheaper member. This
The static analysis of trading blocs rests on the work of is inefficient since it implies production against what
Jacob Viner in 1950 who introduced the terms trade creation comparative advantage would dictate. However, it is still
and trade diversion. possible that the effect improves welfare as both consumers
and producers within the importing country face prices
Trade creation refers to an increase in imports that displace closer to the true world price levels. For example, consider
less efficient domestic production. The elimination of the the USA, Mexico and South Korea. Assume that the USA
internal trade barriers in a trading bloc will lead members has a 20% tariff on shoes imported from both Mexico
to import from one another goods and services that were and South Korea. Initially the USA is importing shoes from
previously produced domestically. Some domestic production South Korea as this country is the cheapest, more efficient
will be replaced by imports from another member. This producer, despite the tariff. If, though, the USA and Mexico
increases efficiency since production shifts away from a agree to sign a customs union then shoe tariffs will be
domestic producer with high costs to a foreign member scrapped for Mexican shoe exporters, but will still be in
producer with lower costs, leading to fewer scarce resources place for South Korean manufacturers. The USA may switch
being wasted. away from the more efficient South Korean shoe imports
Trade diversion arises when imports shift from an efficient because Mexican shoes will now be artificially cheaper.
non-member to a less efficient member due to the The relative size of trade creation and trade diversion will
preferences the latter enjoys. The external tariff for non- vary from case to case and it will determine whether the
members may render some member artificially cheaper agreement enhances or diminishes static efficiency.
in the production of a good. Another member will then
switch importing from the truly efficient and lowest cost

160
 Dynamic advantages of trading blocs France has more bargaining power in negotiations with

UNIT 4: THE GLOBAL ECONOMY

• A trading bloc expands the size of the market for all the USA if it is negotiating through the EU.
firms so higher investment rates will follow. Higher rates • If the regional agreement leads to increased prosperity,
of investment will accelerate growth. This has been a then greater political stability may follow, and local
significant argument for developing countries. By forming conflicts are less likely.
a trading bloc, they could accelerate the process of • It is much easier for a country to reach an agreement
industrialization. when negotiating with only a few other countries than
• Phasing out and eliminating tariffs and other barriers when negotiating with 163 other countries within the
exposes firms to more competition. More competition in WTO. This is a major advantage that explains why the
turn leads to lower prices for consumers; greater efficiency number of regional agreements has increased so much.
in production, resulting in less waste; and a more efficient • Since the number of member countries is smaller than in
allocation of resources. the WTO these agreements permit member countries to
• Consumers will also have a greater variety of products to integrate deeper than they would have within the WTO.
choose from. Regional agreements have started to deal with areas
• If within a regional trading bloc there is free movement of such as investment and labour movement, competition
labour then employment opportunities increase, resulting issues, intellectual property rights, e-commerce and anti-
in less overall unemployment. corruption efforts that a country alone cannot deal with.
• Seamless borders also permit faster technology transfer. • (HL) Since firms will be selling in a bigger market they
may grow and achieve economies of scale. This may
• The bargaining power of members increases: they can lead to lower prices and increased competitiveness in
exercise greater economic leverage in negotiations than world markets.
if they had acted individually. This is especially true for
smaller countries but even a large country such as, say,

Possible disadvantages of trading blocs countries are in a weaker position to defend their trade
• A major criticism of regional agreements and their interests. Regional agreements may prove discriminatory
proliferation is that they undermine multilateral trade against smaller, often developing, countries as they
liberalization through the WTO. Multilateral agreements allow the powerful to use their huge bargaining power
that lower or eliminate trade barriers for all countries to achieve their preferred outcomes. This may explain the
are superior to any regional trading agreement but have proliferation of such agreements.
become more difficult to achieve. The latest WTO Doha • The proliferation of preferential trade agreements has
round of trade negotiations has been deadlocked for many also resulted in a “spaghetti bowl” of tariffs and rules of
years to the extent that it is now considered effectively origin which increase business and administrative costs for
over. There is thus a risk that the world may end up split trading firms.
into a few major blocs, each a potential “fortress” to • A country will sacrifice to various degrees its sovereignty,
the others. This explains why many economists consider as some decisions will either be a compromise or will be
preferential trade agreements as “stumbling blocks” to made outside the country.
trade liberalization. • (HL) It is likely that trading blocs are often formed as
• An additional risk arises when large economies (such a result of lobbying efforts of self-interested member
as the USA, China, India or the EU) sign preferential producers who hope to benefit from any resulting trade
agreements with smaller individual countries. Smaller diversion effects.

Monetary union
A monetary union is formed when members of an economic • There are lower transaction costs as currency conversions
union adopt a single currency and transfer the responsibility are not necessary. Every time an individual or a business
of monetary policy to a common central bank. In 1999 a has to exchange one currency for another, a fee has
subset of countries of the EU adopted a common currency, to be paid to the bank. This cost is eliminated for any
the euro, and established theEuropean Central Bank (ECB). transactions within a monetary union.
The eurozone has 19 member countries and since November • There is greater price transparency, which makes
2019 Christine Lagarde is the President of the ECB. comparisons of prices of goods, services and resources
much easier. Buyers (consumers and firms) are able to
Advantages of a monetary union spot quickly the lowest price available in the market for
These are mostly of a microeconomic nature. They include whatever good or service they are looking for. This
the following.

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 increases competition, forces inefficient producers to • Members lose economic sovereignty. If a country is
become more efficient and prices for tradable goods tend deprived of an independent monetary policy, if it cannot
to gravitate towards the lowest offered in the union. exercise an independent exchange rate policy, if its ability
• Exchange rate risk and the resulting uncertainty costs are to use fiscal policy is limited, then it has transferred at
eliminated. Exchange rates tend to vary, and this implies least part of its economic sovereignty outside the country.
increased uncertainty for businesses engaged in exports This has been a major argument for many EU countries
and imports of goods and services because the exchange against joining the euro.
rate may change between the time of purchase and that
of payment. Investors who buy and sell stocks and bonds Recap
also face the same risk as they cannot be sure what the
Advantages and disadvantages of a
exchange rate will be at a future date when they may
monetary union
wish to sell their asset and convert the proceeds into their
home currency. Note that exchange rate risk is greater Possible advantages of being a member of a monetary
for smaller businesses and investors who may therefore union include:
drop out of the market. This risk disappears with a single • lower transaction costs as currency conversions are
currency, encouraging more trade and a greater volume unnecessary
of investment within member countries. Many empirical • greater price transparency, facilitating price comparisons
studies have found evidence that membership in a
• no exchange rate risks and the associated uncertainty
monetary union has a positive impact on both trade and
costs
cross-border investments.
• greater negotiating and bargaining power in world
• A group of countries with a common market and a
affairs.
common currency will enjoy greater influence and
bargaining power in world affairs. Possible disadvantages of being a member of a
monetary union include:
Disadvantages of a monetary union • no independent monetary policy
These are mostly of a macroeconomic nature. They may • no exchange rate policy
include the following.
• limited room for independent fiscal policy
• Member countries are deprived of an independent
• loss of economic sovereignty.
monetary policy. Since there is one currency and one central
bank there is one monetary policy for all members. This
“one-size-fits-all” approach may make things very difficult The World Trade Organization (WTO)
for some members if business cycles are “asynchronous”.
This term simply means that when one economy is booming The WTO was established in 1995. It is the successor of the
and overheating another country may be losing steam and GATT (General Agreement on Tariffs and Trade), a 1947
about to enter recession. Theory dictates that the former agreement between 23 countries to promote free trade by
should tighten monetary policy, increasing interest rates, phasing out or eliminating tariffs and other trade barriers.
while the latter should loosen monetary policy, decreasing GATT and the WTO agreements are known as multilateral
interest rates. If they are members of a monetary union, agreements and are anchored on the most-favoured nation
most probably the smaller country will suffer. (MFN) principle that requires every member country to treat
all other member countries as it treats its most-favoured
• Members are deprived of an independent exchange rate trading partner, effectively not allowing discrimination.
policy. A central bank is also responsible for conducting
exchange rate policy. Being a member of a single currency Objectives and functions of the WTO
area deprives a country the possibility to lower the • The WTO has become closely associated with the process
value of its currency. Lowering its currency’s value would of globalization. It provides a forum for trade negotiations
decrease the foreign price of its exports, boosting export that cover goods, services and intellectual property. The
revenues and thus aggregate demand in a recession. It WTO promotes free trade by persuading countries to
cannot increase the value of its currency in the face of abolish import tariffs and other trade barriers.
mounting inflationary pressures either. Not only is there • It ensures that agreements are implemented and adhered
no exchange rate to manipulate between members, but to by requiring that national trade policies are transparent
also one member alone cannot influence the external and by carrying out periodic reviews.
value of the common currency as there is an independent
• It is the arbitrator of trade-related disputes. This means
central bank.
that all disagreements or grievances between member
• There is limited room for pursuing independent fiscal countries are settled within the WTO. The seven-member
policy. Even though each government can manipulate Appellate Body makes the final decision which all
its own expenditures and taxes, the freedom to do so is parties in any dispute must accept. The WTO empowers
limited because budget deficits and public debts must its members to enforce its decisions by imposing trade
somehow be financed. Fiscal and monetary policies are sanctions against countries that have broken the rules.
not as independent as they may seem.

162
• It provides additional assistance to developing countries is considered the main reason why the negotiations known

UNIT 4: THE GLOBAL ECONOMY

to build their technical expertise and their trade capacity. as the Doha Round failed.
• It is claimed that the WTO has tried to force developing
Evaluating the WTO nations to change their policies, laws and regulations
• The GATT, and its successor the WTO, have been quite by declaring them in violation of its rules. It has also
successful in decreasing trade barriers over the past been accused of paying insufficient attention to
70 years and this has resulted in world trade growing the displacement of labour that trade liberalization
dramatically. According to OECD and World Bank data, unavoidably brings about, as well as to rising income
world trade (sum of exports and imports) as a percentage inequality issues (even though one may argue that such
of world output (gross world product) increased from policies are in the realm of national governments).
roughly 25% in 1960 to 59.4% in 2018.
• According to critics the WTO also does not sufficiently
• The greatest success resulting from the WTO is that, as consider the possible adverse effects of trade liberalization
an institution, it has established rules and order in the on the environment and it has not paid sufficient
trading world and so it has managed, at least until now, to attention to child labour issues and to production
decrease uncertainty. processes in so-called “sweatshops”.
• The WTO proved instrumental in preventing national However, few would disagree that as the net effect of
governments from resorting to escalating trade protection the WTO on world welfare has been positive. There is of
in response to the 2008–09 world recession. Members, course room for improvement but the current scenario of
bound by the rules of the WTO, did not resort to raising no international body regulating the rules of world trade is
tariffs and quotas to appease domestic political pressure. alarming.
As a result of Covid-19, the WTO estimates that the volume
of world merchandise trade will contract by 13% in 2020
compared to a year before. For economies to rebound,
Recap
the WTO must ensure that markets remain open and that The World Trade Organization (WTO)
members adhere to the rules of global business activity. The WTO:
• Rules are enforced because members have agreed that the • was set up in 1995 as a successor of the GATT (1948)
WTO has the authority to impose sanctions on the parties
• has 164 member countries responsible for 98% of
that lose in a dispute. The Appellate Body, the “supreme
world trade
court” of the WTO, consists of 7 “judges” whose four-year
appointment must be accepted by all 164 members, each • sets trade rules and ensures that they are followed
with the right to veto a nomination. The USA, though, • is the arbitrator of trade-related disputes
has been blocking the re-appointment of new judges • provides assistance to developing countries.
since 2017. Since December 2019 the dispute settlement
Evaluation—the WTO:
system of the WTO that prevented countries from resorting
to trade protection has been paralyzed. The EU and 16 • has decreased tariff and other trade barriers and
other members of the WTO agreed to develop a temporary has helped world trade to increase dramatically,
arrangement that will allow members to maintain a stimulating growth
dispute settlement system until the WTO Appellate Body • has prevented governments to resort to protection
becomes operational again. The hope is that countries will during crises
not resort to generalized successive rounds of protection. • has been able to enforce trade rules and to settle
• Of course, the WTO has been subjected to plenty of trade disputes
criticism. With 164 members it has been very difficult and • is accused of being biased in favour of the USA, EU
time consuming to reach agreement, which has led to the and other large economies while being inconsiderate
proliferation of regional trade agreements. to the needs of developing countries; for example,
• The WTO has been accused of mostly catering to the services and other markets in developing countries
needs of advanced economies, neglecting those of have been forced open whereas US and EU
the developing world. The WTO has pushed for the agriculture is still protected with subsidies and other
liberalization of services in developing countries so that barriers
multinationals from advanced economies gain access • has been accused of paying insufficient attention
to their growing markets at the cost of local firms. At to increasingly important issues such as the
the same time, it has not done enough to force the USA environment, child labour, health and workers’ rights.
and the EU to open up their own agricultural markets to
imports. The inability to reach an agreement in agriculture

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 4.5 Exchange rates
The exchange rate of a currency is defined as the price of a we get the price of one US dollar expressed in terms of
currency expressed in terms of another currency. For example, pounds, or USD 1.00 = GBP 0.8019. You should realize that
on 2 July 2020: the one exchange rate is the inverse of the other, so if the
• GBP 1.00 = USD 1.2471, so you needed 1.2471 US dollars price of the pound goes up with respect to the US dollar
to buy one British pound then this means that the price of the US dollar decreases in
terms of the British pound.
• USD 1.00 = INR 74.682, so you needed 74.682 Indian
rupees to buy one US dollar If the exchange rate of the British pound with respect to the
US dollar is equal to (e) then the exchange rate of the US
• Euro 1.00 = NZD 1.7264, so you needed 1.7264 New
dollar with respect to the British pound will be equal to (1 ).
Zealand dollars to buy one euro. e
You should also realize that whoever is buying pounds in
The exchange rate is one of the most important prices in an
the foreign exchange market is at the same time selling
economy. It is determined in the foreign exchange market,
dollars or, more generally, the buyer of one currency is at the
which operates on a 24-hour basis, 365 days a year. Being
same time a seller of another currency. This means that in a
a price, it is determined by the demand for the currency and
diagram of demand and supply for a currency, the demand
the supply of it. When the exchange rate changes, it has
for the currency that is being bought is also the supply of
consequences for almost everything and everyone.
whichever currency is being sold.
Focusing on the exchange rate above of the British pound
expressed in US dollars and dividing both sides by 1.2471

Exchange rate systems

The exchange rate of a currency is affected by the demand for currency in a floating exchange rate system. Consider the
it and the supply of it but whether it is the result of only the following.
interaction of demand and supply depends on the exchange • 5 August 2019: £1.00 = $1.2037.
rate system the country has chosen to operate by.
• 9 December 2019: £1.00 = $1.3325.
There are three different exchange rate systems within which
• 16 March: £1.00 = $1.1650.
exchange rates are determined: floating, fixed and managed
exchange rate systems. The value of the pound is obviously not fixed. The pound and
the dollar operate in a floating exchange rate system. We
• Floating (or flexible) exchange rate system: this is when
say that between 5 August 2019 and 9 December 2019 the
the exchange rate is determined only by the interaction
pound appreciated against the dollar. Between 9 December
of demand and supply without any government or central
2019 and 16 March 2020, the pound depreciated against the
bank intervention.
dollar. It should be clear that when the pound is appreciating
• Fixed exchange rate system: this is when the exchange against the dollar, the dollar is depreciating against the pound
rate is set by the government at some level and is and when the pound is depreciating against the dollar, the
maintained at that level through appropriate intervention dollar is appreciating against the pound. Remember, the one
by the central bank. exchange rate is the inverse of the other.
• Managed exchange rate system: this is when the In a fixed exchange rate system, when the central bank
exchange rate is allowed to float but there is periodic decides to set the exchange rate at a lower level, we say that
intervention by the central bank whenever the direction there has been a devaluation of the currency. If the central
or the speed of change is considered undesirable. The bank decides to increase the official rate, we say that there
frequency of such interventions varies. Most currencies are has been a revaluation of the currency.
traded in a “managed float” system.
Denmark maintains a fixed exchange rate against the euro
Appreciation and depreciation versus but keeps its currency, the krone (Kr), floating against all
other currencies. Specifically, the Denmark’s National Bank,
revaluation and devaluation
Denmark’s central bank, keeps the krone fixed against the
When the price (the value) of a currency changes in a euro at what is known as the central rate of €1.00 = Kr7.468
floating exchange rate system we describe the change using and permits it to fluctuate only within a +/– 2.25% band.
the terms appreciation and depreciation. On the other hand,
If for whatever reason Denmark’s central bank decides to
when its price (its value) changes in a fixed exchange rate
set the central rate of the krone at €1.00 = Kr7.60 then the
system we describe the change using the terms revaluation
Danish krone will have devalued (since the euro is more
and devaluation.
expensive, the krone is cheaper). Conversely, if the central
More specifically, the term appreciation refers to an increase rate was set at €1.00 = Kr7.30 then the krone will have
in the price of a currency in a floating exchange rate system. revalued (since the euro is now cheaper).
The term depreciation refers to a decrease in the price of a

164
Therefore, devaluation and revaluation are terms reserved for firm or establishing a new firm in the US. Think of British

UNIT 4: THE GLOBAL ECONOMY

deliberate official changes in the value of a currency whereas investors wishing to take advantage of higher US interest
depreciation and appreciation are reserved for exchange rate rates on dollar deposits. They will have to sell their UK
changes induced by market forces. pounds to buy the necessary dollars to make the deposit.
The supply of pounds therefore also reflects cross-border
Who demands a currency and why; who investments into the UK, which are referred to as financial
supplies and why? (or capital) outflows.
Let us for simplicity initially assume a world where only • Pounds may be supplied by those who want to sell a
British pounds and US dollars are bought and sold by the currency because they expect it to fall in value. They may
participants in the foreign exchange market. We are also sell pounds now when its price is high and buy pounds
assuming that there is no central bank intervention, so we later when its price is lower.
are analysing a floating exchange rate system. So, trade flows and financial (capital) flows are two of the
For now, let’s focus on the exchange rate of the British most important reasons why foreign exchange is demanded
pound. Who would demand and buy pounds in this market and supplied in foreign exchange markets. However, there
and what for? Who will supply and sell pounds in this are also other reasons for buying or selling a currency in the
market and what for? foreign exchange market.
Pounds may be demanded by the following groups. • Pounds may be supplied in the foreign exchange market
• Individuals who want to buy UK goods and services (that by migrant workers from, say, Bangladesh working in
is, UK exports) demand pounds. If Americans are buying London and sending money back to their families in
British goods and services, then dollars will have to be sold Dhaka. They will send them pounds which will have
for pounds to be bought. Consider a New York department to be exchanged for Bangladeshi taka, the currency of
store planning to add to its selection a range of coats made Bangladesh. Amounts of money that migrants send to
by UK manufacturer Burberry. The store will need to buy their country of origin are referred to as remittances.
pounds in order to pay Burberry. Now think of an American • Lastly, central bank intervention will affect the demand
planning to attend the London School of Economics. She and the supply of a currency and thus the exchange rate.
needs pounds to pay for her tuition so she will have to For example, the Swiss National Bank, which is the central
exchange her dollars for pounds. The demand for pounds bank of Switzerland, may decide to buy euros by selling
therefore reflects UK exports of goods (Burberry’s coats) Swiss francs. The supply of Swiss francs will increase
and services (education). (as will the demand for euros).
• Investors will need pounds to make investments into the Figure 4.5.1 illustrates the equilibrium exchange rate for the
UK, meaning here to buy UK government bonds or shares UK pound expressed in terms of US dollars.
sold in the London Stock Exchange, to make bank deposits
in pounds, to acquire a British firm or to establish a new Price of pound S of £
firm in the UK. If Americans wants to make deposits in $
British pounds, they will have to buy pounds with their US (in USD) ( )
£
dollars. The same applies if they want to buy UK bonds
or shares, a British company or to set up a factory in
Manchester, UK. The demand for pounds therefore also
reflects cross-border investments into the UK which are e1
referred to as financial (or capital) inflows.
• Pounds may be bought by those who buy a currency
because they expect it to rise in value. They may buy
pounds now when its price is low and sell it later when its D for £
price increases. Buying and selling a currency hoping to
make a profit from a change in its value is referred to as
speculation. Quantity of pounds
Pounds are supplied by the following groups. (traded per period)
• UK importers of US goods and services supply pounds. Figure 4.5.1 The market for UK pounds
A British firm buying (importing) Abercrombie and Fitch
shirts will have to sell UK pounds to buy the necessary US Since Figure 4.5.1 focuses on the exchange rate of the
dollars for the purchase of these shirts. An Englishman UK pound with respect to the US dollar, the vertical axis
visiting New York for Christmas with his family will need to is the price of the pound and the horizontal is the quantity
exchange his pounds for US dollars to pay for the holiday. of pounds traded per period. On the vertical axis, the price of
The supply of pounds therefore reflects UK imports the pound is expressed in US dollars, so it is US dollars per
of goods (Abercrombie and Fitch shirts) and services $
one UK pound or £ .
(vacations in New York).
To avoid a common error, remember that whatever currency
• British investors in the USA supply pounds. Such is on the denominator of this fraction is also on the
investments include buying US government bonds or horizontal axis of your diagram. In Figure 4.5.1, demand
shares sold in the New York Stock Exchange, buying a US for pounds D1 is equal to the supply of pounds S1 at the

165
 exchange rate e1, say, $1.31 per pound. Any change in any So, the quantity of pounds demanded at the lower pound
factor affecting demand for pounds or supply of pounds will exchange rate will increase. The supply of pounds is
lead to appreciation or depreciation of the pound. upward sloping for the symmetrical reason. If the pound
Why is the demand for pounds negatively sloped? The becomes cheaper then UK residents will need more pounds
reason is that if the exchange rate decreases and the to buy a US dollar. US imported goods will become more
pound becomes cheaper then fewer dollars will be needed expensive in the UK. Investing in the USA will also become
to buy a pound. British imported goods will become more expensive for British residents. They will therefore
cheaper and more competitive for Americans to buy and supply fewer pounds in the foreign exchange market at a
it will also be cheaper for Americans to invest in the UK. lower pound exchange rate.

Changes in demand or supply for a currency

The exchange rate will appreciate or depreciate depending S1 of £
on whether excess demand or excess supply arises in Price of pound
$
the foreign exchange market. A currency will appreciate (in USD) ( )
£
if there is excess demand. It will depreciate if there is
e2
excess supply. Excess demand will result either because
demand for the currency increased or because supply of the e1
a b
currency decreased. Excess supply will result if demand for
the currency decreased or because supply of the currency
increased. More specific examples are given below.
D2 for £
Currency appreciation: Excess demand
D1 for £
If for whatever reason the demand for pounds increases
Quantity of pounds
and shifts to the right from D1 to D2 then excess demand (traded per period)
for pounds equal to ab will put pressure on the exchange
rate to increase to e2 in Figure 4.5.2. The pound will have Figure 4.5.2 Impact of an increase in the demand for UK pounds
appreciated from e1 to e2.
S2 of £
If for whatever reason the supply of pounds decreases Price of pound S1 of £
$
and shifts to the left from S1 to S2 then excess demand (in USD) ( )
£
of pounds equal to ab will put pressure on the exchange
rate to increase to e2 in Figure 4.5.3. The pound will have e2
appreciated from e1 to e2. a b
e1
Currency depreciation: Excess supply
If for whatever reason the demand for pounds decreases
and shifts to the left from D1 to D3 then excess supply
of pounds equal to fh will put pressure on the exchange
rate to decrease to e3 in Figure 4.5.4. The pound will have D1 for £
depreciated from e1 to e3. Quantity of pounds
If for whatever reason the supply of pounds increases (traded per period)
and shifts to the right from S1 to S3 then excess supply
Figure 4.5.3 Impact of a decrease in the supply of UK pounds
of pounds equal to fh will put pressure on the exchange
rate to decrease to e3 in Figure 4.5.5. The pound will have Price of pound S1 of £
depreciated from e1 to e3. (in USD) ( )
$
£
Causes of changes in the exchange rate
of a currency h
e1 f
Changes in trade flows
Remember that: when a country exports goods and services e3
then foreigners need to buy its currency; when it imports
goods and services it will need to sell its currency to buy
foreign currencies.
Changes in the foreign demand of a country’s exports D3 for £ D1 for £
Assume that a country is experiencing growing demand Quantity of pounds
for its exports. Growing exports implies that foreigners will (traded per period)
need more of the domestic currency to pay for these exports. Figure 4.5.4 Impact of a decrease in the demand for UK pounds
Demand for the currency by foreigners will therefore increase

166
 UNIT 4: THE GLOBAL ECONOMY
S1 of £ S1 of Rp
Price of pounds Price of rupiahs
$ S3 of £ $ S2 of Rp
(in USD) ( ) (in USD) ( )
£ Rp

e1
f h
e1

e3 e2

D1 for £ D for Rp
Quantity of pounds Quantity of rupiahs
(traded per period) (traded per period)
Figure 4.5.5 Impact of an increase in the supply for UK pounds Figure 4.5.6 Effect of a growing economy on the exchange rate

and the demand curve will shift to the right. Excess demand In Figure 4.5.6 the price of the Indonesian rupiah
for the currency will create pressure for the currency to expressed in US dollars is initially at e1. If Indonesian
appreciate. This is illustrated in Figure 4.5.2. growth accelerates then Indonesians’ incomes are rising.
On the other hand, a decrease in the foreign demand for a Consumption expenditures will rise. This means that
country’s exports will lead to a depreciation of the currency. Indonesia will also buy more imports.
This is illustrated in Figure 4.5.4. Indonesians will have to supply more rupiahs in the foreign
Changes in the domestic demand for imports exchange market to buy the necessary dollars to pay for the
increase in imports. The supply curve for the rupiah will shift
Assume that domestic demand for imports increases. To buy to the right to S2 as imports are now greater. The rupiah will
more foreign products, importers must sell the domestic therefore tend to depreciate to e2.
currency to buy the necessary foreign currency. The supply of
the domestic currency will increase and therefore the supply This is a very interesting result that is seemingly
curve will shift to the right. Excess supply for the currency counterintuitive. A growing economy may witness a
will create pressure on the currency to depreciate. This is depreciating currency. It will be shown that this is not
illustrated in Figure 4.5.5. necessary if the growing economy attracts more investments.
A decrease in the domestic demand for imports will lead Changes in relative inflation rates
to a decrease in the supply of the domestic currency and If inflation in a country accelerates it means that prices of
so the currency will appreciate. This is illustrated in goods and services in that country are rising on the average
Figure 4.5.3. faster than they used to. Its products will become less and
If the demand for a currency reflects the value of its exports less competitive abroad while imported goods and services
and the supply of its currency reflects the value of its imports will seem more attractive domestically.
it follows that if exports rise faster than imports then, ceteris Foreign demand for its exports will decrease and therefore
paribus, the currency will tend to appreciate. In contrast, if so will the demand for its currency. In addition, domestic
imports are rising faster than exports then, ceteris paribus, demand for imported goods and services will increase,
the currency will tend to depreciate. increasing the supply of its currency.

Factors affecting trade flows S1 of Rp

Price of rupiahs
The above analysis shows that any changes in a country’s $ S2 of Rp
trade flows will affect its exchange rate. Changes in growth (in USD) ( )
Rp
rates and changes in inflation rates are two factors that will e1
affect exports and imports of a country and thus the demand
and the supply for its currency.
Changes in relative growth rates
A higher growth rate implies that incomes in the country e2
are now rising faster than previously. Rising incomes
imply rising consumption expenditures and household
consumption expenditures include spending not only
on domestic but also on foreign goods and services. It D1 for Rp
D2 for Rp
follows that in a growing economy, demand for imports
will rise. Now let’s focus on the Indonesian rupiah (Rp) Quantity of rupiahs
(traded per period)
and assume that the growth of the Indonesian economy
Figure 4.5.7 Effect of higher inflation on the exchange rate
is accelerating.

167
 Figure 4.5.7 shows the effect of higher inflation in Indonesia other words on the interest rate they pay the owner. Whether
on the rupiah. Initially the rupiah exchange rate against it becomes more attractive to own more shares in a foreign
the dollar was at e1. The higher inflation in Indonesia will stock exchange or to establish a new presence in a foreign
decrease its exports as they will become less competitive country critically depends on the growth prospects of that
abroad, decreasing the demand for the rupiah from D1 to country. More specific examples are given below.
D2 in Figure 4.5.7. Changes in relative interest rates
At the same time imported goods and services will seem If interest rates in an economy increase relative to interest
more and more attractive to Indonesians. Imports will rates in other economies then government bonds and
therefore tend to increase. More rupiahs will be supplied deposits in that country’s currency become more attractive
in the foreign exchange market, shifting the supply curve as the owner of such assets will earn relatively more, ceteris
of rupiahs from S1 to S2. The decrease in the demand for paribus. Financial investors will have an incentive to buy the
rupiahs and the increase in the supply of rupiahs will lead to currency in order to make the deposits and/or to buy bonds.
its depreciation to e2. Demand for the currency will increase and the currency will
Inflation in an economy will tend to depreciate a currency. tend to appreciate. For example, if the Bank of England
Changes in cross-border capital flows increases interest rates then the higher rate of return will
make UK bonds and deposits in UK pounds more attractive
Inflows and outflows of financial capital for investment
to financial investors. They will buy UK pounds in the foreign
purposes will also affect the exchange rate of a currency.
exchange market, increasing the demand for UK pounds and
We distinguish two types of investment flows: portfolio
shifting the demand curve to the right, as shown in Figure
investment and foreign direct investment (FDI).
4.5.4. The UK pound will appreciate from e1 to e2.
Inward and outward portfolio investments
If the Bank of England decreases interest rates, then the rate
Portfolio investments refers to the buying and selling of of return on UK bonds as well as on deposits in UK pounds
financial assets, including stocks, bonds and deposits. is lower. These assets will be less attractive to financial
If for some reason an economy attracts more portfolio investors so some will decide to sell these assets and switch
investments, then the resulting inflows of financial capital to dollar deposits or US bonds. The supply of UK pounds
will tend to appreciate the currency. For example, let’s will increase and shift the supply curve to the right, as in
say that UK bonds or deposits in UK pounds or shares Figure 4.5.5, and the pound will tend to depreciate. In
of UK firms listed in the London Stock Exchange become addition, demand for UK pounds will also decrease, further
relatively more attractive to financial investors. Those decreasing the value of the UK pound.
investors will need to buy the UK pounds to be able to buy
Note that this analysis raises an interesting question. If
UK bonds, or make deposits in UK pounds or buy stocks in
interest rates in say, Argentina, are the highest right now,
the London Stock Exchange. The demand for UK pounds
why doesn’t Argentina attract all financial investors? The
will therefore increase. The pound will appreciate as a
answer is related to the fact that the decision also depends
result of the inward portfolio investments. This case is
on the expectations financial investors have concerning
shown in Figure 4.5.2.
the future value of the Argentine peso. If there is risk of
If these financial investors later realize that it is now more a depreciation, then many will shy away from holding
profitable to switch to US bonds, or to deposits in US dollars Argentinian assets.
or to stocks listed in the New York Stock Exchange, they
To summarize, higher interest rates will, ceteris paribus lead
will sell UK pounds to buy the necessary US dollars. The
to inward portfolio investment flows and an appreciation
supply of UK pounds will increase. The pound will therefore
of the currency whereas lower interest rates will have the
depreciate as a result of outward portfolio investments.
opposite effect.
Inward portfolio investments lead to an appreciation of the
currency whereas outward portfolio investments lead to a Expectations concerning the growth prospects
depreciation of the currency. This is shown in Figure 4.5.5. of an economy
Inward and outward foreign direct investment (FDI) When will investors be eager to buy more shares in a
country’s stock exchange? When will firms be eager to
Foreign direct investment (FDI) is of a long-term nature
establish a new presence in an economy or to buy controlling
and refers to a firm establishing a new presence in a
interest in the shares of an existing foreign company?
foreign country or acquiring controlling interest of a foreign
company. If for some reason an economy attracts more FDI, There is a single answer, which is significantly related to the
then the resulting inflows of financial capital will lead to an expected growth prospects of an economy. If the growth
appreciation of the currency. For example, if Côte d’Ivoire prospects of an economy are very promising, then investors
attracts more inward FDI then the demand for West African will want to buy stocks and/or establish a new business
CFA francs (the currency of Côte d’Ivoire) will increase and so presence themselves in the country so they can receive the
the currency will tend to appreciate. Conversely, outward FDI expected profits. Demand for the country’s currency will tend
will tend to depreciate a currency. to increase, pushing upward the exchange rate.
A growing economy implies growing and profitable firms
Factors affecting cross-border capital flows and plentiful business opportunities that foreigners will also
Whether deposits and bonds are attractive to financial want to take advantage of. The currency will therefore tend
investors depends, ceteris paribus, on their rate of return, in to appreciate.

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Earlier it was explained that the currency of a growing

UNIT 4: THE GLOBAL ECONOMY

economy may depreciate because of greater import Recap
absorption. It should be clear now that the currency may Factors affecting the exchange rate of a
not depreciate if growth is expected to continue. Continued currency
growth may also increase inward investments, exerting
upward pressure on the currency. Changes in trade flows
Speculation • Changes in the foreign demand for a country’s exports
Buying or selling a currency for speculative purposes If foreign demand increases then the exchange rate
will also affect the exchange rate. If speculators buy the appreciates.
currency, demand for it will increase and the currency will If foreign demand decreases then the exchange rate
tend to appreciate. If speculators sell the currency, supply depreciates.
of it will increase and the currency will tend to depreciate. • Changes in the domestic demand for imports
Even small changes in the exchange rate of a currency can
If domestic demand increases then the exchange rate
produce large profits for currency speculators when their
depreciates.
bets involve large sums of money. Of course, errors may lead
to large losses. What is the main driving force of currency If domestic demand decreases then the exchange rate
speculation? It is the expected path of the exchange appreciates.
rate itself. Trade flows are in turn affected by:
Anticipating an appreciation will lead to speculators buying • changes in relative growth rates—faster growth
the currency. Demand for it will increase and therefore the increases import absorption so the currency will tend
currency will tend to appreciate. Anticipating a depreciation to depreciate (but see below)
will lead to speculators selling the currency. Supply of it will • changes in relative inflation rates—faster inflation
increase and therefore the currency will tend to depreciate. decreases exports and increases imports so the
Note that these are examples of what are known as self- currency tends to depreciate.
fulfilling expectations.
Changes in investment flows
Remittances
• Portfolio investment flows
When migrant workers send money back home, their
families will have to exchange the money received for the If these are inward then the currency appreciates.
home currency. This means that remittances increase the If these are outward then the currency depreciates.
demand for the recipient country’s currency and so lead Portfolio investment flows are in turn affected by
to its appreciation. For example, if Mexican workers in the changes in relative interest rates.
USA send money back home to their parents every month,
• If domestic interest rates increase then the currency
they need to convert dollars to Mexican pesos. Demand for
will tend to appreciate.
pesos will rise, and the peso will tend to appreciate. When
these remittance inflows are large relative to the size of the • If domestic interest rates decrease then the currency
recipient economies the appreciation may prove significant. will tend to depreciate.
Note that foreign aid may have a similar impact on the • Foreign direct investment (FDI) flows
recipient country’s exchange rate. If these are inward then the currency appreciates.
Central bank intervention (in managed and If these are outward then the currency depreciates.
fixed exchange rate systems) FDI flows are in turn affected by growth prospects of
In a floating exchange rate system, there is no central a country.
bank intervention. However, central banks do intervene in • If faster growth is expected in a country then, ceteris
a managed as well as in a fixed exchange rate system. If paribus, FDI inflows will increase and the currency
a central bank needs to make sure that the value of the will appreciate.
currency does not decrease, it will enter the foreign exchange
market and start buying it (using dollar or other foreign Speculation
exchange reserves). In this way, demand for the currency • If speculators expect a currency to appreciate then they
increases or is maintained at the desired level. will buy the currency and it will tend to appreciate.
If a central bank would like to make sure that the currency • If speculators expect a currency to depreciate then they
does not rise in value, then it will start selling the currency in will sell the currency and it will tend to depreciate.
the foreign exchange market, buying dollars or euros or some
other major currency in exchange. For example, the Swiss Workers’ remittances
National Bank (the central bank of Switzerland) was selling Inflows will tend to appreciate the currency of the
Swiss francs (SFr) during the coronavirus outbreak because in recipient country.
times of increased uncertainty financial investors consider the
Intervention by the central bank
Swiss franc a safe haven and demand for it increases. If the
Swiss National Bank sells it, its supply rises, and this prevents • If it buys the currency it will appreciate.
an undesired further appreciation of the SFr. • If it sells the currency it will depreciate.

169
 Consequences of changes in the exchange rate
Impact on the current account balance from France Bordeaux wine at €40 per bottle. Table 4.5.1
The current account will be explained in some detail later shows the impact of a depreciation of the pound on export
but for our purposes it is sufficient here to understand it as and import prices.
the difference between the value of exports of goods and Following a depreciation, we expect that a trade deficit
services and import expenditures on goods and services (that will eventually decrease in size as exports become more
is, X – M). competitive and imports less attractive. (HL will examine the
If X > M then we say that there is a trade surplus whereas necessary Marshall-Lerner condition—see section 4.6,
if M > X we say that there is a trade deficit. Remember that page 177).
net exports, defined as X – M, are a component of aggregate If, for example NX were equal to –$150 million then
demand. following the depreciation NX may have eventually
Perhaps the most important thing to understand and decreased to –$110 million. It should be clear that this
remember is that if a currency depreciates then exports means that aggregate demand will increase, as exports
become cheaper abroad and therefore more competitive became more competitive and imports less attractive.
while imports become pricier domestically and less attractive. The impact of an appreciation is the opposite. An appreciation
To illustrate the impact of a depreciation on prices of exports will increase the foreign price of exports and render them less
and imports, assume for the sake of the example that competitive abroad whereas it will decrease the domestic price
initially £1.00 = €4.00 and that the pound depreciated so of imports rendering them more attractive. A trade surplus
that £1.00 = €2.00. Further assume that the UK exports to will thus decrease and since net exports (NX) will be smaller,
the eurozone Celtic swords priced at £100 each and imports aggregate demand will also decrease.

Impact of a depreciating UK pound on the foreign price of exports and the domestic price of imports
Example: the UK exports Celtic swords and imports Bordeaux wine.
Original exchange rate New exchange rate £1.00 = €2.00
£1.00 = €4.00
UK price of a Celtic sword £100.00 Price in the eurozone: €400.00 New price in the eurozone: €200.00
The UK export is now cheaper in the
eurozone and more competitive.
Eurozone price of a bottle of Bordeaux Price in the UK: £10.00 New price in the UK: £20.00
wine €40.00 The EU import is now pricier in the UK
and less attractive.

Table 4.5.1 Example of the impact of a depreciation on export and import prices

Recap
Currency depreciates
• The foreign price of exports • Exports will tend to A trade deficit Aggregate demand will
falls so exports become rise. (when (X–M) is < 0) tend to increase
more competitive. • Imports will tend to will eventually narrow (as the trade deficit is a
• The domestic price of decrease. (decrease).* smaller negative figure).
imports rises so imports
become less attractive.
Currency appreciates
• The foreign price of exports • Exports will tend to A trade surplus Aggregate demand will
rises so exports become decrease. (when (X–M) is > 0) tend to decrease
less competitive. • Imports will tend to will eventually narrow (as the trade surplus is a
• The domestic price of increase. (decrease).* smaller positive figure).
imports falls so imports
become more attractive.

*The role of the Marshall-Lerner condition (HL) is examined in section 4.6.

170
Impact on economic growth In Figure 4.5.8 the expected impact of a depreciation

UNIT 4: THE GLOBAL ECONOMY

Assume that a currency depreciates. Exports become cheaper is shown. Since exports become cheaper and more
abroad and more competitive while imports become pricier competitive abroad and imports become pricier and
domestically and less attractive. Net exports will tend to less attractive domestically, the value of net exports
increase and therefore aggregate demand will tend to (a component of aggregate demand) is expected to
increase. However, if aggregate demand increases and eventually increase. The AD curve will shift to the right
the AD curve shifts to the right then real GDP will tend to from AD1 to AD2. Real GDP will increase from Y1 to Y2
increase so the economy will grow. This explains why several and cyclical unemployment will decrease. There is no
countries have tried to maintain their exchange rate low—so demand-pull inflation because the economy at Y1 was
that their exports remain cheap, and therefore competitive, operating significantly below full employment output Yf.
in foreign markets. This is the idea behind what is known as Had the economy been originally operating at Y2, the
“export-led growth”. deflationary gap would have been much smaller so the
depreciation could increase AD to AD3. In this case, real
We should note that this growth may prove inflationary if GDP increases to Y3 and cyclical unemployment decreases,
the economy is operating close to its potential output (see but the possibility of demand-pull inflation is evident as the
Figure 4.5.8). average price level (APL) will start rising.
In contrast, an appreciation will decrease aggregate demand
and therefore slow down growth as net exports will tend to Average price AS
decrease. level (APL)

Impact on unemployment
As depreciation leads to an increase in aggregate demand
AD1 AD2 AD3
and so an increase in real output, it is expected that cyclical
unemployment will decrease. A depreciation will not succeed
in decreasing structural unemployment because the skills
of the unemployed are not brought up to date, nor is the
labour market becoming more flexible. Y1 Y2 Y3

In contrast, an appreciation will, strictly speaking, decrease

aggregate demand and so decrease economic activity and
increase cyclical unemployment. However, if the appreciation Yf Real output
succeeds in slowing down the increase in aggregate demand, (Yr)
mitigating rising inflationary pressures, then non-inflationary
Figure 4.5.8 Impact of a depreciation on growth, unemployment
growth may persist and unemployment may decrease or at and inflation
least not increase.
Maintaining the exchange rate high is, as explained later, Impact on living standards
sometimes used to diminish inflationary pressures in an If, as a result of a depreciation or of maintaining a low
economy and maintain price stability. exchange rate, growth accelerates, unemployment drops
and incomes rise then living standards, on the average, will
Impact on inflation increase. Keep in mind that the biggest beneficiaries will be
A depreciation may succeed in helping an economy to all those involved directly or indirectly with the export sector,
increase real GDP and increase employment levels, but which will be driving the country’s growth. Whether a low
it always runs the risk of creating both demand-pull and exchange rate will benefit the population at large depends
cost-push inflation. Demand-pull inflation may result if the on whether the government adopts policies that will ensure
economy is operating close to its full employment (potential) the ensuing growth is inclusive.
level of real output. Cost-push inflation may result if firms An appreciation of the currency may slow down growth
in the economy rely significantly on imported raw materials but may prove very helpful as inflationary pressures will
(such as energy) and intermediate products (such as parts) decrease. Low income households will immediately benefit
as a depreciation leads to higher domestic prices for as the resulting lower import prices will decrease their
imports so that production costs increase across a range of cost of living. Remember that low income households
components. spend a bigger proportion of their income on food and
In contrast, an appreciation by decreasing (or slowing down pharmaceuticals and if these goods are imported then their
the increase) in aggregate demand and by lowering the cost purchasing power will rise.
of imported inputs may dampen inflationary pressures. Beyond these general effects on living standards of a
Note that a depreciation may help an economy avoid or depreciation or an appreciation we must look at particular
escape deflation as more competitive exports may increase groups. For example, a lower exchange rate will benefit
net exports and therefore aggregate demand, whereas an the domestic tourism industry as foreigners will find it
appreciation may push an economy into a deflationary spiral cheaper to spend their vacations in the country.
as net exports and so aggregate demand may decrease. An appreciation will benefit domestic residents travelling

171
 abroad. It will more generally benefit domestic importers households and firms but also decrease the exchange rate,
but hurt domestic import-competing firms and their making exports more competitive and imports less attractive.
stakeholders. This route may prove more effective in a deep recession as it
is not affected by low levels of domestic confidence.
A note on monetary policy Conversely, tighter monetary policy to decrease inflationary
We are now in a position to include an additional route pressures will not only dampen consumption and investment
through which monetary policy can affect aggregate expenditures but also net exports. The higher interest
demand. Easy monetary policy may increase not only rates will appreciate the currency, making exports less
consumption expenditures (C) and investment expenditures competitive abroad and imports cheaper domestically.
(I) but will also net exports (NX), another component Not only will net exports tend to decrease but production
of aggregate demand. Lower interest rates decrease the costs may also decrease if domestic firms rely on the now
attractiveness of saving and the cost of borrowing for cheaper inputs.

Fixed exchange rates

A fixed exchange rate system is defined as a system in In Figure 4.5.9 it is assumed that currency A of country A is
which the exchange rate is set by the government at some pegged against, say, the dollar at e*. If demand and supply
desired level (usually against a major currency, say, the US forces are at D1 and S1 the exchange rate will be at e* so
dollar or the euro), and is then maintained at that level there is no reason for the central bank to intervene.
through appropriate intervention in the foreign exchange Assume now that supply for the currency increases to
market by the central bank . The UAE dirham (AED), for S2, perhaps as a result of accelerating domestic inflation
example, has been fixed for a long time against the US increasing imports. Supply of currency A will shift to S2. At
dollar at AED3.67 per US$1. The Danish currency, the the target exchange rate e* there will now be excess supply
kroner, has been fixed against the euro at a “central” for A equal to HF units of A per period. This excess supply
rate of 7.46 kroner per €1. “Central” means that the kroner exerts pressure on currency A to devalue towards e’.
can fluctuate within a disclosed ± 2.25% band around
The exchange rate will be maintained at the desired target
that rate.
level e* only if somehow the central bank managed to
How is the exchange rate maintained at the set level? increase demand for its currency to D2 to eliminate the
What can and should a central bank do to maintain the excess supply.
rate at the desired level if, for example, there are pressures
How can the central bank do this? One obvious option is for
for it to devalue? If there is pressure for the currency to
it to enter the foreign exchange market and start buying HF
devalue then there is excess supply of it in the foreign
units of A per period using its foreign exchange reserves (for
exchange market. Somehow this excess supply must be
example, dollars). If the central bank starts buying HF units
eliminated. The central bank must therefore increase the
of A per period it is increasing the demand for currency A
demand for the currency. It can do this either by buying the
from D1 to D2.
currency itself using its foreign exchange reserves (such as
dollars) or by inducing foreign investors to start buying it. To defend the exchange rate (meaning to maintain its parity
How can the central bank induce investors? It can increase at e*) the central bank can also increase interest rates. This
interest rates, making deposits denominated in its own would be the next line of defence as the foreign exchange
currency as well as domestic bonds more attractive. This is reserves of any central bank are limited; the central bank
shown in Figure 4.5.9. cannot go on selling dollars to buy its currency if it has no
more dollars left to sell.
S1 of A The higher interest rates in country A will attract inflows
Price of A S2 of A
$ of financial capital because domestic bonds and deposits
(in USD) ( ) 1st shift:
A (increase in denominated in currency A will become more attractive.
imports) Foreigners will buy currency A in the foreign exchange
H F
e* excess supply market in order to buy country A’s bonds or make deposits
(HF) denominated in currency A. This can also increase the
e' 2nd shift
(response by the
demand for A, shifting it to the right from D1 to D2.
central bank) Higher interest rates though impose a real cost on country
A’s economy as growth will slow down and unemployment
D2 for A will increase.
D1 for A
The government may also resort to official borrowing of
Quantity of A
(traded per period) foreign exchange in an attempt to maintain the currency
at e*. However, borrowing to defend the currency cannot
Figure 4.5.9 Fixed exchange rates: how are they maintained?
continue for long as repayment of the loans imposes

172
 significant future costs on an economy. Or, the government

UNIT 4: THE GLOBAL ECONOMY

may try to limit pressure on the currency to devalue by Recap
restricting imports into the country so that supply of currency Fixed exchange rate system—currency
A in the foreign exchange market decreases. Governments devalue or revalue
can also restrict access to foreign exchange in the country,
In a fixed exchange rate system, if there are pressures for
reducing the supply of its currency in the foreign exchange
the currency to devalue:
market. Of course, exchange controls may lead to “black
markets”. • the central bank may start buying it using its foreign
exchange reserves (but these are limited)
If, in contrast, there are forces pushing up the currency then
the central bank can sell its currency, buying dollars in the or
foreign exchange market to eliminate the excess demand • the central bank may increase interest rates to attract
that is causing pressure for the currency to rise above the foreign capital inflows (but high interest rates choke off
target parity. The central bank may also lower domestic economic activity)
interest rates to decrease the attractiveness of domestic or
bonds and deposits in the country’s currency. Note that both • the country may resort to official borrowing of foreign
options increase the money supply and so they may lead to exchange (but borrowing imposes future repayment
accelerating inflationary pressures. costs)
or
• the government may restrict imports and access to
foreign exchange (but “black markets” may emerge).
If there are pressures for the currency to revalue:
• the central bank may start selling it buying dollars or
euros in exchange
or
• the central bank may lower interest rates to create an
outflow of foreign capital
(but both these options increase the risk of inflation).

Managed exchange rates

Between floating and fixed exchange rate systems we have avoid further weakening of its currency it would start buying
the most common exchange rate system, managed exchange it in the foreign exchange market. This, though, would
rates. Within a managed exchange rate system, the decrease the reserves that commercial banks have. If the
authorities try to decrease exchange rate movements and central bank wishes to avoid this decrease in reserves, it could
at the same time maintain some flexibility. The exchange perform open market operations and start buying bonds so
rate floats but there is periodic intervention by the central that bank reserves return to their previous level.
bank whenever the currency starts to move in a direction or
at a speed considered undesirable. In some managed float Maintaining disequilibrium exchange rates
systems, the currency is allowed to float within a targeted Keeping the currency undervalued
but undisclosed to the public band. Sometimes countries try to maintain the exchange rate
To decrease short-term volatility a central bank will typically of their currency undervalued. This means that they try to
intervene in the foreign exchange market by buying or maintain it at a level below the free market equilibrium level.
selling its currency. If it wishes to slow down a fall in its Why would policymakers decide on something like this and
exchange rate it will start buying its currency whereas if it what are some of the consequences?
wishes to slow down an appreciation it will start selling it. An undervalued currency automatically implies cheaper and
Illustrating the former case, a central bank would have to thus more competitive exports. This is the biggest advantage
increase the demand for the currency, shifting it closer to D2 of such a policy. The increased export penetration and
for currency A in Figure 4.5.9, so that the exchange rate does resulting higher export revenues increase aggregate demand
not fall much below e*. In the latter case, a central bank and, through the export multiplier, accelerate growth.
would have to shift the supply of the currency so that it does Undervalued currencies have significantly contributed to
not appreciate as much. the spectacular export–led growth that several developing
Sometimes a central bank will perform sterilized intervention, countries, including China, have achieved.
which means that it will try to neutralize any changes in the How could a country keep its currency undervalued against,
money supply. For example, if a central bank would like to for example, the US dollar? Its central bank would have to be

173
 purchasing US dollars by selling its currency in the foreign industries. The trade barriers would be used to keep out of
exchange market. The supply of its currency would in this the country any goods that could be considered substitute
way be artificially higher. Alternatively, it must keep interest goods in the eyes of domestic buyers, permitting the growth
rates low. of the domestic infant industries. This was a policy to
What are the risks? First, the export success from keeping accelerate industrialization.
the currency undervalued creates trade frictions with trading How could a country keep its currency overvalued against,
partners. One country’s export success means that import- for example, the US dollar? Its central bank would have to be
competing industries of the trading partner will suffer. In purchasing its currency by selling US dollars in the foreign
addition, exports of the trading partner will be more expensive exchange market. The demand for its currency would in this
and less competitive. The distress caused will increase cries for way be artificially higher. Alternatively, it must keep interest
retaliation and protection. Another risk is that by continuously rates high.
selling the currency to keep its price low or by maintaining low The downside was that the overvaluation of the currency acted
interest rates there is increased risk of inflation. as a tax on exports as exports became more expensive abroad.
Keeping the currency overvalued In the case of traditional primary export commodities (for
Sometimes countries try to maintain the exchange rate example, coffee) for which the price was determined in world
of their currency overvalued. This means that they try to commodity markets and quoted in dollars, farmers earned less
maintain it at a level above the free market equilibrium level. units of domestic currency for each dollar earned from their
Why would policymakers decide on something like this and exports. An overvalued exchange rate would hurt the export
what are some of the consequences? sector of the developing country.
Many developing countries have in the past tried to keep Maintaining the currency overvalued may be part of a policy
their currency overvalued as part of an import-substitution to combat inflationary pressures. Exports that are part of
strategy (see section 4.10). The basic idea is that these aggregate demand will decrease, “cooling off” the economy.
countries were trying to shift out of agriculture and into In addition, cheaper imports also help. First, the cost of
manufacturing by substituting domestic production for living of the population is lower (the typical consumer’s
imports. They erected trade barriers to protect their “infant basket of goods also includes imports). It forces domestic
industries” and at the same time maintained their exchange import competing industries to cut their costs increasing
rate overvalued. This sounds absurd because at a higher their efficiency and keeping their own prices low. Lastly,
exchange rates imports become cheaper. However, the goal production costs of domestic firms using imported inputs
was to lower the price of imported machines and other remain low. With inflation contained, the country can keep
inputs (that is, the price of capital goods and raw materials) interest rates low, which encourages long-term investment
that would decrease the production costs of their new and growth.

Fixed versus floating exchange rate systems HL

When comparing floating with fixed exchange rate systems that the Marshall-Lerner condition is satisfied (HL, see
keep in mind that the advantages of one system can be section 4.6, page 184) then the trade deficit will narrow as
considered disadvantages of the other. exports become cheaper abroad and more competitive, while
imports become pricier domestically and less attractive. This
Advantages of floating (flexible) exchange is important because there is less need for the government
rates to adopt costly contractionary demand-side policies (see
Policymakers are free to use monetary policy to achieve section 3.5, page 114) that will slow down growth and
domestic goals. They can use loose monetary policy to therefore decrease imports but also increase unemployment.
boost the economy as the currency depreciation that follows Exchange rate adjustments through time are usually smooth
the lower interest rates will also lead to an increase in net and continuous. This means that currency crises are avoided.
exports, a component of aggregate demand. They can use Concerning speculation: there is risk of destabilizing speculation
tight monetary policy to decrease inflationary pressures as if, for example, the fundamentals of an economy (inflationary
the currency appreciation that follows the higher interest pressures and so on) point to a weakening currency. Speculators
rates will also lead to a decrease in net exports and so in may then start massively selling the currency, leading to an
aggregate demand. unnecessarily sharper decrease in its value.
A trade deficit (when M > X) may be automatically There is less need for the central bank to carry large
narrowed. A trade deficit implies that more of the currency foreign exchange reserves as there is no need to intervene
is supplied than demanded in the foreign exchange market. constantly to maintain the exchange rate at a fixed parity.
The excess supply will depreciate the currency. Assuming

174
Disadvantages of floating (flexible) advantage they have. They cannot hope for a depreciation to

UNIT 4: THE GLOBAL ECONOMY

exchange rates regain any competitive advantage in world markets.
Since in a floating system the exchange rate goes up and down Disadvantages of fixed exchange rates
with any domestic or world economic or political development
Policymakers are deprived of monetary policy as a tool to
affecting it unpredictably, there is a lot of uncertainty in the
affect domestic economic activity. Monetary policy may be
foreign exchange market as to its future path. Exporters and
used only to ensure that the exchange rate remains fixed.
importers, as well as investors, face significant exchange rate
risks against which they can only partially protect themselves. Policymakers are also deprived of exchange rate policy to
As a result, both the volume of international trade in goods and deal with domestic policy objectives.
services and the volume of cross-border portfolio investments Even the use by policymakers of expansionary fiscal
are negatively affected. Smaller firms and smaller investors, with policy is constrained because budget deficits need to be
fewer resources available to protect themselves against such financed somehow. Financing a large budget may lead to
risks, will drop out of the market. either faster growth of the money supply (if the deficit is
Governments lack the “policy discipline” that a fixed exchange financed through “printing” money) or higher interest rates
rate system imposes. A country may therefore be more prone because of crowding out (HL). Neither of these possibilities
to inflation. For example, expansionary policies to accelerate is acceptable under a fixed exchange rate system.
growth could be more easily adopted by a government even if Devaluation or revaluation can prove disruptive as each
it means that the resulting growth will be inflationary. implies a sudden change in the value of the currency.
To avoid the need to resort to devaluation a trade deficit
Recap must be corrected by adopting contractionary fiscal policy
to lower the national income and so decrease import
Floating exchange rates—advantages and absorption. The disadvantages are that this means slower
disadvantages growth, possibly even a recession, as well as higher cyclical
Advantages unemployment.
• Policymakers can freely use monetary policy to The central bank must maintain large foreign exchange
achieve domestic goals. reserves to be able to intervene in the foreign exchange
• Trade imbalances are in principle automatically market and maintain the exchange rate at the target level.
corrected through exchange rate adjustments only. This involves a high opportunity cost as reserves earn either
• Exchange rate adjustments are usually smooth and low or no interest.
continuous.
• There is less need for the central bank to keep foreign Recap
exchange reserves. Fixed exchange rates—advantages and
Disadvantages disadvantages
• At times, there is risk of destabilizing speculation. Advantages
• Increased uncertainty decreases the volume of trade • Less uncertainty and exchange rate risk increases the
and cross-border investment flows and it forces volume of trade and cross-border investment flows.
smaller firms and investors to drop out. • Fiscal discipline is imposed on governments; a fixed
• The government may be more prone to adopt exchange rate system may be a policy choice to
expansionary policies for short-term gains even if maintain price stability.
these accelerate inflation. • Firms are forced to be efficient to maintain any
competitive advantage they have.
Advantages of fixed exchange rates Disadvantages
Less uncertainty and exchange rate risk means that firms • Policymakers cannot use monetary policy to achieve
engaged in international trade can easier predict their domestic goals.
export revenues or import bill. Portfolio investors also avoid • The government is deprived of an exchange rate policy.
exchange rate risk that could lower their return from any • The use of expansionary fiscal policy is constrained
investment. Fixed exchange rates increase the volume of because financing a deficit may affect the money
exports and imports as well as of capital flows. supply or interest rates, neither of which is acceptable.
Since inflation is not compatible with a fixed exchange rate • Exchange rate adjustments are sudden, so they are
system, governments cannot easily pursue expansionary potentially disruptive.
fiscal policy that may prove inflationary. Fixed exchange • Trade deficits are not automatically corrected,
rates impose fiscal discipline on governments. Fixing the requiring use of painful contractionary fiscal policy.
exchange rate has therefore often been a policy choice for
• The central bank may maintain large foreign
governments determined to curb high inflation and maintain
exchange reserves, which is costly.
price stability.
In addition, firms are forced to be efficient and to keep their
costs and prices down to maintain whatever competitive

175
 Calculations HL
1. To convert the cost of good expressed in dollars ($) into asked for the dollar price of the euro ($ ) divide the
pounds (£), just remember that $ €
£ dollar price of the pound by the euro price of the
price in £ = price in $ × $ £
€
pound :
Notice that the dollars ($) on the right-hand side cancel £
$
out so that the result of the multiplication is pounds (£). £ $ £ $
2. To convert the cost of good expressed in pounds (£) € = £ × € = € as the pounds (£) cancel out
into dollars ($) just remember that £
€
$ If you are asked for the euro price of the dollar ( )
price in $ = price in £ × $
£ €
divide the euro price of the pound by the dollar price
Notice that the pounds (£) on the right-hand side cancel £
$
out so that the result of the multiplication is dollars ($). of the pound :
£
3. Calculating a “cross-exchange-rate” is easy. €
£ € £ €
Assume that you are given the price of the pound (£) $ = £ × $ = $ as the pounds (£) cancel out
both in euros (€ ) and in dollars ($ ) then: if you are £
£ £

176
 4.6 Balance of payments

UNIT 4: THE GLOBAL ECONOMY

The balance of payments is defined as a record of the value It is a credit item for Mexico and enters its balance of
of all transactions of a country with the rest of the world payments with a plus sign. For the USA it is an outflow of
over a period of time, usually a year. currency, so it is a debit item and enters the US balance of
Transactions that lead to an inflow of currency are known payments with a minus sign.
as credit items and enter the account with a plus sign. • If Mexico’s largest steel company acquires for $1.2 billion
Transactions that lead to an outflow of currency are referred a Turkish steel manufacturing firm, this is an outflow of
to as debit items and enter the account with a minus sign. currency from Mexico. It is a debit item for Mexico and
The two types of transaction are shown in the following enters Mexico’s balance of payments with a minus sign.
examples. For Turkey it is an inflow of currency so it is a credit item
and enters Turkey’s balance of payments with a plus sign.
• If Raquel, who lives in Mexico City, buys a $250 Italian
jacket, this is an outflow of currency from Mexico. For • If Arturo, a resident of Mexico City, buys $500,000 worth
Mexico it is a debit item and enters its balance of of Delta Airlines shares listed in the New York Stock
payments with a minus sign. For Italy it is an inflow of Exchange, this an outflow of currency from Mexico. It is
currency, so it is a credit item and enters Italy’s balance of a debit item for Mexico and enters Mexico’s balance of
payments with a plus sign. payments with a minus sign. For the USA’s balance of
payments it is an inflow, so it is a credit item and enters its
• If Layla, an American college student, visits Mazatlan in
balance of payments with a plus sign.
Mexico during her spring break and spends $1200 on
her stay, this money is an inflow of currency into Mexico.

Components of the balance of payments

The balance of payments is divided into three major The difference between the value of exports and imports
components, the current account, the capital account and of services is referred to as the balance of trade in services.
the financial account. If it is positive there is a surplus in the balance of trade in
services. If it is negative there is a deficit in the balance of
The current account trade in services.
The current account includes the following components. Often the two accounts are combined to arrive at the
The balance of trade in goods balance of trade in goods and services.
The goods account includes the value of all the goods Net income from abroad (the primary income
(physical or tangible merchandise) a country exports or account)
imports; for example, farm products, oil, machines, cars, This account records differences between income received
laptops, airplanes, wine or medical equipment. More from abroad (inflows) and income payable abroad
generally, it includes imports and exports of raw materials, (outflows). Primary income includes mostly two types of
intermediate products and final products. Exports are credits income.
and are recorded with a plus sign as they lead to an inflow
• It includes profits, interest and dividends from portfolio
of currency. Imports are debits and are recorded with a minus
and direct investments.
sign as they lead to an outflow of currency. The difference
between the value of exports of goods and imports of goods • It includes compensation (wages and salaries) of
is referred to as the balance of trade in goods. If it is positive employees who work in a country but only for a short
there is a surplus in the balance of trade in goods. If it is period of time then return home (so they are not
negative there is a deficit in the balance of trade in goods. considered residents of the country). An example would be
the compensation paid by a South Korean university to a
The balance of trade in services
British academic delivering a series of lectures in Seoul.
The services account includes the value of all the services a
Note that “net income from abroad” is what distinguishes
country exports or imports; for example, insurance, shipping,
GDP from GNI in macroeconomics.
tourism, education, financial, architectural, legal services and
others. Again, exports are credits and are recorded with a Net current (unilateral) transfers
plus sign whereas imports are debits and are recorded with a This account records gifts that a country makes and gifts
minus sign. When Germans visit India it is an export (a credit that it receives. It includes migrant workers’ remittances,
and so a plus sign) for India and an import (a debit and so a international pension flows, donations, transfers related
minus sign) for Germany. When an Italian architect designed to international cooperation between governments (such
the Whitney Museum of American Art in Boston it was an as receipts and payments to EU institutions), foreign
export for Italy and an import for the USA. aid including food aid and emergency aid after natural

177
 disasters and so on. If it is positive (negative) it means that in the Egyptian current account as a receipt of investment
the inflows (outflows) of such moneys exceed the outflows income under the current account. The equal outflow of
(inflows). money (debit) will be recorded in the Turkish current account
Current account balance as a payment of investment income under its current
account.
The sum of net exports of goods and services, net income
and net current transfers over a period of time (a year) is Changes in official holdings of international
defined as the current account balance. If this is positive, we reserves
say that there is a current account surplus. If it is negative, A central bank must hold reserve assets that are generally
we say that there is a current account deficit. acceptable by all countries, so they are readily available for
use to finance balance of payments needs or to intervene in
The capital account the foreign exchange market in order to affect the exchange
Typically, the capital account is small and usually of minor rate.
importance. It includes: These reserve assets include:
• net capital transfers between countries, such as debt • foreign currency holdings and deposits (in US dollars,
forgiveness, which is counted as a debit for the lender; euros, Japanese yen, Chinese renminbi, British pounds,
and the assets (goods and financial assets) of migrants as Australian dollars, Canadian dollars and Swiss francs, as
they enter (credit) or leave (debit) a country these are the eight reserve currencies the IMF recognizes)
• net purchases and sales of non-financial, non-produced • short-term government bonds (such as US Treasury Bills)
assets, such rights to natural resources (fishing rights, that can be easily transformed into a reserve currency
land rights, mineral rights and so on), patents, copyrights,
• gold
trademarks, franchises, leases and internet domain names.
• a few other assets.
The financial account Note here that a decrease in official reserves enters the
The financial account includes direct investment, portfolio balance of payments with a plus sign whereas an increase
investment as well as changes in the official international in official reserves enters the account with a minus sign. This
reserve assets of the central bank of the country. seems strange until we realize that by accounting convention
Direct investment the official reserves are considered assets residing outside
the economy. One way to understand this is to visualize
Direct investment (often referred to as foreign direct
the central bank of a country as a separate entity from the
investment or FDI) refers to long-term investment by firms
economy holding a foreign exchange savings account.
from one country (the source) in productive facilities in
another country (the host). The distinctive characteristic of Interdependence between the accounts
direct investment is the intent of lasting interest.
The following necessarily holds true:
Direct investment includes the following.
CA = –FA – KA
• Building of new facilities (factories, distribution facilities,
or, CA + FA + KA = 0
stores and so) from scratch (“greenfield” investment) is
direct investment. The objective is to establish a new where CA is the balance on the current account, FA is the
presence in the host country and have full control over the balance on the financial account and KA is the balance on
operations of the new firm. the capital account. The capital account (KA) is very small
and therefore insignificant so we will be ignoring it in for the
• Investing in or taking over an existing foreign company
time being, so
(“brownfield” investment) is also direct investment. The
objective is either to gain complete control or to exert CA = –FA (1)
significant control over the management decisions of the This is an identity which means that it always and
firm. The IMF typically requires acquiring at least 10% of necessarily holds true. It simply states that if a country has a
the foreign company’s shares for the investment to qualify current account deficit so that it is importing (that is, buying)
as having a lasting interest. more goods and services from the rest of the world than it
Portfolio and other investment is exporting (that is, selling) to the rest of the world, then it
must have an equally sized surplus in its financial account.
Portfolio and other investments refer to the acquisition and Why? The reason is that it must finance this deficit somehow.
sale of corporate stocks, government and corporate bonds as
well as changes in loans and deposits. For example, when a There must be an inflow (plus sign) of dollars from the
resident of Egypt buys stocks of Turkish companies, or buys financial account of equal magnitude. For example, if the
Turkish bonds, then an outflow of money is recorded in the deficit in the current account is 489 billion dollars (–489),
Egyptian financial account and an equal inflow of money in then the country must have somehow found these 489
the Turkish one. Buying such assets leads to an outflow of billion dollars to pay for the excess of goods and services it
funds—it is a debit item and is recorded with a minus sign. imports over what it exports. It must be that
Note that next year when the resident of Egypt receives –489 = –(+)489 so that – 489 + 489 = 0
dividends and interest payments from the investments then If you are having trouble with this, think of a family. Assume
that inflow of money (credit) into Egypt will be recorded that its income from selling its labour services in 2020 was

178
 UNIT 4: THE GLOBAL ECONOMY
$25,000 (consider these the “exports” of the family). During The central bank used $50 billion from its reserves to finance
the same year the family bought goods and services worth this deficit. The official foreign exchange reserves of the
$28,000 (consider these its “imports”). How could the family central bank decreased by $50 billion and are now equal
have spent more than it earned? It must have somehow to $640 billion. This decrease is recorded with a plus sign
financed the $3,000 deficit it had. It may have sold some because this amount “left” the central bank and “entered”
assets (such as a used bicycle) and/or decreased savings the economy. Remember that by accounting convention the
and/or borrowed from banks. If we add these “inflows” into official reserves held by the central bank are considered assets
the family then its accounts are balanced. residing outside the economy. Note also that if a country has
The financial account includes buying and selling of stocks insufficient foreign exchange reserves it will be forced to resort
and bonds, deposits and loans as well as direct investments. to official borrowing to pay for its financing needs.
It also includes changes in official holdings of reserves of Returning now to the identity above (2) it should make
the central bank. Let’s now separate the changes in official sense:
holdings of reserves of the central bank from the financial CA + KA + FA = Official reserve transactions = 0
account to clarify an important point. We can now rewrite
or
relationship (1) above as:
–470 – 5 + (425 + 50) = 0
CA + FA + official reserve transactions = 0
or, CA + KA + FA = 0 as official reserves are included in the FA.
If we now also include the capital account (KA) the
relationship can be written as Consider now a different example where the inflows of
foreign exchange of a country exceed the outflows. Let:
CA + KA + FA + official reserve transactions = 0 (2)
CA = +228 billion dollars
Items included in the current account, the capital account
and the financial account excluding the official reserve KA = –2 billion dollars
transactions by the central bank are referred to as FA (excluding official financing) = –205 billion dollars.
“autonomous” transactions because they are transactions Further assume that its central bank again was holding
taken for business purposes. Examples are firms importing 690 billion dollars in official reserves.
cars or exporting grain and investors buying or selling bonds The sum of all autonomous transactions is now +21 billion
or stocks or firms. Changes in official reserve transactions are dollars. What happens to the official foreign exchange
referred to as “accommodating” transactions. reserves of the country? They increase by $21 billion and
If the sum of autonomous transactions is negative it is become $711 billion. This increase is recorded with a minus
referred to as a balance of payments deficit. If the sum of sign because this amount “left” the economy and “entered”
autonomous transactions is positive it is referred to as a the central bank. Remember that by accounting convention
balance of payments surplus. the official reserves held by the central bank are considered
For the overall balance of payments to balance there must assets residing outside the economy. Note that a country
be an equal accommodating transaction with the opposite with plentiful foreign exchange reserves may officially lend
sign. This transaction is the change in official financing. other countries.
An example will help clarify. Assume that a country recorded Again, referring to the identity above (2):
the following balance of payments values for some year: CA + KA + FA = Official reserve transactions = 0
CA = –470 billion dollars or
KA = –5 billion dollars +228 – 2 + (–205 – 21) = 0
FA (excluding official financing) = +425 billion dollars. or, + 228 – 2 – 226 = 0 as official reserves are included in
Further assume that its central bank held 690 billion dollars the FA.
in official reserves. Errors and omissions
This country has a combined current account and capital It would be good if every single autonomous transaction
account deficit totaling $475 billion. This means that was recorded properly by the statistical authorities (customs,
$475 billion more flowed out of the country than flowed banks and other financial institutions) but unfortunately this
in. How could that be? This combined current and capital is never the case. It is never the case because data collection
account deficit was financed from the financial account, is costly and far from perfect. Many transactions, especially
which recorded a surplus of $425 billion as $425 billion in the financial account (which is the hardest one to compile
more flowed into the country than flowed out. For example, with accuracy), are simply not recorded and some even
foreigners bought $425 billion more in bonds, stocks and have to be estimated. So, typically the sum of all accounts
domestic companies than domestic residents bought foreign including changes in official reserves do not add up, as they
bonds, stocks or foreign companies. logically should, to zero.
However, there are still $50 billion missing. This is where If the sum is not zero but, say, –5 billion dollars, then statisticians
the accommodating transactions come into play, namely include the aptly named errors and omissions entry at the
the changes in official reserves that the central bank holds. very bottom of the balance of payments equal to +5 billion
The official reserves of the country were used to finance the dollars and therefore artificially force the balance of payments
balance of payments deficit and force it to balance overall.

179
 to equal zero. If the sum of all accounts including changes in If the errors and omissions entry in an economy is relatively
official reserves was not zero but plus 5 billion dollars, then the large, it may point to illicit drugs or arms trade or to
errors and omissions entry that statisticians would add would residents underreporting their income from their offshore
be minus 5 billion dollars to artificially force the balance of investments or sending their wealth abroad without
payments to equal zero. The balancing item therefore has the reporting the transaction to the authorities (part of what is
same magnitude but the opposite sign of the error. known as capital flight—see section 4.9, page 193).

CURRENT ACCOUNT
(1) Net exports of goods
(2) Net exports of services
(3) Net income from investments
(4) Net current transfers
(5) Balance on current account: (1) + (2) + (3) + (4)
CAPITAL ACCOUNT
(6) Net capital transfers
(7) Net purchases of non-produced, non-financial assets
(8) Balance on capital account: (6) + (7)
FINANCIAL ACCOUNT
(9) Net portfolio investments
(10) Net FDI
(11) Changes in official holdings of international reserves
(12) Balance on financial account: (9) + (10) + (11)
(13) (Errors and omissions)
Notes
Items (5), (8), (9) and (10) include autonomous transactions. Item (11) is the accommodating transaction. If the sum
of (5), (8), (9) and (10) is negative then we say there is a balance of payments deficit. By adding item (11), namely the
changes in the official holdings of foreign exchange by the central bank, the balance of payments will balance because the
accounting identity below must hold:
CA + KA + FA = 0
or, (5) + (8) + (12) = 0
If the above sum does not equal zero, then we must add item (13), errors and omissions (the statistical discrepancy) with
the opposite sign, to force the balance of payments to balance.
Table 4.6.1

HL
Relationship between the current account reflects the value of Australia’s exports as Americans need
and the exchange rate AUD to buy Australia’s products. The supply of AUD reflects
the value of imports of Australia as Australians need to buy
We have established that the equilibrium exchange rate is
US dollars to import US goods and services and to buy USD
determined by the interaction of the demand and supply of
they must first sell and offer AUD in the foreign exchange
a currency.
market.
What will happen to the exchange rate if, ceteris paribus, a
Initially the exchange rate for the Australian dollar (USD per
country’s exports decrease and/or its imports increase and the
AUD) is at e1 where the demand for AUD (D1) intersects
current account records a deficit? To answer we will simplify
the supply of AUD (S1). At e1, Australia’s current account
matters and assume that the demand for and the supply of
is balanced as the value of exports (X) is equal to the value
a currency reflect only trade flows (that is, only exports and
of imports (M). Specifically, at the exchange rate e1, e1a
imports of goods and services and no financial flows).
Australian dollars are demanded by Americans to buy
Let’s focus on Australia and the Australian dollar (AUD) Australian products (Australia’s exports) and e1a Australian
with trade flows only between the USA and Australia. In this dollars are also supplied by Australians to buy US products
simplified set-up, shown in Figure 4.6.1, the demand for AUD (Australia’s imports).

180
 Figure 4.6.2 maintains focus on the Australian dollar.

UNIT 4: THE GLOBAL ECONOMY

S1 of AUD
(Australia's imports M) We assume now that Australia is exhibiting phenomenal
Price of AUD S2 of AUD
(in USD) (
USD
) (Australia's imports M') non-inflationary growth and that it is believed that this
AUD
outstanding performance will continue—therefore, investors
e1 a
are eager to invest in the Australian economy. Demand for
b 'ab'=excess supply
of AUD Australian stocks and bonds is increasing and so are the
f
e2 and CAD, as M' > X direct investment flows into its economy.

S1 for AUD
D1 for AUD (investment outflows
(Australia's exports X) Price of AUD from Australia)
USD
Q of AUD per period (in USD) ( )
AUD
Figure 4.6.1 Impact on the AUD of a current account deficit
f
e2
Now, if for whatever reason, perhaps because of faster a b
e1
growth, Australia starts importing more goods and services
from the USA, the supply of Australian dollars will increase D2 for AUD
with the supply curve shifting to the right to S2. At the (reflecting higher
investment
original exchange rate e1, there is now in the foreign D1 for AUD inflows into AU)
exchange market an excess supply of AUD equal to line
Q of AUD per period
segment ab. At e1, the value of exports is e1a but now the
value of imports is greater at e1b. At e1, imports exceed Figure 4.6.2 Impact on the exchange rate of a financial account surplus
exports in value by ab. The distance ab is the current
account deficit that Australia now registers but also the The demand for Australian dollars will increase and the
excess supply of AUD in the foreign exchange market. The demand curve will shift to the right to D2 as investors
AUD, ceteris paribus, will therefore tend to depreciate until need to buy more Australian dollars in order to buy more
it reaches e2. As it depreciates, Australia’s current account Australian stocks and bonds, to acquire controlling share
(its trade in goods and services) deficit will narrow as its of more Australian firms or to establish a greater business
exports become more competitive abroad and imports less presence in Australia. At the original exchange rate e1
attractive. At e2 trade balance has again been achieved as there is now excess demand for Australian dollars equal to
the value of exports and the value of imports are both equal ab, reflecting the surplus in Australia’s financial account
to e2f Australian dollars and there is neither excess demand that results from private American investors investing in
nor excess supply of AUD in the foreign exchange market. Australia more than Australian investors are investing
Australia’s current account deficit has led to a depreciation into the US economy. The Australian dollar will tend to
of the Australian dollar. appreciate to e2. It follows that if there are more private
Note that a current account deficit and therefore an excess financial capital flowing into an economy than flowing out
supply of Australian dollars would also result if instead of an economy then the currency will, ceteris paribus, tend
Australia’s exports had decreased. The bottom line is that a to appreciate.
current account deficit will, ceteris paribus, lead to a fall in This conclusion rests once again on the ceteris paribus clause
the value of the currency. mentioned. Remember that the demand for and the supply
The above conclusion rests though on the ceteris paribus of a currency do not only reflect financial flows (buying
clause mentioned, namely that the demand for and supply and selling of financial and other assets) but also trade
of AUD only reflect trade flows. As explained in section 4.5 flows (exports and imports of goods and services) between
(page 164) the demand for and the supply of a currency do countries.
not only reflect trade flows but also reflect financial flows The bottom line
(buying and selling of financial and other assets) between
Does the financial account have a stronger effect on the
countries.
exchange rate than the current account?
Relationship between the financial account Comparing Figures 4.6.1 and 4.6.2 it should be clear
and the exchange rate that a current account deficit may lead to a depreciation
of the currency, but whether it does or not depends on
What will happen to the exchange rate if, ceteris paribus,
the financial account of the country. It could well be that
inflows into a country’s financial account increase and/
despite a current account deficit, the currency may be
or outflows decrease and the financial account (excluding
appreciating. For example, for the period 1994–2002 the
changes in official reserve transactions by central banks)
USA was recording a rising trade deficit but the dollar was
records a surplus? In order to simplify the analysis, assume
appreciating. How could that be? The USA was attracting
that the demand and the supply of a currency now only
more than sufficient cross-border financial capital inflows to
reflect portfolio and direct investment flows between
offset the downward pressure on the dollar from the current
countries.

181
 account deficit. In terms of Table 4.6.1), the currency may The 2016 current account deficit in Mexico was roughly the
even appreciate even if there is a current account deficit same as in 1992 (only 131 million dollars smaller) but in
(a negative item 5) if the sum of items (9) and (10) are 1992 the deficit represented 6.73% of Mexico’s GDP whereas
positive and greater than item (5) in value. in 2016 it represented only 2.26% of the economy. The
The bottom line is that a current account deficit may lead to Mexican economy grew significantly over this 24-year period
a depreciation (and a surplus may lead to an appreciation) so that the roughly same current account deficit in dollar
of a currency but whether either happens depends on what terms represented in 2016 a much smaller proportion of the
is going on in the financial account. In general, it is more economy. Imagine now comparing the dollar deficits of small
probable that a currency will depreciate in countries that due and large countries. No valid conclusions could be made.
to their current account deficit and their overall economic Given the above, if a current deficit narrows in size is this
prospects do not inspire confidence in international necessarily a positive development for the economy? Again,
investors. it depends. A current account deficit may be the result of
A similar issue applies to countries with current account a growing economy. During a boom, incomes increase and
surpluses. If analysed in isolation, a current account surplus therefore more imports are absorbed, and a current account
will lead to an appreciation of the currency. Why? If exports deficit may widen. It follows that a smaller deficit may not be
exceed imports then more of the currency is demanded than a reason to celebrate because it may be the result of a severe
supplied. The resulting excess demand will push the currency recession.
to appreciate unless residents of the country and perhaps Is a growing current account deficit a cause for concern?
its government (and so the central bank) are buying more Once again, not necessarily. A developing economy
and more foreign-owned assets (stocks, bonds, real estate, attempting to establish certain industries may initially
companies and so on). To buy these assets the central bank be importing expensive capital equipment and record a
will first need to sell the currency in the foreign exchange sizable current account deficit. If the country is successful
market, increasing the supply of the currency and potentially in establishing an export-oriented sector, this deficit may
staving off its appreciation. For example, China was become a surplus.
recording significant current account surpluses, but the yuan What if a country’s exports rely heavily on agricultural
was kept from appreciating against the US dollar as there products and extreme weather conditions in one year
were massive purchases of US Treasury bonds that increased destroy most agricultural output, also wiping out its
the demand for US dollars. exports? Would this be a cause of concern? The concern
might be limited to considering compensation for the
Implications of a persistent current affected farmers in that year, because it would be hoped
account deficit that the extreme conditions would not be experienced
A current account deficit exists if the sum of net exports again in the following year.
of goods and services plus net investment income plus net It follows that a current account deficit should not raise the
current transfers is negative. This implies that the sum of alarm if it is temporary. Temporary deficits are reversible as is
the debit items exceeds the sum of the credit items so that the case of deficits that increase in a boom because they will
outflows of currency are greater than inflows of currency, narrow in a slowdown. Other examples are when deficits are
resulting in pressure for the currency to weaken. of a transitory nature, such as in the cases of the failure of
Several questions arise. Is a current account deficit a cause a particular crop, or a massive labour strike that disrupts the
for alarm? The answers are not simple. As in most questions production process of major exporting industries.
in economics, it depends. First, to evaluate whether a Current account deficits are a cause for alarm if they
current account deficit is a cause for concern we must be represent a significant proportion of the country’s GDP
able to judge its size. Its dollar size is not a useful measure and if they are persistent. A persistent current account
because economies may differ vastly in size. The same dollar deficit is of a long-term nature and often reflects an ailing
size deficit may pose absolutely no problem for a large in economy. Chronic inflation, uncompetitive product markets
size economy, but it may be a cause of concern for a much or rigid labour markets are all possible causes of a persistent
smaller economy. We must therefore “scale for size” and we current account deficit. All of these problems erode the
do that by dividing the size of the current account deficit competitiveness of a country’s exports as they become
by the GDP of the country. Consider the data for Mexico in more expensive in foreign markets while they increase the
Table 4.6.2. attractiveness of imports to domestic buyers.
No matter what the cause of a persistent current account
2016 1992 deficit it will need to be financed and it is this financing that
Current account –24.311 billion –24.442 billion may create problems for the economy. Financing requires
balance in dollars dollars either an inflow of private financial capital from abroad
current USD (selling foreigners financial or real assets such as bonds,
Current account –2.255% –6.73% stocks or firms) or official borrowing. The implications may
balance as a % prove severe.
of GDP The possible adverse implications for various different factors
Table 4.6.2 Current account data for Mexico. Source: data.worldbank.org are described below.

182
The exchange rate As the risk of the country defaulting increases (meaning

UNIT 4: THE GLOBAL ECONOMY

A current account deficit exerts pressure on the exchange rate that there is fear that it will not be able to continue
to depreciate. As long as the economy’s growth prospects look repaying its foreign debt), its credit rating by international
promising it will attract inflows of foreign financial capital credit rating agencies, such as Fitch, Moody’s and Standard
and the currency may not depreciate. The problem arises if & Poor’s, could be downgraded. Such agencies evaluate
foreign investors lose confidence and start to pull their funds the creditworthiness of countries and assign a grade to the
out of the economy. This may lead to a sudden and sizable debt they issue. If it is decided that risk is increasing, the
depreciation of the currency that could prove disruptive as country’s bonds will receive a lower grade, which means
import prices will surge. This will hurt households, especially that investors will only lend to the country at even higher
those with low income, and will increase the risk of cost-push interest rates. This tightens the squeeze on the country as
inflation. Note that there are also positive effects from a the cost of borrowing continues to rise and the economy
significant depreciation, such as increased export sales—but will not avoid a recession. If it defaults on its loans, then
the adverse impact is more immediate. it is typically required to agree to painful restructuring
policies.
Interest rates
Demand management
In order to attract private inflows of financial capital and
to stave off a depreciation of the currency, the central bank Persistent current account deficits require adoption of
may be forced to increase interest rates. Higher interest rates contractionary demand-side macroeconomic policies. Their
make domestic bonds and deposits more attractive to foreign aim is to narrow the current account deficit by decreasing
financial investors, who will want to buy them. The currency aggregate demand and national income since lower income
may not depreciate but this choice is costly. By selling bonds levels will decrease spending on imports. These polices will
to foreigners it is promising them future interest payments be explained below but, clearly, they are painful for the
as bonds represent debt for the issuer. These interest population especially for lower income households, who will
payments may prove costly as government funds will need suffer rising unemployment and loss of income.
to be diverted from domestic purposes. Higher interest rates Growth prospects
will also decrease domestic consumption and investment The points above suggest that the price paid by an economy
spending, lowering aggregate demand and risking recession. for recording persistent current account deficits may be very
Foreign ownership of domestic assets high. The costs usually extend deep into the future. It may
Selling assets requires willing buyers. Willing buyers exist take years for countries to recover from a current account
if either the future prospects for the economy look so crisis. Growth prospects are compromised for many reasons.
good that investors buy shares, businesses or real estate Governments are not in a position to fund necessary public
expecting to collect profits, or if the selling price of the investments. It may take time for foreign investors to return
asset is exceptionally low. In the former case the sale of and lend to the country or make direct investments. The
assets is not considered a problem. In the latter case it may cost incurred is usually higher for lower income households,
prove a problem as the assets sold to foreigners can be which implies that income inequality will have increased.
both sizeable and of significance. A country may be forced This will further dampen growth prospects, as explained
to sell to foreigners significant natural resources, banks, earlier. It is very risky for an economy to consume for a long
large industries or state-owned assets such as airports and time beyond its means.
harbours. Such a development carries the threat of loss of
economic sovereignty. Recap
National debt and credit ratings Persistent current account deficit
If the persistent current account deficit forces the A persistent current account deficit may lead to:
government to borrow from abroad this involves future • a sudden and severe depreciation of the currency
repayment of the capital plus interest. In the future, part of
national income must be diverted away from domestic uses • much higher interest rates to attract lenders
towards the repayment of past borrowing. These funds could • the sale of domestic assets at reduced prices
have been used by the government to finance increased • mounting foreign debt and downgrading by credit
public investments on infrastructure, health or education. agencies
Since repayment of any such borrowing from abroad must be • painful demand-side policies
made in foreign exchange, it also means that future foreign
exchange earnings from exports will need to be diverted • diminished growth for many years.
away from the purchase of imports of often necessary
consumer and capital goods. Correcting a persistent current account
Mounting foreign debt may create increasing adverse effects deficit: Methods and their effectiveness
on an economy. Foreigners will be willing to lend only at higher There are three types of policies available to policymakers to
and higher interest rates to compensate for the additional risk deal with a persistent current account deficit: expenditure-
they face. Higher interest rates, though, imply surging interest reducing policies, expenditure-switching policies and supply-
costs, further worsening the country’s foreign debt problem. side policies.

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 Expenditure-reducing policies If they are implemented then inefficiency also increases as
These include policies that decrease the level of aggregate resources are misallocated. The country suffers the costs of
demand. They thus include contractionary fiscal policy protectionism.
(decreasing G and/or increasing T) but also tighter monetary Supply-side policies
policy (increasing interest rates). By decreasing aggregate Policies to help correct a persistent current account
demand, they reduce the level of national income (Y) deficit also include certain supply-side policies (see also
therefore decreasing spending on imports (M). Remember section 3.7). Supply-side policies are of a long-term nature
that imports are directly related to the level of income. If and can help restore an ailing economy’s competitiveness,
incomes rise, then spending on imports rises; if incomes curing a persistent deficit in the current account. Persistent
decrease then spending on imports decreases. Note that the current account deficits may result from uncompetitive
decrease in aggregate demand will also decrease inflation. product markets characterized by high monopoly power.
This will benefit the export sector as the competitiveness of Excessive regulation of businesses may also be responsible,
exports will increase. All in all, shrinking imports and perhaps as regulations will increase production costs. Rigid labour
rising exports will help narrow the current account deficit. markets dominated by labour unions, high minimum wage
Note though that such an adjustment policy comes at a high laws and high worker protection may also contribute to
cost. Growth will surely slow down or may even turn negative, higher priced, so uncompetitive, goods and services. It
which means that the economy may suffer a recession. follows that market-based supply-side policies that focus
Recessions are painful. Output and incomes decrease, firms on product markets may help restore competitiveness and
contract or shut down and unemployment rises. correct a persistent current account deficit. Such policies
Expenditure-switching policies are considered most important as they may treat the
fundamental cause of the external imbalance.
The aim of this set of policies is to switch spending away
from imports towards domestically produced goods and Unfortunately, supply-side policies have major drawbacks
services. To induce such a switch, imports must become (as explained earlier). Within this framework, the most
more expensive, to make them less attractive, and this can significant drawback is that they are difficult to implement,
be achieved in two ways: by decreasing the value of the and any benefits will appear only after a very long time
currency or by protection. lag. Although these policies are instrumental and necessary
in the long term to achieve and maintain competitiveness,
In a fixed exchange rate system, the central bank may
persistent current account deficits must be dealt with
permit the currency to devalue instead of trying to maintain
immediately.
it artificially at its fixed value. In a managed exchange
rate system, the central bank may permit the value of the
currency to slide and even keep it undervalued. Decreasing Recap
the price of the currency makes imports more expensive Expenditure-reducing, expenditure-switching
domestically. Consumers will switch to relatively cheaper and supply-side policies
domestic goods and services. Import expenditures will Expenditure-reducing policies are policies that decrease
decrease. Note that exports will also become cheaper abroad aggregate demand (such as contractionary fiscal
and more competitive so that export revenues will increase. and monetary policies) and so national income. They
Both effects will tend to correct the current account deficit. decrease imports. They lead to slower growth, possibly
A potential risk of a rapid depreciation or devaluation a recession and higher unemployment.
is that inflation may accelerate. Import prices will rise, Expenditure-switching policies are policies that switch
therefore domestic firms that use imported raw materials away from imports towards domestically produced
and/or intermediate products will experience an increase goods. They include lowering the exchange rate and
in their production costs. In addition, the cost of living increased protection that make imports more expensive.
will immediately increase and this may compel workers They may lead to retaliation and inflation.
to demand higher wages, further increasing production
costs. Aggregate supply may therefore decrease, leading to Supply-side policies include policies to make product
cost-push inflationary pressures. In addition, since exports markets more competitive and labour markets more
will also increase, aggregate demand will increase and the flexible so that costs and prices decrease. They are
demand curve will shift to the right, leading potentially to often necessary but only effective in the long term.
demand-pull inflation.
Alternatively, policymakers could resort to protection. Tariffs The Marshall-Lerner condition and the
and other trade barriers will make imports more expensive in J-curve effect
the domestic market, so less attractive. Households and firms Devaluation or a sharp depreciation implies that the foreign
will substitute domestic products for imports, decreasing the price of exports decreases and the domestic price of imports
country’s import expenditures. increases. With exports more competitive abroad and
Unfortunately, such protectionist policies create trade imports less attractive domestically we expect that export
frictions and invite retaliation from affected exporting revenues will increase and import expenditures will decrease.
nations. In addition, they go against WTO membership rules. Therefore, a trade deficit will improve.

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Such a development crucially rests on the size of the price The J-curve effect

UNIT 4: THE GLOBAL ECONOMY

elasticity of demand (PED) for exports and the PED of Since PEDs are low in the short run and so the Marshall-
imports. The reason relates to the fact that the behaviour of Lerner condition is not immediately satisfied, any
revenues and of expenditures following a change in price improvement in a trade deficit will take time to be realized.
depends on PEDs. In Figure 4.6.3, time is on the horizontal axis and the trade
The Marshall-Lerner condition states that for devaluation balance in goods and services (X – M) is on the vertical axis,
or a sharp depreciation of a currency to improve a current the path through time of the balance of trade following
account deficit, the sum of the PED for imports and the PED devaluation will trace the letter “J”. This is referred to as the
for exports must be (absolutely) greater than one. J-curve effect.
Marshall-Lerner condition: a devaluation (or a sharp
Trade
depreciation) will improve a trade deficit
balance
if (ped(x) + ped(M)) > 1 (X–M)
The proof needs some elementary calculus, but the +
following may help to explain the condition. If we
express the German trade balance in dollars, then a sharp
depreciation of the euro will make American Abercrombie
& Fitch (A&F) shirts pricier in euros even though their
dollar price is constant. Let PED(M) = 0 so that exactly the t1 t2 time
same quantity of A&F shirts is bought in Germany. With –
their dollar price the same and the quantity demanded – $250m
and imported the same, import expenditures expressed
in dollars will necessarily remain the same. Germany’s
trade balance will improve if export revenues (expressed in
dollars) increase. Figure 4.6.3 The J-curve effect

Since the depreciation of the euro made the dollar price of Assume an economy with a trade deficit equal to, say, $250
BMW cars in New York lower, Germany’s export revenues in million deciding to let its currency sharply depreciate (or
dollars will increase if the quantity of BMW cars demanded to devalue if in a fixed exchange rate system). Initially, the
by Americans increase by proportionately more than the deficit becomes larger and larger because the Marshall-
decrease in their New York price so that PED(X) > 1. The sum Lerner condition in the short term is not satisfied: PEDs for
of the two elasticities would thus exceed one. It follows that exports and for imports are very low and their sum does
if the Marshall-Lerner condition is satisfied then the German not exceed unity. Only after time t2 in Figure 4.6.3 is the
trade balance, following a sharp depreciation of the euro, condition satisfied and the trade deficit shrinks below the
will improve. $250 million level.
The condition is not satisfied in the short term, though, Note that an inverted J-curve results after a revaluation
because the PED for exports and the PED for imports (appreciation), where the surplus initially becomes bigger
are initially low. They are low for many reasons. Firms and only starts to shrink later.
and especially households may not even be aware of
the new prices. A sharp depreciation of the euro will Implications of a persistent current
mean that European cars are now cheaper in the USA. account surplus
Will the average US household immediately realize that A current account surplus exists if the sum of net exports of
European cars are now cheaper and more competitive? goods and services plus net income and net current transfers
Not necessarily, as access to new information is not is positive. It is acceptable, even though not strictly speaking
instantaneous. correct, to say that it exists when export revenues from the
Even if it becomes widely known that European cars are now sale of goods and services over a period of time exceed
cheaper in the USA, the typical American may need time import expenditures on goods and services.
to switch away from buying American cars if he or she has A current account surplus in general is not considered an
always bought Fords. Buying habits also need time to be issue, especially if the surplus is small or transitory. Typically,
overcome. it is also not considered an issue if it is a result of an export-
Most importantly, commercial contracts between exporting oriented growth strategy because its perceived benefits to
and importing firms are slow to respond to a currency policymakers and the government outweigh any risks it may
change. Importers may have signed long-term contracts with involve. There may, though, be certain consequences that
foreign firms that are difficult to terminate or change. It need to be explained. These relate to various factors, as
takes time to change business contracts. described below.
Lastly, in the case of firms importing inputs, it may take Domestic consumption and investment
time before they run out of inventories and need to
Two points need to be clear here.
place new orders or before they need to replace an
imported machine. 1. If we focus only on the trade in goods and services
balance of the current account, then if it is positive it

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 implies that the value of goods and services exported Employment
exceeds the value of goods and services imported. To the extent that a current account balance in trade surplus
2. If there is a current account surplus, then there is a increases aggregate demand then the resulting faster growth
combined capital and financial account deficit. Ignoring will increase employment. More workers will be employed
the capital account, as it is small and insignificant, this in the export sector and also more in the import-competing
means that more financial capital is flowing out of the sector.
country that flowing into the country. Domestic residents The response of trading partners
are buying more foreign bonds, stocks and foreign
companies than foreigners are buying domestic bonds, Large bilateral trade surpluses carry the risk of retaliatory
stocks and domestic companies. protectionist measures by deficit countries. To the extent that
the surplus country relies on foreign demand for its growth,
Point 1 implies that the country is consuming inside its retaliation may pose a serious risk. The deficit country may
production possibilities. Consumption bundles that could suddenly adopt highly protectionist policies, blocking out
have been enjoyed are sacrificed. From a static point of view imports, which could halt the growth of the exporting surplus
this implies that living standards are lower than they need country. The recent wave of US protection on China’s exports
to be but from a dynamic point of view this argument may may be understood as the dissatisfaction of many in the
be turned on its head. Foreign markets can and have proved USA with China’s export success, especially in areas that
to be opportunities for long-run growth and have permitted have suffered the greatest import penetration.
many countries to enjoy higher levels of income, with
millions of people escaping poverty.
Policymakers’ perspective
Point 2 may be interpreted to imply that fewer domestic
investment projects are being financed as financial capital Few would disagree that the implications of a
flows out of the country. Empirically this has not been the persistent current account deficit are considered more
case as export performers are usually efficient producers threatening than those of a persistent current account
with high rates of domestic economic investment. In surplus. A nation, as mentioned earlier, cannot spend
addition, the returns from these investments (profits, interest beyond its means for a long time. A persistent deficit
and dividends) boost national income. will somehow have to narrow. Current account deficits
require external sources of finance.
Exchange rates and export competitiveness
However, foreign investors may suddenly decide to
Perhaps the most serious problem associated with a
withdraw their funds if they feel uncertain about the
persistent and widening current account surplus is that it
future prospects of the country. If significant investors
puts pressure on the exchange rate to appreciate. This is
do this, the country will face dire consequences. The
even more serious if the trade surplus is mostly due to one
currency may sharply depreciate, causing import prices
export (for example, oil or natural gas). The appreciation
to soar. Most countries rely on imported oil. Many
means that all other exports of the country become less
rely on imported pharmaceuticals and food. To avert
and less competitive in foreign markets and as result suffer
a sharp depreciation, policymakers may be forced to
a decrease. This is referred to as the Dutch disease. On the
increase interest rates dramatically in order to induce
other hand, the appreciation puts pressure on firms to cut
inflows of private foreign capital that will curb the
down on waste and become more efficient.
pressure on the currency to depreciate. Higher interest
Remember that if the current account surplus is the result of rates also cause distress and, worse still, they may
the country artificially maintaining its currency undervalued prove ineffective in averting a currency crisis.
so that its exports remain cheap and competitive in foreign
It follows that a persistent current account deficit must
markets, then the country runs the risk of inflation.
be dealt with before matters escalate. Expenditure-
Inflation reducing policies should be adopted early even though
A large and growing current account surplus implies that they are also costly. A controlled depreciation of the
the net exports (NX) component of aggregate demand is currency may succeed in restoring competitiveness
positive and increasing. This increases aggregate demand, without surging import prices. Targeted protection
shifting the AD curve to the right. The increase in aggregate may also be considered even though this usually
demand, ceteris paribus, will exert pressure on the average proves counterproductive. Policymakers must try to
price level, leading to accelerating inflation. Such a ensure that growth is not inflationary, that markets
conclusion, though, ignores the possibility that policymakers are not dominated by monopolies, that wage costs
have ensured that domestic economic investment is also are not prohibitively burdensome for firms and, most
increasing so that the productive capacity of the economy importantly, that growth is inclusive so that trust is
is also increasing through time. In this case, the increase maintained and people will be willing to make short-
in aggregate demand will not lead to inflation as the LRAS term sacrifices to reap long-term benefits.
curve will have also shifted to the right.

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 4.7 Sustainable development

UNIT 4: THE GLOBAL ECONOMY

The meaning of sustainable development
Sustainable development is a central concept for our age. Sustainable Development Goals (SDGs)
A wide range of definitions of sustainable development The Sustainable Development Goals (SDGs) are 17 global
exists. The most commonly used one is that of the goals set by the United Nations General Assembly in
Brundtland Commission of the United Nations, which 2015 for the year 2030. The SDGs build on the previous
defined sustainable development as “development that Millennium Development Goals (MDGs) but they go further
meets the needs of the present without compromising the and aim to promote prosperity while protecting the planet.
ability of future generations to meet their own needs” (World The SDGs are listed below.
Commission on Environment and Development 1987a: 43).
Sustainable development has three major aspects: economic 1. No poverty
development, social progress and environmental protection, 2. Zero hunger
and requires a balance between them.
3. Good health and well-being
4. Quality education
Sustainable
development Environmental 5. Gender equality
6. Clean water and sanitation
7. Affordable and clean energy
8. Decent work and economic growth
Economic Social 9. Industry, innovation and infrastructure
10. Reducing inequality
11. Sustainable cities and communities
Figure 4.7.1 Aspects of sustainable development
12. Responsible consumption and production
This means that the promotion of human well-being (which
involves both economic and social dimensions) does not 13. Climate action
result in the destruction of the environment. 14. Life below water
Sustainable development also requires that the needs 15. Life on land
and well-being of future generations are to be taken into
account, given that human actions today might jeopardize 16. Peace, justice and strong institutions
the ability of future generations to meet their needs. For 17. Partnerships for the goals.
example, failure to maintain an adequate natural resource
base could make it impossible for future generations to have These goals aim to address and incorporate in a balanced way
sufficient food supplies. Therefore, resources must not be all three dimensions of sustainable development and they are
depleted; they must be available from one generation to universally applicable, meaning that the rich countries, like
the next. the poor, have to learn to live sustainably.
Lastly, sustainable development also necessitates that the So far, evidence has shown that there has been an
basic needs of all people living today are met, and that the acceleration of poverty reduction, disease control, and
current inequality at the global scale is reduced. This refers increased access to schooling and infrastructure in the
to inequality in the distribution of: poorest countries of the world, and especially in Africa,
• income and wealth as a result of the Millennium Development Goals. The
sustainable development agenda is of course bigger and
• basic social goods such as health and education more difficult to achieve than the Millennium Development
• material goods such as food and shelter. Goals, which themselves were not small challenges. Therefore,
As such, the overall goal of sustainable development is the Sustainable Development Goals include not only the
the long-term stability of the economy, the society and the continuation of the Millennium Development Goals, but also
environment. the integration of these goals with several others, including
social inclusion and environmental sustainability.

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 HL
Relationship between sustainability Moreover, in poor regions there is high population growth,
and poverty which puts an extra burden on the environment as the
growing population tries to maintain its livelihood. Trees
Poverty is a major cause of environmental degradation.
may be cut down to provide clearings for agriculture,
Poor people often rely entirely on agriculture for their
construction materials, and fuel for cooking and warmth.
incomes. As farmers cannot afford the contemporary
This may eventually lead to deforestation. Pastureland
means of production such as fertilizers, machinery or
and fisheries may also become depleted because of
crop protection chemicals they overuse the land, trying
overgrazing animals and overfishing.
to maximize output. When land is continuously used
to grow crops, the soil cannot retain nutrients and Due to these activities, in an effort to survive, poor people
moisture and so the quality and productivity of the often destroy their immediate environment. This poses
land falls over time. a threat to sustainability, as future generations will be
deprived of an adequate natural resource base.

4.8 Measuring development

The multidimensional nature of economic development

Economic development is an aspect of sustainable in a high income country it is above $11,906. The middle
development. More specifically, economic development is income group, which is quite big, is split between the upper
a multidimensional concept. It refers to an improvement in middle income and the lower middle income, with the
living standards which involves increases in per capita income dividing line at $3,855.
levels, reductions in poverty, increased access to health care This classification is useful and may provide us with some
and education, and increased employment opportunities, as information on the level of development. For example,
well as reduced inequalities of income and wealth. few would question that Norway is more developed than
Economic development can be measured either with the Somalia. However, since there several limitations associated
use single or composite indicators. with the use of per capita GDP and GNI as measures of
• Single indicators record the progress made towards a well-being, classification based on per capita income can
particular dimension of development. be problematic. Per capita GDP and GNI fail to incorporate
income distribution considerations, do not take into
• Composite indicators are summary measures of several
account the value of the environmental degradation, fail
dimensions of development.
to include non-marketed subsistence production, conceal
Single indicators useful information on the composition of output and do
not include the value of the stream of services flowing from
GDP/GNI per capita at purchasing power the accumulated social and other capital of an economy
parity (PPP) (see section 3.1). Consequently, such indicators may be
GDP/GNI per capita at purchasing power parity (PPP) can to useful as measures of national economic performance but
some extent provide information on the level of development they are not entirely suitable as indicators of economic
of a country, as there is a positive correlation between per development.
capita income and well-being. Remember that PPP stands
Health and education indicators
for purchasing power parity dollars. These are dollars of
equal purchasing power (that is, they buy the same basket of Health-related indicators include:
goods and services that the national currency buys). • health expenditure per capita
The UN and the World Bank keep systematic records of per • life expectancy at birth (years)
capita GDP and GNI and classify countries on this basis. • infant mortality (per 1,000 live births)
For instance, the World Bank uses per capita GNI to place • malnutrition prevalence
countries into three main categories: high income, middle
income and low income. A country is low income if GNI per • maternal mortality ratio (per 100,000 live births)
capita is below $975 per year. In a middle income country • improved sanitation facilities (the percentage of the
GNI per capita is between $976 and $11,905 per year and population with access)

188
• prevalence of HIV (the percentage of the population aged eutrophication, acidification, toxic contamination, urban

UNIT 4: THE GLOBAL ECONOMY

between 15 and 49 years) environmental quality, biodiversity, cultural landscapes,
• physicians (per 10,000 people) or hospital beds waste, water resources, forest resources, fish resources, soil
(per 10,000 people). degradation and material resources.
Education-related indicators include: Environmental indicators can be used to evaluate whether
the development process is also sustainable.
• literacy rate (the percentage of the population who know
how to read and write) Composite indicators
• mean years of schooling (of people aged 25 years and older) Human Development Index (HDI)
• pupil–teacher ratio The most widely used composite indicator is the human
• school enrolment, primary, secondary and tertiary (the development index (HDI). It was constructed by the
percentage of school age children enrolled in each level). United Nations Development Programme (UNDP) as a
According to the definition of economic development, health comprehensive measure of development. The HDI measures
care and education are important parts of the development average achievements of a population in terms of health,
process. Checking health- and education-related indicators education and access to goods and services. These three
helps to monitor progress in these dimensions. dimensions are measured by the indicators:
Economic/social inequality indicators • life expectancy at birth
Economic and social inequality indicators include: • mean years of schooling and expected years of schooling
• the Gini coefficient, which is the most widely cited • GNI per capita (in US$ PPP).
measure of income inequality Each dimension takes a value between 0 and 1, with 0 being
• the Robin Hood index, which shows the proportion of all the lowest possible value and 1 being the highest. The
income that would have to be redistributed to achieve a composite index is the average of the three dimensions, so
state of perfect equality each country receives an HDI value from 0 to 1 and is then
• the 20/20 ratio, which compares the ratio of the average ranked accordingly.
income of the richest 20% of the population to the Since 1990, the HDI has been reported annually by the
average income of the poorest 20% of the population UNDP in its Human Development Report. One interesting
• the Social Institutions and Gender Index (SIGI), which is a aspect of the HDI is that it demonstrates that some
cross-country measure of discrimination against women in countries with modest incomes, such as Costa Rica, Cuba
social institutions. and Sri Lanka may score relatively highly in terms of human
development since they have life expectancy and literacy
Inequality indicators can be useful in assessing the progress rates comparable with those of advanced economies.
made in terms of reducing inequalities, which is another
important dimension of economic development. Overall, the HDI was successful in displacing per capita
income as a summary measure of development. However,
Energy indicators the HDI has some limitations. It remains an average, as it
Energy indicators include: conceals important differences within a country. Women and
• percentage of traditional fuel energy use rural populations as well as the very old and the very young
often suffer disproportionately but this is not illustrated
• share of households with access to electricity
through the HDI as it does not consider income distribution
• total energy consumption per capita or gender inequalities. In addition, it does not include any
• the ratio of energy use to GDP. assessment of environmental changes or impacts. As a result,
Trends in overall energy use indicate the general relationship a country’s HDI score may rise as a result of improvements
of energy consumption to economic development that in longevity, education and per capita income even though
shows a positive correlation. These trends therefore provide those improvements might be achieved at the cost of
a rough basis for projecting energy consumption and its unacceptable natural resource depletion and environmental
environmental impacts with economic growth. degradation.
Environmental indicators Note that two additional composite indicators
were introduced by the UNDP in 2010 capturing
Environmental indicators include:
multidimensional inequality—the Inequality Adjusted HDI,
• ecological footprint, which relates to land use and CO2 known as the IHDI—and gender disparities—the Gender
emissions Inequality Index.
• the Living Planet Index (LPI), an unweighted index developed Inequality Adjusted Human Development
by the World Wide Fund for Nature (WWF) to indicate
Index (IHDI)
changes in the number and diversity of biological species
The inequality adjusted HDI (IHDI) measures development
• the Environmental Sustainability Index (ESI) developed by
in the same three dimensions as the HDI, adjusted for
the World Economic Forum (WEF)
inequality in each dimension. The IHDI attempts to capture
• the OECD’s “core set of environmental indicators”, which losses in development that arise from inequality. (If there
involve climate change, stratospheric ozone depletion, were no inequality the IHDI and the HDI would be equal.)

189
 Gender Inequality Index (GII) The use of such indicators provides some opportunities—but
The Gender Inequality Index (GII) measures inequalities also raises some issues. On the positive side, composite
between the genders in three dimensions. Often women indicators may provide clear overviews of trends in
and girls are discriminated against in health care, education development, highlighting where performance and progress
and in the labour market. The GII captures the loss in have been particularly strong or weak, and they permit
development of women due to inequalities in these areas. comparisons to be made between countries. On the negative
side, composite indicators have several important limitations.
The UNDP developed another composite indicator, the
Capability Poverty Measure (CPM), which focuses on the • They may contain indicators that are difficult to aggregate,
capacity of people to lead worthwhile lives. especially where different units of measurement are used.
The Capability Poverty Measure (CPM) • A composite indicator, while useful for comparisons between
countries, may be of limited use in informing policy.
The Capability Poverty Measure (CPM) emphasizes the
importance of basic opportunities for personal development • Composite indicators may fail to take account of the
and is measured as a lack of these basic opportunities. It is interconnections between the economic, social and
the arithmetic mean of three variables: environmental dimensions of development.
• the lack of capability to be nourished and healthy, • The use of composite indicators may conceal the fact
measured as the proportion of children under 5 years of that development involves a wide diversity of issues, each
age who are underweight requiring a different indicator, and that those indicators
may be moving in different directions.
• the lack of capability to be educated, measured as the
proportion of females aged 15 years and over who are Consideration of the issues associated with single indicators
illiterate and composite indicators suggests that none of them is ideal
as a measure of economic development. All of the indicators
• the lack of capability for healthy reproduction, measured discussed in this section have certain advantages—but all
as the proportion of births unattended by trained provide selective and partial representations of reality.
health-care workers.
Relationship between economic growth and
It is notable that the CPM places a strong emphasis on the
lack of women’s capabilities, in acknowledgment of the fact
economic development
that, if women are deprived, then the human development Economic growth refers to increases in the real GDP of an
of families and entire societies is adversely affected. In economy through time. Growth does not necessarily involve
common with the HDI, however, the CPM does not take any development. A country may grow without any development
account of the environmental dimension. objective being met.
Another composite indicator that could be used to track The United Nations Development Programme has described
development is the Happy Planet Index (HPI) that was four types of growth that obstruct the development process.
explained in section 3.1. The Happy Planet Index measures They are:
how well nations are doing at achieving long, happy and • jobless growth, where employment opportunities for the
sustainable lives. poor do not expand
Strengths and limitations of approaches to • ruthless growth, where income inequality widens
measuring economic development • futureless growth, where the environment is degraded and
In relation to economic development, the range of possible natural resources depleted
indicators is vast and, in some cases, the suitability of those • voiceless growth, where individual empowerment falls
indicators is questionable. It is not always clear at which behind.
scale—global, national, regional or local—those indicators As such, economic growth does not guarantee that
should be applied. At the same time, the availability and economic development will occur. Usually, though,
reliability of data can also be problematic. Nevertheless, development requires growth. Some economic development
despite such complexities, it is important to have indicators may be possible in the absence of growth in the short
to measure progress—or lack of progress—in promoting term, if the policies followed provide access to basic
development. social services for the poor. However, in the long term,
Given the vast scope of economic development, the use of a the development process necessitates that developing
single indicator to assess economic development fully is “an countries are growing.
impossible dream”. Consequently, an alternative approach
has been to produce attempts and use composite indicators.

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 4.9 Barriers to economic growth and/or

UNIT 4: THE GLOBAL ECONOMY

economic development
There are a number of factors that can prevent countries from growing and developing.

The poverty cycle or trap

Poverty locks individuals into a vicious poverty cycle or trap, or parents, which limits their possibilities for higher earnings.
what Nobel Laureate Gunnar Myrdal called “circular and Therefore, the poverty cycle is a significant barrier to growth and
cumulative causation.” The poverty cycle is shown in Figure 4.9.1. development in the short term but also in the longer term.
Poor people live on a very low income, which is spent entirely Low income
on necessities. This means that, in poor countries, the level
of available savings in the economy is very low. As a result,
investments in physical capital (machines, equipment and
infrastructure) and in human capital (education and health
Low productivity Low savings
care) cannot be financed so they are also low. Productivity will
remain low, so incomes remain low. The country is trapped in a
situation where people’s poverty leads to more poverty.
It is important to note that the poverty cycle is transmitted Low investment
across generations as children are caught in the trap with their
Figure 4.9.1 The poverty cycle or trap

Economic barriers

Rising economic inequality The poor have limited or no access to credit. They cannot
Globally, the lowest 20% of people receive just 1.5% of the borrow to invest in their children’s education or to start or
world’s income—the scale of global inequality is immense. expand a business.
There are also large income disparities within developing High and rising inequality also reduces the overall savings
countries. Latin American countries tend to be highly in the economy, as it is the middle class that saves the most.
unequal. Several African countries also have among the The rich spend large amounts on imported luxuries and
highest levels of inequality in the world. Inequality is also channel their savings abroad to foreign tax havens. This
particularly high in many resource-rich developing countries, results in fewer funds and resources available for domestic
notably in the Middle East and sub-Saharan Africa. productive investments and lower demand for domestically
Table 4.9.1 shows the Gini coefficient based on the most produced goods and services.
recent World Bank estimates for some of the countries High inequality also increases the prevalence of corruption
with the highest income inequality in the world. which reduces the probability of “doing business”. In the
Country Gini coefficient presence of corruption, investment can be discouraged
because entrepreneurs face higher costs in dealing with
South Africa 0.63
“red tape” and regulatory burdens and may even be forced
Namibia 0.59 to pay bribes. Lastly, inequality may lead to social unrest
Zambia 0.57 and political instability, which increases the risks investors
Lesotho 0.54 face and discourages both domestic and foreign direct
investment (FDI).
Brazil 0.53
Rising economic inequality leads to lower growth rates and
St. Lucia 0.51 so restricts the process of economic development.
Panama 0.50
Colombia 0.49 Lack of access to infrastructure and
Mexico 0.48
appropriate technology
Infrastructure refers to the economy’s physical capital
Cameroon 0.47
such as transportation systems (roads, railways, ports and
Table 4.9.1 Gini coefficient for selected countries. airports), telecommunications, energy systems (electricity
Source: https://www.indexmundi.com/facts/indicators/SI.POV.GINI/rankings and gas), water supplies, sanitation and sewerage.
High and rising inequality implies that a large part of the Infrastructure is a major facilitator of economic activity
population does not have access to education and health and contributes to economic development. Infrastructure is
services. The economy is deprived of their skills and talents. typically financed from government funds.

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 However, in developing countries often governments do demand for such products in countries with rising incomes
not have the required resources to invest in and maintain does not grow fast enough to boost growth. Also, the prices
infrastructure. Many parts of Africa are so poor that the most of primary goods tend to fluctuate because farm products
basic infrastructure such as electrification or a road network are affected by weather conditions and other random factors
in many areas does not even exist or is crumbling. Lack of and also have low price elasticity of demand (PED) and price
infrastructure limits growth and development prospects. For elasticity of supply (PES). As prices fluctuate, so do farmers’
instance, inadequate roads and poor road access increase incomes, the country’s export revenues and levels
the cost of transportation and limit the access to local of employment.
markets as well as to education and health facilities.
Closely related to the lack of infrastructure is the lack of
Lack of access to international markets
access to appropriate technology. Appropriate technology Developed economies such as the USA, the European Union
refers to technology that is best suited for a country’s factors and Japan provide large agricultural support to their farmers,
of production. In general, technologies can be distinguished mainly in the form of subsidies. This results in lower world
into capital-intensive, relying mostly on machines, and prices with which developing countries cannot compete and
labour-intensive, relying mostly on workers. Since in most therefore they cannot expand their exports to international
developing countries labour is the relatively abundant factor markets. This inability to access these markets is a barrier
of production, it follows that appropriate technologies as it leads to lower incomes, lower agricultural investment,
are often labour-intensive. Nevertheless, the lack of such lower employment opportunities for farm workers and
technologies means that there is less employment, less increased poverty.
income and more poverty, and therefore less growth and This has been the case with US cotton subsidies and the
development. Cotton-4 (C-4) countries (Benin, Burkina Faso, Chad and
Mali). Cotton is the primary export crop accounting for
Low levels of human capital—lack of access the majority of agricultural export earnings in each C-4
to health care and education country. Cotton is also the dominant source of employment
In developing countries levels of human capital are low, in cotton-producing regions in each of these countries. The
which becomes an impediment to these countries’ growth US administration has been granting subsidies to the US
and development. Compared with developed countries, cotton industry for seven decades, which have contributed
much of the developing world has lagged in its average to a decline in global cotton prices. Due to the prominent
levels of nutrition, health (as measured, for example, by life role cotton plays in the economies of C-4 countries, low
expectancy or extent of undernourishment), and education cotton prices significantly affect the ability of their farmers
(measured by literacy rates or school enrollment ratios). One to obtain sufficient income and to increase production and
of the reasons is that many developing nations are deprived employment. This means that US cotton subsidies may have
of the resources needed to maintain adequate health and obstructed the development of the C-4 countries, which are
education services. Also, poverty may prevent access to listed among the world’s poorest.
health and education. Apart from agricultural support developed economies offer
This lack of health care and education is responsible for to their farmers, they also impose trade barriers, mainly
decreased labour productivity, individuals facing fewer tariffs, to protect their industries from foreign competition.
employment opportunities, higher risk of spreading This further limits the ability of developing countries to
diseases, fewer technological innovations (because of fewer access international markets, impeding both growth and
skilled individuals) and therefore more poverty. Human development.
capital formation is absolutely necessary to achieve higher Note that one criticism of the World Trade Organization
labour productivity, long-term growth and improved living (WTO) relates to this issue. The WTO has been accused of
standards. Remember that achieving better health and treating the developing world relatively unfavourably. IT is
education are themselves development goals. criticized for not doing enough to force the USA and the EU
to open up their own agricultural markets to imports. The
Dependence on primary sector production inability to reach an agreement in agriculture is considered
Throughout Africa, the Middle East and Latin America, the main reason why the Doha Round of trade negotiations
primary product exports have traditionally accounted for a organized by the WTO failed (section 3.4).
sizable proportion of individual gross domestic products. In
some of the smaller countries, a substantial percentage of the Informal economy
economy’s income is derived from the exports of agricultural The informal economy lies outside the formal one and is
and other primary products or commodities such as coffee, where unregistered, unregulated and untaxed economic
cotton, cocoa, sugar, palm oil, bauxite and copper. A few activities take place. Unregistered activities range from
countries may even depend on producing and exporting a street vendors to tricycle drivers and often become a way
single primary commodity. Niger, for example, is extremely for people to survive. In fact, in many developing countries,
dependent on the extraction and exportation of uranium. about half of the employed urban population works in the
This primary sector dependence can be a major obstacle to informal sector.
growth and development. One reason is that demand for The workers in this sector are generally unskilled and
most primary exports is income inelastic and, as a result, they lack access to financial capital. As a result, workers’

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productivity and income tend to be lower than in the Geography—including being landlocked

UNIT 4: THE GLOBAL ECONOMY

formal sector. Another issue is that workers in the informal The geographic location of many developing countries may
sector do not enjoy the measure of protection afforded act as barrier to their growth and development. In fact,
by the formal sector in terms of job security and decent according to Jeffrey Sachs of Columbia University, physical
working conditions. As a result, living standards for these geography is the fourth most important contributor to poverty.
workers are low and as long as the informal economy
remains unregulated the development prospects are limited. Many of the poorest developing countries around the world
Moreover, the government does not earn any tax revenue are landlocked. In Asia, for example, Afghanistan, Nepal,
from informal sector activities—and lower tax revenues also Bhutan and Laos are all landlocked countries. In Africa,
limit the ability to finance pro-development goals. roughly one-third of the countries are landlocked. Economic
growth and development depend heavily on international
Capital flight trade, which is significantly more difficult and costly for
Capital flight refers to the rapid outflow of large sums of landlocked countries. Being on the coast, near ports or near
money out of a country, typically as a result of economic and major rivers allows for a higher degree of international trade.
political instability. A debt crisis can, for example, trigger It allows exports to reach world markets at low costs, and
capital flight as it can induce wealthy nationals seeking also enables the economy to obtain imported inputs at low
safety to send vast amounts of money out of the country. costs. This can boost productivity and provide opportunities
For instance, in 2001 Argentina defaulted on its debt for economic growth and development.
when it owed $100 billion, which led to massive capital Even if not landlocked, countries may have the problem of
flight. Expectations of exchange rate devaluation may also being in mountainous regions, such as Bolivia. This makes
contribute to substantial capital flight, as investors flee from it difficult for them to engage in farming and low cost
the country before their assets lose too much value. Outflows manufacturing. Also, some developing countries are in
of the Chinese yuan occurred several times after 2015, geographic locations that are exposed to natural disasters
when the government devalued the currency. Lastly, political such as cyclones, storms, floods and droughts. This applies
turmoil can also lead to capital flight as better-off residents to a number of small island economies, for instance the
seek to protect their wealth. Philippines and Haiti.
Capital flight can become an impediment to economic Such examples show that geography can play an important
growth and in turn to economic development because it role in the process of economic development. Nevertheless,
involves a loss of financial capital that could have been “geography is not destiny”; countries can come up with
invested within the country. Moreover, since these funds meaningful alternatives when underlying geographical
are no longer subject to tax, governments lose tax revenue conditions are difficult.
that could have been used to support the financing of
development goals. For instance, in the case of Africa, high Tropical climates and endemic diseases
levels of capital flight deprive governments of the ability to There are obviously climate differences from country to
mobilize domestic resources and this has a material impact country but almost all developing countries have tropical
on economic development. Estimates from the OECD show and subtropical climates. This is considered to be a factor
that each year Africa loses up to $50 billion through that has prevented many of them from growing and
capital flight. developing. Climate has a huge effect on crop productivity,
water scarcity or availability, and even labour productivity.
Indebtedness Tropical climates tend to be “less gentle” in terms of the
High levels of indebtedness characterize many developing factors already mentioned and may therefore limit growth
countries as their governments have had a past history of and development prospects.
overspending and over-borrowing. In addition, climate plays an important role for endemic
High debt levels require large repayments to service diseases. Places that are warm all year round, such as
the debt. This implies that governments have fewer tropical Africa, generally have very high year-round malaria
funds available to invest in health care, education and transmission. Besides malaria, schistosomiasis is also
infrastructure, which are all necessary for economic growth prevalent in tropical and subtropical areas, especially in
and development. More specifically, according to the World poor communities without access to safe drinking water and
Bank since 2013, median government debt in developing adequate sanitation. It is estimated that at least 90% of
countries has risen by about 20% of GDP. As a result, in those requiring treatment for schistosomiasis live in Africa.
most of these countries debt payments are absorbing an Since development depends on a healthy population, regions
increasing proportion of government revenues that could beset by a heavy disease burden are held back.
have been used to finance pro-development projects. A great concern going forward is that global warming is
At the same time, high levels of debt imply that any export projected to have its greatest negative impact on Africa and
revenue earned which could have been used to finance the South Asia. Rising temperatures will increase the occurrence
importation of say, pharmaceuticals or machine-parts must of droughts, heat waves, potential crop failures and disease
be diverted to creditors for the servicing of the debt. Hence, incidence in these areas, which may further impede their
indebtedness also obstructs developing nations from using growth and development prospects in the near future.
foreign exchange to attain necessary imports.

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 Recap
Economic barriers to growth and/or development
• High and rising economic inequality deters access to increased poverty. All of these factors impede growth
health care, education and credit, reduces savings in and development.
the economy and can increase corruption while fuelling • An informal economy will have a negative effect on
social and political instability. As such, productivity and economic growth and development. In the informal sector
investment spending remain low, leading to lower growth worker productivity and incomes are low and there is
rates and restricting the development process. decreased job security and poor working conditions. This
• Lack of access to infrastructure increases the cost of means that living standards for workers in the informal
transportation and limits the access to local markets as economy are low. Also, tax revenues are lower and this
well as to education and health facilities. limits the ability to finance pro-development goals.
• Lack of appropriate technology means that there is less • Capital flight is barrier to economic growth and in turn
employment, less income and more poverty. These factors to economic development because it involves a loss of
limit economic growth and development. financial capital and a loss of tax revenue that could have
• Low levels of human capital—lack of access to health been invested within the country.
care and education is responsible for decreased labour • Indebtedness requires large debt repayments and so the
productivity, individuals facing fewer employment government has fewer funds available to invest in health
opportunities, higher risk of spreading diseases, care education and infrastructure, which are all necessary
fewer technological innovations and therefore more for economic growth and development. Also, there is less
poverty. This acts as a barrier to economic growth and foreign exchange to finance the purchase of necessary
development. imports.
• Dependence on primary sector production is an obstacle • Geography, including being landlocked, is often an
to growth and development, because of the low income economic barrier. Economic growth and development
elasticity of demand that prevents demand for primary depend heavily on international trade, which is
products to grow fast enough to generate growth. Also, significantly more difficult and costly for landlocked
primary product prices are highly volatile, leading to countries. Also, countries in mountainous regions or
fluctuations in farmers’ incomes, the country’s export exposed to natural disasters may also face issues in terms
revenues and levels of employment. of growth and development.
• Lack of access to international markets is a result of • Tropical climates and endemic diseases affect the
the agricultural support developed economies offer economy. A feature of a tropical climate is warm weather
to their farmers and of the trade barriers developed all year round, which negatively affects crop productivity,
countries impose. Restricting the ability of developing water availability and labour productivity while favouring
countries’ exports to reach international markets the spread of endemic diseases such as malaria. These
leads to lower incomes, lower agricultural investment, factors lead to slower growth and impede economic
lower employment opportunities for farm workers and development.

Political and social barriers

Weak institutional framework Ineffective taxation structures
There are many economic, legal and social institutions that Tax revenues are needed by governments to make
influence economic growth and development. However, in investments in health care, education, infrastructure
developing countries the institutional framework is rather weak and in other areas important for economic growth and
and this can impede the process of growth and development. development. However, tax revenues in developing
Inadequate legal system countries are not simply low because of low incomes.
The tax system itself is often ineffective in collecting tax
In developing countries, legal systems are often not capable revenues due to complicated procedures, tax exemptions
of applying and enforcing laws equitably and efficiently, and for the wealthy with political influence and corrupt tax
laws often are not subject to predictable interpretation. This authorities. At the same time, the existence of a large
creates uncertainty, which is closely related to the rapidly informal sector may also restrict the amount of tax
increasing number of pending court cases and corruption revenues governments can raise since the transactions
that can all hurt economic growth and, in turn, economic taking place are not recorded.
development. Quite often legal institutions in developing
countries may be a product of elite interests, or may be open Lack of property rights and land rights
to capture by such interests. As a result, these institutions Property rights involve laws that ensure legal rights to
serve to increase the power and wealth of a few at the ownership and transfer of ownership from one owner to
expense of the majority of the community, leaving the poor another. In developing countries, property rights are
suffering the harshest consequences.

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usually not well defined and enforced. This leads to lower Gender inequality

UNIT 4: THE GLOBAL ECONOMY

investment as there is risk of loss of the investment, which In many developing countries there is gender inequality.
can then limit growth. Gender inequality refers to limited access for women to
Peruvian economist Hernando de Soto considers the lack social and economic opportunities compared with men.
of property rights the most significant barrier to economic Being excluded because of their gender, women have less
growth and economic development. According to relevant access to education, formal-sector employment, social
research about 5.3 billion people in the world do not have security and government employment programmes, which
well-defined property rights and so their assets become keeps them excluded. As a result, they are more likely to be
“dead capital” which cannot be used to generate income or poor and malnourished, and less likely to receive medical
growth. For example, entrepreneurs in poor nations lacking services, clean water, sanitation and other benefits.
secure property rights have no ability to leverage their This has significant consequences for growth and
home as an asset to create more business opportunities. As development. In the long term, the low status of women is
a result, the poor remain trapped, hurting individuals and likely to translate into slower rates of economic growth. This
broader economic development. is because the educational attainment and future financial
Related to property rights are land rights. In many status of children are much more likely to reflect those of
developing countries, the majority of land is under the mother than those of the father. So, the benefits of
customary tenure: the rights, rules and responsibilities to current investments in human capital are more likely to be
possess, occupy and use it are based on community customs. passed on to future generations if women are successfully
However, customary-held land rarely enjoys adequate integrated into the growth process. According to Lawrence
protection under national laws. This has often led to land Summers, educating girls yields a higher rate of return than
being appropriated, grabbed and sold by governments, any other investment available in developing countries.
private firms and powerful individuals at the expense of
poorer individuals. In many cases this happens in rural Poor governance and prevalent corruption
areas where these individuals’ livelihoods are much more High levels of corruption hold back growth and development
dependent on land and agriculture. The result is that poverty because the country is suffering from poor governance.
in rural areas persists, hindering the development process. Extreme poor governance and corruption can certainly
Inadequate banking system stop and even reverse the process of economic growth and
development.
Banking services and access to credit are very important
to economic growth and development, as they allow for One major reason is that corruption disproportionately
investments in human, physical and natural capital. Yet the affects the poor. The rich may spend large amounts on bribes
commercial banking system in many developing countries and other pay-offs to corrupt governments, but for the poor
is not properly functioning, as it does not accommodate such payments will be a much larger proportion of their
poor and small-scale producers, farmers and traders. It is income. A small-scale business may pay a higher percentage
therefore a major restraint on growth and development. of its sales revenue in bribes than a large firm. In addition,
This relates to lack of property and land rights explained “government for sale means government for the highest
above. When ownership of assets is not well-defined and bidder”. When corruption is prevalent, the poor find fewer
secured the assets cannot be used as collateral, so loans services in their communities and only have access to poor
cannot be issued. This leaves the poor without access to education and health facilities. This makes it more difficult
credit and therefore unable to finance investment that could to accumulate the means to escape from poverty.
have boosted economic growth and development. Policies containing potential strategies for economic growth and
Note that most developing countries were once colonies development may be damaged by inefficiency or incompetence
of Europe or otherwise dominated by European or other (individually or in combination). The potential strategy may not
foreign powers, and institutions created during the colonial be fully or adequately implemented.
period often had negative effects on development that in
many cases have persisted to the present day. Colonial era Recap
institutions often favoured extractors of wealth rather than
Political and social barriers to growth
creators of wealth, harming development then and now.
and/or development
According to Daron Acemoglu and James Robinson, nations
with extractive political and economic institutions are likely Barriers include:
to be poor, whereas those with inclusive institutions are • a weak institutional framework, in terms of:
likely to be rich. That is to say that “institutions matter” – an inadequate legal system
and colonial institutions, in particular, have played a
– ineffective taxation structures
significant role in shaping the economic development of
colonized countries. For example, Spanish colonialists put – lack of property rights and land rights
Latin America on a path of extractive and unproductive – an ineffective banking system
institutions that still exist and still impede the development • gender inequality
process across Latin American countries.
• poor governance and the prevalence of corruption.

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 Policymakers’ perspective
The mix and severity of the barriers to growth and exporters; some are private-sector oriented, others to a
development described above largely frame the large degree are run by the government. It is important to
development constraints and policy priorities of each appreciate and take into account these differences when
developing nation. They all reflect common problems deciding development policy. According to Jeffrey Sachs,
shared in varying degrees by most developing countries. economists, like medical clinicians, need to learn the
Behind these common barriers however, there are very art of “differential diagnosis”. This implies that instead
substantial differences among developing countries. of unthinkingly relying on standardized policy options,
Some nations are large, others small; some resource- policymakers should focus on the key underlying causes
rich, others resource-barren; some are subsistence of economic distress and use appropriate measures that
economies, others are modern manufactured-good are well tailored to each country’s specific conditions.

196
4.10 Economic growth and/or economic

UNIT 4: THE GLOBAL ECONOMY

development strategies
There are several strategies that can help developing countries overcome the barriers holding them back and promote their
growth and development.

Trade strategies
Developing countries can base their growth and Kong and Singapore (known as the East Asian Tigers) and
development on trade strategies. other countries including, of course, China.
Export promotion has been a success story for many countries.
Import substitution The export revenues earned alleviated problems with the
Import substitution (also known as import substitution balance of payments. For example, the export growth Taiwan
industrialization) is a strategy where a country begins to and South Korea enjoyed contributed over 80% of both nations’
manufacture simple consumer goods, such as textiles or shoes, foreign exchange earnings. With higher export earnings there
aiming to substitute domestically produced goods for imports is less danger of an economy running into foreign exchange
and therefore promote its domestic industry. Import substitution and foreign debt problems. Rising export revenue increases
requires trade barriers such as tariffs and quotas to prevent the aggregate demand, fuelling growth in output and incomes.
entry of imports and to protect the newly established industries.
In addition, firms are forced to learn more about
These barriers stay in place until the firms grow sufficiently in
manufacturing their products more efficiently. International
size and acquire the necessary know-how to lower unit costs.
competition provides the stimulus.
Trade barriers are reduced when the firms are able to compete
with imports and survive within the domestic markets. At the Note that the government’s role is very important for export
same time, the exchange rate is kept overvalued so that prices promotion to be a successful growth and development
of necessary imported manufacturing inputs are low. strategy. It can help exporting firms with state subsidies,
investment grants and tax exemptions while making large
Import substitution has been practised by a number of
investments in key areas such as education that improves the
developing countries in Latin America, Asia and Africa in an
skills of the workforce, in research and development that can
attempt to create a manufacturing sector so that reliance on
lead to innovation, and in transport and communications
the primary sector is reduced. Ultimately, as seen in the case
infrastructure that can assist production. Therefore, through
of industries in South Korea and Taiwan, domestic firms may
varying degrees of state intervention, economies can slowly
be able not only to produce for the domestic market but also
shift their production to manufactured goods, diversify and
to export their manufactured goods to the rest of the world
become more insulated from industry-specific risks.
(see “Export promotion” below).
However, strong dependence on exports makes the economy
However, import substitution may be associated with
vulnerable. If trading partners go into a recession, the
inefficiency because trade protection reduces competition.
exporting economies will be adversely affected. The trade
Secure behind protective trade barriers, many industries
barriers imposed by developed economies may hurt exports
remain inefficient and costly to operate. In some cases, this
and export revenue. Developed economies have imposed
has led to production of goods that are low in quality but
extensive trade barriers, and their rates of protection are
high in cost and price.
often higher against exports from developing countries
The overvalued exchange rate affects primary exports, hurting exports than against those of high income countries. Income
local farmers because for each dollar of exports they earn distribution may worsen as the rural sector may be neglected
fewer units of the domestic currency. This may increase while those involved in the exporting sector will enjoy a
poverty for some parts of the population. Import substitution larger share of national income.
has in practice often worsened the distribution of income by
Lastly, focusing on export promotion as a growth process may
favouring the urban industrial sector while discriminating
lead policymakers to postpone the creation of a social safety
against the rural sector and lower income groups.
net that would include state pensions and health insurance.
The newly established industries may use capital-intensive This is because the growth process does not rely on the ability
production methods, limiting employment opportunities of the population to spend on domestic goods and services.
and leading to jobless growth. This growth is usually not
followed by development. Economic integration
Regional integration among developing countries may
Export promotion prove beneficial as a trading bloc increases the size of the
Export promotion is a trade strategy where a country potential market for each exporting firm. The expanded
attempts to achieve economic growth by expanding its market size can also provide the opportunity for lower
exports. Japan was the first country to have adopted this unit costs for developing countries’ industries. Integration
strategy and was followed by South Korea, Taiwan, Hong helps to avoid the obstacles of the protectionist barriers of

197
 developed countries. In addition, integration can decrease Many attempts to form trading blocs among developing
the level of dependence on developed countries’ markets countries have encountered the following problems. There
while providing member countries with greater political and have been significant organizational and administrative
bargaining power in negotiations with developed economies. problems. Political rivalry between and within countries and
Integration can also be viewed as a mechanism to encourage lack of commitment have also prevented progress.
a division of labour among a group of countries, each of which One of the operational problems for firms is transport costs.
is too small to benefit from such a division by itself. These are especially high, since road and other necessary
Examples of economic integration among developing infrastructure is often poor.
countries include the Latin America Free Trade Association In addition, the structure of production and of trade in
(LAFTA); MERCOSUR, a customs union among Argentina, developing countries lacks a sufficient complementary
Brazil, Uruguay, and Paraguay; and the Asia-Pacific Economic nature, as their economies tend to exhibit high similarity.
Cooperation (APEC), a group of 21 nations that border the This restricts mutually beneficial trading.
Pacific Ocean.

Recap
Trade strategies
Import substitution is the creation Export promotion is when a country Economic integration is regional
of an industrial base to substitute attempts to achieve economic integration among developing
domestically produced manufactured growth by expanding its exports. countries through preferential
goods for imports. trading agreements.
• A manufacturing sector is created, • Export growth increases export • The size of the potential market is
reducing reliance on the primary revenue and foreign exchange increased.
sector. earnings. • The protectionist barriers of
• Foreign competition increases developed countries are avoided.
efficiency in production. • Dependence on developed
• Export growth changes the countries’ markets decreases.
structure of the economy. • Integration provides member
countries with greater political and
bargaining power.
• Division of labour is encouraged.
Disadvantages of trade strategies
Import substitution Export promotion Economic integration
• It reduces competition, leading to • Dependence on exports makes the • There are organizational and
inefficiency. economy vulnerable as it is subject administrative problems.
• It hurts primary sector exports, to any shock its trading partners • Political rivalry and lack of
increasing poverty among the rural may undergo. commitment prevent progress.
population. • The trade barriers of developed • Transport costs are high due to
• Inequality may widen. economies still need to be poor infrastructure.
successfully overcome.
• The increased use of capital- • Similarities in the structure of
intensive production technology • Distribution of income may worsen some countries’ economies may
can lead to jobless growth. as the exporting sector enjoys a restrict mutually beneficial trade.
greater share of national income.
• Policy focus may shift away from
creating a social safety net.

Diversification
One of the major problems that many developing countries At the same time diversification may create new jobs. It can
face is their over-dependence on a narrow range of agricultural lead to the improvement of skills and technologies in order
products. Diversification involves broadening the range of goods to support the broader range of production.
and services developing countries are able to produce. This allows Nevertheless, diversification may not guarantee that
such economies to benefit from worldwide economic growth as developing countries’ exports will no longer be subject
manufactured products and services have higher income elasticity to trade protectionism. Also, some of the benefits of
of demand. Also, they will no longer be subject to price volatility, specialization in the form of efficiency may be lost.
which will stabilize incomes and export earnings.

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Market-based policies

UNIT 4: THE GLOBAL ECONOMY

The idea behind market-based supply-side policies is that Market-based policies, such as privatization and
markets are the most effective mechanism for growth deregulation, increase efficiency and contribute to economic
and in turn for development. Since the late 1980s, a growth. More specifically, the profit motive forces privatized
number of prominent institutions including the IMF firms to cut costs and decrease inefficiencies. Deregulation
and the World Bank have supported a set of free-market decreases production costs and so it leads to higher levels
policies to encourage growth. This set of policies is often of output. In both cases there is faster economic growth.
referred to as the Washington Consensus and includes Labour market reforms are also part of market-based policies
the following. and aim to increase labour market flexibility (see section 3.7,
• Trade liberalization: this refers to the reduction, or complete page 132). As a result, labour costs decrease and firms’
removal of protectionist measures that prevent free trade. profitability, together with employment, increase. Higher
profits may then increase investment and accelerate growth.
• Privatization: this refers to the transfer or sale of state
owned sets (typically firms but also airports, harbours and However, market-oriented supply-side policies can only be
so on) to the private sector (see section 3.7, page 132). effective in the long term. They are not capable of dealing
with short-term problems. Privatization often has led, at
• Deregulation: this refers to the process of dismantling or
least in the short term, to increased unemployment. It can
relaxing inappropriate rules, restrictions and laws in the
lead to monopoly pricing, which is something developing
operation of firms or markets (see section 3.7, page 132).
countries cannot afford. Deregulation may not always be
Trade liberalization can allow developing countries to successful, especially in cases where special interest groups
expand their exports in international markets and enjoy have exerted political pressure to ensure that they enjoy
greater export revenue. Together with all the other benefits preferential treatment.
of free trade (see section 4.1) trade liberalization can
Lastly, labour market related policies increase income
allow for greater economic growth, creating new jobs and
inequality, which is particularly damaging for developing
encouraging rural development, which can significantly
countries where income inequality is often already high.
reduce poverty levels. However, trade liberalization on its
own may not be enough. Developing countries lack skilled In the case of developing countries the goal is to devise
labour, technology and are focused on the primary sector. regulations that improve the functioning of markets.
This means that even with greater access to global markets Environmental or health and safety regulations, which aim
they will still export a narrow range of products and will to promote social objectives when free markets fail to deliver,
therefore have low export shares in world trade. could be helpful in the process of economic development.

Recap
Market-based supply side policies
The market-based supply-side policies that aim to generate and accelerate economic growth are:
• trade liberalization
• privatization
• deregulation.
Disadvantages
Trade liberalization Privatization Deregulation
Developing countries lack skills, The results of privatization can This policy may not always be
technology and are focused on the be unemployment and monopoly successful, especially in cases where
primary sector→ they will still export pricing, which may hinder the special interest groups manage to
a narrow range of products → they development process. get preferential treatment.
have low export shares in world trade.

Interventionist policies
Interventionist policies that aim to reduce income inequality Redistribution policies
and make growth inclusive will encourage development. Redistribution policies include tax policies, transfer payments
Poverty reduction depends not only on income growth but and minimum wages.
also on how income is distributed: poverty is reduced and
development is achieved if there is growth accompanied by High and rising inequality is one major factor that prevents
narrowing income inequality. Redistribution policies can help growth and development. Therefore, implementing policies
in that direction. to redistribute income can be of particular importance.
To do this, governments can use progressive income taxes

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 and transfer payments. By taxing individuals with higher beneficiaries become overly dependent on them, unless
incomes more heavily than those with lower incomes and they are effectively designed as conditional cash transfers
spending more on transfer payments, national income may (see section 3.3). Regarding the introduction of a minimum
be redistributed. This will reduce inequality, allowing for wage, in some cases this has created unemployment.
more growth and development. In addition, the introduction Still, if the minimum wage is not remarkably high then
of a minimum wage can support the incomes of low skilled unemployment may not necessarily increase.
workers and in turn further help in narrowing inequality. Perhaps a more promising but long-term route to a more
Yet, many developing countries have ineffective taxation equitable distribution of income is to improve the quality
systems, which limits the amount of tax revenue that can and access to education and health care. Schools, health-
be raised. In addition, governments usually run on very low care centres, better sanitation and clean water supplies will
budgets, which does not leave much room for government all contribute to an increase in human capital, which will
spending. These factors may therefore limit the effectiveness increase the income earning capacity of the poor leading to
of the measures outlined above. It is also important to note higher incomes, growth and development. Nevertheless, the
that in the case of transfer payments there is risk that the government’s lack of resources may still be an issue.

Provision of merit goods

The government can subsidize or directly provide services depend on the choices made at earlier stages. For example,
such as health care, education and infrastructure. the mother’s health in pregnancy, a healthy childbirth, an
infant’s good health and proper nutrition for a child are vital
Health and education programmes for a productive and prosperous life as an adult. Similarly,
Health and education are vital drivers of growth and in the case of education—given that a child’s cognitive
development. Better health and education increase labour development begins at an early age—the formal education
productivity. Since higher productivity is the key to long- process should begin even before the start of primary school.
term growth, it can also lead to development. In addition,
improved health and education allow individuals to have Infrastructure
more, better and higher paid employment opportunities, Infrastructure includes energy, transport, telecommunications,
improving living standards. clean water and sanitation.
There are also external benefits to health or education. Infrastructure increases productivity and lowers the costs of
A healthy person is not only less contagious but can also production. For instance, transportation systems allow more
benefit the community through more active and productive output to be transported and production costs to be lowered,
participation. Moreover, educated people provide benefits irrigation contributes to higher levels of agricultural output
to people around them, as they contribute more to the while reliable energy systems allow for increased worker
generation of new ideas that benefit the community. productivity through the introduction of simple electrically
Something that adds further to the importance of health powered machines and equipment. At the same time, access
and education is that they are interdependent. Greater to clean water and sanitation have major effects on the
health improves education because health is a critical factor health of a population, preventing illnesses and premature
in school attendance. Also, healthier individuals are more deaths. Therefore, the provision of infrastructure is also
able to use education productively at any point in life. At crucial for growth and development.
the same time, better and more education improves health, Still, it should be noted that health and education as well
because basic skills such as personal hygiene and sanitation as infrastructure are largely dependent on the government,
are often learned at school. In addition, education is needed which can be an issue when the government lacks funds that
for the formation and training of health personnel. There is would allow for subsidies or direct provision. For instance,
also considerable evidence that the better the education of many governments in developing countries have their
the mother, the better the health of her children. investment plans at the ready; they plan for improvements
The points made above show that provision of health and in health and education, building of roads, ports, and power
education can be of substantial importance in growth and grids, access of the poor to safe water and sanitation—but
development. Note that it is imperative that governments they lack the financial resources to carry out those plans.
seek to make health and education services accessible as In addition, poor governance and prevalent corruption may
early in life as possible. This relates to the idea that a person’s impede investments in human capital and infrastructure.
capabilities, health and productivity at any stage of life

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 UNIT 4: THE GLOBAL ECONOMY
Recap
Provision of merit goods
Health care and education Infrastructure
• Increased labour productivity → economic growth → • Lower costs of production → higher productivity →
development economic growth → economic development
• Better and higher-paid employment → improved living • Access to clean water and sanitation prevents diseases
standards → reducing public health risks.
• External benefits
• Interdependence: greater health improves education
while greater education improves health.
Problems
• Developing countries’ governments may be deprived of the funds necessary to subsidize or directly provide health
care, education and infrastructure
• Poor governance and corruption may also prohibit public expenditure on these merit goods.

Inward foreign direct investment (FDI)

Multinational corporations (MNCs) such as Apple, Tata Group, capital. Moreover, FDI can bring along organizational and
Kia Motors, HSBC, Siemens and Unilever are able to establish managerial know-how, as well as new production technologies,
their presence in more than one country through foreign direct which can all be learned and adopted by the local workforce
investment (FDI). FDI refers to long-term investment by firms and local businesses. This contributes to further improvements
from one country in productive facilities in another country. This in human capital and also to technological improvements.
includes investing in new facilities and acquiring a controlling FDI inflows are a source of foreign exchange, which may be
percentage of the shares of existing local companies. used to finance much needed imports and a trade deficit. If
Inward FDI would mean attracting more MNCs in developing the government of the developing country taxes MNCs then
countries. MNCs have good reasons to be willing to expand tax revenues will increase. This provides the government with
their operations in developing nations. They gain access funds to spend in other areas that will assist growth and the
to more markets and so they can expand their sales. They development process. Lastly, the inflows of FDI funds into the
can lower costs of production, as labour costs are usually developing country can increase savings, increasing the amount
lower in developing countries. If they are involved in of investment.
extractive activities, MNCs can benefit from the rich natural Therefore, FDI can help improve technology and human
endowments of oil, bauxite, copper or other metals and capital, add to tax revenues and increase the level of
minerals that can be found in developing countries. investment. All of this leads to higher economic growth and to
In order to attract FDI certain conditions must exist or be increased possibilities for pursuing development objectives.
created within the developing country. Some of the “pull However, this is only the positive side of FDI. The skills of
factors” for FDI are: the local workforce may not improve if workers are used to
• economic and political stability fill only the positions of low skill and no training is provided.
The technology brought may be capital intensive and
• large and growing markets
thereby inappropriate, not creating employment positions.
• public policy with favourable tax treatment and ease of MNCs may hurt local firms by eliminating competition and
profit repatriation by importing intermediate products instead of buying them
• low labour costs from domestic suppliers.
• high levels of human capital and labour productivity The tax contribution of multinational corporations may be
• infrastructure such as roads and ports or considerably less than it should be as a result of favourable
telecommunications tax allowances. Also, MNCs may use their economic power
• membership in free trade areas or trading blocs to avoid to influence government policies in directions unfavourable
tariffs to the development process, such as the weakening of labour
protection laws or environmental protection laws.
• clearly defined property rights and a functioning legal system.
Lastly, in many cases the operation of MNCs has caused
How does FDI help growth and development? environmental damages in the developing country. This is
both against development and against sustainability.
FDI can increase employment opportunities in the developing
country as MNCs may hire local workers in their production These facts suggest that although growth may come about
facilities. At the same time, the local workforce may receive through FDI the development prospects of the country may
training, which leads to skill creation and so it improves human not necessarily improve.

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 Recap
Inward FDI
Advantages include: Disadvantages include:
• increased employment opportunities • lack of training if the local workforce is employed only
• training of the local workforce, leading to improved in low skill positions
human capital • capital-intensive technology that does not create
• transfer of organizational and managerial know-how employment
and new production technologies • elimination of competition
• providing a source of foreign exchange • tax contribution that is not significant
• higher tax revenues that can be used to fund spending • forced relaxation of labour and environmental
in other areas protection laws
• higher savings, leading to more investment. • environmental damage.

Foreign aid
Foreign aid refers to the transfer of funds in the form of loans Why do donors give aid?
or grants, or to the transfer of goods and services in the form There are three main motives for providing aid to developing
of gifts to developing countries. Aid is non-commercial, as the countries.
transfers do not involve buying and selling transactions. Note
that in order for loans to be considered part of foreign aid, they • Humanitarian motives are the moral or ethical reasons for
must be offered in concessionary terms (that is, at lower than providing aid. For instance, given that the consequences of
market interest rates and with longer repayment periods). the Covid-19 pandemic are particularly severe in countries
in where the health-care system is comparatively weak,
• When aid comes from the governments of donor countries Germany made available 450 million euro in aid for
it is referred to as Official Development Assistance (ODA) humanitarian projects to fight Covid-19.
and can be bilateral or multilateral.
• Political motives or strategic reasons may exist, in that aid
− Bilateral aid involves one donor country; aid flows from has been used in an effort to build closer political and
one advanced economy to the developing country. strategic relations with other countries. Donor countries
− Multilateral aid involves an international organization have also used aid programmes as a bargaining tool for
such as the United Nations (UN), the World Bank or international negotiations.
the IMF; aid flows through the organization to the • Economic motives, such as to develop markets and dispose
developing nation. of surpluses, may exist. Aid has often been directed to
• Aid may also come from non-governmental organizations promote a country’s exports of manufactured goods and
(NGOs). NGOs are organizations pursuing objectives for imports of raw materials. China’s post-2000 astonishing
the public interest. Their aim is to prove services to the growth of aid in Sub-Saharan Africa and elsewhere is
public, directly or indirectly (see below). considered to be driven by such a motive.
Aid is usually distinguished into humanitarian aid and
development aid offered through ODA and NGOs. Why do recipient countries accept aid?
• Humanitarian aid aims to save lives and ensure access to The major reason why developing nations have usually
basic necessities such as food, water, shelter and health care. been eager to accept aid is typically economic. Developing
For instance, humanitarian aid may be provided in emergency countries have often tended to accept the proposition that
situations resulting either from violent conflicts or from aid is a crucial and essential ingredient in the development
natural disasters such as floods, earthquakes and tsunamis. process. It supplements scarce domestic resources, it helps
transform the economy structurally, and it contributes to
• Development aid aims to help developing countries
economic growth. The economic rationale for aid is therefore
achieve their growth and development objectives and can
partly based on accepting the donor’s perceptions of what
take the form of:
poor countries require to promote economic development.
− project aid, where the funds must be used to finance the
construction of a particular project (such as a dam, a road Evaluating the impact of foreign aid
or a hospital) The issue of the effects of foreign aid is a highly debated
− programme aid, where the funds are used to support topic. On one side are those who argue that aid is necessary
sectors of the economy, such as health care or education and has indeed promoted growth and development in many
− tied aid, where the funds must be used to buy imports developing countries. Jeffrey Sachs, in particular, argues that
from the donor country. massive infusions of aid are needed to break the poverty

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cycle and considers aid a powerful determinant of long- The role of NGOs

UNIT 4: THE GLOBAL ECONOMY

term growth. Poor countries are poor because they are hot, One of the fastest-growing and most significant forces in the
infertile, infested with malaria and many are landlocked, field of aid is that provided through NGOs. They represent
making it hard to increase productivity without help to specific local and international interest groups with concerns
deal with such endemic problems. Neither free markets nor as diverse as providing emergency relief, protecting child
democracy, in Sachs’ opinion, will do very much for them. health, promoting women’s rights, alleviating poverty,
On the other side are critics who argue that aid does not protecting the environment, increasing food production and
promote faster growth but may, in fact, retard it. They providing rural credit to small farmers and local businesses.
say that aid substitutes for, rather than supplements, Some familiar NGOs include Oxfam, Doctors Without
domestic savings and investment and worsens the balance Borders, the World Wildlife Fund, Project HOPE and Amnesty
of payments deficits as a result of rising debt repayment International.
obligations (when aid takes the form of loans, even if at NGOs have two important advantages. First, they face
reduced interest rates). William Easterly, for example, argues fewer political constraints and most NGOs are able to
that aid does more harm than good. It is often wasted work much more effectively at the local level with the
instead of being spent productively. It may prevent people people they are trying to assist than massive bilateral
from devising their own solutions to the specific problems and multilateral aid programmes can. Second, by working
they face. In addition, critics believe that aid often corrupts directly with local people, many NGOs are better able to
or is granted to corrupt autocrats and undermines local avoid the suspicion and cynicism on the part of the mostly
institutions. It is typically fragmented among too many poor people they serve that their help is insincere or likely
donor countries and is thinly spread over too many sectors to be short-lived. It is estimated that NGOs in developing
with a lot of overlapping and confusion. countries are positively affecting the lives of some
Some aid programmes help more than others. It is not 250 million people.
easy to determine which ones are effective in promoting
development goals and which ones are ineffective. Recently, Debt relief
Esther Duflo, Abhijit Banerjee of MIT and Michael Kremer High indebtedness is another setback for developing
of Harvard University introduced randomized control trials nations. Remember that high debt levels require large debt
(RCT) to help determine whether a particular form of aid is repayments that do not allow enough funds for spending
or is not effective, just as pharmaceutical corporations try to in other areas. Debt relief involves cancelling a portion of
determine the effectiveness of a new drug or vaccine. These debts. This means that the amount that must be repaid is
three economists shared the 2019 Nobel Prize for Economics. reduced, which releases some funds that can finance growth
According to the Nobel Prize committee, RCTs, by carefully and development strategies.
designing such experiments, help to obtain reliable answers This is why the Heavily Indebted Poor Countries Initiative
about the best ways to fight poverty. (HIPCI) and Multilateral Debt Relief Initiative (MDRI)
Positive effects were designed and launched. The goal of the HIPCI was
• Aid is linked with higher growth rates. to ensure deep, broad and fast debt relief and through
this to contribute towards growth, poverty reduction and
• Aid can help developing countries escape the poverty trap.
debt sustainability in the poorest, most heavily indebted
• Aid is effective when it is narrowly targeted to specific countries. The goal of the MDRI was to provide additional
pro-development projects and objectives, such as the support to HIPCs. To date, 37 countries—31 of them in
prevention and elimination of certain diseases. Africa—have debt relief for which they were eligible through
• Aid is effective when it is reinforced by appropriate the HIPCI and the MDRI.
domestic policies and institutions in a non-corrupt
government environment. Multilateral development assistance
• Aid is effective when it is not tied to buying products from Multilateral assistance involves an international
donor countries. organization. The most well-known organizations of such
assistance are the World Bank and the IMF.
Negative effects
• Aid can lead to dependency, as it creates the need for The World Bank is a development assistance
more and more aid. organization that extends long-term loans to developing
• Aid may be abruptly terminated if a donor’s budget countries for the purpose of promoting economic
proprieties change. development and structural change.
• Aid can be ineffective when it is given to countries with The IMF is a multilateral financial institution that
corrupt governments. oversees the global financial system, stabilizes
• Aid can be ineffective when it induces countries to exchange rates and helps countries in financial
postpone improvements of macroeconomic conditions. crises by extending loans. Lately, IMF lending
• Aid can be ineffective when the technologies transferred has become almost exclusively focused on the
and the advice given are inappropriate. developing world.

203
 Both the World Bank and the IMF assist developing However, such loans deprive the borrowing country of control
countries through the loans they extend. The loans offered over its domestic affairs and may have long-term negative
are conditional and require agreeing to adopt particular effects on economic development. For instance, in some cases,
policies (known as structural adjustment policies). Such IMF and World Bank officials have asked impoverished nations
policies usually involve deficit reduction, privatization, to cut budgets, and even to privatize health services as part
deregulation, improved tax collection and labour market of the conditions for lending. Yet, such measures may prevent
reforms. human or physical capital improvements and therefore act
against development objectives.

Social enterprise
Social enterprise refers to for-profit businesses engaged in technology to accelerate change and development in Myanmar.
socially beneficial activities. Social enterprise is a ground- Phandeeyar invests in local start-ups, trains new entrepreneurs
breaking response to the funding problems that many non-profit and builds the pool of tech talent. Another example is the
organizations are facing. Developing countries can greatly Buffalo Bicycle Company; it builds bicycles specifically for the
benefit from social enterprise, as it can provide aspects of aid southern African terrain in order to assist local people with the
that are not addressed through conventional routes. This can transport challenges they are facing. The progress made by
be achieved through innovation. For example, Phandeeyar these types of enterprise has increased recognition that social
is an innovation laboratory that is pioneering the use of entrepreneurship can benefit the developing world.

Institutional change
Improved access to banking only 35% of people have bank accounts but 90% have
The importance of access to banking lies in the simple fact mobile phones. Mobile banking is simple and low cost. All
that, typically, if you cannot borrow you cannot make any that is needed is a mobile phone and a banking SIM card, no
investment in physical, natural or human capital. It follows smartphone or special app is required. Money can be sent and
that a functional banking system is vital in breaking the received by text message. In this way, more people get access
poverty cycle. Yet, the banking system in many developing to formal financial services, allowing for financial inclusion.
countries does not accommodate poor and small-scale According to Jay Rosengard, adjunct lecturer in Public Policy
producers, farmers and traders (see page 195). at the Harvard Kennedy School, financial inclusion improves
the livelihood of individual families and encourages local and
Microfinance national economic growth. In fact, Rosengard’s research in
Microfinance has been heralded as a solution to the banking Kenya showed that thanks to mobile banking, the share of
problems many individuals in developing countries face. Kenyans with access to a financial account jumped from 42%
Microfinance focuses on making available very small loans in 2011 to 75% in 2014. This mobile banking revolution has
to the very poor, helping them to start a small business, also created greater financial stability for Kenyan families, as
expand an existing one, or meet an emergency arising they were able to handle major reductions in their income—
from disease or bad weather. The scheme was initiated by such as a bad harvest, a job loss or a failing business—without
Muhammad Yunus, who created the Grameen Bank several a devastating effect on their living standards.
decades ago. Microfinance can help developing nations as
it can have a positive impact on poverty reduction and it Increasing women’s empowerment
can allow for improvements in health, nutrition and primary Reducing gender inequality can significantly improve
school attendance. Many microfinance institutions lend development. Not only do deprived girls and women benefit,
almost exclusively to women, which has helped women in but also the growth and development process accelerates.
their empowerment; (see below for other aspects of women’s The most important way to empower women is through
empowerment). Women’s participation in microfinance educating girls. An educated mother will enjoy higher
programmes gives them greater bargaining power and earning ability outside the home for each extra year of
enables them to take part in family decision-making. schooling. She will have fewer children, increasing the
However, microfinance has recently come under attack, as income available per child, which can result in even higher
most borrowers do not appear to be climbing out of poverty long-term productivity and output gains. Her children will be
while some are getting trapped in a spiral of debt, according healthier and she will make sure that they are also educated,
to studies and analysts. creating a virtuous circle. Educating women decreases
Mobile banking mortality in children, decreasing the costs of health-care
intervention. Lastly, better and more educated women can
Access to banking has also increased in developing countries
lead to higher women’s participation in the labour force
due to mobile banking. Mobile banking is a useful tool in
as well as in politics, allowing them to influence policy.
countries where there are few banks but where most of the
Educating girls is considered by many as the most influential
people have a mobile phone. In Latin America, for example,

204
investment for accelerating the development process. Over • reduce immunity from prosecution of executive and

UNIT 4: THE GLOBAL ECONOMY

the years, at the primary education level, the enrollment gap legislative figures
between boys and girls has nearly closed and in some parts • provide judicial independence.
of the world girls’ enrollments rates have overtaken those of
Still, with many forms of corruption and many differences
boys at the secondary and tertiary levels.
across nations and communities, there is no single best way
To close the remaining gender gap, legal reform should be to fight corruption.
deployed. For example, given that in some countries gender
barriers are legal, reform can allow women to receive public Property rights and land rights
services, to own and run businesses and to inherit property. As people without property rights cannot use their resources to
This will reduce gender disparities, as women will gain a create wealth, their assets become “dead capital”. If property
more active role in their communities. titles are provided, the capital will no longer be “dead”. The
As for female representation in politics, some societies now poor will be able to use their small assets in order to borrow
require a certain proportion of a party’s representation list to money and start businesses, unlocking the entrepreneurial
be occupied by women. When women enter parliament and potential of billions of people. This will enable them to
government there can be a very powerful effect on changing generate income, reducing inequality while allowing for growth
ideas, norms and policies. Government financial support and development. According to research estimates, providing
for maternity leave and childcare can also play a large the world’s poor with property titles would unlock $9.3 trillion
facilitating role to help women in the labour force. in assets, a substantial amount for poverty reduction.
Lastly, given that a large number of women around the In addition, strengthening the legal framework for customary
world face violence better law enforcement, laws, and public land-rights holders is also crucial for the development
leadership are absolutely necessary. process. Strong, properly enforced land rights allow for the
legal recognition and protection of their holders and can in
Reducing corruption turn boost growth, reduce poverty and strengthen human
Indicators of corruption regularly show that the incidence capital. For instance, World Bank Group efforts have enabled
of corruption is far higher in developing countries than one million hectares of indigenous land in Nicaragua—over
in developed countries. Improvements in governance, in 30% of the country’s territory—to be demarcated, titled
general, and reduction of corruption, in particular, could be and registered, a process that has benefited some of the
means to accelerate the process of development. country’s most vulnerable groups.
To tackle corruption, countries can: Nevertheless, land titling may not always work as expected.
• eliminate inefficient regulations Once land rights are issued then the rich may capture them
as they can pay more to acquire them. Also, the poor may
• make public expenditures more transparent
end up losing their land because they may not be able to
• promote competition in order to avoid too much power repay a loan or may be forced to sell it if they experience a
concentrated in large monopolies crop failure or a poor harvest.
• improve pay and incentives for public servants

Recap
Institutional change
Improved access to Access to banking allows for borrowing which allows for investment in physical, natural or human
banking capital. This can be achieved through microfinance or mobile banking.
Increasing women’s Empowering women can accelerate the development process. This can be achieved through
empowerment educating girls and through legal reforms to ensure more active participation of women in
various domains including business and politics.
Reducing Tackling corruption allows for greater economic growth and development, which can be
corruption achieved by increasing transparency and improving regulations.
Property rights Secure property rights will ensure that the poor will be able to generate income, which will
reduce inequality while allowing for growth and development.
Land rights Strong, properly enforced land rights can boost growth, reduce poverty, strengthen human capital
and so promote economic development. However, land titling does have flaws and may result in
the poor ending up without land rights.

205
 Government intervention versus market- opportunity for all. The government is also needed to
oriented approaches regulate key sectors of the economy. The banking sector
is one of them. Unregulated banking systems tend to
One of the biggest debates in the area of economic growth
experience crises.
and development is whether developing countries should
adopt a more interventionist rather than market-based Nevertheless, corrupt governments may encourage or allow
approach or vice versa. illegality, which neither helps in regulating markets nor in
creating equal opportunities. Overall, national governments
Adopting a market-based approach is based on the idea that
have played an important role in the successful development
market powers always lead to the best possible outcome.
experiences of the countries in East Asia. In other parts of
Indeed, free markets can lead to allocative efficiency as
the world, however, the government often appears to have
the market mechanism typically directs resources in their
been more of an obstacle.
best possible use. The market also provides the necessary
incentives, such as higher incomes and profit, that encourage A market approach is preferable when there is government
economic activity and generate growth. Still, the role of failure while good governance is needed when there is
government in economic development is absolutely crucial. market failure. That is to say, that the roles of the market
and the government are complementary.
The government is vital for financing the building of
infrastructure and is also essential for human capital
formation, which are both necessary for any economy Policymakers’ perspective
to develop. If health care and education are left to the Despite the obvious diversity of developing countries,
market they are underprovided—remember they are most of these nations face the same challenges.
merit goods. Public financing is therefore essential to Complementary human capital, technological, social
ensure that the country has the necessary infrastructure and institutional changes must therefore take place
to function effectively and that the poor have access to if long-term economic growth is to be realized and if
merit goods. economic development is to take place. Developing
However, good governance is not common in many countries can undertake appropriate policy strategies
developing countries. As a result, the available infrastructure, and at least incremental improvements in institutions
as well as the educational and health-care services offered, to speed economic and social progress. Indeed, the
are often inadequate or poor. Yet, when it comes to experience of the past 50 years shows that while
reducing poverty a market approach is highly problematic. economic development is not certain and poverty traps
Markets are basically designed to “ignore” the poor, as their are quite real, it is possible to escape from poverty and
incomes are low, so they cannot “vote with their dollars”. initiate sustainable development.
The government is therefore needed to ensure economic

206
OXFORD IB STUDY GUIDES

Economics
FOR T H E I B D IP LOM A 2020 edition Authors
Constantine Ziogas
Developed to match the 2020 syllabus, this study guide presents all the Marily Apostolakou
content knowledge covered at Standard and Higher Level. With its focused
approach, it distinctly strengthens comprehension of the subject, ensuring
confidence and achievement in the IB Diploma.
● Fully updated, providing concise and comprehensive revision of all topics
on the 2020 DP Economics syllabus
● Student-friendly format focuses on the knowledge and understanding
required to succeed in the IB assessment
● Includes the quantitative material required for HL students, detailed
support for constructing, labelling, and interpreting graphs, as well as a
glossary of key terms online
● Second language students can confidently engage with the
straightforward language and summary tables
Also available:
DP Economics Print and
Enhanced Online Course
Book Pack
978 1 38 202022 0

Online

How to get in contact: ISBN 978-1-382-00942-3

1 web www.oxfordsecondary.co.uk/ib
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