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Economics Revision Notes

Unit 1
Scarcity Unlimited wants exceed finite resources

Unit 2
FOP are economic resources of Land,Labour,Capital,Enterprise
Land: Any natural resource used in production
Supply of land doesnt change much with time however natural resources may be limited in supply
Renewable and non renewable resources
Renewable can turn into non renewable if they are over exploited
Land is geographically immobile but occupationally mobile
Capital: Any man made good used to produce other goods and services
Capital goods are not wanted for themselves but because of what they can produce
Capital tends to increase with time
Gross investment: Total value of capital
Depreciation: Value of capital that has worn out
Net investment: Gross investment - Depreciation

Unit 3
Opportunity cost: The cost of a decision in terms of the next best alternative forgone.
Producers choose the option that will give them the maximum profit
Consumers choose the option that gives them the most satisfaction
Workers choose an occupation depending on Wage and Non-wage factors
If government raises taxes in order to fund more things, the opportunity cost falls on consumers
Economic Good
Takes resources to produce
Has an opportunity cost
Limited in supply

Free good
No resources involved
No opportunity cost
May be Unlimited in supply

Production possibility curve

Unit 4
Three main Economic questions
o
o
o

What to produce
How to produce it
Who is to receive the products produced

An economic system covers the institutions, organizations and mechanisms in a country that influence economic
behavior.
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Planned economy
Government makes decisions as to
what to produce (Directives)
Government owns resources
Government decides who will
receive products using wages and
controlling prices
Most people would have access to
basic necessities

Market economy
Consumers make decisions as to
what to produce via the Price
Mechanism
Private firms own resources
Products are distributed according
to peoples ability to earn high
incomes
High efficiency as firms who
respond the best to changes in
demand and provide products at a
price acceptable to consumers
receive high profits.
Those who earn the highest
incomes exert maximum influence.

Mixed economy
Both price mechanisms and
directives play a part in determining
what is produced
Both governments and firms own
resources
Product distribution is influenced by
both peoples income and
government intervention
Efficiency due to incentive as well as
government benefits

Advantages of a market economy:


o
o
o
o

Consumers are the sovereign


Choice
Efficiency due to incentive and threat
Better quality products

Disadvantages of a market economy:


o
o
o
o
o
o
o
o

Failure to take into account all costs and benefits


There may be a monopoly which can freely raise its prices/produce poor quality products
Immobility of resources may restrict efficiency
Wont produce public goods since people can act as free-riders
Insufficient / asymmetric information
Advertising can distort consumer choice
Very unequal distribution of income
Short termism

Advantages of a Mixed economy:


o
o
o
o
o
o
o
o

Government would take into account all costs and benefits


Government subsidies can encourage consumption of merit goods
Governments can discourage consumption of demerit goods
Governments can finance public goods through taxation
Governments can prevent private firms from exploiting consumers
Governments would provide jobs
Governments may plan ahead and devote resources to capital goods
More even distribution of income by taxing the rich

However Government intervention may make the situation worse

Unit 5
Demand: The willingness and ability to purchase a product
Demand and price are inversely related
Market demand = Individual demand
Changes in demand due to price is referred to as an extension, increase in quantity demanded, expansion
/contraction in demand, decrease in quantity demanded
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Supply: The willingness and ability to sell a product


Supply is directly related to price
A rise in price causes an extension in supply/ increase in quantity supplied while a fall in price results in a contraction
in supply/ fall in quantity supplied
Equilibrium price: Price at which demand and supply are equal, there are no shortages or surpluses

Unit 6
A change in demand results in a change in quantity demanded at every given price.
Causes of changes in demand
o

o
o
o
o
o

Changes in disposable income If the disposable income hence purchasing power of consumers
increases the demand for normal goods would increase. Inferior goods are goods whose demand
decreases as a result of a rise in disposable income since consumers switch to better quality
products.
Changes in the price of related products If the price of a complementary good falls or the price of a
substitute good rises, demand for the product will increase.
Advertising A successful advertising campaign will bring the product to the notice of new
customers and increase existing customers to purchase more thus increasing demand
Changes in population An increase in the population would raise demand for most products while
a change in age composition may increase/decrease the demand depending on the product.
Changes in taste and fashion Affects mainly clothing, food and entertainment.
Other factors Changes in future price expectations and weather

Unit 7
A change in supply occurs when the conditions facing suppliers change and at each price a different amount is
supplied.
Causes of changes in supply
o

Changes in the cost of production If costs of production rise, supply will fall. This intern is cause by:
Change in the price of factors of production
Change in the productivity of factors of production changes unit costs
The price of transporting goods is very volatile since the cost of petrol changes frequently

o
o
o
o
o

o
o

Improvements in technology Increases the productivity of capital goods


Taxes An introduction of a tax or a rise in the rate of a tax will make it more expensive for firms to
supply products thus reducing the supply.
Subsidies A subsidy would reduce the firms cost of production hence increasing supply
Weather conditions Affects agriculture
Prices of other products If the prices of other products that the firm sells rises , they would devote
more resources to producing that product hence decreasing the product in questions supply. An
exception to this would be if the products are jointly supplied in which case in the rise in the price of
one product would increase the supply of the other.
Disasters and wars These would reduce the supply of the product
Discoveries If more sources are discovered, the supply of the finished product would rise

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Unit 8
Price Elasticity of Demand is a measure of the extent to which demand changes as a result of a unit change in price
Price Elasticity of Demand is a measure of a measure of the responsiveness of demand to a unit change in price
PED =

Elastic demand : A change in price results in a greater change in quantity demanded (PED is greater than 1 but less
than infinity).
Inelastic demand: A change in price causes a smaller change in quantity demanded(PED is less than 1 but greater
than 0).
To raise revenue reduce the price in the case of elastic demand or raise the price if there is inelastic demand.
PED is dependent on
o
o

o
o
o

Availability of substitutes If there are close substitutes available then PED would be elastic since
consumers can easily switch to the cheaper alternative.
Proportion of Income spent on the product If the product takes up a small proportion of peoples
incomes, demand would be inelastic since even the price change would be too small for most to
even notice. In contrast if the price of a product that takes up a large proportion of peoples income
rises, it would be significant hence demand would be elastic
Luxury or necessities Necessities have inelastic demands while demand for luxury products is
elastic.
Addictive or not Addictive products tend to have inelastic demand
Time period under consideration Longer the purchase of the product can be delayed, more elastic
the demand since consumers can alter their purchases backed by adequate information.

As people become richer products that were previously luxuries become necessary hence their demand becomes
inelastic.
Perfectly elastic demand: A change in price causes a complete change on the quantity demanded
Unit elasticity of demand: A change in price causes an equal change on the quantity demanded
Perfectly inelastic demand: A change in price has no effect on the quantity demanded.
An increase in price makes demand more elastic
An increase in demand makes PED more inelastic

Unit 9
Price Elasticity of supply is a measure of the extent to which quantity supplied changes as a result of a change in
price.
PES =

Inelastic supply: Quantity Supplied changes by a smaller extent than price


Elastic supply: Quantity supplied changes by a larger extent than price
Factors affecting PES
o

Time taken to produce the product Longer the time taken, more inelastic the supply since there is
a lag before changes in supply can be implemented.
Property of Kirit Narain

o
o

The cost of altering the Supply The more costly it is to alter supply, the more inelastic the supply.
The feasibility of Storing the product If the product can be stored, supply would be elastic since
suppliers may choose not to supply a larger quantity if the price falls while can draw on stores to
increase supply if the price rises

If the product is mobile, the supply would be more elastic


Perfectly inelastic supply: Quantity supplied does not change with price
Perfectly elastic supply: A change in price causes a complete change in quantity supplied
Unit elasticity: A change in price causes an equal change in quantity supplied
As the time period under consideration increases, supply becomes more elastic
Advances in technology by reducing the production period and decreasing costs of production make the supply more
elastic
Producers want their supply to be as elastic as possible since then they can raise a significant amount of revenue by
cutting prices.

Unit 10
In a market system resources are constantly being reallocated away from products whose demand is declining
towards products that have increased demands.
The market responds to changes in costs of production and raises prices, thus clearing the market when supply
decreases as a result of for instance natural disasters.
There is lots of competition hence choice in terms of which products to consume for consumers.
Producers are efficient since they are competing for consumers and subsequently will try to lower their costs of
production in order to lower prices.
There is actual competition Number of competing firms and potential competition Easy for firms to enter and
leave the market in response to changes in profit.
Incentive in the form of profit to be efficient and threat in the form of bankruptcy
The most productive workers whose skills are in demand and are geographically and occupationally mobile receive
high wages while unproductive workers who are unable to adapt to market conditions receive low/no wages.
Allocative efficiency: Resources are allocated in a way that maximizes consumer satisfaction. Firms produce the
products that consumers demand in the right quantities.
Productively efficient: Firms produce at the lowest possible cost per unit. If all producers are productively efficient
the country would be producing on its production possibility curve.
Productive inefficiency Workers lying idle, capital equipment not fully exploited, offices spaces empty
Dynamic efficiency: Resources are used efficiently over a long period of time Technological advancements. Firms
spend money on research and development to innovate.
Advantages of a Market system
o
o
o
o
o
5

Consumers are sovereign They determine what is produced


Choices
Low prices
High quality products
Efficiency Manufacture products that consumers want, in the right quantity and at the lowest
possible cost per unit.
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Promote improvements in methods of production

Unit 11
Market failure occurs when markets are inefficient High prices, shortages, surpluses, poor quality and lack of
innovation.
Nature of Market Failureo

Failure to take into account all costs and benefits- Social costs include external costs as well as private costs.
Decisions taken on the basis of only private costs would lead to overproduction if the social cost is higher
(external costs present). Social benefit includes external benefits and private benefits. Decisions taken on
the basis of only private benefits will lead to underproduction if social benefits are higher (existence of
external benefits)
Information Failure Consumers may lack information about the nature of products on offer, the benefits
they can receive from them and their prices. Workers may lack knowledge about the Jobs on offer, the
remunerations paid, the qualifications required and their location while keeping in mind where their skills
are best suited. Firms need to know about the lowest cost method of production, where good quality raw
materials for a low price can be sourced, what products are in demand etc. If this occur they may make
decisions not in their best interests and consumers may purchase products that are overpriced and are of
poor quality, workers may end up in the wrong jobs and producers costs may be high and revenue low.
There may be a lack of information/ inaccurate information or asymmetric information (consumers and
suppliers do not have equal access to information).

Merit Goods are more beneficial to consumers than they realize and have external benefits hence they would be
under consumed and consequently under produced. In order to increase consumption, governments may
provide information about the merit good, subsidize it, or if it has significant benefits then provide it free of cost
or making its consumption compulsory.
Demerit goods are more harmful to consumers than they realize and pose external costs. They would be
overconsumed and hence overproduced if left to market forces. In order to discourage production governments
may provide information about their harmful effects, impose a tax on them or completely ban the demerit good.
Public goods are both non-excludable It is not possible to stop people from consuming them without paying
(free-riders) and non-rival Consumption by a person does not affect other peoples ability to consume them.
Therefore private sector firms would not produce them and instead they would have to be financed through
taxation. Government can then produce them or pay private sector firms to produce them.
If there is only one firm dominating the market then that firm may abuse its market power by charging high
prices or producing poor quality products since it has the assurance that consumers have no other alternative. It
will not be forced to be productively, allocatively or dynamically efficient. Even if there are multiple firms in the
market, they may engage in uncompetitive practices such as price fixing (all agreeing to charge the same high
price). In order to deal with this, Governments can remove barriers to entry and exit and prevent uncompetitive
practices. It may also stop firms from merging if it is thought that they will act against consumer interests.
In order to achieve allocative efficiency and produce as per consumer demands, it is necessary that resources be
occupationally and geographically mobile which in practice may not be the case. To improve occupational
mobility of labor governments can improve education and provide training in the new skills needed while to
improve geographical mobility governments may construct housing in areas that have a high demand for labour
or provide workers with some kind of financial help. Governments may also provide firms with grants, thus
making it easier for them to switch capital and land.
In a market economy sufficient resources may not be devoted to producing capital equipment since firms may
be interested in making a quick profit thus resulting in a lack of investment and restricting production in the
future. As a result the government may have to cut taxes on firms and undertake some investment itself.
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Since there is likely to be high income inequality, private sector firms may only produce products demanded by
the rich and hence the products needed by the poor would not be manufactured. Therefore governments would
want to ensure that basic necessities are provided to the poor at subsidized rates or free of cost which would be
financed by taxation. Taxation could also be used to reduce income inequality since it is socially divisive and due
to worse health and education, the poorer also tend to be less productive.
However if governments lack adequate information, and for instance find it difficult to calculate the correct
amount of public goods to supply, or overestimate the benefits of merit goods then government intervention
may worsen the situation. Government decisions may be influenced by political factors and by taxing the rich too
high, it may have an adverse effect on the efficiency of the market.

Unit 12
Renewable resources may be turned into non-renewable if they are over exploited
Exploiting resources raises employment, income, living standards and improves the countries trade position.
If non renewable resources are being exploited then it is necessary that an alternative industry is developed for
sustainability.
Choice of whether to exploit resourceso
o
o
o
o

Current living standards


Countries need for income
Where the countries comparative advantage lies
Current world demand
Future world demand

Private costs/benefits: Costs/benefits born/received by those that are directly involved in the consumption or
production of a product
External costs/benefits: costs/benefits born/received by those that are not directly involved in the consumption or
production of a product(Third parties)
Social costs/benefits: The total costs/benefits to the society of an economic activity
Social costs/benefits = Private costs/benefits + External costs/benefits
Socially optimum output: When social costs == social benefits

Unit 13
Public expenditure: Expenditure undertaken by the public sector (Central government, Regional bodies/ SOEs)
o
o

Exhaustive spending Directly buying goods and services (Gov determines use of resources)
Transfer payments Transfer of money to other people (Gov doesnt determine use of resources)

Uses of public expenditureo


o
o
o
o
o

Public goods
Merit goods
Supporting vulnerable groups
Helping private sector industries
Covering losses incurred by SOEs
Managing the economy (Promoting employment)

Public expenditure can be financed byo


7

Taxation
o Income of the country Higher income, more revenue even with a low rate
Property of Kirit Narain

o
o
o

Willingness of citizens to pay taxes May not vote for a gov that wants to raise tax
Reaction of workers and firms to changes in taxation Increased tax would increase informal sector
Tax rates in other countries

Flat taxes have only one uniform rate


o

Borrowing
o Credit worthiness at home and abroad
o State of the economy
o Level of economic development
o Acceptable rate of interest
The more SOEs, higher potential for revenue however if they are making losses then it may drain the
Gov

Privatization
Can raise revenue in the short term but if the SOEs were profitable then it reduces their revenue

Government influence on private sector expenditure


o
o
o
o

Taxing income and expenditure


Providing subsidies
Giving grants
Influencing the level of economic activity (Interest rates)

Private vs Public sector firmso


o
o
o
o
o
o

Private sector would be more efficient due to competition (High quality, low costs, less time)
If private sector firm is a monopoly it may charge high prices, produce poor quality output
SOEs may not be forced to keep its costs down
SOEs may lack technical expertise
Government may take a long time due to delays in decision making
SOEs will take into account all costs and benefits (CBA Cost benefit Analysis)
Government expenditure has an opportunity cost (eg education/healthcare)

Unit 14
Specialization: To concentrate on a particular product or task
What countries are good at producing is influenced by the quantity and quality of resources
If countries specialize in products they have a comparative advantage in, output, employment and living standards
will be better. They can export the product they produce and earn revenue which would be used to purchase
imports that their country needs. However if demand falls suddenly or costs rise the country can run into difficulty.
Diversification spreads risks
Specialization of firms is influenced by the nature of resources. Firms can get to know their markets well, build up a
reputation and it is easier to control firms producing a narrow range of products. If firms diversify, a fall in demand
for one of its products may be accompanied by a rise in demand for atleast one other product. Firms usually start
out by specializing.
Division of workers leads to lower unit costs since by practicing the same task they can become perfect at it and they
can be trained more quickly since they do not need to have knowledge about handling all tasks. Time can be saved
since workers dont have to switch tasks, the production process can be broken down and mechanized. However
workers may get bored thus reducing productivity and raising unit costs, also it will be difficult to replace or cover up
for them. Workers can pursue their interests and become very skilled. If demand for their services falls, they may
find it difficult to find another job.
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Specialization should reduce prices but consumers may loose out in terms of variety.
Extent of specialization
o
o
o

Size of market More workers would be employed hence greater chance for specialization
Transport links Good transport links increase size of market
Internal and external trade Trade/Money facilitates specialization

Functions of money
o
o
o
o

Medium of exchange Products are sold for money which is used to buy other products
Act as a store of value Money can be saved and does not deteriorate with time hence will be acceptable in
the future
Unit of account Money can be used to place a value on an item.
Standard for deferred payments Money allows people to borrow and lend, people can strike an agreement
about the amount of money to be repaid in the future.

Types of money Coins, Notes, Bank accounts


Bank accounts account for the largest proportion of payments via Direct debits and cheques
Legal tender: Forms of payment which by law have to be accepted in the settlement of a debt (Bank accounts are
not legal tender)
Characteristics of money
1.
2.
3.
4.
5.
6.
7.

Generally acceptable
Limited in supply
Durable Will last some time
Portable Can be carried around easily
Homogeneous Every unit of the same value should be exactly the same
Divisible Can be divided into units of different values
Recognizable People can easily see that the item is money

Unit 15
Banks enable more efficient use of resources and encourages the growth of output of economies.
Commercial Banks
o
o
o
o

Commercial Business organization which seeks to make a profit


Joint Stock Limited liability and are in the private sector
Retail Selling the public banking services
High street found in most of the towns and cities

Functions of Commercial Banks


1. To accept deposits Customers can keep their money in a safe place.
Current account/Demand account Immediate access to money but no interest paid. Used for receiving and
making payments.
Deposit/time account Interest is paid however a period of notice has to be given before money can be
withdrawn. Used for saving.
2. To lend Banks make profits by charging a higher rate of interest on borrowed money than that on money
held in the bank.
Overdraft: Enables customers to spend more money than they currently have upto an agreed limit. High rate
of interest charged. Used to cover short term gap between expenditure and revenue.

Property of Kirit Narain

3.
4.
5.
6.
7.

Loan: For a particular purpose and period of time. Rate of interest is lower than that on an overdraft.
Customer may be made to provide some form of security (collateral). If the loan is not repaid, the collateral
can be sold and the money recovered.
Banks act as financial intermediaries.
To enable customers to make payment Via cheques, standing orders, direct debts, debt/credit cards and
online banking.
Exchange foreign currency
Have a safety deposit box so items can be stored
Help with administration of the customers will
Sometimes sell insurance

Aims of commercial banks


The main aim is to make a profit for shareholders which they mainly do by charging interest on loans.
Liquid assets: Assets which can be turned into cash quickly without incurring a loss.
Commercial banks have to balance liquidity and profitability to enable customers to withdraw money whilst still
making maximum profit

Investment banks (Merchant banks) Act as bankers to firms. Accept deposits and lend to them. They manage
the issue of new shares (Also IPOS) and sell shares and other financial securities on behalf of the firms. They also
give advice and help on mergers and takeovers etc
Saving banks Encourage saving particularly among people with low incomes. Make it easy to withdraw cash
with few penalties by investing the money in government bonds and other securities.

Central banks: Single most important bank in the country/region and are owned by the government hence are
responsible to them.
Functions of a central Bank
o
o
o
o
o
o
o

o
o

Act as a banker to the government Tax revenue is paid to their account and they use this account for
government expenditure.
Operates as a banker to commercial banks Commercial banks can settle debts between each other
and withdraw cash if its customers are taking more than usual.
Acts as a lender of last resort Will lend to banks that are temporarily short of cash.
Manages the national depth As time passes, debt tends to build up. Central bank borrows on behalf of
the government by issuing bonds, pays interest on these and repays them when they fall due.
Holds the countrys reserves of foreign currency and gold Keeps currency and gold to influence the
exchange rate
Issues bank notes Prints notes and destroys those that are no longer suitable for circulation. Also
authorizes the minting of coins.
Implements the governments monetary policy Keep inflation low and steady by controlling the
money supply and interest rates (through changing the interest it charges on its loans. Sometimes
governments instruct the bank on interest rates whilst other times central banks are independent.
Controls the banking system Regulates and supervises
Represents the government Meetings with other central banks, World bank and IMF

Governments set the target rate of inflation. Independence of central banks means that they wont be influenced by
politics and they are likely to have more knowledge about the banking system.

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Unit 16
Shares = Equities
Stock exchange/bourse : Enables shares and other financial assets to be bought and sold
Only Listed/quoted public limited companies can sell shares on the bourse
Functions of a stock exchange

Providing a market for the sale of shares (plc) and bonds (governments). Through this they can raise finance
and buyers may make a profit in the form of dividends or capital gains.
Enables firms to grow externally through Mergers and takeovers.
Mobilizing savings for investment People channel their savings through the purchase of shares and bonds
Protecting those who buy shares- Listed companies have to provide a range of information
Providing an indication of economic performance Shares prices are likely to be higher if the economy is
performing well

A bull: Someone who buys shares expecting their price to rise


A bear: Someone who sells shares expecting their price to fall
Nominal price: Face value of the share Price at which it was issued
Market price: Current price of the share
Dividend is expressed is raw terms or as a percentage of the nominal price
Yield is expressed as a percentage of the market price
Reasons why shares are bought

Dividend can act as a source of income


Capital Gains Speculating that their market price will rise
Influence the running of the firm
Merger/takeover

Influences on share prices

Interest rates A rise in interest rates would reduce share prices because
1. Demand for shares would fall since opportunity cost of holding money in the bank would be higher
and borrowing to buy shares would be more expensive
2. Demand for firms products would fall since borrowing would be more expensive and people would
rather save. Thus the firm would earn less profit.
3. Firms costs may rise if they have borrowed
Profit record
Government policy Cut in corporation tax would increase share prices
The issue of new shares Increases supply
Takeovers and rumors of takeovers Would increase share prices to own shares in a larger company

Investment finance

Borrow (External finance) Commitment to make regular interest payments. Banks may seek to influence
firms decision.
Sell shares (plc only, external finance) However may reduce their price and is unlikely to be popular with
existing share holders. It also increases the risk of being taken over.
Retained profits (Internal finance) Firms are more likely to expand when they are making a profit.

Role of profit11

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Incentive for entrepreneurs to organize FOP


Payments to shareholders.
Finance for investment

Unit 17
Wage factors (monetary or pecuniary factors) affecting choice of occupation

Wages
Piece rate system Only possible if workers output can be easily measured and the product is standardized.
(mainly found in primary and manufacturing sectors) Less supervision would be needed but workers may
focus on quantity at the expense of quality. Health of workers may suffer.
Time rate system Employers can easily calculate wages. Workers can collectively bargain about wages.
However does not reward hard work as pays lazy workers the same as productive workers.
Overtime pay
Usually paid at a higher rate. Firms can respond to higher demand. It is easier, less costly and less disruptive
to reduce overtime than fire workers. But workers may become tired and thus their productivity would be
affected.
Bonuses
Paid to workers that contribute to higher profit in some way. Incentive to produce more, better quality
output but there may be resentment if they are awarded unfairly.
Commission
Proportion of the total value of sales

Non-wage factors (non monetary and non pecuniary)

Job satisfaction
Type of work Manual/Non manual
Working conditions
Working hours Longer, Shorter, Flexible, Time
Holidays
Pensions
Fringe Benefits
Job Security
Career prospects Accepting of lower wages if there is a high career prospect
Size of the firm Smaller firms have better work relations but workers may be attracted to larger firms.
Location

Limiting Factors

Qualifications they have


The skills they posses
The experience they have
The place where they live
Occupational immobility
Geographical immobility

Unit 18
Wage determination

12

Demand and Supply


o Qualifications, Length of training required affect supply
o Skilled workers are demanded more and have a lower supply hence are paid more than unskilled
workers
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Demand for workers is influenced by the amount of output they can produce (Productivity )and the
price for which that output can be sold
o People involved in dangerous jobs are often paid slightly more than their counterparts who are in
safer conditions
o Demand for manufactured products tends to increase at a higher rate than agricultural products
Relative bargaining power of employers and workers
o If part of a trade union, bargaining power of workers is likely to be higher
o Higher if workers are difficult to replace
o Public sector workers tend to belong to trade unions since the Gov may be more willing to negotiate
and they find it easier to get together
Government policies
o Policies which promote economic growth tend to push up wages
o Influences public sector workers wages directly
o Labor market policies affect wages NMW
o NMW may lead to unemployment but can also raise productivity and demand
Public Opinion
o Wage claims made by workers
o Put pressure on the government to revise the wages it pays
Discrimination
o Discrimination would lower demand hence reducing wages.
o Women tend to be paid less because
They are generally less qualified than men
They are less likely to belong to a trade union
Still discriminated against

Unit 19
People tend to earn more as they get older due to becoming more skilled (through training) and experienced.
However earnings may also fall if people stop working overtime or have a fall in productivity as they get older
Changes in Earnings

Changes in demand for labour


o Increase in demand for the product (Demand for labour is detived demand)
o A rise in labour productivity
o A rise in the price of capital
Changes in Supply of labour
o A fall in the labour force
o A rise in the qualifications or length of training required to do the job
o A reduction in non-wage benefits of the job
o A rise in the wage/non-wage benefits of other jobs
Changes in bargaining power
Changes in government policy
o Raising NMW
o Supply side Policies Increase quantity and quality of labour thus raising earnings
o Immigration policy
o Government anti-discrimination laws
Changes in public opinion
Advances in technology Reduces demand for some manual workers while raises demand for others
(engineers, programmers)

Extent to which earnings change


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Property of Kirit Narain

Magnitude of change
Price Elasticity of Demand for labour More inelastic, greater the change in earnings
o Proportion of labour costs in total costs
o Ease with which labour can be substituted with capital Easier it is, More elastic
o The elasticity of demand for the product produced More Elastic PED, Greater the elasticity of
demand for workers
o Time period More elastic in the long run
Price Elasticity of Supply for labour More inelastic, greater the change in earnings
o The qualifications and skills required More skills/qualifications needed, More inelastic the supply
o The length of training period Delay in responding + significant rise in earnings would be needed to
attract workers
o The level of employment Higher the employment, more inelastic supply since a significant rise in
earnings would be needed to get workers to quit their jobs
o The mobility of labour Higher the mobility, greater the elasticity of supply
o The degree of vocation The more attached the workers are to their jobs, greater the inelasticity of
supply
o Time period Workers can notice wage changes and gain requisite changes making supply more
elastic

Unit 20
Trade unions: The association of workers to represent their interests and improve their pay and working conditions
Types of trade unions1.
2.
3.
4.

Craft unions Particular skills


Industrial Unions All workers in a particular industry
White collar unions Represent professions
General Union Range of skills from a variety of industries

Role of Unions

Negotiate on behalf of their members


Protect or improve workers rights
Provide information about a range of issues
Help with education and training schemes
Measures to increase demand for the product produced (demand for labour is derived demand)
Provide a range of benefits such as strike pay, sickness pay
Encourage firms to increase worker participation in business decision making

Collective bargaining: Negotiations between union officials representing a group of workers and representatives of
employers
Basis of wage claims

Workers are working harder and have higher productivity


Workers contributed to the rise in industrial profits and the firm and afford to pay workers more
Comparability argument Wages of similar workers have risen (seek to maintain wage differential)
Workers need to maintain their real income Rise in costs of living

Factors affecting the strength of a Trade Union

14

A high level of economic activity If the economy is doing well they can afford to improve pay and working
conditions. Firms may be competing for workers thus may give in to union requests.
A high number of members More funds and the greater the impact on the firm if they do not accept union
demands.
Property of Kirit Narain

A high level of skill Workers are difficult to replace and it is expensive to train unskilled workers
A consistent demand for the product

Industrial Action

Overtime ban only work for their contracted hours


Work to rule Only perform tasks required by the workers contracts
Strike - Official (Organized by the union) and Unofficial (Not organized by the union)
o The number of strikes
o The number of workers involved
o The number of working days lost
Preventing workers from joining the firm
o High qualifications requirement
o Closed shop Only union members can join the firm

If firms and unions cannot come to a resolution, then both parties go into arbitration involving a 3rd party.
Effect of Unions

Revenue is lost and reputation damaged by industrial action


Costs will rise if an overtime ban or work-to-rule is imposed
Consumers may not receive products on time
Less time consuming, less stressful and less costly to negotiate with workers as a whole than with individuals
Useful channel of communication between firms and workers
Unions encourage workers to get involved in schemes which raise productivity thus benefiting the firms
Unions also benefit non-unionized labour since any improvement applies to them as well

Unit 21
Influences on spending

Disposable income as it rises people spend more as a total but less as a proportion of their income
Wealth
o Generates income
o Wealth can be cashed in
o Wealth can be used as security for loans
o Wealth increases confidence
Confidence The more optimistic people are, the more they are likely to spend
Rate of interest If ROI rises, expenditure will fall
o Borrowing becomes more expensive
o Increases opportunity cost of saving
o Reduces the amount spent by those that have borrowed in the past
Distribution of income More even it is, higher the expenditure APC would be higher
Advances in technology Increases expenditure since new products encourage people to replace older ones.

Average propensity to consume: Proportion of disposable income that is spent


Wealth: A stock of assets
Forms of saving
1. Contractual saving Saving a particular amount on a regular basis
2. Non-contractual saving Varies more with time and is heavily influenced by interest rates
Reasons for saving

15

Target savers Save a sum of money for a particular purpose


Property of Kirit Narain

For retirement Saving generates income


To help their children Finance childrens education and/or leave them an inheritance
For precautionary reasons To cope with emergencies
To take advantage of unforeseen opportunities
For income The more people save, the more income it generates both in quantity and as a proportion

Influences on Saving

Income As Disposable income rises, so does the amount saved


Wealth The wealthier people are, the easier they will find it to save
The rate of interest Higher the rate of interest, Greater the amount saved
Tax treatment of savings If tax concessions are given on income earned through saving, the savings would
increase
The range and quality of financial institutions More the quantity saved as well as the amount of people
that save
Age structure Old and young do not save while people in the middle ages save the most
Social attitude

Influences on borrowing

The availability of loans and overdrafts The easier it is to borrow, the more likely people are to borrow
Interest rates Higher the interest rates, Less would be borrowed
Confidence The more confident people are about future economic conditions, the more likely they are to
borrow
Social attitude

Unit 22
Gross income: Total income received by a person before any deductions
Disposable income: Income after deductions including direct taxation (eg income tax)
Real Disposable income: Disposable income that is adjusted for inflation
If real disposable income rises, it indicates that peoples purchasing power has risen and they will be able to but
more goods and services.
Sources of income

Earned income Employment


Investment income Profits(entrepreneurs), Dividends(shareholders), Interest(lenders)
State benefits Unemployed, pensioners

Dissaving: When people spend more than their disposable income Borrowing or drawing on past savings
As income rises the average propensity to save rises while the average propensity to consume falls( However total
amount consumed rises).
=

Patterns of expenditure

16

The poor spend more as a proportion of income on necessities

Property of Kirit Narain

The rich spend more both as a proportion and in terms of amount on Luxury items, consumer durables,
entertainment and services
The pattern of expenditure varies in terms of household composition, tastes and age.
The retired spend more on heating and healthcare but less on entertainment and transport
People in their late teens spend more on clothing and entertainment

APS + APC add up to 1


The poor have a greater need for borrowing however they do find it harder to borrow since they cannot offer any
security

Unit 23
Industries: All firms that produce the same product
Firms(business entity) can have a number of plants (Production unit)
Stages of production
1. Primary sector Extraction and collection of raw material
2. Secondary sector Processing of raw material into semi-finished and finished goods (both capital and
consumer)
3. Tertiary sector Provides services
4. Quaternary sector Collection, processing and transmission of information (ICT)
As a country develops, Workers move away from primary sector production towards Secondary and finally the
Tertiary sector.
Limited liability : Shareholders are only liable for the amount of money they have agreed to pay for the share
Types of business organizations
1. Sole proprietors
Owned by one person Bears risks as well as organizes FOP
Sole proprietors are self employed
Can employ any number of people
Likely to be relatively small since it is difficult for one person to control a large firm
Finance is limited to the amount put in by the owner
Unlimited Liability
Most common type of business organization since they are easy to setup
Flexible Quick to respond to changes in demand
Incentive to be efficient
Personal contact with consumers can promote sales and with employees can motivate them
Sole proprietor may lack full range of skills needed
Success of the business is dependent upon the health of one person
Lacks continuity since if the sole proprietor dies, goes bankrupt or is unwilling to run the business,
the organization ends
2. Partnerships Unlimited liability
Partners are self employed
Can employ any number of workers
Relatively easy to setup
Can raise more finance than sole proprietors, but is still limited
Potentially have more expertise at hand than sole traders
If one of the partners is unavailable, it will hamper the functioning of the firm significantly
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Property of Kirit Narain

Lack continuity since if a partner leaves, the partnership collapses and a new one would have to be
drawn up
Common in professional services
3. Private Limited Companies (ltd)
Joint stock companies- People can jointly own the business
Financial capital is divided into shares
Continuous existence
Limited liability
Relatively small firms since the public cannot buy their shares
Firm is kept in control of a few select hands
Limited amount of finance that can be raised
Have to provide some information to potential shareholders
4. Public Limited Companies (plc)
Joint stock companies
Limited liability
Continuous existence
Can sell shares to the general public
Can raise a considerable amount of finance through the sale of shares
Can grow to a large size
Have to provide more information to the public
May be subject to takeover
Shareholders may be too concerned about high dividends at the expense of long term development
of the company.
The role of entrepreneurs is divided between the shareholders and the board of directors (who can
be voted out at the Annual General Meeting)
5. Multinationals Operates in more than one country
Reduces the firms transport costs by producing in the country where the products are sold
They can keep in close contact with their various markets
They can get around import restrictions
Gain access to cheaper labour and raw materials
May even receive grants from governments in the host country
Can spread their operation through a number of countries
Effect of Multinationals Can increase employment, output and tax revenue
Bring in new technology and management ideas
Help in the development of infrastructure
May pollute
Can put pressure on the governments in the host country to give them concessions
May drive domestic firms out of their home market
Profits may be paid to shareholders in another country
6. Co-operatives Owned jointly by their members and functions for the benefit of these members
Worker Co-operatives
Consumer co-operatives buy in bulk thus they can sell at a cheap price
Public can buy shares in these co-operatives and receive interest on these. But the shares can only
be sold back to the co-operatives.
Each member (shareholder) has only one vote at the shareholders meeting irrespective of the
number of shares they own
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Property of Kirit Narain

Housing co-operatives Buy and manage low cost housing


Trading co-operatives Businesses join together to share techniques, capital equipment and
workers and to buy raw material in bulk
However there may be a lack of management skills
7. Public corporations
State owned enterprises, Nationalized industries are owned by the government
No shareholders
Funds come from the government, government approved loans and from the private sector
They do not seek to make a profit, their aim is to work in public interest
o They base their decisions on the full costs and benefits
o Can be used to influence economic activity (eg increase output)
o Corporations would not abuse their market power (useful as natural monopolies)
o Ownership of the entire industry makes planning and co-ordination easier
o Ensure basic industries survive, produce high quality output and at a low price Other
industries depend on them
o Can be difficult to manage and control Slow decisions
o May be inefficient due to lack of competition and since they cannot go bankrupt
o If they are making losses, government would have to spend money on them thus incurring
an opportunity cost
Privatization (driven by incentive and threat)

Private sector firms would produce products demanded by consumers at a low cost
High quality
Greater choice
Can respond more quickly to changes in demand as compared to SOEs
Less risk of underinvestment Profitable firms will raise high revenue
No guarantee that private firms will be exposed to market forces (may be monopolies)
o Inefficient
o Charge High prices
o Low quality products
Private firms may not take into account all costs and benefits
Reduces governments control over the economy

Unit 24
The FOP employed are influenced by
1. Type of product produced
2. Their productivity
If substitutes, a rise in productivity of a FOP will lead to the replacement of the other FOP
If complements than a rise in productivity of a FOP will lead to an increase in the amount of other
resource employed
3. Their cost
If substitutes, a rise in cost of 1 FOP, will lead to an increase in employment of other FOP
If complements, a rise in cost will lead to a fall in the quantity of the other FOP employed
In the short run there is likely to be at least one fixed FOP (most commonly land and capital)
Firms use the combination of factors of production that results in the highest possible productivity
Demand for capital goods is influenced by

19

Price of capital good Rise in price would cause contraction in demand


Price of other factors of production
Property of Kirit Narain

o If substitutes then a rise in price of the other FOP would raise the demand for capital
o If complements a rise in price would result in a fall in demand for capital
Profit levels Incentive and ability to buy capital goods
Corporation tax Affects firms profits
Income A rise would cause an increase in consumption and hence an increase in demand for capital
Interest rates A cut in interest rates would raise consumption and encourage investment
Confidence levels A rise in confidence would increase demand
Advances in technology More productive, hence higher demand for capital

Demand for land is influenced by

In agriculture, the most fertile land would have the highest demand
Productive land (city center sites) have high demand

FOP are influenced by the economies industrial structure.

Unit 25
Total cost: Total cost of production (Fixed costs + Variable costs)
Average costs/unit costs: Cost of producing one unit (Total cost/output)
Output Total Costs
While economies of scale occur: Output 1/Average costs ; Diseconomies of scale: Output Average costs
Fixed costs (Overheads / Indirect costs): Costs that do not change with output in the short run
Average fixed costs = Total fixed costs / Output
Output 1/AFC
Variable costs (Direct costs): Costs of variable factors; changes with output
Output Variable costs (Tend to rise slower at first due to increased productivity)
Average variable Costs = Variable costs/output
AVC tends to decrease at first (while output increases) and then rises again forming a U shape
In the long run all costs are variable
Average costs = AVC + AFC This is also a U shaped graph due to economies/diseconomies of scale

Unit 26
Total profit = Total revenue Total costs
Profit per unit = Average revenue (Price) Average cost
In a perfectly competitive firm average revenue does not change with output therefore total revenue rises
consistently. However in practice the price is usually decreased to encourage purchase of extra output.
In an imperfectly competitive market:
Output 1/ AR
Total revenue rises at first and then falls (The price would become to low) as output increases
Goals of firms
1. Sales revenue maximization
Produce the maximum amount possible (Therefore greatest revenue)
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Property of Kirit Narain

Makes it easier for firms to raise finance Higher sales will attract external finance
Cheaper to sell in bulk Profit per unit may be lower but total profit can be the same and/or higher
by distributing it over more units. Most common where fixed costs account for a large proportion of
total costs since then the average costs would fall by producing more. For eg Xiaomi sells a lot at low
profit margins Sales revenue maximization

2. Growth
Directors, managers etc pay rises in line with size of the firm
leaders of larger firms are held in higher esteem.
Higher job security in larger firms since it can be difficult to replace people that are controlling large
firms.
Linked to Sales revenue maximization since the greater the sales, larger the firm

3. Profit satisficing
Using up some profits for other goals (Improve working conditions etc)
Managers and directors do this because they do not receive most of the profit as it goes to
shareholders.
Achieve minimum amount of profit to keep shareholders happy
4. Improvement of the environment
Cleaning up their production process and not sourcing from firms that employ child labour
5. Social responsibility
May increase costs in the long term but profits in the long term since people may prefer to purchase
from firms that act in an ethical manner.
6. Profit Maximization
Seek to earn the largest possible profit
Pursuing other goals should increase profits in the long run (eg growth- Economies of scale and
reduction of competitors)
Profit = Revenue Cost
Effects of changes in Profits

Incentive for entrepreneurs to undertake production Encourage more firms to enter the market
Provide firms with more finance for investment
Easier to raise external finance
Easier to recruit top managers, directors and workers attracted by the firms success

Ways of increasing profit


1. Reduce costs of production
Reducing wastages and inefficiency
Increasing productivity of FOP raises costs in the short run but reduces average costs in the long
run and raise revenue by improving quality.
Increasing the size of the firm through mergers and takeovers Economies of scale
2. Raise revenue
If inelastic demand, firms should raise prices while in the case of elastic demand firms should lower
prices.
Increase size of the firm, thus capturing a larger market share
Influence demand for the product- Improve quality, diversify, be more responsive to changes in
customer demands by improving market research and Advertising.

Unit 27
Market structure: Conditions which exist in a Market.
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Property of Kirit Narain

Characteristics of Perfect Competition

Many buyers and sellers Individual firms are price takers, unable to significantly influence market supply
Low degree of market concentration Each firm has a tiny share of the market, small contribution to market
supply
No barriers to entry and exit from the market
Product must be homogenous No branding or advertising
Buyers and sellers must be perfectly informed Buyers will know where sellers are and about their product
while sellers will have knowledge about production techniques, the availability and price of resources.

Behavior of Perfectly Competitive firms

Firms are price takers Cannot raise prices or they will loose all their sales and have no incentive to reduce
prices.
Firms will respond quickly and fully to changes in demand in order to get a competitive advantage
In the long run firms will only earn normal profit. If demand rises (therefore profits), other firms would start
producing the product, increasing supply. If demand falls then some firms will stop producing the product,
reducing supply.

Performance of Perfectly competitive firms

Efficiency in terms of producing the products that consumers wants at a price acceptable to them. Threat in
the form of bankruptcy and incentive In the form of profit.
Good quality products since firms would want to gain a competitive advantage.
Wider choice in terms of sellers
However the price may not be as low as possible since firms cannot take advantage of economies of scale
Consumers dont have a choice in terms of variation of the product

Pure Monopoly: The sole supplier of the product having 100% market share
Characteristics of a Monopoly

The firm is the industry, it has 100% share of the market


High barriers to entry and exit hence it is difficult for other firms to enter the market
Monopoly is a price maker, its supply is the market supply

Occurrence of Monopolies

In the past a firm may have been efficient thus driven out all other firms
Mergers and takeovers
Existed from the start
Given Monopolistic powers by the government
Patents stopping other firms from producing the product

Monopolies continue because of barriers to entry and exit


Barriers to entry

Legal barrier Patent of government act


Scale of production Can produce at a lower unit cost
Expensive to setup if large capital equipment is required
Brand loyalty through branding and advertising
Monopolies access to resources and retail outlets.

Barriers to exit

22

Lon term contract to provide a product


Property of Kirit Narain

Sunk costs Unrecoverable costs such as Advertising and Industry specific equipment

Behaviour of a Monopoly

Can earn supernormal products in the long run


Is a price maker by controlling supply or setting the price, but cant control both

Performance of Monopolies

Absence of competition may lead to inefficiency High prices and poor quality products
May fail to respond to changes in tastes and develop new products
Can be efficient due to economies of scale lower unit costs
Prevents wasteful duplication of capital equipment
High profits can be spent on research and development therefore innovating Incentive since all the profits
would go to the monopoly
Other firms may try to develop better products to overcome barriers to entry

Unit 28
Measures of the size of a firm

Number of workers employed


Value of output produced
Value of financial capital it employs

Influences on size of a firm

The age of the firm Over time firms can grow to a large size
The availability of financial capital The more it can invest in its expansion, the larger it is capable of growing
The type of business organization Public limited companies can sell shares and borrow to finance
expansion while the others cannot sell shares and are likely to find it more difficult and costly to borrow.
Internal economies and diseconomies of scale Economies of scale promote expansion while the reluctance
to experience diseconomies of scale may limit expansion.
The size of the market Larger the demand for the product, greater the possibility for the firm to grow to a
large size.

Growth of firms
1. Internal growth (natural or organic growth)
Increasing the market for its current products or diversifying into other products. Increasing the size of
existing plants of opening new ones.
Internal growth is more controlled.
2. External growth
Joining with another firm through a merger or takeover Integration
Firms can increase their size more quickly however there may be a loss of control, taking the firm past its
optimum size.
Horizontal Integration
Joining of two firms at the same stage of production, producing the same product
o
o
o

23

To take advantage of economies of scale


To increase market share through the elimination of a direct competitor
Rationalization of resources means that firms can sell of redundant (eg duplicate) resources
thus become more efficient.
o However diseconomies of scale may be experienced
o More difficult to control a larger firm
Vertical integration
Property of Kirit Narain

Integration with a firm producing the same product but at a different stage of production.
o Vertical Integration forward
Joins with a market outlet for the firms products
To ensure that there are sufficient outlets for the firms products that are stored and
displayed well in high quality outlets
To help in the development and marketing of new products
o Vertical Integration backwards
Joins with a firm that is the source of raw materials, components or the products it
sells
To ensure adequate supply of good quality raw materials at a reasonable price
To restrict rival firms access to the supplies
o There may be management problems
o The two firms may have been of different sizes which can require some adjustment
Conglomerate Integration
Combining of two firms producing different products
o Diversification Spreading of firms risks
o But management can be very difficult

Effects of integration on consumers

Can lead to economies of scale, therefore lower prices


High quality products
Innovation
However if diseconomies of scale occur consumers will experience higher prices and poorer quality products
Reduced choice for consumers
Exploitation of market power to push up prices

Reasons for small Firms

Small size of the market


Preference of consumers Consumers prefer smaller firms for personal services since they can cater to their
individual requirements and an provide a friendlier and more personal service
Owners preference May not want the firm to grow large since it can become more stressful and may lead
to loss of control.
Flexibility Can adjust quickly to changes in market conditions since there may not be the need to consult
various levels of authority. Small firms that are in regular touch with their customers can pickup on changes
in demand.
Technical factors Lower barriers to entry due to no capital required means that smaller firms do not suffer
a cost disadvantage
Lack of financial capital May lack the finance to expand since it is difficult and more expensive for smaller
firms to raise finance
Location If transport costs account for a large proportion of total costs, local firms may be more suitable
for supplying the product which are likely to be small.
Cooperation between small firms
Specialization Small firms may provide specialist services to larger firms
Government support Governments can provide financial help and advice to small firms since they account
for a high number of jobs, develop the skills of entrepreneurs and have the potential to grow large.

Unit 29
Economies of scale: Advantages in terms of lower long run average costs of producing on a large scale
Internal economies of scale: Lower long run average costs resulting from the firm growing in size
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Property of Kirit Narain

External economies of scale: Lower long run average costs for all the firms in the industry, resulting from an industry
growing in size
Diseconomies of scale: Higher long run average costs due to a firm(internal diseconomy) or industry(external
diseconomy) growing too large
Due to internal economies of scale and diseconomies of scale, the LRAC curve is U shaped.
External diseconomies of scale cause a shift in the LRAC, a downward shift due to EOS and an upward shift is a result
of DEOS
Types of internal economies of scale
Marketing
economies

Buying economies Firms can purchase raw materials and capital in bulk and receive discount, receive
better quality supplies at a faster speed of delivery.
Selling economies Transportation costs, processing costs, packing the goods etc does not rise in line with
the number of orders. Also advertisements can be spread over more units thus reducing unit cost.
Managerial economies Large firms can have specialized staff by spreading their pay over a number of units
therefore lower average costs can be obtained.
Financial economies Large firms find it easier and cheaper to raise finance. Banks are willing to lend to
them since they are well known and can offer collateral, and the administration costs of processing large
loans is not significantly higher than small loans hence the firm has to pay back less interest, reducing costs.
Large firms (plc) can raise finance by selling shares.
Technical economies Large firms may find it plausible to use technologically advanced capital equipment
which is likely to be efficient, reducing unit costs.
Research and Development economies Large firms can invest in R&D thus inventing more efficient
methods of production, reducing average costs and can also invent new products, which raises revenue.
Risk bearing economies Large firms can diversify to spread their risks over a range of products.

Internal Diseconomies of scale

Difficulties controlling the firm Hard to manage and supervise everything therefore a number of layers of
management may be needed which increases administration costs and makes the firm slower in responding
to changes in market conditions.
Communication problems Difficult to ensure everyone in the firm has full knowledge about their duties
and available opportunities (eg training). Workers may not get to effectively communicate their view and
ideas to the management team.
Poor industrial relations Lack of motivation of workers, strikes and industrial action since workers would
have less sense of belonging, it may take a longer time to solve problems and more conflicts may arise due
to the presence of diverse opinions.

External economies of scale (economies of concentration)

A skilled labour force can recruit workers who have been trained by other firms in the industry
A good reputation People may prefer to purchase products from that industry.
Specialist suppliers of raw materials and capital goods Subsidiary industries may be setup that provide for
the needs of the industry.
Specialist services Universities and colleges may run specialist courses, and transport firms may provide
specialist services catering to the needs of the firms in the industry.
Specialist markets - Specialist selling places that provides a market for firms products.
Improved infrastructure Encourage governments and private companies to provide better road links,
electricity supplies, build new airports and develop dock facilities.

External EOS are more likely to occur if all the firms in the industry are located in one area.
External diseconomies of scale
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Property of Kirit Narain

Congestion due to increased travelling of both workers and raw materials/finished products reduced
worker productivity and higher transport costs
Increased competition for resources(key sites, capital equipment and labour) hence pushing up their prices,
therefore costs of production

Unit 30
Government as a producer

Key Industries Seek to ensure that these survive and do well since some of them may be (national
champions) world beaters or potential world beaters. The key industries may be run by the government,
receive favoured loans from banks and governments may stop foreign companies from taking over and
merging with them.
Natural monopolies Governments run these to prevent consumers being exploited by private sector firms
and also because producing at an extremely high output (to reduce average costs) may result in losses for
the monopoly (As output increases, prices decrease)
Essential products Governments provide these so that they survive and/or people have access to them. Ex
housing, education, healthcare etc; These may be provided to people free of cost or at subsidized rates.
Merit Goods Consumers would under consume merit goods so firms would under produce. To stimulate
consumption, governments may pay private firms to produce them, provide information about their benefits
and if necessary make their consumption compulsory.
Public goods Private firms have no incentive to produce them because they are non-rival and nonexcludable. Governments therefore have to produce them or pay private firms to produce them and this is
financed through taxation.

The government as an employer

Gov employs workers and managers to operate its SOEs


Can use this to implement their aims (reduction in unemployment, control inflationReduce wage rises of
its workers, set an example in terms of employment practice)

Unit 31
The performance of the domestic economy is affected by the dynamics of the other economies.
Governments Macroeconomic Aims
1. Full employment
o People who are willing and able to work can find jobs
o Those who are not willing and able to work are not part of the labour force, they are
economically inactive and dependent on those in the labour force.
o

26

Unemployment rate =

100

o Economists define full employment a 3% unemployment Frictional unemployment


2. Price Stability
o Ensures greater economic certainty
o Prevents countries products from losing international competitiveness
o Gov aims for a stable 2% inflation for 2 reasons
Measures of inflation tend to overstate rises in prices Informal economy rises at a
slower rate, people may pay less than the official price (sales and second hand
purchases) and price rises hide improvements in products
Slight rise in prices can provide benefits Producer are encouraged to increase their
output since higher prices may lead to greater profits, firms can cut costs by not raising
wages in line with inflation which is a substitute for a cut in employment.
3. Economic Growth
o Increase in output in the short run Actual economic growth
Property of Kirit Narain

In the long run for sustainable economic growth, the productive potential has to increase
(increase in the quantity and/or quality of resources(FOP)) Potential economic growth
o To analyze economic growth aggregate demand (Consumption + Investment + Government
expenditure + net exports) and aggregate supply(total output of producers) diagrams are used. A
rise in aggregate supply indicates potential economic growth while a rise in aggregate demand
implies actual economic growth.
o Producing more goods and services can raise peoples living standards
o Governments want their economies to be working at full capacity and the actual economic
growth rate to coincide with the potential economic growth rate.
4. Redistribution of Income
o Seek to redistribute income from the rich to the poor since the more money someone has, the
less they tend to appreciate each unit
o Governments redistribute income by taxing the rich at a higher rate and then spending. Some of
the money is spent directly on the poor(unemployment benefits) while some of the other forms
of expenditure particularly benefit the poor who may not be able to afford goods and services
unless they are free of cost or at subsidized rates.
o Governments dont aim for perfectly even distribution of income since it acts as a disincentive to
effort and enterprise.
5. Balance of Payments Stability
o Countries want the value of their exports and imports to be equal
o If import expenditure exceeds export revenue then the country will be living beyond its means
and may accumulate debt.
o If export revenue is higher than import expenditure, the countries citizens will not be enjoying as
many products as possible.
o Sudden changes in the BOP can be disruptive to the economy.

Unit 32
Government macroeconomic policies
1. Fiscal Policy
o Changes in government expenditure(public expenditure) and taxation
o Public expenditure is spent on a variety of items benefits, education, healthcare, transport,
defense and interest on national debt.
o A budget statement outlines the amount of money a government plans to raise in tax revenue
and spend. A budget surplus means that public expenditure is higher than revenue therefore the
Gov will have to borrow to finance some of this. A budget surplus outlines that Government
revenue is higher than expenditure. In a balanced budget, public expenditure and revenue are
equal.
o Governments use a reflationary(expansionary) fiscal policy to reduce unemployment and
promote economic growth Reducing taxation and/or increasing expenditure raises aggregate
demand
o Governments use deflationary (contractionary) fiscal policies to reduce inflationary pressure
Reduction in expenditure and/or a rise in the rate of taxation. Reduces aggregate demand
2. Monetary Policy o Changes in the money supply through namely changes in the rate of interest
o A rise in the rate of interest helps to implement a deflationary monetary policy by increasing the
opportunity cost of saving and making borrowing more expensive thus reducing aggregate
demand. Firms and investors will also invest less. A deflationary fiscal policy helps to improve
the balance of payments.
3. Supply-side Policy
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Property of Kirit Narain

o
o

Measures designed to increase aggregate supply, thus productive potential


Increase the quantity and quality of resources and raise the efficiency of the market
Improving education and training raises productivity
Cutting direct taxes and benefits increases incentive to work
Reforming trade unions may increase labour productivity
Privatization may increase productive capacity if the private firms are more efficient

Government Microeconomic policies Deal with individual firms and industries


1. Subsidies
o Subsidies to infant industries and research grants to innovative firms
o Effect of subsidy depends on the size of the subsidy and PED. More inelastic the demand, greater the
quantity of the subsidy that is passed on to consumers. If PED is inelastic, the subsidy has more of an
impact on the price than the quantity sold while a subsidy on a product with elastic demand has
more of an impact on the quantity sold than the price
o There is an opportunity cost associated with the government granting a subsidy
2. taxes
o Protects domestic industries by imposing taxes on rival imported products
o Governments tax firm profit which has an impact on the willingness and ability of firms to invest
o Indirect taxes raises firms cost of production while direct taxes reduces disposable income
(therefore demand for products)
o Impact of tax is influenced by the size of the tax and the PED. More inelastic the demand, greater the
impact on the price than the quantity sold
o If a government wants to raise revenue it should tax products with inelastic demand while if it wants
to reduce the consumption of a product, it would be more successful if the product has elastic
demand
3. Competition policy
o Seeks to promote competitive pressures and prevent firms from abusing their market power
o Prevention of mergers that would be harmful to consumers
o Removal of barriers to entry and exit
o Regulation of monopolies
o Prohibition of uncompetitive practices
Predatory pricing Charging a price below cost of production to drive out other firms
Limit pricing setting the price low enough to discourage new firms from entering the
market
Price fixing Firms agreeing to charge the same high price
4. Price controls
o Limit ability of firms to set their own prices
o Maximum ceiling on price Has to be set below the market price to be effective
May create a shortage therefore a method of its allocation would have to be introduced to
prevent development of informal market
Designed to enable the poor to afford the product
o Minimum price Has to be set above the market price to have any effect
Designed to encourage production
Problem of surplus will be created that may have to be brought up by the government or
some other official body
Minimum price may be set on labour in the form of NMW
5. Environmental policies
o Designed to improve the environment
o Restriction on the amount of pollutants emitted by firms into land,air or sea. Firms are fined if they
exceed this limit
o Tradable permits Firms are allowed to pollute up to a certain limit and sell the unused portion of
this limit. Reduces costs of the cleanest firms and increases costs of the most polluting firms.
28
Property of Kirit Narain

6. Regulations
o Rules and laws that place restriction on the activities of firms
o May regulate
The target audience of the product
The quality of the product
Mode of staff management
o Easily understood since they are backed up by law
o Government has to check that the regulations are being followed which is difficult and expensive
o Regulation only works if most people agree with it
o Regulations do not directly compensate those that suffer as a result of market failure
o May be too restrictive reducing market flexibility and creating barriers to entry
Private sectors

Built things demanded by the public sector


Provide services to the public sectors
Provide finance to the public sector
May be in partnerships with the public sector providing a part of a service

Unit 33
Conflicts between government aims

Reduction in unemployment and inflation


Balance of payments and economic growth

Unemployment and economic growth benefit from expansionary fiscal and monetary policies while inflation and
balance of payments benefit from deflationary fiscal and monetary policies
Priority

Relative scale of the problem


Consequences of the problem
Which problem the countries citizens are most concerned about

Supply side evaluation

All government aims benefit from supply side policies


Economy can grow in a non-inflationary way
Increases aggregate demand since it will involve government expenditure and workers may earn more
Reduces unemployment since workers should become more productive and occupationally mobile
Improves the countries BOP since they will produce better quality cheaper products
There would be a time lag before the effects of some supply side policies
May be expensive and no guarantee that they will work

Ways in which Governments can improve the economy

29

Supply side policy


Use a number of policies that address individual aims
Have as much and as accurate information as possible
o Size of the multiplier effect
Implement their policies relatively quickly a delay may harm the economy
Advances in technology
Increase global competition

Property of Kirit Narain

Unit 34
Aims of taxation

Raising Revenue to finance Government expenditure


Redistribute income from the rich to the poor Higher tax rates charged on the rich, some of which is spent
on benefits
Discourage consumption of demerit goods
Raise costs of firms that impose costs on others (eg pollution)
Discourage the consumption of imports to protect domestic industries Tariffs
Influence economic activity Fiscal policy measures

Direct Taxes
Levied on a person or firms income or wealth
People and Firms have to bear the entire burden of the
tax
Tend to be progressive or proportional

Indirect Taxes (Expenditure or outlay taxes)


Levied on expenditure
Atleast some of the burden of the tax can be passed
onto other people
Tend to be regressive

Types of Direct taxes

Income tax
o Charged on income people receive from employment or investment
o All income above the tax allowance is taxable
Corporation tax (corporate tax)
o Tax on the profit of firms
Capital gains tax
o Tax on the profit made on assets when they are sold for a higher price than what they were brought
for (eg shareholders)
o Exemptions are usually made such as the sale of peoples main residence
Inheritance tax
o Tax on wealth above a certain limit that is passed onto others when a person dies

Types of Indirect taxes

Sales tax
o Tax imposed when products are sold
o VAT (Value Added Tax) is levied on the value added by firms at each stage of production
Excise duties
o Charged on certain domestically produced goods alcoholic drinks, petrol and tobacco
Customs duties (Tariffs)
o Taxes on imports
Licenses
o License may be needed to use products such as a car

Local taxes: Taxes levied on a local basis and used to pay for local services such as education, fire services, libraries
roads and refuse collection
Types of local taxes
1. Business rates levied on the property of local firms and the revenue is then distributed based on the
number of people in each locality
2. Council tax Based on the value of peoples housing and expenditure
Nature of taxation
1. Progressive tax
30

Property of Kirit Narain

o Rate of taxation rises with income or wealth


2. Proportional tax
o Percentage of income payed in tax remains the same regardless of income or wealth
3. Regressive tax
o The percentage of income payed in taxes falls as income or wealth rises
Total amount of tax received rises in all cases with income or wealth

Unit 35
Tax base: source of tax revenue (things that are taxed)
A wide tax base can enable the tax rates to be low while if the tax rates increase, the tax base is likely to fall (firms
and people may move out of the country)
Tax base 1/ Tax rate
Tax burden: amount of tax payed by people expressed as a percentage of the countrys GDP
Incidence of taxation: Distribution of the tax burden of an indirect tax between producers and consumers

If demand is inelastic, most of the tax burden is passed onto consumers


If demand is elastic, producers have to bear a greater proportion of the tax burden
If supply is inelastic, producers bear most of the tax
If supply is elastic, consumers bear most of the tax burden

Qualities of a good tax

Equity Fairness in the sense that the amount of tax people and firms have to pay should be based on their
ability to pay.
Certainty Tax should be easy to understand and households and firms should be able to calculate of
amount of tax paid by them.
Convenience The tax should be easy to pay
Economy The cost of collecting the tax should be considerably less than the revenue it generates
Flexibility If should be possible to change the tax if economic conditions change or government aims
change. Some taxes (eg income and sales) are automatic stabilizers
Efficiency A tax should improve the performance of the market or atleast not significantly reduce it. (eg
Windfall tax charged on supernormal profits of banks)

Impact of direct taxes

If set too high my discourage effort, enterprise and saving


High rates may stop people from working overtime and taking promotions or prevent some from entering
the labor force, and entrepreneurs from expanding and investing
High tax rates may however encourage those with fixed financial commitments to work harder
High taxes reduce the return from savings hence target savers would have to save more
Can redistribute income and wealth
Act as automatic stabilizers
Good source of tax revenue in with an organized labour market, high literacy rates and high incomes

Impact of indirect taxes

31

Since they tend to be regressive, they fall more heavily on the poor
Indirect taxes may raise prices, setting of a trend of rising prices (workers want to maintain their real
disposable income) Inflation
Indirect taxes are relatively easy and cheap to collect since firms do some of the work
Act as less of a disincentive to effort and enterprise than direct taxes
Property of Kirit Narain

Can be used selectively to achieve certain government aims


Harder to evade
Easier to adjust
People have a choice, the amount of tax payed by them depends upon the products they purchase.
Useful source of income in countries where there is a large informal sector and with low literacy rates

Flat taxes: Income tax, corporation tax and vat being set at the same rate with no exceptions (proportional tax)
Evaluation of flat taxes

Simple to administer for governments and firms


Less incentive to avoid paying taxes
Promotes hard work and enterprise
However have a slight regressive nature

Unit 36
Price indices Seek to calculate the changes in price products that are generally brought by consumers
Stags of constructing a price index
1. Selecting a base year A relatively standard year in which there were no dramatic changes. The base year is
given a figure of 100 (100%)
2. Finding out how households spend their money Decide what items to include in the price index
o Carry out surveys of household expenditure
o Attach weights to items The percentage of income spent on the product
3. Finding out price changes Obtained from
o Shops
o Post offices
o Power companies
o Train companies
4. Constructing a weighted price index Multiply weights of products by the new price index for each category
of products to calculate the change in general price level.

Unit 37
Types of inflation
1. Cost-push inflation
o Price level is pushed up by increases in the cost of production
i. Labour wages rising more than productivity wage-price spiral
ii. Increases in the cost of raw materials
iii. Increases in indirect taxes
iv. Higher cost of capital goods
v. Increase the profit margins by firms
2. Demand-pull inflation
o Price level is pulled up due to excessive demand
i. Consumption
ii. Investment
iii. Government expenditure
iv. Net exports
o Demand-pull inflation only occurs if aggregate supply cannot rise in line with aggregate demand
i. Full employment of resources
3. Monetary inflation
o Excessive demand caused by an excessive growth in the money supply
32

Property of Kirit Narain

Monetarists believe that the only cause of inflation is the money supply growing more rapidly than
output

Effects of inflation are dependent on


1.
2.
3.
4.

Its rate
Stability of price rises
Rate relative to other countries
Response of the government

Harmful effects of inflation

The fall in the value of money may lead to a reduction in confidence


Redistributes income in an unplanned way
o Borrowers benefit while savers loose out less is paid back in real terms
o Workers with low bargaining power and those with fixed incomes loose out
Extra costs imposed on firms
o Staff time will be taken up calculating future prices
o Menu costs costs of changing prices in catalogues, price lists etc
o Shoe-lather costs Money paid to firms will be losing value therefore it will take time and effort to
place the money in financial institutions that pay a rate of interest higher than the rate of inflation.
Uncertainty
o Difficult to plan ahead
o Hard to judge the right prices to be paid
o Firms may be discouraged from investing
Harm the countries balance of payments position
o Countries products become less competitive
o Fall in export revenue and rise in import expenditure
o Rise in unemployment within the country as a result
Fiscal drag
o When governments do not adjust tax brackets in line with inflation therefore people get slotted into
a higher bracket and taxed more.

Beneficial effects of inflation

Low and stable inflation may encourage firms to expand as they will be attracted by higher prices higher
profits
Reduces the burden of debt thus preventing households from going bankrupt
Firms can simply not raise workers wages in line with inflation rather than make them redundant

Causes of deflation

Supply side deflation Beneficial


o Advances in technology
o Increases in labour productivity
Decline in aggregate demand Harmful
o Consumers expecting prices to be lower in the future may postpone their purchases
o Firms are likely to reduce their output leading to unemployment and further reduction in aggregate
demand

Consequences of deflation
1. Supply side deflation
Reduce current account deficit (increase surplus)
Increases in output and employment
2. Demand side deflation
33

Property of Kirit Narain

Rise In unemployment and lower output


Discourage investment and reduce productive capacity
3. Burden of debt increased but lenders will gain more back in real terms
4. Increases the purchasing power of money

Unit 38
Workers need to be occupationally and geographically mobile because at any given time some industries will be
declining whilst others expanding
Reasons for working part time

Fits with their childrens school hours


Enable them to look after elderly relatives
Can pursue other interests
Not able to find full time jobs

Organized sector
Have access to social security benefits, employment
protection and rights
Can be part of union and collectively bargain
Can be self employed or employees
Pay income tax
Tend to have higher productivity and wages

Unorganized sector
Do not have the same access to social security benefits,
employment protection and rights
Does not include unions
Some are Self employed, migratory workers and casual
workers
Do not pay income tax
Tend to have lower productivity and wages

High quality employment Skilled work that is interesting and provides people with good working conditions etc
Low quality employment Unskilled work that consists of poor working conditions, no training etc
Privatization: Selling of SOEs to the private sector
Public sector workers usually have more job security and other non wage benefits but their productivity tends to be
lower.
Flexible Employment
Labour force adjusts quickly and smoothly to changes in market conditions
1. Numerical flexibility Easy to hire and fire workers in order to adjust output.
o Decreases job security
o Increases employment since firms will hire more people if they can be made redundant if market
conditions change
2. Temporal flexibility Ability to change the number of hours people work
3. Locational flexibility - Ability to change the location where people work
4. Functional flexibility Ability to change the tasks workers perform
5. Wage flexibility Ability to change the wages of workers
Both employment and unemployment can increase if the labour force increases in size
Unemployment can fall without a rise in employment if the unemployed reach retirement age, go into full time
education, emigrate or simply stop searching for work.
Size of labour force is influenced by
1. Population of working age people
o Birth rate
o Death rate
34

Property of Kirit Narain

o Immigration/ emigration
2. Labour force participation rate Proportion of people of working age that belong to the labour force
o The wages on offer
o Social attitudes to working women
o Provision of care for children and elderly
o Social attitudes and provision for the disabled to work
o Proportion of school leavers who go for higher education
Employment rate = Number of people in employment / Labour force

Unit 39
Measures of unemployment
1. Claimant count Count those in receipt of unemployment related benefits
o Cheap and quick since the information is gathered by the government anyway
o Tends to understate unemployment since not everyone unemployed at the given time would have
registered for benefits Those on training schemes, people who stay on at school and those that are
forced to retire early.
2. Labour force surveys
o Can be used to make international comparisons
o Captures unemployment more accurately
o However the sample of labour force needs to be representative of the labour force as a whole
o Takes longer and is more expensive as compared to the claimant count
Causes of unemployment
1. Frictional unemployment Workers have to wait some time before joining another job after being fired
from the first
a. Search unemployment Workers do not accept the first job on offer, instead spend time looking for
an acceptable job
b. Casual unemployment People are out of work between periods of employment (eg actors)
c. Seasonal unemployment Labour is not in demand in certain times of the year (eg tourism industry)
2. Structural unemployment Decline of industries arising from long term changes in demand and supply
i. Another country becomes better at producing the product
ii. Substitute for the product is found
iii. Labour being substituted by capital
a. Regional unemployment Unemployment concentrated in one area
b. Technological unemployment Workers are made redundant as a result of ICT
o Persists for longer period than frictional
o Usually affects more workers
Labour immobility (occupational and geographical) plays a key role in the extent of structural and frictional
unemployment. Measures to reduce structural and frictional unemployment involve making labour more
occupationally and geographically (education and training) and increasing the incentive to work (cutting direct taxes
and benefits). Also governments try to encourage firms to move to areas of high unemployment.
3. Cyclical unemployment (demand deficit unemployment)
o More harmful than structural or frictional
o Spreads throughout the economy
o Unemployment decreases the aggregate demand which further causes unemployment
Government will seek to raise aggregate demand (expansionary fiscal and monetary policy)
Consequences of unemployment
35

Property of Kirit Narain

Easier for firms to expand since they can easily employ new workers
Keeps down inflationary pressure by lowering wage rises
Unemployed experience a fall in income and a loss of self-worth that can affect their mental and physical
health, relationships and the children of the unemployed are likely to be worse educated. The longer they
are unemployed, the more difficult it is for them to find a job due to losing out on training in new methods
and technology, lose the work habit and their confidence may dip.
Imposes opportunity cost on the economy since there will be under production, therefore living standards
will also be lower.
Government tax revenue would be lower than possible since reduced revenue from direct taxes (income and
firms profit would fall) while due to the lower demand, indirect tax revenue will also fall.
Puts pressure on government expenditure Opportunity cost
Potentially rising levels of crime

Unit 40
GDP (Gross domestic Output) The total output of an economy.
Circular flow of income: Income Expenditure Output Income
Methods of measuring GDP
1. Output method
o Adding up all the output produced by the countries industries
o To avoid counting outputs multiple times (subsidiary industries), economists include the value added
by each firm at every stage of production
2. Income method
o All income which has been earned in producing a countries output
o Transfer payments are not included since nothing has been produced in exchange for them
3. Expenditure method
o Adding up all expenditure on the countries finished output
o Expenditure = GDP = Consumption, Government expenditure, investment, net exports
Value added: Difference between sales revenue received and the cost of raw materials used (profit)
Nominal GDP (Monet GDP or GDP at current prices) is not adjusted for inflation.
Real GDP (GDP at constant prices) = Nominal GDP * Price index of base year / Price index of current year
Real GDP per capita (head) = Real GDP / Population
It is difficult to accurately measure GDP because of the informal economy

Undeclared economic activity Hidden, Shadow or grey economy


o Illegal activities eg drug dealing
o Work undertaken by illegal immigrants
o People dont want to pay tax on the activity
Size
o Number of activities that are declared to be illegal
o Tax rats
o Penalties for tax evasion
o Number of tasks people perform for themselves
o Size of subsistence agriculture
Tax revenue is below what is possible
Official inflation rate overstates actual inflation since prices in the informal economy rise at a slower rate

Causes of Economic growth


36

Property of Kirit Narain

In the short term a rise in aggregate demand may stimulate a rise in output if the economy has unused
resources.
In the long term for a country to continue experiencing economic growth, there needs to be a rise in the
quantity and quality of resources
o Net investment and an increase in the labour force will increase quantity
o Improvements in education and advances in technology would raise the quality of resources

Consequences of Economic growth

Increase in output would raise living standards Better healthcare, superior education, luxury items etc
Increases government tax revenue which can be spent on reducing poverty (benefits and
education/training), increase healthcare provisions, improve education
Political and economic standing of the country improvise
If the economy is working at full capacity, some resources would have to be switched to making capital
goods which would reduce living standards in the short run
Higher output can increase pollution, lead to depletion of non-renewable resources and damage the natural
environment
Greater stress on workers to produce more, work for longer hours, learn new skills and some may have to
change their job
Impact is influenced by its rate, means adopted to distribute it and the distribution of its benefits
If productive capacity does not increase in line with aggregate demand, there may be inflation
Stable economic growth increases confidence and encourages investment
Some of the resources can be used to reduce levels of pollution, people may pressurize the government to
follow environmentally friendly policies
If the distribution is unequal than some people may actually be worse off
Some of the products produced may actually harm living standards (eg Tobacco)

A fall in the economic growth rate still means more is being produced, when output falls the economic growth rate
would be negative
Recession: Real GDP declines over a period of 6 months or more Decrease in aggregate demand and/or Supply

Unemployment would rise


Lower living standards
Investment would be discouraged

Unit 41
Real GDP per head as an indicator of Living Standards

An increase in Real GDP per capita suggests that living standards have risen
Real GDP per capita is an average and not everyone may equally receive a rise in income
More goods and services would certainly be produced but not all of these add to peoples living standards.
For eg tobacco
Real GDP may understates the level of economic activity due to the presence of an informal economy.
Alternatively Real GDP may overstate economic activity if the quality of output is falling
Living standards are affected by other factors apart from material goods and services (working conditions,
working hours, pollution etc)
Real GDP takes into account inflation and population size therefore is useful

Using an unadjusted currency to compare Real GDP may give misleading results therefore purchasing power party is
more suitable which considers the buying power of a currency in its home country.
Human development Index
37

Property of Kirit Narain

Considers real GDP per head, life expectancy at birth and education (mean years of schooling and expected
years of schooling)
Countries are categorized into very high HD, high HD, medium HD and low HD
Doesnt take into account political freedom and environment. Also it does not consider differences in life
expectancy, education, and differences in income between population compositions.

Index of sustainable economic welfare

Adjusts personal consumption for unequal income distribution then makes a number of deductions and
additions.
Items deducted include those that reduce current or future economic welfare (social and environmental
costs)
Items that make a positive contribution to current or future economic welfare are added (net capital
investment, government expenditure, infrastructure, volunteer work etc)

Multidimensional poverty index

Based on deprivations in education, health and standard of living


Household surveys are taken about health, education and standards of living

Gender inequality index

Considers gender based disadvantages in terms of reproductive health, empowerment and the labour
market
Health is measured in terms of maternal mortality rate and adolescent fertility rate
Empowerment is measured by the percentage of seats in the national parliament held by women and
relative percentage of men and women with at least secondary education
Labour market is assessed by comparing the labour force participation rate of men and women

Happy Life Expectancy Index

Found by measuring life expectancy at birth by average life expectancy

Unit 42
Economic development : Economic growth(Improved material living standards) + Reduction in poverty, expanding
the range of economic and social choices and increasing freedom and self-esteem
Developed economies

High incomes
High living standards
A large proportion of workers employed in the tertiary sector
High levels of productivity
High levels of investment

Measures of development
1. GDP per capita - Only Material living standards
2. Human Development Index More comprehensive
Characteristics of Developing economies

38

Low incomes per head (possibly large income inequality)


Low levels of saving due to low income
Low life expectancy and high infant mortality rate
High rates of population growth High dependency ratio
Low levels of education and healthcare Poor productivity
Property of Kirit Narain

Low levels of capital goods and poor infrastructure Poor productivity


Poor housing and sanitation
Relatively high number of workers, employed in the primary sector
Concentration on a narrow range of exports (Most of which are primary products) Vicious circle of poverty

Vicious cycle of poverty: Low Incomes Low saving Low investment Low productivity
Seeking to achieve development

Economic growth Higher living standards


Distribution of income should not be too uneven so that everyone can experience better living standards
Poor will be better off - Greater productivity and reduction in pollution
Virtuous circle Income and education Savings and investment Productivity Income

Unit 43
Uneven distribution of income

Uneven holdings of wealth Generates income


o Differences in assets inherited by people
o Savings Wealth creates wealth
o Entrepreneurial skills
Differences in the composition of households More people to earn, higher the income
Differences in ability to earn Skills, qualifications and number of working hours

Wealth: A stock of assets that have financial value Shares, Government bonds etc
Even distribution of income

Uneven distribution may be socially devices


Everyone has access to certain standards of living

Government influence on Distribution of income

Taxation Progressive taxes make distribution more even


Provision of cash benefits Help maintain a reasonable standard of living
Provision of free state education and health care Everyone has access to these essential services,
opportunity to improve their living standards
Using labour and macroeconomic policies Minimum wage, legislation, regional policy, measures to reduce
unemployment

Poverty
1. Absolute poverty people do not have access to basic food, clothing and shelter
2. Relative poverty people are poor relative to others and are unable to participate fully in the normal
activities on the society they live in
Reduces productivity, employment opportunities and income and will affect the prospects of their children
Reasons for poverty
o Unemployment
o Low paid work
o Falling ill and growing old
Policy measures to reduce poverty

39

Improve the quantity and quality of education Supply side policy


o Increases the job prospects and earning potential of the poor and their children
Increasing aggregate demand Expansionary fiscal and monetary policies
o Increases output thus benefiting economic growth
Property of Kirit Narain

Introducing or raising a national minimum wage To tackle low wages


Encouraging more MNCs to setup in the country More employment opportunities
Providing benefits or more benefit state benefits
o Helps to avoid absolute poverty
o May help people in the short term and raises aggregate demand
o Can act as a disincentive to effort
Land reform Give land to farmers so that productivity is increased (they will make their own land more
fertile)

Measures to raise living standards

Measures to reduce poverty Higher output and productivity


Improving healthcare, increasing and improving housing stock, improving working conditions and reducing
pollution
Private sector (Reducing government regulation and taxation) or public sector (legislations)

Lorenz curve measures income inequality through calculating the cumulative % of income and comparing it with the
cumulative percentage of the population

Unit 44
Causes of population growth
1. Natural increase Birth rate exceeding death rate
Birth Rate o Average age of the population
o Number of women in the population
o Womens fertility rate (Number of children per women)
1. The age at which women marry
2. The number of women pursuing higher education
3. The labour force participation rate of women
4. The socio-economic status of women
5. The availability of family planning services
6. Availability of government support for families
7. Cost of bringing up children
8. Provision of benefits for the sick and elderly by the government Lack of care would
mean that women stay at home = have more children. Also families would not need
children to support them in their old age.
Death Rate
o Nutrition
o Housing conditions
o Medical care
o Lifestyles
o Working conditions
o Involvement or non-involvement in military action
2. Net immigration More people come into the country to live (immigrants) than people who leave the
country to live elsewhere(emigrants)
o Relative living standards at home and abroad
o Persecution of particular groups
o Extent of control on the movement of people
Sex Distribution

40

Preference in gender
Differences in infant mortality rate of males and females
Property of Kirit Narain

Differences in emigration patterns of males and females

Population pyramids show the age distribution of the countrys population. For a developing country it would be
pyramid shaped (High birth and death rate) while for a developed country it would be more oblong shaped (Reduced
birth rate and death rate)
Dependency ratio = Number in dependent age groups / number in the labour force * 100
Dependents include those below school leaving age and those above the retirement age
Optimum population: The number of people that when combined with the other resources of the country (Land,
capital and technical knowledge) give the maximum output per head of the population.
Overpopulation: Shortage of resources relative to the population size
Under population: country does not have enough human resources to make the best use of its resources
It is difficult to determine the optimum population because the quantity and quality of resources are changing all the
time.
Malthusian theory of population

Population grows at a geometric rate while food production grows at an arithmetic rate
Checks are needed to keep the population within its means of subsistence
o Positive checks (cause the death rate to rise) Epidemics, famine, infanticide and wars
o Preventive checks Moral restraint and contraception
Technology proves this to be false
Overlooks the fact that consumers are also producers

Unit 45
Consequences of a growth in a countries population depend on its

Cause
Size of population relative to optimum population
Rate of population growth

Benefits of an increasing population

Better utilization of resources if the population was previously below the optimum size
The size of markets will increase Firms can make use of economies of scale
Increase in factor mobility If caused by an increase in the birth rate or immigration since they are likely to
be occupationally and geographically mobile. Training costs will be reduced
Extra demand will be generated Stimulate investment and development of new technology
Rise in the labour force Higher dependency in the short term

Disadvantages of an increasing population

41

Concerns about famine If country is currently overpopulated and agricultural production is low they may
not be able to feed more people
Restrictions on improvements in living standards Resources would have to be diverted away from
improving living standards to producing essential goods and services
Overcrowding Pressure on housing and social capital and cause traffic congestion
Environmental pressure Damage to wildlife, water shortages and depletion of non-renewable resources
Pressure on employment opportunities Gov will have to spend more on education and training, surplus of
labour may occur.
Balance of payment pressure Increase in imports and diverting exports back to the home market.
Property of Kirit Narain

Ways of reducing the birth rate


1. Reduce immigration
2. Reduce the countries birth rate
o Improvement of educational and employment opportunities for women
o Better information and increased availability of family planning services
o Improvement of health care and nutrition reduces infant mortality and birth rate since people will
be less concerned about their childrens survival
o Setting up pension and sickness insurance schemes Reduces need for childrens assistance during
old age
o Raise the cost of having children raise school leaving age, stop any financial support
o Incentives for families who restrict the number of children
o Most extreme measure Restrict the number of children per family
Consequences of an aging population

Rise in the dependency ratio


A change in the labour force Old would be geographically and occupationally less mobile but may be
experienced, reliable and patient
Higher demand for health care Opportunity cost
Greater need for welfare schemes
Rising cost of state and private pensions
Change in the pattern of demand Housing for retired people will rise while that for toys will fall

Ways of coping with an ageing population

Raise the retirement age Workers would be more healthy and earn more income to be able to save for
retirement, also raises tax revenue and reduces pensions
Encourage or make it compulsory for workers to save for their retirement
Raise the productivity of workers through education and training
Encourage immigration of younger skilled workers by issuing work permits Reduce the dependency ratio
in the short term

Internal Migration Workers migrate from rural to urban areas

Supply growing industries


Better allocation of resources
Raise living standards in rural areas if there was overpopulation and if they send money back to relatives
If productive workers migrate, agricultural productivity may fall
May be overcrowding, congestion and increased pressure on social capital in urban areas

Effects of Net Emigration

Size of working population would be reduced Most emigrants tend to be of working age
Remaining labour force will have greater burden of dependency
The average age of the population will increase less mobile
The sex distribution of the population will be affected
Shortage of a particular skill if workers from a particular category emigrate
Under utilization of resources Under population
Emigrants may send money home to their relatives

Unit 46
Problems facing developing economies

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Property of Kirit Narain

High growth of population Resources have to be diverted to producing necessities rather than increasing
the productive potential and living standards
High levels of international debt Large proportion of income is taken up repaying previously borrowed
loans.
Reliance on the export of primary products Price of primary products tends to fall with time relative to
manufactured goods so the country spends more on imports but receives less export revenue. Developing
countries use their buying power to keep down prices of primary products. Primary products supply is
heavily influenced by the climate and availability of natural resources.
Lack of investment in human capital and capital good Holds back increases in productivity, introduction of
new technology and international competitiveness.
Emigration of key workers They seek better paid employment abroad
Trade restrictions on their products Cant sell their products abroad on equal footing therefore are
discouraged from building up industries.
Unbalanced economy Underdevelopment in certain sectors.

Measures to promote development

Import substitution
o Protection of domestic industries against foreign competition
o If successful should increase domestic output, employment and improve the countries balance of
trade
o May raise prices and reduce choice
o Other countries may retaliate and put up their own import laws
o Domestic industries may become reliant on government support without seeking to increase
efficiency
Exposing domestic firms to market forces
o Firms will be forced to become efficient
o Foreign firms may be big, experience economies of scale and consumer loyalty therefore domestics
firms may not be able to compete.
Improve the countrys infrastructure, capital stock, education, training and health care systems Supply side
policy
o The government may lack revenue to do this
o Attract MNCs
Increase employment and wages
Train and educate workers
Bring in new technology
Improve infrastructure
MNCs may deplete non-renewable resources
Cause pollution
Put pressure on governments to follow policies that harm economic development
o Borrowing from abroad
Useful if funds are used to increase productivity and earn significantly higher incomes in
order to repay the loan
High interest rates may make borrowing unviable
Countries may accrue debt
Money may be lost due to corruption and spending on unprofitable projects
o Foreign aid
Can create economic and political dependency
Postpone necessary reforms
Bring in inappropriate technology
Corruption if used for unprofitable projects

Foreign aid
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Given because
o Desire to help people
o Win political support
o Gain a commercial advantage
Tied aid Receipt can only spend the money on specific products (eg from the donor country)
Bilateral aid From one government to the other
Multilateral aid Channeled through international organizations
Forms
o Grants which do not require repayment
o Loans charged on favourable terms
o Supply of goods, services, technical assistance and guidance
More likely to promote development if it is generous, multilateral, untied and geared towards the needs of
the recipient

Effect on the development of one economy on other countries economies

Improvement in one economy generates tax revenue which can be spent as foreign aid
Increased aggregate demand for the other countries productions
Setting up of units in foreign countries
Development of education may make population more concerned about other economies Tourism and
foreign aid
Investment in other economies

Unit 47
Balance of payments: A record of economic transactions between one country and the rest of the world over a
particular period of time.
Credit: Money coming into the country
Debt: Money going out of the country
Sections of the balance of payments1. Current Account Income earned by a country and expenditure made by it in its dealings with other
countries.
a. Trade in goods
o Exports and imports of goods
o Visible exports and imports or merchandise exports and imports
o If revenue from exports > Expenditure on Imports = Surplus
o If Revenue from exports < Expenditure on imports = Deficit
b. Trade in services
o Records payments for services sold abroad and expenditure on services brought from
foreign countries
o Invisible balance
o If Services receipts > Payments for services = Surplus
Together the first two parts give balance on trade in goods and services

44

c. Income
o Compensation for employees wages, salaries and other benefits earned by residents
working abroad minus compensation paid to foreigners working in the country
o Investment Income Profits, dividends and interest receipts from abroad minus investment
income paid abroad
Direct Investment income
Portfolio investment income
Property of Kirit Narain

Interest earned from loans


d. Current transfers
o Transfers of money, goods or services which are sent out of the country or come into the
country not in return for anything else.
o Gifts, charitable donations, aid from a government and money sent to relatives.
Current account surplus: Value of credit items > Value of debt items
Current account deficit: Value of credit items < Value of debt items.
2. Capital and Financial accounts
a. Capital Account
o Funds brought in and sent out of the country immigrating/emigrating
o Transfer of funds associated with the acquisition or disposal of fixed assets
o Purchase and sale of patents
b. Financial Account
o Much larger than the capital account
o Records transactions in assets and liabilities
Direct investment Purchase and sale of businesses or establishment of new
businesses
Portfolio investment Purchase of shares and government bonds
Other investment trade credits and loans
3. Official Reserves
a. Items held to settle debts with other countries
b. Foreign exchange, Drawing rights at the IMF, reserve position at the IMF and gold
4. Net errors and omissions
o If everything in the balance of payments has been recorded correctly, the credit items
should match the debt items A current account deficit would be matched by an equal
surplus on the capital and financial account
o Balancing items are recorded in order to make the BOP balance
Causes of financial account deficit Investment abroad is greater than foreign investment coming into the country in
a year

Domestic firms may setup in foreign countries


o Lower tax rates
o Lower costs of production
o Expanding markets
o Good factors of production
o Government subsidies
Buy foreign shares
o Profit levels and dividends are high abroad
Buy foreign bonds and lend to foreign companies and individuals
o High foreign interest rates

Consequences of financial account deficit

In the short term money is leaving the country and potential jobs and incomes are lost to the foreign
economy
In the long term the investment should generate income in the domestic economy

Unit 48
Internal Trade
Within the country
45

International Trade
Exchange of goods and services between countries
Property of Kirit Narain

Smaller market
Source products only from the domestic market or
import them.
Shorter distances so reduced transport costs
Likely to be the same language Not necessarily
Same culture
Unlikely trade restrictions thus reduced prices
Less competition Can establish monopolistic power
Dont have to deal with foreign currency Confidence
and reliability
Pattern of international trade

Can reach a wider market


Take greater advantage of economies of scale
Source products from a wider area
Products have to travel greater distances
May have to deal with different languages (Increased
cost of advertising and pamphlets)
Differences in culture will have to be taken into account
Trade restrictions may make it difficult for firms to sell
their products abroad
Exposes firms to more competition May become
efficient or struggle to survive
Have to deal with foreign currency Exchange rates
fluctuate

Seek to buy from countries with good quality products at a low price and sell to countries with a high and
stable demand
Trade with countries close to them in tastes, development and sometimes geography
Trade with countries who share historical links with the source country
Most trading takes place between developed countries in high quality finished manufactured products
Destinations of exports are also the main source of imports for many countries

Changes in Exports and Imports

The countrys inflation rate A high inflation rate would increase imports and reduce the competitiveness of
domestic exports.
The countries exchange rate- A fall In the exchange rate will reduce imports (more expensive) while
increasing exports (cheaper)
Productivity The more productive a countrys resources are, the lower cost per unit. Therefore exports
would increase and imports would fall
Quality A rise in quality would raise exports and reduce imports
Marketing The more effective the firm is at marketing their products, the more would be sold (Exports
while imports )
Domestic GDP If domestic incomes rise, imports would rise and exports fall (They would be diverted to the
home market)
Foreign GDP If foreign incomes rise, exports would increase
Trade restrictions An increase in trade restrictions would make the countries products more expensive,
hence exports would fall.

Causes of a current account deficit


1. Cyclical deficit low incomes abroad and/or high incomes at home
2. A high exchange rate Exports are expensive while imports cheap
3. Structural problems High costs of production, poor quality products, problems in manufacturing and
strategies adopted to market them
Consequences of a current account deficit

46

Country would be living beyond its means


Reduction in inflationary pressure Low domestic aggregate demand
Output and employment is lower than what is possible
Significance depends on its
1. Size small deficit would not cause much problem
2. Duration if it lasts for a short time it would not be too significant
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3. Cause
Self-correcting
o Import of raw materials and capital goods Would be used to produce at a low cost
o High exchange rate Exchange rate would fall due to increased imports (Supply of
currency would increase)
o Changes in income (Domestic or abroad) Recessions abroad will not last
Serious cause
o Lack of international competitiveness - Structural problems; The government may
have to introduce supply-side policies
Causes of a current account surplus
1.
2.
3.
4.

A low exchange rate Exports will be cheap and imports expensive


High quality of domestically produced products
High incomes abroad
Low costs of production Internationally competitive

Consequences of a current account surplus

Rise in real GDP and higher employment High aggregate demand


More money will come into the country than will leave it Consuming fewer products than it is producing
May result in an appreciation in a floating exchange rate

Unit 49
Countries specialize on those products that their resources are best at making
Advantage of specialization of countries

Higher output Throughout the world consumers can enjoy more goods and services Better living
standards
Lower costs Countries can take advantage of economies of scale by producing a high output and can also
buy raw materials from specialist firms.
Spread of ideas and technology Specialization means countries have to trade
Increase in competition Efficiency and choice

Disadvantages of specialization of countries

There can be a decrease in demand Other countries may become better at producing the product or a
substitute for the product may be developed
There may be supply side products Eg primary products are affected by environmental conditions
Interdependency Countries depend on other countries and this supply may be cut of due to natural
disasters or wars
Trade restrictions Exports may become difficult to sell abroad

Absolute advantage: Country can produce the product using fewer resources than other country
Comparative advantage: Country can produce the product at a lower opportunity cost than other countries.
Changes in comparative advantage

Discovery of new sources of minerals


Country makes is land more fertile
Adoption of new technology
Increased productivity of workers through improved education and training

Terms of trade: The rate at which one countries products are exchanged for those of other countries 47

Property of Kirit Narain

Terms of trade = 100

An improvement occurs if export prices rise relative to import prices Quantity of exports will be exchanged
for a greater quantity of imports

Impact of changes in terms of trade

If export prices rise due to an increase in demand, the country can afford more imports
If export prices rise due to inflation, less quantity would be sold; lower export revenue; country can afford
less imports

Unit 50
Exchange rate: Price of one currency in terms of another currency (or currencies)
Exchange rate index: Price of one currency in terms of a basket of other currencies, weighted according to their
importance in the countries international transactions
Effect of changes in the exchange rate on export and import prices

A rise in the exchange rates would reduce import prices (in domestic currency) and raise export prices (in
foreign currency)
Therefore demand for the countrys exports will fall and its effect on revenue will depend on the PED for the
exports. Most exports have elastic demand due to lots of competition.

Fixed exchange rate

Value is fixed against another currency (or currencies) and is maintained by the government
If the price is being pushed down, the government can buy up some of the currency using foreign currency
or raise the rate of interest (Increasing demand & reducing supply). If the price is being pushed up the gov
can reduce interest rates and increase the supply.
Creates certainty Know the exact amount of money that will be received
Government may have to use up considerable amount of foreign currency and use macroeconomic policy
measures
Devaluation Decreasing the value of a fixed exchange rate
Revaluation Raising the fixed exchange rate

A floating exchange rate

Determined by market forces


Appreciation Rise in the value of the currency
Depreciation Fall in the value of the currency
Helps to automatically eliminate a current account deficit Surplus of currency Exchange rate will
depreciate Raises import prices and reduces export prices
Government can focus on other objectives
Exchange rate can fluctuate, making it difficult to plan ahead

Reasons why currencies are traded


Demand
Purchase of domestic goods and services
Foreign based domestic firms sending money back
Investment income earned from foreign assets and liabilities
Foreign investment in the domestic country
Transfer payments to the domestic countries
Foreign governments wanting to hold domestic currency reserves
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Bullish Speculators buying the domestic currency in anticipation that the exchange rate will
appreciate/revaluate

Supply

Purchase of foreign goods and services


Domestic based foreign firms sending money back
Investment income paid to foreigners
Transfer payments to foreign based individuals/firms/governments
Domestic Investment in foreign economies
Domestic government holding foreign currency as reserves
Bearish speculators selling the currency

Foreign currencies are traded with domestic currency An increase in demand for foreign currency, raises supply of
domestic currency

Unit 51
Changes in the Exchange Rate

Due to Changes in the current account balance Surplus would cause a rise in the exchange rate
Direct and portfolio investment Increases in investment in the country will cause price to rise
Speculation Speculators will act in such a way to materialize their expectations
Government action
o Buying and selling the currency Limited foreign currency in its reserves
o Raise the rate of interest attracts hot money flows (transferred around the world to take
advantage of interest and exchange rates)
o Measures to increase exports and reduce imports

Consequences of a change in the exchange rate

Affects exports and imports


May influence economic growth and employment A fall in the exchange rate raises aggregate demand for
domestic products
Inflation A fall in the exchange rate will
o Increase imported raw material costs and finished product prices
o Reduces pressure on firms to keep price rise to a minimum in order to remain competitive

Measures to correct current account deficit

Expenditure switching measures Make domestic and foreign citizens buy the domestic countries products
rather than foreign products. Eg Tariffs
Expenditure reducing measures Reduce demand for products in general Reduces imports and forces
domestic firms to export more. Eg Interest rates, income tax and indirect taxes
Supply side policy measures Long run Raises labour productivity, reducing costs of production and raising
quality

International Competitiveness

49

A country is internationally competitive when it provides goods and services demanded by consumers at a
price acceptable to them
Indicators
o Economic growth rate
o Share of world trade
o Level of expenditure on research and development
o Quantity and quality of education and training
Property of Kirit Narain

o State of the countrys infrastructure


In the short term changes in exchange rate and inflation rate influence international competitiveness A fall
in both improves competitiveness
Changes in productivity have a long lasting effect Achieved through supply side policies

Unit 52
Benefits of Free Trade

No restrictions on the products brought by firms and consumers from abroad or sold by firms to other
countries and no imposition of special taxes
Countries can concentrate on what they are best at producing Efficient allocation of resources through
exploiting comparative advantage.
Firms can take advantage of economies of scale
Increased competition Forces efficiency
Cheaper access to high quality raw materials and components
Greater choice of products for consumers

Protectionism: Protection of domestic industries from competition posed by foreign industries


Methods of protectionism

Tariff (Custom duty or import duty)


o Tax on imported products To discourage consumption
o Tariff will be set at a rate that makes the foreign products more expensive than domestic products
A quota
o Limit placed on the quantity of a good that can be imported
Embargo
o Complete ban on the import of a product or trade with another country
Exchange control
o Restrict the availability of foreign currency
Quality standards
o Requires imports to reach artificially high standards
o This will either dissuade foreign countries from selling their products in the domestic market or push
up the price of the products
Extensive paperwork
o Make foreign firms fill out a considerable amount of time consuming paper work in order to
persuade them to switch to other markets
Voluntary export restraints (VERs)
o Persuade government of exporting country to limit amount of exported units
Agree to the same
Threaten to impose tariffs or quotas if they do not agree
Subsidy
o Protect domestic industries by enabling them to sell at a price below that of foreign imports

Government may also stop exports if the country is experiencing shortages


Arguments for protectionism
1. Protection of infant industries
o New industries which have a potential to grow may be eliminated by foreign competition
o Through protection these industries can grow, experience economies of scale and become
internationally competitive
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2.

3.

4.

5.

6.

But there is risk that the domestic industry may become reliant on government protection rather
than seeking to improve efficiency
Protection of Strategic industries
o Industries essential to the survival of the country Defense, agriculture
o Risk that imports of these supplies may be cut off.
Protection from unfair foreign competition
o Protectionism to prevent dumping Firms selling at a price below the cost of production to drive out
other firms from the market
Protection of declining industries(sunset industries)
o If labour is immobile, the decline of a major industry can cause significant unemployment
o Through protectionism, these industries can gradually decline and workers can leave of their own
accord and protection can be removed
o But owners of the industry may resist the removal of protectionism
Protection of industries from low wage competition
o Low wages in foreign countries may imply low costs of production (keeping productivity constant)
therefore they can sell at lower prices.
o This should be self-correcting without the need for protection since higher demand is likely to push
up wages in foreign firms
o Also higher wages paid in domestic firms may be offset by higher productivity
Raising employment and improving the trade position
o Protectionism would reduce imports hence increase domestic aggregate demand and
employment/wages
o There is a high risk of retaliation from foreign countries Will then sell fewer exports
o Restricting imports of raw materials may harm domestic firms cost of production

Disadvantages of protectionism

51

Lower choice
Higher prices
Inefficiency
Retaliation

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