Economics

for the IB Diploma 2" Edition

i BrrvEwy e
Economics
for the IB Diploma 2nd Edition

SEAN MALEY
JASON WELKER
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TYSON FOODS INC SEGMENTS. 207; Bank of England: Demand and Milton Friedman: Quote by Milton Friedman 318; John Maynard
Output. Bank of England 263; CREDIT SUISSE GROUP AG: Global Keynes: Quote by John Maynard Keynes 318; Margaret Thatcher:
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Education Ltd 477; MarketWatch, Inc.: US president Donald Trump, Stephanie, and Francisca Alba. The Unemployment Impacts of
May 0f 2020 513; International Monetary Fund: International COVID-19: Lessons from the Great Recession. Brookings, Brookings, 15
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for Economic Co-operation and Development: Untying aid: the right Think again: international trade, Foreign Policy, 1 November 2003 494;
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Poverty & Human Development Initiative (OPHI). 357; Penguin Books Communications Materials ~ United Nations Sustainable Development.
Ltd: Ha-Joon Chang 23 Things They Don't Tell You About Capitalism’ United Nations. 566; The World Bank group: Data from THE
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June 18, 2020 By Associated Press 238; U.S. Department of Justice: (Continued after page 702)
Contents
Introduction

m Introduction to economics
1. What is economics?
2, How do economists approach the world? 24
m Microeconomics
. Demand 36
®

. Elasticities of demand 50
N

Supply Al
O

. Elasticity of supply 87
o

. Competitive market equilibrium 100

N

. ICritique of the maximising behaviour of

©

consumers and producers 120

9. Role of govemment in microeconomics 134
0. Market failure: extemnalities, public goods, and the
market's inability to achieve equity 160
11 Market power: perfect competition
Versus monopoly 186
12 Market power: monopolistic competition
and oligopoly 217

Macroeconomics
13 Measuring economic activity and illustrating its
variations 237
14 Variations in economic activity: aggregate demand
and aggregate supply 254
15. Macroeconomic objective: low unemployment 288
16 Macroeconomic objective: low and stable inflation 307
17. Macroeconomic objective: economic growth 333
18 Economics of inequality and poverty 341
19. Demand management: monetary policy 379
20 Demand management: fiscal policy 4038
21 Supply-side policies 426
 Contents

m The global economy

22. Benefits of international trade 439
23. Trade protection 457
24. Economic integration 476
25. Exchange rates 495
26. Balance of payments 524
27. Sustainable development 556
28. Measuring development 572
29. Barriers to economic growth and development 588
30. Economic growth and development strategies 610

External assessment 648

Internal assessment 668

Glossary 675

Index 693
 INntroduction
This Economics for the IB Diploma 2nd Edition Student Book offers International
Baccalaureate (IB) Economics students an inspiring way to learn and prepare for the
1B examinations at both higher level (HL) and standard level (SL). It will help you to
prepare for your examinations in a thorough and methodical way as it follows the
syllabus outline, explaining and expanding on the material in the subject guide.
This book is based specifically on the new IB Economics curriculum (first examinations
in May 2022) and emphasises the use of the nine key concepts that run through the
course: scarcity, choice, efficiency, equity, economic well-being, sustainability, change,
interdependence, and intervention. The book contains the following useful features:
Relevant learning outcomes identified at the start of each section to help you
identify what you need to know at each step.
HL and SL content clearly distinguished, with all HL exercises and sections clearly
marked (all unmarked content is for both HL and SL students).
Fully referenced tables and coloured diagrams accompanied by clear explanations
in the text.
Practice examination questions at the end of each chapter reflecting the appropriate
form and content of questions that you will find in the new exam papers.
Links to Theory of Knowledge (TOK) conveniently highlighted throughout to help
broaden your knowledge and keep you thinking about the wider applications of
your learning.
Two additional chapters offering specific advice on writing the Internal Assessment
and preparing for External Assessments such as Papers 1, 2,and 3, and the Extended
Essay.
A full glossary of IB Economics subject-specific terms included at the back of the
book, for easy reference.

In addition, the book includes access to an eBook version which contains:

Links to around 100 author videos, offering clear explanatory lessons on all the
essential diagrams and concepts.
Links to online databases and sources of information (via the ‘Research and
inquiry’ features), enabling you to apply the course concepts and carry out further
research.
Worksheets and revision quizzes for every chapter, providing additional support.

vi
 Introduction

How to use this book

Throughout the book you will see a number of coloured features interspersed within
cach chapter, providing different information and stimulus.

Learning outcomes
These appear at the start of each section. They contain the learning outcomes for the
section you are about to read and set out which aspects of learning will be covered.

Learning outcomes
At the end of this section you will be able to:
« distinguish between positive and normative economics
explain how economists use models, theories, logic, the ceteris paribus
assumption, empirical evidence, and refutation in their analysis of human
behaviour.

Case study
Globally inclusive case studies that reference real-world examples (in the same way
that Paper 1 requires real-world examples to be at the centre of your discussion).

Case study - cell service providers and oligopoly

America’s cell phone service market has been narrowed down to three major
providers after the acquisition of Sprint by T-Mobile in spring of 2020. America’s
Federal Trade Commission initially denied the request to merge, citing the undue
market power exerted by a more concentrated market. They also cited T-Mobile’s
previously aggressive pricing as a source of competitive behaviour that would
diminish after the merger. Together, AT&T, Verizon, and T-Mobile now control
98% of the US cell provider market.

Research and inquiry O ]

Highlights areas for further inquiry and research. To see real-world examples
of increased demand from
changes in tastes, conducta
Worked example news search using the term
Examples that show you (in detail) how to work out necessary calculations. ‘rise in popularity’
For discussion and debate:
Worked example 6.3
1 List five found examples
Consider the market for cotton t-shirts. Assume that when the price of blank cotton of taste and preferences
t-shirts rises by 10%, the quantity supplied increases by 15%. With these values we increasing demand for a
product.
can easily calculate PES:
Generate five of your own
~

eamples of products that

have, for taste reasons,
fallen out of favour.

vii
 Introduction

Exercise
In-text exercises to test your knowledge and understanding of that part of the course.

5G]

Certain individuals depend 1 Identify a common product you use or consume.

on particular goods for 2 What is the maximum price you would pay for that good?
their very survival, e:g 3 Whatis your consumer surplus for that good?
people with diabetes 4 Draw an equilibrium diagram of the market for the good, indicating consumer
need insulin to live. If one
were to learn that insulin
and producer surplus.
providers were raising 5 Identify the consumer, producer, and community surplus for this market.
their prices ever higher on
diabetic patients, would
you be obliged to act?
This raisesa question Theory of Knowledge
around the ethics of These stimulate thought and consideration of TOK issues as they arise and in context.
knowledge: How can we
know when we should act
on what we know?’ Video suggestion
These indicate that a clickable link is available (via your eBook) to one of over 200
Video suggestion: author videos. These will help you to review the section of the book you have just read.
You have read about it, now
you can review what you
have just learned by watching Practice exam questions
avideo by the author!
Simply lick here in At the end of each chapter are some practice questions of the style and weight you can
o your eBook for a video expect to find in the examination papers.
on the law of demand.

Practice exam questions

Paper 1, part (a) questions
1. Explain how economics addresses scarcity by answering
the three basic questions of economics. (10 marks)
2. Distinguish, using a diagram, the difference between a
curved PPC and a straight-line PPC. (10 marks)
3. Explain how a production possibilities curve helps demonstrate
the concepts of scarcity, choice, and opportunity cost. (10 marks)
4. Explain, using a circular flow diagram, how the consumers and
producers are interconnected in a free market economy. (10 marks)

You are now ready to start. Good luck with your studies!

viii
Introduction to
economics
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 1.1 What are some of the basic concepts
in economics?

Learning outcomes

At the end of this section you will be able to:

+ explain the social nature of economics
« distinguish between the study of microeconomics and macroeconomics
+ explain the nine key concepts of IB Economics
+ analyse the concepts of scarcity, choice, and opportunity cost
+ explain the three basic economic questions that must be answered by any
economic system
« distinguish between market, planned, and mixed economies.

Look around you. What do you see? Are there tall buildings made of steel? Paved roads
and parking lots? Shopping malls? Fields of crops awaiting harvest? Homes built of
wood, brick, and glass? Factories producing goods for consumers? Perhaps you see a
thick forest or a view of hills stretching to the distance. Or do you see school buildings?
Now ask yourself, how did things get to be this way?
There are many ways to attempt to answer these questions. Biologists tell a story of
evolution based on natural selection. Physicists answer difficult questions by studying
the elemental forces of nature that shaped our universe over billions of years, while
mathematicians observe the quantifiable variables of our lives and seek to understand
our world through numbers. Every field of science views the world through a lens
shaped by its own tools and methodologies. Economics is no different.
Economics is a social science devoted to solving the problems posed by scarcity. Our
existence on Earth is defined by limited resources and the seemingly unlimited wants,
or demands, on those resources. For example, a central question in some societies is
how much food can be responsibly grown in a given area, when resources like water
and fertile soil are diminishing. Scarcity nearly always forces us to make choices
between competing priorities, such as the perceived choice between economic growth
and sustainability. Economics hopes to inform that choice-making to help societies
get the most out of their resources.
Relatedly, a central goal of economics is to seek out efficiency wherever possible.
Given scarce resources, a growing population and its wants, extracting the highest
possible value from those resources is a top priority. However, the pursuit of economic
efficiency does not guarantee a relatively equal access to resources. Economists also
argue that equity should be considered a priority alongside or against pure efficiency.
Are resources allocated without bias or prejudice? As the gap between the rich and
poor in many countries continues grow, questions of equity are raised.

Economics also tries to widen its focus to broader measures of economic well-being,
rather than purely monetary success. As such, factors of daily life such as the overall
health, safety, and security ofa country’s population are now taken into account.
 What is economics?

How is economics a social science?

A social science is a field of academic scholarship that examines the interactions
between humans, our institutions, our organisations, and the natural and
social environment we inhabit. A distinguishing feature of economics is human
interdependence, which focuses on how people interact with each other to improve
their economic well-being. Individually and in groups, humans are influenced and
enabled by their values and their natural surroundings. This web of motivation poses
a challenge to economists secking a degree of certainty about causal relationships.
As asocial science, economic theories are based on logic and empirical data, using
models to represent and analyse this complex reality. Physical sciences work somewhat
differently, and an understanding of the basic distinction may be useful. Physical
sciences seek clear comparisons between an independent variable and its effect on
other variables with control group testing. Social sciences seek the same controlled
environment but this process is complicated by the many possible motivations and
causal factors for human behaviour.
Testing the effectiveness of an idea like universal basic income (UBI) (the provision
of direct cash payments to citizens as a form of poverty relief), for example, is
complicated by other factors that may also influence the control group at the same
time, such as political, regional, or group-specific issues. Social scientists nevertheless
try to approximate control conditions using comparative data sets and statistical
analysis. Because individual and collective motivations and behaviours are complex
and diverse, understanding them entails the interaction of a variety of disciplines
such as philosophy, politics, history, and psychology. Awards for economics
have increasingly gone to research that blends economics with one of these other
disciplines.

Adding another layer of complexity is the dynamic nature of economics. With physical
sciences one can isolate a variable and examine its properties with a reasonable
expectation that those properties are stable or may change in predictable ways.
However, the events under study in economics are subject to change, possibly in real
time. A surge in consumer confidence, for example, may have many causes and can
just as quickly drop should events change.

What is the difference between microeconomics

and macroeconomics?
Economics is broadly divided into two categories of study, microeconomics and
macroeconomics. Microeconomics is the study of specific markets, such as the market
for goods and services, as well as the market for labour. It examines the motivations
and general rules of behaviour guiding buyers and sellers in these markets,
and includes the concepts of supply, demand, and equilibrium prices. While
microeconomics assumes a free market system that uses prices to help allocate
resources, it also attempts to account for failure of the free market, where government
corrections are required.

Macroeconomics centres on national economies as a whole, with a focus on the overall

performance of a national economy. The health of an economy is measured using
concepts such as national economic growth, employment levels, and price level stability.
Discussions of inflation rates, unemployment rates, and income distribution are common.
 A major focus of this branch of economics is understanding the role governments play in
the management of the national economy using the tools of fiscal and monetary policy.
Macroeconomics, too, seeks to work out useful theories and reliable rules to guide policy
making, with the hope of achieving greater national prosperity.

The key concepts of IB Economics

Throughout this book, you will focus on real-world economic issues through the lens
of nine key concepts.

Concept Main idea

Scarcity Scarcity refers to the limited availability of economic resources
relative to society’s unlimited demand for goods and services.
Economics is the study of how to make the best possible use of
scarce or limited resources to satisfy unlimited human needs and
wants.
Choice Since not all needs and wants can be satisfied, economic
decision makers continually make choices between competing
alternatives. Economics studies the consequences of these
choices, one of which is the ‘opportunity cost’, where certain
needs and wants go unsatisfied because resources have been
allocated elsewhere.
Efficiency Efficiency is a quantifiable concept, determined by the ratio
of useful output to total input. Allocative efficiency refers to
making the best possible use of scarce resources to produce the
optimum combinations of goods and services, thus minimising
resource waste.
Equity Equity refers to the idea of fairness. Fairness means different
things to different people and might not be the same as equality.
In economics, the term ‘inequity’ may apply to the distribution
of income, wealth, or human opportunity. It is an issue both
within and between societies. How far markets and governments
can or should create greater equity or equality in an economy is
an area of much debate.
Economic Economic well-being relates to the prosperity and quality of life
well-being enjoyed by members of an economy. It includes:
« present and future financial security
« the ability to meet basic needs
« the ability to make economic choices and so achieve personal
satisfaction.
Economic well-being varies greatly within and across nations.
Sustainability Sustainability in economics is about meeting the needs of the
present generation without compromising the ability of future
generations to meet their needs. The current generation’s
economic activities can create harmful environmental
outcomes, such as resource depletion or degradation, that will
negatively affect future generations. This concept is becoming
increasingly important in economic analysis.
What is economics?

Change Economic theory focuses not on the level of the variables it

investigates, but on their change from one situation to another.
Empirically, the world that is studied by economists is always
subject to continuous and profound change at institutional,
structural, technological, economic, and social levels.
Interdependence | Individuals, communities, and nations are not self-sufficient. In a
highly interdependent economic world, decisions by consumers,
companies, households, workers, and governments generate
many, often unintended, economic consequences for others. An
awareness of this is essential when conducting economic analysis.
Intervention Intervention in economics usually refers to government
involvement in the workings of markets where those markets
fail to achieve societal goals such as equity, economic well-being,
or sustainability. In the real world, there is often disagreement
among economists and policymakers on the need for, and
extent of, government intervention.

What is the problem of choice?

As we are about to look at, a lack of resources compels humans at all levels to make
decisions about how to allocate resources. Be it time, effort, or money, we all make
choices about what is important to us. Economics seeks to enhance the economic
well-being by clarifying and guiding those choices.

What is scarcity?
Scarcity is defined as the state of having unlimited wants and limited resources.
Scarce resources are those things, both natural and manufactured, that are used in the
production of the goods and services that humans consume to survive and to enjoy
life. The problem with scarcity is that while resources are finite, the wants and needs
of humans are infinite. There are simply not enough resources available in the world
to satisfy the limitless wants of the world’s people. Over time, scarcity is intensified by
the natural human desire for more material wealth, safety, and comfort. In doing so,
humans use up more and more of the world’s limited resources.

How is scarcity related to sustainability?

The problem of sustainability is brought into focus by increasing scarcity. For example,
the scarcity of land resources for human farming has led more and more territory to
be converted from natural use to agricultural use. This increased demand or want for
food growing space is in conflict with sustainable production because soil erosion and
deforestation contribute to environmental degradation. With the alarm over climate
change, there are calls for economics, in its role of clarifying the choices around
resource allocation, to play a part in developing sustainable systems that solve scarcity.

What are the factors of production?

Humans provide for their basic needs by combining what economists call the ‘factors
of production’ into goods and services. All are required for the production of any
good or service that might be exchanged in an economy.
 Land
Land resources are those things that are ‘gifts of nature’. The soil in which we grow
food is scarce because fertile land is in limited supply but there is a huge desire for the
food that is grown in such land. Wood is a scarce resource because ultimately all wood
comes from trees, which are grown on scarce land. Minerals such as copper and tin,
and resources such as oil, coal, gas, and uranium are scarce. These materials are all
used to produce energy and other things we desire but they are all in limited supply
and the supplies do not renew themselves.

Labour
Labour refers to the human resources used in the production of goods and services. In
aworld of nearly 8 billion people, it may sound silly to say labour is scarce, but it most
certainly is. Labour is the human work, both physical and intellectual, that contributes
to the production of goods and services. Some types of labour are more scarce than
others. For example, factory workers are desirable in huge numbers in some parts
of the world. In China and India, they are not very limited but are greatly desired,
therefore they are scarce. Medical doctors are desired in all parts of the world, but they
are more limited in number than people able to work in factories. Therefore, doctors
are scarce relative to factory workers.

Capital
Capital refers to the tools and technologies that are used to produce the goods and
services we desire. The word ‘capital’ is also sometimes used to refer to the money that
individuals and businesses need to acquire the tools and technologies of production.
More and better tools enhance the production of all types of goods and services but
the amount of capital in the world is limited, so capital is a scarce resource.

Entrepreneurship
Entrepreneurship can be defined as the innovation and creativity applied in the
production of goods and services. By combining the other three factors into
desirable goods and services, this creativity and innovation have contributed more to
improvements in the well-being of the world's people than any other resource. The
physical scarcity of land, labour, and capital does not necessarily apply to human
ingenuity, which can be renewed and developed through training and education.
The basic economic problem of scarcity has led to the development of various
economic systems and their methods for allocating the resources of land, labour,
and capital, and distributing the output produced.

What is opportunity cost?

Every economic decision involves costs. The opportunity cost is what must be given
up in order to undertake any activity or economic exchange, specifically the next best
alternative to the use of the money or time. Opportunity costs are not necessarily
monetary; rather, when you buy something, the opportunity cost is what you could
have done with the money you spent on that thing. Even non-monetary exchanges
involve opportunity costs, as you might have chosen to do something different with
your time.
 What is economics?

For example, think about your decision to sign up for this economics class. You could
have studied several other subjects: geography, history, psychology, perhaps business.
Your decision to study economics was your choice of how to use the scarce resource
of time during your last two years in school. The cost of your decision is the foregone
opportunity to study one of the other subjects, and all the skills and knowledge you
would have learned had you chosen another subject.
You may be saying to yourself: ‘No, the cost of me taking economics is the tuition
fees or taxes my parents are paying to support my education at this school.’ That is
also true. But in economics, we define costs as more than just the monetary expenses
involved in an economic transaction. The opportunity cost is the opportunity lost when
making a decision of how to use our scarce resources, whether it is time, money,
labour, land, or capital.

To choose one item in place of another in this way is to make a trade-off, a sacrifice of
one thing to get another. We face these kinds of trade-offs every day of our lives. On a
Friday night, you may face several trade-offs: you can go to a movie with friends at the
cost of playing video games with your sister, for example, if that is your next favourite
alternative.

The problem of scarcity and the need for choice gives rise to another fundamental
reality faced by individuals everywhere: the reality that nothing is free. In answering
the basic economic questions, choices must be made and those choices inevitably
involve costs, since resources are scarce.

What is a free good versus an economic good?

A free good is something that is so abundant that it can easily satisfy our unlimited
wants for it. In other words, it has zero, or nearly zero, economic costs. It is difficult
to imagine a free good except perhaps on a local or regional basis. For coastal cities,
salt water is essentially free. For desert residents, sand is essentially free. However,
industrialisation has made resources like clean air and clean water less free and
more scarce in the last 150 years. This leads to the conclusion that to produce nearly
anything is to incur some cost, specifically an opportunity cost. Finally, there’s an old
adage that says that ‘there is no such thing as a free lunch’. Which is to say that even
something that is free to you, like a gift, has incurred a cost to someone else. Nearly
all goods are therefore considered economic goods, goods which have some cost to
society. The lack of free goods again presses the point of scarcity in human existence
and the need to make choices about how to use the Earth’s resources.

What are the basic economic questions?

The existence of scarcity in our world also gives rise to some basic economic questions
that any society must answer with its own economic system. They do so to improve
their economic well-being, influenced by their values and enabled by their natural
surroundings. Some economic systems rely on customs and traditions to answer these
questions, some rely on the commands of a central authority or government, and some
rely on free exchanges between individuals in a market system. Regardless of whether
it is governed by tradition, planned, or exchanges in the marketplace (see Chapter 2),
there are three basic economic questions that any economic system must address.
What should be produced?
This is the decision to prioritise one type of output relative to another, and will reflect a
society’s choices. Should society’s scarce resources (land, labour, and capital) be used to
grow food, make clothes, toys, and tools, or should they be used to provide services such
as healthcare, entertainment, and haircuts? What a particular economy should produce
is one of the basic questions an economic system should answer. An economy based on
tradition may answer ‘produce what has always been produced: food for survival'.
A wartime economy may use resources for armaments. A centrally planned economy
may choose to produce whatever the government decides is most crucial to meeting
society’s needs, while a market economy leaves the answer up to the interactions
between the supply and the demand of self-interested consumers and producers.

How should it be produced?

This is the choice of production methods. Should production be labour intensive or
capital intensive? Should robots replace workers whenever possible or should workers
be a protected resource? To what extent will technological innovation affect the way
things are produced? Economic systems must address the question of how society’s
output will be produced. Whatever the system, economists see economic efficiency as
a primary goal.

For whom should it be produced?

This is answered by the distribution of resources throughout the economy. In other
words, who gets what, and how is that determined? Is this decided by prior access to
family wealth or is social movement possible? Do social relationships take precedence
over education and skill levels? What roles do identity characteristics like gender,
ethnicity, race, and religion play in the allocation of resources? Are levels of consumption
based on social standing? Gender or age? Race or religion? Or should output be allocated
fairly across all sections of society? The distribution of a society’s income studies the
issue of equity in resource allocation in more detail.
The basic economic questions arise from the basic economic problem of scarcity.
Once we recognise that scarcity exists, we must confront these questions in order to
determine how to deal with the problem of scarcity in our allocation of resources and
the goods and services they are used to produce.

What models exist to answer the basic

economic questions?
The two types of economic system are the free market and the planned economy. Free
markets, in their purest form, exclude any government action, and in fact allow for no
functioning government at all. Planned economies, by contrast, use total state control
of the factors of production, which can functionally lead to state control in many other
aspects of life as well.

Each system has benefits and flaws. Mixed economies try to resolve the drawbacks of
each by combining their approaches in a way that suits their priorities. As stated in
the conceptual understandings at the start of this chapter, debates exist in economics
regarding the potential conflicts between economic growth and equity and between
free markets and government intervention. This is because the free market view of the
 What is economics?

future assumes constant economic growth to satisfy human needs, and ignores growing
income inequality and other market failures, as well as general resource scarcity. People
who think inequality and scarcity threaten the general well-being of all argue that smart
intervention is needed for economies to organise for long-term sustainability.

What is a free market economy?

A free market economy is a system of resource allocation dependent on the private
ownership of the factors of production and on the free exchange of goods and services
in a price system. Private buyers and sellers satisfy their wants by paying for each
other’s products in a free exchange.
What should be produced is determined by the market itself. Sellers seek to satisfy
the desires of buyers, and determine what to produce based on what generates the
highest prices. The price system guides how goods are produced as well. High prices
indicate scarcity and firms will move to produce those goods that bring higher
prices. Low prices suggest abundance, and firms will be slow to produce these goods.
In a free market system, the private owners of land, labour, and capital, including
entrepreneurs, receive the benefits of the system in accordance with their value in the
free market.

One of the founders of modern economics, Adam Smith, wrote in the 1770s that
the ‘market’ (a place where buyers and sellers meet to engage in exchanges with one
another) was the most efficient means for allocating scarce resources. It therefore led
to the greatest amount of benefit for the largest number of people, especially when it
was left free of government control.
With regard to markets, Smith advocated a laissez-faire approach to the government’s
management of the nation’s economic activity. ‘Laissez-faire’ is a French term that
translates as let it be’. A government, said Smith, should let an economy be free, since
individual agents in a free market will interact in a manner that results in outcomes
beneficial for both the individual and society. Smith believed that freedom and the
pursuit of self-gain would not lead to chaos and anarchy, but to a socially beneficial
outcome whereby society’s wants and needs are satisfied by the ‘invisible hand’ of the
market rather than an iron fist.

‘Whoever offers to another a bargain of any kind, proposes to do this. Give

me that which I want, and you shall have this which you want, is the meaning
of every such offer; and it is in this manner that we obtain from one another
the far greater part of those good offices which we stand in need of. It is not
from the benevolence of the butcher, the brewer, or the baker that we expect
our dinner, but from their regard to their own self-interest. We address
ourselves, not to their humanity but to their self-love, and never talk to them
of our own necessities but of their advantages.’
Statue of Adam Smith on the Adam Smith, The Wealth of Nations, 1776
Royal Mile in Edinburgh
The idea that individuals pursuing their self-interest could end up contributing to the
well-being of others was rooted in Smith’s moral philosophy that humans’ personal
happiness partly is based on the well-being of those around them, that people are
interdependent to some degree. Smith believed that in a complex society made
up of thousands or millions of individuals whose interests do not always overlap,
10
 an economy governed by tradition or command could not possibly achieve a
more beneficial outcome for the greatest number of people than a system in which
individuals are able to pursue their own self-interest.

Freedom of choice was a fundamental basis for Smith’s economic and social
philosophy, and to this day freedom remains a key characteristic of the economics
we study and of the policies that economic theory helps shape in both national and
international economies. Most economies combine elements of the free market with
some degree of government intervention — these are mixed economies. The degree to
which government is involved varies greatly between countries, and is a central point
of argument in each country’s politics.

Advantages of a free market economy

* People are relatively free within the market system to choose from a variety of jobs
orbusinesses, and to choose how they produce and for whom.
* When the market fosters competition, firms have the incentive to innovate,
improve products, and increase efficiency.
Consumers tend to dominate because consumers vote with their purchases.
Markets respond quickly to consumer preferences to gain more profit.
* Inan open system that depends on self-interest, the price system sends more
accurate information about the scarcity of resources to buyers and sellers.

Disadvantages of a free market economy

* Markets can become dominated by monopoly or oligopoly interests that stifle
competition and raise prices for all.
* Public goods (such as national defence and streetlights) will not be produced
because the free market cannot provide them profitably.
+ Demerit goods (goods that have harmful effects on society such as pollution and
tobacco) will be overproduced.
* Merit goods (goods that have positive effects on society such as vaccines and
education) will be underproduced.
* Extreme gaps between the few rich and many poor develop and have negative
social effects.

What is a planned economy?

A planned economy answers the basic questions with the central government
making all the decisions. In their extremes, they are sometimes referred to as
command economies, suggestive of the control the government exerts over the lives
of its citizens. The specific answers as to what to produce will vary from country to
country, depending on its own priorities, but at the discretion of the government. The
government may choose to prioritise capital goods over consumer goods, or military
goods over consumption. Likewise, the method, or how to produce, will be determined
by the authorities. Decisions about the labour market (who gets what jobs), capital
market (which firms get machinery, which do not), and land use (which resources will
be developed) all happen under central planning. Entrepreneurship, to the extent that
it can flourish at all, does so within the limits of state control. It is the state also, who
determines to whom production is distributed. The state sets wages and prices and so
completely allocates incomes and wealth.
"
 What is economics?

The most noted planned systems were implemented in Mao’s China, Stalin’s Soviet
Union, the Democratic People’s Republic of Korea (North Korea) and Castro’s Cuba.
In each case, these leaders sought to move the economy of their country from an
agricultural base to an industrial and manufacturing base. The mechanism used to
pursue this goal involved total control of the nation’s resources by the government.
Typically, a planned economy requires state ownership of the factors of production
and is guided by the principles of socialism — the notion that society should be
organised to the benefit of all its citizens. These principles place the objective of
equality above that of efficiency. Socialist economies aim to achieve fairness within
society by allocating resources and output based on the common needs of humans
rather than the individual pursuit of self-interest that underlies market economies.
Private ownership of factors of production is therefore abolished. All agricultural and
industrial output is appropriated by the central government and is reallocated among
the nation’s people in what is intended to be a fair and equitable manner.

Because of the lack of individual property rights and the incentive to achieve
maximum efficiency in the use of resources (which characterise private ownership),
the planned economies of the 20th century eventually became highly and notoriously
inefficient. Ultimately, they were unable to provide their nations’ people with the basic
necessities for a healthy and happy existence. Both Russia (the core of the former
Soviet Union) and China eventually abandoned the planned system of economic
management. Of the notable Cold War command systems, only Cuba and North Korea
have remained fundamentally planned economies.

The failure of planned economies to achieve sustainable and meaningful

improvements in the well-being of their people can be tied to the lack of an effective
mechanism for determining the most efficient allocation of society’s scarce
resources. Central planners, it turned out, were too prone to making mistakes in their
determination of what was best for society. Massive inefficiencies and high levels of
corruption emerged as producers in the economy focused less on producing quality
products that society truly demanded, and more on meeting the strict production
targets passed down from the central government.
An economic system that does not appropriately harness incentives towards achieving
efficiency in production will eventually collapse under the mounting inefficiencies
that emerge while attempting to manage the activities of millions of individuals across
the nation. This helps explain why the prominently planned economies of the
20th century failed to thrive and why most of them eventually adopted some market-
based economic reforms granting individual ownership of property and encouraging
the pursuit of self-interest.

Advantages of a planned economy

« Countries that value equity can provide resources to the poor, ensuring basic
housing, income, and healthcare.
« Countries that emphasise full equality can minimise income gaps by paying
equalised wages across the labour market.
The state can establish priorities and move the economy in their direction.
For example, the priority could be to move from an agricultural economy to an
industrialised one, as the Soviet Union did under Stalin in the 1930s.
12
Disadvantages of a planned economy
* The incentives for innovation and entrepreneurship are greatly reduced because the
system rewards individual productivity poorly.
Organising an economy is complex. Routine decisions about resource allocation
in one market, such as how much wood to allocate to paper production, are very
difficult to balance across a whole country.
* State control eliminates competition, and so removes the incentive to find
efficiency, lower costs, and improve products.
* Citizens have little freedom of choice in their work, housing, or where they live
because the government determines all three.

Case study - central planning’s worst disaster

In 1949, the People’s Republic of China emerged from the Chinese Civil War,
after Mao’s Communist Party of China defeated Chang Kai-Shek’s Nationalist
army in a decades-long conflict. The new state was founded on the principles of
Marxist-Leninst socialism, which held wide appeal to a very poor and agrarian
population. After consolidating power over the course of the 1950s, Mao
declared that China must make the great leap to an industrial economy in 1958.
This programme, called the Great Leap Forward was to follow the Stalinist
drive to industrialise in the 1930s by collectivising agriculture and using the
surplus food to power production in heavy industry. Hundreds of thousands of
government officials fanned out across the country to direct the plans. Mao tried
to mobilise the population in a way similar to the days of the Revolution, and
ordered village communes to produce steel in backyard furnaces. Peasants threw
every kind of wooden household object to heat the furnace and all kinds of metal
equipment into the furnaces, to be melted into steel. The result was massive
inefficiency. The metal produced was a pig iron that needed refining by large
smelting plants the country did not have. Worse, countryside peasants spent so
much time on the furnaces they neglected their crops. The result was one of the
worst famines in history, killing between 30 and 50 million people. One lesson
among the many tragedies of this period was the wilful ignorance of scarcity and
value, something that markets provide and central planners rarely can capture
without market signals.

n China
during the Great Leap
Forward era

13
 What is economics?

TP What is a mixed economy?

How would you categorise A mixed economy, as the name suggests, secks to combine aspects of planned
your own country’s
and market economies to suit a country’s needs. All countries, unofficially if not
economy? Is it closer to a
free market economy or s it officially, have mixed economies in that they combine private and public control of
more planned? Some ways some resources. A mixed economy may have a strong private sector for goods and
to check: Ask f the country’s services, with workers earning varied salaries, firms choosing who their workers
higher education system is are, and allocating resources based on their profitability. That country may also have
free to students? Is healthcare
provided by a single government provision in other sectors, such as health care, national defence, and
government entity? Are taxes education. It may also have a strong social safety net to reduce poverty and help the
perceived to be relatively unemployed. These government interventions would be paid for by taxing firms and
high, compared to similar individuals. Mixed economies rely on cultural and political influence to decide the
countries? Are the largest
companies owned by the appropriate place and degree of intervention, and where markets should be free.
government? Another way is
to look up the ‘government Advantages of a mixed economy
spending as a percentage
of GDP' (GDP being gross * Solutions to market failures can be managed on a case by case basis, not bound to
domestic product, or the ideology.
size of the overall economy,) + Governments can use tax revenues earned through its market system to support
Prepare to discuss your underproduced merit goods like education and healthcare.
results with those in your
class to compare the degree * Governments can provide popular goods and services but also limit demerit goods.
of government intervention * Abalance of dynamic market forces and government support can increase overall
in your country’s economy. well-being.

Disadvantages of a mixed economy

* Thereis a potential for social division over the allocation of resources and tax rates.
* There can be political conflict over the role of the government in regulating
production and consumption.

1.2 The production possibilities curv

model (PPC)

Learning outcomes
At the end of this section you will be able to:
* explain, using a PPC diagram, how the production possibilities curve (production
possibilities frontier) model may be used to show the concepts of scarcity and
choice
* usinga PPC diagram, show and explain a situation of unemployed resources
and inefficiency
* using a PPC diagram, demonstrate the concept of trade-offs and opportunity cost
* explain how a PPC may demonstrate the idea of increasing and constant
opportunity costs.

The existence of scarcity and the reality that every economic decision involves trade-
offs and costs can be illustrated in what will be the first of many economics models
you will learn about in this course. The production possibilities curve (PPC) is a model
14
economists use to demonstrate the fundamental economic concepts you have been
reading about so far (Figure 1.1).
The PPC model makes several assumptions:

« the amount of resources (land, labour, capital, entrepreneurship) is static

« thelevel of technology is also held constant
* aneconomy produces only two goods (capital or consumer goods, for example)
« any point on the PPC line represents the full use of all resources and technology,
and is therefore economically efficient
* points inside the curve are levels of output that are inefficient, not using all
resources available
« points outside the curve are impossible unless conditions change
* to change from one point on the curve to another point on the curve is to
reallocate resources, increasing output of one good at the expense, or opportunity
cost, of another
* changing preferred outputs along the efficient PPC line are shown by movements
along the PPC
+ movements along the PPC will demonstrate the trade-offs between production of
one good in terms of another, or how much of one good is lost when producing
more of the other good
* constant opportunity cost PPCs are shown by straight-line PPC
* increasing opportunity cost PPCs are shown by a curved, bowed-out PPC.
Akind of personal PPC can be used to demonstrate some of these basic concepts.
The PPC in Figure 1.1 illustrates the trade-off Sarah faces in deciding how to use her
10 hours of free time each week. She can spend her free time doing one of two things,
playing or working.
Hours spent playing
»

o Figure 1.1 Sarahs

production possibilities curve

1 2 3 4 5 6 7 8 9 10
Hours spent working
15
 What is economics?

Assume that point A represents Sarah’s decision in week 1, when she allocates seven
hours to play and three hours to work. Her decision to allocate her limited time in this
‘manner involves an opportunity cost, which is the benefit she would have gained from
spending more time working and less time playing.
Assume that point B represents Sarah’s decision in week 2, when she has decided to
spend seven hours working and only three hours playing. The opportunity cost of
working four additional hours is the four fewer hours she gets to spend playing and all
the enjoyment she foregoes as a result of her decision.
This simple PPC demonstrates several concepts fundamental to economics.

* Scarcity. Because resources are scarce, there is a limit to the amount of production
or consumption an individual (or a nation) can undertake. Time is the scarce
resource in Figure 1.1. With only ten hours of free time, Sarah must decide how to
allocate her time among competing activities.
* Trade-offs and choices. The two axes in a PPC represent two trade-offs faced by
an individual, firm, government, or society. The axes may represent any economic
activity that can be undertaken by an individual, firm, or nation in the employment
of its scarce resources. Because we face trade-offs, we must make choices, which
involve costs.
* Opportunity cost. Nothing is free. More time playing comes at the expense of the
benefits from time spent working. Likewise, a nation that chooses to produce a
certain good faces costs in the form of the other goods that could have been
produced with the same resources.

The law of increasing opportunity cost

More commonly, the PPC is used to illustrate a nation faced with a decision regarding
what types of goods to use its scarce resources to produce. The PPC in Figure 1.2
assumes that Country I can produce two goods — pizzas and robots.
The law of increasing opportunity cost explains why the PPC is bowed outwards
from the origin. The law says that as the output ofa particular product increases, the
opportunity cost of producing additional units rises.

Varied resources: Country I's PPC in Figure 1.2 has a convex shape (it bows out from
the origin). The reason for this lies in differences in the production of pizzas and
robots. Pizzas and robots require very different resources in their production. Pizzas
are land intensive (large amounts of land are needed to grow the ingredients). Pizzas
also require a particular type of labour and capital: farmers and cooks need not have
advanced degrees and extensive expertise in engineering to grow ingredients and make
pizzas. The land and labour resources required to make robots are very different than
those for pizza. The type of labour needed is highly skilled and educated. Because
Country I's land, capital, and labour resources are not equally suitable to making either
robots or pizzas, the opportunity cost of increasing production of robots increases in
terms of pizzas the more robots are produced.

Increasing opportunity costs to production are shown by the country losing larger
amounts of one good as it tries to increase production of another. For example, as this
country increases output of robots, it gives up more and more units of pizza each time.
Notice, for instance, that when robot production increases from 300 to 400 units, the
16
 « Figure1.2 Theincreasing
cost PPC bows outwards due
to the very different resources
involved

3 4 5 6 9
Robots/ hundreds

cost of the additional 100 robots is just under one million pizzas (since pizza production
falls from 7 million to a little over 6 million). But as robot production increases, however,
from 600 to 700 units, the additional 100 robots costs CountryI around two million
pizzas (since pizza output falls from around 4 million to 2 million pizzas).
Why did the opportunity costs double for the same increase in output? Why did Country
T have to give up twice as many pizzas to increase robot production by 100 units from
600 to 700 than it did to increase production by the same one hundred units two levels
before, from 300 to 400? The explanation lies in the fact that as CountryI started making
robots (between 100 and 400) only the resources best suited for robot design and
production were employed. Electrical engineers and highly educated technicians who
had been employed in the pizza industry quit making pizzas (which they were never any
good at anyway) and started making robots. The land, labour, and capital that was best
for making pizzas remained employed in the pizza industry, and at first Country [ was
able to switch over to the production of robots at a relatively low cost.

17
 What is economics?

Figure1.3 The constant-

cost PPC derives from the
one to one trade f between
pizza and calzones

1 2 3 4 5 6 7 8 9
Calzones/ millions

However, as robot production intensified, resources were increasingly moved out of

pizza production, and into the robot industry. This meant switching resources that
were well-suited to pizza making and forcing them into robot making. Accordingly,
to produce 700 robots, highly skilled pizza makers and land better suited for growing
wheat and flour and tomatoes and dairy cows had to be shifted into robot production.
The cost of robots in terms of pizzas increases the more robots Country I produces.
Because costs increase with each interval of output, the law of increasing opportunity
costs is at work.

Constant-cost PPCs
Similar resources: Not all PPCs are bowed outwards. If the two goods represented in a
PPC are very similar in their production, requiring similar types of labour, capital, and
land resources to produce, then the PPC for the two products is a straight line, such
as Country I's PPC for pizzas and calzones (Figure 1.3). A calzone is basically a pizza
folded in half. Therefore, the opportunity cost of one calzone is always only one pizza,
so the PPC is a constant sloping curve, and the trade-off is always one to one. Real-
world examples of similar resources used in the production of two goods include the
growing of corn and wheat, or the production of smartphones and tablet computers.

Efficiency, inefficiency, and economic growth

The PPC can also be used to illustrate the economic concepts of efficiency, inefficiency,
and economic growth. Look now at Figure 1.4. Points A, B, C, and D are all on the
curve; at each of these points Country Lis producing some combination of goods and
using its existing resources (land, labour, capital, and entrepreneurship) efficiently. This
means that nearly every person of working age who wants a job has a job, the land that
can be used for production of pizza ingredients and robot components is being used
and the nation’s existing capital (factory equipment, ovens, and other tools) is operating
18
 Pizza / millions

o Figure 1.4 Points i

the PPC represent inefficiency,
and points outside are only
possible in future through
growth

5 6
Robots / hundreds

at full capacity —no capital is sitting idle. At these points, an increase in total output is
not possible without an increase in inputs first. A nation achieving its production
possibilities is producing at its full employment level of output. For this reason, the PPC
is often given the alternative name of production possibilities frontier (PPF).

A nation not achieving full employment of resources is producing at a point inside its
PPC.If Country lis producing 500 robots and 3.2 million pizzas (point E), it is under-
utilising its land, labour, and capital. A country is said to be inefficient if it is producing
at a point inside of its PPC. This means that unemployment is likely to be high, land
that could be put into cultivation of food or production of minerals is not being used,
and existing capital is sitting idle. An economy producing inside its PPC may be in a
recession — this means that the level of output has fallen below the full employment
level achieved when producing on its PPC.
Clearly the PPC can also illustrate the possibility of economic growth. A point outside
the PPC is unattainable given the existing quantity and quality of resources, but it
is clearly desirable. At point F in Figure 1.4, Country I would produce 600 robots
and consume over 6 million pizzas. This is clearly beyond the current production
possibilities, but it may be attainable in the future if the economy grows.
Economic growth is defined as an increase in the total output ofa nation over
time, indicating an increase in economic well-being. Growth is possible ifa nation
experiences an increase in the quality or the quantity of productive resources (land,
labour, capital, and entrepreneurship), or an increase in technology. Economic
growth is shown with a PPC in Figure 1.4. In order to achieve a level of production and
consumption corresponding with point F, Country I must increase the amount of land,
labour, or capital in the country or improve the productivity of these resources. Such
a change would create a new PPC boundary line, with a new set of trade-offs between
one type of production and another. Most importantly, more of all goods, in this case
pizza and robots, can now be produced.
19
 What is economics?

How realistic are Productivity is defined as the output attributable per unit of input. If Country I's workers
economic models? How became better at producing pizzas and robots, either through better training and
can we know what to education or through an increase in the quality of the technologies used to produce
include or exclude in a these goods, then the national output of Country I would grow and the country
model?
would move towards point F. Investments in public education by the government or
Consider the above
model, the PPC. To what
investments in better technology and more capital by the country’s businesses could
extent do you think some lead to economic growth. Economic growth is an objective that plays a significant role
of the assumptions above in macroeconomics.
(two types of output,
resources are static), are
very realistic? To what
degree do they identify The circular flow of incom odel
useful ideas? What could
be included to make it
more realistic? How would
that affect the clarity of the Learning outcomes
model?
At the end of this section you will be able to:
describe, using a diagram, the circular flow of income between households and
firms in a closed economy with no government
« outline that the income flow is numerically equivalent to the expenditure flow
and the value of output flow
+ explain how the circular flow demonstrates the interdependence of all sectors
of the economy
* describe, using a diagram, the circular flow of income in an open economy with
government and financial markets, referring to leakages/withdrawals (savings,
taxes and import expenditure) and injections (investment, government
expenditure, and export revenue)
+ explain how the size of the circular flow will change depending on the relative
size of injections and leakages.

The idea that the exchanges between individuals are voluntary and that anyone engaging
in such exchanges benefits from them is fundamental to the market economic system.
This implies that when one person voluntarily gives another something that the
second person wants, the first person must be getting something he or she wants in
return. Thus, both parties are better off following the exchange. In other words, market
economics is not a zero-sum game. When one person wins, it does not necessarily
mean that someone else loses. Both derive some benefit from the trade, or they would
not voluntarily make it.
The circular flow model (Figure 1.5) shows the flow of money through the economy,
as money moves from buyers to sellers, and then from sellers to individuals in the
form of income. Thus money circulates through the economy. The model assumes
that all exchanges in a market economy take place in either the ‘product market’ or the
‘resource market'. In our study of market economies, we will assume that the demand
for resources by firms, and for goods and services by households, is met in one of
these two markets. Households are the ‘owners’ of productive resources, which are
the inputs firms need in order to produce goods and services. To acquire the inputs
for production, firms must pay households for their resources in the resource market.
Households earn their income in the resource market and then buy the finished
products provided by firms in the product market.
20
 Expenditures Revenues
Product
market
Goods and Output
services

The circular flow of money, « Figure1.5 Moneyand

‘ Households resources, and goods and resources flow in opposite
services directions around the circular
flow model

Land, labour, Factors of

NG capital production
Resource
market
Wages, rent, Costs of
interest production

Thus, in Figure 1.5, money payments flow clockwise in the outer loop while resources,
goods, and services flow counter-clockwise in the inner loop. In the resource market,
households provide firms with the factors of production (land, labour, and capital) they
demand in order to produce their output. But these inputs are not free; firms face costs
in acquiring them. These costs translate into money incomes that households receive
for the resources they provide; wages for labour, rent for land, and interest for capital.

Once firms have acquired all the inputs necessary to produce their finished products,
they sell their products to households in the product market. The money households
earn in the resource market goes to pay for the goods and services they demand in the
product market. Household expenditures on goods and services translate into revenue
for the firms.

Thus, the money earned by households in the resource market is ultimately earned
by firms in the product market, and the circular flow is complete. Inputs turn into
outputs, income turns into revenue.

Figure 1.5 illustrates at a basic level how market economies function. Buyers and sellers
are interdependent. A drop in one sector affects the others. Reduced incomes in the
resource market will reduce spending in the product market.

The circular flow model with injections and leakages

‘We can now introduce additional elements into the model to make it more realistic.
The previous model was self-contained but the new model will acknowledge that there
are other actors in the system and that money exits and enters the system in a variety
of ways. Money that exits the system is referred to as ‘leakages’, while money that
enters the system is called ‘injections’.

The government sector: taxes and spending

Probably the single largest actor not included in the simple model is the government.
The government has a profound impact on even the most avidly free market
economies. Governments draw tax money from the population, a leakage of income
21
 What is economics?

out of the model. However, that money should eventually re-enter the model as
government spending on everything from salaries to infrastructure. (Even if we
assume that some of the money is lost through corruption, it may also eventually
re-enter as consumer spending) This idea, that the flow of money never truly escapes
the model, is one that holds true with the other new actors in the model.

The foreign sector: imports and exports

The previous model assumed a closed economy, hardly a realistic notion in a world of
increasingly globalised trade. If we assume that some of the money spent in either the
factor or product market is spent on imported goods, then that income will leak from
the system. However, roughly the same amount of money should enter in the form of
exports sold to other countries. This tendency towards a balance of import and export
flows is explained in more detail in Chapter 26. For now, it is sufficient to acknowledge
the leakage and injection that takes place with the addition of the foreign sector to
the model.

The financial sector: savings and investment

Some consumers save a portion of their money, rather than spend it. Savings would
slow down the flow of expenditure and eventually income. However, money that is
saved in banks is made available to borrowers. These borrowers then inject the savings
back into the economy in the form of investment, whether as capital goods or by the
purchase of housing by households. Thus, the leakages of savings re-enter the system
through loans made by the financial sector.
Figure 1.6 The circular flow Figure 1.6 illustrates the new, more complicated circular flow model, one that includes
model showing leak: s and
injections injections and leakages via three sectors: the government, foreign, and banking sectors.
Injections are insertions of money into the circular flow and include government
v

Exports Taxes
—J

o
Households Firms

e Resource
market
j

Key
—> Leakage
—> Injection Savi';]_-—@
22
spending, export purchases, and investments. Leakages are the diversions of money
outside the circular flow and occur when the government collects taxes, imports
are purchased, or when people save money. Figure 1.6 shows the government sector
taking taxes away from firms and households, then injecting the money into the flow’
again. It shows imports leaking money out of the economy, while exports inject it back
in. It shows savings leaking out of the economy, while investment from the savings
injects it back in.

While the new model s still a simplified one, it makes an allowance for some realities.
If one sector leaks more than it injects, the flow merely becomes smaller. For example,
if imports are greater than exports, the flow may be reduced. If government spending,
an injection, is greater than taxes in any given year, the flow will increase. Of course,
in that event, most governments will borrow money to do the spending. So, it is
likely that, in some future year, taxes will be more than spending to pay off the debt.
Although there is a tendency for the leakages and injections to be equal, in the real
world it is unlikely that they will be at any particular time.

Practice exam questions - assessmel ps (Paper 1 for HL and

Your Paper 1 exam will consist of three pairs of essay questions. You will choose
one of them. Each pair may come from any of the four units: Introduction to
Economics, Microeconomics, Macroeconomics, the Global Economy. Each pair has
part (a) worth 10 marks and part (b) worth 15 marks. You will have 75 minutes to
answer this two-part question.

Part (a) will require you to define terms, explain concepts, and, almost always, use a
diagram to do so. Most questions, but not all, state the need for diagrams, but even
those that do not explicitly say so may still require a diagram for full credit. It is
important to connect the diagram to your explanation. Unexplained diagrams do
not count for much. The use of real-world examples is desirable, as it helps illustrate
the idea.
More information on external assessment is found in Chapter 31. Below are
examples of part (a) questions.

Paper 1, part (a) questions

1. Explain how economics addresses scarcity by answering
the three basic questions of economics. (10 marks)
2. Distinguish, using a diagram, the difference between a
curved PPC and a straight-line PPC. (10 marks)
3. Explain how a production possibilities curve helps demonstrate
the concepts of scarcity, choice, and opportunity cost. (10 marks)
4. Explain, using a circular flow diagram, how the consumers and
producers are interconnected in a free market economy. (10 marks)

23
How do economists
approach the world?
 Economic methodology

Learning outcomes

At the end of this section you will be able to:

« distinguish between positive and normative economics
* explain how economists use models, theories, logic, the ceteris paribus
assumption, empirical evidence, and refutation in their analysis of human
behaviour.

As you start down this path towards learning economics, you will slowly start to
become an economist, which means you will start to look at the world a little differently.
The economic way of thinking is one rooted in logic, reasoning, and both positive and
normative analysis of quantitative and qualitative data drawn from observations of the
interactions of various agents in society, often examined using models. By the end of
this journey, you will be an economist, and you will never look at the world the way you
did before studying economics!

The role of positive economics

Economists may not always agree on everything. An economic statement is positive or
normative depending on whether it is purely an expression of factual information or an
expression of values or opinions based on facts.

Positive economics deals with what is. It focuses on observations and expressions
based purely on factual evidence. For example, it is a fact that when the price of
doughnuts rises, the number of doughnuts that consumers demand falls. This is not
an issue that economists would find it necessary to debate. In fact, the relationship
between the price of a good and the quantity demanded by consumers is so widely
agreed upon that it has become an economic law (the law of demand).

Positive economics is rooted in the use of logic. An economist undertaking positive

analysis will apply a set of tools, often mathematical, always based on formalised
principles or economic ‘laws’, to predict the outcome of a particular event in the world.
For example, a positive economic observation might be, ‘if the government increases
the minimum wage, then more people will seck jobs and at the same time employers
will need to lay workers off, therefore unemployment will increase’. This statement
is based on the basic economic laws of supply and demand and the ceteris paribus
assumption, which economists use to hold ‘all else equal’ when predicting how a
particular change will affect a market or society.

Economists have formalised supply, demand, and many other principles in models
that can be used to predict and explain how society functions. There is empirical
evidence to support these models, and therefore it would be difficult to refute the
above positive economic statements.

25
 How do economists approach the world?

The role of normative economics

Not every economic statement is irrefutable, however. Some are more an
expression ofa particular economist’s opinion or values. Consider the statement,
‘Doughnuts should be taxed because at their current price they are over-consumed
and contribute to obesity.” This may be true in that doughnuts can cause health
problems, but the view that they ‘should be taxed’ is refutable. Therefore, this
statement is normative. Normative economics deals with what should be rather
than what is. Normative economics deals with areas of the subject that are open to
personal opinion and belief.

Or consider the statement, ‘The government should raise the minimum wage, since
many retail workers cannot afford a decent quality of life.” How does this differ
from the previous, positive statement about the minimum wage? The previous
observation is based on economic theories and real-world evidence, while this
statement is based on the subjective viewpoints of the person making it. While it
may be true that it is hard for minimum wage workers to afford a decent quality of
life, the claim that the solution is a higher minimum wage is refutable by anyone
willing to argue that the resulting negative impact on employment outweighs the
benefits of the higher wage.

Positive economic analysis examines human interactions through the lens of

quantifiable, irrefutable, evidence-based observations. There is no role for values
or ethics in the realm of positive economics. Normative economics, in contrast,
allows for the expression of the economist’s values or personal views based
on the quantifiable evidence observed in a particular market or realm of social
interaction.

Normative economics places value on certain principles over others, such as the
importance of equity over efficiency, or vice versa. Equity in economics refers to
fairness. This differs from the concept of equality, where resources are distributed
evenly across society. Equity is when there is an equal opportunity for individuals in
society to achieve economic advantages.

Let us examine two economic statements about education.

A. There s a direct relationship between the level of education attained and one’s
income later in life.
B. Taxing the incomes of the rich at a higher rate to help pay for publicly-funded
schools will benefit society since everyone will have equal access to education
regardless of income.
Which of these is a positive statement and which is normative? If you said A is
the positive statement then you are correct. B, on the other hand, is a normative
What assumptions do statement based on the fact presented in A. While education does, in fact, correlate
economists make when to higher incomes, whether or not the best way to achieve that outcome is to tax the
they apply economic
theories to the real world? incomes of the rich is refutable. The statement places a value on equity over efficiency.
To what extent does
Many people would argue that taxing the incomes of the rich creates a negative
the distinction between incentive to work hard and earn higher incomes, and therefore reduces efficiency
positive and normative across the economy. Others may counter that the money taxed at higher levels is less
statements exist in other
useful to, or needed by, the relatively rich than the money contributed to support the
academic disciplines?
relatively poor.
26
 2.2 A history of economic

At the end of this section you will be able to:

« outline the broad history of economic thought from the 18th century through
the early 21st century.

Economics is a social science, and like other sciences the theories and principles on
which it is based have changed throughout history. As different practitioners have
emerged, each has applied their own unique methodology and perspective to their
objective observations of society’s economic interactions.

The 18th century - the foundation of classical

economics
Economies, the systems by which goods are produced and exchanged in society, have
existed since the specialisation of human labour arose during the first Agricultural
Revolution around 12,000 years ago. The study of how economies function is a relatively
recent field. Modern economics as a field of study has its roots in the 18th-century
English Enlightenment, when the philosopher Adam Smith described how the pursuit
of individual self-interest in free markets could result in socially desirable outcomes, as
some in society seek to get rich by producing what others demand.
A Neolithic rock carving: the
Adam Smith was one of the first theorists of what was later described as classical first Agriculiural Revolution
happened during the Neolithic
economics, the unifying principle behind which was the idea that the value of any period
commodity or good is derived from the amount of labour used to produce it.
This labour theory of value is reflected in the following quote from Adam Smith’s
The Wealth of Nations.
‘The value of any commodity, therefore, to the person who possesses it,
and who means not to use or consume it himself, but to exchange it for
other commodities, is equal to the quantity of labour which it enables him
to purchase or command. Labour, therefore, is the real measure of the
exchangeable value of all commodities. The real price of every thing, what
every thing really costs to the man who wants to acquire it, is the toil and
trouble of acquiring it."
Adam Smith, The Wealth of Nations, 1776

The 19th century - free markets for all

Utility theory
The fields we now refer to as microeconomics and macroeconomics were not yet
formed when Smith was writing about the pursuit of self-interest guiding commercial
interactions as if by an invisible hand in the late 18th century. Microeconomics as a field
of study emerged only in the 19th century with the development of utility theory,
which was used to explain the behaviour of individuals who are able to consistently
rank their choices in order of their personal preferences.
27
 How do economists approach the world?

As economic agents, individuals make rational decisions about what to buy and
consume and how to allocate their limited resources (time, labour, money, etc.) based
on their utility functions for various choices. Utility in economics is the happiness or
satisfaction derived from any particular good, service, or activity that an individual
could choose to consume or pursue.

Utility theory formed the conceptual foundation of what would later emerge as the
market demand and supply models, on which much of microeconomic analysis is still
based. The demand for any particular good in a market is derived from the aggregated
utility functions of all the consumers in that market. Likewise, a supply curve s little
more than the aggregated marginal costs of all the producers in a market, determined
by the diminishing marginal returns experienced as more units ofa variable input are
added to a fixed factor of production.

Economists talk about individuals’ behaviours on the margin. These are behaviours
based on the value of an additional unit of something. The classical economists of the
carly 19th century were the first to examine the concept of the margin, and it forms the
basis of microeconomic theories to this day.

The laissez-faire approach

Another classical economist of the early 19th century, Jean-Baptiste Say, laid
the groundwork for what would be known as the laissez-faire approach to
macroeconomics, which says that the best means by which to manage a national
economy is to not manage it at all, but to let it be’. Say’s Law observed that supply creates
its own demand. Say explained that:

‘... aproduct is no sooner created than it, from that instant, affords a market
for other products to the full extent of its own value’

Jean-Baptiste Say (Translated by CR Prinsep), A Treatise on Political Economy, 1821

The act of paying workers in one factory creates demand for the products from another
factory equal to the value of the labour provided in Factory A. Upon this observation the
belief emerged that an economy left to its own unregulated and unhindered activities will
reach a state of equilibrium where full employment is achieved. Surpluses and shortages
of goods, services or labour (in other words, unemployment or overemployment) will
be eliminated as the market finds a balance between production and consumption.
Macroeconomic shocks like recessions, stagnation, and involuntary unemployment,
according to Say’s Law, are resolved automatically by the free market’s rebalancing
between the amount produced and consumed.

The 19th century - Marx’s critique

Classical economists had faith in the morality of free markets and the socially
beneficial outcomes of the pursuit of individual self-interest. That faith was called into
question in the mid-19th century by several philosophers, most notably Karl Marx.
His critique of the free market theories of the likes of Smith and Say was rooted in
the inequality that had emerged under the market system predominant at the time.
Marx believed that under the market system, human labour had become a disposable
‘commodity’ like the slave labour on which the economies of ancient Rome and Greece
had been based.

28
Marx argued that workers were the slaves of capital and capitalists were the slave masters.
Marx defined ‘capital’ as the wealth possessed by individuals that is used to extract profits
from the production of commodities and ‘capitalists’ as the wealthy owners of capital.

Marx believed the capitalist system exploited labour, because the owners of capital
paid workers less than the value of the output they produced, thus extracting ‘surplus
value’ from the working class to enrich the capitalist class. This exploitation would
create an imbalance over time as the growing classes of exploited labourers would
see their wages pushed downward. As the gap between the rich and poor grew, the
conditions for revolution would emerge, the capitalist system would be overthrown
and workers themselves would take control of the means of production.

The ideal society, according to Marx, was one in which the factors of production were
communally owned, and everyone in society would be rewarded equally for his or her
labour.

‘In a higher phase of communist society, ... only then can the narrow horizon
A
of bourgeois right be crossed in its entirety and society inscribe on its Karl Marx in 1875
banners: From each according to his ability, to each according to his needs!’
Karl Marx, Critique of the Gotha Program, 1891

The 20th century - a battle of ideas

Marxism would form the basis for the communist regimes that emerged in the 20th
century in places such as Russia (the Soviet Union), China, North Korea, and Cuba.
Some degree of Marxist ideology underlies the socialist states that still exist, reflected
in the degree of state ownership of the major industries in modern economies such as
Canada, China, Sweden, the UK, and elsewhere. No modern economies demonstrate
the continuous cycle of class struggle and ongoing revolution that Marx foresaw, and
for the most part experiments with pure communism based on Marxist principles
have been abandoned for the mixed market/government-run economies typical of
most countries in the 21st century.

‘We can see that by the end of the 19th century the two poles of the economic
spectrum had been firmly established by economic theorists, from Smith and Say at
one end to Karl Marx at the other. Finding the balance between them has been the
struggle of every economy in the two and a half centuries since Smith established the
groundwork for the field of modern economics.
In the 20th century, the tug and pull of free market capitalism at one extreme and state-
run communism at the other came to a breaking point as the world's superpowers
collided, not only on the battlefields of the First and Second World Wars, but also in
the factories, fields, mines, and offices of the global economy. The Great Depression
of the 1930s struck a devastating blow to both the capitalist economies of the West
and the communist states of the East. With the Second World War that followed, the
question of the extent to which government should play a role in the economic lives
of a country’s people came to the forefront of history. With the communist Soviet
Union and the capitalist USA both emerging victorious from the war against Nazism
and fascism, a new paradigm for understanding macroeconomics was needed. The
man that emerged from the war as the intellectual thought leader of 20th century
economics was John Maynard Keynes.
29
 How do economists approach the world?

Keynes' voice emerged from a crisis. By 1929, the first great experiment in Marxist-style
communism had been underway for seven years in the Soviet Union. The USA was
at the tail end of its ‘Roaring Twenties’, a decade that saw record growth in economic
activity and the emergence of the thriving monuments to capitalism that investors still
worship today: stock exchanges like those in New York, London, and elsewhere across
the capitalist world. In October 1929, a collapse of share prices on the New York Stock
Exchange, caused by an unregulated and wildly speculative stock market, triggered a
global financial crisis. The ensuing collapse of the banking system ushered in a decline
in economic activity that would later be known as the Great Depression.

Unemployed men lining up P

outside a soup kitchen in
Chicago, February 1931

The depression caused problems for the laissez-faire doctrines of the classical
economists. The economies of the world failed to self-correct from the slump in output
and employment as classical theory suggested they would. Instead, unemployment
reached shocking levels across the rich world. In the absence of government safety nets
such as unemployment benefits, health insurance, food and housing subsidies, and
other programmes that are fairly standard in developed economies today, the decline
in economic activity resulted in increased poverty and unparalleled human suffering.
The free market principles of Adam Smith and Jean-Baptiste Say, it would appear,
had failed the people of the USA and Europe. The Great Depression called fora new
interpretation of macroeconomic principles, and Keynes stepped in to fill that void.

Keynes's 1936 book The General Theory of Employment, Interest, and Money introduced
theories that still predominate macroeconomics today. He observed that following
economic crises, such as the 1929 stock market crash, economies are unlikely to
self-correct, or return to full employment equilibrium, as the classical theory predicted
they would, but would instead risk ever-falling spending and shrinking output. This,
in his view, was due to several factors, including the propensity for households to
save more during economic downturns, businesses’ reduced willingness to invest, the
inflexibility of wages and prices, and the public’s increased preference for ‘liquidity’
(i.e. the desire to hoard cash during downturns), all factors that cause the overall level
of spending to spiral downward, and unemployment to rise during recessions.

Without government intervention, argued Keynes, slumping economies would

become stuck in a ‘liquidity trap’, in which reduced spending leads to rising
unemployment, which reduces business optimism, further reducing spending and
employment. Consumers reduce spending, and so firms earn less revenue and fire
more workers. This reduces consumer incomes further, hurting sales to firms. The
resulting ‘deflationary spiral’ would see recessions turn to depressions that would last
for years if governments did not step in to help restore full employment.

One of Keynes’s greatest innovations was to view the economy as working as a complete
system. Keynes developed modern macroeconomic theory through his ‘general theory’,
which viewed a nation’s economy as a giant machine that could be controlled through
various levers. A fall in household consumption could be counteracted by a tax cut and an
increase in government spending, which would boost overall demand and help maintain
full employment. A decline in business investment could be corrected by increasing
the supply of money, which would cause interest rates to fall and thereby increase the
expected rate of return on new business investment, stimulating demand once more.
Keynes's work recognised that while the self-correction predicted by the theories of
his 19th-century predecessors would eventually come true in the long run, it was not
enough for economic policymakers to sit idly by during an economic downturn and
wait for prices and wages to adjust, while millions of households suffer the hardships
that go with unemployment, including poverty, hunger, homelessness, and depression:

... this long run is a misleading guide to current affairs. In the long run
we are all dead. Economists set themselves too easy, too useless a task if in
tempestuous seasons they can only tell us that when the storm is long past
the ocean is flat again.’
John Maynard Keynes, A Tract on Monetary Reform, 1923

‘The fiscal and monetary policy tools that governments and central banks rely on today to
combat recessions and prevent depressions were first envisioned by Keynes. The models
we learn in IB Economics, including that of aggregate demand and aggregate supply,
are Keynesian models. Keynesian economic theory found a middle ground between the
laissez-faire, free market capitalism of Smith and Say and the state-run, centrally planned
communism of Marx. For this reason, Keynesian economics has, since the middle of the 20th
century and into the 21st, become the target of criticism and revision from thinkers on both
ends of the economic spectrum: the free market advocates call Keynesianism quasi-socialist,
while those who favour the collectivism of centrally planned economies would say Keynes’s
approach does not go far enough to regulate and plan the nation’s economic activity.

One of Keynes’s most vocal critics was the Austrian economist Friedrich von Hayek,
who believed that the central decision making at the core of communism and
socialism undermined liberty and could only reduce people’s standards of living. He
believed no central authority could possibly possess the knowledge of human desires
to allocate resources efficiently in a way that maximises society’s well-being. Any
central planning, including the government interventions advocated by Keynes to
regulate economic activity and promote full employment during economic slumps,
could only lead to authoritarianism. It was a slippery slope, argued Hayek, from a
government increasing its deficit spending during a recession to help keep workers
employed, and total government control over the lives of the nation’s workforce.

Hayek and other followers of the Austrian School of Economics offer a blueprint for
an economic system rooted in liberty: free markets, private property, and individuals
31
 How do economists approach the world?

pursuing their own self-interest, much as theorised by Smith, are the true path
to prosperity, and thus government should play only the smallest of roles in the
economic lives of their people. The tug of war between free markets and intervention
that we see today, as we have shown, has its roots in 19th- and 20th-century debates
between the likes of Smith, Say, Marx, Keynes, and Hayek.

Many economists argue Case study - the battle of ideas in governm responses to
that economics as a social
science is in its infancy, the COVID-19 pandemic
and that with time, as The Keynesian/Austrian debate over the extent to which government should play a role
em| pirical testing methods
and the quality of data in the economy played out in the decades following the Great Depression and the Second
improve, it will become ‘World War, as the governments of Europe, North America, and other rich, developed
more reliable in making parts of the world debated the structure of their economies and the role the government
accurate predictions. should play both in good times and during economic downturns. Given the cyclical
Do you agree with this
statement?
nature of booms and busts, economies experience periods of rising prosperity and
economic hardship, often swinging between the two every decade or so. Recessions, as
periods of declining economic output are called, tend to come along, even in the most
developed economies, once every decade or so on average, and can be triggered by a
myriad of factors, either on the ‘demand side’ of the economy or on the ‘supply side’.

In 2008 there was a ‘demand-side’ recession in the USA and Europe, triggered by a
collapse in house prices, the effects of which reverberated throughout the world’s
financial markets. Millions of workers became unemployed around the world,
increasing poverty and hardship as governments debated, then struggled to address
the downturn with appropriate responses.

The year 2020 marked the next major global economic slump, brought on by the
coronavirus pandemic, this one both a ‘demand-side’ and ‘supply-side’ recession.
Demand for all sorts of goods and services fell as people were forced to stay at home
and limit their social interactions for months on end, while supply chains were hobbled
as factories and offices adjusted to new requirements to limit the spread of the virus.

The anti-Keynesian argument for responding to COVID-19 emerged in the United

States in the summer of 2020, as conservative policymakers in the Republican party
of the US government took strong positions opposing future stimulus involving cash
payments to individuals and extended unemployment benefits to support people who
lost their jobs in the recession. By late 2020, US government support for unemployed
workers ended, as some policymakers argued that continued expansion of benefits
would create an incentive for people to remain unemployed voluntarily, thus slowing
the economic recovery.
Meanwhile, governments around the world once again faced the challenge of
addressing the economic consequences of a downturn in the business cycle, and
just as in the 1930s, the extent to which government should intervene was at the core
of the debate. The Keynesians in government, at least during the early months of
the pandemic, seemed to win these debates, as rich-country governments mounted
massive spending campaigns to prop up demand while households were forced to
stay home, and millions lost their jobs. In the USA, the federal government extended
unemployment payments of $600 per week to anyone who lost their job due to
the pandemic. In many cases, workers’ incomes increased under the generous
government spending packages relative to what they made while employed.

32
 However, by summer 2020, months into the pandemic, the Keynesian fervour of
many governments began to wane and concerns over the cost of continued support
for the economy began to win over. By late 2020, the role the government would
continue to play in the economic recoveries of pandemic-stricken countries was
called into question, as elected officials began to argue that the economy would
eventually need to recover ‘on its own’, much as an Austrian economist of the
20th century might have argued.
In addition to the macroeconomic intervention questions, many economists
grappled with specific questions of epidemiology, public safety, and education
with regards to school shutdowns. Emily Oster, Professor of Economics at Brown
University and pictured at the start of this chapter, created a crowdsourced database
to evaluate the degree of COVID-19 spread in schools, and to weigh this against
the costs of missed schooling. Her use of cost and benefit analysis helped persuade
school districts to open safely more quickly.
The debate between the Keynesians and the Austrians of the 20th century is very
Economics, like any
much alive and well in the 21st century, as evidenced by government responses science, is evolving as
to the coronavirus pandemic. In the future, more economic crises will inevitably students of the subject
occur, and the role of government in response to each will once again be debated in become leading thinkers
the parliaments and congresses of the world’s capital cities. themselves and formulate
new ideas that catch on
and become mainstream
paradigms. As a social
The 21st century - blurred lines science, it might be the
case that there are fewer
Behavioural economics ‘hard truths'in economics
From Smith to Keynes and Hayek, economics has evolved from a branch of philosophy than in the physical
sciences. The social aspect
in the 18th century to a social science with principles rooted in mathematical logic of the field leads some
by the late 20th century. Today the field is undergoing a renaissance once more as to call into question its
innovative economists engage in dialogues with psychologists, ecologists, sociologists, validity, as humans can be
and experts in various other fields. Several recent Nobel prizes in economics have fickle creatures who tend
not to abide by strict rules
been awarded to economists exploring the field of behavioural economics, which of behaviour, as atoms
studies the effects of psychological, cultural, social, cognitive, and emotional factors and molecules do in the
on the decisions individuals make in the social and commercial realms. Behavioural physical world
economics has broadened our understanding of economic interactions beyond Discussion questions:
the view of humans as the purely rational, utility-maximising agents that we were 1 To what extent have
understood to be by the classical economists. individual thinkers
shifted the paradigms
of economics through
Ecological and environmental economics their contributions to
the field over the last
As growing populations and rising incomes have put an increasing strain on the 300 years?
world’s natural resources and the environment, fields of economics that focus on How likely is it that the
~

the relationship between economic systems and the environment have become economics we study
increasingly popular. Ecological economics is an interdisciplinary field that views the today is the same
economics that future
economy as a subsystem of the Earth'’s larger ecosystem. It focuses on the threat to the
students will study?
ecosystem of continued development of technology and the substituting of physical
Does the fact that
capital for natural capital. Environmental economics, on the other hand, shares more of the paradigms of
the traditional beliefs of the classical and Keynesian schools of economic thought, but economics are always
broadens its cost-benefit analysis to incorporate external, environmental impacts changing make the field
of the behaviours of producers and consumers. Both these fields are increasingly any less relevant to the
world we live in today?
emerging as leading fields of study in the 21st century as societies have begun to
33
 How do economists approach the world?

face the increasing scarcity of natural resources and the environmental impacts of
unchecked economic growth and development.
A common critique among ecological and environmental economists of the classical
economic model (that based on the works of Smith, Say, and other 18th- and
19th-century thinkers) is that its focus on the mathematical modelling of human
behaviour fails to take into account the contexts within which economic interactions
take place, including human psychology, society, culture, and the natural environment.
The classical economists can perhaps be forgiven for under-emphasising the natural
environment in their analysis, given that the human population at the turn of the
19th century was only around 1 billion people. However, as population and incomes
have grown, the need to re-examine economic philosophy through the lens of
sustainability has become increasingly urgent.
A recent model of sustainable development is that of the doughnut economy, developed
in 2012 by University of Oxford economist Kate Raworth. The doughnut economy,
according to Raworth, is one in which the ‘safe and just space for humanity’ exists
where we have achieved a ‘social foundation’ but do not live beyond the Earth’s
‘ecological ceilings’.
In order for the whole of the world’s population to live within the ‘safe and just space’,
significant economic growth is still needed in developing countries, where the social
foundation has not been achieved for roughly 1 billion people. Wherever there is a
shortfall within any of the 12 social foundations (visible on the inside of the doughnut),
economic growth and development are required. However, if all 12 are achieved,
further economic growth threatens to ‘overshoot’ one or more of the nine ecological
ceilings, resulting in environmental degradation, and ultimately reductions in living
standards as human systems become unsustainable.
All this is to say that economics is an ever changing and evolving field of study. The
theories you study in this course are only a sample of the myriad branches of social
science that have emerged in its short history. Where the field goes in the future is up
largely to young learners like yourself, and what you choose to focus your studies on as
you progress through the field in the years to come.

Practice exam questions

Paper 1, part (a) questions
1. Using examples, distinguish between positive and normative
economic analysis. (10 marks)
2. Explain how the 20th century ‘battle of ideas’ between
John Maynard Keynes and his Austrian critics, including
Friedrich von Hayek, reflected the earlier ideological debates
between the free market theories of Adam Smith and the
communist theories of Karl Marx. (10 marks)
3. How do behavioural economics and ecological economics
demonstrate the evolution of economic thought as the field
incorporates the work of other social and physical scientists? (10 marks)

34
 Microeconomics

Real-world issue 1
How do consumers and producers make choices in trying to meet their economic
objectives?

Interaction between consumers and producers in a market is the main mechanism

through which resources are directed to meet the needs and wants in an econon
Consumer and producer choices are the outcome of complex decision making.
‘Welfare is maximised if allocative efficiency is achieved.
Constant change produces dynamic markets.
 Learning outcomes
At the end of this section you will be able to:
¢ define a market
* state the law of demand
* explain the negative relationship between price and quantity demanded
. explain the income and substitution effects
. explain the law of diminishing marginal utility
« analyse the relationship between an individual consumer’s demand and
market demand
draw a demand curve and explain that it represents the relationship between
the price and the quantity demanded of a product, ceteris paribus.

What is a market?
A market is any place, physical or virtual, where the buyers and sellers of goods and
services meet. In most languages, the term ‘market’ has connotations ofa direct and
tangible experience, like buying fruit from a local grocery, or meat from a nearby
butcher. These are markets in the traditional sense, but in the modern world a market
can be defined more broadly as any instance where buyers and sellers come together
for the exchange of goods and services.
These interactions can happen at any time or place. Direct buying and selling usually
happens in a specific place, such as when trading your cash for a farmer’s fresh
eggs. But markets can also operate indirectly, when buyers and sellers communicate
remotely. In commodity markets, buyers can purchase massive amounts of basic
goods like coffee or wheat at international meetings with representatives of the
farmers, never meeting the actual producers. This indirect buying and selling may also
happen online - for example, when a share trader buys a stock that you have offered up
for sale. In this case, the buyer and seller have no contact at all.

Product versus resource markets

Another way to think of markets is to distinguish between product markets and resource
markets. Economists view product markets as wherever consumers purchase goods or
services directly from producers. In the resource market, businesses make payments to
the owners of resources such as land, labour, capital, and entrepreneurship. In a market
economy, the recipients of these payments are private individuals or households.

Examples of markets, by type and definition, include the following.

* Retail: corner shops selling directly to customers who are the end-users of the
product or service.
* Wholesale: businesses buying in large quantities to re-sell or transform into final
products.

37
 Demand

TP * Geographic: markets can be defined as local, regional, national, or international.

‘The great virtue of a free + Online: while the majority of goods are still sold directly, greater amounts are sold
market system is that it does online every year.
not care what colour people « Foreign exchange: buyers and sellers exchange one currency for another.
are; it does not care what
their religion is; it only cares * Financial markets: a market exists for company shares (stocks) and government or
whether they can produce corporate bonds.
something you want to buy. * Labour markets: firms are the buyers and workers are the sellers in the market for
Itis the most effective system
we have discovered to enable labour.
people who hate one another
to deal with one another and What is demand?
help one another.
As stated above, every market transaction involves a buyer and a seller. The
Milton Friedman
economic concept of demand takes the consumer perspective, examining what
For discussion and debate:
motivates and limits buyers in any given market. More specifically, consumers can
Assess the validity of
Friedman’s statement.
be private households in the market for end-user consumer goods and services in
Using real-world examples the product market. Businesses also act as consumers in the product and resource
~

cite evidence where market.

Friedmans assertion
may be proven true, and Demand is defined as the quantity ofa good or service that a consumer or group of
others where the evidence consumers are willing and able to purchase at a given price, during a particular time
suggests it may not be period. Note that the quantity of demand is limited to those who are both willing and
supported
able to buy the good.
What kind of evidence
w

or data would help

demonstrate either point What is the law of demand?
of view?

Conduct an internet
The law of demand states that as the price ofa good increases, the quantity demanded
a

search for news articles of the good decreases. The opposite is also expected to hold as true: as the price ofa
that report evidence of good decreases, the quantity demanded of that good increases.
either point of view.
The law of demand implies a negative or indirect relationship between the two
variables of price and quantity demanded. As a result, most demand curves have
adownward-sloping shape. This concept rises to the level ofa law’ in economics
because it conforms closely to everyday reality. As individuals, we are less likely to buy
any good as the price rises (exempting, for the moment, speculative goods like gold or
company stocks, which may be bought with the expectation that they could be re-sold
ata higher price). As the price goes up, our common sense (and budgets) generally tell
us to economise and buy less. And the reverse tends to be true as well. When the price
of something declines, we grow less concerned about the price and may buy a little
more of it as a result, and perhaps others will start to switch to it also, increasing the
amount demanded.

As an example, we can determine a city’s demand for chocolate bars in a given week.
A demand schedule is a list of prices and quantities that show the amount demanded
at each price for a given time period. Table 3.1 shows the city’s chocolate bar demand
schedule for one week. For example, at a price of $2.50, 5000 bars would be purchased.
Demonstrating the law of demand, as the price falls to $2, the quantity demanded rises
0 10,000 bars.

The information on a demand schedule can also be plotted as a graph to give us a

demand curve. Figure 3.1 plots the price and the quantity demanded to derive the
demand for chocolate bars.

38
Table 3.1 Demand schedule for chocolate bars

Price of Quantity of chocolate bars demanded

chocolate bars (P) per week (Q)
$ (thousands)
2.50 5
2.00 10
1.50 15
1.00 20
0.50 25

ocolate bars o
Canada

3 oS
11U DAIRY
LS o BTV ORI

25
8 20
2&
g 15 « Figure3.1 The demanc
25 i
5
3g 10 the sprice d
&
o
o

Demand

5 10 15 20 25
Quantity of chocolate bars demanded
per week (Q) (thousands)
39
 Economics asserts that
In Figure 3.1, the vertical axis shows the price of the good (the independent variable),
some principles are while the horizontal axis shows the quantity demanded of chocolate bars (the
relatively certain, such dependent variable) per week. The curve is downward sloping, reflecting the negative
as the law of demand. slope and negative relationship between the two variables. It is also said that price and
Are some types of
knowledge less open quantity demanded have an inverse relationship, because as one rises the other falls.
to interpretation than In the diagram, as price rises from $.50 to $1.00, the quantity demanded falls by
others? five thousand bars per week.

Video suggestion:
You have read about it, now What is ceteris paribus?
you can review what you
have just learned by watching The term ceteris paribus is a Latin term meaning that we are holding all other variables
avideo by the author! constant or frozen, while we examine how different prices change the amount
Simply click here in demanded. Many other things can influence any decision to buy goods. Holding those
your eBook for a video factors constant permits us to isolate one variable (price) and quantify the effect a
on the law of demand change in price has on another variable (the quantity demanded).

218

The following are some of the factors that underlie the law of demand.
+ Theincome effect: A decrease in the price of a good or service that is being consumed
means that consumers experience an increase in real income, usually allowing
them to purchase more of the product. Real income refers to income that is
adjusted for price changes, and implies the actual buying power of a consumer.
As the price of a good decreases, the quantity demanded increases because
consumers now have more real income to spend. With more buying power,
people sometimes choose to buy more of the same product. So, in our example,
as the price of bars falls from $2.00 to $1.50, part of the 5,000-bar increase in
quantity demanded will be accounted for by some chocolate consumers buying
even more chocolate bars, because they can afford to at the lower price. Their real
income has risen, and they choose to buy more bars with that extra buying power.
* Thesubstitution effect: When the price of a product falls, relative to other products,
there is an incentive to purchase more of the product, since the marginal
utility/price ratio has improved. As the price of a good decreases, consumers
switch from other substitute goods because its price is comparatively lower.
A substitute good is a good that is easily switched for another. In our example,
as the price falls from $2.00 to $1.50, some portion of the 5000-bar increase in
demand is from buyers of cookies, another sweet snack food, who see a drop
in the price of chocolate bars and switch, or substitute, chocolate bars for their
beloved cookies. More specifically, at lower prices, each consumer gets more
utility per dollar of spending now that the price is lower.
+ The law of diminishing marginal utility: This law states that as we consume
additional units of something, the satisfaction (utility) we derive for each
additional unit (marginal unit) gets smaller (diminishes). The law of diminishing
marginal utility does not state that extra consumption causes a decline in
total satisfaction. It merely states that, in this instance, a second or third bar of
chocolate will be less satisfying than the first bar. It may still be delicious and
add to one’s total level of benefit, but the rate at which it satisfies has dropped
with each successive bar consumed.

40
Economists use the term ‘util’ for a hypothetical standard unit of satisfaction. If, Is the assumption of
using the example below, satisfaction was measured in units of utility, one might rational consumer
choice realistic?
say for a typical consumer that the first bar is worth 10 utils, but the second bar only
In recent years, a group of
8 utils. Still satisfying, but not as much so as the first bar. The third bar consumed economists and
would provide the consumer with a smaller number of utils, and so on. In an psychologists have
extreme case, it is possible that a consumer eating repeated bars would find that questioned the
some future bar would produce negative satisfaction, making them ill, and actually assumption of rational
consumer choice
decreasing their overall enjoyment of eating chocolate bars. suggested by utiltarian
theory. The school of
This concept helps explain the law of demand because it is logical that a consumer behavioural economics has
would only buy a second or third unit ofa good when the price was lower, reflecting developed in part by
their lower utility for extra units of the good. In our example, as price falls from examining the notion that
$2.00 to $1.50, some portion of the increase of 5000 bars consumed is accounted consumers both (a) have
perfect information at
for by consumers buying more bars at a cheaper price, reflecting their lower utility their disposal to make
per bar. Therefore, because utility is lower for additional units, it is only at lower decisions and (b) make
prices that more will be demanded. choices based on entirely
objective information
Figure 3.2 reduces demand to the individual demand for chocolate bars each month. when they do. This topic
The diagram shows how a graph can reflect the law of diminishing marginal utility, will be covered more
extensively in Chapter 8
and how the relationship mirrors that shown in the demand curve in Figure 3.1.
As an introduction, try
The theory of marginal benefit says that the price we are willing to pay for a good is making two lists
areasonable approximate measure of our satisfaction from the good — that is, our « First, write down items
benefit. If we are willing to buy ten bars at a price of $2, then we are signalling to the you buy or decisions
world that our benefit is at least $2 from the tenth bar. you make that are highly
researched, where you
Because a demand curve reflects what we are willing to pay for a good, it is an think carefully over the
approximate reflection of the marginal benefit (MB), the extra benefit from each choice. Label that list
additional unit, that we receive from consuming additional units ofa good. If our
"tough choices.
+ Next, write down
consumer were to consume an 11th bar, we would have to assume that his or her
purchases or decisions
satisfaction from it would be less than $2-worth, and that the only way he or she that are made quickly
would buy more than ten bars is if the price were lowered to something below $2. without much thinking
Thus, we see the concept of diminishing marginal utility at work in the everyday Label this lst ‘easy calls’
demand curve. + Identify two or three
ways you gathered
information to make
each type of decision
ingness to pay/price per

~
»
chocolate bar (P) ($)
=
o

« Figure3.2 Agaphof
dual demand for
=
n

late bars illustrates s

the decrease in marginal
o
e
@

Demand = MB
(marginal benefit)
5 10 15 20 25
Chocolate bars demanded
per month (Q)

M
 Demand

Video suggestion: Case study

You have read about it, now
you can review what you Among the more direct attempts to apply economic principles to moral thinking
have just learned by watching was that of John Stuart Mill, who in the 19th century formalised a philosophy of
avideo by the author! human interaction rooted in the very economic concept of the pursuit of utility.
Simply click here in
your eBook for a video ‘Working as a philosopher and social theorist, Mill developed a moral viewpoint
on the income and called utilitarianism.
substitution effects.
Mill wrote that a fundamental method of evaluating moral questions was based on
the greatest happiness principle. In other words, the course of action that is most
morally justified is that which creates the greatest happiness for the most people.

john Stuart Mill, 18

‘While the utilitarian philosophy has been eclipsed by many others since Mill’s time,
the pursuit of utility (happiness) has become embedded in modern economic theories
which hold that individuals in a market economy (whether consumers or producers)
will engage in activities that help them achieve the greatest level of utility (profit).
Mill was influenced by thinkers like Jeremy Bentham, an English philosopher and
political radical, and his own father, the Scottish philosopher and economist James
Mill. His moral philosophy was applied controversially. On questions of women’s
rights and slavery, for instance, Mill’s thinking was viewed by many as radically
progressive and even dangerous to the prevailing ideas of the time.
Discussion questions:

1 Utilitarianism holds that the individual pursuit of utility is itself morally good.
How is this similar to and different from the economic view of utility and profit
‘maximisation?
2 Does modern economic theory attach moral values to the behaviours of
individual consumers and producers in a market economy?
3 To what extent does the pursuit of individual happiness contribute to or
interfere with the achievement of social harmony?

42
 <« Fi

Consumer X Consumer Y Total market demand

How is the individual demand of consumers related

to total market demand?
To get the total market demand for a good, we take the sum of all the individual demand
curves for the same good. Therefore, if we started with the demand for Consumer X,
and added it to the demand for an additional consumer, Consumer Y, we would have the
market demand for chocolate bars between those two people (Figure 3.3). If Consumer X
were to buy one bar at $2.50 as shown on Figure 3.3a, and Consumer Y were to buy one
bar at $2.50 as shown on Figure 3.3, then the market demand together may only be
two bars at a price of $2.50. At a price of $2.00, Consumer X would buy two, Consumer Y
would buy four, and the market demand would be six.

This summation continues at every price until the market demand for chocolate bars
is complete (Figure 3.3¢c). The final market demand for the city adds all the individual
demand curves, with the quantities at each price. Note that the demand curve for
Consumer Y is flatter than that for Consumer X. This is because each has a different
elasticity, a concept covered in Chapter 4. However, the slope is still downwards,
reflecting the law of demand.

3.2 What are the non-price determinants

of demand?

Learning outcomes
At the end of this section you will be able to:

« explain the effects of various non-price determinants of demand

« distinguish between movements along the demand curve and shifts of
the demand curve
* draw diagrams to show the difference between movements along
the demand curve and shifts of the demand curve.

43
 Until now, we have held constant (ceteris paribus) all of the other factors that could
influence the demand for goods so that we could exclusively examine the effect of price
changes on the amount of demand. All of those other factors can be referred to as the
non-price determinants of demand: the variables that will cause overall demand for a
good to increase or decrease.
The non-price determinants of demand fall into five main categories:
* income
« tastes and preferences
« future price expectations
« price of related goods (in the case of substitutes and complements)
* number of consumers.

Income
People tend to increase their spending when their income improves. But whether an
increase in income actually increases demand for any particular good depends on
whose income rises, and on their relationship to that good.

Normal goods
These are goods for which demand increases as income rises and falls as income
falls. Examples of normal goods would be cars, cinema tickets and restaurant meals.
This principle is dependent on the income for a particular population. The relatively
poor, given an increase in incomes, may view bicycles as a normal good, while richer
populations would not. The demand for restaurant meals is shown in Figure 3.4.
Notice that the change in the determinant moves the entire demand curve to the right.
Atall prices, consumers want more of the good. In this case, an increase in income
for normal goods shifts the demand curve to the right. This increases the demand for
restaurant meals at every price.

Inferior goods
These are goods for which demand decreases as income rises and increases as income
falls. Inferior goods are generally considered to be a cheaper alternative to higher
quality goods. Examples of inferior goods could be, for middle-income and richer
populations, bicycles and bus tickets. Other typical examples include raw food
&S
Price per meal (P) ($)

Figure3.4 Restaurant
meals are an example ofa
o@

normal good: an increase in

income shifts the entire curve
o

to the right

0 2 4 6
Meals per month (Q)
44
ingredients like baking flour and millet, since richer consumers are more likely to buy
the finished product. Previously used goods like used cars and clothing are also good
examples. In these cases, an increase in income would result in a shift of the demand
curve backwards or to the left.

Taste and preferences T ]

Demand changes with consumer tastes and preferences. Goods become more or less To see real-world examples
of increased demand from
popular because of fashion, current events, and word-of-mouth recommendations changes in tastes, conduct a
between friends or co-workers. news search using the term
‘rise in popularity’
For discussion and debate:
Future price expectations 1 List five found examples
Consumers think and act according to the information they receive about the world. of taste and preferences
Sometimes consumers believe that the price ofa good will change in the near future. increasing demand for a
product.
This can influence their decisions about buying particular goods at that moment.
If consumers believe that the price of a good is likely to climb rather quickly, they will
Generate five of your own

~
examples of products that
be inclined to purchase more immediately. This means that an expectation of higher have, for taste reasons,
future prices will cause consumers to buy more now (an increase in demand now, fallen out of favour.
ashift to the right). An expectation that prices will decline soon is likely to cause
consumers to defer their purchases until the product becomes cheaper (a decrease in
demand now, a shift to the left).

Price of related goods

Goods may be substitutes for each other, complementary to each other, or not related
atall.

Substitute goods L ]
These are goods that one might easily use in place of another. A substitute good For discussion and debate:
(demand) is one for which demand will increase when the price of another good Generate a lst of three pairs
increases. Demand for a substitute good will decrease when the price of its substitute of complementary goods.
decreases. Because they are so similar, an increase in the price of one may lead 1 Look up the prices of each.
consumers to switch consumption to the substitute. Therefore, the price of one good 2 Speculate how high the
and the demand for a substitute have a positive relationship. As the price of one price of one would have
increases, demand for the other increases.
to go to affect the demand
for the other.
There are many examples among branded goods such as fizzy drinks, or fast food How would demand for
outlets. Other examples include margarine and butter, buses and train travel, and
the complementary good
change?
chicken and beef.
| Generate your own list of
three pairs of substitute
Figure 3.5 shows how an increase in the price of fizzy drink C causes an increase in the goods
demand for its substitute, fizzy drink P. The demand curve for the latter moves to the
Look up the prices of each.
right, increasing the amount demanded at every price. Speculate how high the
~

price of one would have

Complementary goods to go to affect the demand
for the other.
These are goods that are typically used in combination with each other. Therefore, they How would demand
are also purchased and consumed together, and the demand for one is decreased by for the substitute good
the price increase of the other. Therefore, an increase in the price ofa complementary change?
good will appear to the consumer as an increase in the price of enjoying the combined
45
 -
»
Jilhg

g s
Figure3.5 Aneampleof a < <
substitute good: an increase in hiauraiaN §c
8g 075+
the price of one drink (a)
&o 5o
results in a rightward shift in
8
demand for another (b) £
< £

260 8%0 300 4‘50

— Thousands of cans per month (Q)
Thousands of cans per month (Q)

experience of both goods. As a result, the demand for complementary good will
decrease. Examples include goods such as phones and phone cases, computers and
printers, cameras, and memory cards.
In Figure 3.6, a decrease in the price of digital cameras, shown as a movement along
the curve (Figure 3.6a), causes an increase in the demand for memory cards (Figure 3.6b).
The demand curve for memory cards shifts forwards, or to the right, reflecting an
increase in the amount of demand for memory cards at every price.

Number of consumers
All businesses hope to market their goods to the widest audience possible. Two
ways that the number of eligible buyers can change are through new markets and
demographic change. New markets opened by political change or trade agreements
will increase potential demand. In the last few decades, many companies have
relocated major operations to China and India partly because they hope to sell their
product in the world’s largest newly opened market. All of these companies are
attempting to increase the number of potential buyers.
-
»
wS
3

z z
£ E
Figure3.6 Aneampleofa
complementary good: a fall in g 3
the price of digital cameras (2) £2504- S 825
results in a rightward shift in s : g
@ & @
demand for memory cards (b) a : °
& i &
& i

Q Q
L

— Cards per month (Q)

Cameras per month (Q)
46
 P P
Po--
o Figure3.7 Price changes
changes i price ise movements along the
cause movements
along the Demand increases
i e demandcurve.. PN\
determinants shift the whole
.causing ! ! ve (b)
inChanges decreases
] ;: !!
quantity |
: : i b, g
demanded |
Aseries of age-based
)T D |
T
|
: T
o, demographic statistics can
Q Q, Q Q Q show how populations may
Q — Q | be growing younger or older,
and so predict the demand
Correspondingly, a decrease in the potential number of buyers shrinks demand. For for certain types of age-
example, if a trade restriction were to prevent the importing of Japanese electronics related goods and services.
into China, demand for Japanese electronics would drop. Demographic change refers Generally, a dependency ratio
measures the combined
to shifts in the type of consumers within a market. Changes in the proportional ages number of younger (school
ofa population can cause major change in demand. As populations age, demand age) people and older
for health services are likely to increase. Ifa population grows younger, demand for people (over 65 years) as a
education-related services will be higher. proportion of working age
people. Higher dependency
ratios suggest more pressure
on public services for both
Shift in demand and movement along groups, and a squeeze on the
a demand curve earnings of the working age
population. For our purposes,
One significant difference between changes in price and changes in the non-price it is possible to separate
determinants of demand is that a change in price will cause only a movement the measure into the youth
along the demand curve. Something other than price must change to shift the dependency ratio and the
entire curve. elderly dependency ratio.
Conduct an internet search
Figure 3.7 shows the distinction between a change in price and a change in the actual toidentify the three countries
non-price determinants of demand. A change in price causes a movement up and with the highest and lowest
down along the demand curve, changing only the quantity demanded. In Figure 3.7a,
values in each category.
as price rises from P to P,, the quantity demanded decreases from Q to Q.. In Figure 3.7b,
For discussion and debate:
changes in the non-price determinants of demand shift demand at all prices to the
1 How do you think the
demand for particular
right or left. An increase in demand, from D to D, increases the amount of demand goods and services is
at Pfrom Q to Q . But it i true that the quantity demanded will be higher at all prices affected by these extremes?
with the new D, demand curve. Conversely, as demand decreases from D to D,, the 2 Using an example product
quantity demanded at all prices decreases. for each, explain your
reasoning.
Using our example, in Figure 3.8a, a change in the market price from $1.50 to
$2.50 causes a movement along the demand curve and a decrease in the quantity Video suggestions:
demanded from 15,000 to 5000. However, when the non-price determinants of You have read about it, now
demand change, there is a shift of the entire demand curve. The quantity demanded you can review what you
will change at each price.
have just learned by watching
some videos by the author!
Simply click here in
In Figure 3.8b, the initial demand is indicated by curve D. If one of the determinants your eBook for videos
of demand were to change and cause an increase in demand, the new demand on the determinants of
curve would be D, a shift outwards or to the right. More is being demanded at demand and changes in
every price. For example, at $1.50, where once only 15,000 were demanded, now demand versus changes in
a quantity of 20,000 are demanded. The same is true at all prices, all because ofa
quantity demanded,
47
 -
»
250 an increase in price 250~
causes a movement an increase in demand
up and left along the causes a shift in the

Price per chocolate bar (P) ($)

Price per chocolate bar (P) ($)

demand curve ... demand curve....

Figure 3.8 1,50 =i saaa e 1.50 ..increasing the

quantity demanded
eral deman at each price
colate ves up (b

1 quantity!
Hemanded b D "Bj
— ' '
——— i
0 5 10 15 20 25 0 510 15 20 25
Chocolate bars demanded Chocolate bars demanded
per week (Q) (thousands) per week (Q) (thousands)
change in the ceteris paribus variables for chocolate bar demand. The same process
works in reverse as well. If demand were to decrease, then there would be smaller
quantities demanded at each price and a shift of the demand curve backwards or
left would occur.

Consider headlines 1 to 7, and for each:

« state whether there is a shift or a movement along the demand curve

« state the kind of shift
+ create a diagram to demonstrate the shift
* identify the determinant that caused the shift.
1. Asummer heatwave affects the market for electric fans.
2. The price of toy airplanes increases.
3. A formerly communist country is now eligible to buy cars from the rest
of the world.
4. Consumers are expecting the price of beef to rise significantly in the
coming weeks.
5. Diamond sellers are worried about the impact of the recession.
6. The price of toothpaste drops unexpectedly.
7. As the population grows older, the market for bicycles is changing.

Practice exam questions

Paper 1, part (a) questions
1. Distinguish between a shift of the demand curve and a
movement along a demand curve. (10 marks)
2. Explain the relationship between individual demand and
the total market demand for a good. (10 marks)
3. Using three determinants of demand, explain why demand
for petrol-powered cars may decrease. (10 marks)

48
Practice exam questions - assessment tips
(Paper 2 data response questions)
Your second assessment paper will provide a set of text and/or data, to which seven
questions are matched, a through g. Practice with Paper 2 questions will make you
familiar with the way the questions are asked.
Part (a) asks for a definition, usually one from the list of terms in the IB Guide.
Part (b) may require a calculation or diagram directly from the text or data.
Parts () through (f) will ask for a diagram and explanation that is related to the text.
Part (g) is typically worth more points and requires a longer answer that includes
the same types of synthesis and evaluation demonstrated in part (b) of Paper 1.
You are given 1 hour, 45 minutes for Paper 2.

Practice exam questions

Paper 2 questions
Below are questions that align with part (a) and (c) question prompts.

High Demand for Bicycles Causes Shortage

The stay-at-home orders imposed by governments battling the pandemic around the world
have provoked a sharp increase in the demand for bicycles, as people seck to enjoy the
outdoors safely.
“We sold four times as many bikes as usual last week,” said Marty Samuelsson, owner of Big
Swede Bikes in Sussex. ‘All of our basic and mid-range models are sold out.” Samuelsson said
that most buyers are workers stuck at home and in front of screens all day. ‘They are anxious
to get out and move.’
“If you want a weekend bike now, you should go online to re-sale or used bike sites. We are
having trouble even finding parts for them.”
The increased demand for bike parts comes as consumers are looking to repair and upgrade
their current bikes. ‘It’s very frustrating,” said Samuelsson, ‘there are sales and repairs we can’t
make because of the shortage.”

1. Define demand.
2. Using a diagram, explain the change in the market for bicycles.

49
 at is price elasticity of demand

Learning COl 3

At the end of this section you will be able to:

* define the concept of PED
* calculate PED using an equation
* explain, using diagrams and PED values, the various degrees of price elasticity.

In Chapter 3 you learned about the fundamental relationships between the price ofa
particular good and the quantities that consumers demand. The law of demand holds
true in almost every market. At higher prices, consumers buy lower quantities, and
at lower prices, consumers buy more. To extend our analysis of demand, it is useful
to introduce an additional component into our analysis of the relationships between
price, demand, and supply.

This concept of elasticity examines the responsiveness of consumers or producers

to a change in a variable in the marketplace. Elasticity measures how much one factor
changes in response to a change in a different factor. While the law of demand tells
us that when the price ofa good increases, the quantity demanded will decrease, the
price elasticity of demand (PED) tells us by how much the quantity demanded ofa
good will decrease when price increases. PED is a measure of the responsiveness of
consumers to a change in price.

In theory, ifa small increase in price leads to a proportionally large decrease in

quantity demanded, consumers are said to be very price sensitive, and demand is
therefore price elastic. In contrast, if a large increase in price has little effect on the
quantity ofa good demanded, consumers are not very price sensitive, and demand is
said to be price inelastic.

How is PED measured?

To measure the sensitivity of consumers to changes in price, we must compare the
change in quantity demanded ofa particular good with the particular price change
of the good that led to the change in demand. To accommodate the different levels of
output and price, we measure changes in percentages, not raw values. The formula for
determining the PED coefficient is:

pED _ Percentage change in quantity demanded

percentage change in price

or PED _ %AQ,
%AP

where %AQ,, is the percentage change in quantity demanded (A, delta, signifies
change), and %AP is the percentage change in price. Thus, to calculate PED we divide
the percentage change in quantity demanded ofa good resulting from a particular
percentage change in price by that percentage change in price.

51
 Elasticities of demand

Worked example 4.1

If the price of rice rises by 15% and the quantity demanded decreases by 10%, the
PED for rice is:

PED Percentage change in quantity demanded

percentage change in price

=—— =066
15
If the price of a smartwatch falls by 20% and the quantity demanded increases by
40%, the PED is:

PED o Prcentage change in quantity demanded

percentage change in price

Note that in each case the final PED is expressed as a negative integer. Why? Because the
law of demand says that Pand Q, always have an inverse relationship, the value of PED
will always be negative. What is important is the size of the number, denoting the strength
of the response, so economists generally show PED as an absolute value for simplicity, i.e.
we omit the minus sign. (Absolute value is the size of a real number regardless of its sign.)
However, we may not know the percentage changes in quantity and price, and would
therefore be required to calculate them. The formula for calculating PED between two
prices when percentage changes are not known is:

PED Q)0
(B, =P)=P;

where Q,, is the quantity demanded following the price change, Q,,, is the original
quantity demanded, P, is the new price, and P, is the original price. Using this formula,
we can determine the PED between two prices knowing only the values of quantity
demanded and price.

Worked example 4.2

Let us assume that a telecommunications firm offers a typical monthly mobile
data package for RM80 (RM is the symbol for the Malaysian ringgit, the currency
of Malaysia) and sells 100,000 contracts per month. After increasing the price
to RM100, the quantity demanded falls to 80,000 contracts. Assuming no other
variables changed, how responsive are consumers to the change in price of the
product? To determine the PED for the contracts, we can apply the price and
quantity information to the equation above.

52
 percentage change in quantity demanded
[BEDE=
percentage change in price

R OoR Lo
(19, =12 =12,

Percentage change in quantity demanded, the top part of the equation, is:

Q= Qo) + Q
= (80,000 — 100,000) + 100,000
=-02
Next, we multiply the result by 100 to get the value expressed as a percentage.

0.2 X 100 = 20%

Percentage change in price, the bottom part of the equation, is:

(,—P)+P,
= (100 — 80) + 80
=025
Next, we multiply the result by 100 to get the value expressed as a percentage:

0.25 X 100 = 25%

So, for the mobile data contracts:

percentage change in quantity demanded 20 0

percentage change in price T

The PED for these contracts as the price increased from RM80 to RM100 per month
is 0.8. A price increase of 25% led to a decrease in quantity demanded of only 20%.
This suggests that consumers did not reduce their quantity demanded quite as
much as the price rose, suggesting inelastic demand.

What is the theoretical range of elasticity values?

The possible PED values can range from, in theory, 0 to infinity. In reality, most
PED values will fall between those two extremes. Depending on the degree to which
quantity demanded changes when price changes, demand can be price elastic, price
inelastic, or unitary elastic. For simplicity, we will here examine the absolute value of
the PED coefficient, which enables us to analyse positive numbers when comparing
the elasticities of different goods.

PED = 0 — perfectly inelastic demand

For the elasticity value to equal 0, any change in price is met with no change in
quantity demanded. The price of the good could rise ever higher, with consumers
53
 Figure4.1 The curve for >
perfectly inelastic demand is
vertical

Q Q

buying exactly the same amount. The existence of goods for which demand is perfectly
inelastic is highly unlikely, but theoretically possible. To grasp how this might appear
on a demand curve, see Figure 4.1.

In Figure 4.1, the product price rises from P, to P, and the quantity demanded remains
at Q. Thus, perfectly inelastic demand is shown as a vertical demand curve. In terms of
the PED equation, the price rise from P, to P, could be any amount, but the percentage
change in quantity would remain zero. To divide zero by any number results in zero,
the PED value for perfectly inelastic demand is zero. Consumers in this case are
completely unresponsive to price changes.

PED = infinity— perfectly elastic demand

For the elasticity of demand to equal infinity, any price increase at all causes the
demand to disappear completely. The implication of a PED coefficient of infinity is
that any change in price leads to an infinite change in quantity demanded. If the price
of such a product increases even by 1% the quantity demanded falls to zero. Figure 4.2
shows an example of this theoretical scenario.

P($)

Figure4.2 The curve for >

perfectly elastic demand ic
horizontal

54
The demand curve is a straight line, suggesting infinite demand at the price of P,. Any
increase in price above P, however, and none of the product will be bought. Quantity
demanded falls to zero, an infinite decrease in quantity. Recalling the PED equation,
the quantity demanded change will always be infinity. Anything divided into infinity is
equal to infinity. Therefore, the PED value of perfectly elastic demand is infinity, and it
is shown as a straight line. Most goods, as stated before, have values between zero and
infinity. In real life, most goods will be considered relatively inelastic, relatively elastic, or
perhaps occasionally unitary elastic.

PED < 1 — relatively inelastic demand

PED values that fall between 0 and 1 are considered price inelastic because the
responsiveness of consumers to price changes is less than proportionate to the price
change. Recall the data contract in Worked example 4.1 on page 52, prices rose by 25%,
but the quantity of contracts sold dropped by only 20%. The PED was equal to only
0.8 (PED < 1). A proportionate response would have been for contracts sold to fall by
exactly 25% (PED = 1).

Worked example 4.3

When the corner shop’s price for cigarettes, a notoriously addictive substance,
decreased from Bs21 (Bs is the symbol for the Boliviano, the currency of Bolivia)
to Bs14, the quantity demanded rose from 530 to 560 packs per week.

9% change in quantity demanded = (560 — 530)/530 = 0.056

Next, we multiply the result by 100 to get the value expressed as a percentage:

0.056 X 100 = 5.6%

9% chang
in price
e = (” ’21) =-033
21
Next, we multiply the result by 100 to get the value expressed as a percentage:

0.33 X 100 = 33%

PED for corner shop cigarettes = 0.17

The PED of 0.17 is far below 1, suggesting that consumers barely responded at all to
the price decrease. Thus, demand for cigarettes is relatively inelastic, as consumers
only slightly increased their consumption of the good relative to the price decrease.
This change can be seen in Figure 4.3. Notice the demand curve is steeply sloped,
but not perfectly vertical like perfectly inelastic demand. The price decreases
significantly, the quantity demanded increases very little.

Another way to test the elasticity of demand when a price change occurs is to
observe the changes to the total sales value also called the total revenue. As price
decreases, the total revenue of the firm could increase, decrease, or stay the same.

55
 Elasticities of demand

Figure4.3 Demand for

cigarettes is relatively inelast

For price inelastic goods, as price falls total revenues fall. And as price rises, total
revenue rises.

Total revenue can be calculated as price (P) X quantity demanded (Q). And it can be
shown in the diagrams as boxes measured by the height (P) X length (Q). In Figure 4.3,
notice that at a price of Bs42, the areas of total revenue is equal to the combined
areas of boxes a + b. As the price drops to Bs28, the total revenue area is equal to
the smaller combined boxes of b + ¢. By lowering the price, the corner shop has
lowered its cigarette revenues because consumers were relatively unresponsive to
the change.

PED > 1 — relatively elastic demand

PED values that are greater than 1 are considered price elastic because the
responsiveness of consumers to price changes is greater than proportionate to the
price change.
Recall the data contract (Worked example 4.2). Prices rose by 25%, so for
consumers to be price elastic, consumers that are more responsive would have to
reduce purchases by some percent greater than 25% (PED > 1), say 50%, and thus
PED = 50% <+ 25% = 2. Consumers, in that case, responded to the price increase by
reducing purchases at two times the rate of the increase, a very responsive reaction.

Worked example
Assume that the price of movie tickets for a particular movie decreased from $9
to $6, and the quantity sold rose from 250 to 1000 tickets per day. Using the PED
formula:

9% change in quantity demanded =

1000-250
250

56
Next, we multiply the result by 100 to get the value expressed as a percentage:

3 X 100 = 300%

9% change in price = 6’%9 =-033

Next, we multiply the result by 100 to get the value expressed as a percentage:

0.33 X 100 = 33%

300
PED for movie tickets = —— = 9,09
33

The PED of 9.09 is far above 1, suggesting that consumers were significantly
more responsive to the price decrease. Thus, demand for movie tickets is
relatively elastic, as consumers increased their consumption by many times the
decrease in prices.

This change can be seen in Figure 4.4. Notice the demand curve is relatively, but
not perfectly, flat and has a shallow slope. The price decrease causes an apparently
significantly larger increase in quantity demanded.
For price elastic goods, as price falls total revenues rise and as price rises, total
revenue falls.

In Figure 4.4, notice that at a price of $9, the areas of total revenue is equal to the
combined areas of boxes a + b. As the price drops to $6, the total revenue area is
equal to the much larger area of the combined boxes of b + c. By lowering the price,
the movie theatre has massively raised its ticket revenues because consumers were
extremely responsive to the change in price.

P($)

15

10 « Figured.a Theshalon
slope of the demand curve for
cinema tickets ir
relatively elastic dema

12 3 4 5 6 7 & 9 0 Q
(hundreds)

57
PED = 1 — unitary elastic demand
Ifa particular percentage change in price results in an identical percentage change in
quantity demanded, then demand is said to be unitary elastic. If the price of a good
rises by a certain percentage, the quantity demanded falls by the same percentage.
From the data contract example, the rise in contract prices of 25% would be matched
by a decrease in quantity demanded by exactly 25%.
In terms of total revenue, when the PED is unitary elastic, a rise in price will be offset
by the decrease in demand, and there will be no change in total revenue. The same is
true for any price decrease: total revenue will not change.

Table 4.1 provides a summary of the relationship between changes in price,

changes in firms’ total revenues, and the PED value

Price Total revenue | PED value Closer look

Price TR Inelastic 9% change in Q, < % change
0> PED <1 inb
Price | R Elastic 9% change in Q, > % change
1< PED— inb
Price | TRT Elastic % change in Q,, > % change
1< PED—> i"P
Price | TR Inelastic % change in Q,, < % change

0> PED <1 b

Price | TRT Unitary elastic % change in Q,, = % change

PED = 1 ik
Price | TR Unitary elastic 9% change in Q, = % change
PED = 1 inb
 4.2 What are the determinants of PED el T
you can review what you
have just learned by watching
a few videos by the author!
Learning outcomes
Simply click here in your
At the end of this section you will be able to: eBook for videos on PED:
PED formula and
« analyse the determinants of PED: interpretation - part 1
* number PED formula and
closeness of substitutes interpretation - part2
« degree of necessity The total revenue test
§ Of PED - part 1
* time
The total revenue test
+ proportion of income spent on the good. of PED - part 2

When determining whether demand for a good is likely to be relatively elastic or

relatively inelastic, perfectly elastic or perfectly inelastic, or unitary elastic, we must
consider the various factors that influence how responsive consumers are likely to be
to price changes. The degree to which consumers respond to price changes depends on
several factors, which can be summarised using the following acronym: PANTS.
P = Proportion of income
A = Addictiveness
N = Necessity or luxury
T = Time
S = Substitutes, number of

Proportion of income
The proportion of the consumer’s income that the price ofa good represents is
adeterminant of PED. Demand for goods that make up a large proportion ofa
consumer’s income tends to be more elastic since a particular percentage change in
price will appear much larger to a consumer than the same percentage change in price
ofa good that makes up a very small proportion of income.

Take two examples: household refrigerators and toothpicks. A 50% drop in the price
ofa refrigerator may mean a saving of up to €500 or more to a family of four who is
considering replacing theirs. The saving of €500 is a significant amount of money and
will surely be noticeable and therefore have a considerable impact on the number of
families considering a new refrigerator.
On the other hand, a 50% fall in the price of toothpicks may represent only a few cents
savings on a box ofa thousand toothpicks. Toothpicks are already so cheap and make
up such a minute proportion of the typical consumer’s budget that a fall in their price
will have little or no effect on the overall quantity demanded.

Addictiveness
Whether a good is addictive or not affects the PED. Addictive goods such as alcohol,
tobacco, drugs, and fatty or salty foods, tend to have relatively inelastic demand. The
reason is obvious: consumers with a physical dependence on a good will be unwilling
or unable to respond greatly to price increases. This helps explain why certain illicit
59
 Elasticities of demand

drugs sell for extremely high prices on the streets of many cities; once a user is
addicted, he or she is willing to pay almost anything for a drug like heroin or cocaine.
If tobacco were not addictive, the chances are that far more people would quit smoking
in response to the high taxes levied on cigarettes by most governments.

Necessity or luxury
The degree of necessity affects its PED. Goods that are necessary to consumers
will have less elastic demand than the luxuries we can do without if the price rises.
Consumers will likely be less responsive to a 20% increase in the price of natural gas
than they will to a 20% increase in the price of Italian leather handbags. We depend on
natural gas to heat our homes and to cook our meals, yet we do not need fine leather
handbags, therefore can afford to do without them when their prices rise.

Time
The amount of time consumers have to respond to a price change determines the PED.
Immediately following a change in price, it is unlikely consumers will adjust their
consumption by much. With a sudden price increase, it is difficult to identify suitable
substitutes for a good that has increased in price in the short run, but in the long run
new options can be identified and consumers can further reduce their consumption
of the more expensive good. If the price ofa particular good falls, it will take time for
consumers to notice the price change, but once they do it is likely that in the long run
market demand will be more responsive to changes in price.
Video suggestion:
You have read about it, now For example, were there a massive increase in petrol prices, say 100%, the drop in car
you can review what you use would be low at first. Consumers cannot switch to alternatives quickly. But over
have just learned by watching
avideo by the author! time consumers would find ways to drive less or drive alternative-fuel vehicles.
Simply click here in
your eBook for a video
on the determinants of PED. Substitutes
The number of substitutes a good has is one of the primary determinants of how elastic
demand will be. Consumers will be more responsive to changes in the price ofa good

60
with a large number of substitutes than for a good with very few or no substitutes. For o
most coffee consumers, the drink is a good with almost no perfect substitutes. Coffee on particular goods for
consumers are therefore relatively unresponsive to changes in the price of coffee. their very survival, eg
people with diabetes
Products like patented life-saving medicines are another example ofa good that is need insulin to live. If one
were to learn that insulin
highly inelastic because of its few substitutes. Insulin is a popular example, because
providers were raising
people with type 2 diabetes require insulin to survive. Naturally, demand among people their prices ever higher on
with diabetes is very unresponsive to price changes. This type of market can be subject diabetic patients, would
to market failure, as discussed in Chapter 10, when companies manage to preserve their you be obliged to act?
market power over drugs like insulin and raise prices to vulnerable consumers. Thisisesaquestion
around the ethics of
knowledge: How can we
know when we should act
4.3 Why does PED matter to businesses and on what
ve know?
governments?

Learning outcomes

At the end of this section you will be able to:

« discuss the role of PED for firms regarding price changes and their effect on total
revenue
* examine the significance of PED for government in relation to indirect taxes
. explain why PED changes along a straight-line demand curve and is not
represented by the slope of the demand curve
. draw a diagram showing the changes in PED along a straight-line
demand curve
. explain why the PED for many primary commodities is relatively low and
the PED for manufactured products is relatively high.

How might businesses make decisions

based on PED?
The degree to which consumers respond to changes in the price of a firm'’s products
has major implications on a firm when it is considering raising or lowering its prices.
Producers of some goods must be aware of the effect that changes in the prices of other
goods will have on market demand for their products. A perfect example is the decision
by manufacturers, such as Toyota and Honda, to expand their production of hybrid
automobiles in the last decade as petrol prices have risen steadily around the world.

How might governments make decisions

based on PED?
Governments must consider elasticities when deciding which goods to place taxes on
and whether or not to raise or lower income tax. Levying taxes on goods for which
consumers are highly sensitive to price changes will create little tax revenue yet lead to
alarge decrease in the quantity sold in such markets.

Raising or lowering income tax with the goal of stimulating or reducing overall
household spending on goods and services may be futile if consumers’ demand is
unresponsive to changes in disposable incomes.
61
 Elasticities of demand

Until now, products have been categorised as broadly elastic or inelastic. In reality,
elasticity values will change over the course ofa particular product’s demand curve.
It is more correct to state that a found elasticity value is true over a specific range
of prices than for the product generally. However, it can be said that in general,
products tend to be elastic at higher price ranges, inelastic in the lower price ranges
and unitary elastic somewhere in the middle. In fact, the elasticity value should start
high, at the top left of the curve, and steadily decline as one moves along the curve.
Figure 4.5 shows that the PED for a particular good is not constant across all prices.
The higher the price ofa good, the more responsive consumers are to a change in
price; the lower the price, the less sensitive consumers are to price changes.

The demand curve shows the quantity demanded for this good at a series of prices
between ¥10 and ¥0 (¥ is the symbol for the yuan, the currency of China). At the high
price of ¥10, the total market demand is 0 units, so the total revenues for producers
is ¥10 X 0 = ¥0. But ten units can be sold for ¥8 each, generating a total revenue of ¥80.
Figure 4.5(b) plots the total revenue in the industry at each price and quantity
combination. At a price of ¥6, 20 units are sold for a total revenue of ¥120. It can be
assumed that at a price somewhere between ¥6 and ¥4, and a quantity between 20
and 30 units, the revenues earned by producers will be maximised.

‘We can use the total revenue test described above to help understand the change in
elasticity. Generally speaking, at higher prices, demand tends to be relatively elastic
for most goods. But as the price falls and the quantity demanded increases, the
percentage changes in price become larger and the percentage changes in quantity
become smaller, causing the PED to decrease at lower prices and higher quantities.
The observation that a product’s PED is high for high prices and low for low prices
tends to hold true because of the following.

a
10

ad
® 64
=
S
|
0
0

bz
% 120
o
o 80
2Sl
g
E 0
L 0 10 20 30 40 50
Quantity (Q)
62
 + Athigher prices, consumers tend to feel a higher proportion of their income
Research and inquiry
being affected by the same percentage change in price. To what degree do fims
actually use knowledge of
* Mathematically, at the upper left range of the demand curve the PED values elasticity to inform pricing
reflect higher incremental percentage price changes and lower incremental decisions? One problem for
percentage quantity changes. companies is acquiring the
* Similarly, in the lower right range of the demand curve, prices are changing at knowledge of when increases
in demand will occur. It is at
higher incremental percentages, while quantity demanded is changing at lower these times that customers
incremental percentage levels. may signal their inelastic
To confirm the concept, we can calculate the PED coefficient between two sets of demand, and thus pay a
prices.
higher price. The concept of
surge pricing has become
popular with the use of
tide-sharing apps, as well as
Worked example 4.5 in professional sports, and
public transportation.
Using the example in Figure 4.5, the price first falls from ¥8 to ¥6, and then from ¥4 Conduct an internet search for
to ¥2. If the total revenue test holds true, we should find that PED is greater than one ‘surge’ or ‘dynamic’ pricing to
at the high prices and less than one at the low prices. leam more about how it works.
For discussion and debate:
Between ¥8 and ¥6, the PED coefficient is 4, so demand is elastic, supporting our 1 To what degree can surge
observation that an increase in total revenue following a decrease in price proves pricing be explained by
that consumers are relatively responsive to the lower price. elasticity or changes to
demand determinants?
Between ¥4 and ¥2 the percentage decrease in price is larger than it was between
¥8 and ¥6, since the starting price is now lower. Additionally, although quantity L ]
demanded increases by the same number of units as it did after the earlier ¥2 price Many developing countries
drop, the percentage increase in QD is smaller since the starting quantity is now suffer from what s called
larger. commodity dependence, the
state of relying heavily on one
‘When price falls from ¥4 to ¥2, the total revenue in the industry declines from ¥120 or two primary commodities as
to ¥80. This is evidence that consumers are no longer very responsive to lower asource of national income.
This causes problems because
prices, and that the percentage increase in quantity demanded must be smaller than the global market prices of
the percentage decrease in price. commodities tends to fluctuate
significantly.In good years, this
The PED coefficient of the above example at the higher price range is 4, but at the means that high prices, along
lower price range is only 0.66, proving that a fall in price resulting in a decrease with inelastic demand, can lead
in total revenue is evidence of the inelasticity of demand between two points on o higher export revenues. In
bad or low price years, export
ademand curve. At lower prices, consumers are no longer as responsive to price revenues fall and the country
decreases as they were at higher prices. If the industry or firm were to decrease suffers from steep drops in
output and raise its price from ¥2 to ¥4, firms would experience an increase in total revenue. Wide fluctuations
revenue because the inelastic nature of demand at low prices means that consumers cause instability and make
are relatively unresponsive to the higher price, thus despite the lower quantity sold,
future planning difficult
For discussion and debate:
the industry’s revenues would rise.
1 Using the United Nations
Commission on Trade
and Development as a
Why is the PED for primary commodities lower resource, conduct an

than the PED for manufactured products? internet search for articles
with the search terms:
Primary commodities are typically Earth-based products that come from the ‘UNCTAD commodity
categories of mining, forestry, and agricultural goods. Iron, timber, cocoa, and tea are dependence’
all examples of primary commodities. Demand for these goods tends to be inelastic Activity: Select, read, and
because there are few close substitutes, and therefore firms and consumers have little summarise the article to share
choice but to pay the market price.
with your classmates.
63
 Elasticities of demand

Industries that use iron to produce steel and other metals have a difficult time replacing
iron, and are therefore not responsive to higher iron prices. Makers of chocolate, of
which cocoa is the essential ingredient, are price inelastic when it comes to cocoa prices.

In contrast, manufactured goods usually have many more substitutes, and are
therefore more price elastic by comparison. Consumer electronics are produced
by hundreds of different makers, with just as many brand marks. If the price of one
maker’s electric toothbrush rises, for example, there are many more available at a more
affordable price. In turn, producers are aware of the different price sensitivities among
consumers, and will offer a range of slightly differentiated products, with more or
fewer features, and prices to match consumers’ willingness to spend.

Answer the questions using the product information in the table below.

Product New price | Old price | New quantity | Old quantity

$ 5 demanded demanded
1. Paper clips, per 2.00 1.00 400 380
box
2. Petrol, per litre 1.00 1.30 5000 4500
3. Brand X bottled 5.00 4.00 120,000 240,000
water
4. Fancy watch 3000 3300 600 900
5. Electricity, per 0.40 0.30 100 110
kilowatt hour

a. Calculate the PED value.

b. State whether the good is price elastic, inelastic, or unit elastic.

c. Calculate the change in total revenue.

d. Does the change in total revenue confirm your finding for the PED value? Explain.
e. Identify the most likely determinant of price elasticity of demand.

What is income elasticity of deman

Learning outcomes
At the end of this section you will be able to:

¢ define YED
* explain how the different signs (+/-) reflect different types of income elasticity
* using diagrams, show income elastic, income inelastic, and inferior goods
* calculate changes in YED from provided data
. explain the importance of YED for firms, and for explaining sectoral
changes in the economy.

64
Income elasticity of demand (YED) measures the responsiveness of consumers’
demand for a particular good to a change in income. As a determinant of demand
introduced in Chapter 3, changes in income have different effects on the demand for
different goods depending on the nature of the good in question, on whether the good
is a ‘normal’ or an ‘inferior’ good.
If a good is a normal good, then rising income leads to greater demand. Normal goods
tend to be service-related or more expensive versions of everyday goods. Examples
of normal goods include restaurant meals, taxi rides, clothes, air travel, streaming
packages, or anything else consumers tend to buy more of as their incomes rise.
If arise in income leads to a decrease in consumption of a particular good, that good
is said to be inferior. Inferior goods tend to be necessities, and may include items such
as fast food, generic brand groceries, public transport, second-hand clothes or any
other product consumers tend to consume less of as incomes rise. Because consumers’
demand for certain goods responds differently to changes in income, the YED
coefficient can be either negative or positive.
YED is found by dividing the percentage change in quantity demanded for a good by
the percentage change in the consumer’s income.

_ %AQ,
YED
%AY

%AQ,, is the percentage change in quantity demanded, and %AY is the percentage change
in income. If the percentage changes in quantity and price are not known but the values
are known, then the simple YED formula can be used to determine the coefficient:

YED = Qp, = Q) * Qy
(%, 2 —)=, 1
where Q,, is the quantity demanded following the income change, Q,, is the original
quantity demanded, Y, is the new income, and Y, is the original income.
If there is a direct relationship between income and demand, then the YED
coefficient will be positive, indicating that the good in question is a normal good.
If, on the other hand, the relationship between income and demand is indirect, in
which case a rise in income would lead to a smaller quantity and a fall in income to
an increase in the quantity, then the YED coefficient will be negative, indicating the
good in question is inferior.
YED is + — normal good
YED is —— inferior good
YED can be applied to measure the change in an individual's consumption of particular
goods following a change in the individual’s income, or it can be applied to analyse the
effects of changes in national income on the demand for particular goods and services
in a nation as a whole.
For instance, it is fairly typical for recessions (a general decrease in income when
the country’s gross domestic product (GDP) shrinks) that the demand for expensive

65
 Elasticities of demand

TP durable goods and discretionary leisure tends to fall. Automobiles and expensive
The coronavirus pandemic vacation travel decrease. A recession would likely cause inferior good demand to rise,
of 2020 caused significant including that of fast food, discounted home goods, and camping supplies.
recession globally, as
planetary GDP dropped, as
italso did in nearly every Interpreting the YED coefficient
country. As with the other types of elasticity covered in this chapter, YED can be elastic,
What were some goods that
rose in demand during this inelastic, or unitary elastic. The value of YED gives us information about the extent
time, and what were some to which the good is responsive to changes in income.
that fell? Conduct an internet
search to identify several If YED is less than 0, or negative, the goods are considered inferior goods.
examples of each.
For discussion and debate:
YED for public transport =
—3% _ —0.6
Were these goods 5%
demand changes due
to the recession or the For example, ifa 5% rise in income leads to a 3% fall in the demand for public
pandemic?
transport, the YED for public transport is —3 <+ 5 or —0.6. The negative sign
Separate your items into
indicates that public transportation is an inferior good, and the fact that the
~

three groups: recession-

related’ ‘pandemic- absolute value of the YED coefficient is less than one is evidence that demand is
related’, and 'both’ income inelastic. Public transport consumers are negatively responsive to changes
in their income.

As stated above, positive YED values are considered normal goods. Within that
category, products can be divided into necessities and luxuries.

If YED is between 0 and 1, demand is said to be income inelastic. These goods

are assumed to be necessities. For example, ifa 50% rise in income leads to only
a10% increase in the demand for noodles (pick your favourite), then the good is
considered a necessity.

10%
YED for dried noodles = —— = 0.2
50%

Consumers do buy more as their incomes rise, but not by the same rate as the rate
of increase in income.

If YED is greater than 1, demand is said to be income elastic, and these goods are
broadly considered luxury goods. As an example, as incomes rise, consumers may
quickly switch from an inferior good like cheap athletic shoes to more expensive
shoes.

Ifa good is highly and positively income elastic, then a particular percentage
change in income will lead to a larger percentage change in the quantity
Video suggestions: demanded for the good. For example, if a rise in consumer income of 5% results
You have read about it, now in a 12% increase in the quantity demanded of hybrid cars, the YED for hybrid cars
you can review what you
have just learned by watching is12+5=24.
some videos by the author!
Simply click here in 12%
your eBook for videos YED for hybrid cars = =24
5% %
on YED and applications of
demand elasticities. Demand for hybrids is said to be income elastic, and a luxury good.

66
 Quantity demanded of Good X

<« Figure4.6 Demand (D) for

necessity goods grows at a
slower rate than disposable
income

Income

What is an Engel curve?

The Engel curve is named after the German statistician Ernst Engel, who was among
the first to examine the relationship between income and demand for particular goods
and services. The change in disposable income is shown on the horizontal axis, while
the volume of demand for Good X is shown on the vertical axis.
Figure 4.6 shows an essential or necessity good. Were the rate of consumption equal to
the rate of increased income, the line would follow the 45-degree line. For this necessity
good, observe how consumption grows slower than the rise in disposable income.
Figure 4.7 shows a superior or luxury good. Its consumption grows faster than the rise
in disposable income. Note the positive relationship between the two variables, but the
diminishing rate of increased consumption.
Figure 4.8 shows an inferior good. Consumption decreases as disposable income rises.
Note the negative correlation between the two variables, with consumption falling as
income rises.
Quantity demanded of Good X

Figure4.7 Demand for

luxury goods rises faster than
disposable income

0 Income
67
 Quantity demanded of Good X
Figure 4.8 Demand for
inferior goods decreases as
income rises, as consumers
switch to more expensive
alternatives

0 Income

Income elasticity can help inform the decision making of firms, who are trying
to maximise profits, and governments, who are trying to improve the overall
economic well-being.

Income elasticity and firms

Understanding YED allows businesses and governments to analyse the effects of
changing incomes among consumers and taxpayers on the level of demand for
particular goods in an economy. A firm that must decide on production numbers
for its product may wish to determine whether the incomes of its consumers are
likely to rise or fall in the future.
If a firm produces a good that is considered inferior, then a recession could be
good for business and it will increase its output in order to meet the rising demand
among consumers whose incomes are harmed by the recession. Producers of
normal goods, on the other hand, may scale back production as incomes decline.
Understanding the responsiveness of consumers of their products to changes in
income better enables firms to produce at a more efficient level of output over time.

Income elasticity sectoral change in the economy

Governments, in steering their economy towards prosperity, must face the basic
economic question of ‘what’ to produce. Governments try to forecast which goods
will rise in demand, and then shift production away from lower demand goods.
Income elasticity provides a clue to greater demand because global income is generally
expected to rise year by year. Assuming that incomes rise, demand for superior and
luxury goods are likely to grow in demand much faster than necessity goods.
The theory of sectoral change in economies identifies three sectors to any economy.
+ Primary sector: ‘gifts of the Earth’, such as agriculture, mining, fishing, and
forestry products, are considered primary commodities.
+ Secondary sector: manufactured goods take the raw materials of the primary
sector and turn them into finished goods. These products range from simply
produced tools, furniture, clothing, and consumer goods, to sophisticated
machinery and technology.
68
« Tertiary sector: this consists of services offered to the public, including
healthcare, food service, financial services, bureaucratic, educational, and
computing services.

Income elasticity helps explain why most countries seek to diversify their
production away from exclusively primary production and into manufacturing and
services. Generally primary production tends to be more income elastic overall,
being mostly necessity goods. As incomes rise globally, demand will instead
increase for manufactured goods, which tend to be more income elastic, superior
goods, and luxury goods. Services, too, tend to be highly income elastic.
To take advantage of this understanding, countries seck to leave farming and
mining behind, and to industrialise in order to capture the expected profits from
rising global demand in manufactured goods and services. This follows the model
set initially by the UK in the Industrial Revolution of the 1800s, and followed by
most rich nations since then.

Knowing this is more complicated than enacting it. In today’s global trading
environment, a country keen to diversify its output (say, start producing steel),
will face highly developed competition from all over the world. Even with some
allowances from the World Trade Organization (WTO) to protect newly formed
industries, these industries face challenging odds.

Case study - India’s structural nsformatio What practical problems

does economic theory
The trend in countries away from primary production towards secondary and attempt to solve? Discuss,
tertiary production is evident in the case of India. This chart measures the value using examples from the
added to GDP by sector over the last several decades. In 1969, India’s primary sector concepts in this chapter.
added the most value to GDP. Thirty years later, it is the smallest contributor and is
still declining. Manufacturing rose slightly but stopped increasing, while services
have steadily increased. Those in charge of India’s economy now should question
whether further sectoral change is possible, with over 15% of the economy still
devoted to agriculture. Should India seek to increase manufacturing again? Should
it aim to shift away from agriculture? Knowing what you do about income elasticity,
what information would you use to make this decision?

60
/Services
gu 2 ;
g£ —/>¢§h Industry
& ———— Agriculture
0
1969 1981 1989 1999 2019
Year
~ Agriculture forestry and fishing value added (% of GDP)
~ Industry (including construcion) value added (% of GDP)
= Services value added (% of GDP)

69
Elasticities of demand

Practice exam questions

Paper 1, part (a)
1. Using three determinants of price elasticity of demand, provide
real-world examples and explain how they demonstrate a high
or low level of elasticity. (10 marks)
2. Using the expected values of price elasticity of demand, explain
the concepts of perfectly elastic and perfectly inelastic PED. (10 marks)
3. Using the expected values of PED, explain the concepts of
relatively elastic, relatively inelastic, and unitary elastic PED. (10 marks)
4. Explain how businesses might use price elasticity of demand
to know how to raise or lower total revenue. (10 marks)
o Explain why PED values may change over the course of
asingle straight-line demand curve. (10 marks)
6. Explain, using expected values, how income elasticity of
demand demonstrates how consumers buy more or less
of a product based on changes to their income. (10 marks)
7. Using diagrams, explain how products may qualify as
income elastic, income inelastic, and inferior goods. (10 marks)
Paper 2, parts (a) and (c) and (g)

Country P Seeks to Enter High-value Industries

For decades, Country P has struggled to raise export revenues from their main agricultural
base of products like sugar, corn, and soy. Barely considered a middle-income country,
Country P’s leaders see the future in more sophisticated processing of their crops, hoping to
capture more of the value, and in manufacturing, where they believe more profits are waiting.
‘The market sets the prices,” said one government minister. ‘If the price of raw sugar is 13 US
cents a pound, we can't charge a higher price. Even though our sugar is better!’ Knowing their
product is price elastic has made sugar producers want to move into sugar processing, where
they can get a higher price.
‘Sugar processing is where the money is,” said a leading industry expert. ‘By manufacturing
sugar into many forms, we capture the profits rather than sending them to the US or Europe.
‘Some government ministers want to move away from agricultural-based products almost
entirely. ‘We need to be making our own clothes, furniture, and technology,” said a member
of the Finance Office. ‘As the world gets richer, we need to sell higher value products, not just
basic goods. We need fewer farmers every year, and those people come to the cities looking for
jobs. We have the labour, but now we need to have industries to hire them.”

1. Define price elastic. (2 marks)

2. Explain why sugar producers in Country P cannot raise
their prices above the world market level. (4 marks)
3. Explain what would happen to Country P's sugar revenues
if they lowered their prices below world prices. (4 marks)
4. |[I® With respect to Country P, discuss the validity of
the following statement: ‘As the world gets richer, we need to
sell higher value products.’ (10 marks)
 Supply

at is supply

Learning outcomes
At the end of this section you will be able to:

* state the law of supply

* explain the positive causal relationship between price and quantity supplied
. explain the assumptions underlying the law of supply:
. the law of diminishing marginal returns
e increasing marginal costs
« describe the relationship between an individual producer’s supply and
market supply
« explain that a supply curve represents the relationship between the price and
the quantity supplied ofa product, ceteris paribus
« drawa supply curve.

Any market transaction requires two parties, buyers and sellers. Demand explores
the buyers’ side of things, while supply takes the perspective of the sellers. Supply is
defined as the quantity ofa good that producers are willing and able to produce at
a given price over a particular time period, ceteris paribus. A supply curve shows us
the relationship between the price of a particular good and how much of that good
producers will send to market at that price.

Figure 5.1 shows the weekly supply of chocolate bars in a major city. On the vertical
axis is price per chocolate bar, and on the horizontal axis is quantity of chocolate bars
supplied.

Again, all other variables are held constant (ceteris paribus) so that we may clearly see
that relationship between price and quantity supplied. As the supply curve shows, this
is a direct relationship: at higher prices sellers wish to provide more chocolate bars to
the market, while at lower prices less chocolate is supplied.

25
Price per chocolate bar (P) ($)

20

15
Figure 5.1 igher prices
leadtoa g er quantity 1.0
supplied

05

5 10 15 20 25
Chocolate bars demanded,
per week (Q) (thousands)
72
Table 5.1 Supply schedule for chocolate bars
Price of Quantity of chocolate bars supplied
chocolate bars (P) per week (Q)
$ (thousands)
0 0
0.50 5
1.00 10
1.50 15
2.00 20
2.50 25

Like demand, the relationship between price and quantity supplied can be shown with
atable or supply schedule, as well as with a supply curve. Table 5.1, a supply schedule
for chocolate, shows that as price increases from $0.50 to $2.50, the quantity supplied
increases as well. The supply schedule in Table 5.1 reflects the same relationship
between price and quantity as the supply curve in Figure 5.1.

What is the law of supply?

The relationship between a good’s price and the quantity producers will be willing
and able to supply to the market s, like the relationship between price and quantity
demanded, so widely established and agreed upon that it has risen to the level of an
economic law. The law of supply states that, ceteris paribus, there is a direct relationship Video suggestion:
between a good’s price and the quantity supplied. As price increases, more ofa good is You have read about it, now
you can review what you
supplied by firms. As price decreases, less is supplied. have just learned by watching
avideo by the author!
The law of supply is reflected in the upward-sloping supply curve, as in Figure 5.1. As Simply click here in
price increases from $0.50 to $2.50, there is a movement upwards along the supply your eBook for a video
curve. Thus, there is a positive relationship between price and quantity supplied. Why do on the law of supply and the
economists hold this relationship to be so true as to be considered an economic law? There determinants of supply
(watch up to 6:10).
are two assumptions underlying the law of supply, the first of which leads to the second.

The first assumption that explains the law of supply is that as more resources
are allocated towards a good's production in the short run, the productivity of
additional resources decreases. In other words, the output attributable to additional
units of a variable resource added to fixed resources decreases the more of the
variable resource is employed.
Okay, that was a mouthful. Let us break that down with an example. Assume a
bakery makes only croissants, and in order to do so it requires four resources:
bakers (labour)
raw materials (ingredients)
ovens (capital)
W

aspace to work (land).

73
 Supply

The short run is defined as the fixed capital and land period. In the short run our
bakery owner cannot acquire more ovens or space to work, but she can employ
more or less labour and use more or less raw materials. In our example the labour
and ingredients are the variable resources and the ovens and bakery space are the
fixed resources.

Now, let us go through a scenario in which our bakery owner wishes to change
her level of output in the short run. She can increase or decrease the number of
croissants she bakes daily by employing more or less labour and raw materials.
Let us assume she has only two ovens in her workspace. Table 5.2 shows a
possible production schedule for our bakery, given its fixed amount of capital and
workspace, but with different numbers of bakers employed.

Table 5.2 Bakery production schedule

Number Number of croissants Number of croissants

of bakers produced each hour attributable to the last worker
employed (total product = TP) hired (marginal product = MP)
0 0 e

1 25 25

2 55 30

3 80 25

4 98 18

5 108 10

6 110 2

7 105 5

Let us put the values from our production schedule into a graph showing the total
product and the marginal product of labour. Figure 5.2 shows the productivity curves
(total product and marginal product) for our bakery.

Figure 5.2 shows us that the rate at which the bakery can increase its output of
croissants in the short run is not constant; rather, it diminishes as output increases.
Sa3 9
Output per hour
(# of croissants)
@3
NG

Marginal
0 1 2 3 4 5 6
Number of workers

74
 The first baker can make 25 croissants, while the addition ofa second worker Do businesses need to
increases output to 55. The second worker’s marginal product, in other words, know and understand the
law of supply?
was 30 croissants. The marginal product of labour is the amount of output
We learn economic laws
attributable to the last worker hired, or the change in total product experienced and are taught that they
when one more worker is employed. are immutable, meaning
they are always true.
What happens to the marginal product of labour in the short run as more workers An increase in a goods
are hired? We can see in Figure 5.2 that beyond the second worker, marginal price willlead to an
product decreases; in other words, as more workers are hired and put to work increase in the quantity
supplied, assuming all
using the bakery’s two ovens, the number of croissants each additional worker is else s held constant,
able to produce decreases. While total product increases, it does so at a decreasing While economists might
rate, and eventually, with the addition of the seventh worker, the bakery’s output abserve this relationship in
of croissants actually decreases. The marginal product of the seventh worker is real-world markets, does
that mean that individual
negative; he or she actually gets in the way of the other six workers and makes the business owners really
bakery less productive than it would have been with fewer workers. need to understand it to
operate?
The law of diminishing marginal returns describes the predictable outcome of An object in motion stays
adding more and more of a variable resource (usually labour) to fixed resources in motion until acted
(land and capital). Because the ratio of capital to labour decreases as more labour upon by an outside force.
is added to a fixed amount of capital, the productivity of labour diminishes in the This is Newtorts fist law
of motion, leamed in
short run as output increases. any physics class. Laws
in economics might be
What does this have to do with the shape of the supply curve, you ask? That brings like laws in the physical
us to our second explanation for the law of supply. science: a ball needs
to know or understand
Newtorss first law just as
much as an individual
business owner needs to
We just defined marginal product as the output attributable to additional units of know or understand the
a variable resource added to fixed resources towards a good’s production. Let us law of supply. Whether
isolate the marginal product curve from our bakery example in its own graph, there is knowledge of the
seen in Figure 5.3. laws or not i irrelevant; a
ball will remain in motion
After the second worker, additional workers become less and less productive due to regardless of its level of
understanding,
just as a
the lack of additional capital (ovens) needed to keep them more productive. Firms market will respond to
must consider the productivity of labour when deciding the optimal amount of price changes regardless of
labour to employ: the baker in the example would be irrational to hire a sixth or the understanding of the
seventh worker, for example, due to the fact that these two workers contribute agents participating in that
market of the underlying
laws that describe its
operation
Do you agree or disagree
with the thoughts above?
W
&
Output per hour
(# of croissants)

Discuss!
S &
NN

« Figure5.3 Amore detaled

o

look
at the bakery's marginal
produ ive
o
w

0 1 a4 8 45 G\
Number of workers -
Marginal
product

75
 Supply

almost nothing (only two croissants per hour for the sixth worker) or actually
decrease overall production (by five croissants each hour for the seventh workerl).

How do firms determine just how many workers to employ, then? What businesses
care about, just like any rational economic agent, is marginal costs and marginal
benefits. Marginal cost is defined as the cost of producing an additional unit of
output, and it is a function of the marginal product of labour.

ploy a fourth baker?

Because the productivity of labour decreases as labour is added to a fixed amount of

capital and land in the short run, the firm needs more and more workers to produce
less and less additional output, meaning that additional output becomes more and
more costly to firms in the short run. Marginal cost (the cost of additional output),
therefore, is inversely related to the marginal product of labour. When additional
workers are more productive than those hired before them (as was the case with the
second worker in our bakery example), the cost of the output attributable to the
worker is lower than that produced by previous workers. However, when additional
workers are less productive (as with Workers 3 through 7 in our bakery), the output
they produce increases in cost to the business owner.

Figure 5.4 shows the short-run marginal cost for a typical producer. Notice that
marginal cost decreases as output increases at first (reflecting the fact that additional
workers are more productive when added to fixed capital at first), but then marginal
cost increases as output increases (as marginal product decreases, increasing the
cost of additional output).
Marginal
Cost

Figure5.4 Incontrastto Py
margin al product, marginal
cost tenc 0 go up as output
ncreases

0 Quantity of output

76
 Marginal cost

Cost
Firm experiences
diminishing marginal
returns « Figure5.5 Marginal cost is
related to the marginal
product of labour
Quantity of output
Firm experiences
increasing marginal
returns

A firm’s marginal cost curve is downward sloping over the range of output during
which the marginal product of labour increases (known as increasing marginal
returns), but marginal cost increases when the marginal product of labour decreases
(known as diminishing marginal returns). Figure 5.5 identifies the ranges of output over
which the firm experiences increasing and diminishing marginal returns of labour.
What are the implications for a producer facing an upward-sloping short-run
marginal cost curve for their willingness to supply more of a good to the market?
‘Well, this brings us back to the law of supply, which describes the direct relationship
between a good’s price and the quantity supplied. The law of diminishing marginal
product results in the cost of additional units of output increasing as a firm
produces more of its product in the short run. For this reason, the only way a firm
is willing and able to bring more of its product to the market is if the product’s price
increases, as described by the law of supply.

Strictly speaking, a supply curve describes the total quantity that all producers
ina market are willing and able to produce at any given price; it is a market supply
curve. There is no such thing as an individual firm’s supply curve. However, a firm’s
‘marginal cost curve basically represents what that firm is willing and able to
produce at any given price. Consider Figure 5.6, which puts price and cost on the
vertical axis and quantity of output on the horizontal axis.
MC = Supply
Price

« Figure5.6 The marginal

cost curve equates to an
individual firm’s supply curve

0 Q. Quantity
of output

7
 Supply

Video suggestion: The price has increased from P, to P,, and with it the firm has increased its output
You have read about it, now
from Q, to 7 Q. The higher
igher pi price allows the firm to cover the higher
g marginal
g cost
you can review what you 1 = .
e ey e of the Q, level of output relative to the lower cost Q, level of output. As such, the
avideo by the author! marginal cost curve is an individual firm’s supply curve: it shows how much output
Simply click here in a firm is willing and able to produce for the market at a given price.
your eBook for a video
on why supply slopes i s % a3its
upwards Relationship between an individual producer’s
supply and market supply
If we were to aggregate all the individual supply curves of the producers in a market,
we would end up with the market supply curve. For example, if our baker from the
example earlier in this chapter were to settle on an output of 50 croissants per hour at
aprice of $2, and there were 20 bakeries of similar size facing similar costs in the same
city, then the city’s market supply would be 1000 croissants at the market price of $2.
Figure 5.7 illustrates such a scenario.

The market supply ofa good is the horizontal sum of the individual firms’ supply curves
in that market. The law of supply dictates that any change in the market price will lead
individual firms to change their level of output based on the cost of producing the
good, thereby causing the market quantity supplied to increase or decrease depending
on how the price changed. Figure 5.8 shows what happens when the price of croissants
decreases from $2 to $1.50.
A decrease in price has caused a movement along the individual bakery’s supply curve
and a movement along the market supply curve. The next question is, what can cause a
shift in market supply, or, in other words, an increase or decrease in supply?
&
Price ($) ®

Price ($)

Supply

Figure5.7 The market P

supply of a good (b) is the
horizontal sum of the X 20 bakeries= 2
individual supply
curves (a)

0 50 Quantity 0 1000 Quantity

of output of output
a b
= =
3 Supply ¥ Supply
& £
Figure 5.8 Amovement P
along an individual firm's % 20 bakeries = 2,00 4-----------
supply curve (a) i reflectedin Tl eesrssance ]
the market (b) - o

0 40 50 Quantity 0 800 1000 Quantity

of output of output
78
 5.2 What are the non-price determinants
of supply?

Learning outcomes
At the end of this section you will be able to:

« analyse the non-price determinants of supply:

changes in costs of factors of production
prices of related goods
« indirect taxes and subsidies
« future price expectations
changes in technology
* number of firms.

Aside from price changes, a variety of non-price factors can also affect supply. These
non-price factors are called determinants, as in demand theory. They will cause the
supply curve to shift outwards or inwards to reflect a change in the market at every
price.

As shown in Figure 5.8, a change in a good’s price causes a movement along its supply
curve. However, when non-price determinants of supply actually change, there is a
shift of the entire supply curve. When supply shifts, the quantity supplied changes at
every price. Consider the market supply for chocolate bars in Figure 5.9.

Chocolate bar supply has shifted from S, to S, At every price a greater quantity of
chocolate bars is now brought to the market (10,000 bars at $0.50 instead of 5000 and
20,000 bars at $1.50 instead of 15,000, and so on). The process also works in reverse.
If supply were to decrease, then there would be smaller quantities supplied at each
price and an inward shift of the supply curve would occur.
Price per chocolate bar (P) ($)

« Figure5.9 Anincreasein
supply will shift the supply
curve to the right

0 5 10 15 20 25
Chocolate bars demanded,
per week (Q) (thousands)
79
 There are several determinants of supply, a change in any of which would cause a
market supply curve to shift:
* changes in costs of factors of production
« prices of related goods
* indirect taxes and subsidies
« future price expectations
« changes in technology
+ number of firms.
Let us look at each of these in turn, using the chocolate industry, guest lodging, and the
market for ethanol as examples.

Changes in costs of factors of production

The ability of a firm to produce is intimately related to the costs of production. Higher
costs obviously make it more difficult to earn profits, all other things being equal. If
firms are selling chocolate bars for $2 per bar and costs rise from $1.50 to $1.75, profits
per bar will fall by $0.25. This reduction in profits may provoke some producers to quit
production, or to simply produce less chocolate and shift resources to the production
of something else that is more profitable.
What causes the costs of production to change? Most generally, the price and
availability of the factors of production will influence costs. As discussed in Chapter 1,
the broad categories of the factors of production are land or natural resources, labour,
financial and productive capital, as well as entrepreneurship or management. For
example, if there is a disruption to the supply chain for cocoa beans, the price of
cocoa beans will increase and the cost of producing a bar of chocolate will rise. This
increased resource cost will shift the market supply curve to the left, as shown in
Figure 5.10.

Furthermore, if the factors of production for chocolate were to become cheaper,

costs would decrease and the supply curve would shift to the right. For example, if
chocolate factory workers’ wages or machine rental fees were to fall, the profitability of
chocolate production would increase and the supply of chocolate bars would increase
accordingly. This would mark an increase in the quantity supplied at every price. Atall
prices, firms would produce more bars of chocolate.
Price

Figure 5.10 Higher costs >

will result in a decrease in
supply overall

0 Quantity
of output
80
 Prices of related goods
From the producer perspective, firms have a choice as to what to produce. Firms
can substitute the supply of goods from those earning lower prices to those
getting better ones. This is most clearly demonstrated by goods that offer joint
supply. Joint supply occurs when two or more goods are derived from the same
product. Animal products are an example. The various parts of an animal can
be sold for different purposes, such as skin for leather and meat for consumption.
When the demand for leather products increases, more resources will be
allocated towards raising animals for leather, increasing the supply of meat
in turn.

Another example of joint supply is corn. Corn can be used to produce a variety of
goods, including corn syrup and ethanol (alcohol) for fuel. Should the price of ethanol
increase, corn producers may choose to sell more corn on the ethanol market and
reduce the amount supplied for corn syrup.

Figure 5.11(a) shows an increase in the price of ethanol, perhaps in response to

concerns about fuel supplies. The quantity supplied increases in accordance
with the law of supply. This is shown as a movement along the supply curve for
ethanol from 10 million litres to 20 million litres. To farmers, ethanol is relatively
more profitable than before, and they switch their supply from other corn-based
products to ethanol. As a result, in Figure 5.11(b), the supply of corn syrup shifts
to the left as producers substitute corn from the corn syrup market to the market
for ethanol.

As we can see in Figure 5.11, one determinant of supply for corn syrup is the price ofa
related good with which it is in joint supply, ethanol.

To return to our chocolate example, let us consider how a change in the price of hot
cocoa powder, a good that is in joint supply with chocolate bars, might affect the
market for chocolate. If cocoa powder is becoming less popular among consumers, the
price might fall, causing the quantity supplied of cocoa powder to decrease. Producers
will view chocolate bars as a more profitable alternative to cocoa powder, and thus will
allocate more resources towards the production of chocolate bars. A decrease in the
price of cocoa powder, a good in joint supply with chocolate, would cause the supply Figure 5,11 Where goods
of chocolate to increase. are in joint supply, an increase
in the supply of one leads to a
decrease in supply of another
v
-
»

Ethanol Corn syrup

Price

Price
o

Increased price for ethanol

causes the quantity supplied to
increase for ethanol and to
decrease for corn syrup

o Q, Q, Quantity o Quantity
of output of output
81
 Supply

Indirect taxes and subsidies

Taxes and subsidies can also strongly influence supply decisions. Businesses view an
indirect tax (defined as a tax on consumption, rather than on income) on their product as
an increase in the cost of production. Indirect taxes are taxes on goods or services that
are collected at the point of sale, and then transferred by the seller to the government,
therefore an indirect tax is essentially another cost of production born by firms. A tax
increases the marginal cost of producing a good because a tax is now added to the
other costs of producing each unit. Thus the market supply decreases when taxes are
increased or a new tax is imposed, shifting the supply curve to the left and reducing the
amount produced at every price.

|
Historic Florence

Consider the example ofa tax placed on short-term rentals (think Airbnb). Assume
the city government of Florence, Italy, has decided that due to the huge numbers
of summer vacationers, there is a need to increase government revenue in order to
maintain the city’s ancient infrastructure. The city decides to impose a 50% tax on all
short-term rentals. The cost to property owners of operating a short-term rental thus
increases by 50% at every price. This means that a €100 per night apartment will incur
an additional €50 to the owner (on top of all other costs of maintaining the apartment,
such as rent or mortgage payments, utilities, cleaning fees, and so on).
The increased cost created by the new tax will make using apartments for short-term
rentals less profitable, thus decreasing the supply of short-term rentals at every price.
Figure 5.12 shows the effect ofa 50% tax on short-term rentals on the supply of such
units in Florence, Italy.

An apartment costing €100 per night now costs owners €150, which includes a
€50 tax paid to the city government. As a result of the increased cost of renting out
apartments, the supply decreases from S, to S,. Now, at €100 fewer apartments are put
up for short-term rental, reducing the quantity available from Q, to Q,.

Subsidies, on the other hand, have the opposite effect. A subsidy is when the
government pays a producer to make more of the good. While there are different
ways to subsidise production, we will focus on per-unit subsidy. This type of subsidy
pays the firm for each unit produced. This has the effect of reducing production costs.
Therefore, an increase in subsidies will have the effect of shifting supply to the right,
successfully encouraging more supply of the product at every price.
 Nightly rate (P) (€) « Figure5.12 Anew tax
would cause a shift in the
supply curve for short-term
rentals

Number of units available for

short-term rentals (Q)

Consider a government plan to increase the affordability and thus the use of rooftop solar
panels. The German government decides to subsidise each 100-watt solar panel by €50.
Producers now receive a €50 ‘bonus’ from the German government for each 100-watt panel
that comes off their production lines, essentially offsetting the other costs that go into
solar panel production, reducing their marginal costs and increasing the market supply.

L ]
Future price expectations What are some real-world
‘We know how a change in a good’s current price affects supply: producers will bring examples of goods or services
more to market when the price rises and less when the price falls. But what about that are taxed and subsidised
in your community/country?
the expected future price? Even when there is no actual change in a good’s price, but Conduct a local news search
producers expect its price to change in the future, the supply can be affected. for terms like ‘excise tax’ or
‘subsidies, then answer the
Consider the market for an agricultural commodity, such as avocados. Let us assume following questions,
there is a new administration in the USA that ran its campaign on the promise to ‘get For discussion and debate:
tough’ with America’s trading partners, and producers in all markets expect increased 1 Whatis one good on
taxes on imported products. Farmers in California, who can grow any variety of which a specific tax s
fruits and vegetables, and who know that 80% of avocados consumed in the USA are placed in your country?
imported from Mexico, now assume that the price of imported avocados is about to What s one good or
~

service that your country’s

increase thanks to the expected import duties. The very expectation of future price government subsidises?
increases will lead American farmers to allocate more of their resources towards
What are the government's
avocado production today, increasing the supply being produced. intended effects of the
taxes and subsidies you
On the flip side, ifa good's price is expected to fall in the future, rational producers identified for questions
would allocate fewer resources towards the good’s production today (due to the Tand2?
expectation of decreased future profits), shifting the supply inward. In your opinion, are the
-

government interventions
Higher expected future prices should cause a good’s supply to increase today, while the in the above markets
expectation of a price decrease should cause supply to decrease today. successful? Why or why
not?

Changes in technology
New production technologies will positively impact a good’s supply due to the impact
new tech has on firms’ productivity. Productivity is the amount of output per unit of
input. If a new technology allows a firm to use fewer factor resources in the production
process (less labour, less energy, less waste in its application of raw materials, etc.
will spend less on production. If it can get more out of its resources while still getting
the same prices, then it will earn more profit on each unit, thus supply will increase.
83
 Supply

Price
(P)($)

Figure5.13 Theentry 2,00

e firms into
a market will
shift the supply cur

0 1000 1500
Quantity of output (Q)

Productivity can be enhanced in different ways. Managerial insight can lead to better
methods of production. This can also happen via the creation of better incentives for
workers, changing production schedules, or adding new and specialised jobs to increase
efficiency. Generally, though, productivity is enhanced through better technology.
For example, robotic systems can replace expensive labour. Data management can
reduce accounting costs and find new ways of marketing products. Both methods and
machines play an important role in reducing costs and improving efficiency.

Using our initial example, if chocolate producers adopted a software program that
improved workflow and minimised inefficiencies in staffing at their factories, the cost
of producing chocolate would decrease and chocolate supply would increase, meaning
more chocolate bars would be produced at every price.

Number of firms
The final non-price determinant of supply is perhaps the easiest to understand: the
number of firms in a market. Let us revisit our bakery example from earlier in this
Video suggestion: chapter. We assumed that there were 20 bakeries producing 50 croissants each hour at
You have read about it, now a price of $2 per croissant. What happens to market supply if more bakeries open up in
You can review what you the city? Obviously, there will be more croissants produced at every price, or in other
have just learned by watching words, supply increases. Figure 5.13 shows the effect of increased competition in the
avideo by the author!
Simply click here in bakery market.
your eBook for a video
on the law of supply and the Without any change in the costs of the individual bakeries, market supply has
determinants of supply increased due to the influx of more competition in the market. Of course, if firms drop
(watch from 6:10 until the out ofa market or allocate their resources towards a different market, then the supply
end of the video).
decreases and a smaller quantity is produced at every price.

Case study - market supply of webcams

As the summer of 2020 unfolded, schools the world over weighed the costs and
benefits of reopening for face-to-face instruction as the COVID-19 pandemic
continued with varying degrees of intensity around the world. One thing was
certain; more schools than ever would be conducting remote learning of some
sort, meaning there would be record demand for the technologies required to allow
students to interact with their teachers and classmates from home.

84
 In a July 2020 interview with American financial news broadcaster CNBC, the CEO
ofa company that manufactures USB webcams for personal computers said ‘We're
working like crazy to make sure we have enough [products], especially for colleges
and for education of all levels ... We've really expanded our capacity of webcams to
make sure ...’

For discussion and debate:

1 Is the change described here an example of the law of supply at work, or does it
describe a change in the supply of webcams?
2 Which determinant or determinants of supply are driving the changes described
by the CEO? Explain?
3 What s likely to happen to the cost of producing additional webcams in
the short run as the industry ramps up production?

5.3 Movements along and shifts of the

supply curve

At the end of this section you will be able to:

+ distinguish between movements along and shifts of the supply curve

* show these using diagrams.

To wrap up our examination of supply, we'll revisit the two main concepts introduced
in this chapter, and examine how each relates to the law of supply. In any market, two
things can disrupt the current level of output produced by firms: a change in the good's
price or a change in a non-price determinant of supply.

When price changes, ceteris paribus, there is a movement along the supply curve
from a smaller quantity to a larger quantity or vice versa. When chocolate prices
fall, firms have a harder time covering the costs of production, making chocolate
production less profitable, leading them to allocate some of their limited resources
out of chocolate production. A decrease in price thus causes a movement along the
supply curve.

However, when any factor affecting supply other than price changes, the entire supply
curve shifts. A change in costs of factors of production, in the prices of related goods,
indirect taxes or subsidies, future price expectations, changes in technology, or the
number of firms will cause supply to shift, increasing or decreasing the quantity
brought to market at every price.

85
 & a
P s,
P,
Figure5.14 Itisimportant =,
to distinguish between the
effect of change in price and a P,
change in a non-price
determinant of supply

0 Q, Q, Quantity 0 Quantity
of output of output

To review, we'll look at the difference between these two outcomes one more time.
Figure 5.14 shows the difference between the effect of a price change and a change in
anon-price determinant of supply.

Can laws in economics, Understanding the law of supply, the determinants of supply, and the differences
such as the law of demand between changes in supply and changes in the quantity supplied provide us with
and the law of supply, one more tool to analyse the outcomes of real-world market interactions between
have the same status
as laws in the natural buyers and sellers. In the next chapter we'll dive deeper into supply, looking at the
sciences? responsiveness of producers to price changes, building on the knowledge of elasticity
that was introduced in Chapter 4.

Practice exam questions

Paper 1, part (a) questions
1. Explain the difference between a movement along the supply
curve and a shift in the supply curve. (10 marks)
2. Using an appropriate diagram and your knowledge of the
determinants of supply, explain why the supply for solar power
might increase. (10 marks)

86
 Elasticity of supply

6.1 What is price elasticity of supply?

Learning outcomes
At the end of this section you will be able to:
+ explain the concept of price elasticity of supply
calculate PES
* explain, using diagrams and PES values, the concepts of:
« elastic supply
« inelastic supply
* unitary elastic supply
« perfectly elastic supply
« perfectly inelastic supply.

In the last chapter we introduced the concept of supply, defined the law of supply,
and learned the various factors that can cause a change in a good’s supply. We now
know that there is a direct relationship between price and quantity supplied: a price
increase allows producers to cover the additional cost of producing more of their
output and therefore leads them to bring more to market, and the opposite happens
when price falls. In the same way as Chapter 4 looked more closely at demand,
this chapter will move beyond the basic relationship between price and quantity
supplied, and ask how much the quantity supplied will change in response to a
particular price change.

Price elasticity of supply (PES) measures the responsiveness of producers of a

particular good to a change in the price of that good. PES is a quantitative indicator of
producer sensitivity to price changes. Depending on how quickly producers are
able to ramp up production following a price increase, or scale back production when
prices fall, our PES value, and thus the elasticity of supply will be either high or low. This
has implications for markets, including those for primary commodities like minerals,
those for high tech manufactured goods like smart phones and electric cars, digital
goods markets, labour markets and service industries. PES values can vary based on
numerous factors, which we will explore in this chapter.

How is PES calculated?

The PES coefficient, like that for the different elasticities of demand introduced in
Chapter 4, is determined by calculating the percentage change in quantity observed
following a particular percentage change in price, and dividing it by the percentage
change in price.

Worked example 6.
We can use the supply schedule for chocolate from Chapter 5 to calculate the PES
for chocolate between various prices.

88
 Price of Quantity of chocolate bars supplied
chocolate bars (P) per week (Q)
$ (thousands)
0 0
0.50 5
1.00 10
1.50 15
2.00 20
2.50 25

First, the formula:

PES = (%A in Q)/(%A in P)

If the percentage changes in quantity and price are not known, they can easily be
calculated, giving us the following formula for PES:

PES = ((Q,— Q)+ Q)/((P,—P) = P)

where Q, is the quantity following the price change and Q, is the original quantity
while P, is the new price and P, is the original price.

First we'll measure elasticity when price increases from $0.50 to $1.00.

P, = $0.50
P,=$1
Q=5
Q,=10

The elasticity coefficient between $0.50 and $1.00 is equal to 1. For this supply
schedule, any combination of prices and quantities we choose will yield the same
PES value. For example, let us see what happens when the price increases from
$2.00 10 $2.50.
P, = $2.00
$2.50
Q=20
Q,=25
89
 Elasticity of supply

_ (250-2)+2
(25— 20) + 20
025
~ 025
=
Again, we see that there is a constant PES value of1 on this supply schedule. Any
change in price will be met by a proportional change in quantity. When price
increases by 50%, quantity increases by 50%.

The term for a supply curve along which price and quantity always change by the same
percentage is unitary elastic (meaning an elasticity value of 1).
Let us look next at a supply curve that is not unitary elastic, but along which the
elasticity coefficient is less than one.

Worked example 6.2

Consider the market for housing in a densely populated city. Figure 6.1 shows a
supply curve for the annual supply of new homes in Rio de Janeiro.

From the supply curve we can draw values upon which we can calculate PES.
Let us first determine the responsiveness of home builders between the prices of
R$200 per square foot and R$400 (R$ is the symbol for ‘real’ (plural: reais), the
Brazilian currency).
P, = R$200
P, = R$600
Q, =100
Q,=130
Price per square foot (P) (R$)
oS
3

Figure 6.1 Supply cun il 4

38

homes in Rio de Janeiro

Brazi
N5}
3

0 10011 60
130
Number of new homes
built each year (Q)

90
 (130 — 100) + 100
PES =
(600 — 200) + 200
03
3
=0.15

And using R$600 as a starting price we can calculate the PES when the price rises to
R$1,000 per square foot.
P, = R$600
P, = R$1,000
Q=130
Q,= 160
pes _ (160 = 130) = 130
(1,000 - 600) + 600
023
~ 067
=035
Both of our elasticity coefficients are smaller than that which we calculated for
chocolate. The builders of new homes in Rio de Janeiro are relatively unresponsive to
price changes compared to the producers of chocolate. Any increase in price is met
with a proportionally smaller increase in quantity supplied.

o Rio deJaneiro, Brazil

91
 Elasticity of supply

Recall from Chapter 4 that elasticity coefficients of less than one put the good's
elasticity in the inelastic range, meaning that the percentage change in quantity is less
than the percentage change in the good's price.
Finally, we can look at a good for which the supply is relatively elastic.

Worked example 6.3

Consider the market for cotton t-shirts. Assume that when the price of blank cotton
t-shirts rises by 10%, the quantity supplied increases by 15%. With these values we
can easily calculate PES:
%AQ
PES=——
%AP

With an elasticity coefficient of 1.5, producers of cotton t-shirts are the most responsive
to price changes from among our three examples. A particular change in price will be
met with a proportionally larger change in quantity supplied — supply is elastic.

What are the possible ranges of PES?

A good’s supply can be inelastic, unitary elastic, or elastic, and the PES coefficient can
range from zero to infinity. On the extremes, a good could theoretically have a perfectly
inelastic supply or a perfectly elastic supply.

Perfectly inelastic means that no matter how much the price increases or decreases the
quantity supplied remains fixed and unchanged. Consider the market for tickets to a
hugely popular show in London’s West End. There is one performance per day in a theatre
that contains 1000 seats. The daily supply of tickets for this show is shown in Figure 6.2.

Supply
Price per ticket $ (P)

Figure 6.2 The supply of P

tickets for popular theatre
shows is inel
limited theatre

0 1000
Quantity of tickets
supplied
92
 o Figure6.3 The perfectly
elastic supply curve is
horizontal

Supply for tickets is perfectly inelastic. The PES coefficient is equal to zero —no matter
what people are willing to pay, the quantity is fixed at 1000.
At the other extreme is a good with perfectly elastic supply. Any change in price will lead
to an infinite change in the quantity supplied. While examples of this from the real
world are rare if impossible to find, the idea behind perfectly elastic supply is useful in
understanding the ranges over which the elasticity coefficient can vary.
Supply can be close to perfectly elastic for a good if large inventories exist for
that good or if the good has a marginal cost of zero (meaning there is no cost to
produce and bring to market an additional unit of the good). Inventories are the
amount ofa good held in stock by a firm. Ifa good’s price rises and large inventories
exist, producers can respond to the increase in price instantly by releasing their
inventories onto the market to meet the increase in consumer demand. Even in the
short run, supply can be perfectly elastic in markets in which firms have substantial
quantities of inventory.

Digital goods (think songs and movies on streaming services, computer software,
smartphone apps, weapon packs in online video games, digital study guides, or
downloadable files like pdfs), incur no marginal cost to their producers. In other
words, to sell one more song, one more pdf study guide, or one more weapons pack in
World of Warcraft costs nothing to the companies that sell these digital goods online.
Therefore, once a price is set, as much or as little of such goods can be sold without the
price having to increase or decrease.
For example, a publisher might sell downloadable pdf study guides through its website.
The supply of these digital study tools is perfectly elastic. In a particular month he
may sell five study guides or 150 study guides, but no price increase is necessary for
the publisher to be willing to make more of them available. Likewise, if students were
suddenly willing to pay less, the publisher would not ‘decrease’ the quantity supplied.
Instead, fewer would be sold at the same price.
To summarise, a good’s elasticity of supply can range from perfectly inelastic (PES = 0),
to inelastic (PES > 0 and < 1), unitary elastic (PES = 1), elastic (PES > 1) and perfectly
elastic (PES = o). In the next section we'll examine the factors that determine the PES.
93
 Elasticity of supply

[T Exercise 6.1
In 2019, ticket prices for
the hit Broadway musical Calculate the PES for the following goods using the values provided. For each,
Hamilton rose higher than indicate whether supply is inelastic, unit elastic, or elastic.
$850 at the box office, and
some sold for much more 1 The price of commercial air travel falls by 20% and the number of seats offered
on the secondary market. on commercial flights decreases by 5%.
The show was the costliest
2 The price of corn increases from $25 per bushel to $30 per bushel and the
musical ever to show
on Broadway, but some amount of corn brought to market increases by 40%.
commentators observed that 3 The average price of cellular data plans increases from $50 to $75 and the
even at $850, the show might number of plans supplied by cellular providers increases from 100 million to
have been underpriced, due 150 million.
to the difficulty people still
faced in getting tickets. 4 When the price of milk doubles, the amount supplied increases by half.
For discussion and debate:
Answers:
What s the price elasticity
of supply of tickets to a 1 PES of commercial air travel = =5% <+ —20% = 0.25. Air travel supply is inelastic.
show like Hamilton? PES of corn = 40% ~+ [(30- 25) + 25] = 40% + 20% = 2. Corn supply is elastic.
Why doesnit the high price 3 PES of cellular data plans = [(150—100) +100] =+ [(75—50) +50] = 50% + 50% = 1.
~

lead to more tickets being

made available by the Supply of cellular data plans is unit elastic.
shows producers? 4 A doubling of the price of milk is a 100% increase. An increase by halfis a 50%
What could change increase. The PES of milk = 50% +100% = 0.5. Milk supply is inelastic.
w

in the long run that

could increase the
responsiveness of the
producers of Hamilton to
the high ticket price?
6.2 What are the determinants of PES?

At the end of this section you will be able to:

* explain the determinants of PES, including:

e time
» mobility of factors of production
* unused capacity
« ability to store stocks
. explain why the PES for primary commodities is relatively low and the PES
for manufactured products is relatively high.

A good’s PES depends on time, the mobility of factors of production, the degree of
unused capacity, the ability to store inventories, and the rate at which costs increase.

Time following a change in price

An important determinant of how responsive producers are to price changes is the
amount of time following a change in price over which producers are able to adjust
their output. Figure 6.4 shows three possible supply curves for the same product, corn.

Assume the price of a bushel of corn increases from $5 to $6. The three supply curves in
Figure 6.4 represent the supply of corn in the market period, the short run, and in the long run.
94
 Price of corn (P) ($/bushel)

< Figure6.4 PES increases

over time as producers adapt

i
Bushels of corn produced (Q)

S, - the market period

The period immediately following a change in price is known as the market period,
and during this time supply is highly inelastic. In the market period, producers do not
have the time to adjust their output to changes in price. Corn producers can release the
little inventory they have and can perhaps harvest their crop earlier than planned, but
the amount of land, labour and capital allocated to growing corn is fixed in the market
period. Quantity can increase minimally, from Q, to Q,, due to the fixed factors of
production and limited inventory on hand.

S, - the short run

Within a few months of the increase in price, corn growers will be able to increase the
intensity with which they use their fixed capital and land resources for growing corn.
More labour and better or more fertiliser and pesticides can be applied to the existing
crop in an attempt to increase the yield in order to meet the rising price. The short run
is the period of time over which land and capital are fixed, but labour is variable and
therefore the intensity with which land and capital are used can increase, resulting in
more elastic supply than was possible in the market period. In the short run, output
increases from Q, to Q, bushels of corn; supply is more elastic than it is in the market
period due to producers’ ability to mobilise variable resources such as labour and other
easily added inputs towards corn production.

S, —the long run

In the long run, supply is highly elastic. The long run is defined as the period of time
over which all factors of production are variable. In the case of corn, the long run may
be one or two years, a period of time over which farmers can switch land that was
being used for other crops to corn production and bring idle land into production
of corn as well. In addition, farmers can allocate more capital and labour towards
growing corn, allowing them to be much more responsive to the increase in price. In
the long run, output can be increased from Q, bushels to Q, bushels, reflecting a much
more responsive supply than that observed in the market period and the short run.

Over time, producers are much more responsive to changes in the price of a good.
In the period immediately following a change in price, all factors of production are
95
 fixed and therefore firms are unable to change their output much. In the short run,
capital and land are fixed but firms can hire more workers to respond to a price
increase or lay workers off to adapt to falling prices, thereby using existing land and
capital more or less intensively. In the long run, all factors of production are variable,
so firms can be highly responsive to changes in market price.

Mobility of the factors of production

The more mobile the factors of production (the labour, land and capital resources
needed for the production ofa good), the more responsive a firm can be to changes in
price. Whether a good is land intensive in its production or labour and capital intensive
makes a significant difference to producers’ ability to quickly shift resources into or
out of production following a change in price.
Low-tech manufactured goods (e.g. clothes, toys, and simple electronics) and low-
skilled services (e.g. haircuts, laundry services, and housekeeping) tend to have relatively
elastic supply. Producers can easily hire more workers and acquire more raw materials
and capital resources to meet increases in demand for such goods, thus they are highly
responsive to increases in the price. When price falls, producers of these goods find it
quick and easy to lay off workers, take capital out of production, and cancel orders for
raw materials, thus they can respond quickly to decreases in demand as well.

The easy mobility of resources for manufactured goods and low-skilled services
allows for supply of these items to be relatively responsive to changes in price.
The harder it is to shift factors of production into or out of the production of a
good, the more inelastic the good’s supply will be. The markets for heavy industrial
goods such as airplanes, residential and commercial construction, and automobiles,
high tech goods, and highly skilled services (e.g. doctors, financial experts, or
university professors) tend to exhibit highly inelastic supply. Additionally, primary
commodities that are land intensive in production, such as coffee, rice, corn, wheat,
coal, oil, gas, and minerals also exhibit immobility of the factors of production,
even in the long run, relative to less capital-intensive goods or lower skilled services.
It is extremely time consuming and costly to bring into production new plants for
heavy industrial goods and primary commodities to meet rising demand, or to take
them out of production in response to falling prices. Thus, the supply of such goods
tends to be relatively inelastic.
Primary commodities likewise require substantial amounts of land and capital to
produce. These are fixed resources that cannot be quickly put into production or
taken out of production once a substantial investment has been made towards the
extraction of a particular commodity. For instance, if diamond prices are rising, the
quantity of diamonds brought to market will increase only minimally (assuming there
are not large inventories of diamonds on hand). Why is this? It is because locating new
potential sites for diamond mines is extremely difficult and expensive. Also, once a site
is located, installing the machinery and training the workers to extract the diamonds
is very time consuming and requires a substantial capital investment. When diamond
prices fall, the firms that extract diamonds are unlikely to walk away from their mines,
given the large investment they have made in getting them operational.

96
 Diamonds are just one example of a primary commodity of which supply is highly
inelastic, even in the long run, due to the substantial amount of fixed land and capital
that goes into their production. Manufactured goods, on the other hand, tend to
have relatively elastic supply curves due to the ability to quickly mobilise factors of
production into and out of the manufacturing process. The lower tech and more
simple a good’s production process, the more elastic supply tends to be, while higher
tech, more capital-intensive goods typically display a more inelastic supply.

The degree of unused capacity

Excess capacity refers to the amount a firm is able to produce in the short run without
having to expand its plant size and the amount of capital and land employed in
production. If an industry is operating at a level of output at which it has large amounts
of unused capacity, then producers are able to quickly and easily respond to changes
in the good’s price. If, however, an industry is operating at or near full capacity, supply
will be highly inelastic in the short run, as in order to meet any increase in demand,
firms must first acquire new capital equipment and open new factories to meet the
rising demand for their output. Such expansion takes time and means that supply will
be relatively inelastic following a change in price.

The ability to store inventories

If large inventories of a good can easily be stored in warehouses or kept on hand by
producers, then supply of the good can be highly responsive to changes in the price.
Items such as video games, software, low-tech manufactured goods, and certain non-
perishable commodities can be produced in large quantities that are not necessarily
sold but added to inventories to be stored and used to meet future demand. If, in the
future, prices for such goods rise, producers can quickly and easily release stored
inventory onto the market to meet the increase in price. Likewise, when the price
for non-perishable commodities falls, producers can respond by putting supply into
inventory and quickly reducing the quantity available in the market.
However, not all goods can be easily stored. When the prices of perishable goods
such as milk, fruit, some grains, and large-scale industrial goods such as airplanes

-« Stockpiled goods

97
 Elasticity of supply

cost/price
Marginal
o
Figure 6.5 The marginal
cost curve omes steeper
due to capacity

0 Q Q Q Q Quantity
@

and ships rises, producers have a very limited stock to dip into. Likewise, some goods’
inventories cannot be added to when price falls. The producers are not very responsive
and must accept a lower price to sell the current output that would otherwise go bad or
be very costly for the firm to store.

The rate at which costs increase

Recall from Chapter 5 that an individual firm’s ‘supply curve’ for a good is actually the
firm’s marginal cost curve. One of the explanations for the direct relationship between
price and quantity supplied was the fact that marginal cost (the cost of an additional
unit ofa good’s output) increases as output increases for most goods, due to the
diminishing marginal returns experienced as more labour is added to a fixed amount
of capital and land to increase production. The rate at which costs increase is therefore
adeterminant ofa good's PES.
Consider the market for cotton candy, which requires three inputs to produce: labour
(the person operating the cotton candy machine), land (the physical space the machine
is located and the raw ingredient, which in this case is sugar, an agricultural product),
and capital (the cotton candy machine). Figure 6.5 shows the marginal cost curve for a
single cotton candy producer.

Atlower quantities the cotton candy producer is able to increase her output (Q, to Q,)
with only a minimal increase in price (P, to P), due to the fact that her marginal costs
increase only slightly. However, at higher quantities (Q, to Q,) the same increase
in output requires a much larger increase in price (P, to P,) due to the increasingly
constrained capacity of the cotton candy machine. The intensity with which the
labourer can work the machine is limited when output is at Q,, and supply becomes
increasingly inelastic as the rate at which costs increase becomes greater in the short
run. To increase responsiveness to price changes, a second cotton candy machine is
needed, which would once again lower the marginal cost as excess capacity is restored.

6.3 Why does PES matte

This chapter extended your understanding of the economic principles behind market
supply by focusing on the responsiveness of producers to changes in price. The
formula for elasticity of supply measures the percentage change in quantity supplied
over the percentage change in price. We learned that goods can have perfectly
98
inelastic supply (think theatre tickets) or perfectly elastic supply (digital downloads). Video suggestion:
Understanding how firms respond to price changes helps all businesses to be prepared You have read about it, now
for changes in variables such as price, government policy, and market demand. These you can review what you
can affect business decisions on how much to produce now and how to prepare for have just learned by watching
the future.
avideo by the author!
Simply lick here in
your eBook for a video
In later chapters we'll examine how government interventions in markets, such as on PES and its determinants.
indirect taxes, subsidies, price ceilings, and price floors, will have dramatically different
impacts on buyers and sellers depending on the relative elasticities of demand and
supply. For now, it is time to put our knowledge of both demand theory (Chapters 3
and 4) and supply theory (Chapters 5 and 6) together to explore the concept of market
equilibrium, which will be introduced in Chapter 7.

Practice exam questions

la. Explain the factors which influence price elasticity of supply.
Hlustrate your answer with reference to the market for a
commodity or raw material. (10 marks)
b. Discuss the importance of price elasticity of supply for
producers of primary commodities in less developed
countries. (15 marks)
2. Using examples, explain why supply of primary commodities tends
to be more inelastic than that of secondary commodities. (10 marks)

99
Competitive market
equilibrium
 7.1 How is a market equilibrium determined

Learning comes
At the end of this section you will be able to:
* explain, using diagrams, how demand and supply interact to produce market
equilibrium
* analyse, using diagrams and with reference to excess demand or excess supply,
how changes in the determinants of demand and|or supply result in a new
market equilibrium.

This chapter will draw together many important concepts from everything you
have learned so far. As described in Chapters 1 and 2, free market systems depend
on interaction between consumers and producers as the main mechanism through
which resources are directed to meet the needs and wants in an economy. This is the
relationship from which these societies answer the questions of what to produce how to
produce and for whom to produce. Having examined demand and supply separately, we
now combine them to analyse markets more completely.

Market equilibrium
‘When demand and supply are combined, there is a tendency for the market to reach
a market equilibrium. Equilibrium is defined as a state of rest, self-perpetuating in the
absence of any outside disturbance. This suggests balance or stability. Market equilibrium
is defined as the point where the quantity ofa product demanded is equal to the quantity
ofa product supplied. This creates the market-clearing price and quantity where there
is no excess demand or excess supply. The price at which the quantity supplied and
demanded are equal is called the equilibrium price. At this price, the amount purchased
is exactly equal to the amount sold. There is no surplus product available on the market,
nor are there shortages of supply at that price. For this reason, the equilibrium price is also
called the market-clearing price. Everything put on the market, at that price, is sold.

Returning to the example of chocolate bars we used in Chapter 3, the total market
schedule shows the equilibrium price is $1.50 per bar (Table 7.1). At that price, the
amount supplied and demanded is 15,000 bars per week. All the bars offered on the

Table 7.1 Demand and supply schedule: chocolate bars

Price of Quantity of chocolate bars | Quantity of chocolate bars
chocolate bars (P) | demanded per week (Q,,) supplied per week (Qg)
$ (thousands) (thousands)
2.50 5 25
2.00 10 20
1.50 15 15
1.00 20 10
0.50 25 5

101
 ¥4 Competitive market equilibrium

Price per chocolate bar (P) (5)

200

) 1.50 - £QUIErUmN/ \arket equilibrium

Figure 7.1 A
equilibrium s at th
quan
1.00

050
Equilibrium ‘quantity
0 5 10 15 20 25
Chocolate bars demanded per
week (Q) (thousands)
market are purchased by consumers. Prices set above or below the market price will
result in market disequilibrium, because there will be excess supply or demand.

On a diagram, the equilibrium price is found at the intersection of supply and demand.
In Figure 7.1, the supply and demand intersect at $1.50. At that price, as noted
previously in the table, the quantity supplied is 15,000 bars, and all those bars are
purchased as quantity demanded is also 15,000. The market ‘clears’ because there are
no extra bars available, nor any shortage at that price.

Market disequilibrium
A market disequilibrium occurs at any price at which the demand and supply quantities
are not equal. Let us look at specific examples of market disequilibrium, and analyse the
results of attempting to set prices anywhere other than the equilibrium price.

Excess supply
Excess supply occurs where the price ofa good is higher than the equilibrium
price, such that the quantity supplied is greater than the quantity demanded. Table 7.2

Table 7.2 Demand and supply schedule: chocolate bars

Price of Quantity of Quantity of Specific
chocolate chocolate bars chocolate bars consumer surplus
bars (P) supplied per demanded (demand price —
$ week (Q) per week (Q,) market price)
(thousands) (thousands) $
2.50 25 5 1.00
2.00 20 10 0.50
1.50 15 15 0.00
1.00 10 20 —
0.50 5 25 =
102
 250
Excess supply

Price per chocolate bar (P) ($)

\ /7
1.50 Market equilibrium
« Figure7.2 A price higher
than the equilibrium price
results in excess supply

0.50
: Equilibrium!
. quantity |

0 5 10 15 20 25
Chocolate bars demanded
per week (Q) (thousands)

and Figure 7.2 show the market price to be $1.50. If the producers of these chocolate
bars had an exaggerated sense of their value, they might set the price too high. Let
us say, for example, that they greedily set the price at $2.50 per bar. At that price, the
quantity demanded is much smaller than at the equilibrium price. Quantity demanded
drops from 15,000 to 5000 bars per month. This is equivalent to a movement along the
demand curve, as shown in Figure 7.2, to a price of $2.50 and quantity of 5000 bars.
As price increases, the quantity demanded decreases or moves upwards and left along
the demand curve. At the same time, setting the price higher induces producers to
increase production as they expect higher profits at higher prices. Quantity supplied
thus moves in the opposite direction, moving upwards along the curve to a quantity
0f 25,000.

Thus, we can say at $2.50, an excess supply for bars exists, with more quantity supplied
than demanded. What happens to this surplus? Producers can only sell the extra goods
if they lower the price. As they do so, more quantity is demanded, and producers
reduce production. This narrows the gap continuously until the surplus is reduced to
zero at the market-clearing, equilibrium price.

Excess demand
Excess demand occurs where the price of a good is lower than the equilibrium price,
such that the quantity demanded is greater than the quantity supplied. Let us take up
the opposite case and assume that firms are not aware of the market value of their
bars, and they under-price them at $0.50, as shown in Figure 7.3. At this price, the
quantity demanded is much higher, now 25,000 bars, while the lower price is not
well received by producers. They scale back production to only 5000 bars. This gap
between relatively higher quantity demanded and lower quantity supplied is called
excess demand.
‘When excess demand exists, market forces take over. With relatively scarce amounts
of the good on the market at $0.50 (an excess demand of 20,000 bars) some consumers
103
 Price per chocolate bar (P) ($)
Market equilibrium
Figure 7.3 A price lovier P
than the equilibrium price

20
results in excess demand 1.00

Excessidemand
0.50

0 5 10 15 20 25
Chocolate bars demanded
per week (Q) (thousands)

start to bid the price higher in an attempt to get more of the good. As bars quickly fly
off the shelves, producers also realise they can charge a higher price. So, at the higher
price of $1.00, producers make more (10,000 bars) and some consumers drop out of
the market, reducing the quantity demanded to 20,000. Now the shortage is smaller
(10,000 bars) but there is still a shortage. This prompts producers to raise the price
again, with some consumers dropping out again, a process that continues until all of
the extra demand is satisfied at the market-clearing price of $1.50.

Video suggestion: Therefore, at any price other than the market-clearing price, either excess supply or
You have read about it, now demand will exist. Furthermore, unless firms are compelled by law to keep their prices
you can review what you at some disequilibrium level (too high or too low), market forces will urge producers
have just learned by watching and consumers towards a market-clearing price where everything offered is purchased.
avideo by the author!
Simply click here in
o your eBook for a video What causes changes to market equilibrium?
on market equilibrium,
disequiibrium, and allocative The tendency of a market towards equilibrium is strong. When prices are too high
efficiency. or too low, the market tends to clear eventually. And when markets are in balance,
it requires some external force or event to alter that balance. Recall that for all
equilibriums, like the one above, ceteris paribus is in effect. All other factors are being
held constant. However, in reality, market forces are dynamic, and market equilibriums
are changing often. Shifts in either market supply or demand will change the market
equilibrium, changing the market-clearing price, and quantity as well.

Shifts of demand
Ceteris paribus, an increase in demand will increase the scarcity of the good, and cause a
temporary shortage. That shortage will cause the price to be bid higher and higher, to
a point where quantity demanded and supplied meet. At that new market equilibrium,
the result is an increase in the equilibrium price and quantity.

For example, suppose consumer demand for mango juice significantly increased
following reports that it contained very high levels of antioxidants. As a result, demand
104
 35.00

30.00

B 55,00 -nermrmrm
e N Final equilibrium
&
£v 2000 fermeeeenmremennnnnns? o Figure7.4 following arise
< Starting equilibrium in demand, the equilibrium
& 1500 price willsetdle further up the
£ £
& 10,00
5.00

0 90 110 1 30
Litres (Q) (millions)

for all products using mango increased, shifting demand for mangos to the right.
As shown in Figure 7.4, demand for mangos shifted to the right, causing a temporary
shortage at the old equilibrium price of R20.00 (R is the symbol for the rand, the
currency of South Africa). The quantity demanded (Q,)) is thus far greater than the
quantity supplied (Q,). In this case, the excess demand is 40 million litres. As producers
realise they can raise the price, they produce more, a movement upwards along the
supply curve. And as consumers see the higher prices, they decrease the quantity
demanded, a movement up and left along the new demand curve. The quantities of
supply and demand settle at the new equilibrium price of R25.00 and equilibrium
quantity of 110 million litres. As a result of the increased demand, prices are higher
and quantities greater than before.

106
 Price per automobile (P) (AU$)
Figure7.5 Followinga fall
in demand, the equilibrium

&
S
8
price will settle further down
the supply curve
21500

350 750 1130

New automobile sales (Q) (thousands)

Conversely, a decrease in demand will decrease the scarcity of the good, and cause
atemporary surplus. That surplus will cause the price to drop lower and lower, to a
point where quantity demanded and supplied meet. At that new market equilibrium,
the result is an increase in the equilibrium price and quantity. For example, a decrease
in a country’s income might decrease the demand for all normal goods. Automobile
sales, in particular, tend to be immediately affected by decreases in income, and a
recession causes a decrease in demand for automobiles.
In Figure 7.5, a decrease in demand of this type results in a temporary surplus of 800,000
automobiles at the equilibrium price of AU$30,000 (AUS is the symbol for Australian
dollar, the currency of Australia) (fewer new automobiles being sold); producers cut
prices to entice buyers (increasing quantity demanded, moving down along the new
demand curve). Eventually, the market settles at a new, lower market price and quantity
(AU$21,500 and 750,000 automobiles): fewer automobiles are being sold at lower prices.

Shifts of supply
Supply shifts can also have important effects on price and quantity. When supply
increases, a good becomes less scarce and a temporary surplus occurs. This causes the
price to drop until settling at the price where quantity supplied and demanded are equal.

In Figure 7.6, the market for rubber ducks shows the effect of synthetic rubber
production. Synthetic rubber is much cheaper than rubber collected from rubber trees,
s0 it becomes much less costly to produce rubber items, including rubber ducks. As a
result, the supply of rubber ducks shifts to the right. A temporary surplus of 7 million
ducks exists at the old equilibrium price of $$3.75 (S$ is the symbol for Singapore
dollar, the currency of Singapore). This surplus is eliminated by cutting prices and
selling off the excess supply. Consumers do their part by buying up the residual
amounts at successively lower prices, an increase in quantity demanded at each lower
price. The increase in supply therefore results in a lower equilibrium price for rubber
ducks at $$2.25, and a higher equilibrium quantity of 12 million sold.
A decrease in supply will have the opposite effect. When supply decreases, a good
becomes more scarce and a temporary shortage occurs. This causes the price to rise
until settling at the price where quantity supplied and demanded are equal.

106
 « Figure7.6 Followingan
Price per duck (P) (S$)

increase in supply, the

ilibrium price wil
ther to the rigf
demand curve

85 12155
Rubber ducks (Q) (millions)
Figure 7.7 shows a decrease in supply, in this case the effect of a deep winter freeze across Video suggestions:
the Mediterranean which damaged orange crops in Cyprus, Greece, Italy, and Spain. You have read about it, now
As aresult, the number of oranges available for juice products decreased dramatically. you can review what you
Oranges are an input cost for orange juice, so the supply of orange juice decreases, have just learned by watching
some videos by the author!
shifting supply to the left. The reduced supply causes a temporary shortage of 700 million Simply lick here in
litres at the old equilibrium price of €1.50 per litre. Producers therefore begin to increase your eBook for videos
their prices, and consumers respond by decreasing the quantity demanded. The final on the effect on market

price and quantity settle at €2.10 per litre and 550 million litres consumed. Thus, the equilibrium of changes in
decrease in supply has caused a decrease in quantity available and increased prices.
demand and/or supply.

Case study - the oil crisis

Perhaps the greatest single supply shock in the modern era occurred with the 1973
oil crisis. The Organization of the Petroleum Exporting Countries (OPEC) launched
an embargo of oil in response to US support of Israel during the Yom Kippur War.
The price of il quadrupled to a then-record $12 per barrel. This resulted in long
queues at petrol stations, price controls, and rationing in the USA, Europe, and
Japan. It also stoked inflationary tendencies at work during this period, and is credited
with starting the era of stagflation (higher price levels and low economic growth).
ek
Price per litre (P) (€)

o Figure7.7
decrease
in supply, th
&

equilibrium price wil

further to the left along the
deman:

Litres (Q) (millions)

107
 ¥4 Competitive market equilibrium

Exercise 7.1
For each of the following headlines (1) create a fully labelled diagram of the product,
(2) show the shift and the changes to equilibrium price and quantity, and (3) identify
and label the determinant of demand or supply that caused the shift for each.
a. Heavy rainfall affects the market for rubber boots.
b. Diplomatic agreements open the market for Chinese airplanes to several new
countries.
c. Consumers learn that cars will be much more heavily taxed starting with next
year's models.
d. House-building companies are gloomy about new business during the
recession.
e. Ababyboom 15 years ago influences the market for popular music and
cosmetics today.
f. The government places more regulations on food preparation after several
poisoning scares.
g. A maker of t-shirts moves production to a country with significantly lower
labour costs.
h. A severe winter frost decimates the crop of grapes from which French
champagne is made.
i. Country X joins the EU and its wheat farmers reap massive subsidies.

7.2 What role do prices play in allocating

resources?

Learning outcomes
At the end of this section you will be able to:

« explain why scarcity necessitates choices that answer the ‘What to produce?’
question
« explain why choice results in an opportunity cost
* explain, using diagrams, that price has a signalling function: rising prices signal
scarcity and falling prices signal abundance
* explain, using diagrams, that price has an incentive function, which results in
areallocation of resources when prices change
« discuss how a price system helps perform the rationing of resources in a free
market economy.

The concept of scarcity was introduced in Chapter 1. Because human wants are
unlimited in a world of limited resources, choices must be made about what to
produce and what to consume. Such choices will always incur an opportunity cost,
which is the value of the next best alternative use of the resource. To act efficiently, and
to improve one’s overall economic well-being, one needs reliable information about
the relative scarcity of the resources being used.
108
How does a functioning price system signal
scarcity?
Resource allocation is the manner by which society selects which resources are used
for what purposes. These decisions about the allocation of precious resources derive
important information from a functioning price system. When markets operate freely,
the price system is the organising principle around which all resources are allocated.
The interaction of supply and demand tells us those goods which are most scarce
(lowest supply relative to demand) because they have the highest prices, and least
scarce (lowest demand relative to supply) because they have the lowest prices.
In competitive markets, we have seen that buyers and sellers come to a settlement
oragreement on the appropriate market price. This is not done through any central
command or by the guidance of some overseeing body of government. Instead, the
establishment of a market price happens when countless buyers and sellers, each
making rational choices about their scarce resources, make the best decision for
themselves. Buyers are conscious of their time and income levels, while suppliers
watch closely their costs and the selling potential for their goods. This decentralised,
seemingly random process produces one of the most important benefits of
competitive markets: an efficient rationing of resources through the price system. Free
markets serve an important signalling function, where signalling is understood to be
the sending of a signal revealing relevant information to a participant in a transaction.

Rising prices signal scarcity

In Figure 7.8, if the demand for a good were to increase, a temporary shortage would
existat the current price. All of the extra demand would bid the price upward from P, to
P, to reflect that there is more demand for the good relative to the same amount available.
A decrease in supply would likewise indicate more scarcity, and prices would rise.

Falling prices signal more abundance

1f demand for a good decreases, it is wanted less, and the price drops accordingly. Were
supply to increase, there would be more abundance and less scarcity, dropping prices
as well.

Without price information, it is very difficult to make informed, efficient decisions

about production. Centralised economies make mistakes for this reason. In these
situations, planners fight over resources, like rubber, steel, and textiles, to be used

a b
New higher equilbrium
P ‘rice Sgnal product S
scarcity
producers raise
prices and produce
more while consumers P | -
decreaseamount
demanded
2 o Figure7.8 Rising prices
| signal scarcity following a rise
Piqrorrmmmnee X D, L X in demand (a) with a new
; 1 demand shit ; ) higher equilibrium price (b)
:) s mporryb
rertagen |:

|i D !i D
Q Q Q Q Q
109
 Competitive market equilibrium

in production of other goods. What are these resources worth? They do not know,
and may overuse steel, for example, in the building of automobiles, when it is more
desperately needed in building construction, or railway repair. Without prices, making
arational decision, based on costs and benefits, is nearly impossible.

How does the price system influence incentives

in a free market economy?
When prices rise and fall, producer and consumer incentives are changed. Incentives
refer to events that cause behaviour to change, in this case the behaviour of consumer
and producers. When a resource or product rises in price, buyers try to use it less
frequently, and producers try to make more of it to increase their profits. If, in Figure 7.8,
the price increase occurred in the market for high-quality beef steaks, cattle ranchers
would have a greater incentive to sell more, and would respond by trying to offer more
of their animals up for sale. If a supply decrease caused the price rise, steak buyers have
anew incentive to reduce their consumption and find substitutes.

It works the other way as well. When the price ofa resource drops, buyers will find
reason to use it more since it is cheaper. Firms will be discouraged from production
because the low prices offer less reward for their time.

What is the rationing function of the price system?

Rationing is a term used to describe an artificial process by which goods, services, or
resources in general are distributed. In a price system, resources are rationed because
prices indicate scarcity, and the resources are available to anyone willing and able to buy
them. This may seem obvious, but compare that with other rationing systems to see the
difference. One might allocate resources, as in a planned system, by groups of government
officials deciding what is important to produce, and what is not. Because of the lack of
signalling and incentive functions described above, this leads to inefficient outcomes.
Surpluses and shortages of critical goods are a common feature of planned systems.

The value of a price system is that nearly all the relevant information about the market
is revealed naturally, without outside intervention. Figure 7.8 shows how a competitive
market uses supply and demand to ration resources in this way. As demand for a good
increases, a temporary shortage occurs (Figure 7.8a). Firms see the shortage and begin
to raise the price of the good. This acts as incentive to produce more, helping to relieve
the shortage. At the same time, consumers reduce the quantity they demand, and there
is a movement up and to the left along the demand curve. Eventually, the price settles
atanew equilibrium (Figure 7.8b). The rise in prices has told consumers to ration their
consumption and producers to make more.
To take an example from the resource market, Figure 7.9 shows a market for capital
equipment (i.e. any kind of machinery or service that is used in production). Here, an
increase in the supply of this resource sends critical information to the producer, who
buys the capital equipment as an input for the products. The information about lower
prices says that this resource is more available and will cost less. A wise producer may
look for ways to use this resource more frequently, and for ways to use other, relatively
more expensive resources, less frequently. A rational reaction to this information
would be for producers to look for ways to hire more capital equipment (which now
costs less) and less labour.
110
 « Figure7.9 Lover prices
would signal to producers a
greater availability of capital
Capital equipment is now less equipment
scarce and producers use
more of it

o o °
Thus, the forces of supply and demand work towards an efficient allocation of
resources. This is what Adam Smith referred to when he coined the term the ‘invisible
hand of the market'. Market forces, Smith argued, consistently and accurately guide
us to produce and consume to get the best outcomes. Buyers and sellers are rationing
resources, based on prices, to get the most from what they have. In the process,
consumer wants are satisfied with the least possible cost to society.

-« PPE prices soared in the first

half of 2020

]
Command economies,
because they do a poor job
of placing a value on goods,
are famous for producing
shortages. A noteworthy
shortage occurred in 1980
when, in parts of the Soviet
Union, milk was in such short
supply that it was rationed by
Case study - demand for PPE medical prescription. Little or
poor-quality food often led
Market shocks can raise serious ethical dilemmas about the ways a free market to work stoppages. A chronic
system will ration resources. As the COVID-19 pandemic began in 2020, demand lack of medical supplies and
for certain types of medical equipment rose rapidly. Hospitals, governments, and basic necessities had a long-
individuals were suddenly hunting down surgical masks, ventilators, coronavirus term debilitating effect on the
population. Even nurses were
tests, and personal protective equipment (PPE). The PPE prices soared because scarce because the job was
of the scarcity, perceived scarcity, and people taking advantage of the panic. For difficult and did not pay.
example, stories emerged about celebrities and powerful government officials For discussion and debate:
getting tested regularly, when in most countries getting a test was very difficult. 1 Conduct an internet search
Billionaires were believed to be buying up ventilators to personally keep in reserve, for ‘soviet food shortages’
even if they were healthy. and observe cases across
several decades. Were the
Discuss the following question: To what degree will a free market system solve or shortages a result of crop
failure or failures of the
exacerbate a shortage of resources during a health crisis? planning system?
m
 Competitive market equilibrium

7.3 How do competitive markets achieve

efficiency?

Learning outcomes
At the end of this section you will be able to:
explain the concepts of consumer surplus and producer surplus
« identify consumer surplus and producer surplus on a demand and supply
diagram
« explain the concept of social or community surplus and identify it on a demand
and supply diagram
« explain that allocative efficiency is achieved where MB = MC and that this is at
equilibrium price
« explain that allocative efficiency is where community surplus is maximised
explain that at any price other than the equilibrium price there will be reduced
community surplus and a welfare loss
. calculate consumer surplus, producer surplus, and deadweight loss from
adiagram.

Competitive markets can also yield benefits beyond the signalling, incentive,
and rationing functions explained above. Your study of free market equilibrium
encompasses the key concept of efficiency. Recall from Chapter 1 that ‘efficiency is a
quantifiable concept, determined by the ratio of useful output to total input’. In this
section, we will employ a specific measure of efficiency to analyse the qualities ofa
market equilibrium. Allocative efficiency refers to making the best possible use of
scarce resources to produce the combinations of goods and services that are optimum
for society, thus minimising resource waste. To understand allocative efficiency in the
context of market equilibrium, it is useful to examine the concepts of consumer surplus,
producer surplus, and community surplus.

Consumer surplus
Consumer surplus is the benefit consumers receive when they pay a price below
what they are willing to pay. The difference between the two is considered a buyer’s
consumer surplus for that product. Let us return to our example of chocolate bar
demand in a major city. A partial demand schedule is shown in Table 7.3 on page 114.

The equilibrium or market price for chocolate bars is, as with all other markets,
the intersection of supply and demand. In Table 7.2 (page 102), it is evident that the
equilibrium price is $1.50, where 15,000 bars are sold. However, a closer look at the
demand schedule tells us right away that there are chocolate fans who are willing to
pay considerably more than the market price. Here it is $1.50, where 15,000 bars are
expected to be sold. For each buyer willing to buy at a price of $2.50, and who only
pays $1.50, the consumer surplus is $1.00. For only that group of consumers the
consumer surplus is found this way:

Price willing to pay ($2.50) — Equilibrium price ($1.50) X Quantity (5000) =

Total consumer surplus at that price = $5,000
12
 Price per chocolate bar (P) ($)

Market Figure7.10 Consumer

L equilibrium surplus is the difference
between the price consumers
are willing to pay and the
1.00 market price

0.50

0 5 10 15 20 25 30
Chocolate bars demanded per
week (Q) (thousands)

Thus, the demand schedule reveals that this consumer surplus can be calculated as
the difference between what consumers are willing to pay and the market price they
ultimately pay (Table 7.2).
The total market consumer surplus can also be shown on a diagram, as the area
between the demand curve and the market price (Figure 7.10).
The demand curve reflects the demand schedule. Each point shows the highest price
consumers are willing to pay for the product. The difference between what a consumer
is willing to pay and any market price below that is considered consumer surplus.
Thus, the area of the triangle below the demand curve extending down to the market
price is the total area of consumer surplus. It can be inferred (from the schedule or the
diagram) that any decrease in price will have the effect of increasing consumer surplus,
ceteris paribus. Any increase in the market price will shrink that difference, causing a
decrease in consumer surplus.

To calculate the area of consumer surplus, use the formula for calculating the area
of a triangle:

__ (base X height)
area =
2

In the example above:

consumer surplus = W = §11,250

7

Note the consumer surplus is expressed in money terms, and should reflect the
units and amounts of the market being studied.

113
 Table 7.3 Demand and supply schedule: chocolate bars

Price of Quantity of Quantity of Specific

chocolate chocolate bars chocolate bars producer surplus
bars (P) supplied demanded per (market price —
$ per week (Q,) week (Q,) supply price)
(thousands) (thousands) $
2.50 25 5 —
2.00 20 10 —
1.50 15 15 0.00
1.00 10 20 0.50
0.50 5 25 1.00

Producer surplus
Itis also possible to see the same type of benefit accruing to producers. Producer
surplus is the benefit producers receive when they receive a price above the one at
which they were willing to supply the good. A close look at the supply schedule
in Table 7.2 should reveal this phenomenon. Even at the lowest price listed, some
producers are willing to produce. Perhaps they are very efficient. They would produce
5000 bars at a price of just $0.50. However, because the prevailing market price is
$1.50, $1.50 is what they receive for every unit sold. Therefore, they enjoy a producer
surplus of $1 per unit. Table 7.3 shows the producer surplus at each price.

The total market producer surplus can also be shown on a diagram as the area
between the supply curve and the market price (Figure 7.11). Each point on the
supply curve shows the lowest price at which producers are willing to sell the
product. Any market price above that is considered producer surplus. Thus, the
Price per chocolate bar (P) ($)

Figure 711 Producer > Market

surplus is the difference equilibrium
between the market price and
the lowest price at which
producers are willing to sell

0 5 10 15 20 25 30
Chocolate bars demanded per
week (Q) (thousands)
114
area of the triangle above the supply curve extending up to the market price is the
total area of producer surplus. It can be inferred (from the schedule or the diagram)
that any increase in price will have the effect of increasing producer surplus, ceteris
paribus. Any decrease in the market price will shrink that difference, causing a
decrease in producer surplus.

To calculate the area of producer surplus, use the formula for calculating the area of
atriangle:

area
(base X height)
2

In the example above:

15,000 bars X $1.50

producer surplus = = $11,250
2

Note the producer surplus is expressed in money terms, and should reflect the units
and amounts of the market being studied. Also, note that in this case, the amount
of consumer and producer surplus is equal. Were the general elasticities of demand
and supply different, the size of each surplus would also be different.

Community or social surplus Video suggestion:

Taken together, consumer and producer surplus are equal to community surplus, also You have read about it, now
you can review what you
called social surplus. We will use the concept of community surplus to analyse the have just learned by watching
concept of allocative efficiency in the section that follows. avideo by the author!
o Simply lick here in
your eBook for a video
Allocative efficiency and competitive markets on consumer surplus and
Allocative efficiency is generally considered to be in effect if society is getting the goods
producer surplus.
and services it wants most in the right amount. More specifically, allocative efficiency
is achieved if society produces enough of a good so that marginal benefit (MB) is equal
to marginal cost (MC). This most directly relates to the ‘what’ should be produced
question of economics. Through the price system, free and competitive markets
should bring consumers what they desire. But a look back at marginal cost and benefit
theory makes the case clearer.

You will recall from Chapter 3 that the MB derived from any good tends to drop
as more is consumed. In other words, satisfaction tends to decline with extra
consumption, and the demand curve’s downward slope reflects this principle.
Also, recall from Chapter 4 that the additional cost of producing more and more
units tends to increase. In other words, the MC tends to rise as more is made. This
explains why MB (demand) tends to slope downwards, and MC (supply) tends to
slope upwards.

115
 3.00
Community surplus
2.50

Price per chocolate bar (P) ($)

2,00

Market
Figure7.12 Communiy P 10 equilibrium
surplus s also known as
social surplus
1.00

0.50

0 5 10 15 20 25 30
Chocolate bars demanded per
week (Q) (thousands)

Figure 7.12 shows a market producing at equilibrium, with consumer surplus

represented by the area above equilibrium price and below the demand curve, and
producer surplus by the area below equilibrium price and above the supply curve.
Allocative efficiency asks whether a market produces what consumers want, and
part of the answer comes from the demand/marginal benefit curve. Figure 7.13
reproduces the demand curve showing that what consumers are willing to pay for
agood is our best guess at the value (or benefit) society places on it. It also shows
asupply curve indicating the rising cost to producers with each rise in output,
reflected in the minimum price at which sellers will offer up each new level of
chocolate bars.
Price per chocolate bar (P) ($)

Figure7.13 Allocative
efficiency is achieved where
marginal benefit is equal to
marginal cost

0 5 10 15 20 25 30
Chocolate bars demanded per
week (Q) (thousands)
116
 Allocative efficiency is achieved when, in a free market, supply (MC) is equal to
demand (MB). This is true in Figure 7.13: at $1.50, MC = MB. At any other price
or quantity, the market does not achieve equilibrium, nor allocative efficiency.
Ata price of $2.50, the MB is much higher ($2.50) than MC to society ($0.50). This
result suggests the market is producing too little, and that more of the good should
be produced and consumed. Why? There is still consumer and producer benefit
to be captured by increasing quantity, at least until the point where MB = MC.
However, any quantity and price combination beyond 15,000 units will see
marginal costs to society rise above the benefits of those units (MC > MB). This
suggests that the market is producing too much of the good, and output should
be scaled back.
If allocative efficiency is achieved, welfare is maximised. We can also demonstrate the
fact of allocative efficiency in free markets another way. Allocative efficiency is
also achieved when community surplus is at its maximum. In other words,
when supply (MC) equals demand (MB), community or social surplus will have
its largest possible value, and largest area on the diagram. In Figure 7.14a,
compare the allocatively efficient result with one where the price is set artificially
high. This could be legally required, as with a price floor (of which there is more
discussion in Chapter 9), or it could also be a mistake by sellers eager to get a
higher price.
In Figure 7.14b, the price is raised to P,. At that price, MB is greater than MC.
A movement along the demand curve occurs, as consumers reduce their quantity
demanded in response to the higher price at P,. The area of consumer surplus
is significantly smaller. The area of producer surplus will likely rise because
producers receive a higher price. Most importantly, whole areas that were
once community surplus (in orange), a combination of consumer and producer Figure7.14 Allocative
efficiency maximises
surplus, disappear. That loss of surplus is designated as a welfare loss, or welfare (2), but allocative
deadweight loss (DWL). DWL is a situation where the market loses producer or inefficiency results in
consumer surplus. deadweight loss and
reduced welfare (b)

v
a b

Reduced community
Community surplus surplus
 Price per chocolate bar/ $ (P)
Figure 7.15 Calculating
deadweight loss

0 5 15 20 25 30
Chocolate bars demanded per week
(Q, in thousands)

As a subject, economics Figure 7.15 reinforces the notion that it is only at the free market equilibrium price
is sometimes reduced to and quantity that allocative efficiency will be achieved, and community surplus will be
being all about 'supply maximised. You will study examples of government intervention in Chapter 9 where
and demand;, or rather the equilibrium is not allowed to be in place, and a similar loss in welfare will be
the competitive market
equilibrium you have the result.
studied in this chapter.
Why is this area of
knowledge so important?
To calculate the area of DWL, use the formula for calculating the area of a triangle:

(base X height)
D)

In the example above:

deadweight loss = 200X8L _ 5 500

2

Note the DWL is expressed in money terms, and should reflect the units and
amounts of the market being studied.

Exercise 7.2
Identify a common product you use or consume.
AW =

What is the maximum price you would pay for that good?
What is your consumer surplus for that good?
Draw an equilibrium diagram of the market for the good, indicating consumer
and producer surplus.
5 Identify the consumer, producer, and community surplus for this market.

118
Practice exam questions - assessment tips (Paper 1, part (b))
In Chapters 1 and 2, you were introduced to the part (a) sections of Paper 1
assessment. Part (b) requires students to evaluate and sythesise information, as well
as using the economics skills you have employed in part (). Expect to see command
terms such as: compare and contrast, discuss, evaluate, examine, and justify.

Part (b) asks students to see many perspectives on the question and to develop a
balanced argument. Competing ideas should be explored and weighed by the writer
to show serious judgement.
Part (b) answers are best illustrated with real-world examples that you have
collected over the course of your study in each topic. Your instructor may provide
some, and your research and inquiry may also.
And, as with part (a) questions, be aware that diagrams are typically useful, if not
required, to gain full marks. Below you will find several part (a) questions and a full
Paper 1 question.

Practice exam questions

Paper 1, part (a) questions:
1. Using a diagram, explain how an increase in demand for a good will change the
market equilibrium.
2. Using a diagram, explain the concepts of consumer surplus, producer surplus,
and community surplus.
3. Explain that allocative efficiency is achieved where community surplus is
maximised.
Paper 1, full question
a. Usinga diagram, explain the effect of a wheat shortage on the
price of bread. (10 marks)
b. Discuss the ways a functioning price system uses the signalling
and incentive functions to ration resources in a free market
economy. (15 marks)

119
2 _ { 4.
Critique of the /=
maximising behaviour [
of consumers and
producers
 8.1 What classical ideas are being challenged
by behavioural economics?

Learning outcomes

At the end of this section you will be able to:

« discuss how classical theory views consumer behaviour
* evaluate the concepts of consumer rationality, utility maximisation, and of
perfect information, providing real-world examples.

Asis described in Chapter 2, the assumptions and theory presented in this book so
far rest largely on a foundation of classical economic theory, a collection of ideas
formulated by various economists in the late 1700s to the mid-1800s, primarily in
Britain. Adam Smith, Jean-Baptiste Say, and David Ricardo were among the more
prominent writers who asserted that humans should be assumed to be rational beings,
who weigh the costs and benefits of any decision and act to make their own lives better.

This view may sound obvious and commonplace to modern readers. However, at the
time of their writing, this notion was part ofa broader movement of liberalism which
asserted that ‘man’ had intrinsic liberty to act freely and independently of traditional
bases of authority. Emerging as a distinct branch of Enlightenment thinking, liberalism
challenged the prevailing notions of hereditary privilege, state religion, absolute
monarchy, and the divine right of kings. Liberalism promoted the concept of natural
rights for all people, the rule of law rather than by fiat, and general democracy rather
than traditional authoritarianism.

‘Within economics, Smith and the other classical economists challenged the view
of colonial wealth-building by advocating for free trade rather than the mercantilist
approach that appeared to serve Britain so well at the peak of its empire. Ricardo
advanced the concept of comparative advantage, about which you can read in
Chapter 22, which asserted the virtue of free trade for all actors, regardless of power
or efficiency. On the microeconomic level, classical economists presented humans as
homo economicus, or ‘economic man’.

Homo economicus is the idea that human beings are pursuing their own self-interest,
acting in a consistently rational manner, while making themselves as ‘happy’ as
possible, on their own terms.

Rational consumer choice

The idea that people are constantly weighing the costs and benefits of any decision and
acting in their own interests falls under an area of economic thought known as rational
consumer choice. This has application in areas outside consumer choice, for example
when deciding how much time is reasonable to work and how much time to spend on
leisure. However, within consumer theory, rational choice applies mainly to our view
of goods and services. We buy, according to classical economists, whatever we like
best, taking into account our preferences. Rational choice theory centres on individual
preferences and assumes that what is beneficial or not is decided on a personal level.
121
 Critique of maximising behaviour

The perceived value of any good or service matters only to the individual buyer. It is
not possible to assign universal value. However, these collective preferences determine
the market demand for a good.

Utility maximisation
Recall from Chapter 3 how the concept of utility helped explain the law of demand.
Economists broadly define utility as ‘satisfaction’ or ‘contentedness’. Classical
economic thought assumed that each of us are utility maximisers, in that all humans
seek as much satisfaction or contentment as possible. This view allows for perceived
acts of selflessness or charity as ones that generate psychic happiness, if not material
success, and still can be considered rational acts for the individual. As applied to
consumer theory, utility maximisation assumes that we buy what we buy to maximise
our total utility, one purchase at a time. In other words, we buy the most ‘important’
things, those with the highest utility relative to what we can afford, first, and then
move down the line to less essential or less satisfying goods.

Perfect information
Classical free market theory also asserts that buyers hold all the necessary information
to make a buying decision. To buy an electric fan, for example, one would know all the
product models available, their features, levels of quality, and reliability. And buyers would
weigh these variables against their own preferences and budget, and shop accordingly.
This theory holds that this is true for all consumers at all times, and for all products.
Therefore, whether evaluating supermarket purchases or healthcare procedures, plastic
toys or financial instruments, consumers know and understand all their options fluently.

Collectively, the classical economists asserted that homo economicus will always
maximise his or her own utility, making rational choices, and using perfect
information. It is this view that behavioural economics began to challenge in the
middle of the 20th century.

8.2 What does behavioural economics say

about the assumptions of rational
decision making?

Learning outcomes
At the end of this section you will be able to:

* compare and contrast behavioural economics and classical economics

* examine how cognitive biases like rule of thumb, anchoring, framing, availability,
and imperfect information conflict with the notion of rational choice.

Behavioural economics is a branch of economic research that adds elements of

psychology to traditional models in an attempt to better understand decision making
by economic actors. It challenges the assumption that actors will always make rational
choices with the aim of maximising utility.
122
While the classical view of economies as self-regulating mechanisms on the national
level was challenged contemporaneously by socialist thinkers like Karl Marx and
Friedrich Engels in the 1800s, disputations of the notion of homo economicus only
developed a century later, in the mid-1900s. Prominent work in the field has only
been recognised by the Nobel Committee in recent years, starting with the awarding
of prizes related to behavioural economics in 2002, then 2013, and 2017. Since then,
many governments around the world have established behavioural economics groups
to inform policy and to create more positive social outcomes by guiding the actions
and choices of their citizens.

What is cognitive bias?

Cognitive biases are systematic deviations from rational judgement. The study of
cognitive bias has influenced behavioural economics to question the basis of rational
decision making as a valid assumption about human behaviour. Cognitive biases are
attempts to solve the problem posed by imperfect information, which is the idea that
consumers are unlikely to be able to absorb and process all correct information to
make decisions in a way that rational choice theory would assume. In the absence of
the time, energy, and concentration needed to make rational choices, we rely on these
biases instead.

Rules of thumb
Also known as heuristics, these are mental short-cuts for decision making to help
people make a quick, satisfactory, but often not perfect, decision about a complex
choice. Tonly shop when there are sales’ is an example. Or ‘I always buy my airplane
tickets early, because that is when prices are lowest.” These short-cuts will shape
choices, even when more research and a fuller understanding of all options would
produce a different outcome.

Anchoring
Anchors are mental reference points, relating to ideas or values, which are used to
make decisions. One way to look at anchors is that by using them you are giving too
much ‘weight’ to the first piece of information you learn. Anchors can establish a value,
imprinting it on our mind. There it serves a reference point for decisions. Retail shops
use anchoring by displaying a manufacturer’s recommended retail price (MRRP) far
above their expected price, and listing a ‘sale’ much closer to their desired market price.
Buyers, influenced by this anchoring effect, may assume they are getting a good deal.
As an illustration, imagine a shopper excited to buy a simple white t-shirt that has
been marked down by 75%, from 1,600 (% is the symbol for the rupee, the currency
of India) to 7400, and thinking he is getting a ‘good deal’. In reality, the t-shirt’s
equilibrium price is closer to 2400 than to 21,600, but the 75% ‘sale’ creates the
perception that it is a great deal.

Framing
Framing is the way that choices are described and presented. Changing the framing of
a choice may affect tastes and preferences. Both options have the same outcome, but
framing influences the choice.

123
 Critique of maximising behaviour

For example, if given the opportunity to ‘save 90 out of 100 lives’ or ‘risk losing 10 out
of 100 lives’ many would choose the ‘save’ option.

Below are some common choices that all have the same outcome. Which would
you choose?

* Meat that is advertised as 75% fat free’ or 25% fat’.

* A $1,000,000 lottery ticket that says ‘1 in 10,000 are winners’ or ‘9,999 in 10,000 are
losers’.
* Birth control that is ‘99% effective’ or that has a ‘1% failure rate’.
* Signalling cheap prices by listing a toaster for $19.99, or signalling luxury or taste
by round number prices, like a designer bag for $700.
Y
Veggf 4
Like other cognitive biases, framing undermines the idea that consumers absorb all
the relevant information around every choice, weigh the options completely, and take
the more beneficial choice. If consumers behave consistently in a rational way, framing
would have little effect.
A
influence
consumer choices. Why Availability
d"1% hich is the Availability bias makes us believe that something is more likely because we have
same idea, have a less positive heard of it or that comes to mind first. No deliberate calculation of risk or rewards is
response than ‘9% fat free?
involved. Examples could include the following.

TPy * A popular movie depicting shark attacks makes beachgoers reluctant to swim.
¢ Local news watchers see crime stories every night and vastly overestimate the
Find your own examples of actual amount of violent crime.
cognitive biases shown here.
Conduct an internet search * Aspate of colder than usual weather might condition some to ignore data on the
for such examples and share incremental process of climate change because their current experience says
them with your class. Do otherwise.
these examples apply to you? * Pharmaceutical advertising may underestimate the effectiveness of therapies that
do not involve taking medicine and overestimate those that do.

8.3 How does behavioural economics explain

consumer decision making?

Learning outcomes
At the end of this section you will be able to:

« discuss how a dual system model of decision making differs from the classical
view of rational choice
* examine the concepts of bounded rationality, bounded self-control, and
bounded selfishness, identifying real-world examples.

Behavioural economists Daniel Kahneman and Amos Tversky developed a model that
allowed for both views of decision making (that described by the classical economists
and those explored by 20th-century behaviouralists) to co-exist.
124
 The dual system model
Kahneman and Tversky’s dual system model describes System 1 as the impulsive,
irrational, and cognitively biased approach to decisions. System 1 allows for quick
decisions based on short-cuts, limited available information, and is susceptible to
framing and anchoring effects. System 2 thinking, in contrast, refers to deliberative,
reflective, and careful thinking that would more closely resemble the rational analysis
implied by homo economicus.

System 1 is used whenever solving problems or making decisions ‘without thinking. It

is intuitive, emotional, fast, and prone to error. You would use System 1 when:

* quickly adding 50 + 50
* having a casual chat with your friend
« reading the text on the cover ofa magazine
* buying a sweet or dessert after a meal.
System 2 thinking is employed when doing more complex tasks, and involves slow,
thoughtful, logical processing. You would use System 2 when:
multiplying 265 X 19
« finding the cause ofa mysterious ache or pain
* deciding how to invest your money
* buying a house or property.

Of course, humans toggle between these two approaches, depending on their time,
interest, and the cost ofa particular decision (monetary or intrinsic), among many
possible variables. Because we make thousands of decisions every day,
System 1 allows us to reserve our time and focus for decisions that we believe
require System 2.

Behavioural economics, therefore, builds a case that the notion of humans as cold,
rapid cost-benefit calculation machines should be expanded to include a more realistic
concept of rationality. L ]
Decoy pricing is a strategy
that uses behavioural
What is bounded rationality? economic theory to increase
revenue by presenting
Bounded rationality suggests that most consumers and businesses do not have limited choices appealing to
enough information to make fully informed choices and so opt to satisfice, rather cognitive biases. For example,
than maximise their utility. Satisficing is a combination of the words ‘satisfaction’ and by presenting three differently
‘suffice’, meaning that to arrive at this kind ofa choice is to find an acceptable, or ‘good | priced product options, it
might point the customerto
enougly’, choice in that context. a medium-priced option by
encouraging them to perceive
Influenced by our cognitive biases, and pressed for time to make thousands of choices a cheaper version as inferior
every day, humans rely on bounded rationality to make choices. We may not have and a higher-priced version
the brain power to calculate sophisticated decisions, and therefore resort to System 1 as too expensive for them
thinking and make decisions based on short-cuts, framing, and emotion. For discussion and debate:
1 Conduct an internet
Choosing ice cream in a large supermarket can be a daunting task, with many brands, search for examples of
flavours, and choices on offer. To optimise your choice and select the ‘best’ may require decoy pricing
consultation with your friends or family, checking online reviews, even the sourcing 2 Summarise one example
of the milk used (if that is important to you). It is far more likely that one will rely on and share it with your
rules of thumb and anchoring, among other cognitive biases, to decide. You may avoid dlass.
125
 ice cream priced too high based on rules of thumb. Furthermore, among the more
typically priced brands, you may buy what is on sale if you perceive it to be discounted
based on your perceived ‘right price’.

Some of behavioural economics research casts doubt on the rigidity of foundational

economic concepts, such as the law of demand. In one prominent study, researchers
surveyed wine consumers and asked for their perceptions of the quality of wine at
different prices. In response, drinkers reported higher levels of satisfaction from wine
they were told cost more, even when they were served cheap wine. This suggests that
pricing itself can influence the perceived benefits of a good, rather than exclusively a
factor on the cost side. Moreover, it also suggests that some businesses might actually
be able to sell more of some goods at higher prices than if they were priced lower: a
contradiction of the law of demand.

Herd behaviour
The existence of market bubbles also challenges the notion of cold rationality. In
markets for financial assets, for instance, if buyers truly behaved in fully rational ways,
investors would quickly notice the overvaluation of assets, such as stocks or mortgage
bonds, and would sell them off before prices escalated significantly. But often they do
not, and prolonged overvaluations (bubbles) take hold, indicating that instead of being
rational decision makers, investors are subject to a ‘herd mentality’.

Risk and loss aversion

Another facet of bounded rationality is in the area of risk. Generally, research indicates
that people tend to feel losses more painfully than the pleasure received from an equal
reward.

One way to know if you are risk averse is to ask how you would answer this dilemma:
Given two envelopes, one with zt500 (zt is the symbol for the zloty, the currency of
Poland) cash and one with z10, you are asked to either choose from the two envelopes
or accept a cash amount instead.

* Ifoffered 21250 cash and you accept, you are ‘risk neutral’ because you accepted a
payoff equal to the probability of your expected payoff from the choice between
envelopes.
* Ifoffered z1355 and you decide to try the envelopes, you are generally ‘risk tolerant’
because you rejected a cash payment that is higher than the expected return of
21250 from the envelopes in the hope of getting lucky and getting the z1500.
* Ifoffered z£245 and you accept, you would be ‘risk averse’ because you would accept
less than the expected payoff from choosing envelopes, since you would prefer the
guarantee of 21245 over the 50% chance you get the envelope with nothing in it.
Loss aversion is observable in the use of ‘free trials’ to consumers. If offered a free
trial for a streaming service or grocery delivery service, consumers are less likely
to quit after the trial and lose’ the product. In the same manner, shoppers are not
influenced by a 5-cent reward for bringing their own bags, but will do so more often
if charged 5 cents.

126
 Case study - the ultimatum game
Economists use the ultimatum game to demonstrate how humans behave
irrationally depending on the situation. In the game, one player is given $100 and
will offer a split with the other player. If offered less than $50, what would you do?
Players rejected such offers much more frequently than offers of $50 or more. This
defies rationality, because the players stood to receive no money at all before the
game. Why not accept any offer, $1 or higher? $1 is better than $0. But the player’s
decisions were complicated by notions of what is ethical or fair.

Bounded self-control
Another way of explaining seemingly irrational behaviour is the concept of bounded
self-control. In reality, consumers are often not rational in their self-control and do not
stop consuming, even when it is sensible to stop. They consume even though the price
of the good or service is greater than the marginal utility they gain from consumption.
To understand how consumers could so directly contravene their own rational
assessments, the idea of hyperbolic discounting is useful. This is the idea that people
can discount future costs in favour of current consumption. Should one buy and
eat a second slice of chocolate cake? Consumers can easily devalue the costs of such
consumption, which in a small way will contribute to health problems later, and make
the less beneficial choice. Tied to this idea of bounded self-control is the idea that
people sometimes have difficulty in delaying gratification, and would rather indulge in
short-term rewards.

Bounded selfishness L ]
Also known as bounded self-interest, bounded selfishness allows for the fact that people Do the wealthy give more
act on behalf of the well-being of others, not only themselves. Why race into a burning to charity than the less
building to save a stranger? Why donate money to charity? Acting in accordance with wealthy? Explore the notion
of bounded selfishness by
rational cost-benefit analysis, you may not. Bounded selfishness recognises that people researching the connection
sometimes act on perceived moral grounds, or with regard to the social norms of others between income level and
even when that comes at some risk ofa net loss in satisfaction. charity. Look for giving rates
expressed as a percentage
of income to find a more
Is behavioural economics really new? accurate comparison.

To what degree does behavioural economics really challenge the rational behaviour
world view? Behavioural economists tend to assert that the less-than-rational
individual is a new paradigm, one that should be added alongside the classical view.
Critics of this view argue that a definition of humans as rational largely incorporates all
the poor decisions described above, that even if a calculation about costs and benefits
discounts future costs (see cake example above), this choice still qualifies as a rational
choice on its own.

In this view, time and effort used to evaluate all the alternatives is also a cost, and
cognitive biases that are described negatively actually help us reduce those costs and
make decisions quickly. Furthermore, if rational thinking were only defined as System 2
thinking, nobody on Earth would be considered rational because everyone uses
short-cuts. Rational choice has always, it is argued, been subjective, and that the model
allows for cognitive bias.
127
 Critique of maximising behaviour

What behavioural economics has contributed, some say, is a more realistic depiction
of rational thinking, one that is very good at describing situational behaviour that
may appear at-odds with obvious cost-benefit analysis. Nonetheless, if the place of
behavioural economics within classical theory is not completely settled, its role in
shaping decision making in business and government is more popular than ever.

8.4 Can behavioural economics help

governments improve social welfare?

Learning comes
At the end of this section you will be able to:

* examine the general approach taken by nudge theory towards business

decisions and government policy
« discuss how choice architecture works to alter choice among consumers.
and citizens
« compare and contrast default, mandated, and restricted choices
* evaluate the extent to which nudge theory can support social welfare.

Governments have begun to take notice of behavioural economics, and in some

cases have even launched agencies that put its theories to use in improving social
welfare, including through education, legislation, and enforcement. ‘Nudging’, another
application of behavioural economics, uses choice architecture to preserve an aspect
of free will while structuring the options to subtly guide behaviour.

What is nudge theory?

Nudge theory rose to prominence with the publication of Richard Thaler and Cass
Sunstein’s 2008 book Nudge: Improving Decisions About Health, Wealth, and Happiness. In it, the
authors draw on elements of psychology and economics to develop techniques targeted
at specific populations to alter their choices. It has been employed in the private sector
and by governments, most notably those of the USA, Singapore, China, and the UK.
A nudge, according to Thaler and Sunstein, should not forbid any options or significantly
change their incentives. Nudges must be ‘cheap and easy to avoid. Nudges are not
mandates. Putting fruit at eye level counts as a nudge. Banning junk food does not.

Therefore, nudge theory is a form of subtle government intervention, but one that
does not change the basic cost-benefit analysis. Taxes, subsidies, and price controls all
change the fundamental cost-benefit ratio, while nudge policy presents the choice in a
different way, to encourage the socially beneficial choice.

Some prominent examples of successful nudge experiments include the following.

Putting healthy food at the cash desk of train station kiosks in Dutch train stations.
* Making organ donation the default choice in Spain, where citizens must opt-out of
the programme if they do not wish to donate.
* Onenergy bills, the display of average use by neighbours and conservation tips to
reduce energy consumption in the UK.
128
What is choice architecture? L P
Choice architecture is a collection of tactics designed to shape decision making Using your school library
that use the layout, sequencing, and range of choices that are available. Firms and research engines and
your own search tactics,
governments use choice architecture to generate more of the results they desire. investigate how choice
architecture influences
Nearly all retail environments employ choice architecture to maximise profits. Luxury decision making i different
goods with high prices are prominently displayed. To find necessities, one must hunt contexts (for example, its role
to the further reaches of the store. When entering a large department store, the sales of in a supermarket, or how
fragrances, makeup, and beauty products are staged on the main floor, while shirts and it may influence the rate of
shoes will be further away. Supermarkets put sweets at the cash desk, knowing that
organ donation in different
countries),
after an hour of shopping, few customers can resist the temptation.

What are defaults?

Defaults are choice frameworks where one option is pre-selected and the decision
maker must take active steps to opt-out of the scheme. Organ donation, as noted above,
as well as the enrolment of college students into health insurance plans, and enrolment
into savings plans, all have used default options to encourage the desired behaviour.
Defaults are believed to be successful in part because the decision maker views the
default choice as an endorsement of the selection by a more informed party. Default
selection may be influenced by status quo bias: the notion that behavioural inertia
reduces people’s appetite for change, as well as the extra effort required to opt-out
ofa choice. Defaults tend to work well in situations where the ‘presumed consent’
fits the target population. However, this can lead to strong objections where such
a presumption is out of line with popular sentiment. When installing software,
consumers generally prefer having a recommended setting rather than choosing from
many alternatives. With organ donation, the presumption can be taken negatively.

What are mandated choices?

Mandated choices are when consumers are required to state whether or not they wish
to take part in an action. Also known as a choice requirement, one that typically forces
a choice before continuing along a process. Compared to defaults, required choice
presents the options as relatively equal, and any choice as more explicitly voluntary. In
the organ donation example, mandated choice is sometimes more popular than default
mechanisms. For example, in the US state of Illinois, people are asked if they would
like to choose organ donation as they are receiving their drivers licences. This has
increased the positive response rate significantly.

What are restricted choices?

Restricted choice is when the choice ofa consumer is restricted, but still exists. The
placement of healthy food at eye level is an example. With little effort, junk food lovers
can still buy what they want, but consumers who are acting quickly will buy a healthy
option with that subtle change in placement. Restaurants use restricted choice and
anchoring to encourage spending by having a menu item that is much more expensive
than all the others. They do not expect many to order the item, but to instead order
the next most expensive. Having been anchored by the higher price, consumers feel
permission to order the next lower option. Credit card companies have managed to
lower the payback rate, and therefore earn more on interest, by stating a ‘minimum
amount due’ on all bills.
129
 Critique of maximising behaviour

[Ty Nudge theory can be viewed as an attempt to apply the behavioural critique of classical
economics to improve social outcomes. If consumers do not behave rationally, in the
Asocial credit system is
a means of generatinga strictest classical sense, because of time constraints, complexity, or emotion, nudge-based
unified reputation score policymaking can fill the information gap, save time, and improve results. Firms, too, can
on one’s behaviour in a use this approach to raise profits (though not always to improve social outcomes).
prescribed set of community
interactions. Using nudge At the same time, critics are debating whether nudges amount to ‘liberal paternalism’
theory rather than laws to that denies true freedom of choice and the extent to which nudges become ‘shoves’
affect behaviour, the system
has positive behaviours add and the state’s behaviour becomes coercive. Preliminary studies of the acceptance of
to one’s score, and negative policies based on nudge theory suggests that countries with high trust in government
ones reduce it. Examples regard it most positively, and those with low trust in government regard it with the
of negative behaviour that most suspicion.
can be cited are playing
loud music, failure to sort
personal waste, and generally What about the maximising behaviour of producers?
dishonest behaviour. Positive
acts, like giving money to Producers and consumers have rather oppositional aims when each is ‘maximising’ on
charityor volunteering, can their own behalf. As we have seen, the theory suggests that consumers are generally trying
add to the score. Based on to maximise their utility. Producers, we assume, are trying to maximise profits. Throughout
such 'trustworthiness' scores,
a citizen may be approved or this chapter, we have called into question whether rational consumers really maximise
denied choices of housing, utility all the time, and it is fair to question whether producers always maximise profits.
travel, and use of public In fact, in Chapter 11, we will explore business strategies that specifically avoid pure profit
services. maximisation, such as satisficing and increasing market share.
For discussion and debate:
1 Conduct an internet
search into the different Case study - behavioural economics used to fight a pandem
examples of social
credit systems in various The coronavirus pandemic and consequent spread of COVID-19 disease starting
countries. in 2020 was viewed as a complicated scientific, health, economic, and behaviour
Using multiple problem. Early on, it became evident that part of the solution to the spread of the
~

perspectives of the virus was changing behaviour. ‘Bending the curve’ meant reducing rates of infection
possible stakeholders to avoid overwhelming health systems and to buy time to develop treatments and
affected by such a policy,
discuss the ways in which vaccines. In particular, the need for everyone to behave differently made spread
social credit systems may prevention a collective action problem. In these problems, everyone would be better
have positive and negative off if everyone cooperated but may not do so because of competing interests that
effects. make it difficult to work together.
Remember the assumption of perfect information? In the best of times, and under
clear scientific consensus, techniques like vaccinations against common disease
have become areas of controversy. In a pandemic where little is known, information
changes daily, and initial opinions are revised, many people found it difficult to
process and understand the complex sets of information shared every day. ‘Is there
enough testing? How many cases is too many? How big a risk am I taking going to
the gym?’ Information is decidedly imperfect.
Behavioural economics and psychology also described other reactions to the
pandemic. Besides status quo bias, one area of cognitive bias at work in the crisis
was loss aversion as people rushed to stores and stocked up on food, cleaning
products, and toilet paper. Was this rational? Game theorists point out that if
everyone believes the stores will be sold out, it makes sense to ensure your own
supply. Another was optimism bias, the idea that one’s odds of suffering the disease
were lower than they actually were, going to clubs, religious gatherings, and densely
populated events.

130
Because the virus required collective action, governments were challenged to
encourage self-sacrifice, trust, and cooperation. As the causes of COVID-19 became
more clear, nudge theory was employed to educate the population to the risks, and
to aggressively attack the status quo bias against preventative actions. To change
behaviour without draconian legal tactics, authorities, schools, and businesses
resorted to several different nudge techniques.
+ Posting clear signs encouraging social distancing of between 1 and 3 metres.
* Multi-media advertising of the need to wash hands.
+ Community leaders modelling mask-wearing to encourage compliance.
* Marking floors with socially distanced places to stand while waiting in line at the
cash desk as an example of choice architecture.
* Social media campaigns to wash hands thoroughly, while singing ‘happy
birthday’.
+ Government press conferences in the UK with messages written on the front of
the podium, in camera view, saying ‘Stay Home. Protect the NHS. Save Lives'.
* The free distribution of masks to the poor or anyone who wanted them.

o Social distancing and mask

wearing in public

Some measures like quarantine orders, mask requirements in public spaces, and
work-from-home rules were also reinforced by fines and threats of imprisonment.
However, in most instances, authorities relied on the more direct and indirect
persuasive tactics. Here, as in the examples of nudge tactics above, social trust as
well as trust in one’s government, played a key role in predicting compliance with
the new rules.

Discussion questions:

1 What kind of rules did your school or local government put into place to
encourage safe behaviour?
What kinds of biases did these tactics attempt to diminish?
Was compliance widespread or fragmented? Why do you think this was true?
W

Would you change some of the tactics employed, or when they were employed?
vk

Why might guidelines based on nudge theory be preferable to legal

enforcement?

131
 Practice exam questions
Paper 1, part (a)
1. Distinguish between the classical view and behavioural
view of rational decision making. (10 marks)
Paper 1, full question
a. Using three cognitive biases, explain how consumers can be
guided when making buying decisions. (10 marks)
b. Evaluate, using real-world examples, the degree to which nudge
theory may be used to create more socially efficient outcomes. (15 marks)

132
 Real-world issue 2
When are markets unable to satisfy important economic objectives —and does.
government intervention help?

The market mechanism may result in socially undesirable outcomes that do not
achieve efficiency, environmental sustainability, and/or equity.
Market failure, resulting in allocative inefficiency and welfare loss.
Resource overuse, resulting in challenges to environmental sustainability.
Inequity, resulting in inequalities.
Governments have policy tools that can affect market outcomes, and government
intervention is effective, to varying degrees, in different real-world markets.
Role of government
in microeconomics
 9.1 Reasons for government intervention
in markets

Learning outc

|
At the end of this section you will be able to:

+ comment on the reasons for government intervention in markets.

In Chapter 1 we introduced a different range of economic systems, with completely

free market economies and centrally planned economies at the two extremes and
the most common systems, mixed economies, found in the middle of the spectrum
between free market and centrally planned economies. Every national economy in the
21st century (except perhaps that of North Korea) falls somewhere in between the two
extremes of the spectrum of economic freedom; in other words, almost all economies
exhibit some characteristics of free markets and some of planned economies.
Government intervenes in the economy in various ways to promote economic
objectives that are unmet by the free market system.

When are markets unable to satisfy important

economic objectives?
Markets are great at providing society with most of the goods and services people desire.
When there is a large enough group of willing buyers for a product, their demand signals
potential producers that there is a willingness to pay for the good or service. In response,
entrepreneurs form businesses to gather the resources needed to produce the good and
to supply it to the buyers. Like magic, a market is formed to satisfy society’s wants.

However, the market mechanism may result in undesirable outcomes that do not
achieve efficiency, environmental sustainability, and/or equity. When markets fall
short of these desired outcomes, there may be a need for government intervention.

When markets fail

Additionally, market failures may result, in which particular goods are either
overproduced or underproduced due to the existence of negative or positive effects
imposed on third parties arising from their production or consumption. Sometimes
markets fail to achieve allocative efficiency, as it is described in Chapter 7, and in
these cases government intervention might help promote a more desirable level of
production that increases overall social welfare.

When sustainability is threatened

Markets also sometimes result in resource overuse, which threatens the overall
sustainability of the economic system as a whole. A system is sustainable when it is
able to endure in its current form indefinitely for generation after generation. The
market often under-values or under-prices non-renewable resources, resulting in
their exploitation in the present at a rate that depletes them faster than they can be
replenished. When resources are overused today, they will be unavailable for future
generations, thus the system under which they are exploited becomes unsustainable. 135
 Role of government in microeconomics

To fund government
The very existence ofa government requires a funding mechanism to allow the
government to operate. It may seem odd to state this, but the government itself is
agood that is not provided under a free market system. To finance the functions of
government, some degree of intervention in the market is necessary. Taxes on income,
production, or consumption, for instance, help generate the revenues necessary for the
government system to function; thus, intervention in markets is a necessary condition
for the very existence of government.

To promote equity
Governments may also intervene in the market to support firms or households through
subsidies or transfers (when income is reallocated through taxes from one group in
society to another). Government intervention can influence both the level of production
and of consumption in a market to correct market failures or to promote equity.

Does government intervention help?

Governments have policy tools that can affect market outcomes, and government
intervention is effective, to varying degrees, in different real-world markets. However,
government intervention does not always improve market outcomes, and one of the
roles economists play as social scientists seeking to understand markets is to evaluate
the extent to which government intervention is necessary, and when it exists how
well it achieves its stated intention, be that to raise revenues for government, to help
producers or consumers, to incentivise more or less production ofa good, to provide a
good that might not be provided by the free market, or to regulate a good’s production
or consumption to promote sustainability, equity, efficiency, or any other welfare-
increasing outcome that might not have been possible under free market conditions.

9.2 Price controls

Learning outcomes

At the end of this section you will be able to:

* explain why governments impose price controls, giving examples
. analyse the impacts, using diagrams, of price ceilings and price floors on
market outcomes
« comment on the possible consequences of price controls for markets
« discuss the consequences for stakeholders of imposing price controls.

While free markets have many virtues, there are situations where the outcomes are
not optimal for all the participants. In some of these situations, the government enacts
maximum prices or minimum prices in order to benefit either consumers or producers.

Price ceilings
A price ceiling is a maximum price imposed by the government below the equilibrium
price in a market. In this market situation, the government determines that there is a
136
 Price (P)(€)
<« Figure9.1 Theimpositior
price ceiling leads to
shortage

0 Q=4Q:=6Q,=8 qQuantity(Q)
: (millions)
Shortage = 4 million
potential for higher than desired prices, and makes a goal of keeping prices low. Often
governments take this step to make basic goods and services more affordable for lower
income households. Thus, by preventing an increase, the government places a ‘ceiling’
on the price ofa good.
Assume the French government wishes to keep baguettes (a small loaf
of bread)
affordable for people of all income levels; therefore, the government sets a maximum
price of €2 per baguette in the market. Without the price ceiling, let us assume the
equilibrium price of baguettes would be €3. Figure 9.1 shows the daily baguette market
with the price ceiling in place.

Under free market conditions, the price ofa baguette would be €3 (P)) and the
equilibrium quantity would be 6 million baguettes per day (Q,). The French
government has imposed a ceiling price of €2 (P,), however, which has led to a greater
quantity demanded (8 million) and a smaller quantity supplied (4 million). The lower
price imposed by the government has sent signals to French consumers to demand

137
 more baguettes and to French bakers to bake fewer baguettes. The laws of demand
and supply drive a wedge between the quantities demanded and the quantity supplied,
resulting in a daily shortage of baguettes.

What are the effects of price ceilings?

As we can see from Figure 9.1, a price ceiling has several effects on the market,
including the following.

Shortages
With a binding price ceiling (i.c. one that is actually below the equilibrium price)
producers will reduce output while consumers demand more, creating a shortage in
which there is excess demand for the product.

Rationing
Without price to guide the rationing of the good, consumers and producers will use
other means to determine who receives the product. Some methods of rationing
include government-created ration cards or vouchers, which may have their own
system by which consumers receive the product (perhaps ‘family size’ if the product is
astaple food). Waiting in line fora scarce good is common. Additionally, special barter
deals may be arranged with the seller, which effectively increase the price of the good.

Decreased market size

With the reduced quantity supplied, less of the good is produced, reducing
employment opportunities in the affected industry and the actual level of
consumption among buyers.

Increased consumer surplus

The intent of a price ceiling like that on baguettes in the example is to make a staple
good more affordable to consumers. To that end it succeeds, but the trade-off is fewer
overall consumers. While some people are able to buy the price-controlled good at a
discount compared to the equilibrium price, fewer people overall will have access to
the good. In the case of our baguettes, this may mean that bakeries are sold out of fresh
baguettes by 11 a.m. every day, and people who cannot make it to the bakery by that
time are unable to have a fresh loaf of bread. At a higher price, bakers might be willing
to bake enough bread to keep their shelves stocked all day long.

Elimination of allocative efficiency

Allocative efficiency is achieved when marginal benefits (MB, represented by the
demand curve) equal marginal costs (MC, represented by the supply curve). The price
ceiling eliminates this efficiency. Now, the price is set by the government, not where
MB = MC. Society is not producing enough of the good with the price ceiling in place.
Figure 9.2 shows the deadweight loss (DWL) that results from a binding price ceiling.
* The lower price has increased consumer surplus relative to what it would have been
at equilibrium.
* Producer surplus is reduced, since less of the good is sold at a lower price.
138
 Price (P)
« Figure9.2 A binding price
ceiling results in the loss of
community surplus

0 Q Q% Quantity (Q)

+ The red area represents the DWL, or the loss of overall efficiency and welfare
created by price ceiling. The increase in consumer surplus is less than the decrease
in producer surplus, so overall the market is made worse off.

Emergence of black markets

The disequilibrium created by a price ceiling puts pressure on sellers to withhold their
output from the formal market and instead sell it on the informal or black market.
‘Whenever there is an imbalance between the quantity demanded of a good and the
quantity supplied, sellers will turn to the black market to meet the excess demand
by selling their product at a higher price than the government’s ceiling price. This
undermines the validity of the price control's intended outcome; instead of buying
baguettes at the more affordable €2 each, buyers may be forced to turn to the black
market where they can be purchased at €4, a price higher than what the market would
have provided them for without any government intervention.

What are some examples of price ceilings?

Besides staple foods, governments have implemented price controls on all sorts of
goods and services in an effort to aid consumers. Some common markets in which the
government places maximum prices include health insurance, taxi fares, diapers and
baby food, certain prescription drugs, and, notably, the market for low-income housing.
Rent controls, as price ceilings in the housing market are called, have been employed
by countless cities around the world to control increases in rental rates for housing
within their jurisdictions in order to make housing more affordable for middle and
lower income residents. The city of Oakland, California, for instance, has a rent control
law that prohibits the rate of increase in rents from exceeding the rate of inflation.
For instance, if inflation for 2020 turned out to be 1%, then no landlord in the city of
Oakland would be allowed to increase rent by more than 1% between 2020 and 2021,
no matter what the conditions in the market for housing are.
Figure 9.3 shows the impact rent controls might have had on the market for two-
bedroom apartments in the city of Oakland assuming that housing demand increased
at a steady rate between 2020 and 2021.
The actual demand for two-bedroom apartments has increased from D in 2020 to
D in 2021. With higher demand landlords are motivated to charge higher rents; the
139
 Rent (R)
R, 2021
Figure9.3 Rentcontrols
limit the rate of increase in
R.2021b
rents but also lead to shortage R, 2020

Shortage

equilibrium rent increases from R, 2020 to R, 2021. However, due to the city’s new law
limiting rent increases to the rate of inflation, the allowable increase in rent is only to
R_2021. At this lower than equilibrium rental rate, the quantity supplied of apartments
only increases incrementally, from Q, 2020 to Q,, while the quantity demanded
increases more dramatically (to Q), resulting in a shortage of affordable housing
ofQ, = Qs
As with all price ceilings, the intended beneficiaries of the rent control are both helped
and harmed. The lucky renters who are able to find apartments at R 2021 are better
off than they would have been had rent been allowed to increase to R, 2021. However,
there is now excess demand for affordable housing. Some families that wish to rent an
apartment are unable to find an available unit. Landlords who might have been willing
to put their units onto the rental market at R, 2021 are unwilling to do so at R . 2021,
due to the reduced potential for profits at the government’s allowable rental rate.

Price ceilings create winners (the lucky consumers who get the good at the controlled
price) and losers (consumers who are cut out of the market and producers). When
binding, they reduce market size, require a system of rationing, and reduce allocative
efficiency, creating more harm than good for the market overall.
However, when implemented carefully, which might mean combining them with other
forms of government intervention such as subsidies (outlined later in this chapter),
price controls can improve access to essential items like food, sanitation products, and
affordable housing, to those who otherwise might be unable to afford these goods. In
this way, price ceilings can increase equity and equality in society, levelling the playing
field for those who otherwise might be left behind by the free market system.

Price floors
Whereas a price ceiling is set by the government below equilibrium to help consumers,
aprice floor is the opposite: a minimum price set above the equilibrium price ina
market aimed at helping producers of the good.
Price floors are often established to help producers of essential commodities like
food crops earn an income that allows them to continue in the market even when
equilibrium prices fall to a level at which they might otherwise choose to leave the
140
 Price per 60 kg
33& bag (P) (R$) « Figure9.4 A price floor set
oo
[N
QG
e below the market equilibrium
price has no effect

0 Qe Quantity of
60 kg bags (Q)

market. Another popular price floor used in many countries is the minimum wage,
which is used to guarantee ‘working class’ individuals a living wage and to prevent the
blatant exploitation of lower income labourers by employers that have the power to
control the wage rate they pay their workers.
Consider the market for coffee, shown in Figure 9.4. Coffee is one of Brazil's key
agricultural products and a source of income for thousands of Brazilian farmers. In an
effort to protect the incomes of coffee farmers, and assure they can cover the costs of
keeping their plantations operational year after year, Brazil's government sets a price
floor for coffee of R$360 (R$ is the symbol for the real (plural: reais), the Brazilian
currency) per 60 kg of coffee. As long as the market equilibrium price is higher than
R$360, this floor price remains non-binding. But if market conditions drive the price
below R$360 reais, the government steps in to enforce its floor price.
At the current equilibrium price (P)) of R$450 the government’s price floor is non-
binding. In other words, it has no effect on the market. However, if market conditions
were to change in a way that the equilibrium price were to decrease, the price floor
would become binding and the government would step in to enforce the minimum
price. Figure 9.5 shows a situation in which the supply of coffee increased (perhaps due
to coffee imports from Ecuador), driving the market price down to R$300 per 60 kg bag.
Price per 60 kg
bag (P) (R$)

« Figure9.5 A price floor

Sv comes into effect where
P, =450(------------- an increase in supply drives
Price the market equilibrium
P, =360 price down
P, =300

0 QQQuQ Quantity of
60 kg bags (Q)
Surplus
141
 Supply has increased, driving equilibrium price down to R$300 at P,. The price
floor of R$360 is now binding; sellers are not allowed to sell coffee below this price.
Therefore, the quantity demanded increases only slightly, from Q, to Q,, while the
quantity supplied increases more than it otherwise might have from Q, to Q. There is
now a surplus of coffee in the Brazilian market, also known as excess supply.

In order to enforce its price floor and avoid the emergence of black markets in which
coffee growers unload their excess supply at illegally low prices, Brazil's government
must intervene further and purchase the extra beans from farmers. This, in essence,
props up market demand and keeps the price steady at R$360. We will examine the
effect of government payments to sellers later in this chapter when we look at subsidies.

What are the effects of price floors?

As with price ceilings, binding floor prices will have several effects on a market,
including the following.

Surplus output
The laws of demand and supply dictate that a price set above equilibrium will
necessarily result in reduced quantity demanded and increased quantity supplied.
The excess supply this creates is known as a surplus (not to be confused with
consumer surplus and producer surplus, which represent welfare and should be
maximised, a ‘surplus’ represents wasted resources and should be avoided).

Reduced market size

Whereas price ceilings reduce the market size because less is produced, a price floor
reduces the market size because less is demanded.

Allocative inefficiency
When quantity supplied exceeds quantity demanded, the MC (represented by supply)
producers face is higher than the MB (represented by demand) that consumers derive
from the last unit of the good produced. In other words, resources are overallocated
towards the price-controlled good since the cost of producing the last unit exceeds the
value consumers place on it.

Figure 9.6 The increase in >

producer surplus under a
binding price floor is less than
the loss of consumer surplus,
creating deadweight loss

0 Q Qs Quantity (Q)

142
+ The higher price has increased producer surplus relative to what it would have been
at equilibrium.
+ Consumer surplus is reduced, since less of the good is demanded at a higher price.
+ Thered area in Figure 9.6 represents the DWL, or the loss of overall efficiency and
welfare created by price ceiling. The increase in producer surplus is less than the
decrease in consumer surplus, so overall the market is made worse off.

Informal markets
Output that remains unsold due to a price floor might be bought by the government
(in the case of coffee in Brazil), but in the absence of a government scheme to purchase
surplus output it might also be disposed of (every year dairy farmers dump tonnes of
milk down the drain thanks to excess output resulting from price control schemes) or,
in some cases, sold on the black market. Unlike in the case of price ceilings, in which
case shortages are relieved by goods being sold on the black market at prices higher
than the government’s maximum price, when price floors are in place excess output
might end up being sold at prices below the floor price on the black market. Such
undercutting of the government’s price floor undermines the intended effect of the
price control, but also prevents the excess output from going to waste.

What are some examples of price floors?

Perhaps the most commonly used price floor is the minimum wage. Most countries
have them, and in many cases individual states, provinces, or municipalities will
impose a minimum wage that is higher than the national wage floor. Minimum wages
are very controversial, and for good reason. Helping workers at the lowest rung of the
income ladder seems like an easy way to increase equality in society and reduce the
gap between rich and poor that inevitably arises under the market economic system.
Figure 9.7 shows the effect of a $15 minimum wage imposed by the American city of
Seattle on the market for fast food restaurant workers. The previous minimum wage
of $10 per hour was non-binding, meaning that no fast food restaurants were actually
paying a wage that low. Instead, the equilibrium wage rate had been $12, deemed too
low by the city’s governing council for a worker to be able to afford to live in Seattle.

g2 sL
o8
oe
W,,=15 Minimum
wage2
W, =12}-nm- o Figure9.7 Aminimum
W,, =10 Minimum wage creates unemployment
wage1

0 QL, QL QL Number of
workers (QL)
Unemployment

143
 Role of government in microeconomics

Video suggestions: SLrepresents the supply of labour in the fast food industry, or how many workers
You have read about it, now are willing to work in fast food restaurants at a range of wage rates. DL represents the
you can review what you demand for workers, or how many workers fast food restaurants are willing to employ
have just learned by watching at a range of wage rates. W, is the previous minimum wage; it was below the actual
some videos by the author!
Simply click here in market wage rate of $12 (W), therefore it was non-binding. When city council votes to
o your eBook for videos raise the minimum wage to $15, the price floor becomes binding; at the higher wage
on price controls. rate more people wish to take jobs in fast food restaurants (up from QL, to QL) while
restaurants wish to employ fewer people (down from QL_ to QL,).

The increase in the quantity supplied of labour in the face of layoffs by fast food
Re: L]
restaurants creates a situation in which unemployment results. More job applications
Starting in 2014, the US city are being submitted to restaurants that are actually looking to replace workers with
of Seattle began phasing in a
minimum wage increase from technology or simply make their existing employees do more work with reduced
the state of Washington's staffing. As with other price controls, minimum wages have their winners and losers.
minimum of $9.47 per hour
to $11, then a year later to
Winners of minimum wages
$13 per hour, and finally,
in January 2017, to $15 per Workers who are able to find jobs at the binding minimum wage are better off than
hour. In a 2017 study, the they would have been with no minimum wage; they will have more disposable income
University of Washington, and will enjoy a higher quality of life.
located in Seattle, released
a study of the impact of the Some argue that overall demand is increased by a minimum wage. Because the
city's minimum wage policy.
Perform a web search using higher wage earners spend their additional money into the circular flow (often on
the terms ‘Seattle minimum goods like food, rent, and consumer goods), overall demand increases. This increased
wage study’ to find articles demand offsets the increased wage job losses or may even create more employment
about the study's finding opportunities in those industries.
or even the study itself.
Investigate the study’s key
findings, then discuss the Losers of minimum wages
questions below with your Workers who are unable to find jobs at the higher wage rate are worse off. They may
class or answer them yourself.
remain unemployed until an opening comes up at a fast food restaurant or may seck
For discussion and debate:
work in another industry. However, with most minimum wages applying across all
1 Did the Seattle minimum
wage study support or industries the outcome may just be higher unemployment across the economy.
refute the conclusions
of our analysis of Producers (fast food restaurants in this example) are worse off. Wages are the resource
minimum wages on the cost of labour; higher resource costs are a determinant of supply, so the market supply
level of employmentas curve of industries affected by minimum wages should decrease, resulting in higher
demonstrated in Figure 9.77 prices, less output, and reduced profits.
We concluded in our
~

analysis that ‘workers who Consumers in the affected industry are worse off. As stated above, reduced supply
are unable to find a job drives prices up in the industries in which minimum wages have increased producers’
at the higher minimum
wage are worse off. What costs. Higher prices lead to reduced quantity demanded and less consumer surplus
evidence is there in the among the consumers of the finished product. Fast food consumers should expect
Seattle minimum wage higher menu prices when a binding minimum wage is imposed in the market for fast
study to support or refute food workers.
this conclusion?
What were the limitations As with price ceilings, price floors are complicated in that there are not clear winners
w

of the Seattle minimum and losers. Some producers are made better off by price controls, but not all.
wage study? What did the
researchers conclude they Government should think carefully before imposing price floors on a market, and
could do in future studies consider important questions like whether surpluses will be created, and if so, what is
to provide a clearer picture the least inefficient way to dispose of the excess supply and whether unemployment
of the effects of increasing will increase, and if so, who will support affected workers when they can no longer
the minimum wage?
find a job due to an increase in the minimum wage.
144
 Video suggestion:
Price controls can be
With some simple maths is it possible to calculate the effects of price controls on described as the bluntest of
amarket. instruments at a government’s
disposal for influencing
Worked example 9 market outcomes. For this
reason, they are often heavily
Consider the maximum price imposed by the city of London on taxi fares of criticised by economists.
£8 per kilometre. At peak commuting hours, the fare the market is willing to pay is Simply lick here in
your eBook for a video
much higher than the maximum, at £12 per kilometre. Therefore, the price ceiling is in which economist Milton
binding during peak hours. With only 10,000 kilometres of taxi transport provided Friedman answers a students
and 15,000 kilometres demanded, there is a shortage of taxis during peak hours. question about the wisdom
of the governments use of
With the price ceiling in effect, we can calculate the impact on consumers (or wage and price controls.
commuters, in this case), producers (taxi drivers), and the market as a whole. Questions for discussion:
| 1 How might governments
Consumer surplus has increased. Before the price ceiling consumer surplus justify the use of price
was represented by the green triangle above P, and below the demand curve controls as a ‘cure for
(dotted green in Figure 9.8). With the maximum fare in place, there is a inflation'?

new area representing consumer surplus, shown as dotted green in Figure 9.9. In his analogy ofa kettle

~
The change in consumer surplus can be determined by adding the new dotted green
onastove, is the kettle’s
lid used as an example
rectangle below £12 and above £8 and subtracting the top portion of the DWL ofa price floor or a price
triangle. ceiling?
If Friedman opposes

w
(15-12) X 2000 price ceilings as a way of
Increasein CS = (12-8) X 10,000) - —————— preventing prices from
rising, what does he
= 40,000- 3000 = 37,000 think is a better way to
maintain low and stable
inflation in an economy?
The maximum fare causes consumer surplus to increase by £37,000. (Hint: this one requires
some knowledge of
(12-8)
X 2000 macroeconomic policy,
Loss in PS = (12—8) X 10,000 + = 40,000 + 4000
2 which of course you have
not studied yet, but give it
= 44,000 your best shot!)
9 Price per kilometre
(P)(£)

« Figure9.8 Total surplusin

| the market for taxi transport
~
[

without any price controls

is maximised, even at

Q=12
Quantity (Q) (thousands of kilometres
of taxi transport)

145
 Role of government in microeconomics

Price per kilometre

(P)(£)
Figure 9.9 Witha pp
maximum prics for taxi
journeys imp Price ceiling
loss of commun y surplus at
peak hours

1012 15
Quantity (thousands of kilometres
of taxi transport)

Taxi drivers are worse off. We can see that a portion of their surplus from before the
price ceiling has been transferred to consumers. In addition, the lower portion of
the DWL triangle in Figure 9.9 is also lost to producers. The sum of these two areas
represents the loss in producer surplus.

Producer surplus is reduced by £44,000. This represents the lost income and
welfare of taxi drivers who are willing to drive fewer kilometres and allowed to
charge a lower fare than they would if the market were allowed to set its own
equilibrium price.

Finally, we can calculate the amount of DWL resulting from the price
control, which represents the lost surplus across the entire market resulting
from the government intervention. There are two ways to calculate DWL.
It can be found by subtracting the loss in producer surplus from the increase
in consumer surplus, or by calculating the area of the red DWL triangle
in Figure 9.9.

DWL = 37,000 — 44,000 = —7000

or
(15-8) X 2,000
DWL =————"— = 7000
2
The first method gave us a negative result. This is because the £7,000 of
DWL does in fact represent a loss of welfare in the market for taxi transport.
Calculating the area of the red triangle yielded the same amount. The end result
of the price ceiling is a transfer of welfare from taxi drivers to taxi passengers,
but a loss of overall surplus (and therefore a reduction in efficiency) in the taxi
transport market.

The effects of price floors can be calculated using the same method: finding the
areas of rectangles and triangles on our graphs that represent the changes in
producer and consumer surplus or the DWL from the government’s intervention
in the market.

146
 9.3 Indirect taxes and subsidies

Learning comes
At the end of this section you will be able to:
* explain why governments impose indirect taxes
« distinguish between specific and ad valorem taxes
. draw diagrams to show specific and ad valorem taxes and analyse their
impacts on market outcomes
« discuss the consequences for market stakeholders of imposing an indirect tax.

How do indirect taxes affect a market?

Indirect taxes are those taxes placed on goods and services. They are described as
indirect because the government collects the revenues from the supplier after the
supplier has collected them from the purchaser. Therefore, the government collects the
money from the consumer indirectly. A sales tax is collected by the seller and delivered
to the government: it is an indirect tax.

Indirect taxes can take either of two forms:

« aspecific tax — the amount of the tax is a fixed value per unit of output, such as
$2 per pack of cigarettes
* anad valorem tax — the amount of tax is a percentage of the sale, such as a value
added tax (VAT) of 19% on the sales of most goods is an ad valorem tax.

The term ‘excise tax’ is used to refer to the taxing of one type of good, like cigarettes,
alcohol, or hotel accommodation. Excise taxes can be either specific or ad valorem.

In contrast, income taxes are collected by the government directly from the
individual or household, and are therefore called direct taxes. Firms generally view
taxes as an increase in their operating costs because the tax is likely to erode the
profitability of their product. For this reason, economists show the effect of the
tax as a decrease in supply: a shift left of supply at all prices. This shift is shown
differently, however, depending on whether the tax is specific tax or ad
valorem tax.

What is a specific tax?

Specific taxes charge a fixed amount to be paid for every unit ofa good sold. Figure 9.10
shows the initial effect of a specific, per-unit tax of #6,000 (& is the symbol for the naira,
the currency of Nigeria) on tyres. The supply curve shifts upward the amount of the tax,
from Sto S . This is a parallel shift because the amount of the per-unit tax is the same no
matter the price or quantity of units. Whether a tyre sells for %60,000 or #150,000, the
tax the seller must pay to the government will be the same at %6,000 per tyre.

147
 tyre (P) ()
Price per
Figure9.10 A specific,

o
per-unit tax will shift the
supply curve upwards

0 Q Quantity (Q)

What is an ad valorem tax?

In contrast to direct taxes, ad valorem taxes base the tax on a percentage of the
purchase price. Therefore, the higher the price of the good, the greater the amount
of tax paid by producers to the government. Consider the effect of an ad valorem tax
of 50% on tyres. The seller will pay the government #50,000 for a tyre that sells for
#100,000 but will have to pay #25,000 on a tyre that sells for #50,000. Figure 9.11
shows the effect of an ad valorem tax. Supply still shifts upward by the amount of the
tax, but the distance between S and S, grows as the price increases. This reflects the
increased amount of tax charged as the price increases.

Video suggestion: While the value of the tax increases at higher prices, the percentage of the tax relative
You have read about it, now to the price is the same. P, — Pis half the distance between P, and 0. P, — P, is half of
you can review what you P,— 0, but larger than P, — P. As price has increased, the amount of tax the seller has to
have just learned by watching pay the government increases with it.
avideo by the author!
Simply click here in
your eBook for a video Who shares in the burden of a tax?
on the effects ofa tax on

supply. Let us look at the effect of a specific per-unit tax imposed on a market with a
downward-sloping demand curve and an upward-sloping supply curve. Figure 9.12
shows decrease in supply resulting from a specific, per-unit tax of P,
tyre (P)(N)
Price per
w!%

Figure 9.11 An ad valorem >

og3u
L

tax will cause the new supply

curve to diverge from the
original one
o
Ay

0 Q, Q, Quantity (Q)
148
 < tyre (P) (%)
Price per
« Figure9.12 Adding the full
amount ofa specific tax to the
price creates
a surplus

0 Q, Q. Quantity (Q)

The tax has shifted the supply curve vertically. As a result, sellers have raised the price
from P, to P, (the full amount of the tax). Let us examine the effects of their attempt to
pass the entire tax onto consumers by raising the price by the full amount of the tax:
the quantity demanded has decreased from Q, to Q,, while sellers continue to produce
Q, units of the good. In other words, there is a surplus in the market. Q, is no longer an
equilibrium price, and consumers are not willing to pay the new price of P, to buy the
output sellers are producing.
Figure 9.12 shows what happens when sellers attempt to make buyers pay the full
amount of an indirect tax. Figure 9.13, on the other hand, shows the more likely
outcome when the government imposes an indirect tax on a good, but when buyers
and sellers share the burden of the tax.

Figure 9.13 shows the same tax ‘wedge’ between supply and demand, but now the price
has increased not by the full amount of the tax but only a portion of the tax amount,
from P, to P,. Consumers pay more for the product, but the quantity demanded has
not fallen by as much as it did when they were asked to pay the full tax. Now, producers
share a portion of the tax’s burden by keeping a lower price of P, after they have paid
the government. The market is in a new equilibrium at P, and Q,, unlike when the full
tax was passed onto consumers, which resulted in a disequilibrium in the market. The
consumers’ tax burden is represented by the dotted green area, producer burden by the
red shaded area. The two areas together represent the total tax revenue.
tyre (P) (%)
Price per

« Figure9.13 A new market

mo

equilibrium is found when

o

consumers and producers

share the tax burden

Quantity (Q)
149
 tyre (P) ()
Price per
o
Figure9.14 The graph can
be used to analyse the effects

o
g]
of indirect taxes

o
o Qy Q. Quantity (Q)

In nearly every case, a tax imposed on a particular good or service, or even ad valorem
taxes like the value added tax (VAT) or sales tax (a tax on nearly all goods and services that
is a common source of government revenue in nearly every country), the burden is
shared by consumers and producers. Consumers pay more when taxes are imposed on
consumption, but producers also end up making less than they would if there were no
consumption taxes.

What other effects does a tax have on a market?

We can analyse the effect of indirect taxes on various stakeholders, including
consumers, producers, the government, and the market as a whole, by taking a closer
look at the impact the tax has on our market supply and demand diagram.

Figure 9.14 places labels in the different areas of the graph representing consumer and
producer surplus.

Without a tax, consumer surplus in the market would be represented by the triangle
above P, and below the demand curve, or area ‘abed’. The tax has resulted in an
increase in price to P, and a decrease in consumer surplus to area ‘', meaning
consumers have lost an area of surplus equal to ‘bed’.

Producers are also worse off after the tax, with producer surplus falling from ‘efghi’ to
only ‘hi’, a decrease represented by the area ‘efg’.
The tax has harmed both producers and consumers; so who benefits? Taxes are paid
to the government, which uses tax revenues for all sorts of activities, which in theory
should provide benefits to the public. Therefore, not all of the surplus lost to consumers
and producers is lost to society; there is an area of tax revenue on our graph represented
by ‘beef’ that goes back to the government for the provision of other goods and services.
Consumers are worse off, producers are worse off, the government collects revenues,
and society as a whole, it turns out, experiences a DWL (a decrease in overall
community surplus) represented by the triangle ‘dg’.
We can also look at the impact on sellers’ revenues. Before the tax sellers in this
market earned revenues determined by multiplying the number of units sold (Q) by
the equilibrium price (P,), or the large rectangle ‘efghijk’ in Figure 9.14. With the tax,
producer revenues have fallen; less output is sold, and after paying the tax, sellers get to
keep less money per unit. Total revenues after the tax are represented by area ‘hij’.
150
 Why do governments impose indirect taxes?
Indirect taxes can be imposed by governments to discourage the production or
consumption ofa good deemed harmful by the government. When a tax is imposed to
correct the market failure of over-consumption or over-production it is called a Pigouvian tax,
after economist Arther Pigou, whose work first explored the use of taxes to incentivise
more socially optimal market outcomes. Beyond correcting market failures, indirect
taxes can provide significant government revenue to finance regular government
operations including the provision of important public goods such as healthcare,
infrastructure, and education.

One argument against the use of consumption taxes for revenue generation, however,
is that they are regressive, which means a tax on consumption places a larger burden
on lower income households than it does on higher income households. Regressivity
refers to the proportion ofa consumer’s income that is spent on a particular tax. Any
consumption tax, because it is calculated as a specific amount, or as a percentage of
the taxed good’s price, is the same regardless of which consumer buys the good.
Alower income consumer earning, say, #1.2 million per year, would therefore pay
the same amount of tax on any particular good as a richer consumer, earning say 24
million per year. However, for the richer consumer, any tax paid represents a smaller Video suggestions:
proportion of her income than it does for the lower income individual. Therefore, it You have read about it, now
you can review what you
places a smaller burden on the rich than it does the poor. have just learned by watching
some videos by the author!
Indirect consumption taxes, while effective at generating revenue, can exacerbate Simply click here in
inequality in society, as the incomes of the poor are strained more than the incomes o your eBook for videos
of the rich. In comparison, direct, graduated taxes on income, which will be explored on the effects of a per-unit tax
in the macro section of this textbook, are progressive, which means the burden increases in the cases of inelastic
as a percentage of incomes as incomes rise.
demand and elastic demand

9.4 How do subsidies affect a market?

Learning outcomes
At the end of this section you will be able to:
* explain why governments provide subsidies, and describe examples of subsidies
* draw a diagram to show a subsidy, and analyse the impacts of a subsidy on
market outcomes
« discuss the consequences of providing a subsidy on the stakeholders in a market,
including consumers, producers, and the government
« plot demand and supply curves for a product from linear functions and then
illustrate and/or calculate the effects of the provision ofa subsidy on the market
(on price, quantity, consumer expenditure, producer revenue, government
expenditure, consumer surplus, and producer surplus).

A subsidy is a payment made by the government to a firm for the purpose of increasing
the production of a good. Governments may have several different motivations to
subsidise.
151
 Price (P)
Figure9.15 The benefit of P [ TE—
a per-unit subsidy is shared Subsidy A
between consumers and
producers Pl s

0 Q Q, Quantity (Q)

Toincrease the consumption of some goods by lowering the price. This might
address a positive externality such as the underconsumption of some healthcare
services.
« To support a particular industry by helping with production costs. The industry
might be considered critical for economic security — e.g. steel - or might be one of
political influence.
* To address a balance of payments deficit by increasing export revenue. Subsidies
may lower costs enough to make a particular good more competitive on the world
market.
Subsidising a product will cause the supply curve to shift downwards by the amount of
the subsidy. Firms find that their costs of production are lower at every price, making
production at every price more profitable. Therefore, supply expands and more is
produced at every price. Figure 9.15 shows the supply shift for a per-unit subsidy.

The supply curve has shifted ‘downward’ by the amount of the subsidy, increasing
the equilibrium quantity and decreasing the good’s price. The price, however, does
not fall by the full amount of the subsidy. Recall from our examination of indirect
taxes that a taxed good's price does not rise by the full amount of the tax. The same
principle applies here. A subsidy benefits both producers and consumers. While the
price consumers pay decreases, it does not fall by the full amount of the subsidy.
Instead, producers end up receiving some of the subsidy and collect money from
the government for each unit they produce. The per-unit subsidy essentially drives a
wedge between supply and demand, increasing both quantity demanded and quantity
supplied.

How do subsidies affect consumers and producers?

Let us examine the welfare effects of the subsidy by adding labels to the different areas
on our graph and looking at how consumers, producers, the government, and the
market as a whole are affected. Figure 9.16 adds area labels to our subsidy graph.
Before the subsidy, consumer surplus in the market was represented by area ‘ab’. The
subsidy has caused the price to fall to P, and the quantity demanded to increase to Q.
As aresult, consumer surplus increases by the area ‘efg’. Consumers are better off.
Producer surplus before the subsidy was area ‘eh’ (below P, and above S). The subsidy
acts like a ‘top off’ to the price consumers pay. While consumers enjoy a lower price
152
 Price (P)
« Figure9.16 The effects of
Subsidy< P, a subsidy can be analysed
by looking at the areas in
the graph

0 Q Qq Quantity (Q)

of P, after the government has paid producers for each unit sold (Q,, units), producers
take home a higher price of P,. Therefore, producer surplus increases, since both the
quantity and the price collected for each unit sold have increased. Producer surplus
thus increases by area ‘bc’, and is now the whole area below P, and above S. In the end,
the areas of consumer and producer surplus overlap, as seen in Figure 9.17.
Consumers pay a lower price than producers receive. Both consumer and producer
surplus are higher than they were before the subsidy.
It would appear on the surface that a subsidy is a win-win proposition. If both
stakeholders are made better off, then who is made worse off? What we are missing
from this conclusion, of course, is the government, whose limited funds have been
allocated away from other purposes to subsidise the production and consumption
of a certain good. The third element of our analysis is to look at the subsidy’s cost to
taxpayers.
This can be found by looking back at Figure 9.16 and identifying the area representing
the total cost of the subsidy, which is the per-unit subsidy multiplied by the number of
units sold, or (P,— P,) X Q,, an area represented by ‘bedefg’.
Finally, we can compare the combined increases in consumer and producer surplus
to the cost imposed on the government. Consumer surplus increased by ‘efg’ and
producer surplus by ‘bc’, for a combined increase in surplus of ‘beefg’. The cost
to taxpayers, again, was ‘bedefg’. Comparing the two, we can see that the cost to
Price (P)

< Figure 9.17 Like other

Subsidy< P, forms of intervention,
subsidies create a
deadweight loss

Quantity (Q)
153
 Video suggestion: taxpayers exceeded the benefit to producers and consumers, specifically by an amount
You have read about it, now represented by area ‘d’.
you can review what you
have just learned by watching Not surprisingly, subsidies, just like the other forms of intervention in markets we
avideo by the author! have studied in this chapter, create a DWL. In this case, the subsidy’s cost to taxpayers
Simply click here in outweighs the benefits it creates for consumers and producers. On our graph, the
o your eBook for a video
on the effects ofa per-unit DWL can be seen as the triangle wedged between supply and demand between the free
subsidy. market equilibrium quantity and the subsidised quantity, as in Figure 9.17.

In Figure 9.17 the dotted yellow area represents producer surplus, the green
area consumer surplus, and the red area the DWL. The rectangle outlined in red,
meanwhile, is the cost the subsidy imposed on taxpayers. This is money that could
have been spent on something else, or simply left in taxpayers’ pockets to spend on
whatever they like in the marketplace.
So once again we are left with a question: if subsidies impose more costs on society
than the benefits they create, then why do governments use them? Well, as with taxes
and price controls, there are situations in which subsidies are justified to improve
overall economic well-being. Sometimes the free market under-allocates resources
towards the production of certain goods, such as renewable energy, healthcare,
affordable housing, nutritional foods, public transportation, and so on. Subsidies are a
way for the government to prioritise socially beneficial goods or goods that are deemed
strategic assets, without which the economy would struggle to function efficiently.
Another example is military and acrospace technology. There simply would
not be much of a market for high tech aerospace equipment if it were not for
the government’s support of such industries over the decades. Subsidies make it
appealing for producers to enter new markets and remain in them, even in the face of
extraordinarily high start-up and operating costs.
Without subsidies, there are entire industries that would not exist in our economy
today. That is not to say that all subsidies are justified. Frequently firms survive
‘market slumps or changing tastes and preferences among consumers only because
of government support, and there are many economists who argue that when private
demand is not enough to keep an industry alive, it should not be the job of government
to doso.

Nonetheless the close ties between large industries and the governments of the world
is a fact of life and despite economists’ best arguments against government support of
certain industries, it has persisted and will continue to do so. Only when the affected
good would be under-provided by the free market is subsidising its production
justifiable, according to most economists. We will explore examples of market failure,
including positive externalities and public goods, under which economists argue that
subsidising output can increase total welfare in society, in a later chapter.

154
As we demonstrated in the section on price controls, calculating the effects of a
government’s intervention in the free market can be as simple as finding the areas of
different shapes in our diagrams.

pack (P) (%)

Price per

Tax =
45.00
cigarettes

0 80 100 Quantity (Q)

(thousands of packs)

Worked example 9.2

Consider the effect of the £5 (£ is the symbol for the Turkish lira, the currency of
Turkey) per pack tax on cigarettes shown in Figure 9.18.
From this graph we can easily calculate the tax’s impact on consumer surplus,
producer surplus, government tax revenues, and total welfare.

First let us calculate the lost consumer surplus, represented by the dotted green
rectangle and the top half of the red DWL triangle.
Decrease in consumer surplus

= ((617.5 — $15) X 80,000 packs)

, (B175-815) X 20,000 packs
2
= $200,000 + £25,000
= $225,000
Consumer surplus is reduced by £225,000. The loss in producer surplus can also be
calculated.

Decrease in producer surplus

= ({615 — £12.5) X 80,000 packs)

, (815 -4125) X 20000 packs
2
= 1£225,000

166
 Role of government in microeconomics

Both consumer and producer surplus have decreased by 225,000 as a result of the
5 cigarette tax. Next we can calculate the amount of tax revenue generated, which
is represented by the green and dotted yellow areas in Figure 9.17.

Tax revenue = (617.5 — $12.5) X 80,000 packs

= $400,000

Not surprisingly, a £5 tax applied to 80,000 packs of cigarettes generates £400,000

in tax revenue. Finally, we can calculate the DWL resulting from the tax, or the red
area on the graph. There are two ways to do this: (1) we can simply subtract the tax
revenue from the total loss of consumer and producer surplus; or (2) we can find
the area of the red triangle. Either way will yield the same result, so let us do the
latter:
(£17.5—%12.5) X 20,000 pack
Deadweight loss = (E17.55712.5) 320,000 packs = £50,000
.
The DWL is £50,000, representing the net loss of community surplus in the market
resulting from the £5 tax.

As mentioned earlier in this chapter, taxes like those on cigarettes may be justified
despite the resulting DWL in the market if it is determined that the good’s
production or consumption are socially harmful, as is almost certainly the case
with cigarettes, which are considered a demerit good, or one that creates harmful
effects for those who consume it and for third parties, such as non-smokers who
suffer the effects of second-hand smoke.

Using the same methods, the effects of subsidies can be calculated, allowing us to
weigh the monetary benefits and costs of government intervention in the markets
for particular goods.

9.5 Other forms of government intervention

in markets

Learning outcomes
At the end of this section you will be able to:

* explain the need for direct provision of services by government, giving examples
* analyse the effects of regulation and legislation
+ comment on government use of ‘nudges’ to influence markets, including the
default option and social reinforcement.

Direct provision of services

Government intervention in the markets for particular goods can take the form of
price controls, taxes, or subsidies, but in each of these cases there must first be an
actual market for the good. In some cases, the free market itself fails to provide certain
156
goods or services, and government provision is required. In Chapter 10, we will
examine the market failure known as public goods, or goods that the free market will not
provide due to certain characteristics they exhibit.
Vaccines are an especially good example. Vaccines for polio, smallpox, and hepatitis
are estimated to have saved millions of lives in the past. As a reference, immunologists
estimate that 80% of the population must receive a vaccine if herd immunity is to be
achieved. Left to the free market, it is likely that fewer than 80% of people would be
willing and/or able to purchase and receive the coronavirus vaccine. Therefore, the
government must intervene to provide the vaccine at little or no cost to consumers.
Through government provision, the vaccine can be provided for ‘free’ and nearly
everyone will receive it, thereby achieving herd immunity.
Government provision takes the concept behind subsidies to its logical extreme. Rather
than simply supporting the provision of a good by paying producers a specific amount
for each unit they sell, the government pays for the entire production and may even
handle the good or service's distribution. Beyond healthcare goods such as vaccines, other
examples of services governments provide include education, police and fire services,
road construction and maintenance, and even health insurance in many rich countries.
Governments have determined that without public intervention, the markets for these
and other public goods would fail to provide them at anywhere near an adequate level to
allow for an efficiently functioning economy and a healthy, well-educated society.

Command and control - regulation and legislation

Another way the government can intervene in the markets for particular goods is through
regulation and legislation. Governments make the rules by which certain industries have
to play, and by tweaking these rules certain behaviours can be incentivised or required
by producers and consumers. Environmental and health regulations, workplace safety
regulations, anti-monopoly regulations, and a host of other rules by which markets
must comply allow the government to act as referees in the free market economy.
Below is a list of regulatory agencies in the USA, along with a brief description of the
role they play in the markets for different goods and services.
+ Consumer Product Safety Commission (CPSC) enforces federal safety standards.
+ Environmental Protection Agency (EPA) establishes and enforces pollution
standards.
+ Equal Employment Opportunity Commission (EEOC) administers and enforces
Title VIl or the Civil Rights Act of 1964 (fair employment).
+ Federal Aviation Administration (FAA) regulates and promotes air transportation
safety, including airports, and pilot licensing.
+ Federal Communications Commission (FCC) regulates interstate and foreign
communication by radio, telephone, telegraph, and television.
+ Federal Deposit Insurance Corporation (FDIC) insures bank deposits, approves
mergers, and audits banking practices.
* Food and Drug Administration (FDA) administers federal food purity laws, drug
testing and safety.
+ Federal Reserve System (the FED) regulates banking; manages the money supply.
+ Federal Trade Commission (FTC) ensures free and fair competition and protects
consumers from unfair or deceptive practices.
1567
 Role of government in microeconomics

Given the demonstration Each of these agencies intervenes in a different market with various ends in mind,
of the distinct types of the result being that the ‘free market' is less free, but perhaps more equitable, safer,
government intervention and more likely to act in the greater interest of society as a whole and not just in the
shown in this chapter, interests of the producers and/or consumers within the market itself. In adhering to
it begs the question of
which policies are best the regulations laid out by government agencies, industries face higher costs, possibly
in which situations. How reducing the supply of their goods as a result, reducing some of the negative effects
does one decide that? their consumption or production might have on society.
More specifically, what
knowledge criteria should
government policymakers
use to make choices
IEI8 Consumer nudges
between alternative
A more recent form of government intervention, introduced in Chapter 8, is the
policies? government’s use of ‘consumer nudges’. Nudges can tweak the incentive structure
ever so slightly, without relying on government regulations, rules, mandates,
or laws; thereby nudges offer fans of free markets and free societies a means of
promoting socially desirable outcomes without taking away people’s freedoms.

Two examples of nudges at work are the cases of the ‘default option’ and ‘social
reinforcement’.

Case study - pension enrolment default option

In a 2009 Q&A article for the publication Yale Insights, Richard Thaler provides an
example of how changing the ‘default option’ can lead to better outcomes for both
individuals and society.

‘A default option is simply what happens if you do nothing. Normally, nothing

happens, but sometimes even when you do nothing, something happens.’

‘A good example is in the area of pension policy. In many company

sponsored, optional retirement plans, the default option is not to join.
If you are going to join, you have to fill out some paperwork. Some
companies have tried the opposite default, which is that you are enrolled
unless you fill out some paperwork. We know that speeds enrollment
greatly and doesn’t really cost anything . No one is forced to join it.
People sign up of their own free will, but in the first company where we
did this we more than tripled savings rates.’
Almost everyone understands that saving a part of their income is important,
both for the individual who needs to plan for their future retirement but also for
the economy as a whole, which depends on household savings to provide funds
for private and public sector investment. Without savings, the circular flow of the
economy is slowed and less economic growth can take place. The nudge Thaler
describes above is a simple way to increase the amount of savings in the economy,
without requiring anyone to save more. Simply by making the default option to be
/ A
enrolled in a pension plan, rather than to not be enrolled, the amount of savings tripled.

Case study - social reinforcement during a pandemic

Nudge theory has also been applied in the current fight against the COVID-19
A
pandemic. Early on in the pandemic, the UK’s Behavioural Insights Team, a public—
An image ofa fly applied in
the centre of a men’s urinal private partnership that ‘exists to improve people’s lives and communities ... often
is a classic example of a using simple changes to tackle major policy problems’ (in other words, the British
nudge aimed at improving government’s ‘nudge unit’) tackled the challenge of nudging people to touch their
users aims
158
faces less in response to scientists’ claim that coronavirus transmission was likely
to take place when people touched contaminated surfaces and then transferred the
virus to themselves by touching their eyes, nose, or mouth.

The BIT's suggestions to help change people’s face-touching behaviours included

people asking their friends and family to use verbal reminders whenever they saw one
another touching their faces, such as shouting ‘FACE!" whenever one attempted to do so.
Another suggestion was for people to enforce self-conscious behaviours to replace
subconscious face-touching, such as folding their arms in front of them or putting
their hands in their pockets. Over time these conscious behaviours could become
subconscious (like face touching is for many people) and replace the more dangerous
behaviour. According to the BIT, ‘These may seem to be absurdly small and unimportant
things to be discussed. In fact, they are crucial. Creating substitute behaviours and new
barrier-forming habits are the most effective way of curbing face touching.’
As the infection rate rose across the UK, and even the country’s prime minister, Boris
Johnson, fell ill with the virus, the efficacy of nudge theory came into question and
ultimately, as many countries, regions, and locales did, mask mandates were passed and
the public was asked to cover their faces. Thus, social reinforcement aimed at limiting
face touching became a moot point, as with a mask on, people are far less likely to touch
their face as well as transmit the virus to those whom they might be standing near.

Despite its status as a relatively new branch of economics, within the umbrella
category of behavioural economics (discussed in Chapter 8), nudge theory is being
employed not just by private businesses, but by governments to create the
conditions under which individuals make decisions that are in both their own
self-interest and society’s self-interest, when they might otherwise have acted
in an irrational way that harms social and even personal well-being.

Practice exam questions

1. Explain, using a diagram, the effect ofa specific tax on
various stakeholders. (10 marks)
2. Explain, using a diagram, the effects of a per-unit
subsidy on various stakeholders. (10 marks)
3a. Explain the concepts of maximum and minimum
price controls. (10 marks)
b. Evaluate the idea that government intervention in the
form of price ceilings and price floors is well intentioned,
but often leads to undesirable side effects. (15 marks)
4a. Using an appropriate diagram, explain the likely effects
ofa decrease in the maximum price set for petrol (gasoline),
which is already set below the market price. (10 marks)
b. Evaluate the effects of this kind of government intervention
into the market for petrol. (15 marks)
5a. Using a diagram explain the effect on various stakeholders
of a high specific tax on alcohol. (10 marks)
b. Evaluate the effectiveness of a policy that would impose
substantially higher levels of taxation on the sale of alcohol. (15 marks)

159
 Market failure:
externalities, public
goods, and the
market’sinability to
achieve equity
 10.1 Externalities and common pool
Or commaon access resources

Learning comes
At the end of this section you will be able to:
« define the concept of market failure as a failure of the market to achieve
allocative efficiency
« distinguish the concepts of marginal private benefits (MPB), marginal
social benefits (MSB), marginal private costs (MPC) and marginal social
costs (MSC)
« analyse the failure of the market to achieve a social optimum where
MSB = MSC
* explain, using diagrams, the meaning of positive and negative externalities
of production and consumption, giving examples of merit and demerit goods
« comment on the problems of unsustainable use of common pool resources.

Socially optimal output

‘We have so far looked at how effective markets can be in bringing society what it wants
with efficiency. However, the strict conditions that apply for free markets to achieve
socially optimal outcomes are not always in effect. Market failure is any situation
where the allocation of resources by a free market is not efficient. These situations,
from society’s viewpoint, could be improved on if resources were allocated differently.
Market failure is most often associated with the existence of externalities, common
pool resources, public goods, asymmetric information, and market power.

First, it is important to remember that many markets function quite well if left free and
competitive. Consumers enjoy allocative efficiency, and large amounts of producer and
consumer surplus are produced. You will recall that the demand and supply curves
introduced in Chapters 3 and 5 also represent the marginal benefit (MB = D) and
marginal cost (MC = S) curves. Furthermore, allocative efficiency is achieved where
MB equal MC. Normally, this is where supply meets demand.

‘We can now expand the idea of marginal analysis to include society’s benefits and
costs, and so MB becomes MSB (marginal social benefit) and MC becomes MSC
(marginal social cost). The difference between MB and MSB is that MSB includes any
external benefits that may arise from a good’s consumption. Likewise, MSC includes
the marginal private cost of producing a good plus any external costs to the rest of
society. External benefits and costs are called externalities by economists, and include
any spillover effects arising from a good's production or consumption imposed on a
third party that was not directly involved in the market.

‘When a good's production and consumption do not create any externalities,

the marginal private cost (MPC) (in other words, supply), and the marginal private
benefit MPB (demand) are equal to the MSC and the MSB. In such a case the market
equilibrium output is the socially optimal, allocatively efficient level of output.

161
 S =MSC
(marginal
social cost)

Consumer surplus + producer surplus

community surplus (P)
Figure 10.1 Community
surplus is maximised at
market equilibrium

D = MSB
(marginal social
benefit)
Q Q

Figure 10.1 shows the supply (MSC) and demand (MSB) curves at market equilibrium.
AtP,and Q,, to produce any greater quantity would cause costs to exceed benefits.
Any less output, a quantity to the left of Q,, and some portion of consumer/producer
surplus is left unenjoyed. Therefore, at equilibrium community surplus is maximised,
where community surplus is the combination of producer and consumer surplus. The
market illustrated in Figure 10.1 is allocatively efficient, thus there is no market failure
taking place.
At competitive market equilibrium, economists argue that there exists a state of Pareto
optimality. ‘Pareto optimal' refers to a market situation where no one can be made
better off without making someone else worse off. Look again at Figure 10.1. There are
no other possible combinations of price and quantity that can improve one group’s
situation without hurting the other. If the price were higher than P,, consumers would
be worse off. If price were below P, producers would be worse off. If the quantity
produced were greater than Q,, society’s costs (MSC) would be greater than its benefits
(MSBY), so everyone would be worse off. If the quantity were less than Q,, some amount
of community surplus would be lost. Thus, maximisation of community surplus,
Video suggestion: achieved where MSB = MSC, is synonymous with Pareto optimality.
You have read about it, now
you can review what you Competitive markets provide Pareto optimality by maximising community surplus.
have just learned by watching These markets also tend to be allocatively efficient, delivering the goods society wants
avideo by the author! by matching MSB and MSC. However, markets often do not meet the conditions of free
Simply click here in competition, and we admit that markets can fail. When resources are not allocated in
your eBook for an
introductory video on market an optimal or socially efficient manner, this is called market failure. When this occurs,
failure. it is left to governments to address the problem to help society get the most from its
resources. This chapter considers various forms of market failure and evaluates the
solutions most often proposed to deal with them.

What are externalities?

There are many instances where someone outside of a transaction, a third party, may
suffer the costs or enjoy the benefits of someone else’s transactions. When this occurs,
162
itis called an externality. Someone outside the original transaction is being affected
by it, either positively (enjoying benefits) or negatively (suffering costs).
‘When the side effects are good, it is called a positive externality. When the side
effects are bad, it is called a negative externality. Another term for externality is
‘spillover’, which suggests that costs or benefits have gone beyond the initial actors
in the transaction. Thus, someone suffering the effects of a negative externality
may be bearing some of the spillover costs. Someone feeling the effects of a positive
externality is enjoying spillover benefits.

‘When an externality occurs, there is a difference between society’s experience and that
of the individual firm or consumer. No longer can we assume that the private benefit is
equal to society’s benefit or that social cost is equal to private cost.

Positive externalities of consumption

A positive externality occurs when a good's production or consumption creates
spillover benefits on the rest of society that exceed the benefits enjoyed by the
individual consumers of the good itself. In other words, the MSB derived from
the good’s consumption exceeds the MPBs. In the case of a positive production
externality, the good’s cost to society is lower than its cost to the firms producing
the good itself. In both cases (consumption and production externalities) the result
is a situation in which the market equilibrium quantity of the good is less than the
socially optimal quantity.
Consider the market for healthcare in Figure 10.2.
Healthcare is a service that provides health benefits to individuals who have access
to it, but also to society as a whole. When my neighbour has good health, Iam more
likely to remain healthy. When an employee in a company I work for is healthy, my
company is more productive and all employees and the business’s owners are better
off as a result. Healthcare is a service that creates social benefits that exceed the private
benefits, thus MSB is greater than MPB.

The problem is, if left alone the market will provide only a Q_ level of healthcare. At
Q, the MSB (point ‘a’ on the graph) is higher than the marginal social cost (point 'b).

P S =MSC

Potential welfare gain

« Figure102 Positive
consumption externality

163
 The optimal amount of healthcare, however, is at Q,, (socially optimal quantity),
where MSB = MSC. Thus, the free market will not produce enough healthcare
by itself. And, if society’s true value for healthcare were included, if demand were
reflected in the MSB curve, the demand would be higher than it is. Society would gain
considerably by consuming more healthcare. The amount of the potential gain in
welfare is shown by the dotted blue triangle. The potential welfare gain is congruent
with deadweight loss (DWL); it is the welfare that the market is losing out on by not
producing at the optimal quantity.

Merit goods
Healthcare is an example of a good whose consumption creates positive externalities.
These are known as merit goods: goods that are under-consumed because the benefits
they create are not purely private, therefore private individuals will only consume
as much as they demand for themselves, neglecting to take into account the
social benefits they create. As a result, if left entirely to the free market the level of
consumption will be less than the socially optimal level.

Other examples of merit goods include the following.

* Education. Like healthcare, getting an education makes the individual who
receives it better off, but also society, as an educated workforce is more productive,
pays more in taxes, and results in a more prosperous society as a whole.
* Open spaces (such as parks). There are private parks, like Disneyland, that allow
paying customers to come and enjoy beautiful spaces and entertaining rides.
However, open spaces provide social benefits beyond the enjoyment of those who
actually use them, such as contributing to public health, cleaner air, habitat for flora
and fauna, and so on. Because the benefits of public spaces are not purely private,
they tend to be under-provided by the free market.
* Security. Public safety is another good that would be under-provided by the
free market because its provision is expensive and the benefits of providing
it are not purely private. The richest in society may be able to afford private
security; but we cannot all have bodyguards. This does not mean that we do not
all need security. Because its benefits are not purely private, but mostly social,
public safety is, in most countries, left up to public security forces, e.g. police
and sheriff departments.
* Renewable energy. The consumption of renewable energies, like wind and solar
power, benefit not just the individuals who choose to install solar panels on their
roofs, but also others in society, who will see their own electricity bills get cheaper
as aresult of the reduced demand for non-renewable energy. Additionally, as most
renewables are non-polluting, their consumption results in cleaner air quality,
reduced health effects of energy consumption, and a more sustainable economy, all
which benefit society as a whole, not just the individual business or household who
chooses renewables over non-renewables.
* Public transportation. Taking the train or bus to work reduces traffic and
therefore benefits drivers who drive themselves in cars. While the bus passenger
benefits by having a relatively cheap and stress-free option for commuting, drivers
of private automobiles enjoy spillover benefits in the form of less traffic and a more
speedy commute. Thus, the benefits of public transportation are not purely private
but social as well.
164
 < Meij Jingu public park,
Tokyo, Japan

Positive externalities of production

‘While most of the goods described above can be understood as goods whose
externalities result from their consumption, other goods create positive externalities
through their production. When it is the process of manufacturing a good that creates
spillover benefits, rather than the consumption of the good, we can analyse the
market from the supply side, rather than from the demand side. Consider the market
for honey. In order for bees to make honey, their keepers must constantly provide
them access to pollinating plants. Farmers whose crops require pollination by bees
are a third party, not directly involved in the honey market, who benefit from the
production of honey.

The costs of making honey can be very high. But because the benefits of honey
production are enjoyed by farmers who do not make or sell honey, but whose crops get
pollinated by honeybees, the social cost of honey production is actually lower than the
private cost. Figure 10.3 shows the market for honey, a good with a positive production
externality.

P S = MPC

« Figure10.3 Positive
Potential welfare
gain externality of production

165
 The private costs of honey production are greater than the social costs, since its
production creates spillover benefits for farmers growing crops that depend on the
activities of pollinators like honeybees. If beekeepers act only in their own self-interest,
they will produce less honey (Q,) and it will sell for a higher price (P) than what is
socially optimal (Q,, and P, ). At Q, the MSB of honey (point ‘a’) is higher than the
MSC (point ‘b). Honey production benefits society more than it costs. Therefore, not
enough honey is produced.

Video suggestions: The existence of positive externalities of consumption and production results in
You have read about it, now market failures. In both cases the good creating externalities will be underproduced
you can review what you by the free market. Later in this chapter we will examine ways the government can
have just learned by watching intervene in response to merit goods and goods that create positive externalities
some videos by the author!
Simply click here in through their production to promote a more socially optimal level of production and
your eBook for videos consumption.
on positive externalities of
consumption and positive
externalities of production. Negative externalities of production
Sometimes, the most innocuous products cause problems for other people, but not
for the consumer who enjoys using it nor for the producer who is paid for it. Third
parties, who had no part in the transaction, suffer costs ranging from the small to the
very large, from lost money to poor health. These production costs are called negative
production externalities. Beyond private costs, the external costs suffered by others
increase the overall social costs.

There are many examples of negative production externalities.

Coalis produced with significant air pollution as a by-product, along with the
deaths of hundreds of miners working in dangerous conditions every year.
« Oil production appears to be growing more and more costly, as spills and refinery
pollution cause significant external losses worldwide, not to mention the depletion
of reserves.
* Textile manufacturers in developing countries have faced accusations of exploiting
child labour, allowing dangerous work spaces, or paying workers a lower than
living wage, externalising some of the costs of the production of their goods onto
the communities from which their factory workers come.
Chemical-intensive industries such as industrial agriculture have long abused the
environment by discharging harmful by-products from their activities into the
water, air, and soil.

The list could go on and on. If one were to dig deep enough, the production of almost
any industrially manufactured good could be said to create spillover costs on the
environment, the communities employed in their production, on human health, or on
other third parties not directly involved in the goods’ production.
Using MB and MC analysis, it is possible to represent negative production externalities
using a typical market diagram. Figure 10.4 illustrates the market for a good that
creates environmental pollution in its production processes.

Note that the supply curve has been split. MPC is another name for the supply curve
representing the costs paid by the firm to produce. At the market equilibrium price
of P, quantity Q_ is produced. At that quantity, the external costs to society are quite

166
 MSC

S=MPC
Deadweight
oss

o Figure104 Negaiive
production externality

QG Q& Q

high, represented by the distance between points ‘a’ and ‘b’. This implies that if the
good were priced to cover all of the relevant costs, the price would be much higher.
At the market equilibrium quantity of Q, however, the cost the good imposes on
society (point ‘) is higher than the benefit society derives from the good’s production
(point ‘b’). Too much of the good is produced by the free market.
In fact, the entire MSC curve lies above the MPC curve, showing that the private costs
of production are less than the costs to all of society at every price. This is not a shift
to the left of the supply curve, merely a more accurate representation of the full costs
of production. You could refer to the MSC curve as the ‘true’ supply curve because it
shows all the costs to society.
Moreover, if the marginal social costs are the accurate costs to society, the intersection
of MSC with the MSB curve should provide the optimal equilibrium point, the best
allocation of resources, at the point where MSC = MSB. The socially efficient price and
output would be P, and Q. When all the costs are added into the process, it appears
that the optimal amount of production is Q,, significantly less than Q,. We can also
conclude that the equilibrium price would be higher, at P, than the current free
market price of P,.
The above implies that goods whose production creates a negative externality are
overproduced, and are sold at prices that are too low, or below what the market would
show if all costs were added in. Furthermore, because production is not where MSCs
are equal to MSBs, resources are being misallocated. The distance between MSC and
MPC at Q, represents the negative externality at that point. If the optimal output and
price are Q, and P, then the production beyond that amount produces the negative
externality, shown by the area of the shaded triangle, which again, is the DWL.

Negative externalities of consumption

Spillover costs can occur on the consumption side as well. They are the negative effects
that are suffered by a third party when a good or service is consumed. In these cases,

167
 aperson’s use of a product affects others adversely. A surprising number of products
create obvious third party costs.
* Cigarettes create second-hand smoke when consumed that can make
non-smokers ill.
Alcohol consumption increases the chance of automobile accidents and domestic
abuse, meaning even non-drinkers can suffer the effects of alcohol abuse.
* Gambling is considered to be addictive, and the gambling industry has ruined the
lives of many families whose loved one has fallen victim to it.
* Private automobiles are responsible for tens of thousands of premature deaths each
year, are responsible for a significant percentage of the planet’s carbon emissions,
and cause clogged streets and reduced productivity due to traffic congestion in
many of the world’s cities.

Recently, some have argued that the consumption of high-fat diets, which contribute
to heart disease, constitutes the same kind of consumer spillover cost. In the case of a
negative externality of consumption, the costs are seen on the MB curve.
While this may seem counter-intuitive, remember that this is a consumption
externality and, therefore, it is the demand (or consumption) side where the costs
occur. For negative externalities of consumption, the MSBs are less than the benefits
enjoyed by the private consumer. In other words, the benefit of a fast food meal
enjoyed by a consumer is greater than society’s benefit. This is because the consumer is
apart of society, so their enjoyment is part of the total. But others will eventually pay
some of the costs of eating fatty foods (by paying higher insurance premiums or taxes
for government health programmes). This cost to others actually reduces the overall
benefit to society. Figure 10.5 shows the negative externality of fast food consumption
where MSB falls below the MPB.
The amount of fast food that is actually consumed (Q,) corresponds with a social cost
(point ‘') that exceeds the social benefit (point ‘b’). More fast food is consumed than
what is socially optimal (Qy), and therefore there is a DWL imposed on society. In the
case of fast food, the DWL triangle represents the additional healthcare costs borne by
members of society for whom fast food is not a regular part of their diet, but who face
higher healthcare costs nonetheless.

P
$=MsC

a
Figure 105 Negative P
consumption externality [
b ™ Deadweight
» : loss
i b
8 MsB D= MPB
Q
168
Demerit goods Video suggestions:
Goods that create negative externalities through their production are known as You have read about it, now
demerit goods. The word ‘demerit’ literally means ‘to take away good’, or ‘negative you can review what you
have just learned by watching
good. In contrast to a ‘merit’ good, which could be understood as a ‘good good’. a few videos by the author!
Demerit goods are ones whose consumption harms society, but for whom the Simply click here in
individual consumer does not suffer some of the good's negative effects. Tobacco, cars, o your eBook for videos
prostitution, and alcohol are all demerit goods. The free market will provide more of on negative externalities of
production and consumption.
these goods than what is socially optimal, thus they represent a market failure.

Common pool resources

Another form of market failure is the existence of what are called common pool, or
common access, resources. American ecologist Garrett Hardin warned of what he
called the ‘tragedy of the commons’ in a 1968 essay. Hardin explained that when
there exist common resources, for which there is no private owner, the incentive
among rational users of the resources is to exploit it to the fullest potential in order
to maximise their own self-gain before the resource is depleted. The tragedy of the
commons, therefore, is that common resources will inevitably be depleted due to
humans’ rational, self-interested behaviours, leaving us with shortages in key resources
essential to human survival.

The classic example is that ofa herd of stock animals using a common pasture. Each
animal’s owner has a strong private incentive to place his animals in the pasture for
feeding. The cumulative effect of this, however, is the long-term destruction ofa
once lush resource, as overgrazing renders the pasture unusable. The lack of private
ownership of the pasture has allowed individuals to graze their animals to the fullest
extent possible while the grazing was good, ultimately depleting the pasture and
rendering it useless to all. Economists and environmental scientists have also applied
the idea to the world’s common fishing waters, citing the dwindling of fish stocks
everywhere.

The critical problem is that common access resources like open grassland and the
world’s oceans are essentially ‘free’ to the user, but use of them depletes the availability of
the resource to everyone else. Economists and scientists call these subtractable resources.
Because users do not pay a market price for use of the good, they have little incentive to
ration it wisely. Economists call this behaviour the free-rider problem: those who benefit
and draw from a resource but do not have to pay for it. Examples are abundant.

+ Water sources in nearly every country are receivers of toxic waste, thus diminishing
ecosystems.
« Forests on public lands (which are owned by the ‘public’ and not any private
individual) are slashed for wood and to make way for farming, which reduces
oxygen production and erodes the soil.
* The atmosphere is infused with pollutants generated from industry, cars, and the
methane output of animals that are kept for meat production.

Case study - public health as a common pool resource

An imminent example of the tragedy of the commons is the threat to public
health arising from people who may choose not to vaccinate themselves and their
families against COVID-19. Given the 95% effectiveness rate of vaccines currently

169
 Market failure

available, epidemiologists estimate that up to two-thirds of the population will

need to receive a vaccine in order to achieve *herd immunity’ — the state in which
the virus is no longer able to spread within the community due to a lack of viable
vectors.

Common pool resources are non-excludable, but rivalrous. This means that
no individual can be excluded from consuming a common resource, but when
one person consumes it the benefit enjoyed by all other consumers is diminished.
Consider the example of fish in the ocean. Anyone with the right boat and
equipment can go into the ocean and catch as many tuna as they want, since ocean
fish are non-excludable. But a fish caught by one person can obviously not be
caught by another person, so fish are rivalrous.

Now let us consider our vaccine example. Unless there is a law passed requiring
that everyone get vaccinated, individuals will have the freedom to choose
whether or not to receive the vaccine. In other words, no one can be excluded
from making the decision not to get it (it is non-excludable). However, if more
than one-third of any given population does not receive the vaccine, then the
virus can be expected to persist within that community and continue to spread.
Therefore, the decision not to get the vaccine is rivalrous; it diminishes the
benefit the vaccine provides the rest of society through the increased likelihood
that the pandemic will continue spreading within the community, albeit in a
diminished capacity.

The vaccine question is a classic example of the free-rider problem: individuals

who choose not to receive a vaccine will still benefit from everyone else in their
community getting vaccinated, but they personally do not have any input into
achieving the disease’s eradication. A common pool resource is one for which there
is no cost for anyone to use (it is non-excludable). Not having a vaccine is essentially
ano-cost decision in many places. Therefore, when people are free to choose not to
receive a vaccine, the efficacy of the vaccine at eradicating COVID-19 (or any other
disease) is undermined, for if more than a small minority make this decision, the
disease is likely to persist within the community.

Governments have put systems in place to incentivise vaccination, including, in

the USA, the passing of the 1986 National Childhood Vaccine Injury Act, a law
which recognises potential injuries, disabilities, and conditions that might result
from a long list of different vaccines and provides victims a means of receiving
compensation for vaccine-related injury or death. By offering compensation to
victims of vaccine injuries, the government relieves the pharmaceutical companies
that manufacture them from the potential legal exposure that might result from
patients who feel they are owed compensation following an adverse reaction to a
vaccine suing the companies themselves. The Vaccine Injury Act increases the MPB
of receiving a vaccine (in other words, demand for vaccines is greater, since parents
can expect compensation following a potential injury), while stabilising the supply
(since manufacturers are more willing to supply vaccines when the government is
there to cover injury claims). Thus, government intervention is employed to correct
the market failure of too few people receiving vaccines.

170
Ultimately, the tragedy of the commons arises from a tendency among humans to
act in their own rational self-interest while undervaluing the collective consequences
of their individual actions. A fisher who ignores catch limits on ocean fish, a factory
owner who refuses to invest in air-pollution reducing technologies, a chemical plant
or farmer who knowingly allows runoff into freshwater sources, a neighbour who
drills a well and pumps more than ‘a fair share’ out ofa common aquifer— these are
just some examples of the tragedy of the commons and how it impacts our world
today.

In his 1968 essay Garrett Hardin said:

‘Ruin is the destination towards which all men rush, each pursuing his
own best interest in a society that believes in the freedom of the commons.
Freedom in a commons brings ruin to all.’
Video suggestions:
‘Wherever common pool resources exist (which is everywhere) sustainability ouhaveread abotitinow
e thraatEnsa A . e A . il you can review
what you
is threatened, and negative externalities of consumption and production wi [ S
persist. The goal of sustainable development is to avoid resource depletion some videos by the author!
and encourage environmentally benign forms of economic progress. Simply click here in
Recognising the obstacles to sustainability posed by the tragedy of the podicEooK odadeos
o : on the tragedy of the
commons allows us to better assess the ability of society to grow and develop commorns.
in a sustainable manner.

10.2 Government intervention in response to

externalities and common pool resources

Learning outcomes
At the end of this section you will be able to:
* explain, using diagrams, the use of policy responses, including market-based
policies (taxation and tradable permits), and government regulations, to the
problem of negative externalities of production and consumption
* evaluate, using diagrams, the use of government responses, including subsidies,
legislation, advertising to influence behaviour, and direct provision of goods and
services
* evaluate, using diagrams, possible government responses to threats to
sustainability, including legislation, carbon taxes, cap and trade schemes, and
funding for clean technologies
* explain, using examples, that government responses to threats to sustainability
are limited by the global nature of the problems and the lack of ownership of
common resources.

‘When the free market fails to achieve a socially optimal outcome, the government
may choose to intervene to either increase or decrease the amount of production and
consumption or to regulate the market in a way that promotes sustainability.

m
 S=MPC

MPC with subsidy

MSC
Figure 10.6 Inthe case of 2 Ps
merit good, a per-unit subsidy
moves price and quantity
Perunit ) P,
supplied closer to socially subsidy | p
optimised levels | P Potential welfare
gain

D = MSB

Subsidies
‘When a market under-produces a good, as in the case of merit goods or goods whose
production creates positive externalities, measures that increase the good's production
are required. The government can actively encourage more production through the
payment of subsidies. This may occur in the form of a lump-sum payment to the
industry, or more commonly as a per-unit subsidy. The goal would be to reduce the MPC
of production so that private producers have an incentive to produce more of the good.

Figure 10.6 shows the effect of a subsidy for a merit good, affordable housing, provided
by the government to developers who choose to build middle- to low-income housing
inan urban area.
The private cost of building additional low-income housing decreases due to a per-
unit subsidy of P, — P,. As a result, the supply of affordable housing increases, the
equilibrium price falls to P, and the quantity demanded increases to Q. There is
still a positive externality from affordable housing, therefore a potential welfare gain
still exists; however, the market is more efficient following the subsidy than without
it because Q, is closer to the socially optimal level of housing (Q) than the amount
constructed without the subsidy (Q,). Government intervention has made the market
for affordable housing more efficient by reducing the private cost so that it is closer to
the social cost, thus increasing equilibrium output.

The subsidy, however, is paid for by tax revenues, and is drawn from other areas of the
government budget. So again, the opportunity cost of using these resources must be
considered. Furthermore, the granting of such subsidies can create a political problem.
Other industries may see an opportunity to be subsidised, which may lead to a barrage
of appeals to the government for subsidies on the basis of the external benefits their
products create.

Taxes
When demerit goods impose spillover costs on third parties, or when a good’s
production harms the environment or human health, government intervention to
reduce the quantity of the good produced may be in order. Whereas subsidies can
increase market output, indirect taxes, as we know, will lead to a decrease in output.
A tax on a good meant to reduce its output to a more socially optimal level is known as
172
 Swithtax s = MsC

« Figure 107 The imposiion

of a Pigouvian tax on a
Per unit h demerit good moves price
P and quantity supplied closer
tax T
Deadweight loss to socially optimised levels

D=MPB
Q,Qu Q¢ Q

a Pigouvian tax, after economist Arthur Pigou, who in his 1920 work The Economics of
Welfare, first distinguished between ‘marginal private net product’ and ‘marginal social
net product’, or what we refer to as equilibrium quantity and socially optimal quantity.
Pigou argued:
‘Itis ... possible for the state, if it so chooses, to remove the divergence
[between social and private costs] in any field by ‘extraordinary
encouragements’ or ‘extraordinary restraints’ upon investments in that field.
The most obvious forms which these encouragements and restraints may
assume are, of course, those of [subsidies] and taxes.’

A Pigouvian tax, in other words, is one that ‘restrains’ the investments in an industry to
‘remove the divergence’ between MPCs and MSCs. The classic example of a Pigouvian
tax is that on cigarettes, although many other examples exist, including taxes on sugary
beverages, fatty foods, petrol (gasoline), non-renewable energies, alcohol, marijuana
(in countries where it is legal), and carbon emissions. Figure 10.7 shows the effect of a
tax on alcohol, charged to the sellers, but shared by both producers and consumers.
A per-unit tax of P, —P_has been imposed on alcoholic beverages, increasing the cost
to sellers and thus reducing supply from S = MSC to § with tax. Equilibrium price has
increased to P, and quantity demanded has decreased to Q,,. The tax burden is shared
by sellers (who receive only P, for each unit of alcohol sold) and buyers (who pay more
for each unit bought).
Pigouvian taxes are ‘corrective’ taxes in that they help to correct the market failure.
The amount of alcohol bought after the tax (Q,,) is closer to the socially optimal quantity
(Qyp)- The DWL from alcohol consumption (domestic abuse, drunk driving, reduced
productivity, and poorer health) is smaller thanks to a government intervention that
required alcohol sellers and consumers to share in the burden that alcohol places on
society, thereby ‘internalising’ the externality.

Carbon taxes
Of course, taxes on alcohol and cigarettes are so common that they are expected
in nearly every country. Few people question their effectiveness at both reducing
consumption from what it might be without taxes but also at raising revenues for
city, state, provincial, or federal governments (depending on which tax authority
collects the tax revenues). More controversial is the use of Pigouvian taxes to limit the
173
 Market failure

consumption of goods that are less avoidable than cigarettes, alcohol, or marijuana:
taxes on goods that nearly everyone has to buy just to get through the week.

Carbon taxes, for example, have been proposed in many countries as a means of
shifting consumers away from carbon-intensive fuel sources such as gas, coal, diesel,
and petrol, and towards renewable energy and transportation fuels such as wind
and solar energy and more fuel efficient or even zero emissions cars like hybrids and
electric vehicles.

Industrial emissions,
1P Be

A carbon tax would be levied on manufacturers of different products based on the

amount of carbon dioxide emitted through the good’s production. For instance,
let us assume the US government places a tax of $30 per metric tonne of carbon
emitted anywhere in the USA. Every producer in every industry would be required
to track their carbon emissions, report their figures to the government, and pay
$30 per tonne emitted in tax. The result would be an increase in the MPC of
producing any good that emits carbon through its production process. Not all
goods, of course, are responsible for carbon emissions, but even intermediate goods
like minerals, plastics, chemicals, and other inputs used in the production of goods
that are thought of as relatively ‘clean’ will be taxed. Thus, the tax will be passed on
through the chain of production, increasing the costs of most manufactured goods
throughout the economy.
The higher cost would reduce the supply of affected goods, driving the price up
and reducing the quantity demanded. Opponents of carbon taxes point to the
assumed macroeconomic impacts of reduced overall output, higher prices, and
lower standards of living among houscholds whose incomes are stretched due to
higher prices. Whereas, supporters argue that revenues from carbon taxes can
be used to pay for income tax cuts for households, and with increased disposable
incomes consumers will be free to buy goods that are less carbon intensive, which
will become more attractive due to their lower prices. Over time the carbon
tax will generate much needed government revenue, but more importantly will
incentivise producers and consumers to shift their production and consumption
patterns away from carbon-intensive goods and towards a more sustainable
pattern of economic behaviour.
174
Legislation and regulation ]
Corrective subsidies and taxes provide governments with means of ‘encouragement’ Carbon taxes are still rare,
or ‘restraint’, in the language of Pigou, to narrow the divergence between private
but very popular among
economists who would like
costs and social costs in markets where externalities exist. A potentially more blunt to see Arthur Pigou’s vision
instrument of government intervention is the use of legislation and regulation. In of ‘removing the divergence’
Chapter 9 we gave examples of government agencies in the USA that are tasked between social and private
with overseeing and regulating the activities of various industries, from the aviation costs applied on a larger scale
than the targeted taxes on
industry to the transportation sector to the markets for energy and education. When individual goods like alcohol
governments pass laws or make rules that require certain behaviours of producers and and cigarettes.
consumers, they are intervening in markets to try and produce more socially optimal To further explore the
outcomes than what might be achieved otherwise. potential effects of a carbon
taxon the US economy, do
Some examples of government regulations and legislation to correct market failures aweb search for the 'RFF £3
include things as common and familiar as speed limits on public roads, minimum ages Carbon Pricing Calculator.
Once you have located the
to drink and smoke, laws against child labour, the regulation of toxic substances, the calculator, play around with
illegality of hard drugs, workplace safety laws, and requirements that children attend it by trying different carbon
school until a certain age. In each of these cases the government has determined that tax rates and tax growth
without rules and regulations, private individuals and producers might make decisions rates, examining the different
effects on annual emissions
that they deem to be in their own self-interest (1am late to work, therefore I will and on tax revenues.
drive 150 kilometres per hour on this state highway'l) but which are clearly not in the For discussion and debate:
interest of society as a whole. 1 How much less carbon
would the USA emit in the
year 2030 with a $30 per
Case study - the ethics of individual liberty versus social good tonne CO, tax, increasing
at 1% above inflation
Rules, regulations, and laws are the glue that hold society together in the face of the each year, compared to
sometimes-fierce libertarian instincts of many people within a community. A case the amount it would emit

in point is the conflict in the USA over the wearing of cloth face coverings in public without a carbon tax?
during the COVID-19 pandemic. Millions of Americans refused to wear masks What percentage of 2005
levels of CO, would the
voluntarily, thus when those who were knowingly or unknowingly infected with US emitin 2030 with a
the coronavirus ventured into public places, they were highly likely to spread the $30 per tonne carbon tax
virus through seemingly innocuous activities like breathing, sneezing, coughing, or increasing at 1% above
simply carrying on a conversation with others. inflation each year?
How would your answers
Because simple appeals from public health officials were not enough to get the to (1) and (2) change if the
majority of the population to wear masks, governments at different levels, from the tax were increased to
$50 per tonne?
city to county to state, passed ‘mask mandates’, which were essentially temporary
laws requiring that citizens wear masks in public. Violators could be cited with a
Explain the slope of the
=

annual gross revenue

fine or arrested depending on the provisions of the mandate. curve. What happens
when you increase the
In this case, government intervention is required to reduce the MPB of ‘not wearing rate at which the carbon
amask’ to essentially zero, since the socially optimal number of people who should tax increases annually?
NOT be wearing masks in public during a pandemic is zero. Another way to look at Why do revenues from the
carbon tax decrease over
it is there are external benefits of wearing a mask right now; therefore by fining or time?
arresting people who do not wear masks, it increases the MPB of wearing a mask so What are the opportunity
thatitis closer to the MSB, thereby reducing the potential welfare gain of masking up. costs of imposing a tax
on all carbon emissions?
Discuss the trade-off society faces between individuals’ freedom to make decisions What are the benefits?
about their own health and the conflict with successfully achieving public health. In your opinion, are the
Do you think mask mandates were the right approach for governments to take benefits worth the costs?

during the COVID-19 pandemic?

175
 Education - awareness creation
Whereas regulations, mandates, rules, and laws are examples of government
intervention in markets to require behaviour that is more socially optimal (staying in
school until the age of 16, driving at a reasonable speed, drinking only when you are
of an appropriate age, or wearing a mask during a public health crisis), educating the
public on good behaviour presents another, perhaps less direct, means of promoting
socially desirable market outcomes.

Examples of education for reducing market failures are health education in general,
which may aim to educate young people about the importance of a healthy diet and
avoiding tobacco and drugs, and even driver’s education, which makes sure that only
people who have been instructed on safe vehicle operation are allowed on the roads,
thereby reducing instances of traffic accidents and deaths.
Public and private organisations that promote safer behaviours are essentially aiming
to increase the MPB of those behaviours, thereby reducing the potential welfare gain
from healthy and safe practices.

Tradable permits
When the goal of an intervention is to reduce the amount ofa good that is produced or
consumed, taxes, regulations, or education can be employed, but another method is to
simply require a permit for each unit of the good a user wishes to consume. Consider
the example of carbon dioxide once more. Earlier in this chapter we discussed carbon
taxes as a means of internalising the external costs of producing goods that emit
carbon in their production. A carbon tax generates revenue for the government and
creates a disincentive for firms to use carbon-rich production methods. A tax acts as
a‘punishment’ for polluting, but offers no ‘reward’ for firms that clean up their act.
In colloquial terms, a tax is ‘all stick, but no carrot’.

Now consider a tradable pollution permit. The government could issue permits to
every manufacturer in the country that would allow them to emit a certain amount
of carbon dioxide based on the industry and historical levels of pollution. Some firms
‘may already be using ‘green’ production methods and may not need the permits
they are issued. Other firms, meanwhile, may be using older, less efficient means of
production and might require more permits than they are issued. The beauty of a
tradable pollution permit is that rather than paying the government for each tonne
of carbon dioxide a firm emits (which a carbon tax requires), a heavy polluter instead
must pay another firm for additional permits. The total amount of pollution can thus
be capped at a ‘safe’ level by the government, and rather than paying the government
to pollute at whatever level they desire, firms must acquire a permit from among the
limited number available from other firms that are polluting less and therefore do not
require the permits they possess.

Tradable pollution permits act as both a carrot and a stick, since they reward good
behaviour and punish bad behaviour. In contrast, a carbon tax only punishes bad
behaviour. Firms that adopt greener production methods are rewarded by being able
to sell unneeded permits. Additionally, the government can control the total level of
pollution by limiting the number of permits available. Supply of permits is perfectly
inelastic, in other words; increased demand for carbon dioxide emitting technologies
does not lead to increased emissions, only a higher cost to pollute. In the long run,
176
 P(¥)

« Figure10.8 The supply of

tradable pollution permits is
50 fixed according to the number
issued by government

2 billion Q

demand for polluting technologies should decrease, since permits are in essence a
complementary good that must be purchased in order to produce goods that emit
carbon dioxide. If the government wants to reduce pollution, it simply issues fewer
permits, which increases the cost to pollute and further rewards firms that reduce
their emissions.
Figure 10.8 shows the market for tradable permits for the emission of carbon dioxide by
producers. Each permit allows a firm to emit one tonne of carbon dioxide. A firm that
emits 50,000 tonnes each year, in other words, would be required to hold 50,000 permits.

The government has issued 2 billion permits that allow for 1 metric tonne of carbon
dioxide pollution each. Supply is set by the government, while demand is downward
sloping. The cheaper it s to pollute, the more polluting firms will wish to do. However,
the amount of pollution permitted is fixed; so, what happens if demand for polluting
technologies or products increase? Let us assume that economic growth increases the
demand for all kinds of carbon dioxide-related production, from energy to industrial
use. Figure 10.9 shows what happens when there is more demand for pollution permits.

P(¥)

80

<« Figure10.9 As demand for

pollution permits rises, higher
50 prices reward and incentivise
‘greener firms

2billion Q
177
 Market failure

Producers now demand more pollution permits, but the quantity supplied has stayed
fixed at 2 billion. The cost to pollute, however, increases to ¥80 (¥ is the symbol for the
yuan, the currency of China) per tonne. As overall demand for pollution has increased,
firms that have reduced their emissions are able to sell their permits to those that
wish to pollute more, increasing the greener firms’ profits and making pollution less
profitable. Total emissions, meanwhile, remain unchanged.

International agreements
Many of the market failures we have discussed in this chapter are global in nature,
not local. Global carbon dioxide emissions contribute to climate change, a market
failure arising from the common access resource that is our atmosphere, which is non-
excludable but rivalrous. International agreements provide a means of holding countries
accountable towards taking steps that help prevent the tragedy of the commons.

In an effort to overcome the global challenge of climate change, world leaders have
come together several times in recent decades in an effort to work out agreements over
steps all countries will take to share the burden of reducing greenhouse gas emissions.
The 2016 Paris Climate Agreement is one example.
The Paris Agreement central aim is to strengthen the global response to the threat
of climate change by keeping a global temperature rise this century well below 2°C
above pre-industrial levels and to pursue efforts to limit the temperature increase even
further to 1.5°C. Additionally, the agreement aims to strengthen the ability of countries
to deal with the impacts of climate change. To reach these ambitious goals, appropriate
financial flows, a new technology framework and an enhanced capacity building
framework will be put in place, thus supporting action by developing countries and
the most vulnerable countries, in line with their own national objectives.
Without agreements, Other examples of international agreements aimed at reducing the harmful impacts
the free-rider problem arising from negative externalities of the unsustainable exploitation of resources
arises once more. Why
should Vietnam require associated with common access resources include:
its industries to reduce
greenhouse gas emissions « Basel Convention on the Control of Transboundary Movements of Hazardous
by 30% if Bangladesh ‘Wastes and their Disposal (1989)
continues to allow its
« Convention on Biodiversity (1993)
producers to pollute at
ever increasing levels? The + Convention on International Trade in Endangered Species (1973)
costs of mitigating climate * Montreal Protocol on Substances that Deplete the Ozone Layer (1987)
change would be unfairly * Stockholm Convention on Persistent Organic Pollutants (2001)
borne by certain countries,
while others free ride on * United Nations Environment Programme (UNEP) (founded 1972)
their actions and enjoy the
climate benefits without In each of these agreements, a global common pool resource is being protected.
making any sacrifices. When international cooperation is required to achieve sustainability, international
Where in your own life agreements are the best way to get countries to work together.
do you see the free-rider
problem at play? Are Several challenges arise that may limit the effectiveness of international agreements
there free-riders in your at protecting common pool resources: monitoring the extent to which participating
school or your community
who do not take the best countries adhere to their pledged reductions in harmful activities, for one. There is no
action for society asa ‘world government’ that can track or enforce limits on air pollution by participating
whole in pursuit of their countries. In most cases, one country cannot ‘punish’ another country for failing to
own self-interest? Give: meet emissions targets or to take necessary steps to protect a particular resource or
some examples. endangered species.
178
 International agreements present a version of what economists call the ‘prisoner’s
dilemma’. Assume, for example, that 100 of the most developed countries agree to
reduce greenhouse gas emissions by 5% per year starting in 2020. The climate benefits
of countries undertaking such reductions would be enjoyed by all, but by some
countries more than others (those with expansive, low-lying, heavily populated coastal
zones, for example, which would benefit from a reduction in sea level rises).

However, if every country assumes that all other countries are taking the difficult steps
to reduce their emissions, then it becomes less important for any individual country
to reduce its own emissions. One country, in other words, could free ride on the good
behaviour of all the other countries. The problem is, when more than one country
(say, a dozen, or 25, or 50!) of the hundred in the agreement make the same rational
decision that it is no big deal if they do not reduce their emissions since they will enjoy
the climate benefits of everyone else reducing theirs, then we end up in a situation
where the international climate agreement fails altogether.
The ‘prisoner’s dilemma’, a thought experiment used by game theorists to predict the
outcome of situations like this, predicts that when multiple agents must cooperate
to achieve an outcome that is good for all, but not the best possible outcome for each
individual agent, the agents tend to ‘cheat’ and pursue the outcome that benefits each
agent the most; thus the effort to achieve the socially optimal outcome fails. Often game
theory is used to analyse the behaviour of oligopolistic firms in imperfectly competitive
markets (Chapter 12), but it applies rather well to understand why international
environmental agreements are often unsuccessful at achieving their stated environmental
aims. Once again, the selfish behaviours that give rise to the free-rider problem described
earlier in this chapter contribute to market failures even at the international level.

0.3 Public goods

Learning outcomes

At the end of this section you will be able to:

« using the concepts of rivalry and excludability, and providing examples,

distinguish between public goods (non-rivalrous and non-excludable) and
private goods (rivalrous and excludable)
* explain, with reference to the free-rider problem, how the lack of public goods
indicates market failure
« discuss the implications of the direct provision of public goods by the
government.

What are public goods?

Earlier in this chapter we defined common pool (or common access) resources as ones
that are non-excludable but rivalrous. No individual can be excluded from consuming or
participating in the use ofa common pool resource, but their use or consumption is
rivalrous, meaning one person’s use diminishes the benefit the good provides to the
rest of society. As a result, common resources tend to be over-consumed, leading to an
unsustainable depletion of such resources.
179
 A similarly defined, but very different, type of good is one that is non-excludable, but
also non-rivalrous. A public good, such as national defence, is one that every person
is able to benefit from but that one person’s benefit or use of does not diminish the
benefit or use enjoyed by the rest of society. National defence, by which we mean
the existence of armed forces that protect all people within a country’s borders from
aggression by foreign forces, benefits everyone within the country’s borders. No
individuals within the country are excluded from the protection the defence force
provides.

However, when one more person, or a hundred, or a million more people, enter the
country, their presence does not subtract from the value the defence force provides
the people who were already there. This is in contrast to a common pool resource like
fresh drinking water. A million people who move into a watershed will put increasing
strain on the supply of fresh drinking water, while contributing to sources of water
pollution, diminishing water supply and quality for everyone else. Fresh drinking
water, in contrast to defence, is non-excludable, but rivalrous. Defence, meanwhile, is
both non-excludable and non-rivalrous.

The market failure that arises due to the existence of public goods is that due to the
inability to exclude certain people from benefiting from the good and the fact
that the benefits are universal (for everyone), there is no incentive for private
firms to provide the good. Without government, pure public goods would not be
available. This explains why armies, navies, air forces, and other defence forces are
always ‘national’. Private militias or paramilitary groups, in contrast, provide
defence to the private parties that hire or finance them, or to the small communities
from which their ranks are drawn. The services of private defence forces are
excludable; if you are not part of the community paying for protection, you cannot
expect to receive protection.

Other examples of pure public goods include things like roads and sidewalks,
streetlights, lighthouses, fire departments, police and sheriff departments, the legal
system, and the criminal justice system. Consider streetlights. Once a street is lit, no
individual walking, driving, or cycling along that street at night can be excluded from
using the light to see where they are going. Nor does having a second or third or fourth
person within the arc of a particular streetlight diminish the benefit the light provides
all other users. Streetlights are non-rivalrous and non-excludable. So, who installs and
pays for the operation of streetlights? Well, usually that is the municipal government
of the area in question. Why not a private business? Because, of course, it would be
impossible to charge each individual who benefits from the light for its use.
Direct government provision of public goods is most common, but in some cases
private sector firms might be contracted to provide goods at public expense.
Motorways like Germany's autobahn, Italy’s autostrada, or the interstate highway
system in the USA, while financed at taxpayer expense, are rarely constructed by
government employees themselves; rather, private contractors will bid for the jobs, and
enter into a contract with the government, earning a profit in the process. In contrast,
most militaries are fully public; servicemembers in national armies are directly
employed by the state. The same could be said for publicly-funded school teachers and
doctors and nurses working at public hospitals. In most developed countries today,
however, the provision of public goods is made possible by partnerships between the
government and the private sector.

180
 The market failure of public goods is perhaps the ultimate market failure. Whereas T
other goods that we have studied in this chapter are either over- or under-provided (demerit You have read about it, now
and merit goods) or over-consumed (common pool resources) in the free market, there you can review what you
simply is no market for pure public goods. Owing to their non-excludability, the free- have just learned by watching
. . o s " e some videos by the author!
rider problem explained earlier in the chapter exists for public goods as well: individuals o imply click here in
who benefit from the good may do so without doing anything to help pay for the your eBook for videos
good. This is why the provision of public goods is left to the government and paid for on public goods as a market
not by the willing expenditures of the users of the good at the point of consumption, failure
but through the obligatory collection of direct or indirect taxes, collected by the state,
and used to provide the goods that otherwise would not be provided. Government
provision is the only solution to the market failure of pure public goods.

vt 10.4 Asymmetric information

How does information asymmetry lead

to market failure?

Learning outcomes
At the end of this section you will be able to:

* explain, using examples, that market failure may occur when one party in an
economic transaction (either the buyer or the seller) possesses more information
than the other party
. evaluate possible government responses, including legislation, regulation,
and provision of information.

Market theory presupposes that all actors are in possession of the same perfect levels
of information regarding market transactions. All consumers, for instance, will know
the variety of prices and quality levels available fora particular good. Of course, this is
highly unlikely, as consumers are constrained by time and access to such information.
Even in the digital information age, when far more information on any product is
widely available, consumers make a decision about the opportunity cost of absorbing
all the alternatives, and rarely possess anything close to perfect information.

What is adverse selection?

With this reality in mind, it is more than likely for consumers to make ‘mistakes’
regarding purchases, in pure market theory terms. Today, consumers are also
more likely to be subjected to sophisticated marketing techniques that aim to limit
information and choice. One variety of asymmetric information has one party in a
transaction holding more information than the other party. For example, the seller of
aplot of land might know that neighbouring land will, in the near future, be used for a
chemical plant, while the buyer is ignorant of this information. The buyer will pay too
much for the land — an example of market failure.

Adverse selection refers to a situation where the seller has more information about the
characteristics or the quality ofa good than the buyer, or vice versa. A used car dealer

181
 may withhold information about the service history of a vehicle that a customer is
considering buying in order to make the car more attractive to the buyer, thus earning
ahigher selling price. Without correct information, the buyer will pay too much,
and across several transactions the seller will extract consumer surplus from their
customers who are ill-informed about the true nature of the cars they are buying; more
used cars will be sold at higher prices than what is optimal for the market as a whole.

Entire industries can experience adverse selection if producers withhold information

they know to be true from their customers. Cigarette producers in the tobacco
industry were aware of studies linking smoking to cancer for decades, but withheld or
denied knowledge of the adverse health effects of their product, assuring consumers
that there was nothing to fear by consuming a ‘healthy’ volume of cigarettes each day.
The result of withholding scientific facts from their customers was higher than optimal
cigarette usage and a public health crisis that was only brought under control once
the government began regulating and taxing tobacco firms to reduce supply of and
demand for their products to a more socially optimal level.

Adverse selection can also occur when the product is relatively complex for the
average person to understand. The 2008 financial crisis was partly caused by the sale of
complicated mortgage loans to borrowers, as well as the repackaging of those loans to
potential investors. Health and life insurance policies are notoriously complex. Finally,
consider the ‘terms and conditions’ statements that app and websites require for our
use. Do we ever read them?

What is moral hazard?

Another market failure arising from asymmetric information occurs when a party
provides misleading information and changes behaviour after a transaction has
taken place.
An example is a life insurance company that takes on a customer who, in his or her
application, claims that he or she does not participate in any extreme sports or work ina
job that is particularly hazardous, but then takes up sky diving and takes work as a coal
‘miner. Sky diving and working in mines are both extremely dangerous activities; if the
insurance company had known their client was going to be participating in these activities,
they would have thought twice about taking them on as a customer, or at the very least
charged much higher premiums to cover the increased risk the individuals lifestyle poses.
Moral hazard describes the tendency for individuals to engage in activities that they
might not otherwise participate in because of a previously agreed upon arrangement
that mitigates the risk to the individual’s financial well-being. Another example of
moral hazard is when someone rents a car and takes out the full insurance coverage;
once he or she leaves the lot he or she is not financially responsible for any damage to
the vehicle, including damage they may cause. Therefore, the renter is likely to drive
the car far more recklessly than she would if it were their own property on which he or
she would share in the cost of any repairs to damage done.

What are appropriate responses to asymmetric

information?
The result of market failures arising from information asymmetry is that too much of
some goods are consumed at too high of a price (in the case of adverse selection), or
182
too low ofa price (in the case of moral hazard: think of how the insurance company
or the car rental agency would have adjusted their premiums or rental rates if they had
known the truth about how their clients would act once the contract had been signed).
The solutions to these market failures lie in improving access to information, and there
are both private and public examples of appropriate responses.

Government responses to asymmetric information include consumer protection

legislation, regulation, and direct provision of information. These include laws that
make it illegal for producers to supply false information about their products (such as
truth in advertising laws, which require that advertisements on the television, radio, or
the internet, are ‘truthful, not misleading, and, when appropriate, backed by scientific
evidence’), and the existence of regulatory agencies (some of which were mentioned in
Chapter 9) whose responsibility is to monitor and require certain disclosures of firms
in various industries; both aim to improve access to information among consumers.

Beginning on 2 January, 2020, the US Department of Agriculture’s Bioengineered Food

Disclosure Law, for example, began requiring all US food manufacturers to disclose on
their packaging when a food includes ingredients that are or may be bioengineered.
Doing so allows consumers who may have concerns about bioengineered foods to
make informed decisions at the point of purchase, and avoid such products should
they wish to do so.

Private responses to asymmetric information are myriad. There are publications

Video suggestions:
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that are dedicated to offering potential buyers detailed product reviews of different you can review what you
categories of goods so they can make informed decisions before buying. Amazon, have just learned by watching
the world’s largest online retailer, includes a robust customer review feature that some videos by the author!
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allows shoppers to read reviews for individual products, such as a set of Bluetooth your eBook for videos
earbuds, before buying; these private solutions make it increasingly difficult for sellers on asymmetric information as
to withhold information about their products with the aim of exploiting unwitting a market failure
consumers.

The market’s inability to achieve equity

Learning outcomes
At the end of this section you will be able to:
. discuss how the workings of a free market economy may result in an
unequal distribution of income and wealth.

Why do markets sometimes fail to achieve equity?

Throughout this chapter, and indeed the first ten chapters of this book, we have
examined the strengths and weaknesses of the free market system at providing society
with the goods and services it wants and needs. When private property rights are
clearly established, when perfect information is shared among buyers and sellers,
when markets are competitive and the private costs and benefits are equal to one
another, and when the goods produced are both excludable and rivalrous, we generally
accept the market system as being the best system for producing a good or service.
183
 The signalling mechanism of prices allows buyers to communicate to potential sellers
the value they place on the good and sellers to signal to buyers the relative scarcity of
different resources and goods. Thus, free markets tend to achieve allocative efficiency
and to maximise societal welfare.

However, markets fail in many ways, too, many of which have been explained in
detail in this chapter. The results of market failures range from the over-provision of
some goods to the under-provision of others, to the lack of a market altogether for
yet others. When markets fail, the effects can be felt on the environmental, health, and
societal levels among others. One of the social consequences of market failure is the
inability of the market to achieve equity, or fairness, which leads to an unequal playing
field in which certain groups in society enjoy higher incomes and a greater level of
wealth than others.

Inequities (or unfairness) that are intrinsic to the market system lead to inequalit;
situation in which a relatively large percentage of the world’s wealth is shared by a tiny
proportion of the population. Some of the most unequal countries are, perhaps not
surprisingly, those in which government plays the smallest role in the economy. The
under-provision of merit and public goods like education, healthcare, security, and
infrastructure means that those with wealth can afford to access such goods on the
free market, while those without wealth must get by without them (or only have access
to poorer quality services). The inequitable distribution of income and goods by the
free market leads to generational inequality, where people who are born poor are likely
to remain poor while those lucky to be born in rich families are given opportunities in
life that almost guarantee they end up rich.
To promote greater equity, governments intervene in the free market to:

« provide or support the provision of merit and public goods

* break up monopolies that tend to result in wealth concentration among the owners
of capital
« regulate or tax industries whose externalities disproportionately harm the poor
« redistribute income through progressive taxation systems
« provide social safety nets in a way that helps elevate the living standards of those
who the market system might otherwise leave behind.
Inequity is, it could be argued, the ultimate result of market failure, and government
intervention, when done well, helps to make markets moral, while protecting the
system of incentives and rewards that make the market system so effective at delivering
the goods and services we all need and want.

184
Practice exam quest 5]

a8 Using an appropriate diagram, explain how negative

externalities are a type of market failure. (10 marks)
b. Evaluate the measures that a government might adopt
to correct market failure arising from negative externalities. (15 marks)
2a. What are positive externalities and how do they arise?
Ilustrate your answer with examples. (10 marks)
b. To what extent should governments attempt to influence
markets where positive externalities exist? (15 marks)
3a. ‘National policies and international agreements must be
implemented in order to reduce global environmental
problems’. Using the concept of market failure, explain the
statement above from an economist’s point of view. (10 marks)
. With reference to both national policies and international
agreements, discuss three solutions that could be
recommended by economists. (15 marks)
How does the under-provision of merit goods by the free
market give rise to inequality in society? (10 marks)

185
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 11.1 Introduction to market structures

At the end of this section you will be able to:

* describe, using examples, the assumed characteristics of perfect competition:

* alarge number of firms
+ ahomogeneous product
« freedom of entry and exit
« perfect information
* perfect resource mobility
* describe, using examples, the assumed characteristics ofa monopoly:
* asingle or dominant firm in the market
* no close substitutes
* significant barriers to entry
* describe, using examples, barriers to entry, including:
+ economies of scale
* branding
¢ legal barriers.

In Chapter 10 we examined many ways that markets fail to achieve socially optimal
outcomes. Whenever the market equilibrium quantity ofa good is greater than or
less than the socially optimal quantity, a market failure exists. While externalities,
common pool resources, public goods, and information asymmetry all give rise to
market failures of their own, perhaps the most common situation in which markets
fail to achieve efficiency is when there exists imperfect competition. The degree of
competition in a market tells us, before we even consider the characteristics of the
good or services in question, whether the market is even capable of achieving a socially
optimal, allocatively efficient, level of production.

Let us back up. A market’s structure refers to the degree of competition among
producers or suppliers in general (since this could apply to labour markets as well).
Any particular market’s structure falls along a spectrum of competition, from perfect
competition on one end to pure monopoly on the other. Figure 11.1 provides a conceptual
image of such a spectrum.
The two ends of our spectrum are where we will begin our examination of market
structures, beginning with perfect competition.

What is a perfectly competitive market?

A perfectly competitive market is one in which individual firms produce such a small
proportion of the overall supply of the product that altering their own output has no
Perfect Monopolistic
competition competition Oligopoly ~ Monopoly « Figure11.1 Theless
«——e— o o o+ > competition a firm faces,
the more it has in
Less market power More market power the
(many firms) (few firms)
187
 Market power: perfect competition vs monopoly

influence over the market price of the product. In this regard, firms in such an industry
are price-takers; this means that they find it impossible to charge a price higher than
that charged by their competitors, nor can they successfully offer their output at
alower price since competition forces the price down to the producers’ lowest
average cost.
In addition to perfectly competitive markets consisting ofa large number of identical,
price-taking firms, the model also assumes that the firms:

produce completely identical products (the goods are not differentiated and act as
perfect substitutes for each other)
can enter or exit the market very easily (with effectively no barriers to entry or exit)
« will produce where marginal social benefit equals marginal social cost, achieving
allocative efficiency (this is assuming there are not externalities arising from the
good’s production or consumption).

While perfectly competitive industries are rare in the real world, examples of markets
with some of these characteristics do exist in certain industries, including some
agricultural commodities, such as coffee or cocoa, low-tech manufactured goods,
certain types of low-skilled labour, markets in which there are many firms producing
nearly identical products or millions of households supplying an identical resource
(such as labour). Despite being rare, perfectly competitive markets are worth studying
for what they teach us about resource allocation and the efficiency resulting from high
levels of competition between firms.

Assuming there are no spillover benefits or costs (externalities) in the production

or consumption of the product, perfectly competitive markets result in the most
socially optimal level of output and price of any of the four market structures, and are
therefore considered allocatively efficient. Shortages and surpluses are non-existent in
perfectly competitive markets, wherein the high level of competition ensures that the
marginal social benefit ofa particular product will align with the marginal social cost
and neither too much nor too little will be produced. The perfectly competitive model
can be held up as an example of perfect efficiency when compared to less competitive
market models in which the price-making market power of individual firms results
in alevel of output that is lower than and a price that is higher than that achieved
under perfect competition. This provides evidence that efficiency decreases as markets
become less competitive.

What is a monopoly?
Let us move now to the other end of our market structure spectrum, to monopoly.
A monopoly is a market where one firm dominates the market for a good that has no
substitutes and where significant barriers to entry exist. To most people, monopoly
might seem akin to autocracy, where one company makes the rules, sets the prices,
and controls its destiny. As you will see, monopolies can occur in different types of
markets and take many forms.

The Dutch East India Company offers a historical example ofa monopolistic firm.
Throughout the 17th and 18th centuries the company exerted nearly total control
over the spice trade between Europe and Asia, giving it monopoly power in the
European spice market. Its power was derived from its control of access to spices, and
thus its dominant market share. Trade with Asia took place almost entirely along sea
188
routes controlled by the company, so the limited volume of spices that made it to the
continent over land accounted for such a tiny share of total sales that the Dutch East
India Company enjoyed a high degree of monopoly power.

More recently, Mark Zuckerberg’s Facebook has emerged as a dominant player in the
social media industry, where Facebook-owned apps controlled 56% of the market
(based on site visits in May of 2020). As the dominant firm in the social media market
Facebook has great power over the fate of its customers: not only the users whose
private information the company stores and sells access to, but just as importantly
the thousands of businesses that pay for online ads on Facebook’s platforms. Its
market power gives Facebook great influence over prices for online ads and earns the
company substantial profits.

Another well-known modern-day monopolist is Jeff Bezos, former CEO and now executive
chairman of the board of Amazon, the world's largest online retailer, which controls 49%
of America’s online retail market (and an increasing share of the markets in the rest of the
world, where the company is rapidly expanding its operations). Amazon’s dominance has
not necessarily harmed consumers, who benefit from the firm’s economies of scale and
wide selection of goods that can be delivered right to their doors, but traditional brick and
mortar retail businesses have suffered as Amazon has increasingly taken over the markets
for countless goods that used to be purchased locally in physical outlets.
None of the three examples above describe a pure monopoly, or a market with only
asingle seller. That is because such markets are extremely rare. Examples include
nationalised industries like railways and airlines (in some countries) or natural
monopolies (defined later in this chapter) for local utilities such as the electric company,
the garbage collection company, or the wastewater treatment company. In markets for
consumer goods monopolies are rare, and the two forms of imperfect competition
in the middle of our spectrum are the dominant market structure: monopolistic
competition and oligopoly. These will be explored in detail in Chapter 12.
For now, let us examine the characteristics of a monopolistic market.

Single seller
‘When a firm controls the market entirely and is the only producer of the good, it is
called a pure monopoly. The term ‘monopoly’ is derived from the Greek mono (single)
and polein (to sell). However, the case where a single firm controls a dominant share of
the market is much more common than a pure single seller.

No close substitutes
Being the single seller of a good would hold little value if that good were easily
replaceable with something else. Therefore, for true monopoly power, a firm must be
selling something that has no substitutes.

Price-maker
As the single seller of a good without substitutes, the firm will have some power to set
the price of the good. The extent of that power is limited by the overall demand for the
good, but this power can be considerable. In contrast to the perfect competitor, which
must accept whatever price is set in the larger market, the monopolist has significant
price-making power.
189
 Market power: perfect competition vs monopoly

Barriers to entry
A monopolist keeps the dominant position because there are significant barriers
to other firms’ entry into the market. In the absence of competition, the firm can
maintain its price-making power, and will continue to make abnormal profits. Entry
barriers may include:

* legal barriers (permits or licences required by government but held by a single

ora few firms)
+ economies of scale (prohibitively high fixed costs to enter a market), patents, or
copyrights
« control or ownership of key resources, and other factors that prevent competition
from entering a market.
Where an industry sits along our spectrum of competition determines several factors,
such as the level of efficiency and the degree to which the firm achieves socially
optimal levels of output, the price level of the goods being produced, the amount of
consumer surplus relative to producer surplus, the profitability of the firms in the
market, and the amount of deadweight loss (DWL) resulting from production.
The more firms there are competing in a market, the closer the market will come to
achieving allocative and productive efficiency. The less competitive a market, the more
likely firms are to earn profits, but at the expense of consumer surplus and allocative
efficiency. These and other concepts will be explored further in this chapter and the next.

Ih Profit maximisation

Learning outcomes
At the end of this section you will be able to:
* explain the meaning of economic costs
« distinguish between explicit costs and implicit costs
« analyse the difference between total revenue, average revenue, and marginal
revenue
« illustrate, using diagrams, the relationship between total revenue, average
revenue, and marginal revenue
« calculate total revenue, average revenue, and marginal revenue from a set of data
and/or diagrams
« distinguish between economic profit and normal profit
« analyse why a firm will continue to operate even when it earns zero economic
profit
* explain the meaning of loss.

Businesses, like individuals, respond to incentives in the pursuit of their economic

objectives. The goal of individual consumers in a market economy is to maximise
their utility or happiness which, in the economic realm, is achieved through increased
consumption of goods and services made possible through increased income. Individuals,
therefore, seek to maximise their incomes by selling their productive resources (land,
labour, and capital) to those firms that demand them in the resource market.
190
 The objective of most firms, conversely, is to maximise their profits through the
production and sale of their various goods and services in the product market.
The interaction of firms and individuals in the resource and product markets is the
defining activity of the market economic system. In the pursuit of their goal of profit
maximisation, firms must accomplish two distinct objectives: reducing costs and
increasing revenues until the difference between the two (the profit) is maximised.

Costs in economics are those things that must be given up in order to have something
else. Costs can be explicit or implicit. Explicit costs are the monetary payments that
firms make to the owners of land, labour, and capital in the resource market (i.e.
rent, wages, and interest, respectively). Implicit costs include the opportunity costs
of entrepreneurs who decide to allocate their time and energy to one enterprise over
other possible economic activities (in economics, the implicit cost of an entrepreneur
is called normal profit, a concept that will be defined later in this chapter).

Revenue is the income earned from a firm’s sale of its goods or services to consumers
in the product market. A firm’s profit is the difference between its total revenue (TR)
earned in product market and its total cost (TC) in the resource market, as shown in
the following equation:

Economic profit = TR—TC

Table 11.1 shows the costs and revenues (in euros) faced by a bakery that correspond
with different daily output levels of its most popular product, croissants. Assume the
bakery sells its croissants in a competitive market at a price of €3 per croissant. At this
price the bakery can sell as many croissants as it wishes. Therefore, its total revenues at
each level of production equal the number of croissants produced times the price
(TR=PXQ).

Table 11.1 Short-run costs of production

Number of | Total | Marginal | Average | Total | Marginal | Average
croissants | cost cost cost | revenue | revenue | revenue
produced | (€) (€) (€) (€) (€) (€)
Q
0 100 = — 0 3 3
20 120 1 6 60 3 3
40 130 0.5 3.25 120 3 3
60 150 1 25 180 3 3
80 180 15 225 240 3 3
100 220 2 2.20 300 3 3
120 270 25 225 360 3 3
140 330 3 236 420 3 3
160 400 3.5 25 480 3 3
180 480 4 2.67 540 3 3
200 570 45 2.85 600 3 3

191
 Market power: perfect competition vs monopoly

From Table 11.1 we can analyse some of the key cost and revenue figures a business
must consider in deciding on how to maximise its profits.

Total cost
The firm’s TC includes its fixed costs, which are the costs of its capital and land
resources (which do not change with the level of production) and its variable costs,
which are the costs of labour and raw materials (and do change with the level of
production). For our bakery, the fixed costs equal €100 per day, evidenced by the fact
that even when the bakery is producing zero croissants it still faces a TC of €100.
This may include the rent it pays on its bakery space and the utilities it pays (water,
sewerage, electricity, gas, etc.), none of which vary much with the level of output.
Also included in the bakery’s TC are its variable costs, or the costs of the resources
that must be added to its fixed resources in order to actually produce croissants. As
discussed in Chapter 5, a firm’s variable costs include the labour and raw materials that
must be employed as more output is produced.

Total costs therefore equal the sum of a firm'’s fixed and variable costs. Not surprisingly,
TC increases as output increases, since more variable resources must be employed to
produce more croissants.

Marginal cost
3
Abusiness, like an individual, tends to make decisions based less on total costs and
revenues, but on marginal costs and revenues. A firm’s marginal cost shows how much
the last unit of output cost to produce. Since more resources are needed to produce more
output, the cost of additional units of output tends to increase. Recall from Chapter 5
that, according to the law of diminishing returns, as more variable resources are added
to fixed resources to increase output, the productivity of additional variable resources
decreases due to the decreasing ratio of labour to capital. Therefore, the cost of
additional units of output tends to increase in the short run.

In our bakery’s marginal cost column, we can see that the cost of additional
croissants eventually increases. At first, when the bakery goes from 0 to 60 croissants,
192
 the marginal cost decreases; this is due to the fact that the first workers and raw
materials employed were more productive than those employed before them due
to the abundance of capital (baking implements, ovens, etc.) available to them.
However, beyond the 60th croissant the marginal cost (the cost of additional
croissants) increases. The 60th croissant costs the bakery €1 to produce, the 100th
costs €2, the 140th €3, and so on, until the 200th croissant, which costs the bakery
€4.50 to produce. The reason additional croissants cost more to produce, recall, is
the diminishing marginal returns (Chapter 5) experienced as the bakery employs more
workers and adds more raw materials to its fixed capital.

Average cost
Marginal cost, we will see, helps a producer decide the optimal level of output to
produce, since at a certain point the cost of an additional unit will exceed what the
unit can be sold for and it will therefore stop making sense to increase production.
However, once the optimal level of output is decided, the question of whether a profit
oraloss is being earned requires a business to know its average cost (which can be
compared to its average revenue, or the price of the output).

Average cost is simply the per-unit cost of production. It is found by dividing the firm’s TC
by its total output, or the quantity produced.

Total revenue
A firm’s revenue is the amount it earns from the sale of its product, and can be found
by multiplying the firm’s output by the price it is sold for. Revenue should not be
confused with profit, which is the firm’s revenue minus its costs.

Marginal revenue
The change in a firm’s total revenues experienced when output is increased by one unit
is the firm's marginal revenue. Again, firms make decisions based as much on marginal
analysis as anything else. As we will soon see, by comparing the marginal revenue
and the marginal cost from an additional unit of output, a producer will be able to
determine whether an increase in output will increase or decrease its overall profits.
In a perfectly competitive market like that in which our bakery produces croissants,
afirm's marginal revenue is always equal to its price, since additional units of output
can be sold at whatever the market price happens to be. Later in this chapter we will see
that in imperfectly competitive markets, like monopolies, marginal revenue is always
less than price, since in order to sell additional units of output an imperfect competitor
(as a price-maker) must lower its price. For our bakery, however, marginal revenue
(MR) =P,

Average revenue
‘We have defined total costs and average costs, TR and marginal revenue, and now
define average revenue. This one’s really simple. In any industry, the average revenue is
the price the output sells for. It is the TR divided by the quantity. Recall that TR equals
quantity multiplied by the price. Therefore, by the transitive property, price equals
average revenue. When we compare a firm’s average revenue at a particular level of
output to its average cost, we will be able to calculate the firm'’s per-unit profit.
193
 600

500

400

Revenues/costs (€)
Figure 11.2 Comparing TR
and TC reveals the bakery is 300
in profit at outputs above
40 croissants
200

100

0 20 40 60 80 100 120 140 160 180 200

Quantity

What is the profit-maximising rule?

We have already defined a firm’s economic profit as its total revenues minus its total
costs. As an agent interested in maximising its profits, a firm'’s goal is to find the
optimal level of output at which the difference between its TR and its TC is maximised.
Let us first look at a graph of our bakery’s total revenues and costs over its possible
levels of output. Figure 11.2 shows these values, with TR in green and TC in red.
Any level of output at which total revenues are greater than total costs represent a
profit-earning situation for the bakery. Beyond about 40 croissants, in other words,
our bakery can earn a profit. Below 40, the cost of producing each croissant exceeds
revenues; it is not worth the bakery considering a very low level of output, in
other words.

To find the profit-maximising level of output, however, we must consider the per-unit
and marginal costs and revenues. Figure 11.3 shows the bakery’s marginal costs (MC),
average costs (AC), MR, and average revenue (AR) over its range of possible output.

The first thing to notice is that the firm’s MR and AR curves are the same. That is
evidence that this bakery sells its product in a perfectly competitive market, in which it
is a price-taker. The bakery has no control over the market price of croissants, therefore
it can sell as few (0) or as many (200) as it likes at the equilibrium price of €3. Demand
for the individual seller’s output is perfectly elastic in a competitive market.
The question the seller faces, therefore, is not what price to charge, rather what quantity
to produce in order to maximise profits. Figure 11.4 shows the bakery producing at its
profit-maximising level of output, where MR = MC.

At 140 croissants the cost of the last croissant equals the price the bakery could sell it
for (MC = 3and MR = 3). The bakery breaks even on the 140th croissant but earns a
profit on every croissant it produced up to that point.
194
 Revenues/
costs (€)
6.00 -

5.00
MC

4.00
« Figure11.3 Firms look at
marginal costs and revenues
P, =3.00 + MR = AR in order to set output at the
"AC profit-maximising level

2.00 4

1.00 4

— T T
0 20 40 60 80 100 120 140 160 180 200 Quantity

Using the data from our table we can calculate the bakery’s profits at its profit-
maximising level of output of 140, shown in Table 11.2.
The firm's profit equals €420 — €330, or €90 per day, when it produces 140 croissants at
a cost of €2.36 per croissant.

The per-unit profit can also be calculated. With a price of €3, and a cost of €2.36, the
bakery earns a profit of €3.00 — €2.36 = €0.64 per croissant.
You may have noticed that the profit-maximising quantity is not, in fact, the quantity
at which the bakery’s average cost is lowest, which is where the marginal cost curve

Revenues/
costs (€)
6.00

4.00
Figure11.4 The profit-
maximising level of output is
P.=3.00 where MR = MC

2.00

0 20 40 60 80 100 120 140 160 180 200 Quantity

195
 Market power: perfect competition vs monopoly

Table 11.2 Profits at profit-maximising level of output (140)

Number of | Total | Marginal | Average | Total | Marginal | Average

croissants | cost cost cost revenue | revenue | revenue
produced
Q
140 330 3 236 420 3 3

crosses the average cost curve somewhere between an output of 100 and 120. This
is the cost-minimising level of output, where the per-unit cost of croissants is lowest.
However, producing at the cheapest quantity does not necessarily maximise the
bakery’s profits. Figure 11.5, which shows the amount of profit the bakery would earn
at the cost-minimising level of output, illustrates why.

In Figure 11.5 our baker is producing around 105 croissants, the quantity at which its
average cost is lowest. The red dotted rectangle represents the firm’s economic profit
at the cost-minimising level of output. Profit, recall, is the firm’s TR minus its TC. Our
graph shows per-unit, not total, revenues and costs, therefore, the dotted red area
represents (AR— AC) X Q, or the per-unit profit multiplied by the number of units.

How do we know that the cost-minimising level of output is not necessarily the profit-
maximising level of output? Because the blue triangle represents possible additional
profits the firm could earn by producing more croissants. For each croissant between
105 and 120, where the marginal cost equals the marginal revenue, the next croissant
will sell for more than it costs to produce (MR > MC).

To summarise, a firm that faces an upward-sloping marginal cost curve in the short
run, explained by the law of diminishing marginal returns (Chapter 5), can maximise
its total profits by choosing to produce at the level of output where the cost of the last
unit produced (MC) equals the revenue the firm earns from its sale (MR).

Revenues/
costs (€)
6.00 {

5.00 4

4.00 {
Figure 11.5 The cost-
min imising level of output is
whi average cost is lowest

2.00

1.00

T
—_— T —————
0 20 40 60 80 100 120 140 160 180 200 Quantity

196
 Revenues/
costs (€)
6.00

5.00

4.00
|
o Figure11.6 Atalover
price the firm is breaking even
3.00 - (only earning normal profits)
P,=€220 AC
2.00 + "!
!3

1.00 4 !
3
|!
T T T T T
| T T T T o
0 20 40 60 80 100 120 140 160 180 200 Quantity

What is the difference between normal profit and

abnormal profit?
Our bakery, when producing 140 croissants at a cost of €2.36 and selling them at a
price of €3 apiece, is enjoying what economists refer to as abnormal profit. Abnormal
profit is earned when a firm covers all of its explicit and implicit costs of production,
and then some. Let us look at a situation in which only a normal profit is being earned.
Figure 11.6 shows what happens if the market price of croissants falls and our bakery is
only able to sell them at a price equal to its minimum average cost of €2.20.
The market price has fallen, and with the lower price the firm’s profit-maximising
quantity has decreased to 105 croissants. At that quantity, the average cost is equal to
the price of €2.20; the bakery is ‘breaking even'. This may make it sound like the firm
is earning no profits, but economists distinguish between the experience of a firm that
is covering all its costs and earning a normal level of profit and a firm that is earning an
abnormal profit, as our bakery was at a price of €3.
A normal profit is earned by a firm that is covering all its explicit costs and implicit
costs. Let us distinguish between the two.

Explicit costs
Explicit costs are the monetary payments a firm makes to the owners of the resources
it employs in the production of its output. Wages for workers, raw material costs,
energy and transport costs, rent payments for factory or retail space, and interest
payments to banks are all explicit costs a firm may face.

Implicit costs
Implicit costs refer to the opportunity costs faced by the entrepreneur who undertakes
abusiness venture and who could otherwise have earned money by hiring his self-
owned resources out to another employer. The founders of all business enterprises face
197
 Market power: perfect competition vs monopoly

implicit costs that represent the foregone wages of the entrepreneur who chose to start
abusiness as opposed to earning a wage working for someone else. Also considered an
implicit cost is the normal profit an entrepreneur expects to earn above and beyond all
his or her explicit costs.

Normal profit is the entrepreneur’s implied value of his or her own talent; it is the cost
to do business, and ifa firm's revenues do not cover the normal profit, the firm owner
may choose to shut down and direct his or her efforts towards another industry or area
of employment.

To demonstrate the difference between explicit and implicit costs, imagine a chemist
who chooses to leave her job paying €100,000 at a pharmaceutical company to start
her own research firm. Her explicit costs as a new business owner are the wages she
must pay herself and her five researchers, the rent she pays for her lab space, and the
interest she pays the bank for the loans she took out to acquire equipment for her
laboratory.

The chemist’s implicit cost is her perceived value of her entrepreneurial talent,
represented by the profit she expects to earn above and beyond her old salary to
compensate her for the risk she took when starting her own business. Assume the
chemist expects to earn the €100,000 she sacrificed when she left her old job, plus an
additional €50,000 to compensate her for the risk she took by starting her own lab.
The €50,000 is her normal profit, which she must earn in order for her to consider the
venture worth her while.

Back to our bakery example. When our baker is selling her croissants for €2.20 apiece
she is covering her explicit costs (paying her employees and her rent and utilities,
buying raw materials, etc.) but she is also earning a normal profit. In other words, she
is making just enough above and beyond her explicit costs to make it worth her while
to remain in the market. Any less than €2.20 per croissant and the bakery owner
would decide it was not worth her keeping the bakery open, even though she would
still be able to pay her workers and her rent and could still afford all the ingredients to
keep operating.

What are ‘economic losses’?

‘When the market price at which an individual firm can sell its product is equal to
the firm’s minimum average TC, the firm is able to earn a normal profit, but not an
abnormal profit. When the price is below the firm’s minimum AC, even a normal
profit is not possible, and the firm is facing a situation where it is minimising its
economic losses. Let us consider what happens to our bakery when the price of
croissants in the market falls below its minimum AC of $2.20. Figure 11.7 shows such
asituation.

In Figure 11.7 the price has fallen to €1.50. According to the profit maximisation rule,
the bakery should produce where MC = MR, which is at a quantity of 80 croissants.
Not surprisingly, the lower price leads the bakery to reduce its output (as predicted
by the law of supply). The problem is, at the lower price the firm is not able to cover
all its costs of production: the average cost is now higher (around €2.25) than average
revenue. The baker is losing about €0.75 for each croissant she sells. She is no longer
covering all the explicit and implicit costs, thus she is not earning the normal profit she
requires to remain in the market.
198
 Revenues/
costs (€)
6.00

4.00
« Figure11.7 Wit the
market price below average
3.00 cost, the firm adjusts output
to minimise losses

2.00

P, =€1.50 MR =AR

1.00

0 20 40 60 80 100 120 140 160 180 200 Quantity

‘When a firm experiences economic losses, it is only a matter of time before it will
shut down and leave the market. When a firm’s losses exceed its total fixed costs, or
the costs of paying rent and utilities, the firm will have to shut down. In the short run,
losses may be endured as the business owner waits for prices to rise again or attempts
to take steps to reduce her explicit costs. Alternatively, a business owner’s expected
level of normal profit may decrease, which would lower the AC and perhaps allow a
firm to remain in the market even when losses are being earned.

Alternative business objectives

So far we have assumed that all firms are interested first and foremost in maximising
their profits, which requires them to always produce where their marginal cost equals
their marginal revenue. There may be alternative objectives driving firm behaviour,
including satisficing, corporate social responsibility (CSR), or increasing market
share. We'll examine each of these in turn.

Satisficing behaviour
‘When a firm aims to earn a profit but not necessarily maximise its profit due to its
promotion of alternative objectives, the term used is ‘satisficing behaviour’. While
there is no single ‘satisficing rule’, a firm intentionally earning, but not maximising
profits, could be said to be satisficing.
A firm that is satisficing might produce at an output level that is not maximising its
profits but is earning enough profit for the business to do well while also pursuing
other objectives. Satisficing behaviour might allow a firm to pursue one of the other
alternative business objectives described here.

Corporate social responsibility

‘When a business voluntarily engages in activities that aim not to increase its profits,
but to better the community in some way unrelated to its business model, it might
199
 Market power: perfect competition vs monopoly

TP be engaging in CSR. CSR could aim at promoting objectives such as environmental

Global corporations nearly sustainability, public health, education, economic development, or human rights.
all have a CSR mission, and Firms that engage in CSR may be satisficing, meaning they are pursuing profits but
they often love to talk about sacrificing some profitability to promote other ends.
their work in CSR in the
media and through their Examples of CSR firms might engage in include voluntarily investing in renewable
websites. Projecting an image energies to reduce their carbon emissions, donating to charities, participating in
of themselves as responsible
global citizens is a key fair trade (which may increase the costs of their inputs but promotes higher wages
objective of most corporations among those engaged in their production), requiring employees to volunteer in their
that engage in CSR communities, or making socially or environmentally beneficial investments when they
CSR reports are sometimes are not necessary to achieve maximum profits.
issued annually by
corporations to inform
their shareholders and the Increasing market share
public about their efforts to
promote sustainability, health, A third objective that may require firms to sacrifice profits in the short term is the
education, or other outcomes pursuit of growth in order to increase its market share. As we will see later in this
not directly related to the chapter firms in competitive markets are unlikely to earn substantial profits over the
companies' bottom lines. Take long run. Competition forces prices downward and with them profits. Therefore,
a few minutes to skim the
CSR reports from three global increasing market share is a sure way to increase profitability, and to that end firms
corporations, then discuss the might be willing to sacrifice profits in the short run (or even operate at a loss) in order
questions that follow. Below to attract consumers away from their competition and gain market share over time,
are links to three such reports, allowing them to be more profitable in the future.
but you can feel free to do a
web search for a corporation An example of this is the ride-sharing market, which includes large firms like Uber
of your choosing,
and Lift. Neither of these firms has been profitable in their first decade of operation;
- Nestle (food industry): httpsy/
wwwnestle.com/csv they charge fares that are competitive but not profitable, with the goal of becoming
+ Glencore (mining): https:// the dominant ride-sharing operation in any given market. Should their strategy work,
www glencore. com/ Uber or Lift expect that someday, once they have emerged the winner in the price war
sustainability in which they are engaged, their market power might allow them to charge higher fares
* Microsoft (computer and earn abnormal profits sometime down the road.
software): hitps://www.
microsoft.com/en-us/ The pursuit of objectives other than profit maximisation is common among firms
corporate-responsibility in imperfectly competitive markets, due to the ability to focus on things like social
For discussion and debate: and environmental welfare and increasing their market share. Firms in perfectly
1 For each of the three competitive markets, we will see soon, are forced to minimise costs at all times in order
companies you to avoid the losses that would ultimately force them to shut down in the face of high
investigated, identify three levels of competition.
issues not directly related
to their industries on which
their CSR report focused Business growth
What motivations do you
Finally, an objective similar to increasing market share is a business’s goal of increasing
~

think drive corporations

whose key focus could its scale of production. Rather than targeting a larger market share, firms may aim
be on maximising profits to increase the size of their operations in terms of growing their quantity of output,
for their shareholders to which typically allows production to occur at a lower average cost due to increased
undertake CSR? Are there economies of scale. While economies of scale and lower costs often correspond with
any clues on the CSR reports
for the three companies greater profits, the two objectives are different and may require a firm to target not
you chose to investigate? their profit-maximising quantity, rather a level of output beyond what may be the most
Is there a trade-off between profitable in the short run.
w

being responsible corporate

citizens and maximising A classic example of business growth as an economic objective is the American online
profits? Why or why not? retailer Amazon, which for most of its first two decades operated at a loss in order to
increase its scale, allowing it to achieve lower and lower average costs over time. In the
200
process of growing its operations, Amazon also happened to chip away at the market
share of brick and mortar retail businesses, and it became the dominant online retailer
in America and in many other countries.

11.3 The perfect competition market model

Learning outcomes

At the end of this section you will be able to:

* compare and contrast, using a diagram, the shapes of the perfectly competitive
firm'’s average revenue and marginal revenue curves
« analyse how the assumptions of perfect competition imply that each firm is
a price-taker
* explain, using a diagram, that the perfectly competitive firm’s average revenue
and marginal revenue curves are derived from market equilibrium for the
industry
* explain, using diagrams, that it is possible fora perfectly competitive firm to
make economic profit (supernormal profit), normal profit, or negative economic
profitin the short run
* explain, using a diagram, why, in the long run, a perfectly competitive firm will
make normal profit
* explain, using a diagram, how a perfectly competitive market will move from
short-run equilibrium to long-run equilibrium
« compare and contrast allocative efficiency and productive efficiency.

The defining characteristic ofa perfectly competitive market is that there are many
sellers. So many, in fact, that no single seller has any control over the market price;
each firm therefore is a price-taker. Figure 11.9 shows the situation in the market for
croissants, of which our individual bakery is one single firm.

At the current level of demand and supply the equilibrium price is €3 and around
10,000 croissants are produced and sold. The market is made up of many small
bakeries that are each producing a tiny fraction of the total market output. Let us
assume that there are 70 bakeries, each making 140 croissants each day, which
accounts for the market output of 10,000 croissants.

‘When we combine our market model with our model for the individual firm used
earlier in the chapter, we can see how the demand for each individual bakery’s
croissants is determined. Figure 11.10 puts the individual firm and market models side
by side, to show that the price, demand, MR, and AR seen by an individual firm in a
competitive market is derived from the market equilibrium price.

Perfect Monopolistic = .
competition competition Oligopoly ~ Monopoly <« Figure11.8 Firr ina
fectly competitive market

Less market power More market power

(many firms) (few firms)
 P(€)
6.00

4.00

Figure 11.9 A perfectly

competitive market for
croissants
200

1.00
Video suggestion:
You have read about it, now
you can review what you
have just learned by watching 0 2 4 6 8 10 12 14 16 18 20
avideo by the author!
Q (thousands)
Simply click here in
your eBook for a video
on demand, MR, and profit Demand for the individual bakery’s croissants, you will notice, is horizontal, meaning
maximisation for a perfect demand is perfectly elastic. The bakery has no price-making power; any attempt to raise its
competitor.
price and it will not sell any croissants, since there are 69 other bakeries willing to sell at €3.

Figure 11.10 Withina Short-run versus long-run equilibrium in perfectly

perfectly competitive market (a)
any single firm (b) is a ‘price- competitive markets
taker, charging the market The market and firm shown in Figure 11.10 is in a short-run equilibrium, since
equilibrium price supply equals demand, but not a long-run equilibrium. The existence of abnormal
v
b
P(€) Revenues/
costs (€)

3.00

10 Q (thousands)

202
a b
Revenues/
P costs (€)

MC

AC

220 N ] MR = AR
| |
|i |||
i| ||
1i ||
':! D=MB
|
|
T .
12 Q (thousands) 105 Q

A
i d 1 i fi h K he low barri Figure 11.11 In the long
profits (red rectangle) will attract new firms to the market, as the low barriers to entry run, abnormal profits are
characteristic of perfectly competitive markets make it easy for new bakeries to enter eliminated by the entry into
or for existing bakeries to increase their output of croissants in order to capitalise on the market of other producers,
the profits available. driving the price down

As bakeries increase the highly profitable product, the market supply will increase
in the long run and the equilibrium price will be driven down until abnormal profits
are eliminated. Figure 11.11 shows this process unfold: supply of croissants increases,
equilibrium price decreases, and abnormal profits are eliminated.

Abnormal profits attracted more competition to the market for croissants, increasing
market supply to S, and driving the price down to €2.20. Each individual baker now
has a smaller market share; while individual output falls to 105, total output increases
to over 12,000 croissants due to the influx of new competitors.
A perfectly competitive market is in a long-run equilibrium when only normal profits
are being earned by individual sellers. The existence of abnormal profits or of losses
will lead to either an inflow or outflow of sellers until the market reaches equilibrium
at each individual seller’s minimum average cost, where only normal profits can be
earned. Let us consider how the market for croissants would be affected by a fall in
demand that drove the market price down to €1.50. Figure 11.12 shows the result of a
fall in market demand on the individual producer.

Demand has fallen to D, in the market, leading to a lower price and economic losses
for the individual bakeries as MR falls with the price. The market is no longer in a long-
run equilibrium as individual firms will begin leaving the market due to losses. As they
do so market supply will decrease driving the price back to the long-run equilibrium
of €2.20. Figure 11.13 shows how the market will adjust in the long run following the
decrease in demand shown in Figure 11.12.
203
 b
P(€) Revenues/
costs (€)

Q (thousands)

A The market is back in equilibrium at €2.20, which equals the individual bakeries’
Figure 1112 [ the price minimum average cost. At this price, only normal profits are earned, so there is
drops due to lower demand,
individual firms will suffer
no incentive for new sellers to enter the market nor for existing sellers to leave.
economic loss and leave The market, in other words, is in equilibrium.
the market

Allocative and productive efficiency

Figure 1113 The long-run
market equilibrium is where A competitive market in long-run equilibrium achieves what economists refer to as
only normal profits are eamed perfect efficiency. The socially optimal quantity is produced (where MSB = MSC)
by individual firms and individual producers are using their resources in the least cost, most efficient
v manner possible.
b
P(€) Revenues/
costs (€)

MC

AC

220 ___________________________ MR=AR

Q (thousands) Q
204
Allocative efficiency, as we have learned, occurs when market output occurs where Video suggestion:
marginal social benefit equals marginal social cost. Competition assures that output You have read about it, now
will take place at the allocatively efficient level. Imperfectly competitive markets, as you can review what you
we will see in the next section, produce at a level of output that is less than socially have just learned by watching
optimal. Their ability to control prices allows imperfect competitors to charge a higher
avideo by the author!
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price by restricting output. As a result, imperfectly competitive markets under-allocate ° your eBook for a video
resources to their goods, transferring surplus from consumers (who pay a higher on short run and long-run
price) to producers (who earn more profits). equilibrium in perfect
competition.
‘When we look closely at Figures 11.10 and 11.12, in which the firm is earning
abnormal profits and losses, respectively, we can see that in both cases the firm's
average cost is higher than their minimum AC of €2.20. Profits allow a firm to produce
more than it would under long-run equilibrium and charge a price that is higher.
Losses require a firm to reduce its output to a level where the AC is higher than the
minimum. In both cases, the firm is productively inefficient. When the market adjusts in
the long run, however (firms enter to eliminate profits or leave to eliminate losses), the
remaining firms are forced once again to produce at the quantity where their AC are
lowest, resulting in productive efficiency in the long run.

‘We began this chapter by explaining that perfectly competitive markets, while rare in
the real world, are worth studying because they form a basis on which to compare the
relative efficiency of more realistic market models. As we have shown here, perfect Video suggestion:
competition, a model in which many firms that have identical costs and produce
You have read about it, now
you can review what you
identical goods, which are able to enter or exit the market easily in response to profits have just learned by watching
orlosses, result in a socially desirable outcome in which resources are allocated avideo by the author!
efficiently and used to produce output in the most efficient manner possible. Simply lick here in
your eBook for a video
on efficiency in perfectly
competitive markets.
11.4 The monopoly ket model

Learning outcomes
At the end of this section you will be able to:
* explain that the average revenue curve for a monopolist is the downward-
sloping market demand curve
* explain, using a diagram, the relationship between demand, average revenue,
and marginal revenue in a monopoly
* explain, using a diagram, the short- and long-run equilibrium output and
pricing decision of a profit-maximising (loss-minimising) monopolist
* explain the role of barriers to entry in permitting the firm to earn economic
profit
* explain, using diagrams, why the profit-maximising choices of a monopoly firm
lead to allocative inefficiency (welfare loss) and productive inefficiency
* explain the meaning of the term ‘natural monopoly’ and draw a diagram to
illustrate.

‘When a single firm controls a dominant share of total market sales, it has monopoly
power over the market. Recall from earlier in this chapter that pure monopolies, in which
there is only a single seller, are rare; but industries in which a large firm accounts
205
 Market power: perfect competition vs monopoly

Perfect ~ Monopolistic
Figure 1114 Monopoly competition competition ~ Oligopoly ~ Monopoly
power allows large firms to
influence price Less market power More market power
(many firms) (few firms)

for a significant proportion of sales are not uncommon, and include the global beer
market (Anheuser Busch/InBev), the zipper industry (YKK), the global diamond market
(De Beers), poultry and beef in the USA (Tyson Foods), microchips (Intel), computer
operating systems (Microsoft), mobile operating systems (Google), and textbooks
(Pearson, the publisher of this book!).

When a firm has a dominant share of the market, it is a price-maker. This means simply
that in order to sell more output, it must lower the price of its goods. Similarly,
price increases lead to less quantity demanded. In other words, monopolists face a
downward-sloping demand curve. Contrast this with the perfectly competitive seller,
for whom demand is perfectly elastic and horizontal, determined by the price set by
the market as a whole. Since a monopolist is the market’s main supplier, the market
demand curve is the firm’s demand curve.

The following table shows hypothetical figures reflecting the market demand for beef
in the USA, of which a single firm, Tyson, accounts for over 40% of market sales, giving
it significant monopoly power in the industry. Demand for beef is inversely related to
the price. Table 11.3 shows the demand for beef as seen by Tyson, as well as the total
and marginal revenues Tyson would experience at a range of prices.
Nextlet us plot Tyson’s demand and MR curves on a graph. Figure 11.15 plots beef
demand and MR as seen by Tyson Foods.
The price-making firm faces a downward-sloping demand curve and an MR curve that
slopes twice as steep as demand. Because the price for all its output must be lowered to
sell additional units, the monopolist sees its MR decrease faster than the price, and so
MR will drop at two times the rate of decrease in the price.
206
Table 11.3 Demand for beef

Price ($ perkg) | Quantity demanded | Total revenue | Marginal revenue

(millions of kg (millions of §) ATR
per week) T aQ
14 0 0 —
12 2 24 12
10 4 40 8
8 6 48 4
6 8 48 0

4 10 40 =y
2 12 24 -8
Source: htps:/Jcsimarket.com|stocks/segments.php?code=TSN
The profit-maximising monopolist
To determine the profit-maximising level of output a monopolist must consider the
same variables as a competitive firm: its MR (shown in Figure 11.15) and its MC. The
MC and average cost curves for a monopolist, assuming it employs variable resources
like labour and raw materials in combination with fixed resources like capital and land,
will look similar to any other firm’s: MC will slope down then up, reflecting the law of
diminishing marginal returns, and AC will slope down until MC crosses it, then increase
as additional units of output cost more than the average, pulling the average up.

P($/kg)
14N

« Figure11.15
T stmust drop
tional units
D=MB

2 4 6 ) 10 12 Quantity (Q)
=24 (millions of kg/week)

—4

—6

—8
MR

207
 P($/kg)
14Y

Figure 11.16 Atthe profit- >

maximising quantity of
5 million kg/week, this firm
earns $4/kg profit

Quantity (Q)
(millions of kg/week)

—4

=6

—8
MR

Figure 11.16 adds the MC and AC curves to our graph showing Tyson’s demand and
MR in the beef market.
The price-maker has chosen to produce at its profit-maximising quantity and price,
determined where the MC (the increase in total costs attributable to the last kilogram
of beef produced) equalled the MR (the increase in TR attributable to the last kilogram
of beef produced). The firm will produce 5 million kg of beef and charge a price of
$9 per kg. With an average cost of $5 per kg, Tyson Foods can expect to earn a profit
of $4 per kg, or $20 million in total ($4 X 5 million = $20 million).
When firms in competitive markets earn abnormal profits like those shown in
Figure 11.16 they can only be expected to last until new competition is attracted to the
market; ultimately the inflow of new businesses and increased market supply will drive
the price down and eliminate the profits. However, due to the nature of monopolies,
high barriers to entry prevent competitors from entering, allowing the monopoly to
‘maintain its abnormal profits in the long run. In the case of beef production, large
economies of scale allow firms like Tyson to produce beef with great efficiency using
expensive, high tech processing machinery, making it difficult for smaller firms to join
the market, even when significant profits can be expected.
Let us do a thought experiment and imagine how the price and quantity in the market
might look if it were perfectly competitive. We know that in a competitive market, entry
climinates profits, and that in the long run the equilibrium price and quantity will occur
where demand equals supply, or where marginal benefit equals MC. We can determine
where the competitive market equilibrium would occur by looking at the monopolist’s
MC curve, which instead of representing the MC of a single firm, would represent
the market supply in a competitive market, because at each price there is a different
208
 P($/kg)
14N

- AC
—‘———
Figure 11.17 Atthe
competitive market
equilibrium, profits are
approximately half those at
D=MB the monopolist's equilibrium

2 4 T 6 8\ 10 12 Quantity(Q)
3 5 (millions of kg/week)

64

—g4
MR

quantity supplied. The demand curve, rather than representing demand for one
company’s beef, would represent total market demand from all companies. Figure 11.17
compares the likely competitive market equilibrium with the monopolist’s equilibrium.
A competitive market would produce where MC = MB, at a quantity of 8 million kg Video suggestion:
and a price of $6 per kg. Compared to a market under monopoly, a competitive market You have read about it, now
would, not surprisingly, produce more output at a lower price. Notice, however, that you can review what you
the profit rectangle would be smaller (yellow dotted area) if Tyson were to sell more have just learned by watching
beef at the lower price. Abnormal profit at the competitive price and quantity would be
avideo by the author!
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in the range of $10 million (around $1.25 per kg X 8 million kg), just one-half of what your eBook for a video
the firm earns at its monopoly price and quantity. introducing pure monopoly.

Allocative inefficiency and welfare loss

Itis important to observe that because of the tendency of monopolies to restrict their
output below the level that would be produced in a competitive market and charge
ahigher price, there are several consequences for consumers, producers, and overall
efficiency in the market.
First, because less output is produced, the monopolist fails to achieve allocative
efficiency, which occurs when equilibrium is where marginal benefit equals marginal
cost. Monopolies are allocatively inefficient. Figure 11.18 illustrates the reason
monopolies are allocatively inefficient because at the monopolist’s equilibrium
quantity, the MB > MC.

By restricting its output to maximise profits the monopolist under-allocates resources

towards its good. Society would be better off by producing at the perfectly competitive
209
 P($/kg)
14Y

Figure 11.18 At the >

monopolists equilibrium,
marginal benefit is greater
than marginal cost

Quantity (Q)
2 (millions of kg/week)
v

—4

=6

—8
MR

level of output where MB = MC, since the last unit produced would create as much
value for society as it cost to produce it.
Second, because consumers pay a higher price and get less of the good under
monopoly than they would under perfect competition, there is less consumer surplus
and aloss of total welfare in the market. Figure 11.19 shows the DWL arising from a
single seller dominating the US beef market.
The red shaded area in Figure 11.19 represents the DWL, or loss of social welfare,
resulting from a single firm dominating the market for beef. The top half, above
the competitive price of $6, represents lost consumer surplus, while the bottom
half represents the producer surplus that would exist if more producers were able
to compete in the market. Overall, the market is worse off because fewer firms are
producing beef and consumers are paying a higher price for less beef than they would
get under a more competitive market.

Do monopolies always earn profits?

We have assumed that due to its market power, its ability to set prices, the lack of
competition, and the high barriers to entry, a monopoly is likely to earn abnormal
profits, unlike less fortunate (and less powerful) companies struggling to survive in
perfectly competitive markets. Just because it is the sole seller does not guarantee
that a monopoly will earn abnormal profits, however. Monopolists, just like firms in
competitive markets, are subject to the changing tastes and preferences of consumers,
changes in incomes, change in the prices of complementary goods, changes in
expectations, and other determinants of demand. Likewise, input prices, regulations,
210
 P($/kg)
14N

o Figure11.19
The manopoly results
in deadweight loss

2 4 T 6 8\ 10 12 Quantity(Q)
2 L (millions of kg/week)

64

—g4
MR

taxes, and subsidies can all change, causing a monopolist’s costs to increase and
reducing or eliminating its abnormal profits.
Figure 11.20 shows a situation in which demand for a monopolist's product decreased.
For instance, assume that Americans’ demand for beef drops dramatically, due to
changing dietary preferences or a health scare such as mad cow disease/BSE outbreak
that hit the UK in the 1980s.
A decrease in demand for beef has forced the firm to lower its price in order to
maintain sales. The firm still produced where MC=MR, but this now corresponds with
amuch lower price, at which P, =AC. The firm is now breaking even; it is earning only
anormal profit.
Another scenario could see an increase in marginal and average cost, leading to
economic losses. Figure 11.21 shows the result from an increase in government
regulation or taxation of the beef industry, driving Tyson'’s costs up, eliminating its
profits and even causing economic losses.
A combination of reduced demand and higher costs has driven our once profitable
beef producer into loss minimisation mode. If it is to return to profitability the
firm will have to find a way to increase demand for its product (through marketing,
differentiation, or improvements in quality), or reduce its costs (increase efficiency,
lobby for lower taxes or reduced regulation).
As we can see, monopoly power does not guarantee abnormal profits will always be
earned. What it does promise is that profits will not be eliminated through the increase in
competition that results in more competitive markets only breaking even in the long run.
211
 P($/kg)

Figure 11.20 A reduction >

in demand would lower the
monopolist’s profits

Quantity (Q)
2 (millions of kg/week)

=4

—6

—8
MR

P($/kg)
14Y

124
MC
10

Figure 11.21 Increased >

costs further lead to
economic losses

12 Quantity(Q)
T T
2 ATe &\ 10
= (millions of kg/week)

—44

—64

-84
MR

212
What is a natural monopoly?
From our analysis above we can conclude that in the case of typical consumer goods
monopoly is a less socially desirable market structure than perfect competition. Higher
prices and lower output mean less consumer surplus and a loss of total welfare. Monopoly
power is a market failure, since resources are under-allocated towards the monopolised
market’s output. The quantity produced is less than the socially optimal quantity, since the
marginal benefit of the last unit produced is greater than the marginal cost.
Not all industries that are monopolies necessarily need to be monopolies; sometimes
firms have monopoly power for legal or technical reasons.
* When a firm has an exclusive permit from the government to provide a particular good
* Whena firm has ‘cornered the market’ for a particular resource needed to produce
the good.
* Whena firm has priced competitors out of the market using predatory pricing
strategies.

Any of these sources of monopoly power could be considered economically inefficient

and therefore undesirable to some extent.

However, there is a type of monopolistic industry in which the dominance of a single

firm is economically justifiable and actually beneficial for society; such a market is
known as a natural monopoly. A natural monopoly is an industry in which a single firm
produces all the output because of its large economies of scale, and in which demand for
the good is low relative to the very high fixed costs. In the graph below we see a natural
monopoly, recognised because demand intersects AC while it is still downward sloping.
Figure 11.22 shows a naturally monopolistic electricity company’s AC and MC and the
monthly demand for electricity.

If the firm is left to produce at its profit-maximising price and quantity, it will limit
its production to 30 million kwh (where MC = MR) and charge a price of Mex$6.00
(Mex$ is the symbol for the Mexican peso, the currency of Mexico) per kWh. The
socially optimal quantity of electricity (where MB = MC) is 60 million kWh and the
socially optimal price is Mex$1.00 per kWh.

Price
(Mex$/kWh)

Figure 11.22 A natural

monopoly such as a utilities
company underprovides
important goods without
government intervention

213
 Price
(Mex$/kWh)

Figure 1123 Atthe socially 6.00

optimal price the company
makes losses and would leave
the market in the long run |
ATC = 2.00

1.00

N et
(kWh million)

Clearly, the utility company, if left to pursue its profit-maximising agenda, will
overcharge for and underproduce electricity. There is a loss of consumer surplus
represented by the red triangle as a result of the monopoly abusing its power.
To ensure that a naturally monopolistic industry produces at a level closer to the
allocatively efficient or socially optimal price and quantity (where MB = MC), either
subsidies or price controls should be imposed by the government. Figure 11.23 shows
the effect of a price ceiling set by the government at the socially optimal price of
Mex$1.00 per kWh of electricity. As a result, the electricity company has increased its
output to the socially optimal level (60 million kWh in this case). There is one problem
with a price ceiling set at the socially optimal price in a natural monopoly, however.
It will always be at a price lower than the firm’s AC, meaning the firm will experience
economic losses. The red area on the graph above represents this utility company’s
losses when it is forced to charge the socially optimal price of Mex$1.00. At this price,
the company will choose to shut down in the long run.
The solution, therefore, is for the government to provide the firm with a lump-sum
subsidy to cover the losses it experiences when producing at the socially optimal level.
In the case of our utility company, the subsidy would have to equal at least the level of
losses the firm experiences at Mex$1.00 per kWh. We can calculate the losses the firm
will experience at a price of Mex$1.00 and a quantity of 60 million kWh. The firm's
average cost is Mex$2.00 and its AR (the price) is Mex$1.00. With these values we can
calculate the firm’s losses.
Economic losses = (AC— AR) X Q

= (Mex$2.00 ~ Mex$1.00) X 60 million

= Mex$1.00 X 60 million

= Mex$60 million

214
 Price
(Mex$/kWh)

6.001
o Figure 1124 A'fair rewrn!
price ceiling is set where the
natural monopoly company
Price ceiliny makes normal profits
240 g

1.00+

A Mex$60 million lump-sum subsidy (payment) from the government to the utility
company will assure it is able to stay in operation even while charging the socially
optimal price of Mex$1.00 per kWh and producing the socially optimal quantity of
60 million kWh.
Another option for regulating natural monopolies that would not involve
providing lump-sum subsidies is to establish what is called a ‘fair return’ price
ceiling. This is a price ceiling set at the price where demand crosses the firm'’s AC,
as seen in the Figure 11.24, in which the government has set a price ceiling equal to
the firm’s AC.
A price ceiling of Mex$2.40, which is equal to the firm’s AC, will increase quantity
demanded to 50 million kWh and make electricity more affordable, promoting a
more socially optimal level of production and price. Since the firm breaks even, no
government subsidy is necessary. This is called a ‘fair return’ price because the firm
charges a price that earns it a normal profit. No abnormal profit is earned at the
expense of consumers who would be unable to afford electricity.

Subsidies and price controls are two commonly used interventions in naturally Video suggestion:
monopolistic utility industries such as electricity, water, gas, public transportation, You have read about it, now
waste management, and recycling. Capping the price that monopolistic producers you can review what you
are allowed to charge at or closer to the socially optimal price (where MB = MC) have just learned by watching
and using subsidies to cover any resulting losses will assure that essential services
avideo by the author!
Simply click here in
are provided at a relatively low cost and at a relatively high level to society. your eBook for a video
on natural monopoly and the
In our final chapter in the Microeconomics unit we will do a deep dive into the two need for government
remaining market structures, both of which lie in the middle of our spectrum of regulation,
competition: monopolistic competition and oligopoly. While the lessons taught
by our study of the perfect competition and monopoly market models will help us
better evaluate the consequences for consumers and producers of the other two
market structures, they are quite rare in the real world. In contrast, the vast majority
of markets for the consumer goods that we buy on a daily basis are produced by
monopolistic competitors or oligopolistic firms.

218
 Market power: perfect competition vs monopoly

Practice exam questions

la. Using a suitable diagram, explain the difference between
short-run equilibrium and long-run equilibrium in perfect
competition. (10 marks)
b. To what extent is the perfectly competitive market likely
to exist in the real world? (15 marks)
2a. Using a diagram, explain how allocative and productive
efficiency will be achieved in long-run equilibrium in perfect
competition. (10 marks)
b. Evaluate the view that consumers, not producers, are the
‘main beneficiaries of perfectly competitive market structures. (15 marks)
3a. A firm in perfect competition is producing at the
profit-maximising output, but making a loss. Using diagrammatic
analysis, explain how this is possible. (10 marks)
b. Discuss the claim that all costs are identical among different
firms in a perfectly competitive market. If this claim is correct,
then why do some firms shut down before others when
earning economic losses? (15 marks)
4a. Explain, using an appropriate diagram, how the monopolist
determines the profit-maximising level of output and price. (10 marks)
b. Discuss the view that competitive markets are always more
efficient than monopolies. (15 marks)
5a. Explain, using examples and an appropriate diagram, the
concept of a natural monopoly. (10 marks)
b. To what extent do natural monopolies act against the best
interest of society? (15 marks)
6a. Explain how a monopolist may earn economic profits in the
long run. (10 marks)
b. Evaluate the view that, compared to competitive markets,
monopolies will always harm the consumer. (15 marks)
7. ‘Monopoly price is higher and output smaller than is
socially ideal. The public is the victim'. (JK Galbraith, 1974)
a. Explain the economic reasoning behind the statement that
‘monopoly price is higher and output smaller than is
socially ideal. (10 marks)
b. Do you agree that the public is always the ‘victim’ of monopoly?
Justify your answer. (15 marks)

216
 TL R R I L A Frees

3 / >

Market power:
monopolistic
competition and
oligopoly
 Market power

1] at is monopolistic competition?

Learning outcomes
At the end of this section you will be able to:

* describe, using examples, the assumed characteristics of monopolistic

competition:
« alarge number of firms
« differentiated products
« absence of barriers to entry and exit
* explain that product differentiation leads to a small degree of monopoly power
and therefore to a negatively sloping demand curve for the product
* examine, using a diagram, the short-run equilibrium output and pricing
decisions of a profit-maximising (loss-minimising) firm in monopolistic
competition, identifying the firm’s abnormal profit (or loss)
* explain, using diagrams, why in the long run a firm in monopolistic competition
will make normal profit
« discuss, using a diagram, why neither allocative efficiency nor productive
efficiency are achieved by monopolistically competitive firms
* compare and contrast, using diagrams, monopolistic competition with perfect
competition, and monopolistic competition with monopoly.

What are the characteristics of

monopolistic competition?
We have so far looked at two extremes in the market: monopoly and perfect
competition. Monopoly sits at one end of the spectrum of competition, with the most
market power. In this chapter, you are going to examine two models that are more
commonly found in the real world: monopolistic competition and oligopoly. Our
guiding principle of distinction, relative market power, is still in effect here. With that
in mind, monopolistic competition can be seen as a step up from perfect competition
in terms of market power whereas oligopoly is a step closer to the ultimate market
power of a monopoly firm.

Monopolistic competition is a market structure where there are many buyers and
sellers, producing differentiated products, with no barriers to entry or exit, and it is
based on the following assumptions.

Many firms, most of them small in size

This trait is shared with perfect competition, without being quite as extreme. The
number of firms is high enough that it is unlikely, but not impossible, for one firm to
influence the market. Cooperation between firms is not possible as there are too many
firms for this to take place.

Perfect Monopolistic
Figure 12.1 n monopolistic competition competition Oligopoly ~ Monopoly
competiti 1 ———o—00—
Less market power More market power
(many firms) (few firms)
Relatively free entry and exit
Like perfect competition, there are few barriers to entry and exit. It is rather easy to get
into or out of the business.

Product differentiation
Product differentiation is a form of non-price competition, where a firm competes in
areas other than price to win customers. Differentiation marks the most significant
departure from perfect competition, where products are completely identical.
Monopolistic competitors strive to differentiate their products in the hopes of deriving
some market power (price-setting ability). Product differentiation occurs when
consumers perceive a product as being different in some way from other substitute
products. Firms differentiate products in a number of ways.

+ Appearance. Shape, colouring, materials, look and feel’, as well as packaging can
influence perceptions of a product.
+ Service. Firms can be faster with assistance and sales, or offer additional help with
home delivery, product guarantees, and more.
+ Design. Products having the same function can be designed for more ease of use
or with more fashionable styling.
+ Quality. Variations in quality can bring higher or lower market power, depending
on the good.
+ Expertise[skill. The perceived level of skill can significantly differentiate one firm
from another, especially in service industries.
+ Location. Some firms will benefit from location, such as the last petrol station for
100 kilometres, or exchange bureaus and convenience stores in airports.
+ Brand reputation/image. Many firms spend advertising money persuading and
reminding customers how their products are superior or priced well (creating a
brand image can also differentiate one firm from another).
+ Distribution. Selling online rather than through traditional retail outlets is a
means of differentiating.
Examples of monopolistically competitive industries include restaurants, bars,
nail salons, jewellers, car mechanics, plumbers, book publishing, clothing, shoes,
restaurants, consumer services, and specialist retailers of all kinds.

How is monopolistic competition distinguished from

perfect competition and monopoly?
Monopolistic competition shares attributes with both monopoly and perfect
competition. However, the single distinguishing feature of monopolistic competition,
when compared with perfect competition, is product differentiation. The degree to
which a firm can ‘create’ demand for its goods is the degree to which it can create
market power, or price-setting ability.
Figure 12.2a shows a perfectly competitive firm with no such power. It is a small firm
in a massive market, and the price and demand curve for the firm is set in the overall
market. Its demand curve is, therefore, perfectly elastic. Because goods in perfect
competition are exact substitutes, any attempt to get a higher price will fail; none of
the higher price goods will sell.
219
 Figure 122 Elasticity of P
demand in monopolistic
competition (c) falls
somewhere between that for a
perfectly competitive market (a)
and a monopoly (b)

o\ :
0 o Q © Qe 00 O Q
In contrast, firms in the monopoly market face a downward-sloping demand curve
(Figure 12.2b). This curve is relatively steep, suggesting a generally inelastic demand
for the good. This comes from the fact that the monopolist is the only provider of the
good, 50 no substitutes are available. Thus, demand is relatively more inelastic or rigid.

The firm showing monopolistic competition (Figure 12.2¢) is viewed as a hybrid of

the previous two. It is relatively elastic; consumers are price sensitive because there
are similar goods available from many producers. However, the firm that successfully
differentiates its product may have inspired a belief that its goods are not exactly the
same as other goods, and may be somewhat better.
This gives us insight into the behaviour of the monopolistic competitor. A more steeply
sloping demand curve, where demand is more inelastic, means more market power.
It means more power to set higher prices and earn higher profits. A more inelastic
demand for your good, it is logical to conclude, is highly desirable for your bottom line.
Firms often advertise to persuade consumers of the uniqueness of a particular brand.
By differentiation and advertising, a firm can make its product appear essential or
necessary to more buyers, and thus inspire brand loyalty and inelasticity of demand.
Thus, firms can increase the demand for their product, moving it outwards, and also
make demand steeper at the same time.

What are the short- and long-run profit possibilities

for the monopolistic competitor?
The monopolistically competitive firm operates under the same demand, revenue, and
costs situation as the monopolist, except for its much more elastic demand curve.

Short-run profits
In the short run, a monopolistic competitor can earn abnormal profits. Figure 12.3 shows
the monopolistic competitor producing quantity Q, where marginal cost (MC) and
‘marginal revenue (MR) are equal. Like the monopolist, the monopolistic competitor sets
the price at that quantity by charging as much as the demand at that quantity will allow,
P, AtQ,, average costs (AC) are below the price P, therefore abnormal profits are being
carned. The area of the shaded box gives the total abnormal profit. In a numerical example,
this could be calculated using the formula: total abnormal profit = (AR — AC) X Q...

Short-run profits to long-run normal profits

Asitisrelatively easy to enter and exit the industry, the profit-making industry will get
attention and new entrants rather quickly. When this occurs, the demand experienced
220
 « Figure12.3 Monopolistic
competition allows abnormal
profits in the short run

=
=
§2 "
g
8 ATC
2
5
8
v

Q. MR Q

by each individual firm will decrease, shifting demand to the left. This will cause MR
to intersect MC at a smaller quantity, reducing output and profitability for the firms in
the industry.
If abnormal profits are still present, this process of new entrants to the market will
continue until all the abnormal profits have been eliminated. The long-run result is
normal profits, as shown in Figure 12.4. Here, demand (D = AR) and marginal revenue
(MR) for the individual firms has shifted to the left so that it is only touching a portion
of the AC curve. Thus, only normal profits are earned.

Short-run losses
The monopolistic competitor may also experience losses in the short run. Figure 12.5
shows the firm producing at the profit-maximising/loss-minimising point where
MR = MC, and so producing Q, output. The firm sets the price as high as demand will
allow at P, but this still falls below the AC experienced by the firm at this level of output.
As aresult, the firm is clearly making losses, shown by the area of the shaded rectangle.

Short-run losses to long-run normal profits

‘Where firms are losing money, some will be forced to shut down. As firms shut down,
the remaining demand is divided between fewer firms; thus the demand curve faced by
Costs and revenues (P) ($)

« Figure12.4 Inthelong run,

abnormal profits will be
eliminated as they attract new
entrants to the market
reducing the individual firms’
demand

221
 Costs and revenues (P) ($)
Figure12.5 The
monopolistic competitor
may experience
short-run losses

cach firm shifts to the right. This increases output because the new MR = MC quantity
will occur at a point to the right of the previous equilibrium. Also, because demand
shifts upwards and outwards, the firms remaining in the market will experience a
decrease in losses. This process will continue, with particularly weak firms shutting
down, and demand increasing for the remaining firms, until normal profits are attained.
In Figure 12.6, demand has shifted right to D = AR, reflecting the increased demand
and market share enjoyed by this firm as a result of some of its competitors leaving the
market. And it shows demand equal to the AC at the profit-maximising quantity of Q..
Firms will no longer leave the industry if they are making normal profits. Therefore,
after the long-run adjustment to short-run losses, only normal profits are attained.

Exceptional cases of long-run profits in monopolistic competition

Since the long run is basically a series of short runs and monopolistic competitors can
carn profits in the short run by differentiating their products, continual differentiation
may enable firms to earn abnormal profits, even in the long run. In particular, when
monopolistic competitors grow large enough and enjoy some economies of scale, they
can also lower their costs to maintain profits. For example, restaurants generally are
subject to long-run normal profits as many are small family-run businesses, but some
large restaurant chains may sustain their profits for long periods of time by taking
advantage of differentiation, advertising, and economies of scale.
Costs and revenues (P) ($)

Figure12.6 Short-run
losses adjust to long-run
normal profits as some firms
leave the market

222
 Costsand revenues (P) ($)
Figure 12.7 Productive
efficiency, where MC = AC, is
not achieved in monopolistic
competition

Q MR Q

Do monopolistic competitors achieve efficiency?

As with monopoly and perfect competition, we assess the efficiency of monopolistic
competition based on whether the firm achieves allocative and productive efficiency.
As detailed previously, allocative efficiency is achieved where P or (AR) = MC, and
productive efficiency is achieved where P = minimum AC. When viewed in terms of
the long-run equilibrium, it seems clear that neither form of efficiency is achieved in
monopolistic competition.

Productive efficiency
Figure 12.7 shows long-run equilibrium for the monopolistic competitor. In
Figure 12.7, the firm's productively efficient quantity is noted. The monopolistic
competitor produces too little and at too high a price to qualify.

Allocative efficiency
In Figure 12.8, the firm’s allocatively efficient point is indicated by the point where
D = MC. Clearly the monopolistic competitor produces at a price above and quantity
below that. Thus, allocative efficiency is not achieved and a welfare loss, shown as the
grey triangle, occurs. Recall that whenever firms produce at a level where the price, as
a proxy for marginal benefit, is higher than the MC, a welfare loss occurs. The shaded
Costs and revenues (P) ($)

Figure12.8 Allocative
efficiency, where D = MC, is
not achieved in monopolistic
competition, leading to
welfare loss

223
 Market power

e e area represents the loss of consumer and producer surplus that takes place when firms
Small firms hit hard by the do not produce the allocatively efficient level of output.
pandemic
Because the monopolistic competitor has a downward-sloping demand curve and MR
The COVID-19 pandermic curve, it will not achieve either type of efficiency, both of which would require the firm
that started in 2020 hit
service industries especially to produce more output at a lower price; but as a profit maximiser it will not do so.
hard because these firms As aresult, monopolistically competitive firms are often said to have excess capacity.
offer in-person contact. Car
services, beauty salons, bars,
restaurants, and dentists How does monopolistic competition compare
were at times forbidden to to perfect competition?
see customers, and after
restrictions ended customers Perfect competition is the closest market structure to monopolistic competition,
only returned slowly. especially in the number of firms and the ease of entry. How do they compare overall?
For discussion and debate:
Conduct a brief search Profitability
for examples in one of
the above industries, or In the long run, both industries achieve only normal profits. Because it is easy to enter
any monopolistically and exit, profits are consistently ‘competed away’ while attrition reduces losses over
competitive industry of the long run.
your interest.
Select a country and Efficiency
~

investigate the effect of the

pandemic on the number Perfect competition is more efficient. While the perfect competitor achieves both types
of firms remaining. of efficiency, the monopolistic competitor achieves neither.
Has the number of firms
w

recovered?
Product variety
How would the loss of
Choice and variety are greater among monopolistic competitors. Product differentiation
~

competitors be shown on
ashort-run to long-run provides consumers with a wider range of choices than perfectly competitive firms.
diagram? This expanded choice is consistent with the free market idea of allowing consumers and
producers to act based on price information and the profit incentive.

How does monopolistic competition compare

to monopoly?
While they share a name, monopolistic competition and monopoly share some
characteristics, while also having several key distinctions from one another as market
structures.

Profitability
Monopolists can earn long-run profits because they have barriers to entry. The
monopolistic competitor will see profits eroded by new entrants.

Efficiency
Neither industry is efficient. Their downward-sloping demand curves restrict output
and price goods higher than in perfect competition, lowering efficiency on both
allocative and productive grounds.

Product differentiation
The monopolist faces no real competition, thus its product is unique. Monopolistic
competitors do face competition, and so have an incentive to differentiate their
products from those of other firms.
224
 « Sewice industries have beer
COvID-19

Economies of scale
Cost savings of economies of scale are far more likely under monopoly, whereas the
monopolistic competitor is unlikely to grow large enough to see these benefits.

12.2 What is an oligopoly?

Learning outc 1]

At the end of this section you will be able to:

* describe, using examples, the assumed characteristics of an oligopoly:
« the dominance of the industry by a small number of firms
« the importance of interdependence
« differentiated or homogeneous products
« high barriers to entry
* examine why interdependence is responsible for the dilemma faced by
oligopolistic firms — whether to compete or to collude
« discuss how a concentration ratio may be used to identify an oligopoly
* define the terms ‘collusion’ and ‘cartel’, give examples, and state that they are
usually (in most countries) illegal
« discuss the incentive of cartel members to cheat
+ analyse the conditions that make cartel structures difficult to maintain
« discuss the behaviour of oligopolies including reference to ‘tacit collusion’,
price leadership by a dominant firm, strategic non-collusive decision making,
non-price competition, and the risk of price wars.

One step further up in the realm of market power lies oligopoly. From the Greek for
‘few authorities’, the oligopoly model represents a significant concentration of market
power within a few firms.

Oligopoly is defined as a market structure where a few sellers dominate the market.
There may be more than a few in the entire market, but a small group exert significant
market power. Examples of oligopoly markets include smartphone operating systems,
computer operating systems, passenger airlines, cellular phone service in most
countries, and the US beer industry.
225
 Perfect Monopolistic
Figure 12,9 Oligopoly sees Py competition competition Oligopoly Monopoly
a significant concentration
of market power among
afew firms Less market power More market power
(many firms) (few firms)

Oligopoly and monopolistic competition are grouped together in this chapter because
it is sometimes difficult to discern a clear difference between the two in the real world.
As more areas of local and national economies expand to a global scale, the frequency
of oligopoly has increased.

Assumptions of the model

Oligopolies can be very different from each other. What follows is an attempt to
summarise some key points of similarity and comparison.

A few large firms

Concentration ratios can mislead one into thinking that all the firms share their
concentration equally. This may be the case. However, it is also possible that one firm
is significantly larger than the other three or four. What can be said is that the market is
dominated by a small group of firms that are relatively large compared to the others.

High barriers to entry

Oligopolies are characterised by high barriers to entry. These barriers may be the same
types as those enjoyed by monopoly firms: high initial fixed costs, access to resources,
economies of scale, legal barriers such as licences and patents, and the employment of
aggressive anti-competitive tactics.

Differentiated or non-differentiated (homogeneous) goods

Oligopolies may produce differentiated goods, like the monopolistic competitor.
Oligopoly industries like soaps, soft drinks and sodas, breakfast cereals, and automobiles
all strive mightily to differentiate their products in hopes of drawing customers away
from their competitors. Other oligopolies, typically in the provision of raw materials like
timber (wood), oil, and aluminium, produce essentially the same good.

Interdependence
A distinct feature of oligopolies is that with relatively few firms in the industry there
is a tendency towards interdependent relationships between firms. In other words,
a firm’s actions in the market are watched by its competitors, which may react with
actions of their own. Recall that in more competitive markets, the actions of one firm
had no effect on the overall market. With an oligopoly, the single firm is large enough,
relative to the market, to affect the market by its actions.

Strategic thinking
One result of interdependence is that firms are inclined to think strategically, considering
the possible reactions of other firms to any particular initiative. As they do so, the firms
have relatively few other firms to monitor, and this leads to a choice between following
the strategies employed by most of the other firms, or to compete with them.

With oligopoly, firms are regularly tempted to cut prices to win customers away from
competitors. This type of price competition can reduce profits throughout the industry,
especially if it leads to a protracted ‘price war’. An alternative approach would be to
226
keep prices high, either passively or in active coordination with other firms. This is only
possible because the collective firms have enormous market power. The strategy can yield
extra profits as a result. Thus, the oligopoly must choose between opposite strategies, to
compete or to collude. This is explored in the remaining sections of this chapter.

How does a concentration ratio help us

identify an oligopoly?
Oligopolies markets may have just a few firms, or they may have several more. A common
method of determining whether or not an industry operates under oligopoly conditions
is called the concentration ratio. A concentration ratio attempts to quantify the density
of market power held by a certain number of firms. It is expressed as CR, where X is
the number of firms controlling a certain percentage of the market. A value for CR |
would tell us how much of the market is controlled by the top ten firms. The higher the
percentage, the greater the market power. Typically, the CR, is the guideline measure
for determining the type of industry. Figure 12.10 shows the CR, percentage criteria for
classifying a firm as a particular type of industry.
Concentration ratios are calculated by taking into account the total sales revenues of
the top firms and dividing them by the industry’s total revenues. What a concentration
ratio does not show is the relative size of each firm, which is also important for market
leadership. For example, a CR, of 90% would indicate a near monopoly situation even
if the four firms were approximately equal in sales. However, if one firm held 70% and
the other three held the remaining 20%, concerns about the large firm’s dominance
would be greater. It is likely that the 70% firm would lead the market for many strategic
decisions, including price setting.
For example, in the USA, the domestic airline industry is concentrated among Delta (22%),
American (21%), United (18%) and Southwest (15%) for 76% of the market, which
places the industry in the zone of oligopoly, and with roughly equal market share.
In the market for organ dialysis, two firms dominate with Fresenius (49%) and
DaVita (43%) in an apparent duopoly. In e-commerce, Amazon has half the market (49%),
with eBay (7%) and many smaller firms. In social networking, Facebook has an
85% market share, followed by LinkedIn (10%), and Twitter (5%).

Economists will point out that concentration alone should not be a basis for assessing
market power. Other questions should be asked: Are prices higher than expected?
Is output lower? Are there other harmful market effects? Nevertheless, concentration
ratios provide a clear starting point for evaluating an industry’s level of competition.
Low Medium High
concentration concentration concentration
0% 50% 80% 100%

®20 @ o <« Figure12.10 The higher

@ ° the concentration ratio, the
@ ° e greater the market power

Perfect competition Monopolistic Oligopoly Monopoly

competition
227
 What is the difference between collusive
and non-collusive oligopolies?
This section explores in further detail the distinction between firms that actively
cooperate to fix prices and restrict output (i.e. collusive oligopolies) with firms that
do not (i.c. non-collusive oligopolies). Collusion need not be explicit, it can be tacit
and happen without specific coordination. But it can also be formal and explicit, with
agreed strategies that seek to maximise profits for the entire industry.

Formal versus informal collusion

Informal or tacit collusion occurs when a single dominant firm establishes price
leadership. The leading firm sets general price levels, and smaller firms follow with
comparable prices. While no specific agreement exists, the informal understanding
can endure because the smaller firms resist the urge to cut prices as the dominant
firm would be able to survive any price wars. This does not prevent all forms of
competition. Firms may still compete on service or brand power, or on another basis
of non-price competition. Industries that have seen instances of price leadership
include rental cars and breakfast cereals.

Informal collusion, while perhaps more common than the formal kind, is still
somewhat difficult to achieve. Cost and demand differences among firms cause each
firm to have their own incentives. Firms are still tempted to cheat. And this kind of
price-fixing may also be illegal.

What is a cartel?
When oligopolists agree to take specific market action in a coordinated and sustained
effort to enhance profits, a cartel is at work. A cartel is a group of competitors that
successfully limit competition and keep prices above a competitive norm. Cartels
differ from occasional acts of market coordination by being continuous business
arrangements. Firms can coordinate a variety of market behaviours together. They can
restrict output to drive up prices. They can fix prices within a specified range. They
can decide to restrict innovation and avoid extra costs of research and development.
They can agree not to advertise or in any way compete with each other.
When the firms agree to fix the market price and output level, they are essentially acting
as one industry. Figure 12.11 shows the collusive oligopoly in action. It functions just
Costs and revenues (P) ($)

Figure 12.11 A collusive

oligopoly functions like
amonopoly, leading to
welfare loss

228
as a monopoly would, with firms producing at the profit maximisation output where
MR=MG, setting price at the demand curve at P, and enjoying whatever profits are
produced, shown by the shaded area of the diagram.

Recall that monopolies keep prices high, and output low, and that this results in a net
loss of welfare, a loss of consumer and producer surplus compared to competitive
markets, shown in the shaded grey area. This would be true of collusive oligopolies,
who imitate monopoly in their pricing and output decisions.

While overt collusion across whole industries is rarely achieved, most price-fixing
takes place covertly on the specific market level, for particular products like illness-
specific drugs, or airline routes between cities. However, public attention to the market
power of concentrated industries is growing. In recent years, governments have
investigated Apple for fixing the price of ebooks, the top five German car makers for
car prices, Google for internet search advertising, and Swiss airlines for shipping rates.
The most famous and public cartel is the Organization of Petroleum Exporting
Countries (OPEC), a group of 12 oil-producing countries founded in 1965. OPEC
regularly meets to set production quotas in the hope of establishing the ‘right price’
for oil in world markets. OPEC countries possess nearly 80% of latent oil reserves, and
currently produce 30% of all oil. Thus, they have considerable influence on world oil
markets. In fact, OPEC is a useful example to keep in mind when observing the dual
tendencies to collude or compete. After agreeing to production quotas with a target
oil price in mind, countries are tempted to produce and sell secretly. This, of course,
would lower world prices and reduce profits for all.

The paucity of outright collusive cartels provides a clue to the difficulties oligopolists
face when attempting to work together in a sophisticated fashion. Price and
production fixing is specifically illegal in the EU, the UK and the USA, which drives
the practice underground, if it is practised at all, in those areas. Aside from illegality,
the incentive to cheat other firms makes collusive cartels less common. Firms, it
should also be noted, are not all alike in their demand and costs situations. Some
firms could compete on cost, which would make them more likely to compete rather
than collude, on prices. Their opponent might need higher prices to survive, and so
they each face different incentives regarding collusion. Furthermore, even if firms
successfully coordinate and earn very high abnormal profits, this could encourage
entry into the market by potential competitors, reducing the market power of the
remaining firms.

Non-collusive oligopoly
Non-collusive oligopoly occurs when firms do not cooperate and, therefore, exist in
a strategic environment where one must consider the actions and reactions of other
firms at all times. Even when firms actively collude, the tension between the strategies
to compete and to collude is still in force. Firms may agree to collude but still have
strong incentives to cheat on this arrangement.

Non-collusive oligopoly players are constantly weighing the possible decisions taken
by their opponents, requiring strategic behaviour to a much larger degree than the other
firm types. As the prisoner’s dilemma and the example below will also show, firms in
an oligopoly are interdependent on each other’s actions. One’s behaviour relies on the
actions of another, also a feature that is unique among the four types of firms.
229
 Game theory offers an opportunity to demonstrate the strategic thinking and
interdependence involved in non-collusive oligopolies. Game theory uses applied
mathematics to understand how individuals act strategically, where their success
depends on the choices made by others in the so-called ‘game’. The simplest form of
game theory can illustrate the quandary posed to the oligopolist. Called the prisoner’s
dilemma, this form of a game has two players, in effect a duopoly.
In the original game, two prisoners are held for questioning regarding a robbery. They
are held separately, and face the dilemma of colluding to stay silent and receiving a
modest sentence on a lesser charge, or ‘cheating’ on their agreement and confessing,
thereby securing the lowest possible sentence for themselves and the highest for their
opponent. In the end, both have the same incentive to cheat/confess and are rather
likely to do so. What is important is that the prisoners face divergent incentives, to
collude or compete, and are influenced by what the other player may do.
The above dilemma can be applied to market duopoly, where firms are deciding on
whether to maintain their price or lower it, a common dilemma for oligopolistic firms.
In Figure 12.12, two cola companies, Company C and Company P, are assessing their
incentives. If the firms split the market 50% each, and both maintain their price, then
their profits will be $5 billion each.
However, if Company C lowers the price and Company P does not, it will win
over vast numbers of new customers and earn $7 billion, mostly at the expense of
Company P, who will earn only $1 billion. (This might be enough profit to allow
Company C to buy Company P and become a monopoly.) Of course, the reverse
is true, as Company P will dramatically out-earn Company C if it lowers price and
Company C does not. Thus, both firms have a strong incentive to compete (lower
price) rather than to collude. At the same time, if they both compete and lower
price they both wind up with $4 billion profits, and have lost $1 billion in profits.
The dilemma each faces, to compete or collude, reflects the interdependence of
these firms.

Game theory would help firms make strategic decisions when they can know the
payoffs of all players and the number of players is relatively small. If the model
incorporates additional players or more strategic choices, such as whether to advertise,
the calculations become very complex and less reliable. However, where true the
duopoly game theory model suggests that firms may not compete on price if they can

Company C
Maintain price Lower price

$5 billion $7 billion
Figure 12.12 This duopoly Maintain price
payoff matrix illustrates a $5 billion $1 billion
—

ccommon dilemma for

oligopolies. Should they Company P
collude or compete?
$1 billion $4 billion
Lower price
$7 billion $4 billion

230
 avoid it and will collude if they can do so. That leaves firms to compete in areas other
than price to win market share. The above highlights one of the risks oligopolies face
in relation to each other. Competitive behaviour on pricing can lead to ever lower
prices. The risk ofa price war acts as an implicit floor on the desire of firms to compete
on price, knowing that it will directly reduce profitability and perhaps hurt the image
of the product in the market.

What is non-price competition?

Oligopoly firms often seck ways other than price to maximise profits. Service,
design and appearance, quality, and brand power are among the most typical forms
of non-price competition. Evidence of non-price competition among oligopolists
occurred in the early decades of commercial flight, when most airlines were heavily
regulated on the prices they could charge customers. As a result, airlines competed
in every other way possible, including offering lavish meals with beverages. Only
after deregulation did ‘budget’ airlines offer an alternative, with no meals and reduced
services, to attract price-conscious customers.

Furthermore, as with monopolistic competition, actual differences in product are only

important insofar as they are perceived to be different by consumers. This is where
advertising plays a pivotal role in oligopoly as well as monopolistic competition. Firms
spend lavishly with the purpose of convincing the public of sometimes rather small
differences in products. Recall that they do so in the hope of yielding abnormal profit
(at least temporarily, until the competitor copies or counters the innovation), or of
preventing a loss of market share (the fate of firms that choose not to compete).

Furthermore, strategic brand differentiation can mask the ownership concentration

in a market. Supermarkets may appear to offer thousands of choices, but many brands
are owned by a few food, beverage, and consumer product firms, creating an illusion of
choice and more power to set prices than the consumer might imagine.

12.3 When should governments intervene to

reduce market power and what do they do?

Learning comes
At the end of this section you will be able to:
« identify the risks and advantages of excess market power
+ explain the market conditions that may provoke government intervention
* examine the ways governments seek to limit market power and discourage
anti-competitive practices
« discuss the effectiveness of government measures to restrain market power.

What are the advantages and risks with oligopoly

and excess market power?
While oligopoly tends to have the most complicated type of firm, it is possible to
establish some areas of criticism and possible benefit.
231
 Economic risks
Disadvantages to oligopoly are the apparent lack of allocative and productive
efficiency. Like monopoly and monopolistic competition, the downward-sloping
demand curve of the collusive oligopoly has the same effect. Figure 12.11 shows the
oligopolist raises price above MC (P> MC), and so allocative efficiency is not achieved
and a welfare loss occurs. Oligopoly also brings the profit-maximising level of output
to the left of where AC is at its minimum. Thus, productive efficiency is also not
achieved.

The other major problems with oligopoly involve the tremendous incentives to
coordinate and collude. These incentives seck merely to take advantage of the firm’s
market size and to discourage the competition that could yield innovation and
efficiency. Excess market power such as this is likely to result in higher prices and less
output for the market, reducing consumer welfare. It also acts as a transfer of income
from buyers to sellers that is less likely to happen in a competitive market.

Economic advantages
Oligopolies, like a monopoly, may earn continuous abnormal profits as a result of the
barriers to entry. Thus, firms do have the economic resources to conduct research and
development. When profits invested into R&D result in better products, more choice,
and lower prices, overall consumer welfare may rise.

Natural monopolies are a good example of beneficial monopoly power. As you read
in Chapter 11, these monopolies are granted by governments to reap the benefits of
economies of scale for public utilities and transport. Prices are in fact lower and output
higher with natural monopolies, rather than with multiple producers. While they
need regulation and subsidies to achieve near-allocative efficiency, the single producer
model is the basis for greater social welfare.

How do governments discourage and restrain

excess market power?
To enjoy the benefits of competitive markets, governments must protect the market
from practices aimed at dominating or rigging it in a few firms’ interests. Where
governments perceive a market failure, they can intervene in the market to correct
it. Each government sets its own level of tolerance of market power, and attention
to market power can vary from election to election. Government intervention may
include the following.

Legislation and regulation

Anti-trust laws form a body of anti-monopoly law that seeks to keep markets
competitive. Anti-trust law seeks to protect consumers and producers from
unfair competition. Such laws typically forbid or restrict:

* price-fixing
* bid-rigging
« mergers, horizontal and vertical
* anti-competitive bundling of products
« predatory pricing.
232
 tricity networks are often
state c wined

Furthermore, governments often create ‘watchdog’ agencies whose role is to enforce

antitrust laws and ensure fully competitive markets. The EU Competition Commission,
the UK Competition and Markets Authority, and the US Federal Trade Commission are
all examples of such agencies. Their powers and responsibilities include:

* setting quality conditions

« establishing market rules and prices
investigating claims
* issuing fines
« making criminal indictments of offending executives
recommending a break-up of offending companies.

Government ownership
Industries can also be taken over by the government, or nationalised, if there are
sufficient welfare gains or positive externalities to be captured by public provision.
Natural monopolies, because they provide necessities like water, gas, or electricity,
are often under complete government control.

Fines
The power to levy major fines can discourage anti-competitive behaviour. By issuing
fines, government authorities affect the cost-benefit ratio that firms weigh when
deciding to seek market power advantages. Such fines are nearly always appealed in
court and negotiated after the fact. The effectiveness of fines depends on the degree to
which they match the social costs of the offence, and discourage the market power-
seeking behaviour. Fines that are too light, for example, simply reduce the profitability
of the practices without discouraging the behaviour by making them unprofitable or
loss making, or holding managers accountable.

Case study - cell service providers and oligopoly

America’s cell phone service market has been narrowed down to three major
providers after the acquisition of Sprint by T-Mobile in spring of 2020. America’s
Federal Trade Commission initially denied the request to merge, citing the undue
market power exerted by a more concentrated market. They also cited T-Mobile’s
previously aggressive pricing as a source of competitive behaviour that would
diminish after the merger. Together, AT&T, Verizon, and T-Mobile now control
98% of the US cell provider market.

233
 Market power

e e Case study - internet advertising and oligopoly

To find recent examples
of market power being Internet advertising is a growing business that tends to be dominated by a few
challenged by government small firms. In 2019 in the USA, Google (37%), Facebook (22%), Amazon (8%),
action, conduct an internet and Microsoft (8%) collectively made up 75% of the market. Based purely on CR,
search using the following standards, the industry could qualify as a highly concentrated oligopoly.
terms: 'EU Competition
Commission or ‘Federal Trade Discussion questions:
Commission, paired with
“price-fixing, fines’, or ‘market 1 Aren't the above companies’ services ‘free’ to users? Who is being charged by
power’
whom in this situation?
For discussion and debate: 2 Why might the concentration of market power in this industry be a problem for
1 List the agency and industry. consumers or the public?
Identify the main allegations 3 What evidence would help you decide if this level of concentration is a problem?
~

against the firms involved. How could the government intervene to protect social welfare and restore
Listthe possible government competition?
w

interventions in response.
Discuss how the
interventions may help Practice exam questions
address the market power
violations in the case. Paper 1, part (a)
1. Explain, using examples, how monopolistically competitive
firms use differentiation to increase market power. (10 marks)
2. Explain, using a diagram, the degree to which monopolistically
competitive firms achieve allocative and productive efficiency. (10 marks)
3. Explain, using a diagram, what happens to a monopolistically
competitive firm that experiences short-run abnormal profits. (10 marks)
4. Explain, using a kinked demand curve, the existence of price
rigidities in an oligopoly market. (10 marks)
Paper 1, part (b) questions
1. Evaluate the view that market power negatively affects
consumer welfare. (15 marks)
2. Using real-world examples, evaluate the view that governments
should strictly enforce anti-market power laws and regulations. (15 marks)
3. Using real-world examples, discuss the forms of government
intervention used to address extreme market power. (15 marks)
4. Using real-world examples, discuss the position that collusive
oligopolies should be investigated and forcefully controlled. (15 marks)
Paper 2

Former Bumble Bee CEO Sentenced to Prison for Fixing Prices of Canned Tuna
Christopher Lischewski, former Chief Executive Officer and President of Bumble
Bee Foods LLC, was sentenced to serve 40 months in jail and pay a $100,000
criminal fine for his leadership role in a three-year antitrust conspiracy to fix
prices of canned tuna, the Department of Justice announced.

Lischewski was charged on May 16, 2018, in an indictment returned by a

federal grand jury in San Francisco. Aftera four-week trial in late 2019, he was
convicted on the single count of participating in a conspiracy to fix prices of
canned tuna. In imposing Lischewski’s 40-month prison sentence, the Court

234
found that Lischewski was a leader or organiser of the conspiracy and that it
affected over $600 million dollars of canned tuna sales.

‘The sentence imposed today will serve as a significant deterrent in the C-suite
and the boardroom,’ said Assistant Attorney General Makan Delrahim of the
Justice Department’s Antitrust Division. ‘Executives who cheat American
consumers out of the benefits of competition will be brought to justice,
particularly when their antitrust crimes affect the most basic necessity, food.
Today'’s sentence reflects the serious harm that resulted from the multi-year
conspiracy to fix prices of canned tuna.’

‘This sentence is the result of our commitment to holding corporations and

senior leadership accountable for their actions, whether they operate in the food
supply industry or elsewhere,’ said FBI San Francisco Division Special Agent in
Charge, John F. Bennett. ‘This brings us closer to our goal; allowing our citizens
to be able to purchase food in an unbiased market within an efficient and fair
economy, free of corporate greed.”

Bumble Bee pleaded guilty and was sentenced to pay a $25 million criminal fine.
In September, StarKist Co. was sentenced to pay a statutory maximum $100 million
criminal fine. In addition to Bumble Bee and StarKist, four executives, including
Lischewski, were charged in the investigation. The other three executives
pleaded guilty and testified in Lischewski's trial.

The sentence announced today is a result of the Department’s ongoing

investigation into price fixing in the packaged-seafood industry, which is being
conducted by the Antitrust Division’s San Francisco Office and the FBI's
San Francisco Field Office. Anyone with information on price fixing, bid rigging,
or other anticompetitive conduct related to the packaged-seafood industry
should contact the Antitrust Division’s San Francisco Office.
Define price-fixing. (2 marks)
Explain how the firm’s behaviour is an example of formal collusion. (4 marks)
e

Explain, using a diagram, how this collusive oligopoly earns large

abnormal profits. (4 marks)
Explain, using examples, how tuna firms might engage in two
kinds of non-price competition. (4 marks)
Evaluate the effectiveness of government intervention to restrain
market power. (8 marks)

235
 Macroeconomics

Real-world issue 1
‘Why does economic activityvary over time and why does this matter?

Change in the conditions of the demand and supply sides of the economy cause
economic activity to vary over time.
Fluctuations in economic activity impact the economic well-being of individuals
and societies.
Different schools of macroeconomic thought identify different causes and offer
different solutions for macroeconomic problems.
ERE
el
l[ =1 EH. L ]

e '*““*f?“m
*w! ?’lflL "‘r‘u o= §9m.d

0L B EF
Measuring economic
activity and illustrating
its varlatlons
 Measuring economic activity

13.1 How is the overall level of economic

activity measured?

Learning outcomes
At the end of this section you will be able to:
describe, using a diagram, the circular flow of income between households and
firms in a closed economy with no government
« identify the standard measurements for the four macroeconomic objectives
+ explain the three approaches used to calculate gross domestic product
* identify the four factors of production and their respective payments (rent,
wages, interest, and profit) and explain that these constitute the income flow in
the model
« outline that the income flow is numerically equivalent to the expenditure flow
and the value of output flow.

This chapter begins the study of macroeconomics, the study of national economic
activity. With it, the scope of the subject changes from the individual markets
of microeconomics to the broader measures of total well-being. In seeking to
improve the general livelihood of their citizens, governments tend to prioritise four
macroeconomic concerns or objectives:

« full employment, as measured by a low unemployment rate

+ economic growth, as measured by increasing national income
« price stability, as measured by a low inflation rate
* income distribution, as measured by a more equitable distribution of income.
This chapter will explain how each objective is measured, starting with gross domestic
product, or GDP, as a measure of national income. This measure of economic activity
is determined in three different ways, and to grasp those different approaches it is
useful to revisit the circular flow model of the economy from Chapter 1.

How is national income measured?

When economists set out to add up the value of a country’s economic output, they
have an enormous task. The equivalence of expenditure to income guides them as they
seek to check the validity of their conclusions. With this in mind, economists have
three main methods of counting national income:
« the spending (expenditure) approach
« theincome approach
« the output approach.
In Chapter 1, you looked at the circular flow model of the economy showing the
movement of resources and money through the economy. That model included
leakages and injections for the trade, banking, and government sectors.

238
 T

——
The circular flow « Figure 131 Thesimplified
circular flow model shows
Outer flow: factors of production
and goods and services households and firms
interacting in the goods/
Inner flow: money payments and
money income services and factors of
production markets

m Product

Figure 13.1 shows a simplified model, showing the economy roughly divided into
two types of market, with two types of economic agents interacting (households and
firms). In the goods and services market, households bought goods and services, and
in exchange paid money to the firms. In the market for factors of production, firms
buy land, labour, capital, and entrepreneurship from households. Households, in a free
market economy, own these factors, and thus earn income in the form of rent, wages,
interest and profits, respectively. Money flows in one direction while goods, services
and factors of production flow in the other.

The circular flow model illustrates that each of the three methods should derive
essentially the same national income result. All of the goods and services produced
will be measured with the output method. All of that output is eventually bought, and
those expenditures are recorded with the expenditure methods. Furthermore, each
and every transaction involves money spent on the buyer side that will be income on
the selling side.
The identity of output as equivalent to the value of income may at first seem odd, or
an overly tidy result. However, when viewed at the level of an individual transaction,
the identity becomes clearer. Consider the purchase of an apple from your local
market for NZ$1 (NZ$ is the symbol for New Zealand dollar, the currency of New
Zealand). This price represents the value of the output to you, the consumer. To the
seller, it represents income. Some portion of that NZ$1 goes to the grower, transporter,
wholesaler, and final market. This income may go to pay wages, to profits, even to rent.
Thus, we can say that spending on output must, at the same time, represent income to
the factors of production.

The expenditure approach

The expenditure (spending) method counts the total spending on final new goods and
services in a given year. Final goods are ready for consumption; this category does
not include goods that will be input goods or are raw materials for other production.

239
 Measuring economic activity

Apples bought at the grocery store count as final goods, apples sold to a baker for
apple pie are not counted until they are sold in their final form. This approach places
such spending into four broad categories.
* Consumption (C). Consumption includes the durable and non-durable goods and
services purchased by private individuals and households.
Investment (I). Investment refers to spending by firms on new capital equipment
and by households on new housing.
* Government spending (G). Government spending is all spending on government
purchases, which includes salaries for workers as well as capital goods spending
and transfers.
* Net exports (X —M). Net exports deducts the outflow of import purchases (M)
from the inflow derived from export revenue (X).

The expenditure approach can be expressed as:

GDP=C+1+G+(X—M)
LG L] [T GDP is gross domestic product, which is commonly defined as measuring the final
How is your country’s GDP value of all goods and services produced in a country in a given period, usually a year.
composed? Which of the four
spending categories would An example of the expenditure method is shown in Table 13.1. This shows the
you think s the largest? The spending totals for each sector in the US economy for 2019. In the USA, a free market
smallest? To find out, conduct economy, the largest spending sector is consumption. This is typical of free market
an internet search using the
term ‘GDP by composition economies. Next is government spending, then private investment, and net exports.
by end use. Now checka Net exports is expressed as a negative number (US$-659 billion), which means that the
country you expect to be USA imported that much more than it exported in that year.
very different from your
own. Compare the results
Was one sector considerably The income approach
larger than another’s sector?
What factors do you think The income approach to national income accounting attempts to count GDP through
influenced this difference? the market view of the circular flow of income. The income approach roughly
approximates to the returns for factors of production described in Figure 13.1. Wages,
interest, rent, and profits are the factor payments made for labour, capital, land, and
entrepreneurship. These forms of income are used to buy goods and services in the
product market, and should be roughly equivalent to those expenditures.

Again, it is assumed that for every transaction there is a buyer and a seller. A buyer’s
spending is recorded by the expenditure approach, and that same spending is
recorded as revenue income on the income approach. Thus, we economists assume
the identity as:

WHI+R+P=C+I1+G+(X-M)
(GDP from income) = (GDP from spending)

Table 13.1 Expenditure approach to GDP: USA, 2019 (USS billion)

(C) personal consumption expenditure 14,188

(I) gross private domestic investment 3,766
(G) government expenditures 3,569
(X —M) net exports goods and services —659

240
 The output approach
The output approach takes a completely different view when adding the overall level of
economic activity. Like the other approaches, the output approach seeks to ascertain the
total value of all final goods and services produced in a year. When adding production,
however, it would be easy to double count by counting goods that are intermediate
goods and then counting the final product. To avoid this, economists attempt to
identify the value added at each stage of the production process. An automobile’s raw
materials, then parts, then the whole are calculated separately to measure each interval
of production. The total is then added to the national income number.

As you study macroeconomics, it is useful to keep in mind that the overall economic
activity ofa country can go by any of these categorisations:

GDP = national output = national income = national spending

|2 G EER
The table below shows sample figures for the GDP of Nigeria, calculated using the
expenditure approach.

US$ million
Household consumption 969,600
Government expenditure 60,600
Investment, gross private 179,376
SIOS P! Video suggestion:
Exports 144,228 You have read about it, now
you can review what you
Imports 159,984 have just learned by watching
Total 1193.820 avideo by the author!
s Simply click here in
) o ) i your eBook for a video
1 Which sector of GDP is Nigeria's largest? Is this result a surprise? on measuring GDP using the
2 Calculate the percentage of spending by each sector. income approach and the
3 Whyis it necessary to subtract imports from exports? expenditure approach.
4 How does this compare to the size of the sectors in the country you researched
in our research and inquiry?

gnificant is household
g in the Nigerian
economy?

241
 Measuring economic activity

13.2 What is GNI and how is it distinguished

from GDP?

Learning outcomes
At the end of this section you will be able to:
« distinguish between GDP and GNI as measures of economic activity
« calculate GDP and GNI from sets of national income data
« distinguish between the nominal value of GDP and GNI and the real value of
GDP and GNI
« calculate real GDP and real GNI, using a price deflator
« distinguish between total GDP and GNI and per capita GDP and GNI
+ explain real GDP/GNI per capita at PPP.

GDP defines its measurement of income geographically. All output that is domestically
produced, regardless of who owns the factor of production, is measured in a
country’s GDP. For example, the sales of many UK-owned firms that have factories or
outlets in Ireland will count towards Ireland’s GDP. And similarly, Irish firms operating
in the UK will add their sales to the UK’s GDP. Gross national income (GNI) instead
measures income by nationality of ownership of the factors of production wherever
they are. GNI s specifically defined as the total money value of all final goods
and services produced in an economy in one year, plus net property income
from abroad.
GNI statistics track income flows by subtracting from GDP any income to foreign
factors of production. At the same time, it adds any factor income from domestically
owned factors of production located in other countries. In our Irish example, Irish
production in the UK would be subtracted from UK GDP and added to Irish GDP to
help arrive at Irish GNI. Meanwhile, the UK-owned firms’ production in Ireland would
be subtracted from Ireland’s GDP and added to the UK’s to arrive at each country’s
GNIs. The term for this is ‘net property income’ from abroad, which takes the sum
of income from domestically owned assets abroad, minus the income from foreign-
owned assets within the country. It is possible to summarise the method of accounting
for GNI as:
GNI = GDP + net property income from abroad
What accounts for the differences between GNIand GDP depends on the country.
Countries that have a much higher GNI than GDP are likely to have workers or firms
overseas who send income back to home country accounts. Correspondingly, the
presence of foreign workers and firms, and the profits and income they repatriate,
is lower by comparison. Countries with higher GDP than GNI may have significant
foreign presence, in either workers or companies. Therefore, they suffer a net income
loss when GDP is compared to their GNI Net income is reduced by the outflow of
foreign-earned income on the country’s soil.

242
What is the difference between nominal and real
GDP, and between nominal and real GNI?
Nominal GDP measures output in current values, while real GDP will adjust the
measure for inflation levels. Economists hope to determine the actual level of output
produced every year and to avoid accidentally counting changes to price levels instead.
Because GDP is counted by tabulating the transaction prices charged at the time, price
changes can distort attempts to measure actual output. Economists seek to distinguish
between the nominal value of output as it is shown in current prices and the real
value. Nominal values may be higher (inflated) or lower (deflated) than they were in
the previous period. Real GDP seeks to adjust for that and show the value of output at
constant prices.

For example, consider a car manufactured and sold for #15 million (# is the symbol
for the won, the currency of South Korea) in a given year. One year later, exactly the
same car was manufactured and sold for 18 million. Simple mathematics tells us that
the price has increased by 20%, but nothing about the car is actually 20% greater than
in the previous year. So, a nominal measure of GDP for the second year would count
every car sold at a 20% increase in price as a contribution to national output, when
really it is only an increase in the price of the good. This is how price increases from
inflation could cause GDP to be overestimated, causing us to think the economy is
doing better than it is in reality.
‘When taking account of goods and services at their current prices, economists use the
term ‘nominal’. Nominal GDP is simply the value of goods and services produced in a
country in a given year, expressed in the value of the prices charged for that year. In the
example above, the new car would have added 3 million to nominal GDP, providing
an artificially high estimate of how much output actually grew.

* Pricelevel rises (inflation): nominal GDP exaggerates value of output compared to

real output.
« Price level falls (deflation): nominal GDP underestimates value of real output
compared to actual output.

The same distinction between real and nominal values applies to GNI.

Real GNI = Nominal GNI adjusted for inflation

Similarly, rising prices in a measured year can result in an overestimate in real output
due to inflated GNI numbers, while falling prices may underestimate the real level of
output by showing deflated GNI numbers.

[5G (TR K
Calculating real GDP and real GNI using a price deflator
To adjust for inflation, economists use a price deflator, which is defined as a
coefficient that removes the impact of inflation when measuring economic
statistics. The GDP deflator is a price index that expresses price level changes

243
 Measuring economic activity

relative to a base year value of 100. If the base year is 2010 and the value of the GDP
deflator is 155 in 2020, prices have increased 55% from 2010 (deflator = 100) to
2020 (deflator = 155).

To adjust nominal GDP to real GDP use the following equation:

Nominal GDP
Real GDP = X
Price deflator
For example, if Country X has $1.6 billion in nominal GDP and a 125 deflator:

1 000 , OO0
G P11 00U,
125

=$1,280,000,000

Nominal GDP has been ‘deflated’ from $1.6 billion to $1.28 billion.
Using the figures below, calculate the expected values in each blank.

Nominal GDP (US$ million) | GDP deflator | Real GDP

726,000 219

2,356,002 2,012,442

1,843,994 142

110 459,432

396,421 95

What is real GDP/GNI per capita?

While real GDP adjusts for price changes, economists use another measure to
adjust for population size. After all, we would expect countries with large
populations to have large economies: their supply of labour resources and human
capital can be a tremendous advantage. At the same time, it is important for a
country to be growing enough economically to keep pace with the growth of its
population. A simple mathematical adjustment provides a more accurate picture.
By dividing GDP by the population size, we arrive at a per capita (per head) income
for the country. Per capita GDP is the amount of national income divided by the
population size. It gives us a better sense of the approximate standard of living in a
country than total GDP does.

Table 13.2 shows the difference between sheer size ofa country’s economy and
the value compared to population size. Viewed this way, our top five countries are
completely different.
In total terms, all of the above are large diverse economies in countries with hundreds
of millions of people. On a per capita basis, only the USA ranks in the top 10 of both
size and average GDP. China ranks 68th, Japan 27th, Germany 18th, and India 142nd.
Clearly, a better measure of average economic well-being is per capita GDP.
244
 Table 13.2 The top five countries by total nominal GDP are very different to
the top five by nominal GDP per capita

Country Total GDP (USS trillion) | Countryper | Percapita GDP

(GDP rank) [per capita rank] capita rank (US$)
United States 21,374,418.88 [10] Monaco 185,741
China 14,342,902.84 [68] Liechtenstein 173,356
Japan 5,081,769.54 [27] Luxembourg 114,705
Germany 3,845,630.03 [18] Switzerland 81,994
India 2,875,142.31 [142] Ireland 78,661

Exercise 13.3
Calculate real GDP/GNI per capita
Using the figures below, calculate the expected values in each blank.

Nominal GDP (US$) Population Per capita GDP (US$)

3,600,000,000 80,000,000
7,364,000,000 300,000,000
9,000,000 75,000

What is real GDP per capita using PPP?

Look closely and you will notice that Table 13.2 uses nominal measures of GDP. This
may explain why all of the top five per capita GDP countries are places where the cost
of living is relatively high. Without adjusting for cost of living, the higher overall price
levels in those countries are inflating their nominal GDP numbers relative to the rest of
the world.

Adjusting for domestic inflation, using real GDP numbers, would only help us measure
the value of output relative to previous years within that country. Economists have
developed a method to adjust for cost-of-living differences between countries. Called
purchasing power parity (PPP), this adjustment is based on the theory that exchange
rates between currencies are in equilibrium when their purchasing power is the same
in each of the two countries.

‘Why do this? The spending power ofa Norwegian kroner may be very different
from that of the Thai baht. Resources, goods, and services may be more expensive in
Norway than in Thailand, which means that more income may be needed to enjoy the
same standard of living as in Thailand.
PPP is based on the law of one price, which states that an identical good in one country
should cost the same in another country, and that the exchange rate should reflect that
price. For our purposes here, PPP is a tool to assess more accurately the standard of
living available for a given amount of income in a country.
For example, the Norwegian krone equivalent of $100 (Nk588) may buy a certain
amount of food, perhaps three pizzas. The Thai baht equivalent of $100 (THB2994)
245
 Measuring economic activity

Table 13.3 High-income countries may move down the ranking for per capita
GDP once the cost of living is taken into account ...
GDP selected high-income countries: per capita GDP adjusted with
PPP accounting
Country by GDP | GDP per capita/ GDP per capita GDP/capita
per capita (rank) thousands (US$) | PPP[thousands (US$) PPP rank
Luxembourg (3) 114,705 109,100 4
Switzerland (4) 81,994 61,400 11
Ireland (5) 78,661 72,600 7

‘may buy six pizzas, because staple goods are cheaper in Thailand. This means that
every $100 of income earned in Norway will buy less in goods and services than the
same amount in Thailand. Therefore, Norway’s high GDP per capita may overrate the
standard of living there.
When the purchasing power is factored into national income measures, it produces
arefined view of the GDP data. Table 13.3 shows how the per capita GDP leaders in
Table 13.2 are adjusted for purchasing power in their countries. In each case, PPP
adjustments reduced the per capita GDP. All of these are West European countries,
where the cost of living tends to be higher.
In the case of middle- and low-income countries shown in Table 13.4, these result
as having GDP per capita PPP greater than their nominal GDP values. This suggests
that when ranked against other countries nominally, their potential standard of
living is underestimated. What these countries also share is some level of regional
underdevelopment within the country. Economists pay attention to PPP-adjusted GDP
levels to better understand the attainable quality of life, and to compare one country
with another in this regard.

How can national income statistics be used to

measure economic well-being?
The compilation of good economic data is not easy. It requires enormous
administrative work, as well as persistent and rigorous mathematical analysis. It can
also be quite expensive. The US government’s primary agency for national income
accounting, the Bureau of Economic Analysis, spends nearly $100 million dollars a
year to do this job. A logical question is whether this kind of information is worth that

Table 13.4 ... while middle- and low-income countries may move up the ranking
GDP selected middle- and low-income countries: per capita GDP adjusted
with PPP accounting
Country by GDP | GDP per capita] | GDP per capita PPP| | GDP/capita PPP
per capita (rank) | thousands (US$) | thousands (US$) rank
Egypt (141) 2,000 15,000 93
Thailand (93) 6,595 17,800 86
Mongolia (120) 3,620 12,820 101

246
kind of money or, as an economist would say, is the opportunity cost too high?
This is a dimension of positive (rather than normative) economics that everyone
agrees on — the need for accurate data. Furthermore, when agencies openly publish
the methods used to obtain the data, it allows experts to determine the full value of
the information. Economists would justify the pursuit of correct information on the
grounds that it can be useful for comparisons between countries and for the
evaluation of economic performance over time.

Comparing country by country

As our previous tables have shown, national income can help us compare the relative
standard of living across countries, especially on a per capita basis. This leads to
further evaluation of a country’s economic progress and prospects for further growth.

Evaluation of economic performance over time

Policymakers and economists of all kinds can use the data to evaluate the overall
performance of the economy. Making good policy to affect the economy depends
on good information as the basis for those decisions. Questions such as ‘Has our
expansionary fiscal policy been effective?” or ‘Did reducing the money supply help
reduce inflation?’ can be intelligibly answered with good data.
* These results can inform further changes to government policies.
* Voters can use these results to assess the effectiveness of the current governing
approach, and therefore confirm or evict current office holders.
* Businesses can use this information to forecast changes in markets and predict
demand.

What are the limitations of national income

statistics?
Does wealth make one happy? This age-old question arises quite appropriately when
the question of GDP and well-being is raised. In other words, to what degree does a
higher GDP per capita mean a better quality of life? Economists use the term ‘welfare’
to describe a way of speaking about the quality of life. We would assume that, ceteris
paribus, more income is better than less income. And so, we could easily conclude that
countries ranked according to per capita income levels could be ranked in the same
order for welfare.

However, it is possible to argue that GDP only partly represents our view ofa
country’s true welfare. Some have contended that GDP has little relevance for the
everyday person. Economists have noted that national income accounting sometimes
exaggerates well-being, and sometimes underestimates it. And sometimes, it misleads
in unpredictable ways.

How do national income statistics underestimate

economic well-being?
Increasing life spans
The fact that people are living longer is not included. Longer life expectancy is a
universal goal among all countries. Most countries have seen their life expectancies
climb. GDP does not tell this story.
247
 Measuring economic activity

Black market and parallel market activity is not included

For some countries, the estimated value of black market or parallel market activity
is quite high. The income generated in these markets is not counted in final GDP
numbers. Just as importantly, this income is not taxed by the government and
therefore reduces the government’s ability to produce public and merit goods like
education, healthcare, and infrastructure.

Unpaid output is not counted

In other words, GDP only counts paid work. Volunteer efforts, which can be
considerable in some countries, are not counted. Housework and childcare done by
parents at home, while clearly desirable socially, are not counted. Furthermore, the
work of poor farmers in subsistence economies is not counted, since these families
will eat the product of their labour, rather than sell it. GDP figures show countries with
subsistence economies to be less developed than perhaps they really are.

Rising quality, falling prices

Technological and managerial techniques are expected to improve the choice, quality,
and safety of most of our material goods and services. These improvements are unseen
by GDP figures, which merely report the type of output and the purchase price value
of the product. For example, consider the calculators that many students use in their
maths classes. To replicate the collective computing power of these small, inexpensive
1 h [T
machines in a single computer would once have required a machine the size of a room,
How big is your parallel costing thousands of dollars. However, the falling price of these instruments would be
economy?
While there are some recorded as reduced income for the vendors, and a fall in GDP.
interesting cross-country
comparisons of parallel
economies available, it may How do national income statistics overestimate
be just as interesting to
examine your own country’s economic well-being?
experience Negative externalities
For discussion and debate: GDP numbers will include clearly negative social behaviours and transactions as net
Conduct an internet search positives for national output, despite their ill effects. These include the environmental
for your country, paired damage from many kinds of production. Furthermore, the money spent to jail
with terms like 'shadow
economy, ‘black market, criminals, fight wars, and consume unhealthy products all add to GDP figures, without
“parallel economy’, and contributing much to overall welfare.
‘underground economy’
2 Lok for estimates of Under-reporting the loss of natural resources
the size of the parallel
economy as a portion of The degradation of rainforests is more likely to count as increased production than the
GDP despoiling of potentially valuable resource bases and watersheds. Strip mining of metals,
Also seek out examples of the destruction of endangered species, and other environmentally harmful endeavours
w

the types of activity that

are going unrecorded. Is count as adding to GDP, though their long-term consequences may be devastating.
it simply untaxed sales of
legal goods and services?
Is it illegal activity? What other information about economic well-being
Do you think the level do national income statistics fail to give us?
~

of unrecorded activity
presents problems for Composition of output
your home country Does the economy produce large amounts of demerit goods, such as weapons or
government?
cigarettes, or spend money controlling the damage of natural disasters and criminal
248
activity? Or instead does the economy have more hospitals and doctors than average,
with greater access to education? Raw GDP numbers do not communicate the types of
production, or their value to society.

Quality of life
Community activity that includes participation in groups beyond the family (e.g. social
clubs, volunteer participation, church groups, sports, or outdoor activities) have been
linked to greater life satisfaction. Faith in government, trust in the law and the courts,
a sense of mutual responsibility among citizens, all these are desirable qualities for any
country, but are unreported by national income data.

Distribution of income
In other words, national income cannot tell us who gets what. Income distribution
can be very divergent, with a large gap between rich and poor. Furthermore, there
is no guarantee that those at low-income levels are experiencing growth along with
growth in GDP. While GDP may grow, individuals at the lowest levels of income may
experience decreased standards of living.

18.3 Alternative measures of overall economic

well-being

At the end of this section you will be able to:

* explain and comment on alternative measures of overall economic well-being:
* Better Life Index
+ Happiness Index
* Happy Planet Index.

In response to the criticism that macroeconomic measures like GDP and GNI offer a
very limited view of economic well-being, economists in different realms have offered
alternative approaches to measuring overall quality of life.

What is the OECD Better Life Index?

The Organisation for Economic Co-operation and Development (OECD) is an
intergovernmental economic organisation with 37 member countries. It was founded
in the early 1960s to share information, identify common policy issues, identify good
policy and coordinate policies that may require collective action. OECD members are
typically high-income countries that describe themselves as committed to democracy
and a market economy. The OECD developed the Better Life Index (BLI) first published
in 2011. The BLI is a composite measure that adds 11 dimensions of well-being into
one summary score. The BLI includes (continued on the following page):
+ housing
* jobs
249
 Measuring economic activity

L] * education
The BLI emphasises user civic engagement
interactivity by allowing users « life satisfaction
to prioritise some dimensions
over others and ‘create your « work-life balance
own' BLL. You can choose * income
to emphasise income and * community
health, for example, and see
how the rankings change: * environment
* health
For discussion and debate:
1 Find the Create Your Better safety
Life Index on the OECD * Happiness Index
website.
* Happy Planet Index.
2 Toggle the indicators to
reflect the aspects of life The BLI continues to broaden its measure of well-being by adding an examination
you value most highly. of gender disparities across the OECD. In other words, it shows how different are the
3 Create your own index. levels of satisfaction that men and women enjoy on the various indicators within
4 Screenshot and share your cach country. One interesting feature of the BLI is a regional comparison tool. An
rankings. example is shown below. Taking, for example, the Seoul region of South Korea as
5 Discuss with your astarting point, the BLI will display regions with similar levels of well-being in the
classmates.
same categories.
a. Which countries
dropped in your Figure 13.2 shows Southern-Kanto, an area that includes Tokyo. It has similar rankings
rankings, which rose?
b. What accounts for the in the same dimensions in what could be very different types of regions such as
changes? Sardinia and Central Portugal.

What is the Happiness Index?

The United Nations publishes the World Happiness Report every year, a product
of the United Nations Sustainable Development Solutions Network. One portion
of this report includes rankings of national happiness based on self-reported
surveys of individuals in over 150 countries. Inspired by the Government of
Bhutan'’s Gross National Happiness index, the survey asks respondents to rank
their life from 0 to 10, with 0 being the worst possible life and 10 being the best.
High rankings on the Happiness Index tend to correlate with six key variables that
support well-being: income, healthy life expectancy, social support, freedom, trust,
and generosity.

Figure13.2 The OECD >

Better Life Index shows
which regions in other
countries have a similar
well-being profile

250
What is the Happy Planet Index? (E TR,
The Happy Planet Index (HPI) is an index of well-being that incorporates Find your country’s ranking
environmental impact. By weighting a country’s ecological footprint in the index, in GDP per capita, the BLI,
Happiness Index, and Happy
the HPI combines self-reporting happiness surveys with life expectancy, as well as Planet Index
equality of outcomes within a country on happiness and life expectancy. Perhaps
For discussion and debate:
the most significant feature of the HPI is trying to adjust for the level of sustainable
1 What accounts for the
resource use. Because GDP may include ecologically ‘expensive’ activities in terms differences in rankings?
of external costs, the HPI will revalue sustainable use. The environmental impact
2 Do the results surprise you
is estimated by quantifying the amount of natural resources used on a per in any way?
capita basis. 3 Speculate as to what
policies might help your
As you might guess, HPI rankings can be very different from GDP, BLL, or happiness country move up or down
scores. The top five HPI countries in the most recent ranking were middle-income a particular index
countries like Costa Rica, Mexico, Colombia, Vanuatu, and Vietnam. Moreover, some
countries that are typically top scoring in the other measures drop considerably on the Video suggestion:
HPL Australia, with cities often ranked as the best quality of life in the world, dropped You have read about it, now
t0 105 on the HPI, and the USA to 109. you can review what you
have just learned by watching
avideo by the author!
Simply lick here in
your eBook for a video
on the limitations of GDP
3.4 What is the business cycle?

Learning outcomes
At the end of this section you will be able to:
+ explain, using a business cycle diagram, that economies tend to go through
a cyclical pattern characterised by the phases of the business cycle
+ explain the long-term growth trend in the business cycle diagram as the
potential output of the economy
« distinguish between a decrease in GDP and a decrease in GDP growth.

The business cycle is a term used to describe the fluctuations of national income
from expansion to contraction to recovery. It can also be associated with changes in
price levels. Economies tend to rise and fall, sometimes with warning and at other
times rather suddenly. The fluctuations of GDP, and the important changes in
employment that go with it, are often called the business cycle because there
sometimes appears to be a pattern of increase and decrease, followed by another
increase and then decrease. However, as Figure 13.3 shows, a more appropriate term
might be the business roller-coaster.
Economic growth, as you now know, is an increase in the GDP from one year to the
next. But sometimes, the economy shrinks. A recession is defined as two consecutive
quarters of declining national output. In other words, if real GDP contracts over a six-
month period, it is classified as a recession.

The lowest point ofa recession is called the recessionary trough, seen here at the
bottom of the GDP line. Nobody really knows exactly when this point is reached
until output has begun to recover and growth has resumed. Hopefully, the economy
251
 Measuring economic activity

GDP Peak

Recession 1

Figure 133 In the business

cycle there are peaks and Expansion
troughs along the road to
long-term growth Recovery

Trough
Time

will quickly enter a recovery period. Recovery, shown as the GDP line rises from
the trough, is defined as an increase in GDP from a recessionary level to match
the level of output produced before the recession. The economy is getting back to
where it was before the contraction. Should the economy grow beyond its previous
level of output, it is called expansion. For most countries, expansion happens in
short bursts, rather than a steady level of growth. When these bursts hit an apex
(just before a recession) it is called the peak. Again, a peak is only observed aftera
recession begins.

The specific ways an economy can go from recession to recovery, and from recovery
to expansion to recession again, are covered in detail in the chapters that follow.
What is important to note here is that short-term fluctuations, the highs and lows of
the roller coaster, can be quite dramatic. In the early years of industrial capitalism,
when severe recessions were common, Karl Marx identified this tendency for swelling
and collapse in his Crisis Theory, and predicted that these convulsions would inspire
class struggle between labour and capital interests. These predictions appeared to
come true with the rapid rise in the popularity of socialist movements after the
Second World War until and into the Great Depression era of the 1930s. At that
time, John Maynard Keynes labelled the phenomena a ‘boom and bust’ cycle that
required massive government intervention, but not socialist revolution, to control.
Today, it is widely accepted that the job of government policymakers is to ‘smooth
out’ the peaks and troughs, to allow for more economic stability whenever this is
possible. The economic crises of the 20th and 21st centuries have inspired calls for
more government intervention to avoid major recessions and to have steady, reliable
growth instead.
Also important is that the roller coaster moves generally upwards. While wide swings
Most economists agree between peaks and troughs can cause significant pain and political instability, an
thata growing economy upward average trend should be present in nearly all economies. Look again at Figure
is an essential ingredient 13.3 and note the trend line that runs through the peaks and troughs. The trend
for rising living standards line suggests that, over the long term, the economy is growing. This may mean an
In the absence of statistics
and news information improvement in the standard of living, if the growth matches population growth and
about the economy, is distributed widely. While economists agree that GDP is not the only measure of
how might people judge national well-being, most agree that a growing economy is an essential ingredient for
whether the economy is rising living standards.
doing well?
252
Practice exam
Paper 1, part (a)
1. Usinga circular flow diagram, explain how two methods
of measuring GDP will produce similar results. (10 marks)
Paper 2, parts (a) and (b) and (g)
Australia and Argentina: divergent stories
In terms of overall size, the economies of Argentina and Australia started at similar
points in the early 2000s. Their stories diverge, however, in the experience of each
over the last decade. For Australia, the growth of real GDP has been steady, reliable,
nearly constant. For Argentina, economic performance has been much more
volatile, with several recessions in that short span.

a. Define real GDP. (2 marks)

Define recession. (2 marks)
b. Using a diagram, explain the business cycle experience of
Argentina from 2006 to 2011. (4 marks)
g Discuss the view that GDP can provide conclusive evidence
of a country’s overall economic well-being. (15 marks)

o
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S
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T
Argentina
GDP, PPP

Eg
g

E Figure1 GDR Australia

~ 1.00 and Argentina
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=
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T T T T T T
2006 2008 2010 2012 2014 2016 2018
Year

253
Variations in.economic 4
activity: aggregate ‘
demand and
aggregate supply
T
 Learning comes
At the end of this section you will be able to:
« distinguish between the microeconomic concept of demand for a product and
the macroeconomic concept of AD
¢ constructan AD curve
* explain why the AD curve has a negative slope
* describe consumption, investment, government spending, and net exports as
the components of AD
« for each of the various factors, explain how changes in the components of AD
can lead to a shift in the AD curve.

It was December 2019 and on the eve of a new decade the economies of the world
were operating under conditions that most would describe as ‘business as usual’. The
decade began, however, with a slow and unsteady recovery from what was later coined
the Great Recession, the biggest global collapse since the 1930s. In the run-up to 2019,
most of the world had been experiencing stable and steady economic growth for the
second half of the 2010s.
Figure 14.1 shows the GDPs of the USA, the EU, and China from 2015 through to the
end of 2019.

Almost no one on New Year’s day of 2020 could have predicted that within a couple
of months, nearly every country in the world would be in the midst of a record-setting
decline in economic activity. Unemployment rates reached all-time highs, businesses

United States

«
=£
A}
T
£ European Union < Figure14.1 GDPof
2 selected economies, 2015-19
£
o
a
o

T T T T
2015 2016 2017 2018 2019
Year
258
 Variations in economic activity

large and small faced bankruptcy and closure, and governments scrambled to devise
emergency measures to prop up their economies and protect the livelihoods of billions
of their citizens.

Figures 14.2a-c tell a bit of the story of what unfolded in the world’s three largest
economies in the first half of 2020.
What happened in the early months of 20207 Well, we all know about the global
pandemic that swept across nearly every country in the world. However, in addition to
the public health crisis, the world’s economies found themselves in an aggregate demand
and aggregate supply crisis due to the unprecedented response required to slow the spread of
COVID-19. The stay-at-home orders and forced shut downs of all but ‘essential businesses’
constrained both aggregate demand (AD) and aggregate supply (AS) in a manner and
with a speed never experienced in modern history. While the Great Depression of the
1930s unfolded over months and years, the shocks that struck the countries of the
world between February and April of 2020 occurred over just days and weeks.

To understand the causes and consequences of the economic collapse that occurred
during the first half of 2020 (and in some places continuing well through the summer
and fall), we must apply a new economic model that builds on the basic concepts
introduced in our study of microeconomics. The concepts of demand and supply, which
apply to the markets for individual goods and services, will be adapted to apply to
entire nations’ economies. The aggregate demand and aggregate supply model (AD/AS) is the
subject of this chapter.

We begin by looking at AD, defined as the total spending in an economy consisting of

consumption, investment, government expenditure, and net exports.

If we think of AD relative to its microeconomics counterpart, demand, the differences

are clear: Demand represents the amount of a particular good that consumers are willing
to buy at a range of prices in a period of time. AD, meanwhile, is the amount of total
output, or all goods and services produced by an entire country, that households,
businesses, the government, and foreigners are willing to buy in a period of time at a
range of price levels. It is broken down into its four components, each representing a
category of spending undertaken by a different stakeholder in a country’s economy.

What are the components of AD?

Demand for a nation’s output comes from households, from firms, from the
government, and from foreign consumers of domestically produced goods, services,
and resources. The four components (with the abbreviation for each) that make up a
country’s aggregate demand are as follows.
+ Consumption (C): Consumption measures all spending by domestic households
on goods and services during a particular period of time.
+ Investment (I): Investment is short for gross domestic private investment, and
measures the total spending by firms on capital equipment.
* Government spending (G): Government spending is short for gross government
investment and spending and measures a country’s government’s expenditures on
goods and services.
* Net exports (X—M, or Xn): Net exports measures the total income earned from
the sale of exports (X) to foreigners minus the total amount spent by a nation’s
256
 GDP growth (%)
-329

i T T T T T =0
Jul2017 Jan2018 Jul2018 Jan2019 Jul2019 Jan2020 Jjul 2020
Year

5
29 28 25 5,

g=
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o rates July 2017 to July 2020
& (2) USA (b) EU () China

144
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Jul2017 Jan2018 Jul2018 Jan2019 Jul2019 Jan2020 Jul 2020
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257
 Variations in economic activity

households, firms and government on goods and services imported (M) from other
countries. Net exports can be negative or positive, depending on whether a nation
spends more on imports than it earns from the sale of its exports.

AD can therefore be expressed using the following formula:

D=C+I+G+(X-M)

The AD curve
The AD curve describes the relationship between the price level and the quantity of
goods and services demanded in a country. Consider Figure 14.3, showing the AD for
ahypothetical economy.

Recall from Chapter 13 that the GDP deflator price index measures the average price
level of all the goods and services in a country. The vertical axis in our AD model
depicts the average price level as measured by the deflator. Along the horizontal axis
we see the amount of national output (in billions of dollars) demanded by houscholds,
firms, the government, and foreigners at every possible price level.
In later graphs, we will use the label ‘rGDP’ for ‘real GDP’ along the horizontal axis, and
‘PL for ‘price level’ along the vertical axis. When identifying levels of national output,
we will use Y, which is short for ‘national income’ and PL on the vertical axis.

The negative slope of the AD curve reflects the fact that at lower price levels, more of
anation’s output is demanded, while at higher price levels less output is demanded,
assuming all else is held constant. Households, firms, the government, and foreigners
will demand more of a country’s goods and services as their average prices fall, and less
as their prices rise. In this regard, AD is a reflection of the microeconomic concept of
demand, which observed that at lower prices, more of a particular good is demanded,
and vice versa. The same logic applies to total output. When a nation’s goods become
Price level (GDP deflator price index)
~S

Figure 143 The aggregate

s8

demand curve shows the

relationship between average
price levels and total demand
o3

for goods and services in a

nation's economy

600 800 1000

National output demanded
(real GDP, $ billion)
258
cheaper, ceteris paribus, households, the government, businesses, and foreigners
wish to buy more of them, while at a higher price level a smaller amount of output Video suggestion:
is demanded.
You have read about it, now
you can review what you
have just learned by watching
A change in the price level, therefore, causes a movement along the AD curve, while avideo by the author!
a change in one of the components of AD causes the whole curve to shift, meaning Simply lick here in
more or less output will be demanded at every price level. In the following section we o your eBook for an
will break down each of the components of AD and describe what factors can cause introductory video on
changes in G, I, G, or Xn.
aggregate demand

What are the factors that can cause a shift in AD?

Any change in the components of AD (consumption, investment, government
spending, or net exports) that is not due to changes in the price level leads to a shift of
the AD curve. When a determinant of one or more of the components of AD changes,
the entire AD curve will shift in or out, and the quantity of output demanded at every
price level will change.
Assume, for example, consumption increases. The result is an increase in AD and an
outward shift of the AD curve. Figure 14.4 demonstrates how this would be illustrated
in our AD model.

Owing to an increase in consumption, households are now willing to buy more output
at every price level (at AD,) compared to before (at AD).

Any change in the level of business investment, government spending, or net exports
will likewise cause the AD curve to shift. Consider the impact of a decrease in exports
to other countries, which would cause the net exports component of AD to decline.
Figure 14.5 shows the effect of a decrease in one of the components of AD.
Owing to a decrease in demand for its exports, Snowlandia has seen its AD shift
inwards, meaning less of the country’s output is demanded at every price level.
Price level (GDP deflator price index)
NS

o Figure14.4 Anincreasein
S3

any one determinant of AD

results in a rightward shift of
o3

the AD curve

1000 1200 1400

National output demanded
(real GDP, $ n)
259
 Variations in economic activity

Price level (GDP deflator price index)

~S
o3
Figure 145 Adecreasein,
say, exports would shift the

o3
AD curve to the left

200 400 600

National output demanded
(real GDP, $ billion)

Let us look more closely at the factors that determine the level of each of the
components of AD, beginning with consumption, for most countries the largest single
component of aggregate demand.

What are the determinants of consumption?

The level of household consumption may increase or decrease at every price level,
thereby causing a shift in aggregate demand, due to the following factors:
consumer confidence
* interest rates
o wealth
* income taxes
* level of household indebtedness
* expectations of future price levels.

Consumer confidence
The 20th-century economist John Maynard Keynes used the term ‘animal spirits’ to
describe the confidence (or lack of confidence) among households and firms in an
economy. Consumer confidence is an economic indicator that measures the degree of
optimism that consumers feel about the overall state of the economy, and is therefore
an important determinant of overall household consumption.

During periods of economic growth with low unemployment and stable prices,
confidence tends to be high and consumer spending strong. In periods of
macroeconomic uncertainty, when overall output is falling, unemployment is
rising and prices are declining, consumer confidence can collapse and households
will reduce their consumption and increase savings in the expectation of future
economic hardships.

Figure 14.6 shows the Organisation for Economic Co-operation and Development’s
(OECD) consumer confidence index, as measured between 2014 and the summer of 2020.
260
 s "N
100.0 W V\
/-J
99.5 < Figure14.6 The OECD's
consumer confidence index,
99.0 2014-20

985
OECD-Total —V

2014 2015 2016 2017 2018 2019 2020

Year

Not surprisingly, with the onset of the 2020 pandemic, the index took a steep
dive, part of the explanation for the fall in output described at the beginning of
this chapter.

Interest rates
‘When most people think of interest rates they are likely to think of the return
they can get by placing their money in a savings account or perhaps the additional
amount they have to pay a bank or a credit card company when repaying money
they borrowed. Both of these are correct understandings of what an interest rate is.
However, from a purely economic perspective, the interest rate is simply the
opportunity cost of spending money.

For example, assume an individual has €100 cash in his pocket. He can decide whether
to spend that money today on a new outfit or to place that money in the bank and
spend it sometime in the future. If the interest rate is 2%, then the opportunity cost
of spending his €100 today is only €2 over the next year, as this is his expected rate of
return by saving the money. However, assume instead the interest rate is 10%. Now
he stands to earn €10 in interest income over the next year. The opportunity cost
of spending his cash today is now five times greater than it was with the lower
interest rate.

< Splashingoutona

261
 Variations in economic activity

We can begin to see how interest rates might affect consumption. At higher interest
rates, there is a greater opportunity cost to spending money today, while at lower
interest rates the opportunity cost of current spending is lower since less future
income is foregone by spending money now.
Another way to think about it is from the perspective of a borrower. Much household
spending in the economy is financed through borrowing. This is particularly true for
expensive items (sometimes called durable goods by economists), such as cars, boats,
new household appliances, or other items that people may not have cash available for.
Car dealers make loans to buyers to allow them to take home a new car. Appliance
retailers might do the same to allow a shopper to equip their kitchen with shiny new
appliances. These loans come with an interest rate attached, and any amount borrowed
must be repaid with interest. When interest rates are low, households are inclined to
borrow more to finance the purchase of durable goods. At higher interest rates, the
cost of borrowing is higher, so consumption will be lower.
All else equal, a decrease in the interest rate should cause household consumption to
increase and AD to shift out, while higher interest rates should cause a decrease in
consumption and a contraction in AD.

Wealth
Household wealth is another important determinant of the level of household
consumption. Wealth is not to be confused with income. Income is the money
households earn during a particular period of time. Wealth is the value of all of a
household’s assets minus the size of its liabilities. In other words, wealth is what
someone has minus what they owe. Later in the chapter we will look at the ‘what they
owe’ side of this equation when we consider the level of indebtedness as a determinant
of consumption, but here let us look at ‘what someone has’.

In many countries, the primary source of household wealth is, not surprisingly,
the house itself. While houses are not the only source of wealth, they are the most
significant for the typical middle-class citizen in most developed countries. In the USA,
for example, 52% of households own stocks, but 50% of all the stocks owned are in
the hands of the top 1% of households. Meanwhile, 65% of American households own
their own home, meaning a significant proportion of the wealth encapsulated in the
US housing market is in the hands of a majority of the US population.

Houses are an asset the price of which fluctuates with supply and demand, just like the
prices of all assets. When house prices are rising, household consumption tends to rise,
because households feel wealthier. The psychology of this relationship is straightforward.
If Mia, a UK businessperson, earns £60,000 per year and lives in a house that is valued at
£250,000, she will base her consumption in a given year on both her actual income and
her perceived wealth, which includes the equity she has in her house. If, however, her
home is valued the following year at £350,000, Mia's wealth has increased by 40%. Without
any change in her income, Mia's perception of her own wealth has increased. Mia is now
inclined to increase consumption, perhaps by taking on new debts to buy big ticket items
like a new car or boat, since the value of her biggest asset has increased substantially.

This hypothetical situation can be observed in real-world data. Figure 14.7 shows
the actual relationship between changes in house prices in the UK and UK household
consumption.
262
 30 o
I3 : 9 RS
8%R 6 g€
B3
g
28
£ B
& >10 3 52 < Figure 14.7 UK household
consumption changes in line
f°-§ 0 0o 28 with real house prices
EE 10
-8
& =

20 6
1970 1976 1982 1988 1994 2000 2006 2012 2018
Year
Adam Smith, the father of
There is almost a perfect correlation between the two variables. When house prices modern economics, laid out
rise, UK households consume more (1994-2006). But when house prices fall, his foundational theories in
consumption falls lockstep (2006-09).
his 1776 book The Wealth
of Nations, Smith called
into question the prevailing
Consumption, which measures the amount households spend on finished goods and
18th-century mercantilist
services, rises and falls with household wealth, and in many countries, the main source definition of wealth, under
of wealth is the house itself. A recent example of the power of house prices on consumer which wealth consisted of
spending is the Great Recession of 2008-10 (which can be seen in the dip during these the nation's accumulated

years in Figure 14.7). A collapse in house prices in the USA, the UK, and across the EU, reserves of gold and silver.
The way to increase wealth
triggered a financial crisis and a collapse in consumer spending that sent the world’s was by boosting exports and
largest economies into a deep recession, with unemployment rising to levels not seen restricting imports in order
since the 1930s in many countries. Eventually, the housing markets stabilised and with to build up reserves of gold
the recovery in house prices came a recovery in consumer spending, as households and silver.
across the developed world saw their wealth recover from the shocks of the late 2000s. Smith disputed this. To learn
more, read about the broad
themes of The Wealth of
Income taxes Nations on the Adam Smith
Institute website (https://
The level of income taxes in a country is one factor influencing household wwnwadamsmith org/the-
consumption over which the government has direct control. When income taxes are wealth-of-nations).
reduced, households are left with more disposable income, increasing demand for all For discussion and debate:
goods and services at every price level. Higher income taxes reduce disposable incomes 1 If not gold and silver, what
and cause consumption to decrease. did Adam Smith consider
to be the true wealth ofa
Changes in the level of taxation aimed at stimulating or contracting aggregate demand nation?
are a tool of a government’s fiscal policy, which will be explored in more detail in What were two ways Smith
~

Chapter 20. believed national wealth

could be increased?
What are some of
Level of household indebtedness the threats to wealth
accumulation Smith
As mentioned earlier in the section on wealth, another factor influencing consumption is the
observed and warned us
level of indebtedness among a nation’s households (or ‘what they owe)). Sources of debt can about?
include the money owed for all kinds of spending, but in most countries household debt is How did Smith's definition
=

largely made up of mortgage debt, or money owed to banks for the purchase of a home. of wealth differ from that
introduced in this chapter?
In the short term, taking on debt allows a household to increase its consumption, since the What s the modern term
money borrowed can be spent on cars, boats, or education fees. But when a household’s used to describe what
debt burden grows too large, banks and other lenders (like car dealerships or credit card Smith considered the
wealth of a nation
companies) will think twice before making additional loans, as the risk of lending increases
263
 Variations in economic activity

as a consumer’s debt load grows larger. Additionally, servicing past debts (making interest
payments on past debts) increasingly dips into consumers’ disposable income, leaving
them with less money at the end of each month to buy other things. Just paying back past
debts reduces the amount of disposable income available for new consumption.

So, debt is a double edged sword. At first, increasing household debt equates with
increasing consumption; but over time, high debt levels force consumers to tighten
their belts and pay down past debts before taking on new ones, and the interest
payments themselves act similarly to taxes, reducing disposable incomes today and
forcing households to consume less, reducing AD across an economy.

Expectations of future price levels

A final determinant of household consumption is the expected inflation rate. There is a
‘micro equivalent here: recall from Chapter 3, Demand, that ‘future price expectations’ is one
of the determinants of demand for particular goods. Similarly, if a nation’s consumers expect
the average price level of all goods to increase in the future (in other words, they expect
higher inflation), then the demand for output today increases. It is perfectly rational to spend
money now while it is worth more rather than wait until the future when the value of your
money has decreased. Inflation essentially decreases the value of money, since more dollars
or euros or yen are needed to buy the same amount of goods when inflation increases.
Similarly, expected deflation will constrain current spending. If households expect the
average price level to fall in the future, the rational thing to do is reduce spending today
and wait for lower prices tomorrow, which increase the value of money in the future.

There are implications for policymakers of the power of expectations over consumer
spending. In Chapter 19, Demand management: monetary policy, we will study the
role of central bankers in targeting a low and stable level of inflation through their
control of the economy’s money supply. By doing so, policymakers can manage future
price expectations and help prevent unexpected shocks to consumption and aggregate
demand that threaten to plunge the business cycle into unwanted peaks and troughs.

What are the determinants of investment?

Investment is defined as the addition of capital stock to the economy, or more simply,
expenditure by firms on capital equipment and technology. Nearly all investment in
an economy is undertaken by business firms; the one exception is when households
purchase houses or real estate. A house purchase is distinct from consumption, since
the home is not a consumable good; rather, a house is an asset that can be used to make
money in the short term (a homeowner may choose to rent it out) or, in the longer term,
be resold at a higher price (assuming house prices rise over time, which they tend to do).

Many of the determinants of investment will sound similar to those for consumption,
so we will not go into quite the detail we did in the last section. The factors affecting
investment are:

* interest rates
« business confidence
« technology
Dbusiness taxes
« level of corporate indebtedness.
264
Interest rates
As with household consumption, business spending is interest sensitive. The same
principles apply: at higher interest rates the opportunity cost of borrowing money or
spending cash a business already has increases, since more future income is given up
by not saving. At lower interest rates borrowing costs are lower, making more potential
investments attractive to a business owner.

For instance, if the expected rate of return on the purchase ofa 3D printer for a toy
manufacturer is 7% (meaning the purchase of the printer would increase revenues
by 7%) but the increase in costs due to the added interest payments is 5%, then the
investment stands to increase profits by 2%. However, if interest rates are higher,
the cost of borrowing to buy the 3D printer increases, and the investment may not
prove profitable.

Higher interest rates will constrain investment spending and AD, while lower interest
rates will stimulate investment and AD. Central banks have a role in controlling
monetary policy and setting interest rates. In Chapter 19, we will look more closely
at the role of central banks in managing levels of investment and consumption in
an economy.

Business confidence
Again, just as household spending is influenced by consumer confidence, investment
spending is subject to changes in the level of business confidence. The OECD tracks
abusiness confidence index, which ‘provides information on future developments,
based upon opinion surveys on developments in production, orders and stocks of
finished goods in the industry sector. It can be used to monitor output growth and
to anticipate turning points in economic activity. Numbers above 100 suggest an
increased confidence in near future business performance, and numbers below
100 indicate pessimism towards future performance.’

101.5

101.0 /TN
1005
1000 o \'\Vl‘/ \
995 \ « Figure14.8 Business
confidence index for OECD
99.0 V\ member countries, 2014-20
985 \
980 OECD-Total —‘-\7

2014 2015 2016 2017 2018 2019 2020

Year

265
 Variations in economic activity

Not surprisingly, business confidence and consumer confidence track very closely
with one another. When households are feeling good about the current and future
economic outlook, they are likely to spend more, which leads businesses to invest in
order to be able to meet the expected increases in future demand from their customers.

When business confidence falls, however, spending on new capital equipment and
technology is likely to slow down as well, contributing to a decrease in AD. The decline
in confidence in early 2020 is a result of the stay-at-home orders and forced shutdowns
that contributed to the recessions across the world during the COVID-19 pandemic.

Technology
The availability of new technologies are assumed to be followed by bouts of increased
investment. There are countless historical examples to choose from, such as the
invention of early industrial technologies like the cotton gin, the steam engine, and
later the railroads, to later innovations in automobiles, air travel, and high-speed trains.
More recently, the internet has given rise to perhaps the longest and largest boom in
business investment, as e-commerce, gaming, communications, entertainment, and
other industries have increasingly moved online.
The year 2020 saw an explosion in investments in video-conferencing and remote-
working technologies as hundreds of millions of workers were forced to work from
home due to the closures of shared work spaces. People expected that this might be
aturning point in how workers in the high-skilled sectors interact with one another.
New technologies will continue to develop, leading to increased investments from
businesses as they look to capitalise on the enthusiasm for, and reap the benefits of,
innovations in various sectors.

Business taxes
Once again we return to a determinant of AD that government can directly affect. You
will recall from Chapter 5, Supply, that taxes and subsidies are determinants of supply.
A cutin business taxes will increase business profits and incentivise new spending
on capital goods. The expected return on any potential investment increases when
the government promises to take a smaller share of profits that investment earns.
Similarly, higher taxes make new investments less profitable and will lead firms to
retain more of their earnings in order to pay their taxes.

Level of corporate indebtedness

Justas with households, increases in corporate indebtedness promise to stimulate
spending in the short term, but reduce it in the long term. Managing debt payments
requires firms to find a balance between spending their revenues on new capital and
servicing the debts accrued from the purchase of existing capital. Ifa firm takes on too
high a debt level to expand its operations today and then its revenues grow too slowly
to allow it to easily service past debts, then the firm'’s debt burden will prevent it from
taking on new investments in the future.
So, as with households, debt is a double edged sword. Too much debt will slow
investment, but not enough will slow it as well. The right amount of debt will allow firms
to pay interest on past loans while growing their operations and earning revenues that
cover costs, allowing for a sustainable level of expansion over time.
266
What determines the level of government
expenditures?
Government spending includes a broad range of expenditure: publicly-funded
schools and universities, national defence, highways and roads, parks and hospitals.
Governments may spend directly on the provision of goods and services or they may
subsidise provision of certain goods by the private sector.

The proportion of total AD made up of government spending varies hugely across

nations. Government spending makes up the largest proportion of the economies of
northern and western European nations such as Denmark, Sweden, the Netherlands,
France, and Germany. In these countries, the government provides services such as
healthcare and education to all citizens, paid for almost entirely by taxpayers.

In countries with large government sectors, taxes on households and firms tend
to be much higher than in those where government spending makes up a smaller
proportion of AD. This makes sense since ultimately all government spending on
goods and services must be financed by the nation’s taxpayers.
The level of government spending in a nation in a particular year depends on
the government’s fiscal policy, which refers to the government’s use of taxes and
spending to stimulate or contract the overall level of AD in an economy. Fiscal policy
is explained in detail in Chapter 20, but what you need to know here is that its use
can raise or lower the level of government spending in a given period to help meet
macroeconomic objectives.

What are the determinants of net exports?

In a global economy, nearly every nation depends to some degree on foreign demand
for its output as a component of its AD. Net exports measures the spending by
foreigners on a nation’s goods and services minus the amount spent by domestic
households and firms on imports from other countries. Net exports is, therefore, the
only component of AD that can be negative. This occurs when a nation spends more
on imports than it earns from the sale of its exports.

Case study - net exports for the USA and German

In 2019, the USA’s net exports were about —$500 billion. Yes, that is negative
$500 billion. Germany, on the other hand, experienced net exports of around
$274 billion (yes, greater than zero). How can we understand the discrepancies
between these two large economies’ net exports? While the USA sold a lot of stuff
to the rest of the world (exports), they imported a half a trillion dollars more
than they exported. Meanwhile, Germans love imports as much as Americans do,
but the German economy specialises in the production of goods that the rest
of the world also craves, and as a result Germany exported goods whose value
exceeded imports by over a quarter of a trillion dollars.

The determinants ofa country’s net exports are:

* income of trading partners

* exchange rates
« trade policies.
267
 Variations in economic activity

Income of trading partners

The macroeconomic health and household incomes of a nation’s trading partners
determine demand for the nation’s exports. For example, Canada’s largest trading
partner is the USA (75% of Canada’s trade takes place with the USA).

Case study - Canada

As incomes in the USA fell during the recession of 2008-09, Canada’s exports fell
from $460 billion in 2008 to $323 billion in 2009, a decline of 30%.

However, during the same period, Canada’s imports from the rest of the world also
declined, from $415 billion to $327 billion, a decline of 21%. Canada’s net exports in
2008 were $44 billion but in 2009 fell to —$4 billion, a decline of $48 billion in one
year. Falling incomes in the USA are the most likely explanation for this massive
decline in Canada’s net exports, supporting the fact that household income in
trading nations is a major determinant of a nation’s net exports.

Exchange rates
An exchange rate is the value of one currency expressed in terms of another. For
example, if US$1 = €0.8, then $1,000 will buy €800 worth of German goods. However,
if the dollar appreciates, say to $1= €1, then suddenly Americans’ ability to buy German
goods improves, as US$1,000 will now purchase €1,000 worth of Germany’s output.

A stronger currency will cause demand for imports in a country to increase, and demand
for that country’s exports to fall. A weaker currency, on the other hand, will lead to
an increase in exports and decrease in exports (assuming all else is held constant,
of course). The relationship here is a bit counterintuitive: while a ‘strong currency’
sounds like it should be good for an economy, from an AD perspective it is actually
contractionary, since a stronger currency causes net exports to fall. On the other hand,
when currency depreciation (decrease in the exchange rate) occurs, net exports
increase as a country’s goods get cheaper abroad and imports get more expensive.

Trade policies
In Chapters 22 and 23 we will study the advantages and disadvantages of free trade
and protectionism, which can be defined as government policies that limit the flow
of imports or promote exports in order to boost domestic AD and employment.
The extent to which a government intervenes in the international flow of goods and
services will directly influence its net exports.

Export promotion policies like subsidies to domestic producers that make their output
cheaper to foreigners will increase the export component of Xn. Import substitution
policies such as tariffs (taxes on imports) or quotas (physical limits on the quantity of
Video suggestion: imports allowed) will shift domestic consumers away from foreign-produced goods
You have read about it, now and increase demand for domestic output, increasing net exports in the process.
you can review what you
have just learned by watching
avideo by the author! We have looked closely at the demand side of the macroeconomy. We now know that
Simply click here in changes in a country’s price level, ceteris paribus, will cause a movement along the AD
your eBook for a video curve, leading houscholds, the government, businesses, and foreigners to demand
on movements along the AD. more or less output. We also now know that, autonomous of the price level, there
curve versus shifts in AD, are determinants of AD that can cause aggregate spending to expand or contract,
268
increasing or decreasing the amount of national output demanded at every price
level. But to truly understand the causes behind macroeconomic shocks like the Great
Depression (1930s), the Great Recession (2008-10) and the 2020 COVID-19 recessions,
we must incorporate another element into our macroeconomic model, and that, of
course, is aggregate supply.

1 at is short-run aggregate supply

Learning outcomes
At the end of this section you will be able to:
* define the term aggregate supply
* explain, using a diagram, why the SRAS curve is upward sloping
* explain, using a diagram, how the AS curve in the short run (SRAS) can shift
due to factors including:
* changes in resource prices
* changes in business taxes and subsidies
* supply shocks.

With our definition and graphical analysis of AD complete, it is time to consider

the ‘supply side’ of the economy. Aggregate supply (AS) is the quantity of goods and
services that a country’s producers are willing and able to produce at a range of price
levels in a period of time. The short-run aggregate supply (SRAS) curve describes the
relationship between the price level and the quantity of goods and services supplied in
an economy in the period of time during which wages (the price of labour) and other
input prices are fixed, or inflexible.

In the short run, a nation’s output will vary with the level of AD; when AD increases,
the level of output will increase and when AD decreases the level of output will
decrease. Later in this chapter we will examine long-run aggregate supply (LRAS),
which is dependent not on the level of demand, but on the availability of resources in
the economy.

The SRAS curve

The term ‘short run’ in macroeconomics is defined as the ‘fixed-wage period’. At the
core of this concept is the debate over how long it takes prices and wages to adjust
to changes in demand. The fixed-wage period describes the period of time following
achange in AD or the price level over which the wage rate paid to workers in an
economy is fixed. Wages will remain fixed (or at least, relatively inflexible) in the short
run due to several factors, including labour contracts, minimum wage laws, the ability
for workers to collect unemployment benefits for a period of time after losing their
jobs, and the power of labour unions.

Owing to these and other factors, firms are unable to raise and lower wages quickly
in response to a macroeconomic shock such as an increase or decrease in AD, and
therefore workers are more likely to be hired and fired in the period following such a
shock rather than their wages simply adjusting to the level of demand in the economy.
269
 Variations in economic activity

Price level (GDP deflator price index)

No
Figure 14.9 Agg

S8
supply has a direct
relationship with price leve

o3
in the short run

600 800 1000

National output demanded
(real GDP, $ billion)

When the prices for which producers can sell their output rise, while the wages they
must pay their workers and the prices of other inputs remain fixed, producers will wish
to supply a greater quantity of goods and services due to the opportunity for higher
profits resulting from an increase in the price level. At lower prices levels, producers
will reduce the quantity of output they supply and reduce the amount of labour they
employ as the prospect of losses force suppliers to reduce output and employment.

This direct relationship is reflected in an upward-sloping SRAS curve, as seen in

Figure 14.9.
There is a positive relationship between price levels and real GDP. At higher price
levels, producers will supply a greater quantity of output. The corresponding
increase in employment causes the unemployment rate to decrease in the economy.
However, low unemployment is achieved in the short run only by accepting a
higher price level, therefore more inflation. The upward-sloping SRAS curve has
implications for policymakers that we will examine in more detail in later chapters:
in order to achieve a lower unemployment rate, policymakers may have to accept
a higher inflation rate, a trade-off that could result in negative consequences for
certain stakeholders in an economy.

Sticky versus flexible wages and prices

The SRAS curve is upward sloping because of sticky wages and prices. To better
understand the implications of sticky wages for a nation’s producers, look at the SUV
case study, which focuses on how a single producer would be likely to respond to a
sudden decrease in demand for its output.

Case sf \ cky wages

Assume that demand for luxury sport utility vehicles (SUVs) suddenly decreases.
‘Tekla’, a manufacturer of a popular model of SUV, the ‘Unibog’, is faced with a
collapse in demand.

270
 Tekla’s CEO must cut costs or face bankruptcy. In a world in which wages were
perfectly flexible, the CEO could simply reduce every worker on the Unibog
assembly line’s wage by, say, 30%, in order to ‘weather the storm’ of falling demand
for Unibogs. However, Tekla’s workers are unionised, and the union has threatened
astrike should the firm try to reduce wages. Additionally, there is a state-wide
minimum wage that prevents Tekla from cutting wages by 30%. Finally, the
government provides generous unemployment benefits, so many of Tekla’s workers
may choose to leave their jobs should their pay fall by 30% and simply collect
unemployment benefits while they search for a new job.

Tekla's ability to cut workers’ wages is limited by labour union power and
government regulations. Therefore, our CEO, facing ‘sticky wages’, must reduce
employment instead. Rather than lowering everyone's pay by 30%, the boss must
lay off 30% of the firm’s workers and reduce production numbers in order to cut
costs in the face of falling demand.

Now consider how sticky wages affect the national economy. In a country in which all
employers face the same constraints as the case study example, Tekla, falling output
prices will be met by falling employment and reduced output. In other words, in the
short run, when wages are sticky, there is a direct relationship between the price level
and the level of output and employment. Falling prices lead to less output and less
employment, while rising prices lead to more output and more employment.

What causes shifts of the SRAS curve?

A change in the average price level causes a movement along the SRAS curve. Any
factor that causes production costs to change will cause the SRAS curve to shift. When
any of the following changes, AS will cither decrease and shift inwards or increase and
shift outwards.
* Wage rates: Higher wages cause SRAS to decrease, lower wages cause SRAS
to increase.
* Resource costs: When rents for land, interest rates, or raw materials prices
increase, SRAS will decrease. Lower resources costs cause SRAS to increase.
* Energy and transportation costs: Higher oil or energy prices will cause SRAS to
decrease. Cheaper energy and transportation cause SRAS to increase. Changes in
energy and transport costs are referred to as supply shocks.
* Government regulation: Regulations impose costs on firms that can cause SRAS
to decrease. Reduced regulation makes it cheaper to produce output, increasing
SRAS.
* Business taxes/subsidies: Taxes are a monetary cost imposed on firms by the
government, so higher taxes will cause SRAS to decrease. A tax cut or increased
subsidies to producers reduce firms’ costs and cause SRAS to increase.
* Exchange rates: If producers use imported raw materials, then a weaker currency
will cause these to become more expensive, reducing SRAS. A stronger currency
makes imported raw materials cheaper and increases SRAS.

Ashift in SRAS results in a larger or smaller amount of output being produced at

every price level. Assume, for example, the government has reduced environmental
271
 Variations in economic activity

Price level (GDP deflator price index)

~S
o3
Figure 14.10 Reduced »
regulation would result in an
outward shift of the SRAS

o3
curve

800 1000 1200

National output demanded
(real GDP, $ billion)

regulations, making it cheaper for firms to produce their output as they are not
required to pay for costly waste-reduction and air purification technologies. As a
result of reduced regulation, the country’s producers are willing to produce a greater
quantity of output at every price level. The impact is an outward shift of the SRAS
curve, as seen in Figure 14.10.

The shift from SRAS to SRAS, reflects an increase in aggregate supply resulting from
reduced government regulation. Falling wages, lower energy prices, reduced business
tax rates, and a stronger currency would cause a similar increase in SRAS. Higher
wages, rising energy prices, increased regulation or taxation, or a weaker currency
would cause SRAS to decrease, as in Figure 14.11.
Price level (GDP deflator price index)
~S
s8

Figure14.11 Reduced P
regulation would lead to a
o3

decrease in SRAS

400 600 800

National output demanded
(real GDP, $ billion)
272
Owing to a depreciation of the currency, causing imported raw materials to become
costlier, SRAS has shifted inwards, resulting in a smaller quantity of national output
produced at each price level.
Our analysis above assumes that the wage rate (the cost of labour) is fixed, and
therefore firms will respond to varying price levels by changing their output and levels Video suggestion:
of employment. But what if wages were perfectly flexible, rising or falling depending You have read about it, now
you can review what you
on what happens to aggregate demand and the price level in the economy? According have just learned by watching
to classical economic theory, wages and prices are fully flexible in the long run, and avideo by the author!
therefore there is no trade-off between inflation and unemployment. In the next Simply lick here in
section we will examine the classical view of AS and a 20th-century interpretation of your eBook for a video
the model known as the Keynesian view.
on SRAS.

14.3 What are some alternative views of A

Learning comes
At the end of this section you will be able to:
* explain, using a diagram, why the monetarist/new classical model of the LRAS
is vertical at the level of potential output (full employment output)
* explain, using a diagram, how the Keynesian model of the AS curve has three
sections corresponding to different levels of spare capacity in the economy
* suggest what could cause shifts in supply according to these models.

It might seem odd that in the 21st century, almost three hundred years after the start
of the first Industrial Revolution, in an era of globalisation, high-speed internet,
instantaneous communication and connectivity between countries, and rising incomes
the world over, there is still debate about whether an economy’s output is dependent
or independent of the price level and the amount of demand in the economy. Yet,
alternative views of AS still persist, the result being that our model of AD/AS is
actually a hybrid model, in which there is not one, but two, AS curves.

What is the monetarist/classical view of LRAS?

The SRAS curve described above represents how producers will respond to changes in
demand and the price level in the fixed-wage period. However, over time, economists
observe that wages that were fixed in the short run are likely to become flexible in the
long run. In other words, even as things like unemployment insurance, minimum
wage laws, labour unions, and contracts contribute to sticky wages, over time,
following a change in AD, wages will become flexible, and either fall (if demand is weak
and the price level is low) or rise (if demand is strong and prices are high).

The LRAS curve shows the level of output achieved in an economy when wages and
prices are fully flexible and adjust to the economy’s price level. In a world of flexible
wages, a firm like Tekla would be able to maintain its level of output and employment
even as demand for Unibogs falls. In such a scenario falling prices would simply be
offset by a decrease in wages and other input prices. Sellers would maintain their ‘full
employment’ level of production and consumers would simply pay lower prices for
273
 Variations in economic activity

SRAS

Price level (GDP deflator price index)

~S
o3
Figure 14.12 In contrast to
the upward-sloping SRAS
curve, the LRAS curve is

o3
vertical

600 800 1000

National output demanded
(real GDP, $ billion)

their output. Workers would earn lower nominal wages, but since prices fall across the
economy as a whole, real wages and real output would not be affected.

In the case of a rising price level, firms would face higher wages and thus would not
be willing or able to increase their output as the price level rose. And while workers
nominal wages would increase, their real wages and the level of real output would
remain constant as all prices increased across the economy.
In the long run, all prices and wages are fully flexible, while in the short run some input
prices (namely wages) are fixed. A consequence of flexible long-run prices and wages is
the lack of a long-run trade-off between inflation and unemployment. The LRAS curve
is vertical at a country’s full employment level of output, or the real GDP that would
be produced when all resources are fully utilised and wages have fully adjusted to
the price level in the economy. Figure 14.12 shows a hybrid view of aggregate supply,
including both the upward-sloping SRAS curve and the vertical LRAS curve.
In Figure 14.12, the LRAS curve is vertical at an output of $800 billion, meaning
that once wages and price have fully adjusted and resources are fully employed, the
country should produce this much output, which is considered the full employment
level of output at which unemployment will settle at a natural rate. In the short run,
when wages are fixed, output will increase or decrease for the reasons outlined in
our Tekla example.

What is the Keynesian view of AS?

A third version of the AS curve is attributed to the depression-era economist John
Maynard Keynes, who recognised the downwardly inflexible nature of wages in the
short run, but understood that as an economy approached its full employment level,
the limited degree of spare capacity for increased production would drive wages and
other resources upwards, limiting potential output at a certain level.

Figure 14.13 shows the three-segmented Keynesian view of AS, on which there is
ahorizontal segment (at levels of output well below full employment, where there
274
 o Figure 1413 The
Keynesian AS curve has three
segments determined by
capacity

rGDP

is ample spare capacity in the economy), an upward-sloping segment (as output

approaches full employment, when spare capacity begins to decrease), and a vertical
segment (beyond full employment, where there is no further spare capacity).

Each level of output in Figure 14.13 corresponds with a different level of spare
capacity in the economy. Y, represents the economy’s full employment output level.
There is no spare capacity, meaning nearly all workers are employed and capital is
being used at maximum productivity. Any attempt to increase output beyond Y, will
only cause inflation, but no actual increase in output. In other words, beyond Y, AS is
perfectly inelastic. Any increase in prices will be met by no change in output due to the
lack of available resources needed to actually expand output.

Y, represents a level of output below full employment, at which there is some degree
of spare capacity available for increased output. However, the fact that resources
are close to being fully employed means that an increase from Y, to Y, will be
accompanied by a greater proportional increase in the price level. In other words,
between Y, and Y, AS is relatively inelastic. An increase in the price level will be met
with a proportionally smaller increase in output, due to the limited availability of
resources to expand output.
At Y, the economy is producing well below its full employment level. There is
considerable spare capacity in the economy, meaning that AS is nearly perfectly elastic.
Any increase in prices will be met with a proportionally large increase in output as
firms will scramble to hire the abundance of available workers and put idle capital
back into production to profit from the rising price level. At Y, the economy has a large
negative output gap, or a gap between what it is actually producing and what it could
produce if resources were fully employed. Video suggestion:
You have read about it, now
The Keynesian view of AS acknowledges that wages are downwardly inflexible, which you can review what you
have just learned by watching
explains the horizontal range of AS below full employment. However, at or beyond avideo by the author!
full employment wages are highly flexible and will rise to prevent an economy from Simply lick here in
producing beyond its full employment level, due to the fact that increases in demand your eBook for a video
for resources will be checked by the increasing scarcity and rising costs of resources, on long-run aggregate supply
limiting the nation’s potential output.
and the Keynesian AS model
275
 Variations in economic activity

PL SRAS

Figure 1414 Ouput

below or beyond full
employment is known as an
output gap

500 800 rGDP

($ billion)
Negative output
gap = —$300 billion

What are output gaps?

Inboth the hybrid SRAS/LRAS and in the Keynesian AS models, output can be shown
to take place either at full employment, below full employment, or, in the case of the SRAS/
LRAS model, beyond full employment.
The existence of output gaps results from a situation in which an economy is producing
atalevel of output below or beyond full employment. Assume, for example, that the
economy is producing at an output of $500 billion in Figure 14.14.

With the economy producing just $500 billion when it could be producing $800 billion,
an output gap of ~$300 billion exists. The economy is producing a level of output that
is $300 billion below what it would be if all resources were fully employed. The lower
price level of PL, explains why the output gap exists; at PL, firms cannot afford to pay
workers the expected wage rate they earned at the higher output and price levels of
$800 billion and PL . We can assume that this economy is experiencing sticky wages,
and that once wages adjust, output should return to the full employment level.

In the Keynesian AS model, a negative output gap can also arise because of sticky
wages. Figure 14.15 shows such a situation.
Owing to sticky wages, firms have reduced output and employment as the price level
has fallen to P,. The economy is producing below full employment and has spare
capacity in the form of idle workers and capital.

Positive output gaps are possible in the short run in the SRAS/LRAS model.
Figure 14.16 shows such a situation.

At $1 trillion the economy has a $200 positive output gap. How s it possible that
an economy can produce an output level that is beyond its full employment level?
According to the SRAS model, even at full employment an economy still has some
spare capacity, meaning some workers and capital will be available to hire and put
towards production. Given the stickiness of wages in the SRAS model, an increase in
276
 Figure14.15 Anegative
output gap is also possible in
the Keynesian AS model

V1 e rGDP

Negative output gap

the average price level (to PL, in Figure 14.16) will lead producers to wish to increase
output and employment, which they are able to do to a limited extent.
In contrast, the Keynesian model predicts that an economy producing at full
employment is unable to increase output due to scarcity of resources. In Figure 14.17 we
can see what will happen at price levels beyond that prevailing at the full employment
level in the Keynesian model.

The price level has risen, but output remains at Y,. Because resources are fully
employed, higher prices lead only to higher costs and no increase in output.
The competing views of AS offer economists and policymakers various models on
which to base their predictions of how an economy might respond to macroeconomic
shocks like changes in the level of AD, changes in resource costs, exchange rate

PL LRAS

« Figure14.16 Fositive
output gaps are possible in
the SRAS/LRAS model

800 1000 GDP

($ billion)
Positive output
gap = $200 billion
277
 Variations in economic activity

Figure 14.17 The Keynesian

AS model does not allow
output beyond the ful
employment level, instead
predicting price inflation

rGDP

variability, taxation, or subsidies, changes in interest rates, inflation rates, or other

variables. At the core of the debate between advocates of the SRAS model, the LRAS
model, and the Keynesian AS model is the extent to which wages and other costs of
production respond to changes in the price level.

To understand what might cause a change in the equilibrium price level and the
level of national output, we must combine our models of AD and AS to determine
‘macroeconomic equilibrium, which we will do later in this chapter. First, we'll look at
factors that can cause shifts in LRAS and the Keynesian AS curves.

What can cause shifts of the LRAS and the

Keynesian AS curves?
The LRAS curve corresponds to the production possibilities curve (PPC) because
they both represent maximum sustainable capacity, or full employment output. An
increase in a country’s maximum sustainable output will shift both the PPC and the
LRAS curves outwards.

Full employment output increases when there is an increase in either the quality or the
quantity of a country’s factors of production.

* Labour: An improvement in the productivity of labour or in the size of a country’s

workforce will increase a country’s maximum sustainable capacity, shifting the
PPCand LRAS curves outwards.
+ Land: An improvement in the efficiency with which land resources are used
through improved technology (better farming, mining, fishing, or logging
techniques) will increase the potential output produced on a fixed amount of
land. An increase in the amount of land available to a country (through territorial
expansion or land reclamation) will increase maximum sustainable capacity and
shift the PPC and LRAS curves outwards.
Capital: Technological improvements increase productivity in the
manufacturing, service, and primary (agriculture, mining, etc.) sectors of the
economy and increase the maximum sustainable capacity, shifting the PPC and
LRAS curves outwards.
278
 PL LRAS, LRAS,

Capital goods
< Figure 14.18 Shifts of LRAS
curve correspond to those of
the PPC
PPC, PPC,

Yo Vi rGDP Consumer goods

+ Entrepreneurship: Entrepreneurship refers to the willingness of individuals to

pursue creative and risky ventures aimed at providing new and unique products to
the marketplace. An increase in entrepreneurship or an influx of entrepreneurial
talent in a country will increase the economy’s maximum potential capacity and
shift the PPC and LRAS curves outwards.

An outward shift of LRAS and the PPC illustrate economic growth, or an increase in the
actual and potential output of goods and services in a country over time. In Figure 14.18
we can see the effect of economic growth in an AS model and in a PPC model.
In Figure 14.18 the country has experienced an increase in its potential output due to
an increase in the factors of production. In the LRAS model output increases from Y,
oY, (Y, = full employment national output), and in the PPC the curve has shifted
outwards, indicating a higher level of maximum sustainable output.
In the Keynesian model, a shift in AS can be seen as an increase in the potential output
achieved at the vertical range of aggregate supply, as seen in Figure 14.19.
A change in the quantity or quality of factors of production, improvements in
technology, or increases in efficiency could explain the shift in AS shown in Figure 14.19.
Atevery price level up to full employment the economy can now produce more output.

PL

« Figure14.19 An outward
shift of the Keynesian AS
curve results in an increase
in output at the vertical range
of AS

FE1 VFEZ rGDP

279
 Variations in economic activity

Beyond full employment future increases in output are impossible due to limited
resources, and only inflation will occur if producers attempt to further expand output.
Let us now combine our models of AD and AS to examine what determines
macroeconomic equilibrium.

14.4 What is meant by macroeconomic

equilibrium?

Learning outcomes
At the end of this section you will be able to:
+ explain, using a diagram, the determination of short-run equilibrium, using the
SRAS curve
+ explain, using a diagram, that if the economy is in equilibrium at a level of real
output below the full employment level of output, then there is a deflationary
(recessionary) gap
« discuss why, in contrast to the monetarist/new classical model, the economy
can remain stuck in a deflationary (recessionary) gap in the Keynesian model
+ explain, using a diagram, that if AD increases in the vertical section of the
Keynesian AS curve, then there is an inflationary gap
+ explain why, in the monetarist/new classical approach, the economy will always
return to the full employment level of output in the long run
* examine, using diagrams, the impacts of changes in the long-run equilibrium.

A country’s full employment level of output is its maximum sustainable output

assuming all resources are efficiently employed. The macroeconomic equilibrium real
output and price level, on the other hand, is what a country’s economy achieves at a
particular period of time given the level of aggregate demand and AS in the economy.
Macroeconomic equilibrium can occur below, at, or even beyond full employment.

What is short-run equilibrium in the AD and

SRAS/LRAS model?
Short-run equilibrium occurs when the aggregate quantity of output demanded and
the aggregate quantity of output supplied are equal, at the intersection of the AD and
SRAS curves. In Figure 14.20 the economy is in a macroeconomic equilibrium at an
output of $800 billion and a price level of 100.
Notice that at its current equilibrium, the country is also producing its full
employment level of output. The AD curve intersects the SRAS curve and the LRAS
curve in the same place. Resources are fully utilised and unemployment is low.
The short-run equilibrium output can be at the full employment level of output,
above it, or below it, depending on whether the economy is experiencing a negative
or positive output gap. A positive shock in AD (resulting from an increase in either
280
 PL

100
< Figure 14.20 Equilibrium is
at full employment output.
where AD = SRAS = LRAS

rGDP
£ (¢ billion)

consumption, investment, government spending, or net exports) causes output,

employment, and the price level to rise in the short run. Assume, for example, that
there is a depreciation of the currency, causing net exports to increase as foreigners
demand more of the country’s goods. The economy will move from an equilibrium at
full employment to a situation in which both the price level and output increase in the
short run, as in Figure 14.21.

Owing to a positive demand shock, the economy is temporarily producing at a short-

run equilibrium level of output that is beyond its full employment output. Notice that
the GDP deflator price index (used to measure the price level) has increased from 100
to 115, equating to a 15% inflation rate. The output gap between equilibrium output
and full employment level of output is also called an inflationary gap. The economy
is essentially overheating — the unemployment rate is lower than it would be at full
employment and inflation is higher than it should be.

« Figure1421 Short-run
equilibrium can be beyond
full employment in the case of
a positive output gap.

800 950

Output gap
281
 Variations in economic activity

Figure 1422 Anegative P

output gap, resulting in
output below full employment
level, is also called a
recessionary gap

rGDP
e ($ billion)
Output gap
=—$150 billion

Next let us assume there is a negative demand shock due to an increase in income
taxes and reduced government expenditures. A fall in private and public spending will
cause AD to decrease. Figure 14.22 shows the effect ofa negative demand shock on
macroeconomic equilibrium.

Owing to sticky wages, firms are forced to lay off workers and reduce their output as
the price level falls from 100 to 85. Costs must be cut in the face of falling prices, and
the only way to reduce costs is to reduce output and employment since wages cannot
be lowered in the short run. The fall in output causes a negative output gap (also
called a recessionary gap) of $150 billion, representing the amount by which equilibrium
output is below the country’s full employment output.

Inflationary and recessionary gaps are short-run phenomena arising because wages are
sticky. In the case of AD increasing to create an equilibrium beyond full employment,
firms must compete for the limited number of available workers in order to increase
output in response to increased demand and rising prices. While wages remain fixed,
firms demand more labour and increase their output in the short run.

What is long-run equilibrium in the AD and

SRAS/LRAS model?
In the long run, nominal wages will begin to rise following a positive demand shock
or fall following a negative demand shock. In the case ofa positive output gap,
workers will have more bargaining power as the labour market tightens and they
will begin to demand pay hikes to keep up with the rising prices. As the nominal
wage rate rises, firms will find it less and less attractive to continue employing more
workers and some firms will be forced to cut back on output and employment.
Notably, as the nominal wage rate is a determinant of SRAS, it will decrease in
the long run, pushing prices up further and causing output to fall back to its full
employment level. Figure 14.23 shows how the economy will adjust in the long run
following an inflationary gap.
282
 PL
SRAS,

< Figure 1423 The long-run

adjustment following a
positive demand shock ends
with limited output and a rise
in prices

AD,

GDP
800 950 ($ billion)

The initial increase in output to $950 billion proved unsustainable as tight labour
markets led to rising wages and a reduction in output and employment back to the full
employment level of $800 billion. The price level is driven up initially by rising AD,
and then by decreased SRAS caused by rising nominal wages. In the long run, output
is limited by the available stocks of land, labour, and capital. The short-run boost in
output caused by stronger export demand proves temporary as the economy is unable
to sustain its higher output due to limited resources.
The process of self-adjustment following the positive demand shock described above is
the result of the flexibility of wages in the long run. An economy will return to its full
employment level of output following any shocks to AD or AS once wages and other
input costs have adjusted to the price level. A similar story unfolds following a negative
demand shock and a recessionary gap.

A recessionary gap will likewise be resolved in the long run once wages have adjusted
to the lower price level. Going back to our negative demand shock resulting from a
tax hike and decreased government spending, we can assume that in the long run the
excess supply of labour resulting from the fall in equilibrium output and employment
will eventually lead to a fall in the nominal wage rate. As government benefits for
unemployed workers expire and labour unions lose their bargaining power, new
contracts offering lower wages will eventually be accepted and firms will once again
begin hiring workers and increasing output due to the falling costs of production.
Figure 14.24 shows how an economy will self-adjust from a recessionary gap. Video suggestions:
You have read about it, now
The recession caused by the fall in AD eventually comes to an end as wages decrease in you can review what you
the long run, causing SRAS to increase. Firms rehire workers who are now willing to have just learned by watching
accept lower wages, restoring output to its full employment level. While the nominal a few videos by the author!
wage rate falls, real income and output return to full employment as lower wages are
Simply click here in
your eBook for videos
offset by lower prices across the economy. on short-run equilibrium in
the AD-AS model, demand
A country’s equilibrium level of output can be above or below its full employment and supply shocks in the
output in the short run, creating inflationary or recessionary gaps. However, in the AD-AS model, and long-run
long run, when wages and other input costs have fully adjusted to the price level, equilibrium in the AD-AS
national output will return to its full employment level. This process of self-adjustment
model
283
 Variations in economic activity

PL

Figure14.24 Thelong-run P
adjustment following a
negative demand shock
restores full employment, with
lower wages offset by the
lower price level

650 800 r GDP

($ billion)

is the foundation of the classical theory of LRAS, which as we have shown is vertical at
full employment output. In the long run there is no trade-off between unemployment
and inflation. The unemployment rate will always settle at a ‘natural rate’ (a concept to
be explored in Chapter 15), even as inflation rises and falls with changes in the level of
aggregate demand.

What is equilibrium in the Keynesian model?

The Keynesian model offers a slightly different prediction of what will happen to an
economy that experiences an output gap. First of all, we must remember positive
output gaps are not possible in the Keynesian model. An economy at full employment
that experiences a positive demand shock will see inflation, but no increase in output,
due to the upward flexibility of wages in an economy where resources are already fully
employed. Figure 14.25 illustrates the outcome of such a scenario.

PL

Inflationary
gap
Figure 1425 Any positive Py
demand shock results in an
inflationary gap according
10 the Keynesian model

284
 « Figure14.26 In the case of
a negative demand shock, the
Keynesian model predicts
persistent recession

rGDP

Unemployment

Greater demand has caused a negligible increase in output (which remains around Y,))
but a substantial rise in inflation.
‘Wages are flexible upwards, but sticky downwards, which means following a negative
demand shock, the economy s likely to end up ‘stuck’ in a recession, as seen in Figure 14.26.
‘When AD falls, the economy experiences a decrease in output and a rise in
unemployment. Unlike the classical LRAS model, the Keynesian model assumes wages
will remain sticky, even in the long run, preventing the economy from self-adjusting.
For this reason, Keynes predicted economies in recession could remain stuck in a
deflationary|recessionary cycle where falling employment leads to falling incomes,
reducing consumer confidence and household incomes, causing demand to fall
further. Uncertainty and pessimism prevail across the economy, leading businesses to
reduce investment, further exacerbating the economic slump.

14.5 What are the assumptions and

implications of the models?

Learning comes
At the end of this section you will be able to:
* explain that the Keynesian approach to macroeconomics is one of ‘demand-
management’ to promote macroeconomic objectives such as full employment
* explain that the monetarist/new classical model of the economy implies that
a ‘laissez-faire’ approach to the economy is best.

285
 Variations in economic activity

The persistence of recessions and inability of economies to self-correct is the defining

distinction of the Keynesian model from the monetarist/new classical, LRAS model.
Some context to Keynes's theories might help understand this profound difference.
Keynes’s model was based on his observations of the economies of Europe and North
America during the 1930s, when the Great Depression saw unemployment rates of
up to 25% persist for years across the developed world. Despite the predictions of the
classical theorists like Say and Smith, wage flexibility never prevailed, and the world’s
economies remained trapped in the vicious cycle of deflation and unemployment for
years on end.

One implication of the Keynesian model, as we will see, is that an economy left to
its own devices, reliant on the ‘free market mechanism’ of prices to send signals
to producers and consumers, may not be enough to manage fluctuations in the
business cycle over the long term. Keynesian economics, to this day, approaches
macroeconomic policy with an activist mindset. Under this approach governments
must do more than just create an environment where markets can thrive. They must
look for instances where the market fails to achieve the efficiency and flexibility
necessary for full employment to prevail, and in such instances governments must
intervene to manage the level of aggregate demand, stimulating it or contracting
Macroeconomists in the
itin order to avoid the two evils apparent in the Keynesian model: persistent
21st century tend to align unemployment, recession, and deflation on one hand, and uncontrolled inflation on
themselves with either the the other.
Keynesian, demand-side
school of macroeconomic Keynesian economics is sometimes referred to today as ‘demand-side’ economic
thought or the new theory, since in the Keynesian view an economy’s ability to achieve and maintain full
classical, supply-side
school of thought. To employment is dependent upon managing the level of demand in the economy, since
what extent do political sticky wages will prevent AS from rising or falling to meet the level of demand at the
beliefs and ideologies, full employment equilibrium.
such as the debate over
whether government The monetarist/new classical models of SRAS and LRAS, on the other hand, predict
can solve problems or that, at least in the long run, flexible wages and prices will allow an economy to
whether government is
the problem, influence self-correct from any macroeconomic shocks it may experience. Therefore, the best
a persorts preference approach policymakers can take to ‘managing’ the economy may just be to not try and
for one school of manage it at all. The supply-side, ‘laissez-faire’ (let it be) school of economic thought
macroeconomic thought is one embraced by small government, conservative-minded government officials and
over another? Discuss.
policymakers the world over.

Case study - the global recessions of 2020

The global recessions of 2020 were crises of both AD and AS. As governments shut
down their economies and issued stay-at-home orders during the first wave of the
pandemic, both AD and AS experienced unprecedented shocks.
1 Using an AD/AS diagram, illustrate the effect on equilibrium output of
government orders that forced all but ‘essential’ businesses to close during the
months of April and May.
2 Onthe same diagram as above, illustrate the effect of the stay-at-home orders
which limited consumers’ ability to engage in normal patterns of consumption.

286
One of the first responses of governments in Europe and North America during the
economic shutdowns was the expansion of unemployment insurance programmes
aimed at providing workers in non-essential businesses with incomes during the
shutdown.
3 How did the extension of unemployment benefits contribute to the stickiness of
wages during the pandemic?
4 Using a Keynesian AD/AS model, show the impact that the extension of
unemployment benefits would have likely had on equilibrium output and
employment in the months following the shutdowns of spring 2020.
As summer 2020 unfolded and the world's economies began returning to some
semblance of ‘normal’ the debate among government policymakers turned to the
extent to which additional government support was required to help struggling
households and firms during what was expected to be an unsteady economic
recovery. Two schools of thought emerge: One (let us call it side A) argued that
continued support of struggling workers and businesses was essential to prevent
the economy from becoming trapped in a longer than necessary recession. The
other (side B) argued that rolling back government support was essential to
speeding the economic recovery.
5 Which of the sides of the debate over the best policy response represents a
Keynesian view of the economy, A or B? Which represents the monetarist/new
classical ‘supply-side’ view? Explain.
6 Using two different AD and SRAS/LRAS models, explain and illustrate the
desired long-run economic outcomes as envisioned by those arguing:
a. SideA
b. SideB.

Practice exam questions

la. Using the Keynesian AD|AS diagram, explain why an
economy may be in equilibrium at any level of real output. (10 marks)
b. Evaluate the view that an economy will always self-correct
following a negative output gap. (15 marks)
2. Explain how an increase in the level of taxation can
influence the level of aggregate demand in an economy. (10 marks)
3. Using an AD/AS diagram, explain one reason why
deflation may lead to a higher level of unemployment. (4 marks)
4. Assume an economy is currently producing at its full
employment level of national output. Using an AD/AS
diagram, explain the effect of a decrease in real interest
rates on equilibrium national output in the short run
and in the long run. (10 marks)
5. Evaluate the view that an increase in aggregate demand
will always correspond with an increase in national output. (15 marks)
6. Explain how a rise in consumer confidence and business
confidence might affect equilibrium national output. (10 marks)

287
Macroeconomic
objective: low
unemployment
The level of employment is a critical indicator of an economy’s overall health.
Therefore, low unemployment is a primary macroeconomic objective of policy
makers the world over. Employment is viewed as a measure of overall economic
well-being because wages from work are most households’ primary source of income,
and national income is a measure of living standards.
Changes in unemployment can be rapid, and can cause major social disruption as
aresult. While some forms of unemployment may be accepted as normal, rising
unemployment levels can threaten the interdependence of the economy’s circular
flow. As fewer people have jobs, spending on goods and services falls, thereby reducing
revenues for firms. Such events inspire governments to stage forms of intervention to
reduce the causes and effects of unemployment.
1
.1 The meaning of un

Learning outcomes
At the end of this section you will be able to:
* explain what is meant by unemployment
* define the unemployment rate
* explain how the unemployment rate is calculated
« calculate the unemployment rate from a set of data
* explain the difficulties in measuring unemployment, including hidden
unemployment and unemployment rate disparities by subgroups.

What is the unemployment rate and how

is it calculated?
From an economic perspective, to be unemployed means that you are actively seeking
but unable to find work. A person who is not working is not necessarily unemployed.
According to the United Nations International Labour Organization (ILO), to be
considered unemployed in an economic sense a person must ‘be out of work and
willing to accept a suitable job or start an enterprise if the opportunity arises, and
actively looking for ways to obtain a job or start an enterprise’.
Governments monitor the level of unemployment by calculating the unemployment
rate, which is found by dividing the number of unemployed people by the labour force
then multiplying by 100 to establish a percentage.

number of unemployed 2
Unemployment rate (%) = 100
labour force
According to the World Bank, a country’s labour force is the sum of employed and
unemployed persons aged 15-64 (although the exact age range may vary from nation to
nation). Persons who are neither employed nor seeking employment are not in the labour
force; this includes retired persons, full-time students, those taking care of children or
other family members, and others who are neither working nor seeking work.
289
 Macroeconomic objective: low unemployment

Examples of people who are part of the labour force include the following.

* A part-time retail sales clerk, who is also going to college, is part of the labour force
because she is employed.
A full-time nurse is part of the labour force because he is employed.
A factory worker whose plant closed and who is applying for jobs at other firms is
part of the labour force because she is unemployed.
* Arecent college graduate interviewing at different companies for his first job is part
of the labour force because he is unemployed.

Examples of people who are not part of the labour force include the following.

* Astay-at-home parent is not part of the labour force because he or she is not
employed nor seeking employment.
* A college graduate who volunteers in a community centre is not part of the labour
force because, although she is working, she is not formally employed nor is she
seeking employment.
* Adiscouraged worker who has been looking for a job for 18 months but has given
up the job search is not part of the labour force because he is no longer seeking
employment.
* Anengineer who goes back to school to earn a teaching degree is not part of the
labour force because she is not currently secking employment.

Figure15.1 Avera Figure 15.1 shows average unemployment rates over the years 2018-20 for 17
unemployment rate developed and developing countries. National governments employ their own means
17 selected developed of collecting unemployment data, but the Organisation for Economic Co-operation
developing countries, 2018
and Development (OECD) uses the method devised by the ILO. Therefore, the data in

29.8
 Figure 15.1 can be compared with confidence despite the fact that the figures reported ]
by each individual nation may vary due to different methods of collection. For alarger set of data,
search online for data from
Unemployment rates vary across countries depending on the current macroeconomic the World Bank and find
conditions and institutional factors in each, such as the existence of social safety nets, the unemployment rates
the education levels of the workforce and the evolving structures of the economy, and compare them for the
among others. following groups.
+ Home region: find the rates
for your home country and
two nearby countries.
Worked example 1 Low income: find the rates
for three low income
In 2019, Brazil's labour force totalled approximately 106 million people. countries,
The number of people of working age, but who were unable to find work High income: find the
(the unemployed) in Brazil totalled 12,751,800. rates for three high income
countries.

What is Brazil's unemployment rate? For discussion and debate:

number of unemployed Sl 1 How wide is the variance
Unemployment rate (UR) = 00 between them?
B R labour force 2 What might account for
those differences?
_ 12,751,800 % 100
106,000,000

=12.03%

What are the difficulties in measuring unemployment?

Itis often the case that
Methods of data collection fwo or more economists
The source and method of calculating the unemployment rate can vary observing an identical
significantly, affecting the degree of comparability between countries. One method set of macroeconomic
data (such as the
is to report unemployment claims. Another is to rely on survey data of thousands
unemployment rate for a
of people. Counting unemployment benefit claims may undercount the actual rate particular country), arrive
of unemployment, especially during prolonged recessions, which may last longer at very different
than the period of time government provides benefits to unemployed workers. explanations of events.
Survey methods are often considered more reliable but may also miss marginal How can an ability to
understand different
populations (immigrants, undocumented workers) that are unlikely to be captured perspectives account for
by household surveys. this difference?

Disparities by group
Subgroups within the broad population may have higher or lower unemployment
rates than the overall national figure.
+ Regional disparities: Larger countries tend to have greater variance than smaller
ones. Turkey is among the countries with the largest variance, with a 20-point
difference between regions with the lowest and highest rate.
« Ethnic/racial disparities: Unemployment rates are typically higher among
ethnic minorities, especially those that have experienced formal and informal
discrimination. Countries that identify indigenous populations typically also
report higher unemployment rates among those populations.

291
 Macroeconomic objective: low unemployment

* Gender variance: The ILO reports that globally approximately 75% of men
participate in the labour force, compared to only 50% of women. Many women,
therefore, may not have work but are not counted in the official unemployment
figures (see below). Officially, the unemployment rate for women is 6.1% while for
men it is only 5.1% (ILO). However, this varies tremendously by country. Algeria
reports that unemployment for women is twice as high as for men, while Saudi
Arabia reports four times the level of unemployment for women as for men.
(Source: OECD. https:/jwwiw.oecd-ilibrary.org))

What is ‘hidden unemployment’?

The true level of joblessness can be masked by the specific rules guiding the
calculation of the unemployment rate: what is left uncounted is considered hidden
unemployment.

Workers leave the labour force

Any unemployed worker who leaves the labour force may still be without a job, but
will not be counted as unemployed. At times, this leads to the unemployment rate
significantly undercounting the actual number of jobless. People leave the labour force
for many reasons, including:

* Forced retirement: Workers above the age of 50 may find it difficult to find
employment and retire ‘early’.
* Return to school: Some choose to go back to school for more training rather than
compete in a bad labour market.
Family childcare: In countries without subsidised childcare, workers may decide
their low wages are not sufficient to cover child care costs and so decide to stay at
home.

Discouraged workers
Especially during recessions, when the number of cyclically unemployed people
grows dramatically, workers may find it difficult to find new jobs. Whatever their
motivations, when discouraged workers stop looking fora job, they leave the labour
force, and are therefore no longer considered unemployed. These people, when
added to the official figures, can raise the ‘true’ level of unemployment by several
percentage points.

Part-time workers still technically employed

A worker paid for one hour of work per week is still considered employed, even if
that worker is seeking a full-time job. The official unemployment rate will not show
the degree to which workers seeking full-time employment can only find part-time
work.

The quality of employment is unknown

Unemployment figures do not reflect the level of wages or the working conditions of
acountry’s labour force. Developing countries with few social services may have low
unemployment rates, yet their workers may experience a high level of poverty relative
to workers in richer economies, simply because the alternative is absolute poverty, or
the state of being unable to afford even the basic necessities of life.
292
Underemployment Video suggestions:
The unemployment rate does not reflect the degree to which qualifications match You've read about it, now

actual jobs. Highly skilled workers working low-skills jobs (engineers working as you can review what you've
justlearned by watching a
housekeepers) are examples of such underemployment. Countries with a poor match few videos by the author!
often have workers shifting to informal and temporary work to earn money. Simply lick here in
your eBook for videos
on the limitations of the
unemployment rate.
Calculate the missing values in this table of labour market data.

Country Labour force | Number of unemployed | Unemployment

(millions) (millions) rate (%)
L T
Germany 43.5 13 You can research the gender
unemployment gap in your
Tunisia 0.64 16 country by using the online
South Korea 283 41
tool provided by the ILO.
For discussion and debate
Mexico 57.1 1.94 1 Isit higher or lower than
the world' average gap?
If higher, what legal and

~
cultural factors may have
contributed to this result?

If lower, what legal and

cultural factors may
influence this result?
.earning outcomes

At the end of this section you will be able to:

+ explain, using a diagram, how the labour market sets the equilibrium wage and
quantity of labour
describe, using examples, the meaning of frictional, structural, seasonal, and
cyclical (demand-deficient) unemployment
« distinguish between the causes of frictional, structural, seasonal, and cyclical
(demand-deficient) unemployment
+ explain, using a diagram, how a deflationary gap causes cyclical unemployment
+ explain, using a diagram, that structural unemployment is caused by changes
in the demand for particular labour skills or changes in the geographical
location of industries
+ explain, using a diagram, how labour market rigidities, such as a minimum
wage, contribute to structural unemployment
+ explain that the natural rate of unemployment (NRU) is composed of
structural and frictional unemployment
* evaluate government policies to reduce the different types of unemployment.

What is the labour market?

Alabour market is where households and firms meet to buy and sell labour. In the real
world, labour markets are not tangible places, rather they exist for different industries
where there are employers looking to hire workers and households looking for jobs.

293
 Macroeconomic objective: low unemployment

An example of a labour market is that for international school teachers: around the
world there are thousands of international schools that employ tens of thousands of
teachers across all subject areas.

In the market for any particular type of labour, it is households that provide workers to
an industry and firms that demand workers. In Chapter 7 we studied product markets,
in which households are the demanders and firms are the supplier. In labour markets,
which are an example of a factor market, the roles are reversed. The supply curve
therefore reflects the willingness of households to provide workers to a particular
market at a range of wage rates (the price of labour) and the demand curve represents
the willingness of firms to hire workers at a range of wages.
Consider our example, one with which you might relate, of the market for
international school teachers. In the international teacher marketplace the buyers,
representing the demand for labour, are international schools and the sellers,
representing the supply of labour, are households whose family members are willing
and able to teach in international schools. Much like in a product market, there is a
“price’ for labour, which is called the wage rate, and there is a quantity of labour, which
can be interpreted as the number of workers currently employed or the total number
of hours worked, depending on how you look at it.
The equilibrium wage rate and quantity of labour employed in any particular market is
determined by the demand for and supply of labour at any given time. In Figure 15.2
the demand for labour (DL) represents how many teachers all the international
schools are willing and able to employ at a range of wage rates. At higher wage rates,
the number of teachers demanded is lower, as schools will choose to have larger class
sizes or offer more online classes due to the high cost of employing teachers. However,
at lower wage rates the number of teachers demanded is much greater, and schools
will have much smaller class sizes and opt for more face-to-face classes due to the
comparatively low cost of employing teachers. In other words, there is an inverse
relationship between the wage rate and the quantity of labour demanded.
Labour supply (SL), representing all households who might be willing to enter the
international teaching field, is up-sloping, reflecting the direct relationship between the
wage rate and the quantity of labour supplied. At higher wages more people are willing
to become international teachers, due to the comparatively high income relative to
Wage rate

WR,
Figure 152 Market for
international school teachers

Q. Quantity of labour
294
other professional fields. At lower wage rates, fewer people are willing to teach in
international schools, since other careers will appear more attractive due to the low
wage offered to teachers.
As in all markets, the equilibrium level of employment (Q,) and wage rate (WR,)
are where the demand and supply meet. Later in this chapter we will learn that
unemployment arises due to a disequilibrium in the labour market, or when the wage
rate does adjust efficiently to the level of demand for and supply of a particular type
of labour, resulting in structural unemployment. But first we will look at a type of
unemployment that can occur in a nation as a whole, not just in a particular labour
market. For this we use the AD/AS diagram, and then we will use the labour market
diagram to demonstrate changes in a particular labour market.

What happens when demand for all types

of labour decreases?
Cyclical (demand-deficient) unemployment
Without question, the type of unemployment that poses the greatest problems
and, therefore, the one which policymakers attempt to avoid at all costs is cyclical
unemployment. Cyclical unemployment affects all types of labour, not just workers in
a particular labour market. Workers whose skills are in demand given the structure of
the nation’s economy but who lose their jobs because of a fall in total demand for the
nation’s goods and services are cyclically unemployed.
Cyclical unemployment arises due to fluctuations in the nation’s business cycle.
Itis also referred to as demand-deficient unemployment (simply meaning workers
lose their jobs because of weak demand). Cyclical unemployment occurs when a
contraction in private or public spending (consumption, investment, government
spending or net exports) reduces aggregate demand and leads to a fall in national
output. Reduced output requires fewer workers, and so firms lay off workers.

The most dramatic example of cyclical unemployment in the modern era is almost
certainly the increase in joblessness that resulted from the decline in economic activity
accompanying the spread of the novel coronavirus, SARS-CoV-2, and the resulting
COVID-19 pandemic of 2020. Most of the decade preceding the onset of the global
pandemic had been characterised by growing economic output and record low
unemployment rates the world over; but within the span of a couple of months, across
countries both rich and poor, the unemployment situation rapidly deteriorated as
economies were shut down and consumers forced to stay at home.

In the two months between February 2020 and April 2020, unemployment in the
United States went from a near historic low of 3.5% to the highest level the country
had seen since unemployment statistics began being measured in the 1950s, at 14.7%
(Figure 15.3). Nearly 20 million Americans lost their jobs in the first two months of
the COVID-19 pandemic: the result not of any shift in the structure of the American
economy nor by the decision of millions of people to quit their jobs in search of another
job, rather because of a massive fall in the total demand for goods and services brought
on by the mandatory stay-at-home orders imposed on the citizens of all 50 states.
A public health crisis aside, cyclical unemployment is normally the result of more
regular fluctuations in an economy’s business cycle. For example, the last global
295
 Macroeconomic objective: low unemployment

150
— Unemployment Rate April 2020 - 14.7% 1
125
§10.0 ~——a_
Figure153 US 38 75 \\‘
unemployment rate, February 2020 - 3.5%
2010-20 50 N
25
Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

recession of 2008-9 saw unemployment rise around the world as household wealth
declined amid a collapse in housing prices, triggering a decrease in aggregate
consumption across Europe and the United States. Between 2009 and 2013 the Greek
economy saw unemployment climb from 8% to 27%, largely as a result of a debt crisis
that required the Greek government to massively reduce its public sector spending.
In other cases, cyclical unemployment can result from declines in private sector
investment or in response to falling exports.

In other words, cyclical unemployment arises whenever workers lose their jobs not
because of a lack of skills, a change in the composition of the economy’s output or any
other structural shifts in the economy, rather because of a decline in either household
consumption (as was the case in 2009 and 2020), government spending (Greece between
2009 and 2013), private sector investment, net exports or any combination of these.

Cyclical unemployment arises because of the short-run ‘stickiness’ of wages illustrated

by the upward sloping short-run aggregate supply curve. When aggregate demand
falls, firms are forced to reduce the level of employment rather than simply reducing
wages to offset the decline in revenues resulting from falling sales. Recall that wage
‘stickiness’ simply refers to the fact that wages are not perfectly responsive to changes
in demand for labour due to things like labour contracts, minimum wage laws, the
ability for workers to collect unemployment benefits from the government, and the
influence of labour unions in wage negotiations. The result of wage rigidity is that even
as demand for labour falls during a recession, firms are unable to slash wages and must
lay workers off instead. The result is cyclical unemployment.

Cyclical unemployment is shown in an aggregate demand (AD)/aggregate supply (AS)

model as the gap between equilibrium national output and full employment national
output when a deflationary gap exists following a decrease in AD.

In Figure 15.4 aggregate demand has fallen from AD to AD1 due to a contraction in
either consumption, investment, government expenditures or net exports. Falling
demand leads to a decrease in the price level from PL_ to PL, and a decrease in
equilibrium output from Y, (full employment national income) to Y, (equilibrium
national income, which in this case is below full employment).
The notion that wages tend to hold steady during a recession originated with the
Keynesian explanation of the Great Depression of the 1930s, and has several rationales.

1 Firms choose to fire some workers and retain the rest at full wages to avoid the
morale reducing effect of lower wages.
296
 « Figure15.4 Keynesian
model: a deflationary gap
causes cyclical unemployment

Y, Y, Real GDP
S
Deflationary gap

2 Unemployment benefits may reduce the need for workers to automatically take
any lower-paying job after being laid off.
3 Unions can negotiate wages that are higher than average, and may also lock firms
into those wages for several years at a time, regardless of a sudden recession.
Because of this wage stickiness, the equilibrium wage holds for some time, creating a
surplus of workers in the economy, otherwise known as cyclical unemployment.

1f wages were perfectly flexible, the economy would be able to maintain output at the
full employment level even as aggregate demand decreased. Recall that the monetarist/
new classical view of aggregate supply assumes that wages are perfectly flexible and
thus the economy is always at its full employment level of output. Figure 15.5 shows
that in a world of perfectly flexible wages and prices, a fall in aggregate demand
would result in no change in output and employment, but a much larger decrease in

PL LRAS

« Figure15.5 Neo-classical
model: flexible wages and
prices allow the econommy to
remain at full employment
when AD falls

Real GDP

297
 Macroeconomic objective: low unemployment

PL LRAS
SRAS
SRAST

Figure 15.6 Cyclical »

unemployment is eliminated PL femnnmnnnesNCeee y
in the long run when wages
fall and the economy PL feremnnmeees
self-corrects PLfemeeees )

: AD

AD1
¥, W Real GDP

the aggregate price level, as workers’ nominal wages are slashed in response to weak
demand, while employment and output remain at the full employment level.

However, in the real world wages are sticky in the short run, therefore a disequilibrium
results in the nation’s economy when aggregate demand decreases: as demand for output
and workers decrease, wages remain stubbornly high, therefore firms must lay workers
off to reduce their costs in the short run. In the long run, cyclical unemployment may be
reduced as wages adjust to the decreased demand across the economy.
Only over time, whatever period it takes for wages to fall, will cyclical unemployment
begin to decrease and the economy settle at a new, lower wage rate, while employment
recovers. Recall from Chapter 14 that in the long run an economy self-adjusts following
anegative demand shock; high cyclical unemployment puts downward pressure
on wages, and as wages fall the quantity of labour demanded increases, causing
employment and output to slowly increase back towards the full employment level.

Figure 15.6 shows the self-adjustment that takes place to reduce cyclical
unemployment in the long run following a demand-deficient recession. In later
chapters, we will explore government interventions that could help either avoid
cyclical unemployment altogether or help reduce it without having to wait for wages
to decrease in the long run, an outcome based more in classical/monetarist economic
theories than in observations of real world economic outcomes.

What happens when demand for a particular type

of labour decreases?
Structural unemployment
We have just learned about the most harmful type of unemployment: that which
results from a demand-deficient recession. Workers can also find themselves
unemployed for reasons other than a decrease in aggregate demand. When a worker
loses her job due to the changing composition of the nation’s economy, the individual
becomes structurally unemployed. Structural unemployment is a form of involuntary
unemployment among workers whose skills are no longer in demand. Automation
298
 may replace workers with technology. Firms may move operations ‘off-shore’,
outsourcing production to lower-cost countries. Shifts in technology may make some
jobs, and the skills for producing them, irrelevant.

Structural unemployment arises when demand for a certain type of labour decreases, as
opposed to demand for all labour decreasing (as in the case of cyclical unemployment).
As with cyclical unemployment, however, the stickiness of wages is at the core a cause
of structural unemployment, as we will see below.
An example of structural employment occurs when a developing country moves from
an agricultural base to a manufacturing base. New farming techniques are less labour
intensive and more capital intensive. Farmers whose skills were passed down through
generations find themselves unemployed as their old techniques for tilling the land are
replaced by new technology. Likewise, as a more developed nation transitions from
amanufacturing base to a larger service sector, factory workers’ skills may no longer
be in demand, while the demand for highly educated and highly skilled ‘knowledge
workers’ increases.

In both of these examples, the nation as a whole is getting richer as productivity

grows and the country shifts from the primary to the secondary and tertiary sectors.
However, structurally unemployed workers typically face a longer path back to gainful
employment, and government intervention sometimes is desirable.

Structural unemployment is shown using a labour market diagram, as in Figure 15.7.

Initially, textile production in South Korea pays US$10 per hour and Q. is the
equilibrium quantity of labour. The demand for textile workers in Korea decreases
from DL1 to DL2; this is caused by structural factors such as the relocation of
textile factories to lower-cost production in China or Morocco or the increased
use of automation in textile manufacturing. The decreased demand for labour puts
downward pressure on wages, but due to institutional factors outlined earlier in this
chapter the wage rate remains stuck at US$10, resulting in a disequilibrium in the
labour market as the number of workers demanded falls to Q4 while the number of
workers wishing to work remains at Q..
Wage rate

$10F----
o Figure15.7 Market for
textile workers: structural
unemployment arises when
demand for labour falls

Quantity of labour

Unemployment
299
 Macroeconomic objective: low unemployment

Because textile wages in South Korea cannot fall to the level required to ‘clear the
market’ (that is, firms decide it is once again worth hiring back unemployed workers,
who are now more competitive compared to overseas workers or compared to
technology), textile jobs will leave the country and relocate to lower-wage economies.
Previously employed textile workers in South Korea have become structurally
unemployed. If they wish to work again they must either accept a wage rate
competitive with what workers in China or Morocco earn or learn skills that will allow
them to gain employment in an industry in which labour is still in demand at the wage
rates expected of workers in South Korea.
Structural unemployment can be resolved by the free market when one of two things
happen: either the equilibrium wage rate in the affected industry must fall to a level
that ‘clears the market’, or the supply of labour
in the industry must decrease until the
quantity of labour supplied once again equals the quantity demanded at a wage rate
that workers are willing to accept. For supply to decrease, structurally unemployed
workers in the affected industry must leave that industry and either exit the labour
force or seek employment in another sector.
The emergence of structural unemployment in an economy may at first seem
incredibly undesirable, as those who have been ‘made redundant’ are the unfortunate
victims of economic change. However, structural unemployment is considered a
‘natural’ form of joblessness as it is expected that as a nation grows, its production will
become more capital intensive and it will incorporate into the global economy, causing
both a change in the makeup of its output and the types of skills demanded of its
workers. Generally, however, the existence of structural unemployment accompanies
economic growth and an increasingly diverse and globalised national economy, thus it
is both natural and desired.
Economists view unemployment derived from an effective minimum wage as part of
structural unemployment as well. Recall from Chapter 9 that putting a price floor on
labour can cause unemployment. Figure 15.8 shows a labour market diagram in the
Wage rate

$15
Figure 15.8 Market for >
retail employees with a
minimum wage 1

A
Unemployment

300
market for retail shop workers who before government intervention were earning an
equilibrium wage rate of US$11 per hour. The government has established a minimum
wage at US$15.
The imposition of $15 minimum wage has caused a movement up and to the left
along the demand for labour curve from Q_ to Q,, as the quantity demanded for retail
workers has fallen. At the same time, more workers are drawn into the labour market
by the higher wage, shown by a movement upward along the supply of labour curve,
from Q, to Q,. With retail businesses demanding fewer workers while more people
desire to work in retail, there emerges a disequilibrium in the labour market, resulting
inunemployment of Q, - Q,.
Unlike with cyclical unemployment and most kinds of structural unemployment, a
minimum wage causes unemployment to increase not because of a fall in demand for
labour, but because of a government intervention that is intended to help workers.
‘While some workers are indeed made better off (those who are still employed at Q, in
the market above), some are inevitably harmed (those who are left without a job at the
higher wage).
Strategies for reducing structural unemployment include increased worker training
and improved education and protectionism.

* Governments could offer assistance to workers relocating from job-poor areas to

ones that are job-rich.
* Protectionist policies, such as tariffs and subsidies, can be used as a short-term
method of slowing the trend away from some industries. However, this is more
likely to prolong the decline of the industries, and works against the concept of
economic efficiency outlined by comparative advantage theory. Tariff revenues
could be spent on transitioning to more promising forms of production and
employment.
* To reduce structural unemployment over the long term, a nation must invest
heavily in public education and training for adult workers in the skills that will
be needed for the future economy, as well as developing systems of matching
education to the skills currently in demand by industries.

What are frictional and seasonal unemployment?

‘Workers who are in between jobs or just entering the labour force for the first time are
referred to as frictionally unemployed. A person may be relocating to a new area and
seeking a new job. Someone may be leaving a job in an attempt to find a better one.
Students finishing university and graduate school with fresh training may spend time
looking for a job. One example is a worker who quits his job in retail with the training
and expectation of taking up a job as a nurse. During the period of time between the
old job and the new job, which he is fairly certain he will be able to acquire rather
quickly, he is frictionally unemployed.

Frictional unemployment is generally short term (three months or less) and is often
voluntary, meaning the unemployed person has chosen to seek employment in a
different location or industry. The key characteristic of the frictionally unemployed
is that they possess skills that are demanded by the nation’s employers, thus their
prospects for employment are generally positive. Another characteristic of frictional

301
 Macroeconomic objective: low unemployment

unemployment is that it tends to decrease during recessions, when workers are fearful
of losing their current jobs, and tends to rise during economic expansions when job
prospects are better.
Workers who do seasonal labour (for example, golf course employees, migrant
farmers, ski-lift operators or summer-camp instructors) may be unemployed
between seasons. Seasonal unemployment is also considered a type of voluntary
unemployment as many such workers choose their jobs for the freedom and other
benefits such employment offers.

Government policies that affect incentives among the labour force may increase or
decrease the level of frictional and seasonal unemployment. The longer unemployment
benefits can be collected, the less the incentive to rush the job search process and
take the first decent job offered. Additionally, if information about employment
opportunities around the country is readily available and systems exist to quickly
match frictionally unemployed workers with employers through job centres or online
employment services, then the duration of frictional unemployment and its prevalence
in the economy may be reduced.

Case study yclical, structural, o

you deci
‘When the novel coronavirus struck in late 2019 and early 2020, the effects
on unemployment around the world were immediate and severe as economies
saw jobless rates double or even triple in the span of a few weeks. But even within
countries themselves there were extreme variations in the virus's impact on
employment between regions, provinces, or states.
Figure 15.9 shows the unemployment rates in ten US states in early April, 2020,
just one month after the US president declared the COVID-19 pandemic a ‘national
emergency’.

Considering what you have learned about unemployment in this chapter, answer
the following questions:
1 What s likely to account for the large variation in unemployment between the
states with the highest rates and the states with the lowest rates in the early
months of the COVID-19 pandemic?
2 Why might a state like Hawaii, where tourism makes up 21% of the economy,
have experienced the greatest unemployment effects of the coronavirus?
3 Is the high unemployment resulting from the COVID-19 pandemic structural,
frictional, seasonal, or cyclical? Explain your answer.
4 This data is from just one month into the coronavirus outbreak in the United
States. What do you think most likely happened to the unemployment rates in
the states hardest hit at this stage versus those least affected in the months that
followed?

What is the natural rate of unemployment?

An economy producing at full employment still experiences frictional, seasonal,
and structural unemployment. These combined are known as the natural rate of
unemployment (NRU). This can be a confusing concept because the term ‘full
302
 Hawaii Michigan Rhode Pennsylvania Nevada Connecticut Florida ~ West Colorado South
Island Virginia Dakota
States with the 5 highest ratios States with the 5 lowest ratios
A
: : . : . Figure15.9 Unemployment
employment’ : makes it sound as if everyone has a job. Nonetheless, economists believe rates in ten US st
that a dynamic economy requires people to change jobs for structural or frictional 9 April 2020
reasons, and that some level of unemployment is natural, even desirable.

structural frictional ~ _ natural rate of

unemployment unemployment unemployment (NRU)

The NRU varies widely from country to country. Its variance depends on several
factors, including factors that influence the levels of both structural and frictional
unemployment:
« low information about job vacancies and available talent
* labour immobility, the instance of qualified workers unable to relocate to available
positions
* mismatch of workers’ training/education and skills needed by employers
« hysteresis, or the fact that unemployed workers become less employable the longer
they are out of work
* labour laws that protect jobs that are no longer needed
« thelevel of unemployment benefits provided.

As countries try to manage their overall economies, the NRU is used as an important
guideline for the calibration of fiscal and monetary policy. Ceteris paribus, if a country’s
unemployment rate exceeds the NRU, some cyclical unemployment is occurring and
will require an expansionary response. Conversely, when unemployment drops below
the NRU, the labour market may be considered ‘tight’. In this case, the heated job
market may indicate rising wages and future inflation. Policymakers may then choose
contractionary policies to ‘cool off’ the potential inflation.
303
 Macroeconomic objective: low unemployment

Using the concepts

of 'natural rate’ of
unemployment and
‘full employment, how
might the language
we use to describe
economic circumstances At the end of this section you will be able to:
affect our perception
of individuals in society « discuss possible personal and social consequences of unemployment, including
who are affected by those increased crime rates, increased stress levels, increased indebtedness,
circumstances? homelessness, and family breakdown
Further thoughts « discuss possible economic consequences of unemployment, including a loss
While structural and of GDP, loss of tax revenue, increased cost of unemployment benefits, loss of
frictional unemployment income for individuals, and greater disparities in the distribution of income.
are considered ‘natural’
forms of unemployment
that exist in an economy
thatis producing at What are the personal costs of unemployment?
its full employment
level, the reality for Unemployment can be a personally traumatic experience. More broadly, the social
those experiencing and economic consequences of unemployment can be severe and long-lasting as
unemployment in a well, which explains why maintaining a low level of unemployment is an important
healthy economy may macroeconomic objective.
be no less unpleasant
than that experienced Decreased household income and purchasing power
by someone who has
lost their job due to a An obvious consequence of the unemployment of one or more members of a
recession. However, household is a decline in a household’s income and consequently its standard of
when economists living. The decline in personal income could result in foreclosure or repossession of a
consider some types of
unemployment ‘natural, mortgaged or rented home, or worse, an inability to feed the household.
it risks diminishing
the hardships of Increased levels of psychological and physical illness
those experiencing Asignificant personal consequence of unemployment is the psychological and even
unemployment
physical toll it imposes on the unemployed. Some studies have shown that higher
1 How could economists
unemployment rates are correlated with higher rates of depression, cardiovascular
employ language to
assign terms that better disease, suicides, and psychiatric hospital admittances.
reflect the experiences
of unemployed What are the social consequences
workers, many of
whom are struggling to of unemployment?
support their families Increased poverty
while they search for
work? Regions or cities in which unemployment occurs may become depressed and
2 How do different therefore less attractive to new investment by businesses. The low income levels
languages translate of the largely unemployed population can therefore deter businesses from starting
the concept of or expanding businesses, further contributing to the unemployment and poverty
unemployment?
Does it have different problem in that area.
connotations in those
languages than it does Transformation of traditional societies
in English? Unemployment in particular regions or sectors of the economy can lead to social
upheaval. Where farming and hunting offer economic self-sufficiency on a familial
or small village level, the social web flows from these relationships. Economic
development, especially the move from labour-intensive home production to
capital-intensive organised production, can separate a labourer’s work from these
relationships, and sever them from their traditional social web. China’s shift, over the
last 40 years, to massive industrialisation, is an example of this on a grand scale.
304
What are the economic consequences Video suggestions:
of unemployment? You've read about it, now
you can review what you've
Downward pressure on wages for the employed justlearned by watchinga
High unemployment means the supply of available labour has increased in the nation.
few videos by the author!
Simply click here in
Since wages are determined by supply and demand, an increase in the labour supply your eBook for videos
can lower the equilibrium wage rate for those who still have jobs, forcing them to on Types of Unemployment,
accept pay cuts and reducing the real incomes of all workers. the Business Cycle, and the
Natural Rate of
Unemployment (NRU):
Lower level of aggregate demand
i
Closely related to wage losses is the level of consumption. A major component of Video suggestions:
aggregate demand, consumption is primarily determined by disposable incomes. You've read about it, now
Unemployment lowers households’ disposable income and consumption, reducing you can review what you've
the level of demand and output in the nation as a whole. This leads to more justlearned by watchinga
few videos by the author!
unemployment and can pull an economy into a recession. Simply click here in
your eBook for videos
on 'Factors that can cause
Under-utilisation of the nation’s resources the Natural Rate of
Unemployment means a nation is not fully utilising its productive resources, therefore Unemployment to change'
anation with high unemployment is producing within its PPC at a level below that
which is most beneficial to an economy trying to improve the economic well-being of [ DL i
its people. For discussion and debate:
1 Conductasearchto
Brain-drain determine the NRU
for your country. This
Skilled workers may choose to leave a country with high unemployment if job is sometimes referred
opportunities are more abundant elsewhere. This further leads to a fall in the to as the long-term
production possibilities of the nation with high unemployment. unemp\oymer\t rate.

2 Nextseek out the NRU

for two other countries.
A turn towards protectionism and isolationist policies What, based on what you
Rising unemployment is often blamed by politicians and policymakers on competition know of each country,
from cheap foreign producers. This can lead to the rise of protective tariffs and quotas might account for the.
differences?
or increased government spending on subsidies for domestic producers. Such policies
lead to a misallocation of society’s scarce resources and in the long run will make the
Investigate the NRU over
several decades (try 1990,
nation less competitive in global markets. 2000, and 2010) for one of
the countries you selected.
Has it changed much?
Increased budget deficits Can you make a guess
Unemployed workers do not pay income taxes, but instead receive monthly payments as to why this may have
from the government to assist them until they find work. High unemployment reduces happened?
the total tax revenues received by a government while simultaneously increasing public
expenditures on financial support for the unemployed, pushing national budgets
towards deficit. It therefore necessitates cither a decrease in government spending on
public goods, such as infrastructure, education, defence and healthcare or an increase in
government borrowing to finance its budget deficit. As you will see in Chapter 22, large
government budget deficits bring their own set of problems to a nation’s economy.
The individual, social, and economic consequences of unemployment are not limited
to those outlined above, but it should be clear that the costs of unemployment are
wide-ranging, thus making low unemployment a worthy and important goal for
macroeconomic policymakers.
305
 Macroeconomic objective: low unemployment

Practice exam questions

Paper 1 questions
la. Distinguish, using examples, between the causes of structural,
seasonal and demand deficient unemployment. (10 marks)
2a. Explain the difficulties in measuring unemployment. (10 marks)
3a. Explain, using a diagram, how labour market rigidities such as
the minimum wage contribute to structural unemployment. (10 marks)
Paper 2 questions

Germany Unemployment Rises, Budget Deficit Set to Increase

July 2020
Germany’s unemployment rate rose in June from 6.2%, up from 6.1% in May, and a
percentage point higher than in March, when it scored 5.1%. Jobless claims are more than
600,000 higher than the same time last year.
Germany’s labour force is currently 43.5 million people. This number may drop if the crisis
continues and workers drop out of the labour force as discouraged workers. By 2021, some
economists project 3 million people will be unemployed.
Unemployment has risen more slowly and less severely in Germany due to ‘short-work’
programmes that subsidise wages to firms up to 60% of previous levels, encouraging firms to
retain employees through the crisis. Also known as ‘furloughs’, these programmes pay firms
to pay workers, even if there is little work or demand for the firm'’s output.
One result of the extra spending on firms and workers is that Germany also announced recently
that it expects to borrow a record 218 billion Euro in 2020, the country’s largest deficit spending
ever. Its debt to GDP ratio will rise from below 60% to above 75% for the current year.

a. i. Define unemployment. (2 marks)

ii. Define budget deficit. (2 marks)
b. i Assuming the labour force is stable, calculate the expected
unemployment rate for Germany in the next year. (2 marks)
ii. Using the formula for calculating the unemployment rate, explain
the effect of an increase in the number of discouraged workers. (3 marks)
c. Explain, using a diagram, that demand deficient unemployment is
caused by a fall in aggregate demand. (4 marks)
d. Explain, using a diagram, how Germany’s wage subsidy programme
acts as an automatic stabiliser for aggregate demand. (4 marks)
e. Explain two reasons unemployment is difficult to
measure accurately. (4 marks)
f. Using examples, explain two types of unemployment. (4 marks)
g Using information from the text and your own knowledge of
economics, discuss the economic, social, and personal consequences
of unemployment. (15 marks)

306
 Macroeconomic
objective: low and
stable inflation
 Macroeconomic objective: low and stable inflation

At the end of this section you will be able to:

« distinguish between inflation, disinflation, and deflation
+ explain how a CPI measures changes in prices
. construct a weighted price index, using a set of data provided
« calculate the inflation rate from a set of data
« analyse the limitations of the CPI in measuring inflation and the alternative
measures used by economists
+ draw a diagram to show how demand-pull inflation is caused by an increase in AD
+ useadiagram to explain cost-push inflation.

In addition to maintaining a low level of unemployment, governments and central banks

also focus their policies on maintaining a stable rate of increase in the average price level
of goods and services in a nation; in other words, low and stable inflation. Maintaining
price level stability is considered a fundamental objective of macroeconomic policy,
since price level instability can have negative effects on a nation’s economic health.
Inflation is defined as an increase in the average price level of goods and services in an
economy over time. Deflation, on the other hand, occurs when the average price level
of goods and services decreases over time. The key word in these definitions is ‘average’
since inflation does not measure changes in the relative prices of particular goods.
For instance, certain types of technology (e.g. smartphones, electric cars, and solar
panels) have come down in price considerably in the last decade due to expansion of
their markets and productivity gains in their manufacturing. The fall in prices of these
particular goods does not mean that nations have experienced deflation, since only
certain types of goods have become cheaper. Even as certain goods have fallen in price,
the overall price levels of most countries have risen over the last decade.

Figure 16.1 provides a snapshot of the levels of inflation across every country in the
world. The further left the colour s in the key, the lower the inflation rate, with the
lowest rates recorded in 2019 being at around 1% (Saudi Arabia). The further to the
right-hand side of the key, the higher the inflation rate, with the highest rate in 2019
being around 90% (Venezuela). The meaning of these values will be made clearer in the
next section of this chapter.

So why does inflation matter to economists? Another way of understanding inflation

is that it causes the value of money to decrease over time. An increase in the price
level essentially makes money less valuable and reduces its purchasing power. In an
environment of inflation, a particular amount of money will buy less in the future
than it does in the present. Therefore, inflation encourages households and firms to
spend now rather than postponing spending until the future when prices are higher.
The anticipation of future inflation can trigger a positive feedback loop in which
households increase their spending now, thereby causing inflation and encouraging
further increases in spending. The increased spending worsens scarcity across the

308
 [-1.00--015 E-015--070 WO07-16 E16-24 E@2-25 FEA25-47 47— 70 E70-92
A
economy, fuelling more inflation and eroding people’s real incomes and wealth over Figure 16.1 Worldwide
time. If left unchecked, inflation can destroy economic value. inflation variations, 2019

So high inflation is bad. Does that mean that its opposite, deflation, is good? Deflation
occurs when the average price level decreases over time. A fall in prices results in an
increase in the value of money, since its purchasing power increases. A particular
amount of money will buy more in the future than it does in the present when
deflation occurs. Deflation incentivises savings over consumption and investment,
since households and firms will wish to postpone purchases until the future when
prices are expected to decline. Much as anticipated inflation can trigger an inflationary
spiral, anticipated deflation can create a deflationary spiral in which spending falls,
driving prices down, encouraging even less consumption and investment. As we
learned in Chapter 14, falling demand will lead to rising unemployment in the short
run, as firms faced with sticky wages are forced to reduce the size of their workforce.
Deflation, therefore, can lead an economy into a period of rising unemployment and
prolonged recession.
Okay, so high inflation is bad, deflation is bad, what are policymakers to do, then?
A final term requiring a definition is disinflation. Disinflation refers to a decrease in the
rate of inflation from a higher level to a lower level. Generally speaking, disinflation is a
desirable outcome in a country that is experiencing high inflation. However, if inflation
is already very low, disinflation may be undesirable because it could push the economy
into deflation.
Have you heard the story of Goldilocks and the three bears? If not, here is the gist of it.
Alittle girl wanders into the woods and finds a cabin with the door left open. Inside
are three bowls of porridge left on the dining table. Goldilocks is hungry, so she takes
a spoonful from the first bowl: too hot. She tries the second bowl: too cold. So she
tries the third bowl: just right. She eats up all the porridge. Goldilocks then spots three
309
 Macroeconomic objective: low and stable inflation

rocking chairs. Chair one is too hard, chair two too soft, but chair three is just right.
Finally, she wanders upstairs to the bedrooms, as she is tired after her walk and her
snack. There are three beds. The first bed is too hard, the second bed is too soft, but the
third bed is just right.

\
Too hot, too cold, just right >

Much like Goldilocks, economic policymakers must target a rate of inflation that
is neither too high, nor too low, rather one that is just right. The target inflation rate
may vary depending on the underlying macroeconomic conditions of a particular
economy, but in the more developed countries of Western Europe, East Asia, and
North America, the just right level of inflation is believed to be between 2% and 3%.
And these are the inflation ‘targets’ for policymakers in those countries. In Chapters
19, 20, and 21 we will explore the role of policymakers at targeting a low and stable
rate of inflation in more detail. For now, we will move onto inflation measurement, the
limitations of measuring inflation, and the causes and costs of inflation and deflation.

How do price indexes help economists

measure inflation?
Changes in price levels are monitored on a monthly or quarterly basis by most
governments. The method for collecting inflation data is similar across countries, and
employs a tool known as a price index. The consumer price index, or CPI, measures
the change in income a consumer would need in order to maintain the same standard
of living over time under a new set of prices as under the original set of prices.

Calculating a price index involves the government conducting a regular survey

of the prices of hundreds or even thousands of different consumer and producer
goods. The basket of goods measured for the CPI may include items such as
clothing, food, fuel, electricity, rents, airline tickets, bus fares, laptop computers,
and so on. It also includes services, and its composition may be updated annually or
biannually as new types of products become fashionable among consumers.
A price index is found by dividing the price of a basket of goods in one period by the
price of the identical basket of goods in a base period and multiplying by 100.

310
 Worked example 16.1
To determine the price index, first a base period index must be established. For
instance, imagine a country where the typical consumer only buys three goods:
pizza, haircuts, and coffee. Table 16.1 shows the prices and quantities purchased
of the three goods by a typical consumer over three years, along with the amount
spent.
Table 16.1 Prices of three consumer goods over three years, 2019, 2020,
and 2021.

Good | Quantities | Price | Amount | Price | Amount | Price | Amount

or purchased | in |spentin | in |[spentin| in spent
service 2019 2019 2020 2020 2021 | in2021
(@xP) (QxP) (Q@xP)
Pizza 20 $10 $200 [ $10.50 $210 $12 $240
Haircuts 10 $20 $200 $19 $190 $22 $220
Coffee 40 $8 $320 $10 $400 $9 $360
Total basket price In2019| $720 (In2020| $800 |In2021| $820

The ‘quantities purchased’ assigns a weight to each of the goods in the CPI basket.
The more a consumer purchases of a good, the more weight that good has in the
overall CPI measurement.

Assume 2019 is the base year, and we want to calculate the CPIs for 2019, 2020, and
2021:

Price of the basket of goods in 2019 720

SRl Price of the basket in base year L0 720 % 10
=100

__ Price of the basket of goods in 2020 _ 800

T == ofthe basket in bascyear 720 < 10
=111.1

CPLfor 2020 = P1% of the basket of goods in 2021 _ 820 % 100

Price of the basket in baseyear 720
=1139

The CPI for 2019 is 100, which makes sense since 2019 is our base year. The price
of the same basket of goods in 2020 increased from $720 to $800, giving us a CPI of
111.1.In 2021 prices continued to rise, with the same basket of goods going up to
$820, giving usa CPLof 113.9.

In Worked example 16.1 the CPl increased in each of the three years. Notice also that
not all three goods are weighted equally in the basket. While coffee is the cheapest of
the goods, it carries more weight since coffee is consumed at twice the rate of pizza
and four times the rate of haircuts. A change in the price of coffee, therefore, will have
a greater proportional effect on the CPI than a change in the price ofa good that is
consumed less than coffee.
311
 Macroeconomic objective: low and stable inflation

Video suggestion: What does the CPI tell us, then? It tells us whether the average weighted price level of the
You have read about it, now goods consumed by the typical consumer have increased or decreased over time. To
you can review what you determine the inflation rate, however, we must calculate the rate of change in the CPI
have just learned by watching between two periods of time.
avideo by the author!
Simply click here in
your eBook for a video Calculating the inflation rate from a price index
on calculating a CPI
The inflation rate is measured as the rate of change in the CPI between two periods
of time. While inflation can be measured quarterly or even monthly, it is standard to
report inflation annually. To do so, we must divide the change in the CPI between two
years (year 1 and 2) by the original CPI (year 1) and multiply the result by 100.

Worked example 16.2

Using our CPI data from the previous worked example we can calculate inflation
between 2019 and 2020 and between 2020 and 2021:

Inflation between 2019 and 2020 = w X 100 = 11.1%

Inflation between 2020 and 2021 = %1 X 100 = 2.5%

Video suggestion:
You have read about it, now
you can review what you This country experienced inflation between all three years, of 11.1% between 2019
have just learned by watching and 2020 and then 2.5% between 2020 and 2021. Average prices rose between
avideo by the author! 2019 and 2021. Another way to say this is that a typical consumer would need to
Simply click here in experience a 13.9% increase in their nominal income in order to maintain the same
o your eBook for a video
on calculating inflation using standard of living in 2021 as she enjoyed in 2019.
acpl

What are the limitations of the CPI in measuring

inflation?
The official inflation rate, like other macroeconomic measurements, is an aggregate
measure, in this case of the average price level of what the typical household
consumes. However, not all households’ consumption patterns will be accurately
reflected by the CPL

Different effect on consumers of different income levels

For example, a lower income household may be more affected by inflation in their
everyday consumption decisions than a wealthier household. Poorer consumers
tend to spend a greater percentage of their income on goods and services, whereas
richer consumers tend to save more. Therefore, an increase in the CPI could have a
disproportionate effect on lower income consumers than on the rich.

Additionally, the composition of the basket of goods consumed by different

households will be very different. Higher income households may be able to substitute
imported goods for domestically produced goods when domestic inflation accelerates,
sheltering them from rising prices at home.
312
Changing consumption patterns
The inability of the CPI to reflect the consumption patterns of all households is one
obvious shortcoming of its usefulness as a measurement of economic well-being.
Another is that the consumption patterns in a nation may change faster than the
composition of the collection of goods whose prices are included in the CPI measure,
which may only be updated once a decade or so, even as the goods purchased by actual
consumers change every year. If the goods in a CPI are not updated frequently, the
usefulness of the inflation rate will diminish as consumers switch to newer, different
products.

Improvements in product quality not captured

Additionally, the CPI might overstate inflation as prices rise even as the quality of
the goods consumers are buying increases exponentially. For example, a £25,000 car
purchased in 2010 might have increased to £30,000 by 2020, a 20% increase in price
(an average of 2% per year over ten years). However, the quality of the car purchased
in 2020 may have increased exponentially. Improvements in safety, comfort,
entertainment, and navigation systems, self-driving or ‘autopilot’ capabilities, and
other factors affecting the consumer’s experience of the 2020 model are not reflected
in that average 2% increase in its price over ten years. When technology and product
quality increase disproportionately compared to goods’ prices, the inflation rate will
overstate the burden of higher prices on consumers.

Volatility of energy and food prices

Another limitation of the CPl s that it could be skewed by the price volatility of
particular ‘core’ goods, namely energy and food prices. Because of the inelastic nature
of demand and supply for energy and food (see Chapters 4 and 6), small shifts in
demand or supply can cause large changes in prices of these goods.

For example, in 2020 the price ofa barrel of crude oil dropped from $61 on 1 January
(before the COVID-19 pandemic began) to $11 on 21 April (when most economies
were on shut down during the first wave of the pandemic). In the USA, where oil
and other fossil fuels are important sources of energy production, energy is given a
considerable weight in the overall CPI (7%). Motor fuel, of which oil is the key input,
is weighted at 3% of the overall CPI. Together energy and motor fuel account for 10%
of value of the consumer price index. The price of oil, an input into both of these, fell
by 82% between January and April. Given the considerable weight of goods that use
oil, this drop would have impacted the CPI in a noticeable way, despite the fact that
lower oil prices say little about how prices across all other industries changed during
the shutdown.
In order to provide a picture for how most goods and services are changing in price,
not including those energy and food commodities whose prices tend to fluctuate more
wildly, economists measure what is known as the core CPI to determine core inflation.
Core inflation measures the price ofa basket of goods consumed by the typical
household, excluding energy and food. It gives a clearer picture of the long-run trends
in living costs, ignoring short-run fluctuations in certain commodity prices.

Figure 16.2 compares the USA’s CPI for all items (known as the ‘headline’ inflation rate,
in blue) to the core CPI (in dotted red) between January and July 2020. The area shaded
in grey indicates the period during which the US economy was officially in a recession.
313
 Macroeconomic objective: low and stable inflation

~
)
Change from
yearago (%)
&
1.0
Figure 162 Core inflation
was less volatile than 0.5
headline inflation in the USA, 0.0 T T T T T T 1
January-July 2020 Jan Feb Mar Apr May Jun Jul
2020 2020 2020 2020 2020 2020 2020
Month
— Consumer price index for all urban consumers: All items in US city average
«us- Consumer price index for all urban consumers: All items less food and energy
in US city average

As we can see, the core inflation rate was much more stable during the first half
of 2020, while headline inflation fell from 2.5% in early January to 0.2% by May, a
significant amount of disinflation. Core inflation, which excludes the change in food
and energy prices, meanwhile, remained more stable, falling from 2.26% in January
to 1.2% in May. All other goods beside food and energy, in other words, experienced a
much less precipitous slowdown in inflation compared to what was experienced when
including food and energy.

CPl is not useful to producers

Another limitation of the CPlis that it is useful only for communicating the effect
of price changes on consumers, but lacks relevance to a whole other group of
stakeholders in an economy, producers. For this reason, many governments also use
asecond price index, known as the producer price index (PPI), to communicate the
impact of changing prices on firms. The PPl includes more primary commodities, such
as those produced by the mining, manufacturing, agriculture, fishing, and forestry
sectors, as well as natural gas, electricity, construction, and other goods that are more
likely to be purchased by a country’s business firms, rather than the finished goods and
services purchased by households.
Figure 16.3 shows that while the CPI and PPl generally rise together over time, the PP
(blue) appears to be far more volatile than the CPI (dotted red). This fits with what we
know about primary commodities. Supply and demand both are relatively inelastic
compared to manufactured goods, resulting in greater fluctuations in price when
relatively small changes in their demand or supply occur.
Also notice that during recessions (shaded grey in the chart), the PPI tends to
experience steep declines, while the CPI typically experiences slower growth
(disinflation) or a relatively small drop (mild deflation). This is explained by the fact
that demand for primary commodities is also relatively income elastic, and that primary
commodities are a normal good. Normal goods see demand decrease when incomes fall
(as they do during recessions).
Additionally, given the relatively steep decrease in commodity prices during recessions
relative to consumer prices (which include more manufactured goods), we can
assume that producers of primary commodities face more income elastic demand
than producers of finished goods and services. This may have to do with the ability to
314
 260
100
100, index 1982-84

Figure 16.3 A comparison

between the CPI and PPl of
the USA between 2000 and
Index 1982

2020 shows how the PP! is

relatively volatile

120
ZdOO ZdOS Zd1 0 Zd1 5 2620
Year

— Producer price index for all commodities

«+++ Consumer price index for all urban consumers: Allitems in US city average

store inventories of primary commodities. When a recession begins, firms may cancel
orders for newly extracted or produced inputs (causing prices to tumble) and instead
dip into existing inventories while they reduce output and wait to see how aggregate
demand evolves as the recession unfolds.

The CPl as it is reported by governments offers a measure of inflation as it affects an

‘average’ consumer. It is just that though — a single metric that has some advantages
but also many shortcomings as an indicator of economic welfare. To accommodate
for its disadvantages, several alternative measures of inflation are employed, including
the ‘core’ inflation rate and the PP Next we'll ook a little deeper into the causes of
inflation.

What are the causes of inflation?

Inflation can be caused by one of two ways, either as a result of an increase in aggregate
demand (AD) or as a result of a decrease in aggregate supply (AS).

What is demand-pull inflation?

Demand-pull inflation occurs when there is an increase in total demand for a nation’s
output, either from domestic households, foreign consumers, the government, or
firms (C, Xn, G, or ). When AD increases without a corresponding increase in AS, the
nation’s producers cannot keep up with the rising demand, and prices are driven up as
goods become scarcer.
Demand-pull inflation can be illustrated in the AD-AS model, as in Figure 16.4.

In the Keynesian model, demand-pull inflation is likely only if AD increases in an

economy that is already producing at or close to full employment. An economy in a
recession, with lots of spare capacity, is unlikely to experience demand-pull inflation.
Figure 16.5 shows an economy with a recessionary gap experiencing an increase in
AD, but no increase in inflation.
315
 Macroeconomic objective: low and stable inflation

Figure16.4 Rising demand P

creates demand-pull
inflation in the AD-AS model

Figure 16.5 The Keynesian

model predicts no demand-
pullinflation in an economy
in a deep recession due to the
existence of spare capacity

rGDP

What is cost-push inflation?

Cost-push inflation, shown in Figure 16.6, occurs as the result of a negative supply
shock. This arises from a sudden, often unanticipated, increase in the costs of
production for the nation’s producers. Cost-push inflation could result from a change
in any of the determinants of short-run aggregate supply (SRAS) that causes SRAS
to decrease, including an increase in the wage rate, in resources costs, in energy or
transportation costs, in business taxes, or a decrease in the exchange rate (causing
imported raw materials to become more expensive). A stricter regulatory framework
imposed by the government can also cause cost-push inflation if enough of the
nation’s producers are forced to implement costly new production methods.

Notice one big difference between demand-pull and cost-push inflation: when AD
increases and pulls prices up with it, it is also accompanied by a short-run increase in
aggregate output (real GDP). Meanwhile, cost-push inflation is accompanied by a fall in
316
 « Figure16.6 Ashifiin SRAS
can result in cost-push
inflation in the AD-AS model

rGDP

output, or at the very least a decrease in the rate of economic growth. For this reason,
cost-push inflation is sometimes referred to as stagflation, which combines the words
‘stagnation’ and ‘inflation’. When SRAS decreases, the economy tends to stagnate,
or stop growing. While stagflation does not always equate to a recession, it always
means slower growth, since higher costs of production make it less profitable for an
economy’s producers to increase their output.

Considering demand-pull inflation once again, it might be tempting to argue that it is

desirable, since it is also accompanied by an increase in real GDP. However, the short-
run increase in output should not be confused with economic growth (which will be
explored in more detail in Chapter 17). Rather, an economy that produces beyond its
full employment level of output is not producing sustainably. Recall from Chapter 14
that when AD increases to an equilibrium beyond full employment, it is only a matter
of time before wages and other costs become ‘flexible’ and begin to rise to adjust to the
higher price level in the economy. Workers, who are given bargaining power in a tight
labour market, will demand wage hikes that will eventually result in firms reducing
their output and laying some of their workers off. The economy will self-adjust in the
long run, with SRAS shifting left as wages increase, restoring the full employment level
of output at a yet even higher price level.
For this reason, demand-pull inflation is just as undesirable as cost-push inflation Video suggestion:
and stagflation, since an increase in AD beyond full employment, if left unchecked
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to deal with both demand-pull and cost-push inflation. Here, we will next look at the on demand-pull and
cost-push inflation.
costs of a high inflation rate to the economy.

What are the economic and social costs of a high

inflation rate?
‘While we have hinted throughout the chapter at the reasons inflation is undesirable,
we have yet to break down the costs it imposes on various stakeholders in society.
Inflation does more than reduce the purchasing power of money.
317
 Macroeconomic objective: low and stable inflation

Here are a few quotes from famous figures in history that point to some of the costs
inflation can impose on society:

John Maynard Keynes: By a M aret Thatcher: Inflat

parent of unemployment
al een robber of
mposed without secretly and unobserved, an those who have saved.
egislation. important part of the wealth of
their citizens

Uncertainty
High inflation creates an environment of uncertainty among consumers and
producers over future conditions. Expectations of higher prices in the future can drive
demand for current inputs and outputs, creating shortages as producers struggle to
keep up with rising demand. The inflationary spiral described earlier in this chapter
is an almost inevitable result from unchecked inflation today. Rising demand leads to
shortages, causing input and output prices to rise, causing cost-push inflation and even
more demand for current output as buyers expect prices to rise even more.
Low and stable inflation, on the other hand, creates an environment of certainty and
stability, as the expectation of moderate price increases prevents panic buying and the
resulting inflationary spirals.

Redistributive effects
Another effect inflation has on society is the redistribution of wealth from one group
to another. Businesses typically like some inflation, particularly of consumer prices,
as it means the prices of the goods they sell increase over time, allowing them to
enjoy higher profits. Consumers, on the other hand, find their wallets squeezed in an
inflationary environment and must face tough choices about what to cut back on in
order to make their money last.

Another redistributive effect of inflation is the transfer of wealth from lenders to

borrowers. An individual or a country with lots of debt benefits from inflation, especially
when the interest rate owed on that debt is fixed or rises more slowly than the inflation
rate. Rising prices mean the value of money decreases, including the value of the money
adebtor owes his or her lenders. Money borrowed is worth more than money repaid.

Effects on saving
The Thatcher quote above points to the negative effect inflation has on savers.
When the inflation rate increases while interest rates remain the same, the

318
real rate of interest savers earn decreases, and may even become negative. For example,
assuming you have COL$4 million (COLS is the symbol for the Colombian
peso, the currency of Colombia) in a savings account earning 3% interest annually,
as long as inflation remains below 3% the real value of your savings increases
each year, since your nominal return will outpace the increase in the price level.
However, if inflation rises to 4%, 5%, or even higher, every percentage by which
inflation exceeds your nominal interest rates represents a 1% decrease in the real
value of your savings each year.
Remember, one definition of inflation is a ‘decrease in the value of money over time’.
Money saved decreases in value in an inflationary environment, which also explains
why inflation encouraged consumption over savings.

Damage to export competitiveness

On an international level, inflation erodes a country’s competitiveness with other
economies as domestic prices rise and make the exports less attractive to foreign
consumers. Higher domestic inflation will also make imports more attractive to
domestic consumers, as prices abroad may be rising less than prices at home. As
exports decrease and imports increase the net exports component of AD falls, but
more importantly, domestic firms will find demand for their goods at home and
abroad to be less than in an environment of low and stable inflation.

Impact on economic growth

Inflation is an expected companion of economic growth. Rising prices send the
signal to a nation’s producers that demand for output is growing, which leads firms to
allocate more resources towards production and increase their output to meet
growing demand. The increase in AD and AS that results is what is meant by economic
growth: over time the real output of nations grows as prices increase steadily, driving
more growth.
Too much inflation, however, creates scarcity and stymies growth. Once again we
return to the story of the inflationary spiral. Demand-pull inflation leads to cost-push
inflation as wages and other resource costs increase due to the inability of supply
to keep up with demand. Low and stable inflation, on the other hand, promotes
sustainable economic growth characterised by increasing AS and AD.

Inefficient resource allocation

The shortages inflation creates are a microeconomic phenomenon that can be
associated with allocative inefficiency. When prices rise due to shortages, we have a Video suggestion:
situation in which the quantities supplied and demanded do not match. The marginal
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on the consequences of and
Allocative inefficiency arises in an inflationary environment, as markets fail to achieve
solutions to high inflation.
equilibrium due to shortages of key inputs and scarcity of finished goods.

319
 Macroeconomic objective: low and stable inflation

P s deflation?

Learning outcomes
At the end of this section you will be able to:
* identify the causes of deflation—changes in AD or SRAS
« distinguish between disinflation and deflation
+ examine the costs of deflation—uncertainty, redistributive effects, deferred
consumption, association with high levels of cyclical unemployment and
bankruptcies, increase in the real value of debt, inefficient resource allocation,
policy ineffectiveness.

Inflation is one side of the CPI coin. When the price index increases, the cost of living
of the typical household goes up and the real value of money goes down. When the
CPI falls, the cost of living goes down and the value of money increases. Deflation is a
sustained decrease in the average price of a nation’s output over time. Deflation exists
when the inflation rate is negative.

What are the causes of deflation?

Deflation has two causes: a decrease in AD or an increase in SRAS.

Changes in AD
A substantial and sustained decrease in AD can push a nation with low and stable
inflation into a deflationary state. Assume, for example, an economy is experiencing
1% inflation. While this is a bit lower than the target inflation rate in most countries
(29%-3%), it is still a low rate that should be consistent with economic growth. However,
due to an unexpected collapse in the stock market, household wealth is negatively
impacted and there is a fall in household consumption. The effect will be a negative
demand shock, which will push the economy from economic growth into recession.
Figure 16.7 shows the effect of the negative demand shock on equilibrium national
output, employment, and the average price level.

Figure16.7 A sudden >

reduction in aggregate
demand leads to lower
national output, employment,
and prices

rGDP

320
The collapse in consumption has pushed the economy from price level stability into
deflation. The CPI decreases due to a fall in demand for aggregate output and the
inability of producers to adjust wages quickly enough to maintain full employment
output. Prices decrease, forcing firms to lay workers off. The deflation is accompanied
by rising unemployment and a recessionary gap (from Y, to Y, ).

Changes in SRAS
Another cause of inflation is a positive supply shock. If the deflation caused by a fall in AD
is unequivocally bad, then deflation caused by an increase in SRAS is, well, perhaps a
good thing. A positive supply shock occurs when SRAS increases due to a decrease
in resource costs, wage rates, business taxes, business regulations, oran increase in
the value of the currency (causing imported raw materials to become cheaper), or any
other factor that causes SRAS to increase.

Figure 16.8 shows the effect of a positive supply shock on equilibrium output, the
average price level, and employment.

The supply shock has caused equilibrium output to increase from Y, to Y,, while the
average price level has decreased to P,. Employment increases as costs of production
fall, leading businesses to increase their output and therefore their demand for labour.

Deflation caused by a positive supply shock could be considered desirable since the fall
in output and employment that accompanies deflation from a fall in AD do not occur.
The question to consider is, however, whether the positive supply shock is a short-term
phenomenon and will be offset by rising wages due to tight labour markets or whether
itis permanent, and will eventually lead to an increase in long-run aggregate supply
(LRAS) as well. Video suggestion:
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unlikely to be maintained if the lower price level is only temporary. on what causes deflation.

« Figure16.8 Asudden
ncrease in aggregate supply
leads to higher national
output and employment but
lower prices

rGDP

321
 Macroeconomic objective: low and stable inflation

Disinflation versus deflation

In reality, a decrease in AD or an increase in SRAS are unlikely to immediately cause
deflation. Referring back to Figure 16.1 at the beginning of this chapter, only a few
countries in the entire world experienced deflation in 2019. That is because the typical
inflation rate a country producing at or close to full employment experiences is positive —
as we have said most countries aim to maintain inflation of between 2% and 3%. However,
in developing economies, inflation rates that are much higher are not uncommon. Across
the 54 countries in sub-Saharan Africa, for instance, inflation averaged 8.38% in 2019
and 9.32% in 2020. A decrease in AD in one of these countries, therefore, is unlikely to
immediately result in deflation, since the inflation rate is already so far in the positive.

The more likely result from a negative demand shock or a positive supply shock, therefore,
is disinflation, or a decrease in the inflation rate. Typically, disinflation is considered a
good thing, since bringing inflation down to the ‘low and stable’ level of 2-3% promotes
macroeconomic stability and economic growth. The exception is when an economy is
already within its desired range; in such a case disinflation is the first step towards deflation.

What are the costs of deflation?

Many of the costs of deflation will sound similar to those of inflation, only for the
opposite reasons. Therefore, we'll summarise them briefly where possible.

Uncertainty
Inflation creates uncertainty about higher prices in the future, deflation about lower
prices. When prices are expected to fall businesses will reduce output now and lay
off workers in expectation of reduced revenues and profits tomorrow. The resulting
uncertainty permeates throughout the economy, depressing both consumer and
producer confidence and throwing the economy into a deflationary spiral of falling
demand, deflation, high unemployment, and recession.

Redistributive effects
Whereas inflation redistributes wealth from lenders to borrowers, deflation does
the opposite. The real burden ofa debt increases when prices fall, as the value of the
money that has to be repaid is greater than the value of the money that was borrowed.
Additionally, while inflation reduces the real interest rates on loans, deflation
increases the real cost of borrowing. For example, with a nominal interest rate of 3%,
and an inflation rate of 2%, the real cost to the borrower of a loan is only 1% (since
inflation reduces the value of the money that is repaid). However, with deflation of
2%, the real interest rate is 3% — (~2%), or 3% + 2%, which is 5%. Lenders are better off
when there is deflation, while those who borrowed money in the past are worse off.
Wealth is redistributed from those who owe money to those who are owed money.

Deferred consumption
Deflation shifts consumers’ expectations towards lower prices in the future, thus affecting
the psychology of consumers today. The rational thing to do when prices are expected
to fallis to defer consumption, or delay purchases until the future when your money will go
further. The result is a decrease in current consumption and a fall in AD, along with all the
negative consequences a negative demand shock has on employment and output.
322
Association with high levels of cyclical unemployment
and bankruptcies
‘When prices fall, businesses find it hard to both continue paying their workers and
servicing their debts. Businesses have debts for all sorts of reasons, from the mortgages
on office or factory space to money borrowed for the purchase of capital equipment.
‘When revenues decrease in a deflationary environment, servicing their debts becomes
more difficult for firms, and bankruptcies might result. When firms across the
economy go bankrupt, the owners of their debt likewise experience a decrease in the
value of their assets, reducing wealth and consumption across the economy.
Cyclical unemployment is that which results from a decrease in AD (Chapter 15).
In a deflationary environment, the unemployment rate will increase above the
natural rate, indicating cyclical unemployment. When workers whose skills would
normally be in demand in a ‘healthy’ economy lose their jobs, the economy as a whole
underperforms, indicating inefficiency and an underutilisation of resources.

Inefficient resource allocation, policy ineffectiveness

Inflation, recall, results from shortages in key inputs and outputs. Deflation, on the other
hand, is evidence of surplus goods in the economy. A surplus arises when the quantity
supplied exceeds the quantity demanded in the market for a particular good, leading to the
good's price to fall over time. Deflation is evidence of this on a macro scale: the amount
of output supplied exceeds the amount demanded, meaning prices must fall to clear the
markets. Allocative inefficiency results; individual markets are producing at a level of Video suggestion:
output where the marginal costs of producers exceed the marginal benefits of consumers. You have read about it, now
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equilibrium price level and real GDP. on the consequences of and
solutions to deflation.

16.3 HL Potential conflict between

macroeconomic objectives — low
unemployment and low inflation

Learning comes
At the end of this section you will be able to:
draw SRPC and LRPC diagrams showing the relationship between
unemployment and inflation
« discuss the view that there is a possible trade-off between the unemployment
rate and the inflation rate in the short run
* examine stagflation with reference to an outward shift in the SRPC due to
adecrease in SRAS
* evaluate the view that the LRPC is vertical at the natural rate of unemployment.

In the pursuit of certain objectives economic policymakers often find themselves

running into conflicts between those objectives. In the pursuit of a more efficient
free market, for instance, greater inequality might emerge as tax rates are cut on 323
 Macroeconomic objective: low and stable inflation

PL SRAS

PL,
Figure 169 Thereisa P ! Higher price level
direct relationship between PL,f-eeennen 1 leads to more output
the average price level and ! and a higher level
oL femeenns? i of employment
employment along an
SRAS curve

rGDP

high-income earners and corporations. In the pursuit of economic growth society

might face a higher level of environmental degradation. One such potential conflict
that might result from the pursuit of the two macro objectives we have examined in
Chapters 15 and 16 is that between low unemployment and low inflation.

As we learned when studying short-run aggregate supply in Chapter 14, when the
average price level increases, output increases in the short run. At higher levels of
output, firms employ more workers; therefore, unemployment decreases as the price
level increases. When the average price level decreases, output decreases in the short
run. At lower levels of output, firms employ fewer workers; therefore, unemployment
increases as the price level decreases.

Figure 16.9 illustrates the relationship between the average price level and employment
in the short run, using an SRAS curve.

Owing to the stickiness of wages and other input costs, there tends to be a
short-run trade-off between inflation and unemployment. As the price level increases,
unemployment decreases and as the price level decreases, unemployment increases.
In the long run, as we will see, this relationship does not hold, and there is no trade-off
between inflation and unemployment.

The short-run Phillips curve

The short-run trade-off between inflation and unemployment is so fundamental
to macroeconomics that economists have developed a model just to illustrate this
relationship, the short-run Phillips curve (SRPC). The Phillips curve model shows
the rate of inflation on the vertical axis and the unemployment rate on the horizontal
axis. The curve itself is downward sloping, showing the inverse relationship between
the two indicators in the short run.

Assume that in the country represented by the Phillips curve in Figure 16.10 the
natural rate of unemployment is 5% and the target inflation rate is between 2% and 3%.
Points along a country’s SRPC correspond with different combinations of inflation and
unemployment that the economy might experience in the short run.

* Atpoint A the inflation rate is 5% and unemployment is at less than 1%. The
economy is producing beyond full employment with a positive output gap.
324
 (% change in CPI)

Figure 16.10 The short-run

Inflation rate

Phillips curve illustrates the

fundamental relationship
between the rate of inflation
and the unemployment rate

Unemployment rate
(% of labour force)
SRPC

+ At point B inflation is within the target range of 2-3% and unemployment is 5%,
close to the natural rate of unemployment.
+ Atpoint C the economy has lower than desired inflation of 1% and unemployment
that is greater than the natural rate at 9%. The economy has a recessionary gap.
+ Atpoint D the economy has inflation of —1% (deflation) and unemployment of 13%.
The economy is experiencing a deep recession.

The long-run Phillips curve

The long-run relationship between inflation and unemployment can be illustrated
by the long-run Phillips curve (LRPC), which is vertical at the natural rate of
unemployment. Recall from our study of the AD-AS model that the LRAS curve is
vertical at the full employment level of output, explained by the fact that wages and
other input costs are fully flexible in the long run. Since output always returns to the
full employment level in the long run, the unemployment rate will always return to the
natural rate of unemployment (NRU).
Figure 16.11 shows both the SRPC and the LRPC, which is vertical at the country’s
NRU of 5%.
LRPC
(% change in CP1)

« Figure16.11 The long-run

Inflation rate

Phillips curve is vertical at the

natural rate of unemployment

-1 NRU=5% Unemployment rate

(% of labour force)
SRPC
325
 Macroeconomic objective: low and stable inflation

Inflation rate
-1 NRU=5%
Unemployment rate
rGDP -2
(% of labour force)
SRPC

A
Figure16.12 AD-AS and Long-run equilibrium corresponds to the intersection of the SRPC and the LRPC.
the Phillips curve models in In the short run, when wages and other input prices are fixed, an economy can produce
long-run equilibrium anywhere along its SRPC. However, in the long run, when all prices are flexible,
a country will return to its NRU.

Demand shocks in the Phillips curve model

Changes to aggregate demand cause a movement along a country’s SRPC. Assume
acountry is currently producing at its full employment level and is in its long-run
equilibrium in both the AD-AS model and the Phillips curve model, as in Figure 16.12.

Let us examine how shocks to AD and SRAS will affect the short-run and long-run
Phillips curves.

Positive demand shocks

Figure 1613 Positive
demand shock in the AD-AS A positive demand shock will cause an increase in output, employment, and the price
and Phillips curve models level in the AD-AS model, and a movement up and to the left along the SRPC in the
v Phillips curve model, as seen in Figure 16.13.
(% change in CP1)
Inflation rate

-1 "
. Unemployment rate
rGDP % of labour force)
=2 ) " ) SRPC
326
 5

3
2
g 2
<
2
E
E
0

-1 B
INRUES% Unemployment rate
Y, w YY rGDP =2 ( (% of labour force| ) e

A move from point A to B in the AD-AS model causes a move from point A to point B A
in the Phillips curve model. Figure 16.14 Long-run
self-adjustment in the
In the long run, an economy producing at point B (beyond full employment) will AD-AS and Phillips curve
experience rising wages and input costs, causing the SRAS to decrease and output models following a positive
to return to the full employment level. As this happens, inflation will increase and demand shock
unemployment will return to the NRU in the Phillips curve model, as seen in Figure 16.14.
Rising wages and other input prices causes the SRAS to shift in, restoring full
employment in the AD-AS model at a higher price level. The inward shift of the SRAS
causes an outward shift of the SRPC, restoring the NRU in the Phillips curve model at a
higher inflation rate.

Negative demand shocks

Figure 16.15 Negative
A negative demand shock will cause a decrease in output, employment, and the price denand dockinthe AD2AS
level in the AD-AS model, and a movement down and to the right along the SRPC in and Phillips curve models
the Phillips curve model, as seen in Figure 16.15. v
(% change in CP1)
Inflation rate

Unemployment rate
Ve rGDP -2 (% of labour force)
SRPC
327
 Macroeconomic objective: low and stable inflation

(% change in CPI)
Inflation rate
rGDP
Unemployment rate SRPC
(% of labour force)

Figure16.16 Long-run
self-adjustment following a A move from point A to B in the AD-AS model causes a move from point A to point B
negative demand shock in in the Phillips curve model.
the AD-AS and Phillips
curve models In the long run, an economy producing at point B (below full employment) will
experience falling wages and input costs, causing the SRAS to increase and output
to return to the full employment level. As this happens, inflation will decrease
and unemployment will return to the NRU in the Phillips curve model, as in
Figure 16.16.
Falling wages and other input prices caused the SRAS to shift out, restoring full
employment in the AD-AS model at a lower price level. The outward shift of the SRAS
causes an inward shift of the SRPC, restoring the NRU in the Phillips curve model at a
lower inflation rate.

Supply shocks in the Phillips curve model

Whenevera factor leads to a shift in the SRAS curve, the SRPC shifts in the opposite
direction.

A negative supply shock causes both higher inflation and higher unemployment. For
example, assume there is an unexpected increase in energy prices. SRAS will shift in
as the cost of producing output increases. Firms reduce both employment and output,
while raising prices to consumers.

A negative supply shock causes higher inflation and higher unemployment. A country
experiences stagflation when SRAS shifts in and the SRPC shifts out.
A positive supply shock leads to more output and employment and lower prices.
The SRPC shifts inward, allowing a country to enjoy both lower inflation and lower
unemployment.

A positive supply shock causes output to increase and the price level to fall.
More output means lower unemployment and a lower price level means
lower inflation, as shown in Figure 16.18.

328
 LRPC

(% change in CPI)
Inflation rate
o SRPC,
2 4/ 6 8 10 14 6 18
-1 _
R Unemployment rate
Yo Y rGDP 2 (% of labour force) SRPC

A
Figure 16.17 Negative
supply shock in the AD-AS
and Phillips curve models

LRPC
Figure 1618 Fositive
supply shock in the AD-AS
and Phillips curve models
(% change in CP1)
Inflation rate

=1 SRPC,
Y, Y, rGDP
-2 Unemployment rate SRPC
(% of labour force)

Shifts of the LRPC ‘

Factors that cause the NRU to change will cause a shift of the LRPC. Recall that the
NRU consists of two types of unemployment.
* Structural unemployment that arises due to changing technology or other factors
that result in a mismatch between the skills of a nation’s workforce and the needs
of employers.
* Frictional unemployment that arises from workers who are between jobs and
cannot quickly and easily be matched up with firms that demand labour.
329
 Macroeconomic objective: low and stable inflation

LRPC LRPC,

(% change in CP1)
Inflation rate
Figure 1619 Anoutward
shift of the long-run
Phillips curve

0
2 ATG 8 10 12 14 16 18
. NRU=5% NRU,=8%
-2 Unemployment rate
(% of labour force)
Video suggestions:
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have just learned by watching Anincrease in structural or frictional unemployment causes an outward shift of the
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° your eBook for videos
on the SRPC and the LRPC. A decrease in structural or frictional unemployment causes an inward shift of the
LRPC and a lower NRU.
As our discussion
ofthe Phillips curve Is the Phillips curve model still applicable?
demonstrates, there
are often conflicts In the decade since the Great Recession of 2008-10 the applicability of the Phillips
between important curve model has been called into question, as the rich economies of Western Europe,
macroeconomic East Asia, and North America saw unemployment rates decline from historically high
objectives. So, which
is more important, levels during the recession back to, or even below;, their natural rates of unemployment
low inflation or low by late 2019 (before the onset of the COVID-19 recessions). As employment and
unemployment? What output recovered throughout the 2010s, the Phillips curve model would have predicted
kind of knowledge criteria rising inflation. What happened instead, however, was an apparent ‘flattening’ of
should policymakers
use to make decisions in
favour of pursuing one
objective over another? LRPC, LRPC

28
Figure16.20 Aninward g.E
shift of the long-run | S go
Philips curve &5
€5
8

= NRU= NRU=
25% 5%
— Unemployment rate
(% of labour force)

330
 (% change in the CPI)
Inflation rate

Figure 1621 There has

been a flattening’ of the
Phillips curve since 2010
6 8 10 12

Unemployment rate SRPC

2 (% of labour force)

L ]
How have inflation and
the SRPC. While unemployment rates fell, inflation rates remained at or only slightly unemployment changed
above their recession levels, with many countries struggling to meet even the lower in the years since the Great
Recession and since the
range of their target inflation rates. COVID-19 recessions of
20207 Follow the link here,
The result is a Phillips curve that has flattened out, meaning that the inflation rate has https://bit ly/32126d, to
become less responsive to changes in the unemployment rate, as in Figure 16.21. the GapMinder tool, which
allows you to track economic
According to Phillips theory, economic recoveries following a recession should be variables for different
characterised by falling unemployment and rising inflation, until the NRU is restored. countries over time. A few

Continued decreases in unemployment below the NRU should cause wages to climb developed economies have
already been selected for you,
and inflation to accelerate, keeping the rate of expansion in check and forcing output but you may choose your
to be restrained by rising costs. However, in the decade since the Great Recession own country or any others
ended, unemployment rates have mostly continued to decrease while inflation has that you like, to answer the
remained below the target rate. questions that follow.
You can control the years for
Possible explanations for this breakdown in the inflation/unemployment trade-off are which data s displayed by
that the unemployment rate might misstate the amount of spare capacity or ‘slack’ in using the slider tool at the
bottom of the chart. Change
the economy. As unemployment fell in the USA, Europe, and Japan throughout the the year and watch how the
2010s, people who had not been participating in the labour force (women, older folks, two indicators have changed
students, etc.), who had not been counted as unemployed, were tempted back into over time in the countries

work, allowing for expansion without inflation. you selected

For discussion and debate:
Another possible disinflationary influence in the rich world could be the increased Consider the following
globalisation of supply chains, allowing for an increasing number of goods that might questions after observing
have been produced domestically, and thus subject to rising prices as labour markets changes in unemployment
and inflation over time.
tightened, to be imported from lower cost countries like China. Although given the
relatively small share of rich countries’ CPIs made up of imported goods, this theory
1 Is there a decade in
the last 60 years during
has its limitations. which the relationship
between inflation and
The final explanation might just be that prices take time to adjust, and tightening unemployment predicted
labour markets have not translated into higher inflation due to the stickiness of wages by the Phillips curve model
and other costs. Had the world’s economies not slipped into another recession in 2020, was most apparent?
itis possible that the inflation predicted to result from low unemployment by the Describe the relationship
~

Phillips curve could have set in. The COVID-19 induced recessions of 2020, however,
between inflation and
unemployment in your
have thrown the model into question once more, as unemployment rates climbed selected countries over the
throughout 2020, yet inflation rates remained relatively unresponsive. Time will tell years since 2008. Does it
whether the Phillips curve model still has a place in economic textbooks as the world match what is predicted by
crawls its way back towards full employment in the years to come.
the Phillips curve?
331
 Macroeconomic objective: low and stable inflation

LEEEET
il Practice exam questions
3 Select three countries:
Mo oA 1. Use the data in the table below to answer the questions that follow.
Germany. Scroll through
time over the last 50 Year CEI Inflation rate
years. |s there an ‘average’ (from previous year)
long-run unemployment
rate around which the 2020 1053 22
three countries tend to 2021 106.4 10
hover? If so, what are
they? Why might some 2022 105.8 o
countries’ natural rates of
unemployment be higher 2023 = 32
or lower than others?
e e a. Calculate the missing inflation rate between 2021 and 2022. (2 marks)
Japan, Turkey, and b. Calculate the missing CPI for 2023. (2marks)
e c. Explain why governments weight categories in the measurement
‘average' inflation rate. i —— 2 mark
around which the three Gt (ienie)
Coune tendlio Rover? 2a. Explain the difference between cost-push and demand-pull
If so, what are they? Why inflation. (10 marks)
might some countries’
average inflation rates be b. Discuss the view that inflation of any amount is undesirable. (15 marks)
higher or lower than other 3. Outline three limitations to the Consumer Price Index as a
countries? means of measuring inflation. (6 marks)
Distinguish between deflation and disinflation. (4 marks)
5. Whatare two factors that can cause a movement along a
country’s short-run Phillips curve? (4 marks)
6. Outline the consequences of deflation for different stakeholders
in an economy. (10 marks)

332
 - ( | 2l

Macr oeconomic
objective:
 W4 Macroeconomic objective: economic growth

17.1 How do we measure and report

a country’s economic growth?

Learning outcomes
At the end of this section you will be able to:
* define economic growth as an increase in real GDP
« calculate the rate of economic growth from a set of data.

‘A rising tide lifts all boats.

—New England Chamber of Commerce, 1960s

The essential truth in this old aphorism suggests that a growing economy will offer
prosperity for all. Economic growth is defined as the growth of the real value of output
in an economy over time, usually measured as growth in real gross domestic product
(GDP). Growth, to put it plainly, is good. This, at least, is the established consensus
among macroeconomic policymakers. As a nation’s output increases over time,
the quantity and quality of goods and services available to the people of the nation
increases. One expects that such growth can be used well, and a country can raise its
standard of living year by year.
In Chapter 15, you learned about the ways an economy’s size can be measured.
Generally, GDP or gross national income (GNI) are the primary statistics used for
comparisons between countries and within countries over time. Also, one should
expect to measure GDP using ‘real’ or ‘purchasing power parity’ GDP calculations to
adjust for inflation or deflation. In this chapter, we will add to your understanding of
economic growth by using new calculations, reviewing our diagramming of economic
growth, and discussing the ways growth can go right and wrong.

What is the economic growth rate?

The standard statistic used for measuring economic growth is called the economic
growth rate (GR). It is the percentage increase or decrease in real GDP over the
previous year. Economists measure the rate of economic growth in a nation by
comparing the total value of the output of one year to the output of the previous year.
The GR in real GDP is found by the formula:
GDP,-GDP,
=— 2 " lx 100
ok GDP,
Economic GRs vary from country to country for year after year based on the
‘macroeconomic conditions within each country. A positive GR indicates the total
output of goods and services has increased from one year to the next. Negative growth
is evidence of a recession, caused by either a decrease in aggregate demand (AD) or
adecrease in aggregate supply (AS). However, a fall in the rate of growth does not
necessarily mean an economy is experiencing a recession, rather that the level of
output is increasing at a slower rate.

334
 Worked example 17.
Calculating economic growth
Consider these GDP figures for Egypt:

Year | Real GDP (constant prices, US$)

2014 965,888,437

2015 1,008,117,312

2016 1,051,396,500

2017 1,095,920,375

To calculate the real GDP GR we use the formula:

(GDP,~GDP))
R S\ CDP 100
1
So, in 2015 the GR is:
(1,008,117,312 — 967,888,437) L
00
967,888,437
40,228,875
= X 100
967,888,437
=415%
For 2016 the calculation is:

(1051396500
1008 17312) 100
1,008,117,312
43,279,188
T 00117312
=429%

And in 2017 it is:

(1095920575 ~1051,396500) | o
1,051,396,500

=4.23%

Exercise 17.1
Calculate the value of the GDP GR for 2013 and 2014.

Year | Real GDP (US$, 2017 prices)

2012 37,089,000,000
2013 38,136,000,000
2014 40,658,000,000

335
 Macroeconomic objective: economic growth

17.2 How do we use diagrams to illustrate

economic growth?

Learning outcomes
At the end of this section you will be able to:
+ useaPPC curve to illustrate two types of economic growth
+ explain, using a diagram, the manner in which a change in AD causes
economic growth
+ explain, using an LRAS diagram, how sustained economic growth is caused
by increases in the productivity, technology, or an increase in the quantity or
quality of the factors of production.

PPCs and economic growth

Recall that a production possibility curve (PPC) model is designed to show several
economic concepts, among them scarcity, opportunity cost, and trade-offs, but also
economic growth. Figure 17.1 shows a country whose two goods are consumer and
capital goods. Figure 17.1 illustrates growth in two ways.

Movement from within the PPC to a point on the PPC line

Point X is inside the nation’s PPC, indicating that the economy’s resources are
underemployed or not being used to their greatest efficiency. If the nation were
to move from point X to points A or B (both on the PPC), then the nation would
experience an overall increase in the total output of goods and services, achieving
economic growth. This would correspond with a movement from below full
employment in the AD/AS model to a level of output at which the AD curve
intersects the long-run aggregate supply (LRAS) curve at the full employment level
of output.
Consumer goods

Figure 17.1 The PPC

model can show two types of
economic growth

Capital goods
336
 « Figure17.2 Anincreasein
AD leads to an increase in real
GDP and economic growth

L Y rGDP

Economic growth shown as an increase in potential output

An outward shift of a nation’s PPC shows that the nation is able to produce and
consume more of everything. A movement from point A to point C in Figure 17.1 is
only possible through an increase in the quality or quantity of the nation’s productive
resources, or improved productivity. Increases in these areas could lead to economic
growth shown by an outward shift of a nation’s PPC. This shift is equivalent to an
increase in a country’s LRAS, shown in Figure 17.3.

AD/AS and economic growth

Short-run growth
The most useful and detailed model for illustrating economic growth in both the long
run and the short run is the AD/AS diagram (Figure 17.2). Economic growth occurs
any time a nation’s GDP increases. An increase in GDP occurs any time AD increases
when an economy is below its full employment level of output. An economy in a
recession that begins to recover is, therefore, technically growing as output returns
to its full employment level. On a PPC, this is similar to a movement from X to C in
Figure 17.1 above.

Long-run growth
As we know from Chapter 14 when we studied AD/AS theory in the long-run, movements
of AD by themselves only produce short run changes in growth. In Figure 17.2, during a Video suggestions:
recession, a rise in AD may fill a recessionary gap. If the economy were starting from | You have read about it, now
Y, full employment, a rise in AD would provide a burst of extra activity, as well as you can review what you
higher price levels, but eventually short run aggregate supply (SRAS) would shift left have just learned by watching
and the economy would land back at Y, with extra inflation. In short, only shifts of
a few videos by the author!
Simply click here in
LRAS can increase long-run growth. your eBook for videos
on economic growth in the
Figure 17.3 shows an economy experiencing long-run economic growth. Whatever short run and long run, in the
changes in AD and SRAS occur, sufficient and sustained changes to productivity or AD/AS model and in the
in the factors of production produce a shift of LRAS, one which corresponds to an PPC - the capital versus
outward movement of the PPC. The increase in LRAS is what allows this economy
consumer goods trade-off
337
 17 Macroeconomic objective: economic growth

PL LRAS, LRAS,

o
Figure17.3 Long-run P
—
2= >
growth involves a shift of
LRAS corresponding to an £5
outward shift of the PPC 8 PPC, PPC,

Y Y, Real GDP Consumer goods

to achieve a greater level of output in the long run. Without increases in LRAS, this
economy’s ability to grow is restrained to the full employment level by its limited
supply of land, labour, and capital.

17.3 What are the potential consequences of

economic growth?

Learning outcomes
At the end of this section you will be able to:
« analyse the impact of growth on living standards
« discuss the possible conflicts between growth and aims of low inflation,
environmental protection and sustainability, and income distribution.

While the notion that growth is positive for society may seem obvious, it is worthwhile
to identify how growth can affect specific macroeconomic goals and concerns.

Economic growth’s impact on living standards

An expanding economy by definition helps people reduce the constraints of scarcity.
More of our unlimited wants are likely to be satisfied in a growing economy. Some of
those gains will come from better buying power. More income may allow families to
buy more nutritious food, or consume greater levels of healthcare than before, leading
to greater life satisfaction. Expansion may raise incomes enough to allow people to
work less and increase their leisure time or time with friends and family. Moreover,
higher income may relieve the strain that money can place on families and improve the
stability of marriages and child-rearing.
On a more mundane level, rising GDP will increase tax revenues, allowing the
government to buy merit and public goods, increasing living standards. Also, if one
assumes that the general quality of consumer goods and services rises over time, one’s
enjoyment of better cars, appliances, furniture, and entertainment technology can
make life more enjoyable.
338
Sources of potential success and conflict between
Research and inquiry
macroeconomic objectives
Growth can broadly support and also diminish achievements in macroeconomic Macro country report
cards
progress, depending on the composition of increased output.
Your goal here is to chronicle
the successes/failures
Economic growth and low inflation in meeting government
objectives, based on data
As demonstrated by the short-run Phillips curve (SRPC), the relationship between collected for a variety
full employment and inflation is often a negative one. Increases of AD, in particular, of countries over a period
are likely to increase growth (corresponding to lower unemployment), while raising of time.

prices and thus increasing inflation. Calibrating monetary and fiscal policy to create For discussion and debate:
just the right level of growth, a level that will not push spending too far (beyond a 1 Identify a group of three
country’s ability to match that spending with more goods and services), is a difficult geographically related
countries.
and sophisticated task.
Research and chart their

~
ten-year performance in
Economic growth’s impact on the environment and sustainability the key macro objectives
(growth, low inflation, low
Here the effects of growth depend almost entirely on the composition of output and the unemployment).
manner in which it was made. Clearly, some types of production generate significant Using World Bank data

w
environmental spillover costs. As noted in Chapter 10, fossil fuels power or supplement and graphing tools, plot the
quite a lot of raw economic growth. That growth creates significant and growing risk results for each objective
on a separate graph
of climate change, and all the potentially massive planetary consequences that come
with it. A region or country that chooses growth in land development, carbon-based
Compare the relative

~
success of each country in
power production like coal-electric power, or the relaxing of environmental rules to each variable.
lure companies to their economy, is choosing immediate growth over sustainable Does it appear thata

«
development. However, large investments in green infrastructure would be reflected as country struggled to achieve
positive in environmental terms as well as higher growth numbers. greater success in all three
areas at the same time?

o Emissions from a coal power

station

339
 17 Macroeconomic objective: economic growth

What do the themes Economic growth’s impact on income distribution

of economic growth Growth does not necessarily lead to rising standards of living. As noted previously,
discussed here identify growth may not be distributed evenly, and the gains from growth may be rather
about knowledge that is
rooted in particular social tightly concentrated among the wealthy. It is not uncommon for rapidly growing
and cultural groups? countries to experience large disparities between the relatively rich and poor. In rich
countries, these widening gaps are highly correlated with increased social problems.
That said, growth provides the resources to correct inequality and redistribute income.
Ethics Growth may raise tax revenues, especially if the tax system is progressive, and increase
Consider the following spending on merit goods like healthcare and education. A progressive tax rate can also
quote: simply reduce inequality by reducing after-tax incomes among the rich and reducing
“Economic growth the tax burden on the poor.
may one day turn out
to be a curse rather
than a good, and
under no conditions Practice exam questions
can it either lead Paper 1, part (a) question
into freedom or
constitute a proof for 1. Explain, using a diagram, the difference between short-run
its existence.” economic growth and long-run economic growth. (10 marks)
German-American
thinker, Hannah Paper 2, part (b) question
Arendt
2. Using real-world examples, discuss the positive and negative
1 Explain the quote to effects of economic growth. (15 marks)
another student.

2 Identify ‘curses'that are Paper 2: 4-mark questions

caused by growth. 3. Explain, using a PPC diagram, two ways to show economic growth. (4 marks)
3 Towhat degree does 4. Using an AD/[AS diagram, explain how an increase in population
economic growth lead
to freedom? could lead to economic growth. (4 marks)

340
 Economics of inequality and poverty

18.1 What is the meaning of economic

inequality?

Learning ’comes
At the end of this section you will be able to:
« analyse the tension between the goals of economic efficiency and economic
equality
« distinguish between equality and equity
+ explain the difference between distributions of income and of wealth.

What is the tension between efficiency

and equality?
Market economies are considered proficient at several things:
« allocating resources efficiently, with the notable exception of externalities of
market failure
* encouraging innovation and creativity when property rights exist to protect the
inventions brought to market by entrepreneurs
« achieving increases in total output and average standards of living through the
pursuit of self-interest and profits in labour, capital, and product markets.
For these reasons, market economies score well in areas of efficiency, or, in other words,
getting the most out of the scarce resources that are available.
Planned economies, in which society’s scarce resources are allocated not by the
forces of supply and demand, rather by the very visible hand of the state, failed
throughout the 20th century to achieve long-run growth and improvements in the
overall living standards of people of the nations in which such economic systems were
implemented. What command economies did manage to achieve to some extent,
however, was relative equality in the distribution of the nation’s income and output
across the nation’s people. However, critics of the socialist system pointed out that
while such economies may have strived to achieve equality, by the time everyone was
equal, they were equally poor.
Free market advantages in efficiency, however, are often accompanied by a reduction
in equality. A major source of conflict in economics is that between efficiency and
equality. There is nothing inherent in a market economy that promotes equality
in the distribution of income and output. Freed from the organising principles of
state control, most of the new free market ‘transition economies’ of the formerly
communist sphere reported larger and larger gaps between rich and poor. Meanwhile,
in the rest of the world, average incomes in most emerging market economies have
risen, but the distribution of income has become increasingly unequal. Rich countries
have observed the same pattern.

342
As inequality has grown sharply, more economists are wondering if the trade-off
has swung too far in the direction of market efficiency and too far away from equity,
especially in the area of income and wealth distribution. If economies are to be judged
on overall economic well-being, they think, the social ills generated by inequality may
themselves qualify as a form of market failure.

What is the distinction between equality

and equity?
First, a distinction is helpful for this discussion. When referring to equity, a notion of
fairness is paramount. More specifically, a society that is highly equitable is one where
opportunities are accessible to all. This may mean that different people are treated
differently to ensure the availability of opportunities. In contrast, equality can be
interpreted to mean a standardised result for all. One could view measures to achieve
equity as being in service to greater equality across the population, but not necessarily
guaranteeing it.

‘Whereas the market system may fail to promote equity or equality due to the very
system of incentives aimed at encouraging efficiency, these are not unachievable
goals for economic policymakers. What is fair is not necessarily equal. For instance,
a taxation system rooted in the idea that those who can afford to pay the highest tax
rates should pay the highest tax rates, while those whose incomes are lowest should
pay lower rates is not equal treatment (some are treated differently that others), but it is
widely considered to be more equitable.
A market system can be equitable even if it cannot create total equality. To a certain
extent, a free market economy is in fact more equitable than a command system,
in that every individual is free to improve him- or herself through education and
professional growth, and then make his or her labour available to the market. In the
pursuit of self-interest, however, there are sometimes those who are left behind. In
this regard, it is the responsibility of government to promote equity through policies
that give every citizen in society a fair shot at achieving economic success in the
free market.

What is the difference between income

and wealth distribution?
The term income refers to the money earned in all forms over a period of time,
typically one year. Wealth refers to the accumulation of income or assets up to that
time. For example, a person might earn Ft3.6 million (Ft is the symbol for the forint,
the currency of Hungary) in a year from various sources: a primary job, short-term
employment projects, and perhaps rental income from a property. The same person
may have much more (or less) in net wealth, say from the accumulated value of her
savings, rental property, and the equity in her home that equals perhaps Ft17 million.
The analysis that follows will largely explore differences in income, which is more
flexibly adjusted by government policy, but will also consider inequities in wealth
distribution, which tend to be more acute and enduring.

343
 Economics of inequality and poverty

18.2 What is the distribution of income

and how is it measured?

Learning comes
At the end of this section you will be able to:
* define income distribution and distinguish between relatively equal and unequal
distribution of income
analyse data on relative income shares of given percentages of the population to
show differences in income distribution
+ draw a Lorenz curve and explain its significance
+ explain how the Gini index and coefficient is derived and interpreted
. build a Lorenz curve from income quintile data.

Economic inequality refers to the degree of distributions of both income and wealth.
To what degree are they equal or unequal?

What is the distribution of income?

In order to determine the equality or inequality of income distribution across a
nation’s population, economists first use income shares, or rather how much of a
nation’s total income is earned by the richest and the poorest groups of households.
Table 18.1 divides five nations’ households into five quintiles representing the richest
20% of households down to the poorest 20% and then indicates what percentage of
total income is earned by each quintile.

From Table 18.1 you can see that the highest concentration of income among
the top 20% of households exists in South Africa, where the richest fifth of
the population earns 68.9% of the income. The poorest fifth of South African
households, on the other hand, earn only 2.5% of the nation’s income. Algeria,
another developing country with a population about one-third smaller than

Table 18.1 Income Distribution for Selected Countries (latest data sourced from 2014-2018)

Country Percentage of total income earned by:

First quintile | Second quintile | Third quintile | Fourth quintile | Fifth quintile | Gini
(lowest 20%) | (next to last 20%) | (middle 20%) | (next to top 20%) | (top 20%) | index
(Perfect equality) 20 20 20 20 20 0
Czech Republic 10.2 14.7 17.7 22 354 249
Nigeria 7.1 16.2 17.48 22.7 424 35.1
Netherlands 8.8 13.8 17.5 223 37.6 28.5
Indonesia 6.9 10.9 15.2 221 44.9 37.8
Honduras 3.0 7.4 127 20.8 56.1 521
South Africa 24 4.8 8 16.5 68.2 63

344
South Africa’s, displays a more even distribution of income; its richest 20% of
households account for 37.6% of the income while the poorest earn 9.39%. Both
South Africa and Algeria have large numbers of poor people, but the poorest 20% of
people in South Africa are much poorer relative to the poorest 20% in Algeria. South
Africa’s poor have a much smaller ‘slice of the gross domestic product (GDP) pie’ than
do Algeria’s poor. And South Africa’s richest are relatively much richer than the top
income group in Algeria. Put simply, income is distributed less equally in South Africa
than in Algeria.

What is the Lorenz curve?

The Lorenz curve is a graphical representation of a country’s income distribution.
It plots the cumulative percentage of the nation’s income across the cumulative
percentage of the population (Figure 18.1). As a general rule, the further away a
country’s Lorenz curve is from the 45-degree line of equality, the more un-equal the
distribution of income.

The line of equality is the 45-degree line, representing a country in which each quintile
(20%) of the population earns exactly the same income as each other quintile. No
country has perfectly equal income distribution, therefore the line of equality is only
used for comparison. The Lorenz curve in Figure 18.1 represents the data shown
above for the Netherlands and Honduras. Starting at the origin, for Honduras, the
bottom 20% of the population earns 3% of the income. Moving on to the next quintile,
the bottom 40% of the population earn 10.4% of the income (3% + 8.4% = 11.4%).
This process repeats until the last quintile, where the top 20% of income earners in
Honduras account for around 56.1% of the national income.

For the Netherlands, the cumulative income is larger at each quintile, showing that
each 20% of the population earns more relative income than in Honduras, keeping

100

o 80
£s
g
£
S
@
2 60
2 Netherlands: Figure 18.1 The Lorenz
s top 20% curve for the Netherlands and
o earns 37.7% Honduras shows how far they
2 40 are from a perfectly equal
£ Honduras: distribution of income
2 top 20%
3 earns 56.1%
20 Honduras:
Point A: Bottom 20%
earns 3% of income.
Point B: Bottom 40%
earns 10.4% of income.

20 40 60 80 100
Cumulative percentage of population

345
 Economics of inequality and poverty

Video suggestion: the Lorenz curve for the Netherlands closer to the 45-degree line of equality. As noted
You have read about it, now above, the top 20% of earners in the Netherlands earn significantly less proportion of
you can review what you total income, 37.7%, compared to 56.1% taken in by the top earners in Honduras. This
have just learned by watching demonstrates that more unequal distribution of income, the more bowed out (further
avideo by the author!
Simply click here in away) a country’s Lorenz curve and more equally distributed income countries will
your eBook for a video be closer.
on the Lorenz curve and
income distribution.
What is the Gini coefficient?
Rather than draw Lorenz curves for every country to illustrate the level of income
inequality, economists use a tool called the Gini coefficient to quantify the degree
of income inequality in a nation. The Gini coefficient is the ratio of the area above a
country’s Lorenz curve and below the line of equality to the total area below the line of
equality. In Figure 18.2, the Gini coefficient is the ratio of area A to the area A + B. The
further away the Lorenz curve is from the line of equality, the greater the proportion
of area A to the total area below the 45-degree line. Therefore, the higher the value of
A + (A + B), the greater the Gini coefficient and the more inequality exists in income
distribution in the nation.
On Honduras’ Lorenz curve, the ratio of area A to area A + Bis 0.52, indicating that
the area between the line of equality and the Lorenz curve makes up 52% of the total
area below the line of equality. Honduras’ Gini coefficient is 0.52.

What is the Gini index?

Economists more commonly refer to the Gini index. This is the Gini coefficient
multiplied by 100. A Gini index of 100 would indicate perfect inequality of income
distribution in the nation. The top 1% of the population earns 100% of the income.
This represents an extreme example and is not technically possible, since even in a
Cumulative percentage of income

coeffi itfor Honduras is

the ratio of area A to the
whole of the area below the
line of equality

20 40 60 80 100
Cumulative percentage of population
346
 Table 18.2 Gini index for selected countries

Country Gini index (latest year available

between 2015 and 2018)
Norway 27
Switzerland 327
Ethiopia 35
China 38.5
Indonesia 39
USA 41.4
Turkey 419
Ecuador 454
Brazil 53.9
Namibia 59.1

nation in which poverty is extremely widespread the large number of poor require
some income just to survive.

On the other extreme, a Gini index of zero would indicate perfect equality of income
distribution. The Lorenz curve would lie along the line of equality, meaning every
household in the nation would enjoy an identical share of the national income. There
would be neither rich nor poor citizens since everyone's income would be the same.
Just as a Gini index of 100 is impossible, so is an index of zero. Even in the world’s
nominally egalitarian countries, such as the communist countries of the Soviet bloc,
there existed a rich elite whose share of the national income was larger than others.
This was because of their control of essential resources or political connections
or corruption.

A Lorenz curve and the Gini index can provide useful comparisons in the income
distribution between countries. See above in Table 18.2 showing countries with a
range of Gini index values. While these measures of relative equality provide some
indicator of relative position in each country, it is not a perfect predictor of levels of
economic development. Countries with high development scores like the USA may
have rather high Gini coefficients (41.4), while some relatively equal countries may do
poorly in overall development terms, like Ethiopia (35). The Lorenz curve and Gini
values are only a part of the overall picture in a given economy.
At the same time, these measures of inequality can be useful for comparing a single
country’s change in income distribution over time. As countries grow more unequal,
they may reconsider policies to address it (covered below). If equality is desirable
and rising, they can ask what policies are contributing to that and if it is worth any
perceived trade-off with economic efficiency.
Video suggestion:
You have read about it, now
you can review what you
While it is important to avoid drawing firm conclusions about the link between have just learned by watching
inequality and development levels, one should consider the geographical evidence avideo by the author!
for income distribution as well. Figure 18.3 shows distribution of income across the Simply lick here in
world, based on data points over 20 years. This suggests some clusters of inequality o your eBook for a video
in South America and Southern Africa, as well as patches of more equal distribution
on the Gini coefficient
347
 Economics of inequality and poverty

Gini index
[1200-249 [§25.0-29.9 F300-349 [7350-39.9 [M40.0-44.9
[ 45.0-49.9 [l 50.0-549 [ 55.0-59.9 [ 60.0-64.9 [l No data
A
Figure18.3 The areas
towards the end of the key
have more income inequality
according to this world map, To build a Lorenz curve, one needs data on the income shares by quintile
based on Gini index data,
(20% shares) or decile (10% shares). With these numbers one can plot each point
1999-2019
on the Lorenz curve to show cumulative income at each level.
Each point on the Lorenz curve represents the cumulative income of the poorest
quintiles to that point. Thus, each point does not represent only the share of income
earned by that quintile, but by all preceding quintiles. For example, in Japan the
middle 20% of earners earn 17.30% of income. On the Lorenz curve, however, one

Table 18.3 Income shares and cumulative income shares

by quintile for Japan
Quintile Share of | Cumulative share of Point on
income (%) income (%) Figure 18.4
Lowest 20% 740 | 7.40 Bottom 20% = A
Second Lowest 20% 12.90 7.40 +12.90 = 20.30 | Bottom 40% = B
Middle 20% 1730 17.40 +12.90 + 1730 | Bottom 60% = C
=37.6
Second Highest 20% 2270 | 7.40 +12.90 + 1730 | Bottom 80% =D
+22.70 = 60.3
Highest 20% 3970|740 +12.90 +17.30 | Total 100% = E
+22.70 + 60.3 = 100

348
 100

80
Cumulative percentage of income

60

D=740+1290 +
% 1730+22.70=603
< Figure18.4 Each pointon
C=740+1290 + the Lorenz curve for Japan is
17.30=37.6 the total of the income shares
20 for the quintiles preceding it

B =740 +12.90 = 20.30

20 40 60 80 100
Cumulative percentage of population

adds that income to the second lowest (12.90%) and lowest quintile (7.40%) to get
the cumulative income earned by the bottom 60% of earners, which is only 37.6%
of income (7.40 + 12.90 + 17.30 = 37.6%). We can see this in Figure 18.4.

in Europe, Canada, and Australia. The patterns and differences in income distribution
lead to more questions about the sources of inequality. In other words, why do some
countries have more equality than others? This is discussed in section 18.3.

What is the distinction between income inequality

and wealth inequality?
Income distribution takes into account the yearly earnings of households, without
considering the total wealth accumulation. By examining wealth distribution, one can
observe the historical summation of yearly income distribution. Some argue this is a
better measure of rich and poor since wealth distribution accounts for what households
currently own in terms of assets, rather than just what is been earned in a given year.
By this measure, global inequality is more extreme than mere income distribution would
lead one to believe. Wealth measurement is more complicated than income measurement,
especially when considering debt levels and determining the correct value of assets.
Nevertheless, economists recognise that income distribution only tells part of the story,
and are increasingly concerned about the concentration of wealth into fewer hands.
In Figure 18.5, notice the difference between countries shown previously with income
distribution and compare their wealth distribution.

Sweden, for example, ranks highly in equal distribution of income, but appears to
have wealth concentrated narrowly. Likewise, the USA, Russia, Brazil, India, and
Saudi Arabia appear to be countries who have the greatest wealth concentrations.
349
 Economics of inequality and poverty

Income inequzlity

‘Why does wealth concentration matter? Two reasons stand out. First, if the market system
is to work, in accordance with the ‘invisible hand’ of incentives that inspire competition,
effort, and innovation, then rewards must be possible. Where wealth is concentrated
without mobility, these incentives are blunted. In other words, if such wealth is
transferred from generation to generation and it is difficult to rise up through one’s own
ingenuity or hard work, then the talents of the clever and hard working are unrewarded.

Gini index
W02 [ 85.0-89.9 80.0-84.9 [l 75.0-79.9 [ 70.0-74.9

[ 65.0-69.9 [l 60.0-64.9 [ 550-59.9 []49.8 [ No data

350
Second, the concentration of wealth is likely to result in political power and dominance by an LT
elite class. The greater the concentration of wealth, the more important a wealthy individual The 20:20 ratio for income
or family becomes as sources of influence, fundraising, and informal types of support for inequality
those seeking office or representation. While authoritarian regimes may simply reflect Economists have been
the merging of state and wealthy interests, such as with the Saudi royal family or Chinese developing new ways to
Communist Party, democratic systems of government are also vulnerable to influence by the quantify inequality. One that
is growing in recognition s
rise of a billionaire class that is perceived to pursue its own economic interests. called both the 20:20 ratio,
and also the 80:20 ratio.
Case study - distribution of wealth | Both measure the same
way by comparing the
The Swiss bank Credit Suisse publishes a Wealth X Report and in 2019 it stated that median income in the top
‘the bottom half of adults account for less than 1% of total global wealth in mid-2019, 20% to the median income
while the richest decile (top 10% of adults) possesses 82% of global wealth and the of the bottom 20%. That
ratio expresses how much
top percentile alone owns nearly half (45%) of all household assets’. more the top earners make
compared to the bottom.
Discussion questions: For example, the OECD ratio
from 2015-19 shows that
1 What characteristics of the free market explain how such a disproportionate amount among OECD countries,
of global wealth could be held by such a small minority of global population? the Slovak Republic hasa
2 Whatare the social and economic consequences of half the world's population 2020 ratio of 3.2, meaning
holding only 1% of global wealth? that on average the top 20%
earn only 3.2 times that of
What role should the government play in redistributing wealth? the lowest 20%. Selected
w

4 Canyou think of two policies governments could employ to reduce the large countries include the
gap in global wealth distribution? Netherlands (4.2), Japan (6.2).
and the USA (8.4).
For discussion and debate:
1 Why might the 20:20 ratio
18.3 How is poverty measured and how is it be a more useful metric
for understanding and
related to inequality? communicating inequality
than the other measures?

Search for the OECD 2020

~

Learning outcomes or 80:20 ratio and look

at the span of countries
At the end of this section you will be able to: and their values. Does this
match your impression of
« distinguish between absolute and relative poverty the relative inequality for
* explain how international poverty lines measure absolute poverty them?

« explain how standards of minimum income measure poverty levels Speculate as to whata
country with a high ratio
« analyse a country’s performance using composite indicators of poverty
might do to reduce it, and
« discuss the difficulties in measuring poverty what the countries at the
* identify and explain the different major causes of inequality and poverty low end might be doing to
« discuss the various impacts of income and wealth inequality. achieve this level.

Video suggestion:
What does it mean to be poor? You have read about it, now
Despite the popular belief that there are rich countries and developing countries, in you can review what you
reality there is poverty in every country in the world. There are also incredibly rich have just learned by watching
avideo by the author!
people even in the world’s least developed countries. So, it is an oversimplification Simply lick here in
to say that one country is rich while another is poor. Poverty exists everywhere; but your eBook for a
in higher income countries, poverty is typically relative, while in the least developed video on the 20:20 ratio as
countries, we are looking at absolute poverty. Notably, one of the goals of the United atool for quantifying
income inequality.
Nations Sustainable Development Goals is to ‘end poverty in all its forms by 2030".
351
 Economics of inequality and poverty

How does one distinguish between absolute and

relative poverty?
For our purposes, we will define poverty as the scarcity or the lack ofa certain amount
of material possessions or money. Absolute poverty is measured in terms of the basic
need for survival. It is the amount of income a person needs to have in order to stay
alive. Relative poverty is a comparative measure of poverty. A person is said to be
relatively poor if they do not reach some specified level of income, for example, 50% of
average earnings for the country. Both measures convey different and useful measures
of poverty.

How can absolute poverty measurements inform

our understanding of poverty?
Measures of absolute poverty seek to quantify the number of people without the basic
needs for survival including food, shelter, clothing, and basic levels of healthcare and
education. International poverty lines are used to make meaningful comparisons
between countries. The World Bank’s international poverty line in 2020 was valued at
$1.90 per day in international dollars in terms of 2011 purchasing power parity, which
equalises its purchasing power across all countries and currencies.

The metric used by the World Bank is called the poverty headcount ratio, and by using
purchasing power parity it translates the money income earned into wages needed
to obtain basic needs. For higher cost of living countries, the poverty line would be
higher in nominal terms, reflecting the higher price levels for goods and services. And
in some very low-cost countries, it is possible to reduce the poverty line to a level
below the $1.90 per day amount.

As one might expect, absolute poverty is more ofa problem in developing countries.
There has been significant progress in the reduction of absolute poverty (also known
as extreme poverty) in the last 20 years. In its Sustainable Development Goals, the
United Nations reports that ‘Globally, the number of people living in extreme poverty
declined from 36 per cent in 1990 to 10 per cent in 2015.’ This is an enormous
achievement worth marking. At the same time, nearly 700 million people, about
10% of the world's population, still languishes in abject poverty. More alarming is
that the World Bank warns the gains of recent years may be entirely wiped out by the
COVID-19 pandemic and oil price drop of the early 2020s.

Figure 18.6 shows the dramatic reduction in absolute poverty on a global scale, broken
down by regional totals. In several regions extreme poverty has decreased, such as
Latin America, East Asia, and South Asia. In some it has decreased only slightly, but
from very low levels to start with, including the Middle East/North Africa, and
Europe/Central Asia. Only in sub-Saharan Africa have such poverty levels continued
to rise. While there will be more discussion of poverty in relation to economic
development in the section of the course on the global economy, it is important to
understand different measures of relative poverty.
If the average income of a nation rises and the income distribution remains the same,
the level of relative poverty will stay the same, while the number of people in absolute
poverty will decrease. It is important to keep this distinction in mind as we examine
the efforts of policymakers to eradicate poverty. While absolute poverty may be
reduced through international economic development strategies (Chapters 27-30),
352
 Figure 18.6 There vasa
marked reduction in the
number of people in the
world living in absolute
poverty, 1990-2015

1990 1995 2000 2005 2010 2015

Year
[ Latin America 1 South Asia # Europeand M Other high income
and the Caribbean Central Asia
B East Asia M Middle Eastand Bl Sub-Saharan Africa
and Pacific North Africa

relative poverty persists and could lead to macroeconomic instability unless policies
aimed at redistributing the nation’s income is enacted on a national level. In other
words, a country’s economic growth may assuage absolute poverty, but may leave
relative poverty, and the problems that go with it, in place.

How is relative poverty measured?

Relative poverty is measured in many ways, often according to a national approach
that suits the government’s macroeconomic goals.

Median income benchmarks

The OECD defines relative poverty as the percentage of people living with less
than 50% of median equivalised disposable income. So, if the median income is
approximately €22,000 per year in France, someone living on half of that, just
€11,000, is at the relative poverty line.

Countries can define their relative poverty line in their own way. Some consider
disposable income to be all income after housing payments, others include taxes.
Some countries use a measure of 60% below median disposable income rather
than 50%. However, the OECD has tried to standardise its estimate using the 50%
benchmark. Figure 18.7 shows the relative poverty scores across OECD countries.

The measure shown in Figure 18.7 also shows disparities by gender. In nearly all
countries women experience more relative poverty than men. Furthermore, those
most likely to experience poverty in all countries are children, youth, the elderly,
and women.
353
 Economics of inequality and poverty

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Colombia
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50% of median equivalised | Minimum income standards
disposable income, by gender,
in 2016 (or nearest year) Another measure of relative poverty has been the creation and use of minimum
income standards (MIS). Also sometimes referred to as a ‘living wage’, the
standard is the amount of income one needs to fully participate in society, not to
merely get by on a subsistence level. MIS differs from statistical income benchmarks
in its approach to identifying those needs. In the UK, MIS researchers ask focus
groups of particular socioeconomic cohorts to identify the required goods and
services to be included as essential. Different household types, because they have
different needs, generate different lists. Older people, single adults, and different
family sizes each have different lists and levels.

The 2020 UK estimate for a two person household, one adult and one small child, is
shown in Table 18.4.

Table 18.4 UK
‘Weekly outgoings ‘Weekly income
Minimum Income
£656.34 £656.34
Standard: the estimate
for one adult and Food £58.15 | Pre-tax earnings £789.81
small child in 2020. Alcohol £5.36 | Income tax £110.02
Clothing £22.48 | National insurance £72.82
Water rates £10.20 | After tax earnings £606.97
Council tax £20.98 | Working tax credits £0.00
Houschold insurances £1.36 | Child benefit £21.05
Gas, electricity, etc. £15.55 | Child tax credit £28.32
Other housing costs £1.92 | Childcare tax credit £0.00
Household goods £20.71 | Housing benefit £0.00
Houschold services £13.50 | Council tax support £0.00
Childcare £251.76 | Income support/Jobseeker’s £0.00
Personal goods and services £30.58 | allowance
Travel costs and motoring £66.66
Social and cultural activities £51.60
Rent £85.53
Mortgage £0.00

354
Note that a living wage is not the same as a minimum wage, which you learned about
in Chapter 9. A minimum wage is the legal wage floor while the living wage may be
well above this standard. For many researchers and living wage advocates, the point
of identifying a living wage is to show the difference between the wages currently
available and the level of wages actually needed by families.

What is the multidimensional poverty index?

The standards shown above are single indicators that are limited to showing a
single perspective on poverty. A useful contribution to poverty studies is the use of
composite indicators that put several characteristics of the problem into one measure:
the Multidimensional Poverty Index (MPI), developed by the UN Development
Programme (UNDP) and the Oxford Poverty and Human Development Initiative,
claims that ‘new data demonstrate more clearly than ever that labelling countries — or
even households —as rich and poor is an oversimplification’.

As an example of differences within a country, 55% of Uganda’s population experience

multidimensional poverty, in line with the rest of sub-Saharan African countries. However,
in the capital city of Kampala, the rate is only 6%. But in the rural region of Karamoja,
the MPlis 96%. On a more specific level, households themselves may experience poverty
differently. The report cites that 25% of South Asian children live in a household where one
child is malnourished, but another child in the same household is not.

Among those who fall into the category of multidimensionally poor, children are
hit hardest, more likely to feel all of the effects of poverty from ill health to poor
sanitation. Children are affected far more frequently than adults. The MPI finds that
one in three children worldwide are multidimensionally poor, which is only true of
one in six adults.

The MPlis calculated by identifying the different aspects of poverty, measuring their
frequency and assigning each factora relative weight based on the likely impact each
dimension will have on the experience of poverty. Among the most heavily weighted
values involve health and education: nutrition, child mortality, years of schooling
and school attendance. Table 18.5 shows the full range of measured dimensions and
their weighting.

According to the MPI, households must be deprived in one of the following ways in
order to be considered multidimensionally poor:

* atleast six standard of living indicators

« three standard of living indicators and one health or education indicator
* two health or education indicators.
So, a family experiencing insufficient levels of electricity, water, housing, fuel,
sanitation, and without basic assets will qualify. Or a family without perhaps poor
water, sanitation, and electricity with either little schooling or poor nutrition would
qualify. In the last case, a family with acceptable levels in standard of living but with
poor health or poor education also qualifies.

What does the MPI tell us about poverty?

By this measure, the MPI estimates that 1.3 billion people are multidimensionally poor,
nearly double the measure found in extreme poverty by the international poverty
355
 Economics of inequality and poverty

Table 18.5 Multidimensional Poverty Index, dimensions, and weighting

Dimensions | Indicator | Deprived ifliving in the household where.... . ‘Weight
of poverty
Nutrition | An adult under 70 years of age ora child is undernourished. 1/6
Health Child Any child under the age of 18 years has died in the five years preceding the 1/6
mortality | survey.
Yearsof | No household member aged 10 years or older has completed six years of 1/6
ohe el
Education Ll ling.
School Any school-aged child is not attending school up to the age at which he[she 1/6
attendance | would complete class 8.

line measure. Perhaps surprisingly, two-thirds of the multidimensionally poor live in

middle-income countries. Half of the multidimensionally poor are children. Between
some countries in South Asia, there are massive differences in poverty and education
deprivation for girls. The study also analysed ten countries for change over time, and
found that the biggest gains came among the poorest groups in each country. This
finding roughly corresponds to the reduction in extreme poverty worldwide according
to international poverty line measurements.
A distinguishing value of the MPl is that it provides information about the specific
nature of poverty in a country, giving policymakers an idea of how to prioritise their
poverty reduction goals.
Figure 18.8 shows Laos and Zimbabwe, who each scored the same overall on the MPL.
However, they differed in the aspects of life where deprivation hit hardest. For Laos,
amuch bigger contributor to poverty was fewer years of schooling and attendance,
where for Zimbabwe, poverty was more directly related to a lack of necessities for
standard of living: not enough fuel, water, electricity, or sanitation. Government
officials and non-governmental organisations (NGOs) aiming to reduce poverty
in each country should therefore target their solutions to the most pressing issues.
Measures like the MPI help inform more precise policymaking.

356
 100

%0
80
[ Nutrition
70 B Child mortality
e I Years of schooling
g B School attendance Figure 18.8 While Laos
=§ M Cooking fuel and Zimbabwe score the
=
so0 B Sanitation same overall on the MPI, they
E 40 [ Drinking water differ in the aspects
g B Electricity contributing most to poverty

§ 30 [0 Housing
£s 5 B Assets

10
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Laos Zimbabwe

What are the difficulties in measuring poverty?

Despite the apparent progress in the quality and quantity of poverty measures, getting
a precise and reliable view of poverty is challenging for a variety of reasons.
Household survey data is a major source of poverty information. Such surveys are
subject to sampling and weighting issues that may distort the true picture of poverty.
Definitions of poverty vary from country to country. Countries may prioritise the
gathering of some kinds of poverty data over others, which makes standardising
the data across countries difficult.
Non-income aspects of poverty, many of which are covered by the MPI, can be
even more difficult to measure than income data. Many data points, like nutrition
levels, are context specific and so require more resources to collect.
Country data can be skewed to reflect the priorities of a national government, who
may have the incentive to adjust poverty lines to falsely report better outcomes
than actually exist.
Data from conflict zones is notoriously difficult to collect as the disruption to
everyday life and communication systems render all kinds of statistical data
gathering difficult to perform.

What are some of the major causes of poverty?

Poverty arises from a variety of factors, some of which are related to each other and
which also reinforce each other.

Inequality of opportunity
Free market schools of economic thought, from classical to new classical, have emphasised
the role of incentives to self-interest to economic growth and self-improvement. One can

357
 Economics of inequality and poverty

getrich with effort and cleverness, it is argued, because the system rewards these qualities.
However, what if access points to self-improvement are not available?

Those born into households where there is poor nutrition, little healthcare available,
and no schooling are starting well behind everyone else. More specifically, a child who
is poorly nourished may be more likely to be out sick from school, if such a school
is available. One alternative is to work to earn money for one’s family, which helps
in the short term but limits educational attainment, and caps lifetime earnings. In
general quality of life terms, this is a family which spends most of their waking hours
working and has little time for anything that brings joy or connection in life. They are
consumed by the need to meet basic needs, and few resources to move past this point.

In contrast, those born into a different household may be enrolled into steady
schooling, where they can develop their skills and work towards employment in
jobs that offer a living wage. They can have access to bank loans to buy property or
abusiness and build their family wealth. Such children have a chance, though not a
guarantee, at a future equal to or better than that of their parents.

Both examples above, though simple, illustrate a sort of circular dynamic. However,
in the first case, the poor child may be locked into a poverty trap that prevents
them from improving their standard of living. In the second case, the child raised
with certain basic levels of education, health, and income can maintain their level or
perhaps even move higher.

How does one measure equality of opportunity?

In one sense, the poverty measures above give a vivid picture of likely opportunity
from country to country. The gaps between life chances in a rich and a developing
country can be profound. For life spans, the average person in the richest country can
live 60% longer, or 30 years, longer than the average citizen of a poor one. Children
go to school nearly 10 times longer in rich compared to developing countries, and
incomes can be an astonishing 172 times higher, even after adjusting for price levels.
When it comes to opportunities from birth, life, as the saying goes, is not remotely fair.
One factor that could mitigate such inequity is if it were still possible to rise from such
deprivation. In other words, is it possible to move up the ladder in your country, or
are positions fixed? Economists try to measure this by calculating intergenerational
income mobility. This refers to the relationship between the socioeconomic status of
parents and the status their children will attain as adults. It attempts to measure the
likelihood that one’s wealth is largely determined by one’s inherited advantages.
The idea is that while poverty is undesirable, it may be excusable in societies where
upward mobility is possible. If the poor are able to move up, then poverty itselfis not
as significant a problem as when the poor are trapped in their circumstances.

However, the World Bank estimates suggest that income inequality is highly correlated
with upward mobility. In other words, where incomes are most unequally distributed,
there is less opportunity.

Worryingly, the narrowing of opportunities for the poor is most pronounced in

developing countries. While there is considerable variance from country to country,
the World Bank found that in many countries mobility rose in the decades leading up
to 1980, but that since then the path to life improvement has become less accessible.
358
In many poor parts of the world, or poor parts within developing countries, far too
many children’s standard of living is defined by the level attained by their parents.

Different levels of resource ownership

Relatedly, there are significant differences in the ownership of resources, in particular
that of capital. The ownership of capital, in either money or the form ofa business,
puts one in a position to generate more income from that resource. A relatively small
portion of the world’s population holds ownership of meaningful physical or financial
capital. Over the last several decades the growth in incomes has been far greater as a
return on capital than to rises in worker wages or other income sources.

Different levels of human capital

Labour markets tend to reward labour that is highly skilled, and rewards to higher-
skilled labour have grown faster than those for lower skilled workers, for a variety of
reasons, including greater mobility in physical capital (outsourcing). This increases
the value of greater educational attainment, which is an expensive merit good that
individuals and countries struggle to afford.

Globalisation and technological change

Globalisation has vastly increased the size of markets for capital owners, it has made
the relocation of factories and firms easier. This has made it possible for firms to
hop from country to country seeking the lowest labour costs. Globally, wages for
manufacturing jobs have been suppressed. Even for low-income countries that draw
such investment, the rewards in terms of improved capital and rising wages may be
transitory. At the same time, demand for managers and mid-level positions within
such companies have been much higher, compounding inequality.

Market-based supply-side policies

As described in Chapter 2, the consensus around free markets and government
intervention shifted significantly from the post-Second World War period to the 1970s
(Keynesian), to the 1980s into the present (new classical). It was in the 1980s in the
UK and the USA that major shifts towards supply-side economic policies took place.
‘While much more will be said of supply-side approaches in Chapter 21, the market-
based approach of the 1980s required the rolling back of many layers of government
intervention, including many that protected workers and the poor.
Specifically, under UK Prime Minister Margaret Thatcher and US President Ronald
Reagan, respectively, both countries reduced social welfare programmes for the poor,
believing that they reduced the incentive to work. They lowered marginal tax rates
as well, believing that lower rates encouraged work and innovation. Both engaged in
active efforts to reduce the power of labour unions, which have traditionally served to
fortify wages in typically low-wage jobs. These and other market-oriented policies of
that era made greater numbers of workers and the unemployed at risk of poverty.

One product of the sweeping anti-regulatory approach of the 1980s was to

encourage the deregulation of financial markets. As a result, banking grew quickly,
relative to the overall size of the economy, and also as the leading profit maker in
the economy. However, it also led to the financial crisis of 2008, which plunged
millions into bankruptcy and caused a global recession. Since that time, most of
359
 Economics of inequality and poverty

the gains in GDP in rich countries have gone not to the poor or middle class but to
the top 20% of earners.

Discrimination (gender, race, and others)

Ablind spot in pure classical economic theory is the insistence that racial and gender
discrimination should not occur, because it violates the notion that competition seeks
out efficiency and quality, regardless of irrelevant factors. More specifically that it is in
the best interest of firms, for example, to hire the most talented people regardless of
race, gender, religion, or other charateristics. This ignores years of anecdotal, historical,
and increasingly data-based evidence that discrimination plays a major role in creating
inequality between groups.

The USA demonstrates glaring gaps by race in nearly every standard of living
category. The average white family in America holds nearly nine times more wealth
($171,000) than the average Black one ($17,150) , and the yearly income disparity is
similar. Of course, the roots of this disparity go back hundreds of years. Nearly all
of the African Americans in the USA, a group that made up 16% of the country’s
population at the peak of slavery, were property themselves from the 1600s to the
1860s. From the 1860s to the 1960s, most American blacks suffered under segregation
laws that restricted property ownership, denied black children an education, denied
the right to vote, and allowed comprehensive forms of discrimination, especially in
employment.

Research and inquiry The USA is distinguished, but not alone, in permitting racial discrimination in the basis
Seek out gender and of its economic system. Ethnic minorities in many countries suffer from racially based
racial minority wage gap discrimination in many areas of economic life.
information or other
information pertaining to Gender disparities are another notable source of income inequality. This too varies
inequality based on identity. greatly country by country. Figure 18.9 shows one example of wage inequality by
gender, within selected countries. Where the gaps are greatest, policymakers might be
left to wonder if norms and policies that discriminate in this way destroy the incentives
for self-advancement that are assumed to be open to all. If so, many people may reduce
their ambitions because of systematic inequalities of opportunity, and greatly reduce a
country’s human capital.

Unequal status and power

As abroad source of inequality, unequal status and power refers to the interconnected
characteristics of many of the above categories, and include others that may not
specifically be mentioned here. A country can have its own combination of inherited
wealth, forms of discrimination, lack of opportunity, and lack of enfranchisement
that combine with other contextual factors to produce versions of a social underclass.
Members of such an underclass are hardly ever united in any common struggle for
better treatment and conditions. They typically lead isolated lives, work in soulless
employment, and have little opportunity to address their grievances.

Government tax and benefits policies

Despite the classical economic vision of an economically neutral government, most
governments have policies in place that reward different groups in different ways.
This can help to promote or, as we will observe later in the chapter, to reduce income
360
 South Korea 33,59%
Russia
Switzerland 17.38%(2014)
Brazil 15.97%(2014)
Denmark 15.96%(2014)
France 15.5%(2014)
Norway 4.45%(2014)
Country

Spain o Figure18.9 The gender

Pakistan wage gap in selected
Vietnam countries
Uruguay 862%(2014
Poland 7.73%(2014)
Belgium 6.54%(2014)
Colombia
0% 5% 10% 15% 20% 25% 30% 35%
Unadjusted gender gap in average hourly wages, 2016
(% of average male earnings)

inequality. As mentioned above, free market supply-side policies have accentuated

the gap between rich and poor in many ways over the years. For example, differences
in tax rates can imply favouritism to classes of work. Where corporate or capital gain
taxes are lower than income taxes, it appears that the relatively rich, those who own
capital and have shares in companies, pay less than their share to the government
relative to wage earners. This effect is compounded when governments insist on
reducing pension, health, or other benefits in order to pay down government debts.

What are the consequences of inequality

and poverty?
Less economic growth
Research into the link between inequality and growth has shown mixed results, with
some showing inequality reduces growth and some showing the opposite correlation.
The debate has two sides. One may argue that in unequal societies, the increased
profits and savings of the rich contribute to higher levels of funding for investment and
innovation. Conversely, if inequality reduces the incomes of the poor and squeezes out
amiddle class, the lack of their spending on goods and services reduces the circular flow
and reduces potential GDP. Furthermore, if paired with reduced economic opportunity,
inequality has the effect of reducing levels of educational attainment and the
development of human capital that would otherwise contribute to potential growth.

Less social stability and social cohesion

Inequality and poverty affect social trust and participation. Unequal societies have
lower rates of civic participation, lower voter turnout, and appear to have fewer acts of
altruism. The poor, who may not believe the system works for them, are far less likely
to join clubs and social groups, and vote less frequently. This only contributes to the
comparative political power of the relatively wealthier groups. Moreover, research
finds that physical and psychological health levels are much lower in unequal societies.
Higher levels of obesity, mental illness, depression, infant mortality are found in
unequal societies. This is especially true of inequality in rich countries.
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 Economics of inequality and poverty

Individual and family struggles

For workers and families, the grinding demands of living without enough resources
can have significant damaging effects on emotional and cognitive well-being. Research
on poverty, specifically the effects on poor children show a bleak picture. Adults who
were poor as children tend to have memory deficits. Brain research indicated that low-
income children are more likely to suffer from irregular brain development, and have
deficits and verbal and spacial memory. Research on adults has found that the stresses
induced by poverty reduce the ability to make evidently beneficial decisions about
many types of family economic problems.

18.4 How do tax systems and government

intervention affect inequality?

Learning outcomes
At the end of this section you will be able to:
« distinguish between direct and indirect taxes, providing examples of each
+ examine the potential role of direct taxes in redistributing income
+ compare and contrast progressive, regressive, and proportional taxation,
providing examples of each
. calculate the amount of indirect tax paid from information given
. calculate total tax and average tax rates from a set of data
« discuss the arguments for and against progressive taxation as a method for
reducing income inequality.

Governments at many levels hold the power to tax: at the national level, the regional
or state level, and the city or town level. They levy taxes in a variety of ways and for
many purposes. Generally, governments may tax demerit goods, ones which generate
negative externalities, in the hope of reducing consumption of them. These taxes,
as well as others, may also fund important government goods and services. Finally,
authorities may use tax rates to redistribute income to reduce the gap between high-
and low-income groups.
Indirect taxation, such as the specific taxes on demerit goods you studied in Chapter 10,
or the value added taxes to goods more generally are one way of collecting taxes.
Another method is direct taxes, where the payee pays the government directly via
cash, ebanking, or with credit cards. Direct taxes can be in the form of income taxes,
property taxes, corporate profit taxes, and wealth taxes. A personal income tax takes a
percentage of your salaried income from each year. Corporate profit taxes are similar
to a personal income tax in that a particular tax rate is applied to yearly company
profits. A wealth tax levies a rate based on the accumulated assets of an individual or
family. Property taxes are a particular form of wealth tax, based on real estate holdings.
The rates on all of these taxes can vary, and these differences are where political
discussions around equity arise. In some countries, the value added tax (on all goods)
and the income tax rate paid by most families, is actually higher than any form of
362
 property tax, corporate tax, or wealth tax. This discrepancy famously prompted the
multibillionaire investor Warren Buffet to claim that he paid a lower tax rate than his
secretary, whose income was hundreds of times lower.
Corporations and the wealthy who can afford it take advantage of loopholes and
legally written advantages for investment income. In the case of corporations, rules
can be relaxed to lower the rates paid by influential firms. Using publicly available
corporate reporting information, the Institute on Taxation and Economic Policy found
that 60 US corporations paid $0 in US taxes in 2018. Among them were: Amazon,
Chevron (oil), Netflix, General Motors, Eli Lily (pharmaceuticals). The practice of tax
avoidance, by wealthy individuals and corporations together, is estimated to cost
countries up to $600 billion per year in lost income. Of that figure, $200 billion would
be payable to low-income countries, for whom it is much more needed and could
otherwise be directed to public works. It is also more than the amount of foreign aid
sent to low-income countries ($150 billion) each year.

What are the historical perspectives on taxation?

The Marxist view
On the far ‘left’ of the economic spectrum is Marxist/socialist ideology, which believes
that households’ money incomes should be made obsolete and each household’s level
of consumption should instead be based on the labour-value of the output which it
produces. In a purely Marxist/socialist economy, money incomes do not matter since
the output of the nation will be shared equally among all those who contribute to its
production. Private ownership of resources and the output those resources produce
are wholly abolished in a socialist economy.

With regards to taxation, the slogan ‘from each according to his ability, to each
according to his need’, made popular by Karl Marx, summarised his idea that a
household’s consumption should be based on its level of need, rather than the amount
of capital it owns and the income it can earn from that capital. The logical conclusion
of this idea is that all households in a nation have essentially the same basic needs,
therefore household incomes and consumption should be equal across the nation.
With that approach in mind, that Marx disapproved of wealth and inequality to begin
with, the Marxist view of taxes would be harsh on the highest earners and lower
incomes workers would be net receivers of subsidies.

The laissez-faire view

On the other extreme of the economic spectrum is the classical, free market model
which argues that the only role the government should play in the market economy
is in the protection of private property rights, ensuring that the private owners of
resources are able to pursue their own self-interest in an unregulated marketplace
where their money incomes are determined by the exchange-value of the resources
they own, including capital, land, and labour.
In a market economy, the level of income and consumption of households vary greatly
across society because the exchange-value of the resources owned by households
is what determines income, not the principle of equality, which drives a socialist
economy. Each individual in society is free to pursue his or her monetary objectives
through the improvement of his or her human capital and the accumulation of
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 Economics of inequality and poverty

physical capital and land and the resulting increase in exchange-value in the resource
market. And so, everyone should be taxed minimally, if at all.

The modern, mixed economy approach

In today’s world, there exists neither a purely socialist economy nor a purely free
market economy. In reality, all modern economies are mixed economies in which
governments do much more than simply protect property rights, but do not go so
far as to own and allocate all factors of production. The role of government in the
distribution of income in today’s economies is relegated to the collection of taxes and
the provision of public goods and services and transfer payments.

Differences between progressive, regressive,

and proportional effects taxation
Taxes can be proportional, regressive, or progressive in nature. This means that
different taxes place different burdens on the rich and the poor.

Proportional tax
A proportional tax is a tax for which the percentage remains constant as income
increases. The rich will pay more tax than the poor in absolute terms, but the burden
of the tax will be no greater on the rich than it is on the poor.
A houschold earning €20,000 may pay 10% tax to the government, totalling €2,000.
Arich household in the same country pays 10% on its income of €200,000, totalling
€20,000 in taxes. There is a difference in total value but the proportional burden is the
same on the rich household as it is on the poor household.

Proportional taxes are generally uncommon in advanced economies, with the

exception of Russia and some former Soviet bloc countries who use the flat rate to
encourage tax compliance. Although some payroll taxes (i.e. those collected to support
social security or welfare programmes) are based on a percentage of employees’
incomes up to a certain level. For instance, the US social security tax is 6.2% of gross
income up to $108,000. Regardless ofa person’s income below $108,000, he or she will
pay 6.2% to the government to support the country’s social security programme.

Regressive tax
A tax that decreases in percentage as income increases is said to be regressive. Such a
tax places a larger burden on lower income households than it does on higher income
carners since a greater percentage of a poor household’s income is used to pay the tax
than a rich household’s.
You may be wondering why a government would ever levy a tax that harms the
poor more than it does the rich, but in fact almost every national government uses
functionally regressive taxes to raise a significant portion of its tax revenues. Most
indirect taxes are actually regressive, which may not make sense at first, since a sales
tax is a percentage of the price of products consumed. The regressive nature becomes
apparent when the amount of the tax is compared to the income of the consumer.

To demonstrate how a sales tax is regressive, imagine three different consumers who
purchase an identical laptop computer for €1,000 in a country with a value added tax
of 10% added to the price of the computer (Table 18.6).
364
Table 18.6 Indirect taxes are regressive because the tax paid is a smaller
proportion of the income of a rich person than the income of a poor person

Income of buyer/€ Amount of tax paid/€ % of income taxed

10,000 100 1

50,000 100 0.2

100,000 100 0.1

The higher income consumer pays the same raw total of tax as the lower income
consumer (€100), but the tax makes up a smaller percentage of the former’s income
(0.1%) than it does of the latter’s (1.0%). Although they appear to be equitable since
everyone pays the same percentage of the price of the goods they consume, indirect
taxes such as value added tax (VAT), goods and services tax (GST), and sales taxes are in
fact regressive taxes, placing a larger burden on those whose ability to pay is lower and a
smaller burden on the higher income earners whose ability to pay is greater.

Progressive tax
This is a tax for which the percentage paid in tax increases as income increases. The
principle underlying a progressive tax is that those with the ability to pay the most
tax (the rich) should bear a larger burden of the nation’s total tax receipts than those
whose ability to pay is less. In this way, a progressive tax is the most equitable of the
three types of taxes a government collects.
Lower income households not only pay less tax, but they pay a smaller percentage of
their income in tax as well. Most nations’ income tax systems are progressive, the most
progressive being those in the Northern European countries which, not surprisingly,
also demonstrate the most equal distributions of income. Of the various types of taxes,
a progressive income tax aligns most with the macroeconomic objective of equity in
the distribution of income.

Comparing tax systems

Figure 18.10 shows the relationship between an individual’s income and the amount of
tax the individual will pay under each of the three tax systems.

Assuming a proportional tax, for instance, each household will pay an identical
proportion of its income in tax, so as income rises, the amount of tax paid rises ata
constant rate.

Under a regressive system, on the other hand, lower income households pay a larger
percentage of their income in taxes. Regressive taxes are mostly indirect, consumption
taxes, so higher income households still pay more in tax (since they consume more),
but the amount paid increases at a decreasing rate because at higher incomes the Video suggestions:
marginal propensity to consume becomes less and more income goes towards
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A progressive tax places very little burden on low-income households, since under Simply lick here in
most progressive income tax systems, the lowest income earners actually pay no tax o your eBook for videos
at all. At higher income levels, a greater percentage of income is paid as tax, so the on the different tax systems’
effect on income distribution.
amount paid increases at an increasing rate as household income rises. The highest
365
 Economics of inequality and poverty

Progressive
tax
Proportional
tax

Amount of tax paid

Figure18.10 The >
relationship between tax paid
and income differs between Regressive
tax
progressive, regressive, and
proportional taxes

Amount of income

income earners in the economy pay the most tax in all three systems. However, only
under a progressive tax system do the richest households also bear the greatest tax
burden, meaning that they pay a higher proportion of their income in taxes than lower
income households.

A progressive income tax typically consists ofa marginal tax bracket in which
the increasing tax rates apply to marginal income, rather than to total income.
In such a system, the average tax a household pays increases less rapidly than the
marginal tax because the higher marginal rate only applies to additional income
beyond the upper range of the previous bracket. In other words, each successively
higher tax rate is only charged on the income in excess of that already taxed at the
previous level.
Table 18.7 shows a set of possible marginal tax rates. The third column shows the
cumulative tax rate paid when tax on all the income in a given bracket has been
calculated.
Few countries tax the most basic levels of income. The first portion of income
earned in any period is not taxed, and then each successive level is taxed at a
different rate, as the person graduates into a higher level or bracket.
Table 18.7 Income and marginal tax brackets
Income (¢£) (¢ is the symbol
for colon (plural colones),
Tax level or bracket | the currency of CostaRica). | Marginal tax rate
A 0-6,000,000 0
B 6,000,001-18,000,000 20%
C 18,000,001-27,000,000 40%
D 27,000,001-36,000,000 50%

366
In the example above, a person who earns ¢:21 million will have the following tax due:
From Level A, the first 26 million is not taxed = 0
From Level B, the whole ¢:12 million is taxed at 20% = ¢*2.4 million

From Level C, only ¢3 million is taxed (¢21 million — ¢18 million)

at40% = (*1.2 million

Total tax due = ¢3.6 million

Another set of examples will be useful. With the table below, Diya is shown as
earning 350,000 and Maria earning 100,000 (s is the symbol for lev, the currency
of Bulgaria). We can calculate the total tax due based on the tax brackets, as well as
working out the average tax paid by each individual.
Diya’s Income = 850,000

Tax level or Income (ns) Taxrate | Calculation | Tax amount (ms)

bracket
A 0-10,000 0 10,000 X 0 0
B 10,001-30,000 20% 20,000 X 0.2 4,000
C 30,001-45,000 40% 15,000 X 0.4 6,000
D 45,001-60,000 50% 5000 X 0.5 2,500
E 60,001-100,000 60% — —
Total tax:
12,500

Maria’s Income = 100,000

Tax level or Income (ns) Taxrate | Calculation | Tax amount (ns)

bracket
A 0-10,000 0 10,000 X 0 0
B 10,001-30,000 20% 20,000 X 0.2 4,000
C 30,001-45,000 40% 15,000 X 0.4 6,000
D 45,001-60,000 50% | 40,000 % 0.5 20,000
E 60,001-100,000 | 60% | 40,000 X 0.6 24,000
Total tax:
54,000

Note that while Maria earned twice as much as Diya, she pays significantly more
than twice the total tax. To calculate the average tax rate, take the total amount of
tax paid by each and divide by their income.
L
Diya’s average income tax rate: X 100 = 25%

) ) 54,000
Maria’s average income tax rate: ———— X 100 = 54%
100,000

367
 Economics of inequality and poverty

There are two patterns worth observing. First, for workers in each of the income
brackets above, the average rate of taxation is always lower than the marginal rate
of taxation, since tax increases only apply to additional income earned beyond the
previous bracket. Second, in a progressive system, this result would not necessarily
be unusual. Because the higher marginal rates are rising, the average rate of a
high-income earner will rise as well.

Practice exam questions - assessment tips (Paper 3)

For Paper 3, HL students may be asked to make a series of calculations, including
total amount tax paid, average tax rate, total indirect tax from a set of data. Follow
the worked example and then complete the exercise.

Worked example 18.1

The following table shows the marginal tax rates at each level for the USA.

Tax level or bracket Income ($) Tax rate

A 0-10,000 0
B 10,001-30,000 18%
¢ 30,001-45,000 25%
D 45,001-60,000 33%
E 60,001-75,000 39%
F 75,001-500,000 47%

In addition, VAT at the rate of 15% is charged on all purchases.

Donfor works in the USA and earns $47,000. He saves 10% of his disposable
income.

Calculate the tax paid by Donfor as a percentage of his total income (the average
overall tax rate).

a. First apply Donfor’s $47,000 to each income tax bracket:

Level A: $10,000 X 0 =0
Level B: $20,000 X 0.18 = 3,600
Level C: $15,000 X 0.25 = 3,750
Level D: $2,000 X 0.33 = 660
Total income tax = $8,010
b. Calculate the disposable income (income — income tax paid):
$47,000 - $8,010 = $38,990

c. Calculate the amount of disposable income spent:

$38,990 X 0.90 = $35,091

d. Using the amount of disposable income spent, calculate the amount of indirect
tax (in this example the VAT) paid by Donfor:

368
 Donfor’s $35,091 disposable income spent includes the price for all the goods
and services purchased, as well as 15% VAT on top of those purchases, therefore:
Total spending = original spending + VAT at 15%
Total spending = .15x, where x is the original spending
$35,091 = 1.15x
$35,091 + 115 =x
x=$30,514

To get the indirect tax (VAT) amount, take the total disposable income spent and
subtract the original spending amount. What is left is the indirect tax payment total.
$35,091 - $30,514 = $5,039 total indirect tax paid by Donfor.

e. Calculate the amount of combined total tax paid:

Income tax + indirect tax = combined total tax
$8,010 + $5,039 = $13,049

f. Calculate the average overall tax rate:

Combined total tax + income X 100 = average overall tax rate
$13,049 + $47,000 X 100 = 0.277 X 100 = 27.7% average overall tax rate

Exercise 1
Udu also works in the USA, but earns a higher salary of $86,000. She spends 90% of
her disposable income.
Complete the blank fields in the table below.

Worker | Total | Disposable | VAT paid (15% Total Average

income | income ($) | ofdisposable | combined | rate of
tax ($) income tax tax (%)
spent, $) amount ($)
Donfor 8,010 38,990 5,039 13,049 27.7
Udu

What are the arguments for and against

a progressive income tax system?
Arguments for progressive taxation
The argument for progressive taxes rests on notions of fairness. Because the lower
ranges of income are taxed relatively little, the poor are better able to meet basic needs
of food, shelter, clothing, healthcare, and education. It is assumed, in countries with
progressive systems that the marginal utility per dollar decreases with each dollar one
earns, and so it is more fair to tax the billionth dollar (since it will certainly mean less)
more severely than the first (which is essential for everyone). This tax revenue, very
importantly, can be used to further address inequities by providing expensive merit
goods like healthcare and education, as well as subsidies for child-rearing, social care,
and unemployment. Countries that want more redistribution need only make their tax
schemes more progressive and fund those programmes.
369
 Economics of inequality and poverty

Arguments against progressive taxation

The main argument against progressive income taxes is that taxing higher incomes at
higher rates creates a disincentive to work, in effect punishing any increase in productivity
or effort. Supply-side economists would suggest the following example: suppose
you are making $150,000 and you know that if you get a raise you may pay a higher
marginal tax rate on that next amount. Economists debate the degree to which higher
tax rates actually disincentivise working more hours, but it is reasonable to assume that
there is some level of marginal tax that may act as a disincentive. Additionally, market-
oriented views of progressive rates blame these rates for tax avoidance and evasion.
What are the key current
open/unanswered It is worth noting that the research provided in this chapter suggests that inequality
questions in these has significant bad social effects. Moreover, it is not clear that low marginal tax rates
discussions of inequality paired with inequality actually raise the growth levels or even the happiness levels of
and poverty?
the richest in those countries.

Case study - how do we know which countries levy the most

progressive tax rates?
The degree to which a country’s tax system is progressive depends a lot on how it
is organised. An important distinguishing feature of a country is its tax structure;
in other words the mix of taxation types that the country uses to raise revenue. For
many, it is through a progressive income tax. However, as Figure 18.11 shows, some
countries rely on pension or social security contributions for most funding, and
others use sales taxes as their largest source of income.
MAIN SOURCES OF TAX REVENUES
Social security Taxes on goods
Income taxes contributions and services
} { f { | {
100
b
901
80
70
Total tax revenue (%)

STSRR

Figure 1811 This graph,

base from
shows ho tax structures vary
from country to country
IRSRTITRRTs Ty
e SR S

iR TR
SRR
2

EST
LVA

PRT
FRA
POL

ESP

TUR
NLD
AUT

CHL
DEU

GRC
HUN

Personal income tax Social security contributions [l Property taxes

M Corporate income tax Taxes on goods and services [0 Other

370
 Employment insurance
premiums 6.8%

Other taxes and duties

(excluding GST) 5.4%
Other revenues 9.4%
Non-resident income tax 2.5%
In many OECD economies, progressive income taxes typically account for the
largest proportion of total tax receipts by the government. Canada, as shown in
Figure 18.12 has an even higher top marginal tax rate than the USA and, rather than
applying to people earning above $370,000, as it does in the USA, Canada’s top
tax rate kicks in for workers earning just $100,000 per year. In Canada, personal
income taxes account for around 50% of total federal tax revenues, while the
corporate tax and the national GST make up the next largest portions (Figure 18.12).
Who really pays the highest rates? Figure 18.13 shows the top income tax rates of
selected OECD countries for 2019. In this showing, Sweden has the top marginal
tax rate at 60%, while Turkey has the lowest top rate at 30%. However, to grasp the
progressivity ofa tax system it is also important to see the income level at which the
highest rates take hold. The figure above expresses this as a multiple of the average
wage in each country. For Sweden, the highest rate kicks in at only 1.5 times the average
income, while for Japan, which has a similarly higher rate at 55%, that rate only takes
hold when one has earned 8.5 times the average wage. Sweden, one can conclude,
has a significantly more progressive income tax system than Japan. And one can also
conclude that in Sweden, where the tax rates rise at lower income levels described
above, the middle-class earners pay more to support the system.
Among the lower top-rate countries, Mexico and Turkey have a similar top rate
at approximately 30%, but Mexico’s will not take effect until one earns 25 times
the average income, while Turkey'’s takes effect at merely three times the average
income. Comparatively, Turkey has a much more progressive tax than Mexico.
Therefore, one could conclude that among countries with lower top marginal tax
rates, countries like Turkey may be more progressive than one might otherwise see.
= 600
Personal income e tax (%

% 500 1
<« Figure18.13 The highest
w s

al income tax
e
S

are only part

20.0 larker
10.0 he variation
of the rate,
0
ST
FESES S LN
o
St s
(Ji‘\

371
 Economics of inequality and poverty

100

» 80 Sweden - highest
£ marginal tax
g rate = 60%
Figure 18.14 Amore P
5 60
progressive income tax o Mexico - highest
typically corresponds with g marginal tax
more equal income
£ 40 rate = 32%
£
distribution
&3
20

0 20 40 60 80 100
Percentage of population

]
How do tax rate changes affect income
Wait, what is a wealth tax?
The progressive taxes we
distribution?
have discussed so far have Referring back to the Lorenz curve model for showing the distribution of a nation’s
been taxes on income. income, it can be argued that the more progressive a nation’s income tax, the closer the
And yet, research indicates Lorenz curve is to the line of equality. It is no coincidence that some of the countries
that disparities of wealth
are usually even greater with the lowest Gini indexes (Sweden, Germany, and Belgium) also have some of the
than those of income. The highest marginal tax rates in the world, while those with the lowest marginal tax rates
returns to capital ownership, (Mexico, Turkey) have a higher Gini index and a Lorenz curve further from the line of
in particular, appear to be equality (Figure 18.14).
growing, while wages have
stagnated by comparison. Taxes collected from higher income earners in a high marginal tax country like
This reflects the critique of
capital that goes back to Sweden are used to provide goods, services, and transfer payments to those whose
Marx and continues with incomes would otherwise be much lower. The equity of such a progressive tax system
economists like Thomas is derived from the fairness behind making rich households bear a larger burden of the
Piketty, whose book Capital
nation’s tax system. Equity in the tax system leads to greater equality in the income
in the Twenty-First Century
argued that returns to distribution, as seen in the two Lorenz curves for Sweden and Mexico.
capital are higher than
economic growth itself.
Such a trend is bound to 18.5 What are further policies to reduce
result in great inequality and
very likely reduced equity
poverty and income/wealth inequality?
as well. Piketty, as well as
an increasing number of
economists and politicians, Learning outcome
have called for a tax on
accumulated wealth rather At the end of this section you will be able to:
than income.
Find countries that currently * identify and discuss further policies to reduce poverty, income, and wealth
charge a wealth tax. inequality.
1 What are the assets being
taxed?
2 Are wealth taxes popular Higher marginal taxes on income or wealth can immediately reduce the inequality
with the public? Find out. gap. In after-tax terms incomes are literally more equal than before. However, there
For discussion and debate: are other policies that typically target improving equitable chances. In other words,
3 Is awealth tax more or less policies that support the poor by providing them with essential needs and a better
fair than an income tax?
chance at economic improvement.
372
Policies that reduce inequalities of opportunity
Investment in human capital
The term human capital may sound sterile, but it conveys an important element
ofa productive society, one seeking ever higher degrees of health and education.
It can be easy to simply promote ‘more healthcare and education’, without seeing
that these goals can be self-reinforcing. More or better healthcare of certain kinds
may allow more children to go to school rather than be sick at home. Every extra
day of school counts. More and better education, in turn, helps people make more
informed decisions about healthcare. Such improvements, reported in longer
lives, more years of schooling, and other measures usually translate into higher
productivity in the workforce as well, creating further economic benefits. These
improvements may also increase social mobility for those previously disadvantaged
by their systems.

To help quantify the value of human capital, the World Bank compiles its Human
Capital Index (HCI) which estimates the value of a country’s human capital in
comparison to what it could be at full potential. The HCI uses indicators of child
survival, education quality and quantity, adult survival rates, and healthy growth. As
an example it finds that as of 2018, Tajikistan’s children are estimated to be ‘50 percent
as productive when they grow up as they could be if they enjoyed complete education
and full health.’ This suggests plenty of scope for improvement, but it is noteworthy
that Switzerland, who scores well above average among countries in their region, only
scores a 76%.

Health policies
* Nutrition and basic food provision programmes to food-insecure families will
improve health for vulnerable people.
* Prenatal and postnatal care provision for all families will prevent early disease and
death.
* Universal healthcare or insurance programmes to reduce costs for the poor will
improve overall health because the poor will not avoid care because of costs.
* Social insurance and poverty reduction programmes for the elderly can be very
effective at preventing penury in old age.

Education policies
* More pre-school years of care and education for the children of poor families can
help bridge learning differentials that occur because some children do not have
access to early years education.
* Improved resources and training for teachers, especially in disadvantaged areas,
can support equity by improving opportunities.
* Programmes and attention for underperforming students who are more likely to be
poor.
+ Subsidies for post-secondary education can help ensure that successful students get
access to further education.
* After school programmes for children with working parents allow workers to keep
longer hours and stay on a career path.
Finally, advocates of higher spending levels on human capital point out that
such gains increase productivity and overall economic growth. This, in turn, can
increase the tax base and make further investments in the country’s well-being.
373
 Economics of inequality and poverty

How can transfer payments reduce poverty and inequality?

Transfer payments refer to government programmes that shift tax revenues gathered
from taxpayers and deliver them to various groups and individuals without an exchange
of goods or services. Examples of transfer payments include unemployment insurance,
financial aid, pensions for the elderly and sick, as well as government subsidies for firms.

The value of transfer payments may seem obvious because they are commonplace, and
therefore taken for granted.

Pensions
Pension schemes for the elderly, for example, also known as ‘social security’, are
relatively new, having been instituted after the Second World War in Western
countries. These schemes have had powerful effects, and are credited with significantly
reducing poverty for the old, and helping to increase life expectancy by lowering
poverty-related health risks.

Unemployment insurance
Similarly to pensions, unemployment insurance builds a ‘poverty floor’ for those who
are suddenly without a job by paying a portion of the salaries of the unemployed,
ora simple flat rate, for a period of up to two years. In extraordinary circumstances,
such as the financial crisis or the COVID-19 pandemic, countries will extend these
programmes to negate the effects of mass cyclical unemployment.

Business subsidies
At times, business subsidies prevent mass layoffs and the consequent poverty, such
as the rescue of a prominent industry. More commonly, agricultural sectors receive
large subsidies to maintain a robust and independent food supply, and to prevent farm
poverty, which was not unusual a century ago.

What is universal basic income?

Abold proposal that is gaining notoriety in recent years is that of universal basic
income (UBI). It is also called an ‘income guarantee’ or ‘citizen’s income’, and as the
name suggests, UBL is a periodic payment delivered to all citizens ofa population. The
idea behind a basic income is that it would go a long way towards meeting the basic
needs of any citizen. UBI levels would ideally be set somewhere near the poverty line.

One appeal of UBI plans is simplicity. Most current transfer payment programmes
that involve unemployment or housing subsidies tend to require time-consuming
administration, along with the bureaucracy designed to catch fraud and waste. UBI
avoids those costs. Moreover, it reduces the disincentives sometimes attached to
current programmes. Some of these are poorly designed so that taking work or
carning beyond a particular level will eliminate the whole transfer, which effectively
punishes the recipient for working. Basic income would avoid this by awarding the
money to everyone, regardless of income. Getting a slightly better job would always be
desirable and never a detriment to income.
One trend that has inspired more thinking around basic income is that leaps
in information technology and automation can cause significant structural
unemployment. If fast food workers, basic accountancy jobs, retail cash desk jobs,
374
 <« Swiss activists celebrate the
gathering of enough
signatures to force a
referendum on a monthly
basic income of CHF2,000,
which failed, with 77% voting
against

and manufacturing are all replaced by artificial intelligence and automation, perhaps
the modern economy simply requires fewer people to run efficiently.

Advocates of UBI cite the static trend in basic wages over the last several decades.
As earnings to capital have risen, wages have fallen behind. The income gap, and
costs associated with childcare and basic needs has led young people to be especially
pessimistic about their standard of living. They tend to delay starting families, and also
have lower home ownership than previous generations. A basic income can begin to
correct this enduring wage inequity.

Of course, basic income tends to be very expensive. Most schemes would massively
increase budget deficits unless offset by raising taxes, presumably on the wealthiest
segments of society to make the redistribution effective. One could counter that inequality
is expensive as well, costing society in terms of negative externalities and high social costs.

Arguments against a UBI

Another argument is the one that surrounds most transfer payment schemes, that of
reduced incentive to work. Most hypothetical UBI plans keep the subsidy to a poverty
line level, so work would be required to live a modestly acceptable lifestyle. However,
the idea is that any ‘free’ income is expected to reduce the motivation to work.

Finally, some critics ask, ‘Why everyone? Even the rich?’ Universal programmes tend to
be popular ones because of their common national purpose, with examples ranging
from free university education to national health insurance. Testing for incomes would
also raise bureaucratic costs, something basic income can avoid almost completely.

How might policies to reduce discrimination help

reduce poverty?
Income disparities from gender and racial discrimination may be the result of active
discrimination or of ingrained and subconscious cultural practices. Accrued over
375
 Economics of inequality and poverty

decades or longer, these deficits in opportunity and income from discrimination may
account for much of the differences in wealth between genders and racial groups.
Explicit policies and norms to combat it are readily available:

« anti-discrimination laws that bar discrimination on the basis of race or gender in

areas of education, employment, and housing
* rigorous enforcement of existing anti-discriminatory laws
This discussion of
inequality has presented * equal pay for equal work laws to address gender pay gaps
significant evidence of the « the implementation of target employment levels or quotas of underrepresented
harmful effects inequality group
can have on society.
What responsibilites rest « target levels for management and company boards
on you, the knower, as a « greater spending on housing and education for vulnerable groups in recognition of
result of your knowledge historical discrimination
about inequality?
wealth taxes to correct the inequities and fund the programmes above.

Case study - equity in the USA

“To be at 1970s levels of equity, workers should receive nearly double their
current pay.”

In 2020, New York magazine reported that a RAND Institute research paper
concluded that the median wage is $42,000 below what it would be, if the income
distribution in effect in 1970 were still in effect today. Compared to current US
median wages of $50,000, a worker today should earn $92,000 to keep up with the
income gains that have accrued to the wealthiest segments of the US population.

Will a minimum wage help reduce poverty and

L e inequality?
Is a minimum wage good A minimum wage, as discussed in Chapter 9, is a legally required price floor for labour.
orbad?
As such, it has the potential to cause surpluses, like any price floor. However, in this
Many countries enforce a
minimum wage. Conduct an case a higher than equilibrium wage may cause a surplus of workers. In other words,
internet search for real-world higher minimum wages may raise costs to firms, and firms may need to fire some
examples and information workers. Notably, research to assess the effects of minimum wages on employment
about a specific country’s levels has not delivered clear answers for or against the policy. Some argue that the
minimum wage. Try to find elasticity of supply for certain kinds of low-wage labour is not so sensitive to prices
out the following.
The level of the wage floor, (clastic) that firms will fire very many workers. At the same time, minimum wage
in either hourly, weekly, or advocates point out that the higher incomes overall will raise demand for goods and
monthly terms. services and negate whatever unemployment effects occur.
Whether there’s any
~

research on this country

policy.
Whether the minimum
w

wage level is across the

entire country, despite
variations in cost of living.
For discussion and debate:
4 Is aminimum wage a
helpful way of addressing
income inequality?
376
 Practice exam questions
Paper 1, part (a) questions
1. Using a Lorenz curve diagram and examples, distinguish between
a country with a high level of income equality and one with
alow level of income equality. (10 marks)
2. Distinguish between progressive, regressive, and proportional
taxation, providing examples of each.
Explain the distinction between equality and equity.
Identify and explain three causes of inequality.
Explain the difference between relative and absolute poverty. (10 marks)
Paper 1, part (b) questions
3. Justify the claim that poverty’s consequences make its elimination
the most important objective of economic policy. (15 marks)
4. Evaluate the effectiveness of a progressive income tax at bringing
about a more equal distribution of a nation’s income. (15 marks)
5 Using real-world examples, evaluate the effects of a country
making its tax system more progressive. (15 marks)
6. Using real-world examples, discuss the extent to which transfer
payments can eliminate poverty. (15 marks)
4-mark questions from Paper 2 or HL Paper 3
7. Person A makes $100,00, while Person B makes $50,000. Each pays
$10,000 in total tax. Identify and explain which person is paying tax
in the more regressive system. (4 marks)
8. Using a Lorenz curve, show the effect of a change to a more
progressive tax system on the distribution of income. (4 marks)

377
 Real-world issue 2
How do governments manage their economy and how effective are their policie

Government intervention attempts to achieve macroeconomic objectives

through a choice of policie:
Political, economic, social, and environmental factors are interdependent and will
influence the effectiveness of government policies.
 Demand management: monetary policy

1 What is monetary po

Learning outcome
At the end of this section you will be able to:
« outline the role of central banks as regulators of commercial banks and bankers
to governments.

Monetary policy refers to actions taken by a country’s central bank that increase or
decrease the supply of money in the economy in order to change interest rates and
cither expand or contract the amount of aggregate spending.
A demand-side policy, monetary policy aims to increase or decrease aggregate demand
(AD) by changing the interest rate, which as you will recall from Chapter 14, is a
determinant of both investment and consumption. A secondary objective of monetary
policy is promoting trade objectives, since a change in the interest rate can affect a
country’s exchange rate, and thus a third component of AD, net exports.

What is a central bank?

To understand monetary policy, we must first have an understanding of what a central
bank is and how central banks differ across countries. Defined simply, a central bank
is the ‘government’s bank’. It is the institution that regulates all commercial banks (the
for-profit institutions with which households and firms can save or borrow money).
In addition to setting and overseeing bank regulations, central banks act as the
bankers’ banks. In other words, when commercial banks need to borrow money to
extend credit in the economy, they can do so by borrowing from the central bank.
Additionally, commercial banks’ reserves (the share of total deposits that they do not
lend out) are held by the central bank. In this regard, central banks act for commercial
banks somewhat how commercial banks act for households and firms: they hold
onto the assets of commercial banks and make loans to commercial banks, just as
commercial banks do for the rest of the economy.
The most important function of a central bank, beyond regulating and offering
services to commercial banks, is overseeing the process of money creation in the
economy. It may seem odd, but the amount of money in an economy at any given time
exceeds the size of the monetary base (the amount of actual cash and coins plus banks’
reserves) by some multiple determined by the central bank’s minimum reserve
requirement — the proportion of total deposits the central bank requires commercial
banks to keep in reserve. When this number is changed, the amount of credit, and thus
the total supply of money in the economy, can be increased or decreased. Additionally,
central banks have the ability to inject or withdraw money from the economy directly
through open market operations, or the buying and selling of government securities
(bonds) from commercial banks. Through the implementation of these and other
tools, the central bank can control the interest rate in the economy and thus expand or
contract the level of aggregate demand. The various tools of monetary policy will be
explored in more detail later in this chapter.

380
A final note on central banks is to distinguish between the different roles they play
across countries. In most Western democracies, such as in Europe and North America,
central banks, while technically a part of the government, make monetary policy
decisions independent of the other branches of government. They are not political
institutions, in other words, and officials working for the central bank are neither elected
nor are they expected to respond to the demands of elected officials. Central bank
independence is necessary to promote certainty among all stakeholders in an economy
that the levers of monetary policy will not be pulled for the political advantage of a
particular elected official or political party, and instead will be harnessed solely for the
promotion of the previously studied macroeconomic objectives.
There are many countries, however, in which central banks are not independent of the
country’s government, and instead act as national banks, promoting the objectives of
whatever party controls the government. An example is China’s People’s Bank, which
actively promotes aims laid out by the Chinese Communist Party, which might
include the expansion of credit, inflation control, or intervention in the foreign
exchange markets for its currency, the yuan, for the promotion of international
trade objectives.

Before we dive deeper into the tools of monetary policy, which only HL students must
know the details of, we will look more closely at monetary policy’s goals.

9.2 at are the goals of onetary poli

Learning outcomes
At the end of this section you will be able to:

* explain the goals of monetary policy, including:

« inflation targeting
* low unemployment
« reducing business cycle fluctuations to promote stable, long-term growth
+ promoting external balance.

Inflation targeting
In Chapter 16, Macroeconomic objective: low and stable inflation, we use the story
of Goldilocks as an analogy for the goal that economic policymakers pursue a low
and stable rate of inflation. An inflation rate that is too high, recall, threatens to push
the economy into an inflationary spiral, where too much demand chases too few
goods, and prices are continually driven upward while wages struggle to keep up
with increases in the consumer price index (CPI). An inflation rate that is too low, on
the other hand, will dampen consumer and investor confidence and lead to delayed
consumption and investment, possibly pushing the economy into the deflationary
spiral described in Chapter 16, in which rising unemployment leads to falling
consumption and investment, deflation, and further increases in unemployment. The
resulting recessionary gap can be difficult to close as wages are slow to adjust to the
depressed price level.

381
 Demand management: monetary policy

Thus, both deflation and high inflation are some of the most dreaded evils that
monetary policymakers strive to avoid. Inflation targeting refers to the central bank’s
efforts to increase or decrease the supply of money and control interest rates with
the aim of keeping inflation within a narrow range of values. In most developed
economies this range is typically between 2% and 3%.

Low unemployment
While most central banks today explicitly target an inflation rate, a mostly unstated
objective of doing so is to promote a low unemployment rate. The Phillips curve
taught us that, at least historically, there has been a trade-off between inflation and
unemployment in an economy. A very low inflation rate (or deflation) is typically
accompanied by high levels of unemployment, as weak AD puts reduced pressure
on price levels and also leads firms to reduce the size of their workforce. Very high
inflation, on the other hand, is typically associated with very low unemployment,
as high AD pushes prices up and leads firms to hire more workers to produce more
output.
You will recall from Chapter 15 that high unemployment results in several
consequences for society, including personal, social, and economic costs. Very low
unemployment, evidence of an economy that is overheating, has consequences as
well, first among which is the increased likelihood of an inflationary spiral. Therefore,
an implicit objective of monetary policymakers is to promote a balance between low
inflation and full employment with economic growth. The secondary objective of
inflation targeting is low and stable unemployment.

Reduce business cycle fluctuations and promote

long-term economic growth
In Chapter 13, Measuring economic activity, the business cycle model was introduced,
showing how economies tend to fluctuate between periods of expansion and
contraction, experiencing peaks and troughs over time. With these business cycle
fluctuations come uncertainty and the resulting shocks to AD, rising and falling
unemployment, and unstable inflation. Implicit in both inflation targeting and the
promotion of low unemployment is the reduction in fluctuations in the business
cycle. Because monetary policy influences AD, it is a powerful tool to moderate the
business cycle.

Stable, long-term economic growth is evidence of a country’s central bank practising

responsible monetary policy. Not all fluctuations in the business cycle are the result of
irresponsible monetary policies, but it has been argued that economic collapses like
the Great Recession of 2008-10 were partly the fault of central banks in the USA and
Europe. The property and stock market bubbles that burst in 2007 might have been
checked at an earlier stage if interest rates had been increased in the mid-2000s. The
2007 collapse in asset values led to a drop in aggregate demand and pulled the world's
economies into recession in 2008 and 2009. Figure 19.1 shows a business cycle for the
world economy from 2000 to 2018.
The contractions in 2008 and 2014 each represent a period in which overall global
output decreased. Many argue that the economic hardships experienced during
recessions can be mitigated if responsible policymakers make decisions based on
382
 90
World
80
on)

70+
Economic output (US$ t

60

50q « Figure19.1 Theworld

business cycle, 2000-18,
40 1 shows output decreased in
2008 and 2014
30 4

20 +

10q

0 T T T T T T T T T
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Year

the best available evidence, and do not hesitate to take measures, even if they are
unpopular, to constrain demand during periods of unsustainable economic growth.
Of course, knowing when an economy’s growth rate is unsustainable is a challenge
that few can say they are able to achieve with 100% certainty.

External balance
A final goal of monetary policy is the promotion of international trade objectives,
which might include the promotion of exports to other countries, increasing the
availability of imported goods such as capital equipment or medical devices, or simply
promoting stable, balanced trade with the rest of the world. A country’s external balance
refers to the flow of goods, services, and investments between the country and all other
countries. External imbalances, such as when a country spends far more on imports
than it earns from the sale of exports, have consequences that will be explored in later
chapters, many of which are detrimental to the economy’s health. Therefore, a goal of
monetary policymakers is to promote some degree of balanced trade and investment
with the rest of the world.
How does monetary policy affect external balances, you might ask? As we will see, a
country’s interest rate is a strong determinant of its exchange rate, or the value of its
currency relative to other currencies on foreign exchange markets. You might recall
from Chapter 14, on AD and aggregate supply (AS), that one of the determinants
of net exports is the exchange rate. By raising or lowering interest rates, therefore,
central banks can strengthen or weaken the value of their currencies relative to
other currencies, and thereby either encourage or discourage exports or imports.
If policymakers see their country’s trade balance moving too far into the negative,
for example (meaning imports are increasing and exports are decreasing), an interest
rate cut can devalue the currency, which makes imports more expensive and exports
cheaper. The result could be a reversal of the trade imbalance, as net exports increase,
contributing to a boost in AD at home.

383
 Demand management: monetary policy

9.3 HL. How do banks ‘create’ money?

Learning outcomes
At the end of this section you will be able to:
« outline how commercial banks operate using fractional reserve banking
« distinguish between required reserves and excess reserves
* analyse how excess reserves are the basis of expansion of the money supply by
the banking system
* explain how the money multiplier is calculated and that the size of expansion of
the money supply depends on the money multiplier.

To understand how central banks ‘create’ money in the economy, we first must explore
the role that commercial banks play. Commercial banks are those that offer services
to the general public and to businesses. By accepting deposits in checking/current and
savings accounts, commercial banks protect households’ and firms' financial assets,
and by making loans banks provide money for investments in infrastructure, capital
equipment, and housing for the economy. Banks act as the primary intermediary
between houscholds who wish to earn interest on their savings and businesses who
want to borrow money for investment.

What is fractional reserve banking?

By accepting deposits from households, then lending out a proportion of those
deposits to borrowers, which themselves end up being deposited and lent out again
and again, banks create new money through their everyday activities. This is possible
because banks only keep a fraction of their deposits in reserve; thus, the system of
money creation described here is known as fractional reserve banking.

What are required reserves?

Commercial banks are required to keep a certain percentage of deposits in reserve.
Required reserves are the portion of a bank’s deposits the bank is required by the
country’s central bank to keep in reserve. A reserve requirement of 20% means
that a bank with total deposits equalling ¥100 million (¥ is the symbol for yen, the
currency of Japan) would have to keep ¥20 million on reserve at the central bank.
This money may not be loaned out by the commercial bank.
With the other ¥80 million, the bank can make loans and charge interest on those
loans. The bank’s business model is to charge a higher interest rate to borrowers than it
pays to households saving money with the bank.

What are excess reserves?

Excess reserves are a bank’s actual reserves minus required reserves. Banks are allowed
to make loans only from their excess reserves.

384
For example, assume Bank Y has €30,000 in total deposits, and that in the country
in which Bank Y operates the minimum reserve requirement is 50% (or 0.5). We can
calculate Bank Y’s minimum required reserves by multiplying the reserve requirement
by the bank’s total deposits.

Minimum required reserves = 0.5 X €30,000 = €15,000

Bank Y is required to keep €15,000 in its reserves. Let us assume that Bank Y’s actual
reserves equal €18,000. We can determine the bank’s excess reserves by subtracting its
required reserves from its actual reserves.
Excess reserves = Actual reserves — required reserves

= €18,000 — €15,000 = €3,000

Excess reserves are the money with which a bank is able to make new loans. Once a
loan is made to a client and that money gets spent, earned, and deposited in someone
else’s bank, new reserves will be created, some of them required, some excess, which
can once again be loaned out. Excess reserves, therefore, are the basis on which
commercial banks can create new money in a fractional reserve banking system. Video suggestion:
You have read about it, now
The fractional reserve system of banking described here, in which commercial banks you can review what you
are only required to keep a fraction of their total deposits in reserve and are allowed have just learned by watching
avideo by the author!
to loan out the excess reserves, forms the basis on which the supply of money in Simply lick here in
an economy can be increased or decreased via the central bank’s interactions with your eBook for a video
commercial banks. Before we explore the tools through which central banks can on money creation ina
expand or contract the money supply, we have to first understand more details about fractional reserve banking
system.
how fractional reserve banking works.

What is the money multiplier?

‘Whenever a bank makes a loan to a borrower, new money is actually being created by the
banking system. It sounds crazy, but it really does happen.

Assume that Bank X receives a deposit of $/100 (S/ is the symbol for Peruvian nuevo
sol, the currency of Peru) and that the central bank requires all commercial banks to
keep 20% of their total deposits on reserve (the minimum reserve requirement is 0.2).
Figure 19.2 illustrates how this $/100 deposit will lead to the creation of $/400 of new
money across the banking system.

Money deposited in one bank creates excess reserves, which can be loaned out to
borrowers, spent, and deposited in other banks, creating more excess reserves that can
be loaned out again. In this way, an initial change in bank deposits will lead to a greater
change in the overall money supply in an economy. The degree by which the money
supply will be affected depends on the size of the money multiplier.

1
The money multiplier = ——— ——————
Minimum reserve requirement

To determine the total impact on the money supply of an initial change in a bank’s
deposits, we can multiply the initial change in excess reserves by the money multiplier.

385
 Demand management: monetary policy

5/100 5/80 /64 §/51.20

deposited loaned out, loaned out,
ina bank spent, and spent, and
Figure19.2 The expansion P deposited deposited
of money in a fractional ..and so on
reserve banking system

$/20in $/16in
reserve reserve

Wi ed example
‘When /100 is deposited in Bank X required reserves increase by $/20 and excess
reserves increase by S/80. Assuming the bank loans out all of its excess reserves, we
can multiply the change in excess reserves by the money multiplier:

1
S[80 x e 580 X 5 = S[400

The initial deposit of S/100 will lead to the creation of $/400 of new money
throughout the banking system.

Now that we have the mechanics of money creation in a fractional reserve banking system
down, it’s time to examine the ways central banks can pull levers to create or destroy
money in an economy, and by doing so, stimulate or contract the level of aggregate
spending to promote the macroeconomic objectives outlined earlier in this chapter.

19.4 w. What are the tools of monetary

policy?

Learning comes
At the end of this section you will be able to:
+ Outline the different tools monetary policymakers employ to either expand or
contract the level of aggregate spending, including:
* open market operations
* minimum reserve requirements
« changes in the central bank minimum lending rate
* quantitative easing.

Monetary policy refers to the tools central banks use to increase or decrease the supply
of money in an economy. By changing the money supply, a central bank can cause
interest rates to change, which can then influence the level of aggregate expenditures in
the economy. A central bank has three tools for increasing or decreasing the supply of
money in an economy.
386
Open market operations
Open market operations refer to a central bank’s buying and selling of bonds in the bond
market and are the most commonly employed monetary policy tool. Every commercial
bank will invest some of its depositors’ money into government bonds. Bonds are not
money. So if a central bank wishes to increase the supply of money in the economy, it can
buy bonds from commercial banks using newly printed cash (which IS money!) If the goal
is to reduce the money supply, a central bank can sell bonds to commercial banks, which
results in less money in circulation and more government bonds on banks’ balance sheets.
Open market operations can be employed s either an expansionary monetary policy
(one that increases the money supply and reduces interest rates) or as a contractionary
monetary policy (one that reduces the money supply and increases interest rates).

In order to reduce interest rates, a central bank will buy bonds from commercial banks
and the public. An open market purchase of government bonds will cause the money
supply to increase by a magnitude determined by the money multiplier.

Worked example 19..

Assume the central bank that regulates Bank X from earlier in this chapter decides to
reduce interest rates by increasing the money supply by S/10 billion. With a minimum
required reserve ratio of 20%, the money multiplier equals 5 (for each sol deposited into
the banking system, S/5 of new money can be created through banks’ lending activities).
Therefore, in order to increase the money supply by $/10 billion the central bank
10 billion
must increase bank reserves by g , or /2 billion. The central bank must

purchase S/2 billion of bonds from commercial banks in order to increase the
money supply by /10 billion. Commercial banks will see an immediate increase
in their excess reserves of S/2 billion, allowing them to make new loans that will
eventually be multiplied until there is S/10 billion of new money in the economy.

As we will see in our next section, the initial increase in reserves will lead to a decrease
in the equilibrium interest rate in the economy, stimulating consumption and
investment, and boosting aggregate demand.
In order to raise interest rates, the central bank must reduce the money supply,
requiring the central bank to sell bonds on the open market.

Worked example 19.3

Assume the central bank decides to decrease the money supply by S/15 billion. With a
‘money multiplier of 5,a /3 billion sale of bonds to commercial banks would be required.
Desired A in money supply
Needed sale of bonds =
money multiplier
—$15 billi
10 R —$3 billion

In selling bonds to commercial banks, excess reserves in the banking system decrease
by S/3 billion, leading to a decrease in the overall money supply of /15 billion.

387
 Demand management: monetary policy

Open market operations, involving the purchase or sale of government bonds by the
central bank, are the most commonly pulled lever of monetary policy, but not the only
one. A more powerful, albeit less frequently used tool of monetary policy is changing
the minimum reserve requirement itself.

Minimum reserve requirements

When a central bank changes the minimum reserve requirement itself, the size of the
money multiplier changes, and banks will find that they either have more excess reserves
with which to make loans (when the reserve requirement is decreased) or smaller excess
reserves (when the reserve requirement is increased). Lowering the reserve requirement
would increase the size of the money multiplier, while raising the reserve requirement
would cause less new money to be created whenever a loan is made.
Despite the immediate and dramatic effect changing the minimum reserve
requirement can have on the money supply, central banks rarely do so. This is likely
because so many commercial banks operate with very low levels of excess reserves;
therefore, any increase in the reserve requirements would create liquidity problems for
commercial banks (in other words, they would not have the cash on hand to meet the
increased requirement). Reducing the reserve requirement could create new money
immediately and lead to more lending activity in the economy, but once lowered,
banks would be strapped for cash once the central bank inevitably tried to raise the
reserve requirement in the future to constrain aggregate demand.

Changes in the central bank minimum lending rate

(base rate/discount rate/refinancing rate changes)
Recall from earlier in this chapter that in addition to regulating commercial banks and
acting as the reserve bank to the commercial banking system, central banks also make
loans to commercial banks when they are in need of liquidity. If a central bank wishes
to increase the money supply, one way it can do so is by reducing the interest it charges
commercial banks on these loans.
The central bank’s lending rate goes by different names in different countries, including
the ‘base rate’, the ‘discount rate’, and the ‘refinancing rate’. If this rate is lowered,
commercial banks will be more willing to make loans to private borrowers and interest
rates will fall; thus a decrease in the central bank’s lending rate is an expansionary
monetary policy. If the central bank’s lending rate is increased, commercial banks
will be less willing to loan to private borrowers and the interest rate will increase, a
contractionary monetary policy.

Quantitative easing
A final tool of monetary policy is one that was only recently added to central banks’
policy quiver: quantitative easing (QE). QE is the process of the central bank loaning
money directly to the government by purchasing government bonds. The difference
between QE and an open market bond purchase is that in open market operations the
central bank buys bonds that have already been bought by the public and are held by
commercial banks in a secondary market. In QE, on the other hand, a central bank
buys bonds directly from the government, essentially financing government deficits
and debt with newly printed money.
388
QE increases commercial bank reserves as they sell bonds to the central bank. By
financing government debts directly, QE increases the overall money supply in the
economy and allows the government to spend money that might not have been made
available by the private sector, keeping interest rates low in the economy. Lower
interest rates lead to reduced debt payments of those who have already borrowed,
freeing up funds for consumption and investment. A secondary effect of QE is
downward pressure on the exchange rate, which adds the additional stimulus of
increased net exports. Chapter 25 will explain the relationship between interest rates
and exchange rates in more detail.
QE was introduced during the global financial crisis of 2007 and the subsequent
Great Recession of 2008-10, when private investor confidence hit an all-time low
and government deficits across the developed world hit all-time highs. The US
Federal Reserve Bank and the European Central Bank (the central banks of the
two respective economies), along with the Bank of Japan turned to QE as a way of
massively increasing the amount of money in the economy, keeping interest rates
low, but also financing actual spending, rather than pumping money into the private
sector where it would only be saved due to uncertainty and low consumer and
business confidence.

One of the shortcomings of traditional monetary policy tools (open market

operations, changing the reserve requirement, and changing the central bank’s
lending rate) is that pumping money into the banking system and lowering interest
rates only stimulates AD if households and firms are confident enough to borrow Video suggestion:
money and spend it. When private sector confidence is very low, as it tends to be You have read about it, now
during deep recessions, QE can be employed to lend money not to the private sector, you can review what you
have just learned by watching
but to the government, who can pump newly minted money into the economy avideo by the author!
through infrastructure projects, education, and health spending, increased transfer Simply lick here in
payments to unemployed or low-income households, or other public spending your eBook for a video
programmes that promise to prop up aggregate demand during a downturn in the on the tools of monetary
business cycle.
policy.

Case study - experiments monetary pol 4

During the summer of 2020 the US Federal Reserve Bank invented yet another tool
of monetary policy. For the first time the ‘Fed’ began intervening in the market not
only for government bonds, but for corporate bonds as well. A corporate bond is a
certificate of debt issued by a private business, or corporation. When the COVID-19
pandemic struck and the world’s economies began shutting down in spring 2020
the markets for private corporate debt began to shudder, as investors feared that
with their consumers trapped in their homes large companies would struggle to
pay the interest on their past debts and possibly even default on their bonds, leaving
bondholders stuck with worthless investments.
In mid-May 2020 the Fed began purchasing shares in ‘broad-based exchange-traded
funds’, which are basically bundles of lots of different corporations’ bonds. Much like
an open market purchase of government bonds injects money into the banking system
and drives interest rates down, a central bank purchase of corporate bonds helps keep
borrowing costs for businesses low and instils confidence among investors in bonds
and in equities (also called stocks, equities represent ownership shares in businesses)
that large firms will not go bust even as aggregate demand falls across the economy.

389
 Demand management: monetary policy

Discussion questions:

1 How does the Fed’s intervention in the corporate bond market affect the level of
household wealth in the USA?
2 Whyis it important to protect wealth during recessions?
3 Whatare the risks of a government bank buying up the bonds of private companies?
4 Should a central bank take steps to keep interest rates for private firms lower than
they would be otherwise without central bank intervention? Why or why not?

19.5 wt How are equilibrium interest rates

determined?

Learning outcome
At the end of this section you will be able to:
+ explain, using a demand and supply of money diagram, how equilibrium
interest rates are determined, outlining the role of the central bank in
influencing the supply of money.

With the tools of monetary policy behind us, it is time to employ a model of the
‘money market to show how changes in the money supply and money demand affect the
equilibrium interest rate in an economy.

Money demand
The demand for money shows the inverse relationship between the nominal interest
rate and the quantity of money people want to hold. People demand money for one of
two reasons: either as an asset or to purchase goods or services.

Asset demand
The asset demand for money is inversely related to the interest rate. At higher interest
rates less money is demanded as an asset, because the opportunity cost of holding cash
is higher due to the interest income foregone by holding money instead of investing
it in savings accounts, government bonds, or other interest-earning assets. At low
interest rates the asset demand for money is greater since there is less opportunity cost
of holding cash since alternative financial assets (savings accounts, bonds) would earn
less interest income.

Transaction demand
The transaction demand for money depends on the level of output produced in the
nation and the interest rate. At lower interest rates households are more willing to
spend money on goods and services due to the lower opportunity cost of spending
rather than saving. At higher interest rates the public demands less money for
transactions, since the opportunity cost of buying stuff is higher when more interest
can be earned in financial assets.
390
 interest rate (R,)

« Figure19.3 Money
demand drops as the nominal
Nominal

interest rate rises

$600 billion $1 trillion

Quantity of money demanded (Q,)

As national income rises, the demand for money for transactions increases at every
interest rate, as people wish to consume more when their incomes are higher. During
recessions, when national income falls, the transaction demand for money decreases at
every interest rate due to the fall in income and consumption.

The inverse relationship between the demand for money as an asset and for
transactions and the nominal interest rate s illustrated in a money demand curve.
Figure 19.3 shows an economy’s money demand curve.

Figure 19.3 shows that at a 4% interest rate, households wish to hold $600 billion as an
asset and for transactions, while at 2%, $1 trillion is demanded.

A change in national income and consumption would cause a shift in the money
demand curve. Assume, for instance, the economy enters a recession and household
incomes fall, leading to a fall in consumption of goods and services. Now, at every
interest rate, consumers demand less money for transactions. The decrease in money
demand is shown as an inward shift of the D, curve in Figure 19.4.

o Figure19.4 A recession
leads to a decrease in money
demand at every interest rate

$400 billion $800 billion Q,

391
 Demand management: monetary policy

Figure 19.5 Money supply P

s determined by the central 3%
bank and is therefore vertical

$800 billion Qu

Owing to falling income and consumption, money demand has decreased. Now, only
$400 billion is demanded at an interest rate of 4% and $800 billion at 2%.

Money supply
The money demand curve is just one side of the money market model. Any demand
curve is lonely without its counterpart, the supply curve. Money supply is determined
by a country’s central bank and is independent of the nominal interest rate. As we
have learned, the central bank can increase or decrease the money supply in order to
influence the equilibrium interest rate and promote its macroeconomic objectives, the
primary one being low and stable inflation.

The money supply curve is vertical at the central bank’s desired quantity of money.
1If, for example, the central bank sets the money supply (cash and demand deposits) at
$800 billion, the money supply curve is as shown in Figure 19.5.

The money supply, established by the central bank’s monetary policy, is vertical at
$800 billion.

Equilibrium in the money market

The interest rate does not affect the supply of money; rather, the equilibrium interest
rate is achieved where the quantity of money demanded is equal to the quantity
supplied by the central bank. In order to determine what the equilibrium interest rate
is in Mongolia, in other words, we must consider both the money supply and money
demand, as in Figure 19.6.

By including money demand and money supply in the same graph we can see the
equilibrium interest rate is 3%. At this rate households demand ¥800 billion (¥ is the
symbol for t6grog, or tughrik, the currency of Mongolia) for transactions and as
cash to hold onto as an asset. At 3% the quantity of money demanded is equal to the
quantity supplied.

392
 o Figure196 The
equilibrium interest rate is
where money demanded is
equal to money supplied

#800 billion Q

Disequilibrium in the money market

Disequilibrium nominal interest rates create surpluses and shortages in the money
market. For example, assume commercial banks attempted to charge borrowers and
offer savers 4% instead of 3%. The impact on the market can be seen in Figure 19.7.
At 4%, there is a surplus of money in the system; the quantity supplied (¥800 billion)
exceeds the quantity demanded (¥600 billion). Market forces would drive nominal
interest rates towards equilibrium, as banks must lower rates to incentivise borrowers
to take out and spend the extra 200 billion that banks have in their reserves.
Atarate below equilibrium, a shortage of money arises and market forces would
drive nominal interest rates up as banks would be unable to meet the demand from
households and firms that wish to hold more money for transactions or as an asset

4% [ssssasaansan

« Figure19.7 Aninterest rate

above equilibrium creates a
surplus of money

¥600 ¥800 Q,
billion billion "
%200 billion
surplus

393
 Demand management: monetary policy

Figure 19.8 Aninterestrate

below equilibrium creates a
shortage of money 2%

¥800 ¥1000 Q,
billion billion "
%200 billion
shortage

than there is available. At 2%, for example, a shortage of #200 billion would exist, as
seen in Figure 19.8.

Shortages and surpluses in a country’s money market exist when either the quantity
of money demanded by households and firms is greater than or less than the quantity
supplied. As in the market for anything (cars, toys, food, houses), market forces tend
to drive the money market towards equilibrium, where the quantities of money
demanded and supplied are equal. The equilibrium nominal interest rate is where
households and firms demand just as much money as the central bank supplies.

Changes in equilibrium
Factors that shift the demand for money, such as changes in national income or the
price level, and supply of money, such as monetary policy, change the equilibrium
nominal interest rate.

Previously we explained how a change in national income can shift the demand for
money. Recessions cause money demand to fall, while expansions cause it to rise.
Changes in the price level can have similar effects on money demand. Inflation, which
occurs when there is an increase in the price of consumer goods and services, causes
money demand to increase and drives up the nominal interest rate (when things
cost more, more money is needed to buy them). Deflation, on the other hand, causes
money demand to fall and nominal interest rates to decrease.

Figure 19.9 shows the effect of recession or deflation (a) and economic expansion or
inflation (b) on the equilibrium interest rate. In both cases, we assume the central bank
holds the money supply constant at ¥800 billion.

A decrease in money demand caused by falling income or falling prices causes the
nominal interest rate to fall. Banks must lower interest rates in order to maintain
the quantity demanded at the same level as the quantity supplied. Without a drop in
interest rates, excess money would be available in the system and banks would not be
able to loan out all the money they have in reserve.
394
 Biion °M bition Qu

An increase in money demand caused by rising incomes or rising prices causes the Figure19.9 Money
nominal interest rate to increase. Banks must raise interest rates in order to maintain demand will shift to the left
the quantity demanded at the same level as the quantity supplied. Without a rate hike, following recession or
there would be a shortage of money in the system and borrowers would not be able to deflation () and to the right
following economic
access the money they demand for transactions and as an asset. expansion or inflation (b),
causing interest rates to adjust
Monetary policy’s effect on the equilibrium
interest rate
A change in a central bank’s monetary policy causes the money supply to shift and
leads to a change in the equilibrium interest rate. When the supply of money in an
economy increases as the result of expansionary monetary policy, the nominal interest
Figure 19.10 Interest rates
rate falls in order to maintain equilibrium in the market. A decrease in the money also respond to expansionary
supply resulting from a contractionary monetary policy causes interest rates to rise monetary policy (a) and
as money becomes scarcer thus the cost of borrowing it or the reward for saving it contractionary monetary
increases. Figure 19.10 shows the effect of expansionary and contractionary monetary policy (b)
policies on the money market.
v

¥800 #1000 Q, ¥600 %800

billion billion M billion billion
395
 Demand management: monetary policy

Video suggestion: Changes in the money supply are the result of a central bank’s deliberate intervention
You have read about it, now in the money market through the use of monetary policy. Expansionary monetary
you can review what you policies (including buying bonds on the open market, lowering the minimum reserve
have just learned by watching requirement, lowering the central bank’s borrowing rate, and QE) increase the money
avideo by the author! supply and cause the equilibrium interest rate to decrease. Contractionary policies (selling
Simply click here in
o your eBook for an bonds, raising the reserve requirement, or increasing the central bank’s borrowing
introductory video on the rate), cause money supply to decrease and result in a higher equilibrium interest rate.
money market.

19.6 What is the difference between real and

nominal interest rates?

Learning outcomes

At the end of this section you will be able to:

* describe the nominal interest rate as the rate of interest paid for a loan,
unadjusted for inflation
* explain that lenders and borrowers establish nominal interest rates as the sum
of their expected real interest rate and expected inflation
« calculate a real interest rate in hindsight by subtracting the actual inflation rate
from the nominal interest rate.

The nominal interest rate is the annual rate a borrower must pay back a lender for
the use of borrowed money or the annual rate a lender receives in payment for their
investment. The real interest rate is the nominal interest rate adjusted for inflation.

Lenders and borrowers will establish nominal interest rates based on their desired rate
of return and the expected rate of inflation. For example, if a bank is lending money to
Rahim, and the two agree that the bank should earn a real return of 5% each year the
loan is paid back, then the bank and Rahim must establish a nominal interest rate that
takes into account the expected inflation rate. Let us assume both parties expect an
inflation rate of 3%. If the bank’s desired return on a loan to Rahim is 5%, then the bank
must factor in inflation of 3% and charge Rahim 5% + 3%, or 8%.
Inflation will reduce the value of money a borrower repays, so lenders must add the
expected inflation rate to the real rate in order to establish a nominal interest rate.
Nominal interest rate = Real interest rate + Expected inflation rate
A real interest rate can be calculated in hindsight by subtracting the actual inflation
rate from the nominal interest rate:
Real interest rate = Nominal interest rate — Inflation rate
Lenders charge an inflation premium by adjusting the nominal interest rates they
charge borrowers by the anticipated inflation rate. Higher expected inflation will
lead banks to raise the inflation premium and increase the nominal interest rate on
new loans. This way, banks are protected from the diminished purchasing power of
the money they are repaid. The nominal interest rate established is the expected real
interest rate plus the expected inflation rate.
396
 Exercise 19.1
For each of the following scenarios, determine either the nominal interest rate, the
real interest rate, or the expected rate of inflation.
1 Alender expects to earn a real interest rate of 3%, and the expected inflation rate
is 1.5%. What nominal interest rate is the lender charging its borrowers?
2 Inflation is currently —2%. Commercial banks are charging nominal interest
rates of 1%. What is the real interest rate?
3 A car dealership offers financing to its customers. The dealership expects.
inflation of 4% on average over the next few years, and it wishes to earn a real
return of 5% on loans it extends. What nominal interest rate should the
dealership charge its customers?
4 A mortgage company is charging its borrowers a nominal interest rate of 3.5%,
with the expectation that it will earn a real return of 1.5%. What inflation rate
does the mortgage company expect?
Answers:

Nominal interest rate = 3% + 1.5% = 4.5%

=

Real interest rate = 1% — (—2%) = 3%

A

Nominal interest = 5% + 4% = 9%
Expected inflation = 3.5% — 1.5% = 2%

19.7 How can monetary policy be used to

close output gaps?

Learning outcomes
At the end of this section you will be able to:
* explain how changes in interest rates can influence the level of AD in an economy
* describe the mechanism through which monetary policy can help an economy
close a deflationary or an inflationary gap
* construct diagrams to show the potential effects of expansionary and
contractionary monetary policy.

Expansionary or contractionary monetary policies are used to restore full employment

when the economy is in a negative or positive output gap.

Expansionary monetary policy

Assume, for example, that the economy is experiencing a recession with lower than
desired inflation; because output is falling and prices are rising more slowly than usual,
business investment has declined and household savings has increased as business
and consumer sentiment are low. In an effort to stimulate spending and restore full
employment the central bank engages in an expansionary monetary policy, which
reduces interest rates and stimulates consumption and investment.
397
 Demand management: monetary policy

Figure 19.11 Expansionary P

monetary policies close a
negative output gap
by stimulating an outward
shift in AD

In Figure 19.11, monetary ‘stimulus’ has lowered interest rates, increased AD, and
closed a recessionary gap in the economy. Notice that before the expansionary
monetary policy this country had a recessionary gap of Y.~ Y,. However, after the
stimulus, AD has increased to the full employment level.

Contractionary monetary policy

A contractionary monetary policy will have the opposite effect on output,
employment, and the price level. Assume that rather than a recession, the economy
is facing high inflation. The central bank can contract AD and reduce inflation
by reducing the money supply, causing interest rates to increase, leading to less
consumption and investment. Figure 19.12 shows the effect of a contractionary
monetary policy.

A ‘tight’ monetary policy has increased interest rates, reduced AD, and closed an
inflationary gap of Y, - Y,_.. Inflation is brought within its target range, consistent with
the full employment level of output and a natural rate of unemployment.

Figure 19.12
Contractionary monetary
policies shift AD inwards to
close an inflationary gap

Y, 1

398
 19.8 How effective is monetary poli

Learning objectives
At the end of this section you will be able to:
« outline the constraint on monetary policy, including:
« thelimited scope of reducing interest rates when close to zero
* low consumer and business confidence
« outline the strengths of monetary policy, including that it is:
incremental
« flexible and easily reversible
* responsive, with short time lags in its implementation relative to other
policy options.

This chapter has gone deep into monetary policy: its aims, the role of central banks,
the different tools at central banks’ disposal, the money market, and how it can be
used to close output gaps. With its mechanics understood, we can now consider the
effectiveness of monetary policy at achieving its desired objectives, which as we have
seen include low and stable inflation, full employment, and other desired outcomes.

Constraints on monetary policy

While effective in some circumstances, there are situations in which monetary policy
will prove inadequate or have only limited effect, particularly during deep recessions
when interest rates have been lowered close to zero and when consumer and business
confidence are depressed.

Limited scope for reducing interest rates when close to zero

Here is the thing about interest rates: when they are high, lowering them makes new
spending by households and firms really attractive. Money becomes ‘cheap’, savings
becomes less attractive, and therefore consumption and investment are likely to take off.

o Free money!

TRl 399
 Demand management: monetary policy

But what about when interest rates are already low, or even close to zero percent?
Economists have a term for such a situation: the ‘zero-bound’. Zero percent is logically
as low as interest rates can go; at this level the cost of borrowing money is, well, FREE,
and the benefit of saving money is, well, nothing. There is no return on savings and
N0 cost to borrowing. In normal economic times, when an economy is close to full
employment, zero percent interest rates would likely lead to a spending spree that
pushes the economy into an inflationary spiral.

However, during deep recessions zero percent might not be enough to incentivise
the level of spending needed to pull the economy back to full employment.
Such a situation is known as a liquidity trap; even when money is ‘free’, private
stakeholders prefer to hold onto it as an asset rather than spend it. Alternative
monetary policy tools, such as quantitative easing, are needed, when faced with a
liquidity trap.

Some central banks, such as Switzerland's and Japan’s, have experimented with negative
nominal interest rates to stimulate spending when faced with a liquidity trap. The idea
is by saving money, houscholds and firms will actually see their savings lose value over
time. A CHF100 savings account in a bank with —1% interest rates will have only
CHF99 in it a year later. Negative rates give individuals motivation to spend now before
their money loses value in the future. Of course, referring back to the section of this
chapter that distinguished between nominal and real interest rates, we realise that
individuals do not make decisions based only on the nominal rate, and will consider
the effect inflation will have on the value of their money as well. A negative nominal
interest rate will, in fact, translate to a positive real rate if there is deflation in the
economy. To illustrate, considera Swiss individual facing a —1% interest rate on her
savings. If inflation is 2%, then the real interest rate can be calculated by subtracting
the inflation rate from the nominal interest rate.

Real interest
rate = —1% — (—2%) = —1% + 2% = 1%

Whereas the Swiss central bank is trying to push households to spend by driving
nominal rates below zero, in a deflationary environment there may still be an incentive
to save.
The zero lower bound of nominal interest rates poses a limitation on monetary
Video suggestion: policy’s effectiveness at stimulating aggregate demand during deep recessions.
You have read about it, now
you can review what you
have just learned by watching Low consumer and business confidence
avideo by the author!
Simply click here in As we hinted above, low consumer and business confidence can create a liquidity trap, in
o your eBook for a video which households and firms prefer to hold onto cash for the future rather than spend it
on evaluating the now, no matter how low interest rates get. Money is an asset that becomes more valuable
effectiveness of monetary over time when there is deflation in the economy. In such a situation monetary policy
policy during recessions.
becomes almost useless at stimulating consumption and investment.

Strengths of monetary policy

Monetary policy is usually the first line of defence against high inflation or rising
unemployment and deflation. This is because it has several strengths over the other
two types of policies the government has to choose from: fiscal and supply side, both
of which will be explored in the following two chapters.

400
 Incremental
First of all, monetary policy can be enacted relatively quickly and in small increments.
Central bankers refer to changes in interest rates in ‘basis points’. One basis
point is equal to 1/100th of 1%. That is SMALL! Typically, when expansionary or
contractionary policies are enacted, central bankers will announce their changes in
terms of how many basis points by which they are changing the nominal interest rate,
and in most developed economies these changes rarely happen in increments larger
than 25 basis points. In other words, a monetary stimulus might lower the nominal
interest rate by 1/4th of 1%: for example, from 3.75% to 3.5%.

Flexible with short time lags

Compared to fiscal policies and supply-side policies, which require the national
government to convene and agree upon a set of spending and taxation changes that
will help promote the government’s macroeconomic objectives, monetary policy is
typically able to be enacted quickly and with more flexibility. Recall from earlier in this
chapter that central banks and the officials who work at them are typically independent
from the elected politicians in government.
Central bankers are considered technocrats, meaning they make decisions based solely
on available scientific evidence, not political priorities or social expectations. In
addition, when a central bank announces an expansionary or contractionary policy
change, the impact on the markets is instantaneous. Interest rates fluctuate thousands
of times each day based on market conditions, and when an interest rate hike is
announced by the central bank, its effect will be felt immediately, leading investors
and consumers to respond within minutes or hours. There are short time lags, in other
words. In contrast, a government spending package or tax increase will take months
to be enacted and their effects will only trickle down into the real economy over a very
long period of time.

Easily reversible
Finally, monetary policy changes are easily reversible. Interest rates, once lowered,
can be raised within days if necessary, and vice versa. Technically, the same could
be said for changes governments make to spending and taxation. But in reality,
government fiscal policies (Chapter 20) are far harder to reverse once enacted.
For example, if a government lowers taxes on the middle class to stimulate AD, but
then a couple of years later high inflation is threatening economic stability, it is
almost impossible for elected politicians to stand up and tell their voters that
‘I promise to raise your taxes to bring down inflation.” A tax cut, it turns out, is very
hard to reverse once put in place. Same with government spending: once a
government has increased spending in some sector of the economy, stakeholders
become accustomed to the increased income from government sources and
any elected official would be risking his or her career by threatening to roll the
government’s spending back.
Once again, because of their independence from political influence and their tendency
to act as technocrats, central bankers are able to do what is best for the economy at
any given time, responding with flexibility and speed to macroeconomic shocks. For
these reasons, monetary policy is typically the first line of defence against unwanted
fluctuations in the business cycle.
401
 Demand management: monetary policy

Practice exam questions

la. Explain how an increase in interest rates might affect the
level of aggregate demand in an economy. (10 marks)
b. Evaluate the effectiveness of monetary policy when an economy
is in deep recession. (15 marks)
2, Using appropriate diagrams, explain how a central
bank’s sale of government bonds to commercial banks will
affect the equilibrium interest rate and level of aggregate
demand in the economy. (8 marks)
3. How does an increase in the inflation rate affect the real interest
rate in the economy, assuming all else is held constant? (4 marks)
4. Outline two monetary policy tools a central bank could
employ to help close a recessionary gap. (4 marks)
5 Compare and contrast quantitative easing with an open
market purchase of bonds by the central bank. (10 marks)
6. Whatis inflation targeting and why is it a worthwhile goal of
monetary policymakers? (8 marks)
7z Using a money market diagram, explain what would
happen if commercial banks attempted to charge borrowers an
interest rate higher than the equilibrium interest rate. (8 marks)
8. Country Y is currently experiencing a negative output gap.
Assume the minimum reserve requirement is 0.4 and the central
bank engages in a $15 billion purchase of government bonds on
the open market.
a. Calculate the maximum change in the money supply that might
result from the central bank’s open market operations. (2 marks)
b. Using a money market diagram, illustrate the effect the
government bond purchase will have on the equilibrium
nominal interest rate. (2 marks)
c. Using an AD|AS diagram, illustrate and explain the effect the
central bank’s open market operation will have on equilibrium
output, employment, and the price level in the short run. (4 marks)

402
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 Demand management: fiscal policy

20.1 What is fiscal poli

Learning outcomes
At the end of this section you will be able to:
«+ outline the sources of government revenue
+ explain how government spending can be classified into current expenditures,
capital expenditures, and transfer payments, providing examples of each
« distinguish between a budget deficit, a budget surplus, and a balanced budget.

In Chapter 19, Demand management: monetary policy, we learned all about how
central banks, which are the government-affiliated, but usually politically sheltered
institutions that control the money supply and set interest rates, can promote
macroeconomic objectives by harnessing the various tools at their disposal.
Monetary policy, we explained, is typically deployed as the first line of defence against
fluctuations in the business cycle.
Because it is relatively nimble and has short time lags, monetary policy can be put into
action quickly to fend off recessions or dampen inflation. However, when it fails, either due
to the economy already having very low interest rates or due to depressed consumer and
business confidence, the government often brings out the ‘big guns’ of fiscal policy. Fiscal
policy refers to the central government’s use of taxation and government spending to
cither directly or indirectly stimulate the level of aggregate demand (AD) in the economy.

Like monetary policy, fiscal policies are demand-side policies, meaning they are
primarily used to target aggregate expenditures. Therefore, fiscal policy can be used to
close output gaps with a view to promoting the macroeconomic goals of:
« low and stable inflation
« low unemployment
* astable economic environment for long-term growth
« reduced business cycle fluctuations
equitable distribution of income
* external balance.

As we will see, fiscal policy has several strengths and weaknesses, as well as potential
long-run consequences that must be considered before government officials decide
the extent to which it should be employed, particularly during recessions or periods of
stagnation. Before we get into its evaluation, however, we will lay some groundwork
for understanding what makes up the government budget, because fiscal policy is all
about the flow of money into and out of government coffers.

What are the sources of government revenue?

Governments, like businesses and households, earn money and spend money. (Unlike
households, many governments can also create money, which will be explored later in
this chapter.) While households earn income by providing resources, most notably
labour, to factor markets, and firms earn money through the sale of goods and services
404
 Business and other 10% < Figure20.1 Mostof the
UK governments £873 billion
total revenue for fiscal year
2020 is from direct and
indirect taxation

in product markets, governments earn revenue through various sources, but most
notably taxes. Together, direct taxes (taxes on income) and indirect taxes (on goods and
services) are the primary source of government revenues in every country. Figure 20.1
depicts the sources of government revenue in the UK in fiscal year 2020, when the UK
government's total revenues equalled £873 billion.
The 17% of UK tax revenue that comes from ‘national insurance’ is, in fact, another
form of direct tax, as all UK workers pay 12% on weekly income of between £183 and
£962 and 2% on earnings over £962 into the national insurance programme. Other
direct taxes include the 32% of the UK’s tax revenue that comes from income taxes paid
both by households and firms.

The 41% of revenue generated by indirect taxes includes consumption taxes such as the
value added tax (applied to all goods) and excise taxes (applied to specific goods, such
as cigarettes, alcohol, and certain imports).
Finally, 10% of the UK’s revenue comes from ‘other’ sources, which may include sales
of businesses owned by the UK government or the sale of government property or
other assets.

Case study - do taxes really ‘pay’ for government spending?:

an introduction to modern monetary theory
It should be noted that while the £873 billion generated by the UK government
through taxation and other sources is typically thought of as income for the
government, it is not necessarily the case that the government relies on this money to
pay for its expenditures (which we’ll examine in a moment). In reality, the UK, as a
country with its own currency, finances government spending through its treasury,
which credits bank accounts with ‘new money’ whenever the government orders an
expenditure.
According to modern monetary theory (MMT), the role of taxation in a country with
its own currency (like the UK) is to create a demand for currency (if everyone
has to pay taxes in British pounds, there is guaranteed to be demand for the
pound), to control inflation (money can be taken out of the economy when too
much demand threatens higher prices), to address income inequality (money
can be redistributed from one group to another through transfers), and to
discourage bad behaviour (Pigouvian taxes, Chapter 10, are those that discourage
the consumption of harmful goods), but NOT to finance government spending.

405
 Demand management: fiscal policy

Governments in countries with their own currencies (in contrast to countries

that are in a monetary union, such as the eurozone) coordinate and execute
government expenditures through their treasury departments or ministries. For
example, when the government goes to pay for an infrastructure project such as
anew highway, the treasury deposits newly ‘printed’ money into the accounts of
the private sector contractors doing the work for the government (in reality, these
transactions are mostly electronic, as paper money forms only a small fraction of
the reserves in the banking system).
According to proponents of MMT, the idea that the government keeps tax revenues
collected from households and firms in some account that it then uses to pay for
new expenditures is a misunderstanding of how government finances actually
work. While it is true that individuals and firms set income earned aside for
expenditures or savings, the government collects taxes not in order to spend money,
but to destroy it. Taxes are a means of ‘de-circulating’ currency that, if allowed
to remain within the circular flow, would create inflation when added to new
money the government injects into the economy through its current and capital
expenditures.
MMT, described above, is a relatively new and somewhat controversial take on
macroeconomic theory that we will explore further throughout this chapter. For
now, let us assume that orthodox, mainstream, Keynesian economics is correct, and
that a pound spent by the British government must either be collected as taxes or
borrowed through the issuance of bonds.

What are the types of government expenditures?

Revenues represent the money taken out of the economy by the government.
Expenditures are the money the government injects into the circular flow of the
economy. Government spending takes three forms: current expenditures, capital
expenditures, and transfers.

Current expenditures
Spending that keeps government institutions operating year after year is classified
as current expenditures. This includes spending on education and healthcare, defence,
general government operations, and public transportation, among other things.
Current expenditures include the wages for all public sector employees plus other costs
of ‘keeping the lights on’ at public institutions, such as utilities, rent, interest expenses,
and so on.

Capital expenditures
When the government spends money on new capital or infrastructure it is considered a
capital expenditure. Any spending that adds to the economy’s stock of public capital
is a capital expenditure, including new roads, bridges, airports, schools, hospitals, or
military bases paid for by the government. In contrast to current expenditures, capital
spending does not have to be renewed each year as projects are likely to have a start
and an end date. Current expenditures, on the other hand, must be renewed each year
just to keep public services functioning.
406
Transfers
Transfers are payments from the government to individuals or businesses for which
no goods or services are provided. The term ‘transfer’ implies that money is being
taken from one set of stakeholders in the economy (higher income earners, who pay
more taxes, for example) and transferred to another group (families earning lower
incomes, who may receive a wage subsidy, for instance). Transfers include spending on
unemployment insurance, social security (old age pensions), subsidies for producers,
and welfare payments to the poor.

Pensions and welfare are transfers, while healthcare, education, defence, protection,
interest, transport, and general government are current expenditures. We can
assume that a share of ‘other spending’ is made up of capital expenditures by the
UK government.

The budget balance, deficits, and surpluses

You may have noticed that in 2020 UK government spending (£928 billion) exceeded
government revenues (£873 billion). When a government spends more than it collects
in revenues the government has a budget deficit. When in deficit, the government is
injecting more into the economy in the form of spending than it is subtracting through
taxation. On the other hand, a government may collect more revenue than it spends, a
situation known as a budget surplus. When in surplus, the amount of money subtracted
from the circular flow is greater than the amount the government injects.
Budget deficits are expansionary, since injections are greater than subtractions.
Surpluses, which may sound like something to be pursued, are contractionary, since
more money is withdrawn from the economy than is injected. An expansionary fiscal
policy, therefore, typically requires the government to reduce taxes and increase
government spending, increasing the size of its budget deficit in order to stimulate
the level of AD and close a recessionary gap. A contractionary fiscal policy, which may
be employed to close an inflationary gap, requires raising taxes and/or reducing
government expenditures, which moves the budget towards surplus.

AT is the government debt?

Learning come
At the end of this section you will be able to:

* analyse the relationship between budget deficits/surpluses and the public

(government) debt.

You will recall from Chapter 14 that debt is defined simply as ‘what one owes’. Debt
is a liability incurred when an individual, a business, or, in this case, a country’s
government, borrows money to pay for something. According to mainstream
Keynesian economic theory, the government debt is the means by which governments
finance their deficits; when expenditures are greater than revenues, government must
borrow to make up the difference.
407
 Demand management: fiscal policy

US government bonds

Video suggestion: How does the government ‘borrow’ money?

You have read about it, now While an individual may have several channels through which money can be
you can review what you
have just learned by watching borrowed (credit cards, commercial banks, family or friends) governments typically
avideo by the author! borrow money from the public by issuing and selling government bonds. A government
Simply click here in bond (called a security by some countries) is essentially a certificate of debt; it is an 1OU’
your eBook for an that promises whoever buys the bond that at some point in the future (1 year, 5 years,
introductory video on bond
markets and interest rate
10, or even 30 years later) the government that issued it will pay back its full face value.
determination. The reason individuals might wish to buy a government bond today, and thereby
lend a government money, is that in addition to being paid back once the bond has
‘matured’, the buyer also receives a ‘coupon rate’, which is an annual payment made
to the bond holder.

What is the relationship between budget deficits,

surpluses, and the national debt?
Figure20.2 Rising national Figure 20.2 shows the national debts, in euros, of four European countries between
debt indicates a budget deficit
the years 2000 and 2020.
v

259 Italy
= UK
2204 Germany

e5154
3
g 104
é'IO
£
g
8 0.5+

077777 Estonia
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
Year
408
 100

T s0q Germany
3
w 0 \ Estonia
g
S Italy
35 504 uk
B5
2 -100
<&s
@ -1504

—200 T T T T T T T T T
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Year
A
Figure20.3 The graph of
budget deficits/surpluses
Observe from Figure 20.2 that Italy, the UK, and Germany all have large national shows that Estonia alone of
debts that increased over the 18 years following 2000, and by 2019 were all between these four nations had a
balanced budget, 2000-18
€2 trillion and €2.5 trillion. Estonia, meanwhile, has a national debt that appears
close to zero (in fact, it was around €2.4 billion in 2018).

‘Why do each of these countries have any debt at all? The answer s that, at least for the
three heavily indebted countries, they ran budget deficits for most of the first two decades
of the 21st century. Every year the national debt increases for a country we can assume
that country’s government ran a budget deficit that added to the total debt level.
In years in which governments have budget surpluses, the national debts decrease.
Figure 20.3 shows the actual budget balances of our four countries over the same time
period, allowing us to more easily identify years when budget surpluses and deficits
were experienced.

Once again Estonia stands out; we can see that the smallest of the European economies
ran a nearly ‘balanced budget’ during most of the two decades represented. In fact,
until 2016 Estonia ran small budget surpluses, and then small deficits from 2016 to
2018. Our big three economies, on the other hand, experienced sometimes sizeable
deficits as large as —€175 billion in the UK in 2009. Germany stands out as being the
only big economy to experience budget surpluses, which it had briefly in 2006, then
again from 2013 onward.

What is meant by ‘debt to GDP ratio’?

Itis a bit unfair to compare the big three economies of Europe to tiny Estonia on
the same charts. Estonia looks like a shining example of fiscal responsibility, after
all, because its lines are quite nearly 0 for every year represented. To provide a
more relevant comparison of deficit and debt situations, therefore, we can look at
the size of each country’s budget deficits/surpluses and national debts relative to
each country’s gross domestic product (GDP). After all, ifI were to tell you that I
personally had debts equal to halfa million dollars, you might think, ‘Wow, this
409
 Demand management: fiscal policy

140+
Italy
120 4
National debt as % of GDP
100 +
UK
80+

60 + Germany
40
20+
Estonia
T T T T T T T T T
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Year

A
Figure 20.4 Debt to GDP
ratios compare the size of textbook author is in some deep trouble financially!” But then if you learned that
the national debt to Iam also a billionaire, that halfa million would not seem like such a big deal.
national income (Editor’s note: the author of this textbook is most definitely not a billionaire!) Like
individuals, a country’s debts are significant in relation to their national incomes, or
their real GDPs.

Figure 20.4 shows us the sizes of each country’s national debts expressed as a
percentage of their GDP.
Once again we can see that Estonia is, in fact, the country that has relied least on
debt as a means of financing its government expenditures. Italy, meanwhile, has
accumulated debts equal to 130% of its national income. This is equivalent to an
individual who earns €100,000 each year in his or her job owing the bank, his or her
credit card company, and other lenders €130,000. This is not a financial situation most
individuals would wish to find themselves in. Later in this chapter, we will explore the
consequences of large national debts on whole economies.
Finally, we can observe the relationships between our four countries’ annual budget
deficit/surplus and their GDPs. Figure 20.5 does just that.

Finally, Estonia begins to blend in a bit more with the other countries, following a
very similar track to its fellow fiscally responsible European neighbour, Germany.
Both countries have managed to maintain budget deficits of no greater than 3% of
their GDPs for almost the entirety of the two decades. The exception is in 2010, when
Video suggestion: Germany had to borrow an amount equal to about —4% of its GDP to support its
You have read about it, now economy in the midst of the Great Recession. Italy and the UK, on the other hand, have
you can review what you
have just learned by watching experienced deficits as large as —5% of their GDP (in Italy’s case) and as large as ~10% of
avideo by the author! its GDP (the UK in 2009).
Simply lick here in
o your eBook for a video Later in this chapter we will put our knowledge of government debt to use in our
on the relationships between evaluation of fiscal policy, when we will explore whether using deficit spending to
budget deficits surplus, and promote macroeconomic objectives is sustainable in the face of an ever increasing
the national debt. national debt.

410
 Germany
Surplus/deficit as % of GDP

Estonia

—~104

-12 T T T T T — T T T T
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Year
A
Figure20.5 Thisgraph
looks at government surplus/
deficit as a percentage of GDP
20.3 Expansionary and contractionary fiscal
policies in order to close deflationary/
recessionary and inflationary gaps

Learning outcomes
At the end of this section you will be able to:
* examine how changes in the level of government expenditure and/or taxes can
influence the level of AD in an economy
* evaluate the mechanisms through which fiscal policy can help close deflationary
and inflationary gaps
* draw diagrams to show the potential effects of expansionary and contractionary
fiscal policies.

As a demand-side policy, fiscal policy can be used to manage the level of AD inan
economy and therefore help to close output gaps.

How can fiscal policy help close a negative T —

(recessionary) output gap? You have read about it,now
You can review what you
An economy experiencing a negative output gap has seen AD decrease, | have just learned by watching
unemployment increase, and either disinflation or deflation. The government some videos by the author!
can counteract the negative consequences of weak AD by engaging in an Simply click here in
expansionary fiscal policy, which requires the government to run a budget ouERcob gy
on expansionary and
deficit. A reduction in the income tax rate will increase households’ disposable contractionary fiscal policies.
incomes, leading to increased consumer spending. Increases in government
expenditures will lead to a direct injection into the economy due to the
government’s ‘fiscal stimulus’.

411
 Demand management: fiscal policy

SRAS

Figure 20.6 Fiscal stimulus >

pulls equilibrium national
output back to the full
employment level by
increasing AD in both the new
classical model of AD/AS (a)
and the Keynesian model (b)

Figure 20.6 illustrates the effect of expansionary fiscal policy in an economy

experiencing a negative output gap. Figure 20.6(a) takes the monetarist/new classical
approach, which assumes that short-run aggregate supply (SRAS) is upward sloping.
Figure 20.6(b) looks at the effect of fiscal stimulus from the Keynesian perspective.
In both interpretations of the economy, fiscal stimulus has achieved an increase in AD
and equilibrium national output from a level that was below full employment back to
the full employment level.

Expansionary fiscal policy, while an effective tool for closing a negative output gap,
is not necessarily a means of increasing the rate of long-run economic growth in an
economy already producing at full employment. Figure 20.7 shows the effect of fiscal
stimulus.

Expansionary fiscal policy has resulted in an increase in real GDP from Y to Y, in both
models. However, due to the limited spare capacity in the economy, these gains are
only temporary, as in the long run labour and resource shortages will drive wages and
other costs of production up, leading to higher inflation and reductions in aggregate
supply (AS) and output.

Expansionary fiscal policy, in other words, may be an effective means of stimulating

demand in an economy experiencing a recession, but it is not in all cases an effective
means of promoting long-run economic growth in an economy producing its full
employment output. In Chapter 21, Supply-side policies, we will explore the types of
government expenditures and tax policies that might actually encourage long-run
economic growth, but by targeting AS rather than AD.

How can fiscal policy help close a positive

(inflationary) output gap?
While tax cuts and increases in government spending can stimulate demand and help
an economy experiencing a recession get back to full employment, an overheating

412
PL

« Figure20.7 Fiscal simulus

in an economy already
achieving full employment
leads to inflation in both
the new classical model of
AD/AS () and the
Keynesian model (b)

rGDP iy, GDP

economy with high inflation might require a contractionary fiscal policy, such as an
increase in taxes or a decrease in government expenditures.

Figure 20.8 shows the effect of a tax increase, which would reduce households’ and
firms’ disposable incomes and therefore cause consumption and investment to fall, or
a government spending cut, which would directly reduce the amount of spending in
the economy.
In both models, inflationary gaps (Y,~Y,,) have been eliminated due to falling AD.

PL

- Figure20.8 Contractionary
fiscal policies reduce AD
and close an inflationary gap
in both the new classical
model (2) and Keynesian
model (b)

rGDP rGDP

413
 Demand management: fiscal policy

John Maynard Keynes

believed that private 20.4 4. Multiplier effects
individuals are driven as
much by their animal
spirits as they are by
rational thought. He Learning outcomes
therefore believed that At the end of this section you will be able to:
free market theory
was flawed because it + explain, with reference to the concepts of leakages (withdrawals) and injections,
assumed humans always
act rationally. the nature and importance of the Keynesian multiplier
‘Even apart from the + calculate the multiplier
instability due to + use the multiplier to calculate the effect on GDP ofa change in fiscal policy.
speculation, there is
the instability due to
the characteristic of
An open question is just how much stimulus to AD is required to fill an output gap?
human nature that a
large proportion of Is it $1-for-$1, more than that, or less? In reality, in order to achieve a particular
our positive activities change in real GDP, a smaller change in expenditures or taxes is required, due to
depend on spontaneous what are known as the multiplier effects. When any component of AD (consumption,
optimism rather investment, government spending, or net exports) changes, the ultimate change
than mathematical
expectations, whether in real GDP will be greater by some multiple determined by the proportion of the
moral or hedonistic resulting change in household income that is spent on domestic goods and services.
or economic. Most, This is true for both expansionary and contractionary fiscal policy. The more of their
probably, of our income households tend to spend on domestic output, the greater the multiplier
decisions to do effect will be.
something positive, the
full consequences of
which will be drawn out
over many days to come, What is the spending multiplier?
can only be taken as the
esult of animal spirits A $1 change to one of the components of AD leads to a greater change in total
- a spontaneous urge expenditures and total output. The Keynesian spending multiplier quantifies the size
o action rather than of the change in total spending as a result of a change in any one of the components
inaction, and not as the
outcome ofa weighted of AD.
average of quantitative
benefits muliplied by Let us consider how a change in government spending will impact total spending
quantitative probabilites. and total output in a fictional country, Snowlandia. Assume the government
- John Maynard Keynes, increases spending on infrastructure by #1 billion (# is the symbol for flake, the
The General Theory of currency of Snowlandia). Assume also that there is no increase in taxes to ‘pay for’
Employment, Interest and
Money, 1936 the new government spending. The #1 billion of new spending in the economy
willlead to an increase in household incomes of #1 billion. As their incomes
Discussion questions:
rise, households will increase their spending on goods and services (remember,
1 What are some
examples of decisions incomes are a determinant of consumption.) Owing to increasing consumption,
you or people you the economy’s AD is stimulated by more than the initial #1 billion increase in
know have made that government spending.
were decided more
by emotion than by While a portion of income is typically saved from each round, the spending and
rationality? income process continues: More spending leads to more income which leads to more
2 How can the actions spending. Ultimately, the initial change in expenditures is ‘multiplied’ throughout the
of society as a whole,
when driven by emotion economy by a factor determined by the amount by which households increase their
and irrationality, result in consumption in response to a particular increase in income (this is called marginal
economic instability and
ultimately recession and
unemployment?

414
propensity to consume, and will be explained further below). The Keynesian spending
multiplier quantifies the size of the change in AD as a result ofa change in any of the
components of AD.

What is the tax multiplier?

The multiplier concept can be applied to the taxation side of fiscal policy as well.
Assume that instead of increasing spending on infrastructure by #1 billion,
Snowlandia’s government instead lowers taxes on the country’s households by
#1 billion. Snowlandians now see an immediate increase in their disposable incomes,
which in turn will lead them to increase their consumption by some amount less than
#1 billion (assuming they choose to save, buy imports with, or pay more tax on some
of their newly disposable income).

The initial tax cut will lead to an increase in consumption, which leads to an increase
in incomes and a further increase in consumption. The process continues: lower
taxes leads to more income which leads to more consumption and more income.
Ultimately, the initial change in taxes is ‘multiplied’ throughout the economy by a
factor determined by the amount by which households increase their consumption in
response to a particular increase in disposable income. The tax multiplier quantifies the
size of the change in AD as a result ofa change in taxes.

What are the ‘marginal propensities’?

To estimate the size of the spending and tax multipliers, we must know how much
of any change in income the typical household will use to buy domestic goods and
services, how much will be saved, how much will go to paying taxes, and how much
will be spent on imports. The marginal propensities measure the change in different
variables divided by the change in disposable income experienced by a country’s
households.

Change in consumption spending (AC)

Marginal propensi taamsume(MPC)
1ginal propensly Change
in income (AY)

Change
in saving (AS)
Marginal propensity to save MPS)
Change in income (AY)

Change
in taxation (AT)
Marginal propensity to tax (MPT )
Change in income (AY)

Change in import spending (AM)

Marginal propensity to buy imports | MPM | = ————————————
Change in income (AY)

The sum of the marginal propensities is equal to one. Any new income earned by
households that is not spent on domestically produced goods, in other words, is saved,
paid in taxes, or used to buy imports.

MPC + MPS + MPT + MPM = 1

415
 Demand management: fiscal policy

Worked example 20.1

Let us assume that in Snowlandia the typical household spends #0.80 of every
#1 increased income, saves #0.10, pays #0.05 in taxes and buys #0.05 of imports.
The marginal propensities can be calculated:

08
MPC=—"_ g

0.1
MPS = — = 01
il
5
MFT ==== 0,05
0.05
MPM = —— — 005
1

How do we calculate the size of the multipliers?

The sizes of the spending and tax multipliers depend on the marginal propensity to
consume. To estimate the magnitude by which a particular change in expenditures will
affect AD, we can determine the expenditure multiplier as a function of the marginal
propensity to consume (MPC):

Keynesian spending multiplier _ !

or———————————
1—MPC MPS+ MPT + MPM

Worked example 2
With an MPC of 0.8, Snowlandia’s spending multiplier can be determined:

This multiplier indicates the amount by which any initial change in expenditures
(C, 1, G, or Xn) must be multiplied to determine the final change in total spending in
the economy. We can calculate how much the government’s #1 billion increase in
infrastructure spending will increase overall AD using the multiplier:
Ain AD = initial A spending X spending multiplier
Ain AD = #1 billion X 5 = #5 billion
Given an MPC of 0.8, an initial increase in spending of #1 billion can ultimately
expect to see increased AD in Snowlandia of #5 billion.

The lower the MPC, the smaller the spending multiplier will be, explained by the fact
that consumers will not spend as much of any increase in income they experience,
choosing to save instead. Table 20.1 shows the multiplier calculations for different
marginal propensities to consume.
416
Table 20.1 The spending multiplier decreases as the MPC decreases

MPC Spending multiplier Effect on GDP of $1 billion

increase
in AD
0.9 1
H: 10 $1bX 10 = $10b

0.6 1
a =25 $1b X 2.5 = $2.5b

0.5 i
E =2 $1bX 2= $2b

0.4 i
E =1.67 $1b X 1.67 = $1.67b

0.2 1
E: 1.25 $1bX 1.25
= $1.25b

The tax multiplier is also a function of the marginal propensities to consume and save. The
magnitude by which a particular change in taxes will impact AD is found using the formula:
Tax multiplier _ _— MPC
1 - MPC

Worked example
With its MPC of 0.8, Snowlandia’s tax multiplier can be calculated:

08 _
0.2

Every #1 decrease in taxes will increase AD in Snowlandia by #4. We can estimate the
impact of a #1 billion tax cut given to Snowlandian citizens using the tax multiplier.
A in AD = initial A taxes X tax multiplier

—#1 billion X —4 = #4 billion

Notice that the tax multiplier is negative, explained by the fact that there is an inverse
relationship between taxes and spending. Tax cuts (a negative change in taxes, like
that experienced in Snowlandia) cause disposable incomes and consumer spending to
increase while tax increases cause spending to fall.
Notice also that the tax multiplier effect is smaller than the spending multiplier effect.
Consider Snowlandia’s two government policies: a #1 billion increase in infrastructure
spending versus a #1 billion tax cut. The first option would result in a #S5 billion increase
in total spending while the second would only result in #4 billion of new spending.
The difference is explained by the fact that government spending is a direct injection into
417
 Demand management: fiscal policy

the circular flow of income, while a tax cut is an indirect injection. Before Snowlandians
saw their incomes rise, AD had already been boosted by #1 billion in the case of new
infrastructure spending. On the other hand, no jobs are directly created or output
actually produced by a tax cut; the stimulus only occurs after households who receive it
have saved, paid taxes, or bought imports with 20% of their increase in income.

How do we calculate the effect of a change in

government spending or taxation on GDP?
The ultimate impact of any change in aggregate expenditures or taxation is determined
by the spending muliplier or the tax multiplier, both of which are a function of the
marginal propensities to consume, save, pay taxes, and buy imports. The larger the
proportion of any change in income households use to buy domestic goods and
services, the larger the multipliers will be. If consumers tend to save more of the new
income they earn, the multiplier effects will be smaller, meaning a particular change in
spending or taxation will result in a smaller change in total output.

Worked example 20.4

Assume the MPC in a country is 0.6. With this value we can calculate the multipliers:

—MPC S0.6!
The tax multiplier = = A
1-— MPC 04

With these values we can calculate the impact of a change in government spending
or taxation. For example, assume the government reduces spending on defence by
$10billion. The impact on overall AD can be calculated:
Total A in AD = Initial A in spending X Spending multiplier
= —S$10billion X 2.5
= —$25billion
A $10billion decrease in government spending will result in a $25 billion decrease
in AD.

Next let us consider the impact of a $10 billion increase in taxes.

Total A in AD = Change in taxes X Tax muliplicr
Video suggestions:
You have read about it, now = $10 billion X —1.5
you can review what you
have just learned by watching = —$15billion
a few videos by the author!
Simply click here in
your eBook for videos
on the government spending Notice that a $10 billion dollar decrease in government spending has a larger impact
multiplier, the tax multiplier, on total spending than a $10 billion increase in taxes. Again, this reflects thata
and the multiplier effect in the change in government spending affects AD directly while a change in taxes affects
AD-AS model AD indirectly. Of course, this holds true when fiscal policy is used to close negative
418
output gaps as well. For example, if there is a $25 billion negative output gap, then
a$10 billion increase in spending should be enough to restore full employment
(assuming an MPC of 0.6), but a $10 billion decrease in taxes would not be adequate.

How effective is fiscal poli

Learning outcomes
At the end of this section you will be able to:
« discuss the constraints on fiscal policy, including:
political pressure
+ timelags
* the sustainability of government debt
. crowding out
* evaluate the strengths of fiscal policy including:
« theability to target sectors of the economy
the direct impact on AD
« theeffectiveness of promoting economic activity in a recession
. examine how progressive taxes and unemployment benefits
automatically help to stabilise short-term fluctuations in output.

What are some of the constraints on fiscal policy?

Political pressure
A potential shortcoming of fiscal policy is the fact that policy decisions rest in the
hands of politicians whose incentives may not lie entirely in the best interest of the
nation’s economy. Politicians may promote and push through fiscal policies that are
popular among voters, even if they are economically irresponsible.
Political hijacking of fiscal policies may lead to what economists refer to as political
business cycles in which total spending in the economy fluctuates depending on
politicians’ desire to enact popular tax breaks and government handouts even when
an economy is close to or at full employment. The goal of such irresponsible policies,
of course, is to maintain political support and earn votes in the next national election,
while the effect is often prolonged periods of expansion and inflation.
For example, in 2017, during Donald Trump’s first months as the president of the USA,
he signed the ‘Tax Cuts and Jobs Act’, which reduced the corporate and individual tax
rates in the USA: a fiscal stimulus at a time when US unemployment was already at
the lowest rate it had been in decades. The resulting budget deficits helped grow the
US national debt while doing little to stimulate economic growth in an already fully
employed economy.
Compared to its central bank-enacted sibling, monetary policy, fiscal policy is likely
to be subject to the political agendas of the elected leaders who are charged with
enacting it, therefore, as was the case of the ‘Trump tax cuts’, it can actually exacerbate
macroeconomic problems rather than alleviate them.

419
 Demand management: fiscal policy

The government is Time lags

best which governs Recall from our evaluation of monetary policy that one of its strengths is the short time
least. lags. Central bank officials meet at regular intervals to discuss possible interventions in
This aphorism is the money markets, and once announced, central bank actions have immediate effects
sometimes used to argue
against the active role on the interest rate, meaning they can begin to influence economic activity relatively
of government in an quickly in response to a macroeconomic shock.
economy. Do you agree
that society is better off Fiscal policy, in contrast, demonstrates much longer time lags. Often, by the time
with less government? policymakers have identified a macroeconomic problem (a recession or an overheating
Would we all be better off economy), quantified it (determined the size of the output gap), determined the size
without any government
in our lives? What do of the multipliers and debated the appropriate policy response in the halls of congress
governments do that or parliament, the economy will have already self-corrected or demand may have
contributes to our well- recovered on its own. A real economy is a dynamic machine that is always changing.
being? What do they do Time lags refer to the fact that in the time it takes policymakers to figure out how to
that detracts from our
well-being? respond, everything could have changed in the economy.
For this reason, some government policymakers prefer to wait for an economy to
What practical problems self-correct from recessions or from demand-pull inflation. The laissez-faire approach
can be solved through the: to economic policy is often to ‘wait and see’ how an economy will respond to
application of knowledge
from macroeconomics? macroeconomic shocks.

Earlier in this chapter we discussed the relationship between government budget

deficits and the national debt. Fiscal policies, most likely to be used to close negative
output gaps, necessitate budget deficits, which by definition mean the national debt
increases following the use of fiscal policy.
The question s, is there such a thing as too much debt? Why should governments care
about the size of the national debts, and what would it mean for the national debt to
become unsustainable?

The answer to these questions lies in our earlier explanation of how bond prices
and bond yields can be affected by the basic principles of supply and demand. In
years when a government must borrow a significant amount of money to finance
a deficit it must increase the supply of its bonds, and in order to attract new lenders
(bond buyers) the government may have to increase the coupon rate as well. As
bond supply increases, bond prices fall, and the government’s cost/benefit ratio
shifts towards costs, away from benefits, as the government gets less money for each
bond sold and has to pay a higher effective yield to whoever bought it. The cost of
borrowing literally increases as the government needs to borrow more. The amount
the government must pay back its bondholders increases as the size of the national
debt increases.
To make matters worse, a government with a level of debt that is very large relative
to its GDP may see its credit rating downgraded and risk losing the faith of bond
buyers who might begin to question whether the country’s large debt burden will
make it difficult for the country to continue servicing its debt in the future. If this
happens, demand for that country’s bonds could decrease, lowering bond prices
and shifting the cost/benefit ratio even further towards costs, as effective bond
yields continue to grow relative to the amount of money borrowed.

420
 In short, a country that runs persistent budget deficits will see its national debt
grow year after year after year. If its GDP also grows, and at a rate equal to or
greater than the rate of growth in its national debt, then the debt burden
(the debt to GDP ratio) will actually shrink over time, and there is little to worry
about with regards to a growing debt number. However, if debt grows faster than
GDP, then the cost to the government (and taxpayers) of servicing that debt
(paying the yield on its bonds and repaying bondholders the face value when the
bonds mature) increases over time, requiring the country’s limited tax revenues
to be increasingly allocated towards debt servicing and away from the provision
of important public goods such as education, infrastructure, defence, and
healthcare.
We can conclude that, according to mainstream economic theory at least, one
objective of government policymakers is to maintain a ‘sustainable’ level of national
debt. For most developed countries, this means keeping annual budget deficits
below 3% of GDP and keeping the overall debt below 60% of GDP.
Again, just as target inflation rates vary widely depending on countries’ income
levels and their levels of economic development, the same can be said for debt to
GDP ratios. Some countries may be able to sustain far larger national debts relative
to their GDPs than others. Japan, for instance, has maintained a debt to GDP ratio of
well over 200% for over 20 years. Greece, on the other hand, experienced a complete
economic collapse in 2011 when its debt grew to nearly 160% of its GDP. There
is no ‘one size fits all’ rule for inflation, debt, or other macroeconomic indicators
including the level of unemployment, the rate of economic growth, or the degree of
income inequality in society.

MMT revisited
According to MMT, a sovereign government in a country with its own currency is
not financially constrained in its ability to spend. There is no level of debt, in other
words, that is unsustainable, because government spending is not financed by debt,
it is financed by the treasury, which issues the currency that the government uses to
finance its spending.

When a government engages in an expansionary fiscal policy, it either increases

spending or decreases taxes or does both simultaneously. The resulting budget
deficit, financed by government borrowing, could drive up interest rates in the
economy and therefore ‘crowd out’ private sector spending.
Recall that both consumption and investment are interest sensitive, meaning
that at higher interest rates, both households and firms will constrain their
spending and opt to save more instead. When a government issues new bonds to
finance a fiscal stimulus, the result is an increase in bond yields, which attracts
investors who might otherwise have made their funds available to the private
sector. The theory of the crowding out effect argues that in an economy with
limited funds available for loans, government borrowing reallocates money away
from businesses and households who might have spent it and puts it in the hands
of the government.

421
 Demand management: fiscal policy

PL

SRAS

4
Figure 209 Fiscal stmulus o
is ‘crowded out by a decrease
in private sector spending

-« 2

Vz rGDP

Actual increase in GDP

smaller than desired increase in GDP

In short, government borrowing might cause higher interest rates, due to the
increased yields on government bonds needed to attract investors to the bond
market. If this happens, then the resulting signal to households and firms is to
‘spend less, save more’. The intent ofa fiscal stimulus is to increase AD, but the
unintended consequence may be to constrain AD through reduced consumption
and investment. The multiplier effect of a tax cut or increase in government
spending might, therefore, be smaller than anticipated due to the decreased private
consumption and investment.

Figure 20.9 shows the effect of crowding out. A government that enacts a fiscal
stimulus aimed at increasing AD from AD, to AD, might find the economy only
achieves AD,, assuming the resulting budget deficit drove interest rates up and
led households to increase their savings and firms to reduce their investment. The
government’s stimulus was ‘crowded out’ and AD increased by less than desired.
There are many problems with the crowding-out theory. First of all, there is
almost no evidence that it happens in the real world. During the 2010s, as the
developed economies of the world climbed out of the trough created during the
Great Recession of 2008-10, many countries ran persistent budget deficits and saw
their national debts grow year after year. According to mainstream theory, such
a scenario should have seen higher interest rates lead to falling investment by the
private sector. Neither happened, however. Even as government spending increased
and public debts grew (see Figure 20.2), interest rates in the developed economies
remained low and private investment grew as well.
The Keynesian explanation for why crowding out has not occurred in the last
decade is that much of the developed world might have been in what Keynesian
economists call a ‘liquidity trap’. The government is most likely to engage in
expansionary fiscal policies only when the economy is producing below its full
employment level of output. During deep recessions, crowding out s less likely
to be a concern than when fiscal stimulus is applied in an economy already

422
 producing at full employment since, due to low consumer and business confidence,
investment demand is weak during recessions, while due to uncertainty about
future employment opportunities and the expectation of disinflation or deflation,
household savings is higher during recessions.
When investment demand is very weak and the level of household savings is very
high, a country may experience what is called a liquidity trap, which occurs when
the equilibrium interest rate actually falls below 0%. When the amount of savings
exceeds the amount of investment by the private sector, there is room for the
government to borrow from the public without actually driving up interest rates
and depressing private investment and consumption. Think of it this way, during
deep recessions, when private consumption and investment are already depressed,
government spending does not crowd out private spending, rather it ‘picks up the
slack’ created by decreased expenditures by the private sector. It quite literally picks
up the extra funds that everyone in the economy is saving and turns those idle
funds into active expenditures, injecting money into the economy that otherwise
would have been leaked through savings.
Thus, crowding out is highly unlikely to occur following a fiscal stimulus during a deep
recession. On the other hand, when private sector spending is healthy and strong and
the economy is producing close to or at its full employment level, it is more likely that
adeficit financed fiscal stimulus will create incentives for the private sector to cut back
on their own spending and allocate more funds towards government debt.

Case study LRV § wding

According to MMT, crowding out does not occur because sovereign governments
with their own currencies do not, in fact, have to borrow to finance deficits. As we
have stated, government spending is paid for by the treasury depositing currency
into private banks when ordered to pay for a particular government expenditure.
In this regard, the opposite of crowding out should occur when government spends:
private sector spending might in fact be ‘crowded in’, as bank deposits increase due
to more money flowing through the system following an increase in government
spending ora tax cut.
According to MMT, deficit spending should drive down interest rates, encouraging
investment and ‘crowding-in’ economic activity. This may just be another way to
describe the multiplier effect outlined earlier in this chapter; but either way, there
is plenty of evidence from the post-Great Recession era to support the view
that increased deficit spending might stimulate, rather than crowd out, private
sector spending.

What are the strengths of fiscal policy?

Targeting of specific economic sectors
Unlike monetary policy, which increases or decreases the money supply to influence
interest rates and the level of consumer and business spending in general, fiscal policy
has the potential to be far more specific and targeted in its application. For example,
a‘tax cut’ does not mean that all taxes are cut equally. The government may choose to
reduce the value added tax, an indirect tax, in order to free up income among the
country’s poorer households, who tend to spend a larger proportion of their income
423
 Demand management: fiscal policy

on goods and services compared to the rich, who save more. Lowering consumption
taxes, a fiscal stimulus, will also achieve the objective of reducing income inequality in
society since the greatest beneficiaries will be lower income earners.
Likewise, there are countless sectors towards which an increase in government
expenditures could be targeted. In the USA there is growing support among elected
officials for a ‘Green New Deal’, a proposed multi-trillion dollar federal government
programme that would massively increase spending on renewable energies and improve
the country’s energy infrastructure. In contrast, there are some in government who
prefer to see more government spending on healthcare or simply prefer to cut taxes on
the rich or corporations. Each of these proposed fiscal policies would have varying effects
depending on the sector or the population towards which the policies are targeted.

Government spending may be more effective in deep recessions

For reasons already explained throughout this chapter, fiscal policy is a highly
effective alternative to monetary policy during deep recessions. The ‘zero lower
bound’ described in Chapter 19 limits the effectiveness of monetary stimulus in an
economy where interest rates are already close to 0%. The liquidity trap’ experienced
when household savings increase while private investment is depressed allows the
government to borrow money at almost no cost and stimulate AD during deep
recessions, ‘picking up the slack’ left by depressed consumption and investment. In
short, the government can be the ‘spender of last resort’ in an economy in which
consumer and business confidence are extremely low and in which the business cycle
is on a precipitous downward slope.

‘When government policymakers get together and decide to take fiscal actions
to either contract or expand AD, they are implementing discretionary fiscal policies.
However, when changes in output or employment trigger automatic increases or
decreases in spending and taxation, an economy is employing automatic fiscal stabilisers.
Automatic stabilisers are the built-in changes in transfers and taxation that
happen when an economy’s output and employment increase or decrease. Consider
what happens after a fall in AD results in rising unemployment and decreased
output. Unemployed workers who have lost their income stop paying income taxes,
so there is an automatic decrease in the amount of tax collected by the government.
Additionally, as they lose their jobs workers become eligible for unemployment
insurance, a transfer payment by the government to people who are unable to find
work. In other words, government spending increases automatically following a
decrease in aggregate output.
During a demand-deficient recession tax revenues decrease automatically as GDP
falls, preventing consumption and the economy from falling further. At the same
time, transfer payments increase, helping maintain consumption among those who
have lost their jobs. The effect of these automatic stabilisers is to, well, stabilise AD
and prevent it from falling as much as it would if these effects did not kick in.
Next consider what happens when an economy already producing at full
employment experiences an increase in AD. Workers who were structurally or

424
frictionally unemployed will be hired, causing unemployment to fall below its
natural rate. Newly employed workers start paying income tax, which automatically
increases tax revenues for the government, and since they are no longer
unemployed, the same workers will stop collecting unemployment benefits from
the government, automatically reducing government spending on transfers.
Furthermore, rising output and employment drives wages upwards, pushing some
workers into a higher income bracket, at which they are likely to pay a higher tax
rate. A progressive income tax is one that increases in percentage as incomes rise.
Progressive taxation acts as an automatic stabiliser as rising incomes automatically
trigger higher tax rates for those earning them.
During an expansion, tax revenues increase automatically as GDP rises, slowing
consumption and preventing the economy from overheating. At the same time,
transfer payments decrease, helping prevent consumption from rising more than it
otherwise would. The effect of these automatic stabilisers is to prevent an economy
from overheating that otherwise might follow an increase in AD.
While discretionary fiscal policies (those that require the government to come to
some agreement and put new spending or tax policies into action) can fairly be
criticised for the associated time lags, automatic fiscal policies like unemployment
benefits and progressive taxes do not suffer this shortcoming. The changes happen
automatically, thus there s little or no time lag. However, when the economy
is threatened with more than just minor inflationary or recessionary gaps, the
automatic stabilisers described here will fall short of helping an economy restore its
full employment output.

Practice exam questions

la. Explain the impact of automatic stabilisers on an economy. (10 marks)
b. Evaluate the effectiveness of fiscal policy in achieving
economic growth. (15 marks)
2. Explain how expansionary fiscal policy can be used to close
a deflationary gap. (10 marks)
5 Using an AD|AS diagram, explain the implications for
government policymakers if the crowding out effect
is more powerful than the multiplier effect of an
expansionary fiscal policy. (10 marks)
4. Using an AD|AS diagram, explain the effect of contractionary
policy on a positive output gap (demand-pull inflation). (10 marks)
5. Assume the marginal propensity to consume is 0.75. Calculate the
effect the fiscal policies below would have on AD:
a. A $6 billion increase in infrastructure spending. (2 marks)
b. A $8billion increase in income taxes. (2 marks)
c. A $5billion increase in transfer payments. (2 marks)
6. Outline the strengths and weaknesses of expansionary fiscal
policy as a tool for combatting deep recessions. (10 marks)
7. Discuss whether fiscal policy is effective at promoting long-run
economic growth in an economy already producing at its full
employment output level. (10 marks)

425
 21.1 What are supply-side policies and what is
the goal of such policies?

Learning outcomes
At the end of this section you will be able to:
* explain that supply-side policies aim to positively affect the production side of
an economy by shifting the LRAS curve to the right
« distinguish between market-based and interventionist supply-side policies
. analyse the goals of supply-side policies including:
increasing long-run growth
* improving competition
* improving labour market flexibility
* reducing inflation
* creating incentives for firms to innovate.

Supply-side policies aim to positively affect the production side of an economy by

improving the quantity or the quality of the factors of production. These policies
attempt to develop a healthier institutional framework for production to occur. On an
aggregate diagram, successful supply-side policies shift right the short-run aggregate
supply (SRAS) curve (Figure 21.1a), and ideally a long-run aggregate supply (LRAS)
curve to the right, increasing the overall productive capacity of the economy
(Figure 21.1b). This pushes future full employment income, Y, out to the right to Y, ..
This shift of LRAS would correspond to a shift outward of the production possibility
frontier (PPC), which suggests an increase in overall potential capacity in the economy.
Supply-side policies fall in to two categories: government based and market based.
Governments can act directly to improve the economy’s capacity to produce.
Government intervention seeks to provide capital goods or services where, it is
believed, the market itself has failed to provide them. In contrast, market-based policies
seek to unleash the full power of open markets to improve incentives, open labour
markets, and create competition.

pL LRAS, LRAS,

Figure 21.1 A successful

supply-side policy will shift
both long-run AS (a) and
short-run AS (b) to the right

el Y FE2 rGDP Y, ) YFEI rGDP

427
 Supply-side policies

The primary goals of supply-side policies are:

1 long-term growth by increasing the economy’s productive capacity
2 improving competition and efficiency
3 reducing labour costs and unemployment through labour market flexibility
4 reducing inflation to improve international competitiveness
5 increasing firms’ incentives to invest in innovation by reducing costs.

21.2 What are market-based supply-side

ololllei(=54

Learning outcomes
At the end of this section you will be able to:
« analyse the use of market-based policies including:
* deregulation
privatisation
« trade liberalisation
anti-monopoly regulation
+ explain the effects of labour market policies such as:
« reducing the power of labour unions
« reducing unemployment benefits
« abolishing minimum wages
* outline the idea behind incentive-related policies such as cuts in personal
income tax, business tax, and capital gains tax
* evaluate the effectiveness of market-based supply-side policies in terms of
their effects on:
+ employment
* inflationary pressure
* economic growth
« the government budget
* equity
« theenvironment.

Market-based supply-side policies generally act to reduce government intervention

with the goal of unleashing market forces to improve macroeconomic efficiency and
capacity. More specifically, market-based supply-side policies try to improve
incentives, open labour markets, and create more competition in the market.

What are the origins of market-based supply-side

policies?
The impetus behind the criticism of Keynesian policies came from an influential
group of new classical economists. Among the most prominent was Milton Friedman,
who also became renowned for contributions to thinking about the money supply.
428
 Friedman and the other new classical economists followed in the tradition of
Friedrich von Hayek, an Austrian economist who had openly clashed with Keynesian
approaches since the 1940s. The term ‘new classical’ implied a harking back to old,
accepted classical economics precepts. Energised by the economic crises of the
70s, new classical economists fiercely criticised the heavy regulation of markets
and government ownership of major industries that had become emblematic of
Keynesianism.

Their protests took root as politicians in the UK and USA began to advocate freer
markets and less government control. Most notably, UK Prime Minister Margaret
Thatcher privatised and shrank the coal industry in the UK, causing large-scale strikes
and subsequent unemployment in the industry during the 1980s. Ronald Reagan,
meanwhile, crushed a prominent strike by US air traffic controllers in 1981, sending
a signal that the days of trade union ascendancy were over.
These policies aimed to open up competition, free up markets from government
involvement, and return influence to the private sector. At the same time, the countries
that implemented them likely suffered some of the negative effects that the policies
can bring.

What are incentive-related policies?

Reducing personal income tax
Lowering marginal tax rates increases the after-tax income of those affected. It should,
therefore, increase the incentive to work since every hour of work results in greater
pay. At some level of marginal tax, a worker may find that the diminished value of the
disposable income derived from that hour is less valuable than an hour of leisure or
childcare. Lowering the rate tips the cost-benefit calculation in favour of the benefits
of extra work. In theory, this will cause workers to seek more work, and become more
productive and the value of labour as a factor of production will rise, contributing to
the aggregate supply (AS) of a country.

Reducing business and capital gains tax

A tax on business profits obviously diminishes profits. Cutting corporate taxes,
it is said, encourages firms to produce more by reducing the costs of production.
Itis also possible that this extra profit will be ploughed back into the business in the
form of investment if it is not simply taken as dividend/income by the owners.
If it encourages more production and investment, lower corporate taxes will shift
AS to the right. The taxes on capital gains work in a similar way. First a capital
gain is a profit made on the sale of an asset, which could be profit from the sale
of property or company shares. The idea is that reducing these taxes encourages
entrepreneurial investment spending in property and companies, which helps keep
firms well-capitalised.

Labour market policies

Supply-side economists see government efforts to regulate and manage labour
relations as an intrusion into the operation of free markets, and believe that
inefficiencies result. Reforms in this area are intended to make labour markets more
responsive to supply and demand.
429
 Supply-side policies

Reducing trade union power

This could be viewed as the counterpart to anti-monopoly rules, if one takes the view
that trade unions attempt to assume a collusive or monopolistic control over the
market for their work. Trade unions generally seck to raise wages for their members,
as well as to improve working conditions. Where successful, unions keep wages
above the market level and raise non-wage costs for firms, reducing the supply of
goods produced by firms. On a macroeconomic level, this translates into a diminished
aggregate supply. Restricting trade union power to organise and bargain collectively
with employers would decrease their wage-setting power and condition-setting power.
In theory, firms produce more at lower costs, and the economic growth that results
will result in more overall employment.

Reducing unemployment benefits

Unemployment benefits, according to supply-side economists, reduce the incentive
to find employment. The supplementary income received creates a disincentive for
workers to accept jobs at lower wages during periods of unemployment, and thus
prolongs the economy’s return to full employment. For a measure of comparison,
some countries offer up to 80% of wages for two years, whereas some offer a low flat
rate far below median wage levels for a shorter time. Supply siders argue for benefits
that are smaller and shorter in duration.

Ending the minimum wage

The minimum wage sets a price floor for labour, which raises costs for firms and
reduces overall supply of goods and services. Moreover, such price floors are believed
to create a surplus of workers who will not be hired at the government-enforced wage
rate, and so require more unemployment benefits, which require more tax revenue.
Figure 21.2 shows a binding $15 minimum wage, one which has increased the
quantity supplied of labour and reduced the quantity demanded, causing a surplus of
unemployed people. Eliminating that minimum wage would allow the price to drop
back to W, at $12, where the market clears and there is no unemployment. Repealing
minimum wage laws would reverse the surplus of workers, keeping costs low for firms,
freeing up government revenue, and allowing the AS to grow.

Wage rate
($ per hour) st

W,,=$15 Minimum

Figure21.2 Effect of > w,=$12

ending a binding
minimum wage

Q. Q Q. Number of
workers (QL)
Unemployment
430
 orkers
day strike in 2016, cal ing
$15 minimum wage, paid sick
days, and union rights

What are policies that encourage competition?

]
Another group of supply-side policies aim to open the market to greater competition.
| Supply-side economics
They flow from the free market philosophy that greater competition encourages asserts the desirability of
harder work, more innovation, lower prices, and better quality in an attempt to earn reducing union power
money and win customers. as a universally accepted
approach to labour market
flexibility. However, labour
Deregulation unions have a long history
Supply siders argue that governments discourage business by applying stringent or of fighting for working hours
and conditions, many that
unnecessary regulation to markets. Rules about professional qualifications, products we now accept as normal but
standards, worker health, and safety requirements may be well justified by public that were bitterly contested
concerns, but they impose costs on firms. Deregulation can be applied to a variety of at the time. The end to child
situations in order to reduce bureaucracy as well as the required costs of complying labour, a 40-hour working
with government rules. Tearing away the rules should therefore automatically reduce week, a six- or five-day
working week, and basic
costs and encourage greater production. worker safety standards were
| long advocated by labour
Privatisation | unions before they were
grudgingly agreed to by
One legacy of the Second World War industrial policies in many countries has been owners.
government control of the ‘commanding heights’ of the economy. In many otherwise For discussion and debate:
free market economies in the Cold War West, the industries of steel and iron, energy, 1 Conduct an internet search
and transportation industries were under government ownership and control. Supply to find the ‘pros’ and ‘cons’
siders believed that most of these had become bloated with unnecessary employees of labour unions.

and operated inefficiently because they lacked the right incentives. Privatisation, it Read your sources
was argued, would encourage owners to lower costs and thus prices to the public if
carefully, checking for
reliabiliy
they were run more like private businesses. Prominent examples of implementation
Look for historical
include the coal industry in the UK, as well as telecommunications and airlines in references to support each
many countries. side.
Set up an informal debate
=

with your classmates

Trade liberalisation (free trade)
around the values and
Supply-side economists applied the free market principle to international trade as well. They limitations of labour union
opposed tariffs, quotas, and subsidies that encouraged dependence on the government. power.
431
 Supply-side policies

They encouraged free trade, reduction of trade barriers, and open competition. Such
competition, according to the idea of comparative advantage, would encourage countries
to work to their relative strengths and improve global macroeconomic efficiency.

Anti-monopoly regulation
Where monopoly power exists, it gives producers the ability to restrict output and
increase prices. Monopolies therefore extract extra producer surplus, and profits, from
consumers without necessarily adding extra value to the market. Anti-monopoly laws
(also called antitrust laws) seek to prevent or dismantle monopolies. It is thought better
for most industries to have competition, as Adam Smith suggested, to keep firms
from exploiting customers with simple control of the market. Antitrust laws prevent
monopolistic mergers and seek to break up monopoly firms that harm consumers.
Fewer monopolies make for more competition, greater innovation, and lower costs
and prices, all of which contribute to aggregate supply. Chapter 12 explores the
problems and solutions for monopoly power in more detail.

What are the advantages and disadvantages of

market-based supply-side policies?
Advantages
* Inlabour markets, the withdrawal of government intervention in the forms of
minimum wages, trade union rights, and unemployment benefits may indeed make
the labour market more flexible and responsive to market forces.
By reducing monopolies and improving competition, a country benefits from
lower costs, more innovation to win customers, and greater corporate integrity.
The gains to output are at no cost to the government, and require no extra
expenditure of resources. The allocation of resources in the market becomes more
efficient, as determined by the forces of supply and demand.
Disadvantages
* Labour market reforms such as eliminating the minimum wage and reducing union
power, and cutting unemployment benefits expose vulnerable people to the quixotic
consequences of the market. Workers paid below minimum wage would be ever
more dependent on their employers, and therefore at more risk of exploitation.
* While trade unions explicitly and openly exist to drive up wages, they also help to
protect workers from illegal and coercive treatment by employers. This could
worsen if unions are further diminished.
* Dropping unemployment benefits may inspire the jobless to take whatever work is
available. However, those out of work for structural reasons need time to retrain or
even relocate to new jobs.
* Privatised firms can be bought on the cheap by politically connected elites, robbing
the public of their true value, while firms charging free market prices may harm the
public interest by overcharging for essential services like power and water.
« Itis not clear that policies to lower taxes actually result in more or better work.
Cutting corporate and capital gains taxes may merely be taken as extra income
rather than being used to invest and grow the company.
Deregulation can expose natural environments and delicate ecosystems to the risk
of ruin. Eliminating or loosening these rules allows firms to externalise their costs
and the public will eventually pay through taxes to clean up the problem or simply
through diminished quality of life.
432
 Case study - how flexible is your country’s labour market?
In an attempt to quantify the level of a country’s labour market flexibility, a
consortium of free market non-profit groups headed by the Lithuanian Free
Market Institute using World Bank data compiled the Labour Market Flexibility
Index 2020. Using criteria such as minimum wage levels, mandatory work hour
rules, redundancy regulations, and costs, the group ranks EU and OECD countries.
At the top for flexibility were the USA, Japan, and New Zealand. At the bottom were
Mexico, Luxembourg, and France. Where did your country rank, and why? Find this
publication online and see if you agree with these results.

21.3 What are interventionist supply-side

policies?

Learning comes
At the end of this section you will be able to:
* explain how investment in:
* education and training
* research and development
* improved infrastructure
will raise the levels of ‘human capital’, result in new technologies and have a
short-term impact on AD, as well as increasing LRAS
* comment on the effects of targeting specific industries through tax cuts, tax
allowances and subsidised lending, in terms of promoting growth in key
areas of the economy and increasing AD in the short term, as well as
increasing LRAS
* evaluate the effectiveness of interventionist supply-side policies with regard to:
* timelags
* creating employment
* reducing inflationary pressure
* economic growth
* impact on the government budget
* effect on equity
* theeffect on the environment.

Interventionist supply-side policies require some kind of government action to

improve the factors of production. Note that most of these require immediate
spending, which will initially stimulate aggregate demand (AD). However,
well-crafted policies should create an enduring expansion of LRAS. Such
policies include:

+ investment in human capital

+ investment in research and technology
+ investment in infrastructure
+ direct support to specific industries.
433
 Supply-side policies

Investment in human capital

Labour and entrepreneurship are two of the four factors of production, and can
collectively (if somewhat coldly) be called human capital. Enhancing the productivity
of that capital is likely to require significant government investment.

Education spending
Public education is a common policy in most countries. This has not always been true, but
has gradually become accepted as a necessary ingredient of a modern economy. Learning
basic literacy and numeracy, in particular, is rewarded with large jumps in the incomes
of those so educated. Education improves the skills and productivity of the workforce as
well. High levels of educational achievement are highly correlated with national income.

Investment in worker training schemes

Specific training for some jobs may not be offered in schools, and may be offered by
special job training centres established by the government. This helps businesses find
productive employees and thus should enhance economic growth.

Improving and extending health services

In countries where public health is poor, it is difficult for children to regularly attend
school, and worker absenteeism is chronic. Government efforts to improve healthcare
can improve labour productivity in these situations. For example, at a basic level,
prenatal care and inoculations can help ensure healthy births and childhoods. Most
governments recognise this benefit, although some developing countries find the costs
difficult to manage. Investing in education, training, and health services will, by the
building and staffing of these institutions stimulate AD. However, the lingering effects
of a well-trained, educated, and healthy workforce should endure into the future,
pushing LRAS outwards by improving labour and entrepreneurship.

Investment in research and technology

Policies that encourage research and development have an immediate impact on AD.
However, the more enduring effect should come through the resulting new technologies
and knowledge that will increase LRAS. When the government hires or sponsors the
hiring of scientists and engineers to work in a particular area, this government spending
stimulates AD in the immediate term. When their work results in new life-enhancing
drugs, increased food production, and safer or cleaner technologies, the entire productive
capacity is enriched, pushing LRAS outwards. This can be accomplished by public/private
sector partnerships, as well as tax incentives for research and development.

Investment in infrastructure
Infrastructure is the building of large-scale public projects such as ports, highway
systems, bridges, communications networks, as well as power and water systems. This
kind of spending most certainly increases AD in the short run, but should also expand
the capital base of the country in the long term, increasing LRAS in the process. The
creation of a port, for example, makes it easier for the country to import goods, which
may enhance the capital base of that country. At the same time, exports of goods
will also be improved. The expanded market for domestic goods spurs investment to
produce for overseas markets.
434
Direct support to specific industries (E d ing Y
Governments may support specific industries; perhaps an industry where the country Often a country’s bureaucracy
has comparative advantage fulfils a strategic need, or one with good long-term has departments that are
designed to both regulate
prospects. The government can support the industry with reduced taxes, subsidised and promote the industries
loans, and even direct subsidies. These all reduce the costs to the firms, and encourage under their supervision. These
more production. Industries believed to be potentially competitive in the world can include a department
market may get this special treatment. Compared to their global competitors, they may of agriculture, or a ministry
of energy, for example.
currently be too small to enjoy the benefits of economies of scale. Governments can Conduct an internet search
put down protective tariffs or quotas to keep foreign competition out until the firm is of your home country’s
sufficiently large and developed. major agencies and find an
industry-specific ministry.
1 Identify which groups it
What are the advantages and disadvantages of represents
interventionist supply-side policies? 2 List its recent actions in
the news with regard to
promotion and regulation.
Advantages
+ Inmany of the above policy situations, the government is providing for goods that
are underprovided in the free market. Education, training, healthcare, research, and Ethics
infrastructure are merit goods that the free market finds little profit in providing at Having learned so much
sufficient levels. Where economics defines these goods as providing significant about macroeconomics
50 far, itis fair to question
economic benefits, such support is well justified on its own terms. how you may have
changed your thinking,
Disadvantages And i this s true for you,
+ Interventionist policies come with considerable expense. Countries weighing the that you think differently
costs and benefits of interventionist policies worry that the budget expense will not now that you have learned
more about this subject,
yield the desired economic benefits. Budget deficits can be excused if the spending is it true for people in
brings enough economic growth that paying them off is affordable. Prioritising general? Do established
such expenses poses a major challenge to any country, especially developing ones values change in the face
for whom tax revenues are especially precious. of new knowledge?
+ Interventionist policies take time to implement and bear results. Building a road
system, for example, in the name of greater infrastructure, can take a decade. Video suggestion:
Improvements to education can take even longer to show up. Therefore, a balance You have read about it, now
between short-term and long-term achievable goals is desirable. you can review what you
+ Because interventionist policy requires government decision making and action, as have just learned by watching
avideo by the author!
well as money, they are inherently political decisions. They are subject to political Simply lick here in
debate, controversy, and opposition. This may make long-term commitment to your eBook for an
particular goals difficult to sustain. introductory video on
supply-side policies,

1.4 How are demand and supply-side

policies related?

Learning outcome
At the end of this section you will be able to:
« analyse how supply-side and demand-side policies are interconnected.

435
 Supply-side policies

Itis important to see the distinction between supply-side and demand-side policies as
the different areas where government policy takes hold. However, such policies can
have different longer term effects that result in outcomes in the opposite area.
For example:

What are the demand-side effects of

supply-side policies?
Supply-side policies can affect AD in the short run, even if they are intended to
influence LRAS. Market-based policies that reduce union power or minimum wage
laws may reduce income in the short run, reducing AD, while reductions in tax rates at
all levels could increase AD.
Interventionist policies, because they require increased government spending, will
immediately increase AD, and then eventually long-run supply. Increased spending
on company subsidies, education, infrastructure, and healthcare will all stimulate the
economy, providing short-run AD-based growth before growing the supply capacity
of the country.

What are the supply-side effects of fiscal policies?

Itis possible that the reduction of taxes that are intended to have short-run AD effects
(to fill an output gap, for example) may also increase supply through boosting the
labour and entrepreneurship factors of production.
Expansionary fiscal policy that involves increased government spending, perhaps to
meet short-run recessionary policy goals, will boost AD. However, spending on power
grids and road projects, mainly intended to increase employment and spending, could
also result in long-run supply improvements.

21.5 What is the appeal of supply-side policies

in terms of growth, employment, and
inflation control?

Learning outcome
At the end of this section you will be able to:
* evaluate the effectiveness of supply-side policies in achieving growth, full
employment, and stable price levels.

In theory, supply-side policies are especially desirable because they improve the overall
macroeconomic environment in which individual actors operate. Good policies would
encourage productivity as well as create more and better factors of production. In
this environment of productive surplus, growth is the logical outcome. Furthermore,
increasing LRAS manages to expand the economy without generating inflation, a
typical problem with expansionary demand-side policies.
436
In particular, supply-side policies appear to address one of the most serious challenges
of macroeconomic policies — stagflation. This is a loathsome combination of economic
recession with rising inflation that is unresponsive to demand-side approaches. The
economies of many Western nations were widely seen as locked into a period of
stagflation in the 1970s, where the equilibrium price levels were high and increasing,
while output was below full employment. Movement of AD would have either (in the
case of expansionary policy) increased inflation further or (in the case of deflationary
policy) driven the country into deeper recession.

In practice, some supply-side policies are criticised for hurting the economically
vulnerable. In particular, those labour market reforms designed to reduce union power
and eliminate the minimum wage, while they may increase employment, will also
create more jobs that are poorly paid, and that put workers in situations where they
have little legal protection against various kinds of exploitation and mistreatment. For
some, this approach does little to increase general economic well-being but instead
increases employer power at the expense of workers.

Both problems can be eased, however, by increasing AS. Successful supply-side

policies would push SRAS to the right, reducing inflation and encouraging recovery to
full employment.

Practice exam questions

Paper 1, part (a) questions
1. Using examples, distinguish between market-based
and interventionist supply-side policies. (10 marks)
2. Explain the difference between demand-side policies
and supply-side policies. (10 marks)
Paper 1, part (b) and Paper 2, part (g) questions
3. Evaluate the view that demand-side policies are
more effective than supply-side policies in reducing
the level of unemployment. (15 marks)
4. Using real-world examples, discuss the effectiveness
of three interventionist policies that might be used
to increase aggregate supply. (15 marks)
5. Using real-world examples, discuss the effectiveness
of labour market reforms that may be used to
increase aggregate supply. (15 marks)
4-mark Paper 2 and HL paper 3 questions
6. Using an appropriate diagram, explain how
supply-side policies are expected to affect
national income. (4 marks)

437
 The global economy

Real-world issue 1
Who are the winners and losers of the integration of the world’s economies?
* Theincreased interdependence of economies has benefits and costs.
* Increased economic integration may result in efficiency, welfare gains, and
improvements in economic well-being but the benefits may not result in equity.
 Benefits of
international trade

-
 Benefits of international trade

22.1 Introduction to international trade

Learning C 3

At the end of this section you will be able to:

« analyse the various benefits of international trade
* draw diagrams to show imports and exports when world prices are lower/higher
than domestic prices
e calculate the quantity of imports/exports and expenditure/revenue from
a diagram.

International trade involves the exchange of goods and services between two
countries. In recent years, the debate around free trade has inspired economists to
revisit both the theoretical principles and the real-world evidence of its benefits. This
chapter will explain and explore the benefits of trade, and Chapter 23 will discuss
protectionism and look deeper at the debate around the role of trade in the world
today.

What are the benefits of international trade?

One idea on which the vast majority of economists tend to agree is the axiom that
‘trade is good". The market economic system, after all, is based on the free exchange of
goods, services, and resources all the way down to the level of individual households and
firms. On the global scale, the same benefits from free trade experienced between
individuals apply to entire nations, therefore, free international trade is an ideal towards
which most economists would agree societies should strive.
The benefits economists see in international trade are outlined below.

Increased competition
Free trade will expose domestic firms to international competition. This gives domestic
firms a further incentive to improve quality, lower price, and improve efficiency. Under
competition, companies are pressed into lowering prices and improving service, or
they suffer from their rivalry with the foreign firms.

Lower prices
Countries, just like individuals, can specialise in particular areas of expertise. This
means they produce more efficiently than if each country tried to produce enough of
everything for all its needs. Thus, a global division of labour takes place, where these
multiplied efficiencies add to the overall wealth of consumers everywhere. In short, we
get more output for less resources. Trade should therefore drive down real prices of the
goods and services we all want.

Increased variety/choice
More sellers will lead to greater variety in the products available in all countries. A brief
check around your room or class will reveal an array of goods from many places:
440
for example, a computer assembled in China, a glass from Russia, and clothes from
Cambodia, Egypt, and the Dominican Republic. As the number of countries in the
global market has grown, so has the amount of choice. Even a simple desk lamp is now
available in nearly any size, colour, design, and wattage. While some find these choices
overwhelming, others enjoy the power it gives to consumers to make decisions about
their own purchases.

Acquisition of needed resources

Some countries lack critical goods to improve their standard of living. In some cases,
production ofa needed good is simply impossible. Trade is the only way to get it. This
need can range from a vital natural resource like natural gas for heating, to the need
to import capital goods that might improve industry or agriculture. Adding these
imported goods can improve production or improve everyday life for buyers.

More foreign exchange earnings

Exporters generally want to be paid in their home currency. So, when foreign
consumers buy a country’s exports they must also buy their currency to pay forit.
In doing so, the exporting country accumulates larger amounts of the foreign currency.
For example, when Guatemala exports commodities like bananas and coffee to the
USA, it earns US dollars that it can use to buy cars and capital goods from the USA and
elsewhere because the dollar is easily exchanged for other currencies. For smaller and
developing countries, in particular, an important feature of trade is getting access to
foreign exchange that can be used to buy goods and services from other countries.

Access to larger markets

Often countries find that they are so productive in a particular product that their
own country’s market is too small to satisfy all the supply available. When supply is
much greater than demand, prices are low, and incomes stay low as well. For example,
if Paraguay were to sell its soybeans only in Paraguay, with its population of just
7 million people, a massive surplus and a drop in price would result. Instead, Paraguay
trades with the neighbouring countries in the MERCOSUR trade area (which includes
Brazil and Argentina with combined 260 million people). Because of their access to
larger markets, soybeans are a leading export.

Economies of scale
Firms that trade internationally experience larger markets, as noted above, and so their
production levels grow ever larger. Because they are producing such large runs of output,
firms can now enjoy bulk buying power, as well as the specialisation of managers and the
introduction of expensive technology to improve the productivity of a given business
sector. The benefits of extreme specialisation bring lower and lower average costs. These
low costs drive down prices, which benefit consumers as well as making the firms more
internationally competitive. But these gains come from large-scale production and
would not be likely to occur if production were limited to the domestic market.

Taking advantage of different factor endowments

No two countries share exactly the same resource base. Some are by the sea, some
blessed with fertile farmland, some with ample deposits of minerals, and others placed
441
 Benefits of international trade

well to act as a hub to facilitate trade between other countries. Trade takes advantage of
these differences between countries. For example, Saudi Arabia, flush with oil deposits,
buys technology from South Korea, which has few natural resources but a very skilled
technical and technology sector. Both are better off.

More efficient production

Firms are both pressed to develop more efficiencies but at the same time have greater
opportunities to increase productivity. By facing competition, local firms have greater
incentives to innovate and cut costs. But they also enjoy the benefits ofa larger market
and so can vastly increase their economies of scale as a global competitor. Also, by
having access to a large international market for resources, producers will be able to
have reliable, appropriate quality inputs at competitive prices.

Taken together, the above benefits of trade suggest that there are enormous gains to
be enjoyed by trading internationally. After exploring the theory that supports this
premise in more detail for the remainder of the chapter, we will turn to arguments
against free trade in Chapter 23.

How did theories of free trade develop over time?

The Scottish economist and moral philosopher Adam Smith first developed our view
of the division of labour at the village level with his analogy of the pin maker:
‘... aworkman not educated to this business, nor acquainted with the use
of the machinery employed in it, could scarce, perhaps, with his utmost
industry, make one pin in a day, and certainly could not make twenty. But if
they had all wrought separately and independently, and without any of them
having been educated to this peculiar business, they certainly could not each
of them have made twenty, perhaps not one pin in a day; that is, certainly, not
the two hundred and fortieth, perhaps not the four thousand eight hundredth
part of what they are at present capable of performing, in consequence of a
proper division and combination of their different operations ..."

— Adam Smith, The Wealth of Nations (Book 1), 1776

To Smith, the benefits of specialisation were obvious. Everyone develops special

efficiency, and auctions off that efficiency in the free market. Thus, through self-
interest and trade, prosperity is made possible.

Smith’s observations were seconded by the work of David Ricardo just a few decades
later. Ricardo, a banker and member of parliament, wrote an essay in 1815 entitled
Essay on the Influence of a Low Price of Corn on the Profits of Stock in which he argued
that the British Corn Laws protected wealthy landowners and drove food prices up
for everyone else. In particular, he viewed the laws as a redirection of income and
resources away from relatively new and dynamic industries. In the process of fighting
the Corn Laws, Ricardo developed the theory of comparative advantage. The theory
holds that even countries that are more productive in all aspects should still trade with
their otherwise inferior partners.

The French economist and philosopher Frédéric Bastiat took up the theme on the
national level. In his ‘Petition of the Candlemakers’, first published in 1845 in the
French Journal des Economistes, Bastiat satirises the impulse to protect this or that market.
442
 The candlemakers in this work see the Sun as a rival and propose that the illumination
of buildings with natural light be made illegal, as this would benefit the candle trade.
Furthermore, by protecting candlemakers, all suppliers of candle-related goods would
benefit: tallow producers, whale hunters who sell the blubber, the shipping industry, by
extension all of France would benefit from the new rule. However, Bastiat's ridicule did
not end the impulse to restrict markets.

More recently, James Ingram presented another way to demonstrate the benefits of
trade, with the story of Mr X. This secretive and mysterious businessman tells the
world he can turn simple primary goods like grain, coal, and cotton into TVs, radios,
and cars, very cheaply. Mr X opens his factory, and the results stun the world. True to
his word, the basic goods go in and the relatively advanced ones roll out. Consumers
love the cheaper prices, competitors loathe the competition. Mr X jealously guards
his trade secrets but a little boy wanders onto the property one day and discovers the
truth: there are no miraculous manufacturing techniques, no special processes. The
company, it turns out, is one big import—export business. The gains Mr X produced
were made by trade alone.

Case study - a battle over free trade inspires the foun LR

LGN STl T
The Corn Laws were protectionist tariffs placed on imported grain to protect British
landowners from foreign competition. Most British members of parliament were
aristocratic landowners, who staunchly supported high prices and high tariffs on
agriculture. A member of the anti-Corn Law lobby, James Wilson, founded
The Economist to offer succinct and persuasive arguments in favour of free trade and
in particular cheaper food for the residents of Britain's growing cities. The repeal of
the Corn Laws in 1846 marked a significant shift towards freer trade by the British
Empire, which had previously pursued mercantilism. While the players are not the
same today, and mercantilism has faded, many of the free trade and protectionist
disputes today resemble that over the Corn Laws, with vested interests arguing
against competition and lower prices from foreign competition.

James Wilson (1805~

campaigner for free trade and
founder of The Economist

443
 Benefits of international trade

Price of
sugar

S, 'DoMEsTIC

Figure 22.1 Sugar imports P

resultin an expansion of
consumer surplus compared
to when the market is closed
P
WORLD WORLD

| ' D, bowesTic
0 Q Q Q, Quantityof
sugar

How can the benefits of trade be shown

with diagrams?
Basic supply and demand graphs can demonstrate the benefits of trade from the
import and export sides. Figure 22.1 shows a domestic sugar market that is opened
up to trade. The closed market price P, is determined by the domestic suppliers
and buyers. If this country is suddenly allowed to trade, all the world’s sugar is now
available at whatever the free market price is, here shown as P .. No matter how
much the country wants, the price will be P, - and so the global supply S . is
shown as a flat line: any amount will be sold at that price. Because global sellers offer at
amuch lower price, domestic buyers get a much lower price (P, instead of P,) and
enjoy a much larger market (0 - Q, compared to 0 - Q,). We could further show the
benefit in terms of expanded consumer surplus, the shaded blue area.

From the perspective of an exporting country, the view is reversed. In Figure 22.2,
we can observe a country that produces cotton very competitively. Domestic cotton
suppliers have a low domestic equilibrium price at P, compared to the higher P,
price. Ataprice of P . this country will increase its domestic supply, causing a
movement along its supply curve to where it is offering Q, for sale. It will then export
the quantity between Q, and Q,.

This increases the size of the market for firms, increasing revenues, and expanding
producer surplus, shown in yellow. Note an interesting side effect: the higher
prices paid for cotton at home. This could raise prices for cotton-using firms
inside the country. Overall, however, this shows the expanded markets benefiting
some sellers, which may in turn lead them to develop economies of scale in the
expanded industry.
444
 DOMESTIC

“
WORLD
<‘ Figure22.2 A higher global
price for cotton means
domestic suppliers can
increase their output,
enjoying greater
producer surplus

D, bomesric
Q, Q Q, Quantityof
cotton

How does free trade come about?

The term ‘free trade’ describes the process of lowering protectionist barriers and
thereby realising those gains from trade. Countries work out these agreements through
tedious negotiation at the global level through the World Trade Organization (WTO)
and on the regional level through trade blocs such as the EU, the US-Mexico-Canada
Agreement (USMCA) or Mercado Comtin del Sur (MERCOSUR), also known as the
Common Market of the South. How the WTO works and how countries form such
trade blocs is discussed in more detail in Chapter 24.

HL Exercise 22.1
From a diagram, you should be able to calculate the quantity of exports, the
quantity of imports, import expenditures, and export revenue. These calculations
use your understanding of supply and demand, as well as the calculations of
total revenue we have already learned. Try the examples below to test your
understanding.
Calculate the following based on the import diagram:

domestic revenue before trade

=

quantity of exports after trade

domestic quantity after trade
W

export revenue after trade

voh

domestic revenue after trade.

445
 Benefits of international trade

Price of bananas
(Uss$/kg)

5] DOMESTIC

2,50+

D, bomesric
0 400 800 1200 Bananas
(kg millions)

Calculate the following based on the export diagram:

domestic revenue before trade
quantity of exports after trade
S v oo

domestic quantity after trade

export revenue after trade
domestic revenue after trade.

Price of bananas
(Uss$/1 kg)

5 DOMESTIC
5 WORLD

P,=0.75+

D, bomesric
0 10 50 0 Bananas
2 (kg millions)

446
 Case study es trade lead to peace? To what extent would
increased economic
‘Merchants have no country. The mere spot they stand on does not constitute integration ever be
50 strong an attachment as that from which they draw their gains.’ considered undesirable?
Consider modem
—Thomas Jefferson, 1814 examples as well as
historical ones as you
Trade requires relationships and attachments. Merchants want predictable supply consider your answer.
of their imported resources and hope to maintain steady and reliable output
to customers abroad. They abhor disruptions to everyday business and future
planning.
This, economists believe, helps discourage conflict and helps keep the peace.
A playful metaphor for this was popularised by Thomas Friedman as ‘the golden
arches theory of conflict resolution’, which holds that no two countries with a
McDonald's have ever fought a war, nor are they likely to do so because it goes
against their mutual interests.
The updated version of this analogy suggests the same sort of pacifying effect to
countries who are part of Apple’s or Huawei’s phone supply chain.
However, more profound examples may offer evidence as well. After hundreds of
years of conflict, reaching an apex of destruction and misery in two world wars in the
20th century, most of Western Europe has since enjoyed a period of relative quiet and
peaceful relations. They have also, not coincidentally, embarked on an extraordinary
experiment in economic integration. Decade by decade, the six founding countries of
the original European Economic Community (EEC) (created in 1957, and often referred
to as the European Common Market) have been joined by 21 others while lowering
barriers and opening borders to goods, services, and now workers. While this period
of calm may seem small compared to the ages of bloody rivalry that preceded it,
economists and political thinkers generally agree that trade and integration have
consistently encouraged compromise and resolution over conflict and antagonism.
For discussion:

Is this notion still alive today? How has the Golden Arches theory held up?
Have the trade wars of the 2010s significantly affected trade flows?
s W

Have nationalist movements succeeded in breaking up trade relationships?

What kind of trends could jeopardise the apparent correlation between trade
and peace?

22.2 HL. Absolute and comparative

advantage

- LRI (T
At the end of this section you will be able to:
* explain the theories of absolute and comparative advantage, giving examples
* suggest the sources of comparative advantage

447
 Benefits of international trade

useaPPC diagram to show the gains from trade from comparative advantage
* calculate opportunity costs from a set of data in order to identify comparative
advantage
« discuss the real-world relevance and limitations of the theory of comparative
advantage.

What is absolute advantage?

It is important to acknowledge what may be obvious: some countries are simply more
efficient at some forms of production than other countries. Called absolute advantage,
this is where a country is able to produce more output than other countries using the
same input of factors of production.

Table 22.1 shows two fictional countries trading two goods. This theory assumes that
cach country uses the same amount of resources to produce wheat and oil. This table
shows the limits of production for these countries: Maleyland produces thirty units of
oil or ten units of wheat; Welkeria can produce three units of oil or six units of wheat.
Maleyland is far superior to Welkeria in both oil production and wheat production.

Maleyland clearly has an absolute advantage in both goods. Based on this informa-
tion, should the two countries specialise and trade? In fact, should more efficient
countries ever trade with less efficient ones? It would appear that the answer is ‘no’,
but if we employ the concept of comparative advantage, we will see that the answer is
usually ‘yes’.

What is comparative advantage?

Comparative advantage is where a country is able to produce a good at a lower
opportunity cost than another country. Comparative advantage theory says that
even countries that are much more productive in all industries should trade with less
productive ones. This sounds illogical, so why does it make sense?

To better grasp the problem, imagine the following example. Lawyer] worked her
way through school doing accounting, and became quite good. After establishing a
successful law practice,] thought to save some money by doing her own accounting. Is
this a good idea? In economic terms, let us assume that Lawyer ] possesses an absolute
advantage in both accounting and lawyering. (She is good at both.)
However, she is rewarded very differently for each activity. When she does her own
accounting, she saves the $40 per hour she would normally pay her accountant. When
she is working as a lawyer, she is paid an average of $300 per hour. If the answer seems
alittle clearer now, let us clarify the reasons why.

Table 22.1 One country can produce more of a good using the
same resources and is said to have an absolute advantage
Country/Product oil Wheat
Maleyland 30 10
Welkeria 3 6

448
 Table 22.2 A simple production possibility matrix enables us to work out the
opportunity costs of production

Country/Product TVs (thousands) Smartphones (thousands)

Siliconia 15 5
The Solid States 20 15

Because she earns so much more as a lawyer (and would not earn that if she chose to
do accounts for that hour), it is logical to conclude that she should always work as a
lawyer. This is the activity with the lower opportunity cost. Therefore, even though she
has an absolute advantage in both jobs, her comparative advantage lies in lawyering
because she loses less by doing it.
The same principle applies to countries. Comparative advantage theory says that
countries should specialise in the production of whatever has the lowest opportunity cost
(saying something has the lowest opportunity cost naturally implies that it is the good
whose production has the most value). Countries that specialise produce more efficiently
and should trade their output with other countries to enjoy a higher standard of living.
David Ricardo was the first to show the benefits of comparative advantage
mathematically, in the early 1800s. With countries, the theory assumes a simplified
example involving just two countries producing only two goods each. For a country to
produce more of Good A, it must shift resources away from Good B and sacrifice some
amount of Good B. Whatever is lost is the opportunity cost of more of Good A, and
the reverse holds true for shifting resources to more of Good B.
Table 22.2 shows the output possible for each product and each country, if each
produced only that good. For example, if Siliconia produced only TVs, it could
produce 15,000 TVs and no smartphones. If the Solid States produced 15,000
smartphones, it could not make any TVs. If either country wanted to produce more
of one, it would need to sacrifice some of its production of the other. In this regard,
Table 22.2 represents the countries’ production possibilities.

Based on their output, it is rather easy to determine who has the absolute advantage.
‘Which country produces more efficiently? The Solid States produces more TVs, as well
as more smartphones. Therefore, the Solid States has the absolute advantage in both
industries. Like LawyerJ, the Solid States is better at both tasks. However, the Solid
States may still benefit from trade with the clearly inferior producer, Siliconia.

Domestic opportunity cost

To find out who has the comparative advantage, we need to calculate the domestic
opportunity costs in each country for both TVs and smartphones. In other words,
what is the trade-off for production inside Siliconia and the Solid States?

Worked example 22.

In calculating domestic opportunity cost for an output problem, we use the
equation:

Opportunity cost of x = Output Y/Output X

449
 Benefits of international trade

For Siliconia:
Opportunity cost of producing 1 TV = 5 smartphones/15 TVs = 0.33 smartphone
Opportunity cost of producing 1 smartphone = 15 TVs/5 smartphones = 3 TVs
For the Solid States
Opportunity cost of producing 1 TV = 15 smartphones/20 TVs = 0.75 smartphone
Opportunity cost of producing 1 smartphone = 20 TV15 smartphones = 1.33 TV

Cross-market comparison
To more easily compare these values, we can place opportunity cost values inside the
table to clarify the choices. Table 22.3 shows the trade-offs for making one good, in terms
of another. For example, for Siliconia, to produce 1 TV would require the sacrifice of 0.33
of a smartphone, and for Siliconia to make one smartphone, it would lose three TVs.

In the market for TVs, Siliconia has the lower opportunity cost, giving up only 0.33 of
asmartphone for every TV made, whereas the Solid States gives up 0.75 ofa smart-
phone for every TV made. Thus, Siliconia has the comparative advantage in TVs,
because it has the lower opportunity cost.

In the market for smartphones, the Solid States has the lower opportunity cost, giving
up only 1.33 of a TV for every smartphone made, whereas Siliconia gives up three TVs
for every smartphone made. Thus, the Solid States has the comparative advantage in
smartphones, because it has a lower opportunity cost.

Specialise and trade

With comparative advantage determined, it is rational for each country to specialise
in the production of the good for which it has the lowest opportunity cost. This
maximises production between the two countries, which then trade their goods with
each other. The Solid States may consume the number of smartphones it likes, then
trade the rest for TVs. Siliconia can consume their own TVs, and trade any surplus to
the Solid States.

The situation described in Table 22.2 can also be shown with production possibilities.
In Figure 22.3, you can see the limits of each country’s production, as well as the rate

Table 22.3 The addition of opportunity costs reveals which country hasa
comparative advantage
Country Output Opportunity | Output of Opportunity
of TVs cost of smartphones cost of
(thousands) | producing (thousands) producing
1TV 1 smartphone
Siliconia 15 0.33 5 3TV
smartphone
The Solid 20 0.75 15 133TV
States smartphone

450
 Televisions

Figure22.3 Absolute and

The Solid States comparative advantages can
be inferred from these
straight-line PPCs.

0 S5«———15
Smartphones

of opportunity cost as you move from one output combination to another. The PPC
demonstrates the Solid States’ possession of absolute advantage in both industries by
having a PPC that goes beyond Siliconia’s in every direction.
It may also be possible to infer the comparative advantage from these PPCs. If the Video suggestion:
scale of the axes is the same, and there is a country with clear absolute advantage, You have read about it, now
the comparative advantages for the more efficient country is where the gap between Yyou can review what you
the two PPCs is greatest, in this case shown by the lower arrows. The comparative have just learned by watching
avideo by the author!
advantage for the less efficient country is where the gap is the smallest, in this case Simply lick here in
shown with the upper arrows. This is a handy double check on your opportunity your eBook for a video
cost calculations. Another way to view it is that Siliconia’s line is steeper, suggesting on determining absolute and
that it probably gives up TVs more rapidly as it tries to increase its production of comparative advantage.
smartphones. We could then infer that the Solid States had the lower opportunity cost
of smartphones. Logically, Siliconia would then have the better opportunity cost of
TVs. Straight-line PPCs will always show the rate of trade-off, and therefore the relative
domestic opportunity cost, enabling you to make this assessment.

How can one show the gains from trade

using a PPC?
Itis possible to show the gains from trade using a PPC. Looking at Figure 22.4, let us
assume a trade rate of two TVs for one smartphone. Next, assume that the Solid States
is currently consuming along their own PPC at point x, which provides 10,000 TVs
and 7500 smartphones. The Solid States will specialise in smartphones and use all
their resources to produce 15,000 phones. The Solid States can now trade at a rate of
one phone for two TVs. By trading 6000 of the 15,000 phones, keeping 9000, they gain
12,000 TVs, a combination shown as point y. By specialising and trading the good in
which they have a comparative advantage, the Solid States now enjoys more of both
goods (an extra 2000 TVs and 1500 smartphones).
451
 Benefits of international trade

30,000

20,000
Figure22.4 Gains in
o goods are made by
specialising in the good

TVs
that offers a comparative
advantage and trading some
units away in return for the 12,000
other good 10,000
Specialise in smartphones
and trade 1 smartphone
for 2Tvs

0 7500 9000 15,000

Smartphones

For Siliconia, assume the same trade rate of two TVs for one smartphone. Next,
assume that Siliconia is currently consuming along their own PPC at point x, which
provides 7500 TVs and 2500 smartphones. Siliconia will specialise in TVs and uses all
their resources to produce 15,000. Siliconia can now trade at a rate of two TVs to buy
every phone. By trading 7500 TVs they gain 3750 smartphones, a combination shown
as point y. By specialising and trading the good in which they have a comparative
advantage, Siliconia now enjoys 1250 more smartphones.

15,000

Specialise in TVs
and trade 2 TVs.
for1 smartphone

Figure 22.5 Despite not >

having an absolute advantage,
Siliconia also gains by
specialising and trading

0 2500' 5000 7000

3750 Smartphones
452
 @
<
G3
a Figure22.6 The equal
s
S

Bushland gradient of two countries'

£ PPCs indicates identical
opportunity costs and
therefore no comparative
advantage

0 20 30
Wheat (millions of bushels)

While it is important to know the specifics of this method, a larger point is

demonstrated here as well. According to comparative advantage theory, a country can
consume beyond its means, as measured by the limits of a PPC. Levels of consumption that
appear ‘impossible’ because they are beyond the PPC are made possible by the gains
from trade, and this is possible for both countries.

Animportant exception to the principle of comparative advantage is when both Video suggestions:
countries have the same opportunity cost. In that event, neither country will You have read about it, now
possess a comparative advantage and there will be no observed gains from trade. Yyou can review what you
In Figure 22.6, note that the PPCs have exactly the same gradient, which means have just learned by watching
a few videos by the author!
the rate of trade-off between one product and another is exactly the same for Simply click here in
each country. your eBook for videos
on the gains from
Figure 22.6 shows the respective production possibility curves for cotton and wheat international trade in the PPC
in Bushland and Grainia. For Bushland, the trade-off shown is 15 bushels of cotton for and demand and supply’
every 30 bushels of wheat, or one cotton for two wheat. For Grainia, the trade-off is models, and on whether two
countries can benefit from
between 10 bushels of cotton and 20 bushels of wheat, still a one cotton for two wheat trade if neither has a
trade-off. With exactly the same domestic opportunity costs, neither country stands to comparative advantage.
benefit from trade.

What are the sources of comparative advantage?

It might be easy to say a country with more of one resource than another has the
comparative advantage. If a country has an abundance of oil, for example, do they
have a comparative advantage? Not necessarily. Such a situation may only be a source
of reciprocal absolute advantage because it trades something it has in abundance with
a country that has much more of something else, like manufacturing labour,
for example.

Comparative advantage is more subtle than this. Let us imagine two countries that
both produce corn and soybeans. Country Z is more productive than Country
Aatboth. Country A makes fewer of both crops, but is still a good producer. If
their opportunity cost is different, then there will be a comparative advantage in
each country, and trade will be beneficial. Comparative advantage does not mean
necessarily being the ‘best’ at anything, it just means having a lower opportunity cost
ina product compared to your trade partner.
453
 Benefits of international trade

The following table gives output figures of two countries, Podland and Canesia,
for two commodities, sugar and cocoa. The countries have the same quantities of
resources for production.

Podland Canesia

Cocoa Sugar Cocoa Sugar

(million kg) (million kg) (million kg) (million kg)
60 0 80 0
50 5 60 40
40 10 40 80
30 15 20 120
20 20 0 160
10 25
0 30

1 Calculate the opportunity costs of producing cocoa and sugar for:

a. Podland
b. Canesia.
Assume the two countries exchange cocoa and sugar at a rate of 1 : 1, 1 kg of sugar
to 1kg of cocoa.
2 Draw a PPC diagram for Podland at its current domestic opportunity costs; add
the tradeline of 1: 1.
a. Mark with an X the point where Podland would be consuming 40 million kg
cocoa and 10 million kg sugar.
b. Using the diagram, show and explain what happens if Podland specialises.
in cocoa and consumes 40 million kg cocoa and trades the extra cocoa to
Canesia at the 1: 1 ratio. Label this point Y.
3 With a new diagram, draw a PPC diagram for Canesia at its current domestic
opportunity costs; add the trade line of 1: 1.
a. Mark with an X the point where Canesia would be consuming 120 million kg
of sugar and 20 million kg of cocoa.
b. Using the diagram, show and explain what happens if Canesia specialises in
sugar and trades the rest in exchange for cocoa at the rate of 1: 1. Label this
point Y.

454
What are the limitations of comparative
advantage theory?
While recognised as essentially valid in theoretical form, the theory of comparative
advantage is heavily criticised for not being an accurate representation of real trade.

Overspecialisation
In theory, a country might devote its entire resources to the production ofa
single good. This makes the relative prosperity of the country dependent on
the value of that good. If the good is a commodity, the country’s entire income is
bound to the price of the commodity. A long-term concern is whether a country
will be trapped in a certain type of production, thus limiting its potential for full
development.

Transportation costs
Transport costs, assumed to be irrelevant in theory, cannot be ignored in practice.
They can raise costs enough to eliminate a comparative advantage.

Assumption of homogeneity
Goods are assumed to be identical. Wheat is wheat, whether from the USA or
Ukraine. However, goods often have some differentiation, especially in the world of
manufactured goods. It is difficult to assess true comparative advantage when the
goods are not the same.

Imperfect information
Perfect information about the availability and prices of all available goods is assumed,
but given the vast nature of global markets such knowledge is not easy to find.

Constant costs
The theory assumes relatively constant costs. This is reflected in the PPCs with
constant slopes. However, one would expect improvements in production that may
lead to significant economies of scale.

Bilateral versus multilateral trade

The two-country model is unrealistic, making the determination of comparative
advantage difficult in a multinational world. However, multi-country analysis is
possible with appropriate mathematical modelling.

Migration and cross-border investment

Itis assumed that the factors of production stay in-country. However, people migrate
from country to country, and capital (either financial or physical) can move between
countries as well. The relocation of a factory from one country to another is just one
example of this.

455
 Benefits of international trade

Barriers to trade
Finally, the assumption that countries practise free trade is highly debatable.
While tariffs and other forms of protectionism have been significantly reduced
in recent decades, many countries still protect markets with tariffs, subsidies,
quotas, and bureaucratic barriers. These practices distort the market, making
the gains from comparative advantage difficult to discern, and even harder
to realise.

In summary, comparative advantage is a drastically simplified model, used to explain

the likely benefits of trade between countries. While the reality may be quite different
at times, the theory helps justify the general principles of free exchange and the gains
from trade.

Practice exam questions

Paper 1 part (a) questions
1. Using examples, explain three gains from international trade. (10 marks)
2. Using real-world examples, explain the theory of comparative
advantage. (10 marks)
Paper 2, part (b) question
3. Using real-world examples, discuss the extent to which comparative
advantage theory accurately describes international trade. (15 marks)
Paper 2 Questions
4. Define absolute advantage. (2 marks)
5. Using two-country PPC diagrams with different domestic
opportunity costs for coal and steel, explain how to determine
comparative advantage using the gradient of the PPCs. (4 marks)

456
C
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 Trade protection

Despite the obvious gains made possible by trade, most countries try to protect at least
some industries from unpredictability and the threat of foreign competition, a practice
known as trade protection — or protectionism. Protectionism can take many forms and is
practised to varying degrees by every country. Some of the most ardent free trade countries
still shelter or support large portions of their economies with a variety of protectionist
methods. Other countries openly promote protectionism as their fundamental economic
growth policy. Why is protectionism so popular? This chapter explores the arguments
around protectionism and evaluates the effects of protectionist policies.

23.1 What are the arguments for and against

protectionism?

Learning outcomes
At the end of this section you will be able to:
« discuss the various arguments in favour of the use of trade protection
measures, including:
« for the protection of infant industries, domestic employment, national
security, and health and safety and environmental standards
* asananti-dumping measure
* to combat unfair competition
* to correct the balance of payments
* toraise government revenue
* todiversify aless economically developed country (LEDC)
* examine the disadvantages of protectionism, including:
« the misallocation of resources
* retaliation
* increased costs
* higher prices
* less choice
¢ poor incentives
« reduced export competitiveness.

The proponents of protectionism argue that their vulnerable domestic markets face
unfair and damaging foreign competition. As global trade has expanded dramatically
in recent decades, many of the following arguments continue to be raised, especially
in the wake of economic crises like the Great Recession of 2008-10 and the COVID-19
pandemic of 2020-21.

What are the arguments for protectionism?

To protect infant (sunrise) industries
Many countries, perhaps especially less economically developed countries (LEDCs),
believe they have industries that are future champions. Countries can argue that their
industries are as yet underdeveloped, and have not grown large enough to achieve
lowered costs through economies of scale. These industries should therefore be
458
sheltered until they can face on more equal terms the powerful multinational corporations
and highly developed industries of rich countries. The strategy is to block imports
with tariffs, subsidise, and offer industries administrative support until the ‘infant’ has
grown into ‘adulthood’, being large enough to enjoy economies of scale. In theory,
these firms will eventually grow strong enough to compete without such assistance.
Advocates of the sunrise industry perspective point to the success of countries that
have developed dramatically in a relatively short period, citing the Asian tigers of
South Korea, Singapore, Taiwan, and Hong Kong. Major industrial powers like the
USA, Germany and others have histories of protecting their heavy industries as they
grew. These countries identified potential growth industries and supported them with
state subsidies, as well as discouraging domestic consumption by levying high import
tariffs. Critics take issue with these results, citing evidence of higher education levels
and lower wages as the drivers of productivity in the tiger economies in particular.
At the same time, critics of the sunrise industry view also note that most sunrise
industries never grow up fully, and often require state support long after their infancy
or even adolescence has passed. These dependent firms, they argue, will continue to
draw government subsidies and will cry out for protectionism long into the future.

Case study - modern economists - is industrial policy a

good idea?

A number of economists have developed lines of thinking that run counter to the
orthodox view of free trade as explained by David Ricardo. Those critics, like
Ha-Joon Chang, point out that the theory of comparative advantage is only a theory, and
does not take into account the different starting points of each country. Chang points
out that the government should and must ‘pick winners’ by directing industrial
policy towards promising, high-value fields. Britain waited to open its markets, he
argues, until well after it was a global empire, as did the USA, which advanced free
trade in earnest only after the Second World War. In 23 Things They Don't Tell You
About Capitalism, Chang challenges the notion that governments are necessarily bad
atidentifying and supporting industries in the economy. They are no worse and can
be better than, he says, private firms in some cases. ‘The reality is that winners are
being picked all the time both by the government and by the private sector, but the
most successful ones tend to be done in joint efforts between the two.’

459
 Trade protection

To protect national security

Plausible arguments can be made that military or defence-related goods should
be produced domestically for national security reasons. Buying sophisticated
telecommunications equipment from foreign suppliers, for example, could make a
country vulnerable to information theft (for example, the concerns the USA raised
over purchasing 5G technology from the Chinese manufacturer Huawei in 2020).
Or it may leave a country vulnerable to supply problems if relations between partners
deteriorate. This could also be true of any strategic commodity, like food and medical
equipment as well.

To enforce product standards

Product standards exist to protect consumers from hazardous products as well as to
ensure a reputation of quality production across an industry. These standards are likely
to raise the cost of production. In recent years, countries have used product standard
rules to challenge some imports on the basis that those products threaten national
safety or health. These claims can be derived from scandals in the news, or they can
be based on disputed scientific claims about new methods of production, such as the
long-running conflict over US hormone-injected beef. Several European countries,
as well as Japan, have restricted such imports from the USA, citing public health
concerns. And in recent years, the EU has allowed small quotas of hormone-injected
beef, which may come from any country, not just the USA. All such disputes must be
arbitrated by the World Trade Organization (WTO) as well as associated agencies, like
the World Bank and the World Health Organization, and be based on science-based
concerns. The standards may be difficult and very costly to comply with. Developing
countries, in particular, will struggle to achieve and prove compliance.

To protect against product dumping

To prevent the dumping of foreign goods onto the domestic market. Dumping is the
selling of a good in another country at a price below its unit cost of production. This
implies that exporters are losing money on these goods and hoping to steal away
domestic consumers with unsustainably low prices. In the short term the foreign firms
‘may lose money, but can raise prices after driving domestic firms out of the market.
Dumping in this way might be seen as a form of predatory pricing.
Dumping firms might also be selling off surplus goods, having extracted higher prices
for them in their domestic markets. For example, in recent years, the sell-off of excess
clothing and textiles to African countries has prompted objections to dumping from
domestic clothing makers there. If this were only an occasional instance, there would
be little harm done. But when the practice is sustained over time, long-term damage to
domestic sellers can occur. The benefit to domestic consumers, in the form of cheaper
clothes in the long run, is debatable if the practice prevents the development of higher
value industries that would bring higher incomes.
Countries that believe they are victims of dumping can take their case to the WTO.

Allegations of dumping, however, have proven difficult to prove. Wide differences

in cost structures, as well as a lack of transparency and uniform accounting
procedures, can make the calculation of relative costs exceptionally complicated.
If one country wins a dumping complaint against another in the WTO, it can

460
 establish peremptory protectionist measures against the offender. However, this
approach, as with any escalation of protectionist barriers, can lead to bitter and
counterproductive trade wars.

To protect against unfairly low labour costs

A popular argument among wealthy countries is that many imported goods are
produced at wage rates far below those paid in their own domestic industries.
This argument can be further extended to include hiring and working conditions
that would be considered unacceptable at home. The combination of lower wages
and reduced labour standards makes it impossible for industries at home to pay
a living wage to their workers and provide them with safe and reasonable work
environments.

However, for many countries a surplus of labour is their primary comparative

advantage, allowing them to produce competitively in industries where they may lack
technological knowledge or the latest capital equipment. The Chinese coastal town
of Datang has become known as Sock City for its massive share of the global sock
market. Many of Datang’s workers sewed socks by hand in the 1970s, and the industry
grew in large part because of its labour-cost advantage. All the while, China and other
low-cost labour markets have won this share from Europe and the USA — countries
with a high labour cost.

To overcome a balance of payments deficit

The balance of payments measures the flow of money into and out ofa country. The
overall system of balance of payments will be covered in more detail in Chapter 26.
For now, it is important to know that the export and import of goods and services,
called the trade balance, is normally a major part of that accounting. In national
income accounting for gross domestic product (GDP), this would be recorded via
the expenditure approach as net exports (X — M) from the equation for aggregate
demand, AD = C + I + G + (X~ M). Therefore, countries that find they are spending
excessively on imported goods are worsening their trade deficit. More money flows out
to buy imports than is flowing in from exports. In response, governments may enact
protectionist policies to address this imbalance.

This approach, called expenditure-switching, is regarded by most economists as

only a temporary solution. While it may lower imports for a short time, the causes
of the imbalance are not addressed by this policy. In the meantime, higher tariffs or
stricter trade barriers continue to distort trade and deny the potential gains from
comparative advantage.

To raise government revenue

A nation can raise revenue through a variety of tax methods. In developing countries,
where income tax compliance is low, customs duties can provide a vital source of
money. Nevertheless, the additional taxes still distort the market by taxing goods that
are wanted or needed by the domestic population. By raising import prices, they may
also limit the importation of important resources needed for growth and development
to flourish by taxing needed capital goods or health products. Table 23.1 shows
selected countries and their reliance on tariffs for tax revenue.

461
 Trade protection

Table 23.1 Tariffs may raise a significant proportion of

tax revenues in developing countries
Country Total tax revenues
from tariffs (%)
Somalia 36.5
Bangladesh 245
Ethiopia 21.9
Philippines 209
Nepal 16.0

To protect domestic employment

A prominent argument among protectionists is the desire to preserve employment
and save jobs. It is most likely to be heard from industries that are in a ‘sunset’ stage of
relative decline compared to their international competition. The vested interests here
include the company itself, the workers and any unions associated with them, as well
as related industries that rely on the business. When the USA rescued its automobile
industry from bankruptcy in 2008, the jobs at stake were estimated to be 3 million,
of which more than one-half were not directly employed by the automobile industry
itself. Clearly, this kind of government subsidy was granted to protect domestic
employment.

Firms making the employment argument typically vie for more time to adjust to
the market, to modernise and improve efficiency. Rather ironically, this kind of
modernising would usually eliminate many of the jobs these industries profess to
want to save. However, in most situations, these firms are in long-term decline and
protectionist measures merely delay an inevitable loss of market share.

Nevertheless, industries threatened in this manner will often see management

and labour unions join forces to press parliament or congress for protectionist
advantages.

To diversify the economy of a less economically

developed country
Many developing countries export a limited range of goods, and typically these
goods are basic commodities. Because commodity prices tend to be volatile, some
LEDCs go quickly from an excellent year of export revenues to near-collapse
when prices fall. At the same time, developing countries generally do not have
higher value production that drives up national income. So, it is argued that some
developing countries would benefit from selectively protecting some domestic
markets in an attempt to diversify the economic base. With such protection,
perhaps for sunrise industries, the country would be less vulnerable to wide swings
in global market prices for their goods.
This argument draws strength from the worries about over-specialisation when
countries trade based solely on comparative advantage. The expression ‘a one crop
economy’ used to be used to describe countries that were centred on a single good.

462
The same could be true of those reliant on a metal or another primary commodity. Ethics
It is understandable that a country would not want its entire economic future to be Free trade is advocated on
dependent on one industry. Brazil in the 1960s feared that coffee would be its only the grounds that it leads
viable export, a situation that currently concerns Ethiopia. Tobacco makes up 69% of to greater efficiency. Yet
it results in both winners
Malawi’s exports, and Burkina Faso’s exports rely almost exclusively on gold mining. and losers. Do econormists
Furthermore, where these countries rely on extraction industries like mining, the have a moral responsibility
worry can become rather acute as the resource is gradually depleted. Many sub- towards the losers when
Saharan African LEDCs (Cameroon, Congo, Angola) are hugely dependent on oil they advocate free trade?
production. For all of these countries, protecting a new industry may help it grow and
help the country diversify its exports.

What are some arguments against protectionism?

The arguments against protectionism are closely related to the advantages of free
international trade explained in Chapter 22. After reading the arguments in favour of
protectionism, it is worth another look at these arguments.

Misallocation of resources
Countries that protect declining industries compel their consumers to pay higher
prices. This is an unnecessary misallocation of income to inefficient producers.
Furthermore, because such industries are larger than they would otherwise be, they
draw more workers and capital than would occur under free trade conditions. It
follows that industries with the potential to realise their comparative advantage do not
get these workers, nor the benefit of access to capital. It all goes to the inefficient but
politically connected ‘dinosaur’ firm.

The risk of retaliation and a trade war

‘What might start out as a dispute over subsidies or unfair bureaucratic barriers
can degenerate quickly into a damaging trade conflict. When this occurs, trade can
grind to a halt and economic growth is put at risk. This kind of escalation took hold
during the Great Depression, as desperate governments resorted to protectionism
as a way to prevent unemployment from deepening. Many economists have
blamed this rapid shutdown of world trade as a major factor in the entrenchment of
the crisis.

During the Great Recession of 200810, trade complaints grew rapidly, while many
governments and the WTO urged everyone to stay calm and avoid sparking a round of
retaliatory policies. Despite a few isolated incidents of a tariff or quota, trade remained
largely as free as it was before the crisis.
However, after the US Trump administration raised US tariffs on many European,
Canadian, and Chinese imports many countries retaliated with their own charges,
resulting in an escalating trade conflict that some labelled a ‘trade war’. The conflict
hurt several industries quite hard on both sides. When China responded to tariffs on
its goods with retaliatory action against American soy farmers, the US government
agreed to pay $28 billion in subsidies to farmers. Trade disputes like these can lead to
growth-strangling trade wars.

463
 Trade protection

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Government protection creates bad incentives for domestic firms

Protected firms quickly understand that their real profits come from staying protected,
and thus put more energy into persuading the public and politicians of their case.
They have less of an incentive to actually modernise or innovate for greater efficiency.
e Afterall, that would weaken their case for assistance the next time the laws are up for
Trump, the trade wars, renewal. With such poor incentives, firms tend to be complacent and resist change.
and China Thus, consumers and firms that buy from the protected firm pay higher prices, and
Starting in 2018, the USA often for worse products.
initiated a series of tariffs
against Chinese industries,
as well as EU, Canadian, Increased import prices to consumers and higher costs to firms
Mexican, and other
producers. Conduct an Protectionist measures directly affect the consumers and firms who buy imported
internet search to see what goods. These higher prices might drive some imports out of the market entirely,
some of the main issues relegating domestic producers and consumers to pay higher prices for possibly
were. Suggested search terms inferior quality goods. This reduces the real income for families and the higher costs
include: Trump Trade Wars,
‘China steel tariffs, and ‘US of production reduce the supply of domestically made goods and services.
tariffs on European goods'
For discussion and debate: Less variety and choice of goods
Identify the main The more stringent the protectionism, the greater the impact on the choice and variety
rationales supplied by the
countries levying tariffs. of goods offered on the domestic market. This undermines a core tenet of capitalism,
Discuss whether those that consumers vote with their spending and lead the market to more efficient outcomes.
~

claims, based on your

knowledge now, are
justified. Reduced export competitiveness
List the pieces of Those domestic firms that use imported resources will pay higher costs, and firms
w

information you would that hope to export suffer reduced competitiveness on the world market. They endure
like to know to be more
the indirect harm of having workers and resources (capital) drawn away by inefficient
sure of your answer to
question 3 domestic producers. For example, if a country protects its domestic lumber industry
Checkin on the status of with high tariffs, then its domestic furniture makers will pay higher input costs and be
~

these trade disputes today. ata disadvantage compared to foreign furniture manufacturers. In 2018, the US Trump
Are they stllin effect, or administration was opposed by many US firms whose costs were expected to rise after
has there been a change ever higher tariffs were announced, including firms in the retail, automobile, furniture,
over time?
and building materials industries.
464
 23.2 What are the different types of
protectionism?

Learning outcomes
At the end of this section you will be able to:
« discuss, using a tariff diagram, the various effects of imposing a tariff on
imported goods
* examine, using a diagram, the effects of setting a quota on foreign producers
* explain, using a diagram, the effects of subsidies
* describe and discuss the effects of administrative barriers that may be used as
ameans of trade protection
@ calculate from diagrams the effects of imposing tariffs, quotas, and
subsidies on different stakeholders.

Protectionist policies have different approaches but the same goal: promote selected
domestic industries at the expense of foreign ones. These policies might seek
to expand the market for a successful domestic industry or merely defend a less
competitive one from global competition.

What is a tariff?
A tariffis a duty (tax) that is placed upon imports to protect domestic industries from
foreign competition and to raise revenue for the government. To understand the effect
of a tariff, recall the basic free trade diagram from the perspective of the importing
country, which was explained in Chapter 22. The domestic producer’s equilibrium
price, P, is much higher than the world price P, oi*.. The global market can supply all
the domestic market could wantat P, ., so global supply is perfectly elastic at S 'WORLD.
Remember that taxes are viewed as an added cost of production by firms, so a tariff
shifts the supply curve to the left or backwards. Take for example a widely produced
commodity, in this case rice, and examine the various effects of a tariff on the market.
In Figure 23.1, a tax on imported rice shifts the supply curve S 'WORLD. upwards, reflecting
higher costs imposed by the tax.

SDOMESI\C
Price of rice (P) ($)

P « Figure23.1 Atariff
P WORLD « TaRfe | S, 'WORLD + TARIFE designed to reduce the
quantity of imported rice has
a variety of effects

L 2 A bowestic
Q % Q Q
Quantity of rice (Q)
465
 Trade protection

Effect on domestic producers

Before the tariff, the domestic quantity supplied was 0 — Q,, from which the revenue
carned is shown by taking P, .. X Q,, or the area of box ‘g’. Now at the new tariff
price of Py o, ransp domestic producers can afford to produce more, and so increase
production to 0 — Q,, and earn greater revenue ata +b + ¢ + g+ h.

Effect on foreign producers

Before the tariff, foreign production (imports) was Q, — Q,and earned revenue h + i +
j + k. At the higher tariff price, domestic producers take the share of the market shown
by Q, — Q,, and the consumer quantity demanded decreases from 0 — Q,t0 0 — Q,.
So now foreign production (imports) drops to Q, — Q, and import revenue declines to
i+ j. Foreign producers do not, however, enjoy the benefit of the higher prices, as the
government collects the difference between the world import price and the new tariff
price, shown by d + e.

Effect on government
Government collects the import tax, which can be a substantial benefit to the
country’s revenue base. This tariff revenue is shown in the areas d + e.

The effect on consumers

Consumers pay higher prices, from P to Py o and now buy less of the
product, from0 — Q,t00 — Q,.

Welfare loss
The new market share enjoyed by domestic producers only occurs because of the
artificially high tariff price. The area of the blue triangle ¢ represents an inefficiency
form of welfare loss, because that amount would already be produced at the world
price, but now consumers must pay more for domestic producers to supply it. This
other lost surplus is represented by the blue area f. Because of the higher prices,
consumers reduce their overall quantity demanded from 0 — Q,t0 0 — Q,asa
result of the tariff price, and so consume less. The reduced consumption overall
represents another welfare loss, the loss of consumer surplus enjoyed before the
tariff raised prices.

In sum, the tariff causes the price of the affected good to rise. If this product were a
factor cost in other products (e.g. tyres for cars) then the price of the final goods (cars)
would rise as well. Smaller quantities of the good are consumed, harming domestic
consumers and reducing their welfare. Domestic producers enjoy the benefits of
this protection, earning more revenue and producing more output, but they do
so inefficiently and at the expense of consumers paying the higher tariff prices.
Meanwhile, the government can gain some tax revenue that was not possible before
imposing the tariff.
It is logical to conclude that domestic producers have a strong incentive to keep the
tariffin place, while the government also enjoys the benefit of the tariff. Consumers,
however, may not be aware of the impact of the tariff. If consumers are conscious
of the tariff, it still represents a relatively minor impact on their welfare in terms of
higher prices when measured against the gains made by the producer, which can be
466
very large. The result is that consumers feel a relatively smaller incentive to fight the Is it ethically sound for
tariff politically. Foreign producers, while not having a political voice on the issue, can economically developed
urge their governments to retaliate against the country imposing the tariffs. This can countries to demand that

result in arbitration with the WTO or an outright trade war should the matter escalate less developed countries
remove their trade barriers
beyond this dispute. in the interests of free trade
when they continue to
provide income support
to their farmers? Can one
Exercise 2 country know what s right
Assume that Brazil, seeking to protect its domestic electronics industry, decides to for anotherto do?
place a large tariff on South Korean TVs. Create an appropriate diagram to show
this situation from the Brazilian television industry perspective. To the left of your
Video suggestion:
diagram list the beneficiaries of this policy under the heading of ‘helped’, and to the
You have read about it, now
right of the diagram make a list of the injured parties under the heading of ‘hurt’. you can review what you
Be prepared to explain the reasons for each item on your list. have just learned by watching
avideo by the author!
Simply lick here in
o your eBook for a video
on protectionist tariffs.
What is a quota?
A quota is an import barrier that sets limits on the quantity or value of imports that
may be imported into a country. For example, in the recent past, the US has placed
strict quotas on imported textiles, a limit that most profoundly affected Taiwan and,
more recently, China. Like a tariff, a quota tends to raise both domestic and import
prices, but in ways that are unusual compared to the other protectionist diagrams.

Ina closed market (Figure 23.2), producers will produce Q_ at a price of P,. If that
market is open to trade, world producers can sell at a much lower price, P, . Among
domestic producers, relatively few can produceat P, , and they produce only the
amount 0 — Q,. World producers can sell the rest, Q, — Q,. Note that the world supply
is perfectly elastic at that price, reflecting the fact that for most commodities, the size
of the market is quite large compared to the demand of any single country. Therefore,
the world market can supply as much as this country is willing and able to buy,
represented by domestic demand, at the market price P, .. For domestic producers,
this marks a dramatic fall in revenue. Now they only receive a, where the foreign sellers
receiveb +c+d +e.

S, DOMESTIC
S, 'DOMESTIC + QUOTA

z
£
g « Figure23.2 Aquo
S is designed
£ | tice impoi
& ;
" i ) Sworo

. _t
i e ; Dogyesrc
Q QQ @
Quantity of rice (Q)
467
 Trade protection

At this point, domestic rice producers are likely to call for protection from the
overwhelming competition of foreign suppliers. If they convince the government to
implement a quota, world producers will be limited to a specific amount, Q, — Q..
So,at P, the domestic market still supplies only 0 — Q , and Q, — Q, is imported.
From this point onwards, there is a gap between the amount demanded, 0 — Q,, and
the amount supplied, which has stopped at 0 — Q,. This shortage will cause producers,
including foreign ones, to start raising prices. Producers begin to supply more to the
market at higher prices, and consumers reduce their quantity demanded along the
demand curve.

This process, denoted by the two green arrows, continues until the market is cleared at
Pouoraand Q. As producers supply more, this creates a new extension of the domestic
supply curve, .., quora Shown by the red arrows. Therefore, the market settles
at a price below the domestic equilibrium P, but above the free trade price Py -
This situation creates clear winners and losers, as well as market inefficiencies and
deadweight losses.

Effect on domestic producers

Before the quota, domestic producers earned revenue represented by area a. After the
quota, they earna + f,and i + j + ¢ + d where domestic suppliers resumed production.

Effect on foreign producers

Before the quota, foreign producers earned revenue represented by areasb + ¢ +d + e.
After, foreign producers sell fewer units, but get a higher price (P, ;) for each of
them. Their new revenue is shown by areas b + g + h. This could be viewed as an
improvement over the alternative of a similar tariff, where the increased revenue
from higher prices (g + h) would all go to the government. Here, the foreign producer
receives that revenue.

Effect on consumers
Before, consumers paid the lower price P, and could buy more on the market,
0 — Q,rather than 0 — Q. The quota causes higher prices and less consumption.

Effect on government
Government gains no obvious advantage from a quota, although it is possible that
overall sales tax receipts would be lower with fewer goods on the market.

Effect on market efficiency

Where domestic supply resumes and begins to rise again, at Q,, domestic producers
only supply more with the incentive of higher prices. Before the quota, that same
quantity was produced at the lower world price. This unnecessary increase in prices
marks a global market inefficiency, where consumers pay more than the market would
otherwise require, and is denoted by the blue area j.

Welfare loss
When the post-quota quantity demanded decreases to Q,, it represents a loss of
consumer surplus previously enjoyed by buyers of the good. This loss is marked by
468
the blue area k. Over the long term, like all forms of protectionism, quotas can lead
to the dependence of domestic industries on government assistance rather than their
own efforts.

What is a voluntary export restraint? Video suggestion:

‘When a trade dispute is looming, the exporting country can offer to voluntarily limit You have read about it, now
you can review what you
the amount of their exports. This has the exact same effect as a quota ofa similar size. have just learned by watching
This may pre-empt a worse outcome for the foreign producer, and may satisfy the avideo by the author!
protectionist demands of the domestic industries. A voluntary export restraint has Simply lick here in
advantages for the exporting country. Like a quota, any increase in market prices goes your eBook for a video
on protectionist quotas.
to the foreign producers. Politically, it prevents a tariff or quota from becoming law,
and as a result is more likely to be flexibly applied in the future.

Exercise 23.2
In the 1900s and early 2000s, the US imposed quotas on imports of textile goods
from Taiwan and China. Create a diagram that shows an active quota on US imports
of Chinese textiles. To the left, list beneficiaries of this policy; to the right, list
injured parties. Be prepared to explain the reasons for your lists.

What are international trade subsidies?

A country can also choose to protect domestic producers by subsidising them.
Subsidies are sums paid to firms by the government to produce a particular good.
Areview of simple, closed-economy subsidies is found in Chapter 9. In the international
trade context, subsidies are designed to defensively protect firms against foreign
competition and to perhaps aggressively help an industry earn export revenue
overseas. Subsidies can be of two types: lump sum or per unit. A lump-sum subsidy
has the effect of lowering overall costs and encouraging production. Per-unit subsidies
are payments made for every extra unit produced. We will consider protectionist
subsidies from the per-unit perspective. If the country in question were to subsidise its
rice market, it would pay a specific amount for each level of output (number of bushels,
kilograms, or tonnes).
Figure 23.3 demonstrates the effects ofa subsidy intended to reduce the amount of
imported rice. Facing open competition before the subsidy, domestic production only
measures 0 — Q,. The rest of the market is satisfied by foreign producers selling
Q,— Q,atamarket price of P, ..,.. Domestic producers earn far less, represented by
box a, whereas foreign producers earn b + ¢ + d. This kind of potent competition
could devastate local production, so domestic rice farmers request government help.

If that help takes the form ofa subsidy, the government would pay a subsidy that can
be seen as the distance between the two supply curves, or as the distance between
Pomn@d Py < insiny That amount would be paid for each unit of production and
has the following effects on stakeholders.

Effect on domestic producers

This has the effect of lowering the production costs for local rice farmers, increasing
supply to a new level of production, 0 — Q.. Imports of rice drop to Q, — Q,.
469
 Trade protection

15; DoMESTIC
S, 'DOMESTIC + SUBSIDY

z per-unit subsidy
=
Figure23.3 Asubsidy P
2 Puono . sussioy
could be intended to reduce
® perunit
the quantity of imported rice
& subsidy
& WoRLD | Sworo

0
Quantity of rice (Q)

Note: the price of rice has not changed. Domestic producers are merely now able to produce
‘more at the world price than before. Domestic producers now earna + b +e +f+g.

Effect on foreign producers

Foreign imports go from 0—Q, to Q, —Q,, while foreign revenue drops fromb + ¢ +d
tojustc +d.

Effect on the government

The total amount of government expenditure on the subsidy is shown by the amount
of the per-unit subsidy multiplied by the amount produced domestically, which is
ultimately0 — Q.. So, the government spends e + f + g on rice subsidies.

Welfare loss
Just as with tariffs and quotas, this form of protectionism ignores comparative
advantage and distorts the market. In the market for rice, the amount Q, — Q,
switches from foreign, low-cost production, to domestic higher cost production.
Foreign producers would have produced that amount without a subsidy, but domestic
producers could only enter the market because they were paid the subsidy. The triangle
g shows the area of inefficiency, where resources are being misallocated.

What are export promotion subsidies?

If a country is already exporting a good, and the government decides to subsidise its
exporters, then a subsidy acts as a means to promote exports, rather than restrict
imports as described above. Figure 23.4 shows how an industry that is already producing
and exporting at the world price can be further helped by an export subsidy.

In this case, domestic producers are already competitive, and already exporting
Q, — Q,. The government grants a large subsidy so that they can produce even more
atP, .., pushing exports to Q, — Q,. Domestic export revenue soars. The extent of
market inefficiency grows, as resources are more pervasively misallocated.
This policy is part of a programme called ‘export-led growth’ that requires
governments to select likely export ‘winners’ from their domestic industries.
470
 S,
DOMESTIC 3¢S, 5510y

P
Z Puowo woro
=
go3 - o Figure23.4 Insome cases
® asubsidy can be used to
2 promote exports
£
PW

: nomesnic
0 QA Q% Q Q,
Quantity of rice (Q)

Ideally, such winners would be somewhat competitive on world markets and need only Video suggestion:
arelatively small subsidy to become export competitive. It is worth noting that such You have read about it, now
subsidies will come at significant cost to taxpayers, and mark a major redistribution of Yyou can review what you
resources from those taxpayers to the favoured industries. have just learned by watching
avideo by the author!
Simply click here in
What are administrative barriers? your eBook for a video
on protectionist subsidies and
Bureaucratic barriers or ‘red tape’ evaluating protectionism.
Countries may impede the penetration of their markets with waves of paperwork
and legal requirements that raise the cost of importing. While any imported good
must clear appropriate customs checks for health, safety, and valuation, it is possible
to extend and amplify these requirements so as to frustrate potential importers.
Compliance with bureaucratic demands raises costs to producers. Eventually, the time
and energy required may prevent potential importers from making the attempt, so
imports are effectively reduced.

Product standards
Health, safety, and environmental considerations can also be used to exclude goods
from the local market. Imports may be expected to meet specific technical standards,
and importers may be required to test and prove the safety and quality of their goods.
This may raise costs to the point where many importers decide the extra cost is not
worth it, and thus quit their attempt to enter the market. Where domestic producers
and government regulatory agencies create these import standards with the primary
goal of limiting imports, they are engaging in protectionism.

Environmental standards
Environmental standards provoke passionate debates in trade matters. The depletion
of common access resources sparks fierce argument, with endangered species being
particularly controversial. Japanese whalers, for example, have long argued that theirs
is a legitimate activity, based on the use of available resources, and that restrictions
against it are disguised protectionism. In these cases, the WTO is asked to rule on the
legitimacy of the claims.
47
 Trade protection

Embargoes
Embargoes are extreme quotas that completely stop some or all trade with a particular
country. They can be applied unilaterally or multilaterally, by a trade block. Embargoes
on the dealing of weapons and arms is fairly common. Typically, embargoes are
organised to achieve strategic or political aims. In recent years, the EU and US
maintained an embargo on the Republic of Iran, forbidding Iran’s oil imports and
denying consumer goods exports from the two largest economies. Here the stated
aim was not to bargain about further trade rules but to constrain the Iranian nuclear
programme.

What is a nationalistic campaign?

Governments can also resort to campaigns of persuasion designed to promote more
conscious consumption. ‘Buy American’ and ‘Buy British’ advertising campaigns, for
example, exhort consumers to buy local goods whenever possible. These efforts appeal
to national pride and hope to make a marginal difference in buying patterns, ideally
supporting domestic firms and employment.

I/ ed example 23.1
For HL Paper 3, you may be asked to use diagrams to calculate the effects of tariffs,
quotas, or subsidies on the different stakeholders. Here is an example of the kind of
question you may face, with solutions worked throughout.

Price of coffee
(P) ($/kg)

DOMesTIC

tity-of cof e (Q)

o

kg millions|

1 Show the domestic equilibrium price and quantity on the diagram.

2 Coffee may be imported at the world price of $2/kg. Draw world supply on the
diagram.
3 How much coffee will be supplied by local (domestic) producers and how much
will be supplied by foreign producers (imports)?
4 If the government imposes a subsidy of $.50/kg, show the effect of the
international trade subsidy on the diagram.
5 Calculate the change in producer revenue from before and after the subsidy.

472
6 Calculate the change in consumer spending before and after the subsidy.
7 Calculate the change in government spending on the subsidy before and after.
8 Explain the impact of the subsidy on any three stakeholders in the market
for coffee.

Worked example 23.2

Price of coffee
(P) ($/kg)

B Soovestic
/Snowsm suBsioy
4 /

T = $0/50 subsidy
P.=3
Prvoruo »sussior = 2:5 |-~ A 1" = Efficiency loss
Puons =2 T <
: wWoRLD
1 :
: Doowesnc
0 RIS B 4
Quantity of coffee (Q)
(kg millions)

1 The equilibrium price and quantity are shown as $3 and 2 million kg.
2 The world supply curve () is shown above.
3 Inaclosed economy before trade, domestic firms produced 2 million kg. After
trade they produced only 1 million. Foreign producer quantity is equal to the
total quantity supplied of 3 million — 1 million domestic quantity supplied =
2 million kg.
4 With the subsidy, the domestic supply curve has shifted down (right) by $0.50 at
all price levels. Domestic production rises to 1.5 million kg, still at a price of $2.
Foreign production has been reduced to 1.5 million.
5 Producer revenue before the subsidy was $2 X 1 million = $2 million. Producer
revenue after the subsidy was $2.5 X 1.5 million = $3.75 million.
6 Consumer spending before the subsidy was $2 X 3 million = $6 million.
Consumer spending after the subsidy was $2 X 3 million = $6 million.
7 Government spending before the subsidy was 0. Government spending on the
subsidy is $.50 X 1.5 million = $.75 million or $750,000.
8 Stakeholders in this event are domestic producers, foreign producers,
consumers, the government, and market efficiency. The question requires a
discussion of any two of the following.
a. Domestic firms who were harmed by free market imports before the subsidy
are now able to produce and sell more at the P . market price. This
increases their revenues to nearly double the free market level. Domestic
profits and employment will rise.
b. Foreign firms lose a share of the market to the subsidised domestic firms.
They sell less quantity and suffer lower revenue. This is likely to reduce
profits and employment in that industry.

473
 Trade protection

c. The government suffers the loss of $750,000, which is tax revenue that could
have been spent on infrastructure, housing, healthcare, education, or any
other government priority.
d. Market efficiency suffers a welfare loss, as shown by the blue triangle above.
After the subsidy, the market stays the same size of 3 million kilograms and
at the same price of $2. However, a large amount of production (500,000 kg)
is paid for through subsidies, a quantity that would have been supplied to the
market without the subsidy.
e. Consumers are equally well off as before, getting the same quantity and price
as before the subsidy. However, they are likely to be indirectly paying the cost
of the subsidy through their own tax payments.

Practice exam questions

Paper 1, part (a) questions

1. Explain, using a diagram, the effect of the imposition ofa tariff. (10 marks)
2. Explain, using a diagram, the effect of the payment of an
international trade subsidy. (10 marks)
3. Explain, using a diagram, the effect of the imposition of a quota
in the market for an imported good. (10 marks)
4. Explain three arguments in favour of protectionism. (10 marks)
5. Explain three arguments against protectionism. (10 marks)
Paper 1, part (b) questions
1. Using real-world examples, discuss the advantages and
disadvantages of free trade versus protectionism. (15 marks)
2. Using real-world examples, evaluate the case for protectionism. (15 marks)
Paper 2: two-mark and four-mark questions
Anti-dumping worries prompt Thailand to enact tariffs
The US-China trade war has left Asia flooded with an oversupply of steel, and
importing countries are fighting back with more than a dozen anti-dumping
accusations in recent months.

Among those countries was Thailand, who alleged that China was dumping a
range of steel products on its market. Motivated by these concerns, Thailand
placed a tariff of nearly 40% on two Chinese steel products.

China is the world’s largest producer of steel, producing over half of the world's
output. It has frequently been accused of distributing cheap and subsidised steel
to global markets.
The recent pandemic has dampened demand for industrial products across
the world, and Thai manufacturing sectors have suffered. Decreased domestic
demand for steel in Thai industries has hurt steel sales at home, and prompted
calls for retaliatory measures against China.

474
2-mark questions
Define the following terms, indicated in bold in the data:
1. tariff (2 marks)
2. subsidised (2 marks)
3. dumping (2 marks)
4-mark questions
4. Using an international trade diagram, show the effect of
Thailand’s tariff on China’s steel imports. (4 marks)
5. Using an AD/AS diagram, show the effect of ‘dampened
demand for industrial products across the world’
on the Thai economy. (4 marks)
6. Using a labour market diagram, show the effect of China’s
steel subsidies on the wage rates of steel workers in Thailand. (4 marks)
HL Paper 3 Questions
Below is a market for bananas in a country:

Price of bananas
P) ($/ki

5 DOMESTIC

D, bomesTic

0 1 2 3 4
Quantity of bananas (Q)
(kg millions)

1. Show the domestic equilibrium price and quantity on the diagram.

2. Bananas may be imported at the world price of $1.5/kg. Draw world supply on
the diagram.
3. How much coffee will be supplied by local (domestic) producers and how much
will be supplied by foreign producers (imports)?
4. If the government imposes a tariff of $1.00/kg, show the effect of the tariff on
the diagram.
Calculate the change in producer revenue from before and after the tariff.
S ISOE
W

Calculate the change in consumer spending before and after the tariff.
Calculate the change in government revenue after the tariff.
Explain the impact of the subsidy on any three stakeholders in the market
P

for coffee.

475
 M Yy
Economic integration’ ' A

&Y
‘ N v
 Pz at is ‘economic integration’?

Learning outc
At the end of this section you will be able to:
* define economic integration as a staged process of working towards free trade
through negotiated trade agreements between countries.

Chapters 22 and 23 introduced the theories of free trade and protectionism. You
learned about the theory of comparative advantage and the principle that when
countries engage in free trade, there are mutual benefits enjoyed by many stakeholders,
such as lower prices, greater variety of goods and services, greater efficiency, and larger
markets for producers. Of course, there are always losers whenever nations engage in
trade but, in most cases, the gains of trade for society outweigh the costs.
Free trade based on the principle of comparative advantage is an ideal that
would promote maximum allocative efficiency of the world’s scarce resources.
Unfortunately, it is an ideal that is far from being achieved in the real world today.
Since the Industrial Revolution and the end of colonialism, the status quo for most
of the world’s nations has generally been protectionist and anti-trade. During much
of the 20th century, many of the world’s economies were ideologically aligned in
opposing camps; divided by the Iron Curtain into capitalist and communist systems.
With the break-up of the Soviet Union and the reduction of its influence of the Eastern
Bloc, the ideological battle seemed to end as the vast majority of nations pursued free
market reforms in an effort to promote long-run economic growth and development
in their economies.
However, while free market reforms have prevailed within nations and trade has
flourished among the citizens of the emerging market economies, free trade between
nations has grown more slowly than many would have hoped it would. Nations often
act out of the fear of losing current industry, rather than seeing the opportunities and
benefits of open trade. And so, they resist further economic integration.
The hesitancy among nations to open their borders to international trade has led
to the need for clearly articulated agreements between nations as a precursor to
economic integration. Trading blocs are arrangements between two or more nations
through which tariffs, quotas, and other barriers to trade of most goods and services
are cither reduced or eliminated altogether. Trading blocs may take several forms and
can be categorised by the stages of economic integration achieved. The lowest stage
represents the first steps between two or more nations at integrating their economies,
while the highest stage is complete economic integration.

477
 Economic integration

4.2 What are the different levels of economic

integration?

Learning outcomes
At the end of this section you will be able to:
* define preferential trade agreements
« distinguish between bilateral and multilateral (WTO) trade agreements
« distinguish between a free trade area, a customs union, and a common market
* evaluate the advantages of trading blocs, including trade creation, greater
access to markets, freedom of labour, stronger bargaining power, and political
stability and cooperation
* examine the disadvantages of trading blocs, including trade diversion,
loss of sovereignty, and challenges to multilateral negotiations
« distinguish between a common market and a monetary union
e analyse the possible advantages and disadvantages of a monetary union for
its members.

Completely free trade between nations is the outcome many economists dream of,
but, in reality, countries tend to take small steps towards eliminating barriers to trade
between one another. The types of trading bloc nations may enter into with other
nations, in order of the degree to which member countries’ economies are integrated
with one another, from least to most integrated are:

1 preferential trade agreement

2 freetrade area
3 customs union

4 common market
5 monetary union.

Trading blocs can be either bilateral (between two nations) or multilateral (between
more than two nations). Typically, preferential trade agreements are agreed between
two nations or between a group of nations that are part of a free trade area and another
nation. At the other end of the spectrum, there is only one major monetary union in
the world today — the eurozone: European nations using a common currency, the euro.
However, several economic and monetary unions are in various stages of proposal and
development.

Preferential trade agreements

A preferential trade agreement (PTA) is when two or more countries reduce or remove
tariffs on particular goods or services produced in participating countries, or make
other agreements reducing the barriers to free trade between the nations. A PTA is the
first stage of economic integration, and differs from higher stages in that not all goods
are necessarily exempt from tariffs, nor must tariffs be eliminated completely on the
goods included.

478
Abilateral agreement is between two countries. A multilateral agreement is between
three or more countries. Multilateral agreements can include as few as three, but as
many as 186 countries, which is how many countries are members of the World Trade
Organization (WTO) as of 2020. The WTO will be examined in more detail later in this
chapter.

The term ‘preferential’ points to the fact that when nations sign up to such an
agreement, the result is that one nation ends up preferring to buy goods and services
from the other rather than from countries not included in the agreement. Preferred
trade differs from free trade in that tariffs are not completely eliminated on all goods
and services, and tariff reductions only apply to select nations, not all ofa country’s
trading partners. Therefore, PTAs result in increased trade between participating
nations at the expense of trade with the rest of the world. PTAs fall short of achieving
an efficient allocation of resources, even between their members.

PTAs can be either bilateral or multilateral. Table 24.1 shows some contemporary
PTAs.

Table 24.1 Preferential trade agreements

Name of PTA Countries involved Coverage | Year created
Asia Pacific Trade Bangladesh, China, India, Goods only 1976
Agreement Lao People’s Democratic
Republic, Republic of Korea,
Sri Lanka
Latin American Argentina, Bolivarian Goods only 1981
Integration Republic of Venezuela,
Association (LAIA) | Bolivia, Brazil, Chile,
Colombia, Cuba, Ecuador,
Mexico, Paraguay, Peru,
Uruguay
Lao PDR-Thailand | Lao People’s Democratic Goods only 1991
Republic, Thailand
Economic Afghanistan, Azerbaijan, Goods only 1992
Cooperation Islamic Republic of Iran,
Organization (ECO) | Kazakhstan, Kyrgyz Republic,
Pakistan, Tajikistan,
Turkey, Turkmenistan,
Uzbekistan
Melanesian Fiji, Papua New Guinea, Goods only 1994
Spearhead Group Solomon Islands, Vanuatu
(MSG)
South Asian Bangladesh, Bhutan, India, Goods only 1995
Preferential Trade Maldives, Nepal, Pakistan,
Arrangement Sri Lanka
(SAPTA)
Chile-India Chile, India Goods only 2007

479
 Economic integration

Two of the agreements in Table 24.1 are bilateral (Lao PDR-Thailand and Chile-India),
others are regional (such as the Economic Cooperation Organization (ECO), which
includes countries in the region of Central Asia), while one includes nations that are
in very different geographical locations (Chile-India). All the agreements involve
reductions in or removal of tariffs on selected goods. Services are not included in any
of these PTAs.
A PTA represents a step towards free trade, but it must be noted that it is a rather small
step. Such a pact between two or more nations promotes increased integration of the
small number of countries involved, but only on selected goods and at the expense of
increased integration with the rest of the world’s economies.
For example, when Chile and India enter into a PTA, the reduction in tariffs on
Indian goods in Chile will certainly increase the demand for Indian imports in Chile,
but possibly also a decrease in demand for other countries’ goods. Indian rice is
cheaper for Chilean consumers because of the PTA between the nations. This may
mean that Chile imports more Indian rice, but it also means that Chile imports
less Thai rice. PTAs, in other words, are preferential, but not free trade agreements.
Under totally free trade, Chile would import rice from the country that has the
lowest opportunity cost in rice production, which may not actually be India. Under
a PTA, Chile imports more rice from India, even if India does not have the lowest
opportunity cost, simply because the tariff on Indian rice is lower than that on rice
from other countries.

Free trade areas

A free trade area (FTA) is formed when two or more nations make an agreement to
completely eliminate trade barriers on most (if not all) goods and services traded between
them. FTAs are at the second level of economic integration, closer to truly free trade
than a PTA where tariffs are reduced or eliminated only on certain goods.
Countries in an FTA agree to eliminate tariffs on goods and/or services produced
in other member countries, but maintain the right to set their own tariffs on non-
member countries.

There are hundreds of separate free trade agreements in the world today, some
bilateral, some multilateral. The USA alone is involved in 14 separate FTAs with
20 countries, including Australia, Bahrain, Canada, Chile, Costa Rica, South Korea,
Mexico, Morocco, Peru, and Singapore (plus ten morel).

Some examples of FTAs are shown in Table 24.2.

Each of these FTAs requires the removal of tariffs in the member countries on
goods and|or services produced in and imported from all other member countries.
The intended effect of such an agreement, of course, is to allow for a more efficient
allocation of resources based on the principle of comparative advantage among the
member states.

Customs unions
Next on the spectrum of economic integration is the customs union. A customs union
is an agreement between two or more countries to phase out or eliminate tariffs and

480
Table 24.2 Free trade areas
Name of FTA Countries involved Coverage | Year enacted
Australia— Australia, New Zealand Goods and 1989
New Zealand services
(ANZCERTA)
Ukraine—Russian Ukraine, Russian Federation | Goods only 1994
Federation
United States— Canada, Mexico, US Goods and 1994
Mexico-Canada services
Agreement (USMCA)
EC-Egypt Austria, Belgium, Bulgaria, Goods only 2004
Cyprus, Czech Republic,
Denmark, Estonia, Finland,
France, Germany, Greece,
Hungary, Ireland, Italy, Latvia,
Lithuania, Luxembourg,
Malta, Netherlands, Poland,
Portugal, Romania, Slovak
Republic, Slovenia, Spain,
Sweden, Egypt
South Asian Free Bangladesh, Bhutan, India, Goods only 2006
Trade Agreement Maldives, Nepal, Pakistan,
(SAFTA) Sri Lanka
US-Morocco US, Morocco Goods and 2006
services
ASEAN-Japan Brunei Darussalam, Goods only 2008
Myanmar, Cambodia,
Indonesia, Lao People’s
Democratic Republic,
Malaysia, Philippines,
Singapore, Vietnam,
Thailand, Japan
China—New Zealand | China, New Zealand Goods and 2008
services
Canada—Peru Canada, Peru Goods and 2009
services
Japan-Switzerland | Japan, Switzerland Goods and 2009
services

other trade barriers and establish common external barriers towards non-member
countries. Thus, a customs union differs from a free trade agreement in that:
* ina free trade agreement, each member nation maintains the freedom to determine
the barriers to trade it will impose on imports from nations that are not part of the
FTA
+ inacustoms union, member nations adopt common tariffs on non-member
nations’ goods and services.
481
 Economic integration

Table 24.3 Customs unions

Name of customs Countries involved Coverage | Year enacted

union
East African Burundi, Kenya, Rwanda, | Goods only 2000
Community (EAC) Tanzania, Uganda
Economic and Cameroon, Central African | Goods only 1999
T Monetary Community | Republic, Chad, Congo,
Nearly every country in the of Central Africa Equatorial Guinea, Gabon
world is part of at least one
trade bloc. Usinga search (CEMAC)
engine, enter the name Gulf Cooperation Bahrain, Kuwait, Oman, Goods only 2003
of your country, followed Council (GCC) Qatar, Saudi Arabia, United
by ‘trade agreements to
investigate the various trade Arab Emirates
blocs of which your country Eurasian Economic Belarus, Kazakhstan, Goods only 1997
isapart
Community (EAEC) Kyrgyz Republic, Russian
For discussion and debate:
Federation, Tajikistan
How many trade
agreements is your country Southern Common Argentina, Brazil, Goodsand | 1991 (goods)
currently in with other Market (MERCOSUR) | Paraguay, Uruguay services 2005 (services)
countries?
Of these, how many are
~

bilateral? How many are In 2020, there were 15 customs unions in effect worldwide — a selection is shown in
multilateral?
Table 24.3.
Is your country part of any
w

customs unions? Common

markets? Monetary union?
Common markets
Choose one of the
agreements you uncovered The fourth type of trading bloc is the common market. This is like a customs union in
in your investigation. Dig a that goods and services are traded without tariffs but, in addition, member countries
little deeper by looking for agree not only to free trade of goods and services but also to free movement of capital
awebsite for the trade bloc and labour. In other words, the barriers to the flow of labour, land, capital resources,
or agreement. Answer the
questions that follow. and entrepreneurial talent are also reduced or eliminated. The aim is to improve the
4 Does the trade bloc allocation of resources within member nations and between them. In order to facilitate
cover specific goods or the flow of productive resources between nations in a common market, shared
all goods? If it only covers regulations and policies regarding labour and capital employment must be adopted by
specific goods, what are member nations.
three categories that are
covered?
The most successful example of a common market is the European Economic Area
Does the agreement (EEA), which includes the 27 countries in the EU plus Switzerland, Norway, and
w

reduce or eliminate tariffs?

Liechtenstein. Another example is the East African Community (EAC), a common
Which producers in
o

your country benefit market formed in 2010, which includes six partner states: Burundi, Kenya, Rwanda,
from membership in the South Sudan, Tanzania, and Uganda.
selected trade bloc? How
do they benefit? One fact worth pointing out is that each type of trading bloc includes the characteristics
7 How do consumers in of the trading blocs lower down on the integration ladder. For example, a customs
your country benefit union is an FTA, but one in which member nations also share common external
from membership in the tariffs. A common market is a customs union, but one in which member nations also
selected trade bloc?
allow the free flow of labour and capital. In other words, as we move up the ladder of
Who are the potential
economic integration, each level of trading bloc builds on the lower levels (for example,
©

losers of your country’s

membership in the the EAC which was a customs union of five nations formed in 2000, and later became
selected trade bloc? a common market in 2010 of six nations). Increased integration increases the level of
competition across member nations’ producers and within labour markets.
482
Advantages and disadvantages of trading blocs
Trading blocs represent a step towards economic integration, and within common
markets the economies of member nations are all but fully integrated, with only
monetary and fiscal policies remaining under the control of each sovereign nation. While
the trend over the last century has been towards greater economic integration globally,
the free trade ideal that economists imagine is still largely one that only exists in their
imaginations. Economic integration has advantages and disadvantages for countries that
pursue it, and the consequences of increased integration with other economies are felt
across all levels of society, from businesses to households and the government.

Advantages

Trade creation occurs when the formation of a trading bloc, whether bilateral or
multilateral, shifts production from a higher cost country to a lower cost country,
increasing the level of efficiency by assuring that goods are produced where the
least amount of resources are required for their production.

Let us consider a possible outcome of the Asia Pacific Trade Agreement as an

example. The APTA includes, among other nations, India and South Korea. Prior
to joining one another in a trade bloc, the two countries likely had tariffs on most
imports between them. However, over several rounds of negotiations tariffs on
over 4000 items traded between the two countries have been reduced or eliminated,
increasing the flow of goods between them.
South Korea, a country with an advanced automobile industry, exports more cars
and car parts than any other country in APTA. India, on the other hand, has a
relatively undeveloped automobile sector and likely faces higher average costs in
car manufacturing than South Korea. If, as a result of their membership of APTA,
India ends up importing more cars from South Korea and producing fewer cars
domestically, then trade has been created as a result of the FTA. Production has
shifted from a higher cost country (India) to a lower cost country (South Korea).

A Hyundai
y Mot
line at Asan, South Kc

483
 Economic integration

Meanwhile, India, which has a large and productive agricultural sector, is likely
to see its production of grain and other food products increase because of its
trade with South Korea, where land is scarcer and food production less efficient.
Trade is once again created because of the two countries’ membership in an FTA;
agricultural production shifts from South Korea (a higher cost country) to India
(alower cost country).

Unfortunately, not all trade blocs result in trade creation. In our next section we'll
look at examples of where trade is diverted, which occurs when a trade bloc causes
production to shift from a lower cost country to a higher cost country.

Greater access to markets

‘When two or more countries enter into a trade bloc the producers in each country
enjoy access to a larger customer base than they would have without economic
integration. Producers that are able to compete with foreign firms on price and quality
will see demand for their products grow, allowing them to achieve economies of scale,
which are the cost advantages firms experience when they produce a larger quantity of
output for more consumers. Economies of scale result from things like bulk buying of
inputs, greater specialisation of labour as more workers are hired to do specific tasks
within an industry, and the cost savings from producing and shipping products in bulk
rather than in the smaller quantities firms might have produced at for their domestic
markets alone.

Freedom of labour
Free movement of labour, a characteristic of common markets but not the lower
levels of the trading bloc, provides increased employment opportunities and a larger
pool of available workers for the households and firms of the partner nations. For
example, in Germany, where labour markets are notoriously tight (the natural rate of
unemployment is around 3.5%), firms are more likely to maintain domestic production
facilities if workers from other EEA member nations are able to migrate to Germany to
meet the demand for labour when it arises. Workers from Poland, the Czech Republic,
Estonia, and other nations are available to fill the jobs that German workers may be
unable or unwilling to complete.
From the households’ perspective, joining a common market can provide for
opportunities that might not be available in the domestic economy. Unemployment
rates across member countries should converge on one another as excess labour in one
country migrates to where there are labour shortages. The result is greater efficiency in
labour markets, higher employment overall, and lower production costs for the firms
that would find themselves at a competitive disadvantage without the common market
in the face of lower wages abroad.

Stronger bargaining power

Another advantage to workers of trading blocs is the ability to leverage increased
employment opportunities abroad to negotiate higher wages at home. Take our
example of Estonian workers, who as part of the EEA have the freedom to emigrate
to Germany or any other EU nation in search of work. When domestic firms go to
negotiate wages with labour unions in Estonia, their position is strengthened due to
484
the ease with which workers could take jobs in the rest of Europe. The outcome is
higher wages for workers in Estonia.
This outcome is reversed from the perspective of higher wage countries, however.
German firms gain bargaining power because of the availability of lower wage workers
who could come from Estonia or elsewhere in the EEA to do jobs that German workers
might otherwise have taken. Employers now have the upper hand in wage negotiations
with German labour unions, as German workers find themselves competing not just
with one another, but with workers from lower wage countries within the EEA.

Inboth cases, the outcome is greater efficiency in labour markets, once again, as both
employment rates and wage rates converge across countries within a common market
agreement.

Political stability and cooperation

When countries’ economies become integrated with one another, the consequences
ofa conflict become much greater than if no economic ties exist. As economists, we
always think in terms of costs and benefits. At least for the countries within a trading
bloc, the economic costs of conflict (in terms of lost revenues or decreased access
to resources or goods through trade) often outweigh potential benefits. The result
is increased political stability and cooperation between nations whose economic
fortunes are tied together through trade agreements or other forms of economic
integration.

Disadvantages

Trade diversion occurs if the formation of a trading bloc between two or more
nations results in the production of a good shifting from a nation with a lower
opportunity cost to one with a higher opportunity cost. Such a scenario may
seem unlikely, but it occurs rather commonly at the higher levels of economic
integration, such as in a customs union. When two or more nations agree to
eliminate barriers to trade between themselves, but to maintain common external
tariffs on all other nations, it is possible that the result will be the diversion of trade
from low-cost producers to high-cost producers.
Take, for instance, the EEA, which includes the 27 countries of the EU plus Norway,
Switzerland, and Liechtenstein. All 30 countries in the EEA are middle- or high-income
nations that have agreed to eliminate tariffs between all member nations. However, the
EEA has common tariffs on non-member imports, many of which are low-income
countries that may have a comparative advantage in the production of certain goods
over high-income EEA nations. Owing to the agreement between member nations, the
existence of external tariffs could increase trade between European economies at the
expense of trade with lower cost economies outside of Europe.
For example, Poland, a middle-income country with a comparative advantage in
the production of intermediate manufactured goods such as automobile parts,
joined the EEA in 2004. As a member of the EEA, Poland enjoys duty-free exports to
Germany, its largest trading partner, also a nation with a large automobile industry.

485
 Economic integration

O Germany most likely began importing more auto parts from Poland after its entry
When the UK voted to leave into the EEA in 2004 than it had before, since these goods could now be obtained
the EU, the vote surprised duty free, whereas goods from countries outside the EEA would be subject to
many observers and even
‘leave’ voters who expected tariffs. Butif this increase in trade with a middle-income European neighbour came
to stay in the EU, but wanted at the expense of trade between Germany and a lower cost non-European nation,
1o register a vote of protest. such as China, then trade was not created, it was diverted. When trade is diverted
No country had ever voted due to the formation of a trade bloc, overall efficiency is reduced.
to leave the EU since its
foundingin 1993. To better
understand the issues at Loss of sovereignty
stake over ‘Brexit, conduct
an internet search for Some degree of national sovereignty is by definition sacrificed when a country joins a
articles published before the trade bloc. The freedom to set tariff rates on other countries is abandoned when joining
referendum on 23 June 2016. a customs union, for instance, as common external tariffs must be shared with other
For discussion and debate: members of the union. When joining a common market each member nation’s ability
Seek out reliable sources to set not only tariff rates, but minimum wage rates and other labour market policies, is
for the ‘leave’ side of the
undermined. A minimum wage in one country is only effective if businesses cannot easily
debate.
move across the border to a neighbouring country and set up shop where wages are lower.
Seek out reliable sources
~

for the remain’ side of the

The nationalist inclinations of many countries’ citizens make economic integration
debate.
with other nations politically unpopular, even while the potential economic benefits are
Discuss and debate with
w

your class the trade-offs understood. The UK’s 2016 referendum on whether or not to remain in the EU, known
suggested by these points, as the ‘Brexit’ vote, showed that, after decades of ever increasing integration between the
and a decision to leave UK and European economies, the majority of British citizens ultimately preferred more
sovereignty over more integration. On 31 January 2020, the UK officially withdrew
from the EU common market, marking a new era of economic dis-integration for
66 million British citizens, now free to determine their own economic future.

Challenges to multilateral trading negotiations

‘When countries lock into their respective trade blocs, it may interfere with the work
of the WTO to create a broader coalition of global trade rules and partners. Since the
last WTO global round of negotiations started in 2001, dozens of regional trade
agreements have been negotiated. Some of them, like the Comprehensive and
Progressive Agreement for Trans-Pacific Partnership (once known as just the TPP)
are large multilateral agreements that are being negotiated in place of a larger global
agreement with the WTO. Frustrated by a lack of progress there, countries are finding
the best trade deals they can in lieu ofa bigger deal.
Negotiating the terms of trading blocs can be a several year process and in many cases
may fail altogether, as various industry representatives are consulted, who may have
competing desires that stall progress towards an ultimate agreement.

Case study - is the USMCA just a ‘Trump’ branded version of

NAFTA?
‘When Canada’s Prime Minister Brian Mulroney, Mexican President Carlos Salinas, and
US President George H.W. Bush agreed the North American Free Trade Agreement
(NAFTA) which came into force on 1 January 1994, the world’s largest free trade
area was formed. In the decades that followed, all three countries enjoyed increased
trade, economic growth, and rising living standards, in no small part as a result of the
benefits the agreement provided both producers and consumers in North America.

486
 When President Donald Trump came into office in January 2017, he planned to
remove NAFTA and replace it with a new trade agreement that would benefit
American producers, who he argued had been suffering for decades under NAFTA;
losing out to lower cost producers in Mexico and Canada. Over the next year and a
half the Trump administration engaged in negotiations with trade representatives
from Mexico and Canada to work out the details of what many have called the
‘new NAFTA’, but what was officially called the United States-Mexico—Canada
Agreement (USMCA).

So, what changed from NAFTA to USMCA? To find out, conduct a web search using
the term ‘NAFTA USMCA trade deal differences’. One of the top results should
direct you to an article with information about the difference between these two
free trade agreements.
Discussion questions:

1 Is the new rule that requires 75% of a car’s parts to be made in one of the three
countries in order to be traded tariff free likely to result in trade creation or trade
diversion? Explain.
2 How will the requirement of workers making car parts most likely affect
where car parts are manufactured in North America? Do ‘minimum wage’
requirements increase or decrease efficiency of resource allocation between
trading partners?
3 Which country’s farmers are most likely to benefit from the changes to USMCA
compared to NAFTA?
4 Overall, do free trade agreements like USMCA represent ‘free trade’ or
‘preferential trade’ What is the difference between these two concepts?

Monetary unions and complete economic

integration
Monetary unions
The final stage of economic integration is the monetary union, which comprises
a common market in which member states also adopt a common currency
managed by a single central bank. A monetary union, for all intents and purposes,
joins the economies of member states into one single economy. The only thing that
distinguishes a monetary union from complete economic integration (which is when
different states or provinces are united under a single national government) is that
the governments of member states in a monetary union still control their own
national fiscal policy.

Two examples of monetary unions are the USA (which essentially combines the
economies of America’s 50 states under one central bank sharing one currency, the
US dollar) and the eurozone, which includes 19 European nations that adopted the
euro.
Monetary unions share all the characteristics of lower stages of economic integration:
« tariffs between member states are eliminated
* common tariffs on non-member nations are adopted by member states
487
 Economic integration

+ land, labour, and capital resources may flow free of intervention between member
states
* regulations regarding labour and capital are shared between member states.
In addition, members adopt a single currency, thereby foregoing their ability to
control the money supply in their own economies. Commercial bank regulations and
monetary policies, such as changes in the interest rate and foreign exchange market
interventions, are determined by a shared central bank rather than by each individual
state or country’s government.
The states in the USA began sharing a single currency almost immediately after
declaring independence from Great Britain, and since 1913 the US money supply has
been managed by the country’s central bank, the Federal Reserve. When the euro was
launched in 1999, the 11 original eurozone economies each switched from their own
currencies (the deutschmark, the franc, the lira, and so on) and thereby lost the ability
to independently determine their own monetary policies. Today, the European Central
Bank controls the money supply in the 19 nation eurozone economy, setting interest
rates across the monetary union.
‘While a monetary union represents nearly complete economic integration, the states
in such an arrangement maintain much of their fiscal sovereignty, albeit with strict
guidelines established by the central bank. In Chapter 20, Demand management: fiscal
policy, we learned why member states in a monetary union are held to strict standards
regarding deficit and debt levels: by limiting the sizes of annual deficits of members
states, a central bank protects the value of the currency on foreign exchange markets
and prevents individual governments from undermining its ability to set interest rates
across the union. Large deficits and high levels of national debt tend to drive interest
rates up and threaten to turn international investors away from a currency, which
could cause it to weaken on foreign exchange markets, an outcome that may not be
compatible with the central bank’s desired policy outcomes.

Complete economic integration

Beyond countries joining one another in a monetary union lies complete economic
integration, in which member states completely abandon independence of both
monetary and fiscal policies. The difference between the USA and the eurozone is that
the 50 states in the US are subject to the monetary and fiscal policies of the US federal
government, while the eurozone nations are subject only to the monetary policies of
the European Central Bank.

The USA therefore represents an example of complete economic integration; but

since each nation in the eurozone is free to determine its own government budget
and allocate government tax revenues as it sees fit, the eurozone is not a completely
integrated economy. The 19 euro nations are integrated economically and monetarily,
but not fiscally. Each nation’s government can decide its own fiscal policies, unlike
each US state government. A group of states joined in complete economic integration
essentially become one nation, foregoing economic sovereignty over the majority of
the economic policies and activities in the integrated economy.
The loss of fiscal sovereignty may explain why the euro countries have thus far avoided
complete economic integration; it is not yet politically viable to the culturally and
socially diverse citizens of Europe to accept the sacrifice of fiscal sovereignty and hand
over control of their governments’ budgets to a federal European government.
488
Advantages
The benefits of joining a monetary union are clear for prospective members:
sharing a currency with other countries vastly smooths the process of trade
between economies. In addition to sharing a currency, countries in a monetary
union have no trade barriers between them and investment can flow freely
across borders; even labour can migrate as if there is only one economy across all
countries, which, essentially, is the case.

Producers in member countries find the markets for their products vastly expanded
within a monetary union, and since consumers in other countries even share a
currency, the demand for firms’ output is higher than it would be without a shared
currency. Workers who take jobs in another country and send money home
will find the lack of exchange rate fluctuations provides more stable income and
eliminates the resulting uncertainty of moving to another country to find work.
Finally, increased macroeconomic stability is a likely result for smaller countries
that join a monetary union in which larger economies are already a part. Greece,
one of the smaller members of the eurozone, has benefited from bailouts during
periods of financial uncertainty in the past decade thanks to its membership in
the eurozone economy. A member of a monetary union will not be left to default
on its national debt by other members, as doing so would undermine the stability
of the currency across the common market. The downside to this, of course, is
a sort of moral hazard where smaller countries within a monetary union may
lack the fiscal discipline required to assure monetary stability, and therefore
strict oversight might be needed to protect the value of the currency on foreign
exchange markets.

Disadvantages
Nations in a monetary union must give up the ability to control their own
monetary policies, reducing each country’s ability to manage aggregate demand
in its domestic economy by raising or lowering interest rates or manipulating the
exchange rate of its currency relative to its trading partners’ currencies. Since no
single nation in a monetary union can determine the level of interest rates or the
exchange rate on its own, control of the nation’s macroeconomy is to some extent
essentially handed over to a multinational central bank, a sacrifice many nations are
not eager to make.
This explains why some of the nations in the EU (in which there are 27 countries)
are not currently seeking to become a part of the eurozone (in which there are only
19 countries). Giving up its own currency prevents a country from increasing its
attractiveness to foreign consumers and investors by keeping domestic interest rates
low and the value of its currency weak.

489
 Economic integration

To what extent would

increased economic 4.3 What is the World Trade Organization?
integration ever be
considered undesirable?
Learning outcomes

Video suggestion: At the end of this section you will be able to:
You have read about it, now
You can review what you * describe the objectives and functions of the WTO
have just learned by watching * explain what factors affect the WTO's influence, including the difficulties in
avideo by the author! reaching agreement and the unequal bargaining power of its members.
Simply click here in
your eBook for a video
on the six stages of economic
integration The largest multilateral trade agreement in the world is the WTO, which advertises
itself as the ‘only international organisation dealing with the global rules of trade
between nations. Its main function is to ensure that trade flows as smoothly,
predictably and freely as possible’. In 2020, there were 159 countries in the WTO.

How and when was the WTO formed?

The WTO originated from negotiations on trade that followed the Second World War.
It was generally thought that a wave of protectionism in the 1930s drew countries
closer to the war that followed. Thus, in 1948, 23 countries signed the General
Agreement on Tariffs and Trade (GATT).

During the same negotiations, held in Bretton Woods, New Hampshire, USA, the
International Monetary Fund (IMF), the World Bank, and the Bretton Woods
exchange rate system were also established with the aim of creating stability and order
to world trade and income flows. In time, the GATT developed from an agreement to a
forum for future negotiations, and eventually an organisation in its own right.
Every few years, GATT negotiations were staged with the goal of creating standardised
trade rules. After holding seven rounds of negotiations, the final round culminated
in the creation of the WTO in 1993. The WTO extended and expanded the GATT
mission, with greater scope over services and capital flows, as well as increased
authority. It is based in Geneva, Switzerland, and has a staff of over 600.

The main barriers faced by the WTO in achieving increased economic integration
between member states surround reluctance of rich countries to reduce their heavy
subsidies and protection of agricultural markets. In turn, rich countries are secking
reductions in allowable tariffs on developing country protectionist measures. At stake
are hundreds of billions of dollars in new markets for developing countries.

What are the WTO’s aims?

The WTO secks to expand international trade by lowering trade barriers and
improving the flow of trade. It has specific objectives that enhance this overall goal.

Trade without discrimination

'WTO members are all asked to subscribe to ‘most favoured nation’ status. This means
that goods from all WTO member countries are treated equally. A tariff applied to one
is applied to all, and there are thus no real favourites. At the same time, foreign goods
should be treated the same as domestic goods.
490
Freer trade through negotiation
The success of each trade round is attributed to the combined efforts of continuous
negotiation. This ensures that changes to trade policy are done by direct dealing, and
also that they are done gradually. This allows affected countries to prepare for the
adjustments that will probably be enacted when the new agreement comes into force.

Predictability through binding agreements and transparency

Binding refers to the commitment among members to keep tariffs at or below certain
rates. This allows importers to assess markets more accurately and make better
decisions about trade. Openness about trade rules also encourages more trade.

Promoting fair competition

While devoted to free trade, the WTO also claims to seck trade that is more fair. Rules
against dumping and intellectual property theft, for example, are aimed at increasing
fair competition. More generally, the creation of a system of trade rules promotes fair
play by establishing some fundamental guidelines for most trade.

Encouraging development
Nearly two-thirds of WTO members are developing countries. These countries are
granted special trade concessions because it is assumed that their industries need time
and space to grow to a level of direct global competition.

What functions does the WTO perform?

With the above objectives in mind, the WTO performs the following functions:

« provides a forum for trade negotiation

* executes WTO agreements
* evaluates and rules on trade complaints by member countries
« provides technical assistance to developing countries on trade issues
« tracks changes in member trade policies.
What factors affect the influence of the WTO?
The WTO had a tough decade following the Great Recession of 2008-10. As the
world’s economies recovered from the deepest slump since the 1930s Great
Depression, global trade struggled to resume the pace of expansion that occurred
in the 1990s and early 2000s. In their efforts to restore output and employment to
pre-recession levels, many governments embraced import substitution and export
promotion policies that required the erection of trade barriers, undermining much
of the progress the WTO had made pre-recession towards increased economic
integration and reduced protectionism among its member countries.

Then came 2016. The election of Donald Trump as the 45th president of the USA
immediately called into question the future of the WTO. A key message of the Trump
campaign had been ‘America First’, and during his campaign rallies one of his go-to
messages was that China was partly responsible for America’s sluggish recovery and
loss of jobs in manufacturing over the previous decade. Trump proudly called himself
a‘tariff man’ and promised new taxes on foreign imports once he took office.

As the world’s largest economy by gross domestic product (GDP), the largest
importing nation and the second largest exporter (after China), America’s embrace
491
 Economic integration

of protectionism under president Trump put a halt to decades of increased global

economic integration. In response to new tariffs on steel and other metals, lumber,
agricultural commodities, automobile parts, and thousands of other items, America’s
largest trading partners, including China, Mexico, Canada, Germany, and other EU
economies all began raising tariffs on goods from the USA and from other countries.
The era of WTO progress had come to an end.
‘While the Trump administration may have struck a death blow to the WTO's progress
(perhaps temporarily, as we have yet to see what will occur now Trump has left office; Joe
Biden the 46th president as already indicated he intends to unpick a lot of what Trump
undertook), the organisation had been struggling to meet its objectives for some time. One
of the factors affecting the influence of the WTO was its inability to effectively influence
non-market economies like that of China, which since its accession into the WTO in 2003
had made little progress in the liberalisation of its markets, resulting in an unequal playing
field as state-run and subsidised industries increasingly competed on a global market in
which free trade rules assume a limited role of government. The backlash among China’s
trading partners, notably the USA, to the perceived unfair trade with China, contributed to
the rise of nationalistic economic policies in the two decades following China’s accession.
Another factor limiting the effectiveness of the WTO in the 21st century was its
inability to find a balance between its legislative and its judicial functions. As a
legislative body, the WTO is expected to make rules that govern free and fair trade
between its member nations. The development of these rules is supposed to take place
through regular meetings, or ‘summits’, during which trade representatives negotiate
agreements about what freer trade might look like, establishing rules that can later
be enforced through the WTO's judicial branch. When a member country is thought
to be violating a WTO rule, another member can take the dispute to the WTO, which
will make a decision and impose penalties if a rule is determined to have been broken
(often allowing tariffs to be erected against the violator nation).
However, in the 1990s and early 2000, the legislative branch of the WTO repeatedly
failed to establish agreed upon rules for the judicial branch to enforce, leaving member
countries with outdated rules established decades earlier, which were often irrelevant
in 21st-century trade disputes surrounding issues such as intellectual property theft,
which was not covered in the earlier rounds of legislation. As a result, the judicial
branch of the WTO had no means for settling many of the disputes that arose among
member countries in the 2000s and 2010s, meaning the WTO overall became less
effective as a forum for promoting and facilitating free trade.
Agreements on intellectual property rights were not the only rules lacking; the WTO
also struggled to establish rules for trade in services, which by the 2000s was expanding
rapidly thanks to the growth in broadband internet, which increasingly allowed skilled
workers to provide services to customers around the world. Primary commodities, the
most basic of exports, also proved controversial, as member nations often favoured
domestic producers over imports for strategic and political reasons, making it difficult for
the WTO to establish rules governing the liberalisation of trade in primary commodities.
A final factor limiting the effectiveness of the WTO, and a criticism economists have
had of the organisation going back to the GATT days of the 1950s, is the unequal
bargaining power of member nations. As WTO membership has expanded to include
three-quarters of the countries in the world, the voices of the least developed, lowest
income countries have largely gone unheard. Global trade rules, it turns out, have been
492
largely written by the dominant players in global trade, often ignoring the interests LT
of the developing countries for whom free trade is supposed to bring the greatest The WTO has been the target
benefits. Without creating a level playing field on which less developed economies of much criticism since its

can feel like they are given equal bargaining power to the rich countries of the world, founding in the early 1990s,
buy-in among member nations will continue to be limited and countries of all income ranging from its disregard
for labour and human
levels will continue to favour inward oriented growth and development strategies over rights to unfair treatment of
the idealistic, open border, free market-oriented approach envisioned by the WTO. developing countries relative
to rich ones, to its impact on
environmental destruction
Is the WTO making a difference? and contributions to climate

Free trade, in theory and in practice, is among the more hotly debated international change, to its tendency
to undermine national
topics of our time. Research continues to inform this debate, with more and more data
sovereignty.
employed to establish some reliability to its conclusions. We will conclude our chapter
Perform a web search using
on economic integration with a few observations by the Indian economist Arvind the following phrase: ‘Top
Panagariya, who addressed some popular notions surrounding the role of free trade in 10 Reasons to Oppose:
an article for Foreign Policy in November 2003: the WTO? Criticism, yes
misinformation, no!' The

“Notion 1: Economies that are open to trade grow faster. Poor countries grow richer search results will provide
when more open to trade, as recent successes in India and China have helped alinkto a page on the
WTO's website where the
to demonstrate. organisation responds to ten
common criticisms levied
Notion 2: Rich countries are more protectionist than poor ones. Not true, since poor against t. Choose three of
countries tend to have higher average tariffs than rich ones. This does not these: summarise both the
address the problem of tariff escalation. criticism and the WTO's
response to it, then answer
Notion 3: Agricultural protectionism in the rich world worsens global poverty. 1f the questions that follow.
subsidies were removed, food prices would rise. These increases could hurt 1 Had you heard of the
nutrition levels in some poor countries that rely on food imports.’ WTO before reading
this chapter? If so, what
— Arvind Panagariya, ‘Think again: did you think about the
organisation's role in the
international trade’, Foreign Policy, 1 November 2003 world before reading this
chapter and investigating
According to Panagariya, trade plays an important role in the continued growth criticisms against it?
and development of the world’s economies, but our notions about that role must What do you think about
~

continually be challenged and refined. In the chapters that come we will further the WTO now that you
explore the role of international trade, including the mechanics of how it actually takes have done investigation?
place, and later, the impact it can have on economic growth and development. On the whole, are you in
w

support of or opposed
to the WTO' aims and
functions? Justify your
Practice exam questions
answer.

Paper 1, part (a) questions

1. Distinguish between a customs union and a
common market, and monetary union. (10 marks) Is it ethically sound for
economically developed
2. Outline the advantages and disadvantages of a smaller, countries to demand that
less developed economy joining a monetary union less developed countries
with larger, more developed economies. (10 marks) remove their trade barriers
in the interests of free trade
Paper 2 questions when they continue to
1. The United States, Mexico, and Canada entered into the North American Free provide income support
to their farmers? Can one
Trade Agreement in 1994. Study the following charts and answer the questions country know what s right
that follow. for anotherto do?
493
 Economic integration

100
90

% of Mexican imports to the

80

US entering tariff free

70
Figure1 The share of US 60
goods imported from Mexico
50
40
30
20
10
0
1989 1991 1993 1995 1997 1999 2001

4
.2
53
£
o2
BE w
Figure2 Average US tariff
on taxable goods imported g2
£g?
from Mexico
SE
°
»E

<2
0
1989 1991 1993 1995 1997 1999 2001

Figure3 US trade balance

with Mexico before and after
NAFTA

e "TNSR
1970 1974 1978 1982 1986 1990 1994 1998 2002

a. Define ‘free trade agreement’. (2 marks)

b. Whatis the difference between a free trade
agreement like NAFTA and a preferential trade agreement? (4 marks)
. Referencing the data in Figures 1 and 2, use a diagram
o

representing the market for Mexican goods in the USA to

illustrate the effect of NAFTA on American consumers,
producers, and the US government. (4 marks)
Referencing the data in Figure 3, summarise the
e

impact NAFTA had on America’s net exports with

Mexico in the years following its signing. (4 marks)
. Evaluate the view that increased economic integration
o

will always lead to an increase in efficiency. (15 marks)

Paper 1, part (a) question
1. Distinguish between trade creation and trade diversion. (10 marks)

494
 Exchange rates

In Chapters 22-24 you have been introduced to the theories of international trade and
protectionism and you have learned about the different stages of economic integration
that countries might pursue as they open their economies to trade with the rest of the
world. In Chapters 25 and 26 we are going to get into the details of how trade actually
works, starting with the role of foreign exchange markets in determining the values of
currencies relative to one another.

The reality is that, despite the trend towards increased international cooperation
and economic integration, there are still roughly 180 different currencies being used
around the world today. Whenever a consumer or producer in a country with its own
currency wishes to buy or sell something from another country, or an investor wishes
to purchase capital, real estate, or financial assets from abroad, an exchange of foreign
currency must take place.
This chapter will explore the role of exchange rates in international trade, the causes
and consequences of changes in a currency’s exchange rate, and the different systems
countries employ to manage their currencies’ values on foreign exchange markets.

25.1 What are exchange rates?

Learning outcomes
At the end of this section you will be able to:
Research and inquiry
* explain that the value of an exchange rate in a floating system is determined by
Many websites provide the demand for, and supply of, a currency
information on current
exchange rates, including « distinguish between a depreciation of the currency and an appreciation of the
XE.com. Using this or a currency
similar site, answer the * draw a diagram to show determination of exchange rates in a floating exchange
questions that follow. rate system
1 Determine the current * calculate the value of one currency in terms of another currency
exchange rates for the * calculate, using exchange rates, the price of a good in different currencies.
following currencies:
a. the US dollar (USD) in
terms of Indian rupee
(INR) How are exchange rates determined?
the euro (EUR) in terms Imagine you have just landed in New Delhi. You have big plans to see the sights, visit
o

of Japanese yen (JPY) museums, try new foods, and generally make the most of your time in India. As your
the British pound (GBP) plane begins to land, you wonder how much money you will need. As you enter the
o

in terms of Chinese
yuan (CNY)
terminal, you observe that the banks are charging different rates from those back
Using the value you home. Are the banks making big profits at your expense, or did something happen to
~

found in part (d) above, change the value of the currency while you were travelling?
determine how much
ahotel room that costs An exchange rate shows the price of one currency in terms of the amount of another.
¥2,000 (¥ is the symbol For example, if the £1 is valued at ¥100 (% is the symbol for the rupee, the currency
for the Chinese yuan, the of India), then the exchange rate between the pound and the rupee is £1 = 2100. This
currency of China) per
night would cost a British valuation can also be expressed in reverse, as the number of pounds needed to buy 1.
businessman arriving in To determine this number, take the reciprocal of the original ratio. In this example,
Beijing for a meeting in %100 would be needed to buy £1.
terms of British pounds

496
 « Tourists at Humayuns Tomb,
Delhi, India

What is the foreign exchange market?

Currency as a market commodity is relatively new. At the close of the Second World
‘War, in an attempt to organise the post-war global financial system, the Allied nations
created a fixed rate system of foreign exchange. In this system, the value of each
currency was pegged in relation to other currencies, and that rate was backed up by
the country’s gold reserves. Since the 1970s, countries have increasingly freed their
currency exchange rates to float with supply and demand.

The foreign exchange market, also known as the forex market, is said to be the
closest to a perfectly competitive market that there is. Information about prices is
immediately discoverable through apps and websites like XE.com, the ‘products’
(which are really just currencies) are perfectly homogeneous, and there are millions
upon millions of buyers and sellers in the market at all times (since anyone can
exchange a currency for another one online, at an airport, or at a money changer
anywhere in the world).
Additionally, forex markets span the globe and operate 24 hours a day. As is
characteristic of perfect competition, profit margins for sellers tend to be low, due to the
single price and the ease with which buyers (people trading their currency) can access
the market. Countless mobile apps are available that allow individuals and businesses to
convert their dollars or lira or pesos to yen or rand or pounds right on their smartphone.

Because of its size and broad access to it across every economy in the world, the global
forex market is gigantic, accounting for over $6.6 trillion in transactions every day. The
market’s size is a testament to the role that international trade plays in the global economy
today. While in macroeconomics we examined the output of individual nations, made up
mostly of the interactions between domestic buyers and sellers, international transactions
contribute no small part to the amount of economic activity in the world every day.
Forex markets cater to a variety of stakeholders, from the smallest retail currency
trader and the backpacking tourist looking for a cheap hostel during their travels to
central banks and multinational investment firms, which may exchange billions of
dollars’ worth of foreign currency in a single transaction as they build their portfolios
of foreign assets. Figure 25.1 presents some of the stakeholders who engage in forex
transactions.
497
 Exchange rates

Speculation/
hedge funds

Remittance
Central banks
Figure25.1 Stzkeholdersin companies
the forex market

Investment
Retail/
banks and individual
other banks

Anindividual buying currency on the streets of Delhi is probably buying at the

retail level, from a small trader who buys from a forex broker. These brokers, at the
highest levels, buy and sell currency to nearly all the other actors on the market. The
brokers normally make profits from charging an explicit service fee of some fixed or
percentage amount. They can also create spread (a gap) between the buying and selling
prices, from which they take their profit.

Video suggestion: Central banks buy and sell currency to influence the exchange rate, but sometimes have
You have read about it, now less power over the rate than the brokers themselves. Remittance companies exchange
You can review what you money for foreign workers who are sending money back home, and therefore need it
have just learned by watching to be converted to their home currency. Investment banks and hedge funds account
avideo by the author!
Simply click here in for a very large share of forex trading, and often do so with pure speculation in mind.
your eBook for an In other words, they buy currency with the specific intent of trading it later at a higher
introductory video on value. At its most dynamic, the forex market is highly speculative and subject to wide
exchange rates and forex
swings in values, as well as to panic selling and runs on a currency when the value of
markets.
one currency suddenly drops.

What is a ‘floating’ exchange rate?

A floating exchange rate is one where the value of a currency is determined by the
free market fluctuations in the demand for and supply of that currency on the foreign
exchange market. A currency floats freely when the country’s government and central
bank refrain from intervening in its overseas markets.
Figure 25.2 shows the market for the most heavily traded currency, the US dollar, in
terms of the second most heavily traded currency, the euro, using the market exchange
rate as of October 2020.

The price axis in a forex market diagram shows the price of one currency in terms of
the other. The market in Figure 25.2 is that for US dollars in Europe, therefore the price
represents how much $1 costs in terms of euros: in this case, €0.85. The price of a euro
in the USA can be determined by calculating the reciprocal, or the inverse, of the dollar
price in Europe.
498
 Price of USD in EUR (euro/dollar)

< Figure25.2 The market for

US dollars in Europe

One US dollar costs a European €0.85 while €1 costs an American $1.18.

Just as with the demand for any commodity, currency demand is downward sloping
and supply is upward sloping. Europeans who demand dollars will want more of them
as the exchange rate decreases, since American goods and investments will be more
attractive when dollars can be gotten more cheaply. On the other hand, as the dollar
price increases in terms of euros, Europeans will demand less dollars while Americans
will supply more. A stronger dollar makes European goods and investments more
affordable to Americans, who will therefore supply a greater quantity as the exchange
rate rises.

Equilibrium in the forex market occurs where the quantity supplied and demanded
are equal. Any exchange rate higher or lower than the equilibrium rate will create
shortages or surpluses in the forex market. Assume, for example, that the European
Central Bank were to announce that the exchange rate of the dollar was fixed at €1,
rather than the equilibrium of €0.85 per dollar. Figure 25.3 shows what happens when
arate higher than equilibrium is established in the market.
At an exchange rate higher than €0.85 per dollar, Americans will supply more dollars
to Europe than Europeans demand. Americans find that when $1 dollar can buy
€1 worth of goods or assets, instead of just €0.85, European goods and investments
become much more attractive, leading Americans to supply more dollars to the
European market. From the European perspective, however, the stronger dollar
has made American imports and investments less attractive, so fewer dollars are
demanded.

As in any market, when a disequilibrium exists market forces will drive the price back
to equilibrium. In this case, an exchange rate of €1 per dollar is too high, resulting in
excess dollars flooding onto the forex market. The exchange rate should fall until it
occurs where demand equals supply.
499
 Exchange rates

Price of USD in EUR (euro/dollar)

1.00

Figure25.3 Disequibrium 085

in the foreign exchange
market would occur if
an exchange rate were fixed
(ie.a fixed exchange rate)

Surplus

An exchange rate set below equilibrium will create a shortage of a currency, as

domestic stakeholders will wish to buy more foreign goods and invest in more foreign
assets than foreigners are willing to allow at the lower exchange rate. Market forces will
drive the exchange rate up until equilibrium is restored where supply equals demand.

Appreciation and depreciation

When floating exchange rates change, the increase in the value of one currency against
another is called appreciation. It follows that the relative decrease in value of the other
currency is called depreciation. Using our dollars and euros example, let us assume
European demand for US dollars decreases. Figure 25.4 shows the effect of a decrease
indemandtoD,.
Price of USD in EUR (euro/dollar)

Figure25.4 A decreasein o 085

demand causes depreciation
of the dollar
0.75

500
 At the new euros-for-dollars exchange rate, it takes €0.75 to buy $1, rather cheaper
than before. The price of dollars, in euro terms, has decreased, and we can say that the
dollar has depreciated against the euro. From the perspective of Americans, the weaker
dollar corresponds with a more expensive euro. The price of a euro can be calculated
by determining the reciprocal of the dollar price.

$1=€0.75

1
€l=—=4133
075

Adollar costs Europeans €0.75 and a euro costs Americans $1.33. The depreciation of
the dollar corresponds with an appreciation of the euro.

A currency depreciation can occur as the result of a decrease in demand, as in

Figure 25.4, or as the result of an increase in supply. For example, if Americans were
to begin supplying more dollars to the European forex market for dollars, the supply
would increase and the dollar would depreciate.

Appreciation has the opposite causes, naturally. An increase in demand for dollars or
adecrease in supply of dollars in the European forex market would cause the dollar to
appreciate. Figure 25.5 shows the result ofa decrease in supply of dollars.

Dollars are scarcer in Europe following a decrease in supply (which could result from
anything that led Americans to do less business in Europe, such as reduced demand
for European exports or reduced investment in Europe by American investors). At the
new exchange rate euros and dollars have achieved parity, ora 1 to 1 exchange rate. The
dollar has appreciated, or gotten stronger against the euro, and euros have depreciated
against the dollar.
Of course, a decrease in supply is not the only change that can cause appreciation; if
demand for dollars by Europeans had increased, dollars would have become scarcer
and appreciated on the forex market. In the next section we will examine all the
Price of USD in EUR (euro/dollar)

<« Figure255 Adecreasein

supply causes appreciation of
the dollar

501
 Exchange rates

Table 25.1 The dollar exchange rate and the price of a $1,000 product in
Let’s plan a vacation! different currencies
Who doesn' love a great 1USD Euro British Indian Australian
beach vacation? For this
activity, you are going to pound rupee $
price out a beach vacation to 1US$ = 0.85 0.77 73 1.45
the Maldives, a lovely island
nation in the Indian Ocean. Price of 1,000 X 0.85 1,000 X 0.77 1,000 X 73 | 1,000 X 1.45
To do so, use a travel website a$1,000 = €850 =£770 =373,000 | =AUS$1450
like Kayak com or Expedia.com
(one where you can book American
both flights and a hotel). product in
Determine how much a plane each currency
ticket would cost from the
closest major city to where
you live to Malé, the capital
of the Maldives, leaving factors that can cause a change in a currency’s demand or supply and therefore an
one week from today and appreciation or a depreciation in a floating exchange rate system.
returning two weeks from
today. Depending on which Notall currencies are allowed to ‘float freely’ on the forex market. Later in this chapter
currency your travel website we will look at two alternative exchange rate systems: fixed (or ‘pegged’) exchange rates
displays prices in, convert the and managed floats, both cases in which a government or central bank intervenes
price of your plane ticket to
either USD or, if it is already in the forex market to control the currency’s value against one or more foreign
expressed in dollars, to your currencies.
home country's currency,
using XE.com to find the
latest exchange rate. How do you calculate prices in different currencies?
Finally, calculate the price of With knowledge of exchange rates, we can calculate how much a good produced
the plane ticket in terms of
Maldivian rufiyaa, again using abroad in one currency will cost a foreign consumer who is spending another
XE.com to determine the currency. Table 25.1 shows the dollar’s exchange rate in terms of four currencies in
current exchange rate. the first row and the price ofa $1000 product to a consumer from each of the four
Next, book a hotel! How much countries in the second row.
would it cost in US dollars,
your home country’s currency, To calculate the price ofa good in different currencies, we must multiply the price of
and in Maldivian rufiyaa to the good in US dollars by the exchange rate of the dollar in each country.
stay seven nights at a high end
resort in the Maldives? Even if we do not know the value of one currency against another, but we know the
For discussion and debate: value of both against a common third currency, we can determine prices. For example,
Which of the currencies while our table does not show the euro/pound exchange rate, we do know the
you found prices for is the eurofdollar and the pound/dollar rates.
‘strongest? Which is the
‘weakest?
Whatwould most likely
~

happen tothe US dollar Worked example 2

price ofa weeks hotel stay in
the Maldives ifthe Maldivian For example, using the information in the table, we can calculate how much a £150
rufiyaa were to depreciate? theatre ticket in London would cost a German tourist in terms of euros.
Explain your answer.
What would happen to First we can convert the £150 to US dollars by taking the reciprocal of the dollar
w

the demand by foreigners exchange rate and multiplying it by 150.

for beach vacations in the
Maldives if the Maldivian $1 = £0.77, therefore:
rufiyaa were to appreciate?
1
£150 X — = $194.80
0.77

502
 Next we can determine how many euros the $194.80 costs our German tourist.
$1 = €0.85, therefore:

$194.80 X 0.85 = €165.58

A £150 theatre ticket would cost a German tourist the equivalent of €165.58.

25.2 What are the determinants of

exchange rates?

Learning col 3

At the end of this section you will be able to:

« analyse the factors that lead to changes in currency demand and supply,
including foreign demand for a country’s exports, domestic demand for
imports, foreign investment, remittances, speculation, relative inflation rates,
relative interest rates, relative growth rates, and central bank intervention
« calculate changes in the value of a currency from a set of data.

‘When you go to the grocery store or to the movie theatre, you expect to see roughly Video suggestion:
the same prices you saw the last time you were there. Sure, once in a while the price of You have read about it, now
adozen eggs or a ticket to a matinee will be adjusted upwards or downwards, but it is you can review what you
not like these prices change every hour or even every minute. Currencies with floating have just learned by watching
exchange rates, on the other hand, are constantly fluctuating in price throughout every avideo by the author!
Simply lick here in
minute of the day, as investors and retail traders buy and sell currencies to facilitate your eBook for a video
their cross-border transactions. on calculating prices in
different currencies using
A currency’s exchange rate changes whenever one of the determinants of supply or exchange rates
demand changes. Given the dynamic nature of international trade and investment,
currency demand and supply are always changing, therefore floating exchange rates
will rise and fall (usually within a fairly narrow range) repeatedly throughout any
given day. Figure 25.6 shows the dollar exchange rate in the UK on a single day,
2 October 2020.

0.7780 A
)’/\Nf\‘\

0.7765
(e
N\ Figure 25.6 Floating
exchange rates fluctuate
A

0.7750 throughout the day; this data

W Wi
shows the dollar exchange
0.7735 M " rate in the UK on the
2 October 2020
0.7720
20ct 6:00 12:00 18:00

503
 Exchange rates

Notice that between midnight and 6 a.m. the dollar was steadily appreciating, from
£0.775 to £0.778. When the UK forex markets opened in the morning, however,
the dollar took a sharp plunge, from more than £0.778 at 4 a.m. to £0.772 by 8 a.m.
Throughout the rest of the day the dollar continued to fluctuate, but at a weaker level
than it started the morning at.

Case study t happened on 2 October 20207

In case you are wondering what happened that may have caused the steep drop in
the dollar exchange rate in the UK on 2 October 2020, it might help to know that
that was the day that then US President Donald J. Trump announced that he had
tested positive for the coronavirus and was therefore sick with COVID-19.
Without reading further in this chapter and learning what the determinants of
exchange rates are, do you have any hypotheses about why the news of President
Trump’s illness might have caused the dollar exchange rate to fall on the forex
market? Who demands dollars, and why might demand have suddenly dropped on
the morning of 2 October 20207

So, what might explain the constantly changing values demonstrated by floating
currencies like the US dollar? There are several determinants of exchange rates, each of
which will be explained below.

Demand for exports and imports

The relative demand for imports and exports can directly influence the purchase of
currencies, and so alter the exchange rate. When demand for a country’s exports
increases, it increases demand for the currency itself. To buy the exports, importers
first need to buy the exporting country’s currency to pay for them. To import
Canadian maple syrup, for example, the importer first needs to buy Canadian dollars.

Thus, demand for a country’s currency is partially derived from the relative demand
for its exports compared to that of the trading country. For example, an increase in
European demand for Thai goods should increase the demand for the Thai baht and
cause an appreciation of the baht in euro terms. Correspondingly, it would result in a
depreciation of the euro versus the Thai baht.

Furthermore, the interaction of imports and exports with the exchange rate can be
self-correcting. As the Thai baht climbs, the price of Thai goods in euro terms rises
and makes them less attractive. European consumers, if sensitive to the price change
caused by the new exchange rate, may reduce overall Thai imports and their demand
for baht will decrease again. Thus, extreme levels of appreciation and depreciation can
be balanced out by the export price and demand changes that are the result. This can
have implications for the balance of payments and specifically the current account
(which will be introduced in Chapter 26).

Foreign investment
Foreign investors may find it necessary to buy a foreign currency to make particular
kinds of investments in that country. To make any kind of significant foreign direct
investment (FDI) by opening a branch location, starting a new firm, or creating a
504
 joint venture in another country, that country’s currency is required to buy capital
equipment, rent space, pay salaries, and purchase materials. Increases in FDI appreciate
a currency, and the loss of FDI depreciates it.

Financial investments such as the buying of foreign company shares, or interest-

earning deposits in a foreign bank, are also likely to require the purchase of foreign
currency. In other words, greater demand for a country’s financial investments
appreciates the currency. The same applies to cross-border real estate purchases; if a
national of one country buys property in another country, demand for the country’s
currency where the investment takes place increases, causing it to appreciate, while
supply of the buyer’s currency increases, leading it to depreciate.

Remittances
‘When a worker from one country earns income in a foreign country, inevitably a
portion of the foreign income will be ‘remitted’ to the worker’s home country. Foreign
remittances refer to money earned by a foreign worker that is sent to family or to other
individuals in their home country. Consider the example of a British banker working in
Hong Kong. The banker, a British citizen, saves for retirement in British accounts and
also owns a house in the UK, for which a monthly mortgage payment must be made.
Therefore, the banker transfers a significant share of his weekly earnings back to the
UK. The act of remitting income home increases the demand for British pounds on
the forex market in Hong Kong, and increases the supply of Hong Kong dollars on the
forex market in the UK. The more remittances flow from Hong Kong to the UK, the
more the British pound will appreciate and the Hong Kong dollar will depreciate.

Speculation
Foreign exchange market investors regularly speculate on currencies’ future values.
As with the buying and selling of shares, speculators may buy a currency hoping it will
appreciate, sell it when they believe it has reached peak value, and take the resulting
profits. The exact portion of forex trading devoted to speculation is unknown, but it is
believed to make up the majority of the daily transactions in the $5 trillion market.
The actions of speculators can cause large swings in exchange rates, particularly during
periods of macroeconomic uncertainty. During the summer of 2011, for example,
demand for the Swiss franc in European forex markets skyrocketed as uncertainty over
the ability of certain European nations to remain solvent in the face of huge national
debts and contracted economic output during the Great Recession led investors to
dump their euro-denominated assets (such as government bonds) and invest in ‘safe’
Swiss assets, namely the Swiss franc itself, which along with gold was considered one
of the safest investments in 2011. Figure 25.7 shows the effect of the ‘run’ on the Swiss
franc in the summer of 2011.
For months the franc had hovered around 0.80 euros per franc, then in mid-July 2011
international investors began to buy the franc due to uncertainty over the value of the
euro. As demand for the franc increased, the franc appreciated, making it an even more
attractive asset for investors to buy. Very rapidly the franc appreciated from 0.80 euros
100.97 euros, a 21% increase in value injust a month.

For Switzerland, an economy for which trade with its European neighbours provides
the life blood, the sudden and unexpected appreciation of its currency posed a dire
505
 Exchange rates

6 September:|Swiss central bank

1.00 announces intervention to devalue
the franc

i
0.95
Figure25.7 Swiss franc
exchange ratein euros from 090
July to September 2011 v
085 N\ \fi-\, /‘
v’
0.80 ~ N
Julm Sep

threat to macroeconomic stability, as demand for Swiss exports would undoubtedly

begin to fall as a result of the franc’s appreciation and Swiss products become more
expensive to consumers in other countries. Fortunately, the peak of 0.97 euros per
frank was short lived, but by early September a second run on the franc appeared to be
underway as its value began climbing once again.
On 6 September, Switzerland’s central bank announced it would begin intervening
in the forex markets to devalue the franc, capping its value at 0.83 euros per franc.
The effect of this announcement can be clearly seen in Figure 25.7 as the franc’s second
climb is instantly interrupted and its value plummets to 0.83 euro overnight on
7 September. The effect of a central bank’s forex market interventions to either devalue
(as the Swiss national bank did) or revalue a currency will be explored later in
this chapter.

Defenders of currency speculation have pointed out that speculators provide a

service because they have an interest in rationally assessing a currency’s true value.
Speculators, they argue, merely accelerate a process that would otherwise take much
longer. With this in mind, it is important to remember that speculators not only make
their bets on a variety of purely economic factors such as the balance of payments
situation and relative budget deficits, but also on political events and other less
tangible factors.

Relative inflation rates

As the average price level in one country rises faster than it does in the economies of its
trading partners, the higher inflation country’s exports become more expensive and,
therefore, less desirable to foreign consumers. At the same time, imports from other
countries where inflation is lower will be cheaper than before and more attractive.

If Paraguay’s prices were to soar relative to its neighbour Argentina, the demand
for Paraguayan exports in Argentina and the corresponding demand for Paraguay’s
currency would decrease, causing it to depreciate. At the same time, Paraguay’s
consumers would demand more imports from Argentina, causing the Argentinian
peso to appreciate.
All else equal, an increase in domestic inflation will cause a country’s currency to
depreciate (as net exports decrease), while disinflation or deflation will cause the
currency to appreciate (as net exports increase).

506
Relative interest rates
A change in a country’s interest rate can attract or repel foreign financial investors.
Should the interest rates offered in one country increase, overseas investors would be
attracted to the higher relative interest rate and buy the local currency to deposit in the
bank or invest in bonds, an outcome referred to as a capital inflow.

The reverse is also true: a decrease in relative interest rates in one country will cause
some international investors to withdraw money from that country’s banks and other
interest-bearing assets and search for a better rate of return in other economies, an
outcome referred to as a capital outflow.
Capital inflows cause a country’s currency to appreciate, while outflows cause
adepreciation. If the Bank of Turkey were to raise interest rates relative to other
countries, foreign investors would buy Turkish lira and put it into Turkish banks or
invest it in Turkish bonds, causing a capital inflow that would raise the exchange rate of
the Turkish against other currencies.

Relative growth rates

It may sound counterintuitive, but assuming, all else is held constant, an increase in
a country’s gross domestic product (GDP) growth rate should cause its currency to
depreciate. The logic is straightforward enough: higher GDP means higher incomes, and
as houschold incomes rise, consumption increases, not just of domestic goods and
services, but also of imports. Higher demand for imports increases the supply of the
domestic currency on forex markets, causing it to depreciate, and increases demand
for foreign currencies, causing them to appreciate.

As an example, consider the effect of a booming economy in Canada while the

economic growth rate in the USA remains constant. Canada’s largest source of
imports is the USA, so as Canadian incomes rise, demand for US exports will increase,
causing demand for the US dollar to increase and its value to rise. To buy all those new
American imports, Canadians must supply more of their own currency to the forex
market, causing the Canadian dollar to depreciate.

Central bank intervention

Last, but most definitely not least in our list of factors that determine the exchange
rate is central bank intervention. We learned in Chapter 19, Demand management:
monetary policy, that one of the roles of a central bank is to manage the value of its
currency to promote domestic macroeconomic and international trade objectives.
A central bank can intervene in the forex market in two ways.

1 Raising or lowering domestic interest rates to attract capital inflows or promote

capital outflows.
2 Directly intervening in the forex market by buying or selling its own currency,
cither adding to or drawing down its official reserves of foreign currency, in order
to devalue or revalue its currency.
‘When a central bank intervenes in the forex market to strengthen its currency, it is
known as a revaluation (distinct from an appreciation, which results from free market
forces). A forced depreciation by the central bank is known as a devaluation of the
507
 Exchange rates

exchange rate. Later in this chapter we will explore the means by which and reasons
behind why a central bank might revalue or devalue its currency.

How do you calculate the change in exchange rates

from a set of data?
Given a set of data, we can calculate the change in a currency’s exchange rate between
two periods of time.

Video suggestion: Worked example 25.2

You have read about it, now
Yyou can review what you Below we are given hypothetical exchange rates of a Mexican peso in terms of
have just learned by watching US dollars over three years:
avideo by the author!
Simply click here in + January 2020: Mex$1 = US$0.03
your eBook for a video * January 2021: Mex$1 = US$0.04
on determinants of exchange
rates in a floating exchange January 2022: Mex$1 = US$0.05
rate system.
Using these values, we can calculate the changes in the value of the US dollar in
terms of pesos for the three years. To do so, we take the reciprocal of the peso
exchange rate for each period:
+ January 2020: US$1 = 1 + 0.03 = Mex$33.33
* January 2021: US$1 = 1 + 0.04 = Mex$25
* January 2022: US$1 = 1 + 0.05 = Mex$20
The data reveals that over the two years from January 2020 to January 2022 the
peso appreciated against the dollar, increasing in value by 66.6% (US$0.05 per peso
is 66.6% stronger than US$0.03 per peso). The peso’s appreciation corresponded
with a 40% depreciation of the US dollar (the 2022 exchange rate of Mex$20 per
dollar is 40% below the 2020 exchange rate of Mex$33.33 per dollar).

25.3 What are some consequences of

a change in the exchange rate?

Learning outcome
At the end of this section you will be able to:
* evaluate the possible economic consequences of a change in the value of a
currency, including the effects on a country’s inflation rate, economic growth,
employment, the current account balance, and the effect on living standards.

Effect on inflation
When a currency appreciates on forex markets the price of imports goes down.
Consumer goods, capital goods, imported energy, and raw materials all become
cheaper, causing an increase in short-run aggregate supply (SRAS) and disinflation.
508
At the same time, a stronger currency will cause foreign demand for the country’s
exports to fall, reducing the level of aggregate demand (AD) at home and further
bringing inflation down.
A depreciated currency has the opposite effects. Allimports become more costly
to domestic consumers, while exports become cheaper to foreigners. SRAS could
decrease as imported energy, raw materials, and capital goods become more
expensive, and AD is likely to increase as net exports rise. Depreciation therefore
leads to higher inflation, while appreciation leads to lower inflation or perhaps even
deflation.

Effect on economic growth

Once again we encounter a situation that may seem counterintuitive at first: a weaker
currency is good for economic growth, and a stronger currency is bad for economic growth.
There are some exceptions to this idea, but let us first review why this is usually the
case. Depreciation will increase AD in a country as net exports increase. In the short
run, more demand means more jobs, more income, and a higher level of output. The
result is an increase in real GDP.

However, in the long run a weaker currency alone will not drive economic growth,
since it stimulates demand while simultaneously limiting the potential increase in
aggregate supply (AS). Most countries depend at least to some extent on imported
capital, energy, and raw materials to drive economic activity; a weaker currency
therefore makes inputs more expensive and could slow increases in SRAS. In other
words, while a weaker currency could fuel short-run economic growth, it could also
limit long-run growth and lead only to inflation as potential output is limited by
constraints on inputs.

A currency appreciation has similarly conflicting outcomes in the short run and in the
long run. From the perspective of producers, a currency appreciation is undesirable in
the short run, as imports become more attractive and exports less attractive. Domestic
consumers will shift some of their consumption to foreign goods, reducing AD in the
home economy. However, in the long run a stronger currency will make imported
capital and other inputs cheaper for domestic firms. Additionally, domestic firms
that are able to might shift some of their production overseas, where costs are lower
thanks to the stronger home currency. In other words, currency appreciation can help
firms in the long run, making production cheaper and increasing the country’s AS,
contributing to economic growth.

The effect of a change in the exchange rate on economic growth is therefore

dependent on whether we are looking at the short run or the long run: in the short
run depreciation increases output as AD shifts outward, but in the long run a weaker
currency only leads to inflation, while appreciation creates more opportunities for the
country’s aggregate output to increase. Generally, therefore, exchange rate stability
is a more desirable outcome for most economies than a constantly appreciating or
depreciating currency.

Effect on unemployment
You might start to notice a pattern here; as with economic growth, the effect of
changes in the exchange rate on employment and unemployment may vary depending
509
 Exchange rates

on whether we are considering the short run or the long run. Obviously, a depreciation
of the currency is beneficial for employment in the short run, as AD will increase
thanks to higher net exports, increasing demand for labour in return. However, if
the weaker currency creates inflation, then in the long run employment gains will be
limited due to rising wages and the constraints imposed by scarcity in the economy.
Since a stronger currency is more likely to increase AS, there may be benefits to
employment from a supply-side perspective; however, appreciation also causes net
exports to fall, leading to less aggregate demand and therefore less demand for labour.
In the short run, currency depreciation will reduce unemployment, while in the long
run, exchange rate stability is most likely to result in stable levels of employment
consistent with the economy’s full employment level of output.

Effect on the current account balance

In Chapter 26, Balance of payments, we will explore in great detail the components of
acountry’s current account, but for now you need to know this: the current account balance
is where a country measures the flow of money between the home country and all
other countries for the purchase of exports and imports. When a country’s currency
depreciates on the forex markets, its exports will increase and its imports will decrease,
and money will flow into its current account. We refer to this as a move towards surplus
in the current account.

An appreciation of the currency, on the other hand, will lead to an increase in imports
and a decrease in exports, causing money to flow out of the current account. When net
exports decrease, we call it a move towards deficit in the current account.

Depreciation moves a country’s current account towards surplus, and appreciation

moves the current account towards deficit.

Effect on living standards

Finally, let us think about how the living standards in a country are affected by changes
in the exchange rate. You may say that a stronger currency is likely to increase living
standards, and you would not be incorrect in assuming so: When your currency
appreciates you will find imported goods to be cheaper, allowing you to afford more
output on the same income, thereby increasing your standard of living. Additionally,
if you are the kind of person who enjoys international travel, an appreciation of your
currency will make such adventures cheaper and allow you to enjoy more comfort and
luxury while abroad than before your currency strengthened.
On the other hand, a stronger currency also threatens domestic households through
the negative effects on domestic employment in the short run. If you are a worker in
an export-oriented industry, an appreciation of your currency might cost you your
job as foreign demand decreases due to higher prices. In this case, a depreciation
might mean more demand for workers in your industry and therefore higher wages
as export-oriented firms scramble to hire workers. While a weaker currency might
mean more employment in the short run, which will increase living standards for
those who get jobs, a depreciation could also be inflationary, reducing real incomes of
everyone in the economy as imported goods, capital, and raw materials become more
expensive.
510
Unfortunately, the consequences of a change in the exchange rate, like so much else The power of
in economics, are not clear-cut. There are advantages and disadvantages to both a language
currency appreciation and a depreciation. Whether an economy is better off or worse Strong s good, weak is
off following a change in its exchange rate depends on whether we are looking at the bad. Appreciation is good,
short run or the long run, producers or consumers, or the level of unemployment or depreciation is bad. Surplus
is good, deficit is bad. In
inflation. We can predict likely outcomes, but ranking their desirability by assigning a each of these statements a
value to any particular outcome is an exercise in normative economics. value is placed to a word.
Itwould be a rare occasion
in which a political leader
would argue for the
25.4 What are fixed exchange rates? ‘weakening' of the home
country's currency, or
to claim that a deficit’
Learning outcomes could be desirable, or that
‘depreciation’ is better
At the end of this section you will be able to: than ‘appreciatior’. As an
example, in May 2020
* describe a fixed exchange rate system involving commitment to a single fixed rate then US President Donald
« distinguish between a devaluation of a currency and a revaluation of a currency Trump told reporters that
* explain, using a diagram, how a fixed exchange rate is maintained. ‘Itis a great time to have
astrong dollar and that
‘strong dollars are overall
very good.
In a fixed exchange rate system, the value of a currency is locked in (pegged) to the How does language
value of another currency. The central bank determines a desirable value and enacts influence our interpretation
intervention to maintain the established rate. Forex market intervention can take the of economic concepts?
form of the central bank buying and selling currency reserves, or raising or lowering Why might leaders favour
interest rates to encourage capital inflows or outflows. The latter form is the more a'strong’currency overa
‘weak’currency? What are
benign means of manipulating the market. the economic effects ofa
strong currency compared
to 2 weak currency?
What does it mean to ‘devalue’ or ‘revalue’ Is it necessarily true that
a currency? ‘stronger’ i ‘better’ when it
comes to exchange rates?
Let us imagine that Argentina’s central bank decided that its currency (the peso (§ is the
symbol for the Argentine peso, the currency of Argentina)) is overvalued at the rate of
$77 required to buy a single US dollar. The exchange rate of the peso is the reciprocal
of the dollar exchange rate, or l, which equals US$0.013 per peso. The central bank
77
decides to devalue the peso, or make it weaker against the dollar. A devaluation requires
reducing the peso exchange rate, so that a single US dollar could buy more than $77.
Assume the central bank wishes to devalue the peso to a level where US$1 could buy
$100.
Devaluing the peso would increase the dollar exchange rate and decrease the peso
exchange rate. If it achieved its goal, $100 would be required to buy a dollar, but only
US$0.01 dollars would be required to buy a peso. In other words, the peso exchange
rate would fall from its current rate of US$0.013 to US$0.010.
In a fixed exchange rate system, Argentina’s central bank would first devalue its
currency, then actively intervene in the forex markets to maintain it at the desired level.
If market pressures caused the peso to appreciate, the central bank would intervene
to devalue it again. If market pressures pushed the value of the peso down, the central
bank would have to revalue the peso, or intervene to strengthen it against the dollar.

511
 Exchange rates

Later in the chapter we'll examine the reasons why a central bank may wish to peg its
currency in the forex markets, and evaluate the advantages and disadvantages of a fixed
exchange rate compared to a floating exchange rate. First, however, we'll look at how
fixed exchange rates are maintained.

How are fixed exchange rates maintained?

Let us look more closely at our example from above, and examine the market for
Argentinian pesos before and after the central bank’s decision to peg it against the
dollar.
Figure 25.8 shows the market for US dollars in Argentina before the fixed exchange rate
has been enacted, with US$1 costing $77.

The central bank wishes to devalue the peso, which would mean increasing the number
of pesos a single dollar could buy on the forex market, to $100 peso per US dollar.
Figure 25.9 shows what would happen if the central bank were to simply set a price
floor on the dollar at $100.

As we can see, without intervention a $100 price floor would simply create a
disequilibrium in the dollar market in which the quantity supplied exceeded the
quantity demanded. Americans would wish to buy more Argentinian products and
Argentinians would demand less American output, but because no actions were taken
to actually achieve the higher exchange rate of the dollar, there is a surplus of dollars
on the forex market.

Because simply setting an exchange rate higher or lower than the market rate will just
create a disequilibrium in the market, a fixed exchange rate system requires the central
banks to actually intervene to establish the desired exchange rate. The two means of
forex market intervention are raising or lowering interest rates and buying or selling
currency directly on the market.
Price of USD in peso (peso/dollar)

Figure25.8 The market for

US dollars in Argentina under
a floating exchange rate

512
 Price of USD in peso (peso/dollar) uso
S3
!

Fixed rate

« Figure25.9 Without
~3
|

intervention a price floor

creates disequilibrium in the
dollar market

Surplus

Raising and lowering interest rates

Now let us examine what happens when the central bank actually intervenes in the
market for dollars to achieve the desired exchange rate of $100 per dollar (or US$0.010
per peso). By reducing domestic interest rates, Argentina’s central bank will make
dollar-denominated assets more attractive to Argentinian investors, and there will be
a capital outflow in Argentina and a capital inflow to the USA. In order to put their
money into higher-yield interest-bearing US assets (savings accounts, government
bonds, etc.), Argentina’s investors will demand more dollars. Figure 25.10 shows the
effect of an expansionary monetary policy in Argentina on the forex market for
US dollars.
Price of USD in peso (peso/dollar)
S3
.

Price floor
« Figure25.10 Lower
interest rates in Argentina
""""""""" would cause an increase in
~3
|

demand for US dollars

513
 Exchange rates

The surplus of dollars is eliminated because now there is more actual demand for
dollars thanks to the relatively higher interest rates US investments are offering
Argentinian investors. An expansionary monetary policy in Argentina has caused an
appreciation of the dollar, and a devaluation of the peso. We can look at the effect of the
central bank’s actions in the peso market as well, which we do in Figure 25.11.

Lower interest rates in Argentina have led to a capital outflow, increasing the supply
of pesos on the forex market in the US as Argentinian investors scramble to put their
money in higher-yield interest-bearing assets in the USA. The peso has been devalued
from its market exchange rate of US$0.013 to the pegged value of US$0.010.
Price of peso in USD (dollar/peso)

Figure 25.11
An expansionary monetary
policy in Argentina would
the supply of pesos
forex market in the USA

0 Qu heso

Direct intervention in the forex market

In order to maintain its pegged exchange rate, Argentina’s central bank must actively
intervene in the market for peso and the market for dollars to devalue or revalue the
peso. If free market pressures lead to the peso’s appreciation, the central bank will have
to either reduce interest rates further (keeping demand for pesos low and supply of
pesos high) or directly intervene in the market by buying US dollars and adding them
to its foreign exchange reserves. Foreign exchange reserves are held by every central
bank in the world, and serve as a means for managing their exchange rate.
Let us consider what would happen if the market exchange rate of the peso were to fall
below US$0.010, forcing the central bank to revalue the peso against the dollar in order
to maintain its fixed rate or ‘peg’.

Decreased demand for Argentinian goods in the US is causing the peso to depreciate
below the central bank’s peg. In order to maintain the peg, Argentina’s central bank
must now revalue the peso. Let us assume it does so by using some of its foreign exchange
reserves of US dollars to buy up pesos in the forex market. The result is an increase in
demand for pesos and an increase in supply of US dollars. In Figure 25.12, the D, would
increase back to D, while in the dollar market the supply would increase bringing the
dollar back down to the desired exchange rate of $100 per US dollar.
514
 Price of peso in USD (dollar/peso)

« Figure25.12 Faling
demand for peso puts
downward pressure on the
exchange rate

Foreign exchange controls

A nation’s government can also manipulate its currency’s exchange rate without
depending on central bank policymakers. Foreign exchange controls are legal limits on
how much of a country’s currency foreign investors are allowed to buy or sell in any
single transaction. Under a floating exchange rate system, governments are unlikely
to have any foreign exchange controls whatsoever, since they are comfortable leaving
the exchange rate up to the free market. However, if a government wishes to devalue
its currency, one way it could do so is setting strict limits on how much of the currency
foreign investors and forex traders are allowed to buy in a single day or for a single
transaction.

Tighter limits on foreign holdings of the domestic currency will limit demand and put
downward pressure on the exchange rate; in other words, foreign exchange controls
will devalue the currency. Loosening foreign exchange controls will revalue the
currency, that is, assuming they were effective at limiting demand in the first place.
1f the market demand for the currency was already less than the limit imposed by the
government, then loosening exchange controls will have no effect on the exchange
rate, of course.

25.5 What are managed exchange rates?

Learning outcomes
At the end of this section you will be able to:
« explain how a managed exchange rate operates, with reference to the fact that
there is a periodic government intervention to influence the value of an
exchange rate
« analyse the possible consequences of overvalued and undervalued currencies.

515
 Exchange rates

PEsO

Price of peso in USD (dollar/peso)

0011+
Figure25.13 Amanaged Ceiling
floating exchange rate Yo O,
establishes a range of
acceptable exchange rates 0.009 4

Now that we have covered the tools that policymakers can use to revalue or devalue
acurrency, we'll look at another exchange rate system that is commonly used by
countries to promote stability in international trade and investment flow: the managed
exchange rate system. A managed exchange rate is one that floats in the foreign exchange
‘market but is subject to intervention from time to time by domestic monetary
authorities, in order to resist fluctuations that they consider to be undesirable.

In our peso—dollar example above we assumed the central bank was ‘pegging’ the
peso against the dollar at US$0.01 per peso and $100 per dollar. Let us assume instead
that Argentina adopted a managed float, and rather than a fixed exchange rate, the
central bank set up a range of acceptable exchange rates between which the peso could
fluctuate. Figure 25.13 illustrates how a managed float might look in a forex market
diagram for the peso, with a maximum exchange rate of US$0.011 and a minimum
exchange rate of US$0.009 per peso.

At the current equilibrium of US$0.010 neither the ceiling price nor the floor price are
binding; therefore, the central bank needs not take any policy action to maintain the
exchange rate.

How do policymakers correct an

overvalued currency?
Assume now that there is capital inflow into Argentina, as foreign investors demand
more Argentinian assets. The inflow puts upward pressure on the peso as demand
increases, driving the equilibrium exchange rate up to US$0.012. Figure 25.14 shows
the effect of the capital inflow on the value of the peso.

Greater peso demand has pushed the equilibrium rate above the ceiling rate of
US$0.011, creating a shortage of pesos. In order to maintain the ceiling rate of
US$0.011 per peso, Argentina’s central bank must intervene in the market. It can do
s0 by either reducing interest rates, which would make investments in Argentina less
attractive and stem the capital inflow, or by using pesos to buy US dollars on the forex
516
 Price of peso in USD (dollar/peso)

0011 4
ER.=0.010 4 « Figure25.14 Acapital
‘ inflow would cause the
domestic currency to
appreciate

Shortage

market, increasing its foreign exchange reserves. A direct intervention would require
the central bank to increase the supply of pesos, which would bring the exchange rate
back below the ceiling rate. A decrease in interest rates would reduce demand from
foreign investors, also bringing it back within the target range.
Figure 25.15 shows the effect ofa decrease in interest rates in Argentina on the peso
market and the equilibrium exchange rate.
Expansionary monetary policy has made investments in peso-denominated assets less
attractive, stemming the capital inflow that caused the initial appreciation of the peso.
The exchange rate has settled at an equilibrium within the central bank’s desired range,
at USS$0.011 per peso.
Price of peso in USD (dollar/peso)

Figure25.15 If Agentina
lowers interest rates, demand
for pesos on the forex market
will go down

517
 Exchange rates

Video suggestions: How do policymakers correct an

You have read about it, now undervalued currency?
You can review what you
have just learned by watching When the market exchange rate falls below the floor price set by the central bank, an
some videos by the author! intervention is required to restore the rate to within the acceptable range. For example,
A if a capital outflow has pushed the exchange rate to US$0.008, then Argentina would
your eBook for videos
e e e have needed to either increase demand for peso or reduce its supply to keep the rate
above the floor rate of US$0.009.
The two ways it could revalue the peso include enacting a contractionary monetary
policy, which would have stemmed the capital outflow as international investors
would find peso-denominated assets more attractive, or an intervention in the
forex market where Argentina buys its own currency, increasing peso demand and
increasing dollar supply. The result would be a revaluation of the peso, bringing its
exchange rate back within the acceptable range.
Managed exchange systems offer policymakers an option that lies between the free
market float and the hard peg described by a fixed exchange rate regime. The map in
Figure 25.16 As this ma
Figure 25.16 below shows the predominant exchange rate systems of every country in
€ of exchange rate regimes- the world in 2013, according to the International Monetary Fund (IMF).
around the world in 2013 } ) .
shows, few countries fix As we can see, fixed exchange rates are quite rare, while managed and floating systems
their currencies are used by most countries.

Floating
Managed (within horizontal bands)
Fixed
Other managed arrangement
518
 25.6 4. What are the advantages and
disadvantages of fixed and floating
exchange rate systems?

Learning outcomes
At the end of this section you will be able to:
compare and contrast a fixed exchange rate system with a floating exchange rate
system
* evaluate the merits of floating versus fixed exchange rates with reference to the
degree of certainty for stakeholders, ease of adjustment, the role of international
reserves in the form of foreign currencies and flexibility offered to policymakers.

As we saw in Figure 25.16, the world is split about 50/50 between floating exchange rates
and managed or fixed exchange rates. There are advantages and disadvantages to each
type of system. The range in which an exchange rate is managed might be very narrow,
meaning the system is close to a peg, or broad, allowing for more market fluctuations.
However, in all cases, some degree of intervention is expected. Therefore, both fixed and
managed exchange rates share some characteristics when compared to the free float.

What are the arguments for floating exchange rates

(and against fixed/managed)?
Domestic policy freedom
Overall growth and inflation management is enormously difficult even under normal
conditions, without the need to factor in the management of exchange rates as
well. Allowing the exchange rate to float freely means that central bankers are free
to manipulate monetary policy, specifically interest rates, to manage domestic AD
towards the objectives of price level stability, full employment, and economic growth.
Exchange rate management as a goal might create conflicts with the other goals of
monetary policy. Therefore, saving monetary policymakers this task allows them to
focus on domestic policy objectives.

More balanced trade

A surge in demand for exports can lead to a surplus in the current account of the
balance of payments (more on this in Chapter 26). Under a floating exchange rate
system, the increased demand for the currency that accompanies an increase in
demand for exports leads to currency appreciation, which in turn should make exports
less attractive and counteract the move towards a trade surplus. In this way, a floating
exchange rate will lead to a self-adjusting trade balance, reducing surpluses and deficits
in trade between nations.
On the flip side, when exports are falling, reduced demand for the currency will cause
depreciation, which should make exports attractive again and counteract the decline in
net exports that would otherwise occur if the exchange rate were fixed.

519
 Exchange rates

Under a fixed exchange rate system, persistent trade imbalances are more likely to
occur, as a consistently undervalued currency will lead to long-run current account
surpluses while an overvalued currency will contribute to long-run current
account deficits.

No surplus currency reserves

As floating exchange rate schemes do not require the stockpiling of currency reserves
to prop up or devalue a currency, financial resources are allocated more efficiently.
Foreign exchange can then be used to more productive ends, such as purchasing
capital goods or imported resources, rather than held in reserve for the time when they
are needed to intervene in the forex market to revalue or devalue the currency.

Flexible response to external shocks

Sudden disruptions to the economy can be managed without the need to devote
resources to fixing an exchange rate. In the event of a massive debt relief package,
such as that agreed by the EU for some of its members in 2010, countries would
normally see their currency depreciate as faith and expectations for growth fall. This
depreciation would allow for greater exports, and for growth to return, helping the
debtor countries pay off their debts.

What are the arguments against floating exchange

rates (and for fixed/managed)?
Uncertainty for investors
When entering new or unfamiliar markets, foreign investors put a priority on
holding as many factors as possible stable and predictable. Exchange rates are very
important here because the foreign company may need to import materials and
capital equipment. Simultaneously, it will be paying wages and property costs in local
currency; this is also true for domestic companies with foreign sales or investment
aspirations. Navigating wide fluctuations in the exchange rate adds administrative cost
and makes both predicting costs and setting product prices very difficult.
Therefore, a developing country hoping to attract foreign investment to increase its
capital stock and to create jobs may favour a managed or fixed exchange rate to calm
the nerves of foreign firms that may be turned away due to exchange rate uncertainty.

Influence of random events prevent automatic adjustment

While floating rates permit a flexible response to economic crises, not all shocks can
be solved by exchange rate self-adjustment. Severe international political tension,
domestic social turmoil, and other random events can depress markets and limit
growth, despite any self-adjustment in exchange rates. By managing its currency,
therefore, a central bank can promote the objective that if left to the free market may
be less likely to be achieved.

Risk of imported inflation

Countries that rely heavily on foreign-sourced factors of production (energy resources,
raw materials, capital equipment, medical equipment, etc.) may find themselves with

520
a persistently low exchange rate due to the high demand for foreign currencies. When
imports consistently outpace exports, currency depreciation causes creeping inflation.
In such a situation, a revaluation of the currency might be necessary to promote
continued economic development and growth.
However, just because a country wants its currency to be stronger does not mean it is
able to make it stronger. Revaluation requires a credible central bank that can assure
foreign investors that buying its currency, even when higher interest rates are offered,
is a safe bet.
Additionally, direct intervention on the forex market requires a central bank to
have substantial reserves of foreign currency, which can only be acquired through
money earned from exports, or, in the case of countries experiencing financial
crises, from development agencies like the IMF, which extends loans to developing
countries to help them stabilise the value of their currencies on forex markets. In
other words, as much as a managed exchange rate might help poor countries achieve
their development objectives, it is poor countries with few exports that will have the
toughest time establishing a successful managed exchange rate regime due to their lack
of foreign exchange reserves.

Volatility
‘Wide swings in currency values make doing business much more difficult, especially
for those who import or export on a regular basis. With this in mind, developing
countries often seek to peg their currency to a large trading partner. In extraordinary
circumstances of great volatility, a rescue of the currency is required. Typically
administered by the IMF, these rescue plans can come with significant conditions that
may dictate the management of domestic fiscal policy.

Practice exam questions

Paper 1 que:

Part (a) ques

1. Explain three factors that might lead to a decrease in
demand for a country’s currency. (10 marks)
2. Explain three factors that might lead to a decrease
in supply of a country’s currency. (10 marks)
3. Explain two methods a central bank might use to
revalue its currency. (10 marks)
Part (b) questions
1. Using real-world examples, discuss the consequences
of the depreciation of a country’s currency. (15 marks)
2. Using real-world examples, discuss the consequences
of an appreciation of a country’s currency. (15 marks)
3. Using real-world examples, evaluate the effect of using fixed
exchange rates on a country’s economic well-being. (15 marks)

521
 Exchange rates

Paper 2 and Paper 3 questions

The chart below shows the euro exchange rate in dollars ($/€) from 2014 to 2016.
Use the chart to answer the questions that follow.

1.40 A \

130 .\M
1.20
110 \

1.00
2014 2015 2016

1. Calculate the euro per dollar exchange rate:

« at the beginning of 2014 (when €1 = $1.4) (1 mark)
« at the beginning of 2015 (when €1 = $1.05). (1 mark)
2. Using economic terminology, describe what happened to the
exchange rates of the euro against the dollar and the dollar against
the euro between 2014 and 2016. (2 marks)
3. Outline two possible causes for the change you described in
question (2). (4 marks)
4. Using a forex market diagram for the euro in the United States,
illustrate the effect of one of the causes you described in question (3).
Use values from the chart to label the equilibrium exchange rates on
your graph before and after the change. (4 marks)
5. Using information from the text/data and your knowledge of
economics, discuss the possible consequences for eurozone
economies of the change in the euro’s value between 2014
and 2016. (15 marks)

Assume that the exchange rate for British pounds and USD is 1.60 USD per GBP.
1. Calculate the value in GBP for 1 USD. (2 marks)
2. From the information given above, calculate how many
pounds would be received in exchange for 1,200 USD. (2 marks)
3. Calculate in USD the price of a Manchester United
football jersey that costs 45 GBP. (2 marks)
4. Assume that large pack of US writing pens costs 10 GBP.
A change in the exchange rate raises their price to 11 GBP.
Calculate the value of the new USD per GBP exchange rate. (2 marks)
More Paper 2 and Paper 3 questions
1. Last year, Japan could import athletic jerseys from China
costing ¥60 (yuan, China’s currency), which cost 720 JPY
(ven, Japan's currency) at current exchange rates. Now the
same ¥60 jersey costs 780 JPY. What is the current
exchange rate? (2 marks)

522
2. Distinguish between currency appreciation and
currency revaluation. (4 marks)
3. Using an appropriate diagram, illustrate the effect of an
increase in domestic interest rates on the value of the
Japanese yen on the forex market in the United States,
assuming all else is held constant. (4 marks)
Paper 1, part (b) questions
1. Discuss the consequences of a currency appreciation for
various stakeholders in an economy. (15 marks)
2. Evaluate the decision by a country’s central bank to go
from a floating exchange rate to a fixed exchange rate,
and in doing so devaluing its currency on the foreign
exchange market. (15 marks)

523
 PIhl hat is a nation’s balance of pa

Learning outcomes
At the end of this section you will be able to:
* explain the role of the balance of payments
« distinguish between debit items and credit items in the balance of payments
« distinguish between a surplus and a credit on an account.

‘When you hear the word ‘balance’ what do you imagine? A scale in an old fashioned
spice store, perhaps, with an even amount of spice on both sides, teetering over its
fulcrum, gently swaying from side to side. Add just a pinch of spice to one side, and the
scale becomes unbalanced.

As one side of a balance scale

rises the other side falls. So it
is with the components of an
economys balance of
payments

Now imagine a scale of massive proportions, one so large that it could hold all the
goods and money that flow into and out of a country as it trades with other countries.
On onesside of the scale would be the goods a country exports, the money its overseas
residents send home, money invested by foreigners in its domestic assets, and other
inflows of foreign spending or investment. On the other side would be the goods it
imports and the money that flows out of the country for investments abroad. The scale
that measures the flows of goods, services, and financial and real capital between a
country and all other countries has a name, it is called the balance of payments.
One side of the scale representing a nation’s balance of payments measures the
credit items, or money that flows into the economy because of international trade and
investment. The other side of the scale measures debit items, or money that flows out
of the economy through international trade and investments. If credits and debits are
equal in one of the accounts included in the balance of payments, then a country has
a zero balance in that account. If credits exceed debits within an account measured by
the balance of payments, then the country has a surplus in that account. And, finally, if
debits exceed credits in any account, then a deficit exists.
528
 Balance of payments

Asscale is used by spice traders to assure that an accurate measurement of how much
spice is being sold can be determined in order to assure that the customer pays the
correct amount. If a scale were imbalanced in the favour of the seller, then she would
earn more money than the value of the spices being sold. If imbalanced in favour of
the buyer, then the trader would receive an amount of money lower than the value of
the spices sold. Likewise, whole economies can experience imbalances in the accounts
included in their balance of payments, in which more money flows into or out of a
country through either trade in goods and services, income transfers, capital transfers,
or international investment. Surpluses and deficits in the different accounts of balance
of payments have consequences that we will explore in detail within this chapter.

First, we must look more closely at each of the accounts that are included in a country’s
balance of payments. These are the components of the scale that measures all the
international transactions a country can possibly engage in with other countries.
Within each of the accounts, we will break down the different transactions and
indicate whether they result in a credit (which moves the account towards surplus) or
a debit (which moves the account towards deficit).

26.2 What are the components of the balance

of payments?

Learning outcomes
At the end of this section you will be able to:
* explain the four components of the current account, specifically the balance of
trade in goods, the balance of trade in services, income and current transfers
* calculate elements of the balance of payments from a set of data
* distinguish between a current account deficit and a current account surplus
* explain the two components of the capital account, specifically capital
transfers and transactions in non-produced, non-financial assets
* explain the three main components of the financial account, specifically: direct
investment, portfolio investment, and reserve assets.

A nation’s balance of payments measures all the international exchanges it engages in

with other countries in three separate accounts.

* The current account measures the balance of trade in goods and services and the flow
of income between a nation and all other nations. It also records monetary gifts or
grants that flow into or out of a country.
* The capital account measures the transfer of ownership of capital goods between a
nation and all other nations and the transfer of ownership of non-produced, non-
financial assets.
* The financial account measures the flow of funds for investment in real assets (such as
factories or office buildings) or financial assets (such as stocks and bonds) between
anation and the rest of the world. The financial account also measures official
borrowing and the official reserves of foreign currencies held at a country’s central
bank.
526
How do you calculate the elements of the balance of payments?

The balance of payments is the sum of the three accounts included in it. In other
words, when we add the current account balance, the capital account balance, and the
financial account balances together we arrive at the balance of payments.

Current account + capital account + financial account = balance of payments

The balance of payments will always equal zero; in other words, our metaphorical
scale must be balanced. This means that if we know the value of any two of the
accounts, we can calculate the value of the third account.

Worked example 26.

Assume that the fictional country of Cranville currently has international balances
as follows:
Current account balance = —$55 billion
Capital account balance = —$2.5 billion
Financial account balance =

We are not given Cranville’s financial account balance, but it can be calculated by
plugging it into our balance of payments equation:
Current account (— $55 billion) + capital account (—$2.5 billion) +
financial account (?) = balance of payments ($0)
—$55 billion — $2.5 billion = — (financial account)
—$57.5 billion = — (financial account)
Financial account = $57.5 billion
Cranville’s financial account balance is $57.5 billion, calculated by determining
the size of the surplus necessary to offset the combined deficits in the current and
capital accounts.

Throughout the rest of this chapter we will use a hypothetical model of New Zealand's
balance of payments as an example of how flows into and out ofa country through
trade and investment affect the different accounts in the balance of payments.

Figure 26.1 provides an overview of the credits and debits that may occur in each of
New Zealand’s balance of payments accounts.

A green arrow in Figure 26.1 represents a credit in New Zealand’s balance of payments,
or money flowing into the economy because of international trade and investment.
A-red arrow represents a debit, or money flowing out. The balance of payments must
always have a total balance of zero. This means that the money flowing into New
Zealand is equal to the money flowing out. This does not mean that each of the
accounts is always balanced, however.
For instance, in a given year, New Zealand’s balance in its current account could
be negative (meaning the country has spent more on imports than it earned from
exports); therefore, the balance in the financial and capital accounts must be positive.
5ot
 Balance of payments

Current account Financial account

Invgslmems
Goods& [ Exports mmmmlpy- G Nz Direct
services —) MVSSMENt [ investment
Imports < abroad
Investments
Figure 26.1 e ot N7 Portfolio
Outflows = \nvgslmsm investment
balar of paym abroa
measures all its international
exchanges in three sep:
Current {'"fl°W5 —) Official reserve
transfers | Outflows <
accou Becse
If current account + If current account +
financial account + financial account +
capital account > 0, capital account < 0,
Capital account reserve assetsrise reserve assets fall
s Capital transferred into NZ
= Capital transferred abroad G —)

The reason for this is simple. Every dollar New Zealanders spend on foreign goods and
services ultimately ends up being spent again on something from New Zealand or held
as an asset by foreign countries with which New Zealand has a trade imbalance.

What is measured in the current account?

A nation’s current account has four components measuring transactions between the
residents of one nation and the residents of all other nations. The account measures
the flow of goods, the flow of services, the flow of income (also called remittances), and
the flow of transfers.

Sometimes a nation’s current account balance is referred to as the balance of trade

because it records the transactions involving goods and services actually produced by
workers in one country and sold to or bought from consumers in another country. To
be clear, however, the balance of trade only includes two of the four components: the
flow of goods and services.
If the sum of the four components of the current account is greater than zero, then a
nation has a current account surplus, which means the total income from remittances into
the country and foreign spending on domestic output is greater than remittances out
of the country and spending on foreign-produced goods and services. On the other
hand, a current account deficit results when the amount that residents ofa nation
spend on imported goods and services and send overseas as income remittances is
greater than foreign spending on exports and remittances from abroad.

Balance of trade in goods

The balance of trade in goods measures the spending by consumers and firms in
one nation on another nation’s goods (both consumer and capital goods) as well as
spending by consumers in the rest of the world on the recording nation’s goods.
* Goods credits (+). Goods exports count as a credit in the current account because
they require that foreigners make payments to the exporting nation. Exports,
as a component of aggregate demand (AD), also contribute to employment and
output ofa nation. However, the level of exports depends primarily on economic
528
 conditions abroad, such as foreign incomes and growth in foreign consumer and
capital markets. Note that the export of both consumer and capital goods counts as
acredit in the current account.
* Goods debits (—). Spending by domestic consumers on goods produced in
foreign nations counts as a debit in the current account, since it requires a payment
to foreign producers. Spending on imports subtracts from domestic AD, since it is
aleakage of national income from the importing nation. The main determinant of
imports is the level of income of domestic households; as incomes rise, domestic
consumers and firms spend more on both imported consumer and capital goods,
as well as on domestic output.

Balance of trade in services

Services refer to non-tangible purchases such as tourism, banking, consulting, legal
services, and transportation. Services can be imported and exported, although there
is no physical movement of a product involved. Many services can be bought and
sold remotely thanks to the high-speed communication made possible by broadband
internet.

* Services credits (+). Services bought by foreigners, either within the nation or
from abroad, count as a credit in the current account, since they require that a
foreign consumer makes a payment to a domestic producer. Earnings from the
tourist industry in Thailand are a credit in Thailand’s current account because
foreigners are spending on transport, accommodation, entertainment and leisure
services within Thailand. On the other hand, an X-ray examination of a patient
in the US analysed overnight by a medical student in Mumbai, India, is a service
export for India that did not require the presence of a foreign consumer within
India’s borders.
* Services debits (—). Services purchased from foreigners and consumed by
domestic households are a debit in the current account because they require a
payment to a foreign producer. The spending by a German tourist travelling in
Thailand and spending income earned in Germany on Thai services, counts as a
debit in Germany’s current account. The Chicago hospital that outsources its X-ray
analysis to India has imported the service from India, so the US experiences a debit
ints current account.

The term ‘balance of trade’ usually refers to a nation’s goods and services balance in
the current account. However, these are not the only flows that are measured in this
account.

Income
‘When citizens of one country earn income from activities in another country, the
transfer of income back to the income earners’ country of origin is also measured in
the current account. This includes the wage income earned by a country’s citizens
from employment by foreign companies abroad.

For instance, an American teacher working at an international school in Germany may

send home a portion of his or her wages to the USA; this would be measured in both
the USA and Germany's current accounts. Income also refers to investment income,
such as interest and dividends earned on investments in foreign bonds or stocks. If
a British citizen living in the UK has a savings account in a Swiss bank, the interest
529
 Balance of payments

carned on his savings counts as a credit for the UK current account and a debit for
Switzerland’s.
« Income credits (+). This includes wages earned by a country’s workers
employed abroad which are sent home, interest on a country’s residents’ savings
and investments in foreign banks and financial markets, and dividends earned
abroad from domestic investors purchasing stocks in foreign firms. Each of these
transactions requires that foreigners make payments to residents in the country in
question, so they are counted as a credit in that country’s current account.
* Income debits (—). Wages that are paid by firms in one country to foreign
workers in that country and which are then sent abroad count as a debit in the
current account. In addition, interest paid to foreign savers in domestic banks and
dividends paid to foreign shareholders in a domestic company are all considered
‘leakages’ and therefore are counted as a negative (debit) in the current account.

Current transfers
A transfer refers to a payment made from one nation to another that is not in exchange
for any good or service, such as a gift or a grant. New Zealand’s central bank explains
why such monetary, non-production transfers are measured in the balance of
payments: ‘Current transfers directly affect the level of disposable income and influence
the consumption of goods and services for the donor and the recipient economies.’

Transfers are divided into two categories: official transfers are payments from one
government to another, sometimes known as ‘aid’. Private transfers are payments made
by citizens of one country to residents of any other country.

Current transfers can be recorded as cither a credit or a debit in the current account.

Transfer credits (+). Official and private transfers from foreign governments or
households to the government or individuals in a country count as a credit in the
current account. All such transfers require a payment from foreigners to domestic
stakeholders, increasing the level of disposable income at home and reducing it in
the foreign country.
Transfer debits (+). Official and private transfers by the government or
individuals within a nation to foreign governments or households count as a
debit in the current account. Both transfers require a payment from domestic
stakeholders to interests abroad, and increase disposable income abroad while
reducing it at home.
To calculate the components of the current account for New Zealand, we must add
together the credits (+) and debits (-) for each of the sub-accounts in the current
account. Table 26.1 shows hypothetical values for New Zealand's current account,
expressed in New Zealand dollars (NZD).

New Zealand has a current account balance of 4.5 billion NZD, meaning the country’s
current account is in deficit. By examining the credits and debits in the sub-accounts we
can see why the country has a deficit.
* While it spends more money on imported goods than it earns from its exports,
the country actually earns more from service exports than it spends, giving New
Zealand a combined trade balance of 1 billion NZD (the =$1 billion goods balance
plus the $2 billion services balance).
530
Table 26.1 Current Account Balance by Category, New Zealand
Sub-account Credits | Debits | Balance |
millions of NZD | millions of NZD | millions of NZD
goods 30,000 —31,000 —1,000
services 12,000 —10,000 2,000
income 3,000 —8,700 —5,700
transfers 1,300 —1,100 200
Total: +46,300 —50,800 —4,500

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income flowing back to the country from abroad, giving New Zealand a =3 billion You can review what you
NZD income balance. have just leaned by watching
avideo by the author!
* The transfer balance is positive, although very small relative to the other sub- Simply click here in
accounts, with 200 million NZD more being transferred to New Zealand than to your eBook for a video
other countries from New Zealand. on the current account of the
balance of payments.
On the whole, New Zealand has a current account deficit of 4.5 billion NZD, meaning
there are more New Zealand dollars flowing out of the country for trade, income, and Economics as a science
current transfers than foreign exchange flowing into the country. As we will see, the generally focuses on
current account deficit will be made up for through surpluses in the other accounts in positive analysis. That is to
New Zealand’s balance of payments.
say, it examines the world
through an objective lens
aimed at examining what
What is measured in the capital account? is,rather than what should
be. An example ofa positive
The capital account measures the transactions involving ownership of capital, statement is: New Zealand

forgiveness of debt, or the acquisition and disposal of non-produced, non-financial spent more on imports in
assets between a nation and all other nations.
2020 than it sold in exports
to the rest of the world.
Normative statements are
Capital transfers more subjective in nature,
‘When a nation’s government or private sector gives money to another nation for
expressing an opinion or
arguing for what should
the purchase of fixed assets or directly donates capital goods to residents of another be, rather than what s
country, this is recorded as a debit by the donor country and a credit for the recipient For instance, itwould be
country. The capital account does not measure the purchase or sale of capital between a normative statement to

nations, rather the actual transfer of fixed assets from one nation to another.
say: New Zealand would
be better offwith greater
* Capital transfer credits (+). If the Canadian government were to make a
balance in its current
account.
$2 million donation to the Ministry of Education in Tanzania to build schools in To what extent is it
rural areas, the transaction would involve the transfer of money from Canada to appropriate for economists
Tanzania for the purpose of helping Tanzania acquire fixed assets in the form of to make normative

new school buildings. Tanzania would record this as a capital account credit. statements such as this?
Should economics stick
* Capital transfer debits (—). If the US Agency for International Development, to analysis of what is and
USAID, were to finance the construction ofa new port facility in Liberia’s capital leave what should be up to
city, Freetown, the money provided would be recorded as a debit for the USA, politicians and the media?
because it would require transfer of income from the USA to a foreign country Ors it appropriate for
economists to determine

Debt forgiveness what should be based on

their analysis of data such
Besides the transfer of cash to acquire new capital or of capital itself, the capital as that of a nations balance
account also measures the forgiveness of debt from lenders in one country to debtors of payments?
531
 Balance of payments

in another. Debt owed by one nation to a lender in another nation, if forgiven by the
lender, counts as a credit for the debtor’s nation and a debit for the lender’s nation in
their capital accounts.

* Debt forgiveness credit (+). If the government of Rwanda were to be relieved of

its debts on a loan made to the previous government by the African Development
Bank, this would be recorded as a credit in Rwanda’s capital account.
* Debt forgiveness debit (—). If a bank in Switzerland which made a loan to the
government of Sierra Leone ten years ago were to decide to forgive the debt still
owed by the Sierra Leonean government, the balance owed to the Swiss bank
would be measured as a debit for Switzerland.

Transaction in non-produced, non-financial assets

Finally, the capital account measures the flow of non-produced, non-financial assets.
This includes the purchase or sale of intangible, non-financial assets, such as patents,
copyrights, trademarks, franchises and licences and the acquisition of land by a
government or international organisation or the disposal of such land.
* Non-produced, non-financial assets credit (+). An American tech company sells
the copyright on a 3D printing technology to a Chinese investment firm. Money flows
into the US capital account as ownership of the copyright is transferred to China.
* Non-produced, non-financial asset debit (—). A Chinese energy company buys
the mineral rights to a large off-shore oil field off the coast of Ghana. The money
it spends for the rights to this ‘non-produced, non-financial’ natural resource is a
debit for China’s capital account.

Table 26.2 shows hypothetical values for New Zealand's capital account, summing the
credits and debits of the different sub-accounts.

New Zealand has an 800 million dollar surplus in the capital account of its balance of
payments. More money has flowed into the country from the acquisition or disposal of
non-produced, non-financial assets than has flowed out of New Zealand.

Table 26.2 Capital account, New Zealand

Account Credits | Debits | Balance

millions of NZD | millions of NZD
Capital account 1,600 —800 800

What is measured in the financial account?

A nation’s financial account measures the exchanges between a nation and the rest of
the world that involve ownership of financial and real assets. Foreigners may buy and
sell a country’s real assets, including real estate, factories, office buildings and other
factors of production. Such transactions are recorded in the financial account because
they involve the ownership of assets, not the purchase of the nation’s output of
goods or services. If an office building in Auckland were sold to a Chinese electronics
manufacturer, none of New Zealand’s output would actually be consumed by
China; this explains why such an investment is not measured in the current account.
Ownership would be transferred, and there would be a flow of money into New Zealand,
moving the country’s financial account towards surplus.
532
In addition to real assets, much of the activity measured in the financial account is the
buying and selling of financial assets such as company stocks and government bonds.
If an investment bank in New Zealand were to invest in Spanish government bonds, the
transaction would require a payment from New Zealand to the government of Spain,
but no goods or services would be exchanged, so the transaction is purely financial. Such
abond purchase would be recorded as a credit for Spain and a debit for New Zealand.

The financial account measures two broad types of investment: direct investment and
portfolio investment.

Foreign direct investment

Foreign direct investment (FDI) occurs when a foreign firm acquires a significant
ownership stake in a domestic business, or vice versa. To be considered FDI a
minimum of 10% of a company’s shares must be owned by a foreign investor in the
domestic economy or by a domestic investor in another nation’s economy. Whether
direct investment counts as a positive or a negative in the financial account depends on
who is buying what.
‘When investors in the home country buy or sell ownership stakes in foreign firms the
following applies.

¢ Credits (+). Domestic investors sell shares in foreign firms, causing an inflow of
financial capital, moving the financial account towards the positive.
* Debits (—). Domestic investors acquire an ownership stake in foreign companies,
causing an outflow of financial capital, moving the financial account towards the
negative.

‘When foreign investors buy or sell ownership stakes in domestic firms the following
applies.

* Credits (+). Foreign investment in shares of domestic firms increases, causing a

net inflow of financial capital, moving the financial account towards the positive.
* Debits (—). Foreigners sell their ownership stake in domestic firms to domestic
investors, causing an outflow of financial capital, moving the financial account
towards the negative.
The dividends and interest income earned from direct investments abroad or paid to
foreign investors at home are counted in the income section of the current account
of the balance of payments. But the flow of financial capital into or out of a country
for the acquisition of ownership of firms as described above is part of the financial
account.
Portfolio investment
Portfolio investment consists of small investors buying and selling equity shares of
companies abroad as part of their portfolio of assets. It also includes ownership of
foreign debt, issued either by governments or private firms. The difference between
portfolio investment and FDI is that portfolio investment includes relatively small
investments (less than 10% of a foreign company), while larger ownership purchases
qualify as FDL

In addition to stocks, portfolio investment includes the buying and selling of bonds
(debt certificates), both public and private. Portfolio investment measures the
533
 Balance of payments

investments of foreigners in domestic equities and debt and of domestic investors in

foreign equities and debt.
Portfolio investment abroad: the money spent by domestic investors on foreign equity
and debt counts as an asset to the investor’s home country. Since domestic investors own
equity or debt in a foreign firm or government, such investment is considered an asset to
the home country and a liability to the foreign firm or government.
Credits (+). Domestic investors sell foreign assets, resulting in a payment to the
domestic investor, which causes an inflow into the financial account.
Debits (—). Domestic investors buy foreign assets, resulting in a payment to foreign
shareholders or bondholders, which causes an outflow from the financial account.

Portfolio investment at home: the money spent by foreigners on domestic stocks,

shares and bonds counts as a liability for the home country. Since a share ofa domestic
firm or government’s debt is transferred to a foreign stakeholder, such investment is
considered a liability to the home country, an asset to foreigners.

Credits (+). A foreign investor buys domestic stocks and bonds, resulting in a
payment to the home country, creating a positive entry in the financial account.
* Debits (—). A foreign investor sells domestic stocks and bonds back to a domestic
investor, resulting in a payment to the foreign investor, creating an outflow in the
financial account.

Just as the profit income earned from direct investment is measured in the current
account, so are the interest and dividend incomes earned from portfolio investments.
However, the financial flows involved in the acquisition of private and public securities
and debt are not considered income, so they are measured by the financial account.

Other investment
Other investment includes loans made by banks to foreign borrowers or money saved
in banks across national borders.
Loans from domestic banks to foreign borrowers and savings by domestic households
in foreign banks count as assets for the home country, since foreign interests owe
money to domestic interests.

Credits (+). A foreign borrower pays back a loan to a domestic bank, resulting in
a payment from abroad into the country’s financial account.
* Debits (—). A domestic bank makes a loan to a foreign borrower, resulting in
money flowing out of the financial account.
Domestic borrowing from foreign banks and foreign savings in domestic banks are
considered liabilities for the home nation and an asset for the foreign nation.
* Credits (+). A domestic borrower takes out a loan from a foreign bank, resulting
in money flowing into the home country’s financial account.
* Debits (—). A domestic borrower pays back a loan taken from a foreign bank,
resulting in money flowing out of the home country’s financial account.
As with direct investment and portfolio investment, incomes earned or interest paid
from other investments are measured in the current account under income, but the
money transferred for a loan or as savings abroad is measured in the financial account.
534
Reserve assets
Foreign exchange reserves refer to the assets of other nations held by a country’s
central bank. Reserves consist primarily of foreign financial assets such as government
bonds and foreign currency. In a given year, if the flow of money into a country due
to its exchanges in the current and financial accounts exceeds the flow of money out
of the country, the difference is added to the central bank’s official reserves of foreign
exchange. If there is a net outflow of money in a year, the difference is made up by a
withdrawal from the central bank’s reserves of foreign exchange.
Domestic currency held in foreign central banks.
* Credits (+). Domestic currency reserves held by foreign central banks increase
due to deficits in the home country’s current and capital accounts, leading to an
accumulation of domestic exchange abroad. An increase in domestic currency held
by foreigners counts as a credit in the financial account.
* Debits (—). Domestic currency reserves held by foreign central banks decrease
due to surpluses in the home country’s current and capital accounts, leading to
diminished reserves of the domestic currency abroad. A decrease in domestic
currency held by foreigners counts as a debit in the financial account.
Foreign currency held in the domestic central bank.
* Credits (+). Foreign currency reserves held in the domestic central bank decrease
due to a deficit in the current and capital accounts, leading to decreased ownership
of foreign assets by the domestic economy.
* Debits (—). Foreign currency reserves held in the domestic central bank increase
due to a surplus in the current and capital accounts, leading to increased ownership
of foreign assets by the domestic economy.

It should be pointed out that, contrary to common sense, a deficit in the current
and capital accounts actually results in an inflow (thus, a positive sign) in the official
reserves account, since the reserves of foreign currency must be drawn down to
finance the current and capital account deficits (since more is being spent than is being
earned). On the other hand, if a country has a current account surplus, then the change
in foreign exchange reserves is recorded as a negative since the ownership of assets
denominated in foreign currencies actually increases.
From an accounting standpoint, running a current account surplus results in a deficit
in the financial account, since the accumulation of foreign exchange due to trade
creates a liability for the surplus country. A current account deficit, on the other hand,
reduces liabilities in the financial account as foreign exchange reserves are drawn down
to pay for the excess of imports in the current account.

In addition to financing trade deficits, having reserves of foreign exchange in the

central bank allows the government to draw on these reserves to intervene in the
market for their nation’s currency to influence the exchange rate, as described in
Chapter 25, Exchange rates.

Official borrowing
Table 26.3 presents hypothetical figures for New Zealand’s financial account, including
each of the sub-accounts.
538
 Balance of payments

Table 26.3 Financial account balance by category, New Zealand

Sub-account Credits | Debits | Balance |
millions of NZD | millions of NZD | millions of NZD
Direct investment 3,900 —1,300 2,600

Portfolio investment 3,900 —6,600 —2,700

Other investment 1,800 —300 1,500

Reserve assets 4,500 —2,200 2,300

Total +14,100 —10,400 3,700

Video suggestion: On the whole, New Zealand has a surplus in its financial account, meaning more
You have read about it, now money has flowed into the country for investments in real and financial assets, and its
You can review what you reserve assets held by foreign banks have increased due to its current account deficits
have just learned by watching for a total financial account balance of 3.7 billion NZD.
avideo by the author!
Simply click here in
your eBook for a video
on the capital and financial 26.3 How do the accounts in the balance of
accounts of the balance of
payments payments relate to one another?

Learning outcomes
At the end of this section you will be able to:
* explain that the current account balance is equal to the sum of the capital
account and financial account balances
* explain that the overall balance between accounts should be zero
* explain that credits should be matched by debits, and deficits should be matched
by surpluses
* examine how the current account and the financial account are interdependent.

Why is there a zero balance in the balance

of payments?
America’s founding father, Benjamin Franklin, once said, ‘A dollar saved is a dollar earned.”
The axiom makes sense on an individual level, but it also has some application when
considering an economy’s balance of payments. Recall, the balance of payments records
all transactions between one country and all other countries, including trade in goods and
services, income transfers, foreign investment, changes in official reserves, and more.
When we think about Franklin's quote, we can tweak it slightly to apply to a country’s
balance of payments. ‘A dollar spent is a dollar earned.’ That is right, when a country
spends money on foreign goods or invests in foreign assets, it will ultimately earn that
money back through increased trade or investment from abroad.
To illustrate, let us look at things from the perspective of the USA. A dollar spent by an
American consumer on a foreign good is a dollar earned by a foreign producer. That dollar
is an American asset owned by a foreign person or company, and when foreign ownership
of American assets increases, it automatically moves America’s financial account towards
536
 surplus. What has happened to America’s balance of payments following a dollar of
spending on an import? The current account has moved $1 towards deficit and the
financial account has moved $1 towards surplus. Before the foreign person or company
even decides what to do with their new $1 of income, the US balance of payments has
reached a zero balance: —$1 in the current account, +$1 in the financial account.

Of course, our foreign exporter will be unlikely to hold onto his or her newly earned
dollar for long. In the short term he or she will convert it to his or her domestic currency
ata commercial bank in their country in order to pay his or her workers. The commercial
bank will exchange the dollar for domestic currency at the country’s central bank,
increasing the country’s official reserves of foreign exchange (keeping America’s financial
account in surplus). The central bank might then make that dollar available to importers
within its country who wish to buy pharmaceuticals or airplane parts or software from
an American firm, which will mean the dollar comes back to the USA in its current
account. In such a case, when US exports increase by $1, the US financial account moves
back towards deficit and the current account back towards surplus. Overall, the balance
of payments remains at zero. A dollar spent by the USA is a dollar earned by the USA.

‘Whichever way you start the story, the outcome is going to be the same. Credits are
matched by debits and deficits are matched by surpluses. When a Korean electronics
manufacturer builds a factory in Vietnam, Korea’s financial account is debited (money
flows out) and Vietnam’s i credited (money flows in). Korea's financial account has moved
towards a deficit and Vietnam’s towards a surplus. Vietnam now has Korean currency
which it can either invest in Korea or buy Korean goods with. If imports from Korea rise,
then Korea’s current account moves towards a surplus and Vietnam's towards a deficit.

‘We come back to our scale analogy once again: the balance of payment must always be
balanced. A deficit in one account is offset by a surplus in the other, and every debit is
offset by a credit.

‘What we discover is that at any given time, every country’s balance of payments
will have a net balance of zero. (In reality, accounting errors will occur and the value
reported by each country for its balance of payments may reflect a slight overall
surplus or deficit.) Let us put the three accounts in New Zealand’s hypothetical balance
of payments together to illustrate. Table 26.4 summarises the current account, the
capital account, and the financial accounts for New Zealand, adding their balances
together to determine the balance of payments.

New Zealand's current account deficit of —4.5 billion NZD means more money is
leaving New Zealand through trade and income transfers than is coming into the
country. Its capital and financial accounts are in surplus by a combined 4.5 billion

Table 26.4 New Zealand’s balance of payments, credits and debits

Balance of Payments | Credits (+) | Debits (—) Balance

account millions of NZD | millions of NZD
Current account 46,300 —50,800 —4,500
Capital account 1,600 —800 800
Financial account 14,100 —10,400 3,700
Total +62,000 —62,000 0

587
 Balance of payments

Video suggestion: NZD, providing the counterbalance to its current account deficit. A dollar spent is a
You have read about it, now dollar earned for New Zealand. While it spends, transfers, or invests 62 billion NZD
You can review what you in other economies (the combined debits in its three accounts) it earns or receives
have just learned by watching investments from abroad of the same amount.
avideo by the author!
Simply click here in The difference between its export income, income transfers, current and capital
o your eBook for a video
on the relationship between transfers, and financial investment income from abroad and the size of its current
the accounts in the balance of account deficit is made up for by foreign holding of New Zealand dollars as official
payments reserves; which again, count as a credit in New Zealand’s financial account since NZD
are an asset of the country held abroad.

26.4 +. What is the relationship between the

current account and the exchange rate?

Learning outcomes
At the end of this section you will be able to:
* explain why a deficit (surplus) in the current account of the balance of payments
may result in downward (upward) pressure on the exchange rate of the currency
* usean exchange rate diagram to show the relationship between the current
account balance and the exchange rate.

In Chapter 25, Exchange rates, you learned the determinants of exchange rates, one
of which is the demand for a country’s exports relative to the demand for imports
from other countries. With this in mind, let us examine the likely effects of a current
account deficit on a nation’s currency’s exchange rate.
When households and firms in one nation demand more of other countries’ output
than the rest of the world demands of theirs, there is upward pressure on the value
of trading partners’ currencies and downward pressure on the importing nation’s
currency. In this way, a movement towards a current account deficit should cause a
country’s currency to weaken.
Figure 26.2 shows the effect on the Korean won (KRW, ¥ and the Vietnamese dong
(VND, &) of an increase in exports from Korea to Vietnam, which results in a deficit in
Vietnam's current account and a surplus in Korea’s current account.

As Korea moves towards a current account surplus, the won appreciates. As Vietnam
moves towards a deficit, the dong depreciates. The stronger won results from increased
demand for Korean exports in Vietnam, and the weaker dong results from the
increased supply of dong in Korea.
All else equal, when the current account balance moves towards (or further into)
deficit, a country’s currency will depreciate on forex markets. A move towards (or
further into) current account surplus causes the currency to appreciate.
In the long run, the depreciation resulting from a current account deficit should be
self-correcting, slowing the move into deficit and helping restore balance in the current
account. Consider our Vietnam/Korea example again. As the dong depreciates due to
538
 a b

ER, (vno/kRw) ER (kRW/ND)

20

16 0.0625

0.05

Q Q Quew Q Qo

A
increased demand for Korean goods in Vietnam, Korean goods start to become more Figure26.2 A surlusin
and more expensive to Vietnamese households (since their currency buys less won Korea’s current account would
than before). The simple law of demand will lead Vietnamese consumers to begin strengthen the won (a), while
demanding fewer Korean goods as the dong depreciates, and over time Vietnam’s a Vielnamese current
account deficit would
current account deficit will move back towards surplus. weaken the dong (b)
From the perspective of Korea, the move towards surplus caused the won to appreciate,
which over time will make Vietnamese goods more attractive to Korean consumers,
leading them to import more from Vietnam. In other words, the metaphorical scale
representing the current account, once tipped into deficit or surplus, will right itself
over time due to the effect of exchange rate appreciation or depreciation.
As we learned in Chapter 26, Exchange rates, not all countries have floating exchange Video suggestion:
You have read about it, now
rate systems (in fact, about half the countries in the world have managed or fixed Yyou can review what you
exchange rates). When currencies are not allowed to float on forex markets, the self- have just learned by watching
correcting mechanism described here is less likely to occur, since a currency that is avideo by the author!
devalued will not appreciate when a current account surplus arises, and an artificially Simply click here in
your eBook for a video
strong currency cannot depreciate to correct a deficit. Therefore, countries with fixed on the relationship between
or managed exchange rate systems are more likely to experience persistent imbalances in the current account and the
their current and financial accounts. exchange rate.

26.5 1L What is the relationship between the

financial account and the exchange rate?

Learning outcome
At the end of this section you will be able to:
* explain why a surplus (deficit) in the financial account of the balance of payments
may result in downward (upward) pressure on the exchange rate of the currency.

539
 Balance of payments

Allelse equal, as a country’s ownership of foreign assets increases, its financial

account moves towards deficit and its currency depreciates. Consider an example:
A Switzerland-based investment bank wishes to invest in a Hong Kong-based real
estate company, and so it acquires a 25% ownership stake in the Hong Kong firm.
The FDI from Switzerland into Hong Kong moves the Swiss financial account towards
deficit: essentially Switzerland is ‘importing’ ownership shares of a foreign company.
Investment funds flow out of Switzerland, exerting downward pressure on the Swiss
franc. In Hong Kong, investment funds flow into the country, exerting upward
pressure on the exchange rate of the Hong Kong dollar. Hong Kong’s financial account
moves towards surplus.
While we do not use the terms ‘export’ and ‘import’ when referring to financial
investments, one useful way to think about financial account flows is that foreign
investment into a country’s domestic firms amounts to ‘exporting’ ownership shares
of a domestic firm. Since exports count as a credit, the financial account moves
towards surplus when foreign investors buy shares in domestic firms.
In the forex markets, the capital inflow in Hong Kong causes the Hong Kong dollar
to appreciate, adversely affecting the current account as Hong Kong's exports to
Switzerland become less competitive due to the stronger currency. The financial
account surplus is therefore countered by a current account deficit.
In summary, a capital inflow moves the financial account into surplus and causes the
currency to appreciate, while a capital outflow has the opposite effect. Under managed
or fixed exchange rate systems, these adjustments do not occur, therefore persistent
imbalances in the financial and current accounts are more likely to result.

26.6 +#. What are the implications of

persistent current account deficits?

Learning outcome

At the end of this section you will be able to:

« discuss the implications of a persistent current account deficit, referring to
factors including foreign ownership of domestic assets, exchange rates, interest
rates, indebtedness, international credit ratings, and demand management.

We have hinted repeatedly at the likelihood that under managed or fixed exchange rate
systems, the self-adjusting mechanism of exchange rate appreciation and depreciation
described in the above sections does not occur, therefore persistent imbalances in the balance
of payments are likely to arise. A persistent current account deficit is experienced when
year after year the debits in a country’s current account exceed the credits. The most likely
cause of persistent current account deficits is that a country spends more on imports
than it earns from the sale of exports, although it is also possible that income outflows are
greater than income inflows (as was the case with New Zealand earlier in this chapter).

Persistent trade deficits have implications for countries. We have already outlined the
effect on the exchange rate (a weaker currency), but the consequences can go much
540 further than exerting downward pressure on the currency.
The effect on interest rates
A persistent deficit in the current account can have adverse effects on the interest rates
and investment in the deficit country. A current account deficit can put downward
pressure on a nation’s exchange rate, which causes inflation in the deficit country
because imported goods, services and raw materials become more expensive. In
order to prevent sustained currency depreciation, the country’s central bank may be
forced to tighten the money supply and raise domestic interest rates to attract foreign
investors and keep demand for the currency and the exchange rate stable.

Additionally, since a current account deficit must be offset by a financial account

surplus, the deficit country’s government may need to offer higher interest rates
on government bonds to attract foreign investors. Higher borrowing rates for the
government and the private sector can slow domestic investment and economic
growth in the deficit nation.
Trade deficits may drive up interest rates as central banks take measures to slow the
inflationary effects of the weaker currency. Higher interest rates attract foreign capital
inflows, but also slow domestic investment and economic growth.

The effect on foreign ownership of domestic assets

By definition, the balance of payments must always equal zero. For this reason, a
deficit in the current account must be offset by a surplus in the capital and financial
accounts. If the money spent by a deficit country on goods from abroad does not end
up returning to the deficit country for the purchase of goods and services, it will be
re-invested into that country through foreign acquisition of domestic real and financial
assets, or held in reserve by surplus nations’ central banks.

Essentially, a country with a large current account deficit cannot export enough goods
and services to make up for its spending on imports. Instead, it ends up ‘exporting
ownership’ of its financial and real assets. This could take the form of FDI in domestic
firms, increased portfolio investment by foreigners in the domestic economy, and
foreign ownership of domestic government debt, or the build-up of foreign reserves of
the deficit nation’s currency.

While it is not necessarily a bad thing for foreign investors to own domestic assets,
some stakeholders may worry about the threat to domestic economic sovereignty and
control that increased foreign ownership of the economy’s factors of production (land
and capital) poses.

The effect on the country’s debt level

One source of credits in the financial account is foreign ownership of domestic
government bonds (i.e. debt). When a central bank from another nation buys
government bonds from a nation with which it has a large current account surplus, the
deficit nation is essentially going into debt to the surplus nation.
In September 2020 the US national debt stood at $26 trillion; of that around 40% was
held by foreigners, meaning that the interest payments that the US government pays
on that debt leak’ from America’s circular flow, and represent a transfer of income
from the American taxpayer to foreign owners of America’s debt. Why do foreigners
own so much of the US national debt? Simple: the USA is a country that runs persistent
541
 Balance of payments

current account deficits, meaning hundreds of billions of dollars are earned by

foreigners each year that are not spent on US exports. This money represents a credit
in America’s financial account, but rather than holding the dollars as cash, foreign
investors prefer to put them in interest-carning assets from the USA, specifically US
government bonds.
On the one hand, foreign lending to a deficit nation benefits the deficit nation because
it keeps demand for government bonds high and therefore allows the deficit country’s
government to finance budget deficits without raising taxes on domestic households
and firms. On the other hand, every dollar borrowed from a foreigner has to be repaid
with interest. Interest payments on the national debt were $240 billion in 2014, or 1.3%
of gross domestic product (GDP), but they are expected to rise to $800 billion by 2024,
or 3% of GDP. With 40% of the country’s debt held overseas, this means that over 1% of
the national income could be transferred to foreign bondholders by 2024, representing
asignificant leakage in spending power from the American economy.

Some argue that In other words, current account deficits do not come cheap. The resulting financial
personal debt is higher account surpluses mean foreigners own a larger share of the domestic economy’s
in countries with higher assets, including debt, and a meaningful share of national income must be transferred
levels of national debt overseas each year.
because the government
sets an example for the
natioris households. Ifa The effect on the country’s credit rating
government accumulates
large amounts of foreign Alarge current account deficit requires a nation to run a financial account surplus.
debt, are individuals As explained above, a surplus in the financial account may consist of foreign ownership
in society more likely of the deficit nation’s government debt. Over time, budget deficits financed through
to accumulate debt foreign borrowing reduce the attractiveness of the deficit country’s government bonds
themselves? To what
extent is the behaviour to foreign investors, harming its international credit rating, forcing the government to
of individuals in offer ever increasing interest rates to foreign lenders.
society modelled after
the behaviour of the
government? The effect on the country’s ability to manage
domestic AD
Owing to the negative consequences arising from persistent current account deficits
outlined above, government and central bank policymakers might find themselves
distracted in their efforts to reduce deficits in the current account from the pursuit
of the other macroeconomic objectives of full employment, price level stability, and
economic growth. Later in the chapter we will outline methods that can be used to
correct a current account deficit, and we'll see that some of these include fiscal and
monetary policies that once enacted might have undesirable effects on domestic AD.

The effect on economic growth

Deficits in the current account mean there is more spending on foreign goods and/
or income transfers abroad than there is spending on domestic output or income
transfers into the economy. The less income and spending there is at home relative
to overseas, the slower the rate of economic growth, due to weaker AD. On the other
hand, the financial account surpluses that arise when a country has persistent current
account deficits might mean increased international investment, which could have a
positive supply-side effect in the economy. Therefore, it is not necessarily the case that
deficits in the current account will slow economic growth, but they do limit the extent
to which AD can keep up with aggregate supply.
542
 26.7 1. What methods can be used to correct
a persistent current account deficit?

Learning objectives
At the end of this section you will be able to:
* explain the methods that a government can use to correct a persistent current
account deficit, including expenditure-switching policies, expenditure-reducing
policies and supply-side policies, to increase competitiveness
* evaluate the effectiveness of the policies to correct a persistent current account
deficit.

The existence of a persistent current account deficit can have many detrimental effects
on a nation’s economy. For this reason, a government or central bank may find it
necessary to intervene to promote greater balance in the nation’s current account. At
the very least, reducing a current account deficit promotes domestic employment as it
leads to an increase in the nation’s net exports, meaning more demand for the nation’s
output and a reduction in unemployment.

Expenditure-switching policies
Any policy by a government aimed at reducing domestic spending on imports and
increasing spending on domestically produced goods and services is known as an
expenditure-switching policy. Such policies could also be called protectionist since
essentially they are aimed at reducing demand for imports and increasing domestic
employment, albeit in the name of promoting a balanced current account.

Exchange rate manipulation

As you know, it is possible for governments and central banks to intervene in foreign
exchange markets to manipulate the value of their own currency relative to their
trading partners (Chapter 25). A central bank may supply a greater quantity of its own
currency on forex markets by demanding more of other currencies so as to devalue
its currency and make imports less attractive to domestic consumers. Alternatively, it
may lower domestic interest rates to make foreign investment less appealing, reducing
demand for its currency and lowering the exchange rate.
Either of these policies will make imports more expensive to domestic households,
who will switch their expenditures to domestically produced goods and services.
Likewise, foreign consumers will find the nation’s output more affordable.

Protectionism
Another method for switching expenditures from imports to domestically produced
output is to increase the barriers to trade with other nations. Import tariffs or quotas,
or subsidies to domestic producers will all make domestically produced goods more
attractive to consumers at home and reduce demand for imports.

543
 Balance of payments

In the short run, net exports may rise and the current account move towards surplus,
but in the long run, such policies promote inefficiency among domestic producers
who enjoy artificially high prices due to government protection. Over time, the
comparative advantage of foreign producers is likely to increase as domestic firms
can get away with being productively inefficient. Instead of focusing on efficiency,
domestic producers have strong incentives to devote resources to preserving or
expanding protectionist laws. In the meantime, foreign producers grow stronger
and more efficient by competing in the world market. Protectionism leads only to a
misallocation of resources and ultimately the costs it imposes on society are greater
than the benefits it brings.

Expenditure-reducing policies
A second set of policies available to governments hoping to reduce a current account
deficit involves the reduction of overall expenditures by firms and households in the
nation. This reduces spending on imports and thus restores balance in the current
account. Clearly, expenditure-reducing policies have adverse effects on domestic
output and employment, and are thus not desirable except as a last resort.

Contractionary fiscal policies

Raising taxes on domestic households and firms reduces disposable income and
reduces overall AD, including demand for imports. Reductions in government
spending would also reduce disposable incomes and overall AD in the nation. In
addition, the fall in import demand, the lower rate of inflation (or, if the decline in AD
is great enough, the deflation) that occur as a result of contractionary policies actually
make the country’s exports more attractive to foreign consumers, further improving
the current account deficit.

Contractionary monetary policies

Another means of reducing overall demand for imports in a nation is to raise interest
rates to discourage consumption of imported durable goods (financed by borrowing)
and firms’ investment in imported capital goods. Higher interest rates also have a
disinflationary (or deflationary) effect, making the nation’s exports more attractive to
foreign consumers. On the other hand, higher interest rates may attract foreign investors,
shifting the nation’s financial account further towards surplus and appreciating the
currency as foreign demand for domestic assets rises. This could have the opposite effect
of that intended by the central bank, as a stronger currency might make imports even
‘more attractive, offsetting any improvement in the current account achieved by reducing
consumption of durable goods and investment in foreign capital goods.

Supply-side policies
Contractionary fiscal and monetary policies will surely reduce overall demand in
an economy and thereby help reduce a current account deficit. But the costs of such
policies are likely to outweigh the benefits, as domestic employment, output and
economic growth suffer due to reduced spending on the nation’s goods and services.
Abetter option for governments worried about their trade deficit is to pursue supply-
side policies that increase the competitiveness of domestic producers in the global
economy.
544
In the long run, the best way for a nation to reduce a current account deficit is to
allocate its scarce resources towards the economic activities in which it can most
effectively compete in the global economy. In an environment of increasingly free
trade between nations, countries like the USA and those of Western Europe will
continue to confront structural shifts in their economies that at first seem devastating.
However, over time, such shifts are likely to be seen as both inevitable and beneficial to
the overall level of efficiency and welfare in the global economy.

The automobile industry in the USA has changed forever due to competition from
Japan. The textile industry in Europe long since passed its apex of production, and the
UK consumer will probably never again buy a TV or computer monitor made in the
UK. The reality is, much of the world’s manufactured goods can and should be made
more cheaply and efficiently in Asia and Latin America than they ever could be in the
US or Europe.

The question Europe and the USA should be asking, therefore, is not ‘How can we get
back what we have lost and restore balance in our current account?’ but ‘What can
we provide for the world that no one else can?' By focusing their resources towards
providing the goods and services that no Asian or Latin American competitor is
capable of providing, the deficit countries of the world should be able to reduce their
current account deficits and at the same time stimulate AD at home, while increasing
the productivity of the nation’s resources and promoting long-run economic growth.
That may be easy to say, and it is fair to ask ‘How can they achieve this?’ This is where
supply-side policies come in. Smart supply-side policies mean more than tax cuts for
corporations and subsidies to domestic producers. Smart supply-side policies that
would promote more balanced global trade and long-run economic growth include
the following.

Investments in education and healthcare

Nothing makes a nation more competitive in the global economy than a highly
educated and healthy workforce. Exports from Europe and the USA will increasingly
come from the highly skilled service sector and less and less from the manufacturing
sector. Highly educated and skilled workers are needed for future economic growth
and global competitiveness, particularly in scientific fields such as engineering,
medicine, finance, economics, and business.

Public funding for scientific research and development

Exports from the USA and Europe have increasingly depended on scientific innovation
and new technologies. Copyright and patent protection ensure that scientific
breakthroughs achieved in one country are allowed a period of time during which
only that country can enjoy the sales of exports in the new field. Green energy, nano-
technology, and biomedical research are emerging technologies that require sustained
commitments from the government sector for dependable funding.

Investments in modern transportation and communication

infrastructure
To remain competitive in the global economy, the countries of Europe and North
America must ensure that domestic firms have at their disposal the most modern

545
 Balance of payments

and efficient transport and communication infrastructure available. High-speed rail,

well-maintained inter-state or international highways, modern port facilities, high-
speed internet and telecommunications; these investments allow for lower costs of
production and more productive capital and labour, making these countries’ goods
more competitive in the global marketplace.

What are the benefits of reducing a current

account deficit?
Reducing a current account deficit will have many benefits for a nation like the USA,
Spain, the UK or Australia. A stronger currency ensures price stability, low interest
rates allow for economic growth, and perhaps most importantly, less taxpayer money
has to be paid in interest to foreign creditors. Governments and central banks may
go about reducing a current account deficit in many ways: exchange rate controls,
protectionism, contractionary monetary and fiscal policies, or supply-side policies
may all be implemented to restore balance in the current account. Only one of these
options promotes long-run economic growth and increases the efficiency with which
anation employs its scarce factors of production.
Supply-side policies are clearly the most efficient and economically justifiable method
for correcting a current account deficit. Unfortunately, they are also the least politically
popular, since the benefits of such policies are not realised in the short run, but take
years, maybe decades, to accrue. For this reason, time and time again governments
turn to protectionism in response to rising trade deficits.

26.8 u. Does currency depreciation always

reduce a trade deficit?

Learning objectives
At the end of this section you will be able to:
« state the Marshall-Lerner condition and apply it to explain the effects of
depreciation/devaluation
* explain the J-curve effect, with reference to the Marshall-Lerner condition.

When a nation runs a persistent deficit in its current account it should put downward
pressure on the country’s exchange rate. In a system of floating exchange rates, such
fluctuations between the currencies of deficit and surplus countries should correct the
imbalances by altering relative prices of imports and exports in a way that moves both
deficit and surplus countries towards a more balanced current account. However, such
shifts do not always occur.

The Marshall-Lerner condition

Whether or not depreciation of a nation’s currency reduces a trade deficit depends
on the combined price elasticity of demand (PED) for imports and exports. If
PED, + PED, > 1, then depreciation in the currency will move a country’s current
account towards surplus. This is known as the Marshall-Lerner condition (MLC).
546
If the MLC is not met, then depreciation ofa nation’s currency will worsen a country’s
current account deficit.
Common sense might indicate that ifa country’s currency depreciates relative to other
currencies, this should lead to an improvement in the country’s balance of trade. For
Country Z whose currency is the dollar, the reasoning is as follows.
+ A weaker dollar means foreigners have to give up less of their money in order to get
one dollar’s worth of Country Z’s output.
* Atthe same time, since Country Z’s dollar is worth less in foreign currency, imports
become more expensive, as Country Z's residents have to spend more dollars for a
certain amount of another country’s output; hence, imports should decrease.
The decrease in imports and increase in exports should reduce Country Z's current
account deficit.

Fewer imports and more exports should mean an improvement in the country’s balance
of trade, but this is not necessarily the case. What matters is not whether a country is
importing less and exporting more, but whether the increase in revenues from exports
exceeds the decrease in expenditures on imports. Here is where the MLC can be applied.

The following is an example of a situation in which the MLC is met and depreciation of
Country Z's dollar results in an improvement in the current account.

* Import spending exceeds export revenues in Country Z, causing depreciation of

Country Z's dollar.
* Ifforeigners’ demand for Country Z's exports is relatively elastic, then a slightly
weaker dollar should cause a proportionally larger increase in foreign demand for
Country Z's output, causing export revenues in Country Z to rise.
* Likewise, if Country Z's residents’ demand for imports is relatively elastic, then
aslightly weaker dollar should cause their demand for imports to decrease
proportionally more than the increase in price of those imports, reducing overall
expenditures on imports.
* Ifthe combined elasticity of demand for exports and imports is elastic (i.e. the
coefficient is greater than 1), then depreciation of Country Z’s currency will shift its
current account towards surplus. In this case, the MLC is met.

So, what if the MLC is not met? Demand for exports and imports may not always be
so responsive to changes in prices brought on by changes in exchange rates. Imagine a
scenario in which a weaker dollar does little to change foreign demand for Country Z’s
output. In this case, income from exports may actually decline (since it now takes fewer
units of foreign currency to buy Country Z's exports) as Country Z's dollar depreciates.
Likewise, if Country Z's residents’ demand for imports is highly inelastic, then more
expensive imports have a proportionally small effect on import demand. In which
case, expenditures on imports may actually rise as they become more expensive. If the
combined price elasticity of demand for exports and imports is inelastic, depreciation
of the currency actually worsens a trade deficit. Country Z's import expenditures rise
while export revenues fall, worsening the current account deficit.

The MLC is basically an application of the total revenue test of elasticity (Chapter 4).
1f demand for a country’s exports is inelastic, a fall in price leads to a decrease in total
revenues from the sale of exports. The same depreciation that caused the price of

547
 Balance of payments

a b
P P

weaker Z$ causes weaker Z$ causes

Country Z's exports to be the price of imports
cheaper to the rest torise in Country Z
of the world
Figure263 The effectof
depreciation on imports and
exports depends on their PED:
f demand is inelastic,
depreciation may worsen a i D D
i
current account deficit. Q Q 2 Q
(a) Market for Country Z's
exports; (b) market for imports g§ TR f-emmmeforeen bful since
g£
but since
in CountryZ
3 demanidis § i s
£ inelastic, w 1is inelastic,
o CountryZ @
= eamsless 3
S TR revenue g
2R fom £
g exports & ) '
=5 R §8 ot
H i
° i i T
= Qe Q Q@ ~ Q Q @Q
exports to fall causes the price of imports to rise, and if demand for imports is inelastic,
then their higher prices causes total expenditures on imports to rise. Thus, the MLC is
not met (Figure 26.3).

If the MLC is met, depreciation of a nation’s currency causes revenues from export sales
to rise and expenditures on imports to fall, moving the country towards a trade surplus.

A comparison of Figures 26.3 and 26.4 show how price elasticity is a critical element
in any decision to devalue a currency. In reality, the MLC can be met even when the
clasticities of demand for exports and imports are separately somewhat inelastic.
For example, a PED, of 0.5 and a PED,, of 0.6, both relatively inelastic by themselves,
combine to have a value of 1.1, enough to satisfy the MLC.

weaker Z$ causes. weaker Z$ causes the

Country Z's exports to be price of imports to
cheaper to the rest rise in CountryZ
of the world

Figure 26.4 Theeffectof Py

depreciation on imports and
exports depends on their PED:
if demand is elastic, D D
depreciation may move a Q Q
country towards a current since foreign since
Total expenditures on imports

account surplus. (a) Market demand is demand

Total revenue from exports

for Country Zs exports; elastic, for imports

(b) market for imports in Country Zs is elastic,
export Country Z
Country Z spends less
on imports

TE

548
The J-curve Video suggestion:
You have read about it, now
The MLC analysis above suggests that a country with an inelastic import and export
you can review what you
demand combination would never want to devalue its currency, because that would have just learned by watching
lead to a worsening of its current account. However, PED changes over time. As avideo by the author!
consumers have time to adjust to changes in the price of particular goods, they are Simply click here in
able to change their behaviour
to consume either more or less of the good in question your eBook for a video
: : the Marshall-Le
depending on how the price changed. SR
condition, SE

For example, when the price of a particular brand of toothpaste goes up, consumers
who are used to buying that toothpaste may continue to do so for a while until they have
found a suitable substitute. Over time, the responsiveness of consumers to a change in
price increases as consumers can alter their decisions about what and where to buy.

- Fine chocolate shop, Geneva,

Switzerland

‘When the exchange rate between two nations changes, consumers in both nations will
be more responsive to the changing price of imports as time goes by. For example, if
the value of the Swiss franc were to fall relative to the British pound, British consumers
would not immediately notice that Swiss goods were getting cheaper in the UK.
Chocolate consumers in the UK would continue to buy, say, French and Belgian
chocolate in the short run. However, over time, they would begin to take notice of
the relatively cheaper Swiss chocolates, and therefore become more responsive to the
lower price of Swiss imports in the long run. Likewise, Swiss consumers would find
British goods more expensive, but Swiss consumers who are used to buying British
beers would be more responsive to the higher prices over time, once they have been
able to find suitable substitutes, such as Belgian and German beers.

The PED for both imports and exports increases over time. Therefore, following
depreciation ofa nation’s currency, it is likely that in the short run, demand for
imports and exports will be inelastic, the MLC will not be met, and therefore the
weaker currency actually moves a country towards a current account deficit. As time
passes, however, and the currency remains weak, consumers at home and abroad
begin to alter their demand based on the changing price of imports and therefore
549
 Balance of payments

Current account balance

Figure 26.5 The -curve >
shows how depreciation of
the nation's currency is likely
Time following a currency
to affect the current depreciation

Video suggestion:
PED becomes more elastic, the MLC is met, and the nation whose currency weakened
You have read about it, now moves towards a current account surplus.
You can review what you
have just learned by watching The implication is that in the short run, depreciation of a nation’s currency is likely
avideo by the author! to move its current account towards a deficit, whereas in the long run, the current
Simply click here in account balance should begin to improve. This is illustrated in a simple diagram
your eBook for a video
on the J-curve. known as the J-curve, as seen in Figure 26.5.

Research d inquiry
Looking for evidence of the MLC
The MLC states that a country’s current account balance will improve if its currency
depreciates as long as the combined elasticity of demand for exports and imports
is greater than one, or elastic. While calculating the PEDs for imports and exports
would require a huge trove of data on export and import prices and quantities,
finding evidence of whether demand for exports and import is elastic or inelastic
should be relatively easy: all we need to do is look at what happens to a country’s
current account balance following a depreciation of its currency.
Using publicly available data we should be able to determine whether the MLC is
met for a particular country in a particular period. To do so, we must find a period
over which a country’s currency depreciated and look at the effect the depreciation
had on its trade balance with the country against whose country it depreciated.
The chart below shows the exchange rate of the US dollar in terms of Chilean pesos
between April and June of 2020.

865
2 —\\
840

815 /-\'\ A

790 \\l\

765 =
Apr 20 Jun
Note that the dollar depreciates from $865 ($ is the symbol for the Chilean peso, the
currency of Chile) peso to $765 pesos over the two-month period.
550
 The table below shows US exports and imports with Chile over the same two-month period.

Month Exports to Chile | Imports from Chile | Trade balance

(millions of US$) | (millions of US$) | (millions of US$)
April 2020 8618 8832 13
May 2020 861.7 679.1 1826

Notice that while exports remain steady in April and May, imports decrease precipitously.
Therefore, the trade balance moves from a deficit in April to a surplus in May.
Given the evidence above, we should be able to draw some conclusions about how
trade flows responded to the depreciation of the dollar in 2020 and from those
determine whether the MLC was met between the US and Chile.
The dollar depreciated between April and May while the US trade balance moved from
deficit to surplus. Based on this, is the MLC met between April and May? Explain your answer.

26.9 L What are the implications ofa

persistent current account surplus?

Learning objectives
At the end of this section you will be able to:
* explain why a surplus in the current account of the balance of payments may
result in upward pressure on the exchange rate of the currency
« discuss the possible consequences of a rising current account surplus, including
lower domestic consumption and investment, as well as the appreciation of the
domestic currency and reduced export competitiveness.

The effect on the exchange rate

If a nation consistently sells more of its output to foreigners than it demands of foreign
output, demand for the exporting nation’s currency will eventually rise and appreciate.
In addition, since the surplus nation demands relatively little of foreign goods, the
supply of its currency in foreign exchange markets will fall, contributing to the
currency’s appreciation.

Over time, an appreciating currency will reduce the export industry’s competitiveness
with the rest of the world and force domestic producers to become more efficient or
shut down as foreign demand for their goods eventually falls.
This adjustment assumes, of course, that exchange rates are floating and the currency
is allowed to appreciate. China, the country with the third largest current account
surplus in 2017 (the year for which most current data is available, behind Germany and
Japan) prevents its currency from appreciating as it would under a floating exchange
rate system by intervening in the forex market to peg the exchange rate to the US
dollar. By closely managing the RMB's value through its use of its foreign exchange
reserves to buy and sell dollars and RMB in the forex market, the Chinese government
ensures that the country’s large trade surplus does not cause an appreciation of its

551
 Balance of payments

currency, which would reduce demand for Chinese exports and slow the country’s
economic growth.
Under a system of floating exchange rates, current account surpluses should be kept
in check by the appreciation of the surplus nation’s currency and the corresponding
decrease in demand for its exports and the increasing appeal of imports among
domestic consumers. However, in a global economy in which governments actively
intervene in foreign exchange markets to devalue their own currencies, massive
imbalances can persist for years and even decades.

The effect on domestic consumption and savings

Persistent current account surpluses imply that households in the surplus nation
are consuming at a lower level over time than households in countries with current
account deficits. The reason for this may not be immediately clear. Essentially, the high
levels of investment in foreign assets, plus the large reserves of foreign exchange held
in the central bank of a surplus nation add up to a form of forced savings among the
surplus country’s households.
Think of it this way: money earned from the sale of exported goods but not spent on
imported goods is money saved by the nation with the trade surplus. The financial
account deficit needed to maintain a current account surplus reduces households’
consumption by re-investing money earned from export sales in foreign assets rather
than spending it on goods and services.
China’s national savings rate is around 45%. This does not mean that the average
Chinese household saves 45% of its income earned in the workplace. It means that
of the Chinese GDP of $12 trillion, nearly half is invested in real and financial assets
at home or abroad. Only around 40% of China’s GDP is accounted for by household
consumption. Compare this to the USA, where 12% of GDP is accounted for by savings
and investment, and 70% was made up of household consumption.

The high levels of savings and investment at home and abroad necessary to maintain
China’s massive current account surplus result in less of the country’s hard-earned
income going towards domestic consumption or spending on imports. Another way
to think about this situation is as follows. Nearly half of the goods produced in China
is exported to and consumed by the rest of the world, but China imports far less
than it exports, meaning nearly half of China’s output is not consumed by Chinese
households, but by foreigners. A trade deficit nation, on the other hand, may actually
be able to consume more than it produces, since many of the goods and services its
households enjoy are produced abroad and are imported using money borrowed from
foreigners in the financial account.

The effect on inflation and employment

In contrast with deficits, current account surpluses can be inflationary and are likely to
increase employment in the short run. An excess of exports over imports stimulates
AD, driving up the domestic price level and the level of employment. Foreign demand
for domestic output competes with that of domestic consumers, putting upward
pressure on prices and tightening labour markets.

552
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Paper 1 questions
Part (a) questions
1. Explain three reasons why a country might experience a current
account deficit. (10 marks)
2. Explain three reasons why a country might experience a current
account surplus. (10 marks)
3. Explain why a country that experiences a surplus on the
financial account will have a deficit on the current account. (10 marks)
Part (b) questions
1. Using real-world examples, evaluate the view that countries
should enact policies that help maintain a surplus in the current
account of their balance of payments. (15 marks)
2. Using real-world examples, discuss the consequences of a
persistent current account deficit. (15 marks)
3. Using real-world examples, discuss the consequences of a
persistent current account surplus. (15 marks)

Paper 2 questions
Read the excerpt below and answer the questions that follow:
Item 1:

Avreduction in inflationary pressures because of slow growth of international demand, and a

deceleration of the world economy, has allowed the Central Bank of Chile to cut interest rates
to their lowest level for 14 years. The low interest rates have in turn contributed towards the
peso (the Chilean currency) hitting a record low; and the depreciation of the peso is raising
import prices.

The Chilean government would like to see foreign trade add to growth, and is planning to
eliminate its remaining controls on capital flows to stop the decline in FDI, and to provide
funds for businesses.
Abilateral free trade agreement with the USA will help in the long run, but Chile's
economy could use a boost now, which may leave expansionary monetary policy as the main
instrument available. Adapted from Business Week.

Item 2: Chile’s real GDP and current account balance

Real GDP (annual % change) Current account balance (% of GDP)

2015 2016 2017 2015 2016 2017

23 1.67 127 -1.32 -1.58 —-215

1. With reference to Item 1, explain the following terms which are in bold in the
passage:
i. depreciation (2 marks)
ii. capital flows. (2 marks)

553
 Balance of payments

2. With reference to Item 2, briefly describe what has happened to

the current account balance since 2015. Using any of the data
provided, give one possible reason for this change. (4 marks)
3. Explain the relationship between low interest rates and the
depreciation of the peso. (4 marks)
4. Use the data and your knowledge of economics to evaluate the
decision of the Chilean government to enter trade agreements
and reduce controls on capital flows. (15 marks)

Country X has a flexible exchange rate and international capital mobility. Political
turmoil outside of Country X generates capital flow into Country X.
1. Using a correctly labelled foreign exchange market graph, explain
the impact of the capital inflow on the international value of the
currency of Country X. (4 marks)
2. For Country X, explain the effect of the change in the international
value of its currency on each of the following:
i. exports (2 marks)
ii. imports (2 marks)
iii. the balance of payments (both the current and
financial accounts) (2 marks)

3. With reference to the Marshall-Lerner condition, explain

why a depreciation of a country’s currency may not improve its
current account balance. (15 marks)

554
 Real-world issue 2
Why is economic development uneven?
Perceptions of the meanings of development and equity change over time and vary
across cultures.
Governments and other economic agents may intervene in an attempt to promote
economic well-being and equity in societies. \
The pursuit of sustainability is subject to various constraints.
Effective strategies should take account of the relevant social, economic, and
political context.
 Sustainable ‘ '
development
 at is economic develop! g

Learning outcomes
At the end of this section you will be able to:
¢ define economic development
« distinguish between economic growth and development
* explain the relationship between economic growth and economic development.

What is meant by economic development?

‘Remember: things can be bad, and getting better.’
—Hans Rosling

For as long as humans have organised into small groups, village councils, city-states
then national governments, their reason for being has been to answer the question:
how can we improve our lives? Economic development is a broad concept involving
efforts to improve standards of living, reduce poverty, improve health and education,
and increase freedom and economic choice. The purpose of development economics
is to better understand the barriers countries face in pursuing these goals and the
strategies that can be used to achieve them.
The benefits of development may be obvious: our modern era of globalisation has made it
possible for more people to live lives of greater wealth, and in better health and comfort than
at any time in history. Globally speaking, people have longer life spans and enjoy comforts
and conveniences only imagined by people living as recently as 100 years ago. However,
this obvious fact runs alongside another, very unpleasant one. Across 47 countries,
880 million people suffer extreme poverty. Approximately 12% of the world’s population
live in the less economically developed countries (LEDCs), many of them in gruelling
conditions. Furthermore, LEDCs account for less than 2% of total world income. Expand the
view more widely and one sees that it is not simplya matter of ‘developing countries and rich
countries’. Significant pockets of underdevelopment exist in developing countries as well.

However, there is cause for optimism. The World Bank reports that in 1990, more
than one-third of the world lived in extreme poverty - living on $1.90 a day or less. By
2015, that figure had dropped to 10%, the ‘lowest level in recorded history’. And that
in the last few decades, more than 1 billion people have risen out of extreme poverty.
It is enormously encouraging to see the progress made by so many so quickly. Surely
something can be learned of this success, and surely these lessons can be applied in
service to the unlucky billions who are just getting by?
Figure 27.1 shows relative development levels geographically. Its findings are based
on scores for countries on the Human Development Index (HDI), a composite
indicator of development (more on the HDI in Chapter 27). This map shows where
some of the biggest challenges currently lie, where the problems may appear to be
interlocking and overwhelming. Remember, though, that many countries were much
less developed 50 years ago. If a better life is possible for 1 billion people in a relatively
short time, why not for the next billion?

557
 Sustainable development

Nodata 0 02 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

==
A
Figure27.1 The Human Why has the focus shifted from growth
Development Index 2017:
a summary measure of key to development?
dimensions of human
For the decades that followed the Great Depression of the 1930s, in the early years
development
of macroeconomics, economists mostly focused on economic growth. Growing
economies, it was logically reasoned, would improve the lives of most citizens.
The emphasis was on investment in infrastructure, creating productive capacity,
stimulating spending, and generally improving income level. In Chapter 13, we
discussed the many measures economists have devised to assess those levels, from
gross domestic product (GDP) to per capita GDP, to adjusting for purchasing power
and the creation of purchasing-power-parity-adjusted per capita GDP. Eventually,
the limits of GDP to assess the activity it claims to record have been acknowledged.
Economists, it could be said, grew better and better at keeping score, but only in a
particular way.
Beginning in the late 1940s and early 1950s there began an age of independence from
colonial rule in many developing countries. From this, there emerged a concern that
growth alone did not always provide a better quality of life. Sheer economic growth
had a mixed record in terms of improving health, education and other basic living
standards. Economists began seeking out new ways to look at economic well-being,
especially for developing countries, which had either missed out on growth or found
its promises unfulfilled.
Development, as noted earlier, takes into account factors beyond monetary income
to include health, education, and other social indicators. Development economics is
abranch of economic theory that has grown up around the idea that it is possible to
understand what makes developing countries poor (and rich countries rich) and to
make policy changes that can turn developing countries into richer ones.
558
Assign of the shift to a wider focus came in 1966, when the United Nations created
the UN Development Programme (UNDP), and by 1971 had consolidated most of
its development-related agencies together. Funded by voluntary contributions of
UN members, the UNDP has contributed technical assistance, consultants’ services,
equipment, and fellowships for advanced study abroad. It has funded projects in
resource planning, training institutes, the application of modern technology to
development, and the building of the economic and social infrastructure.

In 1990, influenced by the work of Amartya Sen, the UNDP began to compile and
publish the HDI, a more inclusive evaluation of economic well-being that has become
the standard international benchmark measure for quality of life. This drive towards
adevelopment focus, rather than pure growth, has gathered momentum through the
work of the UN as well as from a wide variety of academics in the last few decades.
It accelerated in the UNDP's Millennium Development Goals (MDGs) Project, an
ambitious effort to draw attention and resources to the struggles of developing
countries. And it continues today in the Sustainable Development Goals (SDGs),
discussed later in this chapter.

How are economic growth and economic

development interrelated?
Economic growth is rather strictly defined as an increase in real GDP over the
previous year. Economists strive to refine and clarify the idea by measuring it against
population size and relative spending power. But it remains the defining characteristic
ofa country’s economic success. Growth, because it usually means more money and
activity and employment, generally suggests that something is going right with the
economy. A recession, a lack of growth or a decrease in the economy’s size, triggers
attention and policy changes.

Development, in contrast, emphasises specific changes in aspects of people’s lives

in many different dimensions. A primary focus of development economics is the
reduction of poverty, the raising of incomes among the world’s poorest. Furthermore, Economic development
development economics seeks the improvement of general living standards. Typically,
draws from a set of values
set out by Denis Goulet
living standards are measured by long life, general health, education achievement in 1971 (ife sustenance,
and opportunities, as well as measures of income. Development economics, like self-esteemn and freedom).
mainstream views of growth, also focuses on employment, in particular on the types Does this make the pursuit
of employment offered in developing countries, and how countries can adapt and
of economic development
unscientific?
respond to the challenges of their workforces.

Case study - modern economists — Amartya Sen

What does it mean to be free? For Amartya Sen, the question has been personal,
political and professional. Sen was born in West Bengal, then a colony of Great
Britain. As a child, he witnessed the devastating Bengal famine of 1943, an event
that lingered with him and shaped his research as an economist.
Sen achieved top marks at prestigious prep schools in Bengal and India, and
eventually studied at Cambridge. His early years of graduate work were marked by
intense debates between the advocates of Keynesian and new classical economics.

559
 Sustainable development

Eventually, though, Sen made his mark by pursuing a different perspective on

national economic well-being. His study of famines and deprivation led him to
conclude that most famine was unnecessary, a consequence of factors that had little
to do with a lack of resources. More important, he argued, were the capabilities of
the people to fend for themselves. Freedom, he argued, was more than the lack of
government interference in one’s life, but rather the ability to positively do something
to help oneself. To Sen, it is on this basis that all governments should be evaluated.
Famine, he later noted, was far less likely in functioning democracies because the
government is compelled to respond to its people in times of critical shortage.

Sen also promoted a focus on gender inequality, writing famously that ‘more
than 100 million women are missing’, in China and India because of preferential
healthcare for men and sex-selective abortion of girls. Among the most influential
economists, if not intellectuals, of the 20th century, Sen questioned the view that
humans function mainly with a mindset of homo economicus, as purely self-motivated
actors. He was awarded the 1998 Nobel Prize for his work on social choice theory
and his interest in poverty and development. His work in the causes of famine and
on social welfare, drove much of the thinking behind changes in UN development
policy in recent decades, including the formulation of the HDI.

What are the sources of economic growth?

While economic growth occurs with any increase in GDP over the previous year, it is
relevant to make a distinction between the growth of actual production and growth
of potential production. Potential output is an increase or shift to the right of
long-run aggregate supply (LRAS) or a country’s production possibilities frontier
(PPF), as explained in Chapter 17. Once the sources of economic growth are established,
itis possible to examine the relationship with economic development.

The natural resource base

When it comes to natural resources, each country must make the best out of their
‘gifts of nature’. Some countries are blessed with an abundance of water, arable land,
timber, and other natural resources. The US attributes some part of its enormous
wealth to a breadth and depth of natural bounty. Other countries, like Singapore and
the Netherlands, resort to increasing resources like their actual land area by means
560
of impressive technological achievement. Still other countries toil away in hopes of
discovering a precious new resource, as happened in Afghanistan in 2009 when vast
mineral deposits, some including lithium (which is used to power all kinds of modern
batteries) were discovered. The estimated worth of Afghan deposits is nearly 3 trillion
dollars. Such a windfall is extremely rare; the only practical alternative is to seck out
ways to improve the resources already known.

Physical capital and technology

Growth can be achieved by increasing or improving the amount of physical capital. This
includes buildings, machinery, vehicles, offices, and equipment. The resources to purchase
these goods come from savings (and the income earned from savings); the intellectual
power to improve them comes from a more highly educated workforce. Some technology
can be imported from overseas capital products and by hiring foreign expertise.

* Capital widening refers to the extension of capital goods to a larger segment of

workers (e.g. more farmers using simple tools).
* Capital deepening refers to increases in the ratio of capital per worker, so that workers
have more capital to work with (all farmers using better farm tools).

Improved technology refers to acquiring more sophisticated capital goods as well as

better methods for production, and is clearly a source for economic growth.

Human capital
Alarger, healthier, and better-educated population would improve the human capital
of the country.

The quantity of human capital can be increased by encouraging childbirth with better
prenatal and maternal healthcare. It can also be accomplished by encouraging
immigration to the country, adding to the labour force. However, many countries have
too large a population and are seeking ways of reducing it. China’s one-child policy
and Singapore’s incentive system for families are two prominent modern examples.

The quality of human capital can be improved through a variety of approaches to make
the average person more productive. Improved healthcare keeps children healthy, and
parents able to care for them. It also lowers the amount of time workers are absent
orill during working hours. Furthermore, education and worker training are all
investments in human capital, and thus should contribute to the productive capacity
(LRAS) of the country.

Institutional factors
Enduring economic growth can only occur when minimum levels of institutional
factors are in place. A generally equitable and stable legal system is desirable. Political
stability is a prerequisite. A stable banking system ensures the flow of capital.
A minimum level of infrastructure is necessary, so that goods can be transported,
and a minimum level of public health is required. An orderly legal system that affirms
property rights encourages investment. A reasonably good education system, one that
successfully trains students in numeracy and literacy, is also important.

Economic growth is indispensable to enduring economic development. While it is true

that some basic and inexpensive changes to public policy in areas like healthcare can
561
 Sustainable development

yield positive results, many of the requirements for development require the money
that growth provides to pay for them. Better education requires more resources, as
does capital formation, as does improved technology, and a growing economy can
fund these efforts. At the same time, economic growth does not always yield positive
or sustainable development results.

hat is sustainable development

Learning comes
At the end of this section you will be able to:
* define sustainable development
« outline and explain the United Nations’ Sustainable Development Goals
. analyse the relationship between economic development and poverty.

One way to understand the concept of sustainable development is to place it within

the context of macroeconomic perspectives of the last 100 years. The catastrophe
of the Great Depression (1929-39) inspired the creation of macroeconomics, and
the primary focus of this new field was to analyse and engineer economic growth.
Whether one subscribed to the Keynesian school of government intervention or the
non-interventionist classical school approach, growth was the goal.
Starting in the 1960s, during the peak of the post-Second World War boom period, a
small number of thinkers and writers began to question the effects of industrialisation.
In rich countries, worries about air pollution, oil spills, water quality, toxic waste and
nuclear accidents led to the flowering of an environmentalist movement. In the 1970s
and 1980s, environmentalism took political shape in the formation of green parties in
‘many countries, who sought renewable energy resources, clean water, and clean air.

Among the first to identify sustainable development as a worldwide goal was a 1980
report by the International Union for the Conservation of Nature. Shortly after, it
was expanded upon by the United Nations World Commission on Environment and
Development in 1987, who defined the concept as follows:

‘Sustainable development is development that meets the needs of the present

without compromising the ability of future generations to meet their own
needs. The idea encapsulates worries about the impact of human activity on
the planet’s ecosystem, and whether that ecosystem will survive the ravages
of human use. This can run contrary to the notion of economic growth as it
was once understood.’

In theory, economies getting richer led to unequivocally positive outcomes: more

goods and services, perhaps access to transportation, more housing and energy use
across the population. All of this led to a rise in the standard of living of many millions
of people. It also puts an ever-greater strain on the planetary ecosystem as a whole.

In 2000, the United Nations launched the UN Millennium Development Goals (MDGs),
awide-ranging effort to specifically target, promote, and channel efforts towards
562
 development goals. The MDGs sought to eradicate extreme poverty, achieve universal
primary education, promote gender equality, reduce child mortality, improve maternal
health, combat disease, develop a global partnership for development and to ensure
environmental sustainability.

Upon the target date of 2015, the United Nations reported impressive results on the
MDGs. Extreme poverty in developing countries had been reduced from 47% to
17% since 1990. The number of extreme poor dropped by over 1 billion people. The
number of children not in school dropped by 43 million. The period also saw large
gains in school enrolment of girls, and lower mortality rates worldwide. The number
of people with access to piped safe drinking water rose from 2 billion to 4 billion.

The SDGs, released in 2015, replaced the MDGs. They reflect a more ambitious
effort by the UN to improve lives in a more comprehensive manner. The SDGs add
to their goals by including inequality, age considerations, working life, gender equity,
consumption patterns, sustainable industry, and direct action on climate change.

The theme of sustainability runs through many of the goals. The SDGs demonstrate
an understanding that many human systems need to change rapidly in response to the
climate crisis brought on by carbon emissions. Climate change is known to have the
following effects:
* ice melting worldwide, especially at the north and south poles
* sea-levels are rising at 3.2 mm per year, and the rate is likely to increase
* species collapse as rising temperatures affect ecosystems
* increased rain and (paradoxically) more severe drought
* drinking water shortages
« risk of massive crop failures.

Climate change is expected to have further effects on the global environment:

* increased incidence of disease, such as mosquito borne malaria
* less available fresh water as melting glaciers store the majority of the world’s
remaining fresh water
¢ decades-long ‘megadroughts’
* more frequent and more intense extreme weather events causing more natural
disasters.

Climate change is a global crisis that requires global cooperation to solve. However,
those most likely to be affected are the poor, living in coastal areas all around the world.
And with their limited resources and structural vulnerability, they are least equipped to
cope. The SDGs should be viewed as a drive for collective action in the face of extreme
danger. At the same time, the SDGs suggest that progress in the quality of life for all is
synonymous with action on climate change not a question of choosing one or the other.

The SDGs, shown in Figure 27.2, have a target date of 2030.

Each goal is broad on the surface but includes more specific sub-goals designed to
achieve the larger goal. The targets for SDG #2, End hunger, are as follows.
By 2030, end hunger and ensure access by all people, in particular the poor and
people in vulnerable situations, including infants, to safe, nutritious, and sufficient
food all year round.
563
 Sustainable development

LOIDE TR Y
AND WELL-BEING

4
End poverty in all its forms End hunger, achieve food Ensure healthy lives and promote Ensure inclusive and equitable quality
everywhere security and improved nutrition and well-being for all at all ages education and promote lifelong
promote sustainable agriculture learning opportunities for all

CLEAN WATER T
AND SANITATION ECONOMIC GROWTH

Achieve gender equality and Ensure availability and sustainable Ensure access to affordable, Promote sustained, inclusive and
empower all women and girls management of water and reliable, sustainable and modern sustainable economic growth,
sanitation for all energy for all fulland productive employment and
decent work for all

Build resilient infrastructure, promote Reduce income inequality within and Make cities and human settlements Ensure sustainable consumption and
inclusive and sustainable among countries inclusive, safe, resilient, and sustainable production patterns
industrialization, and foster innovation

1 CLIMATE 1 U:3 1 13 1 PEACE, JUSTICE

ACTION LT ONLAND AND STRONG
INSTITUTIONS

Take urgent action to combat climate Conserve and sustainably use the Protect, restore and promote Promote peaceful and inclusive
change and its impacts by regulating oceans, seas and marine resources for sustainable use of terrestrial societies for sustainable development,
emissions and promoting sustainable development ecosystems, sustainably manage provide access to justice for all and
developments in renewable energy forests, combat desertification, and build effective, accountable and
halt and reverse land degradation and inclusive institutions at all levels
halt biodiversity loss

1 PARTNERSHIPS
L2310

Strengthen the means of

implementation and revitalize the A
global partnership for sustainable igure 27.2 United Nations
development
Sustainable Dey 1t Goals
 SDG #2 To end hunger,
achieve food security and
improved nutrition and
promote sustainable
agriculture

By 2030, end all forms of malnutrition, including achieving, by 2025, the

internationally agreed targets on stunting and wasting in children under 5 years of
age, and address the nutritional needs of adolescent girls, pregnant and lactating
women and older persons.
By 2030, double the agricultural productivity and incomes of small-scale food
producers, in particular women, indigenous peoples, family farmers, pastoralists
and fishers, including through secure and equal access to land, other productive
resources and inputs, knowledge, financial services, markets and opportunities for
value addition and non-farm employment.
By 2030, ensure sustainable food production systems and implement resilient
agricultural practices that increase productivity and production, that help maintain
ecosystems, that strengthen capacity for adaptation to climate change, extreme
weather, drought, flooding and other disasters and that progressively improve land
and soil quality.
By 2020, maintain the genetic diversity of seeds, cultivated plants and farmed
and domesticated animals and their related wild species, including through
soundly managed and diversified seed and plant banks at the national, regional
and international levels, and promote access to and fair and equitable sharing of
benefits arising from the utilisation of genetic resources and associated traditional
knowledge, as internationally agreed.
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 a4 Sustainable development

Ave the values on which * Increase investment, including through enhanced international
development is based cooperation, in rural infrastructure, agricultural research and extension
universal or do they services, technology development and plant and livestock gene banks in order to
depend on culture? Are enhance agricultural productive capacity in developing countries, in particular
there some goals among least developed countries.
the SDGs that may not
be acceptable to some: * Correct and prevent trade restrictions and distortions in world agricultural
cultures? markets, including through the parallel elimination of all forms of agricultural
export subsidies and all export measures with equivalent effect, in accordance with
L e the mandate of the Doha Development Round.
Is the UN hitting its SDGs? * Adopt measures to ensure the proper functioning of food commodity
As we approach 2030, itis a markets and their derivatives and facilitate timely access to market information,
good idea to see what kind including on food reserves, in order to help limit extreme food price volatility.
of progress s being made
against the SDGs. Conduct
an internet search for the
‘Sustainable Goals Progress’
or ‘Sustainable Goals Tracker. L
Use the information you
find to conduct research and
discussion with your dlass.
One theme we see in the study of environmental sustainability is the challenges of
For discussion and debate:
affluence. Richer people tend to consume more, in general, than poor people and so
Allocate the goals across
the group. put more pressure on the planets’ resources than the poor do, on a per capita basis.
Find information on each Their carbon footprint, and individual effect on climate change, is larger than those
~

of the targets of your goal. who consume fewer fossil fuels and those people tend to be poorer.
Identify areas where more
However, one cannot ignore how extreme poverty can lead to fairly high
w

attention or resources are

needed. contributions to pollution and climate change among the poorest. About two-thirds
Share a written or verbal of the world’s poorest 900 million people work in agriculture, and several examples
~

summary with your group. help demonstrate this connection between poverty and sustainability. Poor farmers
rarely own their own land, letting out extraneous lots that are the least-good land
available. This leads to inefficient crop production, so it takes more land to get the
same amount of food. Because many poor farmers do not own their land, either
because it is rented or because they cannot get property rights in their land, they do
not invest in the long-term care of the soil. They will choose to neglect crop
rotation practices to get the most of the much needed cash for the crop right away.
This contributes to soil erosion. It is not uncommon for such farming to take place
on commonly held land, demonstrating the overuse of common pool resources.
Deforestation is hastened for similar reasons. In need of cheap farmland, the poor
will cut or burn down forests. The wood can be used for heat or cooking, and the
land used for farming, even if it is of relatively poor quality.
It would be a mistake to blame those in this situation. Just the opposite, as the
poorest are far more likely to be affected by climate change effects (droughts and
famine, sea level rises and floods) than the rich. It is instead very important to
understand that the desperation of the poor can put a greater strain than one might
expect on the planet’s resources, and that addressing inequality (SDG #10), which
is an ethically important goal on its own, will also help take action on responsible
consumption and production (SDG #12) climate action (SDG #13), and life on land
(SDG #15).

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 27.3 What do developing countries have
in common?

Learning outcome
At the end of this section you will be able to:
« discuss, using examples, the similarities between developing countries.

Less economically developed countries tend to share common characteristics, some of

which are outlined below.

Low standard of living

Almost by definition, countries who score lowest on the HDI have low levels of
educational attainment, low incomes, and poorer health, because these attributes are
the chief standards for the HDI. And so, one would expect these countries to struggle in
areas of infant mortality, life expectancy, fewer years of education, and general poverty.

High population growth and birth rates

Measured as the crude birth rate (CBR), global birth rates have dropped steadily over
the last 100 years, but the rates for developing countries have dropped much more
slowly. The global average CBR for 2018 is approximately 18.5 births per 1000 women
of child-bearing age per year. In less developed countries (LDCs), this figure is far
exceeded, with CBRs as high as 31 births per 1000 women of child-bearing age per
year. In other words, birth rates in many LDCs can be about 1.5 times higher than
the global average. On trend, this gap has narrowed in recent years and is expected to
narrow even more in another decade.

High dependency ratios

The dependency ratio is the combined number of people not in the labour force
compared to those who are in the productive population (labour force). In other
words, how many working people are there compared to the number of old and young
people who rely on them? High birth rates tend to lead to high dependency ratios,
another common characteristic of LDCs. Countries with high birth rates and large
populations of younger people fall easily into this category.
At the same time, richer countries with ageing populations are also seeing their
dependency ratios climb. Countries with high dependency ratios are likely to struggle
to meet the needs of their relatively large dependent population. The highest ratios,
typically at or above 80%, imply that for every productive, working person there is
another person to support. Table 27.1 shows several more developed countries (MDCs)
with relatively high old age dependency ratios, with several of the lowest ranking
LEDCs ranking high child dependency ratios.

High dependence on agriculture and primary production

The UN defines commodity dependence as having more than 60% of your total
merchandise exports composed of commodities. Often this is a reliance on
567
 YJ4 Sustainable development

Table 27.1 Old age and youth dependency ratios for selected countries
Country (HDI rank) Dependency ratio, old age (%)
Japan (19) 47
Italy (29) 36
Finland (12) 36
Portugal (40) 35
Country (HDI rank) Dependency ratio, child (%)
Niger (189) 105
Mali (184) 94
Chad (187) 92
Angola (149) 90

agriculture, but it can be mined goods as well. A larger percentage of labour is

employed in agriculture in LEDCs. Generally speaking, developed countries tend
to employ less than 10% of the population in agriculture, while the proportion in
LEDCs may be 50-80%. These countries, along with a large portion of their employed
population, remain vulnerable to weather changes and the typically volatile market for
agricultural commodities.
Commodity dependent LEDCs who rely not on agriculture tend to be oil or mineral
exporters. Table 27.2 shows the relative dependence of several LEDCs on commodities
as a share of their exports.

Note the dominant share of exports for oil exporters, whose export income is entirely
dependent on oil prices. Some countries are heavily dependent on agriculture, and
others on ore and minerals. Cambodia, shown here as a textile exporter, is heavily
reliant on manufacturers in one industry. We could also add some service dominant
countries, typically island countries that rely on tourism. Some countries export
several commodities, such as Cote d'Ivoire, which produces cocoa, nuts, rubber, gold,
to have a diversified but still commodity-heavy portfolio of exports.

Large urban informal sector

The informal sector is defined as being unorganised, unregistered, and unsupported by
the state and its institutions. It may include subsistence production, cottage industry,

Table 27.2 Commodity dependence, selected countries

Country (main exports) Share of exports (%)

Chad (oil) 96.4
Angola (oil) 96.1
Guinea-Bissau (fresh fruit, nuts) 88.4
Zambia (copper) 757
Burkina Faso (gold) 60.8
Ethiopia (coffee) 229
Cambodia (textiles) 93
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 unreported merchant activity, and black market trade. Most LDCs have relatively
high proportions of their economy operating informally. Because such activity goes
untaxed, it does not generate tax revenues the state can use for merit goods.

Poorly functioning markets

Developing country markets face considerable obstacles to smooth operation.
Transport infrastructure can be poor, making logistical efficiency hard to achieve.
Businesses cannot get adequate credit because of an inadequate banking system. Legal
institutions are poorly developed, and so property rights and fair treatment are often
in doubt. All of these make the lives of entrepreneurs far more challenging than they
would be in their developed world counterparts, and slow the growth of industry.

Unequal power relationships to major countries

The small and weak countries that orbit their larger and more powerful neighbours
find themselves negotiating at a disadvantage in many areas: the terms of foreign
investment, foreign aid, and the opening of rich-country markets. The continued
stalling of the Doha Development Trade Round of the World Trade Organization
(WTO), started in 2001 and still yet unfinished, largely over access to rich world
agricultural markets, is one example of this unequal relationship.

4 How diverse are developing countries?

At the end of this section you will be able to:

« discuss the differences between developing countries, using examples.

‘While many less economically developed countries share the imposing challenges
discussed above, they can differ quite profoundly in other ways. These differences are
important to bear in mind as the policies recommended to LEDCs cannot be applied
without consideration for the differences. Some categories of difference are discussed below.

Different resource endowments

While it is understandable to think that a country is developing because it has
little in the way of natural resources, this is not necessarily true. Angola, a
country disrupted by decades of civil war, was once considered the breadbasket
of its region and holds major oil reserves. Myanmar is known to possess large
quantities of oil, natural gas, teak wood, and gems, yet it still languishes in poverty.
Brazil, considered to be as resource rich as nearly any country in the world, has
considerably underperformed in development terms given its resource endowment.
At the same time, some countries have done rather well despite limited natural
resources. Japan, with little arable land and no in-ground resources to speak of,
has consistently been ranked among the top few developed countries in the world.
Famously, Singapore has almost no resources to speak of but has expanded its land
base by increasing its shoreline. Liechtenstein and Andorra, two tiny European
569
 a4 Sustainable development

Ethics principalities, enjoy very high development levels with perhaps their only natural
Economic development resource being their geographical location in Europe.
considers the question
of Why is development Different historical experiences
uneven? but also provokes
the question of What s to Many developing countries were once colonies of developed countries. However,
be done? Some ethicists the effects of colonisation are varied, as well as being disputed. It has been argued
have challenged the rich that countries that experience long-standing occupation, like India and Hong Kong,
world to do more to help
the poor generaly, but benefited by the establishment of legal order and effective institutions. In contrast,
developing countries in countries that were used primarily for resource extraction, such as Myanmar and
particular. Among those is Vietnam, have fared less well. Other studies suggest that the duration of colonisation
Peter Singer, an Australian played a significant role, and that the terms of independence also made a difference.
moral philosopher, who
argues that helping the
poor is an essential part of Different political systems
agood e
“Ifitis in our power to Developing countries have a wide range of political systems. These include democracies,
prevent something bad monarchies, single-party states, theocracies, and military rule. Several have disputed
from happening, without governments, where conflict has rendered government almost completely ineffective,
thereby sacrificing and the problem of governance is discussed in detail in Chapter 29. With such variety it
anything of comparable
moral importance, we is necessary to create policies with consideration of the distinctive political structure in
ought, morally,to do it" any given developing country.
- Peter Singer
To take this argument Different degrees of political stability
to its extreme, as long
as afellow human is in Civil war or intra-state conflict certainly interferes with plans for prosperity and
need, any money spent development. Many of the countries at the bottom of the HDI have suffered from
by others on fiivolities is one or the other of these dangers. However, many other countries have had relatively
basically immoral. This is stable governments, with little conflict over changes in power. This, of course, does
connected to the notion
that the marginal utility of not confirm the relative efficacy of these governments — even the most stable can still
money actually diminishes be corrupt.
the more one acquires
of it. So, the marginal
utlity of one dollar to a Different geographical or demographic makeup
billionaire is practically Developing countries can be big, such as China, Russia, Brazil, and India, or quite small
nothing, but the same
dollar may mean life or like Haiti, Vanuatu, and Kiribati. Some are landlocked countries, like Bolivia, Lesotho,
death fora child on the Congo, Laos, and Burundi. Evidence suggests that being landlocked is a disadvantage in
verge of starvation. terms of access to trade. However, many developing countries have plenty of coastline,
For discussion: such as Mozambique, Somalia, and Indonesia. Some also have very large populations,
1 Do you agree with with the obvious examples of China and India, and others like Kiribati who have
Singers premise, shown populations in the hundreds of thousands.
above?

2 Ifyou agree with Singer’s

conclusion, what do you Different composition of industry
think should be done The clichéd notion of a developing country is one that is primarily agricultural,
about it?
and indeed two-thirds of people who are in extreme poverty work in agriculture,
3 What kind of knowledge
would persuade you however, as countries many LEDCs specialise in non-agricultural industry like basic
that Singer is correct or manufacturing of textiles and others may specialise in tourism service industries.
incorrect?

40n what basis might you In summary, one can say that there are commonalities between developing countries
accept the immorality of but also significant differences. As students of developing countries, it is of little use to
wealth accumulation, but generalise broadly, especially when considering the needs and possible solutions for
stilldefend it? any particular country.
570
Practice exam questions
Paper 1, part (a) questions - (HL & SL)
1. Distinguish between economic growth and economic
development. (10 marks)
2. Define sustainable development and explain two of the
Sustainable Development Goals. (10 marks)
Paper 1, part (a) questions -
1. Explain the relationship between poverty and sustainability. (10 marks)
Paper 1, part (b) question - (HL & SL)
1. Using real-world examples, evaluate the idea that economic
growth ensures sustainable economic development. (15 marks)

571
 Measuring
development
As described in Chapter 27, economic development is multidimensional. The most
commonly accepted standard, the UN HDI, includes measures of income, health and
education. Broader measures can encompass other quality of life measures like safety
and political freedom. This chapter will consider the many ways development can be
measured.
How do economists objectively classify countries at various stages of development?
Countries are usually first ranked by their per capita income levels. However, no
single indicator on its own can render an accurate portrait of any country’s overall
development, and there are a variety of other indicators available. Indeed, because
development involves so many facets of economic life, evaluations of a country’s
progress must involve many indicators taken together, and for this reason a number of
composite indicators have been developed.

28.1 What are the single indicators that are

used to measure economic development?

Learning outcomes
At the end of this section you will be able to:
« distinguish between GDP per capita figures and GNI per capita figures
* compare and contrast these figures for economically more developed countries
and economically less developed countries
* distinguish between GDP per capita figures and GDP per capita figures at PPP
exchange rates
* compare and contrast these figures for economically more developed countries
and economically less developed countries
* explain and give examples of economic and social inequality indicators, energy
indicators and environmental indicators.

Single indicators are specific individual statistics that are intended to demonstrate a
level of economic development. These can come from the realms of health, education,
income, or other measures. Economic indicators are specific points of data gathered
systematically and continuously to better inform economists and policymakers. For
each area, health for example, there may be dozens of different ways of assessing the
level of development.
Much like the gathering of national income data, the compilation and study of
measurement data is useful because:

« Dbaseline indicator data can help set an agenda for progress, with specific goals
* indicator data measured from one year to the next can indicate the level of progress
on that goal
+ continued data gathering enables policymakers to reformulate and adjust policies
to improve performance
* indicators across countries allow for cross-country comparisons of relative
development.
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 Measuring development

Itis important to bear in mind that conclusions based on statistics gathered from
developing countries must be read with caution. Many countries cannot afford the
resources needed for consistent and rigorous information gathering. For this reason,
many countries provide only limited data. Still more challenging is the extraordinary
variety of development indicators. The language and purposes of these can vary
significantly. As a result, some scepticism with regard to the reliability of the data is
warranted. However, where a long-term trend is evident, it is likely that the data have
a certain level of reliability and validity.

Income-based development indicators

GDP and GNI
National income data are usually the starting point for understanding development
levels. You will recall from Chapter 13 that real gross domestic product (real GDP) is
the inflation-adjusted value of all the goods and services produced in the country in
the past year. As such, it provides an indicator of the level of activity within a country’s
borders. GDP counts activity regardless of the flows of income in or out of the country.
So, one could say the GDP still counts production that is foreign owned and so the
profits flow out of the country. GDP will not count the production of domestically
owned companies in other countries, even though that is clearly beneficial to the home
country.
A different measure called gross national income (real GNI) takes the ownership of
resources into account. Rather than tracking production geographically, it considers
the flow of incomes across borders. Real GNI is the total money value of all final goods
and services produced in an economy in one year, plus net property income from
abroad (interest, rent, dividends and profit). In short, GNI = GDP — net income flows.

For example, take IKEA, a popular Swedish furniture retailer operating in China. Its
sales in China count towards Chinese GDP, but would go to Sweden’s GNI. For some
countries, the different calculation can mean a higher GNI value than GDP or a lower
one, depending on the amount of net flows of income. As the level of foreign direct
investment activity (FDI) has increased in the last several decades, some countries with
large international distribution of company ownership can have higher GNI than GDP.

Per capita GDP versus per capita GNI

To get a better understanding of the average level of production or income, per capita
measures are used. These divide national totals by the population to get average
income levels. Compared to national income totals, per capita income data provides a
better sense of the average standard of living.
When viewed comparatively, a number of high-income countries have rather different
per capita GDP and GNI results. Table 28.1 shows such a selection, where Ireland,
with the highest per capita income in terms of GDP, has over $16,000 less income per
capita in GNI terms. What does this mean? It suggests that there is far more economic
activity happening within Ireland than is actually being paid to Irish-owned factors of
production. This also appears to be true, to a lesser extent, for Singapore. Meanwhile,
for Germany the opposite appears to be true. German-owned factors of production
abroad (including repatriated corporate profits and salaries), contribute to Germany’s
income beyond what is generated solely within the borders of the country.

574
Table 28.1 GDP per capita versus GNI per capita for select countries

Country GDP per capita | GNI per capita (Atlas method) | GNI-GDP
(current US$) 2019 (current US$) 2019 (% of GDP)
Ireland 78,661 62,210 -20.9

Germany 46,258 48,520 4.8

Singapore 65,233 59,590 8.6

Vietnam 2,715 2,540 —6.4

Botswana 7,961 7,660 -3.7

Kenya 1,855 1,750 —5.6

In the case of richer countries, GNI may be higher than GDP because firms in those
countries have spread overseas and now generate significant profits that are sent back
to their corporate homes. Germany is such an example.

Some countries, but more often developing ones, may also have a discrepancy between
GDP and GNI numbers. The income generated by production within Vietnam slightly
outpaces the income generated by Vietnamese-owned factors. The same is true for
Singapore, Botswana, and Kenya.

For less developed countries, the differences between GDP and GNI may be for
different reasons. For Kenya, with increasing amounts of FDI, we may see a significant
amount of corporate profits sent out of the country. In the case of developing countries
with higher GNInumbers, it is possible that many have citizens living abroad as guest
workers who repatriate salaries home. These migrant salaries can be a significant
source of income for developing countries. While relatively small in total size, these
remittances can be very important to the local economy. For Tonga (40.7% of GDP),
Haiti (38.5%), and Nepal (26.9%) such income flows are essential for economic stability.
And in those countries GDP alone would likely undercount the income level because
remittances would not be included.

GDP and GNI using purchasing power parity

Of course, when doing any national income accounting, statisticians first calculate
output and incomes in the local currency. But comparisons between Norwegian krone
and Thai baht, for example, would seem meaningless without being translated into a
single currency, usually the US dollar.
While this translation makes comparisons more useful, the spending power of money
in Norway may be very different from that in Thailand. Resources, goods and services
may be more expensive in Norway than in Thailand, which means that more income is
needed in Norway to enjoy the same standard of living as in Thailand.

To more accurately reflect the buying power of any amount of income, and so to
better assess the standard of living in a country, economists use a comparison called
purchasing power parity (PPP). Purchasing power parity is based on the law of

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 Measuring development

one price, which states that an identical good in one country should cost the same
in another country, and that the exchange rate should reflect that price. This has
implications for the way we look at exchange rates (Chapter 25). For our purposes
here, PPP is a tool to assess more accurately the standard of living available for a given
amount of income in a country.

For example, the Norwegian equivalent of $100 (kr588) may buy a certain amount of
food, perhaps three pizzas. The Thai baht equivalent of $100 (B2,994) may buy six
pizzas, because staple goods are cheaper in Thailand (kr is the symbol of the
Norwegian krone, the currency of Norway. B is the symbol of the Thai baht, the
currency of Thailand). This means that every $100 of income earned in Norway will
buy less in goods and services than the same amount in Thailand. Therefore, Norway’s
high GDP per capita may overrate the standard of living there. When the purchasing
power is factored into national income measures, it produces a refined view of the
GDP data.

‘When PPP-adjusted per capita GNI is greater than nominal GNI, it suggests that the
potential standard of living is underestimated. For example, Burundi’s GNI per capita
is only $280, but adjusted by PPP measures is actually $782, which better reflects the
standard of living relative to price levels there. The same is true for many developing
countries. Ethiopia’s income by GNI per capita is only $850 per year, while by PPP
measures it rises to $2,311. It is with this in mind that economists pay attention to
PPP-adjusted GNI levels to better understand the attainable quality of life, and to
compare one country with another in this regard.

Health-based development indicators

Life expectancy at birth
Life expectancy at birth, which tells us how many years a person will live on average,
is the primary measure of health used in the HDI, the UN’s composite ranking of
acountry’s overall development. According to the Organisation for Economic
Co-operation and Development (OECD), life expectancy at birth is defined as
‘how long, on average, a newborn can expect to live, if current death rates do not
change’. What causes long life spans? Lack of conflict, good nutrition, better basic
health practices, better sanitation and disease prevention have all contributed to
longer life spans. The global life expectancy at birth in 2016 was 72 years. However,
life expectancy varies by region and country, and within countries can vary by gender,
economic level, and ethnic group.

Infant mortality
Infant mortality measures the number of deaths among children under one year
of age for every 1000 live births. Globally, this rate is 39 deaths per 1000 live births,
which is approximately 15,000 every day. In some countries this rate is as low as 2,
while in others it can be nearly 100, or 10% of live births. Infant mortality is seen as an
important signifier of overall health levels because prenatal and neonatal care can help
reduce the risk of long-term health conditions early in life, as well as influencing the
life expectancy at birth trends.

576
Maternal mortality ratio
The maternal mortality ratio (MMR), which measures maternal deaths per 100,000
live births, also tends to be highly correlated with overall development levels. This
metric shows death rates for women caused by factors related to childbirth either
before, during, or after pregnancy. When a country has an especially high MMR it is
an indicator that women’s health around pregnancy should be a priority, and this can
support infant health levels as well.

Education-based development indicators

Expected years of schooling
Expected years of schooling refers to the number of years of schooling that a child
of school entrance age can expect to receive if prevailing patterns of age-specific
enrolment rates persist throughout the child’s life. Countries that score lower in
development terms average around 9 such years, while developed countries tend to
have about 16.

Mean years of schooling

Mean years of schooling is the average number of years of education received by
people aged 25 and older. This can range from five years in the least developed
countries to about 12 in the highly developed ones.

Other development indicators

Inequality measures
Lorenz curves, Gini coefficients, and poverty indices are among the indicators of the
degree of economic inequality within society. Social inequality can be measured as
well by analysing different outcomes based on gender and ethnicity. Other measures
that tend to reveal social inequalities are undernourishment rates, rates of child
poverty, adolescent fertility rates, and child labour participation.

Energy indicators
Measures of how much energy is produced and consumed within a country can
give an idea of the level of development. Some useful indicators are electric power
consumption, access to electricity, and affordability.

Environmental indicators
Measurements of environmental sustainability are numerous, and the utility of
such indicators depends on the area of the environment being examined. To study
climate change, one might seek carbon emissions relative to GDP per capita.
To measure water availability, one might measure the population having access
to improved drinking water sources. And to study soil erosion, one may use
desertification levels.

In summary, the use of single indicators provides useful but narrow information
about a country’s overall well-being and level of development. This is why composite
measurements are increasingly used to give a broader view of the multidimensional
aspects of development.
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 Measuring development

28.2 What is a composite indicator?

Learning outcomes
At the end of this section you will be able to:
« explain that composite indicators include more than one measure and so are
considered to be better indicators of economic development
+ explain the measures that make up the HDI
+ compare and contrast the HDI figures for economically more developed
countries and economically less developed countries
+ explain why a country’s GDP/GNI per capita global ranking may be lower, or
higher, than its HDI global ranking
+ explain and give examples of other composite indicators
« discuss the value and limitations of different approaches to measuring economic
development.

Researchers and policymakers have turned to composite indicators to get a better

view of the many sided nature of development. These indicators combine two or more
single indicators, weighting each according to the design of the measurement, and
putting them together in an index.

The Human Development Index

The most influential and important composite indicator is the HDI. The HDI is a
composite index that brings together three variables that reflect the three basic goals
of development: a long and healthy life, a good education, and a decent standard of
living. The variables measured are life expectancy at birth, mean years of schooling
and expected years of schooling, and GNI per capita (PPP USS). It was created by the
UN Development Programme (UNDP) in the late 1980s and put into use in 1990. It was
created as a response to dissatisfaction with the emphasis on economic growth as the
sole means to measure development.

The UNDP was attempting to shift the paradigm for development away from a purely
growth-based model to a broader view, one that encompasses health and education
levels. Amartya Sen, whose work is recognised as providing the intellectual framework
of the HDI, put it this way:

‘Human development, as an approach, is concerned with what I take to be the

basic development idea: namely, advancing the richness of human life, rather
than the richness of the economy in which human beings live, which is only a
part of it.”
— Amartya Sen

With this ideal in mind, the HDI evaluates the performance of a country in three areas:

* long life - measured by life expectancy

* education — measured by adult literacy and combined primary, secondary and
tertiary enrolment ratio
« standard of living — measured by GDP per capita (PPP-adjusted).
578
DIMENSIONS Long and healthy life Knowledge A decent standard of living

INDICATORS Life expectancy at birth Expected years Mean years GNI per capita (PP $)
of schooling lofschoc\ing

DIMENSION Life expectancy index Education index GNl index

INDEX /

Human development index (HDI)

A
Figure 28.1 shows the flow of dimensions to indicators to the dimension index used to Figure28.1 The Human
calculate the HDI Development Index combines
anumber of indicators across
These dimensions are weighted and aggregated into a composite index. Each country’s three dimensions
performance in an area earns a score between 0 and 1; 0 is lowest, 1 the highest. These
areas are then compiled for the composite HDI ranking. Table 28.2 shows the HDI
value range and the scoring classifications.
Table 28.3 shows a selection of countries from each category. For some the HDI
ranking in overall development is similar to the ranking on sheer income, here shown
as GNI per capita. Some degree of correlation between development and income
is to be expected, both because money is required to pay for essential healthcare
and education but also because the HDI itself weights income as a third of its
measurement. This makes discrepancies between these rankings more interesting.
How does a country manage to ‘overachieve’ by ranking highly on development but
lower on income? What is happening when a country scores highly on income but
lower on development?

‘Where there is a difference between HDI and GNI performance, it is typically only
a few spots. In many more, like El Salvador and Indonesia, they are very close.
It would appear that, based on this list, some countries slightly overperform in
development, relative to what their income rank would suggest (Norway, South
Korea, Poland, Cameroon, and Pakistan), while Madagascar (+19) scores significantly
better. Several others, the USA, Nigeria, Senegal among them, slightly underperform
in development compared to their income level, and a few such as Brunei and Qatar,
significantly fall short of what their income levels would suggest.
‘What are the overperforming countries doing right, and the underperforming
countries doing wrong? Policymakers can use this information to assess their priorities
and change their approach. Chapter 29 will explore the barriers to development, which
may help explain why some countries misuse their wealth, and in Chapter 30 we will
consider the strategies that countries can use to make development decisions.

Table 28.2 HDI country classification levels

Classification HDI value
Very high human development 0.800 and above
High human development 0.700 t0 0.799
Medium human development 0.555 t0 0.699
Low human development Less than 0.555
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 Measuring development

Table 28.3 HDI and GNI per capita information for selected countries

HDI Category Country HDI value | HDI rank | GNI per capita | GNIper capita | GNI per capita
(PPPUS$) | (PPPUS$)rank | (PPPUS$)
minus HDI rank
Very highhuman | Norway 0.954 1 76,684.5 7 +6
development
(62 countries)
UsA 0.920 15 65,880 10 -5
South Korea 0.906 22 43,430 29 +7

High human Poland 0.872 40 32,710 45 +5

g(54vt Countries)
opment Brunci 0.845 4 80,303 9 34
Darussalam
Qatar 0.848 41 94,170 2 -39
Medium human Indonesia 0.707 111 11,930 109 -2
development El Salvador 0.667 124 8,700 124 0
(36 countries)
Cameroon 0.563 150 3,730 158 +8

Pakistan 0.560 152 5,210 144 +8

Low human Nigeria 0.534 158 5,170 146 =12

development Senegal 0514 166 1,450 159 -7
(36 countries)
Madagascar 0.521 162 1,660 183 +19

Afghanistan 0.496 170 2,330 173 +3

The values and limitations of using the HDI

While the HDI is a major improvement over the crude use of simple GDP per capita to
measure development between countries, it is likely to mask the vast differences within
each country. Many countries have major differences in development between different
regions, where major cities could rank in entirely different categories of the HDI than
other parts of the country. Gender differences can be stark, with lower levels of health,
income and education for women and girls. Attainment of all three of these key life
measurements can also vary significantly between ethnic groups. With this in mind,
economists and researchers are creating new indices that study other areas of the issue.

3 G LRl
With the data provided in Table 28.3 study the following groups of countries and
make inferences about the difference between their GNI results and their HDI
rankings. In other words, if the HDI consists of income, education and health,
what can be said of countries that are overperforming (+) or underperforming (-)
compared to their income?
1 What would you say about the differences between Poland and Brunei?
2 Nigeria and Madagascar score closely on the overall HDI, but have very different
GNI levels. What do you think might be true of each country relative to the other?

580
Other composite indices used to study development
The Gender Inequality Index
In 2010, the UNDP created the first Gender Inequality Index (GII), a composite
indicator of the disparity in well-being between women and men in three areas:
reproductive health, empowerment, and the labour market. The reproductive health
dimension is measured by two indicators: MMR and the adolescent fertility rate. The
empowerment dimension is measured by two indicators: the share of parliamentary
seats held by each gender and their secondary and higher education attainment levels.
The economic dimension is measured by women’s participation in the workforce.

According to the UNDP, the GII ‘is designed to reveal the extent to which national
human development achievements are eroded by gender inequality, and to provide
empirical foundations for policy analysis and advocacy efforts’.

Comparison of overall HDI rank to GII rank reveals that in some countries, gender
inequality performance is holding back total development. Table 28.4 shows selected
countries and their HDI as well as their GII ranks. The higher the GII rank, the greater
equality between females and males.

The top countries in Table 28.4 have a GII rank well below their HDI rank. This L e
suggests that the HDI scores for these countries would be even higher if there were to What is the relationship
be some improvement in women’s healthcare, women’s comparative education levels, between development and
female employment, or political representation. gender equality? Select from
Table 28.4 one country with
The bottom countries in Table 28.4 have scored extremely highly on the GII (more large negative disparities
equality) compared to their overall HDI rank. As the HDI rankings attest, none of these and one country with large
positive disparities. What are
are especially wealthy or highly developed. But gender equity scores are ‘better than the factors or policies that
expected’ when compared to their HDI rankings. resultin such high or low
scores in each country? Use
search terms like ‘gender
Inequality-adjusted Human Development Index equality policies’, or ‘gender
With the Inequality-adjusted Human Development Index (IHDI), the UN has adjusted disparities/equality in
[your selected country].
the HDI measures by how those achievements are distributed among the country’s

Table 28.4 Countries with large disparities between HDI and GII ranks
Country HDI rank (higher rank | GlIIrank (higher rank | HDI-GII
= more developed) = more equal) disparity
Large negative disparities
Saudi Arabia 36 49 -13
USA 15 42 =27
Iran 65 118 =53
Panama 67 108 51
Large positive disparities

Libya 110 41 +69

China 85 39 +46
Tajikistan 125 84 +41
Portugal 40 17 +23

581
 Measuring development

DIMENSIONS Long and healthy life Knowledge A decent standard of living

INDICATORS Life expectancy at birth Expected years ~ Mean years GNI per capita (PPP $)
of schooling lcfschcoling

DIMENSION Life expectancy Years of schooling Income/consumption

INDEX

INEQUALITY- Inequality-adjusted Inequality-adjusted Inequality-adjusted

ADJUSTED life expectancy index education index income index

S |
INDEX

Inequality-adjusted human development index (IHDI)

A
Figure28.2 The Inequality- population by ‘discounting’ each dimension’s average value according to its level of
adjusted Human inequality. This approach strives to account for the human costs of inequality.
Development Index
Because all countries have some inequality in their distributions of income, education
and health, all countries’ THDI decreased their overall HDI value. In other words, all of
the IHDI values are lower than their HDI ones because all countries suffer development
costs because of their inequality. However, those with the greatest inequality fall
furthest in the rankings while some move up because of their smaller relative
inequities.

The table below shows a selection of countries and their HDI score and rank as well as
their IHDI score and rank, as well as the difference between the two. The final column
therefore shows the rise or fall in rankings because of the IHDI adjustment.
Notice that Singapore dropped several places while Japan moved up. One way to
explain this is to say that the high levels of development in Singapore are concentrated
and not as widely distributed as they are in Japan. We could say the same thing about
Brazil and Chile (both marked down by the IHDI), compared to Kyrgyzstan. By these
measures, the UN is saying that the social costs of inequality will drag down overall
development, and this is especially true for some countries.

Table 28.5 Selected countries’ HDI and Inequality adjusted HDI values and ranks
Country HDIvalue | HDIrank | IHDIvalue | IHDIrank | HDIrank-
IHDI rank
Norway 0.945 1 0.0889 1 0
Singapore 0.935 9 0.810 23 —14
Japan 0.915 19 0.882 4 +15

USA 0.920 15 0.845 28 -13

Chile 0.847 42 0.696 56 14
Brazil 0.769 79 0.574 102 -23
Kyrgyzstan 0.674 122 0.610 99 +23

Namibia 0.645 130 0.417 144 —14

582
 < Singapores developed skyline;
however, the benefits of
development are not as
equally shared as in some
other countries

As described in Chapter 18, inequality carries costs that show up in health levels and
education attainment. Specifically, higher levels of many bad social outcomes such as
obesity, mental illness, depression, and infant mortality are found in unequal societies.

‘Why keep track of these distinctions? As the UN says, ‘The IHDI allows a direct link
to inequalities in dimensions, it can inform policies towards inequality reduction, and
leads to better understanding of inequalities across population and their contribution
to the overall human development cost’. Advocates for more equitable policies in
countries like the USA, Brazil, Singapore, Chile, and Namibia can point to these results
as the inspiration for changing course.

|5 G (TR R
Using the information in Table 28.5, discuss the probable differences between the
following countries who scores similarly on the HDI, but differently on the IHDI.
1 Japanand the USA.
2 Kyrgyzstan and Brazil.

The Happy Planet Index

‘We have already discussed the Happy Planet Index (HPI) in Chapter 13. The HPI
measures well-being, life expectancy, and inequality and adjusts these for the
ecological footprint per person. By doing so, the HPI tries to measure equitable
well-being with sustainability factored in. The results for the HPI vary significantly
from traditional HDI rankings.

The multidimensional poverty index (MPI)

The MPI was explained in more detail in Chapter 18. The MPl is a composite indicator
that contributes to the understanding of the complexity of poverty, one that combines
traditional measures of education and health with specific indicators on standard of
living. The indicators are:
+ health - nutrition, child mortality
+ education - years of schooling, school attendance
+ standard of living - cooking fuel, sanitation, electricity, housing, assets,
drinking water.
583
 Measuring development

The Inclusive Development Index

The Inclusive Development Index (IDI) is a project that comes from the World
Economic Forum’s System Initiative, one whose stated goal is ‘to inform and enable
sustained and inclusive economic progress through deepened public—private
cooperation.’ The IDI itself has three pillars: growth and development; inclusion;
and intergenerational equity with sustainable stewardship of natural and financial
resources.
The IDI tries to incorporate many factors into each of its dimensions, including
measures of income and wealth equity, as well as the financial and environmental
sustainability over time.
Table 28.6 shows sample scores for selected countries from the two groups, advanced
and emerging economies. Among the advanced economies, Switzerland is near the
top at number 4, and the UK, significantly lower at number 21. Switzerland ranks in
Using the IDI, look up your the top 20% for seven of the elements, while the UK is in the bottom 40% for seven
home country, or your
country of residence. Do
clements.
the rankings make sense to
You, or is there something In the emerging economies group, Lithuania is at the top, ranking in the top 20% for
surprising? Now seek out the five of the elements measured. China, while scoring highly in three elements, is in the
results for one emerging bottom 20% for income and wealth inequality, as well as net savings.
and one advanced economy
and share the results with The data offered by the IDI, as well as the numerous other composite indices being
your class. offered, is to energise debate around the ways to best achieve development aims.

What are the strengths and limitations of the

different approaches to measuring development?
With all the measurements available, the study of development may seem intimidating.
How does one compare and evaluate the different approaches? It may be evident that

A
Figure 28.3 Inclusive
Development Index
dimensions and indicators

584
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 Measuring development

single indicators are less useful than composite indicators at evaluating the many facets
to human well-being in any given country. And all such data is only as good as the
methods used to compile it.

One might compare this trend to the notion of an ‘open source’ environment where
the standard no longer is measured through one statistic (GDP per capita) and
distributed by one or two agencies, like the World Bank and the UN. Instead, the open
approach has many different non-governmental organisations (NGOs), research
What knowledge
questions might groups, and intergovernmental agencies all trying out new perspectives and new
be encountered in models. Just as the HDI surpassed old measures of economic growth, so too may
constructing a composite one of the alternative measures here evolve into the baseline standard for country
indicator to measure
development? well-being, ones that include the distribution of well-being, the sustainability of each
country’s way of life, and whether such well-being is broadly enjoyed.

Exercise 28.3
Using the information in the chapter and your own knowledge of economics,
evaluate the strengths and limitations of any two of the composite indices discussed
in this chapter.

Practice exam questions

Paper 1, part (a) questions (HL and SL)
1. Explain the difference between GDP per capita and GNI per capita
as a measure of economic growth. (10 marks)
2. Discuss how three different indicators might be used to measure health. (10 marks)
3. Explain what the Human Development Index measures. (10 marks)
4. Compare two composite indicators, explain how economic
development can be measured differently. (10 marks)
Paper 1, part (b) questions (HL and SL)
2. Using real-world examples, examine the distinction between
economic growth and economic development. (15 marks)
HL and SL Paper 2, 2-mark and 4-mark questions

Country | HDIrank | HDIvalue | GNIper | GDP Cause of death

capita | growth | by communicable
(PPP USS) | rate (%) disease and
nutrition
conditions
(% of total)
Ireland 3 0.942 55,660 5.5 5
China 85 0.752 16,127 6.1 4
Myanmar 145 0.584 5,764 6.5 24
Tanzania 159 0.528 2,805 6.3 56
South 186 0.413 1,716 113 63
Sudan

586
2-mark questions (HL and SL)
8 Define the following terms:
a. HDI (2 marks)
b. GDP growth rate. (2 marks)
4-mark questions (HL and SL)
i, Explain why cause of death by communicable disease and
nutrition conditions would correlate highly with levels of
economic development. (4 marks)
Explain two reasons why the GDP growth rate is not a useful
indicator of overall economic development. (4 marks)

587
 Barriers to economic
growth and development
In our last two chapters we established a definition of economic development, with an
acknowledgement that sustainable development requires a broad look at human well-
being that incorporates economic, social, political, and environmental considerations.
‘We have also examined the common characteristics of less economically developed
countries and looked at the different measurements of economic development, both
single indicators and composite indicators.
In this chapter we will ask the question, ‘What are the barriers to economic
development?' In order for countries to overcome poverty and raise living standards
to alevel at which a healthy, happy life can be enjoyed by all, an understanding of the
obstacles their economies face is crucial.

PACh hat is a poverty trap

Learning outcomes
At the end of this section you will be able to:
* explain, using a diagram, how certain factors can trap a country in a cycle that
perpetuates poverty, including:
natural resource endowments
« geography
+ education
* poor governance
+ conflict.

A poverty trap is any self-reinforcing mechanism that contributes to the persistence

of poverty in a nation. If a country finds itself in a poverty trap over a long period of
time, it is unlikely to escape unless meaningful steps are taken either domestically or
initiated by an outside force to allow the country to escape the trap.
Poverty traps usually have at their core a fundamental obstacle that perpetuates itself
and thereby keeps the country poor. Some examples of poverty traps include the
natural resource trap, the geography trap, the poor education/poor governance trap,
and the conflict trap.

What is the natural resource trap?

A developing country with few natural resources may find itself in a poverty trap for two
reasons. First, without mineral, energy, forest, or marine resources it cannot sustain
its domestic need for such resources. Second, it cannot export resources to earn much
needed foreign exchange. Without a developed secondary, manufacturing sector,
many developing countries (such as the Democratic Republic of Congo and other
mineral-rich countries in Africa) depend greatly on the export of raw materials to
Europe and East Asia.
A country without a secondary sector and a poor supply of natural resources,
however, could find itself in a particularly difficult situation in which the foreign
capital required to invest in its secondary sector is inaccessible due to the lack
of exchangeable commodities from within the country. Figure 29.1 provides an
589
 Barriers to economic growth and development

Resource No
poor exportable
country commodities

Figure 29.1 Inthe natural

resource poverty cycle the Limited
lack of exportable foreign
commodities hampers income
economic development

Low productivi _ Inability to

and Igw incomg import capital
goods

illustration of a poverty trap in which a developing country is kept poor because of its lack
of exportable natural resource commodities. The trap is illustrated in a circle, or a poverty
cycle: a self-perpetuating cycle of poverty from which the country cannot escape.

Poverty persists because a poor resource base prevents the country from accessing
foreign capital. Since the country has few valuable natural resources to exchange with
the rest of the world, it has only limited access to the foreign exchange it would need
to acquire the capital goods needed to develop a secondary sector. Without capital,
worker productivity and incomes remain low, and the people remain impoverished.

Paul Collier, an economics professor at Oxford University, proposes another kind

of natural resource trap, in which a developing country is kept poor because of its
abundance of natural resources. His seemingly contradictory theory is explained by
the fact that if all a developing country has to offer the global market is one valuable
natural commodity (such as diamonds from Sierra Leone or Liberia), domestic conflict
arises over the control of the one natural resource. Political and social upheaval may
result from the struggle for control of the exportable commodity, creating conditions
completely antithetical to those necessary for economic development.

What is the geography trap?

Collier also suggests that a major source of persistent poverty for some nations is
their geographical location. If a nation is landlocked and surrounded by developing
countries, that country is extremely likely to be developing itself. Being landlocked
alone does not mean a country is developing. There are several landlocked countries
in Europe that are among the richest in the world, such as Luxembourg, Switzerland,
Austria, and Liechtenstein. But all these countries are fortunate to have rich
neighbours with whom they have good economic relations.
Alook at the map of Africa, Asia, or South America identifies many landlocked
countries that are among the least developed in the world, including Bolivia,
Paraguay, Niger, Zambia, Nepal, and Afghanistan.

Some of the least developed countries in South America, Africa, and Asia are
landlocked and surrounded by other developing countries, a situation that makes
it incredibly difficult for the landlocked country to begin a journey on the path of
economic development. Figure 29.3 provides an example of the poverty cycle a
landlocked country might find itself in.
590
 [l Landlocked [l Double-landlocked

A
The key to the geography trap is the lack of access to sea ports even in neighbouring Figure29.2 The landlocked
countries. Without access to sea ports, it does not matter how politically stable and countries of the world
economically attractive a country is to foreign producers and consumers. If there are
no means to safely and reliably export their output to the rest of the world, such a
country would not even be on the radar of international investors looking for places to
produce goods for the global market. Without reliable demand from other countries,
it would be nearly impossible for a developing country to increase its national income
and the standards of living of its people.

What is the education and poor governance trap?

One of the most important functions of government s to collect taxes and provide
public goods to the nation’s people, including education, healthcare, and infrastructure.

Country is
landlocked with et
global markets
hostile neighbours
Figure29.3 Inthe
No foreign geography poverty cycle a
income from lack of sea ports blocks access
exports to global markets and
stunts growth
Less
Lower domestic
incomes employment

591
 Barriers to economic growth and development

Poor Low quality

education human
system capital

Figure29.4 Inthe pp
education poverty cycle Minimal Low
under-provision of education spending on productivity
perpetuates poverty and bad public goods
governance
Low tax Low
revenue/ P incomes
corrupt gov't

In a developing country with a corrupt government, an ineffective tax system and a

poor education system, economic development is nearly impossible to achieve. And
Developing countries are under-provision of education perpetuates the bad governance and poverty, as can be
poor because their leaders
keep them poor. To what seen in Figure 29.4.
extent is this statement : P
true? Is a good leader all A poorly educated workforce makes a country less attractive for foreign direct
that is needed to achieve investment, limiting the amount of capital available to workers. Low skill levels and
economic development in limited capital make the nation’s workforce unproductive, meaning lower incomes,
ey less tax revenue, and less ability for the government to provide the very public goods
needed to get the country on the road to economic development.

What is the conflict trap?

Perhaps the worst poverty trap for a country to find itself in is a conflict trap.
Unfortunately, any of the three poverty traps described above can easily deteriorate
into conflict, and if a country finds itself in all three situations (landlocked with poor
natural resources, and a corrupt government) the likelihood of conflict arising is
extremely high. Civil unrest perpetuates poverty for many reasons, but Figure 29.5
shows the basic problem with conflict in a developing nation.

Much of the conflict in developing countries is over the resources that are needed
to generate income that could then be put to work improving people’s lives. But
the existence of conflict ultimately intensifies the scarcity of resources and creates
an environment of political and economic uncertainty that makes the country
unattractive to foreign investors who might otherwise invest in the nation’s economy.

Civil
unrestand
violence

Figure29.5 In the conflict

poverty cyle, scarcity Intense Political and
of resources is both cause
resource economic
scarcity uncertainty
and effect

Reduced
investment
from abroad

592
In this way, conflict born from scarcity actually intensifies scarcity and thereby fuels
more conflict. A country in which many resources are going towards waging an
internal war is most certainly going to remain developing until stability is achieved and
an atmosphere deemed safe for international investors is restored.

29.2 What are the economic barriers to growth

and development?

Learning outcomes
At the end of this section you will be able to:
* examine the role of barriers to economic development including:
* inequality
* lack of access to infrastructure and appropriate technology
+ low levels of human capital
* lack of access to healthcare and education
+ dependence on primary sector production
« lack of access to international markets
« informal economy
capital flight
« indebtedness
* geography including landlocked countries.

What is the relationship between inequality and

economic growth and development?
An unequal distribution of income, demonstrated by a nation’s Gini coefficient, is
common in developing countries. While the vast majority of the population remains
poor, what little income is generated by the economy is often enjoyed by a tiny elite.
Unequal income distribution may be a result of an ineffective tax system, without
which an equitable distribution of income is impossible. Without a system of transfer
payments, the ability of the poor to escape poverty by improving their human capital
is limited, keeping the majority of the country’s population in poverty.
Inequality can be considered both a cause and a consequence of underdevelopment.
In a way, growth and development present a pathway towards greater equity and
equality in society; after all, the larger the pie, the more there is to go around. However,
alow level of economic development can also be caused by inequality, as without
alevel playing field and an equitable opportunity for all in society to pursue and
maintain a higher standard of living, economic development can never get underway.
Equity requires that all people are offered the same opportunities, including access to
education and healthcare. While gaps between rich and poor might exist, they are not
s0 great that they cannot be overcome through individual perseverance and hard work.
The picture painted here is idealistic; in reality the many other social, cultural, economic,
and political barriers to economic development complicate the picture and make
improved equity and a more equal distribution of income that much harder to achieve.
593
 Barriers to economic growth and development

Why do a lack of access to infrastructure and

appropriate technology slow development?
Infrastructure includes roads, highways, airports, rail track, ports, and
communications technologies such as cellular towers, phone lines, and internet.
Italso includes a nation’s stock of schools, hospitals, clinics, community centres,
cultural centres, office buildings, and all other ‘manufactured inputs’ that contribute to
economic growth and development.
Alack of access to infrastructure leaves a country in a permanent state of underdevelopment.
Infrastructure is like the essential biological systems that support the life of a functioning
economy. Roads are the arteries of commerce, telecommunications the neurons, school
the brains, and hospitals the immune system. Without infrastructure, the organism that
is the economy is sick and cannot function efficiently.
Where does infrastructure come from? Once again we return to a chicken and egg
question. Without economic growth, a country cannot afford to invest in infrastructure,
which itself is necessary for economic growth. In other words, some income is needed
before infrastructure improvements can be made. For very under-developed countries,
international aid or foreign investment could provide infrastructure, cither through
private investments from multinational corporations or via aid from international
organisations like the World Bank (which will be explored more in Chapter 30).

What is human capital and why does it matter?

Human capital refers to the level of skill, knowledge, and education among a country’s
workforce. A low level of human capital occurs in countries in which access to
education is inadequate, while good schooling improves human capital.

Why is it important? While growth and development can take place even in a country
with low levels of human capital (an export-oriented growth strategy based on the
employment of unskilled workers in agriculture, mining, or manufacturing industries,
for example) there is ultimately a ceiling at which improvements in living standards will
be capped without investing in human capital. The most developed countries in the
world, in which households enjoy higher incomes, but also better health and a cleaner
environment, are typically those in which human capital has been invested in through
providing high quality education systems for decades. The jobs available to high-skilled
workers are typically safer, pay higher incomes, offer more benefits like paid holidays, and
take a smaller toll on the physical well-being of those who do them. Therefore, improving
human capital is a sure means to promote economic growth and development.

An educated population is able to contribute more to the economic output of a

developing country than if the population has less access to education. There is a
strong correlation between education and income; as access to education increases,
productivity of workers rises, allowing them to contribute to the nation’s output and
increase their own income in the process.

How does a dependence on primary sector

production affect development?
In Section 29.1 we looked at the ‘resource trap’ that many developing countries that are
overly dependent on the production of primary commodities have found themselves in.
594
 Gold 2%
Cocoa beans 2%

« Figure29.6 Mostof
Nigeria's exports are of oil
and gas

Many less economically developed countries tend to over-specialise in a narrow range

of products, oftentimes primary commodities such as energy resources, minerals, and
agricultural goods. Consider Figure 29.6, which shows the composition of Nigeria's
exports to the rest of the world.
Observe from the pie chart that 88% of Nigeria’s exports are of energy resources
(oil and gas). While specialisation in petroleum allows Nigeria to achieve a high level of
efficiency in the production of this valuable resource, it also leaves the country highly
vulnerable to fluctuations in global petroleum prices.
‘When oil prices are high, Nigeria can expect to enjoy booming export revenues,
strong aggregate demand (AD), higher levels of employment and income, and a strong
currency. However, when global oil prices fall, Nigeria’s AD, employment, price level,
aggregate output, and currency exchange rate will all decline. The current account
balance will move towards a deficit and Nigeria’s foreign income will fall, making it
difficult to afford the imports of manufactured goods and technology that it depends
on for economic development.
Consider Figure 29.7, which shows the world ol price between 2005 and 2017. As the
price of its only major export fluctuated, Nigeria's economy would have experienced
macroeconomic shocks as its export earnings rose and fell. When oil prices rise,
Nigeria’s currency appreciates as demand for its major exports increases. High
export revenues and a strong currency allow Nigeria to buy imported technology
and consumer goods relatively cheaply and promote improvements in economic
development as the cost of welfare-improving products becomes more affordable.

140

N M
NS
Price per barrel (US$)
33

-« Figure29.7 Globaloi price

3

60
fluctuations, 2005-17

Vv
20
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Year
598
 Barriers to economic growth and development

Dried legumes 5%

Figure29.8 Malawis
exports
are almost all
agricultural goods

However, when oil prices fall, Nigeria’s ability to buy those development-supporting
imports decreases. The problem with primary commodities, as we learned in our
microeconomic chapters, is that their prices tend to be highly volatile due to relatively
inelastic demand and supply. For this reason, over-specialising in a single or a small
number of primary commodities leads to instability and poses a barrier to economic
development for developing countries.

Let us consider another country that is overly dependent on a narrow range of exports.
Figure 29.8 shows the composition of Malawi’s exports.

Malawi specialises almost entirely in agricultural goods (80% of exports), which like
oil tend to have highly volatile prices on global markets due to their highly inelastic
supply and demand. Consumers are not highly responsive to price changes, so changes
in supply year to year tend to result in sharp spikes or dips in global price. In the short
run, supply of agricultural goods is highly inelastic, resulting in price volatility as
demand rises and falls.
For comparison, let us look at the composition of goods produced in a more
economically developed country, the UK. Figure 29.9 shows the UK’s exports by
category.
Animal products 2%
Paper goods 2%
Textiles 2%
Plastics 4%

Foodstuffs 5%

Instruments 5%
Figure29.9
United Kingdom exports |
include a diverse range Metals 5%
of goods

Precious metals 6%

596
Obviously, the UK produces a much more diverse range of goods for export to the L]
rest of the world, which shelters its economy from swings in the prices in any single The diversity of a country's
category of goods. As a result, the UK’s economy is much more resilient and able to economic output is
survive the volatility that is common in the markets for primary commodities. important for the level of
resilience to economic
shocks the economy might
Does access to international markets matter? face. Overdependence on
a small number of primary
In short, YES! Poet John Donne wrote, ‘No man is an island.’ In the same vein, no commodities, as we have
country is an island. I mean, yes, there are countries that are literally islands, but shown, can present a barrier
metaphorically speaking, no person (or country) is truly self-sufficient. The degree to economic development.
to which less developed countries are integrated with the rest of the global economy A great resource for
plays a huge role in their access both to markets for their exported commodities or visualising the composition of
countries’ output is available
manufactured goods and their ability to import the capital and consumer goods at the Observatory of
necessary for economic development. Economic Complexity. Look it
Up in a web browser, or visit
Access to markets means more than just more places to sell exports to or buy imports https://oec.world. Complete
from. Globalisation means financial integration as well, and at the higher levels free the following tasks, making
movement of labour and capital. Trade blocs in the developing world have increased
observations along the way,
then answer the questions
regionalisation in less developed countries, while bilateral and multilateral trade that follow.
agreements between more developed and less developed economies have broadened Tasks:
the markets for producers on both ends of these deals. 1 Choose one less
economically developed
For all the reasons outlined in Chapter 22, Benefits of international trade, and country, perhaps from
Chapter 24, Economic integration, broadening access to global markets provides a sub-Saharan Arica, South
path towards economic development. On the other hand, an inward oriented strategy Asia, or Central Asia. In the
through which a country attempts to achieve growth and development on its own, search bar where it says
“Explore World Trade', type
is bound to result in perpetual poverty and low living standards. ‘Self-sufficiency is the name of the country
the road to poverty’, argues American economist Russ Roberts. Increased economic you selected and the word
integration, therefore, provides a pathway to prosperity. ‘exports. Click enter.
Study the chart that is
~

returned, which should

What is the informal economy, and why might show the composition of
your selected country’s
a large one affect development? exports.
Large informal markets, or black markets, are common in less developed countries, In a separate tab in your
again largely because of the lack of effective institutions such as a legal system, law browser, do the same thing
enforcement, property rights, or a system of taxation. When an entrepreneur in a for amore developed
developing country sees a business opportunity, her natural instinct might be to take country, perhaps one from
Western Europe, North
the steps necessary to meet the demand she sees, and do so at the lowest possible cost America, or East Asia
in order to maximise her own profits and well-being. Study the resulting chart.
With the two export charts
Black markets may bring to mind illicit or illegal activities, such as drugs or prostitution, on your screen, answer the
but in fact, most informal markets in the developing world are just enterprising questions that follow.
businesspeople meeting the needs in their communities, but doing so without going 1 What percentage of total
through the formal, official, process of starting a legal business, recording and reporting exports are made up by
income to the government, paying taxes and licence and permit fees, and all the other the three largest exports
from the less developed
‘red tape’ that goes along with running a legitimate business. country you selected?
What about from the more
In other words, black markets in themselves are not necessarily barriers to economic developed country?
development; rather, the benefits an economy would experience from more of the What are the largest
~

informal economy becoming formalised. There are benefits to individuals who run exports from each of your
their businesses informally, but there are costs to society as a whole, including reduced countries?

tax revenues and a diminished public sector that, were more of the economy taking
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 Barriers to economic growth and development

Research and inquiry cont. place formally, would be able to provide more of the public goods on which continued
3 Choose one of the primary economic development depends.
commodities that make
up a significant percentage
of your less developed What is capital flight?
country's exports. Do a Capital flight occurs when financial and physical assets are withdrawn from a country
web search for the name due to uncertainty over economic conditions or events that have made the country
of the commodity and
“price chart’ for example, less attractive for foreign investment. Domestic capital flight occurs when domestic
‘copper price chart. investors withdraw their assets and place them in safer, overseas accounts or invest in
a Finda price chart physical assets abroad rather than at home.
showing the changes in
the commodities price Capital outflows might occur due to political turmoil, such as a contested national
over several years. clection or a government takeover by a party hostile to foreign investment. Economic
How would you causes might include an increase in taxes on foreign investment or a decrease in
o

describe the changes in

the commodities price interest rates that suddenly makes investments in the country less profitable to
over the years? foreigners. Exchange rate fluctuations also might make foreign investors jittery and
What might account lead them to withdraw their investments.
for the fluctuations
observed in the When financial and physical capital are withdrawn from a developing country, the
commodity's price over economy will find its capital stock decreased, slowing the rate of economic growth, or
several years? even causing a recession. Foreign investment provides a source of domestic tax revenue, so
Why do the prices of with less foreign capital in the country the domestic tax base, along with the government’s
~

manufactured goods tend ability to provide public goods like education and infrastructures, is diminished.
to be more stable and
therefore fluctuate less Capital flight can be prevented when a developing country tackles some of the
than the prices of primary
commodities? other barriers to development that it faces, including political, banking and finance,
Why does a country's property rights, and legal challenges. Stable institutions foster confidence among both
w

dependence on the export international and domestic investors and create an environment more conducive to
of a small number of attracting and retaining international capital flows.
primary commodities pose
a barrier to economic
development? Is indebtedness a concern?
In the macroeconomics section of this course we learned how countries accrue debt: when
agovernment’s budget is in deficit, it must borrow money to finance that deficit, adding to
the national debt. Every year a country experiences a budget deficit, its national debt grows.
Debt in and of itself is not always a bad thing. The ability to borrow funds to finance a
budget deficit allows a country to fund the current and capital expenditures necessary
to keep the government running, to invest in the nation’s infrastructure, and to
provide the public goods required for economic development.

The countries with the highest debt levels in the world are hardly on the brink of
economic collapse. The USA, with a national debt of over $20 trillion (around 100% of
gross domestic product (GDP)), enjoys macroeconomic stability and a strong currency.
Japan has debt that equals nearly 250% of its national income, yet it is considered one
of the safest economies in the world to do business in.

The problem arises when a country’s debt is mostly owed to foreign investors, AND
when the burden of that debt limits the country’s ability to provide necessary public
goods and to invest in infrastructure. External debt, or foreign debt, is the proportion
of a country’s debt that is owed to international lenders, including commercial banks,
governments, and international financial institutions like the World Bank and the
International Monetary Fund.
598
 450

400
External debt stocks (% of GNI)

350

300

250
«f Figure29.10 External debt
200 stocks as a percentage of GNI
for selected sub-Saharan
150 African nations

100 20

50

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Year
=+=Guyana ===Dem.Rep.Congo +==+Malawi : : - Céte d'voire =—— Uganda

‘When a less developed country accumulates a large amount of foreign debt, servicing
that debt can crowd out essential spending on public goods and infrastructure, and
thus limit the level of economic development in the developing country. Debt servicing
refers to the money that a government must spend to pay the interest on past debts.
The larger a country’s foreign debt, the more of its limited tax revenues it must allocate
to service that debt. If the country has to borrow money to service past debts, its total
debt stock will increase.
Figure 29.10 shows the total debt stocks of several less developed countries as a
percentage of their gross national incomes (GNIs) from 1994 to 2004.
Note that nearly all the countries averaged external debt stocks of well over 100% of
their GNIs over the decade from 1994 to 2004.
To give an idea of the burden high levels of external debt can put on a country’s
economy, consider a country that must service external debt of 200% of GNI, such as
Democratic Republic of Congo (DRC) in 1999.

+ Assume DRC owed external creditors 10% interest on its debt.

* With debt equal to 200% of GNI, this means that as much as 20% of DRC's total
income in 1999 was owed to foreign creditors in interest payments alone.
+ DRC’s government must then collect taxes on its citizens of at least 20% of their
total income, which would be just enough to service its debt.
* That 20% of income would then be handed over to foreign lenders, leaving DRC
with little or no money to spend on infrastructure, health, or education.

High levels of external debt can result in a poverty cycle or poverty trap in which
foreign debt payments limit the ability of a country to achieve economic development,
requiring the government to accrue more debt, leading to higher debt servicing costs.
As Figure 29.10 shows, external debt levels as a percentage of GDP have declined
across sub-Saharan Africa in the decades since 2000, largely the result of debt relief
efforts, which will be explored further in Chapter 30.
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 Barriers to economic growth and development

300

200

Debt servicing (US$

Figure 29.11 PPC showing P
the trade-off between debt
servicing and the provision of
public goods 100

! Opportunity cost
! of debt servicing

100 200 300

Public goods and infrastructure (US$ million)

The dilemma of foreign debt can be illustrated in a simple production possibility curve
(PPC) model showing the trade-off between servicing debt and investing in public
goods and infrastructure. Figure 29.11 illustrates the trade-off between debt servicing
and public goods in a PPC model.
Assuming Guyana's GNIis $1 billion and that the government collects $300 million
in taxes, it must spend $200 million on interest payments to foreigners to service its
debt, leaving only $100 million to invest in public goods and infrastructure. Guyanese
households lose 30% of their income to taxes, but get only 10% back in the form of public
goods, while 20% ‘leaks’ from the economy, ending up in the pockets of foreign creditors.
Servicing international debt also creates balance of payments problems. Recall that
the balance of payments consists of the current account (which measures the flow
of money for the purchase of goods, income flows, and current transfers) and the
financial account (which measures the flow for financial and real assets). Debt servicing
leads to an outflow of funds in the financial account, moving it towards deficit.
To pay back foreign creditors, a country must have foreign currency, which it can
carn from selling exports (measured as a credit in the current account). However, if a
country does not have exports to sell or if the demand for or the value of its exports
suddenly falls (not uncommon in less developed countries that largely specialise in
primary commodities), then the ability to service its external debt is limited, and a
country runs the risk of defaulting on its foreign debts. A default would result in a
country being cut off from international credit markets and limit the government’s
ability to finance future budgets.

Do geography and climate matter for economic

development?
Many observers note that some of the least developed countries in the world lie in the
equatorial zones, leading them to posit that geography and climate might matter for
economic development. While it is true that some of the least developed countries do
lie at or near the equator, there may be more correlation at work than causation. It is
600
also true that some of the richest countries in the world lie near the equator. The oil-rich
emirates of the Middle East, Singapore, Panama, and some of the more prosperous cities
in India all lie near the equator. Geography and climate, in other words, are not destiny.

A country’s geographic location can, of course, be a huge boon to economic

development. Singapore is a case in point. Practically straddling the equator, Singapore
began its modern history as a former British colony that upon gaining its independence
in 1965 was left with a system of institutions established by the British, automatically
giving it an upper hand in its path towards development. However, unlike many other
former British colonies, many of which remain underdeveloped in 2020, over 50 years
since their independence in 1965, Singapore was left with a system of institutions that
gave itan upper hand in its path towards development. However, unlike many other
former British colonies (many of which remain underdeveloped, over 50 years since
their independence), Singapore was also blessed with advantageous geography.
Despite its steamy, equatorial climate, Singapore’s location along key international
shipping routes between the economic powerhouses of East Asia (Japan, Taiwan,
China) and the large consumer bases of South Asia, Africa, and Europe, made
Singapore a natural hub from which international commercial operations could
be established. Though economic development there has many causes, Singapore’s
geography served as a major advantage in its path towards economic development.

As we discussed in Section 29.1, geography can pose a trap. Only a couple of thousand
kilometres northwest of Singapore lies Laos, the only landlocked country in Southeast
Asia, and not surprisingly a country that is far behind Singapore, and even its more
immediate neighbours of Vietnam and Thailand, on its path to economic development.

Climate can also pose both an obstacle to and provide opportunities for economic
development. As the global climate changes, growing warmer in an era of increased
greenhouse gas emissions, some countries are experiencing changes that could
accelerate development, but more are seeing the adverse effects of a warming planet.
More frequent and intense extreme weather events, from floods to typhoons to
droughts and forest fires, are creating environmental and human catastrophes that can
set countries back in their path towards development. In some cases, entire regions are
becoming uninhabitable due to climate change, leading to mass migration and putting
increasing pressure on the limited resources available in already over-populated areas,
especially cities, of the developing world.

Sometimes a country’s climate itself can pose obstacles to development, especially if

the climate is harsh and conducive to endemic diseases like malaria. According to the
‘World Health Organization:
‘Globally, an estimated 3.4 billion people in 92 countries are at risk of being
infected with malaria and developing disease and 1.1 billion are at high risk.
According to the World Malaria Report 2018, there were 219 million cases
of malaria globally in 2017 (uncertainty range 203-262 million) and 435,000
malaria deaths ... The burden was heaviest in the WHO African Region,
where an estimated 93% of all malaria deaths occurred, and in children aged
under 5 years, who accounted for 61% of all deaths.’

The map in Figure 29.12, produced by the International Association for Medical Assistance
for Travelers, shows the countries with high and limited risks of malaria infection.

601
 Barriers to economic growth and development

[l Areas with high rates of Malaria [l Areas with limited risk of Malaria

A
Figure29.12 Malaria A climate conducive to infectious disease means a country will have to allocate its
infection risks impede limited resources towards protecting human life from illnesses that most countries in
ESCNOMNG dfi::fz:fl;;: cooler climates would never have to worry about. The 435,000 deaths in 2017, mostly
among children, represent lost lives that will not grow up to participate in the growth
and development of their economies. The human, social, and economic impact of
climate-related diseases poses an obstacle to development across the developing world,
even in the 21st century.

29.3 What are the political and social barriers

to economic growth and development?

Learning outcomes
At the end of this section you will be able to:
* outline how weak institutional frameworks create barriers to economic
development, including the lack of effective:
legal systems
* taxation structures
* banking systems
recognition of property rights
* examine the role of gender inequality as a barrier to economic development.

602
How does a country’s institutional framework affect
its ability to develop?
Other domestic obstacles to economic development are rooted in the failure of
institutions to lay the groundwork for meaningful improvements in people’s lives.

Legal system
The legal system, a key institution needed to promote growth and development, is a
public good that many take for granted in a country. A legal system includes the laws
themselves, which are typically agreed upon and enacted by government officials, a
constitution or some foundational document on which the laws are based, and the
institutions and structures for interpreting and enforcing those laws.
Alegal system is a public good, meaning that it is not provided by the free market
because the benefits it conveys society are non-excludable and non-rivalrous. A well
functioning government is therefore needed fora sound legal system to exist, and
the existence of one will assure businesses, consumers, and investors (the drivers of
economic activity) that it is safe and secure to participate in a country’s economy.

Without a legal system, a country is essentially in a state of chaos and anarchy: hardly
the characteristics investors, entrepreneurs, and multinational corporations are
looking for when deciding where to do business.

Ineffective taxation structures

With an unclear or ineffective tax structure, a nation is unattractive to foreign
investors who might otherwise invest in the country. Uncertainty about how taxes are
collected deters investment and reduces the amount of foreign capital in the country.
In addition, rich domestic households may choose to save their incomes and wealth
abroad in a country whose tax structure is more stable and predictable. An ineffective
tax structure may allow domestic firms and households to hide their income in
overseas accounts, representing a form of capital flight that deprives the country of
much needed funds for investment in public goods.
A tax structure should be neither too progressive nor totally regressive. A progressive
tax structure is one that places a greater burden on high-income earners than on low-
income earners. The degree of progressivity of a country’s tax system determines to
some extent the effectiveness of the system at incentivising and collecting tax revenues.
Too progressive and the rich will hide their income or send it abroad, depriving the
economy of tax revenues. Too regressive (or not progressive enough) and the poor
will shoulder a larger burden, perpetuating inequality and preventing development
from occurring.

Banking system
Many developing countries lack an effective banking system that is able to offer secure
deposits to savers and access to credit to borrowers. Without a functioning domestic
banking system, houscholds with money to save will likely save it abroad, leading
to capital flight. Without a supply of loanable funds domestically, it becomes nearly
impossible for small businesses to access credit to finance productivity-enhancing
investments. Consumers also find it difficult to borrow money to invest in real estate

603
 Barriers to economic growth and development

or to buy consumer goods, both of which make up significant proportions of more

developed countries’ economies’ AD.

Microcredit is a much talked about and widely used development strategy that
provides financial credit or technology loans to entrepreneurs in poor communities
to create small businesses — ideally businesses with a socially beneficial purpose.
Loans may be issued by community banks or by international micro-finance
institutions. Community banks act like commercial banks in the developed world,
collecting deposits from local savers and using them to make loans to local borrowers.
International microcredit organisations match lenders in the developed world with
borrowers in the developing world.

Such programmes differ from traditional commercial credit like that those in the rich
world have access to. Entrepreneurs with access to financial capital, either through
a community bank or a microcredit institution, are able to put their business skills
to work employing others in providing goods and services that are in demand in
their local communities. Often, the loans entrepreneurs receive are very small, as

604
little as $100 or $200, which may be all that is needed to acquire some simple capital
equipment such as a sewing machine or a vendor stand from which the entrepreneur
can begin producing output demanded by their community. The more successful
borrowers eventually gain access to larger amounts of credit, allowing them to
expand their businesses, employ more workers, and add more value to the developing
nation’s output.

Community banking and microcredit promote the entrepreneurial talents of the

people in less developed countries, and for that reason promise great potential for
long-run economic development. Whereas many of the obstacles to development and
strategies for overcoming them outlined in this chapter require a top-down approach,
microcredit and community banking are grassroots in nature, empowering individuals
within the poorest communities in the developing world to create their own
opportunities while meeting the demands of their community and creating income
and employment for others in the process.

Case study - microcredit in action in Kenya

Microcredit is not always in the form of financial capital. Some development
projects aim to put physical capital directly into the hands of poor entrepreneurs.
In Kenya, for instance, a non-governmental organisation (NGO) known as WISER
aims to match young entrepreneurs with the tools they need to start their own
businesses using donated technology such as copy machines, laptop computers
with cellular internet connections, foot pumps for water, and digital LCD projectors.

The technology is sold on credit to entrepreneurs who are required to pay back
the value of the capital through their business revenues. The capital, once in the
hands of local entrepreneurs, is immediately put to use providing services to the
community. Here are some examples.

The copy machine was installed and powered by a generator. It was the first such
machine ever installed in the community. Local businesses, students, job seekers
and others could, for a few cents, photocopy their documents locally, avoiding
the two-hour drive previously required for such a service.
* The laptops were installed in an internet café and made available to local
students and businesses. Farmers and fishermen could check product prices
in the cities hours away, increasing efficiency and bargaining positions when
intermediaries came to town to buy their produce. Job openings in the city
newspapers’ classifieds could be printed and posted for the local community to
see, improving information symmetry between the poor countryside and the
cities where job opportunities existed. The cost of access to these services was
cheap, yet the entrepreneurs who were granted the laptop loan were able to pay
back the cost of the technology in no time at all, and the community as a whole
benefited from their existence.
* The LCD projector was the first of its kind ever seen in the community. The
entrepreneur who received the projector hooked it up to a satellite dish in order
to capture and project English Premier League football matches onto the wall of
alarge room in a local building. The business was to sell tickets to local football
fans who were more than happy to pay to watch English football matches in full

605
 Barriers to economic growth and development

colour on a wall-sized screen. Before the projector arrived in the community,

football fans had huddled around tiny black-and-white televisions with poor
reception to watch football matches. The football-theatre business was the most
successful of all, and paid back its loan fastest.

Property rights
If foreign investors cannot be sure that their property rights will be respected by the
domestic government, they are unlikely to invest their capital into a developing country.
The guaranteed protection of property rights makes a country more attractive to
foreign investors and increases the amount of capital and thus the productivity and
income of the nation’s workforce. Domestically, a lack of property rights deters
investors at even the lowest levels. Domestic entrepreneurs feel secure in their ability
to reap the rewards of the business ventures when property rights are respected.

Without sound and secure protection of property rights, the entire market system
is undermined, because confiscation of property, either by the government or by
criminals, is a real possibility faced by prospective investors and entrepreneurs.

Does unequal access to political power and status

limit development?
Inequality can extend beyond economic differences between rich and poor to gaps
in political power and status. Often, economic inequality and political inequality are
two sides of the same coin; political influence and status, to no one’s surprise, can
often be bought, giving those with the most income and wealth the ability to influence
government policy in ways that entrench their own wealth and power, excluding
those in society with the fewest economic resources from the political system through
which the playing field could be levelled and greater equity achieved.

For evidence of the lack of access to political power and status among those on the
lower rungs of the income ladder, we need only look at who the political players are
in nearly every country, both more and less developed. From sub-Saharan Africa to
the USA and Western Europe, national political leaders usually arrive at their posts
after growing up among the elite rungs of society. It is relatively rare that someone
born into poverty rises to the level of national political figure; surely if they did, more
attention would be paid among the world’s government to the challenges and barriers
to economic development faced by the world’s poor.

Does gender equality matter?

The extent to which women play a role in society is a crucial factor in determining
whether a developing country is able to achieve meaningful improvements in the
standards of living of its people. Female education in particular should be a goal of
developing countries wishing to promote development. Better-educated women mean
improved chances at development for many reasons, including the two discussed below.

When girls and young women have better access to education, society’s fertility rate
tends to decrease. Fewer children reduce the financial burden on families in developing
countries, allowing limited resources to be better applied towards the continued
education. Children raised in households in which both parents are educated have
606
better opportunities. Better education means a more productive workforce; one in Quite a lot of the subject
which both genders participate and in which the economy achieves a higher level of matter in this chapter
potential output than would be possible without women in the workforce. Greater is about the many
national output means higher per capita incomes and an increased standard of living, problems associated with
thus economic development.
developing countries.
Is an understanding of
the perspective of other
knowers essential in the
pursuit of knowledge?
Practice exam questions
1. Read the extract below and answer the questions that follow.

Karnataka tourism set to gain from admi: ions fever

Being admitted to professional courses in medical, dental, and engineering
institutions in India is the biggest ambition of most of the academically brilliant
students and their parents. Given the limited number of places available in
the Indian Institutes of Technology (IITs), there is a huge demand for admission
to professional colleges —as in the State of Karnataka where thousands apply
every year, not only from within the state, but also from other parts of India and
even from abroad.
Despite a fee of 23,000, there is excess demand for places. This year, a record
number of 127,343 students have applied to Karnataka’s colleges. Of these, as
many as 59,299, or roughly 46.7%, are from outside the state. These candidates
are competing with each other for the 26,000 places in the state’s professional
colleges — medical, dental, and engineering.
With such large numbers of non-Karnataka students, possibly accompanied by
at least one parent or adult to guide them, it is natural that there will be enormous
business opportunities for the hotels, lodgings, and travel operators. The state-
owned Karnataka Tourism Development Corporation (KTDC) has taken the
initiative to offer an elaborate and attractive package.
A spokesperson for the KTDC said, ‘We believe there are many social benefits
arising from the demand for places at IITs and it is our intention to take
advantage of them.’

a. Define the following terms indicated in bold in the text:

excess demand (2 marks)
i i. social benefits. (2 marks)
b. With the aid of a diagram, explain how the social benefits
resulting from the provision of education promote economic
development in India. (4 marks)
c. Identify and explain two possible government responses to
the shortage of spots at the IITs. (4 marks)
d. To what extent is education an essential requirement for reducing
poverty in less economically developed countries like India? (15 marks)

607
 Barriers to economic growth and development

2. Study the extract and data below and answer the questions that follow.
‘Singapore is a high-income economy in South-East Asia. The country
provides the world’s most business-friendly regulatory environment for
local entrepreneurs and is ranked among the world’s most competitive
economies. Presently, the strong manufacturing and services sectors have
become the main drivers of the Singapore economy. There is a wide range of
businesses, with a particular focus on high value added goods and services.’
‘Timor-Leste (formerly known as East Timor) is a developing economy
in South-East Asia. Timor-Leste gained independence from Indonesia in
2002. The country and families were torn apart by violence in the years
before independence. Nearly 70% of all buildings, homes and schools were
destroyed. An estimated 75% of the population were forced to move due to
the violence.”
‘After serious challenges, Timor-Leste has progressed, particularly due to
its endowment of natural resources, especially oil. With the petroleum
revenue boom, fiscal policy has been expansionary and the economy has
grown rapidly as a result of government spending, focusing on major
infrastructure, development of skills, and other institutional changes.
A main goal was to generate increased and sustainable private sector
investment as a means to increase job opportunities and to reduce
poverty. These developments are starting to contribute to poverty
reduction and improved social outcomes.”
Table 1 Selected economic data for Singapore and Timor-Leste — 2013
Singapore | Timor-Leste
Human Development Index (HDI) data
HDI rank 9 128
HDI value 0.901 0.62

Life expectancy at birth 82.32 67.54

Mean years of schooling 10.20 4.42
Expected years of schooling 15.40 11.70
Gross national income (GNI) per capita 72371.23 9673.61
(2011 purchasing power parity (PPP) US$)
Other selected data
Population (millions) 5.41 113
Gross domestic product (GDP) per capita 71474.89 11814.79
(2011 PPP US$)
Urban percentage of population 100.00 29.11
Foreign direct investment (FDI), net inflows 20.62 431
(% of GDP)

608
. Define the following terms indicated in bold in the text.
i. infrastructure (2 marks)
ii. poverty. (2 marks)
. Using a poverty cycle diagram, explain how its history of violence
has presented a barrier to economic development for Timor-Leste. (4 marks)
. Explain how its ‘business-friendly regulatory environment' has
contributed to economic growth and development in Singapore. (4 marks)
. Outline the advantages and disadvantages of Timor-Leste’s
dependence on the export of a single primary commodity, oil, for
its economic growth and development. (8 marks)
. Referring to data in Table 1, discuss the importance of education
and health as a determination of economic development. (15 marks)

609
 Economic growth and =~ =
development strategies
 30.1 What strategies exist to promote economic
growth and economic development?

Learning outcome
At the end of this section you will be able to:
« outline the various strategies to promote economic growth and development,
including: trade, diversification, social enterprise, market-based policies,
interventionist policies, the provision of merit goods, FDI, aid, multilateral
development assistance, and institutional change.

Is economic development a destination towards which countries are striving or is it a

process that countries are always undergoing? This is an important question, because
if it is a destination, then the implication is that at some point all countries could
become ‘developed’, and therefore achieve some end beyond which there is no further
need for improvement. While there is no one correct answer to this question, let us
consider the second alternative, that economic development is not an end towards
which countries strive, rather it is the ongoing process that even the richest, healthiest,
best educated countries in the world are constantly undergoing.
‘When we think of economic development as an ongoing process that every country
in the world is constantly undergoing, the very idea of ‘developing’ versus ‘developed’
countries becomes blurred. There is no such thing as a ‘fully developed’ country;
rather, all nations have room to improve the lives of their people. There is no ‘perfect’,
‘developed’ country we can look at as a model for all other countries to emulate.
With this idea in mind, the last chapter in this unit will explore some of the economic
development strategies that countries can pursue. Just as there is not one ideal of
economic development countries can strive for, there are many paths they can follow
to promote both economic development and economic growth, paths that might
look very different from one another. While some countries have achieved growth
and development following free market-oriented principles, others have harnessed
government intervention as a guiding principle. While many countries have promoted
exports to the rest of the world, others have focused on reducing imports so domestic
firms face less competition as they serve their consumers. While some have turned to
aid from outside organisations, others have promoted trade.
Strategies for growth and development can appear as varied as the languages,
currencies, races, and religious views of the people in the countries implementing
them. Throughout our final chapter, we will explore the various strategies for growth
and development and wrap up our study of economics by reviewing some of the key
themes of the course.

How can international trade help growth and

development?
In Chapter 29 we argued that the idea that ‘no man is an island’ applies to countries as
well. No country can grow its economy and improve the lives of its people without,
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to some extent, depending on trade with the rest of the world. Self-sufficiency is the
road to poverty, so at some point countries must decide how they will harness the
advantages of trade to grow and develop their own economies. There are two basic
approaches to harnessing trade to the advantage ofa less developed economy: the
import substitution approach and the export promotion approach.

Import substitution
When a less developed country (LDC) has a large population among which there is
ahigh level of demand for consumer goods, that demand could be met by foreign
producers in more developed economies, whose advantages of scale and efficiency
allow them to produce the consumer goods that the LDCs households demand at
lower prices than domestic firms in the developing country could achieve. In such a
case, the LDCs would benefit from trade by opening its economy to cheap imports,
allowing low-income consumers to benefit from foreign-produced goods.
However, while low-cost foreign goods stand to benefit poor consumers in an LDC, the
disadvantage is that producers in the developing country will struggle to compete with
more efficient, lower cost, foreign firms. Because imports are cheaper, consumers in
the developing country will choose to buy products from foreign firms over domestic
firms.

A strategy for promoting domestic economic growth in LDCs, therefore, is to enact

protectionist policies that raise the price of foreign goods to the extent that domestic
consumers will substitute domestically produced goods for the now more expensive
imports. Tariffs and quotas (Chapter 23) are the typical tools in an import substitution
model for economic growth. A developing country government can tax imported
goods to the point where it becomes cheaper for domestic households to buy from
domestic firms.

Over time, domestic firms will grow in scale as they meet the demand from domestic
consumers. As they achieve economies of scale that allow them to produce at a cost
competitive with foreign firms, the government will ideally begin rolling back
protectionist measures, at which point they are no longer needed.
In short, an import substitution model of economic growth is aimed at increasing
domestic aggregate demand (AD), and therefore inducing domestic investment in
capital and infrastructure, which in turn increases aggregate supply (AS) and promotes
long-run economic growth. While this sounds like a sure means of achieving growth,
there are many disadvantages, all of which were outlined in Chapter 23.2, What are the
different types of protection. Protectionist tariffs and quotas create a deadweight loss
in the developing country, as consumers, who already live on relatively low incomes,
are forced to pay more in the short run for essential goods that could be bought for less
under free trade.
Additionally, when an LDC imposes tariffs on the imports from its trading partners,
those countries are more likely to retaliate by imposing tariffs on producers from the
LDC. This may not be an issue if the developing country does not have a large export
sector, but there will be losers as exports to other countries will likely be affected to
some extent.

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Clearly, if an LDC wishes to grow its export sector, and is willing to allow domestic
consumers to depend more on imports, then an import substitution policy is not
desirable; instead, an export promotion strategy might be more appropriate.

Export promotion
Export promotion policies are an alternative set of policies for promoting economic
growth and development. The aim is to increase the overseas market for domestic
producers by employing subsidies and exchange rate controls that give domestic
producers an advantage in foreign markets. In contrast to import substitution, which
aims to grow demand for domestically produced goods within the domestic market,
export promotion aims to grow demand for domestic output among foreign consumers.
To do so, domestic producers must be given a competitive advantage on foreign markets.
‘We use the term competitive advantage carefully and intentionally here. Recall from
Chapter 22, Benefits of international trade, that a country has a comparative advantage
in a good’s production when it can produce it at a lower opportunity cost than other
countries. In theory, when countries specialise their production in the goods for which
they have a comparative advantage, and then import the goods that other countries can
produce more efficiently, global resource allocation is most efficient and the highest
possible overall production across countries can be realised. In turn, incomes will be
higher due to greater productivity, and living standards should therefore improve.
‘When countries implement export promotion policies, they attempt to give domestic
producers that lack a comparative advantage an artificial competitive advantage by offering
them subsidies or by devaluing the currency on forex markets. Both of these actions
make domestic output cheaper to foreigners and therefore should stimulate demand
from abroad. The result is a less efficient allocation of global resources as countries
that might not be able to compete in certain industries produce goods that could,
under free trade, be produced more efficiently somewhere else.
Additionally, export promotion comes at an opportunity cost for consumers in the
country that is enacting the policies. A devalued currency, while helping exporters,
makes imports more expensive and reduces the real incomes of consumers. Subsidies,
while helping producers, allocate scarce taxpayer money towards production and
away from consumption, or require allocating funds away from public goods like
infrastructure and healthcare and towards goods meant for export to other countries.
Clearly, export promotion, just like import substitution, has winners and losers. There
are opportunity costs that go along with using government funds to help exporting
firms and with interventions in the forex markets, and just as with import substitution,
there is a deadweight loss as overall global resource allocation is made less efficient by
government intervention in international trade.

Export promotion has been employed for decades by many LDCs, particularly those of
East and Southeast Asia, with varying degrees of success. Malaysia, Thailand, and the
Philippines have all aimed to grow their export sectors through currency devaluation
and targeted subsidies for domestic industries. All three countries achieved strong
economic growth and meaningful improvements in their peoples’ living standards
throughout the 1980s, 1990s, and early 2000s, but this growth came at a great cost to
certain stakeholders within these economies.

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Case study — Malaysia aims to boost exports to grow its

economy
In the 1990s, Malaysia was experiencing rapid economic growth with the stated
goal of achieving developed nation status in a very short period of time. Vision 2020
was an ambitious government plan to make Malaysia the economic powerhouse
of Southeast Asia by the year 2020. In order to achieve this goal, the Malaysian
government believed it needed a large export sector, able to compete with its more
developed Asian rivals, Singapore, South Korea, Taiwan, and Japan.

The Malaysian government believed the nation needed a large exporting automobile
sector in order to be a developed country. The government aimed to develop the
country’s automobile sector through an aggressive set of protectionist policies
focusing on both import substitution and export promotion. Substantial tariffs
were levied on imported automobiles, sometimes as high as 100%, while the state-
owned automobile company, Proton, received billions of Malaysian ringgit over
two decades.

Malaysian car manufacturer Proton has announced an ambitious new five-year plan
to massively boost exports in a drive to halt falling profits due to declining domestic
sales.

The government-backed company hopes new models such as the Suprema S will
prove popular with foreign consumers as it earmarks half of total volume for overseas
markets. Proton currently sells to over 20 countries but its sales lag at below 5%.
Proton’s share of the Malaysian car market dipped below 25% in 2013 as sales
stalled, while exports have also slumped in recent years, with only 6000 units sold
in 2013 compared to over 16,000 in 2011.

The Malaysian government, however, remains committed to bucking this

downward trend.
‘Although running at a loss, Proton will continue to export its models to create
future markets’, International Trade and Industry Minister Datuk Seri Mustapa
Mohamed said.

But has the government’s policy of export promotion led to an overall improvement
in the welfare of the Malaysian people and therefore promoted economic
development? To answer this question, we must look at the overall cost to society of
increased car exports and compare it to the benefit the policy added.

The cost to the Malaysian taxpayer to achieve the government’s objective of greater
car exports and thus a stronger industrial sector was substantial. A not insignificant
chunk of the national income was reallocated from taxpaying Malaysian
households to domestic car manufacturers, representing reduced real incomes
of hard working Malaysians. Opportunity costs include the higher disposable
incomes Malaysian taxpayers could have enjoyed and all the other investments the
country could have made with the tax revenue, including education, healthcare, and
infrastructure investment.

The benefit of the export promotion strategy includes the revenues from overseas
sales of domestically produced cars and the lower prices enjoyed by domestic
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 car consumers. But as with all forms of protectionism, or any other government
interventions that target specific industries, welfare is not necessarily increased,
rather it is transferred from one set of stakeholders to another.
Economic development requires improvements in human health, education, and
access to life-improving goods and services; the cheaper cars resulting from the
subsidy clearly fall short of these goals. Malaysian households might have benefited
more in economic development terms if their tax money had gone towards
improving the Malaysian education system, building more hospitals, training more
doctors, or providing access to sanitation to the poorer parts of Malaysia. These are
just a few examples of what government could have done to bring more economic
development to Malaysia than its decision to promote the export of Protons to
China and India.

Economic integration
Import substitution and export promotion strategies for growth and development
both represent government intervention-oriented approaches; without tariffs, quotas,
subsidies, and forex market interventions, these two strategies would not work. For
countries choosing the free market-oriented approach to growth and development,
increased economic integration, involving the removal of protectionist measures,
offers an alternative approach.

The World Trade Organization (WTO) has tried to alleviate global poverty by
addressing the constraints to global trade that put developing countries at a
disadvantage in the global economic system. Some of the challenges the WTO
has attempted to address and will continue to address in future rounds of trade
negotiations include the following.
* Encouraging LDC to refocus their development agendas away from high tariff
barriers and towards strategies relying on trade liberalisation and integration into
the global trading system.
* Encouraging developed countries to take into account the needs of developing
countries when considering their own trade policies.
* Promoting access to new markets for manufactured goods and primary
commodities from developing countries.
* Working towards meaningful cuts in protectionist agricultural subsidies in
developed countries.
+ Making sure that future bilateral or multilateral trade agreements do not
undermine the industrialisation prospects of developing countries.
* Providing duty-free and quota-free access to imports from LDCs in the developed
world.
* Promoting increased movement of labour, both high skilled and low skilled, among
LDCs and between LDCs and the developed economies. The WTO's role in poverty
alleviation is to bring countries together to develop a fair trade framework that
promotes meaningful development in developing countries.

In the absence of progress at the multilateral or WTO level, a better option for an LDC
than removing all barriers to trade with other nations may be to start locally in trade
liberalisation by joining regional trading blocs or entering into preferential trade
agreements with neighbouring countries.
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The East African Community (EAC) is a common market agreement that includes
Burundi, Kenya, Rwanda, South Sudan, Tanzania, and Uganda. The aim of the EAC is
to enable free movement of labour, services and capital to significantly boost trade and
investments and make the region more productive and prosperous.
By embracing free trade first with its neighbours, and from there entering into
additional preferential and free trade agreements with geographically more distant
trading partners, developing countries may begin to enjoy the benefits of trade
liberalisation without being subjected to the unfair disadvantages that would
result from the failure of more developed countries to reciprocate the removal of
protectionist policies such as agricultural subsidies and import tariffs.

How does diversifying economic output promote

development?
Perhaps the best strategy for a developing country to overcome the external obstacles
to economic growth and development is to diversify the composition of its output.
A developing country that is overly dependent on one or a few primary commodities,
or even low-skilled manufactured goods, faces great obstacles in growing its economy
in a manner that ensures higher incomes, better health, and improved education
among its people.

Investing in human capital may be the best way a government can achieve the
diversification of its national output. Better-educated workers attract foreign
investment from multinational corporations (MNCs) eager to tap the relatively
low-wage, but well-educated workforce available. The inflow of foreign investment
allows the LDC to acquire much needed foreign capital and productivity-enhancing
technology that can be employed in the production of manufactured goods, thus
providing the nation’s households with higher incomes. Higher incomes increase the
level of savings in the nation, providing loanable funds to entrepreneurs and businesses
at home, and further contributing to the nation’s growth and development.
The key fora developing nation’s government is to identify the poverty trap in which
it is ensnared, and then pursue policies that enable it to escape that trap and begin the
journey towards growth and development. This may be harder than it sounds, but
some of the strategies described here will help a nation improve the standard of living
of its people.

What is ‘social enterprise’?

A recent field of development economic studies is the examination of the role of social
enterprises, which are ‘organisations that address a basic unmet need or solve a social or
environmental problem through a market-driven approach’.

In short, social enterprises meet the development needs of society through their
pursuit of profits. The basic principle is that the solutions to development challenges
do not always lie in the hands of governments, outside experts, foreign investors, aid
organisations, or MNCs, but may exist within the stock of domestic entrepreneurial
talent. Social enterprises can address problems at the hyper-local level, ones that may
not draw the attention of government policymakers or international investors. The
aim is to benefit a specific group of people by meeting development needs that are
unmet by the existing resources in their communities.
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 « Aweaver, Shanga River House
social enterprise, Tanzania

An entrepreneur who sees that residents in a poor community lack internet access
may open a computer lab or install a Wi-Fi hub, charging a small fee for locals to
use the service. As a result, an entire community is given access to the internet at a
relatively low cost. Where major infrastructure investments by national or global
telecommunications firms might have been required under a traditional model of
economic development, a social entrepreneur has made a relatively small investment
in an enterprise that has met a development need at a much lower cost. Residents of
the poor community are now able to access the internet to conduct business, enhance
their education, or apply for jobs in the city. A promising business model, the rural
'Wi-Fi hub provides spillover benefits that go far beyond improved individual access to
communication infrastructure, making it a social enterprise.

In Chapter 29, we learned about microcredit organisations, which offer small loans
to individuals and businesses in LDCs who otherwise would lack access to credit.
Microcredit organisations are another example of social enterprises; while the concept
began as an experiment in aid assistance to poor individuals, microcredit organisations
have emerged as successful enterprises that actually turn profits for the investors who
finance them. Thus, an experiment in aid turned into a widespread model of economic
development rooted in the social enterprise model.

Social enterprises offer the best example of how markets, as envisioned by the father of
modern economics, Adam Smith, benefit all the actors that participate in them. ‘Give
me that which I want’, wrote Smith, ‘and you shall have this which you want.” While
Smith’s sentiment could be applied to markets for all sorts of goods from toys to cars
to smartphones and luxury cruises, in the case of economic development, it applies
rather nicely to social enterprises that emerge in the markets for welfare-enhancing
goods that might otherwise not be provided through mainstream channels such as the
government, aid organisations, and national or multinational corporations.

What can the free market offer?

So far in our examination of strategies for economic growth and development we have
swung back and forth from market-driven approaches to interventionist-oriented
models for development. We will continue exploring development and growth
strategies rooted in the market-oriented approach in the following section.
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Trade liberalisation
An alternative to using protectionism to promote growth and development s for a
country to embrace trade liberalisation. The risks associated with a developing country
opening its market to free trade are of course substantial. There is no guarantee that
one country’s opening itself to trade will be reciprocated by its trading partners.

For example, Kenya, an LDC in East Africa, may choose to remove tariffs on imported
grain from Europe in the hope that European nations will remove protectionist duties
on Kenya's exports, thereby liberalising trade between Europe and Kenya. However,
when Kenya embraces free trade it risks exposing its own grain producers to the
heavily subsidised European grains that would likely flood into the domestic market.
Free trade is an elusive goal, as the removal of tariffs in one country does not guarantee
that all its trading partners will likewise roll back protections like domestic tariffs and
subsidies that give foreign producers an unfair competitive advantage over the LDC's
producers.

While the intention of trade liberalisation was to make imports cheaper for Kenyans
and to make Kenya’s exports more attractive to foreign consumers, the result may
be a reduction in the welfare of the primarily rural population of Kenya who find it
increasingly difficult to compete with subsidised food from Europe.

Privatisation
Many of the developing countries in the world today are former colonies of European
empires (primarily in Africa, South America, and South and Southeast Asia), or
‘emerging market’ economies of the former Soviet bloc (mostly in Eastern Europe and
Central Asia). Their historical legacies left many developing countries in the world with
state-run industries, originally established to serve either foreign colonial masters or
the domestic market in a command and control economic system. State-controlled
industries across the developing, emerging market economies of the world have
struggled to compete with the more efficient, free market MNCs that have grown to
dominate global commerce in the 21st century.
One of the surest ways to increase efficiency in developing countries, therefore, is
to break up or sell off state-run enterprises, attracting domestic or foreign investors
who have an eye for efficiency and productivity. Examples of previously state-run
enterprises that have been privatised in developing countries include the sale of state-
run mines and farms across sub-Saharan Africa, petroleum, infrastructure, heavy
machinery, and steel companies in India and China, and state-run airlines around
the world.

In each of these cases large swathes of the economies of developing countries that had
previously been run at a loss by the governments (and therefore propped up with
limited taxpayer funds that could have gone towards public goods) were sold to private
investors. In many cases, the privatisation resulted in efficiency and productivity
improvements that allowed the industries to be run at a lower cost, even becoming
profitable businesses.

The disadvantage of privatisation, of course, is that once an industry is no longer

under control of the government, its ability to provide its output to its consumers
at competitive prices (be those airline passengers, car manufacturers, or petroleum

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refineries) is diminished, creating a cascading effect felt across the economy as key
production operations are handed over to profit-secking firms. However, as is the case
with all forms of government intervention, the operation of state-run enterprises,
particularly those that incur large losses at the expense of taxpayers, comes with
opportunity costs to society that are relieved when the industry is sold to private
investors.

Deregulation
Globalisation is sometimes referred to by its critics as a ‘race to the botton’. In their
efforts to attract inflows of international investment, LDCs may find themselves
deregulating their industries to make it cheaper, and more attractive, to operate
abusiness in their country. In a purely free market economy, there would be no
regulations governing workplace safety, product quality, the environment, labour
rights, wage rates, or any other area of the economy. In such a hypothetical case all
types of industries would likely thrive, as the cost of opening and operating a business
would be low relative to that in economies with more government regulation. The
trade-off, of course, would be high levels of exploitation of both human and natural
resources.
High levels of onerous regulations imposed by LDC governments could deter foreign
and domestic investment; in such a case some degree of deregulation could drive
capital inflows and lead to a more dynamic, efficient, and globally competitive
economy.

When is intervention needed?

Trade liberalisation, privatisation, and deregulation are three means by which a
country can increase its economic efficiency in order to attract domestic and foreign
investment that will stimulate growth, leading to higher incomes and improved
standards of living. We must remember, however, that the free market, which is good
at providing some things (factories, jobs, efficiency, income) fails in many ways.
Economic development is multidimensional; it does not happen simply through
income and job creation. The public and merit goods the free market fails to provide
must be provided by the government; and this is where intervention is needed.

Redistribution policies
Recall from Chapter 18, Economics of inequality and poverty, that the free market
tends to create an unequal playing field, on which those with access to the most
resources, lucky enough to be born into higher income families, are most likely
to end up rich, while those who are born poor are likely to stay poor. The free
market does little to level the playing field, leaving it up to the government to enact
equity-enhancing policies like progressive taxes, transfer payments, minimum wages,
and social safety nets.
Progressive income taxes are those that increase in percentage as income rises, thereby
placing a larger burden on higher income earners than lower income earners. Transfer
payments are the means by which income is redistributed to those who have less in
society, either through subsidies for food, education, or housing, or through direct
payments to people with lower incomes or those who are unemployed, too old,

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disabled, or unable to work for other reasons. Together, these systems are sometimes
referred to as a country’s social insurance.

‘While markets for private insurance exist in most countries, the countries with the
highest level of human development tend to have strong and stable systems of social
insurance. A report prepared by the International Labour Organization found that
75% of the 150 million people unemployed around the world lack any unemployment
insurance protection. The report showed that the countries providing the most
generous support to unemployed workers were Austria, Belgium, Denmark, Finland,
France, Germany, Iceland, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden,
and Switzerland. These 14 countries provide unemployed workers with benefits
averaging 60% of their last salary for more than one year following the loss of their job.
This benefit allows workers and their families to maintain a suitable standard of living
during their period of economic hardship while they have time to look for a new job.

Countries with medium-level systems included Australia, Canada, Ireland, Japan,

New Zealand, the UK, and the US. In these countries, fewer of the unemployed workers
receive benefits and the compensation provided is lower, averaging around 40% of
salaries earned before being laid off.
In the countless countries not mentioned above, there are literally tens of millions
of unemployed workers receiving no benefits whatsoever from the private or
public sectors during their times of hardship. The total lack of any social insurance
is an obstacle to economic development in a low-income country. The families of
unemployed workers in a country without a social safety net suffer:
* children are more likely to go undernourished
« children are more likely to supplement the family income by working rather than
going to school
« healthcare is out of reach for a family with no income.

The lack of social safety nets perpetuates poverty in developing countries and reduces
the likelihood that human welfare will improve over time.

What merit goods promote growth and

development?
A merit good, you will recall, is one that is underprovided by the free market. The
benefits of merit goods are not purely private, but include external social benefits
beyond those enjoyed by the individuals consuming them. For this reason, the private
firms that might provide the goods to the free market will provide them only to the
extent that the market demand (or the marginal private benefit) dictates, ignoring the
spillover benefits they provide, resulting in an underprovision of the good.

Education
Education is good with countless external benefits of consumption. When a nation
educates its children, the nation’s human capital is improved and they are more likely
to grow up to become productive members of the workforce, contributing to the
production of goods and services that benefit fellow citizens, and paying taxes that can
in turn be used to provide more education to future generations.

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Without government intervention in the market for education, resources would be
vastly under-allocated towards schooling for the nation’s youth. Most more developed
countries provide education as a benefit for all citizens to at least the secondary level.
LDCs can learn from the model that has successfully contributed to the economic
growth and high living standards of Western European, East Asian, and North
American countries.

A private education system has many benefits for a nation, but without the support
of the government, only the most privileged and richest members of society are able
to improve their human capital to a level that leads to a higher standard of living.
A publicly supported education system reduces inequalities in society and improves
the well-being of all members of a nation.

Health
Healthcare, like education, is a merit good, or one that is underprovided by the free
market. The benefits of consuming healthcare are clearly private (the person getting
care is likely to be healthier and more productive) but they are also social (society as a
whole is more productive and healthier when each individual has access to healthcare).
Therefore, the amount of healthcare provided by the free market will be less than what
is socially optimal.

Without some degree of government provision, healthcare will be underprovided,

leaving a developing country’s people with poorer health, and therefore a lower level
of human development. Healthcare can be supported through government provision,
or through aid from international development organisations like Médecins Sans
Fronti¢res. One thing is certain, however. There needs to be some effort to increase the
level of access to healthcare beyond what the free market would achieve if a country is
to achieve meaningful improvements in people’s standards of living.

Case s 3 raine’s hybrid approach to healthcare

Since gaining its independence from the Soviet Union in 1991, the country has
undergone a transition from government-provided healthcare (a guaranteed
benefit under the Soviet Union) to a mixed government and free market model for
healthcare. Today, Ukraine has a dual healthcare system: a publicly funded service
available to all citizens, and a private health system available to those willing and
able to afford private insurance premiums.
The state-run health programme is subject to price controls determined by
government policies aimed at making healthcare affordable to all Ukrainian
citizens. On the other hand, in the market for private healthcare, hospitals and
clinics are allowed to charge consumers higher prices, and thus the providers are
willing and able to supply a greater quantity of healthcare than the public system.
Under a government-run monopoly, Ukraine’s healthcare system charged prices
that made healthcare affordable to all, but resulted in shortages, as there was little
incentive for individuals to go into medicine and no room for entrepreneurs to enter
the market to meet the needs of society.

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Privatisation of the healthcare system led to an inflow of investment from private

entrepreneurs seeking to soak up the excess demand for care, attracted by the
chance to earn profits by meeting citizens’ healthcare needs. As a result, throughout
the early 2000s hundreds of healthcare clinics opened across the country, with
prices set not by the government, but by the willingness of consumers to pay for
the service.
On the one hand, the privatisation of the healthcare industry led to an explosion in
investment and a broadening of access to care to millions of Ukrainians. We might
be tempted to assume, therefore, that healthcare is best left to the free market.
On the other hand, without the baseline level of care provided by the government
for free or for very low prices, the free market would exclude millions of Ukrainians
(and billions of people across the developing world) from access to basic care.
Some of the most effective healthcare systems in the more developed countries
combine a hybrid approach where individuals are automatically enrolled as
residents of the country in the national healthcare system, but have the option
to purchase supplemental insurance that provides a higher quality or more
immediate care in cases where the public system falls short. The model could be
applied to LDCs as well, where there are many who are willing and able to pay for
high quality healthcare, but far more who simply could not afford to get care on
the free market.

Infrastructure
A nation’s infrastructure includes more than its roads and railways, although such
capital goods are also necessary for a nation to achieve economic development.
Infrastructure includes telecommunications, transportation, and utilities such as
sewerage, running water, electricity, and gas.
When private firms are given control of a nation’s infrastructure, the results can be
detrimental to the nation’s economic development and growth. Without government
provision or subsidies to providers, such capital goods as electricity and water systems
will be underprovided. Certain types of infrastructure such as roads and railways,
it could be argued, are in fact public goods. Very few private firms would find it
economically feasible to construct highways across a developing country, for instance.
It would simply be too difficult to recover the costs of production through charging
for the use of such a system of roads. Therefore, without government provision, such
major capital investments would simply not take place.

On the other hand, certain types of infrastructure can be provided by the free market
in a cost-effective, profitable manner. The market for cellular phone service, for
instance, has been a hotly contested one in many developing countries.
For instance, in the Democratic Republic of the Congo (DRC), a nation with one
of the lowest Human Development Index (HDI) rankings in the world, there were
22 million cellular service subscribers in 2016, ten times the number of a decade prior,
representing 25% of the population. Of the four providers of cellular service in the
DRC, only one (in fact the one with the fewest subscribers, Congo Chine Telecoms) was
partially controlled by the DRC government. The three leading providers of this service,
so vital to the nation’s human development and economic vitality, were private MNCs.
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Case study - cellphones and electricity in Africa
Cellphones have led to huge improvements in the well-being of the rural poor all
over the developing world. According to the United Nations:
‘Cellphones today are nearly ubiquitous in African society. Teenagers and
young adults are obsessed by them, carrying them around everywhere.’
“The World Bank and African Development Bank report there are 650 million
mobile users in Africa, surpassing the number in the United States or Europe.
In some African countries more people have access to a mobile phone than to
clean water, a bank account or electricity, the agencies add.’

“Youth are using mobile phones for everything: communicating, listening

to the radio, transferring money, shopping, mingling on social media and
more. Furthermore, the industry has transcended divides between urban
and rural, rich and poor.’

The ability of remote, poor communities to engage in economic activities across vast
distances quickly and efficiently with a cellphone increases the incomes of the poor
and empowers them as contributors to the economic well-being of the country.

‘While mobile phones and the network infrastructure needed to operate them
have been sufficiently provided by the private sector, a much more basic, related
good needed to operate the phones has been grossly underprovided. Many of the
remote, rural communities that benefit most from cellphones are so far off the
grid that they do not even have access to the electricity needed to charge mobile
phones. Ironically, the phones, provided efficiently by the free market, depend on
electricity, which has historically been provided by the government, but is currently
underprovided in much of Africa. This poses problems for the rural poor in Africa.

Africa’s 46 sub-Saharan countries collectively have the same electricity generation

capacity as Spain. But dilapidated infrastructure means as much as a quarter of even
this capacity is unavailable, meaning power shortages and regular interruptions to
supply. These outages are particularly acute away from the main urban centres.

The inefficiency of having to spend hours or even days just to charge a cellphone
poses an obstacle to the extent to which this technology can improve the well-being
of those with access to it. The cost to the government of a rural African country
of providing the most remote communities with electricity on the national grid is
prohibitive. But it turns out the free market has recently come up with a possible
solution to a problem traditionally solved by government infrastructure spending.
Entrepreneurs have begun to provide the rural poor in Africa and other parts of the
world with low-priced solar electricity units.
Manufactured cheaply in China, a solar electricity unit can be purchased in Africa
for as little as $80. One unit provides enough electricity for a household to power
several electric lights, a few common appliances and to charge electronics such as
cellphones. The benefits enjoyed by households that have acquired such systems
quickly outweigh the costs. The renewable electricity provided by solar panels has
reduced poor families’ dependence on increasingly scarce heating and cooking fuel,
improved health and provided children with the ability to study under electric lights
after dark, thereby improving the quality of education received.
623
 Economic growth and development strategies

Solar electricity and other such sustainable, low-cost methods of providing the
rural poor with access to those goods traditionally provided by big, government
infrastructure projects are still emerging. Markets have popped up around the
developing world, but there is no reliable supply of resources to meet the ever
increasing demand of the hundreds of millions of poor households still living
without electricity in the world.

What roles does foreign direct investment play in

economic development?
As you now know, countries can become trapped in the poverty traps. In its simplest
form, the poverty cycle shows how limited income makes it difficult to accumulate
savings. Without savings, there is little available capital to grow the economy. To break
free, many countries seek out foreign injections of money and capital goods. These
injections may take the form of foreign direct investment (FDI).

As Figure 30.1 illustrates, inflows of FDI can break the poverty cycle and put an LDC
on a path towards prosperity. FDI refers to the long-term investment by a company
into the market of another country. Inward flows of FDI to a country are when foreign
companies invest in the domestic market of that country. Outward flows of FDI are
Figure30.1 7Dl and/or when domestic companies do the same in foreign markets.
foreign aid break the poverty . . . .
cycle and put a country on Typically, FDI occurs when foreign companies purchase productive assets, such as
the path towards prosperity factories, mines and land. These private companies are, by the act of FDI, MNCs that
v

Prosperity
cycle

Low capital/
productivity

624
are seeking profits by moving or expanding operations to new countries. FDI can be
classified as cither greenfield investment (when companies construct new facilities from
scratch) or brownfield investment (when investors purchase or lease existing facilities).

What attracts MNCs to LDCs?

Multinational firms looking to invest in a developing economy may be attracted to
particular characteristics in economies receiving investment, characteristics that many
LDCs happen to share.

Low-cost labour
Many MNCs choose to relocate production to countries where the per-unit labour
costs are much lower. This lowers overall costs of production for labour intensive
manufactured goods, even when transport costs are included. LDCs may, therefore,
hold a comparative advantage in the production of labour intensive, lower tech
manufactured goods, which could make them an attractive destination for foreign
direct investment by multinational manufacturing firms.

Natural resources
Access to natural resources — be they mineral, metal, timber, or fossil fuel - can draw
the interest of many foreign investors. Some countries in Africa and Southeast Asia
have recently been recipients of attention from China, in the form of aid and foreign
investment. Typically, these countries are resource rich, reflecting China’s need to
create new supply lines for its growing economy.

Domestic market
Part of the attraction of emerging markets is that the MNCs’ products can be sold to
the local population as well. Thus, for some MNCs, the attraction of foreign investment
is to export to the rest of the world (and perhaps back to the home country) and to
expand the market for the MNC’s goods by having a direct presence in the country.
This explains the natural advantage that China and India possess, having huge
domestic markets and major growth potential as incomes rise.

Relaxed regulatory environment

Developing countries may have lax regulations that make it profitable for MNCs to
invest, including in the following areas.
* Profit repatriation. When profits earned by foreign firms can easily be reported
in the country where the firms are headquartered, it becomes more attractive for
foreign firms to invest. However, the downside is the recipient country is deprived
of much needed tax revenues, limiting the government’s ability to invest in merit
and public goods.
+ Environmental regulations. Lax environmental rules are more common in LDCs
than they are in more developed countries, making them more attractive for MNCs
that participate in manufacturing or resource extraction activities that create
negative externalities of production. Again, the trade-off for the developing
country is a less sustainable path towards economic growth and development, as
investment comes with increased environmental destruction.
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 Economic growth and development strategies

* Health, safety, and workplace standards. Similar to environmental controls,

LDCs often have more relaxed rules around worker health and safety and
minimum workplace standards, meaning it is cheaper to operate a production
facility than it would be in a higher income country. While lax standards make
developing countries attractive to foreign firms, they also mean there is a limit on
how much development can take place, with the trade-off being more economic
growth.

Case study - FDI and government intervention in Ethiopia

Isabella Socks Manufacturing, PLC, is located in a large industrial park in the
southern Ethiopian city of Hawassa. Considered Ethiopia’s flagship industrial park,
it was built by a state-owned Chinese firm and cost $250 million. It contains 55
industrial sheds, designed to house up to 20 MNCs.
In 2017, the author visited Isabella Socks and interviewed its Sri Lankan ownership.
The firm, which sews and processes socks that are later sold in the EU, has been
awarded the highest standard for the Business Social Compliance Initiative (BSCI),
asupply chain management system that supports companies to drive social
compliance and labour standards.
Isabella Socks has 70 employees, operates tax-free, and gets government rent
subsidies on the space as a way of encouraging investment. The owner said that
the programme was part of the Ethiopian government’s drive to encourage FDI,
to raise labour standards and wages, and to increase higher value exports from
what has traditionally been an export sector reliant on agriculture and basic
goods.

626
What role does foreign aid play?
Foreign aid is defined simply as, ‘money, food, or other resources given or lent by one
country to another’. Note that aid can be ‘given’ (meaning there is no expectation of
repayment) or ‘lent’ (in which case, the recipient country is required to repay some of
what is given to the donor country).
The vast majority of the over $150 billion in aid given annually is in the form of
official development assistance (ODA) which is aid extended by one government (the
donor) or from multilateral development institutions such as the World Bank and the
International Monetary Fund (IMF) to another government (the recipient).

Aid is also extended, but at a much smaller level, by non-governmental organisations

(NGOs). Some well-known examples of NGOs providing aid to economically LDCs,
along with their primary focuses, include:

* The Bill and Melinda Gates Foundation — global health

* World Vision —food aid and emergency assistance
+ Oxfam — poverty alleviation and debt relief
* Médecins Sans Frontiéres — healthcare services
+ CARE International — poverty alleviation
+ International Red Cross and Red Crescent Movement — humanitarian relief

While these well-known organisations target specific areas of economic development,

aid in general falls into one of two categories, summarised in the table below.

Foreign aid
Humanitarian aid Development aid
Examples: food aid, medical aid, disaster | Examples: grants, concessional loans,
relief aid project aid, programme aid

Most ODA (government to government) is in the form of development aid. Figure 30.2
shows the dollar value of ODA extended worldwide from 1990 to 2016.

160
World /
140
N
Aid flows (current US$ bi

120

100
o Figure302 Official
80 development assistance
exceeded $150 billion in
60 2016,
40

20

0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Year
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 Economic growth and development strategies

50

45

30
Aid flows (current US$
25

Figure30.3 Most ODA >

flows to Africa and the
Middle East

o~
0 * +
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Year
+ Sub-Saharan Africa = Middle East & North Africa === South Asia
Latin America & Caribbean == Europe & Central Asia = =+ East Asia & Pacific
=== North America

Atlast count over $150 billion per year was being extended in foreign aid, mostly from
rich countries to developing countries. When we look at aid flows by region, as in Figure 30.3,
we can see where most of the money given for development assistance is flowing to.
Note in Figure 30.3 that the region receiving by far the largest proportion of foreign
aid is the 46 countries of sub-Saharan Africa, where around 1 billion people live and
where average incomes are lower than in any other region of the world.
Development aid comes in many forms defined below.

Grants are money gifted by a government to another government for the purpose of
improving the country’s infrastructure or other factor contributing to economic
development. Grants are not required to be repaid by countries that receive them.
* Concessional loans are money lent by a government to another government, at least
25% of which does not have to be repaid. A loan is ‘concessional’ in nature when
the interest rate is below what the recipient country could receive from a private
lender, which classifies such loans as ‘aid’.
* Project aid is money given for specific investments in healthcare, education, or other
infrastructure (hospitals, schools, ports, railways, bridges, among others).
* Programme aid is money given to a country that is not designated for a specific
project, including money to help balance a government’s budget or to stabilise its
currency’s value on the forex markets.

Tied aid
According to the Organisation for Economic Cooperation and Development (OECD),
tied aid describes ‘official grants or loans that limit procurement to companies in the
donor country or in a small group of countries’. In other words, a government makes
agrant or a loan to another government, but requires the recipient to use the money to
buy technology or hire services from companies in the donor country.

628
Tied aid is aid with ‘strings attached". It effectively limits the ability of the recipients
to ‘shop around’ for the best value for the goods, services, or work it wishes to invest
in with the granted or loaned funds. Tied aid acts as an indirect stimulus to the donor
country’s economy, masked as development assistance fora developing country.
Since the money has to be spent in the donor country, it boosts domestic output and
employment at the expense of the recipient having the freedom to choose where
and how to spend the money in a way that maximises its impact on the country’s
development.

According to the OECD, the proportion of aid that is ‘untied’ (e.g. the recipient is
able to spend it wherever it gets the most bang for the buck) has increased from 46%
to 82%, vastly increasing its potential impact for good in the recipient countries.
Tied aid provides an obvious benefit for the donor country, but untied aid can stand
to benefit both the recipients and the donors. What may appear as a ‘selfless act’
can in fact benefit both sides of the aid transaction. Donor countries (mostly rich,
more economically developed countries) are better off when the rest of the world
experiences rising incomes, longer lives, and greater levels of education and health.

Debt relief
Debt relief helps countries escape the debt poverty cycle, freeing up scarce government
resources for investments in infrastructure, health, and education. Furthermore, the
foreign revenues earned from exports can be used to buy much needed imported
capital goods and technology, including medical equipment, drugs, communications
and transportation technologies, and other goods that improve the living standards of
the country’s people, rather than on servicing external debt.
Debt relief reduces the chance of a sovereign default (i.e. government bankruptcy) and
leads to greater exchange rate stability on the forex markets, as international investors
are more confident in a developing country’s ability to repay new debts if it has a
smaller level of past debts.

In concert with domestic factors such as improvements in education and health,

international factors such as diversification of exports and economic integration, FDI,
and foreign aid, debt relief has played a crucial role in the economic development
experienced by the world’s developing countries over the last couple of decades, and
will likely continue to do so in the decades ahead.

Official development assistance

‘When a donor country’s government gives directly to another country it is called
bilateral aid. Alternatively, donors can contribute to multilateral organisations like
the UN, World Bank, IMF, or regional development banks like the Inter-American
Development Bank. Subgroups with specific goals (e.g. United Nations International
Children’s Emergency Fund (UNICEF)) can also be the focus of specific giving. These
organisations administer the flow of aid according to their aims and goals.
ODA flows are concessional in nature: they are required to consist of at least 25% grant
money, and the rest in long-term loans with relatively easy terms. These loans can be
in some combination of local currency and the currency of the donor. In reality, up to
three-quarters of ODA funding is grant money, the rest is loans.

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 Economic growth and development strategies

Non-governmental organisations
Aid provided by NGOs typically has a more specific purpose or operates on a smaller
scale than ODA. Oxfam, which is dedicated to poverty relief and the advocacy of fair
trade, is one of the more famous NGOs. Also well known is Médecins Sans Frontiéres,
which sends medical relief to areas of emergency and long-term need.
NGOs focus on areas that official aid may not reach. Poverty relief, accomplished by
working closely with desperate communities, is a major emphasis. Many NGOs focus
specifically on women’s issues, in particular prenatal care, abuse prevention, childcare,
and women'’s healthcare.

What are the motivations for donor countries

to give aid?
Improving development in developing countries creates more consumers for rich-country
firms, a better-educated workforce willing and able to contribute to global production,
and greater economic, political, and social stability, all of which contribute to
favourable conditions for economic growth and increased revenues for firms and
higher incomes for households in rich and developing countries alike.

Case sf oreign aid

Vietnam
In 2016 Vietnam received $2.37 billion in ODA, making it the world’s third largest
recipient nation after Afghanistan and India. Figure 30.4 breaks down the extent,
nature, and sources of the ODA received by Vietnam in 2016.

Note that the largest donor country to Vietnam was Japan, followed by ‘IDA’, or the
International Development Association, the part of the World Bank that helps the
world’s developing countries. According to the World Bank:
“The IDA aims to reduce poverty by providing loans (called ‘credits’) and
grants for programmes that boost economic growth, reduce inequalities,
and improve people’s living conditions.’
‘IDA is one of the largest sources of assistance for the world’s 75 poorest
countries, 39 of which are in Africa, and is the single largest source of
donor funds for basic social services in these countries.’

Official development assistance (US$ million)

0 200 400 600 800 1000 1200 1400 1600 1800
Japan
o DA
2 AsDB special funds
8 Germany
Figure30.4 Vietnam's ODA > Korea
by donor and sector, 2016 Sectors: @ Social infrastructure [ Admin. costs of donors
W Economic infrastructure [ Refugees in donor countries
B Multi-sector [ Debt relief
B Humanitarian aid B Programme assistance
@ Production & Unspecified

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 ‘IDA lends money on concessional terms. This means that IDA credits
have a zero or very low interest charge and repayments are stretched over
25 to 40 years, including a 5- to 10-year grace period. IDA also provides
grants to countries at risk of debt distress.’
The colours represent the sectors within Vietnam that received aid, including
‘economic infrastructure’ (the roads, bridges, transportation hubs, communication
technologies, and other physical infrastructure that makes a country’s economy
function efficiently) and ‘social infrastructure’ (which includes schools, universities,
hospitals, housing, and other goods that improve social welfare).

As we can see, humanitarian aid makes up onlya tiny proportion of Vietnam's total
aid, which is almost entirely in the form of development aid.
Ethiopia
In 2016, Ethiopia was the world's fifth largest recipient of ODA, receiving $1.98 billion.
Figure 30.5 shows the extent, nature, and sources of aid received by Ethiopia.

Like Vietnam, the IDA wing of the World Bank is a major donor to Ethiopia,
providing $1.2 billion of its almost $2 billion in total aid. Concessional World Bank
loans are being used largely to provide social infrastructure to Ethiopia (schools,
clinics, hospitals, etc), followed by economic infrastructure.

Following the IDA is the United States, which unilaterally provided Ethiopia with
almost $900 million in aid, much of which was in the form of humanitarian aid.

Note also that compared to Vietnam, which received almost no humanitarian aid,
over one-third of the aid received by Ethiopia ($700 million) was humanitarian. The
difference can be explained by the fact that Vietnam is a relatively rich-country that
is not as prone to humanitarian emergencies like drought, conflict, flooding, and
outbreaks of disease as compared to Ethiopia.

Official development assistance (US$ million)

0 100 200 300 400 500 600 700 800 900 1000110012001300
IDA
= United States
£ United Kingdom
8 EUInstitutions
AfDF « Figure305 Ethiopias ODA
by donor and sector, 2016
Sectors: @ Social infrastructure [ Admin. costs of donors
W Economic infrastructure @ Refugees in donor countries
B Multi-sector @ Debt relief
W Humanitarian aid B Programme assistance
H Production & Unspecified

What role does multilateral development

assistance play?
Multilateral development assistance is not from individual countries, groups or
countries, or non-governmental organisations, rather from multilateral organisations
work to support global development goals. The two biggest multilateral development
organisations are the World Bank and the IMF.
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 Economic growth and development strategies

The World Bank

The World Bank is an international development assistance organisation that was
created with the purpose of enhancing economic development and structural change.
The bank was created at Bretton Woods, at the same conference as the system of
international exchange rates, the IMF and the General Agreement on Tariffs and
Trade (GATT), which later evolved into the WTO. These institutions were developed
to establish a system of economic order that it was hoped would prevent further
economic collapses like the Great Depression of the 1930s, which created the
conditions for the Second World War.

The World Bank was initially made up of a handful of countries, with the former Allied
countries forming its core. It has since grown to 187 members. Membership influence
is directly related to the amount of donor money given to the bank. In 2010, the bank
revised voting rules to allow a greater voice from developing countries. Currently the
largest voting shares go to the USA (15.8%), Japan (6.84%), China (4.42%), Germany
(4.00%), the UK (3.75%), and France (3.75%).

From the late 1940s through the 1960, a sort of fiscal conservatism dominated the
bank’s thinking and lending. Making safe loans with an emphasis on projects that
would repay the loans easily, the bank focused on infrastructure projects that would
directly increase economic growth. This approach established the financial credibility
of the bank but limited its impact on broader development issues.

By the 1970s, the bank was under new leadership, and its priorities changed to
emphasise the meeting of basic needs in developing countries. Spending on social
programmes increased significantly, including healthcare, education and poverty
alleviation. Lending increased significantly, as did the debt levels of many LDCs, during
this period.

In the 1980s, the bank revisited its fiscally conservative roots under the leadership
of AW Clausen. During this period, the increasing debt loads of LDCs inspired the
bank to create significantly restrictive conditions on the granting of new loans. The
comprehensive economic reforms, called Structural Adjustment Programmes (SAPs),
required major changes in macroeconomic and international economic policy for the
countries that took loans at this time.

A typical SAP required the liberalisation of exchange rates and capital flows, reduced
protectionism and open markets. SAPs normally required significant spending cuts
by governments (in order to repay the loan), cuts that reduced levels of education,
healthcare and support for the poor or unemployed. These policies were later criticised
for being harsh and anti-development in practice.

Since the 1990s, the bank has responded to criticisms of its SAPs by expanding the
focus of its lending and assistance activities. The bank now emphasises sustainable
development methods as opposed to pure economic growth. It supports poverty
alleviation and debt relief for developing countries as well. With these aims in mind,
the bank has supported the work of the UNDP to reach the Millennium Goals of 2015.

S0, has the World Bank made meaningful contributions to economic development in
the developing world? The influence and role of the World Bank has received regular
criticism, especially after the introduction of the SAPs in the 1980s. What follows is a
discussion of some of the more common complaints about the bank.
632
Conditionality
‘World Bank loans come with conditions attached. Recipient countries must follow
the often strict guidelines to receive the funding. The cutting of budget deficits, in
particular, in order to pay back the loans, force large cuts in social welfare spending
on unemployment relief, medical services, and education subsidies. These cuts hit the
poorest and most vulnerable rather hard, critics say. These policies may be mixed with
compulsory liberalisation of domestic industry and trade.

Privatisation may be causing increased unemployment, with fewer resources available

(because of budget cuts) to help the jobless. Increased foreign competition may also
cause domestic industries to fold, creating more unemployment and suffering. While
this criticism of the World Bank has lessened in recent years, as the bank has adapted
its conditions to more specific circumstances, it remains probably the chief complaint
of borrowers and critics.

Loss of sovereignty
A related issue to World Bank conditionality, separate from the effectiveness of
the conditional requirements, is that these loan terms may dramatically reduce a
country’s economic sovereignty. The scope of the change can be all-encompassing.
‘When monetary, fiscal, and international trade policies are all apparently dictated by
non-elected international officials, the borrowing country’s people will question the
legitimacy of the policies.

Dominance of rich countries

The voting procedures of the bank give heavy weight to donor countries, most of
them highly developed countries, and chief among them the USA. Such countries,
it is argued, know little of the challenges faced by developing countries, and thus
‘World Bank policies are disconnected from the needs of developing countries. More
worrisome is that policy prescriptions too often resemble the harsh medicine that
is easier for a doctor to give than to take. During the 2008-10 global financial crisis,
when the USA and European budget deficits began to soar, the World Bank was
demanding fiscal austerity from its borrowers. Such disparities, if not completely
validated by the evidence, do perhaps undermine the bank'’s legitimacy.

Mixed results
The free market emphasis of the World Bank’s approach has, according to some
economists, led to rising inequality in a number of recipient countries. Even further,
the resulting cuts in social spending have potentially lowered some countries’
performance on the HDI, in effect worsening the quality of life in those countries.
More pointed criticism has come from a former chief economist of the bank, Joseph
Stiglitz. While serving for three years in the late 1990s, Stiglitz reported dismay at
the results of the ten-year studies of World Bank policy towards former communist
countries. He left the bank, and has since advocated a much greater government role in
creating economic growth and development.
To Stiglitz, the timidity of developing country businesses and individuals to spend or
invest results in a lack of growth that can be compensated for only by governments.
However, such a role is practically impossible when World Bank/IMF conditionality
forces austere fiscal and monetary policy, as well as compulsory liberalisation. In part
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 Economic growth and development strategies

as a reaction to these lingering critiques from Stiglitz and many others, the bank has
refocused its efforts on a broad array of specific development issues that are designed
to more directly target development goals. These include sustainable development
through carbon-trading funds, conservation efforts, and water-sanitation initiatives.
The bank has sought to fortify institutions by working against corruption, and for
the promotion of legal reform and property rights. It spends on human development
by funding childcare projects, malaria treatment, and HIV/AIDs projects worldwide.
Thus, the World Bank appears to be changing strategy as the development consensus
changes, even if these changes are occurring rather slowly.

International Monetary Fund

The IMF is an organisation of 187 countries, whose dues go towards funding IMF
activities. Among the stated aims of the IMF are to be working towards fostering global
monetary cooperation, securing financial stability, facilitating international trade,
promoting high employment and sustainable economic growth, and reducing poverty
around the world.
Created alongside the World Bank and GATT, the IMF's initial purpose was to act as
the overseer of the Bretton Woods fixed exchange rate system. The IMF was to monitor
the balance of payment situations of member countries and when necessary, act on
behalf of those countries to solve current account problems. Typically, this involved
the risk of some kind of rapid currency depreciation.

The IMF would then loan the country money (an inflow on the financial account) to
finance the current account deficit that is a symptom of the depreciation. Without
this financing, countries with current account deficits might need to devalue their
currencies and upset the fixed rate system. The IMF, to some extent, still plays this role,
as the international lender of last resort. In the 1980s, the IMF expanded its role beyond
‘management of exchange rates to a form of debt relief. Many LDCs experienced
crippling debt crises, and the IMF worked with these countries and the countries and
banks that had lent to them. By acting as a final guarantor of privately loaned funds,
the IMF provided a backstop for many debt crises. Furthermore, most countries
avoided defaulting on IMF loans because this would eliminate their financial safety
should any future crisis arise. However, complying with the IMFs loan rules proved
challenging for many countries. The stabilisation policies associated with these rules
could be far-reaching. This resulted in most of the criticism directed at the agency.
The agency may well be the world’s ‘financial fire department’ but it does not work for
free, noris it considered a kind of public good. The policies, according to the IMF, are
justified because they are aimed at paying back the IMF so that funds will continue to
be available for countries in need and at enabling the IMF to impose unpopular policies
that would have prevented the crisis in the first place.

The policies include a range of market-oriented reforms that, depending on the

country in question, could have enormous impact.

Government budget austerity

In order to pay back loans, governments need to cut their spending. This nearly always
results in significant cuts to social programmes, often in times of crisis, when the need
is greater than usual.
634
Supply-side policies
The IMF may insist on the reduction of minimum wage laws, the privatisation of
industries, and the cutting of state subsidies to firms.

Inflation control
To establish stability and to reduce the drag downwards of exchange rates,
governments may be urged to control inflation with significantly higher interest rates.
These high rates could reduce investment and consumption and usher in a period of
recession, with all the unemployment and social dislocation that goes with it.

Currency floating
Since the ending of the Bretton Woods system, currencies are encouraged to float
to avoid over- or under-valuations. For many, floating rates could lead to a painful
depreciation of the currency.

Trade liberalisation
This includes reductions in protectionist tariffs, quotas and subsidies, as well as ending
restrictions on FDI.

So how does the IMF score in its efforts to promote economic development in developing
countries? Because countries in need of IMF help have such poor credit reputations,
the IMF's willingness to lend offers a hard-won seal of approval, a kind of stamp of
credit-worthiness. This makes countries ever more desperate to land IMF help when
international consensus determines it is necessary for foreign credit and investment to
return to the country. Nevertheless, many of the same criticisms levelled at the World
Bank have been applied to the IMF, including the following.
* Rich-country dominance: Voting follows IMF rules, with the percentages of
votes being, in line with those of the World Bank, heavily dominated by rich
countries. Rather than ‘one country — one vote’, the rules dictate that monetary
donations determine the percentage of voting power.
* Moral hazard: IMF lending, it is argued, frees countries from fiscal responsibility,
and allows them to mismanage their monetary and fiscal policies. With the IMF Ethics
around to help, the consequences of poor management are one step removed from Do economically more
short-run concerns. developed nations have
* Harsh policies: IMF stabilisation policies have a reputation for hitting hardest amoral obligation to
when the population is most vulnerable. The decreased spending on merit goods, assist economically less
developed nations, such
the cutting of already low wages, cuts on food and medical subsidies, and reduction as through foreign aid
in unemployment benefits at times of greater unemployment, all these have been or World Bank lending?
cited as extraordinary and inhumane policies, especially when applied to What criteria should
economists use to make
developing countries where the reserves of savings and private help are low to
such judgements?
begin with.

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 Economic growth and development strategies

What institutional changes will promote

growth and development?
A country’s institutions are like the operating system on a smart phone or laptop
computer. Even a phone with the flashiest hardware (biggest, sharpest screen, thinnest
body, high quality camera) will be ineffective if it does not have a well functioning
operating system. Countries are the same way; an LDC can invest all it wants in human
capital, infrastructure, and technology, but in order forit to achieve meaningful
economic development it must have well-run institutions that assure secure, stable,
equitable economic growth and development.

In Chapter 29 we outlined how the lack of strong institutions poses a barrier to

economic development. By developing and protecting their institutions, therefore,
LDCs can expect a more stable and equitable economy that is more attractive for
investment and therefore likely to promote both economic growth and development.

Improved access to banking

Abanking system provides the medium through which lenders and borrowers can be
matched with one another. Disposable incomes among workers and businesses can be
saved, creating funds that can be loaned to individuals and businesses in turn. Access to
credit is a mandatory ingredient for economic growth and development to take place.

In Chapter 29 we learned about microcredit organisations, which have emerged to

fill the void left by the lack of traditional commercial banks in the developing world.
As developing countries see incomes rise, it becomes increasingly important for a
banking sector to emerge to serve the needs of savers and borrowers, allocating capital
to where it is needed most in the growing economy.

Increased women’s empowerment

‘Women make up half the world’s population, yet, in many parts of the world they
still play a secondary role to men in the economic realm. Empowering women
through extending equal rights, expanding access to education, and providing equal
opportunities in the workplace vastly expands a country’s production possibilities.
Not only do women become productive members of the economy, increasing national
income, but the act of extending rights to women itself directly improves human
welfare, helping a country achieve its development goals.

Reducing corruption
In Chapter 29 we learned about Paul Collier’s poverty traps. One of those was the poor
governance trap, which arises when corrupt officials undermine society’s advancement
towards economic development by demanding bribes, siphoning off state resources for
their personal gain, and engaging in other corrupt acts at the highest level. Corruption
can occur in the private sector, as well, as workers or business owners put their own
wealth and interest above those of the businesses they are meant to work for.
Ending corruption will make for a more efficient public and private sector, allowing
resources to be allocated to where they are needed most, but also making a country
amore attractive place to do business, which could attract FDI and help increase a
developing country’s capital stock and productivity levels.

636
Protecting property rights
A final institution needing protection for growth and development to occur is that
of property rights. As explained in Chapter 29, the lack of property rights creates an
environment of economic uncertainty and instability. Investors, both domestic and
foreign, will only feel safe putting their capital in a country if they are sure that their
assets will remain in their hands no matter what.

30.2 What are the strengths and limitations of

strategies for promoting economic growth
and economic development?

Learning outcomes
At the end of this section you will be able to:
* evaluate the strengths and limitations of trade strategies for growth and
development
* evaluate the impact of FDI for economically less developed countries (LDCs)
* evaluate the effectiveness of foreign aid in contributing to economic
development.

Trade strategies
‘When a country trades with other countries it is guaranteed to broaden the market
for the country’s output and increase the variety of goods available to the country’s
households. When a country specialises in the goods for which it has a comparative
advantage and trades for other goods, it experiences an increase in its production
possibilities, greater efficiency, and higher incomes. Trade, as it turns out, is a
wonderful way for a country to promote economic growth.
Trade does have several limitations, however. It is not a development strategy, since
free trade, despite all its benefits for the countries that participate in it, does little to
protect human and environmental welfare. Trade increases productivity and therefore
incomes, but cannot provide for improvements in living standards beyond more
income. Trade creates externalities, from the increased fossil fuel consumption and
resulting carbon emissions created by the ocean liners that transport commodities
all over the world to the race to exploit the natural resources of countries with lax
regulatory environments, often in a way that profits MNCs but does little to develop
the economies of the countries the resources are extracted from.
In other words, international trade is a means to an end. Through trade an LDC
can expect to increase its incomes, attract foreign investment, and grow its stock of
infrastructure and capital. However, human capital requires more than what trade
can offer. The merit goods of education and healthcare are rarely provided through
trade; in order to achieve economic development, a mixed market and interventionist
approach must be taken. Trade also creates many losers, so countries often adopt an
import substitution or export promotion policy, as described earlier in this chapter.

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However, no man is an island, and economic development is unlikely to take place

without first a country opening itself to international trade.

Foreign direct investment

Because the expansion of FDI in the developing world is expected to continue, it is critical
for LDCs to assess the value of FDI for their own development plans. Keeping in mind the
variety of developing countries, as well as the differences between types of FDI, it is still
possible to make some generalisations about the desirability of foreign investment.

Advantages of FDI
When a developing country receives incoming FDI, valuable financial and physical
capital are injected into the recipient economy, creating several positive outcomes,
including the following.
* Capital injections can help to break the poverty cycle by injecting much needed
capital goods and finance.
* The foreign purchase of domestic assets brings money into the capital account of
the balance of payments, enabling more imports of foreign consumer and capital
goods.
« Foreign investment can induce LDC governments to invest in infrastructure to
support the new firms. This may have spin-off benefits to the country at large if the
works projects have other useful applications.
« Some forms of FDI provide opportunities for enhanced research and development,
which may expand technical capital in the greater economy.
FDI can stimulate domestic industry when the MNC buys locally produced capital
goods and services.
Technology transfer improves the country’s capital stock. As foreign firms bring in
new and more advanced technology, domestic rivals and suppliers are inspired to
adapt technologically as well.

FDI also has positive impacts on income and employment in the recipient country,
including the following.
« If foreign firms hire significantly from the domestic workforce, increased
employment increases incomes and tax revenues.
* Often MNCs will invest in the skills of workers; here FDI can increase human
capital through training.
* The increased income accruing to workers and to the MNC is subject to taxation,
increasing tax revenues that might be used for development purposes such as
improved healthcare and education.

Finally, FDI leads to increased market efficiency and choice, benefiting consumers in
the recipient economy. Some of the benefits in this area include the following.
* MNCs may compete with complacent domestic industries. The added competition
should lower prices and increase market efficiency domestically.
* If MNCs help a country realise its comparative advantages, world trade is enhanced
and lower prices result.
« For domestic consumers, the arrival of foreign firms may initiate meaningful
choice in the market for goods and services.

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Disadvantages of FDI
In reality, FDI may not achieve the outcomes expected in developing countries that
receive it. In the area of employment, for one, there are several possibilities that may
render it an ineffective development strategy.

* Foreign firms may choose to bring large amounts of management personnel to

launch and administer the company. In this case, the employment growth only
comes to the low-skilled and low-wage labour force.
* Where foreign management stays in place, the expected training and skills transfer
effect is limited.
* Some industries do not hire workers extensively as they are capital intensive. Thus,
some FDI companies that earn large revenues have relatively few domestic workers.

The impact on domestic income may also be less than expected due to MNCs’ tendency
to repatriate profits earned through overseas investments, and their ability to use
sophisticated accounting methods to avoid paying local taxes in the developing country.
Additionally, FDI may come with only limited capital injections. In some cases, the
government of the country receiving FDI will require that foreign firms partner with
a domestic company in a joint venture. In other instances, domestic companies are
bought through transfers of share ownership in the new foreign parent company. In
either case, the FDI may simply mean increased foreign ownership of already existing
domestic assets, with little or no injections of foreign capital resulting.
There is no guarantee that the investment spending undertaken by foreign investors
actually originates outside the domestic economy. In reality, many corporations
borrow from local financial markets to finance their investments in developing
countries, pushing up borrowing costs and crowding out investments that might have
come from domestic firms seeking credit in the developing country.
Finally, one likely outcome of FDI in LDCs is a loss of economic sovereignty by the
recipient country’s government and businesses. MNCs hold great power and influence
in the developing countries where they do business. This may include influence over the
regulatory environment and the ability to bully elected officials into keeping tax rates
low at the risk of losing billions of dollars in foreign capital flows. Likewise, attempts by
the recipient country’s government to make policies aimed at improving worker safety
and health or raising the environmental standards to which producers are held could be
undermined by lobbyists for the foreign firms doing business in the home country.
In other words, in their efforts to attract and retain FDI, governments in less
economically developed countries may find their hands tied when it comes to
implementing policies that could lead to meaningful improvements in the lives of their
citizens and promote sustainable development. Once again we are reminded of the
apparent trade-off between health and wealth, between growth and development, and,
in this case, between the desire to attract foreign capital while also protecting the well-
being of domestic stakeholders.

What are the strengths and limitations of

foreign aid?
There has been much debate over the effectiveness of aid in contributing to economic
development. On one side of the discussion are economists like Columbia University’s
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Jeffrey Sachs, who argued in a January 2014 column in Foreign Policy Journal that ‘the
recent evidence shows that development aid, when properly designed and delivered,
works, saving the lives of the poor and helping to promote economic growth’. As
evidence, Sachs points to the reduction in instances of malaria in sub-Saharan Africa
since the turn of the 21st century:
‘At the turn of the new century, malaria was front and centre of the global
aid debate. Research by myself and others ... showed that in addition to
being a health catastrophe, malaria imposes a significant economic burden,
particularly in sub-Saharan Africa. Luckily, though, the world was starting to
take notice. In 2000, the UN Millennium Declaration, The African Summit
on Malaria, and the G8 Declaration all addressed the burden of malaria and
committed the world to action. The debate soon turned to the issue of policy:
how could the malaria burden be reduced?’

“The combination of bed nets and effective medicines, supported by rapid

diagnosis of infections, makes for a powerful one-two punch in saving lives
and reducing malaria transmission.”
‘Without financial support, poor people could not afford either the (bed nets)
or the new medicines. Attempts to sell the nets at a discount, known as social
marketing, had very little take up, since many poor families simply lacked any
cash income at all. The prospect of achieving ‘mass action’ protection through
social marketing was very small. Moreover, impoverished households
would often scrape together the needed money only to buy the cheaper but
ineffective nets, rather than the more expensive but more effective (ones).”

‘Governments of low-income African countries needed donor support for

the scale-up effort since their own domestic tax revenues, even when amply
allocated to public health, could not cover the costs of a basic primary health
system including scaled-up malaria control. The financial calculations, laid
out by the Commission on Macroeconomics and Health, showed that an
impoverished country with a GDP of around $500 per capita, typical for a
poor country in Africa, may be able to muster around $15 per person per year
out of domestic revenues for primary health, while the costs of a basic public
health system would be around $50-$60 per person per year.’
‘... The WHO (World Health Organization) swung its powerful weight
behind the mass free distributions of bed nets throughout sub-Saharan
Africa. Soon after, UN Secretary-General Ban Ki-moon established the
mass free distribution of bed nets as policy for all UN agencies, and called
on the world’s governments and NGOs to support the scale-up effort. Ban’s
leadership tipped the global scales decisively. Close to 300 million bed nets
were freely distributed from 2008-10, with the global fund to fight AIDS,
tuberculosis and malaria and the US President’s Malaria Initiative program
paying for a substantial share of the scale-up.’

‘The evidence is overwhelming that malaria declined precipitously as a result of

these bold measures. WHO's latest report finds a stunning 51 percent drop in
malaria deaths of African children under the age of five between the years 2000
and 2012. These results are historic. Roughly a half-million children, if not more,
are being saved each year that otherwise would have succumbed to malaria.’
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According to Sachs and other aid proponents, without the work of both NGOs
and official development agencies, and the governments that support them, the
poverty reduction and improvements in health and education experienced across the
developing world in recent decades would have been significantly less pronounced.

On the other side of the debate are economists like New York University’s William
Easterly, who argues that due to factors like a lack of accountability and feedback,
corruption, and the fact that recipient countries can become dependent upon
and beholden to donor countries, rather than developing their own capacities as
contributors to global trade, aid has failed to achieve meaningful improvements in the
development of developing countries.

According to Easterly:
‘Economic development happens, not through aid, but through the
homegrown efforts of entrepreneurs and social and political reformers. While
the West was agonising over a few tens of billion dollars in aid, the citizens of
India and China raised their own incomes by $715 billion by their own efforts
in free markets. Once aid agencies realise that aid CANNOT achieve general
economic and political development, they could start concentrating on fixing
the system that fails to get 12-cent medicines to malaria victims.’
“The two key elements necessary to make aid work, and the absence of
which has been fatal to aid’s effectiveness in the past, are FEEDBACK and
ACCOUNTABILITY. The needs of the rich get met through feedback and
accountability. Consumers tell the firm ‘this product is worth the price’ by
buying the product, or decide the product is worthless and return it to the
store. Voters tell their elected representatives that ‘these public services are
bad’ and the politician tries to fix the problem.’

‘Of course, feedback only works if somebody listens. Profit-seeking

firms make a product they find to be in high demand, but they also take
responsibility for the product —if the product poisons the customer, they
are liable, or at least they go out of business. Elected representatives take
responsibility for the quality of public services. If something goes wrong, they
pay politically, perhaps by losing office. If it succeeds, they get the political
rewards.’

‘Aid agencies can be held accountable for specific tasks, rather than the
weak incentives that follow from collective responsibility of all aid agencies
and recipient governments for those broad goals that depend on many
other things besides aid agency effort. Examples of the latter include such
unaccountable goals as the very fashionable campaign to achieve the UN
Millennium Development Goals, or the sweeping goals of economic growth,
government reform, and democracy for poor countries mentioned above.
If a bureaucracy shares responsibilities with other agencies to achieve
many different general goals that depend on many other things, then it is
not accountable to its intended beneficiaries — the poor. No one aid agent
is individually responsible for successfully achieving any one task in the
current aid system. Without accountability, then the incentive for finding out
what works is weak. True accountability would mean having an aid agency
take responsibility for a specific, monitorable task to help the poor, whose
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outcome depends almost entirely on what the agency does. Then independent
evaluation of how well the agency does the task will then create strong
incentives for performance.’
At the very least, opponents argue, aid has played a secondary role, while the primary
driver of economic development has instead been the opening up of global markets
to less economically developed countries, trade liberalisation, FDI, and other market-
oriented approaches to raising incomes and reducing poverty.
To summarise, aid is effective when:

* itis targeted at specific needs for specific communities in developing countries

it meets a need that the free market and domestic government has been unable
to meet
* itis temporary and has achievable, measurable goals.
Aid fails when:

« thereisalack of feedback and accountability, making it impossible for the aid

givers to know whether the aid is working or not
* itis too broad or its objectives are not clearly defined
« the countries receiving the aid become dependent upon it, creating a moral hazard
under which there is less incentive to promote development through their own
means.

30.3 What are the strengths and limitations

of government intervention versus
market-oriented approaches?

Learning outcomes
At the end of this section you will be able to:
« discuss the strengths and limitations of market-oriented policies (such as
liberalised trade and capital flows, privatisation and deregulation), including a
more efficient allocation of resources and economic growth
« discuss the strengths and limitations of interventionist policies, including the
provision of infrastructure, investment in human capital, the provision of a
stable macroeconomic economy and the provision of a social safety net
+ discuss the view that economic development may best be achieved through a
complementary approach, involving a balance of market-oriented policies and
government intervention.

Economics is sometimes called the dismal science. Originally this term referred to the
fact that it dealt with the inevitable problem of scarcity faced by all human societies
and the myriad conflicts that arise over the use and allocation of scarce resources.
Throughout your course, you have explored situations both micro and macro,
local, national and international, ranging from the efficiency of the elusive perfectly
competitive market to the inefficiency of protectionism.
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 You have learned about the theories, models, graphs, and other tools economists
employ to try and deal with scarcity efficiently and equitably, with the well-being of
society as the ultimate goal. The competing objectives of efficiency and equity may
not always coincide but the outcome achieved by Adam Smith’s invisible hand of the
market can be improved on. This can be brought about through the implementation
of re-allocative policies such as taxes, subsidies, and price controls by an economically
informed and well intentioned government.
In this regard, economics is hardly dismal at all. It offers a toolkit for making the world
abetter place. By quantifying the seemingly unquantifiable, such as the ‘marginal
social benefit of healthcare’, economists are able to present realistic, achievable
solutions to challenges affecting human welfare. The central problem of scarcity is
dismal indeed but economics is ultimately a hopeful science offering market-based
solutions to humankind’s biggest problems.
Yet the dismal truth is that good economics is not always valued by those in power
who have the greatest ability to affect the allocation of the scarce resources we depend
on. In reality, good politics does not always equal good economics —a claim for which
the poor decisions of politicians and leaders in countless countries, day after day,
present ample evidence.

Whether it is a decision to cut taxes and increase government spending in a country on

the brink of a debt crisis, or the decision to control the price of fuel in a city where long
queues are already forming at petrol stations, or to privatise a water system in a region
where poor people already find it difficult to maintain health, government decisions
often reflect poor economic judgement.

And the free market itself rarely has all the answers to the problem of scarcity. The idea
that markets promote efficiency and therefore achieve a socially desirable outcome
places great faith in the assumption that competition exists to ensure that efficiency
emerges. In reality, a market system driven by individuals pursuing self-interest does
not always lead to the most desirable outcomes for society as a whole, despite Adam
Smith’s belief in the allocative power of the invisible hand.

Markets tend to experience cyclical fluctuations over time, evolving from periods of
innovation and competition to periods of increasing concentration of market power
among a few large firms, stagnation and inefficiency. The creative destruction of the
free market and innovation in welfare-improving technologies sometimes requires the
guiding hand and watchful oversight of a socially conscious government.
The markets for goods that are vitally important to a nation’s economic development
(healthcare, education, infrastructure, social insurance) and certain welfare-improving
technologies must all be examined carefully with the tools and models of economics
s0 as to decide the extent to which the free market is capable of promoting human
welfare and development. The motives of the free market pursuit of profits lay the
foundation for efficiency, while the interests of society must be attended to by watchful
government regulators.
Development will not be achieved in any country left entirely to the free market;
nor will total government control promote improvements in human welfare. The
complementary approach of a market-oriented development strategy combined with
careful government oversight is the most likely to promote economic development
while creating an atmosphere for sustainable economic growth.
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Is economics the dismal science or the

hopeful science?
Despite all your reading, the conversations in class, the diagrams you have drawn in
your notes, and the pages and pages of analysis and evaluation you have laboured over,
the theories and tools of economics only get us so far in our understanding of how
to make the world a better place. The welfare of human societies ultimately rests in
the establishment and maintenance of economic systems that take into account the
costs and benefits of human behaviour on society, on the environment including other
species with which we share the planet, and on generations of humans both present
and in the future.

Sustainability is defined as ‘the ability to endure’. The ability of any economic system
to endure depends on the extent to which it accounts for the future in its decisions as
to how resources should be allocated in the present. Unfortunately, neither the free
‘market nor government intervention has done a sufficiently good job of accounting
for future generations in the economic interactions and policies of the 20th and
21st centuries.

In the 2003 documentary film The Corporation, the economic and environmental
challenges the world has faced since the Industrial Revolution are compared to the
challenges faced by the earliest pioneers of human flight. Those intrepid adventurers
would push their crafts off high cliffs, flap their mechanical wings, and think they
were flying because the ground was still so very far away. But eventually they would
crash to the ground, as they were doomed from the moment they pushed off the
cliff's edge. Without knowledge of flight mechanics and good design, their craft could
never fly. Like the early flight pioneers, society has yet to develop an economic system
that allows all human civilisation to soar.

Again, like those pursuing the dream of flight, Western civilisation pushed itself
off a massive cliff into the unknown when it embarked on the path towards
industrialisation that began in England over 300 years ago. Today, LDCs around the
world are travelling the same path. The ground in this analogy is the point at which
the world’s resources are depleted to a degree beyond which they are unable to be
replenished. It once seemed so far away that very few people ever considered the
likelihood of civilisation crashing into it. But today it is growing ever closer.
The economic systems we have developed, some argue, are as unsuited to making our
civilisation sustainable as mechanical wings were to flight. Eventually, if we do not
realise that the ground is growing nearer, human civilisation will crash. The question
is, at what point will our civilisation realise it is on a path towards total resource
depletion and self-destruction? At what point will we begin implementing much
needed reforms to the economic systems that govern our allocation of resources?

Can sustainability be achieved?

When will good economics — an economics that accounts for all stakeholders, those
living now and those of future generations — prevail in our exchanges with one another
on alocal, national and international level? Only when an economic system prevails that
accounts for the true costs and benefits of our behaviour to society, to the environment,
and to future generations will human civilisation enter an era in which it can truly fly
and thereby avoid the fate of the flight pioneers and their flapping mechanical wings.
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 Economics is only dismal insofar as it is ignored by policymakers and politicians.
Economics offers a design for a civilisation that could truly fly, allowing humans to
survive indefinitely in a world in which resources are allocated efficiently between the
competing wants and needs of society in a sustainable manner.

The ability of humankind to endure, to sustain itself into the future, is increasingly
questionable. A greater understanding of economic theories, and an implementation
of the models and tools economics teaches us can help ensure that future generations
will live in a world in which human societies everywhere can live happy, healthy lives,
free of fear and conflict. In this regard, economics is the most hopeful science of all.

Practice exam questions

1. Read the extract below and answer the questions that follow.

EU'’s secret plans target markets in developing countries

The European Union (EU) has drawn up secret plans aimed at opening the
service sector markets in the world’s developing countries in return for reducing
its farm subsidies.
The demands made by the EU would allow European firms to charge for
providing water to some of the 1.2 billion people living on less than a dollar a
day. Water has always been regarded as a free good, but this idea is changing. It
would give large gains to European banks, telecommunication businesses and
business service firms.
The EU is under intense pressure to remove export subsidies that depress global
food prices and impoverish farmers in the developing world. Reform of Europe’s
agricultural policy is a top demand from developing countries.
Supporters for less developed countries argue that the EU proposals are not
pro-development, nor do they encourage sustainable development. Many
developing countries would be tied to unfair and irreversible commitments
if they agree to European requests. If these economic decisions go wrong,
developing countries would be affected for generations to come. A more
effective approach would be to encourage export-led growth.
While the privatisation of water would result in a higher price for the
consumer, the advantage is that the water will be clean and filtered, enabling
the population to be healthier and live longer, acting as a positive externality.
Against this is the cost of implementing the privatisation, possible social and
economic upheaval, and institutional and political factors that would act as
significant barriers to economic growth and development.
Among its demands, the EU wants Bolivia to let in more overseas water
companies despite a recent case where a multinational company increased
water prices by 200% in one city. The EU is also looking at Panama with similar
plans where water privatisation plans were scrapped in 1998 after strikes and
demonstrations.

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 Economic growth and development strategies

a. Define the following terms indicated in bold in the text:

i. export-led growth (2 marks)
ii. privatisation. (2 marks)
b. Using an appropriate diagram, explain how European
agricultural subsidies help to ‘impoverish farmers in
the developing world". (4 marks)
c. Using an appropriate diagram, explain why
consumers will buy nearly a constant quantity
of water despite higher prices. (4 marks)
d. Using information from the text and your knowledge
of economics, evaluate the extent to which the
privatisation of the water supply in a less developed
country would benefit consumers in that country. (15 marks)
Read the extracts below and answer the questions that follow.

Fighting poverty in Africa

Item 1: There are those, not least in Africa, who fear this massive debt relief will
produce the same circumstances that have followed smaller debt write-offs.
Incompetent governments will run up large new debt, spend the money on
unrealistic projects and place spare cash into Swiss bank accounts.
— Arab News, Editorial, Saudi Arabia, 12 June 2005

Item 2: Doubling official aid, even if it is tied aid and cancelling Africa’s debt
are theoretically very attractive proposals. They fail because they are based
on a misguided faith that you can rely on human unselfishness to end human
misery. Tony Blair and his partners would do the continent a lot of good if they
promoted trade, removed agricultural subsidies and encouraged investment
relationships, rather than offering kindness and generosity through more aid
and debt relief.
— Andrew M. Mwenda, Sunday Monitor, Uganda, 12 June 2005

Item 3: If we are serious about addressing Africa’s poverty, far more money and
effort will be needed as well as freeing these countries from debt repayment,
which then allows them to invest in economic development and improve the
health and education of their citizens. Africa has 11% of the world's population,
but accounts for only about 1% of the world’s economic output. Export-led
growth is needed. Without more help from the developed countries, the future
looks bad.
— Seattle Times, Editorial, 12 June 2005

Item 4: Africa is not poor. As the Africa commission report has noted, while
it lacks infrastructure, Africa is rich in human and natural resources. The
problem is that Africans have been forced to live in countries that have not
wanted to enrich the lives of people within them, but rather to transfer resources
abroad. The struggle of Africa is to be part of the world economic order based
on mutual respect, not exploitation.
—Ken Wiwa, The Observer, 12 June 2005

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. Define the following terms indicated in bold in the text:
i. tied aid (2 marks)
ii. infrastructure. (2 marks)
. Using an appropriate diagram, explain how
domestic farmers would be affected by the
removal of their subsidies. (4 marks)
. Using an AD/AS diagram, explain the effect of a
successful export-led growth policy. (4 marks)
. Using information from the text and your knowledge
of economics, evaluate the effectiveness of increased
aid and debt forgiveness policies. (15 marks)

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 31.1 What are some essential tips for overall
success in economics?
There are many ways to approach exam revision, and this chapter will address paper-
specific approaches in the following sections. Before doing so, it may be helpful to
discuss some general approaches that are useful across the external and internal
assessments.

Fluency with economics terminology

Economics has its own vocabulary, and your mastery of that vocabulary is assessed
throughout. There is a glossary of subject-specific terms provided in Chapter 33, and
these terms have also been defined where they are used in the text. While the subject
is grounded in logic and common sense, putting your explanations in your own words
should only be a last resort. Command of economic terms is a prerequisite for a solid
performance and can enhance your overall understanding.

Note that fluency is not the same thing as repeating the definitions for every term.
You are only asked to specifically define terms in Paper 2, part a. For writing short
answers or essay-type questions, only define the key terms and strive to demonstrate
an understanding of the other terms in the context of the question.

Clear and well explained diagrams

As you well know by now, the majority of economics theory in this course is
enhanced by a diagram at some stage. Your diagrams are a fulcrum around which your
explanations will revolve. There are simple but important things you can do to make
sure your diagrams are effective.
* Large diagrams are better than small ones. To fit the information needed and to make
it clear, use nearly one-third of a page to draw your diagrams.
* Fully label your diagrams. Use arrows to indicate shifts, and dotted lines to connect
graph coordinates to their respective X and Y axes.
Use a pencil and a small ruler. To keep it neat, be prepared to erase as needed and use
the ruler to draw clear lines.
Explain your diagram with specific references. Diagrams that are unexplained do little for
your paper. General references to a diagram score slightly better. Fully explained
diagrams that refer to specific points, e.g. ‘demand shifts from D to D, causing
price to rise from P, to P, will score well.

Real-world examples (RWEs)

‘Where questions elicit a real-world example, students should provide an actual specific
instance that demonstrates the theory of a particular situation. These can be current
or historical, provided they accurately reflect the principle you are describing. Some
examples include the following.
* Anexample of supply inelasticity in the short run is surgical masks and other
personal protective equipment (PPE) in 2020. After a huge and sudden spike in
demand for PPE, prices were high and supply was short, but after several months,
manufacturers massively increased output and prices dropped accordingly.
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 External assessment

* Anexample of a company that is alleged to command monopoly power is Google,

which has been the subject of regulatory scrutiny over internet search and search
advertising market dominance in recent years.
* Anexample ofa demand deficient recession is the Great Depression of the 1930s,
where output fell by some measures up to 40% and unemployment was as high
as 20%.
* Norway consistently scores among the highest countries in terms of human
development, even when adjusted for inequality, gender equity, and sustainability.

It is recommended that you identify and clearly label your RWEs throughout your
notes. For example, indicate each example with a bold ‘RWE for each appropriate
topic. For revision purposes, comb through your notes to find all the RWEs and add
more where the topic calls for it.

31.2 What is Paper 1 and how should y

prepare for it?
Paper 1 is an essay paper that is drawn from all parts of the syllabus. For SL students,
it is worth 30% of the final grade, and for HL students it accounts for 20% of the final
grade. You are given three options and you are to choose one question and answer it
within 1 hour and 15 minutes. Each question is generally tied to a single and different
unit of the syllabus (i.e. introduction, microeconomics, macroeconomics, global
economy). HL questions are likely to encompass the HL extension material, allowing
or encouraging that material to be included in the response.
For each paper, you will be given 5 minutes of reading time. Use this wisely to both
read each question carefully and to organise your thoughts in response.

It is recommended to use part of this time to be sure you understand the specific demands
of the question. By doing so you can write efficiently and clearly and access the top
‘marks. Many students only catch a general idea of the question and unload all they can
remember on the topic. This takes extra time away from answering other parts of the
paper and does not help your score.

Use another part of this reading time to map your answer. For part (a), this may be a short
list of terms and graphs you want to discuss. For part (b) the notes you write may be
more complicated, but that is the point. It is extremely helpful to have these reference
notes as you look up from writing out a portion of your answer. Instead of forgetting
your brainstormed plan, you have it for reference. This makes following through on
your thoughts, as well as making the synthesis and evaluation points, easier to make
when you are well into your essay.
Paper 1 is typically divided up into two sub-questions or parts on a related topic.

How do you answer part (a)?

Part (a) usually requires you to demonstrate the skills in AO1, AO2, and AO4
(knowledge and understanding, application and analysis, and the use of appropriate
skills and techniques). Part (a) is always worth 10 marks. Note: part (a) questions nearly
always require the use of a diagram, even when it is not explicitly stated in the question.

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Atypical part (a) question might look like these. Some typical descriptors are used
with sample questions.

1. a. Explain the concepts of price floors and price ceilings. (10 marks)
Here explain asks you to tell the reader something in a way that
makes it clear with relevant ideas and possible causes.
b. Analyse the relationship between the application ofa tax and
allocative efficiency. (10 marks)
To analyse something is to examine something and break it down
into its different parts to make it better understood.
. Suggest three ways in which the government could address the
problem of a negative output gap. (10 marks)
To suggest is to offer possible answers without going into
specific detail.
d. Distinguish between expenditure switching policies and
expenditure reducing policies used to correct a persistent
current account deficit. (10 marks)
Here to distinguish is to make the difference between the two
clear to the reader.
To give you a sense of the requirements for full marks, and the distinction between the
top levels, the descriptors for Level 4 and 5 are listed below.

How do you answer part (b)?

Part (b) is typically related to the part (a) question, and it often requires some
combination of all four assessment objectives, with a heavy emphasis on synthesis
and evaluation (AO3). It is always worth 15 marks. You will not need to repeat the
definitions you wrote in part (a), but you may want to redraw diagrams if there is a new

Table 31.1 Paper 1 part (a) levels, marks, and descriptors

Marks 0-10 Level descriptor

7-8 (Level 4) The specific demands of the question are understood and
addressed.
* Relevant economic theory is explained.
* Relevant economic terms are used mostly appropriately.
* Where appropriate, relevant diagram(s) are included and
explained.
9-10 (Level 5) The specific demands of the question are understood and
addressed.
* Relevant economic theory is fully explained.
¢ Relevant economic terms are used appropriately throughout
the response.
* Where appropriate, relevant diagram(s) are included and fully
explained.

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application. For example, part (a) may ask you to discuss a price control, but part (b)
asks about an efficient allocation of resources or may imply that you discuss another
policy as well. This may require new diagrams or redrawn revisions to the previous
ones you wrote in part (a).

A typical part (b) question might look like the following. Evaluate and discuss are the
most common command terms. Example questions, related to the part (a) question
above, are shown below.

b. Using real-world examples, evaluate the effectiveness of price-control

policies designed to improve producer and consumer welfare. (15 marks)
Here evaluate is used to prompt the student to make a judgement about
the effects on different groups and the advantages and disadvantages
of the policy.
b. Using real-world examples, discuss the effectiveness ofa minimum
wage to improve welfare and income for low wage workers. (15 marks)
Here the term discuss asks the student to share the different perspectives
on the issue, supported by evidence and theory.
One might less frequently see compare and contrast, as well as to what extent as command
prompts.
Note the repetition of the call for RWEs. These are essential for you to score in the top
range. With the awareness that you are going to be asked about RWEs in Paper 1, the
collection of RWEs for each topic is very important.

Part (b) is different in that it asks that you evaluate — to make a critical judgement on
the policies in question, based on evidence from the real world, and demonstrating
your understanding of, in this case, the economic concept of price controls.
Evaluation of price controls requires you to measure the effectiveness of price-control
policies against their stated goals of helping either producers or consumers. You
also need to apply relevant knowledge of price-control programmes, and explain the
advantages and disadvantages of such schemes. Do your best to outline the issues,
dilemmas, and key challenges of an issue, using your theory and your real-world
example.

While evaluation will be discussed in some more detail later three tips are worth
noting here. Part (b) is a mini-essay unto itself, and needs some basic structure to be
done well.

1 Youneed an introduction that defines the scope of your answer and the outline
of your thesis. The more specific you can make your thesis, the better.
2 Your main arguments, of course. But every argument has a counterargument,
and these should be acknowledged and addressed in your answer.
3 Asummative conclusion is important for part (b). Often, you ‘write your way to
athesis’ and land on the clearest version of your thoughts when you finish. Be sure
to include that in your answer.
To give you a sense of the requirements for full marks, and the distinction between the
top levels, the descriptors for Level 4 and 5 are listed below.

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Table 31.2 Paper 1, part (b) levels, marks, and descriptors

Marks 0-15 | Level descriptor

10-12 The specific demands of the question are understood and
(Level 4) addressed.
* Relevant economic theory is explained.
* Relevant economic terms are used mostly appropriately.
* Where appropriate, relevant diagram(s) are included and explained.
The response contains evidence of appropriate synthesis or
evaluation that is mostly balanced.
* Arelevant real-world example(s) is identified and developed in
the context of the question.
13-15 * The specific demands of the question are understood and
(Level 5) addressed.
* Relevant economic theory is fully explained.
* Relevant economic terms are used appropriately throughout the
response.
* Where appropriate, relevant diagram(s) are included and fully
explained.
* The response contains evidence of effective and balanced
synthesis or evaluation.
* Arelevant real-world example(s) is identified and fully developed
to support the argument.

31.8 What is Paper 2 and how should you

prepare for it?
Paper 2 is a data response paper. There are two question options and you are to select
and answer one of them. Within each question, the prompts will cover all four areas of
the syllabus. Paper 2 is worth 40 marks, and the time allowance is 1 hour, 45 minutes.
For HL students this paper is worth 30% of the final IB Economics grade, and for SL
students it is worth 40%.

For each question the format is that you are asked to read a selection of information
from a news story and|or study a selection of economic data; you then answer
questions based on the readings. Your answers should also demonstrate your own
knowledge of course topics. Data response questions are more specific and directed
than the extended response questions of Paper 1.

Here you also have 5 minutes of reading time.

1 Useit to skim the questions and question prompts to make a thoughtful selection. Select the
question with prompts that you know well, and feel confident to answer.
2 Next, read the question carefully. Part (g) is a synthesis and evaluation question worth
15 of 40 points. Answering it well requires an understanding of the whole set of
information in the question, not just a few parts.
3 Annotate the text with notes or underlining. This makes it easy to go back and find
RWEs or relevant text to answer a question part.
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The 1 hour, 45 minute time frame may seem like a lot of time, but it is very important
to manage your time wisely. The final question (g) is the most valuable, worth over
athird of the points. A common mistake is to focus on doing a good job on easier
questions and then run out of time on the last question.

What are the four parts of a Paper 2 question?

Part (a)
Part (a) always requires you to define two terms from the document or data supplied.
No more than a definition is required to receive the full two marks for each definition.
Only a clear definition, perhaps a sentence or two at most, is required. Part (a) totals 4
marks.

Part (b)
Part (b) will require two simple calculations, and will be worth a total of5 marks.

Parts (c) to (f)

Parts (c) to (f) typically require you to use an appropriate diagram or to use data in the
tables given to explain something relating to the document or data. Your diagrams,
as always, should be clearly labelled and specifically explained. Pay attention to
the demands of the question and the marks awarded. Your notions of an answer
‘may appear larger than the question actually requires. Use examples from the text
anywhere you can. Each of the parts (¢) to (f) totals 4 marks.

Table 31.3 Paper 2, part (g) levels, marks, and descriptors

Marks Level descriptor

0-15
10-12 + The specific demands of the question are understood and addressed.
* Relevant economic theory is explained.
* Relevant economic terms are used mostly appropriately.
* Where appropriate, relevant diagram(s) are included and explained.
« The response contains evidence of appropriate synthesis or
evaluation that is mostly balanced.
+ The use of information from the text/data is generally appropriate,
relevant, and applied correctly.
13-15 « The specific demands of the question are understood and
addressed.
+ Relevant economic theory is fully explained.
* Relevant economic terms are used appropriately throughout the
response.
* Where appropriate, relevant diagram(s) are included and fully
explained.
* The response contains evidence of effective and balanced synthesis
or evaluation.
* The use of information from the text/data is appropriate, relevant
and is used to support the analysis/evaluation.

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Part (g)
Part (g) typically begins with the words ‘Using information from the text/data and
your knowledge of economics, evaluate ....". Clearly, the assessment objective assessed here
is synthesis and evaluation (AO3). To earn top marks, you must refer to evidence from
the given text, and make an informed judgement regarding the issue addressed. Part (g)
totals 15 marks.
In general, part (g) is also a mini-essay and should include the basic elements outlined
above: introduction, arguments and counterarguments, and a summative conclusion.

To give you a sense of the requirements for full marks on part (g), and the distinction
between the top levels, the descriptors for Level 4 and 5 are listed below. Notice that
there is only one important difference between the descriptors for Paper 1, part (b)
questions and the Paper 2, part (g) questions. Instead of an emphasis on RWEs in
Paper 1, Paper 2 prompts you to use the information from the article. Moreover notice
that the top marks come to an answer that use the information ‘to support the analysis/
evaluation’. In other words, the best part (g) answers will take a position on the question
and support it with economic theory evidence from the article.

31.4 What is the Higher Level Paper 3 and how

should you prepare for it?
Paper 3 is a policy paper and is written only by HL students. It is worth 30% of their IB
final grade. Paper 3 consists of two questions and students must answer both of them.
Each question is worth 30 marks and the paper lasts 1 hour and 45 minutes.

You are allowed a calculator for Paper 3, in order to do basic numerical analysis on
the HL extension topics covered in the course. For example, you might be asked to
calculate the amount of welfare loss from a tax, or the opportunity costs to determine
the gains from trade, or the amount of tax paid from a set of data. You will also be
given a policy-based question that requires your judgement.

What are the sub-questions in HL Paper 3?

Part (a)
Part (a) will consist of approximately eight questions. These will provide tables of
data, diagrams, and short selections of text, and then ask you to make calculations,
draw inferences based on your knowledge of the theory, write definitions, or make
explanations. No synthesis or evaluation will be required for these questions.

Specific requirements and suggestions include the following.

* Your calculations should be figured up to two decimal places.
+ Two-mark questions require the workings to be shown on your paper.
* Itis recommended that you work quickly through the calculations questions to allow
extra time to answer part (b).
* Early errors will not count against further results if the reasoning is correct. Finally,
you should be aware that you will receive a separate answer booklet for your Paper
3 answers.
* Express answers with the units provided (litres, kilograms, GBP, USD, etc.).
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 External assessment

Part (b)
Part (b) will ask you to ‘Recommend a policy ...’ and by recommend the IB
specifically says to ‘Present an advisable course of action with appropriate supporting
evidence/reason in relation to a given situation, problem or issue.’ For example, a
question that discusses the cocoa market and its effects on a particular country might
conclude with the following part (b) question.

b. Using the data provided and your knowledge of economics,

recommend a policy which could be introduced by the government
of Country X in response to the expected fall in the world price
of cocoa. (10 marks)

Some advice on ‘answer these policy’ questions.

« Use appropriate economic theory to support your recommended policy.

* Make specific reference to the data in part (a) to support the analysis and your
choice of policy.
Diagrams may be useful, but may not be necessary.
* Your argument should be well-developed but not strident or overly firm.
Qualifying language is useful here. Phrases like ‘it is likely that’, ‘usually’, and
‘probably’ are examples of this.
* A summative conclusion will connect your evidence back to your initial
recommendation.

You will have 5 minutes of reading time for HL Paper 3. You can use that time
effectively by:
« looking at the part (b) questions
« as you work through part (a) questions, think about how that information might be
used to support your answer in the part (b) question (much like your final question
of Paper 2, some useful information is likely to be found above in the provided
tables, diagrams, and data).
The following is a suggested breakdown of how to allocate your time on HL Paper 3,
for which you have a total of1 hour and 45 minutes:

* Reading time: 5 minutes

* QI part (a): about 30 minutes in total
* QI part (b): about 20 minutes
* Q2 part (a): about 30 minutes in total
* Q2 part (b): about 20 minutes.

Again, to give you a sense of the requirements for full marks, and the distinction
between the top levels, the descriptors for Level 4 and 5 are listed in Table 31.4.

Note the similarity between the descriptors for the Paper 3 policy question and the
final questions from Papers 1 and 2. The use of data, in particular, is important again
here, as is a balanced synthesis and evaluation. Like Paper 2, there is a significant
amount of data that you can use to support your answer, and the data act as ‘clues’ to
the correct interpretation of the issue. Also, like Paper 2, you use your own knowledge,
in this case the recommended policy, to answer the question. Clearly, you want to have
asolid command of the range of government policy options here.
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Table 31.4 Paper 3, part (b) levels, marks, and descriptors

Marks 0-15 | Level descriptor

7-8 The response identifies and fully explains an appropriate policy.
(Level 4) * The response uses relevant economic theory to support the
recommendation.
* Relevant economic terms are used mostly appropriately.
* The use of information from the text/data is generally
appropriate, relevant and applied correctly to support the
recommendation.
The response contains evidence of appropriate synthesis or
evaluation that is mostly balanced.
9-10 The response identifies and fully explains an appropriate policy.
(Level 5) The response uses relevant economic theory effectively to
support the recommendation.
* Relevant economic terms are used appropriately throughout the
response.
* The use of information from the text/data is appropriate, relevant
and supports the analysis/evaluation effectively.
* The response contains evidence of effective and balanced
synthesis or evaluation.

5 What is synthesis/evaluation?
Several components of the SL and HL assessments (both external and internal) require
you to employ effective evaluation. In the examinations, it is required to reach the
highest mark bands for part (b) of Paper 1 questions and part (d) of Paper 2 questions.
In the internal assessment, 4 of the 14 marks available for each commentary are
awarded for effective evaluation. Consequently, this discussion of evaluation is relevant
to the IA component of your course as well as to the examinations.

Evaluation is perhaps the most challenging skill to master. Along with the related skill,
synthesis, it requires that you go beyond the explanation, application and analysis of
economic theory that is required for AO1 and AO2.
Effective evaluation requires you to make a judgement based on evidence. This sounds
simple enough, but making a well-informed, intelligent judgement based on evidence
from the real world is one of the most challenging tasks you face.
Here are some examples of examination questions that require the skill of evaluation.

* Using real-world examples, discuss the ways a functioning price system uses the
signalling and incentive functions to ration resources in a free market economy.
* Using real-world examples, evaluate the effects of government intervention into
the market for petrol.
* Using real-world examples, to what extent should governments attempt to
influence markets where positive externalities exist?
* Using real-world examples, discuss the economic, social, and personal
consequences of unemployment.
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* Using real-world examples, evaluate the alternative ways in which a trade deficit
might be reduced or eliminated.
Using information from the text/data and your knowledge of economics, discuss
methods that the Brazilian government might employ to achieve greater economic
growth and/or economic development.
* Using information from the text/data and your knowledge of economics, discuss
possible economic outcomes for economic growth and economic development
that might arise from Vietnam’s current international trade situation.
These questions are all in the style of Paper 1 part (b) questions or Paper 2 part (g)
questions. The first thing to notice is that only a few of them actually use the word
‘evaluate’. Some other prompts that require you to ‘use economic concepts and
examples to construct and present an argument’ include: discuss, justify, examine,
suggest, recommend, compare and contrast, and to what extent.

What approaches can be taken to answer an

evaluation question?
There are several approaches you can take when answering a question that requires
you to evaluate. The four most trusty and true methods are considered below. In each
case, one of the above questions are given as an example.

Consider short run versus long run

The concepts of short run and long run in economics have different applications
depending on whether the question relates to micro- or macroeconomics. Depending
on the period of time following a particular policy or economic decision by an
individual, a firm or a government, there may be very different outcomes.

Worked example 31.1

Evaluate the alternative ways in which a trade deficit might be reduced or
eliminated.
In the short run, a government may choose to employ protectionist policies to
reduce a current account deficit. Higher taxes on imported goods and services
will make them less attractive to domestic consumers, reducing expenditures on
imports and moving the current account towards surplus.
However, owing to the misallocation of resources resulting from protective tariffs,
and the likelihood that trading partners will impose retaliatory tariffs on the deficit
country, a longer-term solution to a current account deficit requires investments in
human capital, infrastructure and technology.
Such investments will increase the productivity and international competitiveness
of the deficit country. Reducing the country’s dependence on cheap imports and
making its own exports are more attractive to foreign consumers. Such a strategy
will, in the long run, reduce the nation’s current account deficit, increase net
exports, and in the process grow the economy, creating more jobs and a more
productive workforce.

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 Worked example 31.2
Discuss the economic and social consequences of globalisation.
It is helpful to first identify all the stakeholders who are affected by globalisation.
These may include:
domestic households
* domestic firms
* government
« foreign households and firms
* workers in the primary, secondary, and tertiary sector
« foreign workers
« the environment.
Globalisation is generally beneficial for those who experience it; however, not
everyone is necessarily better off as the world's markets become increasingly
interconnected.
In a globalising world, in which different countries have comparative advantages in
different goods and services, the opening of domestic markets to international trade
can lead to major social and economic disruptions for domestic households, firms,
workers and the government. In Europe and North America, globalisation has led
to the loss of millions of manufacturing jobs which, over the last two decades, have
increasingly shifted to low-cost developing countries in which labour-intensive
production s relatively cheap.
On the other hand, skilled workers in the developed world, particularly those with
high levels of education, have benefited greatly from globalisation as the demand
for services such as banking, law, finance and business has expanded dramatically in
the global marketplace.

Examine the impact on different stakeholders

Throughout the economics course, various stakeholders are mentioned. Discussing
the impacts of a particular economic decision, policy or action on the various
stakeholders involved is an effective method for evaluation.
This evaluation could continue by examining the effects of globalisation on workers
and firms in the developing world. It could even discuss the environmental effects that
international trade has wrought, including increased greenhouse gas emissions and the
unsustainable extraction of primary commodities in less developed countries.

Discuss advantages and disadvantages

This may be the easiest and most obvious way to evaluate. Throughout the IB course
you have read about and discussed with your class the advantages and disadvantages of
various economic policies. This approach is best suited to macroeconomics questions.
In approaching a question such as the one below, you may choose two or three policy
options, and weigh the advantages and disadvantages of each.

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 Worked example 31.3
Suggest and evaluate measures to deal with high unemployment.
Both fiscal and monetary policies can be used to reduce unemployment in an
economy. Both policies have their advantages and disadvantages. Expansionary
fiscal policy, for instance, has the advantage of directly stimulating aggregate
demand through government spending and higher disposable incomes among
households who enjoy lower taxes. With greater consumption and government
spending, job creation is highly likely and unemployment should fall.
On the other hand, expansionary fiscal policy financed through increased
government borrowing may have the effect of driving up interest rates in the
private sector, as the government must offer lenders higher rates on its debt. The
corresponding increase in demand for loanable funds may drive up interest rates
and thereby crowd out private investment. In this way, the fall in unemployment
that may have resulted from increased government spending might not occur if
private sector investment decreases at the same time.

Such an approach as this to evaluation is highly effective, especially if the response

were to evaluate the advantages and disadvantages of monetary policy and, based on
the evaluation, draw a conclusion which argued for one type of policy response over
the other.

Prioritise the arguments

This approach to effective evaluation involves prioritising the arguments for a
particular position which you have taken in your response. For example, in answer to
the question below, you may decide to identify and then rank according to importance
the threats posed by a high rate of inflation.

Worked example 31.4

Examine the view that the control of inflation should always be the most
important objective of governments.
The most important reason a government should keep inflation under control
is that a rapidly rising price level drastically reduces the standard of living of a
nation’s people. A high rate of inflation erodes the purchasing power of households’
nominal incomes; therefore, if incomes are rising at a rate slower than that of the
price level, then the real incomes of the nation’s households decline and the average
citizen is actually getting worse off over time.
Second, inflation makes a country’s exports less competitive in the global market,
and, therefore, over time a high rate of inflation will lead to an increasing deficit in
the nation’s current account. The higher price of the nation’s goods makes imports
more attractive to domestic consumers, and exports less attractive to foreigners.
The growing current account deficit will require the nation to sell increasing
amounts of its assets to foreign investors, whose funds will flow back into the
nation in the financial account.

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The above evaluation could continue by identifying a third and perhaps even a
fourth argument for why low inflation should be the most important objective of
governments. On the other hand, you could have taken a very different approach to
the question and argued that inflation should not be the most important objective, and
then prioritised the arguments for why unemployment, economic growth, or income
distribution should be of greater importance to governments.

31.6 What is the Extended Essay?

The Extended Essay (EE) is an exciting and rewarding component of the IB Diploma
Programme. The EE is a detailed paper of 4000 words on a topic in a subject that
interests you. You can choose a topic that fits into one of the subjects on the approved
EE list, which can be obtained from your school’s IB coordinator. The EE encourages
you to think critically and research deeply on your topic, with the goal of gaining
real-world knowledge that furthers your understanding in a meaningful way.
‘What follows is advice on the EE writing process. Before you start, it is important to
put some of your greatest energy into identifying your topic and refining your research
question. By making a solid start in this, you set yourself
up for a clear, focused, and
arguable essay that scores well. The longer you wait to clarify your topic and research
question, the harder your research process and writing will be.

How do you decide on a topic and research

question?
An excellent source for guidance is the Extended Essay Guide. Because the start of your
essay is so important, this exercise from the Guide is reproduced here.

Practice exercise: Formulating well-focused research questions

Developing a narrow, focused research question is an integral part of your extended essay process.
A research question will provide a path to guide you through your research and writing.
Step 1. Choose your | Which subject area is of most personal interest to you? Is there
subject area something you are especially curious about in one of your IB courses?
Did your personal project (if you completed the Middle Years
Programme) spark an idea that can be researched?
Step 2. Choose a Describe your work in one sentence.
topic that interests | [ want to learn about .
ou i )
% Example: 1 want to learn about public funding for the arts.
Step 3. Suggesta Try to describe your research by developing a question that specifies
question something about your topic.
Iam studying because [ want
to find out (who, what, when, where, whether, why or how)

Example: 1 am studying public funding for the arts because I

want to find out how accessible the arts are to those people
who are on low incomes.
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 External assessment

Direct question: To what extent are the arts accessible to

people who belong to the class of the working poor?
Include a command term from your subject area to help
form the research question.
Will you be able to argue a specific position? What are some
possible issues or arguments?
Step 4. Evaluate Answer the questions:
your question Is there a range of perspectives on this topic?
Does the research question allow for analysis, evaluation and the
development of a reasoned argument?
Iam studying because I want to find
out in order to understand (how,
why or whether) .
Example: 1 am studying public funding for the arts because I want
to find out how accessible the arts are to the working poor so I
can determine whether tax dollars support cultural enrichment
for all citizens regardless of their socio-economic status.
Step 5. Restate Asking the question in a different way might help you view your topic
your question in a different way.
using a different How does analysing ...
command term
To what extent ...
Step 6. Review with Is your supervisor able to understand the nature of your research?
your supervisor Isit clear to your supervisor how and why your topic is relevant in your
subject area?
Step 7. Reflection Ifyou can adequately respond to the ‘so what?' question, you may be
on yourway to a clear and focused research question using your initial
topic idea.
Do that here:
You must now start some preliminary reading around the issue or topic.
Remember that you will most likely need to revise your research question
once you start to undertake your research. In this sense your research
question should always be considered provisional until you have enough
research data to make a reasoned argument.

Table31.5 Evaluating research questions

Here are some suggestions on evaluating your question. Is your question

Clear? Will the reader understand the nature of my research? Will it direct
the research being undertaken?
Focused? Will the research question be specific enough to allow for exploration
within the scope of the task (that is, the number of words and time
available)?
Arguable? | Does the research question allow for analysis, evaluation, and the
development of a reasoned argument?
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 Table 31.6 Improving your research question
Unclear, unfocused, and unarguable Clear, focused, and arguable research
research questions questions
Why do African countries suffer To what extent has the lack of
so much in the way of poor health antimalarial medicine in the Democratic
outcomes? Republic of Congo reduced life
expectancies?
Do price controls and taxes on soda To what extent have specific taxes on
really work? sugary beverages in the UK reduced
consumption?
‘What are the costs of palm oil Faced with a European boycott of
production? palm oil, to what extent can Malaysia
profitably switch to sustainable
alternatives?

In Table 31.6 are some examples of poor research questions that have been refined into
quality research questions.

Once you have chosen your subject area, you must meet the following general
requirements.

Observe the relevant regulations

You must have an EE supervisor, who ideally is a teacher of the subject you have
chosen to write on and who works at your school. This teacher, or your school’s IB
coordinator, is responsible for providing you with the Extended Essay Guide, an official
1B publication in which the regulations relating to the EE are laid out.

Meet deadlines
You and your supervisor should agree deadlines for intermediate and final drafts
of your EE. It is likely that your school will have internal deadlines agreed by all IB
teachers. Make sure you are aware of these deadlines, and plan accordingly to meet
the requirements of each deadline so as to ensure your final essay is of the best quality
possible.

Acknowledge sources in an approved academic manner

The easiest way to fail the IB Diploma Programme is to be caught plagiarising. In
your research and writing of the EE, it is crucial that you acknowledge all sources of
information and ideas in an approved manner, most likely through footnotes or a
bibliography following either the APA or the MLA structure.
In addition to these requirements, you are strongly recommended to:

* start work early

« think very carefully about the research question for your essay
« consult your school librarian or library web page for EE research guidance
* plan a schedule for both researching and writing the essay, including extra time for
delays and unforeseen problems
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 External assessment

* record sources as your research progresses (rather than trying to reconstruct a list at
the end)
« outline your essay before starting to write it
* check and proofiead the final version carefully
+ make sure that all basic requirements are met (e.g. word count, section headings).

How do | prepare for EE work?

Before starting work
Read the assessment criteria in the Extended Essay Guide, then read previous essays to
identify strengths and possible pitfalls. Your supervisor should be able to provide you
with past, marked essays to give you ideas of how to begin your own, or you can also
find examples on the ibo.org website.
Spend time working out the research question. A strong research question is essential;
without one, your essay will be weak at best.

Work out a structure for your essay. Before you begin writing in earnest, create a
comprehensive outline of the essay.

During the research and writing

Start work early and stick to your deadlines. Maintain a good working relationship
with your supervisor. Check in with your supervisor often, at least once every few
weeks. Remember, it is your responsibility (not your supervisor’s) to make sure you
have regular meetings. Without initiative on your part, you will not benefit from your
supervisor’s guidance.

Construct an argument that relates to the research question. The research question is
only the starting point for your essay. In attempting to answer it, you must construct a
reasoned argument supported by evidence gathered in your research.

Use the library and online resources, and consult librarians for advice. Librarians today
deal with more than just books. Most school libraries have access to online databases
of scholarly journals, which could be great sources for research. Using search engines
successfully requires sound search technique; be sure to consult a specialist in your
school to get tips on how to go about conducting your online and library research.
Do not be afraid to change your topic and research question if there is a problem
with your original one. If you start early enough, there should be plenty of time to
change topics a few weeks or a month or two into the process if you decide you cannot
successfully write an essay on your original topic.

Use the appropriate language for the subject. Keep the course syllabus, a textbook,
and your class notes in front of you at all times while writing. The biggest threat to
your success is writing 4000 words that repeatedly drift away from the topics covered
in your chosen subject. Keep your essay grounded in the subject by continuously
checking your progress against the course syllabus.
Let your interest and enthusiasm show. Hopefully you have chosen a topic that
genuinely interests you. It is perfectly acceptable to express interest and emotion
in your writing. Some of the best essays are those in which the writer’s voice and
personality are clearly visible.
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Wrapping up the essay
Carefully proofread your essay. Try to have at least one or two of your classmates also
proofread your essay for you (perhaps you can agree to proofread theirs for them).
In addition, you should ask your supervisor to give your final draft one last look
before you submit the true final copy. Check the Guide for the heading and formal
requirements. Check the Guide and with your EE coordinator or librarian to find
guidelines for citations.

What is some subject-specific advice on the

Economics EE?
Make sure economics is the right subject for you
Economics is a very popular subject for the EE at many schools. Some students are
under the impression that economics is an easier subject in which to write an essay in
than, say, the physical sciences such as physics or chemistry.

You should know that this is a myth. There is no sound evidence to support the
assumption that economics is any easier to write a strong EE for than the physical
sciences. In fact, the best economics EEs tend to be those which take a highly scientific
approach to the research and writing process.

‘Why is this? The higher levels of economics are extremely empirical in their analysis.
Economics is a social science, yes, but in their study of human interaction in markets,
economists seek to quantify human behaviours to as great an extent as possible. By
collecting, organising, displaying, and then analysing data representing the interactions
of individuals, firms or governments in a mathematical way, economists are able to
observe the interactions between two or more variables and develop hypotheses about
human behaviour.
In this regard, a top-notch economics essay may appear very scientific indeed; students
hoping to avoid doing experiments and gathering data should perhaps avoid writing
an economics essay.

What does an economics essay look like?

Core principles throughout
An EE in economics should employ the core principles of economics as a basis for
researching a particular topic. Both primary and secondary research should be
conducted to gather data and background information for the essay. Theories outlined
in the course syllabus, as well as the tools, models, graphs, and skills learned during the
IB Economics course should be applied to the topic.

Avoid narrative, descriptive writing

You should avoid writing an historical, narrative essay, even on an economic topic.
In general, topics that are older than five years will be marked down.

Essays should be analytical rather than descriptive. The purpose is not so much to tell
astory as to analyse events in the world around you through the lens of economics.
To this end you can employ the tools and models of economics to develop a deeper
understanding of human interactions and behaviour.
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 External assessment

Answerable research question

It is important that you can answer your research question using economic concepts
and theories. Often, students choose a topic they think is appropriate for economics,
but which would be more suited to business and management. For instance, you may
wish to analyse the costs and revenues ofa particular firm in which you have a relative
who is employed. Be aware that firms do not like to share this information, and it may
not directly relate to the syllabus anyway.

Data, data, data!

Your researched data are very important. While it is not explicitly required, primary
research tends to be a part of the best essays. For an essay in which you undertake an
analysis ofa particular product market, for example, you may include historic price
and output data for the market, surveys of consumers in the market, interviews with
sellers in the market, and so on.

Data should be presented in a visually appealing manner. Where possible, create charts
and graphs rather than presenting large tables full of small numbers.
Do not waste too many words summarising your data. If presented well, it does not
need it. Focus on analysing your data. Attempt to find and explain patterns within
the data, and once identified, apply the tools of micro- or macroeconomics to explain
those patterns.

Secondary research
Secondary research should include analyses of data that already exist from studies
done by others on topics similar to yours. Successful secondary research can bolster
your argument, offering evidence found through similar studies that either supports or
refutes your own hypothesis.

For further guidance on choosing a topic and developing a research question, along
with more information on treatment of the topic in an economics EE, check the IB
Extended Essay Guide.

How do | interpret the EE criteria?

EEs are externally assessed on assessment criteria by examiners appointed by the
IB. Essays are marked out of 34 points allocated between criteria A to E as shown in
Table 31.7. The total score for your essay is used in conjunction with your theory of
knowledge score to determine the number of points awarded jointly to these two
components of your Diploma.

Notice that the largest section of points is C: Critical Thinking. This is where the quality
of your research and your discussion of it is assessed. Obviously, valid and relevant
information is essential, but also your ability to break it down (analyse it) shows your
understanding as well. When it comes to discussing your research, it is here that you
try to connect it to your research question, stating why it is of use to your essay.

Finally, when it comes to evaluating your findings, be aware that you should do so
continuously, as you bring each piece of evidence forward into the essay. Do not wait
until the last pages to do ‘evaluation’. Each article, survey, or data set, should be

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Table 31.7 Extended Essay criteria

Criterion Descriptors Marks

Topic
Criterion A: Focus and Method Research question 6
Methodology

Criterion B: Knowledge and Context

Understanding Subject-specific terminology and 6
concepts
Research
Criterion C: Critical Thinking Analysis 12
Discussion and evaluation

Criterion D: Presentation Structure 4

Layout
o Process
Criterion E: Engagement Réssatehifois 6

Total Marks 34

evaluated ‘in real time’, as to its values and limitations. Some of your research will be
just what you were looking for, but others may be supplementary, or only somewhat
helpful to you.

Be honest about your evidence. Papers with great evidence that is poorly explained and
not properly evaluated will score poorly on Criterion C. Papers with weaker evidence
but whose writers are candid about how the information might be useful but also
carefully point out its flaws will score reasonably well.
This advice, honesty in your reporting, applies to Criterion E: Engagement. Your grade
here is based essentially on your own writing of the ‘Reflections on Planning and
Progress Form (RPPF)’. For these entries, written over the course of your essay process,
try to capture your thinking at each stage. Generally, you will write one after forming
your research question, another after an initial draft, and finally one for the viva voce
when you have completed the paper. Describe your progress and your problems, and
how you are trying to overcome them. Here the IB is rewarding your adherence to the
EE research process, rather than looking exclusively at your finished product. This is
a great place to score points, so see the IB resources for specimen paper examples of
good reflections.

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Internal assessment
 7 hat is the Internal Assessment portfolio
The Internal Assessment (IA) is a very important part of the IB Economics course.
Itis required of all students, and many find the task enjoyable and challenging. You are
encouraged to pursue personal interests within the boundaries of the course syllabus,
and because each commentary is researched outside class time, more deliberation
and planning are possible. This means that the IA process provides an opportunity to
enrich your knowledge.
Building your IA portfolio requires you to engage with real news items and to apply
the economic concepts you have learned. You will write economics commentaries on
three news items.

To find appropriate articles, you will need to read a variety of news items from
various sources, and judge their relevance to economics topics. For each of the
three articles that you choose, you will identify in your commentary the
concepts and aspects of economic theory that are at work in the article. The
commentary will analyse the event, apply the concepts in detail, and explain how
the theory works. This requires good evaluation skills and good command of
diagrammatic skills.
Besides this review of the IA writing process, you are advised to read and review the IA
section of the IB Economics Guide, which should be available from your teacher.

What are general requirements of the IA?

The IA portfolio is worth 20% of your final mark for HL students and 30% for SL
students. The IA writing process should be integrated into your class and use 20 hours
of class time; it is not an independent project. The IA process is summarised as follows.

Variety of sources
You will produce three commentaries from a variety of news sources. Each
commentary will focus on a different part of the IB syllabus. Articles must come
from print news media that include newspapers, magazines, and internet news sites.
Television or radio broadcasts are not suitable. Blogs or other opinion or editorial
articles are strongly discouraged.
Articles should be brief. Long articles are very much discouraged. If you do select
alonger article, the commentary should focus on a short section indicated by
highlighting in the portfolio.
Articles should be in the same language as the commentary. If different from the
commentary language, a translation and the original article should be attached to the
commentary.
Articles must be current, published within one year of the writing of the commentary.
Articles must be from a variety of news sources, a different one for each
commentary. You may not choose two articles from, say, the Financial Times.
You are encouraged to choose articles from a mixture of local, national and
international news sources.
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 Internal assessment

Table 32.1 IA criteria, descriptors, and marks

Criterion and section | Top level descriptors Marks

A: Diagrams Relevant, accurate and correctly labelled 3
diagram(s) are included, with a full explanation.
B: Terminology Economic terminology relevant to the 2
article is used appropriately throughout the
commentary.
C: Application and Relevant economic theory is applied to the 3
analysis article throughout the commentary with
effective economic analysis.
D: Key concept A key concept is identified and the link to the 3
article is fully explained.
E: Evaluation Judgements are made that are supported by 3
effective and balanced reasoning.
Single IA Total 14

Other guidelines
Commentaries should be no longer than 750 words (the IB Guide has a list of items
that are not included in the word count). Do not stuff the graph legend with extra
explanations to stay under the word count. This will be marked down.

Commentaries should be your own work, not done in collaboration. Try not to use the
same articles as anyone else. Your teacher may not assign articles for you to use.

What are the IA rubric requirements?

Your commentaries will be marked by your teacher against a set of rubric requirements
defined by the International Baccalaureate (IB). Table 31.1 shows you the five criteria
that apply to each of your three commentaries, the skill area each criterion tests, the
marks available for each criterion, and the highest descriptor for each criterion.
In addition to the criteria in Table 31.1, criterion F (worth three marks) is applied to the
entire portfolio. Criterion F assesses your complete portfolio on the following five points:

« cach commentary is not more than 750 words

« eacharticle relates to a different section of the syllabus
« eacharticle comes from a different and appropriate source

Table 32.2 Total IA scores

Single IA scores (14 points X 3) 42
Criterion F: Rubric | Each articleis... 3
Requirements + based on a different unit of the syllabus
« taken from a different and appropriate source
+ published no earlier than one year before the
writing of the commentary.
Portfolio total 45

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« eacharticle is no more than a year old
« the portfolio has a summary cover sheet, each commentary has a cover sheet, and
each article is included in the portfolio.

So, each commentary is marked on criteria A~E and is given a score out of 14 marks.
The entire portfolio is then given a score out of three marks for criterion F. Thus, the
full portfolio is scored out of 45 marks (3 commentaries X 14 marks + 3 marks).

32.2 How do | write high-quality comm

How do | find a good article?
Finding a suitable article may seem like the easiest part of the process, but you will be
surprised at just how difficult it can be.

Information balance
For IA purposes, a useful news article should say neither too little nor too much. The
article should describe an issue sufficiently to allow room for analysis and discussion
of an event’s implication. But the article should not provide that analysis itself - that
is your job. This is why general news articles from daily newspapers (or news agency
services) can work out very well, while articles from more economics-focused
publications (e.g. The Economist) or scholarly journals are often less suitable.

Conduct an effective search

The internet has made it possible to search far and wide with incredible speed, but the
volume of information can be overwhelming and stall your progress at a very early
stage. With this in mind, search for a good article with care.

Where to look
Search engines are well suited for finding articles on specific topics. So rather
than going to the homepage of your favourite search engine, begin your search
in the news section. For example, do not start at www.google.com, begin at
http:/[news.google.com, which ensures that your search results will already be filtered
from news websites. But beware — not all news sites are appropriate for an IB commentary.
Be sure to avoid opinion and editorial pages, and try to use trusted news sources.

Use keywords
Often, a web search for a topic from the syllabus that is commonly referred to in the
media (e.g. demand, taxes, trade) will turn up thousands of hits. Searching for an
article by browsing the results of such a broad search will prove tedious and you are
not likely to find more than a very few appropriate articles. However, terms such as
‘income elasticity of demand’ or ‘aggregate supply’ are not typically used by the news
media, even though the concepts themselves are regularly the subject of reports in the
business and economic news.

To find articles relating to such concepts, you must be critical and flexible in your
browsing of search results; move on quickly if your first search attempts fail to yield
any promising results. When this happens, try out associated terms that are linked
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 Internal assessment

with the overall concept. And ask your teacher if there is another way of phrasing your
searches to get better results for the topic you are interested in.

Vet your article

So how can you tell if your article is a worthy candidate for a commentary? Do not
take the first one, as a rule. Of the many articles you have read, you are likely to have
decided early on that a few have the right balance of not-too-little/not-too-much
information and analysis. Once you have narrowed down your options to two or three
for each choice, vet the articles for final selection. You might take the following steps.
* Brainstorm. Pull out a copy of the current IB Guide and turn to the list of topics.
Or you might want to use the vocabulary list for the relevant unit. As you read the
article, check off the relevant terms.
« Identify concepts. As you read each article, make notes in the margin (or on
the website if you are using a social bookmarking tool) of the concepts from
the syllabus to which the article relates. This will help you decide if the article is
appropriate for the section of the syllabus you wish to address.
* Identify diagrams. Typically, a high-quality commentary includes at least two
(but perhaps more) diagrams. Diagrammed items should be part of the core topics
of the commentary, not merely introductory material or of tangential interest.
As you read the article, take note of potential diagrams you can include in your
analysis. If you are not able to identify at least two relevant economics graphs to
Video suggestions: include in your commentary, the article may not be of use to you.
You have read about it, now * Outline. Create a simple outline of each section of your commentary. List what
you can review what you've
just learned by watching a each paragraph will do, including the types of explanation and areas of evaluation.
few videos by the author! Remember that diagrams must be clearly explained in the body of the text, and not
The IB Economics merely attached to the commentary.
1A - getting started.
The IB Economics After completing these steps for each potential article, it should be clear which of your
1A - making an outline. options is best suited to be the subject of an economics commentary that meets the
requirements of the IA.

How do | write my first draft?

Now that you've outlined the key ideas for each paragraph, you can begin to link
together the main ideas in complete prose for your draft commentary.

Satisfy the IA criteria

The IA criteria require that each commentary includes diagrams, definitions,
application, analysis and evaluation of relevant economic theory. The discussions
below will help you more clearly understand these requirements.

Diagrams
Diagrams must be highly relevant and fully explained in the text. Explanations must
make specific reference to graph points (e.g. quantity increases from Q, to Q,) Graphs
should be given priority in your analysis. Make them large and centre them on the
page rather than writing text around them. They should be introduced and then clearly
explained in the text.

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Define and explain
Definitions of relevant terms should be included in each commentary. Not all
economics terms need to be defined — it would be easy to use up halfof your 750 word
count defining terms. Only define terms that are integral to the analysis and evaluation
you plan to conduct in each commentary. Once a term has been defined, do not define
it again in a later commentary in the same portfolio. Explanations require students to
describe clearly, make intelligible and give reasons for an economic concept or idea.
Itis your job to bring clarification to the economic concepts relating to your article.

Analysis and application

Analysis requires you to closely examine the events laid out in your article through the
tools and theories learned in your economics course. A clear analysis will identify the
key ideas and your application will match these ideas to issues in the article. Economic
diagrams should form the heart of your analysis; anything that can be explained
graphically should be explained graphically. With only 750 words, you must be concise
and selective in how you analyse the news on which your commentary is based.

Key concepts
Each entry should identify a key concept from the course list of concepts which
include scarcity, choice, efficiency, equity, economic well-being, sustainability,
change, interdependence, and intervention. Top marks in this category come from
correctly identifying and fully explaining the link between the key concept and the
issues in the article.

Evaluation
This is your opportunity to discuss the implications of an economic issue, and to
assess the effects the issue (or policies to redress it) have on stakeholders. Evaluation
is the skill many students find the most difficult. It requires you to make a judgement
based on evidence. In your commentaries, you can evaluate throughout the text, or
you may choose to conduct the evaluation at the end of each commentary. To make an
evaluation, you can:

* weigh the advantages and disadvantages of certain economic policies

« discuss the effects on different stakeholders in society ofa particular policy or event
* compare the short-run and long-run effects of an economic policy or a decision by
a particular stakeholder in a market
« critically assess the validity of the economic theories you have applied to your
commentary.
Critically assessing the validity of economic theories is the thing many students find
the most difficult to do successfully. Evaluation requires that you call into question
the economic theories themselves. For instance, economic theory would argue that a
progressive tax system is inefficient due to its negative effect on the incentive to work and
earn higher incomes. However, you may argue that in reality there is little evidence that
progressive taxes reduce efficiency, and that the resulting reduction in income inequality
more than justifies the use of such a system in a modern, developed economy. You have
now called into question the economic view that taxes are inefficient.

There are more ideas on how to evaluate effectively in Chapter 31.

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 Internal assessment

Video suggestion: Avoid unnecessary summary

You've read about it, now you The article supplies the fundamental information for your commentary. The grader
can review what you've just will read the article you have supplied, so it is not necessary for you to recap that
learned by watching a video
by the author! information. To do so would waste precious words that count against your limit. You
The 1B Economics IA - should reference the article by including direct quotes and references to data.
writing your first draft.
Reference the article
In each commentary, it is critical that you cite the article in several instances. Each
commentary should include references to the specific circumstances as laid out in
the article. Include at least one direct quote, and whenever there are numbers, such
as prices, quantities or percentage changes mentioned in the article, attempt to
incorporate them into the analysis in your commentary.

For example, if there is mention of airline ticket prices changing for a particular route, then
in your graph of the airline market, include the original price and the new price on the
Y-axis, rather than a generic P, and P,. This demonstrates that you are a skilled economist
able to apply economic theory to real examples. If you use direct quotes, they should be a
brief phrase, or a word or two. Avoid long quotes that will count against your word limit.

How do | revise my commentary for the final draft?

When you have finished your draft, you submit it to your teacher. He or she will provide
you with brief but useful advice about how to improve each commentary. Take this help
seriously— it can significantly improve your marks. You should continue to seck advice,
but remember your teacher can give only limited help from now on. Be sure to observe all
the appropriate language conventions and you can ask a classmate to help copy-edit your
work. Finally, use the following checklist of requirements before handing in your final draft.
* Do lhavea cover sheet with all the appropriate information? What is my word count?
* Areall the relevant economic terms defined? Have I used economic terminology
throughout my commentary, not just occasionally?
* Havelincluded at least two diagrams? Have I explained them carefully in the body
of the text?
* HaveIreferenced the article to a degree that makes it clear my commentary is on
the particular circumstances described in the article, not just a repetition of what I
read in my textbook or took notes on in class?
« Is my analysis complete? Have I considered the major areas of theory that are
related to this topic?
* Havelevaluated effectively? Have I considered the short run and the long run, the
implications for various stakeholders, and the validity of the economic theory itself?

The IA portfolio is intended to be an enriching learning experience. Feel free to seek out
articles in areas of your own interest. You are far more likely to bring insight to issues in
which you are already interested. However, another equally important motivation is to
encourage you to broaden your knowledge of economics and the world by reading widely.
After writing each entry, your teacher will mark it and likely give you feedback to help
you write the next one. After completing the portfolio, your teacher will award the
rubric requirement marks accordingly, and your work will be uploaded to the IBIS
system. The marks for the entire class will be subject to moderation by IB examiners.
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Glossary
This is not an exhaustive list of terms that may be assessed. Any technical term within the Guide can be assessed.

Abnormal profit This arises when average revenue is Allocative efficiency Achieved when just the right amount
greater than average cost (greater than of goods and services are produced
the minimum return required by a from society’s point of view so that
firm to remain in a line of business). scarce resources are allocated in the
Absolute advantage A country has an absolute advantage
best possible way. It is achieved when,
for the last unit produced, price (P) is
in the production of a good if it can
equal to marginal cost (MC), or more
produce more of it with the same
resources or, equivalently, if it can
generally, if marginal social benefit
produce the same amount using fewer (MSB) s equal to marginal social
cost (MSC).
resources compared to another country.
Allocative When either more or less than the
Absolute poverty People living below the minimum inefficiency socially optimal amount is
income necessary to satisfy basic
produced and consumed so that
physical needs (food, clothing, and misallocation of resources results.
shelter); as of October 2015, the
MSB MSC.
World Bank international poverty line
is setat US $1.90 PPP per day. Anchoring Refers to situations when people
Administrative Trade barriers in the form of
rely on a piece of information
that is not necessarily relevant as
barriers regulations that aim to limit imports
into a country. These barriers may
a reference point when making a
decision.
take the form of product safety
standards, sanitary standards or Anti-dumping Typically refers to tariffs that aim at
pollution standards but may also raising the artificially low price ofa
include more stringent than necessary dumped imported good to the
application of customs procedures. level of the higher domestic price.
Adverse selection A type of market failure involving A dumped good is one that is
asymmetric information, where exported at a price below the cost of
the party with the incomplete producing it.
information is induced to withdraw Anti-monopoly Laws and regulations that are
from the market. The buyer, for regulation intended to restrict anti-competitive
example, of a used car, may hesitate behaviour of firms that are abusing
to buy without knowing about the their market power.
quality of the vehicle. The seller, for
example of health insurance, may Appreciation When the price ofa currency
hesitate to sell a policy without increases in a floating exchange rate
knowing the health of the buyer. system.
Aggregate Planned spending on domestic goods Appropriate Technology that relies mostly on the
demand (AD) and services at different average price technology relatively abundant factor an economy
levels, per period of time. Consists is endowed with.
of consumption, investment and Asymmetric A type of market failure where one
government expenditures plus net information party in an economic transaction has
exports. access to more or better information
Aggregate demand A curve showing the planned level than the other party.
curve of spending on domestic output at
Automatic stabilisers Institutionally built-in features
different average price levels. (like unemployment benefits and
Aggregate The planned level of output domestic progressive income taxation) that
supply (AS) firms are willing and able to offer at tend to decrease the short-term
different average price levels. fluctuations of the business cycle
without the need for governments
Aggregate supply Acurve showing the planned level of tointervene.
curve output that domestic firms are willing
and able to offer at different average Average costs Total costs per unit of output
price levels. produced.

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 Glossary

Average revenue Revenue earned per unit sold; average Business confidence A measure of the degree of optimism
revenue is thus equal to the price of that businesses have about the
the good. economic future.
Average tax rate The ratio of the tax paid by an Business cycle The short-term fluctuations of real
individual over their income GDP around its long-term trend (or
expressed as a percentage. potential output).
Balance of payments Arecord of the value of all Business tax Tax levied on the income of a business
transactions ofa country with the rest or corporation.
of the world overa period of time. Capital Physical capital refers to means of
Balance of trade Part of the balance of payments, it production that include machines,
ingoods is the value of exports of goods tools, equipment and factories;
of a country minus the value of the term may also refer to the
imports of goods over a given infrastructure ofa country. Human
period of time. capital refers to the education,
Balance of trade Part of the balance of payments, it is
training, skills and experience
embodied in the labour force ofa
in services the value of exports of services
country.
of a country minus the value of
imports of services over a given Capital account A subaccount of the balance of
period of time. payments that includes credit and
debit entries for non-produced,
Barriers to entry Anything that deters entry of new
non-financial assets as well as capital
firms into a market, for example, transfers between residents and non-
licenses or patents.
residents.
Behavioural A subdiscipline of economics that
economics relies on elements of cognitive
Capital gains tax A tax on the profits realised from the
sale of financial assets such as stocks
psychology to better understand
orbonds.
decision-making by economic
agents. It challenges the assumption Capital transfers Include financial or non-financial
that economic agents (consumers assets for items including debt
or firms) will always make rational forgiveness, investment, non-life
choices with the aim of maximizing insurance claims. They are part of
with respect to some objective. the capital account of the balance of
payments.
Biases Systematic deviations from rational
choice decision-making. Carbon (emissions) Taxes levied on the carbon content of
taxes fuel. They are a type of Pigouvian tax.
Bounded rationality A term introduced by Herbert
Simon that suggests consumers and Central bank An institution charged with
businesses have neither the necessary conducting monetary and exchange
information nor the cognitive rate policy, regulating behaviour of
abilities required to maximise with commercial banks, and providing
respect to some objectives (such as banking services to the government
utility), and thus choose to satisfice. and commercial banks.
They therefore are rational only
within limits.
Ceteris paribus A Latin expression meaning ‘other
things being equal’.
Bounded self-control The idea that individuals, even when
they know what they want, may
Choice architecture The design of environments based
on the idea that the layout,
not be able to act in their interests.
Findings of bounded self-control
sequencing, and range of choices
available affect the decisions made
include evidence of procrastination
(for example, among students, by consumers.
professionals and others) that may Circular flow A simplified illustration that shows
result in self-harm, and submitting to model the flows of income and expenditures
temptation (for example, dieters). inan economy.
Budget deficit When government expenditures Collusive oligopoly A market where firms agree to fix
exceed government (tax) revenues price and/or to engage in other
usually overa period ofa year. anticompetitive behaviour.

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Common market When a group of countries agree Contractionary A policy employed by the central bank
not only to free trade of goods and monetary policy involving an increase in interest rates
services but also to free movement of and aimed at decreasing aggregate
capital and labour. demand and thus inflationary
pressures. Referred to also as tight
Common pool A diverse group of natural resources monetary policy.
resources that are non-excludable, but their use
is rivalrous, for example, fisheries. Corporate The sum of what a corporation owes
indebtedness to banks or other holders of its debt.
Comparative When a country can produce a good
advantage ata lower opportunity cost compared Corporate social A corporate goal adopted by many
to another country. responsibility (CSR) firms that aims to create and maintain
an ethical and environmentally
Competitive market A market with many firms acting
independently where no firm has the responsible image.
ability to control the price. Cost-push inflation Inflation that is a result of increased
production costs (typically because
Competitive market Occurs if in a free competitive market,
of rising money wages or rising
equilibrium quantity demanded is equal to commodity prices) and illustrated by
quantity supplied.
aleftward shift of the SRAS curve.
Complements Goods that are jointly consumed, for Credit items Refers to transactions within the
example, coffee and sugar. balance of payments ofa country
Composite indicator An indicator that is comprised as an that lead to an inflow of currency
average of more than one economic (for example, the export of goods);
variable, for example, the HDI. these transactions enter the account
with a plus sign.
Concentration ratios The proportion of industry sales
accounted for by the largest firms; the Credit rating A grade assigned by certain agencies
greater this proportion, the greater (such as Moody’s or Standard and
the degree of market power of the Poor’s) on the borrowing risks
firms in the industry. a prospective issuer of debt (for
example, ofa bond) presents to
Consumer A measure of the degree of optimism lenders.
confidence that households have about their
income and economic prospects. Crowding out The idea that expansionary fiscal
policy is not very effective in increasing
Consumer nudges Small design changes that include aggregate demand because the
positive reinforcement and indirect increased borrowing needs of the
suggestions that can influence the government to finance the increased
behaviour of consumers. expenditures could lead to increased
Consumer price The average of the prices of the goods interest rates. Thus, reducing private
index (CPI) and services that the typical consumer sector investment, consumer
buys expressed as an index number. spending, and other components
The CPlis used as a measure of the of AD.
cost of living in a country and to
Current account A subaccount of the balance of
calculate inflation. payments that records the value of
Consumer surplus The difference between how much a net exports in goods and services, net
consumer is at most willing to pay for income and net current transfers of a
agood and how much they actually country over a period of time.
pay. Current account Exists when the sum of net exports of
Consumption (C) Spending by households on deficit goods and services plus net income
durable and non-durable goods plus net current transfers is negative
and on services overa period (or simply when debits or outflows are
of time. greater than credits or inflows).

Contractionary Refers to a decrease in government Current account Exists when the sum of net exports of
fiscal policy expenditures andfor an increase surplus goods and services plus net income
in taxes that aim at decreasing plus net current transfers is positive
aggregate demand and thus reducing (or simply when credits or inflows are
inflationary pressures. greater than debits or inflows).

677
 Glossary

Current transfers Anentry in the current account that Demand-pull inflation Inflation that is caused by increases in
records payments between residents aggregate demand.
and non-residents ofa country
without something of economic value Demand side policies Refers to economic policies that aim
ataffecting aggregate demand and
being received in return and that affect
directly the level of disposable income thus macroeconomic variables such
as growth, inflation and employment;
(for example, workers remittances,
pensions, aid and grants, and so on). demand side policies include fiscal
policy and monetary policy.
Customs union Anagreement between countries to
Demerit goods Goods or services that not only harm
phase out or eliminate tariffs and other
the individuals who consume these but
trade barriers and establish a common
also society at large, and that tend to be
external barrier toward non-members.
overconsumed. Usually they are due to
Cyclical (demand- Unemployment that is a result ofa negative consumption externalities.
deficient) decrease in aggregate demand and Depreciation Adecrease in the value ofa currency
unemployment thus of economic activity; it occurs in
in terms of another currency in
arecession.
a floating or managed exchange
Debit items Refers to transactions within the balance rate system.
of payments of a country that lead to an
Deregulation Policies that reduce or eliminate
outflow of currency (for example, the regulations related to the operation
import of services); these transactions
of firms so that production costs
enter the account with a minus sign.
decrease—resulting in increased
Debt relief A reduction of the debt burden of competition and higher levels of output.
developing countries organised by the
World Bank and the IMF. Devaluation Adecrease in the value ofa currency
in a fixed exchange rate system.
Debt servicing Refers to the repayment of principal
and interest on the debt ofa person, a Development aid Aid aimed at assisting developing
firm or a country. countries in their development efforts.
Includes project aid, programme
Default choice When a choice is made by default, aid and debt relief. It is concessional,
meaning that when given a choice it meaning there are low interest rates
is the option that is selected when one and long repayment periods.
does not do anything.
Direct taxes Taxes on income, profits or wealth
Deflation A sustained decrease in the average paid directly to the government.
price level ofa country.
Discount rate The interest rate that a central bank
Deflationary/ Arises when the equilibrium level charges commercial banks for short-
recessionary gap of real output is less than potential term loans (also referred to as the
output as a result ofa decrease in AD. refinancing rate).
Demand The relationship between possible Disinflation ‘When the average price level continues
prices ofa good or service and the to rise but at a slower rate so that the
quantities that individuals are willing rate of inflation is positive but lower.
and able to buy over some time
period, ceteris paribus. Dumping When a firm sells abroad at a price
below average cost or below the
Demand curve A curve illustrating the relationship domestic price.
between possible prices ofa good
or service and the quantities that Economic A multidimensional concept
individuals are willing and able to buy development involving a sustained increase in
over some time period, ceteris paribus. living standards that implies higher
Itis normally downward sloping. levels of income and thus greater
access to goods and services, better
Demand Policies that aim at manipulating
education and health, a better
management aggregate demand through changes
environment to live in as well as
in interest rates (monetary policy) or
changes in government expenditures
individual empowerment.
and taxation in order to influence Economic growth Refers to increases in real GDP over
growth, employment, and inflation. time.

678
Economic integration Economic interdependence between Exchange rate The value of one currency expressed
countries usually involving agreements in terms of another currency; for
between two or more countries to example, €1 = USSL5.
phase-out or eliminate trade and other
barriers between them.
Excludable A characteristic that most goods have
that refers to the ability of producers
Economics Economics is the study of how to to charge a price and thus exclude
make the best possible use of scarce or whoever is not willing or able to pay
limited resources to satisfy unlimited for it from enjoying it.
human needs and wants.
Expansionary Refers to an increase in government
Economic well-being A multidimensional concept relating fiscal policy expenditures andfor a decrease in
to the level of prosperity and quality taxes that aim at increasing aggregate
of living standards in a country. demand and thus real output and
employment.
Economies of scale Falling average costs that a firm
experiences when it increases its scale Expansionary Monetary policy aiming at increasing
of operations. monetary policy aggregate demand through a decrease
Efficiency In general, involves making the in interest rates; also referred to as
easy monetary policy.
best use of scarce resources.
May refer to producing at the lowest Expenditure One of three analytically equivalent
possible cost or to allocative approach approaches of measuring GDP that
efficiency where marginal social adds all the expenditures made on
costs are equal to marginal social final domestic goods and services over
benefits or where social surplus is aperiod of time by households, firms,
maximum. the government and foreigners.
Elasticity A measure of the responsiveness of Expenditure reducing Contractionary demand side policies
an economic variable (such as the aiming at decreasing national income
quantity demanded ofa product) to a and thus expenditures on imports so
change in another economic variable that a current account deficit narrows.
(such as its price or income).
Expenditure Policies aimed at switching
Elasticity of A measure of the responsiveness of switching expenditures away from imports
demand for exports the volume of exports to a change in towards domestically produced goods
their price. and services by making imports more
expensive in order to narrow a current
Elasticity of demand A measure of the responsiveness of account deficit. It includes lowering
for imports the volume of imports to a change in
the exchange rate as well as adopting
their price.
trade protection.
Engel curve A curve showing the relationship
Exports Goods and services produced in one
between consumers’ income and
quantity demanded of a good. It indicates
country and purchased by consumers
in another country.
whethera good is normal or inferior.
Export promotion Growth policies aiming at expansion
Entrepreneurship Refers to the ability of certain
of export revenues as the vehicle of
individuals to organise the other factors
economic growth; often contrasted to
of production (land, labour, capital) and import substitution.
their willingness to take risks.
Equilibrium A state of balance that is self-
Export revenue The revenues collected by exporting
firms.
perpetuating in the absence of any
outside disturbance. Export subsidy Payments made by the government
to exporting firms on the basis of the
Equity The concept or idea of fairness. number of units exported.
Excess demand Occurs when quantity demanded at
External balance Asituation where the value of a
some price is greater than quantity
country’s exports is balanced by the
supplied. value of its imports over a period
Excess supply Occurs when quantity supplied at of time, such that a current account
some price is greater than quantity surplus or deficit does not persist over
demanded. long periods.

679
 Glossary

Externalities External costs or benefits to third Foreign direct When a firm establishes a productive
parties when a good or service investment (FDI) facility in a foreign country or
is produced or consumed. An acquires controlling interest (at least
externality arises when an economic 10% of the ordinary shares) in an
activity imposes costs or creates existing foreign firm.
benefits on third parties for which
Foreign sector Inan open economy the term refers to
they are not compensated or do not
exports and imports.
pay for respectively.
Factors of production Resources used in: the production
: Framin, 8 In behavioural economics, the term
refers to the way choices are presented
of goods and services; include land
(natural resources), labour, capital and as asimple change of the ‘frame’,
that may affect the choice made.
entrepreneurship.
For example, highlighting the
Financial account In the balance of payments this positive or the negative aspects of
records inflows and outflows of the same choice may lead to different
portfolio and FDI funds over a period decisions.
of time, official
0 borrowing and Free goods Goods such as air or sea water that are
changes in reserve assets. not considered scarce and thus do not
Firm An entity such as a business that have an opportunity cost.
uses factors of production in Free market An economy where the means of
order to produce and sell goods economy production are privately owned and
and services and earn profits. It is where market forces determine the
an important decision maker in a answers to the fundamental questions
market economy. (what/how much, how and for whom)
Firms Productive units that transform inputs that all economies face.
(factors of production) into output Free rider problem Arises when individuals consume a
(goods and services), usually aiming at good or service without paying for it
earning profits. because they cannot be excluded from
Fiscal policy A demand-side policy using enjoying it.
changes in government spending Free trade International trade that is not subject
andor direct taxation to influence any kind of trade barriers, such as
aggregate demand and thus growth, tariffs or quotas.
employment and prices.
Free trade area/ An agreement between two or more
Fixed exchange rate An exchange rate system where the agreement countries to phase-out or eliminate
exchange rate is fixed, or pegged, to trade barriers between them,
the value of another currency (or members of the agreement are free
to the average value of a selection to maintain their own trade policy
of currencies) and maintained towards non-members.
there with appropriate central bank
intervention. Frictional Unemployment of individuals who
unemployment are in-between jobs, as people quit
Floating exchange An exchange rate system where the to find a better job or to move to a
rate exchange rate is determined solely different location.
by the market demand and market
supply of the currency in the foreign
Full employment A goal of macroeconomic policy
that aims at fully utilizing the
exchange market without any central
scarce factor of production labour.
bank intervention.
Full employment exists when
Foreign aid Refers to flows of grants or loans the economy is producing at
from developed to developing its potential level of real output
countries that are non-commercial and thus there is only natural
from the point of view of the unemployment (the AD-AS
donor and for which the terms model considers the AD and AS
are concessional (that is, the curves together). In the production
interest rate is lower than the possibilities curve (PPC model),
market rate and the repayment full employment exists when the
period longer). economy is producing on the PPC.

680
Full employment The level of output that is produced Households Groups of individuals in the
level of output by the economy when there is only economy who share the same living
natural unemployment. accommodation, who pool their
income and jointly decide the set of
Game theory A branch of mathematics that studies
goods and services to consume.
the strategic interaction of decision-
makers that may be individuals, firms, Human capital The education, training, skills,
countries, and so on. experience and good health embodied
Gender inequality A composite indicator that measures in the labour force of a country.
index (GII) gender inequalities in three Human Development A composite index of development
dimensions of human development, Index (HDI) that reflects the three basic goals of
namely reproductive health, development, which are a long and
empowerment and economic status. healthy lfe, improved education,
Gini coefficient A measure of the degree of income and a decent standard of living. The
inequality ofa country that ranges from variables measured are life expectancy
zero (perfect income equality) to one at birth, mean years of schooling and
(perfect inequality). Diagrammatically expected years of schooling, and GNI
itis the ratio of the area between the per capita (PPP USS).
Lorenz curve and the diagonal over the Humanitarian aid Aid given to alleviate short-term
area of the half-square. suffering, consisting of food aid, medical
Government The sum of all past budget deficits aid, and emergency relief aid usuallyas a
(national) debt minus any budget surpluses; the total result of a natural catastrophe or war.
amount the government owes to Imperfect A market structure where firms have
domestic and foreign creditors. competition adegree of market power as they face
Government Refers to all spending by the anegatively sloped demand curve and
spending (G) government that is distinguished can thus set price.
into current expenditures, capital
Imperfect When the information about a market
expenditures and transfer payments.
information or a transaction is incomplete.
Gross domestic The value of all final goods and services Import expenditure The value of imports of goods and
product (GDP) produced within an economy over
aperiod of time, usually a year ora services.

quarter. Imports The value of goods and services

Gross national The income earned by all national purchased domestically that are
income (GNI) factors of production independently produced abroad.
of where they are located over a Import substitution A growth strategy where domestic
period of time; it is equal to GDP plus production is substituted for imports
factor income earned abroad minus in an attempt to shift production
factor income paid abroad. away from the primary sector and
Happiness Index Anindex that is used to measure industrialise. This strategy requires
economic well-being ofa population that the domestic industry is
using several quality of life dimensions. protected from import competition.

Happy Planet Index An index that combines four elements Incentive-related Policies that aim at improving
to show how efficiently residents policies economic incentives of individuals
of different countries are using and firms.
environmental resources to lead long, Income Aflow of earnings from using factors
happy lives. The elements are well-being, of production to produce goods and
life expectancy, inequality of outcomes, services. Wages and salaries re the factor
and ecological footprint. reward to labour and interest is the flow
Homogeneous Goods that are considered identical ofincome for the ownership of capital.
product across firms in the eyes of consumers; Income approach One of the three equivalent ways that
examples include mostly primary sector
goods like corn, wheat, or copper. GDP can be measured, by adding all the
incomes generated in the production
Household The money that households owe. process (wages, profits, interest and
indebtedness rent) for a given time period.

681
 Glossary

Income effect The law of demand is explained by the Interest rate The cost of borrowing money or
substitution and the income effect. the reward for saving money over
The income effect states that if the aperiod of time expressed as a
price of a good increases then the real percentage.
income of consumers decreases and,
typically, they will tend to buy less o~ mternational An international financial institution
of 189 countries whose objectives
the good—thus working in thesame ~ MODetary
Fund (IMF) include to improve global monetary
direction as the substitution effect.
cooperation and secure financial
Income elasticity The responsiveness of demand for a stability by monitoring the economic
of demand (YED) good or service to a change in income. and financial policies of its members
Indirect taxes Taxes on expenditure to buy goods
and providing them with advice and
with loans, if they face balance of
and services.
payments difficulties.
Industrial policies A type of interventionist supply-side
International trade Trade that involves the exports and
policies whereby the government
imports of goods or services between
chooses to support specific industries
through preferential tax cuts, subsidies,
countries.
subsidised loans and other means Interventionist A set of policies that aim to increase
as they are considered pivotal in the supply side policies an economy’s productive capacity
growth prospects of the economy. that relies on a greater role for
Inequality adjusted A composite indicator consisting the government; these include
Human Development of an average ofa country’s expenditures on infrastructure,
Index (IHDI) achievements in health, education, education, health care, research
and income all adjusted for the degree and development, and all industrial
of inequality characterising each. policies.
Inferior goods Lower quality goods for which higher ~ Investment (I) Spending by firms on capital goods
quality substitutes exist; if incomes such as machines, tools, equipment,
rise, demand for the lower quality and factories.
goods decreases. J-curve Following devaluation or a sharp
Inflation A sustained increase in the average depreciation, a trade deficit will
level of prices. typically widen before it starts
improving thus tracing the letter “J”
Inflationary gap The case where equilibrium real if plotted against time, because the
output exceeds potential output as a Marshall-Lerner condition is satisfied
result of an increase in AD. onlyaftera period of several months
Inflation rate The percentage change between two following the decreased value of the
periods of the average price level, currency.
usually measured through the CPI. Joint supply Goods jointly produced, for example
Informal economy Refers to the part of an economy beef and cattle hides; producing one
where activity is not officially recorded, automatically leads to the production
regulated or taxed. The activities of the of the other.
informal economy are not included in Keynesian multiplier
a country’senational income figures.
The idea that an increase (or, more
generally, a change) in any injection
Infrastructure Physical capital typically financed will lead to a greater increase (change)
by governments that is essential in real GDP or national income
for economic activity to take because an increase in spending
place, including roads, power, generates additional income that leads
telecommunications and sanitation, to further spending, and thus more
generating significant positive income. Its size depends on the size
externalities. of the withdrawals from the circular
flow, as these reflect income not spent
Injections Within the circular flow model on domestic output.
these refer to spending on domestic
output that does not originate Labour One of the four factors of production
from households and thus includes that refers to the physical and mental
investment spending by firms, contribution of workers to the
government expenditures, and exports. production process.

682
Labour market The labour market is considered Long-run Phillips A curve showing the monetarist view
flexibility flexible if it can adjust fast and fully to curve (LRPC) that there is no trade-off between
changes in labour demand and labour inflation and unemployment in
supply conditions. the long run and that there exists a
natural rate of unemployment at the
Labour union An organisation of workers whose level of potential output.
goals include improving working
Conditions and achieving higher Long run in The period of time when all factors
compensation for members. Unions ‘microeconomics of production are variable.
permit workers to negotiate more
effectively with employers. Long run in The period of time when the prices of
‘macroeconomics all factors of production, especially
Laissez-faire The view that if market forces are left wages, change to match changes in
alone unimpeded by government the price level.
intervention the outcome will be
efficient. Long-term growth Growth over long periods of time.
In the PPC model this is shown by
Land One of the four factors of production outward shifts of the PPC. When
that refers to the natural resources shown in the AD-AS model (the
with which an economy is endowed; AD-AS model considers the AD and
also referred to as ‘gifts of nature’. AS curves together), it is shown by
Law of demand Alaw stating that as the price of a rightward shifts in the LRAS curve.
good falls, the quantity demanded will Long-term Refers to average growth over
increase overa certain period of time, growth trend long periods of time shown in the
ceteris paribus. business cycle diagram as the line
Law of diminishing A short-run law of production stating that runs through short-term
marginal returns that as more and more units of the fluctuations, indicating changes in
variable factor (usually labour) are potential output.
added to a fixed factor (usually capital) Lorenz curve A curve showing what percentage of
there is a point beyond which total
the population owns what percentage
product continues to rise but ata
of the total income or wealth in the
diminishing rate or, equivalently, economy. Itis calculated in cumulative
marginal product starts to decrease.
terms. The further the curve is from
Law of diminishing The idea that as an individual the line of absolute equality (along
marginal utility consumes additional units of a good, the diagonal), the more unequal the
the additional satisfaction enjoyed distribution of income.
decreases.
Loss (economic) Occurs when total costs of a firm are
Law of supply Alaw stating that as the price of a good greater than total revenues. It is equal
rises, the quantity supplied will rise over to total cost minus total revenue.
a certain period of time, ceteris paribus.
Luxury goods Goods that are not considered
Leakages Income not spent on domestic goods essential by consumers therefore
and services. It includes savings, taxes, they have a price elastic demand
and import expenditure. (PED > 1), or income elastic demand
Less economically According to the UN these are low- (YED > 1).
developed country income countries facing severe Macroeconomics The study of aggregate economic
(LEDC) structural constraints to sustainable activity. It investigates how the
development, with low levels of economy as a whole works.
human assets, highly vulnerable to
economic and environmental shocks. Managed exchange An exchange rate that floats in the
rate foreign exchange markets but is
Long-run aggregate Aggregate supply that is dependent subject to intervention from time
supply (LRAS) upon the resources and technology in to time by domestic monetary
the economy, thus being independent authorities, in order to prevent
of the price level. It is vertical at the undesirable movements in the
level of potential output. It can only exchange rate.
be increased by improvements in the
quantity and|or quality of factors Mandated choices Choices made by consumers who are
of production as well as improved required to state whether or not they
technology. wish to take part in an action.

683
 Glossary

Manufactured Products or goods that have been Market failure The failure of markets to achieve
products produced by workers often working allocative efficiency. Markets fail to
with capital goods. produce the output at which marginal
social benefits are equal to marginal
Marginal benefit The extra or additional benefit enjoyed
social costs; social or community
by consumers that arises from
surplus (consumer surplus +
consuming one more unit of output.
producer surplus) is not maximised.
Marginal costs The extra or additional costs of
producing one more unit of output.
Market mechanism The system in which the forces of
demand and supply determine the
Marginal propensity The proportion of extra or additional prices of products. Also known as the
to consume (MPC) income that is spent by households on price mechanism.
goods and services (consumption).
Market-oriented Approaches or policies that are based
Marginal propensity The proportion of extra or additional approaches on the actions of private decision-
to buy imports (MPM) income that is spent by households on ‘makers operating in markets with a
imported goods and services. minimum amount of government
intervention.
Marginal propensity The proportion of extra or additional
to save (MPS) income that is saved by households. Market power The ability ofa firm (or group of firms)
to raise and maintain price above the
Marginal propensity The proportion of extra or additional
level that would prevail under perfect
to tax (MPT) income that is paid in taxes, also
referred to as the marginal tax rate.
competition (or P > MC).
Market share The percentage of total sales ina
Marginal revenue The extra or additional revenue that
‘market accounted for by one firm.
arises for a firm when it sells one more
unit of output. Market supply The horizontal sum of the individual
Marginal social The extra or additional benefit/utility
supply curves for a product of all the
producers in a market.
benefit (MSB) to society of consuming an additional
unit of output, including both the Marshall-Lerner A condition stating that a depreciation
private benefit and the external benefit. condition or devaluation ofa currency will lead
to an improvement in the current
Marginal social The extra or additional cost to society
account balance if the sum of the
cost (MSC) of producing an additional unit of price elasticity of demand for exports
output, including both the private
plus the price elasticity of demand for
cost and the external costs.
imports is greater than one.
Marginal tax rate The proportion ofa person’s extra or
additional income that is paid in tax,
Maximum price A price set by a government or other
authority that is below the market
usually expressed as a percentage. equilibrium price ofa good or service,
Marginal utility The extra or additional utility derived also known as a price ceiling.
from consuming one more unit of a
good or service. Merit goods Goods or services considered to be
beneficial for people that are under-
Market Any arrangement where buyers provided by the market and so under-
and sellers interact to carry out an consumed, mainly due to positive
economic transaction. consumption externalities.
Market-based Microeconomics The study of the behaviour of
supply side policies well-functioning competitive markets individual consumers, firms, and
in order to promote long-term markets and the determination of
economic growth, shown by increases market prices and quantities of goods,
in long-run aggregate supply. services, and factors of production.
Market demand The sum of the individual demand Minimum income A measure of poverty that is based
curves for a product of all the standards (MIS) on the beliefs of people regarding
consumers in a market. what is essential in order to achieve a
‘minimum acceptable standard of liv
Market equilibrium Inamarket this occurs at the price where
the quantity of a product demanded is Minimum lending The interest rate that is charged
equal to the quantity supplied. This is the rate by a central bank when it lends to
market clearing price since there is no commercial banks. Also known as
excess demand or excess supply. discount rate or refinancing rate.

684
Minimum price A price set by a government or Multidimensional An international measure of
other authority above the market Poverty Index (MPI) poverty covering over 100 of the
equilibrium price of a good or service, economically least developed
also known as a price floor. countries. It complements traditional
Minimum reserve A requirement by the central bank
income-based poverty measures by
capturing the deprivations that each
requirements that sets the minimum amount of
person faces at the same time with
reserves that commercial banks must
respect to education, health, and
maintain to back their loans.
living standards.
Minimum wage A type of price floor where the wage
Multilateral Assistance provided by multilateral
rate or the price of labour is set above
development organisations such as the World
the market equilibrium wage rate.
assistance Bank when they lend to developing
Mixed economy An economy that has elements of a countries for the purpose of helping
planned economy and elements of them in their development
a free market economy. In reality, objectives.
all economies are mixed. What is
Multilateral trade An agreement between many
different is the degree of the mix from
country to country.
agreement countries to lower tariffs or other
protectionist measures, currently
Monetarist/new An economic school of thought carried out within the framework of
classical model arguing that the price mechanism the WTO.
along with well-functioning
competitive markets are sufficient to
National income The income earned by the factors of
production of an economy, equal to
lead the economy to full employment.
wages plus interest, plus rents, plus
In this school of thought, government
profits.
intervention is not necessary to manage
the level of aggregate demand. National income The services provided by a statistical
accounting entity in every country that measure
Monetary policy A demand-side policy using changes the economy’s national income and
in the money supply or interest rates to
output as well as other economic
achieve economic objectives relating to
activity.
output, employment, and inflation.
. National income The statistical data used to measure
Monetary union Where two or more countries
tatisti
statstics anation’s income and output,
share the same currency and havea and perform national income
common central bank.
accounting.
Money nything that that i is
Anything generally I accepteted —
A monopoly that can produce enough
as a means of payment for goods output to cover the entire needs of
and services. It usually consists of
amarket while still experiencing
currency and checking accounts. economies of scale. Its average costs
Money creation The process of creating new money will therefore be lower than those of
by commercial banks, which occurs two or more firms in the market.
when they make loans. Nacurilrate of The rate of unemployment that occurs
Money supply ‘The total amount of money available unemployment (NRU) when the economy is producing at its
ata particular time, consisting of potential output or full employment
currency plus checking accounts. level of output. It is equal to the sum
of structural, frictional, and seasonal
Monopolistic A market structure where there are
unemployment.
competition many sellers, producing differentiated
products, with no barriers to entry. Necessity The degree to which a good is
Monopoly A market structure where there is only
necessary or essential.
one firm in the industry, so the firm is the If the increase in demand for a necessity
industry. There are high barriers to entry. good is less than proportional to the
rise in income; then the necessity good
Moral hazard A type of market failure involving
is income elastic.
asymmetric information where a
party takes risks but does not face If the change in quantity demanded
their full costs by changing behaviour fora necessity good is less than
after a transaction has taken place. It proportional to a change in price; then
is very common in insurance markets. the necessity good is price inelasti

685
 Glossary

Negative Negative effects suffered by a third Normal profit The minimum return that must be
externalities party whose interests are not received by a firm in order to stay in
of consumption considered when a good or service business. A firm earns normal profit
is consumed, so the third party is when total revenue is equal to total
therefore not compensated. cost, or when average revenue or price
is equal to average cost.
Negative Negative effects suffered by a third
externalities of party whose interests are not Normative Deals with areas of the subject that are
production considered when a good or service economics open to personal opinion and belief,
is produced, so the third party is thus not subject to refutation.
therefore not compensated.
Nudge theory Nudges (prompts, hints) are used
Net exports (X — M) Export revenues minus import to influence the choices made by
expenditure. consumers in order to improve the
Nominal gross The total money value of all final well-being of people and society.
domestic product goods and services produced in an (OECD) Better Anindex to compare well-being
(GDP) economy in a given time period, Life Index across countries, based on several
usually one year, at current values dimensions that the OECD has
(not adjusted for inflation). identified as essential, in the areas of
Nominal gross The total income earned by all the ‘material living conditions and quality
national income (GNI) residents of a country (regardless of of life.
where their factors of production Official Development Aid that is provided to a country by
are located) in a given time period, Assistance (ODA) another government or multilateral
usually a year, at current prices agency. It is the most important part
(not adjusted for inflation). of foreign aid.
Nominal interest Interest rates that have not been Oligopoly A market structure where there
rates adjusted for inflation. are a few large firms that dominate
Non-collusive Firms in an oligopoly do not resort the market, with high barriers to
oligopoly to agreements to fix prices or output. entry.
Competition tends to be non-price. Open market A tool of monetary policy involving
Prices tend to be stable. operations the buying or selling of (short-term)
Non-excludable A characteristic of a good, service government bonds by the central
or resource where it is impossible to bank in order to increase or decrease
prevent a person, or persons, from the money supply, thus influencing
using it. the rate of interest.

Non-governmental Organisations that are not part of the Opportunity cost The next best alternative foregone
organisation (NGO) government that promote economic when an economic decision is
development and/or humanitarian made.
ideals andor sustainable development. Output approach One of the three equivalent ways
Non-price Competition between firms that is that GDP can be measured, it adds
competition based on factors other than price, up the value of final goods and
usually taking the form of product services produced in a given time
differentiation. period.
Non-produced, A measure of the net international Overvalued currency Acurrency whose value or exchange
non-financial assets sales and purchases of non-produced rate is greater than its equilibrium
assets (such as land) and intangible exchange rate, usually achieved
assets (such as patents and through central bank intervention;
copyrights). may occur in a pegged or managed
exchange rate system.
Non-rivalrous A characteristic of some goods
such that their consumption by one Payoff matrix Atable showing all possible outcomes
individual does not reduce the ability of decisions taken by decision-makers
of others to consume them. Itis a in game theory.
characteristic of public goods.
Per capita Per person. Per capita values are found
Normal goods A good where the demand for it by dividing the variable by the size of
increases as income increases. the population.

686
Perfect competition A market structure where there is a very Positive externalities The beneficial effects that are enjoyed
large number of small firms, producing of production by third parties whose interests are
identical products, with no barriers to not accounted for when a good or
entry or exit, and perfect information. service is produced, therefore they do
All the firms are thus price takers. not pay for the benefits they receive.
Perfect information Where all stakeholders in an Potential output Output produced by an economy when
economic transaction have access to itis at full employment equilibrium, or
the same information. long-run equilibrium according to the
‘monetarist/new classical model.
Perfectly elastic Occurs with a horizontal demand
demand curve signifying that any amount can Poverty Arises when the lack of material
be bought at a particular price. (PED is possessions or money prevent an
infinite.) individual ora family from achieving a
Perfectly elastic Occurs with a horizontal supply curve ‘minimum satisfactory standard of living.
supply signifying that any amount can be Poverty line Alevel of income determined by a
offered at a particular price. (PES is government or international body
infinite.) (such as the World Bank) that is just
enough to ensure a family can satisfy
Perfectly inelastic Where a change in the price ofa good minimum needs in terms of food,
demand or service leads to no change in the
clothing, and housing.
quantity demanded of the good or
service. (PED is equal to zero.) Poverty trap/cycle Any circular chain of events starting
Perfectly inelastic Where a change in the price ofa and ending in poverty—for example,
supply good or service leads to no change in low income leads to low savings,
leads to low investment, leads to low
the quantity supplied of the good or
growth, leads to low income.
service. (PES is equal to zero.)
Personal income Taxes paid by individuals or Preferential trade Where a country agrees to give
taxes households on their incomes,
agreement preferential access (for example,
regardless of the source of the income, reduced tariffs) for certain products to
one or more trading partners.
such as wages, salaries, interest
income, or dividends. Price ceiling A price imposed by an authority and
Phillips curve A curve showing the relationship (maximum price) set below the equilibrium price. Prices
cannot rise above this price.
between the rate of unemployment
and the rate of inflation. Price competition Competition between firms that is
Pigouvian taxes An indirect tax that is imposed based on price; for example, a firm that
wants to increase its sales at the expense
to eliminate the external costs of
production or consumption. of other firms will lowerits price.
Planned economy An economy where the means of Price controls Prices imposed by an authority,
production (land and capital) are owned setabove or below the equilibrium
by the state. The state determines what/ ‘market price.
how much to produce, how to produce, Price elasticity of A measure of the responsiveness of
and for whom to produce. demand (PED) the quantity demanded of a good or
Portfolio investment The purchase of financial assets such service to a change in its price.
as shares and bonds in order to gaina Price elasticity of A measure of the responsiveness of
financial return in the form of interest supply (PES) the quantity supplied of a good or
or dividends. Appears in the financial service to a change in its price.
account of the balance of payments.
(Price) elastic supply Wherea change in the price ofa good
Positive economics Deals with areas of the subject that are or service leads to a proportionately
capable of being falsified, or shown to larger change in the quantity supplied
be correct or not. of the good or service in the same
direction. (PES is greater than one.)
Positive externalities The beneficial effects that are enjoyed
of consumption by third parties whose interests are Price expectations The forecasts or views that consumers
not accounted for when a good or or firms hold about future price
service is consumed, therefore they do movements that play a role in
not pay for the benefits they receive. determining demand.

687
 Glossary

Price floor A price imposed by an authority and Productive capacity The greatest capability of an economy
(minimum price) set above the market price. Prices to produce, usually measured by
cannot fall below this price. maximum possible output of an
(Price) inelastic Where a change in the price ofa economy.
demand good or service leads toa Profit maximisation A possible objective of firms that
proportionately smaller change in the involves producing the level of output
quantity demanded of the good or where profits are greatest: where total
service in the opposite direction. (PED revenue minus total cost is greatest
is less than one.) or where marginal revenue equals
marginal cost.
(Price) inelastic Where a change in the price ofa good
supply or service leads to a proportionately Progressive taxation Taxation where the fraction of tax
smaller change in the quantity supplied paid increases as income increases.
of the good or service in the same The average tax rate increases.
direction. (PES is less than one.)
Property rights The exclusive, legal, authority to own
Price maker A firm that is able to influence the property and determine how that
price at which it sells its product. property is used, whether it is owned by
Includes firms in all market structures the government or by private individuals.
except perfect competition.
Proportional tax A system of taxation where tax is levied
Price taker A firm that is unable to influence ata constant rate as income rises.
the price at which it sells its product,
being forced to accept the price Public goods Goods or services that have the
determined in the market. It includes characteristics of non-rivalry and
firms in perfect competition. non-excludability; for example, flood
barriers.
Price war Occurs when firms successively cut
their prices in an effort to match the Purchasing power A method used to make the buying
price cuts of other firms, resulting in parity (PPP) power of different currencies equal to
lower profits, possibly losses. the buying power of US$1. PPP exchange
rates are used to make comparisons
Primary commodities Raw materials that are produced in of income or output variables across
the primary sector. Examples include countries while eliminating the
agricultural products, metals, and influence of pricelevel differences.
minerals.
Quantitative easing An expansionary monetary policy
Primary sector Anything derived from the factor of where a central bank buys (long term)
production land. Includes agricultural government bonds or other financial
products, metals, and minerals. assets, in order to stimulate the economy
Privatisation The sale of public assets to the private
and increase the money supply.
sector. May be a type of supply-side Quantity demanded The quantity of a good or service
policy. demanded at a particular price over a
given time period, ceteris paribus.
Producer surplus The benefit enjoyed by producers by
receiving a price that is higher than Quantity supplied The quantity of a good or service
the price they were willing to receive. supplied at a particular price overa
given time period, ceteris paribus.
Product The process by which firms try to
differentiation make their products different from Quota Animport barrier that set limits on
the products of other firms in an effort the quantity or value of imports that
to increase their sales. Differences may be imported into a country.
involve product quality, appearance,
services offered, and many others. Rational consumer Occurs when consumers make
choice choices based on the following
Production A curve showing the maximum assumptions: they have consistent
possibilities combinations of goods or services tastes and preferences, they have
curve (PPC) that can be produced by an economy perfect information and they
in a given time period, if all the arrange their purchases so as to
resources in the economy are being ‘make their utility as great as possible
used fully and efficiently, and the state (maximise it). It is assumed in
of technology is fixed. standard microeconomic theory.

688
Rationing A method used to divide or apportion Revaluation Anincrease in the value ofa currency
goods and services or resources in a fixed exchange rate system.
among the various interested parties.
Revenues Payments received by firms when they
Real GDP The total value of all final goods and sell their output.
services produced in an economy in Rivalrous Goods and services are considered to
agiven time period, usually one year, be rivalrous when the consumption
adjusted for inflation.
by one person, or group of people,
Real GDP per Real GDP divided by the population of reduces the amount available for
person (per capita) the country. others.
Real GNI per person Real GNI divided by the population of Rules of thumb Rules of thumb are mental shortcuts
(per capita) the country. (heuristics) for decision-making to
help people make a quick, satisfactory,
Real interest rates Interest rates that have been adjusted but often not perfect, decision to a
for inflation. complex choice.
Recession Occurs when real GDP falls for at least Satisficing Abusiness or firm objective to achieve
two consecutive quarters. a satisfactory outcome with respect
Refutation Amethod used in the natural to one or several objectives, rather
sciences and social sciences where than to pursue any one objective at
any proposition must be subjected the possible expense of others by
to an empirical test in order to see optimising (maximising); for example,
if it can be disproven or refuted. If profit, revenue, or growth. Itis
it is disproven or refuted, then the essentially a mix of the words ‘satisfy’
proposition must be rejected. and ‘suffice’.

Regional trade An agreement between a group Say’sLaw A proposition stating that the supply
agreement of countries, usually within a of goods creates its own demand.
geographical region, to lower or Scarcity The limited availability of economic
eliminate trade barriers. resources relative to society’s
Regressive taxation Taxation where the fraction of tax unlimited needs and wants of goods
paid decreases as income increases. and services.
The average tax rate decreases. All Seasonal Unemployment that arises when
indirect taxes are regressive. unemployment people are out of work because
Relative poverty A comparative measure of poverty their usual job is out of season; for
according to which income levels do example, agricultural workers during
not allow people to reach a standard winter months.
of living that is typical of the society Shortage Arises when the quantity demanded
in which they live. It is defined as a ofa good or services is more than the
percentage of society’s median income. quantity supplied at some particular
Remittances The transfer of money by foreign price.
workers to individuals, often family Short-run aggregate The total quantity of real output (real
members, in their home country. supply (SRAS) GDP) offered at different possible
price levels in the short run (when
Reserve assets Foreign currencies and precious metals
wages and other resource prices are
held by central banks as a result of
constant).
international trade. Reserves may be used
to maintain or influence the exchange Short run in The period of time when the prices
rate for the country’s currency. Reserves macroeconomics of factors of production, especially
appear as an item in the financial account wages, are considered fixed.
of the balance of payments.
Short run in The period of time when at least one
Resource allocation Apportioning available resources or microeconomics factor of production is fixed.
factors of production to particular
uses for production purposes.
Short-run A curve showing the inverse
Phillips curve (SRPC) relationship between the rate of
Restricted choices This is when the choice ofa consumer unemployment and the rate of
is restricted by the government or inflation, which suggests a trade-off
other authority. between inflation and unemployment.

689
 Glossary

Signalling In asymmetric information, the Substitution effect When the price ofa product falls
participant with more information relative to other product prices,
sending a signal revealing relevant consumers purchase more of the
information about a transaction to the product as it is now relatively less
participant with less information, to expensive. This forms part of an
reduce adverse selection. explanation of the law of demand.
Social|community ‘The sum combination of consumer Supply Quantities ofa good that firms are
surplus surplus and producer surplus. willing and able to supply at different
possible prices, over a given time
Social enterprise A company whose main objective is period, ceteris paribus.
to have a social impact rather than
to make a profit for their owners or Supply curve A curve showing the relationship
shareholders. It operates by providing between the price of a good or service
goods and services for the market in and the quantity supplied, ceteris
an entrepreneurial and innovative paribus. It is normally upward sloping.
fashion and uses its profits primarily
to achieve social objectives. Supply-side policies Government policies designed to shift
the long-run aggregate supply curve
Social sciences Academic studies of human societies to the right, thus increasing potential
and how people in society interact output in the economy and achieving
with each other. economic growth.
Specialisation Refers to when a firm or country Surplus An excess of something over
focuses on the production of one or something else. It occurs:
afew goods or services. This forms
the basis of theory of comparative * when quantity supplied is greater
advantage in international trade. than quantity demanded at a
particular price
Speculation Refers to a process where something
+ when tax revenues are greater
is bought or sold with a view to
than government spending
making a short term profit; for (budget surplus)
example, currency speculation where + onanaccount when credits are
currencies are bought or sold so thata
profit can be made when the exchange greater than debits in the balance
of payments.
rate changes.
Stakeholder Anindividual or group of individuals See also ‘consumer surplus’ and
who have an interest, o stake, in an ‘producer surplus’.
economic activity or outcome. Sustainability Refers to the preserving the
environment so that it can continue
Structural Akind of long-term unemployment
to satisfy needs and wants into the
unemployment that arises from a number of factors
future. Relates to the concept of
including: technological change; ‘sustainable development’.
changes in the patterns of demand for
different labour skills; changes in the Sustainable debt Refers to a level of government debt
geographical location of industries; such that the borrowing government
labour market rigidities. can make its payments of interest and
Subsidies Anamount of money paid by the debt repayment while at the same
government to a firm, per unit of being able to meet the economy’s
output, to encourage production and growth objectives.
lower the price to consumers. Sustainable Refers to the degree to which the
Subsidy Anamount of money paid by development current generation is able to meet
(international) the government to a firm, per unit of its needs today but still conserve
output, to encourage production and resources for the sake of future
provide the firm an advantage over generations.
foreign competition. Tariff A tax that is placed on imports to
Substitutes Goods that can be used in place of protect domestic industries from
each other, as they satisfy a similar foreign competition and to raise
need. revenue for the government.

690
Total costs All the costs ofa firm incurred for Unemployment When a person (who s above a
the use of resources to produce specified age and is available to work)
something. isactively looking for work, but is
without a job.
Total revenue The amount of revenue received by
a firm from the sale ofa particular Unemployment Payments, usually made by the
quantity of output (equal to price benefits government, to people who are
times quantity sold). unemployed (and actively secking
employment).
Tradable permits Permits to pollute, issued bya
governing body, that sets a maximum Unemployment rate The number of unemployed workers
amount of pollution allowable. These expressed as a percentage of the total
permits may be traded (bought or sold) workforce.
ina market for such permits.
Unfair competition In international trade this refers to
Trade creation In international trade it occurs when practices of countries trying to gain
higher cost imports are replaced an unfair advantage through such
by lower cost imports due to the methods as undervalued exchange
formation ofa trading bloc or a trade rates.
agreement.
Unitary elastic Occurs when a change in the price of
Trade diversion In international trade it occurs when demand agood or service leads to an equal
lower cost imports are replaced and opposite proportional change in
by higher cost imports due to the the quantity demanded of the good or
formation ofa trading bloc or a trade service (PED = 1).
agreement. Unitary elastic supply Occurs when a change in the price
Trade liberalisation The process of reducing barriers to of agood or service leads to an equal
international trade. proportional change in the quantity
supplied of the good or service
Trade protection Government intervention aiming (PES = 1).
to limit imports andfor encourage
exports by setting up trade barriers Universal basic A regular cash payment given to all
that protect from foreign income persons in an economy that is
competition. independent of any other source of
income they may have. It is intended
Trading bloc A group of countries that have agreed to reduce poverty and income
to reduce protectionist measures like inequality.
tariffs and quotas between them.
United Nations The UN set out 17 global goals
Tragedy of the Assituation with common pool Sustainable including those that aim to end all
commons resources, where individual users development forms of poverty, fight inequalities,
acting independently, according to goals (SDGs) and tackle climate change.
their own self-interest, go against
the common good of all users by Utility A measure of the satisfaction
depleting or spoiling that resource derived from consuming a good or
through their collective action. service.

Transfer payments Payments made by the government Wage Payment received by the factor of
to vulnerable groups in a society, production labour, which is a certain
including older people, low income amount per unit of time.
people, unemployed, and many more. Wealth The total value of all assets owned by a
The objective is to transfer money from person, firm, community, or country
taxpayers to those who cannot work, to ‘minus what is owed to banks or other
prevent them from falling into poverty. financial institutions.
Undervalued A currency whose value or exchange Weighted price index A measure of average prices over a
currency rate is lower than its equilibrium period of time that gives a weight to
exchange rate, usually achieved each item according to its relative
through central bank intervention; importance in the consumers’
may occur in a pegged or managed budgets. Itis used to measure changes
exchange rate system. in the price level.

691
 ‘Welfare loss Aloss ofa part of social surplus World Trade An international body that sets the
(consumer plus producer surplus) that Organization (WTO) rules for global trading and resolves
occurs when there is market failure so disputes between its member
that marginal social benefits are not countries. It also hosts negotiations
equal to marginal private benefits. concerning the reduction of trade
barriers between its member
‘World Bank Aninternational organisation
nations.
that provides loans and advice to
economically less developed countries
for the purpose of promoting economic
development and reducing poverty.

692
Index
abnormal profit 197,202-3,205 anchoring 123 bounded self-control 101,127
monopolies 208,209, 210-11 anti-dumping 460-1 bounded selfishness 127
monopolistic competition 220-1, 222 anti-monopoly regulation 232-3, 432 brain-drain 305
oligopolies 231,232 appreciation 502, 5034, 5534 Brexit 487
absolute advantage 448, 449 determinants 505-10, 540-1, 542 bubbles 126,382
absolute (extreme) poverty 351-3, 559, effects of 268, 510-13, 521 budget deficit 305, 407-10, 411, 421
565,568 monetary policies 546 bureaucracy 471
accountability 6434 Asia Pacific Trade Agreement (APTA) business confidence 265-6, 400
actual growth 675 484-5 business cycle 32-3,251-2, 2956, 382-3
AD[AS models 280-7, 326-8, 329, 337-8 assessment business growth 200-1
cyclical unemployment 296-8 data and diagrams 650, 667, 672 business taxes 266, 2712, 429
deflation 320-1 evaluation 653, 65862, 673
fiscal policy 412-13,422 exam preparation 650-8 capacity 97,98,274-5
inflation 315-17 Extended Essay (EE) 662-8 capital 7,278,359, 563
ad valorem taxes 147,148,150 external assessment 650-68 capital account 528, 529, 5334, 538-40
administrative barriers 471-2 Internal Assessment (IA) 66974 capital expenditures 406
adverse selection 181-2 real-world examples (RWEs) 650-1 capital flight 600
aggregate demand (AD) 256, 258-69, asset demand 390-1 capital gains tax 429
280-5,286~7 assets 534-5 capital inflow 509, 515-16, 518-19, 542
AD curve 258-60 asymmetric information 181-3 capital outflow 509, 515-16, 520,
cyclical unemployment 295-8 Austrian school of economics 32-3 542, 600
deflation 320-2 automatic stabilisers 424-5 capital transfers 533
economic growth 337,339 availability bias 124 capitalism 29-30
exchange rates 268, 51012 average costs 193, 194-6, 205, 207-8, 211 carbon tax 173-4,175,176
fiscal policy 411-19,422-3,424-5 economies of scale 200, 441 cartels 228-9
inflation 315-17 monopolistic competition 220-1, central banks 380-1, 382
monetary policy 380,382, 383,389 222,223 economic integration 489, 490
multiplier effects 414-19 natural monopoly 213-15 and exchange rates 50910, 513-17
supply-side policies 433, 434,436,437 average price level 264, 271,308, 309, money supply 382, 386-90, 392
see also ADJAS models 320-1,324 setting interest rates 399-400, 401
aggregate supply (AS) 256,269-73,279 average revenue 193, 194-6 ceteris paribus 25,40
and deflation 321 average tax rate 367-8 Chang, Ha-Joon 459
economic growth 337-8 choice 3,5,6,15-16, 35, 464
and exchange rates 510-11,512 balance of payments 461, 52730, bounded rationality 125-6
hybrid SRAS/LRAS model 274,276-8, 538-40, 636 cognitive biases 1234
2804 balance of trade in goods 530-1 freedom of 11,130
and inflation 315-17,326-8, 329 balance of trade in services 530, 531 increased 440-1
Keynesian AS model 274-80, banking systems 605-8, 638 nudge theory 128-31,158-9
284-7,315 see also central banks; commercial rational 41,121-3,127-8
LRAS curve 273-4,276-9, 2804, 427 banks choice architecture 129
macroeconomic equilibrium 280-5 bankruptcies 323 circular flow model 20-3,238-9
monetarist/new classical view 273-4, barriers to entry 188,190, 208, 226 classical economics 27-8, 30, 34, 121-2
285,286 barriers to trade see protectionism climate 602—4
output gaps 276-8, 280-5 Bastiat, Frédéric 442-3 climate change 565, 568
SRAS curve 269-73, 276-8, 2804, 427 behaviour 28,121-3 cognitive biases 1234, 130
supply-side policies 427,433,434 behavioural economics 33,122-32, collusive oligopoly 228-9
see also ADJAS models 158-9 colonies, former 478, 572, 603, 620
agriculture 569-70 Better Life Index (BLI) 249-50 command economies 11,13, 111
allocative efficiency 112,115-18,161-2, biases 123-4,130 commercial banks 380, 3846, 387,
204-5 bilateral trade agreements 479, 480-1 388-9,393-4
effect of price ceilings 138-9 birth rates 569 commodity dependence 63, 569-70,
effect of price floors 142-3 black markets 139, 143, 248, 599-600 596-9
monopolistic competition 2234 bond market 387-8, 389-90 common markets 483,618
oligopoly 232 boom and bust 252 common pool resources 16971,
allocative inefficiency 117-18,138-9, borrowing sec loans 178-9,180
142-3,209-10, 319, 323 bounded rationality 125-6 communism 29-30, 32

693
 Index

community banking 607 contractionary fiscal policy 407, decision making 61, 63, 68-9,
community surplus 115,116, 117-18, 412-13, 546 121-31, 247
138-9,145-6,162 contractionary monetary policy 387, decoy pricing 125
comparative advantage 442, 448-56, 615 395-6, 398, 520, 546 default choice 129,158
competition 440,464, 492, 547 core inflation 313-14 deferred consumption 322
competitive advantage 615 Corn Laws 442, 443 deficit 527-8
competitive market equilibrium 101-8, corporate indebtedness 266, 389 deflation 243, 264, 308, 309, 320-3,
161-2,201-2 corporate social responsibility (CSR) 394-5, 400
allocative efficiency 117,204-5 199-200 deflationary gaps 282, 283, 296-7, 397-8,
community surplus 117-18 corruption 594, 638 411-12
consumer surplus 112-13,117-18 cost of living 245-6, 31011, 320 demand 28, 37-49,101-8
excess supply/demand 102-4 cost-push inflation 316-17, 318,319 currency demand 500-3, 506, 514,
vs monopolist’s equilibrium 208-9 Covid-19 pandemic 32-3,84-5,111 515-16
producer surplus 114-15,117-18 behavioural economics 130-1 effect of taxes 148-50
shifts of demand 104-6, 109-11 economic impact 255-6, 257, 266, importsfexports 506, 508-9
shifts of supply 106-7,109-11 286-7 income elasticity 64-9
short-run vs long-run 2024 mask legislation 175 for labour 294-301
competitive markets 1612, 187-8,190 nudge theory 131,158-9 law of 25,38-41,126
allocative efficiency 112,115-18 and unemployment 295-6,302 market demand 28, 2034, 206, 211
ensured by government intervention vaccination for common good 169-70 money demand 390-5
232-3 credititems 527 monopolistic competition 219-22
price system 109-11 credit rating 544 non-price determinants 43-8
resource allocation 108-11,112 cross-border investment 455 perfect competition 201-2
supply-side policies for 431-2 cross-market comparison 450 and price ceilings 137-40
competitiveness 319, 464, 546-8 crowding out 421-3 and price floors 142, 144
complementary goods 456,177 currency 488-9, 523 resource allocation 109,110,111
composite indicators 580-8 demand 500-3, 506, 514, 515-16 shifts of 104-6,109-11
concentration ratios 226, 227 devaluation 509-10, 513-14, 516,517 see also aggregate demand; price
confidence 260-1,265-6, 389, 400 over-Jundervalued 518-20,637 elasticity of demand
conflict trap 594-5 revaluation 509-10, 513, 516, 520 demand curve 38-40, 44-8
constant-cost PPCs 18 supply 500-2, 503 benefits of trade 444-5
consumer behaviour 121-32,158-9 see also appreciation; depreciation; consumer surplus 113
consumer confidence 260-1, 400 exchange rates diminishing marginal utility 41
consumer demand 38, 407, 104-6 current account 528, 529, 530-3, 538-41 equilibrium price 102-7
consumer income 44-5, 59, 65-9 current account balance 512 excess demand 103-4
consumer nudges 128-31,158-9 current account deficit 512,530, 537, excess supply 102-3
consumer price index (CPI) 31015, 320 538, 540-1, 542-53, 636, 659 labour market 294-5
consumer surplus 112-13,117-18 current account surplus 512, 530, 537, marginal benefit 41,115-17
benefits of trade 444 540-1, 5534 market disequilibrium 102-4
effect of price controls 138-9, 142-3, current expenditures 406 market equilibrium 102, 104-7,
145-6 current transfers 532-3 202-4
effect of subsidies 152-4 customs unions 481-3 money market model 390-5
effect of taxes 150, 155-6 cyclical unemployment 292,295-8,323 monopolistic competition 220-2
consumers 38, 46-7, 551 monopoly market model 206-7
benefits of FDI 640 deadweight loss (DWL) 117-18 movement along 46, 47-8
cognitive biases 1234 effect of price controls 138-9, 142-3, and price elasticity 54-5, 56,57, 62-3
decision making 45,121-8,129 145-6 shifts of 44,45, 46, 47-8,104-6, 109
effect of price controls 140, 144—6 effect of subsidies 154 total market demand 43
effect of quotas 468 effect of taxes 155-6 demand-deficient unemployment see
effect of subsidies 152-4 monopoly market model 210 cyclical unemployment
effect of tariffs 466-7 negative externalities 167,168 demand management sec fiscal policy;
rational choice 41,121-3,127-8 debit items 527 monetary policy
response to price changes 51, debt 2634, 266, 389, 407-10, 5434, demand-pull inflation 315-17, 319
59-61 600-2 demand schedule 102,112-13, 114
tax burden 148-50 and deflation 322,323 demand shocks 280-5, 3202, 326-8
consumption (C) 240, 256-8, 259, 2604, and inflation 318 demand-side policies 380, 397-8, 404,
305, 554 sustainable 420-1 411-13,435-6
consumption patterns 313,322 debr relief (cancellation) 5334, 631,636 demerit goods 11,156,169,172-3
consumption taxes 150,151 debt servicing 264, 266, 323, 421, 601-2 dependency ratios 569
694
depreciation 502-3, 504, 521, 522 political and social barriers 604-9 education 164,176, 355-6, 373,
current account deficits 540-1, 542-3, poverty traps 591-5 434,547
548-53, 636 single indicators 575-9 development indicators 579, 580-3,
determinants 505-10, 540-1, 542 sustainable development 34,171, 584-5
effects of 268, 510-13,523 564-8 and economic development 622-3
trade deficit reduction 548-53 see also development strategies gender equality 608-9
deregulation 359-60, 431, 432, 621 economic goods 8 education/poor governance trap 593—4
devaluation 383, 509-10, 513-14, 516, 517 economic growth 238,279, 334-40, efficiency 3,5,12,18-19,223-4,232
developed countries 290-1, 310, 571-2, 5604 competitive markets 112-18,
598-9,613,635 ADJAS model 337-8 204-5
developing countries 290-1, 352, 492, barriers 595-609 and equality 342-3
523,569-72 business cycle 251-2 importance relative to equity 26
geography and climate 592-3, 6024 caleulating 334-5 and international trade 442, 464, 468
indebtedness 601-2, 634-5 consequences 338-40 see also allocative efficiency
institutional framework 593-4, 605-9 and current account deficits 544 elastic demand see income elastic
protectionism 458-9, 462-3 and exchange rates 511 demand; price clastic demand
see also development strategies; and inequality 361 elastic supply 90,92, 93, 95,96,
economic development and inflation 319, 339 97,98-9
development aid 629-37 long term stability 382-3 elasticity 51
development economics 559-62 PPC model 19-20,279,336-7 embargoes 107,472
development strategies 613-49 promoting see development strategies employment 271,434,437, 554
foreign aid 629-33, 6414 relative rates 509 effect of FDI 640, 641
foreign direct investment (FDI) 626-8, sources 5624 protectionism 462
640-1 supply-side policies 436 quality 292
institutional change 638-9 economic growth rate (GR) 334-5 energy costs 271-2,313-14
interventionist-oriented 614-17, economic inequality 342-3, 344, 579 energy indicators 579
621-6, 645 economic integration 447, 478, Engel curve 67-8
market-oriented 617-21, 645 617-18 entrepreneurship 7,198,279, 606-8,
multilateral development assistance advantages 484-6, 490 618-19
633-7 complete 488, 489 environmental economics 33-4
output diversification 462-3, 618 disadvantages 486-8, 490 environmental impacts 178-9,248,2
social enterprises 618-19 levels of 479-83, 488-9 51,339
strengths|limitations 639-45 World Trade Organization (WTO) environmental standards 178-9,
trade-based 613-18, 639-40 491-4 471,627
diminishing marginal returns 77,192-3 economic losses 198-9, 205, environmental sustainability 579
direct provision of services 156-7, 211,214 equality 26, 342-3, 583, 608-9, 638
180-1, 622-6 economic objectives 35,133,190-1, equilibrium 101-2
direct taxes 147, 362,405 199-201 foreign exchange market 501-2
discretionary fiscal policy 424,425 macroeconomic 238, 289, 308, 3234, labour market 294-5,299-301
discrimination 360, 375-6, 491 339-40, 378 macroeconomic 280-5
disequilibrium 102-4 markets fail to meet 135-6 money market 392-6
forex market 501-2, 514 economic profit 191,194,196 national output 412
labour market 298,299, 301 economic well-being 3,5, 154, 246-51, see also competitive market equilibrium
money market 393-5 289, 560-2, 625 equilibrium interest rates 392-6
disinflation 309, 322 economically least developed countries equilibrium price 101-4, 444
disposable income 353 (ELDCs) 494, 568, 6023, 679 demand shifts 104-6
diversification 69,462-3,618 economics 3-9, 644-7 and price controls 136-46
domestic markets 460, 464, 614-15, 627 basic economic questions 8-9 supply shifts 106-8
doughnut economy 34 economic systems 8-14 equity 3, 5,136, 1834, 372
dumping 460-1 free trade theories 442-3 distinct from equality 343
history of economic thought 27-34, importance relative to efficiency 26
East African Community (EAC) 483,618 42,121,428-9 ethnic minorities 291, 360
ecological economics 334 methodology 25-6 European Economic Area (EEA) 483,
economic collapse 30-1,255-6, 382 models 14-23 485-7
economic development 559-62, 645 positive[normative 25-6 eurozone 479, 488-90
composite indicators 580-8 see also macroeconomics; excess capacity 97
economic barriers 595-604 microeconomics excess demand 1034
and economic growth 560-1, 5624 economies of scale 200-1, 208, 222, 225, excess reserves 384-6, 388
and inequality 347, 583-5, 595 441, 455, 485 excess supply 102-3
695
 Index

exchange rates 268, 271-3,498, 524-5 mobility 96-7 free trade areas (FTAs) 481,482, 483,
and aggregate demand (AD) 268, ownership 12,242, 364, 543, 576-7 484-5,487-8
510-12 supply-side policies 427-37 frictional unemployment 301-3,329-30
calculating change in 510 financial account 528, 529, 534-40, Friedman, Milton 38, 145, 318, 428-9
calculating price conversions 504-5 541-2 full employment 238, 302-3, 304
current account deficit 5401, 545, financial account surplus 544 full employment level of output
548-53 financial sector 22-3 274-86,317
current account surplus 553-4 fines 233
determinants 505-10 firms 20-1, 84, 187-90 game theory 179, 230-1
effects of change in 510-13 alternative business objectives gender equality 583, 608-9, 638
and external balance 383 199-201 gender inequality 292, 353,360, 583
financial account deficit/surplus decision making 61, 63, 68 Gender Inequality Index (GII) 583
541-2 investmentin 534-5 General Agreement on Tariffs and Trade
fixed exchange rates 513-17, 522,523 monopolies 188-90,205-15, 220, (GATT) 491
fixed vs floating systems 521-3 224-5 geography 572, 592-3,602-4
floating exchange rates 5004, 505-6, monopolistic competitors 218-25 geography trap 592-3
521-3 oligopolies 225-32 Gini coefficient 346, 350
and IMF 636, 637 perfectly competitive markets 187-8, Giniindex 346-7,372
‘managed exchange rates 51718, 521, 191-9, 201-5 globalisation 359,621, 660
522,523 fiscal policy 31,404-25,436, 546 goods 8-9,11,14,20-1
excise taxes 147 budget deficits/surpluses 407-10, balance of trade 530-1
excludable goods 180, 183 420-3 demand for 44-6, 59-69
expansionary fiscal policy 407, 411-12, closing output gaps 407, 411-14, quality and price 248,313
420-3 420-3 range of exports 598-9
expansionary monetary policy 387, economic integration 488-90 see also specific types of goods
395-6, 397-8, 515-16 effect on GDP 414, 418-19 government bonds 387-90, 396, 408,
expenditure approach 239-40 effectiveness 419-25 420, 5434
expenditure reducing policies 546 government debt 407-10,420-3 government debt 407-10, 420-1, 5434,
expenditure switching 461, 545-6 multiplier effects 414-19 600-2
explicit costs 191,197,198 fiscal stimulus 411-12, 419, 422-3 government decision making 61,
export promotion 470-1,615-17 fixed costs 192,199,213 63, 68-9
export revenue 22, 240, 444, 445-6, fixed exchange rates 513-17, 522,523 government funding mechanism 136
549-50, 597 fixed resources 73-5, 96-7 government intervention 6,29-33,133,
export subsidy 152,470-1 fixed-wage period 269,273 134-59,378
exports 527 floating exchange rates 5004, benefits and social welfare 360-1,
administrative barriers 471-2 505-6, 554 374-5
benefits of trade 444-5 foreign aid 629-37, 641-4 calculating effect of 145-6, 154-6
calculating 445-6 foreign debt 600-2 carbon tax 173-4,175,176
circular flow model 22,23 foreign direct investment (FDI) 5067, direct provision of services 156-7,
competitiveness 319, 464, 546-8 522,535, 626-8, 640-1 180-1, 622-6
determinants of net exports 267-8 foreign exchange controls 517 education/awareness creation 176
and exchange rates 506, 508-9, foreign exchange earnings 441 effectiveness 136
511,512 foreign exchange (forex) market 499-502 fines 233
price elasticity of demand (PED) intervention 509-10, 513-17, 518-20, indirect taxes 147-51,155-6,172-3
548-53 522-3 inequality/poverty reduction 372-6
voluntary export restraint 469 speculation 507-8 international agreements 178-9
external balance 383 foreign exchange reserves 516, 519, 522, interventionist supply-side policies
external debt 600-2 523,537 433-5
externalities 161,162-9,171-9, 639 foreign ownership 538-9, 5434, 576-7 ‘managing’ the economy 286
extreme poverty see absolute poverty foreign sector 22 market-based supply side policies
fractional reserve banking 384-6 359-60, 361
factors of production 6-7,16-18 framing 1234 nudge theory 128,129,130-1,158-9
change in costs and supply 80,85 free goods § price controls 136-46, 214,215
fixed 95-6 free market economy 9-11,110, 342-3, to promote equity 183-4
foreign-sourced 455, 522-3 619-21 reasons for 135-6,231-3
increased quality/quantity 278-80, free rider problem 169-70,178, 181 regulation and legislation 157-8,170,
427,433-4 free trade 431-2, 440, 445, 492, 494 175,183,232-3
‘measuring economic activity 239, free trade agreements 445, 478-9, response to asymmetric
240, 576-7 481-8 information 183

696
 response to excess market power Human Development Index (HDI) and development 347, 579, 583-5, 595
231-3 55960, 569, 580-2 discrimination 360, 375-6
response to externalities 171-9 humanitarian aid 629, 632-3 economic inequality defined 344
specific industries 435 gender 353,360, 583
subsidies 151-4,156,172,214-15 imperfect competition 187,200 income distribution 342-9, 351, 358-9
tradable permits 176-8 imperfect information 123,130, 455 of opportunity 357-9,373
trade policies 268 implicit costs 191,197-8 and poverty 357-62
government ownership 233 import expenditure 22, 445-6 reducing 372-6
government revenue 150, 151, 404-6, import substitution 614-15,616 status and power 360, 608
407, 4612, 466 imports 527 taxation and tax burden 151, 3601,
government spending (G) 21-3, 240, administrative barriers 471-2 362-6,369-72
256-8,259, 267, 401 benefits of trade 444-5 trade-off with efficiency 342-3
effect on GDP 418-19 caleulating 445-6 wealth distribution 349-51
investment 434-5 circular flow model 22,23 Inequality-adjusted Human Development
modern monetary theory 405-6 determinants of net exports 267-8 Index (IHDI) 583-5
subsidies 46971 and exchange rates 506, 508-9, infant industries 458-9, 462-3
targeted 423-4,435 511,512 infant mortality 578
types of expenditure 4067 and inflation 522-3 inferior goods 44-5, 65, 66, 67-8
Great Depression (1930s) 29-31, 463 price elasticity of demand (PED) inflation 243-4, 245-6, 264, 308-10
Great Leap Forward 13 548-53 calculating from CPI 312
Great Recession (2008-10) 32,263,463 quotas 467-9 causes 315-17
gross domestic product (GDP) 240-6 tariffs 465-7 control 436-7,637,661-2
business cycle 251-2 incentive-related policies 429 current account surplus 554
and change in fiscal policy 414-19 Inclusive Development Index (IDI) defining 308-9
debt to GDP ratio 409-10, 420-1 586, 587 effect of high rates on society 317-19
development indicators 576-8, 580-1 income 531-2 and exchange rates 508, 510-11
growth rates 255,257 circular flow model 20-3 imported 522-3
measure of well-being 246-9 and cost of living 245-6 interest rates adjusted for 396-7
value by sector 69 and demand 44-5, 64-9 low and stable 308
gross national income (GNI) 242-5, development indicators 576-8 measuring 312-15
576-8, 580-2 difference from wealth 343 and money demand 394-5
distribution 238, 249, 339-40, 344-9, relative rates 508
Happiness Index 250 372,595 and unemployment 324-31, 382
Happy Planet Index 251, 585 effect of FDI 640, 641 inflation rate 270, 310, 312, 381-2, 3967
Hardin, Garrett 169,171 gross national income (GNI) inflation targeting 381-2
Hayek, Friedrich von 32 242-5 inflationary gaps 281, 282-3,284, 398,
headline inflation 313-14 measuring relative poverty 412-13
health 304, 6034 353-5 informal markets 139, 143, 248, 599-600
development indicators 578-9, 580-3, proportion of 59 informal sector 570-1
584-5 of trading partners 268 infrastructure 406, 434, 547-8, 596,
and foreign aid 642-3 income approach 239, 240 624-6
and poverty 355-6 income effect 40 Ingram, James 443
healthcare 1634, 373,434, 547, 6234 income elastic demand 66, 314-15 injections 21-3
heavy industry 967 income elasticity of demand (YED) institutional framework 563, 5934,
herd behaviour 126 64-9 638-9
heuristics 123 income inelastic demand 66 intellectual property 493
hidden unemployment 2923 income inequality 344-9, 351 interdependence 6, 10, 21,226
homo economicus 121-2 income taxes 147,263, 364, interest rates 261-2, 265
homogeneous products 455 365-72,429 changes to 399-400, 401
houschold consumption 260-4, 363 increasing marginal returns 77 and current account deficits 543
household income 304, 363, 364-5, indirect taxes 82,147-51,155-6,172-3, equilibrium interest rates 392-6
414-18 362, 364-5, 405 and exchange rates 383, 509,
household indebtedness 2634 industrial policies 435, 459 515-16
household saving 423 inefficiency 19,205, 464 and money supply 386-90
household wealth 262-3 inelastic demand see price inelastic realfnominal 396-7
households 20-1,312-13 demand zero-bound 399-400
human capital 373,434, 563, inelastic supply 92-3,95,96-7, 598 international agreements 178-9, 491
596,618 inequality 289,151 International Monetary Fund (IMF)
Human Capital Index (HCI) 373 consequences 361-2 636-7

697
 Index

international trade 440, 599 leakages 21-3 ‘managed exchange rates 517-18, 521,
absolute advantage 448 legal systems 605 522,523
benefits 440-7, 456 legislation 157-8,170,175,183, mandated choices 129
bilateral vs multilateral 455 232-3,493 manufactured products 64, 68, 69, 96,97
comparative advantage 448-56 less economically developed countries marginal analysis 193
and economic development 613-18, (LEDCs) 458-9, 462-3, 559, marginal benefit (MB) 41,115-17
639-40 569-72, 601-2 marginal cost (MC) 76-8,98,115-17,
external balance 383 1 ife expectancy 247,578, 580 192-3,194-6, 2078, 211
free trade theories 442-3 I iquidity trap 400, 422-3 ‘marginal private benefit (MPB) 161,168
trading blocs 478-90 I iving wage 354-5 ‘marginal private cost (MPC) 161-2,
World Trade Organization (WTO) 1 loans 262, 2634, 265, 266, 384-5 165-7,172,173
491-4 cross-border 536 marginal product of labour 74-5,76-7
intervention see government intervention interest rates 396-7 ‘marginal propensities 365, 415-17, 418
interventionist-oriented approaches International Monetary Fund marginal revenue 193, 194-6, 206-8
614-17, 6216, 645 (IMF) 636-7 ‘marginal social benefit (MSB) 161-2,
interventionist supply-side policies minimum lending rate 388 163-4,166,167,168
433-5 World Bank 632-3, 634-6 marginal social cost (MSC) 161-2, 1634,
inventories 97-8 logic 25 165-7,173
investment (I) 22-3, 240, 256-8, 259, long-run aggregate supply (LRAS) marginal tax rate 366-8, 370-2
264-6 273-4,276-9, 2804 marginal utility 40-1
cross-border 455, 5067 and economic growth 337-8 market-based supply-side policies
for increased competitiveness 547-8 and supply-side policies 427,433,434 359-60, 361, 428-33
invisible hand 10, 111, 350, 645 long-run economic growth 337-8 market-clearing price 101-4
isolationist policies 305 long-run equilibrium 202-5, 2824 market demand 28, 43, 203-4, 206, 211
long run in macroeconomics 273, 659 market disequilibrium 102-4
J-curve 551-2 long run in microeconomics 95, 659 market economies 342-3, 3634
joint supply 81 long-run Phillips curve 325-6,329-30 market efficiency 468
long-run profits 200, 202-4, 205, 208, market equilibrium 101-2, 104-8, 2024
Kahneman and Tversky’s Dual System 220-2,224 market failures 133,135,161,162,183-5
model 124-5 long-run self-adjustment 327 asymmetric information 181-3
Keynes, John Maynard 30-2,414 long-run supply 95-6 common pool resources 169-71
Keynesian AS model 274-80, 284-7, 315, long run vs short run 659 demerit goods 169,172-3
316,412,413 long-term growth 251-2 externalities 162-9
Keynesian economic theory 30-3, 285-6, long-term growth trend 252 government intervention 171-9
414,422-3 Lorenz curve 345-6, 347, 348-9, 372 inequity 1834
Keynesian multiplier 414-15, loss aversion 126 monopoly power 213
416-17,418 loss (economic) 198-9,205, 211, 214 public goods 179-81
low unemployment 260,270, 289, market mechanism 133,135-6
labour 7,73-8,143-4, 278, 485-6 323-31, 382,404 market-oriented approaches 617-21,645
labour costs 461,627 luxury goods 60, 66-7 market period 95
labour force 289-91,292 market power 218,219-20, 225
labour market 293-5,299-301, 359 ‘macroeconomic equilibrium 280-5 abuse of 228-9,232-3
policies 429-30,432, 487 macroeconomic stability 490 concentration ratios 226, 227
and trading blocs 485-6 macroeconomics 4-5, 30-3, 236, 378, excess 231-5
labour market flexibility 433 660-1 monopoly power 189-90, 205-6, 210
labour supply 294-5, 461 demand-side policies 380-425 market price 109, 11215
labour unions 296, 297, 359,430, 431, economic growth 334-40 market share 200,203,222
432,485-6 inequality and poverty 341-77 market size 138,142,359, 441, 444
laissez-faire 10,28, 30, 286, 3634 Keynesian theory 30-2,285-6 market structures 187
land 7,278 laissez faire approach 28, 286 monopolistic competition 218-25
land rights 568 low and stable inflation 308-32 monopoly 188-90,205-15
landlocked countries 572, 592-3 low unemployment 289-306 oligopoly 225-31
law of demand 25, 38-41,126 measuring economic activity 238-53 perfectly competitive 187-8,201-5
law of diminishing marginal returns objectives 238,289, 308, 3234, market supply 28, 78, 79-80, 203
73-5 339-40,378 markets 37-8, 571
law of diminishing marginal utility 40-1 short run vs long run 269, 659 access to 441,485, 599
law of increasing opportunity cost supply-side policies 427-37 effect of indirect taxes 147-51
16-18 variations in economic activity effect of subsidies 151-2
law of supply 73,75,77,85-6 254-87 Marshall-Lerner condition 548-53

698
Marx, Karl 28-9,252,363 multinational corporations (MNCs) opportunity cost 7-8, 108
maternal mortality ratio (MMR) 579 626-8 comparative advantage 448-51, 4534
‘maximising behaviour 122,130, multiplier effects 414-19 law of increasing opportunity cost
190-1 16-18
maximum price 136-40, 145-6, 214, national banks 381 and money demand 390
215,518-19 national debt see government debt production possibilities curve (PPC)
merit goods 11,164,172, 435, national income 15,16-18
622-6 compared to national debt 409-10 of spending money 261-2, 265
microeconomics 4, 27-8, 35,133 development indicators 576-8 output 243,248, 316-17
competitive market equilibrium measuring 238-41 composition of 248-9, 596-9, 618
101-19 per capita 244-6, 576-8, 580-2 cost-minimising level 196
demand 37-70 national income accounting 238-41, diversification 69,462-3,618
government intervention 135-59 242,246-7 loss-minimising level 198-9
market failure 161-85 national income statistics see gross profit-maximising level 194-6,197
market power 187-216,218-35 domestic product (GDP); gross output approach 239,241
maximising behaviour 121-32 national income (GNI) output gaps 276-8, 280-5
short run vs long run 659 national security 180, 460 closing with fiscal policy 411-13
supply 72-99 nationalistic campaigns 472, 492-3 closing with monetary policy 397-8
microfinance 606-8, 619, 638 natural monopoly 213-15, 232,233 overspecialisation 455, 4623, 597-9
migration 455 natural rate of unemployment (NRU) overvalued currency 518-19
Mill, John Stuart 42 274,284,302-3,304
minimum income standards (MIS) 354-5 and inflation 325-6, 327, 328, 329-30 Panagariya, Arvind 494
minimum lending rate 388 natural resource trap 591-2 PANTS 59
minimum price 146, 518, 520 natural resources 248, 562-3, 571-2, 627 parallel economy 248
‘minimum reserve requirements 380, necessities 60, 65, 66-7 Pareto optimality 162
385,388, 396 negative externalities of consumption payoff matrix 230
minimum wage 25, 26, 141, 1434, 430 167-8 peace 447
and poverty/inequality 376 negative externalities of production pensions 158, 374,407
and unemployment 300-1 166-7,248 per capita GDP 2446, 576-8
mixed economy 9-10, 11, 14,135,364 negative interest rates 400 per capita GNI 576-8, 580-2
modern monetary theory (MMT) 405-6, negative supply shocks 316,328 per unit costs 194
421,423 net exports (X - M) 240, 256-8, 259, perfect competition 187-8,193,194,
monetarist/new classical view 2734, 267-8 201-5,219-20, 224
280-4,286, 412, 428-9 new classical economics 428-9 perfect efficiency 204-5
monetary policy 31,3803, 386-90 nominal GDP 243-4 perfect information 122,181
economic integration 488-90 nominal GNI 2434 perfectly elastic demand 545,194,
effectiveness 399-401 nominal interest rates 390-7, 400 202,219
expansionary|contractionary 397-8 non-collusive oligopoly 229-31 perfectly elastic supply 93
fractional reserve banking 384-6 non-excludable goods 170, 179-81, 605 perfectly inelastic demand 53-4
freedom 521 non-governmental organisations (NGOs) perfectly inelastic supply 92-3
and interest rates 390-7 629, 632,642-3 Phillips curve model 324-31
monetary stimulus 397-8, 401 non-price competition 231 Pigouvian taxes 151,172-3
monetary unions 488-9, 490 non-produced, non-financial assets 534 planned economy 9, 11-13, 110, 342
money, circular flow model 20-3 non-rivalrous goods 179-81, 605 political pressure 419,435
money creation 380, 384-6 normal goods 44, 65, 66 political stability 486, 572
money demand 3905 normal profit 197-9,203-4, 215,221, political systems 572
money market model 3906 222,224 pollution reduction 173-4,175,
money multiplier 385-6, 388 normative economics 26 176-9
money supply 386-90, 3926 North American Free Trade Agreement population disparities 291-2
monopolistic competition 218-25 (NAFTA) 487-8 population size 244-5
monopoly 188-90,205-15,220, nudge theory 128-31,158-9 portfolio investment 535-6
224-5,432 positive economics 25,26
moral hazard 182, 637 OECD Better Life Index (BLI) 249-50 positive externalities of consumption
Multidimensional Poverty Index (MPI) official borrowing 537-8 163-4
355-7,585 Official Development Assistance (ODA) positive externalities of production 163,
multilateral development assistance 629-31,632-3 165-6
633-7 oil price 107,229, 313, 570, 597-8 positive supply shocks 328
multilateral trade agreements 479, oligopoly 225-32 potential output 273-4,278-9,
480-1,487,491-4 open market operations 380, 387-8 337-8,562

699
 Index

poverty 351-62, 568 imports/exports 548-53, 598 profit 191,194,196

causes 304, 357-61 manufactured products 64 alternative business objectives 199-201
consequences 361-2 primary commodities 634 long-run 200, 202-4, 205, 208,
defining 351-2 range of values 53-8 220-2,224
measuring 352-7 price elasticity of supply (PES) 88-99 maximising 130, 190-200, 207-9,
reducing 372-6, 559, 565 calculating 88-92, 94 213-14
poverty lines 352,353 determinants 94-8 monopolies 207-9,210-11
poverty traps 357-9, 591-5, 601, manufactured products 96,97 monopolistic competition 220-2, 224
618,626 primary commodities 96-7 natural monopolies 213-14,215
power relationships 571 range of values 92-4 oligopolies 231,232
preferential trade agreements (PTAs) price-fixing 228-9 per unit profit 193,195
479-81 price floor 146, 518, 520 perfect competition 202-4, 205
price price indexes 310-15 repatriation 627
AD curve 258-9 price inelastic demand 51, 63,220, short-run 220-1
community surplus 115 549-51, 598 progressive taxation 151,365-71, 605
consumer surplus 112-13 perfectly inelastic 534 property rights 12, 3634, 608, 639
AS curve 269-74 relatively inelastic 55-6, 59-60 proportional taxation 364, 365
in different currencies 504-5 price inelastic supply 92-3,95,96-7, 598 protectionism 305, 442-3, 455-6, 545-6
equilibrium 101-8 price makers 189, 206, 208 arguments forfagainst 458-64
future expectations 45, 83, 264 price mechanism see market mechanism effects of 465-76,492-3, 614-17
and GDP 243-4,248 price stability 238 types of 465-72
incentive role 110 price takers 188,194, 201 public goods 11,157, 179-81, 624
inflation/deflation 308-10 price wars 200, 226-7, 228, 230 public transport 66, 164
international trade 441, 444 primary commodities 634, 96-7, purchasing power parity (PPP) 245-6,
monopolistic competition 218-19, 314-15,493 352,577-8
220 dependence on 569-70, 596-9
monopoly market model 206-9 primary sector 68, 69, 596-9 quality of life 246,249
oligopoly 226-7,228-9,230-1 prisoner’s dilemma 179, 229-30 quantitative casing (QE) 388-9
perfect competition market model privatisation 431,432, 620-1, 624 quantity demanded 38-41,47-8, 51-3,
201-4 producer price index (PPI) 314-15 101-6
producer surplus 114-15 producer surplus 114-15,117-18 see also demand
protectionist policies 464, 465-6, benefits of trade 444 quantity supplied 72-3, 78, 88-93,101-7
467-8 effect of price controls 138-9, 142-3, see also supply
quantity demanded 38-41, 47-8, 145-6 quotas 467-9
51-3,101-6 effect of subsidies 152-4
quantity supplied 72-3, 78, 85-6, effect of taxes 150, 155-6 racial inequality 291,360
88-93,101-7 producers rational consumer choice 41,121-3,
rationing function 110-11 effect of monetary unions 490 127-8
related goods 45-6, 81 effect of price controls 140, 144-6 rationing 110-11, 138
resource allocation 108-11 effect of quotas 467-8 real GDP 243-6, 258, 270, 334-5, 576
signalling function 109-10 effect of subsidies 1524, 469-71 real GNI 243-5, 576
and specialisation 440 effect of tariffs 466 real interest rates 3967
sticky vs flexible 270-1 maximising behaviour 130 real-world issues 35,133,236, 378,
time following change in 94-6 revenue 150 438,557
volatility 313-14 tax burden 148-50 recession 31,32, 656, 251-2, 463
price ceiling 136-40, 145-6, 214,215, product differentiation 219-20, 222, 224, Covid-19 pandemic (2020) 32-3,
518-19 226 255-6,257,286-7
price controls 136-46,214,215 product market 20-1,37-8 crowding out 422-3
price deflator 2434 product standards 460, 471 deep recessions 422-3, 424
price elastic demand 51, 55, 56-8, 59, production costs 80,82-3,271-3 deflationaryfrecessionary cycle 285
549,552 production possibilities curve (PPC) expansionary monetary policy 397-8
perfectly elastic 54-5, 194,202,219 14-20, 278-9, 3367, 427, Great Depression (1930s) 29-31, 463
relatively elastic 56-7,220, 549 451-3, 602 Great Recession (2008-10) 32,
price elastic supply 90,92, 93,95,96,97, production possibilities matrix 449 263,463
98-9 productive capacity 427, 434, 562 and inflation 313-15, 330-1
price elasticity of demand (PED) 51-64, productive efficiency 204-5, and money demand 391-2, 394-5
70,219-20 223,232 recovery following 330-1,492
caleulating 51-3 productivity 20, 73-8, 834 wages 296-8
determinants 59-61 productivity curves 74,75 zero-bound interest rates 399-400
700
recessionary gaps see deflationary gaps signalling function of price 109-10 and economic growth 338, 339-40
recovery 251-2,255 supply and market equilibrium 106-7 and exchange rates 512-13
redistribution policies 621-2 seasonal unemployment 302-3 see also poverty
regional trade agreements 487-8 secondary sector 68,69, 591-2 standards 628
regressive taxation 151, 3645 sectoral change 68-9 state-run industries 620-1
regulation 157-8,175,183,232-3 security 164,460 status and power 360
and aggregate supply 271-2 self-interest 10-11, 27, 28,32,121, sticky wages 270-1,275-6,282, 285,
lax standards 627-8 169-71 296-8
related goods see complementary goods; Sen, Amartya 561-2 storage facilities 97-8
substitutes, services 156-7,180-1, 622-6 strategic thinking 226-7, 229-31
relative poverty 352,353-5 balance of trade 530, 531 structural unemployment 298-301,
relatively elastic demand 56-7, 220, 549 short-run aggregate supply (SRAS) 329-30,374-5
relatively elastic supply 92, 96,97 269-73, 2804, 316-17, 324 subsidies 82-3,151-4,156,172,214-15
relatively inelastic demand 55-6, 59-60 and deflation 320, 321, 322 and aggregate supply 271-2
remittances 507, 577 and economic growth 337 effects on stakeholders 469-71
renewable energy 164, 174, 625-6 and exchange rates 510-11 export promotion 4701, 615-17
rent controls 139-40 and inflation 316-17,326-8 international trade 469-70
required reserves 384-6, 388 and Phillips curve 326-8, 329 poverty prevention 374
research and development 434, 547 and supply-side policies 427 subsistence economies 248
reserve assets 537,538 short-run costs of production 191,192-3 substitutes 45, 60-1, 634, 81,189
resource allocation 6,9,108-11 short-run economic growth 337 substitution effect 40
effect of deflation 323 short-run equilibrium 202-4, 280-2 sunrise industries 458-9, 462-3
effect of inflation 319 short run in macroeconomics 269, 659 supply 28,72-8,101-8
free market economy 10 short run in microeconomics 74, 659 currency supply 500-2, 503
misallocation 305,463 short-run losses 221-2 defining 72
mixed economy 14 short-run Phillips curve 324-5, 326-8, excess 102-3
and opportunity cost 16-18 330-1 increasing marginal cost 75-7
planned economy 12 short-run productivity 73-4,75 of labour 294-5
resource costs 144, 271-2 short-run profits 220-1 law of 73,75,77,85-6
resource endowments 562-3, 571-2, short-run supply 94-5, 96,97 law of diminishing marginal returns
591-2 short-term fluctuations of economic 73-5
resource market 20-1,37-8,110-11 activity 251-2 market equilibrium 101-2
resources 6-7,135,305, 359 shortages 138, 393-4 market supply 28, 78, 79-80, 203
common pool 169-71,178-9, 180 signalling 109-10, 184 non-price determinants 79-85
and international trade 441-2 Smith, Adam 10-11, 27,29, 111, 263, 442 and price ceilings 137-40
natural 248, 562-3, 571-2, 591-2, 627 social enterprises 618-19 and price floors 141-3, 144
restricted choices 129 social insurance 373, 621-2 and production costs 80, 82-3
revaluation 509-10, 513, 516, 520 social reinforcement 158-9 shifts of 85-6,106-7,109-11
revenues 21, 150,191,193 social sciences 3, 4,136 see also aggregate supply; price
see also specific types of revenue social security 364, 370-1, 374, 407 elasticity of supply
Ricardo, David 442, 449 social stability/cohesion 361 supply curve 28,72
rich-country dominance 635,637 social surplus see community surplus benefits of trade 444-5
risk aversion 126 social welfare 128-31, 359, 360-1, 374 effect of subsidies 152
rivalrous goods 170,179, 180, 183 socialism 12,13,29,32,363 effect of taxes 147-50
rules of thumb 123 socially optimal output 161-2, 163, 164, elasticity of supply 90,92-3,95
204-5 equilibrium price 102-7
safety nets 14, 621-2 natural monopoly 213-15 excess demand 1034
sales tax 364-5 perfectly competitive markets 188 excess supply 102-3
satisfaction 40-1 sovereignty 487,489, 635, 641 labour market 294-5
satisficing 125,199 specialisation 440, 441, 442, 449, 450-2 marginal cost as 77-8, 98,
savings 22-3, 318-19, 384, 399-400, specific taxes 147 116-17
423,536 speculation 507-8 market disequilibrium 102-4
Say, Jean-Baptiste 28,29 spending multiplier 414-15,416-17, 418 market equilibrium 102, 104-7
Say’s Law 28 stabilisation policies 636-7 market supply 78, 79-80
scarcity 3,5,6-7,8-9,16 stagflation 317,437 money market model 392-5
demand and market equilibrium stakeholders 660 movement along 78, 81,856
104-6 standard of living 245-6, 252, 569 and price elasticity 90,92-3
poverty traps 5912, 594-5 development indicators 580-2, producer surplus 114-15
rationing 110-11 584, 585 shifts of 79-86,106-7,147-9,152

701
 Index

supply schedule 73,102,114 time/time lags 94-6, 247, 401, 420,435 unfair competition 232-3, 461
supply shocks 271, 316, 328, 329 total costs 191,192,194 unitary elastic demand 58
supply-side policies 427-37, 546-8, 637 total market demand 43 unitary elastic supply 90
surplus 102-3,106, 142,323 total output 256 universal basic income (UBI) 4, 374-5
balance of payments 527-8, 537, 538 total revenue 55-6, 57,58, 62,191, upward mobility 358-9
budget surplus 407, 408-9 193,194 utilitarianism 42
‘money market 3934 tradable permits 176-8 wility 27-8,40-1,42,122
see also consumer surplus; producer trade balance 461, 521-2 utility industries 213-15
surplus trade-based approaches 613-18, 639-40 utility theory 27-8
sustainability 5, 6,135,251, 339, 646-7 trade creation 484-5
sustainable debt 420-1 trade deficit 659 variable costs 192
sustainable development 34,171, 564-8 trade diversion 486-7 variable resources 73-5,192
Sustainable Development Goals (SDGs) trade liberalisation 431-2, 4914, voluntary export restraint 469
565-8 620, 637 volunteer work 248
trade-offs 8,15-16, 18,602
tariffs 465-7, 614, 620 inflationfunemployment 274, wage rate 294-5,299-301
revenue source 461-2 324-5,331 wages 269-76, 278, 282-5
trade agreements 479-83, 486-8 one product and another 450-3 cyclical unemployment 296-8
trade disputes/war 463, 464, 492-3 trade policies 268 downward pressure 298,299, 305
WTO agreements 491-2 trade protection see protectionism fixed 269-70
tastes and preferences 45 trade union power 359, 430, 432, 485-6 labour market policies 429-30,
tax avoidance 363 trade wars 463, 464 432,436
tax multiplier 415,417-18 trading blocs 445, 478-90 living wage 354-5
tax revenue 369, 370-2, 405-6, 4245, traditional societies 304 sticky vs flexible 270-1,296-8
461-2 tragedy of the commons 169-71,178-9 structural unemployment 299-301
tax structures 364-6, 369-71, 605 transaction demand 390-1 see also minimum wage
taxes 21-2,23, 61, 147-51,362-72 transfer payments 374-5, 407, 621-2 wealth 262-3, 318,322,343,
burden of 148-50, 151, 364—6 transport costs 271-2, 455 349-51
business taxes 266, 2712, 429 Trump administration 4634, 488, 492-3 wealth distribution 349-51
calculating 366-9 wealth tax 372
carbon tax 173-4,175,176 UN Development Programme weighted price index 310-12
direct taxes 362 (UNDP) 561 welfare 247, 645, 646
and economic growth 340 uncertainty 318,322, 522 effect of price controls 140, 144-6
effect on GDP 418-19 underemployment 293 effect of subsidies 1524
and fiscal policy 419,423-5 undervalued currency 520 effect of taxes 150-1
and government spending 267 unemployment 30, 143-4,285 welfare gain 163,164,165
historical views 3634 calculating 289-91 welfare loss 117-18,210
and income distribution 372 causes 295-302 effect of quotas 468-9
income taxes 147,263, 364, consequences 304-5 effect of subsidies 470
365-72,429 cyclical 292,295-8, 323 effect of tariffs 466-7
indirect taxes 82,147-51,155-6, defining 289 well-being 12,144, 583, 625
172-3, 362, 364-5, 405 difficulty measuring 291-3 development focus 560-2
and inequality 360-1,362-6 disparities 291-2,304 economic 3, 5, 154, 246-51,
lowering 429, 432 and exchange rates 511-12 289,562
progressive taxation 151, 365-71, 605 frictional 301-3, 329-30 emotional and cognitive 362
proportional taxation 364, 365 hidden 292-3 measuring 246-51, 579, 588
regressive taxation 151, 364-5 high 661 of others 10-11, 127,170
and supply 82 and inflation 324-31, 382 Wilson, James 443
targeted 4234 low and stable 289,382 women's empowerment 583, 638
taxpayers 153-4, 267,374,471, 616 seasonal 302-3 World Bank 352, 358, 373,491, 632-3,
technology 83-4, 266, 434, 5478, 563 structural 298-301, 329-30 634-6
telecommunications 460, 596, 618, see also natural rate of unemployment World Trade Organization (WTO) 460,
624-6 unemployment benefits 430, 432, 622 487,491-4,617
tertiary sector 69 unemployment insurance 374
tied aid 630-1 unemployment rate 270-1, 289-91,303 zero balance 527, 538-9

702
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