an intro to economics

CONTENTS OF ENTIRE BOOK

Unit 1 Markets: How They Work.......................................................................................... 1Positive and normative thinking ................................................................................................1Opportunity cost ........................................................................................................................1The production frontier or production possibility curve ............................................................3Specialisation and foreign trade..................................................................................................6Demand and supply: an introduction..........................................................................................8The elasticity of demand...........................................................................................................20The elasticity of supply.............................................................................................................30Demand and supply: applications to any market are possible..................................................32The market mechanism working...............................................................................................34Consumer and producer surplus...............................................................................................39

Unit 2 Markets : Why Markets Can Fail.............................................................................43What does market failure mean?..............................................................................................44Reason 1 - Monopoly elements or market dominance.............................................................47Oligopoly..................................................................................................................................51Imperfect competition or monopolistic competition................................................................54Reason 2 - externalities, social cost and private costs..............................................................58Reason 3 - public goods............................................................................................................64Reason 4 - merit goods.............................................................................................................65Reason 5 - demerit goods.........................................................................................................66Reason 6 - information failures................................................................................................67Reason 8 - factor immobility....................................................................................................70Other issues and market problems exist: The distribution of income and wealth....................................................................................75Economies of scale...................................................................................................................79Price fixing by government or one of its bodies.......................................................................84

Unit 3: Managing the Economy.............................................................................................90Why is the government involved in the economy....................................................................90How can government try to manage the economy?..................................................................92Inflation.....................................................................................................................................95Unemployment.......................................................................................................................100The balance of payments........................................................................................................106Gross domestic product (GDP)...............................................................................................110Economic growth....................................................................................................................113Aggregate demand..................................................................................................................120Aggregate supply....................................................................................................................122Altering the level of national income.....................................................................................123Macroeconomic policy – what the government does or tries to do........................................128The multiplier.........................................................................................................................136The interest rate and the level of investment..........................................................................136Money and monetary policy...................................................................................................138Fiscal policy............................................................................................................................146Supply side economics...........................................................................................................152The Phillips curve...................................................................................................................158

Unit 4: “The Theory of Production & Costs”....................................................................164The growth of firms................................................................................................................164The external growth of firms:.................................................................................................167Multination corporations.........................................................................................................169

An introduction to production theory and costs......................................................................170Cost curves..............................................................................................................................175The different possible market conditions................................................................................178Perfect competition.................................................................................................................179Monopoly................................................................................................................................184Imperfect competition or monopolistic competition..............................................................188An introduction to efficiency..................................................................................................192An introduction to price discrimination..................................................................................196Pricing strategies.....................................................................................................................199Game theory............................................................................................................................201Oligopoly - the kinked demand curve.....................................................................................203

Unit 5A: Labour Markets....................................................................................................207The supply of labour...............................................................................................................207The demand for labour............................................................................................................210Determining the equilibrium wage.........................................................................................214The effects of trade unions......................................................................................................217Differences in earnings...........................................................................................................222Labour participation, unemployment and ageing...................................................................229An introduction to the distribution of income and wealth......................................................233

Unit 6, The UK in the Global Economy: “Globalisation and Protection”.......................236An introduction to globalisation and protection.....................................................................236Trade protection and trade liberalisation................................................................................238Trading blocs and the world trade organisation (WTO).........................................................242The balance of payments........................................................................................................247The European monetary union (EMU)...................................................................................255Public expenditure in the UK..................................................................................................258Inward foreign investment by multinational corporations......................................................264External shocks and the global economy................................................................................266

Module 2881 The Market System, Unit 1:“Markets: How They Work”

The course is the GCE Advanced Level in Economics, following the old Edexcel syllabus; the new syllabusreorganised the course. You can still use the information here but will have to look at the contents page and/oruse your computer search function to find what you need as you need it. If you are learning economics in adifferent examining body, or perhaps learning economics but not for A-levels, the same applies:you can simply select the parts of this book that are relevant for your current interest. Economics iseconomics! Searching in this way has a spin-off benefit for you — it is good practice for when you get touniversity where you will be expected to search for, think about, and then apply the information for yourself.At many high schools and colleges the teachers often spoon-feed their students with the information that isfelt to be needed. In the short-term this battery-chicken approach can be effective in helping the institutionalinmate to pass exams; but in the long term it does not do these poor clients many favours, as they find it harderto survive in the wilder outside world and pursue interests other than simply passing exams. Things likegetting a good job, holding it down, and rising in your chosen field are important to you.

This is a series of teaching notes that I developed and used until I stopped lecturing and tutoring. Iconsidered rewriting them as a book and selling it commercially but soon discovered that I was too busy todo this; indeed, it seemed unlikely that I would ever get around to rewriting. Rather than leave the materialto languish unread I decided to make them freely available to students such as you to use.

Now down to business! If you want good marks, these notes should be read and reread until you really knowthem. Practise drawing the diagrams until you can do them from memory without making mistakes. It is agood idea to revise something and practise drawing diagrams for a short period every day.

1-1. INTRODUCTION

POSITIVE AND NORMATIVE THINKING

Positive economics deals with what is; normative thinking deals with what ought to be and is value-laden.All sciences and fields of learning try to be positive and deal with facts and models based on facts. Youshould try to be positive i.e. scientific in your statements, especially when writing essays and in the examroom.

Words like "ought", or "should" or “as a nation we must” are all normative statements and you should doyour best to avoid them. Try not to say things like “It would be better if…”,or “the government should….”“it would be a good thing for X to do Y”. Many policy prescriptions you might wish to make are normative,e.g., “The economy would be better off if we….” and it can raise an examiner’s hackles. You might getaway with a general statement such as “Some advocate…”, “It has been suggested that…” or “Many believethat….” as these are positive statements and sound less normative. Note that the words used in an otherwisescientific study can themselves carry a normative feeling, e.g. "freedom", "democracy", "efficiency", or"welfare" may all seem to be “good words to many people; whereas words such as “inequitable”,“exploitation”, "unsound", "interference", "fascist", or "police state" seem "bad" to many people.

OPPORTUNITY COST

We live in a world of scarcity, in the sense that we can never have everything that we might like. As a resultwe must make choices, for instance whether to buy this or that, whether to eat this or that, whether to walk

1

in the park or go to a movie, or whether to produce this or that. Every time we make a choice to do some-thing we automatically exclude something else that we did not do we have given it up. We call this the“opportunity cost”.

Definition “Opportunity cost is the best forgone alternative” i.e. it is what we gave up to get what we did. The opportunity cost of buying new pair of shoes might be alunch forgone.

· The opportunity cost of buying a new shirt might be not going to the cinema.· The opportunity cost of taking a part-time job might be not being able to hang out in the mall with

your friends.

For a producerThe opportunity cost of buying plastic packaging material might be the cardboard he did not buy.

NB there can be many alternatives foregone, but only one will be the opportunity cost you cannot add themup and say they are all the opportunity cost, because it must be a choice between them.

Opportunity cost can be thought of as:

1. The cost in pounds (represents a real thing given up); or2. The cost in time.

Opportunity cost is important

1. We use it whenever we are deciding what to do, for example shall we hire a couple of videos or buy a piz-za instead.

2. It always arises with budget allocations. At some point in your life you may have to draw up a budget andallocate money for different purposes. You will be forced to weigh up what is really needed in your tennisclub, computer society, your country or whatever.

3. It lies behind the cost curves that we draw. How does this work?

Consider two producers, A and B. Producer A might have to pay £20 a ton to get the iron ore to make intomotor cars. Producer A sees the cost as £20, but we see it as the way of making sure he gets the resources,rather than letting B get them! So the opportunity cost really does stand behind the cost curves we draw.

Similarly in consumption: if something costs £10, you have to pay £10 to buy it. That £10 is not only theprice of the object, it is also the amount you have to pay to get the resources, raw materials, labour etc. thatwent into making it. This prevented these resources from going into making something else.

After you buy the item it will be reordered by the shopkeeper and replaced on the shelf. S/he orders from awholesaler who in turn orders more from the producer. The producer then buys the raw materials etc. tomake another of whatever you bought! In this way, resources keep on going into making whatever peopledemand.

4. This is how the price mechanism really works – that is, how it allocates resources to wherever the de-mand is the greatest.

2

THE PRODUCTION FRONTIER OR PRODUCTION POSSIBILITY CURVE

What is it?It shows us the maximum that a country can produce. There is clearly a limit to this at any one time justlike there is a limit to the weight that you can lift over your head or eat at any time. We assume two goods(I will use apples and bananas as these easily can be represented by A and B) for ease of explanation –but it is true of any number of goods.

Drawing the diagram – we start with the maximum amount of good A we can produce if all our resourcesare devoted to producing A which gives us a point on the vertical axis; then we do the same for the case ifwe only produce B to give us a point on the horizontal axis. Then we join the two positions with a straightline. Once we have drawn the line, we do not have to have all apples or all bananas but we can chose some-where along it. Any point on it represents a mix of the two goods that people wish to buy. At the point se-lected above, people consume 0A1 apples and 0B1 Bananas.

[DIGRESSION: DRAWING THE CURVESYou should practise drawing all the diagrams regularly – several times each day is a good idea. In the end,they need to be second nature to you so that you can recall and correctly draw the appropriate diagramwhenever you want. It is most important to be able to this so that you can quickly gain good marks.The wrong diagram, a mislabelled one, or one lacking labels, more or less dooms you to fail. It showsthat you do not really understand what you are saying and examiners hate that. Labels, by the way, are thewords on the diagram, like “apples”, “bananas” or “ppc 1” in this diagram.

When tutoring, I would draw each diagram again in front of the student, and explain the importance of get-ting it right (and remind them of this now and then later). It is important to see how a diagram is built up asthey are really easy to do, but to be suddenly presented with a complicated finished product can be a bitdaunting. For this reason, I have put in a sensible order of drawing the diagram for the first few times Ipresent them. It is just about impossible to get a good mark in economics without drawing diagrams, sostart practicing without delay!

Warning! It may seem easy, but it helps you much less if you download diagrams from the Internet and pastethem into essays. It is more valuable for you to draw them, and learn them, for yourself. END OF DIGRES-SION]

Apples

A1

PPC1

Bananas00 B1

3

The way the diagram of the production possibility curve is drawn.

We usually draw the production function curved , to reflect the law of diminishing returns. Some factors ofproduction are better at producing A and not as good at B, as you might imagine. Some land is simply bet-ter at growing bananas than apples, just as some of your friends are better at doing maths, swimming orplaying the guitar than others. So as we move down the production possibility curve and get more bananas,we can expect to get a few less bananas than we might expect; perhaps we used to give up 5 apples to get 5more bananas, but as we slide down the curve we will get, say, only 4 more bananas, then only 3 more, or 2more, as we keep sliding down.

The line curves in at each end to show this as in the diagram below.

[Digression. It is unlikely in my view that you will be asked why the production frontier is curved as op-posed to a straight line, but if you do, the reasoning above and the diagram explains it. In the diagram youcan easily see that if we had a straight line production possibility curve (like AB) we could produce the max-imum amount of apples at the end of it, that is, at A, and have no bananas at all. But as diminishing returnsdo exist, we are actually on the curved A2B2. The maximum apples possible are at A2 (not A which wecould reach if we were on the straight line ppc ). As diminishing returns put us on the curve not the straight,the difference between A2 and A is the quantity of apples lost because of diminishing returns, End of digres-sion]

It is common to use straight line production frontiers in text books because they are easier to draw and ma-nipulate, so they often look like the diagram below.

0

Apples

Bananas0

Apples

Bananas

PPC1

0

Apples

Bananas

PPC1A1

B1

Apples

Bananas00 B1

A1

Equilibrium pointwhere ppc is justtangent to theprice line AB

A

B

PPCA2

B2

4

What happens if we swivel the curve? If society learns to get better at producing Apples alone, it wouldswivel the curve out along the vertical axis of apples. This reflects the fact that we can get more outputfrom the resources and factors of production that we have. The swivel that gives us more apples reflectsa productivity increase in apples, but not in bananas.

After the productivity increase in the apple growing industry, withe same quantity and quality of factors ofproduction, society can increase the output of apples from 0A1 to 0A2, that is, by the distance A1 to A2.

If we swivel it the other way, and push out B , we would get a productivity increase in bananas, but not inapples.

What if we move the whole curve out? If a country has learned to get better at producing every-thing, this would physically move the production frontier upwards and outward, which is economic growth.

We return to the subject of economic growth in the unit “Managing the economy”.

Apples

A1

PPC1

Bananas00 B1

Apples

Bananas0

A1

A2

B

Apples

A

Bananas00 B

ppc1 =now

ppc2 =4 years time

A1A2

B1B2

5

SPECIALISATION AND FOREIGN TRADE

If people specialise they are more productive – if you are like me, you probably could not make a good pairof shoes, do brain surgery or advise on investing for pensions! We tend to do what we are best at. Imaginethe result if we did what we are worst at!

Countries are the same – if they concentrate on what they are best at, they produce more and better goods orservices. As a rule of thumb, countries that follow a protectionist policy (protecting their industries fromforeign competition) are trying to do what they are worst at, or at least not trying to do what they could bebest at. Most economists would probably think that protectionism is not exactly a good idea.

Two concepts of “advantage”

Absolute advantage – this means a country can produce more of almost everything than another, i.e., it is awealthy country. The USA can produce more than Egypt for instance – clearly, the USA has an absoluteadvantage over Egypt. It is of no particular interest as an idea: the rich are just rich!

Comparative advantage – this means that a country is better at producing something, but not necessarilyeverything, than another. For instance, Sweden is better at making marine engines than the UK, but we arebetter at organising financial markets and insurance. All countries are better at doing a few things more thanothers.

Comparative advantage is the one that matters in economics and it is the main reason why countries tradewith each other. We do not simply buy pineapples from tropical countries because it is too cold to growthem here. We could in fact grow them under glass and with heating, but we clearly lack a comparative ad-vantage in the pineapple producing business. Hawaii on the other hand has a strong comparative advantagein that area.

The gains from trade

If a country tries to produce everything for itself, it will stay poor. Examples: China under Mao Zedong andRussia under Stalin both followed such a policy and the people suffered a very low standard of living as aresult. The message is that trade helps the people in a country to gain wealth!

The gains from trade consist of:

· Comparative advantage – we do what we are best at and thus produce more. We then exchange oursurplus with other countries for something we are less good at. Both the other countries and ourcountry do better and enjoy higher living standards as a result.

· Economies of scale – if we specialise we can follow a system of mass production, and lower ourcosts. We can then exchange the surplus with other countries. Economies of scale are examined inUnit 2.

· We can gain wider consumer choice e.g., we can drive Volvos, Renaults or BMW’s, as well as lo-cally-made Fords!

6

1-2. DEMAND AND SUPPLY: INTRODUCTION

(Abbreviations: S = “supply”; D = “demand”; Y = “income”; r = “rate of interest”)

At the equilibrium price, the quantity demanded just equals the quantity supplied. There are unsatisfied con-sumers who could not buy at that price even though they were willing. What do we mean by equilibrium?Equilibrium is the state of affairs in which there is no tendency to change. How do we show this equilibriumprice? We use demand and supply curves.

DemandWhat is the demand curve? It is a curve showing the quantity that will be bought on the market at differentprices.

The lower the price, the more will be demanded; the higher the price the less will be demanded. Think! Ifall Nike trainers were £2 a pair, would you buy more than if they were £200 a pair? It seems probable!

In economics, “demand” means demand is backed by money – it is not just a need or a desire, but people dohave the money to buy and are prepared to buy.

Supply

What is the supply curve? The supply curve is a curve showing the quantity that will be offered on the mar-ket at different prices. We believe that higher prices cause more people to sell. Imagine: in your classroom,if I offer to buy each T shirt for £500, almost everyone will sell to me; but if I offer £1 each, probably few ifany would be willing If however I were to offer £7, more would sell but probably not everyone. That is whythe supply curve slopes upward.

Price

D

Quantity0

7

Let’s put both the demand and supply curves on the same diagram .

Guess where the equilibrium price will be? Right! Where the two curves cross! As said earlier, at the equi-librium price, the quantity demanded just equals the quantity supplied. There are no unsatisfied consumerswho could not buy at that price even though they were willing and everyone who wanted to sell at that pricecould do so. This happy situation happens at the intersection of D and S with price P and quantity Q.

When I started in economics, I had to chant along with the rest of the class: "price is determined by supplyand demand!” It certainly made it stick in my mind and might help you too!

Let us return and look at demand in more detail (We’ll look at supply later too)

Price

Quantity0

SS

Price

D

P

Quantity0 Q

S

So the demand curve is drawn sloping down-ward, left to right. Examine the one here - at ahigh price, high up on the price axis, little is de-manded as we trace a line down to the quantityaxis. But at a lower price, a greater quantity isdemanded.

8

What determines the D curve? i.e., why is it where it is and not somewhere else?

1. There are four main personal determinants of demand

· Income· Taste· Prices of other goods or service· Expectations about future prices of this good or service

2. AND several other market determinants

· Income distribution - if you think of all the other people in your house and you as you are now, thenif you suddenly got all the total income and savings and the others had none, there would be a dif-ferent pattern of demand from what it is now. They probably do not eat lunch every day if they haveno money. It is the same in society in general: change the income distribution and a new pattern ofdemand curves follows.

· Wealth distribution (as opposed to income distribution). If 10% of the population have 90% ofthe wealth, probably more Porsche motor cars will be demanded than if we all have the same ratherlowish amount!

· Population size - the larger the population, the bigger the demand, ceteris paribus. That is a Lat-in tag meaning “all other things remaining the same” and you might come across it in a lot of eco-nomics books.

· Population age distribution - if there are many old people, important demands in society will be formedicines, hip replacement operations and Zimmer frames but fewer Beastie Boys CDs, or prams.

· The interest rate. This is especially important for house purchases, motor cars, long-life consumergoods often on a credit card, or hire purchase generally. A higher rate of interest means more to re-pay, so people tend to borrow less.

What can cause a shift in the demand curve? (= a new curve)

Price

Quantity0

D here? Or why not here?

D D

9

A change in any of the above determinants of demand will do it!

If demand increases, overall, more of the good/service is bought at any unchanged (the same) price. You cansee this in the diagram below, where at P1 an amount OQ1 is demanded, but after demand increases to D2,at the same price an large amount is demanded, i.e., OQ2. It is easy to remember what “an increase in de-mand” means; there must be a new curve and it will move upwards and to the right.

The effects of an increase in demand are usually analysed using the equilibrium positions determined by theintersection of demand and supply.

You can see that the increase in demand means we move from the equilibrium position P1Q1 to the newequilibrium position P2Q2. More is demanded - we shift from the position Q1 to the position Q2, so the dif-ference (OQ2 minus OQ1) is Q1Q2.

Price

Quantity0

D1

P

Q1

D2

Q2

Price

Quantity0

D1

P1

Q1

SD2

Q2

P2

10

The way the diagram of a shift in demand is drawn,(shown not moving to the new equilibrium, soyou can see that more is demanded at the same price)

The way the diagrams are built up should be reasonably clear by now. If you have any worries, checkback and examine those supplied earlier. The general principles are:

1. Draw the axes and label them immediately (“one axis, two axes”).2. Put in the first curve and label it.3. Add the second curve and label it.4. Draw the equilibrium position – preferably using dotted lines.5. Make the necessary changes, such as shift a curve inwards or outwards by drawing a new curve and la-belling it.6. Draw the new equilibrium position – preferably using dotted lines.7. And finally you compare the new equilibrium position with the first one, using your own words but tryingto get in the necessary jargon phrases such as “increase in demand”, or “economic growth”, whatever isrelevant to the question you are tackling.

Henceforth I shall not be supplying the series of pictures showing how the diagrams are built up, as youshould be able to follow the above principles for yourself. Before long, it will become second nature to ex-amine a finished diagram and work out how it was built up.

If demand decreases, the demand curve shifts the other way, downward and to the left. Again we have anew curve, as in the diagram below.

You will notice that less is bought at any given price, such as P.

Quantity

Price

D1

Quantity

Price

D1

S1

Quantity

Price

D1

S1

P1

Q1 Quantity

Price

D1

S1

P1

Q1

D2

Q2

Price

Quantity0

D2

P

Q2

D1

Q1

11

Again, a decrease in demand is usually analysed by determining the new equilibrium position and the com-paring it with the original one. For this we need to put the supply curve in.

As you can see, if demand decreases, then less is bought (as you might imagine!) and the quantity demandedfalls from Q2 to Q1; price also falls, in this case from P1 to P2

Let us look at supply in more detail

What determines the supply curve, i.e. why is it where it is and not somewhere else?

The answer is, the price, quantity, and quality of inputs used. These consist of things like machinery,equipment, staff and workers, raw materials, and fuel. These are collectively known as “the factors ofproduction”, and are often summarised as land, (L) labour (N) and capital (K) plus a remainder term, R.

Price

Quantity0

D2

P2

Q2

SD1

Q1

P1

Price

Quantity0

S?? S??

12

· Land - is what it says but can include things like diamonds or oil that are found there.

· Labour mostly means workers, but also includes managers.

· Capital means machinery and equipment. A subset of this is“social overhead capital” - like roads,bridges and docks.

[Digression: The whole production of the nation can be summed up as: O = f(L, N, K) + Ror put into words, “output is a function of (= is in some as yet undefined way caused by) land, labour, capi-tal, and a few other things”. You will need this later; I am just sowing a few seeds.]

· The remainder term “R”, which covers things in both labour and capital is the really interesting one

The labour component of “R”. This consists of things like entrepreneurial ability, the managerial methods inuse, labour motivation and how good it is, labour skills, the strength of the trade union and its attitudes, thebonus and other incentive systems in force, the quality of the education system, and the retraining facilitiesavailable in society.

The capital component of “R”. This consists of things like:

The level of technology, knowledge about what technology is available, the adequacy of factory organi-sation, and economies of scale. They can obviously affect the supply curve, or the output possible, if theyare good or bad.

· Maybe the weather, e.g. floods can destroy crops, effect transport, reduce supply, and raiseprice.

· Joint supply - if we increase the number of sheep to supply an increased demand for mutton, it auto-matically increases the wool supply. So the price of related good can be a determinant of supply.Examiners like questions on joint supply, but it is not often encountered in the world in which welive.

· The productivity of the factors of production – this is closely related to technology; but it can also behow hard workers are prepared to work, motivation, and incentives systems etc. (it too can appearseparately, or be included in the remainder term, R, as above).

· The size and number of firms in the industry, including the marketing conditions.

· War and social unrest.

What can cause an increase or decrease in supply?(a shift in the curve)

Like demand, it needs a change in one or more of the determinants. For supply these include things like:· A change in the price of a factor of production.· A change in the productivity of a factor.· New technology invented.· The discovery of a new raw material or fuel.· More worker enthusiasm. This occurs often in war time, because of patriotism.

An increase in supply = the curve shifts downward and to the right (more is supplied at the unchangedprice) - e.g., if labour productivity increases or someone finds a new cheap source of materials.

13

You will notice that the quantity supplied at the unchanged price P1 increases - well, that’s what an increasein supply does!

And if we put in a demand curve we can see both the equilibrium positions and work out that an increase insupply means a fall in price and an increase in the quantity purchased.

Price

Quantity0

SS1 SS2

P1

Q1 Q2

Price

Quantity0

SS1 SS2

D

P1P2

Q1 Q2

14

A decrease in supply is the opposite; the supply curve shifts up and to the left:

Again, less is supplied at any chosen price; we move from a supply of OQ1 to the smaller quantity OQ2.

The new and old equilibrium positions need both a supply curve and a demand curve.

More analysis! A decrease in supply means a fall in the quantity supplied and an increase in price. Work outfor yourself the old and new quantities and prices - good practice!

Price

Quantity0

SS2 SS1

P1

Q2 Q1

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

15

Time Periods And Supply

Three time periods matter:

· the very short run (VSR) (or “momentary supply”),· the short run (SR) , and· the long run (LR).

They have different slopes to their curves and different elasticities (more later!).

The very short run. This is defined as the time when no change can be made in any of the factors of produc-tion – the supply curve is vertical. Examples are the fruit and vegetables that appear in the wholesale marketeach day.

The short run.This is defined as the period in which the variable factors can be altered but not the fixed factors, i.e. we canmake some changes.

· Fixed factors = those that do not vary with output such as factory building, transport fleet, officestaff, and the bill for heating and lighting the premises.

· Variable factors = those that vary directly with output such as raw materials, the energy used, thepetrol in the trucks, and the wages of some unskilled workers who might be taken on whenneeded, perhaps part-time.

The supply curve we usually draw is the short run one.

The long runIs defined as the period when all factors can be varied i.e., the producer can do any changes s/he wants. Thismeans a flatter curve, possibly even downward sloping sometimes.

How the supply curve can vary with the time period we are considering:The flatter the curve, the more elastic it is (“quantity stretches more”). Producers will only make changesthat help them produce more or reduce costs.

Price

Quantity0

S short runfairly inelastic

Falling long run S curve(modern hi tech goods for exampleget cheaper over time)

S long runhigh elasticity

S very short runtotally inelastic

S short run closeto unit inelastic

16

NOTE that all the curves are drawn on the one diagram; this means the scale is the same for all; if you draweach in a separate diagram, the flatter one (S long run) is not necessarily the most elastic, as the horizontalaxis might be on a much wider scale. If this seems incomprehensible to you, Do Not Worry! Just rememberto put them all on the same diagram.

Remember that you should practise drawing the diagrams regularly!

Increases and Extensions of Supply And Demand

We know that the word "increase" means a shift of the curve – but what about extensions?

"Extensions" are movements along an existing curve.

Questions are often set to see if you know the difference between an ”increase” and an “extension”.

[A digression: if a line crosses two others, an increase in one curve always means an extension of the other!The diagram here shows that.

For supply and demand:

With an increase in demand we slide up an unchanged supply curve.

Quantity

Price

D1

S1

P1

Q1

D2

Q2

P2The shift of D1 to D2 isan increase in demand

The sliding up the unchangedS curve is an extension of supply

We see two upwardsloping lines that cross asingle line. The upwardsloping lines reflect anincrease (or decrease)and we slide down (orup) the single line.

It’s clear that an increase in de-mand goes with an extension ofsupply.

17

NOTE that we start on demand curve D1 and supply curve S1 to ascertain the equilibrium price andquantity; then we look at D2 to get the second equilibrium position.

Reminder: In economics, at this level we always start in equilibrium, then we alter something, and move tothe new equilibrium position. We then compare the two equilibrium positions for the analysis.

And we can see an increase in supply goes with an extension of demand, as we slide down an unchangeddemand curve:

With an increase in supply we slide down an unchanged demand curve

Decreases and contractions of supply and demand

A decrease means a new curve, which shifts backwards; a contraction means sliding back along an un-changed curve.

A contraction of demand following a decrease in supply :

Price

Quantity0

SS1 SS2

D

The shift of S1 to S2 isan increase in supply

Sliding down the unchangedD curve is an extension of demand

P1P2

S1 S2

Price

Quantity0

SS2 SS1

D

The shift of S1 to S2 isa decrease in supply

Sliding up the unchanged D curveis a contraction of demand

P2P1

S2 S1

18

A contraction of supply following a decrease in demand:

Here is one of the hoary old trick questions. "Demand increases, so price rises. The rise in price meansfewer can afford the good, so demand decreases and prices fall again." Do you agree with this statement?

Question: what do you think?

At first glance it might seem to make sense. But it is in fact false!

Why is it false? You draw the diagram now on a piece of paper. First increase the demand curve andyou will see the price rise as we extend up the supply curve.

Then think about the new equilibrium. Why on earth should it change? It is an equilibrium position!That was why you learned the definition of equilibrium a little while ago - to be able to detect fallaciesin argument.

This is a proposition in logic, designed to test if you really understand supply and demand. You shouldtry to get the words “extension” and “increase” in to show you can use them properly and you definitelyneed a diagram.

1-4. THE CONCEPT OF ELASTICITY: MEASURING THERESPONSIVENESS OF DEMAND AND SUPPLY (very popular with examiners)

ELASTICITIES

Elasticities are a sort of measure of supply and demand.

If demand increases, and we ask how much does supply extend, we need more than an answer like"quite a lot"!! Government may be trying to raise tax to get a certain amount of revenue for instance.The question is “How much will quantity change, a lot or a little?”

P1

P2

Q1Q200

D1

D2

Quantity

Price

S

Sliding down anunchanged supplycurve is a contractionof supply

19

WE START WITH THE ELASTICITY OF DEMAND

Three broad types of elasticity of demand

1. Price elasticity = the usual one, it deals with 1 good.2. Cross elasticity = a special one, it deals with 2 goods.3. Income elasticity = a special one and it deals with changes in incomes.

1. Price Elasticity of Demand

Definition: "Price elasticity of demand is a measure of the responsiveness of the quantity demandedto a small change in price". Learn this by heart!

[In simpler terms, “is the proportional change in quantity greater or lesser than the change in price?”As an example, if the price was 20 and it falls by 2, the fall is 10% (2 times 100, all divided by 20); andif quantity then increases from 100 to 200, the increase is 100%.

We can see that the increase in Q is greater (100% compared with 10%) - i.e., it stretches out a lot - itis elastic!]

How do we actually measure price elasticity?

Price elasticity of demand is measured by the percentage change in Qd, divided by the percentage changein price:

%∆Qd

%∆P

So the price elasticity of demand is:

∆QQ

------------∆PP

= ∆Q x P Q ∆P

∆Q x Q∆P P

(to divide by fraction invert and multiply)

(gathering the change terms all on side for neatness. Ifthis shuffling makes you unhappy, just remember that3 x 4 is the same as 4 x 3)

20

In the example above, the percentage change in Q was 100 and the percentage changein price was 10 so the elasticity is 100 divided by 10 = 10.0 In the world in which welive this is actually very high! (Anything over 2 in the real world is pretty high.)

Logically the answer can have only 1 of 3 results: <1, = 1, or >1

(< stands for “less than”; > stands for “more than”; if we are looking at “<” left to right, the way we read,we see it goes little to big so it is easy to remember!)

When we look at the fraction, we find that the answer is less than 1 if the top is smaller than the bottom,equal to 1 if the top and bottom are the same, or more than 1 if the top is greater than the bottom.

What does each possible answer mean?a] If the answer is greater than 1 (e.g., 1.62) the demand curve is elastic.

It means that a small change in price led to big change in quantity (Q stretched a lot which means thatit is elastic); graphically the curve tends to look flat when compared with an inelastic curve. Butremember all curves must have the same scale and axis or else be on the same diagram.

Examples of demand curves which are price elastic:

Dell computers (one brand of many substitutes); foreign travel by cheap airlines.

b] If the answer is less than 1, e.g., 0.75, the demand curve is inelastic People do not respond somuch to price cuts and although they buy more, they do not buy a lot more.

Examples:Salt, bread, sets of cutlery (essentials; no substitutes).

c] If the answer just happens to equal 1 it is “unit elastic” (unity = 1), a special case and rarely seen,except perhaps for a small part of a large demand curve! The answer would work out at exactly 1.0 andthe curve is asymptotic; this means that it approaches more and more closely but never quite reaches theaxes.

Reminder: if you draw one rather flat demand curve in one diagram, demand is actually onlyrelatively elastic etc because we do not know the scale - don’t worry about it, it’s technical!Just remember to say “relatively inelastic” or “relatively elastic” in the exam room! If youdraw them on one diagram then you are on safer ground if you just say “elastic”.

What do the different elasticity demand curves look like?Price

Unit elastic D(not well drawn!)

Quantity0

Inelastic D

Elastic D

[The unit elastic de-mand is not drawn well- I am a rotten artist Ifear.]

21

The importance of the elasticity concept

It allows us to get precise answers, not be vague.

We need it for certain questions e.g., if a hairdresser is considering increasing her price for a basic cut from£20 to £25, will profits rise or fall?

What determines price elasticity?

· The number of substitutes - the greater the substitutes, the more elastic the good - a small pricerise means consumers switch to another brand. THIS IS THE MAIN DETERMINANT!

· The proportion of income - the greater the proportion of income going on good, the more elasticit tends to be. Salt is relatively inelastic and very cheap - would you consume a £2’s worth a year?

· Luxuries and necessities - luxuries tend to be more elastic (airfares, foreign travel); necessitiesmore inelastic (electricity). Some economists do not like this “luxuries” point because whatconstitutes a luxury alters too much and in addition they can be personal to different individuals.

· Time - the longer the time, the more elastic demand tends to be, probably because

· More substitutes become available , the good or service is copied by others, new manufac-turers can enter, imports be made etc.

· Habits change only slowly, so we adjust to new prices slowly.· Capital may need to wear out to make change, e.g., if the price of petrol rises, drivers have

to wait until it is time to buy a new and smaller car in order to reduce petrol consumption.

Q. For the hairdresser earlier who is considering a price rise, I asked earlier what would happen to her profit if shecharged more. Assume she is very good and her clients feel that there is no real substitute?

A. The demand curve for her services is inelastic so profit would rise!

Q. But consider what would happen if she were just another high street hair dresser?

Draw the diagram for me now!

Another example of the importance of elasticity: if the government raises the tax on cigarettes, willgovernment revenue rise or fall? And by how much?

The government normally wishes to raise more revenue - although there are health benefits if peoplereduce cigarette consumption, which saves on National Health Service expenditure too.If the government raises tax by 5% and demand is inelastic, the quantity will fall as price rises, but itwill fall by less than 5%, so revenue will increase.

If the government imposes an indirect tax, it pushes up the supply curve by the exact amount of tax.

If the tax is absolute e.g., £1 each item, it pushes the curve up parallel. The original producer faces nochange in supply conditions, but £1 is added to each quantity.

22

When we draw the diagram for the imposition of indirect tax: we start at the original equilibrium, andadd the tax.

When we look at the market equilibrium, we start with a supply and demand curve and see the originalequilibrium. We then add the tax, which pushes up the supply curve and look at the new equilibriumposition, to see what changes the tax has made.

We can see that the original equilibrium position P1Q1 becomes P2Q2 once the tax is imposed. Thereis a rise in price - but by less than the whole tax - and there is a fall in quantity.

The increase in tax per unit is AC, but the price only goes from P1 to P2 = BC; and BC is less than AC(price rises but by less than the whole amount of tax per unit)

Price

Quantity0

SS2 SS1

P1

Q1

P2

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

C

BA

Note that the supplier workson the original S1 curve - theS2 curve merely includes thegovernment tax.

23

What about the change in government revenue? This is the quantity now sold (OQ2 at the newequilibrium position = the number of units) times the tax per unit (AC). This is the area bounded byP2CAP3 in the diagram below.

If the indirect tax is ad valorem (proportional not absolute, e.g., 10%) it pushes up the supply curveat an increasing rate

Q. Why?

A. Because 10% of £1 is only 10P, but 10% of £10 is £1!

Price

Quantity0

S2

S1

D

P2P1

Q2 Q1

C

BA

S2S1

P2

P1

P3

Q1Q2

0

A

B

C

D

Price

Quantity

24

A subsidy is just a negative tax e.g., government gives producer some money (subsidy) ratherthan a producer or consumer giving money to the government (tax).

Subsidy questions are not usually as interesting as tax ones!

Let’s draw the diagram for putting on a subsidy.

We start, as ever, in the initial equilibrium position, P1Q1 on the curves S1 and D1. The subsidy goeson, the size of it is P1 to P2, and the new supply curve is S2. You can see that the unchanged quantity,Q1, is now cheaper at price P2- but we have not yet examined the new equilibrium position to see theresults of the change.

What is the total amount of the subsidy, i.e., the cost to the government? We need to look at the newequilibrium position, which will be at P2Q2, below.

Price

Quantity0

SS1 SS2

D

P1

P2

Q1

Price

Quantity0

SS1 SS2

D

P1P2

Q1

A

B

Q225

The subsidy is AB for each unit in the diagram above.The quantity sold after the subsidy is imposed is OQ2.

So how much does the subsidy cost the government, and ultimately the tax payer?

The subsidy the government pays is the new quantity sold, (0Q2) times the subsidy amount per unit ofBA.We know that BA is the same as CD because the curve shifts parallel.We know that the suppliers continue with curve S1, so they require price 0P3 for quantity 0Q2 (Notethat the supplier works off the original supply curve - there has been no change in the determinants ofhis or her supply.)We see that consumers pay the rectangle 0Q2CP2.We see that the government pays the rectangle P2CDP3 - this is the subsidy cost to the tax payer.And together these add up to the total expenditure of 0Q2DP3.Notice also that consumption rises from 0Q1 to 0Q2 - which is the point of the subsidy: more is pro-duced and consumed.

The limits of price elasticity of demand

Perfectly elastic = a horizontal line; this means that consumers will demand an infinite amount at thatprice! It is merely a limit and obviously it cannot be reached.

Perfectly inelastic = vertical line; this means that consumers will pay any amount at all, such as £1, or £1million, or £1 trillion…. to buy the good or service. Again this is unreasonable, it’s merely a limit. Theylook like this:

Price

Quantity0

SS1 SS2

D

P1P2

Q1

A

B

Q2

P3

C

D

Price

Quantity0

Perfectly inelastic demand

Perfectly elastic demand

26

2. Cross Elasticity of Demand

Definition: "Cross elasticity of demand is a measure of the responsiveness of the quantity demanded ofone good or service to a small change in price of another". Learn this! It is virtually the same as thedefinition of price elasticity earlier - go on, compare them now!

Cross elasticity measures substitutes and complements (note the spelling; it is not “compliments”)

If the supply of beef increases so the equilibrium price falls, it may induce some people to switch fromeating chicken or pork to eating the now cheaper beef. The fall in price of beef causes a decrease inquantity demanded of chicken or pork.

%∆Qd of good A

%∆P of good B

Note the “A” and “B” difference: we are dividing the percentage change in the quantity of A by thechange in the price of B.

If the price of beef fell and the quantity of chicken fell the answer will be positive, because two negativesmake a positive, so any items with a positive cross elasticity are substitutes.

If the price of heating oil falls it may induce some to install oil generated central heating in houses. Wesee that a fall in the price of A means an increase in the quantity of generators, so the answer is nega-tive (one plus and one minus) so these two goods are complements.

Cross elasticity does not seem to be used much in economics, except in exams.

3. Income Elasticity of Demand

Now this is most important! Incomes keep increasing over time, so the demand pattern for various goodsand services keeps changing. This matters for new firms looking to move into the market and producesomething: the market for what goods or services is likely to grow the fastest? That’s the area to be in! Itmatters for existing firms looking to diversify, or be concerned about the prospects for the future in thearea they produce and sell in.

Definition: "Income elasticity of demand is a measure of the responsiveness of the quantity demandedof a good or service to a small change in income". Learn!

Income elastic: a given change in income leads to a greater than proportionate increase in demand forthe good or service. Examples of income elastic goods: foreign travel, good wines, smart motor cars,eating in restaurants, and currently well-regarded brands, e.g., Adidas sportswear or Rolex watches.

Income inelastic: a given change in income leads to a less than proportionate increase in demand forthe good or service. Examples: bread, staple foods generally, cheap stores, and all lowly-regardedbrands. If our income happens to double (lucky us!) we do not spend twice as much on such items.

Income neutral elastic: should it just happen that, say, a 5% increase in income leads to a 5% increase indemand for a good or service, then it is income neutral elastic. This is not really an interesting case,merely a bit strange. Oddly enough, Pizza Hut in Australia claimed in the 1990s that they were like this:in a recession some people stopped eating out so stopped going to Pizza Hut, but other people switchedfrom “proper” restaurants to Pizza Hut which cancelled things out, so the company did not suffer!

Income negative elastic: this is most interesting! This happens when an increase in income causes a fallin demand. Really it indicates that we dislike this product but for some reason we must consume it atthe time. When we can afford not to consume it, then we stop buying it. Examiners like this concept!

27

Examples are scarce, but it is suggested that probably potatoes were like this in Ireland during the Nine-teenth century. Currently, the demand for mealies (sweet corn) in some African countries may be in-come negative elastic. It is a rare event anyway. Negative income elasticity means that it is an “inferiorgood”.

THE ELASTICITY OF SUPPLY

Definition: the responsiveness of the quantity supplied to a small change in price. It is measured by:

%∆Qs%∆P

The measure roughly indicates the slope of the supply curve; the steeper the more inelastic. Why isthis only “roughly”? Because it depends on the scale of the diagram - for instance both the diagramsbelow have the same elasticity, but because the horizontal scale is not the same the slopes look differ-ent. That is why we have to draw two different elasticities on the same diagram where the scale is thesame.

BUT unit elastic supply is any straight line that cuts through the origin! (Just remember this, and donot worry! If you are a mathematician, you may already see why.)

Price

Quantity

Price

Quantity0ll ll ll l l ll l ll l

l

l

l

x x

xx

1 2 3 4 5 1 2 3 4 5

S S

Price

Quantity0

S

S

28

Supply periods and time: (covered briefly earlier)

Very short run = totally inelastic supply = fixed supply (e.g., the amount in a wholesale vegetablemarket delivered each morning; all the works of dead painters or sculptors).

Short run = perhaps moderately inelastic.

Long run = more elastic; or even negative elasticity (it slopes downward).

Why is supply more elastic in the long run?

Because the company can alter both the fixed and variable factors (i.e., all the factors of production). Itcan also find new or cheaper sources of raw materials; improve the training of labour; and introducenew technology or better machines. This allows the company to obtain more output without needingmuch increase in price.

The downward sloping supply curve in the long run is already familiar to you: computers, scanners,TV sets, digital cameras, DVD players and discs, CD players and discs….. Most if not all of the prod-ucts of modern hi-tech industry fall into this category. As the years go by, they get better and a lotcheaper.

Elasticity of supply is probably a bit less interesting to economists than the elasticities of demand - andit is easier to learn as there is less of it!

Price

Quantity0

S short runfairly inelastic

Falling long run S curve(modern hi tech goods for exampleget cheaper over time)

S long runhigh elasticity

S very short runtotally inelastic

S short run closeto unit inelastic

29

1-5. DEMAND AND SUPPLY: APPLICATIONS TO ANY MARKET ARE POSSIBLE

Popular ones that examiners often like to set a question about include:· Housing· Foreign exchange· Agricultural products or raw material production, like tin or coal (often inelastic S and D so fluc-

tuations are common)

But the analysis is virtually identical in each case! You need to mention supply and demand very early inyour answer and then use supply and demand analysis, drawing the curves you need.

Be prepared to handle:

· The concept of equilibrium· The determinants of supply and of demand· An increase in demand and a decrease in demand· An increase in supply and a decrease in supply· An extension of both demand and supply· The elasticity of demand and supply· Minimum price fixing (examined in Unit 2)· Maximum price fixing (examined in Unit 2)· Applying an indirect tax (which shifts S curve up and to right).

An example of foreign exchange

You must use a diagram or two!

The value of a currency is determined by the supply and demand for it - just like any other good orservice, it is the normal equilibrium diagram you need.

The supply of £’s comes from the UK importing goods and services from abroad. We pay in pounds toa bank, which uses them to buy the US $ etc. that we need to pay the foreign supplier. If we import more,we increase the supply of pounds on the market, thus putting pressure on the pound to fall in value.Similarly, if we export, we buy the pounds back, thereby increasing the demand for pounds.

You could usefully practice drawing diagrams to fit these scenarios. They are the standard increase insupply and decrease in supply diagrams, but with “Quantity of £” on the horizontal axis and “Price of £in $” on the vertical one. We have to value the pound in some other currency, such as US$.

Quantity of pounds ininternational markets

Value of thepound in $

D1

S1

($)P1

Q10

30

If the UK increases its imports, this puts more pounds on the international markets as we pay for theextra imports. This means an increase in the balance of trade deficit. This increase in supply then putspressure on the value of the pound, which falls.

If foreign holders of pounds, largely banks but also others such as large international companies aswell as international speculators, decide the pound is overvalued and about to fall, they might sell. Theresults are the same: the increase in supply reduces the value of the pound. This may be termed “selfjustifying expectations”.

An example of the labour market.

If the UK allows more migrants in, this increases the supply of labour. Because many migrants arerelatively young males, they add to the supply of labour, normally producing more than they take outin social security benefits.

The increase in the supply of labour puts pressure on to lower wages, especially for the unskilled orsemi-skilled. It is difficult for many migrants to find more professional work unless their English isgood; they tend to end up in the unskilled sector, even if they have skills and abilities, until their lan-guage skill improves sufficiently and this can take many months or years.

The result is the normal diagram for an increase in supply, in this case of labour. You need the quantityof labour on the horizontal axis and wages on the vertical. Go on, draw it now!

Remember! You must use diagrams to answer questions about price or wages. Many markers glance atthe diagrams first and if they are correct, he or she is immediately disposed to give you a good mark anda decent pass! If your diagrams are clear and correct, they might also give you the benefit of the doubtif they have trouble with your handwriting or standard of grammatical English. In the exam room ineconomics it is virtually impossible to get a good mark without diagrams.

Quantity of pounds ininternational markets

Value of thepound in $

D1

S1

($)P1

Q10

S2

($)P2

Q2

31

1-6 LET’S RECAP AND SHOW THE MARKET MECHANISM WORKING IN ALL ITSGLORY IN A PERFECT WORLD

In a perfect world, a market system will give a perfect result - resources will be allocated exactly towhere people need them to produce what the people demand.

Think supply and demand curves for two goods, both in equilibrium; assume people spend all theirmoney (as this is easier to imagine how it works). Then increase the demand for one good (which meansyou must reduce demand for the other, because they are spending all their money by assumption).

First we look at the goods market - let’s assume they are bread and milk; we start in equilibrium, thenwe will increase the demand for one good and see what happens.

Secondly, we examine the factor market which lies below the goods market. That consists of thoseresources that are used to produce the bread and milk. We use the labour market as the factor of production.

We have simplified the model by using two goods and one factor to show the perfect workings of themarket. With any number of goods and services and more factors we can still get this perfect resourceallocation.

(The whole of Unit One in this course is devoted to this market solution. Unit Two will explain why wemay not in fact attain this theoretical perfection.)

Abbreviations used:

MC = marginal costAC = average costP = priceQ = quantityMR = marginal revenueLab = labourAR = average revenuePPC = production possibility curve (production frontier)

32

We start with the market for goods or services (bread and milk) in equilibrium

And we can also examine the factor market for these goods; in this case we will use the people who makethe bread and produce the milk (Unit 4 covers labour markets in detail). Again we start in equilibrium.(The two diagrams below do not have to look exactly the same as the two above; they just have to benormal supply and demand curves.)

Price

D

P

Quantity0 Q

S

Price

D

P

Quantity0 Q

S

Bread Milk

Wage

D

W

Quantityof labour

0 Qlab

S

Wage

D

W

0 Qlab

S

Bread workers

Quantityof labour

Milk workers

33

THEN, WE CHANGE SOMETHING AND ALTER THE EQUILIBRIUM POSITIONS

let’s increase the demand for bread and reduce the demand for milk. (On the assumption that all in-come is spent, if people spend more on bread they must spend less on milk.) We start as usual in equi-librium, on the demand curve for bread, “D1” and increase it to “D2”. People switch to consumingmore bread and away from milk, so the demand for milk falls, from D1 to D2.

You can see on the left that the price of bread rises (people demand it more) and on the right the price ofmilk falls (less demand).

Because of this change in the demand pattern, we get an increase in the demand for workers to producemore bread and a fall in the demand for milk workers - and we will reach a new equilibrium in the factormarket.

Again, demand increases from “D” to “D1” for the bread workers, and falls from “D” to “D1” for themilk workers.

You can see on the right that wages rise where demand for the product has increased (bread), and onthe left they fall where the product is less in demand than previously (milk).

Price

D1

P1

Quantity0 Q1

S

Price

D1

P1

Quantity0 Q1

S

Bread Milk

D2

D2

Q2Q2

P2

P2

Wage

D1

W1

Quantityof labour

0 Qlab1

S

Wage

D1

W1

0 Qlab1

S

Bread workers

Quantityof labour

Milk workers

D2

D2

W2

W2

Qlab2 Qlab2

34

We can put changes in goods/services market and factor markets together into one diagram, one directlyabove the other and read it vertically to see what happens to the factors of production in both industriesas demand changes.

We see, as the demand for a good or service increases (top left hand side), this sucks factors into thatindustry - but where do they come from?

They come from the contracting industry, where the demand for a good or service has decreased (topright hand side) - the factors of production (land, capital and workers) have to leave that industry (inthe real world, if unemployment already existed, some of the unemployed might be drawn into work).

Where demand for a good or service falls, the workers might simply be dismissed - which reallyannoyspeople, upsets the trade unions, and might have a political fallout with loss of support for the government.

Or the firms may take advantage of “natural wastage”; that is to say that is to say, as people voluntarily leave,they are not replaced.

Price

D1

P1

Quantity0 Q1

S

Price

D1

P1

Quantity0 Q1

S

Bread Milk

D2

D2

Q2 Q2

P2

P2

Wage

D1

W1

Quantityof labour

0 Qlab1

S

Wage

D1

W1

0 Qlab1

S

Bread workers

Quantityof labour

Milk workers

D2

D2

W2

W2

Qlab2 Qlab2

Trace the lines downfrom the equilibriumpositions in the goodsmarket to the corre-sponding equilibriumin the labour marketfor the workers need-ed to produce thequantity in the top di-agrams

35

Who leaves? Several groups may be involved:

· old workers who are retiring because of age· those who get ill and retire· those resigning and moving to a better job as part of a career move· those who move to a new area of the country, following their spouse, to get to a better climate

or school area for instance· those who migrate to a different country· those who die

Unemployed people are naturally very upset and social problems can emerge which the governmentmay have to deal with. But with capital, e.g., trucks, or warehousing facilities, shifting the use of thesecauses little upset - things have no feelings! They may be sold or leased to other companies to use.

Land is similar to capital, it can often be transferred to several other uses fairly easily.

The above diagrams of resources moving from declining sectors to expanding ones and stoppingin equilibrium demonstrate the way the market mechanism (price mechanism) operates.

This was first spotted by Adam Smith in the Wealth of Nations as early as 1776 although the diagramsdid not come until later. Understanding how an economic system works in this fashion led to the phrase“the consumer is king” as the next sentence explains.

Resources (land, labour and capital) flow from where they are not in demand, or demand is falling, towhere they are in demand, or demand is rising. So the price mechanism is well-regarded as a good (butby no means perfect) way of allocating resources to society’s demands.

Later, in Unit 2 “Why markets fail” you will learn what can, and actually does, go wrong with thisapparently brilliant market system.

A reminder: are you revising something and practising drawing a few diagrams each day?

36

1-7 CONSUMER AND PRODUCER SURPLUS

We know that there is an equilibrium market price at which both consumers buy and suppliers sell. Butwhat about the consumers and producers who are not themselves exactly at that equilibrium price? Theyreceive a benefit.

For consumers, we can see from the demand curve that the first consumer, buying at 1 on the quantityaxis, would be willing to pay P1, which is much more than the market price he or she has to pay (P mkt).So the column above P mkt is a sort of surplus that the first buyer enjoys!

Similarly, for the second buyer, at 2 on the quantity axis; and the same goes for the third and subsequentbuyers until we get out to Q1 and P Mkt. All these early consumers would pay more but do not have todo so - and they gain a lot of extra enjoyment as a result. Eventually the whole triangle above P Mkt isfilled in; and the filled in bit of this triangle, indicated by an arrow, is the consumer surplus.

For producers, we have an analogous argument. Some would be willing to supply more cheaply thanthe equilibrium price, P Mkt. In the diagram below, we can see from the supply curve that the supplierof the first unit would be happy to do this at a price well below P Mkt. The column above quantity 1 upto P Mkt is again a sort of extra or surplus - which in this case belonging to the producers.

Moving to quantity 2, again we can see a column, but a bit smaller than for quantity 1. And as we moveout towards Q1, the triangle above the supply curve but below P Mkt is filled in. The arrow again pointsto it. This is “the producers’ surplus”.

Price

Quantity0

D

P mkt

Q

P1

1 2 3

This triangle is theconsumer surplus

Price

Quantity0

P mkt

P1

This triangle is theproduce surplus

S

1 2 3 Q1

37

If we put the two diagrams together, we can see that both the triangles thus make up the total con-sumer surplus and the producer surplus.

Use of the concept

With indirect taxation, the imposition of a tax (or if there already is such a tax, an increase or decreasein such a tax) may impinge more on consumers than producers - or vice versa! “Who gains themost (or who loses the most)?” is the question. This may be called “the incidence of taxation”, “the taxburden”, or a question may be asked, such as “who bears the brunt of the tax?”

The answer as to who gains or loses the most depends on the elasticities involved.

Let us assume that an indirect tax on a good increases. If demand is highly inelastic (consumers willpay almost any high price without reducing consumption much) then the increase must largely fall onthese consumers - they are simply willing to pay!We know they are prepared to do so because the demand curve is relatively inelastic and that is whatinelastic demand means. Cigarettes probably fall into this category, as do all addictive drugs.

Think of a vertical demand curve: if we increase the tax, the supply curve just moves up; there is nochange in the quantity demanded; suppliers still receive the old price (reading off their supply curve S1;the gap between S1 and S2 is all tax and goes to the government not to the supplier). There is clearlyno loss of producer surplus as their situation has not changed at all - and consumers pay all the difference:

Price

Quantity0

P mkt

P1

This triangle is theproducer surplus

S

1 2 3 Q1

This triangle is theconsumer surplus

D

Price

Quantity0

Perfectly inelastic demand

S1

S2

P1

P2

38

It can be proved, but you can take it on trust, that if the elasticity of demand is lower than the elasticityof supply, the consumer loses more than the supplier! In other words, it is the relative elasticities thatcount.

The usual supply and demand situation divides the incidence of tax (who pays it, or more of it) betweensuppliers and consumers - and of course the incidence falls heavier on the side which is relativelyinelastic.You may get a question about the incidence of tax - or one about imposing (or increasing) an indirecttax.

A reminder: in introductory economics we nearly always use “static equilibrium analysis” which meanswe start in equilibrium, change something, and analyse the result.

Who then bears the burden of tax when an indirect tax increases? See the diagram below.

We start on the curves S1 and Demand, with the equilibrium price P1 and quantity Q1.

Then we add a tax (or increase an existing tax!) which shifts the supply curve up to S2, by the amountof the tax. Any tax per unit shifts the supply curve up vertically; the tax is the line BD in the diagramabove.

Having made our change, we look at the result: consumers pay BC of the tax, and producers pay CDof it. The distance CD is smaller than the distance BC, the consumer pays more of the tax, and wealso know that the elasticity of supply must be greater than the elasticity of demand!

We can also look at the areas and see the changes in both surpluses:The consumer surplus reduces by ABC.The producer surplus reduces by ACD.

In Unit 4, “Industrial economics”, we again use the concept of surpluses in our monopoly diagram. Wecan show the deadweight loss of monopoly, as well as the loss of consumer surplus and the increase inthe producer surplus that results from the monopolist being able to set the quantity that he or she pro-duces which results in the most profitable price possible. More of this later!

Price

Quantity0

S1

S2

P1

P2

Demand

AC

B

D

Q1Q2

39

“Five Stars

Although I wish I had read this book before starting uni, Iam still finding it very useful and relevant as I prepare forsecond year. It is jam-packed with useful hints and tips tomake not just study easier and more enjoyable, but thewhole uni experience. It is simply written and also quitefunny which aids readability.

This book is very comprehensive. It covers pretty mucheverything a person new to uni would want to know - fromfinances and transport, through to what to expect in theway of lectures, seminars, tutorials, lab work and oral pres-entations, as well as providing advice on how to writeessays and prepare for exams.” Michael Bower, Amazonreview

If you are finding these free notes useful and feel that you might need a bit of help inwriting essays, getting better marks in exams, and learning more quickly and easily,take a look at a book I have written to help you do better - Going to University: theSecrets of Success, 2nd Revised and Expanded Edition. This can be ordered in anybookshop or is available online from Amazon, Blackwell’s, Foyles, Waterstone’s andWH Smith, amongst other outlets. Make sure you ask for the second edition as a fewplaces may still carry the earlier edition which is both more expensive and less up todate.

40

Copyright Kevin Bucknall

Module 2881 Unit 2: The Market System - WhyMarkets Can Fail

2-1. INTRODUCTION

As we learned in Unit 1, in a perfect world the price mechanism can give us a perfectallocation of resources: what is demanded is produced, changes in demand lead tochanges in what is produced, and the workers move from a dying industry to agrowing one.

But the world is not perfect! Some things stop us getting to this beautiful marketsolution. It only needs one of these particular elements to be operative, and wewill fail to reach the perfect market solution above!

And in fact most of them are frequently operative in the real world in which we live!So we know that free markets do not give a perfect answer. However, we have yet tofind a better way to get what we want produced: running the whole economy bycentral planning gives even worse results. So, poor as they may be, free markets arestill the best way we have found for organising the economy. So almost all countriesuse the market system, then whenever as a society we do not like a particular resultthat they give, the government can step in and change it.

Listing these 8 major factors:

Unit Two deals with such imperfections and reasons for market failure. We will gothrough them in the order just listed.

Q. What can we do if some or all of these are operating and preventing a good marketresult?

A. The government can intervene and put it right.

NB These Units are a way of organising the teaching and learning of economics. You can useknowledge from one unit when answering a question in another unit – and youshould!

o Monopoly elements or market dominance.o Externalities.o Public goods.o Merit goods.o De-merit goods.o Information failures.o Factor immobility.o Undesirable income and wealth distribution.

41


What does market failure mean?

It means that we do not have full efficiency; we could produce more with theresources we have; and we could satisfy consumer demands better with the resourceswe have. There is waste in the system.

Types of efficiency in economics:

A.) Allocative efficiency. This means good resource allocation, when we cannotmake any consumer better off without making some other consumer worse off.

This approach looks at the given resources and tries to get the most output from them– and it also means that firms sell at a fair price to consumers that reflects the realresource use.

B.) Productive efficiency. This means that production is done at the lowest possiblecost.

• We are at the bottom of the average cost curve (which is always U-shaped). Inthat position we have what is called “X-efficiency”.

• And this means we are also on the production frontier, not somewhere insideit.

A.) Allocative efficiency

Allocative efficiency occurs when the value the consumer puts on a good or servicesis the same as the cost of the resources used in producing it. This occurs when price= marginal cost! In this position, total economic welfare is maximised.

In the perfect competition diagram below, where MC = MR for the firm, we haveallocative efficiency because the firm’s price is the marginal revenue (it can sell anyamount at the unchanged price - each extra unit sold at that price provides themarginal revenue), so MC = P. In fact, at that point we have more equalities MC = P= MR = AR.

“AR” is merely another word for price – it is “average revenue” which we get bydividing total revenue by quantity. We know that quantity multiplied by price givesus total revenue, so it follows that price actually is average revenue.

42


AC

0

Price, Costs

Output

P

MC

Ot

B.) Productive efficiency

This exists when we are actually on the production frontier. That means we are usingthe least resources we can. In turn, it says that we are at minimum average costs = thebottom of the AC curve.

Perfect competition is like this – so economists prefer this position and you will recallthat it is known as “X-efficiency” – it is where we are totally efficient.

Where market equilibrium is totally efficient, we cannot make someone better offwithout making someone else worse off (this is sometimes called “the Paretooptimum position”).

The production possibility curve:

When we are below the production possibility curve (e.g., at “X” in the diagrambelow), we can move north-east and get onto the curve, thus making everyone betteroff; only when we are on it do we have proper productive efficiency.

And only when we are on it does the concept of opportunity cost arise. If we arebelow it, we do not have to give anything up to get more of the other thing; we canhave more of both simply by moving out to the curve.

43


Note: we can have allocative efficiency and productive efficiency but still haveinequity in the country, which can also stop us reaching “perfection”.

Example 1. If you personally have all the income in your suburb, the other residentswill be poor and might even starve, which does not sound at all like perfect! Themarket system is amoral i.e., it is not concerned with good or bad. Economics is notabout ethics.

Example 2. Drug dealers could wait at the gates of primary schools, give away drugsfor free to six year old children and in this way build up a market as they becomeaddicted. This would create a demand, which the drug dealers could then supply later– at a price. Most people would regard this situation as totally wrong, exploitative,and immoral – but the market would be working - and possibly very “efficiently” too.

Social efficiency matter not just private!

We might produce too much or too little as a society, for our own good, even if haveperfect competition and an acceptable distribution of income and nothing illegal orimmoral is occurring. This can happen because of externalities. We move on toconsider these next.

NB The whole of Unit Two consists of two main components:

1. What is efficiency, why the market mechanism (price mechanism) provides thebest solution for allocating resources to meet consumer demand, (Unit 1 is how itdoes this, with some overlap on why it is best). You need to be able to defend thisproposition.

2. What prevents the market mechanism from achieving this perfection, which is thecore of this whole unit. You also need to know and answer questions about howthis prevents the achievement of perfection – hence you need to understand whatefficiency is! We turn to consider in detail the things that stop the pricemechanism working perfectly next.

Apples

ppc1

0 Bananas

Apples

ppc1X

Bananas0

44


2-2. MONOPOLY ELEMENTS OR MARKET DOMINANCE = the firstreason for free markets not working perfectly

TR = total revenue.TC = total costs.

MONOPOLY

What is a monopoly?

Definition: Technically a monopolist is a sole supplier, that is to say, one firm is theindustry.

But there are degrees of monopoly - if one firm supplies, say, eighty per cent of themarket, it is close to being a monopolist and will usually act like one.

If two (or more) firms supply most of the output, it pays them to work together, to actlike a monopoly, and to keep prices high (if there are two firms we call it “aduopoly”).

Types of monopoly, (sometimes called “causes of monopoly”; "sources ofmonopoly"; or "conditions for monopoly"

• Economies of scale, i.e. one firm grows large, its costs fall as a result andbecome lower than the others, so it can reduce its price and sell more produce.The others cannot compete because they are small and higher cost. The firmgrows to become the sole one, which then supplies the entire market. Wereturn to examine economies of scale in more detail later.

• The result of law – the government may restrict an industry to one hugenationalised firm, e.g., British Steel in 1964 - or a trade union can have amonopoly over the supply of one kind of labour – the British MedicalAssociation for instance is the trade union for doctors and can stronglyinfluence their supply.

• An agreement between firms, so that all act together as one monopolist - oftenit is illegal but it happens. We call this a cartel. This can happen underoligopoly conditions (which are covered later).

• Exclusive ownership of a unique resource: perhaps there is only one source ofsupply of a raw material, e.g., all the known supply of iron ore in Australiawas once in the hands of a company called BHP, until new sources werediscovered. As another example, in South Africa, de Beers once ownedvirtually all the diamond mining and it still has control over much of theglobal diamond supply.

45


• Copyrights, patents and licences are particular forms of this exclusiveownership.

• So-called natural monopoly. This is often the result of economies of scale -e.g., electricity supply, telephone supply, or railways - because we do not wanttwenty different sets of rail lines, all parallel, between London andBirmingham!

Problems with monopoly (what is wrong with monopoly or "the welfare effectsof monopoly")

• It limits output and keeps price high - as just said. Really this means that amonopolist misallocates (and misuses) resources.

• This behaviour of the monopolist redistributes income from all the consumersof the product (they are paying more than they need) to one firm or person (themonopolist). This is an equity issue.

• A monopolist may develop political and social power over others whichreduces the efficiency of democracy and the amount of equity. There is astrong political danger from a very few rich and powerful people emergingand changing the course of events. Conrad Black? Robert Maxwell? It seemsto be most serious in the media area, like newspapers or TV, as they caninfluence the way people think or what they believe.

• A monopolist may behave badly in an anti-social way. For instance, he or shemay force out a potential rival firm by selling at give-away prices (well belowcost). After they have forced out the honest competitor, they will put the priceback up again.

• **5. Lack of competition tends to encourage inefficiency in the firm. Themonopolist tends to rest on his laurels, has no need to try hard, and lacksdynamism – this is probably the main criticism - said Austin Robinson.

• As a result, we can get the emergence of lazy managers and owners.

• And it may mean that technical progress is slow, leading to slow growth of thecountry as a whole, and a lower standard of living than we could enjoy.

• A monopoly breeds inefficiency which means that the cost curves will behigher than they need be; this means that the intersection of MC and MR maybe higher.

• Resources are misallocated - too many are going to the monopolist who doesnot fully use them. This is a waste for society. It really means that the pricemechanism is prevented from working efficiently.

46


• A monopoly may reduce consumer choice. He may ignore small marketdemands as he cannot be bothered to meet them. As Henry Ford is reputed tohave said about his motor cars “You can have any colour you want, as long asit’s black”.

A quick question: which of the following 10 main economic goals does monopoly hurt?

1. To maximise (raise) economic growth.2. To minimise (reduce) unemployment.3. To end (reduce) inflation.4. To increase the standard of living.5. To keep a satisfactory balance of payments.6. To maintain a satisfactory international value of the currency (£).7. To allocate resources in the best way (to meet the needs of society).8. To obtain an acceptable distribution of income.9. To look after the environment.10. To avoid unwanted fluctuations in above items.

THINK FIRST; WRITE DOWN THE NUMBERS YOU THINK MONOPOLYDAMAGES – THEN TURN TO THE NEXT PAGE AND CHECK

Monopoly equilibrium

The starting place: identify where MC=MR and set the quantity! Later we read the price off the demand(average revenue) curve, to determine the amount of monopoly profit in equilibrium.

Price, Costs

AC MC

Output0

MR

D

Price, Costs

Output

ACMC

MR

D

0

P

Q

AC

The arrow shows where MC = MR and this determines thequantity that will be produced in equilibrium

Once the Q is set, we can read off the price fromthe Demand curve. The monopoly profit is TotalRevenue (P x Q) minus Total Costs (AC x 0Q) orthe coloured bit on the diagram

47


[ANSWERS TO THE EARLIER QUESTION

The long run damaging effects may include slower growth; a lower standard of living;higher unemployment (because employ fewer); higher prices; a slightly poorerbalance of payments; less equal income distribution; and poor resource allocation.That is to say, most of the goals! In the exam room, the inefficiency in resourceallocation, the higher costs, and the monopoly profit are usually worth stressing. ]

Benefits of Monopoly

There are few benefits really - economists are almost united in opposition tomonopolies, and many are against both public and private ones – those on the politicalleft wing tend to prefer public ones more than those on the right wing.

Economists usually favour reducing or ending monopolies and increasingcompetition.

BUT some defence is possible!

• The monopoly profits can be used for research and development, leading toproduct improvement, faster growth, and lower costs.

Joseph Schumpeter's argument on innovation - that big firms are the only onesable to afford the necessary laboratories and research staff – may apply.

Against this, research shows that many breakthroughs come from smallerfirms, not the large ones. For instance, Apple computers began in a garage.

• A monopolist may reap economies of scale, e.g., the Royal Mail, telephonelines, electricity supply, gas supply, or the railways. This means lower costs.

• A redistribution of income is not too bad perhaps:

It is always happening in a dynamic economy anyway.

If necessary, it can be corrected by government action.

Price, Costs

Output

ACMC

MR

D

0

P

Q

AC

If not in equilibrium, the monopolist is not maximising profit. If for instance price is abovemarginal revenue and marginal cost AND MR is greater than MC (I.e. anywhere to the left of Q)profit can be increased by producing more and moving to quantity OQ.

48


OLIGOPOLY

Oligopoly is where there are only a few producers or sellers (between three and ninemaybe! The number is not fixed), so the actions of one can affect another - who may (ormay not) choose to react in some way. For example, if firm A reduces its selling price,firm B may choose to reduce its selling price, or just leave it where it is and instead toincrease its advertising, expand its sales force, or take other measures. Because of theinherent uncertainty of the reaction of rivals, rather than one model of oligopoly, wehave several types, which is to say there is no general theory of oligopoly!

Examples of oligopoly:

In Britain only three companies controlled all computer sales from shops in the highstreet (the main shopping areas) in 1998; they operated under a variety of differentnames, so the consumers thought there was a lot more competition than really existed.

In the same year, De Beers had a 70% share of the marketing of the world’s qualitydiamonds.

The degree of oligopoly is measured by “the concentration ratio”

• This can be measured at the level of, say, three firms, or five firms or sevenfirms.

• The concentration ratio measures their combined share of the total market.• We can measure the share of employment or output in that particular industry

- or both.

An example of the UK in 1992: the 5-Firm concentration ratio:

• Iron & steel had 90.9% measured by employment and 95.3% by gross output.• Wines, cider and perry: 97.7% by employment and 99.5% by gross output.• Tobacco; 97.7% by employment and 99.5% by gross output.

What can increase the concentration ratio? (i.e., reduce competition)

• A merger within the industry (between a firm already in the top 3, or 5 etc. and amuch smaller one previously outside).

• When a large firm (in the top 5 etc.) takes customers away from a small oneoutside the top few.

CARTELS

Cartels work like a monopoly. A cartel exists when several suppliers get together tosell as a group, i.e., they reduce the competition and form a monopoly. The object isto increase profits, usually by increasing the price jointly, to lower the risks, and tokeep out new entrants.

It is often found in the primary produce - usually they say they wish to stabilise theprice – but they actually try to increase it in many cases.

49


Cartels are common with oligopoly. Firms get together and transfer power to thecentre in order to act as one firm. In effect they behave like a single monopolist, therebyobtaining monopoly profits. These will be higher than they can get by competing witheach other. This is called “collusion”.

Cartels are inherently unstable, because:

• It is always in the interests of one member to break the rules, and reduce itsprice a bit, or sell more than it has agreed, so increasing its profits. Effectively,the individual faces a more elastic demand curve than the cartel as a whole!

• The higher (monopoly-type) price attracts newcomers to the industry, whoeventually break the cartel by selling as much as they can at the (high) cartel-established price.

The OPEC oil cartel lasted about a decade (a long time) because of several specialfactors:

• There is a long lead time to find oil and develop new wells.• There is an inelastic supply of oil.• The market for oil was growing rapidly because of global economic expansion, so it

was easier to live with high prices.• Oil is durable – it does not rot if left in the ground.• Arab unity may have helped a bit – though they do not seem very unified usually!

If a cartel is fully successful - the diagram is simply that of a monopolist!

The Wastes of Oligopoly

• An oligopoly restricts output where it can, so less is produced than could be, andat higher position on the cost curve.

• Price is higher than if the firms in the market were perfectly competitive.

• Collusion to try to establish a cartel and behave like a monopoly is likely; ifsuccessful, we get all the problems of monopoly.

• Price wars may emerge, perhaps caused by new entrants, or the existing firmsreduce price because they fear the high price might attract entrants.

• There may be wastes (for society) of high advertising costs, or offers toconsumers of free trips or lotteries. These are not cheap to run and use realresources.

• We may get bribery or other pressure on, government to keep or establishMarketing Boards or other devices of restriction.

50


• There is a time and energy waste involved when firms are forced to watchrivals, try to guess their likely innovations, or whether they will react to what thefirst firm did.

• Industrial espionage and other illegal acts may be promoted. Some firms arereputed to pay people to search the waste bins of their rivals!

• Employment is restricted, because an oligopoly keeps output down.• Uncertainty levels are increased; this is generally felt to be bad thing.

The Benefits of Oligopoly

• Price does not change much (until we get a price war!).

• There is fierce competition to improve the product in order to increase thedemand for one’s own output - so we may see fast technical change, greatdynamism and much R & D effort.

• “Countervailing Power” - if a single monopoly is bad (as we feel), then a fewmore competing firms can stand up against it, so the situation has to be better.

• The size of firms is usually larger – this means they can reap economies of scale(unlike the tiny firms in perfect competition which will never be big enough).

51


IMPERFECT COMPETITION OR MONOPOLISTIC COMPETITION (theterms are interchangeable)

Reminder: this is the bit in the middle!

Monopoly

Monopolistic competitionPerfectCompetition

Oligopoly

WHAT IS MONOPOLISTIC COMPETITION?

It is defined as:

• Many buyers and sellers of that type of good or service (= competition).• Free entry and exit (= competition). But each firm has its own brand of the good

or service (= a monopoly on the brand name).• So each faces a downward sloping demand curve for its own branded product (= a

monopoly effect).

i.e., we see elements of both monopoly and competition, hence the name.

The long run equilibrium position is where the demand curve is tangent to the averagecost curve.

The Long Run Equilibrium Condition

D

P1

0 Ot1 Output

AC

MC

Price,Costs

52


Q. Why is long run equilibrium in this tangential position?

A. Because of the assumptions of strong competition and free entry/exit.

Let’s think about the short term.

If the firm suddenly improves its product, e.g. colours it fashionably, the demand forthe product will increase, this allows a price increase, and hence means higher profitsfor the firm.

So the firm receives monopoly profits and in this short run position, the diagram isidentical with that for monopoly. It has a monopoly because the firm is the only onewith these new fashionable colours.

But what is going to happen? The higher profits and visible higher price draw theattention of this firm’s existing competitors, and there may be new entrants. Bothgroups can successfully compete by colouring their product also! They then earnsome monopoly profits. But the increase in total supply means that price starts to fall.In addition to this, the demand curve of the original producer drifts back, as the firmloses part of its market to these competitors.

Q. How far does it fall back?

A. Until the monopoly profits are eroded to zero – when we are again at the tangentwhich is when competitors will stop coming in! There is no reason to enter once thereare no excess profits to be made.

So in the long run there are no monopoly profits – equilibrium is always tangential!!

The short run increase in demand:

If you draw the basic diagram for monopolistic competition in equilibrium and thenincrease the demand for the product, you will see that it turns the diagram into themonopoly one, with monopoly profits. This situation lasts until the attracted newentrants cease – when we are back to the tangent as just described.

Problems with Monopolistic Competition

• Waste of time and effort – the firms have to worry about competitors’ actions.

• Waste of underused resources. In the tangential position, we are not at the bottomof the AC curve – the firm could produce more, and more cheaply, but cannot doit. This is to say that excess capacity exists.

• There may be too much differentiation – firms often pretend their product is“better” but in fact it is merely different! As a consumer, you should be wary of“miracle ingredient” claims, especially in the health and beauty area.

53


• Advertising wastes.

• Free gifts, free lottery tickets, 2-for-1 offers, competitions to get a free trip toLondon, to the coast, to Paris etc. They all use up real resources to run them.

• We could have had better or cheaper products instead of all these offers!

Benefits of Monopolistic Competition

• The situation is very competitive – firms watch their competitors very closely.

• This strong competition drives the firms along:

• They strive to improve product quality and design, as well as (hopefully) tolower the price.

• The firms engage in much research and development.

• Free entry and exit keeps competition fierce.

• Variety is great – there is more choice for purchasers and hence, we assume,greater consumer satisfaction. Some observers now feel that too much choiceworries people and does not make them happier but the jury is still out on this one.

Some possible areas for data response questions

There may be a question about how insufficient competition prevents the marketsolution from being optimal or the market working properly

You might get asked to explain why monopoly is undesirable generally – or you mightget a specific simple question, like working out what is the monopoly profit in adiagram and/or figures.

You might get asked how much of a monopoly a company is (definitional); be asked towork out a concentration ratio; or expected to mention cartels, or monopolisticcompetition. Duopoly (= only two firms in the industry) is rare but if the examinersfind one in the real world to set a question about, you will be expected to use the term.

It could be teamed with the issue of privatisation, because natural monopolies wereoften nationalised a long time ago, then privatised after Margaret Thatcher becamePrime Minister in 1979. “Efficiency” and “competition” are key words to use!Monopoly is seen as essentially inefficient and bureaucratic with higher costs, as wellas taking monopoly profits, higher than they might be.

54


Privatisation is seen as an effort to increase competition and hence lower costs, toallocate resources better, and to reduce the monopoly profit element.

We will look at these issues more closely later.

55


2-3. EXTERNALITIES, SOCIAL COST AND PRIVATE COSTS = the secondreason for markets being less than perfect.

EXTERNALITIES

Private costs are what they say – the costs incurred when producing something.

Social costs are greater than private costs. Social costs include things like pollutionand congestion that are suffered by society in general, not by any one producer.

These problems are called “externalities” i.e., they are external to the firm producingthem. They can be negative externalities (which harm society) or positiveexternalities (which help).

Social cost = private cost + externality (if any).

Cost-benefit analysis tries to measure all the costs to society of a project.

A new tube line in London may never run at a private profit but still generate largesavings elsewhere. For example, the new line might reduce motorcar use, reducecongestion, speed up traffic flow, and save people’s time. The Victoria line, built1968-71, was established knowing it would lose money - but the social benefits wereso great.

We have a diagram for social costs:

0

Social costs

Social Costs,Price

Private costs

Quantity

Demand(Social Marginal Benefit)

Qb Qa

Pb

Pa

Equilibrium will be where private costs cut the demand curve at Qa, as firms try tomaximise profits and charge price OPa for quantity OQa.

56


But because of negative externalities (pollution maybe), the socially optimum positionshould be where social costs cut the demand curve. These would mean producing atQb, reading from the social costs curve, and selling at the higher price OPb to coverthese costs.

NEGATIVE EXTERNALITIES

Common types of negative externalities by producers:

• Air pollution, e.g., smoky factory chimneys.• Soil pollution, especially by farm chemicals (closely related to the next type).• Water pollution, e.g., rainwater run-off containing farming pesticides and

fertilisers.• Noise pollution. Do you live near an airport or by a building site?

Some types of negative externalities by consumers:

• Pollution of air and water.• Soil pollution, e.g., lead pollution in soils from motorcar exhaust emissions.• Litter on streets; decomposing rubbish in land-fill sites.• Noise pollution, e.g., motorcycle noise in urban areas, especially when the baffles

have been deliberately removed from the silencer.• Vandalism; graffiti on walls.• Smoking and alcohol abuse, causing NHS expenditures to rise.

We are unsure why the urban sparrow population has plummeted in recent decadesbut it would seem to be the result of some externality.

POSITIVE EXTERNALITIES

When these exist, society would gain more than the producer – who therefore isproducing less than the optimal social amount.

Examples include:

• Labour training in firms; one firm may do little, as it knows that when a trainedworker leaves, someone else benefits - but the first firm paid for all the training!

• Education generally.• Health generally, especially in poor Third World countries.• The provision of playing fields at or near schools so that the health and sporting

skills of the children improves.• Free museums and art galleries that can encourage the poor and uneducated to

widen their horizons, educate themselves, and generally improve.

57


To draw the diagram for positive externalities: just reverse the labelling of the curvesof social cost and private costs above. This is done in the diagram below where youcan see that we produce too little for society if firms profit maximise for themselves(as they do). They choose to produce at OQa and sell for a price of OPa, but for thegreatest good of society they should be at OQb and selling at the lower price of OPb.

0Quantity

Social Costs,Price

Social costs

Private costs

Pb

Pa

Qa


Qb

Government intervention may be necessary to correct or offset market failurecaused by negative externalities – usually the government chooses to tax thoseproducing too much, or they may use the law to prosecute for water pollution orwhatever externality the government is tackling.

There are probably fewer cases of external benefits, but if we find any (such as privatefirms training labour well) we can encourage this by tax breaks or subsidies.

Government action with external diseconomies

Government might try (and does):

1. Taxation.2. Regulation.3. Perhaps extending property rights.

58


Let’s think about polluters – what can the government do using the three pointsabove?

a) Taxing polluters

The need is to try to stop the problem being “external” and try to “internalise” it, i.e.,to make the polluter pay for it via a tax. As economists, what we are really doing istrying to get the firm to stop looking only at the private costs and benefits. In thediagram below, we do this by putting a tax on, which shifts the supply curve up from“S Private costs” to “Private costs + tax”. If we get it right, this moves theequilibrium quantity produced from Qa to the smaller output Qb.

0Quantity


Qb Qa

Pb

Pa

S

S + tax

Social Costs,Price

Social costs

In the UK, we now have a Landfill Tax (since October 1996) to encourage recycling.Landfill operators have to pay a tax to the government. It was introduced at the ratefor inactive waste, which is easy to deal with, of £2 a ton and other waste at £10 perton. These amounts might increase shortly.

But there are problems with taxing polluters:

• When it works, output is reduced and prices are higher – but this can reduce theconsumer surplus, which some feel is not a good thing (Unit 4 looks at thisconcept).

• It is often hard to identify the particular firms that are causing the pollution, andthen determine how much each is responsible for the total pollution.

• Poor legislation can hurt the innocent, e.g. households who wish to get rid of largeitems of waste may not be allowed to take them to the dump.

• It is not easy to put a monetary figure on the damage pollution is causing.• Producers can pass on much of the tax to consumers if demand is inelastic and not

pay it themselves.• Taxes on demerit goods (to limit their consumption) can be regressive, i.e., hit

poor households the hardest. The tax on cigarettes does this because the poor arestatistically more likely to smoke than the wealthier.

59


In the UK, the government quite regularly increases duty on petrol, & tax oncigarettes.

b) Regulating polluters approach (a second way that can be used in addition totax)

• Banning cigarette advertising at sporting events, or in places like cinemas.• Making workplaces no-smoking areas.• Increasing the penalties for firms that break the regulations.

c) Extending property rights (a third way that can be used)

If a lorry crashes into your garden and destroys the wall and all your trees you can getcompensation – but if a polluting factory puts out acid smoke and destroys the sametrees you cannot.

If we extend property rights so you could sue for compensation, it would make thepolluter think again and perhaps install anti-smoke devices on factory chimneys!

Benefits

• The property owner knows the value of the property better than the governmentdoes, so the figures will probably be more accurate (but owners can, and perhapswould, lie!).

• The polluter is forced to pay those suffering from his or her activities.

Disadvantages

• The damage may occur abroad, e.g., German acid rain destroys East Europeanforests – but it is next to impossible to enforce law across borders!

• Global interests and national interests may conflict. The UK cannot make Brazilextend property rights over Brazilian trees which are being killed off at a rapidrate, yet the world might feel the destruction of the Amazon rain forest is wrong.

Trading permits to pollute

Many believe that it is so difficult and expensive to stop companies polluting(identifying who did it can be impossible e.g., with one stream and dozens of factoriesdischarging into it) that instead we should auction off the right to pollute. Only thosefirms that pay a high price for the limited number of licences would be allowed topollute. The government could then use the large sum of money raised to tackle thepollution itself. The end result could be much better than we currently have!

60


If we allow a firm to sell its right to pollute (it may have used only 80 per cent of whatit is permitted, for example) then those with the greatest demand for their product, andhence the most profitable, can buy the remaining 20 per cent. It means the things wemost desire still get produced but the government has the resources to tackle theresulting pollution.

Yet many think it is morally wrong to allow permits to pollute at all!

Singapore uses such permits for ozone-depleting substances.

The Kyoto Summit on Climate Change (Dec. 1997) saw a move towards such permitsas being an improvement at least! But the United States and Russia refuse to ratifythis. In September 2004, President Putin of Russia agreed to it, but it still has to gobefore the Russian Parliament.

Coase’s Theorem

Ronald Coase established that there is no need to tax or regulate polluters at all! Hesaw that if polluters compensated those suffering, the market would solve it properly,with just enough “acceptable” pollution occurring and still no one suffers withoutbeing compensated. He got the Nobel Prize in Economics 1991 for this! It is worthtrying to get the phrase “Coase’s Theorem” into an answer about how to deal withpollution.

61


2-4. PUBLIC GOODS, MERIT GOODS, DEMERIT GOODS ANDINFORMATION FAILURES = the third to the sixth reasons why markets maynot give us a perfect solution.

Even when the market appears to be working perfectly, we can have a problem withsome goods. These are:

• public goods;• merit goods; and• demerit goods.

These may all be supplied in the “wrong” amounts, or even not supplied at all. Whenthis occurs, it renders the market system inefficient and it is failing in this area

Public Goods

These are collectively consumed and the market may simply not supply them; e.g.,defence of the country (a police force and army), a fire brigade, street lighting, orlighthouses. The market system does not work well in this area.

Some goods are “semi-public goods”, “quasi public goods” or “collectiveconsumption goods”, for instance roads. These are often supplied by the state, but inprinciple they can be privately supplied, and sometimes are. Examples include theBritish Toll Roads in the Nineteenth Century or the péage motorways in France today;when you use them, you pay.

In some countries, such as Thailand when I lived there, the fire brigade falls in thisarea. People insure with a private fire brigade and call them when the house isburning. If you are not insured and you still call them, the market swings into actionand they negotiate a rate on the spot for putting out the fire – given the urgency of theevent, the demand by the burning house owner is highly inelastic and the price can bevery high indeed!

Public goods require

• The lack of ability to exclude (if I am defended, so are you, even if you do notpay!)

• The consumption by one does not reduce the consumption available to the others(if you walk down the street after dark you do not use up any of the streetlighting.)

These two requirements may be called the “non-rivalry” and “non-excludability”features.

One of the jobs of government, both central and local, is to supply public goods orservices that are needed but otherwise would not be made available by the market.

62


Merit Goods

These are provided by the market - but in smaller amounts than are needed for thegood of the state. Health and education are the most obvious ones – there will besome privately-supplied health and education but the state as a whole benefits ifeveryone has access to them, not just a few. For instance, in the health area, theNational Health service and inoculations tend to reduce mass epidemics; the healthservice also means that fewer people will be off work sick. We see a contemporaryexample with the dispute over the MMR jab for young children. The fear that it maybe linked with autism in children prevents some parents from getting their childinjected and there is a fear that an epidemic of measles could emerge as a result. Inthe case of education, society would not function as well if half the population couldnot read the instructions on the label!

Private consumers individually value merit goods less than the state does. The marketsystem fails to provide enough merit goods which is why the state steps in to makethem more widely available. It does this by subsidising the production of some meritgoods or services.

Merit goods may be targetted at certain groups and rationed; for instance, we mightlimit access to higher education to those passing A levels well! It is assumed thatsuch people are the most intelligent in society. Which of course you are!

In the diagram below, a subsidy equal to AB is applied by the government – this shiftsthe supply curve downward and to the right. The equilibrium position then movesfrom P1Q1 to P2Q2. The result is that more is then consumed at the lower price i.e.,the demand for merit goods has extended. (I am stressing that the demand has notincreased; that would have meant a new demand curve!)

PriceS2

D

A

B

P1P2

0 Q1 Q2 Quantity

S1

63


Demerit goods

Demerit goods are exactly the opposite of merit goods in that they are over-consumedby individual people and this causes problems for the nation as a whole.

Cigarettes are a clear example: they cause unpleasant smoke which is dangerous topeople in the area who are forced to become passive smokers. They also cause cancerand a whole range of nasty diseases, including emphysema. They inflate the nationalhealth bill because both the smokers and the passive smokers get sick and visit thedoctor. But smokers will not stop, perhaps are unable to stop, because they areaddicted.

Too many demerit goods are demanded, so the government steps in and taxescigarettes highly in order to reduce consumption and to raise revenue which is neededanyway to spend on treating smokers. The government also advertises heavily to tryto persuade people to stop smoking and the young not to start and is seriouslyconsidering banning smoking in all public work places, as Ireland did in 2004. Someindividual doctors are also refusing to treat smokers for smoke-related diseases unlessthey stop smoking which adds to the pressure.

The effect of the government taxation is in the diagram below. The indirect tax EB isadded vertically to the supply curve, which shifts upward and to the left from S1 toS2.

This reduces the consumption from OQ1 down to OQ2, (a move from the equilibriumpoint A to B) as price rises from P1 to P2 and consumers contract up the unchangeddemand curve.

Rather than simply relying on tax to decrease the supply curve and force up the price,the government may also try to tackle the demand side. It can do this in the waysmentioned above and the diagram is reproduced below.

Price

B

E

Quantity

S2S1

D

Q1Q20

ACP1P2

64


0

Price

QuantityQ1Q2

P1P2

S1

D1D2

You will observe that, if successful, the quantity smoked falls.

The government uses both methods, reducing demand and taxing heavily, to deal withsmoking as a demerit activity!

Information failures

Knowledge is never perfect!

Consumers lack information on things like:

• What goods are available and what new goods have recently come onto themarket.

• What the quality of the different models or makes available is like.• How long an item will last before breaking down.

Information lack is particularly common in both the health service and in educationwhere consumers do not know much - although we now know more than a few yearsago.

This lack of perfect knowledge means that we may choose badly through ignorance.The demand curves would be different, and better, if we did know everything. Thismeans of course that the existing demand curves do not give us a perfect marketsolution.

65


Producers lack information on:

• What new demands are arising and how old ones are starting to change, so theproducers may produce more (or less) than they should.

• What their existing rivals, and any new ones about to emerge, are doing or mightdo.

Which means that the producers may produce the wrong type of goods or the wrongquantity of goods.

We know that in the world in which we live, new firms start up and many die awaywithin the first two years – they usually got it wrong on the demand for their serviceor goods in that particular place, although sometimes they simply were not goodenough at the job. In the process of being born and dying, the firms used up resources(including the labour of the would-be entrepreneur) in a less than fruitful way.

Workers lack information on:

• All the jobs available now. Many of these will be local but more particularly theyare usually ignorant of opportunities elsewhere in the country or in the EU for thatmatter. So the workers may not move to where they are needed though simplelack of knowledge.

• Which industries will grow and which will wither away in the future. This meansthat workers may join a firm that will disappear in a few years time, throwingthem out of work but not for any fault of their own. Technical change can renderwhole jobs out of date: the handloom weavers are a classic example of the late18th and early 19th century; coal trimmers stacking the coal in the depth of shipsin the mid 20th century; and coal miners of the late 20th century. As a consequenceof workers not being able to predict future job needs, resources may be tied up indying industries too long.

- A real problem is that those leaving school or college may join anindustry and train in skills that will shortly be no longer needed.

So here again the market does not reach the “correct” or optimal solution.

The response to information failures

Private firms gather information and try to sell it.

For instance:

• Private job centres may open up to try to find a job for people. These are mostlyin large cities and for service workers, rather than for manufacturing. Such firmsare trying to improve the flow of information for profit.

66


• Magazines like “Which?” exist. They test and investigate the quality of goodsand services and publish the results.

• Specialist magazines are produced for things like hi-fi, TV, motorcars, orcomputers – such magazines also test and report the results.

• In order to help producers, various trade associations and chambers of commercegather information and inform their members about what is happening. They alsoorganise conferences and set up fact-finding trips abroad and the like.

The state tries to provide information by:

• Establishing job centres.• Providing advice to careers advisers in schools.• Issuing pamphlets and working papers to try to improve peoples’ knowledge. The

newspapers pick up this information and may publicise it.

Overall, as information improves, consumers adjust their demand patterns to favourwhat fits their needs best. Producers chose the most suitable and cheapest sources fortheir inputs. This of course means the market mechanism then works better to supplywhat people want and are willing to pay for.

67


2-5. FACTOR IMMOBILITY= the seventh reason for free markets notproviding a perfect solution.

The factors of production that we have are land, labour and capital plus a remainderterm (L, N, K, + R) – most economists and textbooks focus on labour immobility, butthis is not guaranteed for the exam!

We can also have land immobility

• Some land is good for growing one or two particular crops and not very good atsome other crops. It is not easy to change rice (which needs wet soils) to wheat(which needs drier conditions).

• It is not possible to move land from where it is to somewhere else.• Climate change may be occurring and farmers are often traditional, growing what

they or their family have done for years or even generations. They may be unawareof, or refuse to try growing, a now more suitable crop.

• Economic Union subsidies keep many farmers’ attention on producing the cropsthat are highly subsidised (as it gains them a higher income) rather than what mightbe more suitable for their land or sell better. Quite often the EU gets it wrong, sowe ending up with a lot of produce that is hard to sell. Dumping it on internationalmarkets annoys other countries that produce such goods efficiently as it reducestheir market. Dumping it into the sea causes criticisms of waste in a world ofpoverty.

And capital immobility

• Some capital is specific e.g., it makes light bulbs, and it cannot be transferred toanother use, like producing ball point pens.

• Some capital is very big and heavy, e.g., a steel mill, and it is difficult or impossibleto move it to another geographic areas.

• Some old decaying industries may be subsidised by government and continue toexist for years, well beyond their shelf life. This keeps the capital (and theassociated land and labour) where it is so that it is not released for use where it ismore wanted by society. That is to say, government subsidises prevent factors ofproduction moving to turn out what people now demand. The fact that the industryis decaying shows that demand has changed and people no longer want that good orservice as much as they once did.

• Some (usually small) firms stay in business despite making poor profits because theowner does not want to move or to cease production; or perhaps the owner is tooold to bother to make any major change.

68


Labour immobility (the really interesting one – we ourselves are people!)

Geographic immobility of labour

• People do not up and move easily from Leeds to Watford, just because they canearn £20 a week more there. Even less do they move from Tours in France to Hullin Yorkshire.

• People are usually happy where they are: they have got relatives and friends, theyknow the town and area, and they are members of various clubs and other socialgroupings. They do not wish to move.

• They may not know about the extra £20 they could get if they were to move(“information failure”). Information failure actually costs money to overcome:people must pay to use the Internet, or have to buy newspapers and magazines.

• Moving house costs money: there are estate agents’ fees, lawyers’ fees, agovernment stamp duty and the cost of transporting furniture and all the otherhousehold effects.

• Inertia: people often do not like a big move as they have a sort of fear about it, sothey just stay where they are.

Institutional immobility of labour

• Trade unions and government pass rules or laws that prevent people from entering anew job easily.

• Pension schemes may tie people into a particular company – if a worker moves, heor she will probably lose the amount paid in by the employer on their behalf (thiscan amount to several thousand pounds).

• Council houses (state subsidised housing) are let below market rents and canprevent people moving; if they move it means they must give up their cheap houseunless they are able to arrange for a house-exchange with another council tenant.

• Foreign-trained doctors may not be allowed to work in the UK unless they spendseveral years retraining - and not always even then.

Sociological and economic differences causing immobility of labour

• Minority groups often get paid less. For instance, it may be harder for migrantswho do not naturally speak English to find work and to receive the same pay. Ifthey are not selected for a vacancy, it renders them less mobile. Even women,hardly a minority, find it hard to get the same pay as men, despite the existence oflong-standing legislation.

• We can think of this as a lower demand curve for them, because employers do notlike hiring them as much.

• Married or very close couples: one may not be able to take a better paid job offeredelsewhere because it would render the other partner unemployed, so total familyincome would fall if they moved.

69


• The skills a person has may not fit the new demand for workers, so he or she wouldfind it hard to get another job. As demands in society change (taste + higherincomes + new goods + new technology + fashion and trends…) it means new skillsare needed and old ones become redundant. How many chariot wheel makers dowe now need?

• Age: once past fifty years, or even forty years of age, it is difficult to get a new job.Employers often prefer younger people. If an applicant is old, the employer fearsthat they will not learn new skills quickly; and if the applicant is older than theemployer, he or she may feel uncomfortable giving them orders and so simplyrefuse to hire them in the first place; and old workers who join the firm will onlypay into pension scheme for, say, ten years until they retire, but will take out forperhaps another thirty years until they die. An ageing population makes thisscenario more common.

Such factors mean that wage differences (and unemployment) can permanently existbetween industries and between regions. The market does not work well enough toequalise wages and long term wage differences persist.

Diagram: the wage of labourers in London and Cornwall: London has a greater supplybut a much greater demand so the curves are further to the right. And of course inLondon, the level of wages and the quantity of workers are higher.

0 0

W 1

QlQuantity of labour

S lab

D labW 1

Quantity of labour

S lab

Ql

Wages Wages

CornwallLondon

D lab

70


What can be done? Government intervention may help produce a better marketsolution.

Government training and retraining for the new skills that society needs.

The government may improve or alter the educational system and encourageacademic courses to be more geared to the needs of a modern economy (althoughsome intellectuals disagree and think education should not do this).

We can retrain workers at government expense. The state can pay for retrainingcourses and give generous tax breaks to those choosing to receive new skills.

The government may tackle the geographic problem

It may pay workers to move; or pay the costs of buying or selling the house; or end(or reduce) the stamp duty for such people; or pay the unemployed to travel to look atjob opportunities in a new area.

It may subsidise firms to move to old decaying areas. This approach is generallyinefficient, as it means costs will be higher than they need be, as it is probably not agood location for the firm (which we can assume or the firm would be there already orwilling to go without a subsidy). This would make the UK less competitive withother countries.

The government may allow pension mobility, i.e. when a person leaves a firm he orshe can take their pension rights with them – the new stakeholder pensions do this.The push for people to take out their own private pensions means that workers aremore mobile than they once were. There is a slight problem in that the rich who areusually already mobile are taking out stakeholder pensions, but the poor, less mobile,are tending to avoid them.

The government could change the laws as needed

Example 1. The government could make all company pension schemes pay out theemployer’s contribution when worker leaves.

Example 2. The government could make the British Medical Association (BMA)allow foreign doctors in to work more easily. The BMA is rather restrictive and keepssome well-trained foreign doctors from working in the UK unless they requalify ortake special tests. This reduction in supply means there is a permanent shortage ofdoctors which helps the BMA to pressure the government for pay increases, betterconditions, or whatever it wants.

Example 3. The government could pass “non ageist” legislation to try to stop olderbut good being refused jobs or even fired (government is planning to do this -eventually).

71


Other areas of law no doubt could be similarly changed – watch the newspapers forarticles and examples that you could quote in the exam room.

72


2-6. THE DISTRIBUTION OF INCOME AND WEALTH= the eighth reasonwhy markets may not work perfectly.

The demand curves we see in the economy are for the given distribution of incomeand wealth in that economy. If we were to change the distribution of income orwealth, we could expect to see a different set of demand curves.

For example, if London were to suddenly gain all the income and wealth in thecountry, everyone outside that city would reduce their consumption of almosteverything and do so quickly. They would have no income and have only limitedsavings to draw on. So the demand curves for many goods and services would alter.

We can imagine that if all the income in the UK were to be redistributed so thateveryone had exactly the same income, it would be insufficient per person to buyPorsche or Rolls Royce motor cars, or indeed many luxury goods and services. Thedemand for these would diminish sharply or perhaps even cease to exist.

This means that unless we have a “good”, “proper”, “desirable” or “acceptable”distribution of income and wealth, then the market will provide a less than satisfactoryresult! It merely reflects the existing income distribution and not what would makeeveryone better off. Only if we can all agree that the current income distribution is“the best”, will the market distribute according to what people need rather than havethe money to buy (remember, demand means “effective demand”, that is, backed bymoney, and it is not merely a need). Every time we change the distribution ofincome, we change the pattern of demand.

Note that as time passes the economy grows, and some sectors and people do betterthan others, so the pattern of demand is in fact constantly changing. Other factors thatcan change demand include new technological goods (mobile phones, scanners…);new goods generally; advertising; weather changes; and new tastes or fashion.

Measuring the distribution of income

The Lorenz curve

We can show the degree of inequality in income distribution in a diagram. If 10 percent of families have 10 per cent of the income, and 20 per cent have 20 per cent, andso on, we have perfect equality.

The Lorenz curve shows the actual difference from the 45 degree line of perfectequality. We can actually see the inequality gap in the diagram below!

73


% of families (cumulative)100%

100%

0

Inequalitygap

60%50%

% of income(cumulative)

45 degrees

Perfect equalityon 45 degreescurve

The LorenzCurve

50%

25%

Here, we see that about 60% of the families have only 25% of the income.

The Gini Coefficient

The Gini Coefficient is a more accurate measure than the Lorenz curve - and franklyit is much easier to compare numbers than pictures!

The Gini Coefficient measures the degree of inequality by using numbers – it iscalculated as:

Area between diagonal line and Lorenz curveTriangular area under diagonal line

i.e., this is the inequality gap in the diagram above as a proportion of the wholebottom triangle. The bigger the inequality gap, the closer it gets to the whole;eventually it is the same as the whole and a number divided by the same numberalways equals one. So the higher the Gini coefficient, the less equal is the distributionof income.

Perfect equality = 0.0Perfect inequality = 1.0

74


When the Gini Coefficient equals zero we have perfect equality

Some actual Gini Coefficient figures for three countries

1980 1994UK 0.327 0.345Spain 0.397 0.340France 0.417 0.290

Using these figures, rather than trying to compare by eye some three separatediagrams, we can now compare easily.

We can see that:

• In 1980, the income distribution in the UK is more equal than in Spain.• The UK’s income distribution got less equal (under the Thatcher government).• Spain’s income distribution got more equal over the period.• By 1994, Spain had a more equal income distribution than the UK.• And France, which in 1980 had less equality, is revealed to have a more equal

income distribution in 1994 than either of the other two countries!

% of familes (cumulative)100%0 50%


45 degrees


50%

100%

75


This is the sort of thing that the Gini coefficient is used for.

Oh! One more thing! Latin America has the highest Gini coefficients of any of thecontinents in the world (that is, it has the widest income disparities). That might be auseful statement you could make.

The Gini Coefficient can easily be set in exams, either as an essay or as dataresponse.

76

Copyright Kevin Bucknall 81

2-7. ECONOMIES OF SCALE

What are they concerned with?

We look at what happens to costs as the size (the scale) of a firm increases; e.g., if afirm grows by a given percentage, say 20 per cent, we examine what happens to the coststructure.

There are three logical outcomes if firm grows by 20%:

• Output grows more than 20% = economies of scale or “increasing returns toscale”.

• Output grows less than 20% = diseconomies of scale or “decreasing returns toscale”.

• Output just grows 20% = “constant returns to scale”.

NOTE it does not have to be 20 per cent – it is what happens to costs when the firmgrows by any amount that interests us.

The Envelope Curve or Long Run Average Cost Curve

It often occurs that as a small firm grows, its average costs fall at first, then level out forsome time, then finally start to rise. If we join up the tangents we get the “envelopecurve” or the long run average cost curve (LRAC curve).

Average Costs

Time

AC

AC

AC

0

LRAC

77


Digression: When drawing the envelope curve it is far easier to draw in the LRACcurve first, then fit the small AC curves to it. This is the reverse of the way we actuallyget the LRAC curve.

Remember that the average costs are always drawn U-shaped whatever thecompetitive state of the firm we are considering (perfect competition, imperfectcompetition, or monopoly). This helps you, because so you now know that you canalways start your diagrams in the same way in all theory of the firm questions.

How can we get economies of scale? (“increasing returns to scale”)

1. Technical: a new machine can be used that reduces costs as output increases :

• Such a process is often referred to as “mass production”.

2. Financial:

(a) Banking:• A large company can borrow at cheaper rate than others, e.g., Shell pays lower

interest than I do to borrow money.• When output is larger, it spreads the interest cost of borrowing over a greater

number of units, so the average cost per unit is lower.(b) Insurance

• A larger output again spreads the cost over more units.• A large company may be big enough to do its own insurance and not have to

pay premiums to others.

(c) Advertising• Once more, the larger company spreads the advertising cost over more units.

(d) Purchasing• Bulk buying is cheaper.

3. Managerial

• A large firm spreads the cost of management over more units.• Management may be underused in small firm.• In a large company the managers can specialise: there might be a marketing

manger, a transport manager, a production manager and so on - each does abetter job as a result of specialisation..

78


4. Risk spreading

• A large company can have a greater variety of produce - if the demand for oneproduct falls off, the demand for others will probably be still be good.

• A large company can sell in different markets, perhaps including several exportmarkets.

• The firm’s own insurance can be done (already mentioned).

Note: cost curve eventually turns up at the right hand end. This reflectsdiseconomies of scale, or decreasing returns to scale

Q. Why does it turn up in this way or why do they occur?

A. There are three main reasons:

• Managerial limitations• Financial factors.• Quality deterioration.

1. Management. This is the most important reason usually.

Management becomes a fixed factor in a sense. The firm gets too complex for oneperson to manage everything, mistakes are made, and decisions are slower causing coststo increase.

A firm can increase the number of managers to offset this diseconomy and perhaps putit off until a larger output is reached - but as managers increase in number we canexpect to see new problems arising.

• Red tape arises, that is to say, there is a slow and cumbersome bureaucracy.• Meetings proliferate and a paper war starts.• Factionalism arises, each department starts to try to score off others and do them

down. This is often an effort to advance one’s self in the promotion race butsome people simply develop a loyalty to their own division and start to dislikeother divisions.

• A new idea of safety and security arises. The new managers tend to beadministrators with less entrepreneurial skills, and they also try to protect theirbacks rather than promote the interests of the company.

• A new breed of people, "corporation people" emerge – the firm is no longerchasing profit and taking risks but coasting along.

• Communications falter, up and down as well as sideways. People do not allknow what is going on.

79


Some things may offset the managerial diseconomy:

• Computers and technological progress, e.g., photocopying machines speed upthe paper chain (although they increase its length!)

• Various incentive and bonus schemes are possible, including stock purchaseoptions (mostly for managers who can later buy shares in company at a priceagreed now. It means that if they work hard and the company makes profits, theshare price will rise, and they can buy cheaply - so they get rich).

• Bonus may be linked to growth in profit level, for workers or managers.• No absenteeism or unauthorised sick leave by a worker for a defined period of

time may attract a bonus. British Airways were considering this in 2004.• Possibly a person might receive a bonus if he or she is never late for work for a

defined period (this applies to lower grade workers more often).• Suggestions boxes, meetings to invigorate staff, etc. might be used and can help

to some extent.

2. Financial diseconomies may arise:

As a firm grows, it increases its demand for everything, including perhaps someparticular factor of production, a needed raw material, or certain spare parts. Asdemand increases it can turn the price up against itself (an increase in demand withnormal supply curve; we will look at the diagram again later on).

3. Quality diseconomies may occur:

When a firm starts up, it hires the best labour it can find, and buys from the best sourceof materials available; but when it has taken all that is possible from these sources, togrow further it may be forced to:

a) Hire lower quality labour, which will mean a lower productivity.

0

P1

Price

D1

S

P2

QuantityQ1 Q2

D2

80


b) Take worse raw materials, or hire less suitable transport vehicles (say, not wellrefrigerated) because the really good ones have already been taken and there are none ofcomparable quality left available.

And both these actions will increase the firm’s costs of production.

81


2-8. PRICE FIXING BY GOVERNMENT OR ONE OF ITS BODIES

The government might decide that the prices determined by the market are too high ortoo low and may wish to intervene and change them.

When some institution fixes a price other than at equilibrium, logically it must be either:

a) Maximum price fixing, orb) Minimum price fixing.

a) Maximum price fixing

When fixing a maximum price, it is always set below the equilibrium level.

Q. Why?

A. There is no point setting a maximum of say £1 million for the price of a loaf of bread– it would have no effect! It is always less than that anyway.

When someone sets an effective maximum price we always see the same result:

Demand will exceed supply at the set price. We did this in an earlier diagram but wewill do it again now.

Price

Set Price

P1

0

D S

Qs QdQ1Quantity

With this maximum price fixing we have an excess demand of OQd – OQs (which isthe distance Qs to Qd).

Therefore we can expect to see:• shortages.• black markets emerging.

82


• possibly rationing will be introduced.• corruption might arise.

In the rental housing market if there is “rent control”:• “key money” might be demanded, a bribe in order to be able to rent the cheap

house; or• a silly bet can be made which is deliberately lost, just to hand over money; or• the person renting has to purchase the fixtures and fittings at an extremely high

price; or• perhaps sexual favours will be demanded before the owner will rent to a person.

In other markets, such as for meat in war time, there will be shortages and queues (=rationing by time) until a rationing system is introduced by government.

b) Minimum price fixing:

Minimum price fixing may occur with agricultural products in rich countries, where thegovernment tries to help its farmers by giving them a larger income.

It may also be encountered in primary produce in the third world, with marketingschemes and buffer stocks.

The same results always emerge: the quantity demanded is less than the quantitysupplied at the prevailing price,

Price

Set Price

Quantity

P1

0 Qd Q1 Qs

D S

With this minimum price fixing at “Set Price”, above the equilibrium level of P1, wesee a surplus of OQs minus OQd, or the gap Qd to Qs.

And we can also expect to observe:

83

Copyright Kevin Bucknall 88

• storage problems and high storage costs (agricultural produce is like that!);• the spoilage rate likely to be high (agricultural produce);• there may be dumping of some of the produce in the sea; or• selling part of it below cost to countries abroad.

The surplus will continue to grow each year as long as the minimum price persistsabove the equilibrium one, so the problem (and storage costs) keep on increasing.

Primary produce marketing schemes

Primary produce is prone to large fluctuations in price, the result of both demand andsupply being relatively inelastic, so that a change in either alters price quiteconsiderably.

Supply is likely to alter sharply for all agricultural crops, as the harvest can be poor or abumper one, depending on the weather.

Demand is likely to alter sharply for things like rubber if there is a slump in the motorvehicle industry so that fewer tyres are required.

So if we look at a diagram of inelastic supply and demand and alter either, price willrise or fall substantially.

Remember to draw the curves very steeply – they are very inelastic and the steep slopegives us the large price alterations.

S1

P2

P1

00

D SS2

P2

P1

D1D2

Q2Q1

Bumper harvest,supply increase

Maybe a new diet fad,demand increase

Q1Q2Quantity Quantity

Price Price

84


As a result of the wide price fluctuations, it is tempting to set up a marketing scheme,which can buy when prices are low and sell when prices are high, thus stabilising theprice. A “buying price” and “selling price” are set by the marketing board and allshould be well. This is how it looks (the curves would be much steeper; I have drawnthem flatter so you can see what is happening more easily):

QuantityQ10

P1

Price

D S

Buying price

Selling price

However, there is a major problem! Unless the board guesses the long term price it willset the buying and selling prices incorrectly. If the board buys at a relatively high price,it will run out of money rapidly. If it sells at a relatively high price, it will end up withstocks of the produce that cannot be sold.

In the worst scenario it would look something like this in the diagram below:

QuantityQ10

P1

PriceD S

Selling price

Buying price

You can see that the excess supply is great at the selling price, but there is little excessdemand at the lower buying price. So stocks must build up as supply permanentlyexceeds demand.

Typically this happens, for the board normally also wishes to increase the incomes ofthe farmers a bit so that when setting the prices it tends to err on the generous side.

85


Does this sort of thing occur in the real world? Yes it does! Cocoa, coffee, rubber,sugar and tin have all had such boards and suffered problems with them, includingattempts by the boards to raise the long term price by restricting supply.

NOTE: all price fixing brings problems in its wake, even if the intentions are good!

Economists generally favour free markets for this reason. If there are particularproblems, like pockets of poverty, it is usually better to tackle them directly rather thantry to fix the price of the product for all – which includes the rich and the poor.

Price fixing can also be found in labour markets where the government tries tohelp the lowly paid by setting a minimum wage.

As economic analysis predicts, problems will emerge. In the case of labour, we wouldsee unemployment at the prevailing wage rate. There might also be kickbacks andbribes by workers to get one of the few jobs available. Marlon Brando in the movie “Onthe Waterfront” was involved in such a process – it’s an old film but worth seeing!

That is not to say that we should never have a minimum wage and the benefits (aminimum income, preventing the exploitation of the poor and needy by unscrupulousemployers, and generally feeling that a wealthy society can afford to be slightlygenerous to those at the bottom) may be worth the problems.

What are the problems of setting a minimum wage?

When the government legislates for a national minimum wage, it does not affect allindustries and firms. Many are already paying well above the minimum, in order toattract the right kind and quantity of workers. So minimum wage legislation onlyimpinges on lowly paid jobs in some industries, as in firm C in the diagram below.

0 00 0

W WWSlab

Firm ANo effect

W

W

W Min Wage

LabourQ1Labour LabourQ1

Min Wage

Q2

Firm BNo effect

Firm CMin wage works

Q1 Q3

Slab

DlabDlab

SlabDlab

86


Firms A and B might be city banks, and C might be a small local café for example.

Where minimum wage legislation is effective, as in firm C, we see that after theimposition of a minimum wage, fewer people will be employed. The numbers fallfrom OQ1 to OQ2, a reduction of Q1-Q2. We will also observe unemployment insuch firms, as the number offering themselves for work is OQ3, reading off the supplycurve, but the number that are employed is only OQ2. Unemployment is representedby the distance Q2-Q3 in the above diagram. Those who find a job in such firms nowenjoy a higher income, but fewer can actually find a job than earlier and conspicuousunemployment emerges. It is the usual problem of excess supply at the higherminimum price or wage.

We return to look at the demand and supply of labour and other labour issues in Unit5.

A REMINDER!

If you are finding these free notes useful and feel that you might needa bit of help in writing essays, getting better marks in exams, andlearning more quickly and easily, take a look at a book I have written tohelp you do better - Going to University: the Secrets of Success: KeweiPress, Second Revised and Expanded Edition, August 2009, paperback,204 pages, ISBN 978-0956182319.

“Great for students goingstraight from college. I boughtthis book for my husband as hewent to uni. It is a goodbook..... It has parts aboutstudent living, how to plan yourfinances and get by on abudget. Also a good part onhow to get over the 'OMG this isa whole different world' feelingyou get when you actually walkinto the place (we've all beenthere) a book I wish I had at18.” Aisha V. Shawcross,Amazon review

87

Module 2881 Unit 3: Managing the Economy

Some abbreviations used:

X = exportsM = importsB of P = balance of paymentsGDP = gross domestic product

3-1. INTRODUCTION

1. Why does the government become involved in the economy?

Since John Maynard Keynes’ work, published in the 1930s, we know how we canintervene to reduce unemployment etc., – we have a good theoretical model thathelps us to understand how the economy works.

Increasingly since World War Two (1939-45) it is seen as a task of thegovernment to intervene and work more actively to improve things in general.Interventionism is now expected.

The natural working of the economy can sometimes give undesirable orunacceptable results, such as mass unemployment or inflation.

Because what is happening, or government fears is about to happen, is notwanted. For example, inflation is felt to be too high or there is a fear that it willincrease; or balance of payments is worsening.

Note: since the time of Prime Minister Margaret Thatcher (UK) and President RonaldReagan (US), in the late 1970s and the 1980s, efforts have been made to reduce theamount of government intervention. However, it sometimes seems rather difficult toreduce the share of government in the gross domestic product. The use of freer marketshas definitely increased – but the government share of GDP seems to have increased too.

2. At the micro level: the government wishes to make the market mechanism workbetter.

What main areas of the micro-economy does the government look at or tackle?

Monopoly elements or market dominance.

Externalities.

Copyright Kevin Bucknall ©

88

Public goods.

Public goods.

Merit goods.

De-merit goods.

Information failures.

Factor immobility.

Undesirable income and wealth distribution.

That is, the government looks at all the major elements that we are studying!

3. At the macro level : the government wishes to modify some important areas.

What does the government look at or tackle at the macro level?

Inflation (usually they prefer a low figure, e.g. below 3% ).

Unemployment (they usually prefer it to be low, e.g., below 4%).

Economic growth (they usually prefer it to be reasonably high, e.g., above 2.5%).

Balance of payment (they usually prefer a balance of exports and imports, orperhaps a small export surplus).

The value of the currency which means the price of the pound in internationalmarkets (politicians usually prefer it to be high, although a lower figure meansthat industry benefits as our export goods will be cheaper and so easier to sellabroad).

Allocation of resources (they usually prefer a market solution but it can bewhatever the government feels it wants).

Distribution of income (the Labour Party usually prefers a narrow distribution; theConservative Party perhaps wider? But New Labour seems to accept that a widerdistribution of income is quite acceptable).

Standard of living (they usually prefer high).

Taking care of the environment (a relatively new area of concern).

89

Unwanted fluctuations in any of the above, e.g., if any are felt to be undesirable atthe level they are at, the government may step in and try to alter and improvethem.

How can government try to manage the economy?

There are two main ways: fiscal policy and monetary policy.

Fiscal policy = taxation largely, plus some subsidies. This label also includesgovernment spending these days; once it was separated out in text books as “directaction”, “government spending” or a similar phrase.

Monetary policy = changing the money supply or the rate of interest to alter the level ofaggregate demand.

NOTE: Since 1997 this power was removed from government and given to the MonetaryPolicy Committee of the Bank of England. The government is represented on this and canstrongly influence its decisions but not control it.

Both main ways of managing have certain implications attached:

Fiscal policy: tends to have strong resource allocation effects, for example if thegovernment increases the tax on cigarettes, it hits smokers only; if it increase income tax,it ignores those on low incomes who do not pay this tax.

Fiscal changes are usually done in an annual budget in April – so a desired change can beslow to implement, as we may have to wait until April to announce it! Some changes tocome might be leaked beforehand. In addition to the budget proper, the country mayhave a mini-budget around October. Once a change is announced in the budget, theeffect is virtually immediate.

Monetary policy: the government no longer can do this directly – despite its ability toinfluence the views of the Monetary Policy Committee.

The effects of monetary policy may be slow and it can take between 6 months and 18months to get the full impact of interest rate changes.

What does government actually do?

1. It may try to increase aggregate demand: it might do this if it feels thatunemployment is too high, and inflation is reasonably low; or the standard ofliving could safely be increased; or economic growth could be higher.

- To increase demand:

90

- Monetary policy: government could lower the rate of interest bypersuading the Monetary Policy Committee to act.

3. Supply side: the government might try to push the aggregate supply curve out andto the right. This would reduce inflationary pressure.

The government cannot attain all its goals at the same time because

We are not yet smart enough to know how to do this! (And probably neverwill be.)

Some goals contradict others: to get more of one, we must have less of theother – there is a “trade off” between the two.

Mathematically, it is theoretically not possible to attain ten goals with onlytwo policy instruments.

Examples of what we cannot get at the same time because of conflict

High growth with a good balance of payments (fast growth sucks in imports).

Low inflation with low unemployment - but we are better at this than we oncewere!

High growth with more equal income distribution. Economic growthnaturally causes a widening of income distribution as those who are better,luckier, more intelligent, stronger, better connected, happen to be in the rightplace at the right time….. pull ahead of the pack. The government maychoose to step in to try to equalise it more (New Labour has so far chosen notto do so). It is possible that a wider income distribution actually assists theattainment of higher economic growth (which is part of the supply side view).

- Fiscal policy: government could decrease some or all (unlikely!) taxes;

and/or spend more government money (the “G” in “C+I+G”which is the domestic component of aggregate demand).

2. Alternatively, it may try to reduce aggregate demand: it might do this if it feelsthat inflation is too high, the employment level is too high, or the balance of paymentis poor (imports exceed exports), i.e., we are in the middle of a boom and thegovernment wishes to moderate it.

91

In other words, the goals interact. The pursuit of one goal can harm (or sometimes assist)the attainment of a different goal. We live in a complex world!

Much of the rest of unit 3 is simply explaining the details of the above. What each itemis; how we define individual items; what the government does with them and how it doesthis; what diagrams we can draw to illustrate the workings of the economy and then usethem to analyse what is currently happening or what might be done if some otherequilibrium position is desired.

92

3-2. INFLATION

We need to understand how to measure things like the level of inflation, the level ofunemployment, the balance of payments and the size of gross domestic product.Why?

If we are to see how well the economy is doing we need to be able to measurethe degree of success.

If we want to know if government should intervene or not – and if so, whetherit might wish to expand or to contract the economy.

And, in general terms, we need to understand how we measure so that weknow exactly what we are talking about!

We need the information about measurement methods for use when answeringexam questions.

Finally, we need to understand how we measure to make sense of the actualmodels we use later.

THE RETAIL PRICE INDEX

Inflation is an important economic goal and it matters to a lot of people. For suchreasons, we have to know how much prices are changing or have already changed, whichmeans that we have to take measurements in some way.

It is clearly impossible to go to each shop in the country and price each item once amonth! So we have devised an index to simplify the task. We take a “basket” of goodsand services, typical of what people buy, and price these goods and services at a basedate. Then we look to see what has happened to the prices of the individual things in thebasket since then and tot them up. The government has done this since 1947.

Details: over 600 goods and services go in the basket; once a month we take over120,000 samples of prices of these 600+ items. This is a bit tricky: the supermarkets,corner shops, 24/7 stores and so forth all have different prices and in addition some areaslike London are dearer than others.

Then the statisticians “weight” the items – e.g. housing and transport are more importantthan salt in people’s budgets, so the important things are weighted more heavily than theunimportant ones. If the price of salt rises by twenty percent it really will not affect usmuch! But if bus or train fares went up by that percentage it surely would….

93

If the average rise of all the items, after weighting, is found to have been 0.5% over themonth, the government tells us that; it usually also tell us what annual rate of inflationthis would represent and how it compares with the same month of the previous year.At June 2004, the Retail Price Index was up 1.6 per cent over the previous twelvemonths.

The “RPIX” (which stands for the Retail Price Index Excluding Mortgage InterestRepayments – quite a mouthful!) is a separate measure, which excludes mortgage interestrepayments. This is the one that the Monetary Policy Committee focuses on for its policytarget, and aims for a rate of 2.5%.

Limitations of the RPI

Not everyone is average, and consumes that exact basket of goods and services,so the RPI does not exactly fit all (but it is close for most!). Pensioners andmillionaires obviously have different spending patterns and neither will fitexactly. Pensioners have their own index calculated.

Many goods are “intermediate goods”, e.g., machines to make machines, so theseare excluded because they are not “retail”. The underlaying rate of inflation,which includes the changing prices of everything, can be different from thatreported in the RPI.

The basket gets out of date:

o As people change their consumption habits (e.g., there is more foreigntravel now than in the 1960s – but rather less after the September 11 NewYork terrorist bombing).

o New goods and services come onto the market (e.g., DVD players) thatwere not in the old baskets – so we have to update the basket periodically.This is done each Spring.

o But after we make such a change, strictly we cannot compare the newprice index with the earlier ones, because it covers slightly different goodsand services, or we might have altered the weightings used. We still makethe comparisons however!

The index does not reflect any quality improvements and these steadily occur.

It is better to think of the RPI as an “estimate” rather than a hard accurate figure.

The RPI does not measure the standard of living. It excludes things that have animportant impact on this, such as changes in tax; changes in leisure time; changes

94

in the physical space available for enjoyment; and changes in the quality of goodsand services.

Uses of the Retail Price Index

Unions look at it and may base their wage claims on it.

The government looks at it, to decide if there is a need to intervene and managethe economy (our main interest!).

Journalists look at it, to write articles explaining to people what is happening andtheir comments and advice might be considered by the government.

Economists look at it, to help them understand what happening and of course toadvise others.

Investors look at it, to help decide whether to invest, when to invest, and where toinvest.

It is used in international comparisons to evaluate the performance of the UK andcompare it with other countries.

It is used to calculate the price rise allowed for some privatised industries that aretightly controlled. These were once state-owned public utilities such as the gasand electricity supply companies. The energy sector is controlled by Ofgem.

The RPI is often used loosely as a measure of inflation – although it only reflectsretail prices and indeed not all of those.

What is inflation?

Inflation means persistently rising prices; the term is not normally used by economists(although it may be by the person in the street) for a one-off price rise, for instance if thegovernment increases the level of VAT.

95

What can cause inflation?

Demand pull = demand exceeds supply at prevailing prices.

Cost push = a shortage of raw materials causes their price to rise; these force upthe costs of our producers. Rising import prices can similarly push up ourmanufacturing costs, as can wage-push inflation.

Hybrid inflation = a mixture of the first two. Either starts the process off, then theother jumps in; they may then alternate in an on-going process.

Government policy can do it, forcing us up the Philips Curve (more later); or thegovernment might increase spending before elections to put more people intowork and gain support (this is really a special form of demand pull).

We will investigate the problem through our aggregate supply and demand model later.

Some Problems with inflation

Those on fixed incomes lose out (pensioners, students…). This also changesincome distribution.

Those on sticky incomes lose (often public service workers, as it is not easy toincrease their wages).

If inflation is too high, it puts entrepreneurs and business people off, so they willnot invest as much. Less investment now means slower growth in future.

Benefits of inflation

Moderate inflation can encourage entrepreneurs and business to take risks andinvest, leading to a higher growth rate and less unemployment.

We are used to inflation and seem to feel comfortable with it. We are not surewhat to do if we face deflation (generally falling prices), e.g., Japan has beenstuck in recession since 1990 and also deflating in the last few years. There aresigns in 2004 that this may be ending.

96

Problems with low price rises or even deflation

Low rates of inflation = the situation we are in now (2004).

It may turn into a long-run recession with the danger that we could get stuck, likeJapan.

If this happens, we get low rates of growth, high unemployment and possibly thedevelopment of international protectionism and “beggar my neighbour” policies.

When the economy is growing slowly it makes it harder for the government tointroduce changes; with fast growth, everything is buoyant, government revenueis up and they can do a lot.

When it is harder for the government to make changes it may mean thatdownturns in the economy are likely to be more severe and long lasting.

The ability to use monetary policy gets weaker when prices are not increasingmuch – it is harder to stimulate the economy by reducing interest rates.

Benefits of low price rises

Consumers gain, as goods and services rise little in price.

Fixed income (and sticky income) people gain; groups such as pensioners andstudents are helped.

A low rate of inflation encourages investment, as people can make a paper profiteasily.

Risks are reduced if everyone knows what prices to expect.

97

3-3. THE LEVEL OF UNEMPLOYMENT

Why do we measure unemployment?

Unemployment is seen as a social evil, that should be tackled – we need to knowthe level of unemployment to see how well the economy is doing.

The government needs to know so it can intervene if necessary. Government maydecide to alter the level of aggregate demand or institute special policies e.g.,sponsored training schemes, or expand jobs in the public sector.

We need to know the level of unemployment for social welfare purposes. Thegovernment need to budget and wants a forecast of future payment levels to theunemployed and other social security benefits.

International obligations – the United Nations makes us collect data onunemployment – all members of the UN accept the rules as a condition ofmembership.

Trade unions, political parties, the Confederation of British Industry, anddoubtless others, would strongly object if we stopped collecting the data. So wecould not stop anyway!

How do we measure unemployment?

(This was mentioned briefly last time).

We take the number actually unemployed and divide it into the number in the workforceto get a percentage, e.g., 3.0%. There were 28.3 million in the UK workforce in July2004.

But it is not easy to determine who is unemployed or who is in the workforce.

The “workforce” means those who are 16 years and older who work for pay or elseregister as “available” for such work. This excludes students, housewives or house-husbands, pensioners and the early retired, and all who do not bother to registerthemselves. There were 29.7 million economically active people at mid 2004.

There are two ways we measure unemployment.Method 1 The claimant unemployed. This includes those who claim benefit within thelast month (the “job seekers allowance”); the measure is taken on the second Thursday ofeach month.

It excludes all those not eligible for benefits; all men over 60 years; and all thoseregistered at private commercial job-finding agencies but not state ones.

It includes fraudulent claimers, e.g., those working but claiming benefit at the same time.

98

It is generally thought to ignore “hidden unemployment” and thus underestimates the realfigure.

At mid 2004 the claimant-based rate of unemployment was 2.7 %.

Method 2. The survey method. This is a standardised international measure, based onthe International Labour Organisation method (ILO).

There is a quarterly survey of 61,000 households – a person is counted as “unemployed”if they say they have no job but have actively sought work in the last four weeks or theyare waiting to take up a job offer in the next fortnight.

This measure probably overestimates the degree of unemployment as people can easilyclaim they are looking for work when they are not!

At mid 2004: the Labour Force Survey-based rate of unemployment was 4.8% (cf. 2.7%by the claimant method above).

Some problems involved in unemployment include:

Issues in being able to find work:

o Where a person lives (in the north-east it may be hard to find job, in London itis easy).

o Gender – males are less likely to be fired than females; but unemployedfemales are more likely to be offered a job than men. However, this is likelyto be part-time work even though many might prefer a full time position.

o Race – whites are more likely to be offered work than non-whites.

o Age – youth are less likely to be offered a job, as are older people, say over 50years of age.

Seasonal adjustments - some jobs are more on offer at certain times, e.g., fruit pickersor when school leavers flood onto the market seeking their first job. The governmentadjusts the unemployment figures to take account of it (this is called “the seasonaladjustment”).

The time unemployed: the average can mislead. Some people stay unemployed forlong periods and may never find work, even if the average length of unemployment isonly a few weeks. Also, if a person is unemployed for more than about two years(USA case studies) the person tends to lose their work habits, becomes unpunctual,and may not bother to turn up if he or she does not feels like it. Such people give upin effect, and may never work again.

99

Types of unemployment and the role of the state in tackling them

Other than giving unemployment pay to those who have paid for their stamps (nationalinsurance), we usually do better by tackling the cause of the unemployment if we can.

These causes can be:

Deficient demand.Structural.Cyclical.Frictional.

Deficient demand

If the cause is deficient aggregate demand: the government can simply increase demand.

Structural unemploymentAt any one time, some industries are dying and have surplus labour with skills that fit thatindustry; and some industries are growing and are short of people, particularly those withthe necessary new skills. A major cause of structural unemployment is a change indemand in consumer markets, together with the time lag needed to educate and re-educate people.

In addition to changes on the demand side, some technology changes on the supply sidemean we also need new skills, for example computer scanner repair workers. We alwayssee a mismatch between the skills workers have and the skills employers need, becausesociety is constantly changing.

Note: manufacturing is a dying area and service industries a growing one in all developedsocieties. This has strong implications for the type of education we need and the trainingin particular skills.

To tackle structural unemployment the government may:

a) Provide information on what jobs are available as well as likely in the future. This canbe done via job centres, advertising on TV, informing careers advisors in schools and thelike.

b) Help people to move away from the area of low job opportunity in which they live.

Some possibilities include: subsidise travel to look for work; pay all the costs of sellingthe house and buying a new one elsewhere; allow people in council accommodation indifferent local authorities easily to exchange dwellings; make all pensions transferablebetween companies.

100

A major problem is the house cost around the South-East of England. Prices are so highcompared with the North.

A minor problem is that welfare payments allow people to stay where they happen to beborn, even if there is no work there for them.

People often do not or will not move:

Some people do not want to move away from their families, friends and socialgroups or clubs of which they are members.Some people often unaware of the possibilities elsewhere (lack of knowledge).Local accents are strong and they fear they might be laughed at or not find workeasily even if do move – with some justification.Sheer inertia.

c) We may need to train and later retrain adults through life to gain new skills.

Some possibilities include: subsidise retraining for the worker and for the company theycurrently work in; tax breaks given to those who gain a needed skill; allow the workertime off work with full pay; or “bribe” people with cash handouts. This would seem amore desirable way and less disruptive socially than moving people to new areas wherethey may be unhappy.

Cyclical unemploymentThis is due to the business cycle. We can try to iron out booms and slumps to reduce thistype of unemployment.

Frictional unemploymentThese are people in the process of changing jobs and who are briefly and temporarilyunemployed. We need do little or nothing here.

The 1998 Labour “New Deal”

This was partly to tackle unemployment, partly to tighten up on “dole bludgers” andpersuade people to go back to work.

The unemployed now have three choices:

Stay in school or go back to school.Find a job.Join a recognised training scheme.

101

Their benefits can be cut off if they do not do one of these.

“Full employment”

This does not mean “no one is unemployed”! There will always be frictionalunemployment; some people will never work because of mental or physical incapacity.Lord Beveridge, in 1944, felt that 3% was roughly “full employment” (made up of 1%frictional, 1% seasonal, and 1% because of overseas factors like a fall in demand forsome of our exports).

Now we prefer to focus on the “natural rate of unemployment”, which is the level wherethe rate of inflation does not increase (but there still is inflation). This is abbreviated to“NAIRU”, “the non accelerating rate of unemployment”; there is a bit of confusionaround this term, as some writers use it to mean the level where prices are constant, i.e.,there is no inflation at all, rather than there is some inflation but which is steady. We willlook at NAIRU later in more detail when we examine the Phillips Curve below.

Demographic and social changes and employment (some points that might proveuseful for exams – you never know!)

An ageing population: fewer workers exist to support the greater number of livingretirees which will lead to an increasing burden on the working population.

The population pyramid: this is usually a “normal” shape, i.e., it is like a pyramid.However, in developed countries such as the UK, the base is narrowing as fewerbabies are being born.

The government response has been to encourage people make more provision fortheir own old age and save more. Stakeholder pensions (2001+) encourage people totake out their own private pension plan; Independent Savings Accounts, better knownas ISA’s (1998+) mean people do not pay tax on savings in an ISA account or onshares held in an ISA account.

Women have increased their share of the workforce. Generally they take part-timework more than men. This is partly because they prefer it as they may have childrento cope with; for many, however, they take it because it is all that they can get.

There is a problem hidden in the overall unemployment statistics in that many of theunemployed are full time males; while many of the newly created jobs are for part-time women workers.

102

The participation rate. This is the proportion of the working age group (15-60 or 15-65) that choose to work, i.e. are in work or actively seeking work. The share ofwomen has increased!

Technological change and unemployment

Manufacturing industry is declining as service industries expand (these are now 70%of GDP in the UK). This means that some old skills may be out of date and are nolonger needed, while the demand for new skills is high and also constantly changing.

Age effects: the old learn new skills slowly if at all, so demand for them is low. Oneresult is that it is harder for them to find a job; firms just hire younger workers.

There is a normal distribution curve of intelligence (half the population is below it bydefinition!). In a modern society, heavily based on services and with manyautomated machines, the less intelligent people have fewer and fewer jobs to go for(there is less demand for their services using muscle) but the demand for theintelligent ones steadily increases. The long term prospects of those born slightly dimthrough no fault of their own does not look good, especially if they lack a naturaltalent. If someone is born with an ability to cut hair, they will probably be OK, infact do rather well. But those with a low IQ and no natural skills may find it quitehard. There is probably a social problem in the offing here.

103

3-4. THE BALANCE OF PAYMENTS

[X=exports, M=imports, FX=foreign exchange, b of p= balance of payments]

What is the balance of payments?

It is a record of a country’s economic transactions with all other (foreign) countries. Itlists the trade in goods and services, how we pay for this (or what we owe if we did notpay), and some other financial flows, like foreign investment and company dividendpayments.

There are four categories within the UK balance of payments. In 1998,everything changed to this new method of presenting our international situation.

1. Current account2. Capital account3. Financial account4. International investment position.

The current account includes:

The trade in goods

The trade in services.

Income from working abroad, and from investments abroad.

Current transfers: both central government and private.

NB Do not learn the numbers; just get an idea of what items are included and which arethe biggest and smallest – and the negative ones (which means we import more than weexport). The “*” means the item or sign is worth noting. If you should get a question onthe balance of payments which supplies data and then asks you about it, look for:

The items asterisked here in particular.Any negative items.Any really big figures.

If two or more years’ data are supplied for you to analyse, check to see if there are anylarge changes, using your calculator, as these will be important. You can quote thepercentage changes in your answer.

104

The UK Balance of Payments, 2003 in £ millions – Current Account

CREDITS

(Exports)

DEBITS

(Imports)

BALANCE

GOODS

Food, beverages & tobacco 10,826 21,085 -10,259

Basic materials 3,322 6,128 -2,806

Oil 14,589 10,479 4,110

Semi-manufactures 54,323 55,889 -1,566

Finished manufactures 102,006 138,973 -36,967*

Other goods 2,780 2,582 198

Total Goods 187,846 235,136 -47,290*

SERVICES

Transportation 12,958 17,194 -4,236

Travel 13,928 29,740 -15,812*

Financial services 13,417 3,481 9,936

Other services 49,390 24,661 24,729

Total services 89,693 75,076 14,617*

INCOME

Employment from abroad 1,116 1,057 59

Income from investments 125,224 103,186 22,038*

Total income 126,340 104,243 22,097

CURRENT TRANSFERS

Central government transfers 4,199 10,939 -6,740

Other transfers 8,964 12,078 -3,114

Total current transfers 13,163 23,017 -9,854

CURRENT ACCOUNT TOTAL 417,042 437,472 -20,430

105

Some points to know – you may be able to use some of these in questions about thebalance of payments:

Goods: we import a lot more than we export – especially finished manufactures and food.The balance is always negative.

Services: We export a lot more than we import - although transportation and travel areusually negative (poor weather in the UK so we take holidays abroad?!).

The balance on services has been positive every year since 1966 and helps us to pay forall the goods we import. The surplus on services has increased substantially since themid 1990s.

Income: we earn a huge amount in profits and dividends from investments that we havemade abroad in the past; income from working abroad used to be a small negative itembut became positive in the late 1990s although it is relatively small.

Current transfers: This account has been in deficit every year since 1960. Thegovernment generally runs at a surplus but large deficits elsewhere ensure that the wholeitem is in deficit. The transfers to EU institutions go into the “other” category.

The current account as a whole: a deficit was recorded in each year 1984-2003. It is mostexceptional to be in surplus

THE CAPITAL ACCOUNT = THE 2ND OF 4 PARTS OF WHOLE BALANCE OFPAYMENT

This is not central to our interests for the exam: there is only ownership of fixed assetsand what migrants bring in with them when they arrive (a credit item) or take out whenleave (debit item).

THE FINANCIAL ACCOUNT = THE 3RD PART OF WHOLE BALANCE OFPAYMENTS

This is not central to our interests for the exam either.

This account has expanded rapidly with the globalisation of the international economyand large increase in financial investment flows.

106

When a UK resident buys assets abroad, e.g., shares in a French company, it goes in hereas a debit item.

When foreign residents buy assets in the UK, it goes in as credit item.

THE INTERNATIONAL INVESTMENT POSITION – 4th AND FINAL PART OFBALANCE OF PAYMENTS

Also not important for us for the exam – it just shows the value of the total assets that theUK owns abroad, and assets here owned by foreigners. It is a stock figure, not a flow.

THE 10 ECONOMIC GOALS AND THE EFFECTS ON THE BALANCE OFPAYMENTS

If the economy growsfaster

The B of P worsens, as growth sucks in imports to sustainproduction + higher incomes mean consumers buy moreforeign goods/services (*they are income elastic!).

If the standard of livingrises

The B of P worsens as consumers buy more foreign goodsand services (again, income elastic).

If resource allocationimproves

The B of P probably improves, because the country is doingwhat it is best at.

If income distributionbecomes more equal

The B of P probably improves, as the rich reduce theirpurchases of foreign goods/services; but average incomes donot rise enough to suck in many new imports.

If inflation increases The B of P worsens, as our X’s fall and M’s rise.If unemploymentincreases

The B of P probably gets a bit better, because incomes arelower, so consumption falls and M’s reduce.

Value of the pound If pound gets weaker it encourages our X’s and discouragesM’s, so the B of P probably improves. NB The currencymay be weak because the B of P is already poor!

We return to consider the balance of payments, particularly the current account, in thesixth unit “The UK in the Global Economy”.

107

3-5. GROSS DOMESTIC PRODUCT (GDP)

What is the gross domestic product?

The GDP is the value of all the goods and services produced within a country, usuallymeasured over one year.

How do we measure GDP?

There are three ways of measuring: By output, by expenditure, or by income. All threemethods should give same result.

Why do we get the same result? Because producers have to pay to get the materials andworkers they need (so they receive an income); then what is produced is bought bysomeone (consumers or wholesalers = expenditure; to make it easier to understand weassume that all is sold, although this is not actually necessary); and what was produced ofcourse is output. So income = expenditure = output.

Incomes consist of wages, interest, rent, and profit.

Note that profit always adjusts to make incomes equal output. Why?

Consider this. If we pay out £90 to make an item (it goes as income to someone) andthen we sell it for £100 (which is expenditure), it means that profit is £10.

But we know that incomes + profit (£90 + £10) = £100

And we know that expenditure = £100

Therefore the two are the same.

So incomes must equal expenditure, as profit is always the difference between the two.

Take another example. Suppose we buy for £90 and find that we can only sell it for £85?We still have £90 going to someone as income, but an expenditure of only £85. There isa loss of £5. So either profit or loss adjusts to make incomes identical with expenditure.And of course, a loss is merely a negative profit!

See the diagram below which shows all the flows in domestic national income.

108

Businesses Households

Buy goods and services

Supply labour, capital, land

Sell goods and services

Pay wages, interest, rent

You might see this diagram representing the nation’s production/income/expendituresometimes called “the wheel of wealth”.

It excludes foreign trade (imports and exports) as this refers only Gross DomesticProduct. We can easily add these two extra flows, but why complicate things? If wechose to do add these flows, the diagram would then represent Gross National Product aswe would be considering the whole nation, not just domestic production.

Some technical problems when adding up the GDP

For incomes, we must exclude transfer payments (they are not a reward forproducing anything) like old age pensions or child support.

For output, we must avoid double counting, e.g., we take just the price of a loaf ofbread, not the value of the wheat, flour, transport and storage costs in addition;they are already included in the final price, as the retailer sells at a price thatcovers all his or her earlier costs!

We use value added at each stage to avoid double counting.

For expenditure, we take the market price but we must remove VAT and othertaxes which the government has put on as an extra; and we add in any subsidygovernment has paid, to get the true price are seeking.

Because there are so many items to find and add up, the three methods are neverquite identical in practise – in the real world there is a statistical discrepancy(people make mistakes in recording, there are time lags in pieces of paper moving

109

about, some get lost and so forth) and we use a “balancing item” to make thefigures exactly the same. It is usually quite small.

“Gross Domestic Product” and “Gross National Income” (GNI)

GNI is obtained by adding foreign-earned incomes from property owned abroad oremployment abroad to GDP (remember that “income” is the “I” bit of “GNI”).

“Gross National Income” and “Net National Income” (NNI)

To obtain net national income we subtract a percentage from gross national income toallow for capital which wore out or became obsolete in the year we are looking at. Inshort, to get from gross to net, we make an allowance for the depreciation of capital.

It may seems complex but all you have to remember is:

“Domestic” means no foreign sector is included.“Gross” means no depreciation for capital has been made.“Product” means output, and excludes incomes coming from (or to) abroad.“Income” means we do include foreign income flow.

We can combine these words to get different measures.

We chose the measure we need to answer the question we are asking.

The simplest is GDP, it is the one that is most used and you will encounter, and it is theeasiest to find for more countries.

110

3-6. ECONOMIC GROWTH

What is economic growth and how is it measured?

Economic growth is the increase in output of the value of goods and services in thecountry, usually measured over the period of one year.

In a developed country we typically get a figure like 2.5% or 3.1% - but for a fast-growing poor country like China, it may be as much as 7%-10%.

We can see growth as a movement of the production function in an outwarddirection.

(Here we have chosen to look at growth over four years but annual growth rates ofteninterest us more.)

ppc = production possibility curve.

Starting at C on ppc1, economic growth causes the production possibility curve to shiftout to ppc2, to a new equilibrium position at D.

Apples

ppc1(now)

ppc 2(4 year's time)

A1A2

B1B2

CD

0 Bananas

Only two good are shown - but it works for any number – I cannot draw four-dimensional(or more) diagrams; I am not even good at 3D!

111

Nominal and real economic growth

Nominal growth includes price changes and, if there has been any inflation, itexaggerates the measured rate of growth. Clearly, if all prices were to double but outputwere to remain the same, it is not true to think that we have a hundred percent growthrate!

“Nominal rate of growth” = change in GDP over the year (e.g., 2.9%).

“Real rate of growth” = GDP minus the rate of inflation; e.g., if inflation is 1.4%, the realgrowth rate is (2.9 - 1.4) = 1.5%.

Growth as an indicator of the standard of living

Growth is often seen as most desirable, especially by governments. Growth is one of theten economic goals (remember these?) and higher growth is often thought to be better,although some people criticise high growth rates for their effects on the environment.

A high growth rate is limited, or perhaps can be even misleading, as an indicator ofimproved living standards.

Growth over time within one country: limitations as a measure.

NB these points are also virtually identical with problems in the use of GDP per capita asa measure of the standard of living.

Economic growth excludes much that goes into the standard of living – e.g., theenvironment (air or water pollution, availability of parks and green space; or thenumbers unemployed).

The hours worked are not examined: if we all double our hours worked and GDPrises by 5%, it looks good with 5% “growth” - but most would agree that we areactually a lot worse off! Leisure is excluded from measurements of economicgrowth.

Free services or goods are excluded: for example, the work of housewives orhousehusbands; all voluntary service like teaching computing for Age Concern;looking after a relative as a carer; and the free exchange of labour in service swapschemes such as babysitting clubs.

A change in GDP can be caused by changes in aggregate demand – if demandfalls in one year, growth can be negative – then if demand increases, growthbounces back strongly. This kind of yo-yo effect can be most misleading andcareful selection of starting and stopping years can yield opposite results!

112

Examine the diagram below. If we choose the years T1 and T2, we get a stronggrowth rate on Line 1. Contrast this with choosing years T3 and T4 on Line 2:there is a negative growth rate!

Be most careful when listening to politicians when they are talking about changesover time; some of them have a nasty habit of selecting those years that favour theargument that they wish to make!

0

GrossDomesticProduct

GDP

Time in years

T4T3T2T1

Line 2

Line 1

We need to measure “the underlaying rate of growth” to make a sensiblecomparison over time. This measures what the economy could produce if demandwas enough to buy all that was produced.

Measuring economic growth should be done on a per capita basis – if GDP increases2 per cent but population increases 4 per cent, people are definitely worse off onaverage.

We know that environmental damage is excluded. A related problem is interesting!If we damage the environment, then spend £100 million putting it back the way itwas, the GDP actually increases by £100 million - and on paper we are “better off”and we have growth!

Crime is naturally excluded from GDP as it is not desirable – but if crime increasesand we spend £100 million on more police to combat it, then again the GDP rises by£100 million and on paper we are “better off”. Few would actually feel this to be areal improvement perhaps.

As we enjoy economic growth, it is quite possible for income distribution to have gotworse! It is true we have growth, but the standard of living could have fallen for themajority of the population.

113

Comparing growth between countries can mislead

Slow growth can often conceal a better situation. As an example, let us consider theUK and Egypt. Suppose growth in the UK is 2.2% p.a., but in Egypt 3.3% p.a. Thislooks good for Egypt, but in reality:

- That country started off so much poorer that the extra one percent growthprobably added much less to their output than the UK achieved.

- People probably worked much longer hours in Egypt.- The population growth in Egypt would almost certainly exceed that of the

UK, so the improvement per head in Egypt could be less than in the UK.- The death rate in Egypt is higher, life expectancy shorter, and the standard

of living is much lower than in the UK.

Countries do not always measure their growth rate in identical ways, although theyshould for proper comparisons.

The quality of statistical accuracy varies between countries – the UK figures arebetter, for instance, than the Cambodian ones.

Much more free family work is done in poor developing countries than in richerdeveloped ones – so the figures miss out much real production that takes place in thepoor countries.

“The unofficial sector” or “the black economy” is not picked up in the statistics, andthe size of this differs between countries, e.g., the black economy is thought to bemuch bigger in Italy than in Denmark.

Exchange rates can distort the picture; e.g., if France used to exchange US$1 for 10francs and the exchange rate changes to $1=5 francs, measuring the GDP of France indollars, looks as if there has been a doubling of GDP as 10 francs now buys $2!

What causes growth? = the sources of growth

It is useful to consider this under the headings of Land, Labour, and Capital + Remainder

O = f (L, N, K) + R

(Recall we did this earlier).

114

A) Land factors

Natural resource endowments – if a country has diamonds or oil etc, it helps! But theland factor is not enough to give growth on its own, and it is the least important of thegrowth factors.

B) Labour factors

Labour skills and abilities = education and training. The more of these, the betterfor growth but it should be of the right kind. India, for example, has been accusedof training far too many lawyers and not enough agricultural specialists.

Labour enthusiasm or motivation – the more of this, the better for growth.However, it is not easy to know how to stimulate motivation. Declaring war onsomeone usually seems to increase it although the British invasion of Iraq did notseem to be popular or have a motivational effect.

Labour numbers – the more the better if they have the skills etc. and the countrydoes not start out with a large labour surplus. More workers are less useful inChina or India than they would be in the UK or the USA.

Managers’ ability, training, and enthusiasm. The higher the better.

C) Capital factors

More machinery and equipment = good for growth.

Higher rates of investment = good for growth, because it means more machinesetc will be available. Remember that social investment like docks and harbourscan pay off too.

Higher rates of saving = good for growth because the country can invest more (inthe short term it could harm output if it means that consumers are suddenly notspending as much, but it is generally good for the long term).

Technical progress = good for growth and is the main source of growth in richdeveloped countries.

Desirability of growth = the case for growth or the benefits of growth

Growth means we can increase the standard of living, increase GDP per head, andspend more on things like welfare, transport, education and health for example.

115

The growth we achieved in the past is the source of our present living standards,health levels, and lack of illiteracy etc.

Growth means we are able to tackle all our existing problems more easily,because we have the increased resources to do so. We probably need growth forinstance, to put right any environmental deterioration.

Growth means if we run into a new problem, it is easier to cope with; we aregrowing and thus have more surplus to devote to this problem.

Undesirability of growth = the case against growth

It causes environmental degradation by its very nature.

Blind pursuit of growth means we may often ignore the real problems we arefacing.This objection to growth is sometimes a crude “Back to nature” romanticism –growth is somehow immoral or bad.

Urban congestion, high levels of stress in people, marital breakdowns,generational conflicts and the like may be caused by or at least worsened by ourefforts to grow faster.

Growth by developed countries has forced poverty on poor countries (probably apoor case - although the balance of division of gains does favour the wealthy andpowerful). Poor countries generally are getting richer than ever before - exceptwhere civil wars, invasion or totally unsuitable economic policies have damagedor destroyed the economy. Africa is currently a case in point, with people eitherslaughtered or starving now or in the past in countries like the Sudan, theDemocratic Republic of the Congo, Rwanda, Idi Amin’s Uganda, CharlesTaylor’s Liberia and Mugabe’s Zimbabwe.

A few final points about growth

Generally economists favour growth, although we are aware of the damage it cancause.

If you are asked in an exam, it is usually better to decide in favour of growth, afterpointing out the various problems that might be associated.

The point that without growth it is harder to improve the world we live in hasmerit and is often worth mentioning.

116

And you can say that careful watching and action by government may be highlydesirable or essential to put right any undesirable side effects from growth.

“…Bucknall’s book, written with the aim ofoffering a brief guide to those about to arriveat university (including the often ignoredmature student), explains the fundamentalissues each student is likely to face atuniversity - be it when searching for suitableaccommodation or when delivering theinevitable end of term essay(s). For thenervous pre-university student, it canbecome a reassuring hand on the shoulder.As a succinct guide it can easily be read fromcover to cover.”

Richard Benstead, student, in Durham21, astudent newspaper at Durham University.

If you are finding these free notes useful and feel that you might need a bit of helpin writing essays, getting better marks in exams, and learning more quickly andeasily, take a look at a book I have written to help you do better: Going toUniversity: the Secrets of Success: Kewei Press, Second Revised and ExpandedEdition, August 2009, paperback, 204 pages, ISBN 978-0956182319. £9.95

117

3-7. AGGREGATE DEMAND AND AGGREGATE SUPPLY

This model is the representation of the whole macro economy and this is the diagram weuse to analyse any changes in it. It is crucial that you understand this model and be ableto draw it from memory. (Always draw the two axes first and label them – then put in thecurves and label them too! Having done this you can then start to move the curvesaround. Remember! Examiners see too many unlabelled diagrams.)

Some standard abbreviations: Y = income; C = consumption; I = Investment; G =Government; X = exports; M = imports; r = rate of interest; Y = income; L = land; N =labour; K = capital; Ms = money supply; Md = money demanded.

1. AGGREGATE DEMAND

What is aggregate demand?

Aggregate demand is the sum total of all planned expenditures by the people andgovernment.

= Consumption + Investment + Government expenditures + Exports – Imports

= C + I + G +(X – M)

The aggregate demand diagram

Price Index

0Real GDP

AD

NB. The labels on the axis! This diagram is not the same as the micro demand curve!But if you can cope with the micro one, this one works in a generally similar fashion.

118

The broken lines merely indicate a gap in the number line – you need not draw these butit impresses a bit if you do! Henceforth I am dropping the break lines in the diagrams,mainly because the diagrams look cleaner that way.

The amount demanded varies at different prices: the lower the price index the more isdemanded (the AD curve slopes downward left to right) because of:

• The wealth effect (“the real balance effect”). This says that as prices fall, we arewealthier because we can buy more with the same amount of money. Think aboutit! If all prices were to halve while you read this page, the money you have inyour pocket and elsewhere would buy twice as much.

• The interest rate effect (higher inflation means a higher interest rate, which meansless investment and fewer houses are demanded, as well as smaller quantities ofother long life assets).

• The foreign trade effect. As our prices rise we are able to sell fewer exportsbecause they are relatively expensive; and we buy more imports which are now–relatively cheaper.

If w slide up the aggregate demand curve we can see what happens as the country suffersmore inflation – we demand less in real terms.

Q. What can cause a shift of the aggregate demand curve?

A. Anything that affects C, I, G or X, M

For example:

• A change in attitudes: if we experience a reduced desire to save, it means we consumemore, so the “C” part increases.

• If the government reduces income tax or other taxes on consumption, we willconsume more, so “C” increases.

• A fall in interest rates would lead to an increased demand to buy long-life assetswhich are usually bought with borrowed money. This means investment rises;perhaps business people buy new machinery which means the “I” part increases.

• An increase in the money supply would reduce the rate of interest, again meaningpeople invest more so “I” increases.

• If the government decides to spend more it means the “G” part increases.

119

2. AGGREGATE SUPPLY

What is aggregate supply?

Aggregate supply is the sum total of planned production. In the diagram it is often calledthe Short Run Aggregate Supply Curve (SAS). The Long Run Aggregate Supply curve isthe vertical part only of the SAS curve. (And see below p.125 for an alternative diagram)

Price Index

0

110.0

100.0

90.0

Real GDP

SAS1

It is that shape because rising prices encourage producers to expand their output as theybelieve that they will make extra profits.

3. THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

This is determined by aggregate supply and aggregate demand.

Price Index

Real GDP0

100.0

110.0

90.0

SAS1

AD1

GDP1

120

Guess where the equilibrium is? Right! At the intersection of AD and SAS1.

4. ALTERING THE LEVEL OF NATIONAL INCOME

A change in the level of GDP must be a result of either a change in aggregate demand orin aggregate supply or perhaps in both, because these two determine where the level ofGDP actually is.

How do we show an increase in demand?

We push out the aggregate demand curve, just as we would in the micro diagram.

110.0

100.0

90.0

0

Price Index

Real GDPAD2AD1

Q. What can increase aggregate demand? (which of course = C + I + G + X - M)

A. Anything that affects C or I or G or X or M can change the aggregate demand curve!

Examples:• An increased desire to consume more (an increase in C).• An increase in government spending (an increase in G).• An increase in export sales (an increase in X).

121

How do we show an increase in SAS?

Push it out to the right = more is supplied at any given price level.

Price Index

0

110.0

100.0

90.0

SAS1 SAS2

Real GDP

What can push out the SAS curve to the right?

• An increase in the quantity of factors of production.• Better quality of factors.• Better ways of using or combining the factors (L, N, K) + R.

Some things that can push out the SAS curve:

• New technology is introduced (= better K).• Investment increases (= more K).• Productivity increases (perhaps workers work harder, or managers try harder, take

new training courses, or work longer hours).• More migrant workers enter the UK (= an increase in the supply of N).• An increase in the hours worked by labour (= an increase in the supply of N).• Better education or health of workers and managers (= better quality “N”).• An increase in Direct Foreign Investment from abroad (= more K; and possibly better

K).• A reduction in taxes placed on firms and companies.

Changing the level of equilibrium

We put the two aggregate curves together to get equilibrium and then shift one of them,just like in microeconomics. Let’s increase demand! Maybe exports went up, the “X” bitof total aggregate demand C + I =G + X - M

122

When aggregate demand increases we can see that output expands from GDP1 to GDP2and the general price level rises from P1 to P2. The increase in GDP is accompanied by aslightly higher rate of inflation.

Price Index

Real GDP0

SAS1

GDP2GDP1

110.0

90.0

P2P1

AD2AD1

Now let’s increase supply!

When we increase the short run aggregate supply curve – perhaps a sudden increase inimmigration has added to the labour supply and pressured wages down a little – we cansee that again GDP increases, but this time the price level falls, from P1 to P2.

Price Index

Real GDP0

110.0

90.0

GDP2GDP1

SAS2SAS1

P1P2

AD1

123

The long run aggregate supply curve (LAS)

The long run aggregate supply curve is vertical – it shows us what the maximum outputcan be at the time we are examining. It usually drifts out to the right over time, asproductive capacity increases. This is because of things like a greater capital supply,better technology, better management, improved skills and training of labour – all thethings that go into the production function in fact.

Price Index

Real GDP0

110.0

90.0

GDP1

LAS

100.0

The movement to the right of the LAS is often called “the underlaying rate of growth”,showing us what we could manage if all our capacity were in use. You can see this in thediagram below.

Price Index

Real GDP0

110.0

90.0

100.0

GDP1GDP2

LAS1 LAS2

124

The fun starts when we combine the short and long run curves together

In this diagram we can see that the short run equilibrium position is to the left of themaximum possible. Now this we can manage easily!

LAS

AD

SAS

Price Index

0 GDP1 Real GDP

What we cannot do is get a short term equilibrium greater than we can manage! Theattempt to do so is shown in the diagram below.

AD

SAS

Price Index

0 Real GDP

LAS

GDPmax

GDP1

Clearly it is impossible to produce more than the most we are able to produce but that itwas the economy is trying to do!

125

So what is going to happen?We are experiencing boom conditions, with a lot of excess aggregate demand and all thatcan happen is that prices will rise – and rise quite a lot too! The demand curve ADintersects the long run supply curve (the maximum output possible) and we cannot get toGDP1 at all. What we do find is a level of national income GDP max and a price levelas high as P.

AD

SAS

Price Index

0 Real GDP

LAS

GDPmax

GDP1

P

5. MACROECONOMIC POLICY – WHAT THE GOVERNMENT DOES ORTRIES TO DO

Recall the economic goals.

As you know, there are about ten major economic goals for all countries (the main fourgoals for many governments are asterisked, but each government chooses for itself).

Their actual order depends on the priorities of the government of the day.• Resource allocation.• Economic growth.*• Standard of living.• Income distribution.• Inflation.*

126

• Unemployment.*• Balance of payments.*• Value of the currency internationally.• Protecting the environment.• Avoiding unwanted fluctuations in any of the above.

Even if a country has no policy on some of them, the issues do not go away!

NOTE: this is a useful list to remember. Any event can be analysed using this list as aframework for thinking. For example, the effects of an earthquake; or a new governmentafter a general election; or a new tax being introduced. Any such event will have aneffect on some, perhaps nearly all, of these goals. If you learn the goals and think ofthem, it can save you overlooking valuable points when preparing your essays oranswering questions in the exam room.

There are trade offs between goals; we cannot get them all at once – e.g., if the economyis growing fast it usually means:

• Higher prices.• The balance of payments deteriorates (imports increase).• Income distribution widens.• The currency may strengthen (if people around the world believe the growth is

permanent and the economy will continue to be dynamic).• Or it may weaken (if people believe the economy is out of control and inflation will

continue).• The environmental situation may worsen, e.g., there might be more air and water

pollution, or traffic delays could be longer.

The main question for economic policy is where do we want the equilibrium level ofGDP to be?

It is the government’s choice as to where it wants it – but we may not get there!Economic policy is the effort of trying to get from where we actually are to where thegovernment wants to get.

Let’s look at a new diagram that can show the level of national income as acontinuum from dire slump to mega boom.

When output is zero (at the left hand end of the Real GDP axis) we can start to producewithout any inflation because there is a huge amount of surplus capacity of both

127

machines and workers. This means the aggregate short run supply curve is a horizontalline.

When we run out of capacity and have no spare machines or workers, (towards the righthand end of the Real GDP axis) there can be no short term increase in output and ifdemand increases further prices must simply rise. This means the aggregate short runsupply curve becomes a vertical line.

As we move from the horizontal to the vertical segment, there will be a gradual increasein the slope, as we start to run short of a few machines or types of workers, but not all.

So the aggregate supply curve looks like this.

Price Index SAS1

0

110.0

100.0

90.0

Real GDP

We can use this overall SAS curve to look at the three basic areas the economy can be in:slump, boom, or just about right. I know this sounds like the Goldilocks theory ofeconomics but it is a fair description. Take a look at each aggregate demand curve in thediagram below.

Price Index

Real GDP

SAS1

AD3

AD2AD1

110.0

100.0

90.0

0

128

AD1 = slump or depression: the Keynesian World

Here we see: underused land, labour and capital (unemployment being the most obvious);low growth rates; and a low rate of inflation. We are losing potential GDP that we couldenjoy.

Q. When we are here, what do we wish to do?

A. Increase output, reduce unemployment, and boost growth.

The remedy to adopt is to increase aggregate demand! This will slide us out along theSAS curve and increase the level of GDP, so employment and output rise. We canachieve this without any danger of inflation as we are well to the left of the diagram (seethe diagram below).

• We can best use fiscal policy for this – reducing tax will increase consumption orinvestment quickly and easily.

• This is a basic Keynesian policy and it works when we are around AD1.

• Monetary policy may not work well in a slump, so it is perhaps best avoided. Wecannot force people to borrow and consume, or borrow and invest, just by lowering

interest rates.

Price Index

Real GDP

SAS1

110.0

100.0

90.0

AD2

AD1

GDP1 GDP2

Depression: increase aggregate demand

0

As demand increases, we can increase output but without suffering from inflation.

129

Now look at the original AD2 in the second diagram back = the usual situation weare in. (We use it in the diagram below).

We see reasonably good levels of output, growth, inflation and unemployment, withperhaps a small deficit on the current account in the balance of payments.

Q. What might we want to do?

Maybe nothing – the government might accept that it is OK to be where we are.Or they may try to “fine tune” the economy i.e., to alter GDP a little bit up or down. Thegovernment might fear that a boom is in the offing or a slump is likely to occur and maywish to try to offset it. If the government thinks exports might slump, the governmentmight wish to increase investment to offset this, and thereby maintain the level ofaggregate demand.

If the government decides toincrease aggregate demand, it can increase the level of GDP(= growth) and reduce unemployment, - but at the cost of higher prices as we slide outalong the SAS curve.

Price Index

Real GDP

SAS1

110.0

AD2

AD1

0

100.0

90.0

GDP1 GDP2

If the government decides toreduce aggregate demand, it can lower the level of GDP andreduce the rate of inflation - but at the cost of higher unemployment, as we slide backalong the SAS curve.

Real GDPGDP2 GDP1

AD2

AD1

0

Price Index SAS1

90.0

110.0

100.0

130

The government may use fiscal or monetary policy (or both) should it wish to adopteither of the above changes; and either policy should work.

The original AD3 in the fourth diagram back - full employment = the Monetarists’world

We would be experiencing low levels of unemployment, higher inflation, decent growth,and probably a deficit on balance of payments.

Q. What might we want to do?

The government could just accept it as being desirable.

It is more likely that they would decide to reduce the level of demand in order to pull theeconomy back. The reduced demand would help to tackle inflation and reduce the degreeof over-full employment. In the diagram below, you can see inflation reduces from 125.0to 108.5, and GDP falls slightly, taking the heat out of the system.

Real GDP

100.0

90.0

0

Price Index

125.0

SAS1

108.5

GDP1GDP2

AD1

AD2

Inflation & full employment: reduce aggregate demand

At this extreme right hand of SAS curve, monetary policy can be used easily – reducingthe money supply will reduce inflation.

If we want more growth when we are at full capacity, in the short term we can do little.We cannot increase aggregate demand to give us a higher GDP because we are already atthe limit. An increase in AD would merely lead to a further price increase.

So we have to tackle the supply side and think longer term. In the long run we can try topush the aggregate supply out to the right – to get more growth.

131

Real GDP

100.0

90.0

0 GDP1

Price Index

125.0

AD1

GDP2

104.0

SAS2SAS1

We shall look at the supply side controversy later in more detail.

You can also use our original diagrams to show the boom, slump and “got it right”positions, but I personally find them less illuminating as there is no visible portion wherethe economy is gradually running out and prices are starting to rise then accelerate.

Real GDP

LAS

AD

SAS

Price Index

0Real GDP

AD

SAS

Price Index

0Real GDP

AD

SAS

Price Index

0

LAS LAS

Long & short equilibria aretogether.

BOOMThe equilibrium of shortrun demand and supplyare trying to take us pastthe total amount possible.

SLUMPThe equilibrium of shortrun demand and supplyis below the total amountpossible.

132

TIME TO PLAY! MOVE THE AGGREGATE DEMAND CURVE AROUND!

Start in a recession - you draw a diagram of a slump now, using the short run aggregatesupply curve below and adding the aggregate demand curve.

Price Index SAS1

0

110.0

100.0

90.0

Real GDP

Q. What happens if the government hires and pays a lot of workers to dig holes and fillthem in? Draw this effect on the diagram. Which part of aggregate demand increases?

Q. What happens if government reduces income tax substantially? Again, draw it in adiagram. Which part of aggregate demand increases?

Q. What happens if government increases pensions a lot? Which part of aggregatedemand increases?

Q. What happens if the Monetary Policy Committee reduces the interest rate? Whichpart of aggregate demand increases?

You can repeat the exercise, asking the same questions, for the AD2 and AD3 positions.

You benefit a lot from playing around like this, asking questions, and using the diagramto help you answer them. That is really what a lot of exam questions are seeing if youcan do!

133

THE MULTIPLIER

If we change aggregate demand by a given amount, the level of GDP alters bymore; themultiplier measures this relationship. For example, if we increase consumption by £100million and find that gross domestic product increases by £320 million, the multiplier is3.2 (320 divided by 100).

Why does this happen?

It is not difficult to understand. Assume I buy something from you for £100 – you willspend some of it, perhaps ninety per cent, or £90. Whatever you buy from someone else,they get the £90, and spend some of it – this time £81 (90%). Already you can see thattotal spending has been £100 + £90 + £81 or £271 in all. And the chain is not yet ended!Eventually, the total spending resulting from the first £100 I gave you will reach £1,000.In this case the multiplier is exactly 10.0

What can we use the multiplier for use?

If the government wishes to add £900 million to GDP, perhaps to reduce unemployment,it needs to know how much it should alter, say, income tax, in order to get the desiredinitial change in consumption. Assume you are an economic advisor to the government –if they ask you “how much should we alter tax?” you could not get away with saying“Quite a lot!”, “More than you might imagine!”, or something similar. The governmentwould want an answer in number form and that is what the multiplier provides.

THE INTEREST RATE AND THE LEVEL OF INVESTMENT

(Or how government changes the level of investment in order to alter the level of realGDP).

If we lower the rate of interest, the level of investment should increase.

Why? Businesspeople will wish to increase their investment (to make a profit) becausethey can now borrow more cheaply.

The demand curve for investment (“the marginal efficiency of capital curve”) isordinarily shaped, downward left to right.

134

Rate of Interest

MEC1

Inv 1Investment

0

r1

So if we reduce the rate of interest, we can see more investment will be done.

Rate of interest

Investment0 Inv 2Inv1

r1r2

MEC1

A typical scenario:

a) If the rate of interest is reduced by the Monetary Policy Committee of the Bank ofEngland, the members hope it will increase the level of investment (the “I” bit of C+I+G)– and perhaps add to consumption, maybe housing and the purchase of long life goodslike `fridges (the “C” part of C+I+G)

b) This in turn pushes up the aggregate demand curve.

c) Which increases the level of GDP; and reduces the rate of unemployment; andprobably increases the price level.

A question to think about. When would it not increase prices?

Hint: look at the earlier diagram with three different AD curves on it.

135

3-8. MONEY AND MONETARY POLICY

MONEY

Definition: money is anything generally acceptable in payment of a debt. It can be (andhas at various times and places been) things like sea shells, cigarettes, or bottles of rum.But these are very rare instances!

The functions of money (= what is it for?):

• A medium of exchange• A unit of account• A standard of deferred payment• A store of value

Classification of money (There are lots: M0-M12 or so)

There are many ways of measuring the money supply – but only two really matter to us.

1. M0 = narrow money = notes, coins and bank balances deposited at the Bank ofEngland; in May 2004 it was £41 billion. M0 had a growth rate of 6.0 per cent over thetwelve months to July 2004 (provisional figure).

2. M4 = broad money = M0 + all sterling deposits with banks and similar organisations(those that the Bank of England allows to take customer deposits); at April 2004 it was£1,095 billion, that is, it’s much larger than M0. As a result, many observers focus onM4 as the main one to be looked at. M4 had a growth rate of 9.7 per cent over the twelvemonths to September 2004 (provisional figure).

[Remember! It is useful to scatter the odd statistic in your exam answers – it can impressthe marker that you are interested and aware. That can gain you marks if s/he is uncertainwhether you really understand something; it can help you get the benefit of any doubt.]

M4 contains:

• Notes & coins.• Operational balances at the Bank of England = bankers’ balances = bank deposits at

Bank of England with which each bank can settle its debts to the others.• Sight deposits = current accounts = no-notice accounts (can be withdrawn

immediately).• Retail deposits = all bank deposits less than £50,000 + building society deposits

which require less than 1 month notice.• Wholesale deposits = deposits £50,000.• Time deposits = bank accounts requiring notice.

136

The demand for money

Keynes postulated three demands for money to hold (rather than use to buy bonds). Thisis called “the liquidity preference theory”.

1. Transactions demand = to buy things with in normal daily life.2. Precautionary demand = in case anything goes wrong, it is good to have some cash

around for the sudden emergency.3. Speculative demand = to buy bonds when one is ready to do so. This demand is our

focus of attention.

When the price of bonds is high, the rate of interest must be low (why? See below“Monetary Policy”), so people expect bonds to fall in price; therefore it is sensible to holdmoney (demand money) to buy the bonds later. So at low rates of interest, more moneyto hold is demanded. This gives us a normal shaped demand curve.

Determining the rate of interest = the supply of and the demand for money

We know the demand curve – it just is what it is. And the supply of money at any pointin time is fixed (by the Monetary Policy Committee of the Bank of England). Because itis fixed, it is represented as a vertical line.

0Money

Demandfor money

Rate of Interest

137

Putting the demand for and the supply of money together, we can see the equilibriumlevel of the rate of interest.

MONETARY POLICY

Monetary policy is a second method of controlling the economy (the first was fiscalpolicy). As you know, since 1997, monetary policy and the fixing of interest rates isundertaken by the Bank of England. The interest rate is set by the Monetary PolicyCommittee which meets monthly. The government has given the Bank of England aninflation target of 2.5% p.a. to strive for and the Committee has to set the rate of interestto try to achieve that target. Currently (October 2004) the base rate is set at 4.75 per centbut keep an eye on this in the press; it will change.

0

Rate of Interest

Sm

Qm

r1

Money

0

Rate of Interest

Money

Sm

138

How does it work?

The Monetary Policy Committee merely announces a change in the central bank rate,e.g., a reduction of half a percent. Practically, to achieve this, the Bank has to buy bonds,which increases their price (via normal supply and demand), which reduces the rate ofinterest. This is now explained.

If a bond is issued with nominal price of, says £100 and at 10%, it means that this bondwill always pay £10 p.a. Then let us assume that the rate of interest falls.

If we choose to invest a new £100 in bonds, we will now get only £5 p.a. back. But theold bond still gives £10 p.a.

Q. How much do you have to investnow to get £10 back?

A. To achieve a return of £10 p.a. a person would need to invest £200 at the new lower5% interest rate – so an existing bond returning its fixed £10 p.a. must now be worth£200 also. Therefore the price of the original bond rises to £200. You can see this in thetable below.

Nominal priceof bond

Rate of interest Amount paid by the bondeach year

Actual marketprice (what it

is worth)1. £100 10% £10 £1002. £100 still 5% £10 £200

You can see that at a low rate of interest the price of bonds is high and vice versa.

We can see the rate of interest by means of a diagram of the liquidity preferencetheory of money

When the Bank of England wants to reduce the rate of interest, it buys bonds, pays forthem, and this increases the supply of money in circulation. This is known as the Bankengaging in “open market operations”, whether buying or selling.

We can see this happening in the diagram below, when the supply of money increasesfrom Sm1 to Sm2.

139

0

Rate of Interest

Money

Sm1 Sm2

r2

Qm2Qm1

r1

This increase in the money supply in the above diagram ensures the rate of interest fallsfrom r1 to r2.

The reduction in interest rate then leads to an increase in investment done:

Rate of Interest

MEC1

I1Investment

0 I2

r1r2

Which in turn causes the level of aggregate demand to increase as the level of investmentrises:

Price Index

Real GDP

SAS1

AD2

AD1

0

100.0

90.0

110.0

GDP1 GDP2

140

So that gross national product rises from GDP1 to GDP2.

And of course employment will certainly increase as the level of GDP rises.

Monetarists v Keynes

In the 1950s and the early 1960s, developed countries followed theKeynesian view. Thisheld that money was not very important in determining the price level; and it wasbelieved that interest rate changes did not work well to alter spending (which was roughlytrue back then, although it was based on the situation in the Great Depression throughwhich Keynes lived).

Then the Monetarists emerged – led by Milton Friedman – and they said that the supplyof money really did matter. They used an old formula:

MV = PT

Which said that moneytimes velocity (its turn-over) = price leveltimes transactions(which is a truism i.e., it is always true whatever level these items actually take).

But they went further. If we believe that velocity (V) is stable (that it does not changemuch) then a change in M = a change in PT.

When we are at full employment, we know that we cannot increase T (by definition! Weare unable to produce more), so a change in M must cause a change in P!

For this reason, it was asserted that the supply of money really does matter, and monetarypolicy was held to be the main one to use.

In the 1960s, Keynesians still felt that fiscal policy was best; but the monetarists wantedto use monetary policy instead. By the 1980s, the monetarists dominated policy makingall over the developed world and it looked like the Keynesians might have lost theargument.

However, with the passage of time we found that it was really hard to control the moneysupply accurately, so the monetarists retreated a bit.

Now: there is no real conflict; there is an amalgam of the two views! At the fullemployment position, for policy purposes the monetarists dominate; but at low levels ofaggregate demand, the Keynesians are predominant!

141

•

•

•

•

Diag. A

Some important variables in controlling the economy

The labour market: if this is flexible (which means that wages can rise and fall easily;and people can be hired and fired easily) monetarism works well.

- But if the labour market is rigid, the Keynesian approach seems to work better.

- In the UK, the labour market is more flexible than it once was (and moreflexible than in much of Europe), so monetarism has improved as an approach touse.

Time lags: these are longer on the money side – there may be up to two years beforethe full effects of a change in the supply of money have worked through. With fiscalpolicy, the changes are almost instantaneous.

The shape of the marginal efficiency of capital curve (which is the investmentdemand curve). If this is very steep, then even a large change in the rate of interestwill not alter the level of investment much. (see Diagram A)

• The shape of the liquidity preference curve. If it is very flat, monetarism willnot work well, because the rate of interest cannot be reduced much – if the moneysupply is increased by the Bank of England, people just hold on to the extra money -(see Diagram B).

General expectations about the future A):

If people expect higher inflation, then we can have rising pricesand rising unemploymentat the same time. The use of monetary policy, and possibly a strict use, may be needed tobreak these expectations.

Diag. B

Rate of interest

Amount of investment

SM1SM2

I1 I2

R1

R2Marginal Efficiencyof Capital

Rate of interest

Money supplied& held

SM1SM2

I1 I2

R1R2

LiquidityPreference

142

• General expectations about the future B):

If business people feel very pessimistic and are perhaps on the edge of panic, the MECcan continually drift to the left. This means that nothing works much when we try toincrease the level of GDP, because all the efforts to increase aggregate demand can beoffset by shifts in the MEC curve!

• General expectations about the future C):

If business people are hugely optimistic (which means the MEC may shift out rapidly tothe right), we may need a strong combination of fiscal and monetary to rein it in.

• Where we happen to be in the trade cycle matters too.

– In a slump, and there is lot of unemployment, Keynesian and fiscal policy worksbest (i.e., we probably will notuse monetary policy, especially on its own).

– In a boom, when we have inflation, we are in the monetarist zone - and monetarypolicy works well.

– Usually we are in the middle zone! So we tend to use a mix of both fiscal andmonetary policies. Government should try to aim them both in the same directionfor consistency and to avoid mixing their signals. They are not always able to dothis, however, because the government has different departments and manydifferent goals, and this fact may pull some policies in opposite directions.

143

3-9. FISCAL POLICY

Why the government raises revenue through taxation:

• To cover its expenditure.• To redistribute income, usually from the richer towards the poorer.• To reallocate resources.• To change consumption patterns (reduce cigarette consumption?).• To control the economy (our main interest here).

As you know, there are two major policy instruments available to control the economy:fiscal policy and monetary policy.

The government uses these to try to alter level of national income (GDP), from where wethink it currently is, to where the government would prefer it. (Because of time lags inthe data, we are never really sureexactly where we currently are!)

Price Index

Real GDP

AS1

110.0

100.0

90.0AD1

GDP10

Here, the level of GDP may be thought too low, so the government may wish to increaseaggregate demand and “fine-tune” the economy.

What is fiscal policy?

Fiscal policy means the use of taxation (and maybe a few subsidies which are a sort of“negative tax”) to alter the level of aggregate demand.

Fiscal policy aims at consumption (C) and/or investment (I) and or government (G)

G is not easy to turn on and off for fine-tuning purposes. The government is unable toreduce pensions by fifty percent in order to reduce its total expenditure! Nor can it

144

suddenly stop building a motorway which is ninety per cent finished. In other words,much of government expenditure is not really discretionary at all.

Changes in government expenditure are generally thought of as part of fiscal policy;otherwise we have to see it as “direct government intervention”. Some textbooks maycall it that or use a similar phrase like it.

If the government wishes to increase the level of GDP is means reducing some tax rates,or perhaps abolishing some tax completely, in an effort to increase C or I.

Fiscal policy can also have a strong affect on income distribution. The main aim of anygovernment here is to redistribute income towards those who are felt to be deserving.These are often the poorer, but groups like farmers in all developed countries and, underPresident Bush the oil producers in the United States, seem quite adept at getting incometo move their way.

What taxes has the country got?

This is purely descriptive stuff! I suggest you read it up for yourself in the latest textbookand keep you eyes on what is in decent newspapers. Each country is very different andchanges its tax system quite regularly. Few books can be up to date.

A bit of fiscal detail:

A “direct tax” is placed on directly on people or companies, e.g., income tax, companytax or a capital gains tax, and such taxes can be hard to avoid. In principle they should beimpossible to avoid, but in practice the rich and the powerful trans-national corporationscan often minimise the tax they pay and that to a rather surprising extent.

The other type of tax is an “indirect tax” Indirect taxes are mainly placed on spending;this means that if one does not buy the item, then one does not pay the tax, i.e. it issomething of a voluntary tax! In the UK, value-added tax (VAT at the standard rate of17.5%) is well-known; but we also have “duties”, such as the tobacco tax and the exciseduty on alcohol.

To increase the level of aggregate demand the government could reduce the rate of any orall taxes, like VAT, income tax, corporation tax etc. But such a change is normally onlydone in the annual budget, or sometimes in a mini-budget around October, half waythrough the fiscal year. So if we are considering the timing, fiscal policy is not veryflexible! Monetary policy can be altered at any time, although if interest rates are alteredit will normally be on the first Thursday of the month.

145

Direct versus indirect taxation

Direct tax:

• This can reduce the incentive to work if it is set at high levels (the view of PrimeMinister Thatcher and President Reagan).

• A direct tax can be legally avoided although this can be quite difficult (taxevasion isalways illegal).

• A direct tax, like income tax, can be made progressive. This means that we can taxthe rich proportionately more than the poor. On paper, income tax may lookprogressive but in practice it is often not so. Income tax is easily and legally avoidedby the really rich, but the poorer and those in the middle are forced to pay. For reallyrich people, income tax appears to be rather regressive.

Indirect tax:

• This is seen as regressive as it can hit the poor more than the rich because it is ahigher proportion of their (low) income. The poor also tend to smoke more than therich, so the tobacco tax seems particularly regressive.

• One can avoid paying an indirect tax if one does not buy the item, e.g., as a reformedsmoker I no longer pay tobacco tax or the VAT on cigarettes.

Fiscal changes can strongly affect the distribution of income; monetary policy changesaffect the distribution of income less, because they are as more general in impact.

How the government might increase the level of national income by lowering tax

The government might choose to reduce, say, the level of corporation tax, in an effort toencourage business optimism. This could shift the marginal efficiency of capital curve tothe right and thereby increase the amount of investment undertaken. The increasedinvestment would then cause gross domestic product to rise. (See the diagrams below).

Pushing out the MEC curve

MEC1

I1 I20 Investment

r1

Rate of Interest

MEC2

146

The government is aiming at increasing the “I” part of C + I + G + X – M

The increase in investment pushes up the aggregate demand curve and real GDPincreases.

Price Index

Real GDP

SAS1

110.0

100.0

90.0 AD2

GDP1 GDP2

AD1

0

If the government were to reduce, say, the level of personal income tax, it is aiming at the“C” part of aggregate demand.

Automatic stabilisers

Automatic stabilisers are built into the system and modify its effects – they work a bitlike a thermostat in a central heating system. Automatic stabilisers do not requiregovernment action or initiative; they just come into play naturally. An example isprogressive income tax - any increase in income is moderated, because the taxautomatically rises as income increases.

Automatic stabilisers can help counteract the ups and downs of the business cycle. Theycannot prevent swings, but they do moderate them.

A FEW POINTS YOU SHOULD KNOW

PSNCR = the “Public Sector Net Cash Requirement” which is the difference betweengovernment spending and tax revenue.

Government sells bonds in order to raise money to cover the PSNCR; but to do this it willneed to raise interest rates to attract more bond buyers. Raising interest rates can makeprivate investment more expensive so it can get crowded out!

147

If revenues are greater than expenditures, we have a surplus, which can be used as a“Public Sector Debt Repayment” (PSDR) to buy back government bonds and reduce thelevel of national debt.

What determines if there is a surplus or a deficit?

• The part of the trade cycle we are in. During a boom, government revenues are high(the receipts from income tax and some other taxes increase); and on the expenditureside, payments of social security benefits will be lower. Both these factors mean wecan see a surplus.

• The passage of time – government spending tends to increase over time.• Changes in the political demands of the people. If people want pensions to be higher,

unemployment pay to be greater, and/or family benefits to be improved, this will leadto more expenditure. A deficit is then more likely.

• Government attitude – if the government wants more investment for future growth, itmight try to cut PSNCR as this would help to keep interest rates down. (If thegovernment borrows it has to increase the rate of interest which reduces privateinvestment; as it is trying to encourage investment, the government may try not toborrow).

NB Fiscal policy is the only onedirectly available to the government now. You willrecall that the government gave the right to run monetary policy and set interest rates tothe Bank of England in 1997.

Some problems of using fiscal policy

• The measures adopted may not be in line with the Bank of England’s monetary policymeasures.

• Fiscal changes are only undertaken once a year in the budget – inflexible. There maybe leaks in advance of what the government will be doing in April next! At best wecan have an extra “mini budget” around October to improve flexibility.

• We cannot easily stop and start government spending – takes years to plan and pushthrough a motorway for example; social services expenditure is not easily reduced(very unpopular!)

• We are not sure where we are and sometimes are uncertain as to what direction weshould be aiming for (should we increase or decrease GDP?) because of data andother lags. This applies to monetary policy too.

• Government can be bound by its earlier promises, e.g., the current LabourGovernment promised not to increase income tax rates. It is difficult to use fiscalpolicy if one is not allowed to increase taxes!

• This throws the burden of adjustment entirely onto monetary policy– and it is in thehands of the Bank of England rather than the government itself.

• The desire for fiscal harmonisation within the European Union may mean that taxrates will be controlled in Brussels in part or whole at some time in the future. Thiswould reduce our power to use fiscal policy.

148

• There is an old question of whether or not high income tax is a disincentive to workharder or longer. If it does act as a disincentive to effort, we know that tax rates havebeen reduced in recent years, so we should have seen an explosion of new effort.Have we? Casual observation suggests that it has not, so perhaps there is no strongdisincentive.

• Accurate prediction of deficits and surpluses in the budget are very hard to do!• Altering the level of tax may sometimes lead to unwanted redistribution effects.• Unpopular fiscal change can lead to a fall in business confidence which could cause a

reduction in investment and almost certainly alter the assumptions upon which theoriginal fiscal change was based!

• Borrowing to meet a deficit can crowd out private investment (reducing growth;changing the framework within the government was working; and almost certainlyaltering the assumptions within which the borrowing was to occur).

NB there has been no real test of fiscal policy since the government gave away its powerover monetary policy as the economy has grown reasonably steadily and well. Thecrunch is yet to come. Only when a system is put under pressure do the hiddenweaknesses emerge!

149

3-10. ALTERING THE AGGREGATE SUPPLY CURVE

A quick reminder: we always start in equilibrium in economics. Then we altersomething, usually we shift a curve which reflects some real change that has occurred,and see what the result is.

When we are looking at the macro economy and national income, we have three choicesof the equilibrium in which we may start: recession, full employment, or in between .

Price Index

Real GDP

SAS1

AD3

AD2AD1

110.0

100.0

90.0

0

SUPPLY SIDE ECONOMICS

When we are dealing with supply side economics, it is the right hand end of the diagramthat matters. There we are at the full employment level of national income (GDP)

Q. What happens if increase aggregate demand?The result must be that we can only have inflation; no increase in GDP is possible. Drawit yourself and see! We just slide vertically up the unchanged aggregate supply curve.

This means that to gain more output (which would mean a higher standard of living andwould be economic growth) we can only move the aggregate supply curve outwards andto the right!

Pushing the vertical line to the right isthe underlaying rate of growth of the economy –it is going naturally much of the time. You will recall that it is one of the main economicgoals.

150

Price Index SAS1

0

110.0

90.0

SAS1

SAS2

100.0

Real GDP

We can also see the growth that occurs by means of the production possibility frontierdiagram. Starting on production possibility curve 1 (ppc1) with A1 and B1, we observethat ppc2 shows that we can produce more apples and bananas i.e. more of everything.The actual new equilibrium position is shown as A2B2, with more people preferringapples than bananas.

Apples

Bananas0

ppc1ppc 2

A2A1

B2B1

How can we move the aggregate supply out to the right, as we wish to do?

• More efficient organisation of everything! Better factory layout; better management;better workers (in-house training); reduce management-labour conflicts; increase theflexibility of how and where the firm can use its workers; more flexible wage ratesand payment methods.

151

• More investment.• New technology.• Better education and training in society.• Stronger work motivation among managers and workers.

Generally, it covers all the items that are in the production function (L + N + K) + Rbut especially the elements within the “R” term.

SUPPLY SIDE ECONOMICS IN MORE DETAIL

The general views of the supply side school were popular under Prime Minister Thatcherand President Reagan during the 1980s.

1. A central idea was that there is great scope for increasing GDP and economic growth,by concentrating NOT on the demand side but on the long run supply side. As aconsequence, policies to push out the aggregate supply curve were in vogue.

2. An attached idea was that there was much latent motivation and incentive to effort thatwas simply not being used. People were too highly taxed to wish to work harder - soreducing the high levels of income tax would release much creative effort and peoplewould choose to longer hours and/or more intensively while they were at work. In thisway the aggregate supply side would be pushed to the right as in the diagram below.

Price Index

Real GDP0

110.0

90.0

100.0

GDP1GDP2

LAS1 LAS2

An American economist called Arthur Laffer was associated with developing the supplyside view.

He felt that:

• If income tax were zero the government would get no revenue (they did not askfor any).

152

• If income tax were 100% the government would get no revenue (because no onewould work for nothing).

• So somewhere in between there must be a point that would maximise governmentrevenue.

AND he felt that current levels of income tax were higher than they should be; so if wereduced the level of tax it would increase governmentrevenue .

In the diagram below, if we start somewhere like R1T1, with a high rate of tax T1, thegovernment only receives revenues of R1.

But if we reduce high marginal tax rates, government revenue would increase as we slideup the curve. The maximum government revenue is at R2T2, with lower tax rates andmore effort, leading to greater government revenue and of course a higher output. Theincrease in real GDP is the aggregate supply curve pushing out to the right, which is whatwe wanted to achieve. It all seemed logical and plausible to many, especially to those inthe higher income brackets or with a strong entrepreneurial talent who wished to keep thefruits of their labours.

100%

We may behere now

T1

Govt revenuein pounds mills

Income tax in percent0

R1

R2

T2

There is no need to think the curve must be symmetrical and some feel it is perhaps morelikely to be shaped like the one below. The difference in shape reflects what we assumeabout how fast people alter their behaviour when faced with high marginal rates ofincome tax.

153

0 100%Income tax in percent

Govt revenuein pounds mills

T1T2

We may behere now

R2

R1

3. Supply siders tended to think that monetary policy should be central to governmentefforts to control and fine tune the economy. Hence fiscal policy should not be used oncedirect taxation levels have been lowered to stimulate work-effort to the maximumpossible degree.

They understood that changes in taxation worked on the demand side (e.g., if we reduceVAT [a sort of sales tax], people would spend more) but they were supply-siders, andtherefore they did not like using the demand side much.

Supply side proponents tend to be a small group and individual members may focus ondifferent things that can push the supply curve out as a solution to the economic problemof gaining long term growth and maintaining a low rate of inflation. Here you can seeoutput increasing and a falling rate of inflation.

Price Index

Real GDP0 GDP1GDP2

LAS1 LAS2

AD

110.0

90.0

100.0

154

The things that can push out the supply curve include:

• Investment.• New technology.• Better education and training for workers and management.• Enthusiasm, incentives, attitudes – with a predilection for tax reductions to motivate

people.• Lower rates of income tax (via mechanism of incentive to work longer or harder).

Although not universally popular, the supply siders reminded us that it is important not tooverlook the supply side and that long term growth matters. Tinkering with demand canmislead us into trying quick fixes for the economy, rather than promoting our long terminterests.

A reminder: are you revising something and practicing drawing diagrams each day?If not, it isn’t too late – start today!

155

3-11. THE PHILLIPS CURVE

What is it?

It is a curve showing the relationship between the level of unemployment and the rate ofchange of either wages or prices. It shows the trade-off between unemployment andinflation. The original version was wages and unemployment; later this was changed toprices and unemployment.

What does it look like?

The newer version, relating the level of unemployment to the rate of inflation is the onewe now tend to use.

Rate of changeof prices

Unemployment

PC

0

Trace the trade-off! As we slide up the curve, a country can reduce the level ofunemployment by accepting an increase in the inflation rate.

Below is the original Phillips Curve which related the level of unemployment to the rateof inflation. Notice the different label on the vertical axis – it used to read “wages” butwe now use “prices”.

Rate of changeof wages

Unemployment

PC

0

156

The Phillips Curve was very popular in the 1960s and 1970s as governments sort tointervene and control the economy, using the Phillips Curve approach. They lowered therate of unemployment by expanding the economy and accepted the slightly higher rate ofinflation; they moved from U1 to U2, and from P1 to P2 in the diagram below.

PC

0

P2

P1

U2 U1 Unemployment


BUT! It turned out to be useful in the short term only.

Eventually people, workers and unions woke up to what was happening, and saw thatinflation had increased and demanded more wages – which then pushed up inflationfurther. Milton Friedman pointed it out in “the expectations augmented Phillips curve”.The rate of inflation suddenly jumped up to “X” in the diagram below, rather than stayingat P1.


Unemployment

X

P1

U10

PC

This was a shock and it was not clear what was going on. Eventually we realised thatwhat was happening was that the whole Phillips Curve was drifting up and outwards as

157

workers and unions caught on. Each outer curve represents people expecting a higher andhigher rate of inflation.


Unemployment0

XP2

U1

P1 PC2

PC1

No longer are we on the original Phillips Curve, nor can we easily get back to it. We canend up with the old level of unemployment and much higher inflation!

Then it got worse! The Phillips Curve continued to drift out over time as the processcontinued, like this:

Unemployment

PC3


0

PC4

PC2

PC1

It was a time of dismay. Inflation got higher and higher, reaching an alarming 26.9 percent a year in the UK in the month of August 1975. The level of unemployment was notlow and a new term was invented: “stagflation”, where we suffered stagnation andinflation.

158

When the data were in after several years’ experience, we discovered what had beenhappening. After the government led the economy to slide up the Phillips Curve, peoplewere only fooled for a time. Once they realised what was going on, they upped theirwage demands to take account of the price rises that they expected. And theirexpectation kept rising with the rate of inflation. It took may years of tight monetarypolicy before we managed to break people’s expectations about high future price rises.These expectations, when graphed in the form of the data that made up the PhillipsCurve, revealed that it went up, then out and round, and finally came down again.

Unemployment and the fear of redundancy eventually forced workers to accept smallerwage increases which led to some fall in the rate of inflation and as people learned toexpect smaller price rises, they asked for smaller pay increases, then eventually were justhappy to be in a job at all. This seems to have been what caused the curve to drift backand down.

But it was a most painful process, involving very high rates of unemployment, suffering,and social unrest over some years. This is what it looked like.

Unemployment

PC1

PC2

PC3

0


PC4

PC5

PC6

PC7

The end result of using the Phillips Curve and accepting a bit of inflation to reduceunemployment was felt to be unacceptable. The price is too high! We no longer want touse the short term Phillips Curve for policy purposes, because it eventually leads tohigher inflation and then requires several years’ harsh policies to put us back on track.

Instead, we now tend to look for “the non-accelerating inflation rate ofunemployment” or NAIRU.

159

This is the point on the Phillips Curve where we can exist without forcing inflation toincrease. It is hard to judge exactly where it is and it can alter as people’s attitudes andbehaviour change. It is believed that it may currently be between 3.5 per cent and 5.5 percent of unemployment.


Unemployment

PC

0NAIRU

3.5%? 5.5%?

NAIRU occurs where the aggregate demand for labour = the aggregate supply of labour.If unemployment is reduced below NAIRU, wages may start to rise, costs increase, andinflation accelerates.

What can change NAIRU? We would like it to be smaller.

More flexible labour markets helps. If wages are able to adjust in a downward direction(as the demand for particular type of workers falls) it reduces the average wage rate whileallowing needed adjustments.

Anything that leads to a more efficient working of the whole micro economy helpsreduce NAIRU. For instance, removing bottlenecks in certain types of workers, or kindsof machinery, or particular raw materials reduces NAIRU. If we can do this, we willhave a more elastic supply curve so that demand can increase, we can extend along thesupply curve, and prices will not increase much.

If it were perfectly elastic, people could buy more without forcing the price up at all, as inthe microeconomic diagram below which represents the supply of any needed rawmaterial.

160

0

Price

S

D1 D2

P

QuantityQ1 Q2

“Bucknall’s engaging writing style and genuinebelief that ‘life is beautiful’ shine through and willoffer some reassurance to those fearful few whoworry about what university life will hold for them.A second use for the book will become clearerupon arrival at university. As a well-constructedand concise offering, you can dip into thechapters on oral presentations and end of yearexams, for example, at the appropriate times of theyear. You can either re-read the advice on, say,preparation and delivery or just quickly recap themain bullet points summarised at the conclusionof each chapter....”Richard Benstead, student, in Durham21, astudent newspaper at Durham University.

If you are STILL finding these free notes useful and feel that you might needa bit of help in writing essays, getting better marks in exams, and learningmore quickly and easily, take a look at a book I have written to help you dobetter - Going to University: the Secrets of Success: Kewei Press, SecondRevised and Expanded Edition, August 2009, paperback, 204 pages, ISBN978-0956182319.

161

To leave a legacy for their dependents and perhaps to establish a dynasty.

Reasons for success are harder to pin down, but include:

Copyright Kevin Bucknall ©

Module 2881 Industrial EconomicsUnit 4: “The Theory of Production & Costs”

4-1. THE GROWTH OF FIRMS

The Birth of Firms

Firms usually start small, often as a one-person concern or a family concern.According to Barclays Bank, some 465,000 new firms started up in 2003 alone. Sadly,many of these are doomed to fail. According to government statistics, in 1997, thebusiness survival rate for new firms was only 65.1 per cent after three years; one thirdhad disappeared in that period. About half of these close down voluntarily, and about athird sell the business to another firm.

In many cases they are undercapitalised, and the firm simply runs out of money andcannot borrow any more. In some cases it is a management constraint, in that theperson is ambitious but not talented or skilful enough. Virtually all firms have toborrow to invest and grow.

Why do firms wish to grow?

The usual motives are:

To make higher profits.To establish a business that will see them through life.

Sufficient capital to tide the firm over a bad patch.Access to funds.Good contacts.Willingness to work long hours.Developing a strategy to overcome local or regional disadvantages in location.Developing a niche market or a unique selling point.

The desire for to grow leads firm to try to increase their share of the market. The reallysuccessful ones may gain economies of scale and a few might become monopolies or belarge enough to compete with the big boys.

162

4-2. THE MOTIVES OF FIRMS

1. Profit maximisation.

In economic theory, the main motive for a firm is to maximise profits. This is central tomainstream theory. It involves equating marginal cost with marginal revenue, whateverthe market situation the firm is experiencing.

2. Revenue maximisation

This is another suggested goal. It would be possible for a firm to survive following thisgoal but it would grow more slowly and always be a bit at risk. A lusty profitmaximiser could seize an increasing share of the market, possibly driving the revenuemaximiser out in the longer term.

Using our diagrams, instead of the firm seeking the point where MC=MR as a profitmaximiser would, the revenue maximiser keeps expanding output as long as marginalrevenue is positive. It ceases to be positive where it cuts the horizontal axis at Q in thediagram below. As soon as it becomes negative, total revenue would start to fall, so thefirm stops.

Price, costs,Revenue

AR

ACMC

0 Quantity

P

MRQ

In the above diagram, the revenue maximising quantity is thus OQ and the price is thenread off the demand curve: the firm chooses price OP.

Because the firm reduces price until marginal revenue becomes negative, there is animplication for the elasticity of demand. If a price reduction leads to an increase in totalrevenue, we know that demand is elastic. If a price reduction leads to a fall in totalrevenue we know that demand is inelastic. As we switch from increasing to falling totalrevenue, the elasticity of demand must be neither – it is unit elastic at that point.

163

3. Sales maximisation

This is a third suggested goal. It suffers from the same problem of the revenuemaximisers, in that the firm is vulnerable to profit seeking competitors.

Such a firm will expand output until the average cost curve intersects the demand curve,as in the diagram below.

Price, costs,Revenue

AR

ACMC

0

P

MR Q Quantity

The firm produces OQ level of output and sells it for price P. This price is lower thanthe profit maximiser’s price, or the revenue maximiser’s price – as one would expect asmore sales is what it is all about.

A variant of this model is that the firm may concentrate on maximising sales in theshort term in order to gain a larger share of the market so that in the long term it canearn more profits by switching its goal. It is a sort of long term profit maximiser usingthe route of short term sales maximisation!

Another business variant model of the sales maximiser is that it is possible that whenthe firm becomes large, managers are taken on and they may prefer to maximise salesrather than profits. The shareholders would generally prefer higher profit but they havelittle say in day to day running of a company.

164

4-3. THE EXTERNAL GROWTH OF FIRMS:

Mergers

A firm may grow by merging with, or taking over, another firm. There are twodirections in which it can do this: horizontal and vertical. These refer to the position ofthe other firm within the structure of the industry.

Horizontal mergers

This is when a firm merges with another at the same level within the industry. As anexample, if one video rental firm takes over another video rental firm. In effect theyexist at the same level and they do the same things. They are probably directly incompetition with each other, although some may be located differently. A recentexample of this occurred in 2004 when the supermarket Morrison took over Safeway;Morrison was strong in the north of England but lacked southern outlets. It is, as youwould imagine, difficult for a supermarket to obtain suitable land in or near cities, sothat a take-over or merger is the simplest way of expanding into a new area.

Vertical mergers

This is when a firm takes over another which is earlier or later in the production processwithin the industry. As an example, a wholesaler of shoes might take over a shoe shopor chain of shoe shops, in order to provide itself with outlets. This is an example offorward merger. If it were to take over a shoe manufacturing company, it would be anexample of backward takeover. A current example of a backward merger is the effortin 2004 by the American Wal-Mart company, trading in Britain as Asda, to develop aclose partnership over a section of the milk supply industry at the farm level.Some such mergers are an effort to reduce risks and establish a safe source of supply oroutlet chain.

However, many backward mergers by a dominant firm are an effort to reducecompetition and perhaps lead to a later take over the whole industry. Once a wholesalerowns an important manufacturing unit it can deny the produce to its own more directcompetitors or make them buy on less advantageous terms. There are fears that Asda’srecent efforts in the milk chain supply industry could lead to a less competitivesituation.

Conglomerate mergers

This is where a company in one industry takes over one or more companies in a totallyunconnected industry. The result will be a conglomerate, or a company which spansseveral unconnected industries. A contemporary example is Richard Branson’s Virgin,which began as a mail order record retailer, then opened a retail store and branched outinto running railway trains (Virgin Rail) and airlines (Virgin Airways). He is also in tobook publishing, software publishing, clubs, travel, hotels, and cinemas. Some of these

165

have loose connections, others none. In all he now owns over 150 companies andclaims that they all make money.

166

4-4. MULTINATIONAL CORPORATIONS

Multinational corporations (MNC’s) have grown in importance as globalisationproceeded and they are a factor in encouraging the globalisation process. An MNC istypically a huge corporation spanning several continents with one home base, whichmight be in the UK, the USA, Holland, France, Japan…. it can be anywhere but isalmost always in the country in which it first began. Some are the result of mergers,horizontal or vertical, as a company in country A takes over an existing company in adifferent country. Others are the result of the original company in country A investingmoney in country B to build a factory or firm there.

You will certainly have heard about a lot of MNC’s, even if you did not know thatthis is what they were! Well-known examples are Ford (motor vehicles), Unilever,Sony, IBM, Philips, and Reckitt and Colman.

These large companies have huge sums to invest and the world is their oyster. Theyoften try to locate production where the manufacturing costs will be low, so recipientcountries include places like China, India, Indonesia, Pakistan and Thailand. Variousservice centres will normally be established to cover the different parts of the world.

In the last half of the twentieth century, globalisation was rapid. It was assisted by ahuge fall in the costs of communication and finding information, as well as by tariffcuts and quota reductions or elimination. MNC’s took advantage and grew rapidly aspart of this; in addition they were responsible for pressuring governments to takeaction, such as tariff cuts, which helped the MNC’s to expand. By the end of the lastcentury, trade between multi-nationals themselves has been estimated to account forone third of world trade, and another third is made up of trade by MNC’s with non-affiliates. They are indeed major players!

We return to look at MNC’s, what they do and the arguments for and against them inUnit 6.

167

4-5. AN INTRODUCTION TO PRODUCTION THEORY AND COSTS

Production theory underlies all the theory of the firm, it is related to resourceallocation, and it is where we get the supply curve from.

We assume for simplification:

A one-product firm.

We can identify land, labour and the units of capital used, as well as costs.

Land, labour and capital are homogeneous, which means they are all identical.

Firms aim to maximise profits. Other models do exist, e.g. sales maximisation,but they are not a part of central economic theory.

Profits

Profits are not a dirty word!

But what some people will do for profit can be very dirty indeed! It is alleged that theMafia in the USA will give you a cheap quote for removing and dealing with your toxicwaste - then they might just tip it into reservoirs to get rid of it, and not spend themoney to do it properly.

The function of profits: (what are they for?)

Profits are a signal - a high rate of profit in an industry is a signal that society valuesthat particular good or service highly and will pay a lot to get it. This tells us that moreresources should go into this industry that society values so much. Individual firmsmove in to get the profit and as a result, resources automatically go where they areneeded. Adam Smith was the first to see how a market economy allocates resourcesand publicise it; and this process was what he meant by “the invisible hand”.

Losses are a signal that too much is being produced, that is, output should be reduced.This means that firms ought to leave that industry, as society does not value that goodor service so highly. Where profits are falling in an industry, it often means thatdemand has altered away from that good or service. The lower profits encourage somebusiness people to move out.

The law of diminishing returns says that if one factor of production is increased,while holding all other factors constant, then after a point, the additions to output willstart to fall and ultimately total output will decrease.

As an example, if you were to take your back garden and turn it to growing potatoes,you might start, say, with five people (N) plus five spades (K) and your garden (L).

168

The resulting output may be 100 kg p.a. of King Edward’s potatoes.

If you add a 6th person output (but no more spades or land) output might increase to180 kg – the new person can weed or water while the others dig, etc., so output willrise. The addition to total output is then180-100 or 80 kg. This is the marginal productof the sixth person.

If you add a 7th person, output would still increase, perhaps to 250 kg – the addition tototal output is 250-180 or 70 kg, which is the marginal product of the seventh person.

You can see the 70 kg just added is less than the 80 kg added earlier - i.e., the additionto total output from last person employed is falling, which is to say that returns arediminishing.

You might object that these figures are merely invented – which is true. But think! Bythe time you get to the 200th person, standing in your back garden and only five spadesto work with, output is not going to be large! It is probably zero, in that there is noroom to plant, dig or anything as your garden is wall-to-wall people! At some earlierpoint, output must have reached a maximum then fallen to nothing.

The point where output was at maximum might have been around the fifteenth ortwentieth person, and after this, more people began to be a nuisance. The new personmight start to gossip and distract the others; or perhaps they trip over the new comernow and then, so that output actually fell a little after he was employed. When totaloutput starts to fall, the marginal addition is negative, and total output starts to decreaseat that point.

This law must hold – we can always add enough labourers to completely fill yourgarden, however large, and leave no room for growing potatoes at all. The same appliesto producing anything, for example, T-shirts. The table below shows a possiblescenario.

SEEING THE LAW OF DIMINISHING RETURNS TO THE FACTOR OFPRODUCTION LABOUR

Workers per day Output – T-shirts perday

Marginal product (T-shirtsper worker)

Average product (T-shirts per worker)

1 2 3by (subtraction from col. 2)

4 (col. 2 ÷ col. 1)

0 01 4 4 (4-0) 4.002 10 6 (10-4) 5.003 13 3 (13-10) 4.334 15 2 (15-13) 3.755 16 1 (16-15) 3.206 14 -2 (14-16) 2.667 11 -3 (11-14) 1.57

169

You should observe that in the above table:

1. As we add labour, total product increases.2. Marginal product rises at first, then falls steadily after that, and finally it becomesnegative.3. When the marginal product is above the average product, average product isincreasing; when marginal product is below the average product, average product isdecreasing.

This is the property of averages, it has nothing to do with economics! When the amountadded exceeds the average, it must pull the average up.

Let’s take an example of a Premier League soccer team week by week and see theaverage, total and marginal scores

Soccer Match: Average, Total, and Marginal Goals Scored

MatchNumber

1

Goalsscored inmatch

2

Total goals scored(adding col. 2)

3

Average goalsper match

(col. 3 ÷ col. 1)4

Marginal goalsper match

(col. 2)5

1 2 2 2.00 22 4 6 3.00 43 1 7 2.33 14 0 7 1.75 05 3 10 2.0 3

If you examine the table you will see that when the margin is above the average, it pullsthe average up. And when the margin is below the average, it starts to pull it down.

It not only applies to a team scoring goals, or indeed any set of figures, it works justthe same way in production. We can graph this too!

As a firm adds labour, we can show the changes in marginal product (MP) andaverage product (AP) in a diagram.

So looking at the T-shirt example the soccer scoring table you will see that theinformation on totals, marginals and averages follows a similar pattern.

170

The average product and the marginal product curves

We can also draw a diagram of the total product curve.

The total product curve

Quantity of labour0

TP

Total Output

Why is it that shape?

Before we hire any labour there will be no output, so the curve starts at the origin.

At first, it is easy to produce, we can get the necessary workers and staff we need easily,and so the output curve increases and also accelerates upwards.

Later on, we will start to encounter problems, so the growth in output slows, thenreaches a peak, and finally will fall.

MP

MP & AP

0 Quantity of the factor

AP

171

What sort of problems might be encountered? They could be things like:

We will start to run out of machinery (remember that we are only increasinglabour, holding other factors constant) so that the relationship between thenumber of workers and the number of machines gets worse. In simple terms,the balance is wrong. In the example of your garden, the workers ran out ofspades and had to find something else to do you will recall.

The emergence of bottlenecks in the factory – storage space for materials, semi-finished and finished products perhaps.

Possibly the workers cannot find parking space nearby, which annoys them, andthey then feel disgruntled and lower their efforts. This would not be the law ofdiminishing returns as such, but a loss of motivation.

The production function

The production function shows how many of the factors of production we must use toget various different levels of output. In other words, it shows the relationship betweendifferent inputs and the resulting output.

We can see production function in several ways:

1. We can see it in the generalised form

O = f (L, N, K) + R

(Which means “Output is related in some way to the inputs of land, labour, capital andthe catch-all remainder term”).

2. We can see it as the total product curve above. In the diagram, as we increase the useof labour, we can watch total product increase. This is a simple, one factor model.

3. We can also see it as a box of choices, using two factors of production labour andcapital.

The production function as a box of choices

One question is how can we produce using the resources we have got? How shall wecombine them? (this is called “the choice of technique”).

The firm could use:

1) A lot of capital and a little labour; or

172

2) A lot of labour and little capital.

Engineering information gives us the figures in the box that might look like:

The Box of Choices

Capital (across)Labour (down)

1 machine 2 machines 3 machines 4 machines1 worker 9 18 26 33*2 workers 20 27 33* 383 workers 26 33* 38 424 workers 33* 39 42 455 workers 35 41 44 46

You can see that we can produce 33 units of output in several different ways – the firmswill choose the cheapest method or the choice of technique to use, to maximise profits.

If wages are low (relative to the cost of machines) the firm would use as more workersand fewer machines - four workers and one machine would do it (this is typical of adeveloping country like Indonesia).

If wages are high (relative to the cost of machinery) the firm would choose to use moremachines and few workers – in this case two machines and one worker (this is typicalof a rich developed country like the UK or USA).

COST CURVES

Some definitions:

Total Cost is what it says – total costs are all the costs of the firm (fixed + variable)

Fixed Costs are fixed, irrespective of output; they do not increase as output increases.Examples are the salaries of the managerial staff, the interest paid to the bank on themoney borrowed, or the local council tax.

Variable Costs alter as output changes. Examples include the need to hire more labourto increase production; and using more raw materials to go into the extra output.Clearly the variable costs must rise as output increases.

Average cost is the total cost divided by output.

173

Marginal cost is the addition to total cost from producing the last unit of output [or onemore unit – it is at the margin.]

For all the theory of the firm, and all market conditions, the AC and MC curveslook the same – you can always start by drawing the AC and MC CURVESwithout even thinking!

Why are the shapes that way?

When MC is below AC it pulls it down; when MC is above AC it pulls it up. Thismeans that the MC curve must cut the AC curve at the lowest point.

The AC curve is U-shaped because when starting to produce, the fixed costs must beborn by a few units of output, so average costs must be high; as the firm produces more,the fixed costs are spread over more units of output, so AC falls. Then it reaches aminimum. Eventually the firm is trying to produce more than it was designed for, andaverage costs start to rise.

We can depict this as the mirror image of average and marginal products – as physicaloutput increases so costs fall, but as average product and marginal product fall, socosts must rise.

AC

Output

MC

0

Price, Costs

174

Occasionally there might be a question in an exam asking about the relationshipbetween the two.

AP & MPAC & MC

Output

MC

0

AP

AC

MP

175

4-6. THE DIFFERENT POSSIBLE MARKET CONDITIONS

The theory of the firm covers perfect competition, imperfect (or monopolistic)competition, and monopoly. These are increasingly less competitive in the orderlisted. Oligopoly is considered to be something of a special case.

The Arrow of Competition:

Monopoly

Monopolistic competition

PerfectCompetition

Oligopoly

As just pointed out, all firm diagrams start the same way!

Price, Costs

AC MC

0Output

The equilibrium position is where marginal cost = marginal revenue!

Why? Logic! If a firm is profit maximising, it continues an action, like expandingoutput, until it costs more to do it than it brings in as revenue. As long as revenueexceeds costs, it pays to go on doing it. As an example, if total revenue is £2,000 andoutput is such that the last unit sold increased costs by only £1,500 it clearly added£500 to revenue more than it cost to build and was worth doing. And another unitmight add £1,900 to costs but sold for £2,000 so was also worth it. The next unit,however, might add £2,050 to costs but bring in £2,000 – a loss of £50 so it would notbe worth it. When the last unit just adds £2,000 to costs and brings in an extra £2,000it is marginal – it makes no difference if we produce that last one or not.

176

So what do we know?

The cost at the margin (the addition to total cost from the last unit produced)increases as production rises (the MC curve).The revenue from the last unit sold is the marginal revenue (MR).Logic tells us that the firm will continue expanding output and watching MCrise until it equals what the firm receives from the marginal unit sold (MR).Therefore when MC = MR it is the best the firm can do, so it stops there; it isin equilibrium.

We use the MC curve to trace what happens if a firm changes its output level, for thatvery reason.

PERFECT COMPETITION (the right hand end of the arrow above)

Perfect competition is defined as a situation where there:

Are many small buyers and sellers (firms) each too small to affect the price – thefirms are "price-takers".

Is a homogeneous product [all are identical].

Is free entry and exit. This means that firm can join or leave the industry – it is bothallowed and costs nothing.

Is perfect knowledge.

If we take out “perfect knowledge” (which never exists in the real world) and leave thefirst three assumptions, we get "pure competition”. It is less than perfect, but is still verycompetitive.

The diagram of an individual firm:

MC

Price, Costs

AC

0

P1

Ot1 Output

177

Equilibrium is where the marginal cost curve, MC, cuts the price line, P1. In perfectcompetition any of the tiny firms can sell more without having to lower its price – it istoo small to affect price! This means that the price line above is the marginal revenuealso. The firm always gets the same price at the margin.

The price line is also the average revenue in perfect competition. It’s just the maths.

Total revenue = P x Q

Average revenue = TR ÷ Q

Clearly if we multiply P by Q then divide the result by Q we must end up with Pagain!

Perfect competitors are price takers!

The price is set at the industry level by the total supply and demand curves, in the normalway. Each firm must accept it – because the industry is made up of lots and lots of smallidentical firms; none can affect price.

The price is set in the industry by the demand of the consumers cutting the industrialsupply curve. Where does this supply curve come from? We get it by adding up all theMC curves of each little individual firm in the industry. All these MC curves added upare the industry supply curve as long as we are in perfect competition!

How price is set at the industry level:

SAC ACMC MC

P1

Tiny firm 1 Tiny firm 2

Price is setin the industryby S & D

Each tiny firm accepts that price

Price, CostsPrice, Costs

P1P1

D

Q10 0 0

Quantity in millons Quantity in hundreds Quantity in hundreds

Price

Q Q

178

And the small individual firms are price takers because they are too tiny to be able tochange it - and there is no point selling it for less than they could get.

If demand for the product increases in the industry, it causes an increase in price andfirms move up the MC curve.

Q. Why the MC curve?

A. As was said above, because the firm is interested in increasing output as long as itbrings in a greater revenue than it costs to make the extra bit.

How an increase in demand in the industry affects the perfectly competitivefirms:

We first change the price in the whole industry as demand has increased then tracethis over to see what it would be like for an individual firm. The increased demand inthe industry causes price to increase; each small firm enjoys this sudden increase inprice - and of course its profit increases. The firm then increases output in order tobenefit from as a high a profit as it can manage.

S MC MC

Tiny firm 1 Tiny firm 2

Demand forthe productincreases

Price, CostsPrice, Costs

Each tiny firm enjoys a higher price- sliding up the MC curve

D2

P1 P1

P2P2P2P1

Q1 Q2 0 Q1Q1 Q2 Q2

D1Price

0 0

Quantity in millions Quantity in hundreds Quantity in hundreds

AC AC

Above the equilibrium point where MC cuts the price line P1 (which is also marginalrevenue and average revenue as explained earlier), the firm makes more than itsnormal profit. You can see that at P2 it is operating above the average cost curve.Normal profit is built into the average cost curve – without it the firm goes bust!Above the AC curve, the firm makes “excess profits” or “above normal profits”.However, firms can earn above normal profit like this in the short term only.

Why is this? The above normal profit immediately attracts other firms to enter theindustry. After all, they have perfect knowledge which means they know about it!

179

And the free entry and exit proviso means they can race in! And this means extraoutput, i.e., an increase in supply at the industry level, so price starts to fall back.This process bids away the profits all the way down to where we started where MC =MR = AC = P1. So in the long term, under perfect competition, no above normalprofits are possible.

Q. Can you take the diagram above, draw it for yourself, then increase the supplycurve until P2 falls back to P1? Try it now!

What happens if price falls below AC? At this level, all the firms lose money andcontinue to do so until some firms go out of business. When they do, supplydecreases, so that price starts to increase, and this continues until the price is back tothe original equilibrium position.

Average variable costs versus average total costs

Average variable costs must always be covered (they go directly into the particularitem one is selling); but average total costs are different. Average total costs includeall kinds of things, like new toner for the computer’s printer – these do not go directlyinto any particular item, they just have to be covered in the long run. So a firm cancontinue in business in the short run, as long as average variable costs are covered,even if average total costs are not. Anywhere between A and B in the diagram below,the firms are covering the variable cost of production and earning a little extratowards covering the long term total average costs. So it is worth staying in businessfor some time and hope that market conditions improve (prices rise) so that they willreturn to profitability. [This is a common multiple choice question].

Price, Costs

ATC MC

AVC

0

A

B

Output

180

The advantages of perfect competition

Resources are allocated in the most efficient way to meet market demand andmaximise consumer satisfaction.

- This means that market mechanism works better.

It is the cheapest way of using the factors of production we have.- Which says that we are at the lowest part of the AC curve.

There is no cost of advertising, selling, marketing, or motions. These are often aform of waste to society as a whole, though beneficial for individual firms.

Rapid change is possible to meet new consumer demands – it is very flexible.

The interests of producers are the same as for consumers.

Freedom to choose exists.

It avoids all the wastes of monopoly.

It prevents the emergence of a few rich and powerful people (Conrad Black?Robert Maxwell?) There are a lot of firms, all small, so that no major powerfulpersonality can rise and dominate others.

The disadvantage of perfect (or pure) competition

It produces what is demanded under the given distribution of income. We canimagine a scenario with a very few rich people with pet dogs or cats which dineextremely well on chicken and the like, while the masses starve.

Spillovers and externalities can exist. These are costs caused to others, e.g. thedisposal of nuclear waste or toxic chemicals by dumping them in streams.

No economies of scale possible - all the firms are too small.

Perfect competition is consistent with a limited choice of range of goods;monopolistic competition may have a much wider range. An example ismotorcars – there are an awful lot of different models and competition is muchless than perfect.

Little or no research and development is possible because there are no funds forit. Under perfect competition there are no surplus profits (in the long run theyare whittled away!) R&D is possible under monopoly because of the surplusprofits available.

181

MONOPOLY – THE LEAST COMPETITIVE MARKET SITUATION (the lefthand end of the arrow of competition)

Monopoly

Monopolistic competition

PerfectCompetition

Oligopoly

(There is some overlap between Unit 2 and Unit 4 on monopoly, so this may seemfamiliar to you.)

WHAT IS A MONOPOLY

Definition: Technically it is a sole supplier, i.e., there is one firm in the industry. It isthe industry.

But there are degrees of monopoly - if one firm supplies, say, 80 per cent, it is close to amonopoly and will usually act like one.

Types of Monopoly

Economies of scale. One firm grows large, its cost curves are lower than theothers, so it is able to sell more; in the end it grows to become the sole firm.This is the so-called natural monopoly.

2a) The law. The government may restrict the industry to one nationalised firm.An example was British Steel some decades ago in the UK.

2b) Regulations. A trade union may have a monopoly over the supply of onekind of labour – the British Medical Association covers all doctors for instance.

Agreement between firms, so that they all act together and behave as onemonopolist. This is often illegal but it happens.

Exclusive ownership of a unique resource. As an example, all the knownsupply of iron ore in Australia was once in the hands of a company called BHP;similarly De Beers diamond mining once virtually controlled all (and stillcontrols a lot) of the international supply of diamonds.

Copyrights, patents and licences are particular forms of this exclusiveownership.

182

Marginal revenue and monopoly

Marginal revenue is the addition to total revenue from the last unit sold.

A perfectly competitive firm can sell as much as it wants at an unchangedprice. Its MR curve is equal to the price – every time it sells one more item itreceives, say, an additional 50 pence, which adds 50 pence to TR.A monopolist is the industry, so it faces a normal downward sloping demandcurve.So if wants to sell more of the good or service it must lower the price.And of course it must sell all its products at that lower price. This means itloses by selling the items it used to sell earlier at a higher price at the newlower price.So the price of the marginal product is not the MR – the firm’s total revenueincreases by less than this sale, because of the bit it lost on the price on all theother products.

See the example in the table below.

AS INCREASEQUANTITY

MUST LOWERPRICE (£)

TOTAL REVENUEALTERS (PxQ) (£)

MARGINALREVENUE (£)

1 2 3(1 x 2)

4(by subtraction in 3)

1 7 7 72 6 12 5 (12-7)3 5 15 3 (15 -12)4 4 16 1 (etc)5 3 15 - 16 2 12 - 37 1 7 - 5

Note that marginal revenue is less than price for all quantities after the first one.

Monopoly equilibrium

Equilibrium is where MC = MR, as usual. When you are drawing the diagram andanswering questions you should locate that point first and draw it in.

183

Seeing monopoly profits in the diagram below

Profits = total revenue minus total cost.Total revenue = price times quantity.Total cost = average cost times quantity.

Total revenue = the area 0 P A Q.Total costs = the area 0 AC B Q.

So profit is the difference between these two areas = P A B AC.

Price, Costs

MR

AC

P

Output

D

MC AC

B

A

0 Q

P

Q

MR

Price, Costs

MC AC

Output0

D

184

Problems with monopoly, “what is wrong with monopoly” or "the welfare effectsof monopoly"

A monopoly limits output and keeps price high.

A monopoly redistributes income from all the consumers to this one firm orperson (an equity issue).

Monopolists may develop political and social power over others, which reducesthe efficiency of democracy and is inequitable. There are political dangers of afew very rich and powerful people (Marx called them “monopoly capitalists”who misuse their position and exploit people).

A monopoly may behave badly in an anti-social way. For instance it may forceout a rival firm by selling its product at give-away prices, well below cost andtaking the short term loss. After it has forced out the competitor, it will then putthe price back up again. This behaviour may or may not be legal. It depends onthe country involved and its legislation but it is always reprehensible.

The lack of competition tends to promote inefficiency, the company rests onlaurels, there is no need to try hard, and it lacks dynamism. This is probably themain criticism – said Austin Robinson

The result is lazy managers and owners.

This means that technical progress is reduced, leading to slow economic growthof the country and a lower standard of living than we could have.

Resources are misallocated. Too many go to the monopolist and they are notfully used by him. This is a waste for society and in addition, the pricemechanism is prevented from working properly.

A monopoly reduces consumer choice. There is no one else to buy from and noother producer’s product.

A monopolist may ignore small market demands as he cannot be bothered tomeet them. You will recall that I mentioned earlier that Henry Ford is supposedto have said about his motor cars “You can have any colour you want, as longas it’s black”.

The long run effect from the existence of monopolies is slightly slower growth;a lower standard of living; higher unemployment (because the monopolistrestricts output and so requires fewer people); higher prices (which monopoliescharge); a slightly poorer balance of payments as a result of this; a less equalincome distribution; and poorer resource allocation.

185

Benefits of monopoly – there are not many really, but some case can be made.

A monopolist can use monopoly profits for research and development, leadingto product improvement, faster growth, and lower costs, despite the argumentabove that they are inherently lazy.

- Joseph Schumpeter argued that they are important for innovation; he feltthat big firms are the only ones that are able to afford the necessarylaboratories, equipment and research staff.

- Against this, research exists that shows many of the breakthroughs comefrom small firms, for example Apple began making those computers in agarage.

Monopolists may be able to reap economies of scale, for example the RoyalMail; the provision of telephone lines; the supply of electricity; the supply ofgas; and the provision of railways. Economies of scale mean lower costs(although the monopolist Royal Mail is notoriously inefficient in the newmillennium).

A state monopoly may be safer than a private one. A private monopoly may bemore tempted to cut corners and reduces necessary maintenance to lower costs,and this could be particularly serious in some areas like the railways or airtraffic control.

IMPERFECT COMPETITION OR MONOPOLISTIC COMPETITION

(The bit in the middle!)

What is monopolistic competition?

It is defined as a situation where there are:

Many buyers and sellers of that type of good or service (= “competition”).Free entry and exit (= “competition”).But each with its own brand of the good or service (= “monopoly” on the brandname).So each faces a downward sloping demand curve for its branded product (= amonopoly on the brand name).

Notice the mixed elements of both monopoly and competition, hence the name“monopolistic competition”. You know it makes sense!

A reminder: are you revising something and practicing drawing diagrams eachday?

186

Where is the long-run equilibrium position?

At the tangent of the demand curve and the average cost curve, as in the diagrambelow.

Price,Costs

0 Output

D1

Q1

P1

ACMC

Q. Why is equilibrium tangential?

A. Because of the assumptions of strong competition.

If the firm improves the product, e.g. suddenly changes the colour to a currentlyfashionable one, the demand for the product will increase from D1 to D2 in thediagram below. This allows the price to increase to P2 and more units are sold (OQ2)and hence higher profits are made in the firm.

Why is the new price at P2?

We read off the new equilibrium position from the intersection of the marginalrevenue curve (MR2), (which relates to the new demand curve D2) with the marginalcost curve (MC). This intersection determines the quantity that it is most profitable toproduce, which is OQ2. Then we just go straight up and read the price the firm willset from the new demand curve. Why from this curve? Because the demand curve isthe curve that relates price to quantity, you will remember, and we have justdetermined the quantity.

187

Price,Costs

0 Output

D1 D2

Q1 Q2MR2

P2

P1

ACMC

The firm is then getting monopoly profits – and the equilibrium diagram to revealthese is the same as the standard monopoly diagram. The profits are the area P A BAC in the diagram below.

Output0

Price, Costs

P

QMR

AC

A

B

MC AC

D

But these monopoly profits can occur in the short term only!

The higher profits and visibly higher price draw the attention of competitors who cancompete by colouring their product also!

The demand for the original product then falls back.

188

Q. How far does it fall?

A. Until the monopoly profits are eroded to zero when competitors stop coming in!

So in long run there can be no monopoly profits – the equilibrium position is alwaystangential!

NOTE the price in equilibrium: it is on the average cost curve but is above themarginal cost curve. (Multiple choice questions might ask about this!)

Problems with monopolistic competition

There are wastes of time and effort – the firm will worry about the actions ofcompetitors.

There are wastes of resources, for some are underused. You can see this becausewhere we are operating is not at the bottom of the average cost curve and excesscapacity exists.

There may be too much product differentiation; the firm may pretend its productis “better” but it may merely be different.

There are the wastes of advertising.

There may be other promotional wastes, like free gifts, 2-for-1 offers, orcompetitions to get a trip to Spain etc. instead of lower prices or better quality.Running such schemes does use real resources.

The benefits of monopolistic competition

It is very competitive – the firms watch their competitors very closely.

This competition drives firms along and there is strong endeavour to improvequality and design, as well as to lower price.

Free entry and exit keeps the level of competition up.

Variety is great, there is more choice and hence, we assume, greater consumersatisfaction. Some however argue that there may be too much choice which canconfuse and irritate people rather than help them.

On balance, there is a lot of monopolistic competition in the real world; some argue itis the mainspring that drives the economy forward by producing new goods, cheapergoods, better goods - or at least different ones.

189

4-7. AN INTRODUCTION TO EFFICIENCY

There is some overlap with Unit 2 about efficiency, so some of this you may alreadyknow.

The types of efficiency in economics:

a) Allocative efficiency.b) Productive efficiency.

This concept of efficiency is static. Static efficiency looks at given resources and triesto get the most output from them – and all firms should sell at a fair price toconsumers, which would reflect the real resources used.

A. Allocative efficiency

This occurs when the value the consumer puts on a good or services is identical withthe cost of resources used in producing it. This happens when price = marginal cost.In this situation, total economic welfare is maximised.

Price, Costs

A

0

P

Q

MC AC

D

Output

At A, with P2 and Q2, MC = P we have allocative efficiency.

In the perfect competition diagram below, where MC = MR for the firm, we haveallocative efficiency because firms marginal revenue is the price, so MC = P.

190

MC

Price, Costs

P

QOutput

AC

0

The consumer surplus and the producer surplus

You will recall these concepts which were introduced in Unit 1. If you have forgotten,go back and look it up now, before reading on.

D

0

consumersurplus

producersurplus

Price, cost,revenue Supply curve under

perfect competition

Quantity

P pc

Q pc

Here we are in perfect competition with price “P pc” and quantity “Q pc”.

There is allocative efficiency in a perfectly competitive industry and price equalsmarginal cost.

Note that the whole of the area between the supply curve and the demand curve istaken up by the consumer surplus and the producer surplus.

This is not the case in the monopoly diagram below. In contrast, in that diagram thatarea is not all taken up by the two surpluses. You can see the triangle of “dead weightloss” that goes neither to consumer surplus or producer surplus and so is lost to

191

society! We do not have allocative efficiency (where MC=MR) because themonopolist limits output and sells at a higher price in order to maximise profits.

consumersurplus

0

P

MR

Price &Costs

Quantity

deadweightloss triangle

producersurplus

MC

Q

D

The deadweight welfare loss under monopoly is the small triangle as indicated.

B. Productive efficiency

This kind of productivity exists when we are on the production frontier; this means weare using the least resources possible to produce any given output. This also meansthat we are at the minimum point on the AC curve.

This happens when we are in perfect competition – so economists prefer this state andmay refer to as it “X-efficiency” – it is where we are truly efficient.

Where market equilibrium is efficient, we cannot make someone better off withoutmaking someone else worse off (this is sometimes called “the Pareto optimumposition”).

Note that we can have allocative and productive efficiency but still have inequity. Asan example, if you as an individual have all the income in the suburb in which youlive, the other people living there will be poor and might even starve! The marketsystem is amoral i.e., it is not concerned with good or bad.

192

Social efficiency matter too!

We might produce too much or too little for our own good as a society, even if haveperfect competition and an acceptable distribution of income. This can happenbecause of the existence of externalities. The state might intervene and try toencourage all positive externalities and reduce the negative ones.

Recall the discussion in Unit 2 about externalities, social costs, and private costs. Ifyou are less than certain about these, now would be a good time to go back and revisethat part of the course.

Here as a reminder are the two diagrams involved.

Negative externalities cause the social cost curve to be above the private cost curve.

0

Social costs

Social Costs,Price

Private costs

Quantity


Qb Qa

Pb

Pa

Positive externalities (usually harder to find) cause the social cost curve to be belowthe private one.

0Quantity

Social Costs,Price

Social costs

Private costs

Pb

Pa

Qa


Qb

193

4-8 AN INTRODUCTION TO PRICE DISCRIMINATION

Definition: price discrimination is the charging of different prices to consumers forthe same good or service in order to increase profits.

1. First degree price discrimination:

This means that a firm can charge each consumer the maximum s/he would be willingto pay. If perfect price discrimination occurs, it means that the entire consumersurplus is extracted by the producer, and so it falls to zero.

If we think of the demand curve and price starting to fall price in blocks of one unit –Q1 and P1, the producer can extract the area above equilibrium, which, say, is at P3.

Many companies that supply homes with electricity use this method– the first block ofunits is expensive, then the units get cheaper as the family uses more electricity overthe month. Check your electricity bill at home and see if it is happening to you!

2. Second degree price discrimination:

This occurs when a firm sells at its profit maximising position, and finds it has somegoods/services left over, so it sells this surplus more cheaply to others.

This is commonly done with airline seats and hotel rooms – have you heard oflastminute.com? Look it up on the internet – there are bargains to be had! You mightalso encounter cheaper cinema seats on one day of the week, or perhaps in theafternoon but not the evening.

Where second degree price discrimination exists, fixed costs typically are large, andmarginal costs are low or perhaps virtually constant.

Price

0 Q1 Q2 Q4Q3

P3

P1P2

P4

Quantity

D

194

Here the firm first produces where MC = MR (at Q1 and sells at P1). Marginal costsare constant – think of empty airline seats where the marginal cost is tiny; it is the costof one more meal and a miniscule extra amount of fuel.

The company can increase its profits further by selling the first quantity at the highprice OP1, then expanding its output to Q2 and selling the remainder for price OP2.The computer programs the airlines use are sophisticated, and can offer seats atdifferent prices, starting a bit below P1 and reducing all the way to P2, to earn moremoney. On any full commercial airline, the passengers are normally paying a wholevariety of prices for this reason.

3. Third degree price discrimination:

This is often called “the price discriminating monopolist”.

This happens where a monopolist can sell at different prices in different markets.

To occur at all, it requires three things:

There is a monopolist.The markets can be kept separate.There are different elasticities of demand in each market.

The consumers in the market with the most inelastic demand always face a higherprice.

We locate the marginal cost in the usual way, from the monopoly diagram. We thenapply that MC to both the separate markets. Because each separate market has adifferent demand curve and elasticity, they have different marginal revenue curves.Putting this another way, once we know the actual MC figure, we can trace it across

DMR

Quantity

MC

Price,Costs

P1

MC &P2

Q10

195

to both markets, see the intersection with the MR curve in each, and set the price ineach. This will be different in each market because the elasticities are different.

We determine the overall MC=MR position on the left hand side of the diagrambelow. Then once we have the MC point established, we read this MC across towhere it cuts the individual MR curves in the first two diagrams. That pointdetermines the price in each market, reading up off the demand curve in thoseseparate markets.

The market with the relatively inelastic demand always has the higher price. This isexpected as the greater the inelasticity, the more people want to buy it and areprepared to pay that much more for it.

This situation of different elasticities is typical of foreign markets and home markets.In the world in which we live, for most goods and services the demand in the globalmarket is more elastic than in each domestic market. This is because competition isgreater at the global level - the whole world competes! Therefore, firms that exportoften charge more in the home market (where the elasticity of demand is lower) thanabroad.

Any multiple choice question or data response question about different prices indifferent markets will be about the first, second or third degree discriminationpossibilities. You just have to think about it and decide which one it is, unless thequestion makes it clear upfront.

Price,costs

Market BMRMR

AR

Price,costs

Price,costs

AR

AC

MC

MRQ

Total MarketsA+B

Qa

Pa

Qb

Pb

0 0 0

Market A

AREstablishedMarginalCost

196

4-9. PRICING STRATEGIES

Pricing strategy and promotions

These never exist with perfect competition – as all firms are price takers! There isno need to advertise one’s own product as the tiny firm can sell all that it canproduce at the same market price.Under monopoly there is some need to advertise to keep the product name alive;some of the ads might be of the “Our Company is really nice” type which you willsee on TV now and then.Oligopolistic firms very commonly advertise because they have a competitivestructure and a downward sloping demand curve. They have constantly tocompete with their rivals.With monopolistic competition there is also a lot of advertising, again because ofthe very competitive structure and the downward sloping demand curve for theirproduct.

Collusion and cartels.[Covered already].

Cost-plus pricing

The price is set as the average cost of item + a percentage mark-up.

Predatory pricing

This is when a firm deliberately makes a loss by charging a low price in the short termin order to drive out rivals or new entrants; in the long term this means higher profitsfor the firm as it can enjoy a higher price. It also means an easier life with fewerworries about the actions or reactions of rivals.

Limit pricing

This can be a feature of oligopoly: the firms may try to prevent new entrants byagreeing on a price that they will all charge. It will ensure that they all make goodprofits but not maximum profits. The price and profits are not quite high enough toattract other firms to the industry but will be above those set in perfect competition.

Advertising and sales promotion policies

Advertising is designed to move the demand curve outward and to the right. It mayalso serve to make the demand curve for the firm’s product less elastic whencompared with competitors’ curves. This means a higher price can be charged andmore revenue and profits gained.

197

Non-price competition

One often sees this with supermarkets. It may include:

Special promotions. These may take the form of competitions where one has tosend in two or more box tops to enter; or special offers like 2 for 1 – a form ofprice competition that can stopped and started easily without changing any printedadvertising material.Home delivery.Store loyalty cards (which also track what each customer buys and how often,which is most useful information for the store).Extended opening hours, including Sundays and holidays.Selling petrol on the forecourt.Services such as a chemist being available, dry-cleaning, or photo-printing.Internet shopping facilities.

“Contestable markets”

This occurs where we have a monopoly or oligopoly, but that has few or no barriersto entry and exit. This can force the firm(s) to keep price reasonably low andcompetitive in order to prevent others entering. So although it may be a monopolist itdoes not actually behave like a monopolist and therefore does not enjoy highmonopoly profits.

William Baumol invented the model. He saw such firms producing at the bottom oftheir average cost curve. They have to be efficient or other firms would enter.

For policy purposes, it means it may be better to consider reducing the barriers toentry and exit rather than focussing on the degree of competition or marketconcentration ratios as we usually do.

Barriers to entry include:

High sunk costs (fixed costs).Whether a firm can lease equipment or not. If it is possible to lease, then a newfirm can enter or an existing one leave easily, because it does not have to buy orsell the aeroplane or whatever is necessary.Advertising and brand recognition. It is harder to break into an industry if there isa well-known product already dominating it.The existence of over-capacity which was deliberately built so that the existingfirm can flood the market quickly with more products at lower prices, if a newentrant tries to get in.Predatory pricing. The simple undercutting of the newcomer until he goesbankrupt.

198

4-10. GAME THEORY

This was developed to show what happens in a situation where when one firm makesa decision, it has to consider the possible reactions of others to that decision.

Game theory is particularly useful in the oligopoly area where the reactions of othersare central.

“The Prisoner’s Dilemma” is a nice model which shows that competition cansometimes be bad, but cooperation can be good. Here is an example.

Two men, Arnold and Brian (i.e., A and B), are arrested for robbery with violence andinterrogated separately.

The police say to each that we are certain that we can get a conviction, but:

If neither of you confesses each will be charged with robbery and will definitelyget twelve months in jail.If you both confess then you will each get eighteen months.But if you alone confess, you will be let off with a caution but the other will getthree years in jail. Now, can you trust your friend? If he confesses and you don’t,you will be eating a lot of porridge. Why not confess now?

A problem!

It is tempting for Arnold to confess and hope that the other doesn’t! Then A getslet off scot-free.But if both confess, Arnold knows he will get eighteen months!If he refuses to confess, he will get twelve months in jail if the other keeps quiet –but he will get three years jail if the other confesses!

Clearly both are better off if neither confesses (eighteen months each).But for either alone the “dominant strategy” (roughly the best bet) is to confess(because he gets let off free if other does not confess).However, if he does not confess but the other does it means the full three years!So each is really pressured to confess even although it is better for both theaccused if neither does!

What can we learn from the Prisoner’s Dilemma?

Collusion would solve the problem! If the two involved could discuss it and agree,neither would confess! Both would gain the most that way.

And collusion is common in oligopoly!

199

Price wars with oligopoly:

If there are two firms, it is best if neither starts a price war – if they co-operate andkeep the price high, that is as good as it gets.

Let’s think of an example. Assume that currently each sells 10 units at £4 each, sototal revenue is £40 for each firm or £80 in total. But if firm A cuts his price to £3 hehopes to sell, say, 17 units at £3 and his total revenue would then be £51, a distinctimprovement. The other would of course be able to sell fewer items. Possibly hemight be able to sell 4 units or so at the unchanged price of £4, so that his totalrevenue would be $12 with much reduced profits.

The total revenue of both together is $51 + $ 12 = $63 (and remember it waspreviously $80!) As a pair they are losing out, even if one does better.

Then B might respond: it is tempting for B to cut his price perhaps to £2.50 and hopeto sell a lot more.

This process might continue with both firms cutting prices in turn, and both losing outeven more. Game theory suggests they would be better off to collude and go back tothe original situation of a price of $4 each and total revenues of $80 for the two, or$40 each!

200

4.11 OLIGOPOLY - THE KINKED DEMAND CURVE

The concept was invented to describe the observed stickiness in prices under oligopoly, i.e., to answer thequestion “Under oligopoly, why do prices alter infrequently?”

The theory was developed that when an oligopolist had already set a price, he was reluctant to change it.He felt that if he increased his price, he would lose business to his rivals and competitors (who wouldmake no changes in their price) and so profits would fall. However, he felt that if he lowered price to in-crease his sales, his competitors would follow suit, reducing their prices also, so he would not be any bet-ter off. Indeed selling at a lower price, his profits would fall. So if a price rise or a price reduction couldeasily reduce his profits, he would do neither. Hence the price would remain unchanged for long periods.

If we put this in graphical form, we can see that we start at his current price, chosen randomly in the dia-gram, and look at what he expects to happen if he alters his price.

1. He feels that a price increase would lower profits. This would happen if the good faces an elasticdemand. So above his existing price we see an elastic demand curve.

2. He feels that a price reduction would lower profits. This happens if the good faces an inelastic de-mand. So below his existing price, we see an inelastic demand curve.

If we draw this, we observe the following.

The marginal revenue is the addition to profit from the marginal unit sold (commonly seen as the last unitsold). As price is reduced, the marginal unit sells for less than the previous unit sold – indeed for less thanall the previous units sold. So the firm loses revenue from all the earlier units as well as the current one.For this reason, marginal revenue is always below the demand curve but they both start together on thevery first unit sold. (When the first unit is sold at the price £X, the addition to total revenue is also £X).The marginal revenue curve falls faster than price because of the loss on all the earlier units, once theprice of the marginal unit is reduced.

0

Price, Costs

Q Output

P

D

D

Inelastic part: if reduce priceexpects competitors will do the sameso he cannot gain

Elastic part: if increase priceexpects will lose sales to competitors

201

If we put in the marginal revenue curve and a couple of marginal revenue curves, we see the follow-ing.

The maximum profit point is where the marginal cost equals marginal revenue. If we start with MC1 wesee the MC curve cuts the MR curve in the vertical part and price will be P (reading off the demand curve– the curve that relates quantity to price).

If costs fall to MC2, the price remains the same, P, because we MC2 still cuts the vertical part of the MRcurve, so the optimum quantity and price is unchanged.

This means that price does not alter much, because if we move the marginal cost curve up or down fromwherever it is, it always cuts the marginal revenue curve in the vertical part on the kinked demand curve.

Hence we see sticky prices under conditions of oligopoly - according to the theory of the kinked demandcurve.

Criticisms of the Kinked Demand Curve

· It does not explain why the price is where it is! This is a major hole in the kinked demand curve asa general theory as it only shows us why price does not alter much. In its defence, it was not de-signed to be a general theory.

· In the real world, price changes seem more common than the kinked demand curve theory sug-gests that it should be. Prices do alter!

· The theory may be more beloved of examiners (many of whom like setting it) than a realistic de-scription of the world. After all, the firm can always try to increase or reduce price and see what happens!If it gains, good; if it does not gain it can go back to the original price. This is an easy theory to test forthe firm so there is no reason to think the owner just sits there and worries that he would lose if he chang-es his price.

0

Price, Costs

Output

P

D

D

MRQ

MC1

MC2

MR

202

4.12 REGULATORY CAPTURE

What is it?It is part of “the economics of regulation”. We are aware that some leading members in industry andcommerce, left to their own devices, are likely to behave in ways of which society disapproves. In theabsence of regulation and inspection, some members will engage in price fixing and collusion, bribery ofgovernment officials, lie to customers, break various laws, such as dumping waste produce in NationalParks, and the like.

What does society do to try to protect itself and the general public?The government frequently establishes one or more regulatory bodies to oversee the industry and try tocontrol it, in order to protect society as a whole.

What often happens?The body in charge gets taken over by various vested interests until the regulatory body eventually startsto work for the vested interests and ceases to protect society. In other words, there has been “Regulatorycapture”. In a less extreme form, the regulatory body may not be entirely taken over, but a cosy relation-ship between the body and the industry tends to build up over time so the policing powers become weak.There is always the risk of total capture but many economists feel that this extreme position is perhapsnot all that common.

How can the body be influenced or captured in this way?· The industry is likely to have a lot more money than the government body and so can hire more

and better staff.· The regulatory body frequently consists of members who have several jobs or advisory positions,

and can devote only limited time to the work of the body. The industry, by contrast, can employfull-time workers to try to present a better case and improve the position of the industry.

· The industry can pay for “research” that demonstrates what a good bunch they are and how wellthey behave.

· The industry can lobby individual Members of Parliament (and offer inducements for support,some of them not entirely legal).

· The industry can plant articles in newspapers and elsewhere that support their case.· The appointments to the regulatory body are often top civil servants who know and have worked

with leading members of the industry and so have already developed a friendly relationship.

Examples· It has been alleged (NB I suggest you ALWAYS put in this phrase when you are writing about the

issue in public; it can protect you from being sued by powerful people!) the UK government’sMedicines and Healthcare Products Regulatory Agency is effectively promoting the pharmaceuti-cal industry in its efforts to sell drugs and increase profits, rather than protecting the public andhelping to keep down the drugs bill of the National Health Service..

· It has been alleged that the Food Standards Agency does not work hard to stamp out additives tofoods that might be dangerous to children, including some that promote hyper-activity and poorlearning. It is suggested that the Agency tends to pass the buck to the equivalent European body,as well as to the parents of the children, rather than act to improve things themselves.

What might be done to improve the situation and break the cosy relationship between a regulatoryagency and the people it is supposed to police?It might be possible to:

· Insist that all appointees to a regulatory body are approved by, say, a Parliamentary committee.· Not to allow top civil servants to leave and join the industry (e.g., when they retire) until, say, 4

years have elapsed.203

· Regularly change the members of the regulatory body, to prevent cosy relationships developing.· Not allow inspections of companies in the industry by single inspectors but insist on at least two,

in order to make offers of bribes or other inducements more difficult.· Rotate the teams of inspectors, so that on each visit the industry has to deal with new people.· Protect whistle blowers – people who reveal what is actually going on. Experience suggests that

whistle blowers regularly do badly once they have revealed an unpalatable truth; they are infre-quently promoted; they are often given poor references should they leave; and their names mighteven appear on secret blacklists.

Names associated – you can quote the names in exam answers· Adam Smith in the Wealth of Nations was the first to point out that when business people meet up

they tend to collude to raise prices.

· Richard Posner, at the University of Chicago, is a main name in the regulatory capture debate. Heargued that regulation is not really about serving the public interest (although it should be) but theprocess actually serves the interests of many, all of whom seek to promote their private interests.

What a reviewer said about an earlier study-guide:

“Written for students at Griffith University inAustralia, Dr. Kevin Bucknall covers: housingand transportation, the university and classroomstructure, the role of the student, first yearsubjects, how to study and learn, preparing andpresenting assignments, and some tools of thetrade. One of my personal favorites!!” Penn State University, USA.

And another said:

“How to Succeed as a Student.” Written byKevin Bucknall, really interesting.... take alook”

Dr Clive Buckley, North East Wales Institute.

If you are finding these free notes useful and feel that you might need a bit ofhelp in writing essays, getting better marks in exams, and learning more quicklyand easily, take a look at Going to University: the Secrets of Success: Kewei Press,Second Revised and Expanded Edition, August 2009, paperback, 204 pages, ISBN978-0956182319. Recommended price £9.95

204

Copyright © Kevin Bucknall

Module 2881 Unit 5a: Labour Markets

Much of the analysis of demand and supply in Unit 1: How Markets Work and Unit 2:Markets – Why They Fail applies to labour. The diagrams looks similar and work in thesame way – mostly you just have to change the word “price” to “wage” and “quantity”to “quantity of labour”; similarly you alter “supply” to “supply of labour” and“demand” to “demand for labour”.

5A-1 THE SUPPLY OF LABOUR

The supply curve of labour is the normal shape; if the firms in an industry are willing topay a higher wage more people offer themselves to work there.

If I offer the people in your class £1 an hour to vacuum and dust my flat, few wouldaccept I imagine; but for £7 an hour more would be willing to supply their labour; and at£50 an hour, just about everybody would voluntarily be in the supply curve! That’s theway the world in general behaves also.

Quantity of labour

Wages

0

S lab

Leisure versus work

One reason the supply curve of labour slopes upwards and to the right is that an employerhas to offer a higher wage to get more people to work voluntarily, that is to say, give upsome of their leisure time.

The income and substitution effects

We call it “the substitution effect” when someone gives up leisure to join the work force(they substitute leisure out for work in). The substitution effect may also work when we

205

look at those already employed: it is operating if we find that paying them more (such aspaying higher overtime rates) persuades them to work for longer hours.

“The income effect” has a different outcome; it exists when people focus on the level ofdesired income rather than on substituting leisure for work. For instance, if a person hasa target income he or she wishes to achieve, then once they have reached that level ofincome, they may reduce their work hours or even stop working completely. This couldhappen if they had a target savings goal and the higher income allowed them to stop workearlier.

If an increase in pay leads to fewer people working, or the existing workers choosing totoil for fewer hours, the income effect is said to dominate the substitution effect. Thiscan happen, but it seems to be rare. When it exists, we see a backward sloping supply oflabour curve as in the diagram below, as the “S lab” curve bends back at higher levels ofwages.

S lab

Quantity of labour0

Wages

W1

This situation is alleged to have existed in Indonesia before World War Two, as the localworkers lacked an incentive to improve their lot much above subsistence level. Whencolonial companies increased the wages paid above W1, workers would leave becausethey would reach their target wealth level more quickly.

There is some dispute as to whether this really occurred or not. Some people feel thatracism was involved, when a Dutch researcher looked at the attitudes and behaviour oflocal workers in colonial Indonesia back then. Others feel that it was merely a ploy bythe colonial companies to justify paying really low wages.

206

The working population

The working population consists of all those who are willing to work at the prevailingwage rates, whether they are in employment or unemployed.

It excludes children, the aged, prisoners, house wives and house husbands, some who arerich, some who are “lazy” (i.e. they prefer leisure to work, which means that they have “ahigh leisure preference”), and all students in full-time education. These are designated asbeing “inactive”. Those not in the working population are considered to be“dependents”.

In the UK, the working population in 2004 was close to 29 million people out of a total of59 million, or 49 per cent of the total (if your are nervous in the exam room and forgetthe exact figure, simply say “just below half”).

207

5A-2 THE DEMAND FOR LABOUR

This was covered in Unit 4-1; the section here is a reminder because the marginalproduct curve is important – it is the demand curve for labour.

Marginal productivity theory

This gives us the demand curve for labour.

The total product curve shows us what happens to output as a firm takes on more workersWith no workers, there is no output – as the firm hires one or two workers it producessome output – as it hires more people, output increases and the rate of increase is faster(output is speeding up) because there is a better balance between workers and themachinery they are using. There were too few workers at first; but eventually there willbe too many workers for the machinery they have got, so the increase in output starts toslow down, then eventually output must fall.

An example: if we start growing cabbages on a football ground with 20 spades, 20 hoes,and a lorry for transport we can see that as we get more workers, one, two, three, four…and so on, output can rise rapidly.

But when we get to 1 million workers, output must have fallen to zero as the wholeground is full of people!

0

Total product

Output

Decrease

Factor of production (labour)

Increasing at increasing rate (accelerating)

Increasing at decreasing rate (deceleratig)

Maximum output

Marginal product = the addition to the total product from the last unit of factor added(which is a worker in our example).

The marginal product curve rises rapidly when total product is increasing at an increasingrate (that is, the high marginal product pulls up total product rapidly); the marginalproduct curve falls as total product increases at a slower rate; the marginal product curve

208

cuts the X axis (becomes negative) when the total product is at maximum (as totalproduct starts to fall it must mean that the marginal product being added is negative!)

Average product = total product divided by the number of workers; it is the averageproduct per head.

We put the physical marginal product curve into money terms, by multiplying the numberof units of output by the price we can sell them at. This is done so that we can comparewages (in pounds) with the marginal product (also in pounds). The curve is called the“marginal revenue product curve” or MRP.

Looking at the AP curve and the MRP curve together:

Average ProductMarginal &

AP lab

MRP lab+0

Q of Labour

The demand curve for labour is the MRP curve (the bit below the AP curve because afirm will not pay more than a worker is worth to it on an average basis!).

Why the MRP curve? Logic! An owner will hire a worker for, say, £400 a week if s/headds more to the firm, such as £700, or £600, or £500…. But not if s/he adds less than£400. At the marginal product falls to £399 then the owner stops hiring. This eventuallyhappens as we push out to the right along the horizontal Q of labour axis. The firmsstops hiring when the marginal product added is just equal to the wage that has to bepaid!

The equilibrium wage rate is set in the market for those particular workers, where supplyequals demand. Any firm has to pay the going rate to get the necessary workers. Thefirm could chose to pay more than that, but this means it would be paying more than itneeds and it would not be maximizing profits. (If it should choose to pay more to getbetter workers than average, then it is simply paying the market rate for the betterworkers!)

209

So the marginal revenue product curve is the demand curve for labour! At the level ofthe firm, we can simply read off where the market-determined wage reaches the MPcurve; that then determines how many workers a firm is willing to hire.

Average ProductMarginal &

AP lab

W1

Q of LabourQL1

MRP lab

0

Seeing the Law of Diminishing Returns to a Factor Making Sweaters or Jumpers

Number ofworkers

Output ofjumpers perday

Marginalproduct(jumpers perworker)

Averageproduct(jumpers perworker)

Price ofjumpers

£

Marginalrevenueproduct

£

1 2 3(by subtractionfrom 2)

4(2 ÷ 1)

5(assumed)

6(3 x 5)

0 01 4 4 4.00 10 402 10 6 5.00 10 603 13 3 4.33 10 304 15 2 3.75 10 205 16 1 3.20 10 106 14 -2 2.66 10 -207 11 -3 1.57 10 -30

This assumes: there is perfect competition (the firms do not have to reduce price to sellmore which means there is a perfectly elastic demand curve. If the firm faces a normaldemand curve, it must reduce its selling price below £10 in order to increase sales, so the

210

marginal revenue product would fall faster than if multiplied by an unchanged price often).

If the wage is determined in the market at £30, we can read down the marginal revenueproduct column and see that the firm will hire three workers. However, if the daily wageis only £20, the firm will hire four workers.

“The demand for labour is a derived demand”

People are only hired to produce something – that something is then sold. If the demandfor this product or service increases then the demand for the labour to make it increases.And if demand falls, so the demand for labour falls.

Elasticity of demand for labour

This is very similar to the earlier price elasticities. The elasticity of demand for labour ismeasured by the percentage change in the quantity of labour demanded divided by thepercentage change in the wage rate. i.e. -

% ch Qlab D% ch W

The degree of elasticity depends on

1. The easier it is to substitute another input for the one we are looking at, the moreelastic is demand. In other words, if it is easy to substitute capital for labour, thedemand for labour is more elastic – if the wage rate goes up, firms can easily cutback on labour and use machines instead.

2. The greater the elasticity of demand for the final product, the more elastic. If thefirm cannot pass on price increases, it will try to resist wage increases as it will bedifficult to pass them on.

3. The greater the proportion of total costs (TC) made up by this input, the moreelastic it will be. If it is a tiny percentage of TC, you can see that even a doublingin wage would not affect the final selling price much.

4. Long run elasticity is always greater than short run. This is because any neededadjustments can be made in the long term, which means a flatter (more elastic)curve. For instance, technology could be changed in order to use less labour; inthe long run, whatever the firm would like to change it can.

211

5A-3 DETERMINING THE EQUILIBRIUM WAGE

Equilibrium wages: putting together the supply of and demand for labour.

Quantity of labour0

W 1

Q lab

Wages

D lab (MP lab)

S lab

All the normal supply and demand analysis works!

• An increase in demand for labour means an extension up the supply of labour curve,an increase in wages and an increase in the quantity of labour hired.

• A decrease in demand has the exact opposite effect.• An increase in the supply of labour means an extension down the demand curve for

labour, a fall in wages and an increase in the quantity of labour hired.• A decrease in supply has the exact opposite effect.

What can cause a shift in the demand for labour?

• When labour becomes more (or less) productive it moves the marginal revenueproduct curve out (in).

• When the price of a substitute or complement changes. If a substitute for labour getscheaper (e.g., a particular machine), there will be a decrease in the demand for thattype of labour.

• When the demand for the product in the market alters. An increase in the demand fora product means an increase in the marginal revenue product of labour. (When inperfect competition, marginal revenue product is the physical MP multiplied by theprice; if competition is less than perfect, it will be the physical MP multiplied by themarginal revenue).

212

An increase in the demand for a particular product leads to an increase in demandfor labour to make that product (“the demand for labour is a derived demand”).

• An increase in the demand for a good or service leads to an increase in its price andquantity.

• The increase in price is an increase in average revenue and marginal revenue.• This means more workers will be taken on and there will be an increase in wages for

everyone ( extending up the normal supply of labour curve).

Qn1

W1

0

S lab

W2

Qn2

Wages

Quantity of labour

D lab 1 D lab 2

What can alter supply curve of labour? Lots of things, including:

• A change in the wage offered elsewhere in an industry that workers know about andcan move to.

• A change in non-monetary rewards either in this industry or else in an industry theworkers know about and can move to.

• An increase in the number of people reaching 16 years of age (or whatever age peoplejoin the working population). This would reflect an earlier change in the birth rateand the cohort of children is now coming through.

• More and better education in the skills needed in that particular industry.• New retraining schemes by government, business associations, trade unions and the

like.• Immigration and emigration.• Social changes, e.g., if it suddenly becomes acceptable for women to work in general

or in a particular industry.• Changes in death rates, war, disease, medical advances, public environmental

improvements and the like.

NB The move to a new equilibrium may not be instant – it can take a long time to learnnew skills or retrain – for brain surgeons it takes years! So we can often see a shortage ofa particular group of workers, like doctors, nurses, or teachers. In the case of publicservice workers, the shortage may be because society pays low wages, below theequilibrium level to attract good people.

213

Shortages may appear and persist for several different reasons:

1. There is disequilibrium because of wage fixing (by the government or a tradeunion).

2. Lags in adjustment (these are common).3. There are various special reasons for labour immobility, which are often social

(more later!).

214

5A-4. THE EFFECTS OF TRADE UNIONS

Trade unions prevent the “normal” market supply and demand of the competitivesituation from working perfectly.

There are two kinds of unions:

1. “Inclusive”. These are the normal general trade union we see in the West, such asthe Transport and General Workers Union. This is the focus of attention usually.

2. “Exclusive”. These are craft unions, such as the Musicians’ Union.

The Inclusive TU

The trade union negotiates with the employers and an agreed wage is set for the industry,or a factory if negotiating at that level. In effect this says that any firm may hire as manyworkers as it likes, but it must pay that agreed wage. If it does not pay, there will betrouble with the union, and possibly a strike. Unions try to get a “closed shop”, whereevery worker hired must be a union member and the union then does the collectivebargaining for all workers. The union tries to include all the relevant workers in its ranks.

The Competitive Wage Situation (With No Unions)

Wages

0

S lab

W 1

Q lab

D lab (MRP lab)

Quantity of labour

The Situation with an Inclusive Trade Union

In effect, the negotiated agreement alters the supply of labour from the diagram above tothe one below: note the new thicker supply curve of labour. The horizontal partindicates the firm can hire all it likes but only at the agreed wage. As we push out to the

215

right, once we reach the normal supply curve of labour, the original supply curvebecomes operative again. The union cannot force people to work for that wage and hasto accept the number of workers that are available and are willing to work. Fewerworkers will be employed although the demand curve for workers has not changed; at thehigher minimum wage, we extend back up the existing demand curve.

Quantity of labour0

S lab

D lab (MRP lab)

min wage

Wages

Min wage

Qlab2

W1

Qlab1

By comparing the situations with and without a union, we can examine the changes in themarket:

Quantity of labour0

S lab

D lab (MRP lab)

min wage

Wages

Min wage

Qlab2

W1

Qlab1

• Without a union: the wage is W1 and the employed workers are at Qlab 1.• With a union: the wage rises to the minimum agreed wage, but employment falls

to Qlab 2.• And unemployment appears in the industry, as more workers offer themselves for

work there (Qlab 3 reading from the supply curve) than are demanded (Qlab 2

216

reading from the demand curve). So the unemployed are represented by 0Qlab3minus 0Qlab2 which is the distance Qlab2 Qlab3.

Note: in different textbook diagrams, “the quantity of labour” may be presented as “Q”,“Qlab” or “Qn”; do not let it bother you! Qlab is often preferred as it shows you knowyou are dealing with labour markets and not, say, with the quantity of tomatoes.

The exclusive trade union

The exclusive union tries to prevent (exclude) workers from working unless they join theunion, and to do this they must pass a test. Such unions are common in professions likeelectricians, musicians, and medical doctors. If such a union can organise in the samewas as the inclusive ones above, they might do so. If they cannot organise in this waythen:

1. The union may place its effort on trying to restrict the supply of labour in order toincrease wages.

2. The union may also try to increase the demand for the workers (its members).

The diagram for a decrease in supply is exactly the same as the one you are used to inmicroeconomics for the price of any good or service but with altered labels. And itworks in exactly the way you are used to.

If the union is suddenly able to prevent non-union people from working, the effect is tomove the supply curve upward and to the left.

Wages

0

W 2

Q lab 2 Q lab1

D lab

S lab 2S lab 1

W 1

Quantity of labour

217

The other effort of the union may be to try to increase the demand for its workers. WhenI was a member of it, the Musicians Union steadily tried to get the BBC to us more livemusicians and fewer recorded music items on what were then called “gramophonerecords” as CDs had not yet been invented. (Ah, the days in my youth going round doingone night gigs in the good old “MU”; happy but long gone!)

This is the diagram for the union trying to increase demand:

Qn1

W1

0

W2

Qn2

Wages

Dn1

Quantity of labour

Sn1

Dn 2

In this diagram I switched to using “Dn1” and “Sn1” etc., so that you get used to thedifferent labels you might encounter in different books and not get put off when you do.

Can unions raise wages?

It used to be believed that they could increase the average level of wages in an industryand maybe achieve a wage some 10-20 per cent above the wages in a non-unionisedindustry.

But unions are much weaker now than before the 1970s, so some believe that they canhave much less effect these days. There is a lot more competition, labour markets workmore freely, and unions have simply become less important.

Unions and productivity

Many economists used to believe unions reduced productivity. They did this :

• By demanding, and getting, overstaffing in a firm.• By protecting bad and disruptive workers and not allowing them to be dismissed

despite their negative effects on production.

218

• By not allowing capital in to replace labour.

Some observers now feel unions can actually improve productivity:

• By providing a safety valve for worker irritation.• By allowing proper grievances to be heard without a worker being dismissed for

complaining or being a trouble maker.• A happy worker is a productive worker.

Some feel this is sophistry and although they admit that logically it could happen, theyfeel that the anti-productivity arguments are stronger. It is true that we saw labourproductivity increase when unions were weakened after Prime Minister Thatchersuccessfully attacked the unions. She seemed to believe that the unions had gained suchstrength that they could resist the government, they were a danger to democracy, and theyinsisted on protecting individual bad workers to the extent that they were damagingproductivity. This increase in labour productivity after the unions were weakened mightbe accounted for in part at least by the general increase in competition.

(You would be wise in the exam room to present views that can have a political contentor impact very carefully and not adopt an extreme position. Some markers have strongpolitical views, either left wing or right wing, and these might colour their impression ofyou as a student.)

219

5A-5. DIFFERENCES IN EARNINGS

The reasons for different wages in different occupations are always:

1. Different supply and demand situations; or2. Market imperfections; or3. Non-monetary rewards.

1. Different supply and demand for different occupations or regions

If we look for example at the wages of manual worker wages in London and Cornwall,we find that in London the supply of and demand for manual workers are both greater,but in London the demand is relatively greater than supply. It is no surprise that thewages in London are higher.

0 0

WagesWagesS lab

W 1

W 1

Ql QlQuantity of labour

LondonQuantity of labour

Cornwall

S lab

D labD lab

Notice that the supply and demand curves for Cornwall are well to the left whencompared with those for London. Cornwall has a small population.

The same analysis holds for many earning comparisons, such as:

• why doctors are paid more than nurses;• why general practitioners earn less than brain surgeons;• why the earnings of financial analysts in the City of London are greater than those

of super-market check-out staff; and• why a few star sports earn more than almost everybody!

There are many possible questions about why group X earns more than group Y, but theyall require the above diagram and general approach. It is a supply and demandsituation.

220

This approach can also be used for analysing differences in wages among differentsocial groups:

If the dominant group (A) does not like members of the other groups (B), when membersof the A group are hiring labour, they are more reluctant to take on members of the Bgroup. This means that there is really a different and lower demand curve for the labourof the B group, which means they are both employed less, and where it is allowed, theywill be paid lower wages.

[This can be a difficult topic to discuss as we are talking about real people with perceivedor actual differences, and we are all human beings. Antagonism is easily aroused andtempers might fly. If you have to discuss such issues I can only suggest you take greatcare.]

Wages

0Quantity of labour

Wages

0

W group A

D for group A

Q lab A

S of group A

W group B

Q lab B

S of group B

Quantity of labour

D for group B

Group A (B in brackets) can represent any number of people:

• White skinned (v. non-whites) [racial prejudice in white society].• Chinese (v. West Indians) [a particular antipathy, perhaps against the gangster

Yardies, perhaps because of skin colour or other reasons].• Males (v. females) [the “glass ceiling”].• Southerners (v. Northerners) and vice-versa [geographical cultural bias].• Public school accent (v. local accent) and vice-versa [class war].• Christians (v. Jews) [a 2000 year history].• Christians or the non-religious (v. Muslims) [especially since Sept. 11th but cultural

prejudice goes back at least as far as the crusades of the 11th-14th centuries).• Skilled workers (v. unskilled).

221

The analysis can be applied to any group that can be more or less identified about whichpeople have prejudices in fact. NOTE: This is NOT to condone such prejudices.

The concept of “non-competing groups”:

These are people who do not compete for the same jobs. As an example, shelf-stackers insupermarkets do not directly compete with GPs, so if the earnings of GPs increasesubstantially, shelf-stackers do not pour into medical schools.

It is believed that the competition does work, but indirectly through a ripple effect; as asimple example, students who might have gone into teaching opt for medical school,some people who might have found work directly from school decide to go to universityand become teachers instead, and some shelf stackers take the jobs thus “vacated”. Theripple effect is probably much more complex and can be slow, but the general idea isclear.

2. Market imperfections, another reason why supply and demand may not workperfectly

• The laws of the state may prevent it. An example is minimum wage legislation thatraises the wage for some but an unintended consequence is that it may prevent reallypoor people from ever getting a job (we consider the national minimum wage below).

o (Government response: they might change the law but this is unlikely).

• Trade union restrictions on supply (see above).

o (Government response: they have tried to weaken the unions).

• Union attitudes about maintaining wage differentials. A union might try to ensurethat a clerk gets a wage twenty-five per cent above a cleaner; if cleaners get a rise, theunion might demand and obtain an increase in the clerk’s wages to maintain thedifferential. These established differentials often seem to reflect the demand andsupply situation of long ago.

o (Government response: they have tried to weaken the unions).

• Monopsony which means a sole buyer. If there is one huge employer in a town, s/hemay be able to exploit workers by paying less than the marginal revenue product (seethe analysis and diagram below, p.221).

o (Government response: a national minimum wage).

222

• Time lags. We may never get to the equilibrium before it changes again.

o (Government response: it can do nothing much – it might try telling peoplemore quickly about changes, or speed up the workings of the bureaucracy if itcan).

• Labour immobility.

o Economic: where the local demand for skills does not meet the supply ofskills. There is a strong need for information technology people in the South-east and yet we see unemployed coal miners around Nottingham.

- (Government response: to retrain workers in new skills; they couldalso give a worker money to live on while retraining and finding a newjob; subsidise moving expenses; subsidise house sale and purchase,perhaps guarantee no loss on this).

o Geographic:

People frequently do not know about jobs elsewhere (knowledge is sometimeslisted as a separate reason, with a cost involved of obtaining the informationneeded).

People will not give up a cheap council house with low rent.

And selling one’s home and buying new one elsewhere is expensive.

- (Government response: they can tell people more about opportunitiesin other parts of the country; improve job centres; advertise on TV;and make council house swaps easier. Some are allowed but they arehard to achieve - we could set up a national centre to list them all).

o Social:

Existing pension schemes may tie workers to their current employer.

They have family nearby and not wish to leave them.

Social groups, their friends, the clubs of which people are members all tiethem to an area. Racial or religious ties to an area are common too.

- (Government response: not a lot they can do?)

223

3. Non-monetary rewards

The idea is that some jobs pay less because they are so nice to work in that workers willtake a lower wage – they used to say this about teaching! Now teaching still pays lessand is widely believed not to be a particularly nice job!

It is, in my view, a suspect argument – the best paid jobs also tend to have the best non-monetary rewards, like one can take time off easily, or enjoy good working conditions.People like barristers, accountants, or economists are usually better paid and have goodconditions when compared with agricultural labourers, or conveyor-belt workers infactories. I have done both these latter jobs and I know of what I speak!

The National Minimum Wage

The idea is that there should (normative!) be a minimum wage below which no oneshould have to work. At first sight it certainly seems to be a good social idea, but theeconomics are a bit more dubious.

The diagram is the standard one for price setting, such as we would find for tomatoes. Ifwe raise the wage above the equilibrium level, we will get excess supply of labour andsome unemployment.

0

Wages

Min wageW1

D lab

S lab

Qn QnS Quantity of labour

QnD

Min wage

• The market solution would be at wage level W1 & employment at Qn.

• With a minimum wage we contract up the demand curve for the demand for labour,and at the same time extend up the supply curve for the change in the quantity oflabour supplied. The result is:

a. Wages rise to the level of the minimum wage.b. Employment falls to QnD, reading off the demand curve for labour.

224

• Compared with the competitive equilibrium solution there are fewer in employment,but those who do get a job have a higher income. Which is the better situation is anethical/social question to which economics cannot provide an answer.

Caution - this is a micro diagram but dealing with total unemployment is a macro issue.Unemployment can be tackled more generally as we learned in Unit 3.

There is one time that a minimum wage works well - monopsony:

If a small town has a monopsony employer (the only large company in town) who isexploiting labour locally by paying a low wage, imposing a minimum wage can help.Perhaps surprisingly, it would mean that the employer would not only have to increasewages but also the monopsonist would choose to employ more people.

The monopsony diagram.

With a monopsony, when the firm hires an extra person it can turn the price up againstitself and if the supply curve is normal (as it almost certainly will be), this is going tohappen.

The argument is that if the employer pays the next person employed an extra £5 a weekin order to attract them, he or she has to pay all the existing workers an extra £5 too, orthere will be labour strife. So the marginal cost of one more worker is a lot more than £5!Thus the marginal cost of workers (MCn below) is above the supply curve. The firmselects the number of people to be hired on the basis of MCn but only has to pay on thebasis of Sn! The result is that a monopsonist pays a low wage and hires fewer workers.

Employment

Sn

WageMCn

DnW1

0 E1 E2

Wmin

225

Before the imposition of a minimum wage, the employer chooses to hire E1 (theintersection of MCn and Dn) and pay W1 (the amount needed to get E1 workers, readingoff the supply of labour curve, Sn).

The introduction of a national minimum wage, such as Wmin (which reads straight acrossto the demand curve Dn), will increase wages from W1 to Wmin and increaseemployment form E1 to E2.

Unemployment pay

Many economists believe that when the state gives unemployment pay (social benefitetc., as part of social services) this increases unemployment by allowing people not towork! It is probably true – it is reasonable to think that the normal supply curve wouldwork. Offering more and more money to the unemployed could be expected to attractmore people to give up.

For £2,000 a week I would love to stay home. However, at the relatively low sumsoffered in social benefit to the unemployed, it may only attract small extra numbers, so itis the size of the response at the going rate that matters rather than the principle.

The effect may not matter much, if relatively few are tempted into long termemployment. It would matter if a lot are so tempted! Political prejudice is rife on whatpeople believe here. Labour supporters tend to think either there is no effect or if there isone it is small; conservative supporters tend to think it exists and it is large.

There is one major gain for society when offering money to the unemployed. This isknown as “search time”. This argues that there is be a benefit for society if a person canstay out of work, with unemployment pay, for a few weeks until he or she finds the mostsuitable (higher productivity, best resource allocation) job. Without the money, theperson might be forced to accept the first job, or one of the first jobs, offered, howeverunsuitable. It is far better to wait for a few weeks in order to obtain a position that reallysuits the skills and ambitions of the person.

Many years ago I was personally unemployed for some weeks after I left the British army.The first and only job I was offered by the state unemployment office was sticking upmovie posters on billboards. The fact that I suffer from vertigo meant that this was atotally unsuitable job for me, but it was still offered! I turned it down and went back intoeducation instead.

The search time argument is a decent defence of unemployment pay – but again, we areunsure what numbers are involved.

226

5A-6: LABOUR PARTICIPATION, UNEMPLOYMENT AND AGEING

The labour participation rate

The Labour participation rate is the proportion of the population between 16 years of ageand the retirement age (currently 60 for women, 65 for men) who are in work or who areunemployed but wish to work and are actively seeking work. The figure has recentlyrisen to 75.5% of the UK population (2004) and the figure is expected to continue to riseover the next few years.

Those not in the group (i.e., are economically inactive) consist of:

• those not wanting a job;• students;• those looking after a relative or family at home;• the long-term sick; and• the retired.

When unemployment is high, the participation rate tends to fall, as people feeldiscouraged and stop looking for jobs because they are aware that there are few or nonelocally. Unemployment is currently low so the participation rate is high.

Unemployment: what it is and how it is measured

• This was covered in Unit 3-3.

The changing labour markets – some points you might find useful

• Advances in new technology are rapid, which means that new skills are constantlyneeded. The computing and information technology areas are particular examples.This is a supply side led change.

• There is changing demand for new products, for instance some people constantlydemand the latest mobile phones with special features. This is a demand side ledchange.

• The developed world generally has high labour costs when compared with developingcountries. Many manufactured goods can be made labour intensively or capitalintensively and are much cheaper from, say, China which is a low wage country.This means we tend to import more manufactured goods over time and so domestic

227

manufacturing industry declines steadily. This means that old skills are less neededand some are not needed at all.

• Geographical location of the old manufacturing industries. These are often in thenorth or the midlands which means a localized unemployment problem of people withthe “wrong” skills exists and persists.

• The weakening of trade unions since 1979 means that it is easier for workers to:o move from one job in a firm to a different type of job in the same firm;o move to new occupation, as many restrictive rules that prevented entry have

been relaxed.

• Entry into the European Union has meant easier worker movement and migrationwithin Western Europe. Labour markets are much more flexible now than in the1970s.

An ageing population

All developed countries are similar: they register a low and falling birth rate and a fallingdeath rate. Developing countries on the other hand often have a high birth rate andfalling death rate, so their populations increase rapidly.

There is a lot of evidence that over time, countries start by reducing the death rate, getricher with economic development, and the birth rate eventually falls. But before thathappens there is a population explosion. By now, the developed countries, like the UK,have come out the other end and so have slow growing populations. In some casespopulation is static or even falling, like in Italy. The Asian Development Bank forecaststhat even countries like China, Singapore and South Korea will have decliningpopulations by the middle of this century.

Population movement over time

Countries start with high birth rates and high death rates – which means populationincrease is slow. If you forget which one goes on top, think! We know that the birth ratemust be above the death rate or everyone would be dead before now!

Then the death rates start to fall, and fall sharply, as a result of better public healthfacilities, improved hygiene, more and better doctors, and advances in medicaltechnology. This is the period of population explosion. Many third world countries arein this period today.

After a lag, birth rates start to fall. As people become richer they seem to prefer smallerfamilies and in addition, contraception becomes more easily available as countriesdevelop and it becomes more widely adopted in the society. This situation is typical of a

228

developed country, with low death rates and low birth rates, and little if any populationincrease.

The low birth rate and slow growth of population ensures that we have both an ageingpopulation and a greying population in developed countries. This has severalconsequences:

• Changes in the demand pattern – society needs more wheelchairs, Zimmerframes, retirement/nursing homes and hip operations but fewer prams, babyclothes or primary schools.

• A slowing down in labour mobility – this tends to lessen, as old people are oftenless willing to move than youngsters.

• Changes in demands on government – in particular there is an increase in the needfor higher and higher expenditure on pensions and health care. This is a seriousproblem; the government needs to raise more money in total or else it mayeventually have to reduce the quality and quantity of pensions and health care.

• In 1950 a man retiring at age 67 (the average age at that time) would havereasonably expected to live for only eleven more years; in 2004 the average age ofretirement was 64 and the man can expect to live for a further twenty years,almost twice as long.

• Reducing the standard of pension provision and health care would carry with itthe danger of social and political backlash. For such reasons, the governments indeveloped countries, like the UK, are trying to make workers save more for their

Birth Rates &Death Rates

Death Rate PopulationExplosion (Death rate fall first; Birth rate falls later)

Time0

DR

BR

229

own pensions. An effort is being made to move society away from the approachof expecting cradle-to-grave social security to looking after one’s own old age.

• Change in the participation rate – we will see fewer workers available to take careof the steadily increasing number of dependents (the elderly) because of thepopulation pyramid and the genera ageing. This means there will be a smaller taxbase yet higher demands for tax revenue to meet the growing demands.

• Britain has a serious problem here but because of demographics and the higher pensions paid in most of the rest of Europe, we are better placed relative to the

other European countries in one respect – their pension burden demands will behigher than ours in the future.

A reminder: are you revising something and practicing drawing diagrams each day?If not, go on, have a go at it, starting now!

230

5A-7 AN INTRODUCTION TO THE DISTRIBUTION OF INCOME ANDWEALTH

[This was covered in Unit 2 as one reason why markets do not work perfectly and isrepeated here as a reminder].

Measuring the distribution of income

The Lorenz curve

We can show the degree of inequality in income distribution in a diagram. If 10 per centof families have 10 per cent of the income, and 20 per cent have 20 per cent, and so on,we have perfect equality.


100%

0 50%

50%


45 degrees


231


100%

0

50%Inequalitygap

25%

60%50%


45 degrees


The LorenzCurve

Here, we see that about 60% of the families have only 25% of the income.

The Gini Coefficient is a more accurate measure than the Lorenz curve - andfrankly it is much easier to compare numbers than pictures!

The Gini Coefficient measures the degree of inequality by using numbers – it iscalculated as:

Area between the diagonal line and the Lorenz curveTriangular area under diagonal line

i.e., this is the inequality gap as a proportion of the whole triangle. The bigger theinequality gap, the closer it gets to the whole; eventually it is the same as the whole and anumber divided by the same number always equals one. So the higher the Ginicoefficient, the less equal is the distribution of income.

Perfect equality = 0.0Perfect inequality = 1.0

The Lorenz curve shows the actual difference from the 45 degree line of perfect equality.We see an inequality gap!

232

Actual Gini Coefficient figures for three countries

1980 1994UK 0.327 0.345Spain 0.397 0.340France 0.417 0.290

Using these figures, rather than trying to compare by eye some three separate diagrams,we can now compare easily.

We can see that:

• In 1980, the income distribution in the UK is more equal than in Spain.• The UK’s income distribution got less equal (under the Thatcher government).• Spain’s income distribution got more equal over the period.• By 1994, Spain had a more equal income distribution than the UK.• And France, which in 1980 had less equality, is revealed to a more equal income

distribution in 1994 than either of the other two countries!

This is the sort of thing that the Gini coefficient is used for.

Latin America has the highest Gini coefficients of any of the continents in the world (thatis, it has the widest income disparities). That might be a useful statement you could maketo establish you really know about the issue.

The Gini Coefficient can easily be set in exams, either as an essay or as data response.

Going to University: the Secrets of Success: Kewei Press, Second Revised andExpanded Edition, August 2009, paperback, 204 pages, ISBN 978-0956182319can be obtained from Amazon and elsewhere, including UCAS itself. Price £9.95

“This book is very comprehensive. It covers pretty much everything a personnew to uni would want to know - from finances and transport, through to whatto expect in the way of lectures, seminars, tutorials, lab work and oralpresentations, as well as providing advice on how to write essays andprepare for exams....I found the stuff on developing team skills and processesvery useful. (The research components of my course have a lot of team-basedassessment.) It is well laid out and can be picked up and put down as needed.”Michael Bower, student, Amazon review

233

Copyright © Kevin Bucknall

Module 2881 Unit 6, The UK in the GlobalEconomy: “Globalisation and Protection”

6-1. AN INTRODUCTION TO GLOBALISATION AND PROTECTION

The gains from trade is the same concept as “why nations trade” and these gains liebehind the trend towards increasing globalisation.

• Comparative advantage. To simplify greatly, it means that a country does what itis best at! This is the main source of the gains from trade.

• A country will lack something that it cannot produce for itself, e.g., bananas inBritain. So a country trades to get what it lacks but wants. This is a minorreason.

• There is a gain in the variety of goods and services offered and wider consumerchoice if one can buy from abroad. The country pays for the imports by exportingwhat it produces.

Generally, international trade increases incomes, fosters economic growth, improves thestandard of living, and allocates resources better, both within a nation and globally.

The globalisation process

Globalisation comes about by a reduction in protection, especially by the developedcountries, and the general freeing up of markets. Globalisation involves countriesspecializing in what they are good at and exporting in exchange for goods or servicesthey are poorer at. It requires a reduction in protection in order to allow the increase intrade which is necessary. It also needs the freer movement of capital and the ability toinvest in another country. A company in country “A” can then either set up a factory orfirm in a different country, “B”, or else buy an existing one there. As an example, theBritish company Lever Brothers has operating companies and factories on everycontinent in the world, has a research laboratory in China (among other places), and is agenuine and long-established multinational company.

The motives for reducing protection are:

• To increase a country’s efficiency in production and hence improve the domesticstandard of living, resource allocation and growth.

234

• To reap the gains from trade (comparative advantage).

• To help the poor countries of the third world. This is not really an important motive! The goods that the third world wishes to sell are often kept out of

developed countries by high levels of protection in order to assist their ownproducers. Imports of agricultural produce in particular are often heavilyrestricted for the sake of a relatively small number of farmers.

• Pressure from multi-national corporations on the various governments to allowfreer movement of goods and capital (in order to increase their own profits).

International Exchange

This really means why countries trade! If Britain can run an insurance service morecheaply, say, than New Zealand, then it should do so, and sell it to the world (Lloyds ofLondon does this). In this example, we would buy back something, for instance muttonand lamb. It is not necessary or even desirable to try to balance exports and imports witha single country. We wish to balance multi-laterally, on a global basis.

The global trading pattern:

The developed world trades more with itself than with third world countries, which seemssurprising to some.

But this is reasonable really! Because:

• Income elasticities are high for services and fancy expensive manufacturedproducts, but low for raw materials (revise elasticities and what this means inUnit 1 if you are a bit hazy). The developed world has high incomes, so itimports such things as video cassette recorders and TV sets from Japan.However, few poor developing countries produce such items. Instead they tend toproduce raw materials and agricultural products, such as bananas, coconuts, sugar,sisal and hemp all of which have low income elasticities. Where poor countriesdo export hi-tech goods, like TV sets from China, these are inevitably made injoint-ventures, set up with foreign capital and know-how and owned in part byforeign developed countries anyway. Many Japanese products are now made inthird world countries like China, as Japan has exported much of its manufacturingcapacity, a process known there as “hollowing out” the economy.

• Comparative advantage and wider consumer choice mean that, if we take motorcars as an example, the Germans make Mercedes and BMW; the French makeCitroens and Peugeots; the Italians make Ferraris and Alfa Romeos …. and theyall sell motorcars to each other.

235

• The demand for primary produce (often produced in third world countries) growsonly slowly, so trade with third world countries does not expand rapidly. At thesame time, technological improvements in the rich world often reduce thequantity of raw material needed. As an example, Brazil produces much iron orebut less of this goes into a typical motor car built in the UK now than it did fiftyyears ago.

• An additional factor on the demand side is that most developed countries protecttheir domestic agriculture, which severely limits the amounts that poor countriescan sell to them (remember?)

• The long-term price of many primary products does not increase much, in part forthe three reasons above which limit the growth in demand. A further reason lieson the supply side: output of primary produce has increased over time. This ispartly through increases in yield but also because of the extra supply coming fromnewly developing third world countries as they increase their exports. Withreasonably rapid growth in supply and little growth in demand, the long termprice must fall. At best it will increase but slowly.

Trade Protection and Trade Liberalisation

Trade protection means reducing or preventing imports from foreign countries by meansof measures like tariffs, quotas and non-tariff barrier (ntb’s).

• An import tariff is a tax, e.g., 20 per cent (being set as a percentage it is referredto as an ad valorem levy) or £30 (as a set absolute amount it is called a specificlevy) which is placed on each item imported.

• A quota is a fixed quantity, such as 20 tons; only that amount in total can beimported.

• Ntb’s, as they are usually called, are often rather subtle and clever ways ofreducing imports by the tricky use of laws or regulations. As an example, healthregulations may be used to reduce or prevent wheat imports; or peculiar safetyregulations, such as the minimum distance between brake pedal and clutch pedalin a motor vehicle, may be invented and used to prevent the import of certainvehicles.

Note that in order to reduce protection we:

• Reduce or eliminate tariffs (so importers pay less or nothing).• But increase quotas (so a larger physical amount may be imported).

236

Reasons for protection

• The infant industry argument. This justifies the protection of a new industryduring its early years, in order to allow it to establish and grow behind tariff wallsand quota barriers. Once it is mature, then the protection can be withdrawn. Thisis a respectable argument – but a common problem is that the infants rarely admitto being grown up and protection may continue indefinitely! Eventually, the lackof competition becomes a disadvantage rather than a help and the industry usuallycontinues to be permanently inefficient by international standards.

• Protection in order to level the playing field by keeping out cheap imports. Thisis a poor argument usually

o it goes against the principle of comparative advantage;o it reduces a nation’s flexibility in resource allocation (it freezes industries

as they are);o it lowers the standard of living (people cannot buy from the cheapest

source so must pay more for the good which leaves less money to spendon other things);

o it slows economic growth (if an industry becomes inefficient, it will hardlygrow fast); and

o it may also reduce exports (if the industry is poor, it is unlikely to be ableto sell to others).

• The danger of war. The case goes that we should protect our agriculture or basicindustries in case we are ever cut off by war. There is something in it as apolitical slogan but it is not a very respectable economic argument – few wars inthe future will involve long years of submarine blockades of the UK! The natureof war has changed with the huge technical advances in the military area sinceWorld War Two.

• In order to help some special group, e.g., farmers. The sugar beet industry in theEuropean Union is heavily protected which keeps out much cane sugar from poorcountries and means that as consumers we all pay more for our sugar than weneed.

The movement to reduce protection since late 1970s – why did this occur?

• At that time many developed economies were not in the best of shapes becausevarious long-standing government and other restrictions had led to resourcemisallocation, a lack of motivation, and slow economic growth, which held downthe lower standard of living. There were heavy restrictions in the labour markets,the capital markets and sometimes the goods markets. The growth ofbureaucracy, the emergence of the “nanny state” to look after individualscarefully, and many years of left-wing governments had led to this. The motives

237

of the latter had been good, but there were several alleged and clearly undesirableside-effects e.g., lack of competition, lack of personal incentives and someerosion of the desire to succeed.

• There was a rise in economic theories promoting competition and free markets(“the Chicago School” and Milton Friedman) and these eventually became widelyaccepted. The data since suggest that they were right: lower tariffs do increaseper capita income as well as trade.

• Political – Prime Minister Margaret Thatcher and President Ronald Reagan cameto power and liked the idea of competition and freer markets. They felt that theireconomies were stifled by over-restrictions and hence uncompetitive. They, or atleast their advisors, saw that this encouraged slow growth, resource misallocationand lower standards of living. This was a “timing” factor perhaps and it justmight have happened anyway a little later?

• The collapse of the communist Soviet Union and Eastern Europe in and after1989. This happened following many decades of central planning of the domesticeconomy. Such countries cut themselves off from the international community(known as autarky) which reduced competition and they had fallen well behindinternational standards in many areas. After the collapse of the Berlin Wall in1989 and the events that followed, most of these countries moved out into theglobal area and adopted market mechanisms to try to restore and rejuvenate theireconomies.

• China moved into the global arena after 1978 and slowly but steadily began toadopt many market policies, although without ending communism or totallydismantling central planning. As a result, China is now a weighty player in globalmarkets and its cheap exports keep the level of international inflation lower.

• The other “tiger economies” (Hong Kong, South Korea, Taiwan and Thailandespecially) grew rapidly on a policy of free trade and the use of marketmechanisms and people around the world noticed this – and began to copy thepolicies.

• Technology changed. The rapid rise and spread of computers mean that globalmarkets, especially in finance, are feasible - and inevitable?

• Multi-national corporations rose, and they tend to think globally rather than on anational basis.

238

Why protection hurts the people in the world

Less competition means a tendency for people, companies, and industries to rest ontheir laurels and take it easy. This encourages a nation not to reduce or eliminateslow-growth industries whose products are less in demand or are not competitive withother nations.

As a result we may find:

• Resources become increasingly misallocated for what people wish to buy.

• A lower standard of living because consumers cannot buy products at the lowestprice.

• Growth becomes slower because companies do not strive hard to improve theirproducts, production methods, or technologies.

• Exports are lower than they might be, as the nation is not as good as some othercountries with which we cannot compete. This limit on exports hits third worldcountries in particular. Much of the tariff reduction and quote increase that hasoccurred so far has been primarily to assist the rich developed nations. Relativelylittle has been done in areas that would help the poorer countries.

• There is less foreign trade in the world as a whole – so we have less comparativeadvantage being followed. This means slower world growth, and a lower globalstandard of living.

• The foreign exchange rate may be poorer, as the country is not exporting as wellas it might.

239

6-2. TRADING BLOCS AND THE WORLD TRADE ORGANISATION (WTO)

Trade blocs are of three kinds – these are listed in order, weakest to strongest:

1. Free trade areas: these have no internal tariffs or quotas on trade between themembers, but each country can set its own level of tariffs against the rest ofworld. Recent examples are the North American Free Trade Association(NAFTA) which joined together the USA, Canada and Mexico in 1994.

2. Customs unions: these also eliminate tariffs between members but in additionthey set a common external tariff against rest of world that each member countrymust observe.

3. Common Markets: these cover much more than customs unions or tariffs andquotas. They can, and usually do:

a. Include laws that free up labour and capital movement between themembers.

b. Harmonise taxes which means that one country cannot be too far out ofline with the others.

c. Adopt some common monetary measures, such as all using the samecurrency. The Euro began in 2002 for most of the EU members but theUK has so far chosen not adopt it.

d. Set up a fixed exchange-rate between the members.

Really the members of a common market are moving in the direction of being onebig economy, while retaining their own nationality.

Why set them up?

• To gain economies of scale.

• To compete with bigger nations, e.g., the EU against the USA.

• Political motivation (not our concern in this course).

240

There are two sorts of gains - static gain and dynamic gain

The static gain is the one-off benefit which a country usually obtains at the moment thatit joins.

• Trade creation versus trade diversion

Whenever any trading bloc is set up, or any country joins an existing bloc, there isa trade creation effect. This allows the most efficient producer to expand and sellits produce to the others, so all benefit to some degree. The producer gains alarger market and can reap economies of scale. The consumers gain because theprice will be lower and the quality probably higher than they previously enjoyed.This trade creation feature is always beneficial, and is often referred to as being apositive effect.

There is also a trade diversion effect. This is what occurs when the countryjoining ceases to buy from and sell to its traditional partners and starts to buy andsell within the group. Unlike trade creation, trade diversion can be either positiveor negative. If a country previously imported from the best and cheapest producerin the world, but after joining the organisation is now only allowed to buy withinthe bloc, it has a harmful or negative effect.

So if a country joins a trading organisation it has to hope that both diversion andcreation are positive, or else that the gains on trade creation are bigger than anylosses on trade diversion! (Remember that these are all static gains).

The dynamic gain is the continuing benefit over time of more dynamism as a result of:

• the increased competition;

• the larger market allowing the economies of scale to run for ever;

• a more mobile and probably better motivated labour force;

• and increased capital flexibility.

• All of these lead to greater efficiency in production.

These dynamic gains are always positive, that is to say, continuing benefits will steadilybe achieved.

241

The World Trade Organisation (WTO)

The WTO replaced the General Agreement on Tariffs and Trade (GATT) as a result ofthe Uruguay Round of negotiations (1986-94). You can see that it took eight years togain international agreement!

The aim of the WTO is to increase the amount of world trade by means such aspromoting tariff cuts, increasing and perhaps eliminating quotas, and minimizing, orbetter yet solving, disputes between members. The WTO holds occasional meetings tonegotiate further reforms.

The WTO will not allow a nation in a recession to increase its tariffs or reduce the size ofthe quotas it sets. In other words, it is not allowed to increase the level of its protection.This rule is believed to have helped avoid the sort of harsh global economic slump thatwe saw in the 1930s.

Present contentious and unresolved issues are:

• Agricultural trade is still restricted by the developed world (which hurts many poordeveloping countries).

• Developing countries feel left out of the WTO progress and many believe that theyare discriminated against by the rich developed countries. It is often seen in the thirdworld as a sort of rich man’s club that has accepted poorer members but ratherignores them.

• The concern in the West about working conditions and human rights in some poordeveloping countries is a touchy issue. Poor countries usually want to get richer first,then worry about things like working conditions later. They often resent beinglectured to by the rich club members and told that they should not do the things thatearlier made the rich rich!

The WTO is attacked by radicals – often physically - at international gatherings,such as the one in Seattle in 1999.

The stated grounds for attack are that the WTO promotes globalisation and globalcapitalism. The extreme radicals dislike these for both political and socio-economicreasons:

242

The political views of the radicals (not economics but related to it)

• The radicals are strongly antagonistic towards capitalism as the preferred economic-political system.

• The radicals are usually anti the USA, which is seen as the leader of the system.

• Some radicals are against the banks generally and international banking in particular.

• And some radicals seem to be pro communism; or pro anarchy; or pro nature andgoing back to living in more primitive ways that are seen as natural rather thanartificial.

The socio-economic views of the radicals,

Many believe that the process of globalisation has led to the world’s poor people andpoor countries becoming even poorer, and therefore it is bad and must be resisted. Theyoften argue that the world’s income distribution has altered in favour of the rich.

Actually, in many cases people in the poorer countries are wealthier absolutely, but theyare poorer relatively to the rich. What often happens is that nearly everybody has gotricher but the rich have got richer faster and so the gap is widening. Those at the bottomimprove a bit but those at the top improve a lot more. It must be admitted that noteverybody gains: a tiny minority who happen to be unlucky, situated in the wrong placein the country, or who are physically or mentally challenged always seem to lose. Theonly way they can improve their lot is for their government to step in and help them.Few governments in poor countries feel that they can afford to do this yet and it mustwait until the country is more developed.

Where the people are absolutely poorer – and this does happen - it is almost alwaysthe result of one or two things (and sometimes both):

• Bad governments that have adopted poor economic policies (Zimbabwe, theSudan, Nigeria).

• Wars, rebellions, or coups (sadly common in much of Africa).

So it is often politics and people that cause it rather than capitalism or the rich nations.

243

The case that the weather causes the problems

Now and then the poverty and problems are the result of bad or changing weatherconditions, which lead to drought or floods that in turn cause famine and death. But suchsevere results mostly occur in an area that is undergoing war, rebellion, or revolt.

More stable countries suffer from weather problems too but they can usually cope withthem without major and long running disaster. It rather looks as if the military orpolitical turmoil is the main factor involved where suffering is both intense andprolonged.

It is common and understandable for bad governments to blame freak weather, or globalwarming, or international capitalism, or indeed any thing they can think of to explainaway their own mistakes.

Be warned that the cause of such problems is a contentious issue which is much debated.These views are mine, based on many years of living in third world countries, anddecades of studying the problems. But I might be wrong! You should consider theevidence, think about it, and then make up your own mind.

Since I wrote the above paragraphs, the evidence of global warming has becomestronger and clearer. There is still dispute, but the majority of scientists working inthat area now appear to accept that global warming is a reality. Some dire warningshave appeared. Currently, the worst worst situations still occur where war, civil waror insurrection, or gross economic mismanagement raise their truly ugly heads.

244

6-3. THE BALANCE OF PAYMENTS

This was introduced in Unit 3but I repeat a bit here, then expand it to consider how wecan deal with problems in it.

• What is the balance of payments?

The balance of payments is a record of a country’s economic transactions with other(foreign) countries. It includes the trade in goods and services, reveals how we pay forthis, or if did not pay it tells us what we still owe. It also includes other financial flows,like foreign investment and company dividend payments.

1. The current account.

2. The capital account.

3. The financial account.

4. The international investment position.

THE CURRENT ACCOUNT

This course focuses heavily on the current account, which includes:

• Trade in goods.• Trade in services.• Income from working abroad, and from investments abroad.• Current transfers: central government and private.

We used to consider the balance of payments was divided into two: thecurrent account and the capital account. In 1998 a new method of presentingour international situation was introduced which contains four categorieswithin the balance of payments.

245

The UK Balance of Payments, 2003 in £ millions – The Current Account(Simplified)

CREDITS DEBITS BALANCEGOODS

Food, beverages & tobacco 10,827 21,099 - 10,272Basic materials 3,325 6,125 -2,800Oil and other fuels 16,478 11,128 5,350Semi-manufactures 54,244 55,751 -1,507Finished manufactures 101,961 138,255 -36,294Other goods 868 1,594 -726

Total Goods 187,703 233,952 -46,249

SERVICESTransportation 11,424 16,679 -5,255Travel 13,673 29,443 -15,770Financial services 13,244 3,277 9,967Other services 49,965 25,060 24,905

Total services 88,306 74,459 13,847

INCOMEEmployment from abroad 1,116 1,059 57Income from investments 125,250 101,922 23,328

Total income 126,366 102,981 23,385

CURRENT TRANSFERSCentral government transfers 4,173 10,942 -6,769Other sectors 8,886 11,860 -2,974

Total current transfers 13,059 22,802 -9,743

CURRENT ACCOUNT TOTAL 415,434 434,194 -18,760

246

The Ten Economic Goals and the Effects on the Balance of Payments

WHAT MIGHT OCCUR THE EFFECTS WE MAY EXPECT TO SEEIf we grow faster. The B of P worsens, as growth sucks in imports to

sustain production + higher incomes mean consumersbuy more foreign goods and services (these are generallyincome elastic).

If the standard of livingrises.

The B of P worsens as consumers buy more foreigngoods/services.

If resource allocationimproves.

The B of P probably improves, as the country is doingwhat it is best at.

If income distributionbecomes more equal.

The B of P probably improves, as the rich reduce theirpurchases of foreign goods/services but other incomeswill not rise enough to suck in many more imports.

If inflation increases. The B of P worsens as our exports fall and imports rise.If unemploymentincreases.

The B of P is probably a bit better as incomes are lower,which means consumers demand fewer imports.

Value of currencychanges.

If the pound gets weaker it encourages our exports anddiscourages imports, so the B of P probably improves.Note that the currency may be weak because the B of Pis already poor!

What can we do if the balance of payments gets into a “fundamentaldisequilibrium” state?

A fundamental disequilibrium state means that:

• imports are considerably more than exports; and• there is a persistent balance of payments deficit; and• there is no likelihood that this situation will change.

The IMF will only allow major changes in exchange rates or special action to help thebalance of payments if the country can persuade the IMF officials that there actually is afundamental disequilibrium.

There are three possible ways of tackling this:

1. Via the exchange rate system – if the exchange rate is fixed (like China whichcurrently fixes the yuan against the US dollar) we might alter our exchange rate

247

(although countries are bound by the IMF agreement as long as they are members.This solution is not applicable to the UK as our exchange rate floats (see below).

2. Via demand side management of the domestic economy. Lowering the level ofaggregate demand would provide short term help by reducing imports andpossibly freeing up some goods and services for exports.

3. Via supply side management of the domestic economy. Pushing out the long runsupply curve would provide permanent help.

The first way of tackling a balance of payment problem: changing the foreignexchange rate

The exchange rate methods that a country might have adopted

1. Floating.2. Fixed.3. Managed.

1. Floating rates:

These are normal for most countries these days; floating rates are currently in force forthe UK.

The supply of and demand for the pound determines its value.

1. The demand for pounds comes from foreigners who wish to buy British goods orinvest in Britain.

2. The supply of pounds comes from the British, as we buy goods or services fromabroad or we send money abroad to invest there.

This is the normal supply and demand curve situation: if we increase our imports, thesupply of pounds increases, so the value of the pound starts to fall.

248

0 Quantity of pounds

Price of poundin dollars

S1S2

P1P2

Q2Q1

D

When this happens, a second element might swing into action. Speculators might jumpin and sell pounds, hoping the fall will continue so that they will be able to buy themback later at a lower rate. Should speculators sell in this way, it will drive the pound evenlower.

2. Fixed rates (the regime a country might have adopted):

The government sets the value of the currency in the foreign exchange market. It isusually set well out of line with the foreign exchange rate that the market woulddetermine – there is no point otherwise because it can simply be left to the market Thismethod is not used much, except by a few communist countries.

Linking the rate to another country fixes it in a kind of way, but as the value of the othercountry’s currency alters, so does yours! Malaysia currently links to the US$ whichhelps it to stabilise its export and import prices for the USA and set them for othercountries in international contracts.

With our floating rate: if the balance of payments deteriorates, the foreign exchange rateworsens automatically – thus making our exports cheaper and imports dearer, so it shouldautomatically correct the imbalance in time.

With a fixed FX rate: with “a fundamental disequilibrium” the country could devalue – ifthe IMF will let it! Secret meetings would normally be held and the government wouldtry to persuade the IMF officials that there really is a “fundamental disequilibrium”.

249

A small digression: what can affect the balance of payments (and hence the value ofthe currency)? (Note: you may need this for the exam).

1. Our demand for imports.2. The demand of others for our exports.3. Our inflation rate compared with that of others.4. Our rate of interest compared with that of others.5. Speculative capital flows.

Our demand for imports: if we import more, the balance of payments on current accountweakens and pounds flow abroad. This increase in the supply of the pound reduces itsvalue. The normal supply and demand curve analysis applies, as in the diagram above.

The demand of others for our exports: if foreign countries increase their demand for ourexports, our balance of payments improves and the value of the pound rises. The othercountries demand pounds in exchange for their currency, as they have to pay us in poundsin the end.

Our inflation rate compared with that of others: if other countries inflate more slowlythan we do, our exports become relatively dear (so we can sell less), and our importsbecome relatively cheap (so we import more), with the result that the balance ofpayments deteriorates. This causes the pound to fall in value. You can see that when wepay for the extra imports it puts more pounds on the market, while selling fewer exportsmeans we earn less foreign exchange.

Our rate of interest compared with that of others: if our interest rates rise (and no othercountries match it) then foreigners send more money to us to earn a higher rate of interestand hence a bigger income. The influx of foreign capital then increases the value of thepound and strengthens the balance of payments.

Speculative capital flows: “hot money” can race around the world seeking the highestrate of interest commensurate with safety and risk. As the world gets wealthier andmultinational corporations increase, the size of the flow gets larger. If hot money racesinto a country, it strengthens the balance of payments and increases the value of thatcountry’s currency. The real danger will come later when it races out again! The valueof the currency could then fall sharply and the balance of payments could weakenrapidly. The total effect can be very destabilizing. The IMF will usually lend money tohelp a country offset the sudden flood out.

3. Managed rates of exchange (the regime a country might have adopted):

This system is much like the floating one. The difference is that the value is notcompletely free to move for ever. The government may step in (should it feel like it) toshore up the foreign exchange rate if it starts to fall. It does this by buying pounds, using

250

the foreign exchange and gold reserves to do so. If the value of the pound begins toincrease, the government may judge it right to step and moderate the increase by sellingpounds on the international market. This would then increase the foreign exchangereserves.

Although Britain has a floating exchange rate system, in the past the government hasbeen known to intervene to protect the value of the pound by buying and selling foreignexchange. The rate of interest set by the Bank of England also affects the value of thecurrency, as you will recall, because relatively high rates of interest attract foreign moneyto be placed on deposit here. The government is influential in deciding on what rate willbe set. We know how the voting on the Committee went but the internal arguments arenormally secret.

The second way of tackling a balance of payments deterioration: demand sidemanagement

Reducing the level of aggregate demand can have a short term effect and help the balanceof payments.

If we see the balance of payments weakening, perhaps because of high levels of domesticconsumption and imported consumer goods, the government can reduce the level ofaggregate demand, take the heat out of the economy, slow growth or even reverse it,increase unemployment, and reduce inflation. This will help the balance of payments byreducing imports and also by releasing goods for export that are no longer consumedhere.

Price IndexSAS1

90.0AD2

AD1

GDP1GDP20

100.0

Real GDP

110.0

251

Generally, this would be a short term response to a sudden crisis – the governmentchooses to squeeze the economy because too much is going wrong within the ten goals.

The third way of tackling balance of payment problems: supply side management

Changes on the supply side tend to be a long term thing and it is not a tool that cansuddenly be wielded in a crisis to give quick results. It is a theoretical possibility but anation is usually well advised to keep trying to push out the supply curve anyway as partof an ongoing process.

If we can increase the long run aggregate supply curve (the vertical part of the SAScurve) it pushes down prices as well as increases output. This means our exports getabsolutely cheaper, so we are able to sell more, and hence the balance of payments willimprove. We also import less because our imports are relatively dearer now whencompared with home produce.

SAS1

AD1

P1P2

GDP1 Real GDP

0

SAS2Price Index

GDP2

Here we see the SAS curve moving to the right (an increase in the underlaying rate ofeconomic growth) and gross domestic product increasing.

Other than the initial increase in growth and the improvement in the balance of payments,we would see benefits for some other goals too: there would be an increase in thestandard of living (as prices fall and as incomes rise); and we can also expect an increasein the number of people employed.

252

6-4. THE EUROPEAN MONETARY UNION (EMU).

When a member of the European Union (EU) joins the EMU its central bank loses somepower.

It gives up:

• The ability to determine monetary policy and fix interest rates; it accepts the oneset for all the members of EMU.

• The management of the exchange rate of its own currency. The countryhenceforth uses Euros which are set to the national currency at a fixed rate.

The UK is not currently a member of EMU but it is a member of the EU.

The costs of joining EMU

• The UK would lose some sovereignty and power – we would be in the hands ofthe decision makers for the EMU countries.

• If what is decided about the interest rate is good for most of the EU, but happensto bad for us, we would lose. It might mean that if we were in a recession but theother members were booming, interest rates might be set to curb the boom. Thiswould be inappropriate for our situation and it might force us to stay in recessionor even worsen it. Germany was like this in 2003 and still is. It is unlikely thatthe average rate of interest set for all will be perfect for everyone: it will almostcertainly be set too high for some, and too low for others.

The benefits of joining

• We would have a fixed price of our exports to and imports from Europe. Wewould not have to undertake currency exchange each time we import and exportinvolving other members. We would also not have to worry about the possibilityof future currency movements, as there would not be any.

• This means that there would be fewer shocks and fewer risks, as business peoplewould know what price they would get when they sell.

• This should lead to an increase in trade, lead to a reallocation of resources alongcomparative advantage lines, help to increase the standard of living, speed upeconomic growth, encourage more employment and help the balance of payments.

253

• We would still be able to use fiscal policies to counteract undesirable changes inour economy.

Fiscal policy for those in the EMU

Fiscal policy can be set independently by the members – but some suggest that in thelong term, tax rates will have to be roughly similar, if not identical (tax harmonization).

What would happen if a country’s tax rates were well out of line with the others?

• Labour or capital might flow from the high tax regime country to one wheretaxation is lower.

• People might appeal to the EU or courts to obtain equal treatment under an EU-wide piece of legislation and if successful could get a different tax rate applied.

It seems probable, however, that different countries would be able to retain their own taxrates safely as long as they were not seriously out of line.

Opposition to joining the EMU

Many people are against joining the EMU, just as many are for it. The economic casewas presented above. Currently, the political opposition to joining is a worry to thegovernment, which has been going slow on the issue for some years.

Remember! This is an economicscourse and exam, not a political one. This means thatyou can mention that there is both political support and opposition but you should not gointo much detail. For you own information here are a few points.

• Many people who have the vote fear that we would lose autonomy, which is true(see above).

• The Conservative press is largely against joining.

• Prime Minister Tony Blair seems to be nervous about public reaction; the currentChancellor of the Exchequer, Gordon Brown, might be in favour of joining, buthe has seems to have concerns that it would limit his power over the economy. Inaddition, some allege there is a long-standing rivalry between these twopoliticians for power and influence and internal Labor Party factionalismcomplicates the issue.

254

• Some people suffer from xenophobia and feel that we cannot trust foreigners ingeneral.

• Some believe that we cannot trust the bureaucrats in Brussels to do the right thing.

• Some believe we should only join when the conditions are right; this can bemeeting the Five Tests of Gordon Brown, or merely a way of ensuring that wenever join, by permanently claiming that conditions are still not right.

The five tests are concerned with:

• Convergence: is our economic cycle, as well as our rates of interest, in line with the othercountries in Europe?

• Trade and investment: would our firms get better access to capital and export markets inEurope and would European and other investment increase in Britain?

• Flexibility: has the EU sufficient flexibility to cope with problems like inflation?

• Finance and the City of London: will the financial sector do well in the EU, especiallywith the single currency?

• Economic growth and employment: will we do better if we join?

255

6-5. PUBLIC EXPENDITURE IN THE UK

What determines the size of public expenditure?

• Where the country is in the economic cycle – if we are in recession (around thefloor or trough in the diagram below) the government may choose to spend moreand increase the “G” component of aggregate demand (consumption + investment+ government) thus pushing out the aggregate demand curve.

GrossDomesticProduct

0 Time in years

Peak, orCeiling

Floor, ortrough

Downswing BoomGDP

Upswing Slump

This is shown in the diagram below.

Price Index

Real GDP

SAS1

AD2

AD1

0 GDP1 GDP2

100.0

Conversely if we are in a boom, the government may choose to spend less, reduce the“G” component of aggregate demand and pull back the aggregate demand curve, thusreducing public expenditure. You can see the results in the diagram below. The levelof gross domestic product falls from GDP1 to GDP2 and the rate of inflation fallsfrom P1 to P2.

256

Real GDPGDP1

SAS1

AD2

AD1

GDP20

Price Index

P1

P2100.0

• If the government fears there is about to be an international recession or believesthere could be events that could lead to a downturn or downswing, they mightincrease spending to offset it. There might, say, be a fear that investment orconsumption is about to fall.

• The government gets elected on its policies. If their manifesto stated they wouldincrease expenditure and solve certain problems, perhaps for instance to fix thetransport system, then they really should be spending if democracy is to meananything.

• The government’s general attitude, e.g., Old Labour taxes and spends more thanNew Labour or than the Conservative Party.

The budget deficit or surplus

If the budget is in deficit, it means that public expenditure exceeds government revenuewhich comes largely from taxation. The government may have to borrow to cover thedifference.

It is acceptable to run a budget deficit, if for instance, the government is deliberatelytrying to increase the level of aggregate demand, expand the economy, and lead us intoan upswing. The policy of the current Chancellor of the Exchequer, Gordon Brown, is tobalance the deficits and surpluses over the whole economic cycle but he does not aim todo so in any one year.

257

Public borrowing

The “public sector net cash requirement” (PSNCR) is what the government must borrowin order to fill the deficit gap. The gap, if any, includes the total accounts of the centralgovernment, local governments and the public corporations.

How is the PSNCR measured?

• The nominal PSNCR is the simple addition of the financial accounts of the abovethree sectors.

• The seasonally adjusted PSNCR takes account of our place in the economic cycle– the deficit and PSNCR increases naturally in a recession because thegovernment is paying out more to the unemployed and at the same time, taxrevenue is lower owing to the lessened economic activity.

• The PSNCR as a percentage of GDP is a useful measure;

o it helps us to judge how “large” it is in context;o and also to compare our situation with that in other countries. We keep

our eye on the other EU countries in particular.

Does government borrowing matter?

There are both advantages and disadvantages in the government borrowing money. Allgovernments do it!

The advantages

• By borrowing and building things like roads, bridges, and docks (known as socialoverhead capital) and providing better education or health for the people it canspeed up future economic growth. This will make it easier to pay back what isbeing borrowed now, as well as what was borrowed in the past, because societywill be richer.

• The extra expenditure (“G”) might prevent a fall in national income and so thegovernment will not forgo the tax revenue it would otherwise have lost, or have tospend more on the unemployed.

• Borrowing prevents the government from having to raise taxes now.Governments that increase the rate of tax tend not to be popular and thegovernment wishes to be re-elected!

258

The disadvantages

• When the government borrows it tends to increase the rate of interest rate offeredand this might crowd-out private investment. Those who save might divert theirsavings towards the government and away from industry or the banks (who lend itto industry). A reduction in investment can harm future growth prospects.

• The sum borrowed has to be repaid (or else the level of national debt increases,which is in itself not particularly bad). If the government raises taxes to do this,not only will it be unpopular, it would reduce consumption and the standard ofliving, and might reduce investment which could be detrimental to long termgrowth.

• When the government repays its earlier borrowings, whatever sum it repayscannot then be spent on what is deemed important at that time.

• To some extent, the disadvantages and advantages depend on what thegovernment decides to spend the borrowed money on and how effectively itspends it.

Gordon Brown’s “Golden Rule”.

The Chancellor Gordon Brown decided that it is safe and desirable for the government toborrow in order to spend on investment for the future, but not to borrow to cover currentconsumption. He believes that the consumption component of government expendituremust be financed by taxation.

He also tries to balance out borrowing and spending over the economic cycle, so thegovernment can borrow for a few years of recession but should then pay it back in timesof boom.

Public expenditure and income distribution

Generally, when a government wishes to redistribute income it prefers this to be towardsthe poor rather than the rich, and it often does this via the social security system.

The problems with trying to redistribute income include:

• The really poor, sleeping in doorways etc, may not know about the benefits thatare available or even qualify for them (a fixed address may be required forinstance) so they do not benefit from the intended redistribution. The neediestpeople can miss out.

259

• The sheer complexity of the rules mean that many who qualify do not apply forstate benefits – so the poor and aged do not get all they should. This is a widelyrecognised problem that still awaits solution. Some other people, often the elderlywho were brought up to fear “accepting charity”, may refuse on principle to take ahandout from the state, even when desperately poor. The means test in order todetermine exactly how poor they are also deters some, perhaps many.

• The middle class tends to be good at getting its share because is educated andvocal, when compared with those at the bottom end of society.

• The rich tend to be able to avoid a lot of income tax, and other taxes, in a varietyof ways. They are able to buy the advice of experts, set up trusts, live abroad forpart of the year and avoid tax, or simply conceal the income they obtain. The trueburden of taxation often seems to fall on the group in the middle rather than thericher top end of society.

• A special problem is that governments have a tendency to subsidise groups whichare seen for some reason as desirable, whether the members are rich or poor.Farmers are a particular example of this, where extremely poor hill farmers inWales receive a subsidy and so do the large, rich farms owned by millionairefamilies who use managers rather than sweat themselves.

• Government may also change the tax system to favour a particular group e.g., toincrease or reduce the help for those paying mortgages. Such action alters incomedistribution.

• Logic suggests that we should not subsidise groups at all, but should simplyidentify the poor and those who need help - and then help them. Subsidising therich seems bizarre and wrong. Subsidising things rather than people seemspeculiar, e.g. council houses, but this is done and rarely questioned. The result isan anomalous situation where many really poor are excluded from the benefits ofcheap public housing, and some recipients of it are now moderately wealthy butare still subsidised.

• In the United States under President Bush, many rich people have received substantial windfall income increases owing to changes in the tax system

apparently designed to benefit the wealthy. It is uncommon in Britain forgovernments to alter the rules to favour the rich rather than the poor, althoughPrime Minister Thatcher did this.

• It is perhaps more common for lethargy or inaction to allow the rich to be favoured. As an example, the current Labour government has refused to increase

the rates of income tax on the rich. Further inaction has maintained the cut-offpoints in the tax system, so that many quite ordinary people who might bedescribed as “comfortable” rather than rich have now moved up into the top ratetax bracket.

260

• As a further example in the UK, governments for a long time have refused toclose certain legal loopholes that favour the rich, such as the current rules thatallow low rates of income tax for those living in the Channel Islands. Naturally,the millionaire population of these islands is well above average, as large numbersof rich people have moved to live there in order to preserver their wealth andavoid paying taxes to help run the country.

261

6-6. INWARD FOREIGN INVESTMENT BY MULTINATIONALCORPORATIONS

These were introduced in Unit 2 – go back and revise if you have forgotten. It is nowtime to increase our knowledge of how they operate.

The case for MNC’s investing in the UK and the rest of Europe

The EU likes MNC’s and the investment that they bring in:

• They bring in skills.• They create jobs (this is usually well-publicised when a new factory is opened.)

• They add competition to a smaller economy.• They help to increase output.

• This pushes out the long run aggregate supply curve and is a good source ofeconomic growth.

• They add to the capital available and the technology they bring is probablymodern and very advanced. (Recall that increased capital plus technicaladvances are the main source of growth in most developed countries.)

• They generally add dynamism to the economy.

The case against MNC’s

There is a lot of myth and story-telling and the case against sometimes looks a bitspeculative rather than hard-fact based but here goes.

• They take their profits in the lowest tax regime country in which they operate. Itis easy to do, as they simply sell from one branch in high-tax country “A” at a lowprice (so making little or no profit there) to a branch in a low-tax country “B”which then makes high profits as a result – and of course pays little tax. Thisprocess is called “transfer pricing”.

• They have often proved to be either corrupt or behaving in ways that border uponcorruption, in order to help themselves and improve their position and profits.

262

• They may favour their head-office home base country over the interests of thelocal nations in which they operate.

• They will prevent cheap versions of their patented goods being made in poor thirdworld countries, even if the people are dying of aid. (This is not an economicargument.)

• They successfully pressure national governments to water down environmentaland tax laws so as to favour their own profits.

263

6-7. EXTERNAL SHOCKS AND THE GLOBAL ECONOMY

All large shocks have an impact on the world level of economic activity, e.g., higher oilprices; the war in Iraq in March 2003; or the Asian financial crisis of 1997.

All questions about external shocks can be tackled in the same general way:

1. The impact of the event on the ten major economic goals. (You will need tothink about them and apply them to your particular case. If you jot all tendown, say in the margin of your exam question paper, you can ensure that youdo not miss any out).

2. The transmission of the event and its consequences around the world, which isgreater and faster than it used to be as a result of globalisation. Remember thatthe exports of one country are the imports of another. The flows of liquidcapital might also be affected. Naturally, some countries will be affected morethan others.

3. You can almost always use the diagram of the determination of nationalincome by means of aggregate demand and supply to show the domestic effectsof any major external shock.

But clearly there will be differences in what will happen and not all events have exactlythe same results.

You might be asked about the effects on the UK specifically, or the question could bemore general and concerned with the effect on a wider area; always tailor your answerto the question asked.

As an example, let us examine the effects of the current war in Iraq following theinvasion by British and American troops on our national economy.

• All wars increase the level of aggregate demand and tend to have an inflationaryeffect.

War means increased demand for many things, e.g., steel, armaments, the defenceindustry generally, and hospital and medical equipment. This means an instantincrease in the level of aggregate demand.

264

The effect of war on the macro economy: an increase in aggregate demand and inflation.

Price Index SAS1

AD10 Real GDP

AD2

GDP1 GDP2

103.0

110.0

100.0

The invasion and occupation mean an increase in aggregate demand in the UK, a boost inoutput, with an associated increase in the level of employment, and extra inflationarypressures, as in the diagram above. (The figures are assumed and the movementexaggerated, in order to show the effects). The level of gross domestic product increasesfrom GDP1 to GDP2, and inflation rises from 3.0 percent to 10.0 per cent.

• It also pushes up the price of oil because of the extra demand for oil to use in the war.In the case of the Iraq war, there is the additional fear that the war may drift on for along time and later could involve invasion into other countries in the Middle East.This means an increase in the price of petrol, as you or your parents will probably bewell aware if you have a vehicle to run.

If the economy starts off in recession before the war:

The war can be helpful as it brings the economy out of the recession. This happened inWorld War Two in 1939 when the British economy was stimulated, as was the Americaneconomy. There is a strong school of thought that says the efforts in the USA to boosttheir economy throughout the severe slump of the 1930s failed and only the advent ofwar stimulated a recovery. The diagram below shows an economy such as in the USA inthe 1930s. An increase in demand would increase output and end the slump.

265

Starting a war in the middle of a recession

110.0

100.0

90.0

0

AS1Price Index

AD2AD1

GDP1 GDP2Real GDP

Demand increases, output expands, which means more jobs become available to thosewho are unemployed. Inflation does not increase as there is much spare capacity whenwe start.

But if the economy starts off at full employment:

You will notice in the diagram below that no increase in output is possible, so theincreased demand because of the war all spills over into a higher rate of inflation.

It is arguable that Britain had a strong and buoyant economy on the eve of the invasion ofIraq, and so the full employment diagram below is perhaps the more relevant one.

Starting a war when we already are close to full employment

Real GDPGDP1 &GDP2

108.0

111.0

Real GDP

Price Index SAS1

AD2AD1

100.0

266

The length of time involved

A short war can sometimes be helpful to an economy, especially when starting in arecession or slump. The initial increase in demand is real and boosts national income butbeing short the war is over quickly and the uncertainties vanish. On the other hand, thewar diverts resources to engage in war that could be allocated to areas such as health,education, the private standard of living, pensions, or investment for future growth, sothere is a real cost to society.

A long war is generally harmful. If it is conducted in part on home territory there will bemuch destruction of buildings and property. In these days of increased terrorism, there islikely to be some damage wherever the war is fought. The war can breed new uncertainties,divert investment towards the armaments industries away from consumer goods andservices, which reduces the standard of living, as well as add to inflationary pressures.

A long time ago, a major recession was common after the end of a major war.

This seems to have happened over all human history, including the First World War(1914-18) Post-war there was a sudden fall in the level of aggregate demand. It wasdifficult to reallocate resources quickly to the sort of goods and services demanded inpeace time and in addition the vast influx of discharged soldiers meant severeunemployment.

There is now less of a danger of this happening: because of the work of Keynes we knowthat government can increase the level of aggregate demand to offset the automatic fallthat peace brings. This is how we avoided the emergence of a slump after the SecondWorld War (1939-45) in the UK, the rest of Europe, and in the United States.

It is also now much quicker and easier to reallocate resources than it once was, whichwill help us after any major conflict in the future. This is the result of the changes begunby Prime Minister Margaret Thatcher after 1979 in the labour markets and financialmarkets and perhaps to a lesser extent to the freedom given to the Bank of England toreduce interest rates to stimulate investment and consumption.

To list the ten goals with possible effects from the invasion of Iraq war:

• Economic growth: is boosted in the short term; but probably slowed in the longerterm as resources go to waging war, rather than investing for the future.

• Allocation of resources: towards war goods and away from peace-time goods, such as education or health.

• Inflation: the war worsens the inflationary pressures; this is particularly noticeable inthe price of petrol.

267

• Standard of living: reduces a bit; or at least not increases as much as it wouldotherwise have done.

• Distribution of income: moves towards the suppliers of armaments, munitions,uniforms and the like, as well as to the firms that reconstruct the Iraq economy whenthe war is over.

• Balance of payments: possibly harmed a little, as we probably had to import a fewthings with which to wage war; plus we probably lost a few exports as the goods orservices were diverted to Iraq. The net effect is probably small?

• Value of the pound: probably not affected much.

As another example of an external shock and how to tackle it, let us look at theeffects of a sustained rise in the price of crude oil.

Unlike the previous example which was focused on the demand side, a sustained rise inthe price of oil is a supply side problem. Such a price increase passes on through thegeneral economy quickly because of the immediate increase in the price of transport andfuel. This increases the costs of virtually all producers and pushes up their micro supplycurves. In turn, this means an immediate shift upwards in the aggregate supply curve.

Note: the figures are all assumed in order to demonstrate the principle involved.

Price Index

Real GDP

SAS2 SAS1

0

100.0

110.0

101.5

GDP2 GDP1

The results can be read off the diagram: we see inflation increasing from 1.5 per cent to10.0 per cent and the level of national income falling from GDP1 to GDP2. There is little

268

a government can do under the circumstances. It is unable to increase the level ofaggregate demand to tackle the fall in output and the associated rise in unemployment,because we are already close to full capacity working and all we would see after ademand increase would be even more inflation. The only hope is to work on increasingthe general level of efficiency in the economy and stimulating people’s motivation towork harder, i.e. to push the long run supply curve outward to the right. This by itsnature is a slow process. For those governments of countries that are oil producers, suchas the UK, it might make sense to promote the search for more oil beds, but this option isnot open to most countries, as they totally lack oil.

Higher oil prices affect the supply of some things more than others, for example theyhave a disproportionate effect on the prices of petrol, bitumen and chemical fertilizerproduction all of which use crude oil as a major raw material. Such products suffer asubstantial rise in price when the price of crude oil increases. The fear of a general worldrecession is likely to emerge and then grow.

So the rise in the price of crude oil helps those countries that are oil producers, and harmsall oil importers. It can be particularly damaging to many third world countries as theyrely on imports of chemical fertilizer for their agricultural production which is a largeproportion of the economy. The agricultural output is used to feed the people and inmany cases to provide much-needed exports.

Notice that if you memorise and learn to manipulate the diagram for the determination ofnational income via aggregate demand and supply how useful it is. You can use it whentackling a great number of questions. And this is true not only in the exam room!

To list the ten goals with some possible effects from a substantial rise in the price ofoil:

• Economic growth: this is harmed, as fuel and transport cost increase, forcing theshort run aggregate supply curve upward.

• Allocation of resources: (not a lot to say here).

• Inflation: the oil price rise worsens any inflationary pressures.

• Standard of living: reduced a bit. To the extent that the tax on petrol is linked tothe price of crude oil, the retail price of oil tends to rise immediately.

• Distribution of income: moved away from users of motor vehicles as they paymore for their petrol. The government also receives an increase in revenue fromthe automatic tax increase.

• Balance of payments: possibly helped a little, as the UK enjoys net exports offuels.

269

• Value of the pound: probably not affected all that much? The adverse effect ongrowth might be offset by a positive effect from the balance of payments.

THE LAST WORD!If you have found these free notes useful and feel that you might need a bit ofhelp in writing essays, getting better marks in exams, and learning morequickly and easily, take a look at a book I have written to help you do better -Going to University: the Secrets of Success: Kewei Press, Second Revised andExpanded Edition, August 2009, paperback, 204 pages, ISBN 978-0956182319.

It can be obtained from Amazon and elsewhere, including UCAS if you or yourparents prefer.A Five Star Review on Amazon said “Its useful tips for staying motivated arealready helping me to get organised/excited about the new uni year. I will makesure I get myself a `study buddy' next semester to help me mid-semester whenthe work piles up and it's hard to know where to start...I think it's invaluablefor anyone thinking about going to uni, enrolling in uni, or already at uni. Ihighly recommend it.”

And if you are not yet convinced, this is what commentators both in and outsidethe UK have said about some of my work:

“This is an excellent book” Amazon Review

“Highly recommended” Book Review Club

“Excellent book by Kevin Bucknall.” Lock Haven University of Pennsylvania

“Written for students…One of my personal favorites!” Penn State University

“All kinds of tips from A to Z to ensure your success as a student" University ofRegina, Canada

“This book is easy to read , to the point and easy to dip into.” Sheffield HallamUniversity

"Great book” Marius Andreiana, Student, and a Linux/Unix system adminis-trator

“A must for students from year 10 on” Four Star Australian webs

“Kevin Bucknall's How to Succeed as a Student is very helpful for college life”Gettingreal.com

270