Economics Book United World College Mostar

UWC IN MOSTAR: BLUE BOOK ECONOMICS NOTES
TABLE OF CONTENTS
UWC IN MOSTAR: BLUE BOOK ECONOMICS NOTES TABLE OF CONTENTS........................ 1

IB ECONOMICS SYLLABUS............................................................................................. 3
Section 1: Introduction to economics.............................................................................. 3
Section 2: Microeconomics............................................................................................. 3
Section 3: Macroeconomics............................................................................................ 7
Section 4: International economics ................................................................................. 9
Section 5: Development economics ...............................................................................12
SECTION 1: INTRODUCTION TO ECONOMICS................................................................14
1.1 Definitions of Social Science and Economics..............................................................14
1.2 Definitions of Microeconomics and Macroeconomics ..................................................15
1.3 Definitions of Growth, Development & Sustainable Development ................................16
1.4 Positive and Normative Concepts .............................................................................17
1.5 Ceteris Paribus .......................................................................................................17
1.6 Scarcity .................................................................................................................18
1.7 Choice ...................................................................................................................20
1.8 Rationing Systems ..................................................................................................24
SECTION 2: MICROECONOMICS....................................................................................29
2.1 Markets .................................................................................................................29
2.2 Elasticities..............................................................................................................34
2.3.H Higher Level: Theory of the firm...........................................................................42
2.4 Market Failure ........................................................................................................67
SECTION 3: MACROECONOMICS...................................................................................80
3.1 Measuring National Income .....................................................................................80
3.2 Introduction To Development ..................................................................................83
3.3 Macroeconomic Models ...........................................................................................88
3.4 Demand-Side And Supply-Side Policies .....................................................................96
3.5 Unemployment & Inflation ....................................................................................109
3.6 Distribution Of Income..........................................................................................125
SECTION 4: INTERNATIONAL ECONOMICS ..................................................................130
4.1 REASONS FOR TRADE ..........................................................................................130
4.1.H Higher Level Topics: Absolute and Comparative Advantage ..................................132
4.2 Free Trade & Protectionism ...................................................................................133
4.3 Economic Integration............................................................................................140
4.4 WORLD TRADE ORGANIZATION ............................................................................145
4.5 Balance Of Payments ............................................................................................147
4.6 Exchange Rates....................................................................................................149
4.7 Balance Of Payments Problems..............................................................................163
4.8 Terms Of Trade....................................................................................................170
SECTION 5: DEVELOPMENT ECONOMICS ....................................................................174
5.1 Sources of Economic Growth &/or Development .....................................................174
5.2 Consequences Of Growth ......................................................................................181
5.3 Barriers To Economic Growth & Development .........................................................184
5.4: Growth & Development Strategies ........................................................................202
5.5 Evaluation of Growth & Development Strategies .....................................................220
UWC in Mostar: Blue Book Economics Notes, page 1

IB COURSE OUTLINE
The following is the course outline used for students entering UWC in Mostar in
September 2007. The First Year outline was completed during the 2007-08 academic
year. A copy of the syllabus can be found after this outline with the Higher sections
designated with an H in the numbering system.
Course Outline for First Year Economics Higher: 2007-08

• Section 1: Introduction to Economics
• Section 2: Microeconomics
o Section 2.1: Markets
o Section 2.2: Elasticities
o Section 2.4: Market Failure
• Section 3: Macroeconomics
o Section 3.1: Measuring National Income
o Section 3.2: Introduction to Development
o Section 3.3: Macroeconomic Models
o Section 3.4: Demand-Side and Supply-Side Policies
• Section 4: International Economics

o Section 4.1: Reasons for Trade
o Section 4.3: Economic Integration
o Section 4.4: World Trade Organization
• Section 5: Development Economics

o Section 5.1: Sources of Economics Growth and Development
o Section 5.2: Consequences of Growth
o Section 5.3: Barriers to Economic Growth and Development
Course Outline for Second Year Economics Higher: 2008-09

• Section 2: Microeconomics
o Section 2.3: Theory of the Firm
• Section 3:
o Section 3.5: Unemployment and Inflation
o Section 3.6: Distribution of Income
• Section 4: International Economics

o Section 4.2: Free Trade and Protectionism
o Section 4.5: Balance of Payments
o Section 4.6: Exchange Rates
o Section 4.7: Balance of Payments Problems
o Section 4.8: Terms of Trade
• Section 5: Development Economics

o Section 5.4: Growth and Development Strategies
o Section 5.5: Evaluation of Growth and Development Strategies.

IB ECONOMICS SYLLABUS
Section 1: Introduction to economics
Higher level and standard level topics
The purpose of this section is to introduce the basic terminology and concepts of
economics. Students are encouraged to consider what markets and governments can
and cannot do. Students are given an opportunity to begin to explain economic
phenomena through the use of diagrams, data analysis and the evaluation of
economic material. Even at this initial stage teachers and students should consider
the application of economic theories to developing countries, since development
economics is integral to the course.
• Definitions of social science and economics
• Definitions of microeconomics and macroeconomics
• Definitions of growth, development, and sustainable development
• Positive and normative concepts
• Ceteris paribus
• Scarcity
factors of production: land, labour, capital and management/entrepreneurship
payments to factors of production: rent, wages, interest, profit
• Choice
utility: basic definition
opportunity cost
free and economic goods
production possibility curves: definition
diagrams showing opportunity cost, actual and potential output
diagrams showing economic growth and economic development
• Rationing systems
basic economic questions
what to produce?
how to produce?
for whom to produce?
mixed economies
public
private
central planning versus free market
economies in transition
Section 2: Microeconomics
The purpose of this section is to identify and explain the importance of markets and
the role played by demand and supply. The roles played by consumers, producers
and the government in different market structures are highlighted. The failures of a
market system are identified and possible solutions are examined.
The concepts learned here have links with other areas of the economics syllabus; for
example, elasticity has many applications in different areas of international trade and
development.

2.1 Markets
• Definition of markets with relevant local, national and international examples
• Brief descriptions of perfect competition, monopoly and oligopoly as different
types of market structures, and monopolistic competition, using the
characteristics of the number of buyers and sellers, type of product and barriers
to entry
• Importance of price as a signal and as an incentive in terms of resource
allocation
Demand
• Definition of demand: Law of demand with diagrammatic analysis
• Determinants of demand
• Fundamental distinction between a movement along a demand curve and a shift
of the demand curve
Higher level extension topic

• Exceptions to the law of demand (the upward-sloping demand curve)
ostentatious (Veblen) goods
role of expectations
Giffen goods
Supply
• Definition of supply: Law of supply with diagrammatic analysis
• Determinants of supply
• Effect of taxes and subsidies on supply
• Fundamental distinction between a movement along a supply curve and a shift of
the supply curve
Interaction of demand and supply

• Equilibrium market clearing price and quantity
• Diagrammatic analysis of changes in demand and supply to show the adjustment
to a new equilibrium
Price controls
• Maximum price: causes and consequences
• Minimum price: causes and consequences
• Price support/buffer stock schemes
• Commodity agreements
2.2 Elasticities
Price elasticity of demand (PED)

• Formula
• Definition
• Possible range of values
• Diagrams illustrating the range of values of elasticity
• Varying elasticity along a straight-line D curve
• Determinants of price elasticity of demand

Cross-elasticity of demand
• Definition and Formula
• Significance of sign with respect to complements and substitutes
Income elasticity of demand

• Definition and Formula
• Normal goods and Inferior goods
Price elasticity of supply

• Definition
• Formula
• Possible range of values
• Diagrams illustrating the range of values of elasticity
• Determinants of price elasticity of supply
Applications of concepts of elasticity

• PED and business decisions: the effect of price changes on total revenue
• PED and taxation
• Cross-elasticity of demand: relevance for firms
• Significance of income elasticity for sectoral change (primary secondary tertiary)
as economic growth occurs
Higher level extension topics

• Flat rate and ad valorem taxes
• Incidence of indirect taxes and subsidies on the producer and consumer
• Implication of elasticity of supply and demand for the incidence (burden) of
taxation
2.3 Theory of the firm
Higher level topics
Cost theory
• Types of costs: fixed costs, variable costs (distinction between short-run and
long-run)
• Total, average and marginal costs
• Accounting cost + opportunity cost = economic cost
Short-run
• Law of diminishing returns
• Total product, average product, marginal product
• Short-run cost curves
Long-run
• Economies of scale
• Diseconomies of scale
• Long-run cost curves

Revenues
• Total revenue
• Marginal revenue
• Average revenue
Profit
• Distinction between normal (zero) and supernormal (abnormal) profit
• Profit maximization in terms of total revenue and total costs, and in terms of
marginal revenue and marginal cost
• Profit maximization assumed to be the main goal of firms but other goals exist
(sales volume maximization, revenue maximization, environmental concerns)
Perfect competition
• Assumptions of the model
• Demand curve facing the industry and the firm in perfect competition
• Profit-maximizing level of output and price in the short-run and long-run
• The possibility of abnormal profits/losses in the short-run and normal profits in
the long-run
• Shut-down price, break-even price
• Definitions of allocative and productive (technical) efficiency
• Efficiency in perfect competition
Monopoly
• Sources of monopoly power/barriers to entry
• Natural monopoly
• Demand curve facing the monopolist
• Profit-maximizing level of output
• Advantages and disadvantages of monopoly in comparison with perfect
competition
• Efficiency in monopoly
Monopolistic competition
• Short-run and long-run equilibrium
• Product differentiation
• Efficiency in monopolistic competition
Oligopoly
• Collusive and non-collusive oligopoly
• Cartels
• Kinked demand curve as one model to describe interdependent behaviour
• Importance of non-price competition
• Theory of contestable markets
Price discrimination
• Definition
• Reasons for price discrimination
• Necessary conditions for the practice of price discrimination
• Possible advantages to either the producer or the consumer
2.4 Market failure
Reasons for market failure

• Positive and negative externalities, with appropriate diagrams
• Short-term and long-term environmental concerns, with reference to sustainable
development
• Lack of public goods
• Underprovision of merit goods
• Overprovision of demerit goods
• Abuse of monopoly power
Possible government responses

• Legislation
• Direct provision of merit and public goods
• Taxation
• Subsidies
• Tradable permits
• Extension of property rights
• Advertising to encourage or discourage consumption
• International cooperation among governments
Section 3: Macroeconomics
The purpose of this section is to provide students with the opportunity for a detailed
examination of the major macroeconomic issues facing countries' economic growth,
economic development, unemployment, inflation and income distribution.
Section 4 deals with external equilibrium. Income distribution is introduced here in

section 3 but is addressed in greater detail in section 5.
The economic strategies available to governments—demand-side policies, supply-

side policies, direct intervention—are introduced and evaluated. These policies are
applicable to almost all areas of macroeconomics, international economics and
development economics.
3.1 Measuring national income

• Circular flow of income
• Methods of measurement—income, expenditure and output
• Distinction between:
gross and net
national and domestic
nominal and real
total and per capita
3.2 Introduction to development

• Definitions of economic growth and economic development
• Differences in the definitions of the two concepts
• Gross Domestic Product (GDP) versus Gross National Product (GNP) as measures
of growth

• Limitations of using GDP as a measure to compare welfare between countries
• Allowance for differences in purchasing power when comparing welfare between
countries
• Alternative methods of measurement
• Problems of measuring development
3.3 Macroeconomic models

• Aggregate demand—components
• Aggregate supply
short-run
long-run (Keynesian versus neo-classical approach)
• Full employment level of national income
• Equilibrium level of national income
• Inflationary gap
• Deflationary gap
• Diagram illustrating trade/business cycle
3.4 Demand-side and supply-side policies

• Shifts in the aggregate demand curve/demand-side policies
fiscal policy
interest rates as a tool of monetary policy
• Shifts in the aggregate supply curve/supply-side policies
• Strengths and weaknesses of these policies

• Multiplier
calculation of multiplier
• Accelerator
• “Crowding out”
3.5 Unemployment and inflation
Unemployment
• Full employment and underemployment
• Unemployment rate
• Costs of unemployment
• Types of unemployment
structural
frictional
seasonal
cyclical/demand-deficient
real wage
• Measures to deal with unemployment
Inflation
• Definitions of inflation and deflation
• Costs of inflation and deflation
• Causes of inflation
cost push
demand pull
excess monetary growth

• Methods of measuring inflation
• Problems of the methods of measuring inflation
• Phillips curve
short-run
long-run
• Natural rate of unemployment
• Non-Accelerating Inflation Rate of Unemployment (NAIRU)
3.6 Distribution of income

• Direct taxation
• Indirect taxation
• Progressive taxation
• Proportional taxation
• Regressive taxation
• Transfer payments

• Laffer curve
• Lorenz curve and Gini coefficient
Section 4: International economics

The purpose of this section is to encourage candidates to understand why countries
trade, the problems involved and how these problems are addressed. Students need
to understand how exchange rates affect international trade. The international trade
theory introduced in this section should be related to real-world examples.
4.1 Reasons for trade

• Differences in factor endowments
• Variety and quality of goods
• Gains from specialization
• Political
Higher level extension topic

• Absolute and comparative advantage (numerical and diagrammatic
representations)
opportunity cost
limitations of the theory of comparative advantage

4.2 Free trade and protectionism
Definition of free trade
Types of protectionism
• Tariffs
• Quotas
• Subsidies
• Voluntary Export Restraints (VERs)
• Administrative obstacles
• Health and safety standards
• Environmental standards
Arguments for protectionism

• Infant industry argument
• Efforts of a developing country to diversify
• Protection of employment
• Source of government revenue
• Strategic arguments
• Means to overcome a balance of payments disequilibrium
• Anti-dumping
Arguments against protectionism

• Inefficiency of resource allocation
• Costs of long-run reliance on protectionist methods
• Increased prices of goods and services to consumers
• The cost effect of protected imports on export competitiveness
4.3 Economic integration
Globalization
Trading blocs
• Free trade areas (FTAs)
• Customs unions
• Common markets

• Trade creation and trade diversion
• Obstacles to achieving integration
reluctance to surrender political sovereignty
reluctance to surrender economic sovereignty
4.4 World Trade Organization (WTO)

• Aims
• Success and failure viewed from different perspectives

4.5 Balance of payments
• Current account: balance of trade and invisible balance
• Capital account
4.6 Exchange rates

• Fixed exchange rates
• Floating exchange rates
• Managed exchange rates
• Distinction between
depreciation and devaluation
appreciation and revaluation
• Effects on exchange rates of
trade flow
capital flows/interest rate changes
inflation
speculation
use of foreign currency reserves

• Relative advantages and disadvantages of fixed and floating rates
• Advantages and disadvantages of single currencies/monetary integration
• Purchasing power parity theory (PPP)
4.7 Balance of payment problems

• Consequences of a current account deficit or surplus
• Methods of correction
managed changes in exchange rates
reduction in aggregate demand/expenditure-reducing policies
change in supply-side policies to increase competitiveness
protectionism/expenditure-switching policies
• Consequences of a capital account deficit or surplus

• Marshall-Lerner condition and J curve
4.8 Terms of trade

• Definition of terms of trade
• Consequences of a change in the terms of trade for a country's balance of
payments and domestic economy
• The significance of deteriorating terms of trade for developing countries

• Measurement of terms of trade
• Causes of changes in a country's terms of trade in the short-run and long-run
• Elasticity of demand for imports and exports

Section 5: Development economics
Throughout the course, students are introduced to several important concepts in
development economics and, in particular, to the fundamental distinction between
economic growth and economic development established in section 3. This important
distinction needs to be re-emphasized at the beginning of this section.
Given the dynamic nature of the international economy, it is problematic to group

countries into clearly established categories such as developed, developing, newly
industrialized countries (NICs) and transition economies. However, students should
understand current terminology and be aware that similarities and differences exist
within different categories. It is important for teachers to help students find relevant
examples of the different categories of countries.
The main purpose of this section is to provide students with the opportunity to
understand the problems faced by developing countries, and to develop an
awareness of possible solutions to these problems.
5.1 Sources of economic growth and/or development

• Natural factors: the quantity and/or quality of land or raw materials
• Human factors: the quantity and/or quality of human resources
• Physical capital and technological factors: the quantity and/or quality of physical
capital
• Institutional factors that contribute to development
banking system
education system
health care
infrastructure
political stability
5.2 Consequences of growth

• Externalities
• Income distribution
• Sustainability
5.3 Barriers to economic growth and/or development

• Poverty cycle: low incomes low savings low investment low incomes
• Institutional and political factors
ineffective taxation structure
lack of property rights
political instability
corruption
unequal distribution of income
formal and informal markets
lack of infrastructure
• International trade barriers
overdependence on primary products
consequences of adverse terms of trade
consequences of a narrow range of exports
protectionism in international trade
• International financial barriers
indebtedness
non-convertible currencies
capital flight
• Social and cultural factors acting as barriers
religion
culture
tradition
gender issues
5.4 Growth and development strategies

• Harrod-Domar growth model
• Structural change/dual sector model
• Types of aid
bilateral, multilateral
grant aid, soft loans
official aid
tied aid
• Export-led growth/outward-oriented strategies
• Import substitution/inward-oriented strategies/protectionism
• Commercial loans
• Fair trade organizations
• Micro-credit schemes
• Foreign direct investment
• Sustainable development
5.5 Evaluation of growth and development strategies

• Evaluation of the following in terms of achieving growth and/or development
aid and trade
market-led and interventionist strategies
• The role of international financial institutions
the International Monetary Fund (IMF)
the World Bank
private sector banks
non-governmental organizations (NGOs)
multinational corporations/transnational corporations (MNCs/TNCs)
commodity agreements

SECTION 1: INTRODUCTION TO ECONOMICS
1.1 Definitions of Social Science and Economics
Unlike sciences where theories can be tested an unlimited number of times in a
laboratory, social sciences are limited to observing human interactions, making
certain assumptions and devising theories and models to help explain human
behaviour. Data can be collected from other observations to test the original theories
and models to see if they really contribute to our understanding of human
behaviour.
Economics tends to focus on what is produced in society, how it is produced, and for
whom it is produced. Over time economists have observed the following aspects.
Specialization
• Until the agricultural revolution our ancestors were hunter gatherers and did
everything for themselves.
• Once agriculture developed and people were able to specialize in the things they
were best at doing, productivity increased dramatically.
• This created a surplus which could be traded for goods produced by people who
had specialized in other areas.
Trade
• Trading occurred in markets where people could buy things more cheaply than
they could make them.
• Originally, goods were traded through barter, but this required a simultaneity of
desire: you had to find someone who had what you wanted and at the same time
they had to want what you had to offer.
• Time was wasted trying to find satisfactory exchanges, and money was invented
eliminating the inconvenience of barter.
o This release of wasted time led to a further increase in the surplus.
Industrialization
• The industrial revolution introduced machinery allowing further specialization:
o Division of labour: workers specialized at tasks increasing productivity.
o Economies of scale: gains from bulk buying, large scale financing, and the use
of large scale machinery permitted even further gains in productivity:
We moved from labour intense production which uses relatively large
amounts of labour compared to other factors, to capital intense production
where relatively large amounts of capital are used compared to other
factors.
o Management economies: many economists believe that economies of scale

only reduce costs by 10% whereas better management can reduce costs by
much larger amounts:
Outsourcing or subcontracting is probably the most familiar recent
example of management economies. It involves eliminating certain
production facilities and functions in the company and subcontracting
them to firms who can provide the goods and services at lower cost.

Just in time delivery: most well known in the auto market where parts are
no longer produced and stored in warehouses, but are produced by a
subcontractor and delivered to the assembly plant at the actual time the
part is needed in the assembly process.
Resequencing: there are many ways to fabricate the parts for a product,
and many different ways of assembling them. By altering the sequence of
actions, a firm can find the most efficient way to fabricate parts and
assemble them into a final product creating further gains in productivity
and reductions in cost.
Economic Sectors
• The primary sector involves the extraction of resources: farming, fishing, forestry
and mining.
• The secondary sector involves the conversion of natural resources into goods:
manufacturing and construction.
• The tertiary sector involves the production of services: finance and tourism.
• In the private sector resources are owned by private individuals:

o Consumers are grouped into households which own the resources, deciding
what to buy and in what quantities
Rather than specialize on their own, most people sell their labour services
to a firm and receive money wages in return.
They also sell the services of other factors to firms in return for income.
o Producers expect to cover their costs with the revenue they obtain from
selling:
Firms are the principal users of factors of production, they account for
85% of employment in more developed countries (MDCs).
Profit maximization is essential otherwise the firm falls behind or is bought
up by another firm which will force the first firm to maximize profits.
• In the public sector production is in public hands: owned and controlled by the
state which both buys and produces goods and services.
o We cannot assume that governments always act in a consistent manner.
o Various governments make laws, the courts interpret these laws and uphold
them.
o Any government measures that impose large costs with few obvious benefits
to the current generation are unlikely to be popular:
Long run benefits are sometimes ignored: the planting of trees will only be
enjoyed by future generations which do not have a vote today, therefore
government will not spend money on planting trees.
There is uncertainty about the future: it is hard to make decisions today
which may have long term consequences.
1.2 Definitions of Microeconomics and Macroeconomics

Economists tend to focus on four main areas of the economy: microeconomics,
macroeconomics, international economics and development economics.
Microeconomics
• Microeconomics deals with individual consumers and firms, how they interact in
markets, and the role of government in overcoming market failure.
• Although microeconomics examines the interactions between individual
consumers and producers, in actual fact economists only rarely look at individuals
and tend to focus on industries, markets or groups of consumers and producers
instead.
• The chief actors are:
o Consumers who demand goods and services and provide the factors of
production by which to earn a living.
o Producers who take those factors of production and combine them in such a
way as to produce the goods and services.
o Governments who intervene when the market fails to provide an efficient and
equitable solution to the basic economic problems of what, how and for
whom.
Macroeconomics
• Macroeconomics is concerned with the economy as a whole and the policies most
likely to help governments deal with major issues such as inflation,
unemployment, economic growth and equitable income distributions.
• The initial focus is on determining the national income for a nation. This is not as
simple as it may seem as there are problems deciding what can be measured and
what should or should not be included.
• Two other important measurements are for unemployment and inflation.
• Aggregate demand focuses on the relationship between national income and the
price level or rate of inflation.
o Keynesian economists focus on the policies most likely to increase aggregate
demand which can lead to an increase in national income and employment.
The problem is that it can also lead to inflation.
• Aggregate supply is determined by factor costs and the productivity of those

factors. As we approach full employment, productivity tends to fall which leads to
higher costs. Hence the aggregate supply curve tends to slope upwards as
national income increases.
o Monetarist economists tend to focus on aggregate supply and the policies
most likely to lead to an increase in the long run. The problem is that it can
also lead to deflation.
1.3 Definitions of Growth, Development & Sustainable

Development
• Development Economics is focused on sources of growth and development, the
barriers encountered in many countries, and the strategies that can be used to
enhance economic growth and development.
• Economic growth is the increase over a certain period of time in the nation’s
national output as measured by nominal or current Gross Domestic Product
(GDP):
o Real GDP: nominal or current GDP is generally adjusted to remove the effects
of inflation
o Real GDP divided by population gives per capita real growth.
• Economic growth takes place when the quality and quantity of factors of
production are increased:

o Industrialization usually takes place through investing in capital equipment
which enhances the capital-labour (K/L) ratio
Because workers have more machines to work with, productivity per
worker (Q/L) is often enhanced at the same time.
o Productivity measures the output per worker (Q/L) and is enhanced through
investments in education and healthcare as well as investments in capital
o Technology is a complementary factor which can enhance the productivity of
both capital (Q/K) and labour (Q/L)
o Management practices is another, complementary factor usually included as
entrepreneurship which involves the organization and management of factors
of production. Some researchers believe that better management practices
are the key to economic growth in both government and private businesses.
• Economic development is a more complex concept which involves looking at

several factors. There are several schools of thought that believe that economic
development occurs if:
o There is a reduction in poverty, inequality, and unemployment
o There is an increase in literacy rates, enhanced nutrition, better shelter, and a
drop in mortality rates
o There is increased spending on public goods such as infrastructure (roads,
bridges, water systems) and merit goods such as education and healthcare.
• Obviously there is a lot of overlap in these approaches to defining economic

development. Some indicators of development focus on certain aspects:
o The UN has developed the Human Development Index which focuses on per
capita GDP, literacy and life expectancy.
o The Human Poverty Index measures life expectancy, literacy, access to
healthcare, clean drinking water, and the proportion of underweight children.
1.4 Positive and Normative Concepts

• Positive economics is based on theories which can be tested by looking at past
data.
o Positive statements concern what is, was or will be: assertions about the
world.
• Normative economics is based on opinion: related to the “norm” or value.

o Normative statements often include words such as ‘should’ or ought to’ and
involve value judgements about what is good and what is bad.
o Normative statements are not testable: 'ought we to be more concerned
about unemployment than about inflation?'
o In democracies normative statements are often settled by voting.
1.5 Ceteris Paribus

• Ceteris paribus: with all other factors or things remaining the same.
• This means that we change one parameter at a time and watch how it influences
the variables.
o For example: if the government cuts income taxes in order to lead to an
increase in personal income, we would like to see whether consumption rises.
o If we hold everything else constant, we expect that most people will spend
more money when their income rises.
However, if at the same time there was a jump in prices and interest
rates, people might not spend more money.
This is why it is so important to isolate one change from another.
In real life, of course, that is usually not possible and we have to make
adjustments.
1.6 Scarcity
1.6.1 Factors of Production
• Natural resources include all the resources we use such as land, trees, water,
minerals.
• There is some controversy about how to include environmental resources such as
clean air, clean water, quietness etc.
o When these are polluted there is a cost, how should that be included, and
who should pay for it?
• Labour is simply the number of hours of physical and mental work put in by a
person.
• Capital is defined as man-made tools and machines used in the production of
goods and services and includes physical plant, machinery, equipment and
buildings. It is not the money that you invest in the stock market.
• Entrepreneurship: comes from the French word and means that someone or a
group of people undertake risk by buying and organizing factors of production in
such a way as to produce goods and services.
o It is estimated that 85% of small businesses go bankrupt during the first five
years. And 85% of those that survive go bankrupt in the next five years.
o There is a great scarcity of good management talent in the world.
1.6.2 Payments to Factors of Production

• Factors of production are priced at opportunity or user cost.
Labour
• Firms pay a wage for labour service.
o Wages are the costs associated with using labour and are usually paid on an
hourly basis.
o Salaries are paid on a monthly basis
Natural resources
• The payment for natural resources has traditionally had two names:
o In Europe, rent is the income paid for natural resources such as land
o In North America, rent is what is paid to rent an apartment and payments for
using natural resources are called natural resource costs or raw material
costs.
• Natural resources are either treated as an input that must be purchased, or
treated like capital if the firm owns them, in which case the same formula as for
capital is used as below.
Capital
• Capital can be rented but is often owned, a cost must be imputed (estimated) for
the capital services:
PK *( r + δ )
where:
K refers to capital
PK refers to the cost of the capital,
r (sometimes “i” for interest rate), refers to the interest on the loan to buy
the capital or if the company owns the capital it is the opportunity cost
rate of return that could have been earned on the money tied up in the
capital (what they could have earned in the money market which is why is
it sometimes called “i”)
δ is the depreciation rate on the capital, where depreciation is the cost of
maintaining the tools and machinery.
o For example: if the cost of a piece of equipment is $100,000 and the interest
rate on the loan is 10% and the depreciation is 5% per year, the cost of
capital for a year is: $25,000 = $100,000*(10% + 5%)
o The return on capital is sometimes referred to as an accounting profit: it is
what must be earned in order to pay the interest on the money borrowed to
buy the capital (or the money not earned in the money market because you
invested in capital instead) plus the wear and tear (depreciation) of the capital
during the year.
Normal and Abnormal Profit

• Often referred to as the return to entrepreneurship.
• We refer to the amount received from sales of goods and services by a firm as
total revenue, and the costs as total costs.
o Thus profit is equal to total revenue minus total cost.
o Return on investment (ROI) can be stylized as:
TR − VC
ROI =
FC
where:
TR = total revenue
Total cost is broken up into:
• VC = variable or operating costs
• FC = fixed costs or investment
o You can see that profit and ROI are very closely related. In real life, the
equation for ROI is much more complex as most projects last about 15 to 20
years and we discount back the revenues and costs over the whole period.
o Most firms maximize profits by trying to increase revenues through better
marketing, and decreasing costs through more efficient systems of
production.
o If firms do not maximize profits, they will either not grow anymore because
there are no profits to re-invest in the business, or they will be bought out by
someone who can force the company to earn a normal rate of return.
• We assume investments in capital equipment earn the opportunity cost rate of

return (r or “i”) in the market:
o As these costs are already included in the cost of capital and we assume the
manager/owner’s salary is included in the labour costs, then normal profits
are earned if the ROI = 0
o Anything earned in excess of the interest rate on capital plus
manager/owner’s salary is referred to as abnormal profit, super-normal profit,
pure profit or economic profit.
o If abnormal or super normal profit is zero, the economist is satisfied that
market equilibrium has taken place: there is no incentive for firms to enter or
leave an industry.
1.7 Choice
1.7.1 Utility
• Most people are assumed to be motivated by rational desires.
• Utility: most people derive enjoyment or utility from the goods and services they
consume, and most understand that the first amount of enjoyment from
consuming a good is often the highest.
o As more and more is consumed, the level of enjoyment starts to decrease.
This is referred to as the concept of diminishing marginal utility. The marginal
utility is the enjoyment received from the next unit of whatever is being
consumed, and it diminishes as more is consumed.
o Most people try to maximize total utility or enjoyment by consuming more
than one good: as the marginal utility from consuming one good starts to fall
from consuming more, you switch to another good where the marginal utility
is higher.
For example, we do not just eat one food such as meat, we get more
enjoyment from mixing it with other foods such as salad, potatoes and
vegetables.
1.7.2 Opportunity Cost

• Opportunity cost: the cost of using a resource measured in terms of the sacrifice
foregone in the next best alternative.
• When the best alternative is chosen from a range of alternatives the second best
choice is the opportunity cost.
• In Europe the term “tradeoff” is often used in place of opportunity cost. It implies
the same idea of a sacrifice: something has to be given up in order to get
something else.
1.7.3 Free and Economic Goods

• Free goods involve no opportunity cost such as fresh air, but they become
economic goods if opportunity costs are involved in such things as removing
pollution from the air.
• An Economic Good is a product or service in limited supply:
o Consumption goods are purchased by consumers and consist of perishable
goods such as fresh food, semi-durable goods such as clothing, and durable
goods such as cars.
o Capital goods, also referred to as producer goods are simply capital used in
the production of consumer goods.

1.7.4 Production Possibility Curves Production Possibility Frontier
• The production possibility frontier (PPF), boundary C
Oranges
(PPB) or curve (PPC) illustrates the various B
combinations of two goods a country can produce A
within a specified time period and given the resources
and technology available during that time period.
• Point B on the PPF shows the maximum that can be Clothing
produced with existing resources and technology, it is a
point of productive efficiency.
• The negative slope of the PPF reflects basic scarcity: you cannot have more of
one good without sacrificing some of the other.
• If the PPF were a straight line, that would imply that the tradeoff or opportunity
cost of moving production from oranges to production of clothing would remain
constant.
• Diminishing returns:
o The use of greater and greater amounts of a variable resource with a given
amount of another resource leads to increasing production but at a
diminishing rate
o No matter how much fertilizer you add, you cannot grow the world’s wheat
supply in a flower pot!
• The law of diminishing returns implies a convex PPF: as resources are transferred
from one use to another, the increment in output becomes smaller and the
opportunity cost increases:
o Resources are being released in the wrong combination:
The amount of labour required to produce clothing per unit of land is
much larger than when growing oranges.
As resources are released from growing oranges, there is too much land
and not enough labour.
o The resources being released are less and less suited to the new use:
Farmers who like growing oranges will be the last to transfer to making
clothing.
The earliest labour transferred from orange production to clothing will be
those best suited to making clothing.
• Point A inside the frontier is productively inefficient: more of one good could be
produced without sacrificing any of the other:
o Note that the concept of opportunity cost or tradeoff is not applicable inside
the frontier: you can get more of both goods.
o Producing inside the PPF implies that either resources are:
Unemployed: not all resources are being fully utilized (typical of a market
system)
Inefficient: resources may be fully utilized but in an inefficient manner
(typical of central planning systems).
• Point C can only be reached through:

o Trade
o The discovery of more resources or new techniques of production.
o Increased labour productivity from greater education and training
o Increased capital productivity from an increase in technological knowledge.

1.7.4.1 Actual & Potential Output
• The PPF illustrates the way in which production can be transformed from making
one type of good or service into another type of good or service: this implies an
opportunity cost or tradeoff.
• Actual output can fall short of potential output if we operate inside the PPF.
• If we move from some point inside the PPF to the PPF itself, then we have
increased production and we can call the process economic growth.
• With trade, we can move outside the PPF because we are trading with a country
that may have a different combination of resources and technology.
o Notice that our PPF does not grow, we are simply able to move outside our
PPF by taking advantage of another country’s productivity through trade.
• When we find resources, develop new technology or make existing factors of

production more productive, we expand the PPF beyond the present boundaries.
o If we do not move to that new PPF, economic growth has not taken place.
o Expanding the boundary increases potential output, but it is not until
production actually increases to the point where we reach the new PPF that
actual output is equal to potential output.
o Factor productivity (Q/L) increases when the output per unit of time and use
of a factor of production increases.
Economic Growth Through
Industrialization (K/L↑) Investment in Capital Goods
Capital Goods
• Potential output can be increased by investing

in capital goods.
• A country at point A1 in the current period may B2
see potential production grow to point A2 in

the next period. Kb B1
• If the country decides to sacrifice in the
current period by producing fewer
consumption goods and investing more heavily A2
in capital goods, the country moves from point Ka
A1
A1 to point B1:
o In the current period, consumption falls
from Ca to Cb while investment increases
from Ka to Kb Cb Ca Consumption Goods
o In the next period, production potential

may grow from point B1 to point B2

At point B2 consumption is almost
equal to that experienced at point A2 Economic Growth Through
The sacrifice in the first period leads to Investment in Public & Merit Goods
Public & Merit Goods

almost the same level of consumption
in the second period, and through
more rapid growth leads to more B2
consumption in the future than if the
country had stayed at the combination
of capital and consumption goods at Pb B1
the A level.
A2
Enhancing Productivity (Q/L↑) Pa
A1
• Some economists believe that 50% to 70% of
growth in potential output can occur by
enhancing factor productivity. In this case the
Cb Ca Consumption Goods
investment takes place in public and/or merit
goods:
o Public goods are associated with infrastructure such as roads, bridges, dams,
canals, water and sewage systems, and electricity
o Merit goods are usually associated with education and healthcare.
• Once again, the PPF curve illustrates that investments in public and merit goods
can enhance the potential output so that the country can grow in the second
period to to point B2 instead of to point A2.
1.7.4.2 Economic Growth & Economic Development

• Economic growth can occur for two reasons:
o When we move from point A to point B inside the current PPF
o When the PPF expands and we are able to increase production from point B
to C.
• Economic development occurs when we reduce poverty, unemployment and

income inequality or enhance the standard of living and quality of life for
humans.
Potential Economic Growth & Development
o By moving from point A
Capital goods
to B we could be Potential PPF given K/L Faster economic growth but

ratio and levels of E no economic development
reducing unemployment productivity (Q/L) in MDCs
which would mean C
economic development Greater spending on

public and merit goods
Current PPF with
is occurring good policies &
leads to greater
economic development
o However, the move good business
management
B
from A to B does not

imply that the benefits
A D
of growth are Poor policies &
Greater economic
development but less
experienced by poorer poor business growth in the future
management
members of the
community or that
income is more
Public & Merit Goods
equitably distributed.
o The move from B to D or from C to D implies that the benefits of growth are
indeed being distributed to poorer members of the community through
spending on public and merit goods.
• Best practices:
o In the 1960s and 1970s it was believed that through industrialization, and the
application of more capital, LDCs would quickly grow from point A to point C.
While this did occur for some countries, it was met with mixed results:
Part of the reason was that economies of scale associated with larger
companies could not offset weaknesses in management in private firms.
Better management techniques can enhance the process of
industrialization considerably.
• Good governance:
o For many LDCs there is no point in trying to expand the PPF to the potential
PPF until they have at least achieved economic growth from point A to B
o Better government policies at both the micro and macro levels can make a
significant difference in achieving growth targets.
• Civil society:
o Businesses and governments are not the only institutions responsible for
fostering growth. It is important for citizens to “give back” to help those who
are poor because they are less skilled, disabled or disadvantaged for some
reason.
o This would imply that the best move is from B to D or from C to D: many
economists believe that investment in public and merit goods will not only
enhance economic development but also increase productivity which is a very
important factor for future economic growth.
1.8 Rationing Systems

1.8.1 Basic Economic Questions
The basic economic problem is that there is a scarcity of goods and services. As
there are only limited resources and means of production, we are forced to make
choices as to what to produce. Although output is limited by the technology
available, there may be enough resources to satisfy basic needs for most humans,
but there will never be enough resources to satisfy all people’s wants and desires.
1.8.1.1 What To Produce

• What is produced is largely determined by the needs and wants of people
• What goods and services should be produced with the resources available:
should we produce consumption goods, investment goods or public and merit
goods?
1.8.1.2 How To Produce

• How can factors of production be used efficiently to produce what is chosen?
• How do we allocate resources amongst the various production systems so as to
maximize output at the minimum sacrifice?
• How we produce depends on available resources and technology.
• In order to maximize welfare we must produce in the most efficient manner
possible to get the most out of our limited resources: this will put us on the
production possibility frontier.
o This point is defined when:
Marginal Social Benefit = Marginal Social Cost
1.8.1.3 For Whom to Produce

• For whom should these goods and services be produced: what is the best
method of distributing production to ensure the greatest benefit to society, are
some citizens more deserving than others?
• Should we use traditional systems, central planning (dictatorship) or the free
market?
• But how do we distribute production in such a way as to maximize utility for
society as a whole?
o Marginal utility for rich people is low as they have the money to afford to buy
everything: in a word they are bored from over consumption.
o Marginal utility for poor people is high because they have only limited income.
o The problem with central planning is that in distributing from the rich to the
poor, there is less incentive for people to work. Communism was found to
lead to great inefficiency and unfairness.
The problem with the market system is that those who work hard are
rewarded so efficiency is achieved. However there are many with the
wrong talents or with assets that are not demanded by the market. They
become discouraged and often become marginalized in society.
1.8.2 Mixed Economies

• Most countries in the world have moved gradually toward a mixture:
o Traditional economic systems: usually associated with indigenous groups or
groups based on subsistence living from natural resources which usually does
not involve much trade outside the group or the use of money
o Free markets are used to allocate resources to achieve efficiency.
o Government planning is used where markets fail to operate successfully, and
to redistribute income to those who are marginalized by the market system.
1.8.2.1 Public
• Traditionally governments have always been a small proportion of the economy,
but with the agricultural revolution, governments started to play an increasingly
important role in the administration of cities, regions and nations. The Egyptian,
Mesopotamian, Greek and Roman civilizations are perfect examples.
• The advent of the industrial revolution led to much greater centralization of
economic resources and higher per capita incomes which could support greater
levels of taxation.
• However, even as recently as 1914, agriculture alone represented, directly and
indirectly, 60% of employment in most Western countries. Governments
represented less than 10% of employment and spending.
• The impact of the depression in the 1930s and the introduction of income taxes
to pay for the First and Second World Wars led to the rapid growth of
governments to the point that where they now represent more than 50% of the
spending in certain socialist countries like Sweden and the Netherlands.
• It would not be possible to manage a modern economy without the presence of
government. The following are very stylized definitions of the various degrees of
involvement:

o Free enterprise: the economy is dominated by privately owned companies and
non-profit organizations, governments provide public goods and services such
as infrastructure which would not be provided by the private sector.
Hong Kong is often mentioned as the best example, but even there
government tends to own much of the land and the housing.
Governments tend to be restricted to what should be produced in very
narrow areas of public goods and services and possibly some merit goods.
o Socialism: the government may not own the means of production or the
resources but it does intervene in the market place to redress perceived social
and market failures resulting from private enterprise.
The private sector will tend to under-provide certain public and merit
goods while producing too much pollution and demerit goods such as
illegal drugs.
Governments are not so involved in questions of how things are to be
produced as they are in what should be produced and for whom.
o Communism: the government owns or controls the means of production and

the natural resources.
Generally central planning techniques are used to decide the three
fundamental problems of what, how and for whom.
Even today, 55% of enterprises are owned by the government in China.
o Fascism: the government does not own, but it does control the means of
production and natural resources.
Goods and services are produced by the private sector so the “how” is
determined by private businesses. But the what and the for whom is
determined largely by government.
• Public ownership: during the 1950s, 1960s and early 1970s it became fashionable
for governments to nationalize private industries.
o This may have been partly a reaction against the fascism of the Second World
War or it may have been a result of over-enthusiastic socialist policies.
• From the mid 1970s to the present, the pendulum has swung back the other way
and many previously publicly owned industries have now been privatized.
o This was a reaction against the poor management of nationalized industries
which led to inefficiency on a large scale.
o Today we are more aware that some industries simply function better when
privately owned and run, while others are better when publicly owned and
managed.
1.8.2.2 Private
Traditional Economies
• Resources and production systems are owned by the community
• Production takes place using traditional technology
• Allocation is based on long established patterns of community sharing.
• The production possibility boundary tends to expand and contract slowly as
population grows, or when there are climatic changes, or when new tools are
introduced
• Advantages of traditional systems:
o Resources are protected and the systems have proven to be sustainable over
long periods of time
o Losses and profits are shared by the whole community, peer pressure forces
decision makers to be careful
• Disadvantages of traditional system: Growth is very slow
Free market
• Resources and production systems are owned by individuals and the allocation of
resources, what, how and for whom, is left to the forces of supply (production)
and demand (consumers) operating in a relatively free market.
• Producers attempt to maximize profits, but if they are poor at predicting:
o They produce too much (surpluses) and will lose money.
o They underestimate (shortages), will miss the potential profit and competitors
will make the profit instead.
o Only those firms which can predict most closely what consumers will want will
earn adequate money to stay in business.
• Advantages of free market:

o Resources are allocated by market forces and the price mechanism without
government intervention.
o Profits provide an incentive to reduce costs and be innovative.
o The free market maximizes community surplus if there are no failures and
imperfections.
• Disadvantages of the free market:

o Market failures and imperfections occur because there is underproduction of
public goods and merit goods; and overproduction of externalities.
o The system of profits and losses is thought to be unfair, substantial
government intervention is needed to cope with income redistribution
problems.
The wealthy are taxed to reduce profits
Those marginalized by the system, are supported with tax money
o The system is incapable of controlling pollution and producing sustainable
growth, planning has been introduced to correct for this problem.
1.8.2.3 Central planning versus free markets

• Resources and production systems are owned by the central government which
allows the government to determine what is produced, how and for whom.
• Enormous information is required due to centralized planning and control.
Government planners must:
o Predict patterns of consumer demand
o Estimate technological possibilities and production capabilities.
• Producers are motivated to underestimate their capability

• Advantages of central planning:
o The government can make the distribution of income more equal
o The government determines what goods are produced and can prevent
production of socially undesirable goods.

o Initially higher growth rates for Russia and China would suggest that as a
system of organizing economic activity, central planning is successful in the
early stages of economic development.
• Disadvantages of central planning:

o Requires large amounts of information: forecasting people’s desires is difficult
and the lack of incentives have led to a number of problems.
o Decision makers do not experience profits and losses and are not strongly
motivated to make the right decisions
Incentives to falsify production information lead to poor production
decisions and massive pollution,
A reluctance to change with the market in forecasting demand:
There are queues when there are shortages (quantity rationing), and
stockpiles if there are surpluses.
o State owned enterprises are managed inefficiently.

o There is no incentive for individuals and firms to be innovative. With no profit
motive goods are often of poor quality and choice is very limited.
1.8.2.4 Economies in Transition

• Economies in transition are countries moving from a centrally planned to a free
market system. Typically this is associated with:
o Rapid inflation as government subsidies fall
o Widespread unemployment as enterprises are forced to become more
competitive.
o Often there is a traumatic drop in real per capita GDP and greater disparity in
income and wealth.
• Economies in transition can also refer to countries where there is a shift from one
sector to another:
o The most well known is often referred to as the rural-urban migration where
people caught up in rural poverty move to an urban setting so they can
participate in the formal economy.
o Families are attracted to the cities because of the spending on public and
merit goods which were not available in their rural communities.
o Typically death rates fall at first, followed by lower birth rates. This can lead
to slower population growth.

SECTION 2: MICROECONOMICS
2.1 Markets
2.1.1 Demand
2.1.1.1 Definition of Demand
• The demand curve shows the quantity of a good that consumers want at each
price, assuming they have the effective purchasing power (income) to pay.
• Quantity demanded refers to a continuous flow of purchases per period of time.
• A single point on the demand curve reflects the quantity demanded at that price.
2.1.1.2 Law of Demand

• The law of demand states that a higher quantity will be demanded at a lower
price assuming other factors such as the price of substitutes are unchanged.
• Movements along the demand curve lead to changes in quantity demanded.
• Price and quantity demanded are negatively related:
o Demand is downward sloping: each increment in consumption leads to less
and less satisfaction, and the consumer will buy more only for a lower price.
o As price rises, the quantity demanded of the good or service tends to fall
o It becomes an increasingly expensive way to satisfy the need or want
associated with the good or service.
o People switch in part to some other goods or services to satisfy the same
need, and less will be purchased of the good that has gone up in price.
o As the price of the good falls, it becomes relatively cheaper and more of it will
be purchased and less of substitute goods.
2.1.1.3 Determinants of Demand

• The demand curve will shift out if more is demanded at each price and is caused
by changes in factors other than the price of the good itself:
• Substitutes: if the price of coffee falls, many people will shift from drinking tea to
drinking coffee and the demand curve for tea shifts in to the left.
• Complements: these are goods which tend to be used jointly.
o If the price of gasoline rises people are motivated to use their car less, and
the demand for cars shifts to the left.
• Real income: when income rises, more people can afford to buy cars and the
demand curve for cars shifts to the right for normal goods.
• Population: if the population grows there are more consumers and demand will
shift out to the right.
• Tastes: more people may want the product or service and demand shifts out.
• Advertising: the more effective the advertising the greater the demand, unless
the government uses negative advertising for things such as the dangers to
health from cigarette smoking.
• Credit: more credit means it is easier to borrow for durable goods like cars and
demand shifts right.

2.1.1.4 Movement along versus Shifts of the Demand Curve
Movement along
Demand Curve
•
Price
A decrease in the price of a product
or service from P1 to P2 leads to
o An increase in the quantity P1 A
demanded from Q1 to Q2
o An expansion along Demand 1 De
from A to B De
m
an
m d
an 1
•
d
An increase in the price of a product 2
or service from P2 to P1 leads to P2
C
B
o A decrease in the quantity
demanded from Q2 to Q1
o A contraction along the demand
curve from B to A
Q1 Q3 Q2 Quantity
Shift of Demand
• A decrease in income, a decrease in the price of a substitute, a decrease in
population, an increase in advertising opposing this good or service, an increase
in interest rates (or reduction in availability of credit), an increase in the price of
a complement can all lead to the demand curve shifting in to the left from
Demand 1 to Demand 2
o At a price like P2, quantity demanded falls from Q2 to Q3.
2.1.H Markets: Higher Level: Exceptions to the Law of Demand

2.1.H.1 Ostentatious (Veblen) goods
• People want to be seen buying more expensive goods.
o If the price rises, people will buy more because they are more expensive.
o This is thought to lead to an upward sloping demand curve.
• It is hard to find examples to support this theory. Perhaps the closest would be
Lamborghini cars or pink diamond rings.
2.1.H.2 Role of Expectations

• Expectations about future prices can play a critical role in demand:
o If prices are expected to rise, for example in inflationary times, people will
buy now which may make prices rise even faster.
o If prices are expected to fall, for example in a deflation, people will postpone
buying which may lead to even further falls in price.
• If the government cuts taxes this increases after tax income which would
normally lead to demand shifting out.
o But if people think the tax cut is only temporary, they will save the money
rather than spend it which will not lead to an increase in demand.
2.1.H.3 Giffen goods:

• All Giffen goods are inferior goods: as income rises, less is purchased.
• This means that when the price of potatoes fell in Ireland during the famine,
people actually bought fewer potatoes and more meat and milk.

o As the price of potatoes fell, there was a substitution effect which meant that
potatoes were relatively cheaper than other goods and people would have
bought more potatoes.
o A drop in the price of potatoes actually led to an increase in real income:
Normally this would mean that people would consume more of everything
including potatoes
However, potatoes were an inferior good and people wanted to buy fewer
potatoes and more of the normal goods such as meat and milk
During the Irish famine, families spent 80% of their income on potatoes.
As potato prices fell, real income rose and money was spent on milk and
meat instead. The quantity demanded for potatoes fell as prices fell.
• The income effect was more powerful than the substitution effect, and less was
bought as the price fell: the demand curve was positively sloped.
2.1.2 Supply
2.1.2.1 Definition of Supply
• The supply curve shows the amount of goods and services that producers are
willing to and able to produce and offer for sale.
2.1.2.2 Law of Supply

• The Law of Supply states that higher quantities will be supplied at higher prices,
all other things unchanged:
o This leads to a movement along the supply curve.
o As the extra cost of producing a unit increases, producers need a higher price
to produce the product.
• Quantity supplied is a flow of goods or services per unit of time.
2.1.2.3 Determinants of Supply

• Changes in supply refer to shifts of the whole supply curve.
• The factors causing shifts in the supply curve include:
o Increase in number of producers in an industry: leads to an increase in
supply.
o Prices of factors:
If there are increases, less is supplied at each price (less profit is being
made), and the supply curve shifts left.
If factor prices fall, the supply curve shifts right.
o Technological changes: always lead to a rightward shift in supply.
o Weather: improvements can increase the supply of farm produce.
o Taxes and subsidies: increases in taxes lead to a fall in supply, increases in
subsidies leads to an increase in supply.
o Changes in the prices of other goods:
Sometimes goods are produced jointly such as wool and lamb’s meat: if
the price of wool falls dramatically and farmers switch to producing
something else, the price of lamb’s meat rises dramatically.
Alternatively, if you could produce two goods from the same factory and
the demand for one rises dramatically:
• Production will switch to that good and it’s supply will shift out.
• Production of the second good will fall and it’s supply will shift in.
2.1.2.4 Effects of Taxes and Subsidies on Supply
Taxes
• An increase in taxes is like an increase in cost for producers. That means that the
supply curve will shift to the left: less is offered at each price as it is more
expensive to produce.
Subsidies
• A subsidy is a gift of money from the government to the producer. That means
the supply curve shifts out to the right: more is offered at each price as it is now
cheaper to produce.
2.1.2.5 Movement along versus Shifts of the Supply Curve
Movement along
• When the price increases:
o It becomes more profitable to produce and sell more so more is offered for
sale at higher prices
o There is an expansion along the supply curve.
• When the price falls:

o It becomes less profitable to produce and so less is offered for sale
o There is a contraction along the supply curve.
Shift in Supply
• A decrease in costs of production, a reduction in government taxes, an increase
in subsidies, a technological breakthrough, or firms entering the industry will all
lead to the supply curve shifting out.
o More will be supplied at the original market price.
2.1.3 Interaction of Demand and Supply

2.1.3.1 Equilibrium market clearing price and quantity
• A market is a meeting of buyers and sellers who do not have to physically meet.
Markets cannot exist unless both buyer and sellers are involved.
• Markets include those for wheat, fruit, stocks and bonds and foreign exchange:
o Wheat produced in one place can be sold anywhere in the world.
o Between the London stock exchange, the New York stock exchange and the
Tokyo exchange, it is now possible to trade certain stocks 24 hours a day:
markets are not limited to certain intervals of time.
o Foreign exchange markets are located in the international telephone networks
and computer hookups.
• In some rural markets, fruits, vegetables and fish may be quite expensive in the
morning but be marked down drastically toward the end of the day, particularly if
there is no refrigerated storage available.

• Non market sectors include non-governmental organizations (NGOs) such as
charities and volunteer organizations which
raise money from the public to pay for goods Equilibrium in the Car Market
and services. The bulk of non market $
production is accounted for by government 14000
Supply
and NGOs: the money is provided by tax 12000
Price of Cars
10000
revenue and donations, and the non market 8000
goods and services are distributed to 6000 Demand
4000
households and firms.
2000
0
• Equilibrium occurs when quantity demanded 0 10 20 30 40 50 60
equals quantity supplied. Quantity of Cars
• Only at a price of $8,000 does quantity
demanded equal quantity supplied.
• Price below equilibrium: households will desire more but firms will not be
prepared to offer as much leading to excess demand.
o Inventories will be falling, and sellers can charge a higher price.
o The price will edge back up to $8,000 where the quantity supplied and
demanded will be equal to each other again.
2.1.3.2 Adjustment to a new Equilibrium

• Price above equilibrium: people will want fewer cars while firms will be only too
happy to supply more leading to excess supply:
o Inventories will be rising and firms will lower prices to clear the carlots.
o Households will be happy to buy cars at lower prices.
• No equilibrium: where supply is everywhere above demand, nothing will be

produced because the highest price consumers are prepared to pay is less than
the minimum price producers need to supply (spaceships).
Price
Supply
• Goods or services with no price:

o In most countries, roads are available free of
charge and people will use them out to the point
De
where demand intersects the horizontal axis

m
an
d
leading to excess demand.

o Rationing does not take place: there is
Excess Demand
overcrowding.
o In some countries medicine is free and again there Quantity of Roads
is excess demand which is likely to get worse as populations age.

o Rationing takes place through queueing (typically the government issues
coupons to stop hoarding).
The Four Laws of Demand & Supply

• A rise in demand: excess demand, inventories fall, price and quantity increase:
o The rise in price acts as a rationing device to lower demand but encourages
existing firms to produce more and for other firms to join the industry, thus
moving resources into the industry to respond to the increase in demand.
• A fall in demand: excess supply, inventories rise, price and quantity decrease.
• A rise in supply: excess supply, inventories rise, price falls and quantity rises.
• A fall in supply: excess demand, inventories fall, price rises and quantity falls.
2.2 Elasticities
2.2.1 Price Elasticity Of Demand (PED)

2.2.1.1 Formula
• Price elasticity of demand: measures responsiveness by dividing the percentage
change in quantity demanded by the percentage change in price.
%∆q ∆q / q ∆q / ∆p
PED = = =
%∆p ∆p / p q/ p
Where: ∆ = change in.
• The term on the top is the slope of the demand curve, while the term on the
bottom is the slope of the ray from the origin to the point on the curve where
you are measuring elasticity.
• As price and quantity demanded are inversely related the equation is always
negative, but we tend to ignore the negative sign and report a whole number.
• Arc elasticity measures the elasticity over a segment of (q2 − q1 )

the curve. (q2 + q1 )
• The slope is taken from the the chord over that arc of the % ∆q 2
η= =
curve. As there are two points, the slope of the ray is % ∆p ( p2 − p1 )
determined by an average: the average quantity over the ( p2 + p1 )
average price. 2
2.2.1.2 Definition
• Elasticity measures the sensitivity of demand (quantity demanded) to changes in
variables such as its own price.
• If the supply curve shifts because of government subsidies, it is useful to know
the impact on the price and the quantity demanded.
Elastic Dem and

2.2.1.3 Possible range of values
S1
• Elastic demand (PED > 1):
Price of Records
S2
o A subsidy leads to an outward shift in supply,
prices fall leading to a large increase in
quantity demanded (%∆q > %∆p). Demand
o If price fell by 10% and quantity demanded
rose by 50%, the elasticity would be equal to
5, an unusually high number for elasticity Quantity of Records
o Perfectly elastic (PED = ∞): infinite change in
quantity demanded (%∆q = ∞)

Inelastic Demand
• Inelastic demand: (PED < 1):
o A subsidy leads to an outward shift in supply,
prices fall but there is only a small increase in Demand
Price of Oil
quantity demanded (%∆q < %∆p) Supply 1
Supply 2
o If price fell by 10% and quantity demanded rose
by only 5%, elasticity is equal to 0.5.
o Perfectly inelastic (PED = 0): no change in
quantity demanded (%∆q = 0)
Quantity of Oil
• Unit elastic demand (PED = 1): if the responsiveness

is about the same as the change in price, then the measure will be equal to
(minus) one (%∆q = %∆p)...
2.2.1.4 Diagrams illustrating range of elasticity values

• Point elasticity measures the responsiveness of quantity to price at a particular
point on the demand curve.
• The slope is given by the tangent to that point, and is often measured as dq/dp,
which is determined by calculus.
• The slope of the ray is given by: q/p, the p and q corresponding to that point are
used (rather than average p and q over an arc of the curve).
Ranges of Demand Elasticity
2.2.1.5 Varying Elasticity Along a Straight

Line demand curve C
• Elasticity along a straight line demand curve

varies from zero at the quantity axis to infinity at E2
the price axis. η>1
Price
• In the figure:
E1
o Below the midpoint of a straight line demand η=1
curve, E3, elasticity is less than one and the
firm wants to raise price to increase TR. E3 η=1
η<1
o Above the midpoint, E2, elasticity is greater Total
Revenue
than one and the firm wants to lower price to
increase TR. Quantity
F
o At the midpoint, E1, elasticity is equal to one.
• For the straight demand curve, the ranges of elasticity are given by the formula:
EF
PED =
CE
• For the curved demand curve, EF is the distance from the point where the
tangent intersects the x axis to the tangency point divided by the distance from
the tangency point to the intersection with the y axis.
o For a hyperbola, the point of tangency will always be the midpoint of a
straight line and therefore, the elasticity is always equal to one along the
curve.
• Where there are two straight line demand curves of the same slope, the one
furthest from the origin is less elastic at each price than the closer one.
• Where two demand curves of different slopes intersect, the elasticities are
different because the slopes are different at that point.

2.2.1.6 Determinant of price elasticity of demand
• Substitutes: if there are many substitutes available, consumers can easily switch
to other goods if prices rise.
• Time: it may be difficult to find substitutes in the short run so demand is likely to
be less elastic in the short run than in the long run.
• Demand within product groups tends to be fairly elastic:
o The demand for gas versus electricity or gas versus diesel is fairly elastic.
o However, for energy as a whole, demand tends to be very inelastic because
there are no substitutes for hydrocarbons.
• Size of item in budget: if consumers spend only a small amount on the item
(such as matches for lighting candles) relative to their budget, it is likely to be
inelastic: not sensitive to price changes
• Addiction: some goods are habit forming and tend to be price inelastic: coffee.
2.2.2 Cross Elasticity of Demand

2.2.2.1 Definition
• Responsiveness of quantity demanded to changes in prices of other goods:
2.2.2.2 Formula:
%∆q x
XED =
%∆p z
2.2.2.3 Sign of complements and substitutes

• Complementary goods:
o Quantity demanded increases when the price of the complement falls.
o If the price of gas fell to 10 cents a litre, sales of cars would increase.
• Substitute goods:
o Quantity demanded of one good falls when the price of the substitute falls.
o If the price of coffee rises, people tend to consume less coffee and more tea.
• Price cross elasticity tells us the relationship amongst goods:

o Bottle makers find they are in competition with producers of cans
2.2.3 Income Elasticity of Demand

2.2.3.1 Definition
• Income elasticity measures the percentage change in quantity demanded as
income changes.
Luxury goods
YED > 1
2.2.3.2 Formula
%∆q
YED =
%∆Y

2.2.3.3 Normal goods
• Normal goods: an increase in
Regions for Income Elasticity of Demand
income leads to an increase in
consumption, demand shifts to the
Inferior goods:
right.
Income
YED < 0
o For basic or necessity goods, 0 <
YED < 1, quantity demanded will Basic or
not increase much as income necessity goods
Normal goods
0 < YED < 1
increases (income elasticity for YED > 0
food = 0.2) Luxury goods

o For luxury goods, YED > 1, YED > 1
quantity demanded rises faster

than income. For restaurant Quantity
meals income elasticity is higher
than for food, because of the additional restaurant service.
2.2.3.4 Inferior goods

• Inferior goods: income elasticity is actually negative, the demand curve shifts left
as income rises. As income rises, the proportion spent on food tends to fall while
the proportion spent on services tends to rise.
• As economies grow, income elasticity helps determine what should be produced:
firms will want to avoid producing inferior goods.
• Countries are at various stages of economic development and so have widely
different income elasticities for the same products. As overseas incomes grow it
may create new markets as demand shifts from inferior to normal goods.
Income and Substitution Effects

When the price of a good falls there are two effects:
• Substitution effect: people buy more because it is relatively cheaper.
• Income effect: real income rises because of the lower price of the good:
o Normal goods: the consumer buys more of all normal goods, the income
effect reinforces the substitution effect.
o Inferior goods: the consumer buys less of all inferior goods, the income effect
works against the substitution effect.
• Giffen goods are inferior goods, as the price falls, people consume less because
the fall in consumption from the income effect outweighs the rise in
consumption due to the substitution effect.

2.2.4 Price Elasticity of Supply
2.2.4.1 Definition Elasticity of Supply
• Elasticity of supply measures the
Price
responsiveness of the quantity
supplied to changes in price:
Elastic
Supply
2.2.4.2 Formula
pp stic
Su Ela
%∆q
ly
PES =
it
Un
%∆p
2.2.4.3 Possible range of values

• Elasticity = 0: if the supply curve is
vertical, and there is no response to
prices. tic
e las ly
• Elasticity = ∞: if the supply curve is In pp
Su
horizontal.
2.2.4.4 Diagrams illustrating range of Quantity

values
• Any straight line supply curve intersecting:
o The origin has an elasticity of one: at every point along the curve, the slope
of the ray (q/p) equals the slope of the line (∆q/∆p).
o The price axis is elastic.
o The quantity axis is inelastic.
2.2.4.5 Determinants of Supply Elasticity

• If costs rise only slowly as production increases, a rise in price will stimulate a
large increase in quantity supplied.
• If costs of production rise rapidly as output rises, then the stimulus to production
which comes from rising prices will quickly be choked off.
Capacity:
• Ease of entry: the fewer the barriers to entry, the easier for firms to enter the
industry to increase supply in response to an increase in price and supply is
elastic.
• Factor mobility: the easier it is to move resources into the industry, the more
elastic the supply curve.
• Ease of switching: if land and labour can be shifted easily from growing one crop
to another, the supply will be more elastic:
o Even if it is possible to shift inputs, if the cost of inputs rises production costs
will rise rapidly as output rises and supply will be inelastic.
• Spare capacity: if there is unused capacity, it is easy to increase production if

demand should start to shift out.
• Ease of storing output: if it is easy to store production, the more elastic supply
response to increases in demand.

Length of time:
• Length of production period: the more quickly the good can be made, the easier
to respond to an increase in price.
• Time period: over time the firm can train labour and invest in more capital
equipment and supply is more elastic in its response to price increases.
o Over the longer term as cheaper inputs are substituted and new production
methods incorporated into the firm, outputs will tend to increase and prices
will tend to moderate.
2.2.5 Applications of concepts of elasticity

2.2.5.1 PED and business decisions: effect of price on total revenue
• Total Revenue: is equal to P*Q.
o By estimating the effect of a price change, firms can plan the number of
goods to produce and estimate their potential revenue.
• Inelastic demand: price and total revenue are positively related

o If firms cut prices by 10% but sales only increase by 5%, revenues fall
o A rise in price will not only increase revenue but will also increase profit as
costs will fall because less is produced.
o The increase in the number demanded is too small to offset the drop in the
price of each good sold.
Example: the oil industry where demand is inelastic, as prices rise,
quantity demanded does not fall very much.
• Elastic demand: price and total revenue are negatively related

o If demand is elastic, a fall in price will increase revenue but not necessarily
increase profit as production must increase quantity demanded increases.
o If quantity demanded increased 50% when price fell by 10%, revenues
increase.
o The increase in the number demanded is more than enough to offset the fall
in the price of each good sold.
• Unit elastic demand:

o Total revenue is constant regardless of changes in prices.
o The cut in prices is exactly offset by the increase in the quantity demanded,
and total revenue to producers will stay the same.
2.2.5.2 PED and taxation

• There are two main forms of tax:
o A direct tax is imposed on income earned and is called direct because it is
usually taken off before the worker receives their paycheque.
o An indirect tax is imposed on expenditures on goods and services and is
called indirect because taxes are only paid when the consumer spends money
on the good or service
People who save rather than spend do not pay the tax
• Obviously a direct tax on income means that all levels of expenditure will be
lower for the consumer
o Note that there is no relative shift in expenditure from one good or service to
another.
• The problem with indirect taxes is that unless they are imposed on all goods and
services at the same rate, there is a tendency for people to shift from goods
which are taxed to goods which are not taxed.
o This is often referred to as the tax distortion: the market solution is distorted
by the tax and people will shift their expenditure from taxed goods and
services to untaxed ones.
o The more elastic the demand for taxed goods, the more substitutes there are
and the easier it is for consumers to shift expenditures to the substitutes
For example: if there were a 100% tax on Coke, everyone would shift to
Pepsi
o For this reason governments impose taxes uniformly on all goods within a
certain group
• Tax efficiency means that the tax imposed leads to very little shifting of
expenditure and very little distortion of the market allocation
o In order to be efficient, governments tend to impose taxes on goods which
are very inelastic as there are few substitutes and very little expenditure
shifting takes place
In the case of perfectly inelastic demand, no distortion would occur.
o The other reason is that if taxes are imposed on elastic goods, not much tax
revenue is earned as people simply switch to untaxed substitutes.
2.2.5.3 Cross Elasticity of demand: relevance for firms

• Firms can determine the impact on sales and revenues of price changes by rivals,
or when they or another industry changes the price of complements.
• During the oil crisis in the 1970s prices rose 400% in the space of three months
but quantity demanded fell by less than 5% the first year.
o More energy efficient cars were bought by consumers
o Companies switched to using coal instead of oil in their furnaces.
• In the longer term, new supplies of oil were found, and the real price of oil
declined as consumers switched to substitutes.
• For goods like energy it takes time to use up the stock of appliances and
machinery and switch to those using energy in a more efficient manner.
2.2.5.4 Significance of income elasticity for sector change as the economy

grows
Specific (Flat Rate) Tax
Price
• As economies grow:
o Firms will plan on producing fewer inferior
goods. Supply + tax
o Production and purchasing of capital goods Supply
and other factors can be planned.
o Production for exports can be planned as
new markets open and close.
Quantity

2.2.H Higher Level: Incidence of Indirect Tax
2.2.H.1 Flat rate and ad valorem taxes
Price
Ad Valorem Tax
• Indirect taxes are placed on suppliers and have the Supply + tax
effect of raising costs shifting the supply curve in:
o Ad valorem taxes add a percentage on to prices
o Specific or unit taxes adds a fixed amount on to Supply
costs.
2.2.H.2 Incidence of indirect taxes and subsidies

on the producer and consumer
Quantity
• Will help determine the impact of an indirect (sales)
tax on quantity demanded and the resulting tax revenue.
• Will help determine the impact of any shift in supply due to subsidies in terms of
consumer spending and producer revenues.
• Firms try to pass these increased costs on to consumers.
2.2.H.3 Implication of elasticity of supply and demand for the incidence

(burden) of taxation
• Who actually pays the tax very much depends on the elasticities of the two
curves.
• If demand is more inelastic than supply the consumer will pay a greater
proportion or incidence of tax.
• It is easier for consumers to shift the tax back to the producer if there are easily
available substitutes.
• If supply is more inelastic than demand, the supplier will pay a greater proportion
or incidence of tax.
• A tax on pure profits should not have any influence on price or output, thus the
producer bears the full burden.
o If the govt imposed a 15% tax, then profits would fall, but this would be true
no matter what level of output would be produced.
• If the definition of profits includes payments to factors such as shareholders, the
incidence of a profits tax could be shared by shareholders (lower profits on
capital), wage earners (lower wages) or by
consumers (higher prices).
S2
B S1
Tax
Deadweight Loss
C
Monthly Rent
R1
• The original equilibrium was at point A. Consumer's
• If a city government placed a tax on rents: Ro
share
o Landlords try to raise rents by the amount of the Producer's A

Share
tax, from A to B R1-t
Deadweight
o There will be excess supply, rents fall and a new Loss
equilibrium at C.
• The landlord receives the rental price of R1, but
pays the tax equal to the difference between R1 and Rental Accommodation
R1-t.
o The landlord’s share of the burden is the difference between what they
originally received and what they receive now: Ro minus R1-t.
o The tenant’s share of the burden is the difference between what they used to
pay and what they pay now: R1 minus Ro.
• The deadweight loss represents the loss in social net benefits that no-one
receives. It occurs because less is supplied than is socially optimal.
o If demand were perfectly inelastic, the tenant would bear the whole burden.
o If demand were perfectly elastic, the landlord would bear the whole burden.
o The deadweight loss is less the more inelastic the demand and supply.
• Often referred to as a distortion: the more quantity responds because the curves
are elastic, the more quantity will fall as taxes are imposed. This is referred to as
a tax distortion because it distorts the way demand and supply would normally
respond in a tax-free market.
2.3.H Higher Level: Theory of the firm
Limited Liability
• The separation of management and ownership through limited liability 500 years
ago is the key to why firms have been able to grow so rapidly and to become so
large.
o In the US only 1000 companies account for 60% of the GDP, the remaining
40% is produced by 11 million businesses and other institutions. The large
firms are 17,000 times larger on average than the small firms.
• Limited liability allows companies to raise money easily, because individuals are
not so afraid of losing everything in the case of bankruptcy.
• A typical company pays out half its earnings in the form of dividends, the rest is
re-invested.
• Firms finance:
o Fixed capital (usually associated with K) by borrowing money from the bank
or by selling bonds in the bond market or through retained earnings,
o Risk capital (usually associated with the entrepreneurial input) by issuing
shares,
o Working capital (usually associated with the L and NR used in production)
from retained earnings or by short term loans from banks.
• Firms must profit maximize in order to earn at least the Opportunity Cost Rate of
Return, otherwise their share value will fall, and another firm will buy them out
and force them to earn at least the Opportunity Cost Rate of Return,
Multinational or Transnational companies:

• Internationally there are 600 multinational companies (MNCs). Today the
majority are associated with entertainment and media compared with banking
and finance, petroleum and chemicals fifty years ago.
• MNC have flourished:
o Rather than fight tariff and non-tariff barriers, MNCs just set up production in
the host country,
o Tastes are different, MNC produce locally to tailor services to the local market,
o Advances in telecom have allowed firms to globalize
• Small Firms: most small companies fail for three reasons:

o Marketing: owners do not understand how to serve the market,
o Poor financing: most do not know how to invest money so that it repays the
capital as well as the carrying costs,
o Poor management: most owners do not know how to delegate tasks, organize
a business in an efficient manner, or coordinate tasks.
2.3.1 Cost theory

• Companies must balance revenues and costs so as to maximize profits.
• Factors of production are priced at opportunity or user cost:
o Labour: firms pay a wage for labour service,
o Capital can be rented but is often owned, a cost must be imputed (estimated)
for the capital services:
PK *( r + δ )
where:
P refers to the cost of the capital,
r refers to the interest on the loan to buy the capital or if the company
owns the capital it is the Opportunity Cost Rate of Return that could have
been earned on the money tied up in the capital,
δ is the depreciation rate on the capital.
o Natural resources are either treated like capital if the firm owns them, or
treated as an input that must be purchased.
• Firms carry inventories which act as shock absorbers so production and sales
never need to stop,
o There are three types: raw materials, intermediate (semi-finished) goods, and
final goods
o Inventories must be financed by working capital and require storage space
2.3.1.1 Types of cost: Fixed and Variable Costs

• Total cost is the sum of fixed and variable costs:
o Fixed costs consists of fixed factor, usually capital, sometimes referred to as
overhead cost. Even if there is no production, fixed costs must be paid.
o Variable costs are associated with the variable factors, usually labour and raw
materials, and are directly related to output: no output, no variable costs.
2.3.1.2 Total, average and marginal costs

• Average cost is total cost divided by quantity of output or the sum of average
fixed and average variable costs:
o If fixed costs are truly fixed, then as output increases, average fixed costs
must be declining steadily.
• Marginal cost is the incremental cost:

o Fixed costs are fixed, there can be no incremental costs coming from K.
o Marginal cost is equal to marginal variable costs only.
2.3.1.3 Accounting cost + opportunity cost = economic cost

• Accountants add up all the visible costs for labour, natural resources and capital
• Until recently accountants did not include an estimate for opportunity cost

o It is usually assumed that the factors of production are paid their opportunity
cost: the price that factor could receive in the next best use
o However, in calculating the rental price of capital we included an estimate of
what the money tied up in the capital equipment could have earned if it had
been invested in the money market instead of in capital.
We generally use the money market as it is the safest place to invest
o Note that we did not make an allowance for the returns to the entrepreneur,
and we must include an estimate of the opportunity cost for the
owner/manager’s time
• Thus economic costs include:

o The accounting costs for the factors
o Plus the money market rate of return (sometimes called the opportunity cost
rate of return) on the money invested in the capital
o Plus the salary the manager/owner could have earned in the next best job.
• Accountants in the USA are now starting to take opportunity cost into account
which means that ROI in the stock market is not going to look as high once the
new system is utilized
o If opportunity costs are taken into account, then companies will appear to
earn less money than they did in the past: economic costs are higher than the
previous accounting costs.
o Indeed, economists believe that if economic costs are used then firms will be
earning a normal profit when economic profit is equal to zero
• This is a critical concept:

o When demand is rising quickly in an industry, supernormal profit will be
earned as TR will be greater than total economic costs and firms will be
attracted into the industry
As firms enter, the supply curve shifts out, prices fall and super normal
profits drop to zero
o When demand is falling in an industry, losses will be experienced and firms
will leave the industry
As firms leave, the supply curve shifts in, prices rise until losses reach zero
and firms are earning a normal profit once more.
2.3.2 Short Run

2.3.2.1 Law of diminishing returns
• The law of diminishing returns states that as more and more of the variable
factor is applied to a fixed amount of the other factor, eventually each additional
unit of the variable factor will add less to productivity.
• In the short run capital is fixed, firms do not have time to build new plant and
equipment or get rid of obsolete ones.
o Only labour can be varied in the short run. As more labour is added to a fixed
plant, total product will increase.
o Average and marginal productivity will rise at first and then tend to fall as
workers have less and less capital equipment to work with.
• In the long run capital can be varied, new plant and equipment can be built, old
ones destroyed or sold off.

o It is a planning period to allow the building of new capital, it can actually be
shorter than the short run!
o In the very long run, it is assumed that new techniques can be invented and
applied which will increase productivity. Average & Marginal Productivity
Productivity of Labour (Q/L)

In the Short Run
2.3.2.2 Total, average and marginal product

• The production function describes the precise Diminishing MP
physical relationship between factor inputs and Diminishing AP

TP
output:
• Marginal product is the increment in output from
an extra worker: MP AP
∆TP
MP = Quantity of Labour
∆L
o MP rises at first as each worker can specialize in doing the task for which they
are trained (specialization and division of labour), but eventually starts to
decline at the point of diminishing marginal productivity.
• Average productivity is given by.

TP
AP =
L
o Eventually, each additional worker will add less to output than the previous
worker, and AP will start to decline (diminishing average productivity).
o the AP curve slopes up as long as MP is above the curve: if the increment is
greater than the average, then it must pull up the average.
o As soon as MP falls below AP, it must start pulling it down: MP is equal to AP
at the maximum point of AP.
2.3.2.3 Short Run Cost Curves
Average & Marginal Cost
• Unlike productivity curves, cost curves AVC
MC AC
vary with output: greater productivity
Cost per unit
on the part of labour means more

output for less labour cost.
• AC and MC tend to fall at first for the

same reason that AP and MP rose:
specialization and division of labour, it
costs less to produce the next unit.
o AFC is constantly falling. AFC
o At first AC (or ATC) is falling
because both AFC and AVC are Quantity
falling: wL↑ < Q/L↑
o Eventually, with diminishing
returns, AVC must turn up because,
wL↑ > Q/L↓, and after a certain point this effect outweighs the constantly
falling AFC and pulls up the AC curve.
o The MC curve cuts the AC curve at its minimum point.
• The vertical difference between AC and AVC is just the AFC, and gets narrower
as AFC gets smaller
o We never need to draw AFC again, as we know it is already on the diagram
between AC and AVC.

• The output associated with minimum AC is called the capacity of the firm:
o The largest output that can be produced without average costs rising.
o Firms operating below this point are referred to as having excess capacity.
o A firm can produce beyond this point, but to do so would lead to rising unit
(average) costs.
Input or Factor Costs

• Up to now we have assumed that input prices remain constant. Costs rise and
fall strictly because of changes in productivity not because of changes in factor
costs themselves (wages per hour stay constant for labour).
• A rise in the price of any of the inputs will lead to the whole set of curves shifting
upward.
o If it is a rise in the cost of K, then AFC will shift up
o If it is a rise in wages, then AVC and MC will shift upward.
• A fall in the price of inputs leads to a fall in the curves.

• If there is an increase in K, then productivity will rise and the AVC, MC, and AC
curves will all shift down.
o There is a different set of curves for each amount of K, that is size of plant.
2.3.3 Long Run

Costs
2.3.3.1 Economies of scale Long Run Average Cost

• LRAC is falling at first due to economies of
scale ( increasing returns to scale) which
arise from:
In
to
cr
s
ea
rn
o Increased opportunities for
sin cal
al t u
sc g re
g e
specialization and division of labour due

s
e
re
n
tu
si
to larger plant size: a bigger company
ea
rn
cr
st
De
o
can employ specialist staff.

Constant returns
o Some factors of production are to scale
indivisible, so that to make full of them
a large output is required: large,
specialized equipment which can only be
profitable if used at large volumes of
output.
o Falling research and development (R&D) Quantity
costs.
o Certain types of marketing which are cheaper the more units made and sold.
o Economies realized through bulk buying, cheaper financing, and
transportation discounts.
2.3.3.1 Diseconomies of scale (decreasing or diminishing returns to scale)

• After a point, LRAC starts to rise due to decreasing returns to scale
(diseconomies of scale) which arise from:
o Difficulties of managing and controlling large enterprises.
o No more opportunities to substitute large scale machines.
o Limits to the economies associated with discounts for large scale purchases.

• For some industries, there is a flat section between the falling and rising parts,
and this is referred to as constant returns to scale.
2.3.3.3 Long Run Cost curves

• The firm reaches long run equilibrium when there is no opportunity for cost
reducing substitutions: the ratio of marginal products to factor costs is equal:
MPL MPK MPNR

= =
PL PK PNR
Where:
PK refers to the rental price of capital (PK{r + d})
PL refers to the wage rate
PNR refers to price of natural resources (rent)
• Firms are motivated to use less of factors that become scarcer to the economy
and more of the factors that become more plentiful.
• The same will be true for regions and nations: if a country has relatively more
land than labour, farming will tend to use the cheaper land more extensively
while economizing on the more expensive labour.
• In China where labour is abundant and K is scarce, a much less mechanized
method of production is appropriate.
• In both the long run and the short run a minimum achievable cost can be found
for each possible level of output, and a curve can be constructed called the long
run average cost curve (LRAC).
o Factor prices are assumed to be fixed. If factor prices rise, the whole LRAC
rises.
o Technology is assumed to be fixed.
• To move from one point on the LRAC to another is very different from the short
run AC: it requires an adjustment in all factors, a new plant must be built.
o All the possibilities are given by a variety of SRAC curves, one for each plant.
o The LRAC is the envelope of the SRACs, it is tangent at just that output where
K is optimal in the MP/P formula above.
o Note there is no long run marginal cost:
The reason is that the LRAC is actually a locus of points, it is not a
function.
That means that a new plant must be built at each point on the LRAC, so
there are no marginal costs only average costs.
Technical Innovation
• In the long run there is great potential to drop costs through technical
innovation. Indeed, sustainable growth in the future cannot come about through
greater and greater use of natural and environmental resources, it must come
from technological change.
• Loss of technical knowledge is very rare, thus technical change always causes the
LRAC curve to fall:
o Labour: through better health and education, productivity of labour inputs can
rise dramatically.

o Natural resources: through better engineering and refining and processing
techniques, better materials can be obtained from natural resources.
o New products are invented which reduce costs dramatically such as the new
wall screen TVs which will be out shortly.
o Capital:
During the industrial revolution capital has been substituted for labour
With the information revolution: thinking machines are replacing human
intelligence.
• Resequencing of production has led to a new lean production system as workers

learn by doing:
o Workers are organized as teams, individuality and initiative are emphasized.
o Parts are delivered by suppliers just in time.
o A worker stops production when a fault is discovered.
o Defective parts and problems are analyzed for a pattern of causes that need
to be understood.
o As the sources of problems are found and solved, work stoppages decrease
o Design teams are non-specialized and work closely with production engineers
and parts producers:
o As new products are developed, tool designers can start developing the tools
that will be needed.
Measuring Technical Change

• The rate of increase in productivity provides a measure of the progress caused by
technical change:
o Q/L: We usually measure productivity as output per hour of labour.
o K/L: As the price of labour relative to capital has risen, firms have substituted
K for L.
o Quality of K: Machines have grown more and more productive over time
(Q/K↑ ), but this has increased dependence on energy.
o No limits to growth: The growth in knowledge and its application has
expanded so rapidly that firms are now able to squeeze more out of limited
resources faster than the expanding population.
• Technical change is often endogenous. It is in response to something going on

in the production process rather than just some accidental discovery going on in
a totally unrelated way.
• Often it is the result of R&D expenditures, and tends to rise as profit incentives
rise. The US, Germany and Japan have all invested heavily in R&D, and
productivity growth has been excellent for them.
Slowdowns in Productivity Growth

• There have been slowdowns in productivity growth:
o For industrialized countries there is less possibilities for gains in productivity.
o Rising oil prices in the 1970s contributed to a slowing down in productivity
growth.
o There has been a shift in the population from younger to older people. Older
people are harder to train in new techniques and less innovative.
• Services: over the last 15 years there has been a massive shift over to the
service sector. We have moved from goods industries where increases in capital
per worker led to enormous increases in productivity. The growth in productivity
does not appear to be as rapid for services as there are less opportunities to
substitute machines for people.
• Pollution: there has also been increasing pollution and environmental degradation
which has lowered the quality of life.
• Crowding out: government deficits have drained the savings from the private
sector which would normally have been invested in K and in R&D.
• The institutional climate has become very hostile to innovation. This is one of
the main reasons for the emphasis on deregulation.
2.3.4 Revenues
2.3.4.1 Total revenue
• Total Revenue is simply the price of the good times the number of units sold
TR = P * Q
2.3.4.2 Marginal revenue

∆TR
o Marginal revenue: MR = =P
∆Q
2.3.4.3 Average revenue

TR
o Average revenue: AR = =P
Q
2.3.5 Profit
2.3.5.1 Distinction between normal (zero) & supernormal (abnormal) profit
• Profit, sometimes also called net revenue, is the difference between total costs
and total revenues,
• If a salary is imputed for the owner, and a cost of capital imputed for the owner's
investment:
o One would expect there to be zero profits on average,
o If profit is greater than zero, the firm is earning supernormal or abnormal or
pure or economic profits.
• Return on investment (ROI) (in the US it is called IRR: internal rate of return):
o The net revenue is divided by the total investment in the firm,
o If there is no attempt to impute a salary and cost of capital for the owner:
The return on investment would be expected to be equal to the
Opportunity Cost Rate of Return, and firms will stay in the industry.
If it is greater than the opportunity cost rate of return, the firm is earning
a supernormal profit, this will become known and firms will attempt to
enter the industry.
If it is less than the opportunity cost rate of return, firms will leave the
industry.
2.3.5.2 Profit Maximization

• As profit maximizers, firms would like to increase revenues and decrease costs.
Thus profit maximization implies cost minimization.
• In the long run all factors of production are variable.
• Short run cost curves show minimum cost per unit for different levels of output,
given a fixed factor. There are an infinite number of short run curves: as a firm
changes its fixed factor over time, a new short run average cost curve emerges.
• Firms substitute inputs in the long run until they achieve the most cost efficient
combination.
MPL MPK MPNR
= =
PL PK PNR
• If the price of K rises:
MPK MPL
o < : the firm will substitute L for K:
PK PL
o The MP of L will fall, and MP of K will rise, equality will be restored.
2.3.5.3 Other goals: sales max, revenue max, environmental concerns

• We have assumed up till now that most firms want to maximize profit.
o As long as there is freedom of entry and exit, firms will only be able to make
supernormal profit in the early days of a new industry or where demand is
rising rapidly
o Once an industry is in equilibrium, the most a company will be able to make is
a normal profit
• However, there are other goals that a firm can pursue in the short run.
o It may decide to maximize sales in order to try and capture a certain segment
of a market.
The firm will do this subject to earning some minimum level of profit,
otherwise larger firms may acquire the firm and force it to become profit
maximizing again.
If it is successful, the firm can carve out a larger market share which may
allow it to acquire some monopoly power which could allow it to earn
supernormal profit in the future.
o Alternatively the firm may pursue the goal of maximizing total revenue
This occurs at the point on the demand curve where elasticity is equal to
one.
The point of revenue maximization is very unlikely to coincide with the
point of minimum cost which means that the firm will not be maximizing
profit and will not be able to maintain this strategy for very long.
o Firms are acutely aware of consumer preference for environmentally friendly

producers and will consciously move in that direction even if it means making
less than maximum profit. However, it may be a very clever long term
strategy
In the short run, being an environmentally friendly company may cost
money
However, in the long run, once a reputation is established, it may lead
consumers to prefer the products of that company which may allow the
company to gain some limited monopoly power and be able to charge a
premium price for its products or services.

2.3.6 Perfect Competition
2.3.6.1 Assumptions of the model
• Perfect Competition: a market in which no one firm or individual has any power
to influence price, they are price takers. We assume:
o The product is homogeneous (identical)
o Consumers understand the product and know all the prices being charged.
o The firm reaches minimum optimal scale or minimum efficient scale (bottom
of the LRAC) at quite a low level of output.
o Each producer is assumed to be a price taker.
o There is freedom of exit or entry. There are no artificial or government
barrier preventing entry into the industry.
2.3.6.2 Demand curve facing the industry and the firm

• In perfect competition, marginal and average revenue must be equal to each
other. The reason is that selling an extra unit does not lower price.
o Even though the industry demand curve will look like a normal downward
sloping demand curve for the industry, the demand facing the individual firms
in the industry will appear to be horizontal
Each firm is so small that no matter how much it sells, it will never have to
lower price, thus it can sell as much as it can at the market price.
2.3.6.3 Profit maximization in the Short Maximizing Profit

Run & the long run Minimizing Cost AVC
MC AC
• In the short run capital is fixed and the
Cost per unit
only way the firm can increase production

is by adding more labour.
• If price falls, it is possible to cut Part of fixed
production, but a point may be reached cost is
covered
where the firm saves more by closing P
than by staying open. All of variable
cost is
o Even if the firm closes, it must still pay covered
the costs of capital. These are fixed
costs and are paid regardless of Q Quantity
whether the firm operates or not.
o The firm will only operate in the short run if the revenue is at least high
enough to cover variable costs, even if fixed costs are not covered:
P ≥ AVC.
2.3.6.4 The possibility of abnormal profits or losses in the short run and
normal profits in the long run
• In the long run no input is fixed and firms are free to enter or exit from an
industry, and adjust capital investment by eliminating or adding plant.
• Normal profits are already included in the costs of production:
o The rental price of capital includes the opportunity cost of using money to
invest in capital.
o Management salaries are included in costs.
• Abnormal profit in the short run:

o The firm will attempt to expand to take advantage of the fact that the return
on investment (ROI) is well above the opportunity cost rate of return (OCRR).
o Once other firms find out, they will move from other industries where just a
normal rate of profit is being made: return on investment is equal to market
interest or rate of return.
As firms enter the industry, or as existing firms expand output, the supply
curve for the industry will shift out to the right.
As it does so, the price will start to decline. It will keep declining until the
point is reached where P = AC for the industry.
This is the point of long run equilibrium, where return on investment is
equal to the Opportunity Cost Rate of Return.
• Loss in the short run:

o The industry price is so low that only variable costs are being covered and
possibly some of the fixed costs.
o Firms will leave the industry.
The industry supply curve will shift to the left, and industry price rises.
Prices will keep rising until P = AC for the industry.
This is called the break-even price: once again, this is the point of long run
equilibrium where return on investment is equal to Opportunity Cost Rate
of Return.
• Normal profit in the long run:

o Each firm is at the bottom of the LRAC curve: the point of minimum efficient
scale (MES) of operation.
o Each firm produces at the point where P = MC = AC.
o ROI = OCRR: no supernormal profits are being made, there is no incentive for
entry or exit.
2.3.6.5 Shut down price, break even price

• Question 1: Should the firm produce at
Price > AVC: Produce
all?
70
o Only if the price is equal to or greater 60 AVC
Cost per Unit
than the average variable cost. 50

o If price is $40, then all variable costs 40
are covered, and some or all of the 30
20
fixed costs will be covered as well. 10
o At $20, the firm may decide to keep 0
going hoping that price will rise Quantity
enough to pay back some of the fixed
costs.
o At $10 the firm will be forced to close
as only part of the variable costs are covered and none of the fixed costs are
covered.

• Question 2: If P > AVC, then the firm will
produce, but at what level of output should Short Run Supply: If P > AVC,
Cost of Output
it produce? then produce where P = MC
MC
o If it produces at q1, MC is greater than
MR which means the extra worker hired MC > MR
costs more than she brings in.

o At q2, MC is less than MR, which means MR
you can hire an extra worker and she MC < MR
will add more to revenue than she will
to costs.
o The optimal position, q*, is where the
marginal worker just adds as much to
q2 q* q1
costs as she does to revenues. Quantity
The Short Run Supply Curve

• We have a rule for firms:
o Produce at MC = MR if P > AVC.
• In perfect competition, MR = P. Marginal workers are hired to the point where
costs equal the price of the marginal unit: where MC = P.
• As price rises, firms produce where MC = P as long as P > AVC.
• The short run supply curve for the firm is therefore: MC above the AVC.
The Industry Supply Curve

• Each industry is distinguished by the good or service it produces.
• To derive the industry supply curve we simply take the horizontal sum of each
firm's MC curve above the AVC.
Industry Supply Curve
First Firm's Supply Second Firm's Supply

50 Industry Supply
40
30
Price
20
10
0
Q1 Q2 Q1 + Q2
o At $10, only the first firm will be prepared to supply at that price and that is
the amount picked up for the industry.
o At a price of $20 we pick up output both from the first and from the second
firm. The sum of Q1 + Q2, gives us the industry supply curve.
Long Run Supply for the Firm & the Industry

• P = MC = MR = AC =AR gives long run profit maximization for each firm.
• The firm’s supply curve:
o Short run: is equal to the MC above the AVC
o Long run: is the MC above the ATC

• If an industry is in long run equilibrium and there is an increase in demand, price
will rise from point A to point B in the figure below:
Long Run Industry Supply Cost curves for a
Price
So representative firm AVC
S1 MC AC
Abnormal
B profit
b
Pb
Price
A C
Long Run Supply
a
Pa
Do D1
Q1 Q2
Quantity qa qb Quantity
o Firms increase production from point a to b, because P = MC at a higher Q.

o Because P > AC, supernormal profits are being made, and each firm will build
a new plant or new firms are attracted into the industry.
o The industry supply curve shifts out to the right (So to S1), and prices will
return to normal (point C), and super normal profit disappears (P = AC).
• Long run supply curve: the locus of long run equilibrium points traced out when
the demand curve shifts around: the points where P = AC for each firm.
Slope of the Long Run Supply Curve

• Note that just like the LRAC is a locus of points rather than a function, the long
run supply curve is also a locus of points and not a function.
• Constant cost industry: the long run supply curve will be perfectly elastic
(horizontal)
o Unless factor costs have risen, the cost structures for each firm, including the
LRAC will remain the same:
o As P falls, so does output until we are back at the original output for each
firm, but industry output is greater as there are more firms.
o Price returns to its original level, the long run supply curve will be flat.
• Increasing cost industry: the long run supply curve is upward sloping
o When new firms enter or new plants are built by existing firms, there may be
a shortage of some critical factor inputs.
The price of factor inputs may rise.
The whole cost structure, including LRAC, will shift upward for each firm.
P = AC occurs at a higher price than the original long run equilibrium.
o When the points of equilibrium are connected it leads to an upward sloping
long run supply curve.
• Falling cost industry: the long run supply curve is downward sloping
o Each firm is already at the MES point, there cannot be a downward sloping
supply curve in a perfectly competitive industry.
o However, it is possible for the industry as a whole to experience external
economies.
Agglomeration economies: spatial location economies which lower the cost
of a certain input because the industry is larger.

For example, as more firms move in to a region, the government may
decide to invest in public infrastructure such as building a railway or
widening the highway which would lower costs for firms.
o Because the long run supply is a locus and not a function, it is impossible to
move backward up the curve if demand should fall
Once innovations and improvement have been made, they will never be
reversed
What is being tracked is the chronological development of the industry, if
demand falls, we simply stay at the same costs so prices will not rise up
the long run supply curve.
o R&D can lead to major technological breakthroughs which lower industry

costs. The best example in recent times is the computer industry.
Very Long Run Supply

• Even if there has been no increase in demand leading to a higher price, as firms
replace worn out plants with more modern ones, the new plants may be more
efficient with a lower LRAC due to technical change.
• Firms with new plants will earn a supernormal profit.
• Old plants will not close down as price is still above AVC: it may be quite
profitable to run them if the price is more than covering variable costs.
• Eventually owners of older plants will find the returns above AVC will continually
be eroded as more and more efficient plants drive down the price:
o Capital may be discarded because it is economically obsolete, not because it
can no longer produce perfectly good products.
2.3.6.6 Definitions of allocative and productive (technical) efficiency

• Efficiency is defined for two different cases:
o Productive or technical efficiency: production of any output at the lowest
attainable cost for that level of output (minimum average cost).
o Allocative efficiency: occurs where firms are producing the optimal mix of
goods.
In perfect competition consumers express their preference through
demand, as it changes firms have to react to stay in business.
2.3.6.7 Efficiency in Perfect Competition

• Perfect Competition: a number of assumptions are made:
o There is a homogeneous product, perfect knowledge on the part of
consumers and producers and no barriers to entry.
o No single firm or group of firms has control over the market.
o The market determines the optimal allocation of resources, and efficiency in
terms of the lowest prices and costs is encouraged by competition.
• If power accumulates in the hands of corporations, Governments or unions,

misallocations of resources can occur which benefit certain interest groups.

Productive Efficiency for the Firm
• Economic efficiency requires that factors of production be fully employed.
However, even if resources are fully employed, they may not be used efficiently.
• Productive efficiency requires being on, rather than inside, the economy’s
production possibility curve.
• Any given level of output must be produced at the lowest cost per unit in the
short run. In the long run, a firm must produce a given output by combining
factors so that the ratio of the marginal product of each factor to its price is equal
to such a ratio for every other factor:
MPL MPK MPNR
= =
PL PK PNR
• As cost minimization is a corollary of profit maximization, all firms will seek to be
productively efficient no matter which market structure they operate in.
Productive Efficiency for the Industry

• This requires the total output to be allocated amongst the firms in an industry in
such a way as to minimize total costs.
• This requires the marginal costs of production to be the same for each firm.
Allocative Efficiency
• Allocative efficiency concerns the choice between alternative points on the
production possibility curve. When a particular combination is allocatively
efficient, we say the economy is Pareto Efficient.. At that point it is impossible to
produce a different combination of goods that makes one person better off
without making at least one other person worse off.
• Allocative efficiency occurs at the output where:
marginal social benefit = marginal social cost
• The economy is allocatively efficient when, for each good produced:

price = marginal cost
• The allocation of resources is efficient when each producer’s price equals its
marginal cost of production in all industries simultaneously.
• In North America technical efficiency occurs when output is produced with the
minimum amount of resources, there is no waste. However, for the IB, technical
efficiency is defined to be the same as economic efficiency.
o There are a number of technically efficient ways to produce output, economic
efficiency means the firm uses that technique which produces a given level of
output at the lowest cost.
o This will occur under perfect competition because firms have to cut costs to
compete.
Sunset Industries
• Sunset industry: this is defined as an industry where the demand curve is
continually shifting to the left. Prices are falling and firms suffer losses.
o Firms will continue to operate capital equipment as long as P > AVC.
o As soon as price falls below AVC, the industry will start to break up.

• It appears that the industry is failing because the old equipment is not being
replaced, but this is the effect rather than the cause of the industry's decline.
• Governments often subsidize sunset industries because the capital equipment
looks so old.
o This delays the inevitable decline which simply occurs more abruptly in the
future when the support is withdrawn.
o Workers should be trained for the sunrise industries, and small entrepreneurs
working in sunrise areas should be encouraged through proper programs that
do not include subsidies.
2.3.7 Monopoly
• Market demand is no different for a monopolist, but the firm is the industry and
faces the whole of the market demand which usually has a negative slope.
• This means that the average revenue is simply the demand curve, and because it
is downward sloping, the average revenue is now downward sloping as well.
• However, the marginal revenue curve will be different. Under perfect

competition because each firm was too small to influence the market, price
stayed the same no matter how much or how little the firm sold. However, if a
monopolist wants to increase sales, it must lower the price, not just on the next
unit but on all previous units as well.
o Marginal revenue must be less than average revenue because if the AR is
falling, MR must be falling even faster in order to pull it down.
o Prices must be lowered on all future units sold in order to sell extra units.
o The addition to the revenue resulting from the sale of an extra unit is less
than the price that it receives for that unit due to cutting price on all units.
2.3.7.2 Sources of monopoly power: Barriers to Entry

• In the long run, if the monopoly is making profits (P > AC), other firms will
attempt to enter the industry. To prevent entry there must be barriers to entry:
o High fixed cost barriers: the cost to a new firm to enter, develop its product,
establish its brand image, and arrange a dealer network may be so high that
entry would not be profitable.
o Government barriers: these are created by granting franchises or charter or
large leases of land such as in the forest industry.
o Patent laws: another type of artificial barrier designed to exclude other firms
from producing a particular good.
o Threats of price cutting, and/or heavy brand name advertising may be enough
to deter a potential new entrant.
Technological Change in the Very Long Run

• Monopoly profits provide one of the major incentives for firms to invest in
innovations and inventions and attempt to create a monopoly situation.
• The barriers can be circumvented by the development of similar products against

which the monopolist will not have protection from another firm's entry.
o Railways compete with water transport, trucks compete with trains.
o Airplanes compete with both trains and trucks.
o The development of fax and e mail has eliminated the monopoly of the Post
Office.
• Computer based flexible manufacturing systems allow firms to switch production

easily and inexpensively from one product line to another, thereby reducing the
minimum efficient scale.
2.3.7.3 Natural Monopoly

• Natural barriers occur because of economies of scale. Supposing minimum
efficient scale (MES) occurs at 10,000 units per week at a cost of $10 per unit. If
the market demand at that price is 11,000 then there is room for only one
producer in the industry. This is referred to as a natural monopoly.
2.3.7.4 Demand curve facing the monopolist

• Because the monopolist is the only producer in the industry, the firm faces the
market demand curve
o If there are few substitutes outside the industry, then the industry demand
curve is likely to be less than elastic.
o If the industry demand is less than elastic, it is possible for the monopolist to
raise price by cutting output
This cuts both ways, if the monopolist wants to increase output, it will
have to lower price: not just on the next unit but on all units that it sells
This means that the marginal revenue curve falls twice as fast as the
demand curve
Note that in perfect price discrimination, the monopolist only lowers price
on the next unit, thus the marginal revenue curve becomes the average
revenue (industry demand) curve.
2.3.7.5 Profit maximizing level of output

From perfect competition
• Cost curves for monopolists are no to Monopoly (Cartel)
Price
different than for competitive firms, they

Abnormal MC
are U shaped in the short run to reflect
profit AC
diminishing returns. b
Pm
• Just like perfectly competitive firms, the a

Ppc
monopolist should only produce if price is
Ma enue
D e nu
rev
em ra e)
above the minimum AVC.

(A eve
rgin
v
an ge
R
•
al
In the same way, the monopolist should

produce at the level of output which
maximizes profit (minimizes cost), MC = Qm Qpc Quantity
MR.
• Price charged: the price charged by the monopolist will be different:
o MR is less than AR, thus the monopolist produces at the Q where MC = MR
o And sets price above that point along the AR (demand) curve.
• The operating zone of the demand curve: as MC is always greater than zero, the
monopolist produces where MR is greater than zero.
o By definition, the zone of the demand curve associated with MR > 0 is
associated with that part of the demand curve which is elastic.
o Where MR = 0, the demand curve has an elasticity equal to 1.
o Thus the monopolist will never produce where the demand curve is inelastic.
• Profit: even if Q is set at the point where MC = MR, and price is set along the AR
curve above that Q, it does not guarantee that price is greater than AC.
o Short run: the monopolist will only produce if P > AVC.
o Long run: if price is persistently below AC, the monopolist will exit, he will
only stay in the industry if price is equal to or greater than AC.
No Supply Curve for the Monopolist

• In perfect competition, firms set P = MC. Given MC, it is possible to know how
much will be produced at each P, the supply curve is the MC above AVC.
• In monopoly, because MR depends on the slope of the demand curve, a given

price can be associated with many different demand curves and many different
levels of output. Thus there is no unique Q for each price, in fact, there may be
many Qs associated with a given price.
2.3.7.6 Advantages and disadvantage of Monopoly vs Perfect Competition
Advantages
• Obviously with a natural monopoly there is an advantage for society when a firm
comes in and produces the goods and services needed at the bottom of the LRAC
curve
o These industries may be regulated by government to ensure prices are
lowered below the monopoly price although the prices seldom drop to the
level one would expect in perfect competition
o Typically regulators will set the price at the AC simply because it is too difficult
to determine the MC.
• In a similar way a monopolist can compete in international markets more

effectively than perfectly competitive firms simply because of size.
• Because monopolies earn supernormal profit, it was assumed for a long time that
they used those profits to invest in research and development (R&D) which is of
benefit to society compared to perfect competition where supernormal profits are
not available for investment in R&D
o However, several studies done in recent years indicate that monopolists do
not invest in innovation
Instead profits are used to erect even higher barriers to entry
Or profits are used to lobby government regulators to allow prices to rise
even higher each year.
The industry model where supernormal profits appear to be reinvested in
R&D is monopolistic competition: with no barriers to entry, firms focus on
innovation to attract consumers.
• In Section 2.3.10.4 below an example is given of a public utility such as an

electricity generating station.
o In some communities the demand curve is not large enough to cover any of
the average costs and electricity will not be produced by a perfectly
competitive industry

o Instead, government can foster a monopoly producer of electricity either by
providing subsidies to cover costs or by permitting price discrimination to
allow the monopolist to extract enough revenue to cover costs
o In this case there is an advantage to monopoly compared to perfect
competition.
Disadvantages
• Remember that unit elasticity along the industry demand curve occurs at the
point where total revenue is at a maximum
o This will occur where MR is equal to zero
o That means that the monopolist will always operate to the left of the point
where unit elasticity occurs on the demand curve
If it operates to the right of the point where MR = 0, marginal cost will be
higher than marginal revenue and the second rule tells us that is not
possible.
The monopolist can maximize profit by cutting production back to the
point where MR = MC
• In perfect competition you may remember that the industry moves to the point
where AR = AC, the point where supernormal profit = 0, and the point where
MR = AR = MC = AC
o To earn supernormal profit the monopolist cuts production back to the point
where the downward sloping MR = MC, and sets price on the demand curve
above that point
o One of the greatest disadvantages of monopoly power is that prices are
higher and output is lower than in perfect competition
• Studies indicate that supernormal profits may allow monopolists to use predatory
practices
A monopolist in one market will enter another market or a similar market
in a foreign country, drop prices to drive out competition, and then raise
prices above historical levels in order to recoup losses and make
supernormal profits
A number of LDCs are very concerned that this may be happening through
globalization where MNCs earning supernormal profits displace local
businesses through predatory practices
Some countries such as Canada have introduced legislation which prohibits
predatory pricing practices on the part of MNCs.
2.3.7.7 Efficiency in Monopoly

• The sum of producer and consumer surplus is maximized only at the perfectly
competitive level of output. This is the only level of output that is allocatively
efficient. Monopoly creates allocative inefficiency because the monopolist’s price
always exceeds its marginal cost. One of the most important issues in public
policy is whether and under what circumstances, government action can increase
allocative efficiency of market outcomes.
• Monopoly power is less efficient than perfect competition:
o The equilibrium point of production is at a point where costs are above
minimum average cost.
o Price is above both marginal and average costs

o Price discrimination does not give consumers the lowest price either as each
pays according to his position along the demand curve.
• Monopoly power is more efficient than perfect competition:

o Price discrimination sometimes allows lower income people to buy a product
that they would be unable to afford if it were sold at a single price that
maximized the producer's profit (Pm).
o Because of the competitive nature of perfect competition, stores are often
located near each other. With monopoly power the stores would be assigned
to the optimal locations and consumers would benefit.
o Economies of scale: small firms will have higher average and marginal cost
curves than a single producer able to capture full economies of scale:
o Public utility case: the alternative is no service at all, and here monopoly
power as it operates through price discrimination is a benefit and leads to an
economically efficient solution.
o Government can subsidize the product or if this is politically difficult it can
nationalize the industry and then regulate prices.
Too often the removal of the profit motive and competition has led to
inefficiency: it is hard to obtain information on marginal costs, and most
regulators set prices at average costs.
• Monopsony power: if there is just one or a few major buyers, then consumer can
exert market power. This can occur where the government is the only
purchaser. It is possible for large users of a service such as a railway or airline to
force the supplier to offer a secret rebate. The consumer extracts part of the
producer surplus and may force the supplier to price discriminate.
2.3 8 Monopolistic Competition

• This is a most interesting model which many economists believe may account for
as much as 50% of businesses in the western world.
• Firms will attempt to differentiate their product or service
o From society’s point of view the most valuable differentiation comes about
through R&D leading to meaningful innovations which all push out the
potential PPF
o Less meaningful differentiation includes branding to create the illusion in
consumers minds that one branded product is superior to another
o Even less meaningful differentiation occurs through varying the shades of
colour on the product from those used by other firms.
• In the short run, by differentiating their product, firms gain some inelasticity on
the demand curve facing their segment of the market
o They are then able to operate like a miniature monopolist and extract
supernormal profits
• In the long run, competitors will copy the differentiation and steal customers
away
o The result is that the demand curve will start shifting in to the left for the
original firm and supernormal profits will disappear.
o Firms will once again engage in R&D to differentiate the product for a new
round of short run supernormal profits
o This is very different from a monopolist which may spend its supernormal
profits erecting ever higher entry barriers.
Monopolistic Competition: Short Run
2.3.8.2 Short Run and long run equilibrium
MC
• All firms charge the same price. If one firm ACmc
AC
charges slightly less, it will steal business
Cost per Unit

Pmc
away from its rivals. If it charges more, it
will lose business to its rivals.
MR D = AR
• Each firm acts like a monopolist, producing at
the output, Qmc, where MR = MC, and Qmc
charging a price above that output along the Quantity
demand curve, Pmc. Note that in this short
run situation, each firm makes a profit equal to (Pmc - AC)*Qmc.
Long Run: Normal profits Monopolistic Competition: Long Run

• If there are profits, firms will enter the MC
ACmc
market. As they do so, they steal away AC
customers and the demand curve starts
shifting in to the left. Costs and Prices Pmc
• It will continue to do so until it is just tangent

to the AC curve, the point of long run MR D = AR
equilibrium.
Qmc
o Firms produce at Qmc where MC = MR,
Quantity
o They price at Pmc on the demand curve
above that output.
o Profits will be zero because Pmc = AC.
• As rivals move in the demand is also likely to get more elastic because of the
presence of substitutes.
• In monopolistic competition firms operate to the left of the capacity point: there
is excess capacity in the industry. This is the price society pays for:
o The variety that comes with product differentiation.
o The great innovations which can help to drive out the PPF curve.
2.3.8.3 Product differentiation

• Creating a real or imagined difference in the mind of the consumer, product
differentiation can include:
o A genuine innovation like LED screens to replace the old CRT screens for
computer monitors and TVs
o A new shade of lipstick.
• If product differentiation is possible, each firm will face a demand curve that is
less than perfectly elastic.
o By differentiating products, each firm has carved out a small segment of the
market which allows it to behave somewhat like a monopolist.

2.3.8.4 Efficiency in Monopolistic Competition
• here is some excess capacity for each firm in the long run as they are not at the
bottom of the AC.
• However, this excess capacity is considered to be a small price to pay for the
differentiation in product that consumers like: innovations shift the PPF out.
2.3.9 Oligopoly
• An oligopoly is characterized by a few firms which dominate an industry.
Typically one is larger than the rest such as General Motors in the US or Toyota
in Japan.
• The key is the way in which rivals react: the interdependence of firms helps to
explain why many product markets exhibit long periods of price stability.
• Fixed costs may be sufficiently great that there is only room for a few producers.
2.3.9.2 Collusive and non-collusive oligopoly

• Collusion is a very difficult thing to prove
o Explicit collusion occurs when firms meet together to fix prices and/or outputs
in an industry or carve markets up geographically or by product segment.
In countries with laws prohibiting such collusion it may be possible to
catch and prevent explicit collusion
o Implicit collusion is much more difficult to track
This typically occurs when there is a dominant firm in the industry which
sets prices and all others follow the example exactly knowing that the
larger firm has determined that a certain price will maximize collective
profits for all firms
When this becomes too obvious, a much smaller firm may take the lead
and all others follow again in an attempt to maximize joint profit
From perfect competition
2.3.9.3 Cartels to Monopoly (Cartel)
Price
• A monopoly can be created by several firms in Abnormal MC

an industry combining together and acting as a profit AC
b
single seller in order to maximize joint profit: Pm
this is a type of collusive oligopoly. a
o Assume the firms were originally in perfect Ppc
Ma enue
competition at Qp charging Pc, and earning

D ve n u
rev
em ra e)
(A eve
rgin
an ge
R
a normal profit, AC = AR = Pc.

d
al
o They agree to cut production to the level

where combined MC = MR.
Qm Qpc Quantity
Quotas are established at Qm which will
maximize profits (MR = MC).
Now Pm > ACm, thus super normal profits are being made.
• Assuming all firms in the industry have agreed to join the cartel, there are still
severe problems involved in keeping it together:
o Internal: it pays to cheat: the firm can reap the full benefit of all other firms'
restraint without having to cut their own production.
o External: its hard to prevent entry, particularly if super normal profits are
earned.
2.3.9.4 Kinked Demand Curve
• Producers are afraid to increase prices as they know rivals will steal customers
away. If a firm tries to raise price, there will be a severe drop in sales, total
revenue will fall.
• If the firm lowers price, it will be exactly Oligopoly: Kinked Dem and Curve
matched by the rivals. Often referred to as a Kink

MC2
price war, price will fall but sales will remain Po MC1
Costs and Prices

the same as before, and total revenue will fall.
• The firm believes it faces a kinked demand
curve as illustrated in the figure: D = AR
MR
o The marginal revenue curve has a vertical
section. This is a result of the fall in total Qo
revenue if the firm tries to raise or lower
Quantity
prices.
• Small changes in cost leading to upward or downward shifts in the marginal cost
curve will have very little influence on output or price.
• Firms will think carefully before increasing prices even if costs have risen. The
result is an extremely stable industry where profit depends more on cost cutting
than on trying to increase revenues.
2.3.9.5 Importance of non-price competition

• Even if there is implicit or explicit collusion on such things as price, there will not
be any agreement on non-price efforts to compete
o The most common example is advertising: once prices are fixed in an
industry, firms will attempt to gain a larger market share by advertising
But advertising is expensive and it seems a constant level is required to
stop consumers switching to a competing product
o Branding is an attempt to bypass all that heavy advertising expense by
creating a permanent image in the consumer’s mind about the superiority of
one good or service over another.
• Other forms of non-price competition include:

o Give-aways: buying one good or service comes with a discount on another,
usually related, good or service
One of the best examples is cell phones which are often given away free
in an attempt to lock consumers into a particular wireless service.
With Microsoft this is most evident with bundled packages of software:
you may only want a word processor but you get all kinds of other
software
The learning curve for new software can be quite steep and once you are
used to using Microsoft programs you will be very reluctant to switch.
o Another example of non-price competition includes quality

This is often combined with branding so that consumers associate the
brand with a certain level of quality
Large MNCs often have many brands each with a different level of quality
to appeal to a different segment of the market

o A more recent example of non-price competition is the scramble for firms to
be perceived as environmentally friendly
The Body Shop has gone to great lengths to convince consumers that they
are the pre-eminent example of an environmentally friendly producer.
2.3.9.6 Theory of contestable markets

• Cartels: illustrate that firms which exercise monopoly power can gain super
normal profits by cutting production and charging a higher price. This is not
economically efficient.
• Kinked demand curve: when costs are high firms do not make super normal
profit, but when costs fall, the savings are not passed on to consumers, and
supernormal profits are made. This is not economically efficient.
• Contestable markets assume no barriers to entry
o There may be imperfect competition which means that the potential for
earning supernormal profits is present
o Nevertheless with weak or few entry barriers, the threat of potential
competition may be enough to force most firms to produce at price and
output levels close to those in perfect competition, regardless of the size of
the firm.
o What is important is the threat of potential competition
If entry is reasonably easy and firms can recover sunk costs if they exit
the industry, then potential competition is very real
Price competition, if it occurs at all, is only likely to take place for short
periods of time
Only normal profits are likely to be earned in the long run as firms know
that supernormal profits will attract entry
2.3.10 Price Discrimination

2.3.10.1 Definition
• Price discrimination involves charging different people different prices for the
same product or service. There are many examples of price discrimination:
o Doctors in private practise charge according to the income of their patients.
o Movie theatres have different prices for different age groups.
o Airlines have different prices for different plans.
• Consumer surplus: demand curves have a negative slope because buyers are
prepared to pay different prices.
o The firm will try to sell each unit at its highest possible price.
o Perfect price discrimination occurs when the entire consumers surplus is
extracted by the firm: only two or three different prices is more common.
• Price differentiation is where different prices are charged because of different

costs of production for different groups of consumers and include such things as
quantity discounts, retail markups, and seasonal variations in price.
• Price discrimination is where the same good is sold at different prices to different
consumers even if the costs of production are the same. Producers use price
discrimination to extract the consumer surplus that would normally go to buyers.

2.3.10.2 Reasons for price discrimination
• Price discrimination will provide a higher total revenue to the firm than the profit
maximizing single price in perfect competition.
• Compared with a single price monopolist: output under price discrimination is

likely to be larger.
• In the extreme case of perfect price discrimination, the MR curve becomes the
AR or demand curve.
o The monopolist goes to the point where P = MR = AR = AC and produces the
same quantity as in perfect competition.
o But profit will be equal to the whole area between the point of production on
the AC and the AR curve (demand curve): it gains the whole of consumer
surplus.
2.3.10.3 Necessary conditions for the practise of Price Discrimination

• Different demand elasticities:
o It must be possible to identify and separate consumers into groups. National
borders are an ideal way of separating consumers.
o Buyers are classified according to age, location, industry, income or the use
they intend to make of the product: different prices are charged each group.
• Monopoly power:
o The firm must be able to prevent entry of other suppliers.
o The firm must control supply to each class or group of consumers so as to be
able to price discriminate between classes and to prevent resale amongst
consumers.
2.3.10.4 Possible advantages to either Price Discrimination: Covering Costs

the producer or the consumer Consmer
Surplus
Loss S = MC
The Public Utility case
Cost per Unit
P1
• With electrical power, the AC curve is P2 AC
typically above the AR curve when a new P3
facility is built. The population is not yet
large enough to warrant the project but D = AR
will soon grow to the needed size.
Qm
• There is a short fall in revenue because Quantity
AC is above AR. In this case the
government allows the electrical utility to charge different prices such as P1 and
P2.
• The firm picks up the consumer surplus in the triangle, it is just enough to offset
the loss:
o Because the loss and the consumer surplus are about equal, the monopolist
only earns a normal rate of return.
o Eventually as the population grows, the demand curve will shift out, and price
discrimination could be eliminated.

2.4 Market Failure
2.4.1 Reasons for Market Failure
• Consumer surplus: the difference between
Community Surplus
what the consumer is willing to pay and
what they actually pay in the market. Consumer
Surplus
• Producer surplus: the difference between S
the price producers are willing to produce

and the price they actually receive in the
Price
market.
• Community surplus is the sum of producer
and consumer surplus. Equilibrium Price &
• In perfect competition the market Quantity
equilibrating mechanism will bring about a Producer

Surplus D
solution that maximizes community surplus.
Quantity
2.4.1.1 Positive & Negative Externalities
Negative Externalities
Prices & Costs
Prices & Costs
Marginal Social Cost > Marginal Marginal Social Benefit < Marginal
Private Cost Private Benefit
PC
Tax = marginal MSC
M
external cost
=
SC
B
M
Pp2
MPC
B Tax = marginal
Pp2 Pp1 A external cost
Pp1 A
MPB
M
PB
=
M
SB
MSB
Qs Qp Quantity Qs Qp Quantity
• In production (pollution): if marginal social costs (MSC) are greater than marginal
private costs (MPC) there will be market failure as too much is produced at Qp
(point A) in the diagram on the left.
o Private producers may take excessive social risks if they do not suffer the
consequences of pollution.
o Common property problem: over crowding on highways, in cities and on
fishing grounds: people keep entering as long as the value they receive
exceeds operating costs, but it takes away from the value for others.
o The government can correct by applying a tax which raises MPC by the
amount of the externality until it equals MSC: called internalizing the
externality, and equilibrium now leads to production at Qp (point B)
o Sometimes firms treat the tax as a cost of doing business and refuse to abate
the pollution. Qp does not drop much and another policy such as jail
sentences for senior executives may be required.
• In consumption (demerit goods): if marginal private benefit (MPB) is greater than

marginal social benefit (MSB) there is market failure
o The good is called a demerit good (example: illegal drugs)
o Too much is consumed at Qp > Qs in the diagram on the right
o The government can correct by applying a tax which shifts supply in until
equilibrium is achieved at Qs (point B)
o If demand is inelastic due to addiction, Qp is unlikely to fall by much and
another policy such as negative advertising may be required as well.
Positive Externalities
Prices & Costs

Marginal Social Cost < Marginal
Prices & Costs
Marginal Social Benefit > Marginal

Private Cost Private Benefit
MPC S1 S1 +
Subsidy
MSC
A A
Pp1 Pp1
Subsidy = marginal
Pp2 external benefit
B
Pp2 B
M
PB
Subsidy = marginal
=
external benefit
M
MPB
SB
MSB
Qp Qs Quantity Qp Qs Quantity
• In production: if MSC is less than MPC there will be market failure as too little is
produced at Qp in the diagram on the left.
o The government can correct by applying a subsidy so that MPC + Subsidy =
MSC and the production increases to Qs in equilibrium at point B.
o Examples would include the training of workers who then leave for another
job or research and development which leads to increases in productivity in
the same or other industries (computer chips).
• In consumption: if MSB is greater than MSP there is market failure, the good is
called a merit good (examples: education or health care):
o Too little is consumed at Qp < Qs in the diagram on the right
o The government can correct by applying a subsidy which shifts supply out
until equilibrium is achieved at Qs (point B).
2.4.1.2 Environmental Concerns & Sustainable Development

• There are several dimensions which give rise to environmental concerns
• In the first, when we use natural resources, particularly non-renewable ones, we
are depleting those resources for future generations
o For renewable resources this is usually the result of the common property
problem as in international fishing where no single country owns the rights to
the fishery and the result is the devastation of international fisheries to the
point where they are badly over-exploited
o For non-renewable resources such as oil, it is not that there are not huge
deposits of hydro-carbons in the earth’s surface, it’s just that the easily
accessible ones have been depleted first as they have the greatest profit
potential and this raises costs for future generations.
Another example is copper ore which is very abundant in the world, but
the grade gets lower as we use up the higher grade deposits first.

o For environmental resources such as air and water the problem is that
pollution can cause irreparable damage to ecosystems which have a limited
capacity to process garbage and restore themselves
Ecosystems may be so fragile that excess pollution leads to catastrophic
decline in the ability of the system to self-correct
Local protests simply lead to the pollution being transferred to a higher
level: instead of dumping chemicals in the river we burn them. This simply
spreads them more thinly over a wider area: the pollution still remains it is
just less obvious and does less damage in the short run
• A second dimension is the impact of local activity on global ecosystems

o Examples from the past include the desertification resulting from cutting trees
and extensive pastoral activities involving particularly sheep and goats.
o The steady deforestation of the planet may seriously impact the ability of the
atmosphere to recycle carbon dioxide back into oxygen.
o Atmospheric chemical pollution seems to collect at the poles and causes
extensive damage to the ecosystems in these fragile environments
o There is also fear that industrial activity is causing global warming which can
lead to a breakdown in the ability to produce food world wide as well as to
extensive flooding in low lying areas. Some estimates claim that as much as
80% of the world’s population lives below 3 metres above the high tide mark:
it is not just the Netherlands, Bangladesh and the South Pacific which will be
affected
• Section 5.2.3 outlines the concept of the ecological footprint which is so closely
connected with the concept of sustainability.
o There are many definitions of sustainable development, perhaps the most
useful is the original one offered by the Bruntland commission:
Sustainable development is development that meets the needs of the
present without compromising the ability of future generations to meet
their own needs.
o Consumers in MDC economies can only consume more by taking more and
more productive areas away from consumers in LDCs.
It is not a war for land, it is simply that the profitability of participating in
the process of globalization results in more and more areas of the world
becoming dedicated to servicing consumers in MDCs.
Not only can this not continue as some estimates indicate that we may be
over-utilizing the world’s productive resources by 20%, but the planet
simply cannot sustain rapid economic growth in the remaining LDCs
The only way that poverty can be eliminated in those LDCs while
maintaining the productive viability of the planet is for the ecological
footprint of MDCs to shrink: that means that consumers in those MDCs
must cut consumption.
2.4.1.3 Lack of Public Goods

• Goods and services are:
o Rivalrous or diminishable: if the use of a good by one person prevents use by
another.
o Excludable: if people cannot use the good unless they pay for it.

• Pure public goods are both non-rivalrous and non-excludable, some people will
be able to enjoy the benefits of the public good without paying a share of its cost
(free rider problem).
o Government tends to provide the good and service and attempts to impose
inefficient systems of charging such as tolls or entry fees.
2.4.1.4 Underprovision of Merit Goods

• Merit goods: a private good with positive externalities and underproduced.
o Government can subsidize production or use advertising to increase demand.
2.4.1.5 Overprovision of Demerit Goods

• Demerit goods: rivalrous, excludable private goods with negative externalities.
They tend to be overproduced.
o They could be banned, or negative advertising used to discourage use or be
taxed heavily.
2.4.1.6 Abuse of Monopoly Power

• By raising prices and lowering output, firms can increase producer surplus at the
expense of consumer surplus.
The Information Problem

• Information is like a public good and is likely to be under produced in the private
sector as the producer of information cannot exclude free riders,
o For example: the government enforces safety and health standards:
o Employers do not supply employees with the correct information about the
dangers and hazards of the workplace,
o Producers do not publish accident histories for their products,
• Standards are often set by engineers with no incentives for economizing on costs
while providing greater safety. Efficiency requires standards be expressed in
terms of some level of performance rather than mandated design and materials,
• Moral hazard:
o People will not clear snow from their sidewalk because private cost exceeds
private benefit if they are insured.
o Experts: if they benefit from lying, they may do so to get the business
o Insurance applicants: low risk will tend to underinsure (adverse selection)
o Government will make it mandatory: medical care to reduce adverse
selection.
Factor Mobility
• It is assumed in perfect competition that factors are free to move to the market
which offers the highest return. Because of such things as owning houses and
being raised in a community with family and friends, it is not always easy for
workers to move to the job with the highest salary.
• Market failure arises from:
o Lack of information: perhaps workers who lose a job in one region may not
be aware of job possibilities in other regions.

o Even if they are aware, unemployed workers may not have the skills required
to move to a new job.
o Even if they have the skills, those skills may be for an industry that is in
decline throughout the country.
2.4.2 Possible Government Responses

2.4.2.1 Legislation
• Governments can intervene directly in markets by controlling quantities of goods
produced and consumed or by controlling prices.
• However, in trying to eliminate market failure through legislation, governments
can in fact create government failure.
Rent Control
Rent Control: Long Run & Short Run
• An excellent example is Sshort run 3
the problem of a Sshort run 1 Slong run 1
Rent
housing shortage and

Sshort run 2
trying to deal with it Slong run 2
through rent control
E
legislation.
• Rents can be controlled D Govt. subsidy:
R2 - for public
quite successfully for a housing or:
short period of time R1 A - for landlords
when there is an Short run

unexpected influx of Rc Long run
C excess
demand
people into a city. excess B
De
• However, in the long demand m
an
d
run, rent controls
transfer real income
from landlords to
existing tenants, and H3 H1 H2 Housing
create severe housing
shortages which lead to government failure.
• As govt. imposes rent control, rents drop from R1 to Rc, we move from point A to
B. In the short run: there will be excess demand equal to the distance between
the vertical short run supply and the quantity demanded at the new lower price
(H2 – H1).
• In the long run:

o Rates of return in the industry fall, and entrepreneurs transform apartments
into office buildings or owned housing and sell the units,
o The supply of housing shifts left (Sshort run 2), and intersects the long run
supply, point C, where the rent ceiling is set (H3):
As short run supply shifts in to the new point of long run equilibrium, point
C, an acute housing shortage appears (H2 – H3).
The existing tenants gain because they pay a lower rent
Existing tenants may lose if they are evicted and the building pulled down,
represented by H1 – H3,
Potential tenants lose as there is no housing at the lower rents,

Landlords lose as they do not earn the opportunity cost rate of return
(OCRR) until housing supply shifts to the long run equilibrium point C.
• A black market appears: landlords will charge large deposits and entry fees up to
the box: R2DCRc, because R2 is the equilibrium rent at Sshort run 2
o Government will protect existing tenants through special laws
o Even with tenant laws preventing eviction, tenants lose as buildings are
allowed to deteriorate,
Solutions to correct Government Failure

• Govt. eliminates the rent ceiling and rents are permitted to rise to R2 where the
short run vertical supply meets the demand curve
o The new higher rates of return attract construction of rental units, and the
short run supply curve shifts to the right (Sshort run 1),
o Supply will stop shifting right when it intersects demand at the point where
long run supply is equal to demand at the old equilibrium rent (R1, H1).
• To correct the market failure which arises from a shortage of housing, the
government builds public housing:
o The short run supply curve shifts out to Sshort run 3, and the ceiling price
becomes the new equilibrium price.
o The subsidy for building public housing is the striped box (it costs more to
build new houses as land is short in the city.
• Landlords can be subsidized and the long run supply curve shifts out to Slong run
2:
o Now it is cheaper for landlords to construct housing and short run supply will
shift out to Sshort run 3, the ceiling price becomes the new equilibrium price.
o Taxpayers now pay for the subsidy which will amount to the same as that
with public housing, the striped box.
Problems With Government Intervention:

• If a government prevents a market from allocating resources according to supply
and demand, it must substitute a non-market system to allocate resources.
Common ways include queuing, rationing through the use of coupons, and
subsidizing. Problems arise:
o Parallel or black markets may develop.
o Monitoring and enforcement are expensive,
• There may be government failure:

o Internal costs: civil service is expensive, rigidity within government can slow
down adaptation to more efficient ways,
o External costs: red tape imposed on businesses: higher safety standards,
reporting, contesting regulations: the level of control may be unnecessarily
high, the most expensive method may be specified,
o Future generations may not be taken into account,
• Government are not subject to the discipline of the market:

o Cities or publicly owned corporations often pollute more than private firms.
o Regulations lead to waste and do not adapt rapidly to changing market
conditions.
• Private groups may lobby or bribe:
o Producers may influence regulators to protect them from market competition,
o Self regulation of physicians is seen as an attempt to maximize income rather
than safeguard the public
• Where externalities cannot be internalized or people need to be protected from

the negative consequences of their actions, government will need to regulate.
2.4.2.2 Direct Provision of Merit and Public goods

• Charities and volunteer organizations can provide services, and insurance
companies can provide some protection against adverse results.
• There is still a need for government intervention: Government can shift supply
out by subsidizing producers or providing the good or service free.
o Non-market:
Public provision of goods and services: schools, parks, health care,
Regulations: against illegal drugs, for pollution, of public monopolies.
Regulation: maximum emission levels can be set.
o Market:
Subsidies to firms or transfer payments to individuals
Taxes and fines: the tax is equal to the value of the gap between marginal
social and private costs: MSC = MPC + externality tax.
Property rights: people are given rights to pollution free air, countries in
Africa can give property right over ‘big game’ animals to local villages.
2.4.2.3 Taxation
Price
Specific (Flat Rate) Tax

Ad Valorem Tax
Price
Supply + tax
Supply + tax
Supply
Supply
Quantity Quantity
• In taxation, governments will use the concept of price elasticity of demand to

determine the impact of an indirect (sales) tax on quantity demanded and the
resulting tax revenue.
• Indirect taxes are placed on suppliers and have the effect of raising costs shifting
the supply curve in:
o Ad valorem taxes add a percentage on to prices
o Specific ( unit or flat) taxes add a fixed amount on to costs.

Tax Incidence
Incidence
Price
S2
• Assume that govt. decides to raise B S1
Tax
taxes by taxing some good, called an Consumer
indirect tax share
C
• If producers try to raise prices by the P2
amount of the tax, from A to B, there Deadweight
will be excess supply, prices fall and a loss
P1 A
new equilibrium is found at C.
• The producer receives the price of P2 P2-t
Market
but must pay the tax equal to the Producer distortion
difference between P2 and P2-t. share
• The producer share of the burden is

the cross hatch box
• The consumer’s share of the tax is the Q2 Q1 Quantity
tripsed box.
• Firms try to pass these increased costs on to consumers.
o If demand is more inelastic than supply the consumer will pay a greater
proportion or incidence of tax.
o If demand is elastic, it is easier for consumers to shift the tax back to the
producer because there are easily available substitutes.
• If supply is more inelastic than demand, the supplier will pay a greater proportion
or incidence of tax.
• If the definition of profits includes payments to factors such as shareholders, the
incidence of a profits tax could be shared by shareholders (lower profits on
capital), wage earners (lower wages).
Price
Deadweight Loss
• The deadweight loss represents the loss in Tax Burden
social net benefits that no-one receives. It

Deadweight loss
occurs because less is supplied than is socially
optimal.
o If demand were perfectly inelastic, the P1 + t
S1 + tax
tenant would bear the whole burden. Direct Burden

Excess
Burden
o If demand were perfectly elastic, the P

S1
landlord would bear the whole burden. Demand
o The deadweight loss is less the more Q2 Q1 Quantity
inelastic the demand and supply.

• The more quantity responds because the curves are elastic, the more quantity
will fall as taxes are imposed. This is referred to as a tax distortion because it
distorts the way demand and supply would normally respond in a tax-free
market.
o In the diagram, if consumption falls from Q1 to Q2, then the little triangle lost
is referred to as the excess burden or deadweight loss as no-one receives it.
o The square box is referred to as the direct burden as the producer pays it,
and the government receives it.

2.4.2.4 Subsidies
• Subsidies are payments by Incidence of Subsidy
Price
government to both consumers and Producer S1
producers share Subsidy
• Governments provide a subsidy in P2+s
S2
order to divert more resources to the
production and consumption of certain A
P1 C
goods which are underproduced
because there are positive social
P2 B
externalities which cannot be captured Consumer
by producers and consumers. share
• Typically from an administrative point E
of view, it is easier to pay the D1
subsidies directly to a few producers.
The costs of paying subsidies to
individual consumers is too great.
Q1 Q2
• It is assumed that the subsidy is no Quantity
larger than the net social benefit that
derives from diverting resources to those goods and services being subsidized
o That is MSB ≥ MSC
o In many countries governments will subsidize basic food items such as milk
and bread.
o They may also subsidize primary and secondary schooling as well.
o The basic reason for doing so is because of the positive externalities
associated with better fed and better educated citizens and workers.
• In the diagram, consumption and production were originally at point A with P1

and Q1
• The government pays a subsidy to producers and S shifts out to S2, prices fall to
P2 and quantity increases to Q2.
• The total cost of the subsidy to the government are the two shaded boxes.
o The consumer incidence is the cross hatch box (what did they use to pay,
what do they pay now?)
o The producer incidence is the striped box (what did they use to receive what
do they receive now?)
• The more inelastic is the demand, the more of the subsidy goes to the consumer.
• Governments are reluctant to subsidize goods and services with elastic demand
unless they want the subsidy to go to producers in order to promote research
and development into a new technology.
2.4.2.5 Tradable Permits

• Pollution is a negative externality which can arise from production or
consumption. Private costs do not include the externalities, and too much of the
product or service is produced.
• Costs can be internalized by making the firm bear the full social costs so that
pollution will be eliminated or reduced to socially acceptable levels.
• The big problem is how do we determine the socially optimal level of pollution?

• In the diagram: Optimal Level of Abatement
Cost of Abatement
o Pollution runs from the right to the
left so the maximum level is at the Marginal
Cost
origin
o Abatement runs from the origin to
the right.
• The marginal benefits of pollution M

ar
abatement are often difficult to gi
na
lb
measure: en
ef
it
o If people think they will be paid
Pollution
compensation, they will claim the
Aopt
pollution is bad (MB shifts out), Abatement
o If people think their taxes will be
raised to pay for cleaning up the pollution, they will claim it is not so bad (MB
shifts in)
o The first levels of abatement are the most noticeable, eventually extra
abatement appears to provide less and less value.
o Abatement is a public good and it is hard to charge free riders.
• The marginal costs of pollution abatement tend to rise in an exponential pattern:

o It is hard to get firms to reveal the true costs,
o Costs rise slowly at first, but as more of the pollution is abated, what is left is
more dispersed and much more expensive to eliminate,
Zero pollution is often not economically feasible
o Abatement techniques may be less than perfect,
o There may be legal and technical constraints on achieving optimal levels
(where MB = MC).
• Once we determine the socially optimal level of pollution or abatement, how do

we move polluters to that level? There are several solutions.
Direct controls
• Emission standards are set but they lead to economic inefficiency:
o All producers forced to cut back the same amount, when low cost firms
should be cutting back more
o Regulatory boards are not motivated to be efficient in the choice of technique
o Monitoring and enforcing are expensive, fines and penalties often too lenient.
Emission Taxes
• Tax revenue is equal to tax times (Aopt – A1), where Aopt is the optimal level of
abatement determined above and A1 is the level the firm can afford to abate to:
o As long as MC is below the tax, it is worth abating pollution
o Once MC is greater than the tax, it is worth just paying the tax.
o Polluters are left to find the most efficient way to abate,
o Firms with high costs of abatement will not be able to afford to abate as much
as the low cost firms:
They will abate to point A1 and then pay a fine equal to Area A
They will save the abatement costs in Area B.
o Monitoring and enforcement are still expensive,
o There is still guess work in setting Aopt.
Tradable Emission Permits:
• Standards are set and each firm is issued with a permit to pollute up to Aopt
(they abate back to Aopt and can pollute from the right up to the Aopt point).
• Firms are permitted to trade emission permits.
• Low cost firms abate beyond Aopt to A2 and sell the right to pollute to a high
cost firm.
o High cost firms will abate up to A1, then buy the right to pollute up to Aopt
o They will pay for the right if it costs less than the tax (the part of Area C they
pay for will be less than Area A that the government would charge).
Low Cost Abater sells Right to Pollute to High Cost Abater

Area C: cost of
Cost of abatement
Cost of abatement
abating beyond the
Marginal Cost Area B: money optimal level set by
for high cost saved by not law
abater abating to Aopt
Area A: fine Marginal Cost

paid for not for low cost
abating to Aopt abater
Tax
Right to Right to
pollute pollute
A1 Aopt Abatement Aopt A2 Abatement
• There are still problems in setting Aopt and in monitoring and enforcement,
• Alternatively government could auction off the rights to pollute rather than giving
them away:
o The government then earns the revenue from selling pollution rights. The
problem is that they typically do not use the money to abate the pollution.
o The rights to pollute can be reduced each year to lower the level of pollution.
• Firms object to paying for the rights to pollute, but the payment simply reflects
the fact that more efficient abaters are rewarded for having lower costs,
• The public objects to giving out rights to pollute:
o Experience has shown that self interest is the most efficient and effective way
to deal with environmental damage,
o More abatement takes place by letting lower cost producers do it.
• Future generations are still not being taken into account:

o Governments have difficulty getting the correct tradeoff between current and
future generations: the future has no voting power today, plus governments
are only interested in projects which will benefit them in the next election.
2.4.2.6 Extension of Property Rights

• As discussed in Section 5.3.2.2, property rights are not well settled in many
LDCs.
o While this has implications for borrowing money from the bank in order to
allow small businesses to be formed to encourage economic growth, it has
equally serious implications when it comes to environmental protection.
• Even in most MDCs, the lack of clear property rights to clean air, clean water and
wilderness areas means there is no economic incentive to protect property.
o The common property problem arises when an asset is held in common rather
than privately
Each new user will keep entering and using a certain asset as long as the
marginal benefit is greater than the marginal cost
However, for all previous users, the entry of a new user lowers the
average benefit
There is no economic incentive to prevent abuse of the natural or
environmental asset and when the point is reached where average benefit
is less than average cost, people will abandon the asset as it has no
economic value.
o For markets to work, some system of property rights must be extended by

government legislation or regulation to ensure natural and environmental
assets are used to the point where MSC = MSB
The system of tradable emission permits does give rights to create a
certain level of pollution and has proved very successful in limiting
pollution.
However, many environmental groups in Europe object to the granting of
property rights to polluters regardless of how successful it can be in
controlling pollution.
2.4.2.7 Advertising to encourage or discourage consumption

• The anti-smoking campaign in many countries, particularly Canada, is an
excellent example of using advertising to discourage consumption
o The first step was to prevent all tobacco companies from advertising through
any form of media: that way the positive inducement to smoke was removed
This caused the demand curve to shift in to the left
o The second step was for governments at all levels to enact legislation making
it difficult to smoke in public places
o The third step was a steady campaign of advertising through many forms of
media showing explicit pictures of what can happen to smokers
This also caused the demand curve for tobacco products to shift in to the
left
o The result has been a 30% drop in smoking in Canada in general to as high
as a 50% drop in smoking in certain regions.
o The savings in healthcare costs has already started to indicate the wisdom of
such a campaign.
2.4.2.8 International Cooperation amongst Governments

• Many steps have been taken by governments over the last 50 years in order to
create a network of rules and regulations which will inhibit goods and services
which lead to negative externalities and will foster goods and services which lead
to positive externalities.
• Multilateral organizations are funded by many countries and with international
cooperation have made good progress in promoting goods and services with
positive externalities
o The UN is deeply involved in helping to fund programs associated with merit
goods such as clean water, education and healthcare
o The WB has been involved in helping to fund projects associated with public
goods to build up the infrastructure to help countries grow and develop more
rapidly.
• Although some international environmental treaties date back to early in the 20th
century, it was not until the 1960s that concern about environmental pollution
and the depletion of natural resources led to multilateral environmental
agreements.
o Earlier ones were single issue, use-oriented, mainly sectoral agreements and
legislation, primarily addressing allocation and exploitation of natural
resources such as wildlife, air and the marine environment
o Later agreements were more oriented toward ecosystems such as the Kyoto
Protocol.
• The UN Environmental Programme has identified the following 10 agreements as

being the most significant examples of international cooperation amongst
governments:
o Convention Concerning the Protection of the World Cultural and Natural
Heritage, 1927
o Convention on Wetlands of International Importance especially as Waterfowl
Habitat 1971
o Convention on International Trade in Endangered Species of Wild Fauna and
Flora, 1973
o Convention on the Conservation of Migratory Species of Wild Animals, Bonn,
1979
o United Nations Convention on the Law of the Sea, 1982
o Vienna Convention for the Protection of the Ozone Layer, 1985
o Montreal Protocol on Substances that Deplete the Ozone Layer, 1987
Based on the hole in the ozone layer above Antarctica the Montreal
Protocol on Substances that Deplete the Ozone Layer was adopted in 1987
and came into force in 1989, when it was ratified by most MDCs.
o Basel Convention on the Transboundary Movements of Hazardous Wastes and

their Disposal, 1989
o United Nations Framework Convention on Climate Change, 1992
The Kyoto Protocol of 1997 is an amendment to the United Nations
Framework Convention on Climate Change, an international treaty on
global warming.
Countries which ratify this protocol commit to reduce their emissions of
carbon dioxide and five other greenhouse gases, or engage in emissions
trading if they maintain or increase emissions of these gases.
A total of 141 countries have ratified the agreement.
o Convention on Biological Diversity, 1992

o United Nations Convention to Combat Desertification in those Countries
Experiencing Serious Drought and/or Desertification, Particularly in Africa,
1994
• While the United Nations Conference on Environment and Development in Rio de

Janeiro, in 1992 certainly focused the world’s attention on abuse of natural and
environmental resources, follow up to the conference consisted mainly of the
Commission on Sustainable Development and the associated boards and
committees.
SECTION 3: MACROECONOMICS
3.1 Measuring National Income
Microeconomics vs. Macroeconomics
• Microeconomics deals with individual markets and with the actions of households
and firms in those markets.
• Macroeconomics deals with the major groups of players in the economy,
consumers, producers and governments
o Prices: instead of looking at individual prices we look at the price level.
o Income: instead of looking at household income we look at National Income.
3.1.1 Circular flow of income
Factor
Markets
en r
y m c to
ts
pa F a
$
Labour, capital &
$
In
co
natural resources Labour, capital &
m
natural resources
e
Govt.
Taxes Taxes
Import
Expenditures & Expenditures &
expenditures
Transfer payments Transfer payments
Import
expenditures Import
Foreign expenditures
Firms Export Households
countries
earnings
Interest Savings
Interest & dividends
Loans
re n
itu tio
$ ceip
Financial Goods & services

nd p
Sa ts
re
pe um
Goods & services

les
institutions
ex ons
C
$
Markets
for Goods
& Services
• Households own the factors of production: labour, capital and natural resources.
They offer them to firms in return for wages, profit and rent.
• When consumers receive income:
o Leakage: they give some of it to government in the form of taxes
o Transfer payments: they receive subsidies from the government
o Leakage: they save some in financial institutions
o Injection: they receive interest on their savings and spend it
o Leakage: they import goods and services from foreign countries
• Firms use the factors of production to produce goods and services.

• In order to produce goods and services:
o Injection: firms borrow money from institutions and inject it back into the
system in the form of investments
o Leakage: firms pay interest to financial institutions
o Leakage: firms must pay taxes to governments on their profits
o Transfer payments: firms receive subsidies from governments
o Leakage: firms import goods and services from foreign countries
o Injection: firms export goods and services to foreign countries.
• Governments tax and spend:

o Leakage: taxation on households and/or firms
o Injection: government expenditures on goods and services from firms and
households
o Injection: government spending on state provided goods and services
o Transfer payments: usually in the form of subsidies to households and firms
o Leakage: imports of goods and services from foreign countries.
3.1.2 Methods of Measurement

• The total of all the goods and services made in any one year in a single country
which go through a market place is referred to as the National Product.
• As someone must have earned money to produce those goods and services, it is
also referred to as National Income.
• One of the most common measures of national income is Gross Domestic Product
(GDP). If real GDP increases then it indicates that the economy is producing
more output each year.
• There are three methods of calculating national income.
The expenditure method:

• This adds up all the spending in the economy: C + I + G + X - M.
• It is called Gross Domestic Product (GDP) at market prices and includes:
o C: Consumption
o I: Investment which includes:
Planned investment in capital
Unplanned increases in stocks or inventories
o G: Government spending on goods and services. Because they are often
provided free of charge (no market value), they are valued at cost.
o X: Exports: the domestic economy receives the money
o M: Imports: these must be subtracted because it is spending on goods and
services from outside the domestic economy.
The income method

• Adds up all the sources of income in the domestic economy.
o Transfer payments (pensions, unemployment and welfare benefits) are
excluded: no good or service is produced for the income.
o Income includes:
Wages and salaries
Self-employed income
Profits: divided into dividends given to shareholders and undistributed or
earnings retained by the firm
Rent which includes the cost of raw materials and intermediate inputs and
imputed rent on any owner occupied housing
Interest
The output (value added) method:

• Adds up the value added by a firm’s production: the value of the firm’s output
minus the value of inputs
• Alternatively this method adds up the output of final goods and services.
• The share of a sector or component of GDP such as manufacturing or agriculture
is measured by the value added contributed by that sector.
• Value added: the addition to value of a product during a stage of production.
o Value added in the cotton textile industry: the value of the textiles when they
leave the factory minus the value of raw cotton used in their manufacture.
o This is equal to payments to the factors of production: wages paid to labour
plus profits, interest, depreciation of capital, and rents for buildings and land.
• If $100 worth of goods and services has been produced (output method) this
must have generated $100 worth of income (income method) for the various
factors of production and will lead to $100 worth of spending (expenditure
method).
• If spending by households is added up this will show the spending at market
prices. But this does not truly reflect income earned by factors because of
indirect (sales) taxes paid by firms to government and subsidies received by firms
from government Therefore:
Market price - indirect taxes + subsidies = factor cost.
Personal Disposable Income

• Personal Disposable Income is obtained by:
o GNP = GDP at market prices + net property income from foreign economies
o GNP at factor cost = GNP at market prices - indirect taxes + subsidies
o Net National Product (NNP) = GNP at factor cost - depreciation
where: NNP is sometimes referred to as Net National Income (NNI)
o Personal Income = NNP - retained earnings - business taxes + transfers

where: retained earnings = undistributed profits
o Personal Disposable Income = Personal Income – personal income taxes.
3.1.3 Distinctions between

• Gross Domestic Product (GDP): the value of final goods and services produced by
factors within the domestic economy must be adjusted to exclude:
o Goods made in previous years and sold this year:
If people do not buy everything produced in the year, firms end up with
stocks of unsold goods called inventories which are included in
investment.
This method assumes the firms ‘bought’ the goods for themselves.
o Capital gains which are just a redistribution of benefits.
• Intermediate goods or semi-finished goods:
o Final goods already include the value of the intermediate good, and it would
be double counting to include intermediate as well as final goods
• Investment includes:
o Circulating capital: inventories or stocks of raw materials, intermediate goods
and final goods.
o Capital equipment, machinery and buildings, and residential housing
o Gross investment consists of:
Net investment (new physical capital and stocks or inventories)
Depreciation or capital consumption: repair and maintenance to existing
stocks of capital or replacement of worn out capital.
3.1.3.1 Gross and Net

• Net Domestic Product (NDP) = GDP - depreciation. Because depreciation is an
estimate, most economists prefer to work with GDP.
3.1.3.2 National & Domestic

• GNP = GDP at market prices + net property income from foreign economies
3.1.3.3 Nominal and Real

• Inflation may have increased values being added and we would like to distinguish
between changes due to inflation and actual changes in the physical outputs.
o To do that we use a price index to deflate the production back to some base
year period of prices, and we call it real national income, Y.
• If national income rises is this an indication of a rise in the standard of living?

• Inflation can cause GDP to rise even if there is no extra production.
• To eliminate this problem GDP is adjusted for inflation:
o Real GDP = Nominal or current GDP/Price deflator
o Does the price deflator take into account the increase in quality of goods and
services and the fall in the prices of goods such as videos and computers?
3.1.3.4 Total and Per Capita

• Standard of living: if the population has grown faster than real GDP, then output
per person has actually fallen. To measure real per capita GDP we deflate GDP to
put it into real terms, and then we divide it by the population.
• Population increases: cause GDP to rise but not necessarily per person:
o To adjust for this problem we divide by the population:
Real Per Capita GDP = Real GDP/Population
3.2 Introduction To Development

3.2.1 Definitions of Economic Growth and Development
Economic Growth
• Economic growth can occur when the GDP rises. Obviously if population also
grows at the same rate, then per capita income will not have changed.
• Generally, most economists view economic growth as taking place when real GDP
or real per capita GDP or “standard of living” grows.
• Increases in the quantity
and/or the quality of the
Capital goods
factors of production are Potential PPF given K/L Faster economic growth but
E no economic development
the most common sources ratio and levels of
productivity (Q/L) in MDCs
of economic growth. C
o These can lead to an Greater spending on
outward shift in the Current PPF with
leads to greater
PPF. good policies &
good business B
o However, an outward management
shift in the PPF does
not necessarily imply
A D
growth. If a country is Poor policies &
Greater economic
development but less
stuck inside the PPF, poor business growth in the future
management
then economic growth
has not taken place,
only the potential for
growth. Public & Merit Goods
• Growth can also take
place when a country is inside the PPF and through better policies is able to
move out to the PPF.
Economic Development
• Economic development occurs if
o There is a reduction in poverty, inequality, and unemployment
o When there has been spending on merit goods such as education and
healthcare
o Increased access to and the means to obtain improved food, shelter, health
and protection under law.
3.2.2 Differences in the Definitions of the Two Concepts

• The traditional theory was that if the rich and influential groups could stimulate
growth in a country, the benefits would “trickle down” or diffuse from the rich to
the middle and lower income groups raising overall living standards and
increasing economic development.
• Most economists agree that this has not been the case. The trickle down theory
has failed to happen in most LDCs.
• While the emphasis on growth has switched more toward development, some
economists believe that development will not take place without growth.
• Other economists believe it is the reverse: only through economic development
will future economic growth occur.
• There are 144 developing economies (LDCs) in the world, of which 83 have
fewer than 5 million people.
o LDCs tend to have low standards of living, and low GNP per capita.
o Low income countries receive $700 per capita, middle income countries
receive from $700 to $8,000 per capita.
o LDCs tend to have a high population growth rate.
o More than 50% of the population is involved in primary production.
Primary goods are the most prominent exports.
Mining tends to be dominated by Transnational Corporations (TNCs).
Infrastructure, often built by colonial powers, is designed to move primary
goods to the coast for shipment overseas rather than to move people.
o All sectors are characterised by low productivity and high unemployment.

Capital equipment and technology is likely to have been imported.
Processing and manufacturing for export is discouraged because MDCs
tend to raise trade barriers against imports of higher value added goods.
o Economic power is unequally distributed both internally and externally.

Latin American and Asian countries tend to have more private enterprise,
African countries tend to have greater state ownership of enterprises.
3.2.3 GDP versus GNP as measures of Growth

• Gross National Product (GNP) includes the value of final goods and services
produced by factors owned by domestic households all over the world:
o GNP = GDP + Foreign investment income – investment income paid to
foreigners
o For developing countries, GDP tends to exceed GNP: factor payments made to
foreigners exceed factor payments received from foreigners
o For industrialized countries, GDP is smaller than GNP: factor payments
received from foreign countries are larger than what is paid to foreigners.
• If economic growth is 1%, it will take approximately 72 years for the value of the
economy to double.
• If the growth rate is 10% it will only take 7.2 years for the GDP to double.
3.2.4 Limitations of using GDP to compare welfare between

Countries
• Perhaps the most important issue is the significant variation in data collection
amongst countries
o Statistical error and incomplete data collection may make it difficult to
compare GDP
• Per capita income still ignores the distribution of income: there could be a few
rich people and large numbers of poor.
• Non-market sector: goods and services traded in an informal or parallel economy
are not reported as output or income. How do we include them?
o In some LDCs the rural and informal sectors may be quite large, perhaps as
much as 50% to 70% of the economy.
• Future growth through capital goods: national income accounting does not
distinguish between the production of consumption and capital goods:
o Producing consumption goods leads to more today but less tomorrow.
o Production of capital goods involves less consumption today but higher future
growth and greater consumption in the future.
• Externalities: pollution and the cleanup of pollution or increased traffic congestion

and the resulting increase in gas consumption can actually lead to a rise in GDP
even though the quality of life may have been reduced.
• Quality of life: pollution regulations or more vacation time can lead to a fall in GDP
but lead to an increase in the quality of life; how should we adjust?
• Government services: how do we value national defense or government medical
services? We count them at cost which may be too high or too low an estimate.
3.2.5 Allowance for differences in purchasing power

• Purchasing power parity: rather than use a single currency to compare we
convert to PPPs which measure the actual purchasing power of domestic income
in terms of what it can buy within the country.
• Accounting systems are different amongst countries. Many LDCs cannot afford
comprehensive systems and use a lot of guesswork or estimation to fill the gaps.
• Climate differences: some countries spend more on energy to heat or cool
houses and offices.
• There may be considerable differences in the distribution of income, the size of
the non-market sector, the balance between consumption and capital goods
production and between production of consumer goods and weapons for war.
3.2.6 Alternative Methods of Measurement

• In addition to measuring GDP and adjusting it for prices, purchasing power
parity, and national versus domestic income, we are looking for measures which
will give a better impression of the welfare or standard of living of people in the
country.
• We are interested in measuring such things as:
o The quality of life looking at those factors that are involved in economic
development: life expectancy, access to health care, education levels
o The sustainability of the current standard of living which means examining the
use of natural and environmental resources.
• While there have been attempts to expand GDP to include some of these
concepts and factors, the UN has moved ahead with two such measures:
o The Human Development Index (HDI) attempts to measure both the standard
of living as well as the quality of life by measuring life expectancy, educational
levels, and real per capital income adjusted by a PPP index.
o The Human Poverty Index (HPI-1) which attempts to measure that portion of
the population which does not benefit from a higher standard of living or
quality of life: the percentage of people expected to die before age 40, the
percentage of adults who are illiterate, and overall economic provisioning in
terms of the percentage of people without access to health services and safe
water and the percentage of under-weight children under five.
o A more recent index called HPI-2 which measures: the proportion of the
population which is likely to die before the age of 60, the percent of people
whose ability to read and write is not adequate, the percent of the population
with an income less than 50% of the median income for the country, the
percent of the labour force which has been unemployed for more than 12
months.
3.2.7 Problems of Measuring Development

Classification of Developing Economies
• The World Bank uses income per capita to classify countries into three groups:
o High income, middle income and low income

A Less Developed Country (LDC) is a country where income is less than
US$6000 per person per year
• The UN uses the HDI to classify countries into high, medium and low human
development
• The IMF classifies by industrial, developing and transitional economies
• Generally most economists classify countries as LDC, Newly Industrialized
Economies (NIE), and More Developed Countries (MDC):
o LDCs can also be divided into two groups:
Very poor LDCs may produce raw materials such as cotton and iron ore
and do not have the facilities for further processing. They are
characterized by having low per capita incomes, poor infrastructure and
dependence on the exports of low value added agricultural goods and raw
materials
Other LDCs are more sophisticated and can import the raw materials and
turn them into things like textiles from cotton and steel from iron ore.
o An NIE is an LDC that has undergone industrialization and is experiencing

rapid economic growth:
Certain NIEs are almost MDCs such as Taiwan, Mexico and Brazil which
produce very sophisticated goods such as computers and cars
Other NIEs such as Egypt and Turkey produce goods such as shirts and
simple electronics by buying the textiles and steel from LDCs
o Even amongst the MDCs there are two categories:
Those which are mainly service based and earn a significant proportion of
their foreign income from selling services: eg. Switzerland
Other MDCs such as Canada and Australia which are heavily service based,
but earn most of their foreign income from exporting raw or semi-
processed natural resources
Characteristics of Developing Economies

• While there are wide differences amongst the 140 LDCs in the world, there are
certain common characteristics
o Low per capita income
This is usually a result of low productivity resulting from low levels of
education and poor transfer of technology
Income tends to be particularly low in rural areas which are often
neglected in favour of government spending in urban areas.
o Population growth rates tend to be higher in rural areas and contributes to

the steady rural-urban migration which leads to overcrowding in the urban
areas.
o Infrastructure tends to be poor and inadequate and there are many price
distortions such as food or housing subsidies in urban areas
The influx of rural migrants puts incredible pressure on the limited
infrastructure
By subsidizing food and housing, governments hope to keep wages low to
attract foreign industrial firms looking for low cost labour
Structural Change
• For most LDCs the critical change is from the primary to the secondary sector
o Workers move from low value added agriculture, forestry and fishing to the
higher value added manufacturing and service (tourism) sectors
o The process of industrialization leads to:
A rapid increase in urban populations
Investment in infrastructure such as power and transportation
The diffusion of new technology which is enhanced through development
of education and employer organizations
Greater specialization and division of labour in the workplace
• At the same time as this process is occurring in the formal economy, typically an
informal or shadow economy is also formed
o These activities do not necessarily have to be illegal in nature, often they are
quite legitimate activities but they do not report income to avoid taxation and
they do not conform to environmental or labour rules and regulations
o The informal sector is often the place where many micro-enterprises and
small businesses are started because the risk of failure may be less
o Often the informal economy is the only place that uneducated workers from
rural areas can find work
o This leads to another form of dualism in the economy: a growing formal
sector which operates side by side with an informal sector. Often the formal
sector will subcontract out work to the informal sector because costs are
lower
o The disadvantage of the informal sector is that they do not pay taxes and can
contribute significantly to pollution and the unsafe exploitation of labour.
• Even in MDCs there is a structural change from manufacturing to services:

o In almost all western economies except Japan and Germany, manufacturing
now represents only 10% of the workforce while service workers represent
75% to 80% of the workforce.
o Even in Germany and Japan, more and more of the work is being
subcontracted out to lower wage countries as manufacturing has simply
become too expensive.
• In more advanced NIEs:

o The rural-urban migration is usually finished and the transition from primary
to secondary sectors is almost complete.
o Also the informal manufacturing and service economy plus the more
traditional forms of agriculture have largely disappeared.
3.3 Macroeconomic Models

3.3.1 Aggregate Demand: components
• Aggregate Demand (AD) consists of C + I + G + X - M
• Internal expenditure or what is sometimes referred to as domestic absorption:
o C = Consumption is a function of income, and the slope of the consumption
function is called the marginal propensity to consumer (MPC).
o I = Investment is a function of income and interest rates often referred to as
the Marginal Efficiency of Investment (MEI)
o G = Government expenditures change slowly as such a high proportion of
expenditures are legislated that government has very little discretion over
budgets.

• External expenditure:
o X = Exports are a function of foreign and not domestic income (X = Px*Qx).
o M = Imports (M = Pm*Qm) are subtracted from Aggregate expenditure (AE)
and are very similar to consumption: they are a function of domestic income
(M = MPM*Y; where MPM: marginal propensity to import)
• (X - M) = Net Exports:
o As domestic income rises, people import more and net exports (X-M) fall.
o If world income rises, net exports (X-M) rise: X is a function of foreign
income.
o If domestic prices rise, exports fall and imports rise so net exports fall.
• If domestic prices rise relative to foreign prices, net exports tend to decline:
o Exports decline because foreigners find domestic goods more expensive.
o Domestic households find foreign goods relatively cheaper and will tend to
import more.
• Depreciation of the domestic currency means that it will buy less of foreign
goods, net exports tend to rise:
o Foreigners will find domestic goods cheaper
o Households will find foreign goods more expensive. Leakages and Injections
• There are three leakages from the system: savings (S), taxes T) and imports (M).
• There are three injections: investment, government expenditures and exports:
o There does not have to be equality between each pair (I = S, G = T, X = M).
o But there does have to be equality between all three injections and all three
leakages: (I + G + X) = (S + T + M) in equilibrium.
The Influence of Income on Consumption

• Consumption is the largest single category of domestic expenditure, accounting
for over 50% of GDP, and including consumption of foreign goods (imports).
• Changes in consumption can be predicted by analysing changes in:
o Income and wealth
o Credit availability:
Goods are divided into perishable (food), semi-durable (clothes) and
durable (cars).
The availability of credit will allow people to buy more expensive durable
goods which means they are able to spend more than their current
income. However, repayment of past debt will limit current consumption.
• Expectations: optimism leads to greater spending, this is why we measure

Consumer Confidence.
• The age profile of the population: younger households spend to build up a
household, middle age households start to save toward retirement.
• Price levels: rising prices reduce the value of money and may lead people to save
more to rebuild real money balances.
• After tax income is divided between savings and consumption:
o If income taxes are 30%, then after tax income is 70% of national income
o If consumption is 80% of after tax income, it is 0.8 times 0.7 , or 56% of
national income.

The Influence of Wealth on Consumption
• Savings depend on wealth and the position in the life cycle for the family.
• People want to smooth their consumption pattern over their lifetime:
o Only with a permanent change in income will people adjust their
consumption.
o With a temporary decline in income, people maintain consumption levels
according to their expected income by running down their savings
• People have a goal for their wealth and will keep adding assets to their portfolio:
o People keep adding to wealth until the income flow from that wealth will allow
them to retire:
o If there is a temporary increase in income
People save it and add it to wealth.
Consumption increases only out of the income earned from that wealth.
• For example: if you receive an extra $10,000 worth of income, and you normally
consume 80% of your income:
o We would expect you to consume $8,000 out of that extra income.
o Instead, if the increase in income is only temporary, you add the extra
$10,000 to your wealth
o If those assets earn $1,000 at 10% interest, you would consume only $800 or
80% of the income earned on your assets
o This has important implications for governments interested in cutting taxes in
order to increase consumption.
• If the level of wealth is below the target, households will save toward the goal.
If the level of wealth is at the target, households no longer need to save.
• An unexpected rise in wealth will lead people to save less, and vice versa.
• If prices rise in the economy, the purchasing power of wealth declines:
o Households will attempt to save more to add back the wealth that has been
lost, this means that consumption will fall.
Aggregate Demand: movement along

• Income effect: the AD curve is downward sloping because as prices rise, real
income falls and people have less to spend.
o Price induced changes in any of C, I , G, X or M leads to movements along the
AD curve.
• Substitution effect: when the price level rises in the economy there are no
substitutes to switch to as in microeconomics. There are three possibilities:
o Real balance effect: as prices rise, the real value of wealth declines, people
tend to build the wealth back again by saving more and consuming less.
o Net export effect: as domestic prices rise relative to foreign prices, exports
become expensive and imports cheaper: thus exports fall and imports rise.
o Interest rate effect: people may try to borrow to maintain their spending,
interest rates rise which discourages durables consumption and investment.
Aggregate Demand: shifts of

• Whenever C, I, G, X and M change, the aggregate demand curve shifts in and
out

o Note these are not price induced changes, if they were they would lead to
movements along the curve rather than to shifts.
3.3.2 Aggregate Supply

3.3.2.1 Short run
• These include the labour force, the amount of capital goods and the available
natural resources.
• As the prices of these factors of production rise, the SRAS curve slowly shifts in.
It simply costs more to produce the same output.
Shifts in SRAS
• If the factors of production become more productive, the SRAS curve shifts out.
• For most countries, there is a slow but steady increase in productivity each year:
o Part of it comes from new investment in capital equipment, and part from
education and training of the work force.
o This increase in productivity causes the SRAS curve to shift steadily outward,
although at a slow rate
o Technology: as technological progress occurs, the SRAS curve shifts out.
Slope of the SRAS

• The aggregate supply slopes upward as the full employment point is reached:
o Not because factor prices are rising: along the SRAS curve it is assumed that
factor prices stay the same.
o Diminishing returns: near full employment some factors, particularly capital,
are fixed in supply, and costs rise because more of a variable factor is added
to a fixed factor.
o Resource Bottlenecks: as full employment is approached even some variable
inputs are in short supply and this slows the production process raising costs.
o Declining productivity:
As firms hire more labour and capital, the people and machines left to hire
are less skilled or less efficient (the best have already been hired as we
approach full employment)
Productivity falls, unit costs rise and firms raise prices to cover increased
costs of production.
3.3.2.2 Long run: Keynesian versus neo-classical approach
Regions of the Aggregate Supply curve

• The actual shapes of the SRAS and LRAS are crucial to the effectiveness of fiscal
and monetary policy:
o Extreme Keynesians believe the SRAS to be flat until full employment at which
point it is vertical.
o Extreme neoclassicals believe the SRAS and LRAS are vertical at the full
employment point.

• A moderate, consensus view is that there
are two curves: Three zones or regions
SRAS
o A vertical LRAS: where inflation of the SRAS
Price level
depends on people’s expectations
Zone 3
(zone 3 of the SRAS is often (Monetarist or
interpreted as the LRAS): Neoclassical)
If people correctly anticipate
inflation, expected inflation will
equal actual
Unemployment only departs from Zone 2
the natural rate when inflation is Zone 1
not anticipated. (Keynesian)
The natural rate of unemployment
will change only if there are Real Income
changes in frictional, structural or
seasonal unemployment.
o An SRAS which is fairly flat (zone 1) until the GDP starts to approach the
natural rate of unemployment at which point it slopes up (zone 2). In zone 1:
The expected rate of inflation is constant
The natural rate of unemployment is constant.
Long Run Equilibrium

• Potential (full employment) income is constant and is shown by a vertical line,
often called the Long Run Aggregate Supply curve (LRAS) at Yfe.
• At E1 we are in short run equilibrium with AD1 = SRAS1, equilibrium income is
below potential income Y1 < Yfe and we get a recessionary gap (negative output
gap).
• At E2, equilibrium is above potential or full employment income and we get an
inflationary gap (positive output gap).
Output Gaps
Price Level
LRAS
3.3.3 Full employment level of SRAS2
national income
SRAS1
• At Yfe the economy is at the full
SRAS3
employment level of income: in long run E3
equilibrium: E2
o Factor costs are neither rising nor E1 Z

falling: wages are rising at the same AD2
rate as productivity is growing. E4
• This is why the vertical line above Yfe is AD1

Y1 Yfe Y2 Real GDP
referred to as the long run aggregate
supply curve (LRAS).
3.3.4 Equilibrium level of national income

• Suppose the AD curve shifted out to the right because one or more of the
components either increased (C, I, G, X) or decreased (M).
• In the figure we move from equilibrium at E1 to point Z:
o AD > SRAS: inventories must be falling and businesses hire labour.

o Increased production leads to an increase in Y: we move along the SRAS
curve from E1 to E2.
o However, as businesses hire more labour, they find that they are less skilled,
productivity falls, unit costs rise, and firms are forced to raise prices.
o The increased price level leads to price induced changes in AD:
Consumption falls, exports fall and imports rise
We move back along AD from point Z to point E2, a point of short run
equilibrium
At Y2: AD = SRAS: inventories are neither rising nor falling.
3.3.5 Inflationary Gap

• The output gap: a measure of the difference between actual and potential GDP.
o If the gap is negative: (Y – Yfe) < 0, we refer to it as a recessionary gap.
o If the gap is positive: (Y – Yfe) > 0, it means that we have gone beyond full
employment and we are in an inflationary gap.
• It is possible to go beyond full employment by running more shifts in factories,
using machines beyond their normal capacity utilization rate, and by paying
workers more per hour to work more hours.
At Y2 where AD2 = SRAS1

• At Y2, income is above the full employment point which leads to an inflationary
gap.
• This can only occur if labour works overtime:
o The average workweek expands from 40 hours per week to as high as 55
hours per week.
o Labour shortages will emerge in some industries and among skilled workers.
o High profits for firms and unusually large demand for labour exerts upward
pressure on wages.
The upward pressure on wages means there is pressure for wages to rise
faster than productivity is rising.
• At the same time, capital is operated beyond the safe capacity:

o Normally firms experience a 15% depreciation rate each year, which means
that only 85% of the machines are running to allow repairs and replacement
of old machines.
o At Y2 capital can be kept going without regular maintenance, but it damages
the machinery and raises the costs of capital.
• The SRAS will shift in to the left because of upward pressure from the labour
market and the increased costs of capital.
• Short run equilibrium is associated with the following criteria:
o AD = SRAS; leakages = injections; and inventories are unchanging.
• Long run equilibrium requires all the above plus:
o %∆wages = %∆productivity; or real wages are unchanging.
3.3.6 Deflationary (Recessionary) Gap

At Y1
• At Y1 income is below the full employment level and we have a deflationary or
recessionary gap:
o Unemployment means there should be downward pressure on wages,
however, unions and workers resist any attempt to lower wages.
• There is unusually low demand for labour:

o There will be labour surpluses and firms will resist upward pressure on wages.
o Wages will increase more slowly than productivity:
%∆Q/L > %∆wages
Unit labour costs will be falling.
o The SRAS will be shifting to the right
o Eventually we will reach long run equilibrium at point E4.
Wages are Sticky Downward

• Unit labour costs fall much more slowly in a recession than they rise in a boom
because there is great resistance to wages being cut.
• Even in quite severe recessions when prices are stable, wages may continue to
rise, although the rate of increase tends to be lower than the increase in
productivity.
3.3.7 Diagram illustrating trade/business cycle

• In Economic Development we will examine how growth can be increased through
various policies designed to increase productivity:
o The economy as a whole moves in an upward direction called the long term
trend or growth pattern which results from:
Population growth
Increases in productivity or output per person which come from:
investment in capital, human capital, and R & D leading to technological
breakthroughs.
• In Macroeconomics we deal with cycles and policies to counteract cycles. During

any ten year period there is a cycle in the economy which appears to be related
to the replacement of worn out capital equipment.
• Seasonal cycles are related to the primary sector: agriculture, forestry, fishing.
• With industrialization, a new manufacturing or industrial cycle appeared:
o The two most powerful cycles appear to be a 3 year cycle and a 10 year
cycle. Because they are not matched, it means that the combination of the
two leads to different patterns each decade.
• Typically at the end of a decade, industrialized countries tend to enter a serious

recession which ends in a trough in the first year or two of the new decade,
followed by an economic recovery.
o Recovery proceeds to roughly the middle of the decade at which point there is
typically a mini-recession with a small peak and a trough.
o A new recovery period begins and countries enter a boom toward the end of
the decade
o Once the economy peaks, a new recession follows.
• The cycles are not exact, and sometimes the mini-recession in the middle of the
decade is deeper than the recession at the end of the decade.

Real Income
Boom Boom
Boom Times or Peak or Peak
• During a boom the Inflationary gap or

economy is operating positive output gap
Yfe
at or beyond full Recessionary gap or
Re
ery
capacity. There is a negative output gap
ce
cov
ss
shortage of skilled
ion
Troughs are associated with Booms are associated with
Re
people and raw - low inflation, - inflation,
- high unemployment, - low unemployment,
materials. It is a - low interest rates Trough - high interest rates
period of excess - low ROI - high ROI
demand. Time
o Prices rise faster
than costs, profits are rising and investors are optimistic.
• The boom can turn into a slump if people decide they do not need to replace
capital equipment because this leads to a fall in spending.
Capital Utilization Rate

• Rather than calling capital unemployed, we reverse the definition and look at the
capacity utilization rate.
o Typically 15% of capital is being repaired or replaced and the average
utilization rate is around 85%.
o During boom times the capacity utilization rate rises to as high as 92%.
The rate of replacement of capital is slower than the demand for services
from capital equipment.
But there is a price for running capital so hard: maintenance schedules are
delayed and the capital wears out at a faster rate.
Recessions
Job Creation & Unemployment
Labour Force
• During a downturn, the job creation Structural

rate is typically slower than the Unemployment
number of people entering the job n
tio
market looking for work: ea
cr
b
Jo
o If there are people looking for ce
f or
work who cannot find it, they are o ur
ab Cyclical
defined as unemployed. el
th Unemployment
o
nt
o As the economy starts to recover, try
i Recession
En
the job creation rate speeds up
and the unemployment rate falls
particularly for skilled people. For Time
the hard core unemployed, there
may be very little change.
Trough
• A trough is associated with high unemployment of labour and unused productive
capacity (unemployed capital).
o Unemployment rises not because people are laid off, but because the job
creation rate is slower than the number of people entering the job market.

o Capacity utilization rates for capital may drop as low as 70%, this means that
machines do not need to be replaced: when a machine wears out, you simply
replace it with an existing machine which has been shut down.
o Business profits are low, and investors are pessimistic.
• A trough cannot last long because capital equipment wears out and both
households and businesses start to replace it.
o Spending picks up and we enter a recovery.
o As sales and profits pick up, investors become more optimistic.
Depression
• If the recession is particularly deep and long lasting, it is called a depression.
o Typically a depression results when there is a financial panic during a
recession.
o Better knowledge about the economy, stronger economic policies and the
steady growth resulting from industrialization and technological breakthroughs
appear to have prevented serious depressions in most western economies
since 1930.
3.4 Demand-Side And Supply-Side Policies

3.4.1 Shifts in the aggregate demand: demand side policies
3.4.1.1 Fiscal Policy
• Fiscal Policy is a tool of stabilization or demand management policy, and is used
to remove recessionary and inflationary gaps by altering G and T.
• The budget balance, “T – G”, is the difference between expenditures and
revenue:
o If G = T (T – G = 0), the government has a balanced budget.
o If T > G (T – G > 0), revenues or FISCAL POLICY: RECESSIONARY GAP
receipts are greater than expenditures LRAS SRAS
and we have a budget surplus Price o
Level
o If T < G (Y – G < 0), expenditures
exceed receipts and we have a budget
E1
deficit.
Eo
• If expenditures (G) are increased without a
AD1
matching increase in T, the resulting deficit
ADo
(T – G < 0) must be financed meaning the
Yo Yfe Real National Income
government must borrow money. e
• A recessionary gap can be removed by
cutting T or increasing G which causes the
AD to shift right.
• Alternatively the government could do nothing:
o Wages will fall, although very slowly, leading to a rightward shift in SRAS.
o Cyclical recovery: there may be cyclical forces in the economy that increase
AD.
o There is a tendency for productivity, Q/L, to increase steadily over time
leading to a rightward shift of the SRAS.

3.4.1.2 Interest rates as a tool of Monetary Policy
• In most countries the Central Bank (CB) is government owned and operated.
• Governments use the central bank to carry out monetary policy.
o The central bank is the lender of last resort: it stands ready to back any of the
chartered banks if there are emergencies such as a run on the bank.
o It looks after government accounts and often buys government bonds,
particularly if the bond market needs to be supported.
• Central banks are also usually responsible for the money supply.
o If the Central Bank (CB) buys a bond from the public, the public receives the
cash in the form of a cheque from the CB and the CB receives the bond.
• Money is created through deposit creation rather than printing currency.
• Central banks are often responsible for bond and money markets.
o Bond markets refer to markets where debt instruments which mature in one
year or more are traded.
• Money markets: where debt instruments maturing within one year are traded.
o In most countries the most common form of money market instrument is the
treasury bill issued by a government
Demand for Money

• Households hold wealth in many forms: cash, bonds, stocks, real estate or in
businesses. We assume that people hold only money or bonds.
• Wealth held in the form of money is called the demand for money.
o Once we know the demand for money, we also know the demand for bonds.
• The opportunity cost of holding money is the interest foregone on the bond that
could have been purchased instead.
• As GDP rises in the economy, people will spend more because consumption rises,
therefore the transactions balances will also rise.
Commercial Banks
• Commercial or chartered banks hold deposits for their customers and permit
certain deposits to be transferred by cheque from one account to another.
o They make loans to households and firms and buy government securities.
• With credit granting systems like Visa, banks form a group to spread the risk.
• Bank deposits are a medium of exchange only because they can be transferred
through the use of a cheque.
• Banks offer a safe place to store money and to earn a guaranteed return,
commercial bank liabilities are the deposits owed to the depositors.
• Banks attract deposits by offering a rate of interest and by providing services for
a small fee such as clearing cheques and providing regular monthly statements.
• Commercial bank assets are:
o The securities it buys which pay interest and dividends
o The loans it makes to its customers.
Banks expect that the loan will be repaid, and that they will make enough
money on the interest to pay for the paperwork and the risk of non-
payment.

• Commercial banks tend to borrow short term from their depositors and lend long
term to people and businesses that need loans. Banks can suffer if interest rates
increase sharply in the short term.
o Part of the job of the CB is to ensure that interest rates move smoothly and
slowly and the range over which rates fluctuate is fairly narrow.
Open Market Operations

• The most important tool for controlling the money supply and interest rates is the
purchase and sale of bonds by the central bank (CB), referred to as open market
operations.
• When the CB buys a bond from the public, the person selling the bond receives a
cheque from the CB which is then deposited in a commercial bank.
o The bank sends the cheque to the CB which then increases the deposits of
the commercial bank. Thus new money is injected into the system leading to
a multiple expansion of deposits through the relending chain.
• When the CB sells a bond to the public, it receives a cheque from the person and
sends it to the commercial bank for payment.
o The commercial bank sends the money to the CB and there is a contraction of
the money supply through the relending chain operating backwards.
o Rather than calling in loans which can lead to bankruptcy, the commercial
bank typically does not make any new loans until its reserves have recovered.
• When the CB sells bonds in the market, there are two effects:
o The reserve effect is that money now leaves the system and is put in the CB
leading to a contraction of the money supply.
o At the same time, when the CB sells bonds, the price of bonds falls and
interest rates rise leading to a contraction of investment and the AD curve.
• In reverse, when the CB buys bonds:

o The money enters the system leading to expansion through the relending
system
o At the same time the price of bonds rise, interest rates fall and investment
increases leading to an expansion of the AD curve.
Closing an Inflationary Gap: Fiscal Policy

• An inflationary gap can be removed by increasing T or cutting G which causes AD
to shift left.
• Alternatively if the government chose to do nothing:
o Cyclical downturn: there may be cyclical forces in the economy that reduce
AD.
o Or wages start to rise, shifting the SRAS in to the left leading to inflation.
o The value of money transactions rises, people sell bonds to obtain more
money.
o Bond prices fall, interest rates rise, there is a price induced fall in investment.
o The fall in real expenditure leads to a movement back along the AD curve.
• Thus inflationary gaps are self correcting as long as the money supply is not
increased, but the process is frustrated if the money supply is increased.
o With inflation of 15%, if the money supply increases 15%, people do not sell
bonds to obtain cash, interest rates do not rise to choke off real expenditure.
Closing an Inflationary Gap: Monetary Policy
• Monetary policy could close the gap more quickly by decreasing the money
supply, leading to a rise in interest rates, a fall in investment: AD shifts left.
• If the central bank wants to raise interest rates:
o They will sell bonds, the money supply will contract
o There will be an excess demand for money
o Households will sell bonds, and the price of bonds will fall
o This leads to an increase in interest rates in the market
Closing a Recessionary Gap: Monetary Policy

• If wages fall, SRAS would shift out, prices would fall and income rise.
o The value of money transactions falls, people buy bonds with the excess
money.
o Bond prices rise, interest rates fall: there is a price induced rise in investment.
o The rise in real expenditure leads to a movement along the AD curve.
• As wages are sticky down, however, the SRAS shifts slowly to the right, and the
fall in prices and the monetary adjustment mechanism operates very slowly.
• Monetary policy could close the gap more quickly by increasing the money
supply, interest rates fall, investment rises and AD shifts out.
• If the central bank wants to reduce interest rates:
o They will buy bonds, the money supply increases
o People will buy bonds with the excess and the price of bonds will rise
o Interest rates will fall, and there is less incentive to hold bonds and eventually
there will no longer be an excess demand for bonds.
Automatic Stabilizers (a type of autonomous fiscal policy)

• AD is constantly changing as a result of shifts in I, C, X and M. As recessionary
and inflationary gaps appear they lead to changes in wage rates and shifts in the
SRAS.
• This makes it difficult to identify when there is a recessionary or inflationary gap.
• In most western economies, there are built in stabilizers which tend to offset the
fluctuations in AD:
o G tends to be very stable, the tax rate tends to be very stable, and
government transfer payments for such things as pensions tend to be stable.
o However, transfer payments for welfare or to the unemployed tend to
increase in recessions, thus automatically increasing G.
o Tax revenues equal the tax rate times income: (T = t*Y)
If income rises as it does during inflationary gaps, tax revenues rise
because both Y is rising and t is rising as people are pushed into higher
tax brackets.
As income falls during recessionary gaps, tax revenues fall.
• Taxes reduce the marginal propensity to consume:

o Even if the MPC is 80%, if taxes take away 50% of income, then effectively
the MPC is only 40% out of national income.
• Short term fluctuations are dampened by the automatic stabilizers even when it
is difficult to recognize when gaps appear and to apply policy.
• Automatic stabilizers impose fiscal drag during recoveries:
o As the economy recovers G falls and T rises which slows recovery.
3.4.2 Shifts in the aggregate supply: supply-side policies

• Because of dissatisfaction with demand management policies, policy makers have
turned to permanently reducing structural unemployment so when cycles occur,
the impacts are less severe:
o If unemployment at the peak of the cycles is 7%, and if it rises to 12% to
13% at the bottom of the cycle, many people will suffer during downturns.
o If the natural rate of unemployment could be reduced to 2% at the peak of
the cycle, then unemployment may not rise to more than 4% at the bottom.
• Supply side policies attempt to shift the LRAS to the right far enough to reduce
inflationary pressures:
o By focusing on incentives:
Taxes and subsidies are reduced to encourage work, risk taking and
investment
Unemployment benefits are reduced, raising the opportunity cost of not
working.
o By increasing productivity of labour (Q/L rises):

Education and training will increase productivity.
Investment in capital will increase the K/L ratio.
o By increasing the productivity of capital (Q/K rises): through tax deductions

for R&D: firms are motivated to find ways to increase capital productivity.
o By reducing the costs of inputs:

Eliminating or reducing the minimum wage and the strength of unions.
Lowering interest rates and thus lowering the rental price of capital.
Providing incentives to find cheaper sources of raw materials.
o By reducing the power of big companies through anti-monopoly regulation.
European - Japanese approach:

• By assisting labour to move from sunset to sunrise industries, structural
unemployment can be eliminated.
• In Sweden, when workers lose jobs in sunset industries:
o They have a choice of training for jobs in sunrise industries,
o The government pays for the full wages of the worker during the retraining,
which usually lasts from 6 months to 2 years,
o The firm guarantees to hire the worker for a minimum of five years.
• In Japan, when firms close down a sunset division:

o The firm approaches the government and asks for training assistance for
redundant workers in a new or existing sunrise division.
o The government pays the full wages during the training period, and the firm
guarantees lifetime employment.
• In Germany students in high school try out careers in sunrise industries to reduce
the numbers of students graduating in a redundant career,
o About 60% of high school students in Germany participate in a work coop
program where they work from 1 to 5 afternoons a week in a firm or
occupation they are interested in entering.
o Students are allowed to change once a year, and employers are permitted to
ask students to leave if they have problems.
o Because students are exposed only to jobs and careers where there are
openings, training for sunset industries is avoided.
o Because both students and firms have a chance to assess each other, by the
end of high school firms are happy to hire students and students are happy to
go to work in familiar firms.
US Approach
• The US government is reluctant to become involved in directing people into
training and careers and has depended on tax cuts to bring about supply side
changes.
• Reducing taxes will increase supplies of labour and capital:
o Lower taxes would increase the return on investment (ROI) and provide an
incentive to invest in capital, thus increasing K/L.
o Lower taxes would also increase the return on research and development
(R&D), leading to investment in even more productive capital.
o People who were already employed would work harder if they could keep
more income after taxes, and those who were unemployed would be brought
into the work force by the boost in income.
• Tax revenue would remain constant, even though tax rates had been cut:
o The increases in productive capacity (capital) and in productivity (labour)
would shift LRAS to the right increasing the taxes collected.
• However, cuts in taxes can lead to an increase in C and I, causing a rightward

shift in AD. During the Reagan administration this policy was pursued:
o In the short run, AD shifted to the right, opening up an inflationary gap.
o The supply side shifts of LRAS were not large enough and quick enough to
counteract the aggregate demand effects.
o Incomes rose, but not by enough to restore tax revenues back to what they
were: the result was bad deficits for the US government
• The supply side effects have been harder to find:

o They were dissipated throughout the economy.
o They did take place but over a longer period of perhaps 10 years or more.
o However, the reforms had a major effect on improving the functioning of the
US economy, and reducing the natural rate of unemployment.
o They also appear to have led to disinflation: a slowing down in the rate of
inflation. (Deflation is where prices actually fall).
3.4.3 Strengths & weaknesses of these policies

Problems with Fiscal Policy
• Fiscal policies attempt to reduce the suffering encountered in a market system by
providing assistance to the less fortunate. The benefits are the counter-cyclical
effects of automatic stabilizers, but the costs include:

o Disincentive to work: welfare and unemployment assistance has encouraged
people supported by the government not to be productive by imposing a "tax"
in the form of a loss of social assistance for those who go and work. This
reduces the motivation to look for a job, and shifts the LRAS to the left.
o Increased taxes: the steady increase in taxes for social security have
increased business costs, this has shifted the LRAS to the left.
o More regulation: greater regulation of industry protects firms from
competition and leads to inefficiency which shifts the LRAS to the left.
o Substitution of capital for labour: there has been greater social regulation
such as labour protection laws which have substantially increased the costs of
hiring employees leading to the substitution of capital for labour which
increases the natural rate of unemployment (shifting the LRAS to the left).
o Underground economy: higher tax rates have led to disincentive problems
and to a significant proportion of economic activity going underground.
Lags
• Discretionary policy often runs into problems with lags:
o Recognition lag: it takes some time before a gap is recognized.
o Legislative lag: it takes time to decide what to do and if it requires a change
in taxes or borrowing, it takes time to get approval from parliament.
o Implementation lag: it takes more time to put the policy into effect.
• The result is that stabilization policy or demand management policy has often
done more to encourage fluctuations than to remove them.
Reversibility
• Another problem is that policies put into effect may be very difficult to reverse:
o If there were a recessionary gap, the government may decide to cut
corporate taxes:
o After the usual lag, businesses start to increase investment.
o By the time the investment shifts out the AD curve, the economy may already
have recovered and the shift in AD may open an inflationary gap.
o The problem then becomes one of trying to reverse the policy. It is extremely
unpopular to raise taxes when businesses have become used to lower taxes.
• To overcome this problem it has been suggested that policies be made short run:
o The government announces that the tax cuts will only last for two years.
o This may help with investment, but many consumers will simply absorb the
increased income into savings as a result of the wealth effect.
Problems with Monetary Policy

• In the long run, because the LRAS is vertical above the full employment income
level, the major impact of monetary policy will be on the price level.
o In boom times, the SRAS curve is very steep (zone 3):
Shifts in the AD curve translate into large changes in the price level and
little change in income.
o At less than full employment (zone 2) demand-side policy can affect both
price and income in the short run.

• Rational expectations: people do not form expectations of future inflation based
on the past; they tend to look ahead and make an estimate based on information
they have available at that moment.
• Expectations can alter the speed at which adjustment takes place. A change in
the expected rate of inflation will change aggregate demand:
o If inflation is expected to rise, consumers will increase current buying,
o If inflation is expected to fall, expenditures may be delayed.
• If the money supply is increased, and the AD curve shifts out to the right,
workers anticipate that increasing the money supply will lead to higher prices and
they will demand higher wages right away:
o The general expectation of an x percent inflation creates pressures for wages
to rise by x percent and hence for unit costs and the SRAS curve to shift in by
x percent.
o As AD shifts to the right, the SRAS shifts to the left.
• Rational expectations means that workers cannot be fooled, there is no “money

illusion”.
o Workers know that real wages remain unchanged, and real income stays the
same.
o Government will be unable to reduce unemployment below the natural rate
even in the short run.
• While it is unlikely that the effects are completely offset, expectations are yet
another reason why monetary policy may not be very effective.
The Transmission Mechanism

• Fiscal policy operates directly on AD through changes in G and T.
• Monetary policy operates through adjustments in the money supply which then
lead to changes in interest rates and investment before impacting on AD.
Problems with this transmission mechanism during depressions can make
monetary policy useless:
o Monetary expansion fails because Banks hold excess reserves rather than
lend money.
o Interest rates may not fall because people may hold money rather than invest
in bonds (liquidity trap)
o Firms may be afraid to invest: the MEI curve is vertical, large changes in
interest rates lead to only small changes in investment.
Lags in Implementing Monetary Policy

• The monetary transmission mechanism takes varying lengths of time from 18
months to 3 years. While there is still a recognition lag, there is no need for a
legislative lag as the government does not have to go to parliament to get
permission to change the money supply.
• There is still an implementation lag.
o Open market operations lead only slowly to changes in the money supply and
interest rates.
o It takes time in companies to adjust investment plans in response to changes
in interest rates.

o It then takes time for investment to be put in place and for the multiplier
respending chain to lead to changes in national income: Economists estimate
it takes 18 months on average for half the effects to be felt in the economy.
• Lags are long and unpredictable increasing the risk that using monetary policy
could lead to destabilizing effects.
• The poor record of monetary policy as a short term stabilizer has led to the
introduction of a monetary rule approach where the money supply would only be
increased by a set amount.
o Some countries chose the rate as equal to the population growth rate plus the
growth rate in productivity.
o Experience since then shows that there have been quite sudden shifts in the
liquidity preference function, also known as the demand for money, which has
made the monetary rule approach less stable than had been hoped.
• Most economists now believe that fiscal policy must be used to restore the
economy to full employment during a serious recession or depression:
o The labour market experiences sticky wages which means wages fall too
slowly
o Weaknesses in the monetary transmission mechanism plus lags mean that
monetary policy is unpredictable.
3.4.H Higher Level Topics

3.4.H.1 The Multiplier Consumption Function
• The consumption function illustrates the
e
in
relationship between income and consumption.
Consumption
L
e
• The 45 degree line indicates the transfers of re 0.8
g
C=
e
MP
D
exactly the same amount from one axis to ion

5
n ct
4
n Fu
tio
another. nsu
mp
• C o
The consumption function cuts the 45 degree
line at the point where consumption equals
income of $40,000: $40,000
o Below that income, the household Personal Disposable Income
consumes more than its income, and savings are negative

o Above that income, consumption falls below income and households are
saving.
• The slope of the consumption function (MPC) is the marginal propensity to

consume.
• The slope of the savings function (MPS) is the marginal propensity to save.
• MPC plus MPS equal one to indicate that any increase in income is divided
proportionately between savings and consumption (slope of 45 degree line = 1).
Equilibrium National Income

• The new components (I, G, X, M) are added on to C to give the AE line.
• Only C is a function of income, therefore the slope of the AE line is the same as
the slope of the consumption function.
• Equilibrium income: determined by the balance between expenditure and output:
o If expenditure is greater than output, inventories will be falling, firms will hire
labour to increase production to meet the new level of expenditures.
o If expenditure is less than output, inventories rise, firms will cut production by
laying off workers, output falls until inventories settle at the desired level.
o Only when inventories are exactly equal to the desired level, neither rising nor
falling, will national income be in equilibrium.
• If AE rises as a result of an increase in Aggregate Expenditure

I, G or X, it has been found that income
45 deg line
often increases proportionately more. 120
C AE2
This is referred to as the multiplier 100
Expenditures
effect and results from the respending 80 B AE1
chain: 60
o People receiving the payment from 40
A
the increase in AE will have to pay 20
taxes on it, will save some, and will 0
0 20 40 60 80 100 120 140 160 180
then consume domestic and foreign
Real National Income
goods with what is left.
o The leakage into savings, taxes and imports means there will be less money
to be respent at the next link in the respending chain: the higher the
leakages, the shorter the respending chain.
• The simple multiplier in a closed economy (no trade) and no government taxation
is given by:
∆Y 1 1
k= = ⇒
∆AE 1 − MPC MPS
where:
MPC = marginal propensity to consume;
MPS = marginal propensity to save.
o As MPC + MPS = 1, then (1 - MPC) is equivalent to MPS.

o This is the simple multiplier assuming no other leakages than savings.
• The multiplier in a closed economy (no trade), and with a government sector
which both spends and taxes is given by:
∆Y 1
k= =
∆AE 1 − (1 − t ) MPC
where:
t = the marginal tax rate
• The multiplier in an open economy (with trade) and with a government sector
which both spends and taxes is given by:
∆Y 1
k= =
∆AE 1 − (1 − t )( MPC − MPM )
where:
MPM = marginal propensity to import
Effect on the multiplier:

• Zone 1: on the left portion of the SRAS curve which tends to be flat and is usually
associated with a recession, income is well below full employment:
o The full multiplier operates: there is enough skilled labour and efficient capital
that unit costs and prices do not rise.
o There are no price induced leakages into savings and imports.
Three zones or regions
• Zone 2: in the upward sloping area of SRAS SRAS
of the SRAS
Price level
the multiplier has been reduced so income
does not increase to A but to point E2: there Zone 3
(Monetarist or
have been price induced leakages into savings Neoclassical)
and imports.
• Zone 3: on the right hand vertical section of
the SRAS curve, typically associated with a
boom in the economy, income is at or above Zone 2
the full employment point: Zone 1
o The multiplier is reduced in effect: there (Keynesian)
are virtually no skilled people left to hire,
and no un-utilized efficient capital Real Income
o Unit costs rise, prices rise, and there are price induced leakages into savings
and imports.
3.4.H.2 The Accelerator

• When sales are increasing and inventories are running down, firms hire labour in
the short run. If the change appears permanent they add to capital.
• Future profit expectations of firms are determined by past output growth:
o Future sales and thus their present demand for capital goods to meet those
future sales, depends on changes in past sales.
• Investment is sensitive to the rates charged for borrowing money:

o When interest rates rise, it costs more to borrow money for investment and
investment falls.
• Investment is also sensitive to Return on Investment (ROI). If ROI rises above

the interest rate, it pays to borrow and invest at the higher ROI:
o As the economy heads into recession, ROI falls below the interest rate and
people stop investing.
o As the economy recovers from recession, ROI may rise above the interest rate
and people start to invest.
• The capital output ratio indicates the amount that must be invested in K in order
to get a flow of value output, the average ratio for most firms is 5:
o To increase production of a particular good so that an extra $10 is added to
net revenue, it is necessary to invest in $50 worth of capital.
Accelerator Example
Sales $ 1,000 $ 1,100 $ 1,200 $ 1,200 $ 1,100
Capital 10 11 12 12 11
Depreciation 1 1 1 1 0
Net Investment 0 1 1 0 0
Gross Investment 1 2 2 1 0
• A company has 10 machines each worth $500 which produce $100 worth of
output each year: 10 machines, total sales of $1,000:
o Depreciation is one machine a year
o Gross investment = depreciation plus net investment: 1 machine per year.

• If sales increase by 10% ($1,100), an extra machine is needed to produce more:
o Gross investment for one year will go up by 100% to 2 machines: one for
depreciation and one for the new investment required for production.
o Note that even though sales only increase by 10%, investment increases by
100%, hence the name accelerator.
• If sales increase by another 10% to $1,200:

o Gross investment for one year will stay the same: 2 machines: one for
depreciation and one for the new investment required for production.
o Note that even though sales have increased, investment does not increase:
for the accelerator to cut in, we need the rate of growth of sales to be
increasing as well.
• If sales stay at the new higher level of $1,200:

o Gross investment falls back to 1 machine: there is no new investment, simply
replacement of a worn out machine.
• If sales fall 10% back to the previous level of $1,100:

o Only 11 machines are required:
As we had 12 machines the previous year and one of them has worn out,
we are left with 11 machines
We do not even need to spend money to replace a worn out machine
o When gross investment falls to zero, this may trigger a movement into a
recessionary gap as aggregate expenditure falls.
• Many economists believe that business cycles come from changes in gross
investment which depend on the multiplier and the accelerator:
o Sales have to be rising in order to prompt a higher level of investment.
o Even though sales settle down at a new higher level, investment falls back.
o If sales actually fall, as they do in a recession:
Net investment will go to zero
Gross investment may also fall to zero: one of the new machines which is
no longer needed because of the fall in sales will replace the old machine.
• The accelerator and multiplier working together can lead to business cycles:
o Coming out of a recession, when aggregate expenditure rises, the multiplier
boosts income.
o If business people feel the change is permanent they buy capital at the rate
of 5 times as much as the increase in sales because of the capital output
ratio.
o The rise in investment leads to another increase in aggregate expenditure and
the multiplier boosts income yet again.
• Eventually the rounds of spending will be finished and aggregate expenditure

stays constant at a new higher level. Or the economy reaches the full capacity
point and cannot grow any more:
o Net investment falls to zero, inventories rise in the capital goods industry,
workers are laid off, aggregate expenditure falls via the multiplier, and a
recession may start.
o As aggregate expenditure starts to fall, spending on replacement of capital
may also fall to zero worsening the conditions in the capital goods industry.
• At the bottom of the cycle, aggregate expenditure may start to rise:

o Consumption may increase because durable goods need to be replaced.
o Investment may increase because capital needs to be replaced.
3.4.H.3 “Crowding Out”

• When governments attempt to increase G, they must finance it somehow:
o They can raise taxes by the same amount as G, but this would lead to a fall in
consumption and investment.
o They can borrow the money, but this leads to a rise in interest rates and a fall
in investment:
The demand for money shifts out, but the supply of loanable funds does
not change so interest rates rise.
This is called the “crowding out” effect because private businesses
wanting to borrow money now find they have to pay more to borrow and
cut investment.
o They can expand the money supply (government borrows from the central
bank equivalent to printing money) and use the money to finance the
increase in G, but this leads to inflation.
• The attempt to use fiscal policy to fine tune the economy is no longer accepted
as a valid stabilization tool. Only where there are large persistent gaps,
particularly gaps associated with recessions or depressions, is it generally agreed
that fiscal policy does have a role to play in restoring the economy to full
employment.

3.5 Unemployment & Inflation
3.5.1 Unemployment
3.5.1.1 Full Employment & Underemployment
• We assume that output and employment are closely related because output can
only increase if employment increases.
• In a recessionary gap (negative output gap), there is a loss of production as a
result of the unemployment: we can never retrieve that production.
• The labour force is often defined as those people between the ages of 15 and 65
who are either working or actively seeking work if they are not employed.
o Only unemployed people who are registered as unemployed will appear in
national statistics.
• In MDCs there is a strong incentive to register because of unemployment
benefits. This is not true in LDCs which means their unemployment statistics are
less accurate.
3.5.1.2 Unemployment Rate

• The unemployment rate is defined as:
Unemployed (those actively seeking work )

Un =
Labour Force (employed plus unemployed )
where:
o Using the International Labour Organization (ILO) definitions:
Employees: people who regard themselves as paid employees. People with
two or more jobs are counted only once.
Self-employed: people who regard themselves as self-employed, that is,
who in their main employment work on their own account, whether or not
they have employees.
In employment: employees, self-employed and participants in government
training schemes and people doing unpaid family work.
Unemployed: those who are without a job, are available to start work in
the next two weeks, who want a job and have been seeking a job in the
last four weeks or are waiting to start a job already obtained.
Labour Force also defined as economically active: those in employment
plus ILO unemployed.
Economically inactive: people who are neither in employment or
unemployment. This includes those looking after a home or retired or
permanently unable to work.
• Full employment: there is no output gap, we are at potential income. There are
no people unemployed for cyclical reasons, but unemployment occurs:
o Search (or frictional): those who are in transition, they have finished studying
and are entering the work force for the first time, or moving between jobs.
o Structural: those who have the wrong skills or are in the wrong location.
There may be job openings but there is a mismatch between the skills
required and the skills of the people looking for work
People are not prepared to move communities to take the jobs for which
they have the skills but which are located in other communities.

o Discouraged workers are usually young people who have had to wait too long
between graduating and finding a career related job.
3.5.1.3 Costs of Unemployment

• The Unemployment Trap is defined as the situation where workers who find work
will lose their benefits and will have to pay tax on the employment income
o They will choose to remain outside the employed section of the labour force
o Obviously this increases costs for governments
• There is a large opportunity cost in terms of the lost output that could have been
produced if the worker had been employed.
• There is the lost tax revenue which governments could have earned both in
terms of direct taxes on income as well as indirect taxes on the increased
expenditures coming from spending out of income rather than out of benefits.
• Having a significant section of the population unemployed leads to greater
income inequality
• The alienation and frustration that set in with unemployment weakens social
cohesion and can lead to greater crime and social unrest.
• Typically there are two types of structurally unemployed workers:
o Those who are unemployed for only a short time: their industry may have
shut down but they have the qualifications and experience to obtain a job in
one of the new, emerging industries
o “Hard core unemployed”: people who refuse to learn new skills and engage in
the newer industries. Frustration and disappointment can lead to crime or to
self inflicted damage such as alcoholism, drug abuse or domestic violence.
3.5.1.4 Types of Unemployment

• Except in depressions or serious recessions, unemployment increases when the
creation of new jobs falls below the net increase in the size of the labour force.
• Short term unemployed: Except during deep recessions or depressions, most
workers who are laid off only experience a short period of unemployment.
• Long term unemployed: people who lack skills or are in the wrong locations.
• Involuntary unemployment: in depressed regions unemployment is higher than
the official figures because people have given up looking for work.
• Underemployment or disguised unemployment occurs if people accept a part
time job because full time work is not available, or if firms are overstaffed.
• Marginal unemployment: workers moving in and out of jobs several times a year.
• Youth unemployment: young workers have a higher unemployment rate:
o They have been denied a working experience early in their careers.
o They may remain as marginal workers who take temporary jobs at low pay
and with little future job security.
o With minimum wage laws employers are discouraged from hiring young
people while providing on the job training.
• Female participation: the rapid increase in female participation has made it very
difficult for markets to respond adequately.
• The inflow of women in the labour force exceeded the speed of new job creation
for women, creating a higher unemployment rate for women.
o As this rate has slowed down, the female unemployment rate has fallen.
o The discrepancy between men and women has narrowed considerably as
women have received training in areas formerly dominated by men.
3.5.1.4.1 Structural Unemployment
• There is a mismatch between the structure of the labour force in terms of skills,
industries and location, and the types or places where jobs are available.
Industrial structural unemployment

• Unemployment develops in sunset industries where international competition
forces change.
• The goods industries operate in an environment of international competitiveness.
Productivity and the ability to compete are fundamental to their success and to
the demand for services: goods and services are starting to merge into each
other.
• This may also be associated with technological unemployment:
o Increasing productivity due to technical innovations can lead to whole
industries becoming obsolete leading to unemployment amongst those
workers displaced either by new technology or by imports from regions where
the new technology is being used.
Sectoral structural unemployment:

• The only sector in which employment has not increased and in many countries
has decreased is in the primary, natural resource sectors.
o Much of this displacement comes about because of competition from imports
from other regions where either wages are lower or productivity is higher
o The enormous technical innovations that have led to massive increases in
productivity on farms has led to huge displacements of populations.
Much of this process is stilling taking place in poorer LDCs where there is
massive rural-urban migration.
• In many industrialized countries there has also been a decline in manufacturing

and construction accompanied by tremendous growth in the service sector.
o Market services: provide inputs to the goods producing industries, the value
of services is included in the goods they help to produce, and include:
Transport, communication, utilities, wholesale and retail trade
Finance, insurance, real estate, business and personal services.
o Non-Market services: are paid for out of taxes, they contribute to human
capital and economic infrastructure, and include:
Health, education and public administration.
• Much of this displacement has come about because of competition from imports
from regions where workers are more productive or wages are lower.
o Again it could be thought of as technological unemployment where steady
improvements in technology have led to greater productivity in the
manufacturing sector of certain regions.
Regional structural unemployment

• In regions where natural resources have run out or where industries cannot
compete internationally or domestically, severe unemployment can develop.

Minimum wage structural unemployment
• Minimum wage laws cause structural unemployment by pricing the unskilled out
of the market.
• While this increases the wages for the workers who are lucky enough to get jobs,
it makes it difficult for elderly people looking to supplement their pension or for
young people who have no working experience.
• Lower wages are needed to pay for on the job training for young people or for
the lower productivity of older workers.
• Retraining and relocation: workers can retrain and develop new skill sets and
move to where there are jobs available. This is unlikely to occur except in the
case of young workers.
o The UK pursued policies of trying to move jobs to the people, but industries
would not move and structural unemployment increased.
o In Sweden, a policy to promote mobility and to assist with retraining kept
unemployment rates low for many decades.
• Unskilled service jobs: the growth in this sector has more than compensated for
the loss of unskilled jobs in the manufacturing and construction industries.
• Jobs do not pay well, are often part time, and do not provide job security.
• They provide work for those who cannot find jobs elsewhere, they offer part time
employment for those looking for such work, and they often provide the first job
experience for young people who are completing their education and looking to
enter the work force.
3.5.1.4.2 Frictional or Search Unemployment

• The normal turnover as young people enter the labour force, and other people
leave and search for a better job.
• Involuntary unemployment occurs when a person is willing to accept a job at the
market wage, but no job is available.
• Voluntary unemployment occurs when a job is available but the person is not
willing to accept it.
o The person is looking for a better job.
o They do not have knowledge of all available jobs and the wage rates.
• The costs of searching are lowered if the household has another source of
income or if there is unemployment insurance available: this makes it easier for
the unemployed to spend longer searching for a better job.
3.5.1.4.3 Seasonal Unemployment

• Workers in these industries or sectors are generally unemployed for certain
periods during the year
o Traditionally this was associated with agriculture, forestry and fishing
There were periods of intense activity followed by periods where there
were few demands for workers
In most western economies, workers in these industries typically represent
less than 5% of the labour force today.
o More recently the huge growth in tourism in both MDCs and LDCs has once
again increased the proportion of workers who are subject to seasonal layoffs:
In countries which cater to winter skiing tourism, the workers have little to
do in the summer.
For countries which offer summer vacations, the workers are layed off in
the winter time.
3.5.1.4.4 Cyclical Unemployment

• At full employment income, there is only search (or frictional) and structural
unemployment.
• During recessions there is cyclical unemployment which can be corrected with
fiscal, monetary or trade policy.
• In most industrialized countries, unemployment rises when the rate of new job
creation slows down during a recession:
o Even in a recession there are thousands of new jobs being created, but the
rate of new job creation is not as fast as the rate of people looking for work.
o Skilled people may have lost a job but will soon find one as soon as the rate
of job creation picks up.
o The structurally unemployed will never get another job even if the rate of job
creation picks up, they do not have the skills or are in the wrong place.
3.5.1.4.5 Real Wage Unemployment

• If labour unions or minimum wages hold the real wage above equilibrium, or if
there is an economy wide rise in real product wages, some firms will not be able
to cover their labour costs and will shut down, leading to unemployment.
• This is most likely to occur when breaking entrenched inflation. Despite the drop
in the inflation rate, unions will push for higher wages and real wages will rise.
• If high real wages persist because there is resistance to wages falling, the firms
that survive will adapt new technology that replaces expensive labour with
capital:
o This leads to unemployment
o Unemployment may eventually force real wages down or new technologies
may be invented which will hire the unemployed despite the high real wages.
3.5.1.5 Measures to deal with unemployment

• Cyclical unemployment can be reduced with appropriate fiscal and monetary
policy.
• Real wage unemployment can be reduced by not allowing inflation to break out
leading to the need to break entrenched inflation which can create the problem in
the first place.
• Search (frictional) unemployment can be reduced by:
o Reducing unemployment benefits.
o Creating employment agencies to reduce the search time.
o Study-work programs such as the German one which allows half the students
in high school to learn by working in a job several afternoons per week.
• Structural unemployment can be reduced through retraining and relocation:

o Older workers resist changes and are reluctant to admit that innovations have
destroyed the value of the knowledge and experience that they already have.
Employers tend to hire younger workers who will learn the new skill faster.
• In many industrialized countries, sunset industries and regions are supported

with subsidies. But agreements with industry to hire un-needed (usually older)

workers increases costs and makes the industry even less viable and puts an
even greater burden on taxpayers.
• In Sweden the state approaches firms in the sunrise area and arranges for
unemployed people from sunset industries to enter into a training program which
eventually leads to a full time position. The government pays all the labour costs
during the training period.
• In Japan, the government approaches companies with sunset divisions and
assists them in investing in new sunrise divisions by paying for retraining of
workers.
• Large, sick, declining industries appear like a national disgrace.
o However, at any point in time there are a number of new firms in sunrise
industries.
o The attempt by government to pick winners and losers has proven to be a
waste of money, and often inhibits the real winners.
o A policy is needed that encourages private initiatives and risk taking.
o Retraining and relocation grants make movement easier and reduce structural
unemployment without inhibiting economic change and growth.
Reducing Unemployment in the Future:

• The Japanese government has found that a certain percentage of the workforce
does not adapt well to industrial manufacturing and it has encouraged the
continuation of quasi-traditional industries like agriculture, fishing, forestry,
ceramics etc.
o By buying the output at subsidized prices and reselling it at market prices
people are able to earn a living without it costing the government a great deal
of money.
o This is not welfare, people are only paid if they produce.
o And the industries must remain labour intensive rather than substituting
capital for labour.
• Knowledge driven methods of production force countries to adjust to structural

changes more rapidly in the future.
• How can countries succeed in global markets while maintaining a humane social
welfare system which encourages workers to cooperate with change?
• Countries which have experienced the most success have streamlined their
capital markets to make investment more attractive and less tied up with red
tape.
o These countries have tended to foster technology extension systems to help
small firms adapt to the new technology.
o They do not shield large, inefficient firms from market discipline but they do
provide training support for change.
• Promotion of small business in Japan:

o A loan guarantee system for small firms is run with no cost to the government
o A small debt policing system prevents large firms from preying on small
supplier firms by refusing to pay for goods or services delivered unless the
small firm lowers the price.

3.5.2 Inflation
3.5.2.1 Definitions of Inflation and Deflation
Inflation
• Inflation is defined as a sustained rise in the price level: prices are rising, and the
purchasing power or value of money is falling
o The purchasing power of money measures the real value of money in terms
of the goods and services that can be purchased with a given amount of
money.
• In most western countries the index most closely watched is the consumer price
index usually called the retail price index in the EU.
o Remember that GDP consists of more than consumption, so a more general
price index is referred to as the GDP implicit price deflator which takes into
account inflation for consumers, investors, government expenditures, imports,
(exports are usually ignored because they do not affect the internal rate of
inflation in a country).
• The rate of inflation is the percent change in the price index being used:
RPI 2004 −RPI 2003

* 100
RPI 2003
o Please note that you must always multiply by 100 so that the percent is
converted to an index.
Disinflation
• Disinflation takes place when the rate of inflation falls:
o There is still inflation, prices are still rising, but at a slower rate
Deflation
• Deflation is defined as a sustained fall in the price level
The History of Inflation

• From 1200 to 1525 prices were very stable, periods of inflation were followed by
periods of deflation.
• The first period of sustained inflation ran from 1525 to 1650 and is associated
with the gold from the New World being brought back to Spain. It is estimated
that the amount of gold increased 5 times, and prices did likewise.
• From 1650 to 1935 prices moved up and down but there were no periods of
sustained inflation or deflation. The inflation in the 1920's was matched by a
deflation in the 1930's.
• By 1935 most developed countries made the decision to go off the gold standard:
there was no check on the money supply and many governments started printing
money. Prices in most countries have risen at least 20 times those in 1935.
• Between 1976 and 1979, most industrialized countries decided not to print
money in excess, and prices have been increasing only slowly ever since.

The Real Interest Rate
• The interest rate is the price paid to borrow money.
• The prime rate of interest is what the banks charge their best business customers
and may be thought of as the market interest rate or opportunity cost rate of
return.
• The real interest rate gives us the return on the investment in terms of
purchasing power and is equal to the nominal interest rate minus inflation:
Real interest rate = nominal interest rate – inflation rate
3.5.2.2 Costs of Inflation and Deflation
Costs of Inflation
• Inflation reduces the real value of anything with a price fixed in money terms. If
people do not anticipate inflation, there will be winners and losers:
o The winners include
People who owe money to others: the real value of the amount owed will
decline
Employers will gain as the real value of the wages they have contracted to
pay declines during the life of the contract
Importers who buy cheaper goods and services from other countries.
o Losers include:
People on fixed incomes
Wage earners who fall behind in real wage terms
People who lend money
Exporters who have to sell more highly priced goods in international
markets
The economy because investors are uncertain how to value future prices
The economy as relative prices become distorted: firms will be able to
raise prices quickly in some industries and more slowly in others leading to
a misallocation of resources
The extra transaction costs involved in people making more frequent trips
to the bank as the opportunity cost for holding cash increases
Retailers who have to change prices more frequently.
• To protect against inflation potential losers can anticipate inflation:

o Wages can have an expectational element built in to contracts to protect
workers
o Banks and other people lending money can charge an interest rate high
enough to include the anticipated inflation
o However, people on fixed incomes, particularly the retired are unable to alter
their pensions, and this group has been very badly hurt by inflation.
• It is unlikely that inflation will be anticipated properly and different adjustment

rates mean that some will gain and some will lose from inflation.
• One problem area is taxation:
o If there is a capital gain (the value of something purchased has gone up
before being sold) some of that gain will be due to inflation and should not be
taxed.
o However, most governments do not make an allowance for inflation in the tax
system.
Costs of Deflation
• There are two kinds of deflation:
o The bad kind typically results from governments suppressing interest rates
below the natural or long term level:
Firms will keep borrowing money and investing until the ROI on the last
investment is equal to the lowered borrowing rate
Once interest rates return to the natural or long term rate, the ROI on
those recent investments will be below the market rate of interest and the
value of those investments starts to fall
The over-investment leads to excess capacity: firms are forced to layoff
workers and cut production as prices are not high enough to cover costs
This will lead to a decline in prices as firms with overcapacity compete
with each other: a recent example is the auto industry.
o The good kind of deflation is where productivity is rising rapidly which lowers
costs of production:
ROI does not fall, it actually increases as costs are falling
There is a steady downward drift in prices but not because of the
competition arising from overcapacity but from the lower costs due to
higher productivity
Firms remain economically viable and bankruptcy remains low.
• Assume that supply side policies have been Deflationary Gap

Price Level
SRAS1
used to shift both the SRAS in the short run
and the LRAS in the long run out to the right LRAS1 LRAS2
SRAS2
o Equilibrium moves from E1 to E2 AD1
o Real GDP is higher, employment is higher
and inflation is lower AD2
•
E1
One of the problems of deflation from a macro
point of view is that as consumers anticipate
E2
prices will fall, they postpone consumption. Yfe1 Y1 Yfe2 Real GDP
o The AD curve shifts into the left from AD1 E3
to AD2 and a recessionary gap opens at

point E3 with income at Y1
• Using monetary policy is ineffective:

o The real rate of interest is:
Real interest rate = nominal interest rate – inflation rate
o In the recent case of Japan, nominal interest rates were 0.25% and the
deflation rate was 3% (negative inflation rate) which meant the real interest
rate was +2.75%
o With an ROI in Japan of 2.5%, it was impossible to get interest rates to fall
below the ROI in which case investment was not stimulated.
• Using fiscal policy appears to be ineffective as well as the stimulus does not lead
to further spending rounds because the savings rate is so high in anticipation of
even lower prices in the future.
• It means the economy can get stuck at point E3, this appears to be what has
happened to Japan during the last 11 years.
• What has assisted Japan recently is the very sizable increase in exports to Japan
which has helped to shift the AD curve from AD2 to AD1
3.5.2.3 Causes of Inflation
Cost Push
• Inflationary shock: any event that tends to drive the price level upward. Supply
shocks arise from:
o Raw materials: increases in price such as the oil shock. Increases in the price
of imported raw materials such as oil are usually isolated and not persistent.
o Labour: continued wage cost push is an example of repeated supply shocks.
• The SRAS shifts inward, to the left:

o The price level rises and income falls below the full employment point. This is
referred to as stagflation.
o A recessionary gap opens, and pressure mounts for wages and other factor
prices to fall.
o SRAS shifts out to the right and there is a return to full employment
accompanied by a fall in prices.
• Temporary shocks lead to inflation followed by deflation.

• If the CB responds by increasing the money supply, we say the price shock has
been accommodated:
o The increase in the money supply leads to an outward shift of the AD curve.
o This eliminates the recessionary gap, but leads to further inflation.
• Keynesians believe that waiting for cost deflation to restore full employment
forces the economy to suffer through an extended slump because wages are
sticky down and productivity grows very slowly in a recession.
Wage-cost push inflation:

• Powerful unions may administer repeated shocks by pushing for higher wages:
o Firms pass the wage increases on in the form of higher prices.
o If the CB does not accommodate, the SRAS shifts inward creating a recession.
o Unions would eventually cease pushing wages up in order to maintain jobs.
o Persistent unemployment will erode the power of unions.
Inflationary gap inflation

• The excess demand for labour associated with an inflationary gap puts upward
pressure on wages and the SRAS curve shifts in to the left.
• The excess supply of labour associated with a recessionary gap puts downward
pressure on wages.
Demand Pull
• A rightward shift in AD can only come about either because of an increase in an
autonomous element or an increase in the money supply:
o An inflationary gap opens up and wages and other costs rise leading to a
leftward shift of the SRAS.
o The rise in the price level induces changes leading to a movement back along
the AD curve to the full employment point. This leads to even more inflation.

• If the CB reacts to the demand shock by increasing the supply of money, it is
validating the shock.
• Government may not want output to fall, particularly if they face an election.
o Wage increases cause SRAS to shift left, but money supply increases again
and AD shifts to the right.
o The price level rises, but output does not fall.
Sticky Wages
• There is a tendency for employers to smooth out the income of employees by
paying steady wages and letting profits and layoffs do the adjusting to the shocks
in the economy.
• Productivity rises as a worker gains experience but falls off as the worker gets
older.
• With wages rising with seniority and layoffs done by seniority, workers and
employers are bound to each other.
• Employers know that self policing is the best policy. If workers feel they are
unfairly treated they will cut productivity, which is one reason why employers are
so reluctant to lower wages.
• It is also a reason why employers tend to pay more than the market wage. They
know that working is better than being laid off, and workers will work hard
without the need for monitoring if they are paid slightly more than the market
wage.
Random Shock Inflation

• These are the supply and demand shocks which often trigger bursts of inflation
which must come to an end unless monetary expansion occurs.
• The cost of labour must be related to growth in productivity. If wage increases
lead to a rise in unit costs, it must be because wages are rising faster than
productivity.
Excess Monetary Growth

• Non-accommodated wage push inflation tends to be self limiting.
• If the CB accommodates, both money wages and prices will have risen.
o Workers are no better off so unions try again.
• If the CB accommodates the new supply shock, costs and prices will rise leading
to a wage price spiral:
o This can only be halted if the CB stops accommodating the supply shocks.
o The longer the CB waits to do so, the more entrenched will be the
expectations.
Employers expect prices to rise and grant wage increases.
Workers push for higher wages as they see prices rising.
o Once accommodation stops, stagflation sets in: rising prices combined with
rising unemployment.
• If inflation is to continue it must be accompanied by continuing increases in the

money supply.
• The general expectation of an x percent inflation creates pressures for wages to
rise by x percent and hence for SRAS to shift by x percent.

• In the long run, shifts in SRAS and AD do not effect employment and output,
they affect only the price level.
o Thus inflation is a purely monetary phenomenon from the point of view of
long run equilibrium.
• If income is held above potential income, the price level will be rising. This can
only happen if the CB is accommodating the increase in wages.
• When the SRAS and the AD curves are shifting up at the same speed, the
inflationary gap remains unchanged. Eventually people will believe that
monetary validation (accommodation) and hence inflation will continue:
o The SRAS will begin to shift up even faster:
If the CB is told to accommodate in order to hold the level of output
constant, it must increase the rate at which the money supply is increased.
The rate of inflation will start to increase which fuels expectations of
increased inflation leading to accelerating or entrenched inflation.
Breaking Entrenched Inflation

• If employers expect 5% inflation, they will
Eliminating Entrenched Inflation: Step 1
agree to wage increases of 5% and raise LRAS
prices 5%. Price
SRAS2
• If the CB accommodates, then AD will be Level
SRAS1
rising by 5% per year as well. E1
Eo
• Even if the CB does not accommodate
completely, the negative demand effect of a AD1
recessionary gap may be rather weak. The

demand effect may be swamped by the Yfe Y1
expectational and random shock effects.
• To break entrenched inflation, the Real National Income
expectation of inflation must be broken:

o Step 1: stop accommodating:
The rate of monetary expansion has to be slowed to lower the rate at
which AD is shifting out.
The SRAS will keep shifting left at the old rate and will soon eliminate the
inflationary gap (from Eo to E1).
o Step 2: because of inflationary

expectations, the SRAS will continue to Eliminating Entrenched Inflation: Step 2
shift left which leads to: Price LRAS

SRAS3
Level
Disinflation: prices are still rising
but at a slower and slower rate.
SRAS2
E2
E1
AD1
Y2 Yfe

Stagnation: rising unemployment which will dampen expectations of
inflation and the inflation will halt leaving a large recessionary gap
The combination of higher prices and rising unemployment is referred to
as stagflation.
o Step 3: return to full employment either: Eliminating Entrenched Inflation: Step 3
LRAS
By waiting for the SRAS curve to shift Price
SRAS3
Level
to the right (moving to E3a) because
productivity is rising faster than wages SRAS2
which lowers prices and increases E3b
output E2
By using fiscal or monetary policy to E3a
AD2
shift the AD curve (moving to E3b). AD1
The great fear is that this may rekindle

Y2 Yfe
inflationary expectations.
• Economists who worry about waiting for

wages and prices to fall, fear that the process will take a long time and create a
great deal of misery for the unemployed.

3.5.H.1 Methods of measuring inflation
• The rate of inflation is the percent change in the price index being used:
RPI 2004 −RPI 2003

* 100
RPI 2003
o Please note that you must always multiply by 100 so that the percent is
converted to an index.
• Calculating the price index: there are two possible methods:

o The Paasche Index is:
Where:
The quantities used are from the most recent year
o Or the Laspeyres index:
Where:
The quantities used are from the previous year
• The Laspeyres index is the most commonly used and is based on the concept of
a basket of goods
o Based on surveys of consumers, a range of goods is chosen for the CPI or RPI
which reflects the typical “basket” of goods that consumers buy during the
year.
• Prices are surveyed once a month to see how they have changed for each item in
the basket

• The price index is calculated by adding up all the prices for the items in the
basket and weighting each price by the importance of the item in the budget
o For example, if housing accounts for 20% of the typical basket, then the price
of housing is multiplied by 0.2 to get the weighted price.
• The summation of all the weighted prices is then set equal to 100 in the base
year. If the following year the sum adds up to 104, then we know there has
been 4% inflation since the base year
• Note that the basket of good is only changed every five years in most MDCs and
every 10 years in LDCs as it requires extensive surveying to discover how
people’s tastes in goods have changed.
o One problem that arises is that consumption patterns change over time, and
the weights on various items change steadily as people's tastes switch to
different products.
3.5.H.2 Problems with measuring inflation

• There are a number of problems associated with measuring inflation:
o Obviously the costs of surveying to determine the optimal basket of goods is
expensive and governments are reluctant to adjust baskets more often than
every 5 or 10 years and yet the menu of items that consumers purchase does
change quite radically:
Two recent examples are the impact of computers and the rising costs of
healthcare as the population ages
o Another problem is that the basket may not be truly representative of the
whole population, only averages are used which may disguise massive
changes which may be taking place.
o Closely related is the concept of weighting: how do we know the range of
importance assigned to each of the items in the basket: education costs may
be more important to the young while housing costs and healthcare costs
may be more important for people who have retired.
o It is quicker and easier to measure CPI or RPI as it is much easier to survey
and get information back. It takes much more time to calculate the GDP
implicit price deflator and yet it is a much more accurate indicator of changes
in general prices:
In actual fact, studies have shown that turning points are much the same
for CPI (RPI) and the GDP implicit price deflator, it is only the magnitude
of the change that differs.
o Perhaps the most serious problem associated with measuring inflation has
been the difficulty in adjusting for increases in quality:
The most famous example is the cost of light: the price of lumens has
dropped dramatically in the last 100 years since the advent of electricity
and fluorescent light tubes
The cars that we buy today are much better quality and yet prices have
risen and it appears they are more expensive to buy when in fact studies
show the real price has actually fallen.
The same is true of healthcare and housing.
o Attempts have been made to adjust inflation for increases in quality, but a
number of economists claim the inflation rate has been much smaller than
what is reported.
3.5.H.3 Phillips curve
• The Phillips curve attempts to answer the following questions:
o Why do wages rise more quickly than productivity during boom times and yet
do not fall very fast when there is unemployment during a recession?
o Has the rate of wage inflation on the vertical axis (this contrasts with the price
level for the SRAS curve)?
• The Phillips curve indicates the direction in which SRAS shifts and how fast the
SRAS curve is shifting when actual income does not equal potential or full
employment income (when we are not in long run equilibrium).
Short run
• When equilibrium Y is equal to potential or full employment income (Yfe):
o Demand for labour equals supply (only frictional or structural unemployment)
o There is neither upward or downward pressure on wages.
o The Phillips curve cuts the axis at potential income, Yfe, at the corresponding
level of unemployment Unat (the natural rate of unemployment).
Above the Full Employment Point

• If the level of income determined by AD and SRAS is Y1, converting this into the
unemployment equivalent gives us U1.
• The Phillips curve indicates that at this level of unemployment wages are rising at
10%.
• For now we assume no increase in The Phillips Curve
productivity in the figure 20
• With wages rising, SRAS is shifting left
Rate of Change in Wages
15
by the annual increase in labour costs.
• As the SRAS shifts to the left, eventually 10
it will be equal to AD at the potential or 5

full employment level of income, Yfe:
0
o This level of Y corresponds to Unat,
U1 Unat
the natural rate of unemployment. -5
(Y=Yfe)
o Wages are neither rising nor falling. -10 Unem ploym ent Rate
Below the Full Employment Point

• If the level of income is below the full employment level, U will be to the right of
Unat in the Phillips curve. People are very reluctant to accept a wage cut, and the
Phillips curve flattens below the axis (wages falling less than 2% per year).
• If we re-introduce productivity increases, the SRAS will slowly shift outward, and
income will eventually rise to the full employment level, and unemployment fall
to Unat.
Long Run
• We have assumed that it is rational for everyone to incorporate expectations of
inflation into their behaviour.
• This will lead to shifts in the Phillips curve:
o There is a difference between the long run and the short run Phillips curves.

o If expectations are fully rational, then the long run Phillips curve will be
vertical, there will be no
% rate of change in
Long Run Phillips Curve
tradeoff.
Wages or Prices
o If the government attempts to Phillips Curve
short run 3
reduce unemployment below Phillips Curve
long run
the natural level, it will just Phillips Curve
short run 2
lead to an increase in the D
inflation rate:
As we move from point A to C
point B, unemployment E
falls but inflation rises (AD Phillips Curve

short run 1 B
shifts out and we get the
first round of inflation) A F
Phillips curve short run 1 U1 Unat Unemployment Rate
does not shift as

expectations have not
changed.
However, with an inflationary gap, the SRAS shifts to the left, and we
move from point A to point B, and inflation subsides.
o If the government attempts sustain unemployment at U1:
AD shifts out again, and this time workers come to expect inflation as we
move from point A to B.
The Phillips curve shifts up to Phillips curve short run 2 and we move from
point B to point C.
The inflation rate associated with U1 rises higher than before
The SRAS will shift in and once again inflation will start to subside unless
the government persists in maintaining unemployment at U1 at which time
the Phillips curve shifts up yet again as we move from point C to point D.
• In order to reduce inflation it will require a severe recessionary gap to be opened

to get the Phillips curve to shift back down again and reduce the upward
pressure on wages.
• Inflationary expectations are stuck:
o Even if the government decides to abandon its policy of trying to force
unemployment below the natural rate:
As the SRAS shifts left it will continue past full employment at point E
Unions want to catch up for all the years they feel they have been cheated
Wage demands drive the SRAS curve even further to the left opening up a
recessionary gap which leads to stagflation at point F
Only with unemployment at point F will unions moderate their demands
The government will have to undertake policies to move from point F to A.
• There may be a tradeoff between inflation and unemployment in the short run,
but in the long run the Phillips curve is vertical, and there is no tradeoff.
• NAIRU: is defined as the non-accelerating rate inflation rate of unemployment.
This means that we do not have to be where %∆wages = 0. As long as the
%∆wages stays the same, we are at the NAIRU point.
3.5.H.4 Natural rate of unemployment

• The natural rate of unemployment means the amount of frictional and structural
unemployment associated with the full employment income level.

o For Sweden and Japan it was 2% for many years, in the US it has been at the
4% level since 1984, and in Canada and Australia it has been around 7.5%.
• During recessions the natural rate of unemployment falls (search). During the
recovery from recessions, the natural rate of unemployment starts to rise again:
o During recessions, people will take a job more quickly, and less time is spent
in searching for the perfect job (search or frictional unemployment falls).
o During boom times, workers are willing to take longer to find a job.
• The natural rate of unemployment is assumed to consist of structural and search

(frictional) unemployment but not cyclical unemployment.
3.5.H.5 Non-Accelerating rate of Inflation (NAIRU)

• NAIRU: the non-accelerating inflation rate of unemployment, also referred to as
the natural rate of unemployment, is that level of unemployment which does not
lead to an increase in inflation
o In other words we are on the LRAS curve in long run equilibrium and prices
are rising at a particular rate
o That is the rate of unemployment where wages are rising at the same rate as
productivity plus whatever the inflation rate is
• NAIRU rose steadily until 1979, the year when most developed nations agreed to
stop accommodating inflation in an attempt to control inflation.
3.6 Distribution Of Income

3.6.1 Direct (Income) Taxes
• Direct taxes are taken from income before there is any expenditure.
• With personal allowances and higher rates for higher incomes, income taxes can
be progressive.
• On the other hand consumption (indirect or expenditure) taxes are generally
levied at a constant rate and can therefore be regressive:
o Poor people pay relatively more tax as a proportion of their income on basic
necessities than rich people do.
o Several countries have exemptions or lower rates of sales or consumption
taxes on things such as food and medicine in order to reduce the regressive
nature of such taxes.
3.6.2 Indirect (Expenditure) Taxes

• Indirect taxes are taxes based on expenditure (consumption), and account for
20% of all taxes collected in OECD countries.
• Value added taxes are assessed throughout the production process: each
intermediary is able to claim back the tax paid on intermediate goods.
o It is more efficient because it is self policing: each link in the chain will be
claiming tax back on the input costs.
o In Europe VAT has now been raised to 20% with little fear of cheating.
• An excise tax is levied on a particular commodity such as cigarettes

• A sales tax is levied on all or most goods which are sold through retail outlets.
• Excise and sales taxes are charged only at the time of sale to the consumer.
o The burden of collecting the tax falls entirely on the seller.
o It can lead to tax cascading: some commodities effectively get taxed more
than once; this is related to the double counting problem.
o It is estimated that widespread cheating will occur once the tax exceeds 10%.
• Indirect taxes are less likely to distort behaviour than income taxes:
o High income taxes may lead some to choose leisure over work..
o With indirect taxes some rich people may choose to save and invest.
3.6.3 Progressive Taxation

• As income rises, the proportion of the direct tax rises as well
o This is typically referred to as being pushed into a higher tax “bracket” as
your income rises
o At lower levels of income, taxes may be 15% of income, but after a certain
level the tax rises to 20% of income.
Alternative tax systems for Direct Taxes

3.6.4 Proportional Taxation
Taxes Paid
Progressive
• As income rises, the proportion of direct tax system
tax remains the same: there are no higher

tax brackets Proportional tax system
o There are calls for a move to a “flat” tax

system which is closely related to a
proportional tax
o Many legal methods are available to tax Regressive
tax system
payers in higher tax brackets to avoid
paying taxes by using systems of
Income
deductions
This may mean that very little tax is
actually collected from the rich
Many economists want to move to a flat tax system where there would be
a fixed percentage which is smaller than the average existing tax rate and
no deductions: the rich would have to pay as much as anyone else as a
proportion of their income.
3.6.5 Regressive Taxation

• There are no regressive income tax systems in the world, if there were it would
mean that the proportion of tax would actually fall as incomes rose.
• Many indirect (expenditure) taxes are regressive:
o Rich people tend to save more than others which means that expenditures
are a smaller proportion of their income
o A tax on expenditures will fall more heavily on people who are not rich as the
items being purchased represent a larger proportion of their income.
o This is why in many countries basic food, clothing and healthcare are not
taxed in order to reduce the regressive nature of indirect taxes.
3.6.6 Transfer Payments

• Transfer payments are money given to an individual or organization with no
production of goods and services involved.
• There are two main types:
o If you bought 100 shares of a stock on the stock market, the money would be
transferred from you to the former stock holder:
No exchange of goods and services is involved only a transfer of
ownership in return for the transfer of money
This is why stock market transactions and capital gains are not included in
GDP accounting, they are not money given for production of goods and
services.
o The second type of transfer payment is when the government gives an

individual or an organization money:
Typical examples for individuals include pension payments, welfare
payments, unemployment benefits, housing subsidies
And for corporations it includes subsidies to lower production costs.
o Although not transfers of cash, many governments are involved in transfers of

services in kind:
For individuals this would include subsidized healthcare and education
For corporations this would include such things as International marketing
or International financing for exports.
Tax Revenue (T = t*Y)

Laffer Curve
3.6.H.1 Laffer Curve
Definition Topt
B
• As the marginal tax rate increases, total tax A

T1
revenue first increases and then falls when
the marginal rate becomes excessive:
o Total revenue is given by t*Y
o As t rises, t*Y rises, and by tax rate topt
total revenue is at a maximum Tax Rate (t)
topt t1
o Beyond topt even though t continues to
rise, Y starts to fall.
• After a certain point the disincentive effects of the tax rate are so great that the
tax base is eroded and tax revenues start to fall:
o People lose interest in working hard and earning money if the marginal rate
gets too high,
o People start to work in the parallel economy where they do not declare their
income and the government does not collect revenue
o People move to another country where taxes are lower.
• By getting rid of excessively high marginal tax rates through using a flat tax
system, more tax revenues could be collected..
• US supply side policies attempted to shift the LRAS curve to the right by reducing
taxes. As this would cause SRAS to shift right:
o Inflation would be reduced, real output increased, and unemployment
reduced.
o If the US was to the right of topt, reductions in taxes would lead back to topt:
Eventually, the boost in productivity and numbers employed would lead to
higher Y and higher tax revenues to compensate the tax cuts.
o Lower taxes would stimulate incentives to work, save, invest, innovate and
accept entrepreneurial risk.
o This would also shift the LRAS to the right, permanently reduce
unemployment and lead to an increased tax base leading to greater tax
revenues.
Problems with the Laffer curve

• Decreases in taxes may induce some to choose more leisure rather than work.
• There are demand side effects which may result in inflation before supply side
effects can counteract this. Large budget deficits and soaring inflation will result.
• The economy's position on the Laffer curve is undocumented and unknown.
• Anti-inflationary monetary policy were instituted in North America, Europe and
Japan in 1981.
o The inflation rate fell much more quickly than was expected, and has settled
around 2% for a number of years with no inflationary gap.
• Full employment and a low, stable inflation rate appear to be compatible in the
long run: as long as the SRAS shifts only because of random shock effects.
• Cost-push inflation can return once the fear of unemployment has disappeared.
This is the problem with governments being committed to a full employment
policy, much of the discipline of the market tends to be removed from wage
bargaining.
• If the goal were a stable price level rather than full employment, the government
might make the maintenance of something close to full employment much more
likely.
o This is why the goal of price stability comes before the goal of full
employment.
3.6.H.2 Lorenz Curve & Gini Coefficient
Lorenz curve 100% B
• The Lorenz curve measures the Lorenz Curve

percent of income received by a
given proportion of the :
ty
population. ali
Income
equ
ct line
• We generally divide the f
rfe e
pe gre
o d e
population into quintiles (20%) Li
ne 45
and portray the income earned zc

ur
ve
n
by the bottom 20% up to the Lo
re
top 20%. 20%

• The percentage of households is
10%
plotted on the x axis, the
A
percentage of income on the y C
axis. 20% Population 100%
• A perfectly equal income

distribution in a society would be one in which every person has the same
income.
o In this case, the bottom 20% of society would always have 20% of the
income.
o Thus a perfectly equal distribution can be depicted by the straight line which
is called the line of perfect equality (AB).

• A perfectly unequal distribution, by contrast, would be one in which one person
has all the income and everyone else has none.
o In that case, the curve would be at income =0 for 99% of the population, and
income would equal 100% for the last person.
o This would give rise to the line of perfect inequality (ACB).
• It is impossible for the Lorenz curve to rise above the line of perfect equality, or
sink below the line of perfect inequality, which means the curve must always be
increasing (it is below the line of perfect equality).
• In the diagram you can see that the bottom 20% of the population only receives
10% of the income if the Lorenz curve has this shape:
o The greater the distance between the 45 degree line and the Lorenz curve,
the greater the inequality in the country.
Gini Coefficient
• The Gini coefficient provides a measure of inequality and is usually expressed as
a number between 0 and 1:
o Where 0 means perfect equality (everyone has the same income)
o Where 1 means perfect inequality (one person has all the income, everyone
else has nothing).
• The Lorenz curve can provide us with a useful way of calculating the Gini
coeffient:
o Take the area between the Lorenz curve and the line of perfect equality (AB
along the 45o line)
o Divide this by the triangular area: ABC
o If there is perfect equality, the area between the line of perfect equality and
the Lorenz curve would be equal to zero and the calculation would yield 0.
o If there was perfect inequality, the area between the Lorenz curve and the
line of perfect equality would be exactly equal to the triangle ABC and the
calculation would yield 1.
• Typically we express the Gini coefficient either as a decimal between 0 and 1 or
as a percentage.

SECTION 4: INTERNATIONAL ECONOMICS
4.1 REASONS FOR TRADE
4.1.1 Differences in Factor Endowments
• Trade is based on the concept of opportunity cost: if a country can produce one
good at a lower opportunity cost than another country, it has a comparative
advantage. It sacrifices less of other goods to make one unit of that good.
• Gains from trade are the increased output resulting from specialization amongst
nations and from trading are called the gains from trade. They lead to an
increase in living standards, but also to increased dependence amongst nations.
• Differences in factor endowments lead to differences in opportunity costs.
Countries where land is cheap and labour is expensive will produce land intensive
goods. Countries where there is little land but abundant labour will produce
labour intensive goods.
• The Hecksher Ohlin theory: countries have comparative advantages in the
production of goods in which they have relatively abundant endowments of
natural resources including climate and weather.
4.1.2 Variety and Quality of Goods

• One of the greatest gifts a government can give to society is to eliminate trade
barriers
o This will introduce competition into the market place which will reduce
monopoly power and give consumers much better prices for goods and
services
Governments must protect against predatory practices where international
firms will import goods at lower than production costs in order to drive out
domestic producers
Once domestic producers have left the industry, the foreign importer will
raise prices dramatically in order to extract a super normal profit.
• At the same time there is usually a significant increase in variety as the goods
and services from other countries are different from those which are domestically
produced
• International competition also ensures better quality goods.
o Perhaps the greatest example is the impact of Japanese cars on the domestic
car market in most countries.
According to Consumer Reports, the reliability, safety and repair record for
Japanese cars is substantially better than for domestically produced cars.
This competition has actually forced European and North American car
companies to increase the quality of their products.
4.1.3 Gains from Specialization

• Arguments for free trade are comparative advantage, economies of scale,
increased competition and the spread of technology.
• However, in the real world, countries do not specialize totally:
o Opportunity costs are not constant in the real world.
o Opportunity costs between land intensive products and capital intensive
products will change as specialization proceeds.

• Transport costs are ignored in the model, but do place limits on trade in the real
world.
• Another limit to the trade in goods and services is the mobility of the factors of
production:
o It is in the interests of the owners of factors of production to move them to
the highest paid location.
o Labour tends to move from low wage to high wage countries.
o Capital moves from low ROI to high ROI countries.
o All this movement in factors tends to alter the comparative advantages of
regions and nations over time.
Economies of Scale
• Unit costs of production usually fall over some range of production as the scale
increases, because some types of K are simply more efficient in large scale
production.
• For smaller countries, the domestic market
Economies of Scale
is simply too small to make it worthwhile
building large plants. Trade allows these 100
smaller countries to specialize in producing 80 a Long run
Unit Costs
Cost
a limited range of commodities at high 60 b
enough levels of output that they will reap 40
the available economies of scale. 20
• Free trade leads to differentiated products 0
q1 q2
with different countries specializing in
Ouput per Year
different sub product lines.
Learning by Doing Learning by Doing

• Countries that specialize in a particular 100 LRAC1
line of production gain experience both in 80
terms of the workers and the managers.
Unit Costs
LRAC2
60 a
The whole cost curve actually falls.
40
• It is particularly important in knowledge
20 b
intensive, high tech industries: costs fall
0
as the total of all cumulative past output
rises (the Σq rather than the level of q). Ouput per Year
• The higher a firm's output, the faster unit costs will fall. This confers large
advantages on firms which are first into the market with a new product or
service, and benefits firms that have large domestic markets to support an initial
high rate of output.
4.1.4 Political
• Comparative advantages can be altered. Through education and investment,
countries can develop new comparative advantages.
o Misguided education policies, tax policies that discourage investment and risk
taking can lead to a rapid erosion of a country's comparative advantage.
• Old view: factor endowments determined the patterns of comparative advantage,

and those countries large enough to gain economies of scale had a comparative
advantage over smaller countries. With trade, each country would specialize in
the products in which it had a comparative advantage and by trading would
access larger markets leading to economies of scale.
• New view: new industries depend as much on human capital which is developed
through training and learning by doing, conferring a new type of comparative
advantage.
o Private entrepreneurial activity plus government intervention to promote
education and investment can alter comparative advantage. The question is
whether government intervention can accomplish the task and at what cost.
4.1.H Higher Level Topics: Absolute and Comparative

Advantage
Absolute advantage
• A country has an absolute advantage in the Wheat Cloth
production of a good if an equal quantity of India 10 6
resources can produce more of the good than Kenya 5 10
another country.
• An absolute advantage does not confer a Gains from Trade
comparative advantage: in order to produce India +10 -6
that good, it may take fewer resources but it Kenya -5 +10
might also involve a greater sacrifice of other GAIN +5 +4
goods.
• Example: given a unit of resources, India can make 10 bushels of wheat or 6
metres of cotton cloth, while Kenya can make 5 bushels of wheat or 10 metres of
cloth.
o If one unit of resource is switched into making wheat in India and into making
cloth in Kenya, the gains, losses and net gains are illustrated in the bottom
part of the table.
o The countries combined produce more wheat and cloth than if they were self-
sufficient; to receive a benefit they must trade.
Comparative Advantage Comparative

Advantage
• Comparative advantage: one country is relatively Wheat Cloth
more efficient at producing one good, even if the India 100 60
other country is absolutely more efficient at Kenya 5 10
producing both goods.
• Example: India is 10 times more productive, but Gains from Trade
relative to Kenya, India is more efficient at India +10 -6
producing wheat than cloth. India can produce 20 Kenya -5 +10
times more wheat than Kenya but only 6 times GAIN +5 +4
more cloth.
• India has a comparative advantage in producing wheat while Kenya has a
comparative advantage in producing cloth.
o One tenth of a unit of resources is transferred from cloth to wheat in India
while one unit of resources is transferred from wheat to cloth in Kenya.
o Gains from trade are positive, both countries can benefit from specializing.
• In the very odd example where the ratios between wheat and cloth are the same
for both countries, there can be no gains from trade as there is no comparative
advantage.

4.1.H.1 Opportunity Cost
• Opportunity cost is the sacrifice in terms of one Opportunity Cost
good to produce the other. Wheat Cloth
• Example: divide the amount of cloth produced India 0.6 1.67
by one unit of resources by the wheat output. Kenya 2.0 0.5
For India, to move one unit of resources out of
cloth production would mean losing 6 metres of cloth to gain 10 bushels of
wheat, thus the opportunity cost would be 0.6.
• India can produce wheat more cheaply than Kenya, but Kenya can produce cloth
more cheaply than wheat.
o Opportunity cost calculations depend on the relative costs of producing two
goods rather than on absolute costs. One country has a comparative
advantage when its opportunity cost is lower.
• If opportunity costs where all the same, no country would have a comparative
advantage and there would be no gains from trade.
• If the trading terms of trade were 1:1, then both would gain:
o India’s internal terms of trade are 0.6:1.67 but with the international terms of
trade they can now buy cloth for one bushel of wheat instead of 1.67
o Kenya would be able to buy wheat for one metre of cloth instead of 2.0
4.1.H.2 Limitations of the Theory of Comparative Advantage

• Trade based on present comparative advantage may lock LDCs into low skilled
labour intense production while NIEs and MDCs continue to grow with high-tech
• Specialization in primary sector goods subjects the LDCs to considerable risk:
o Commodities are income inelastic
o Many synthetic substitutes have been developed to replace primary products.
o MDCs protect their own primary sectors against cheaper imports.
• Prices in reality are considerably distorted by firms who are often price makers.
Government can distort prices by applying indirect taxes and subsidies. And
prices rarely reflect true social costs and benefits.
• Who truly gains from trade?
o In many LDCs, exports are produced by foreign owned subsidiaries of TNCs
and a large proportion of the gains may be sent to the shareowners in MDCs
(called repatriation of profits).
• The model assumes there is full employment, and yet in many LDCs,
unemployment and under-employment are high.
o Increased domestic production may well be gained at low opportunity cost
while providing jobs for the rural poor.
o Protection may be required during the period of transition: referred to as the
infant industry argument.
4.2 Free Trade & Protectionism

4.2.1 Definition of Free Trade
• With free trade there is no government intervention to constrain trade or alter
trade patterns.

• Protectionism is government intervention designed to protect domestic industry
from foreign competition and occurs through price controls (tariffs), quantity
controls (quotas), and non-tariff barriers (NTBs) which are regulatory in nature
and designed to hinder the flow of imports.
4.2.2 Types of Protectionism

4.2.2.1 Tariffs Free Trade & a Tariff
• Tariffs are import duties: a specific

tariff is one that is levied as a specified Dd Sd
amount of money on each imported t

unit. An ad valorem tariff is levied as a d +f+ )
Po
O S rge
tax percent of the price. (la +f )
Sd rge
•
B Sd +f+t
In some LDCs which have trouble
Price
Pb (la
(small)
Sd +f
collecting income taxes, tariffs remain Pa
(small)
A
a very important source of revenue.
• Example: the domestic price before
Mb
trade is Po producing at Qdo.
Ma
o After trade, which leads to a
shifting out of the supply curve, the
Qda Qdb Qdo Qb Qa
price falls to the world level of Pa, Quantity
quantity consumed is Qa, of which
only Qda is produced domestically.
o Domestic producers are not happy as they have lost production and revenue
has fallen to Pa*Qda.
• If a tariff is imposed by a small country:

o The supply curve begins with domestic production and prices rise to Pb. The
new supply curve is Sd+f+t.(small)
o The quantity consumed drops to Qb, domestic producers increase production
to Qdb, and their total revenue rises to Pb*Qdb.
o The government receives the revenue given by the difference between Qb
and Qdb times price Pb-Pa.
o Domestic consumers lose because they consume less of the product and they
have to pay a higher price.
o Foreign exporters receive (Qb - Qdb)*Pa
• If a tariff is imposed by a large country, the analysis is virtually the same except
that the new supply curve is upward sloping Sd+f+t.(large) to reflect the influence
on world prices of the buying power of a large country.
4.2.2.2 Quotas
• An import quota is a restriction on the amount that can be imported (Qb - Qdb).
o The situation is the same for domestic producers as with the tariff.
o But importers now receive the revenue the government used to receive.

• The total supply curve consists of the heavy Free Trade & A Quota
black line: the domestic segment from zero
Sd
to Qdb, plus the foreign segment from Qdb to Dd
Qb, then back to the domestic segment from ta

uo
Pb on. O +q
Po Sd
• In the absence of a quota, equilibrium would +f
B Sd
Price
have taken place along the foreign supply Pb
curve, Sd+f at Pa and Qa. Pa

A
4.2.2.3 Subsidies Mb
Ma
• There are a number of policies used by
governments to promote exports:
Qda Qdb Qdo Qb Qa
o Financial incentives to export producers, Quantity
usually referred to as subsidies, to lower
production costs and in order to shift the domestic supply curve to the right.
o Export credit and guarantees, operation of overseas export promotion
agencies, establishment of Free Trade Zones, Exchange rate manipulation.
4.2.2.4 Voluntary Export Restrictions

• Voluntary export restrictions are imposed by a foreign government on its own
exports and is a way of getting around the WTO rules which forbid tariffs and
quotas
• A very important example is the Japanese car industry which offered to impose
VERs on exports of cars to the US to avoid threatened tariffs. There were several
reasons for this:
o Once tariffs or quotas are in place, it is very difficult to get rid of them or get
them eased as it requires Congressional activity, it is much easier if they are
self-imposed to make changes
o Once VERs are imposed, it is like a quota for a cartel and may allow prices to
be raised to capture monopoly profit
o This is most likely to work if the quota is filled with more expensive cars:
which is exactly what Japanese car makers did.
o With a self imposed quota on the physical volume of cars sold in US markets,
the value of the cars being sold was raised dramatically in order to take
advantage of lower elasticities on that section of the demand curve for cars.
o The result was that fewer but more expensive Japanese cars were sold into
the US and they ended up making even more money than before.
o Assembly of the cheaper cars was done by moving factories to the US where
no tariffs could be imposed and VERs were not needed.
4.2.2.5 Administrative Obstacles

• Non-tariff barriers (NTBs) are erected by government, usually through some
regulation, which impedes the flow of imports into a country without the use of
tariffs or quotas. One of the problems that has arisen from GATT is the set of
rules designed to assist with NTB's.
o What were originally temporary measures often become permanent.
• Exchange controls limit the amount of foreign currency available to exporters.
• Import licensing is a way of rationing imports.

4.2.2.6 Health and Safety Standards
• Health and safety standards may be imposed which make it expensive for an
importer to compete by requiring certain safety or health standards for products.
4.2.2.7 Environmental Standards

• Countries may impose environmental standards on production in order to
preserve natural and environmental resources.
• To prevent TNCs from shifting production to countries with lower environmental
standards, countries may impose tariffs or environmental taxes on incoming
goods to “make the playing field more even”. This is an attempt to stop firms
from exploiting the differences in environmental standards.
4.2.3 Arguments for Protectionism

4.2.3.1 Infant Industry Argument
• If an industry can gain large economies of scale, the domestic government will
protect it until it has reached a large enough size to experience those economies
of scale.
• The country with an industry which is first to reach the lowest LRAC can produce
more cheaply and gain the largest market share, a great advantage.
• Often the protection leads to inefficiency so that when the tariff is removed, the
industry cannot compete.
4.2.3.2 Efforts of a developing country to diversify

• Increased specialization leads to greater dependence which may not be good for
national security reasons
• For national security reasons countries impose tariffs.
• For human development reasons tariffs are imposed to ensure:
o A wider range of occupations to choose from
o Learning by doing
o Greater diversification which leads to less dependence.
• Specialization can be risky: a new technological breakthrough can render the

main production obsolete.
o If a country is specialized in primary goods, market swings in prices and
consumption are more violent than for manufactured goods or services.
o Who chooses which industries are going to be the winners? Governments
have shown they are no good at choosing.
4.2.3.3 Protection of Employment

• The sale of surplus food by the EU on international markets hurts employment in
LDCs.
• Strategic trade policies by large countries can hurt manufacturing employment in
LDCs.
• Groups of countries may alter the terms of trade: for example OPEC which can
hurt employment.
• There is a great deal of pain in the transition from protection to free trade, many
firms go bankrupt and many people lose their jobs.

• Infant industry protection is wrong only if these industries never become efficient
enough to compete. Otherwise it may be the only way to create employment in
industries facing fierce competition from imports.
4.2.3.4 Source of government revenue

• Tariffs have always been a major source of revenue for government, more
popular than income or sales taxes as they were imposed on foreigners. Even
today, many LDCs collect the bulk of government revenue through tariffs.
• For many LDC governments, tariffs are a major source of revenue which are
often imposed not just on importers but also on exporters. It may be hard for
them to collect income taxes, but all imports and exports go through ports which
are easier to control.
4.2.3.5 Strategic Arguments

• Many industries have large
research and development
Net Profit to Firm
STRATEGIC TRADE POLICY

costs, large capital costs,
and often face a steep
learning curve.
•
Stocking Up Period
The product life cycle - Demand: rapidly increasing
-People buy 30 million units/year
indicates that there is a - Supply: no competition
Maintenance or Replacement Period
- Demand: very little growth
window during which a new - People replace 10 million units/year
- Supply: lots of competition
product faces very little
competition and can lead to Window of
substantial profits for a Opportunity
country.
o Protection can increase
Research &
the chances of research Development Period
- Investment costs
and development
Time
leading to a new
product and the
establishment of profitable industry.
o The larger the potential market, the lower the price these firms can set in
order to recover their costs.
o There is a great deal of risk that these products may fail, and with the product
life cycle, the window in time may be fairly narrow before a great deal of
competition enters.
o A few firms, early in the game may make a great deal of profit. Those firms
that are able to establish themselves may be dominant in the future.
• If the government subsidizes the industry, the profits may be so substantial that
they more than repay the costs of the subsidy through increased future tax
revenue.
• Protection through tariffs is another alternative which reduces the need for
subsidies for a government which is short of money.
• The Japanese protect a new industry, restrict the number of companies in the
industry, promote domestic competition to stop inefficiency problems associated
with infant industries, and eventually open the sector up to international
competition. Often the Japanese firms are the strongest in the world.

• Such strategic trade policies require either subsidies or tariff protection during
the product development stage.
o Problems: if all countries tried to pursue these policies, there would be an
enormous waste of money as only a few companies will emerge the winners.
o Governments are notoriously bad at picking winners, and it is not clear that
they would support enough winning industries to compensate for the losing
ones.
• Other countries will retaliate because they will lose key industries and product
manufacturing to countries that have pursued these trade policies. This could
trigger a trade war.
Learning by Doing
• Protection allows workers and managers to learn by producing, a comparative
advantage can be created and the whole LRAC falls.
• It also allows for a rural urban shift to take place in which rural workers move to
the cities and learn new industrial skills.
• Problems with this type of protection:
o Government is usually no good at deciding who the winners will be.
o Protected industries may lose the ability to adapt to competition: they often
grow so weak that they need continued protection in order to survive.
4.2.3.6 Means to overcome a balance of payments disequilibrium

• OPEC has demonstrated that it is possible to intervene in markets and turn the
terms of trade in favour of large suppliers.
• Not only can large suppliers restrict supply, but large purchasers can also group
together to restrict demand to force the terms of trade in their favour.
• Countries will use protectionism to avoid any balance of payments disequilibrium
that may result from such actions.
4.2.3.7 Anti-Dumping
• To prevent foreign industries from gaining an advantage through unfair trade
practices, the WTO permits countries to impose two types of tariffs: anti-dumping
and countervailing duties
• Anti-dumping duties are imposed to prevent foreign firms from selling goods at
prices below production costs for the exporter in the foreign country.
o Dumping occurs when a country wants to get rid of surpluses or as predatory
techniques for destroying the industry in another country.
o The allowance of anti-dumping duties under GATT has helped to redress this
unfair trading practice.
o However, tariffs have often stayed in place permanently:
Producer prices in the domestic market become a minimum price, any
attempt to sell below that price is met with an anti-dumping tariff to raise
it back to the producer price level.
• The use of subsidies in many countries allows exporters to sell into foreign
markets at prices below the costs of production.
o In retaliation, the importing country government is permitted to impose
countervailing duties up to the amount of the subsidy.

4.2.4 Arguments against Protectionism
4.2.4.1 Inefficiency of resource allocation
• “The products of low wage countries will drive out domestic products, and the
domestic high standard of living will be dragged down”. Counter arguments:
o Consumers gain when they buy products cheaply because they are made with
cheap labour.
o Gains from trade depend on comparative not absolute advantage. Imports
must equal exports, we can only import if we have already sold our exports to
some other country.
• “Exports raise national income while imports lower it”. Counter argument:
o If more goods are sent abroad than are received at home, the total goods
available for domestic consumption must fall.
o The gains from trade only come about from the increased consumption of
foreign goods at lower than domestic prices.
4.2.4.2 Costs of long run reliance on protectionist methods

• As long as there is a schedule to remove tariffs, infant industries will learn to
grow up and compete internationally.
• If we continue protection for infant industries, the difference between their costs
and the costs of international competitors will become capitalized into the cost
structure of the companies.
o That is, instead of being cost minimizers, infant industries will simply allow
costs to rise to the import prices plus the tariff. They will never become
economically efficient.
4.2.4.3 Increased prices of goods and services to consumers

• “Trade can never be mutually beneficial, one partner always reaps the gain at the
other's expense”. Counter argument:
o The principle of comparative advantage shows: it is possible for both to gain,
but it is the terms of trade which determine the distribution of these gains.
o Imposing tariffs will raise the price of imports for consumers.
4.2.4.4 The cost effect of protected imports on export competitiveness

• “Don’t buy foreign goods, keep the money at home to provide jobs”. Counter
arguments:
o Foreign countries can only buy exports from your country if your currency can
be purchased internationally to buy your exports. That money can only get
there if you have imported goods and services from other countries.
o It is only because the domestic currency can be used to purchase domestic
goods that foreign countries want it.
o If we continue to protect our import competing industries, we will never
develop the competitive cost structures needed to sell exports. We need
foreign competition to make us more competitive.

4.3 Economic Integration
4.3.1 Globalization
Defining Globalization
• In the industrialized countries (LDC or MDC) there is a fear that the forces of
technological change and geographical shifts in the location of economic activities
are transforming employment prospects in adverse ways, particularly for the less
educated and less skilled.
• The disparity between rich and poor countries widens and environmental
degradation continues.
• A hundred years ago only a few basic goods were involved in international trade.
Goods were generally produced in one country and exported to another.
• Occasionally raw materials were exported from an LDC to an MDC to be
processed and then re-imported as products to the original LDC.
• Today not only are more goods traded, but there is a new global division of
labour. Large scale, assembly line production has shifted to more flexible systems
involving information or knowledge driven processes, including a new global
financial system.
• Some economists believe that nation states no longer matter, consumer tastes
and cultures will be homogenized and serviced with products created by
Transnational corporations (TNCs).
• Others claim the world was much more international 130 years ago, and that the
world has simply returned to an international trading system, not globalization.
• The real situation is in between. Globalization has brought about an extensive
integration of production networks unlike anything before:
o Quantitative: as worldwide demand grows, economic activities take place in
an international context and spread out geographically.
o Qualitative: as supply capability increases, economic activities are dispersed
internationally to take advantage of cost differences amongst countries.
o Regional: there are different degrees of regional integration ranging from the
EU to smaller trading blocks.
Production Networks
• Production chains are linked sequences of functions where each stage adds value
to the process of production. There are four basic elements:
o Inputs of materials and services
o Transformation of inputs into intermediate or final goods and services
o Distribution of goods and services
o Consumption of goods and services
• Technology plays a critical role at each stage, the financial system provides
investment and operating capital, and management is required to coordinate,
regulate and control.
• Services have come to play a critical role because they provide geographical
connections and help to integrate and coordinate all the parts of the global
system.

GLOBALIZATION OF THE WORLD ECONOMY
('If you spend more than 12 minutes a year worrying about the economy, you've wasted
10 minutes.' Peter Lynch)
Market Economy
Government Policy
Corporate Restructuring Restructuring
Productivity Greater reliance on the market :
- Ship to rail to truck to airplane - Dismantle welfare state
- Manual labour to machines - Privatization & deregulation
- Human to machine intelligence Reduce deficits
Re-Engineering - Less spending, more tax revenues
- Hierarchy to networking Education
- Consumer pull processing - Reduction in unskilled jobs
Downsizing - Great need for knowledge workers
- Outsourcing & resequencing - University- corporate partnerships
- Capital surplus, talent shortage - Vast Internet connection
- Parents will demand voucher system
Free Trade Openness

- MNCs have 50 of top 100 world GNPs Trade Agreements
- Integrate communist economies - Asia: ASEAN plus ex-communist
- Services growing faster than goods - North America & Latin America
- WTO meaningless: - European Union & Eastern Europe
- Goods & services only $5 trillion Other Agreements
- Investment $100 trillion - Information Technology Agreement
- Global Telecom Accord
- Intellectual property
Potential Gains & Losses - Financial markets
Growth
- Productivity Gains Potentially Large
- No Inflation - Growth accelerates by combining:
- Integrated markets - The market economy & new technology Environment
- Integration of working women - Government policy & development - No shortage of resources
- Baby Boomers - Large numbers of people join the system - Shortage of waste processing capacity
- Higher income - Gains from trade - Biotech: less pollution
- Save more - Opportunities for entrepreneurship - Infotech: paperless & wireless
- Pay more taxes - Micro credit distribute gains to the poor - Microtech: high rates of efficiency
- Could reach large numbers of families - Hydrogen fuel: cars with no exhaust
- Self help reduces dependence
Losses Potentially Large

- If restructuring is hampered
Technology - If openness is restricted Development
- If the environment is destroyed
Computers - If Africa & Middle East are not integrated Standard of Living
- Integrated into home and work - If financial markets become unstable - Rapid growth in GDP
- Imbedded in tools and products
- Amazing drop in population growth
- Increasing productivity dramatically - More equal distribution of income
- Role of savings, education,
technology
Telecommunications
- Seamless connection
- Fibre-optics
- Satellite systems Policies to Stimulate Growth
- New Internet media - Good banking system
- Electronic cash - Small scale entrepreneurship
- Backward and forward links
Foreign Intervention
Biotechnology - Trade & the primary goods trap
- Health - Foreign direct investment & MNC
- Agriculture - Learning by doing
- DNA computer - Technology transfer
- Managerial training
Nanotechnology
- Micromachines Reducing Poverty
- Miniature sensors - Rural & urban development
- Miniature repairs - From foreign aid to micro-credit:
- Quantum computers - Micro enterprise training
- Desktop production - Peer group lending

• It is the TNCs that play the key role of coordinating production networks which
include:
o Activities external to the corporation which are coordinated through market
systems, typically called out-sourcing
o Internal activities which occur in a vertically integrated system, typically called
in-house.
• Production networks are dominated either by producers or consumers:

o Producer driven production networks are dominated by TNCs in capital and
technology intense industries like cars.
o Buyer driven production networks occur where there are large retailers or
brand name producers such as in clothing.
• Global production networks are not arrayed in a hierarchical fashion:

o Each has a physical location in which they have invested in both capital as
well as social relationships and cultural practices.
• All elements are regulated within some political structure whose basic unit is the
nation state but which includes international agencies such as the WTO
• TNCs attempt to take advantage of national differences in regulatory regimes,
whereas states attempt to minimize regulatory differences:
o This can lead to conflict whether private enterprise, government, a local
community or individual, and these conflicts have to be resolved.
o There are forces for both concentration and dispersal, but with a strong
tendency toward agglomeration into larger centres.
Historical patterns of production clusters

• There may be positive spillover effects:
o These structures may lead to urbanization where activities agglomerate in
cities.
o Structures may also form due to specialization or local economies such as a
shared pool of trained labour, particular kinds of institutions such as
universities and government institutions.
• Typically these centres originated by historical accident, but once established,

they:
o Attract and stimulate entrepreneurship and innovation
o Develop a well educated labour pool
o Foster local institutions
o Lead to enhancement of physical infrastructure (external economies of scale).
• The economy can get locked into a pattern because of historical precedent.
• Globalization therefore links together the activities and functions in a production
network which is based on geographic or local centres of economic activity.
Negative Externalities or Spillovers

• Negative externalities or spillovers typically involve:
o Over-exploitation of both renewable and non-renewable resources: over-
fishing and the rapid running down of world oil reserves.
o Over-exploitation of environmental waste processing capacity typically seen in
the greenhouse gasses and the landfill problems
o Destruction of ecosystems to create space for urban and industrial
development.
• Even with renewable resources such as fisheries, they will become exhausted
unless managed in a sustainable manner
• With non-renewable resources, the more we use today, the less will be available
tomorrow unless there is a massive technological breakthrough.
• Global warming is certainly the most serious of the environmental externalities
which may have very serious consequences for future generations, not the least
because it may be irreversible.
• The environmental problems inherent in globalized production systems raise
serious questions about the sustainability of economy and society.
4.3.2 Trading Blocs

4.3.2.1 Free Trade Areas
Trade Agreement Table
Common
Free Trade Customs Market or
Economic Union
Agreement Union Economic
Community
No tariffs quotas or export subsidies amongst

members: free movement of goods and services √
amongst members
Value Added agreement: goods can only be re-
exported to a member country if a certain
specified amount of value has been added to the √
product after it was imported from a non-member
country.
No internal barriers and a common external tariff:

free movement of goods and services √ √ √
(harmonized trade policy)
Free movement of capital and labour √ √

A common currency and free movement of
investment capital (harmonized fiscal & monetary √
policy)
• Trade restrictions between member states are removed but each state retains
the right to use trade policy against non-member states.
• The world has evolved into three major trading blocks: the EU, NAFTA and the
Japanese dominated investment/subcontracting trading area in the Asia Pacific.
• In 1989 the US and Canada signed a free trade agreement. In 1994 this was
expanded to include Mexico. In 2001 agreement was concluded amongst 34
countries in the Americas to establish a free trade area of the Americas.
• There are a number of smaller trading blocks including:
o ASEAN: the association of South East Asian Nations, currently the group is
considering a free trade area with China, South Korea and Taiwan.
o LAFTA: the Latin American free trade agreement
o CAFTA: Central American free trade agreement
o CARICOM: the Caribbean community
o Mercosur: involving Argentina, Brazil, Bolivia, Chile, Paraguay and Uruguay.

• A free trade agreement requires a value added agreement, otherwise a member
of the group could lower external tariffs and ship goods through without tariffs
from a country which would normally face high tariffs in the importing country.
• Levels of protection and integration between economies in trade groups or
blocks:
4.3.2.2 Customs Unions

• A customs union is a group of countries who agree to free trade amongst
themselves and a common set of barriers against imports from the rest of the
world.
4.3.2.2 Common Markets

• A common market includes free trade amongst member states and a common
tariff for non-member imports. There is also complete mobility of factors
amongst member states.
• An economic union includes a common market plus the eventual harmonization
of monetary and fiscal policies. The best example is the European Union (EU)
which recently signed an agreement with European Free Trade Association
(EFTA) making the combined group the largest free market in the world.
o Norway did not join although it has special trading arrangements with the EU.
• In 1999 European Monetary Union was established among 15 member states.
The UK did not join for fear of losing economic sovereignty.

4.3.H.1 Trade Creation & Trade Diversion
• Trade creation causes total economic welfare to increase as a result of the new
trade grouping.
• Trade diversion occurs as follows:

o A country joining a trading block may have already been benefitting from low
cost goods on the world market before joining the group.
o As members of a trading group, consumers can now buy the product from
another member cheaper than from a country outside the group which may
be lower cost but has to pay an import tariff to sell into the group.
o Consumers are switching to a higher cost, comparative disadvantage producer
inside the group due to the distorting effect of the relative tariffs.
o Trade has been diverted from the external comparative advantage producer
outside the group, and there is a loss of economic welfare.
4.3.H.2 Obstacles to Achieving Integration
Reluctance to surrender political sovereignty

• There is often reluctance to surrender political sovereignty in the various trading
agreements.
Reluctance to surrender economic sovereignty

• There is also reluctance to surrender economic sovereignty:

o The least constricting is the FTA where each state has the power to use trade
policy against non-members.
o The most constricting is the economic union which moves the nations towards
almost complete economic integration. For the EMU nations, they have given
up sovereignty over trade, monetary and most of fiscal policy.
4.4 WORLD TRADE ORGANIZATION

4.4.1 Aims
• Since 1945 trade policy has tended to be set within an international institutional
framework. Until 1995 this was the General Agreement on Tariffs and Trade
(GATT) and since then it has been the WTO.
• The WTO depends on a rule based multilateral trade cooperation which does not
focus on outcomes such as market share or growth, but simply attempts to
establish the general conditions for competition facing exporters.
• There is a general tendency for larger countries to experience greater inter-
regional trade than international trade and for smaller countries to experience
greater international trade than inter-regional trade.
o There are, of course, many smaller countries that are not well integrated into
the international trading system.
o Nevertheless, international trade tends to be a larger proportion of GDP for
smaller countries than for larger countries.
Two outstanding examples are Canada and the Netherlands where
international trade represents a very significant proportion of total GDP.
o In a sense the trade between the various countries inside the EU is matched
by the trade between the various states in the USA.
For the US, inter-regional trade is much larger than international trade.
For the EU, “inter-regional” trade (amongst members) is already much
larger than international trade between EU countries and the rest of the
world.
• For LDCs economic development often involves the production and export of
basic commodity items usually involving natural resources in a sequence
beginning with the ones with the greatest comparative advantage.
o LDCs put tariffs on imports to encourage the creation of a manufacturing
sector.
o As they become more integrated into world trading systems, growth increases
and employment opportunities increase because of the gains from trade.
• Both industrialized countries and NIEs have done well out of GATT regulated
trade. This has not been the case for LDCs which are very poor or for those
which have specialized in primary products.
• The WTO predicts that by 2005 there may be as many as 250 regional trading
agreements covering more than 50% of trade. Such regional arrangements could
damage the rules based multi-lateral trading arrangement fostered by WTO.
Trade in Services
• Future growth in trade will be dominated by services.
o At most, trade in goods will double over the next century.
o Trade in services is larger than trade in goods, and growth will be much
faster.
o In order for there to be free trade in services, each country must extend the
principle of right of establishment and national treatment to the other
country's firms that sell services.
• Firms selling services in one country have the right to establish in the other
country and be treated the same as local service firms.
• Negotiations continue in WTO to complete an international agreement on
financial services which would move it to a rules based multi-lateral system as for
trade in goods. An interim arrangements was reached in 1995 which covered
banking securities and insurance.
Multilateral Trade vs. Free Trade Agreements

• Under WTO (GATT), multilateral trade has increased enormously, but free trade
agreements have reduced the impact of multilateral trade.
o Free trade agreements remove the tariffs between states but leave in place
each nation’s tariffs against foreign countries.
o FTAs can lead to trade diversion where goods are exchanged on the basis of
the lower tariff rather than on the basis of the lowest opportunity cost.
o To prevent trans-shipping of imports through countries with low tariffs, there
is usually a value added agreement in place.
For example, NAFTA does not permit any good to be imported from
outside the group and re-exported to a member of the group unless 35%
of the value has been added by the original importing country.
• Under WTO average tariffs amongst member countries are less than 4%. Thus
free trade agreements do very little to remove tariff barriers. Instead what they
do is allow countries to specialize in producing those products where they can
achieve minimum efficient scale (where full economies of scale are realized).
• Most states in the agreement continue to produce most products, but there are
fewer product lines.
o Exports increase in certain product lines and imports increase in others.
• There is an increase in intra-industry trade through this type of rationalization.

• Competition from Japan and Europe has convinced the US of the need to protect
against loss of competitiveness, hence their desire to form NAFTA.
• Under multilateral trade there is no need for trade to be reciprocal, it does not
matter who you export to or import from. But with free trade agreements, the
scope for trade is narrowed considerably.
4.4.2 Successes and Failures

• More than 140 countries are members and have agreed to several rounds of tariff
cuts. It also has developed a code of conduct relating to unfair trade practices.
• The Kennedy Round was completed in 1967, the Tokyo round in 1986, and the
Uruguay round in 1995.
• The Uruguay round: negotiations began in 1986, agreement was reached in
1996:
o The agreement reduced non-tariff barriers, liberalized trade in services,
reduced domestic subsidies to agriculture, created better dispute settlement
mechanisms, and better copyright protection for intellectual property.

o A current controversy surrounds the proposed Multilateral Agreement on
Investment (MAI) which would take a great deal of power away from
governments and give it to companies investing in a country.
• International protest groups oppose the WTO, the World Bank and the IMF as
they feel they are dominated by leading industrialized countries, particularly the
US.
• The most difficult areas facing the WTO in the future will be:
o The reduction of agricultural subsidies in all industrialized countries which
should open these markets to LDCs
o The establishment of a trade in services agreement
o The integration of China which will strain trading systems as well as impose
new obligations on China to conform to WTO rules.
o The development of a more equitable world trading system where the power
of developed countries is not imposed on LDCs through various kinds of
conditionality and trade-opening requirements.
Developed countries must operate a fairer system of access to their own
markets for poorer countries.
4.5 Balance Of Payments

The balance of payments as recorded in North America consists of three sets of
accounts which include several sub-accounts:
• Current account:
o Exports
Merchandise (goods)
Traded Services (invisible trade: insurance, legal, consulting services,
royalties, patent fees)
Investment income received(interest, dividend or any other foreign
investment income)
o Imports
Merchandise
Traded Services
Investment income paid
For developing countries, this section is usually negative: more is paid
out to foreign investors than is received as interest and dividends
For industrialized countries like the US and Japan, this account is
typically positive because of the large amount earned on foreign
investments.
o Unilateral Transfers:
One way payments or receipts of money for nothing in return such as:
remittances or gifts, foreign aid and grants.
• Capital Account
o Foreign Direct Investment (FDI)
o Portfolio Investment
Equity Securities
Debt Securities: both short term (money market) and long term bonds
o Other Investment transactions (currency, bank deposits, trade credits)
o Statistical discrepancies

• Foreign Reserves
o Official Reserve account (includes gold, foreign currencies, SDRs, IMF
reserves)
4.5.1 Current Account

• The current account includes the trade account which records the goods and
services imported and exported from the home country.
o A deficit on the trade account means that imports are larger than exports.
• Those items which lead to Europeans receiving money from abroad are counted
as positive items in the current account:
o A more technical definition: those items which lead to more Euros being
purchased are counted as a positive item.
4.5.1.1 The Balance of Trade

• Merchandise account: also called the visible account in Britain, which records all
transactions involving goods.
• The Traded Service account which records all transactions involving services.
4.5.1.2 Invisible Balance

• Consists of Traded Services and Investment Income accounts.
4.5.2 Capital Account

• The capital account records financial transactions involving short term and long
term capital movements into and out of the country.
• The Capital account is divided by:
o Direct investments: which includes direct investment in a branch plant or a
subsidiary for a large multinational company or a joint venture agreement
o Portfolio investments: which includes transactions involving securities such as
money market instruments or stocks and bonds.
• When financial capital flows into a country, that country is exporting a security to
the foreigner.
o The security can consist of a money market instrument, a bond, a stock or a
joint venture agreement or some kind of contractual arrangement.
o When those securities are exported, financial capital flows into the domestic
economy and counts as a plus in the Balance of payments.
• If the Japanese invest in US treasury bills, it is the US that gets the money, and
the Japanese that get the TB's:
o It counts as negative on the Japanese balance of payments (and their GDP).
o This is how the balance of payments is always balanced:
If there are negatives on the current account, they must be balanced by a
plus on the capital account.
• As an alternative to direct and portfolio investments, the capital account can be

divided into:

o Short term capital which is held mainly in money market instruments such as
treasury bills or bank accounts (portfolio as opposed to direct investment).
o Long term capital movements which are then divided into:
Portfolio: generally involve the purchase of stocks or bonds.
Direct: investments in capital in the country or joint venture agreements.
Official Reserves
• If we include official reserves, the balance of payments is always in balance.
• One of the easiest ways to think about it is to ask who gets the money.
o Current account: if Japan imports apples from China, the Chinese get the
money, the Japanese get the apples. It counts as a minus in the Japanese
balance of payments (and for the GDP).
o If the Chinese buy cars from Japan, the Chinese get the cars and the
Japanese get the money: a plus on Japan’s balance of payments.
o For services: if the Japanese go skiing in Switzerland, the Swiss get the
money, and the Japanese get the tourism experience. It enters as a negative
on the Japanese balance of payments.
• Factors influencing the balance of payments include:

o Income: as national income rises the demand for imports rise shifting the
current account toward a deficit: M = f(Ydomestic, Pdom/Pfor) and X = f(Yforeign,
Pdom/Pfor).
o Changes in relative prices: as domestic prices rise relative to foreign prices,
imports appear cheaper and exports more expensive and the current account
will move toward a deficit.
o Changes in relative investment prospects: as return on investment rises,
foreign capital will be attracted into the country and the capital account will
move toward a surplus.
o Changes in relative interest rates: as domestic interest rates rise, short term
capital is attracted moving the capital account toward a surplus.
• If the foreign exchange rate is rising (domestic currency appreciating), the

central bank may intervene by selling more domestic currency.
• If the foreign exchange rate is falling (domestic currency is depreciating), the
central bank may intervene by buying domestic currency with the reserve of
foreign currency.
4.6 Exchange Rates

History of Exchange Rate Systems
• For several centuries the developed world operated under a fixed exchange rate
system based on the gold standard. The system worked well until WW1 and the
rapid changes occurring due to industrialization.
• After the depression in the 1930s many systems were tried, but the developed
world chose to switch back to a fixed exchange rate system after W.W.II.
• This was called the Bretton Woods system and included the creation of the IMF
(International Monetary Fund).
• This system was finally terminated in 1973 but the IMF survived. What followed
was a system called the adjustable peg which lasted from 1944 to 1972. This was
followed by a short period during which rates were floating under a flexible
exchange rate system.
• This has been followed in more recent times by a “managed” float system:
o Generally “hard currency” regions such as the US dollar and the Euro tend to
float reasonably freely with some adjustment via interest rates from time to
time
o Smaller currencies such as the Canadian dollar tend to be loosely tied to a
major currency such as the US dollar
If the CAD$ tends to float too high compared to the US$, the Canadian
government will lower interest rates and money will flow out of Canada
reducing the value of the CAD$.
Modern Exchange Rate systems

• The Euro exchange rate is the value of the Euro in terms of another currency.
• The exchange rate is the amount of foreign currency paid to obtain a unit of the
home currency (this is the definition used by the IB)
• If the exchange rate rises, the home currency appreciates, more of the foreign
currency is needed in order to purchase the home currency.
• If the exchange rate falls, the home currency depreciates, less of the foreign
currency is needed to purchase the home currency.
• Except for the US$, the Euro € and the Japanese ¥, most currencies are only
acceptable within the borders of the home country.
o Thus exporters must eventually receive payment for the goods that they
export in terms of the currency of their own country.
• A trade weighted exchange rate index measures the value of the Euro in terms of
a basket of currencies which are weighted by the proportion of trade between
those countries and Europe.
• The effective exchange rate examines how much trade Europe has with the other
country and the extent to which Europe competes with these other countries in
terms of trade.
• The real exchange rate takes into account the effects of inflation. If the Euro
falls by 5% against the Yen but there is 5% inflation in Europe, the real
exchange rate is assumed to be unchanged.
• If Europeans sell software and the Japanese sell cars:
o Europeans who want to import Japanese cars will need Japanese ¥, and they
provide the demand for Japanese ¥ and the supply of Euros.
o Japanese who want to buy European software need Euros and they provide
the demand for Euros and the supply of Japanese ¥.
4.6.1 Fixed Exchange Rates

• Under the fixed exchange rate system rates are fixed at some value and the
central bank intervenes to ensure it stays at that agreed upon rate:
o For centuries the standard was gold
o Some countries fixed their exchange rates to a currency like the British pound
which was convertible into gold.
• From 1944 to 1972, most countries pegged or fixed their currencies to the US
dollar.
o In the face of short term fluctuations, the central banks of each country would
intervene in the market and buy and sell US$.

o As long as the central bank worked around equilibrium, then on average it
would buy about as much as it sold and the policy did not lead to changes in
foreign currency reserves.
o More recently governments of smaller countries have fixed their currency to a
‘key’ currency such as the dollar or Euro with periodic adjustments.
• Given a fixed or adjustable peg system and
Dollars/UK pound
Adjustable Peg Exchange Rate
greater inflation outside Britain, the demand S1
for British pounds shifts out (from Do to D1)
because greater foreign inflation has led to an B
S2
increase in the demand for (lower priced)

exports from Britain: A
C
o There will be pressure on the domestic
currency to appreciate (exchange rate X
rises from A to B).
• If there is a permanent switch away from the D1 D2
agreed on rate, the Bank of England will be UK pounds
faced with constantly selling British pounds to

maintain the old exchange rate:
o This causes the supply of British pounds to shift out to the right and the
exchange rate falls from B to C.
• If there is more inflation in Britain, the demand curve for British exports will shift
in from D1 to Do.
o There will be downward pressure on the exchange rate and the British pound
will depreciate.
With flexible exchange rates, the domestic currency would do exactly that
o However with a fixed exchange rate, the Bank of England would intervene
and start buying British pounds shifting the demand curve from Do to D1 and
raising the exchange rate back to the fixed level at point C.
o There is a limit to the amount of gold, SDRs or foreign exchange a country
can use from its own reserves to purchase its own currency before it is forced
to borrow internationally.
Current Account Adjustments

• Given a fixed exchange rate and an increase in demand for foreign goods:
o The supply of British pounds will shift out from So to S1
o There will be downward pressure on the currency
o The government could impose tariffs or quotas on imports and S1 would shift
back to So
o Or it could subsidize exports in which case demand will shift out from Do to
D1 and the pressure to depreciate would disappear.
o The problem with these solutions is that they may lead to retaliation from
other countries.
Capital Account Adjustments

• Many countries today maintain a type of fixed exchange rate or a flexible one
which is limited to a certain range.
• As the exchange rises and approaches the upward bound, the Central Bank will
decrease interest rates
o This leads to an outflow of short term capital: the supply curve for British
pounds shifts out and the currency will depreciate
o Domestic citizens will be attracted by foreign money market securities and the
supply of British pounds will shift out which leads to even further downward
pressure on the currency
o Lower interest rates lead to macro effects: an increase in aggregate demand
domestically and that may not be the correct policy especially if the economy
is already in a boom
• If the exchange rate is falling and approaches the lower bound, the Central Bank
will increase interest rates
o This leads to an inflow of short term capital: the demand curve for British
pounds shifts out and the currency will appreciate.
o Domestic citizens stop buying foreign money market instruments, and the
supply curve for British pounds will shift in which reinforces the upward
pressure on the exchange rate
o Higher interest rates have macro effects: a decrease in aggregate demand
which may not be appropriate if the economy is trying to recover from a
recession.
Foreign Exchange Reserves

• Foreign reserves are often held in the form of US$ or EU € with only small
amounts held in ¥
• Each member country of the IMF is assigned a quota of Special Drawing Rights
(SDRs), rather like a bank account or a type of currency issued by the IMF
(International Monetary Fund). .
o SDRs can only be used to cope with balance of payments problems.
o Central banks are reluctant to see the system expand because most
Governments have shown irresponsibility when it comes to controlling the
money supply.
o Private acceptance of SDRs has been almost non-existent indicating the
tremendous influence of the US$.
• Effectively the central bank in the US, called the Federal Reserve Board, is the
central bank for the world.
o There have been calls for a return to the gold standard, but there is a
shortage of gold which would lead to further crises.
• Given a fixed exchange rate system, if there is downward pressure on the

exchange rate
o The government can tell the central bank to buy domestic currency:
o The demand for British pounds will shift out to the right from Do to D1
• If these policies do not work, the government will tell the Central Bank to devalue
the currency which may lead to competitive devaluations by other countries.
4.6.2 Floating Exchange Rates

• Under the flexible exchange rate system, rates are allowed to float.
o The purchasing power parity theory assumes floating exchange rates adjust
until a unit of currency can buy the same basket of goods and services as a
unit of another currency.
o Currencies are allowed to float and government intervenes periodically to
influence the price but does not set the price. The currencies are often kept
within some limits or bounds.
Equilibrium: Movements along the curves
• The exchange rate is denoted as the number of Yen required to purchase a Euro.
• Assume equilibrium is at point A with Sa
Price of Currency
and Da and an exchange rate of Pa. Adjustable Peg System
Sa
(Yen/Euro)
• If the exchange rate falls below Pa, there
will be excess demand for European Euros
Sb
o Exports of software start to rise as it
becomes relatively less expensive X
o Imports of Japanese cars will fall as Pa
A
C
they become relatively more expensive
Db
o Traders who need Euros will start B
bidding up the price:
o As the supply curve is upward sloping, Da
the quantity supplied of Euros will rise.
The extent of the increase will depend
on the elasticity of supply.
o As the demand curve is downward Quantity of Euros
sloping, the quantity demanded of Euros will fall. The extent of the fall will
depend on the elasticity of demand.
• If the exchange rate is above equilibrium:

o There will be an excess supply of Euros
o Japanese cars look relatively cheaper so Europeans start offering more Euros
for Yen and the price of Euros will start to depreciate in value.
o As the supply curve is positively sloped, fewer Euros are offered as the value
of the Euro depreciates.
The more elastic the supply, the greater the impact on quantity supplied.
o As the demand curve is negatively sloped, the lower value of the Euro starts
to make European software look cheaper and more will be demanded.
The more elastic demand, the greater the impact on quantity demanded.
• The two effects will finally lead to supply equal to demand in equilibrium.
Shifts in Demand & Supply

• Europeans demand Yen to buy goods and services from Japan, and to invest if
the return on investment is greater in Japan.
• If Europeans want more Japanese goods and services or if they want to invest
more in Japan, the supply of Euros will shift to the right from Sa to Sb and there
will be downward pressure on the Euro.
• If Japanese want more European software or if they want to invest in European
securities, the demand for Euros shifts to the right from Da to Db and the
exchange rate will appreciate.
Income effect (one sided):

• Remember XEU = f(YJapan), therefore if YJapan↑ ⇒ D€↑ ⇒ €↑
• If the income in Japan rises, the demand for Euros will shift out, more Yen will be
offered for Euros, and the Euro will increase in value
• Note this only impacts on the demand and not the supply, a “one sided” effect.
4.6.3 Managed Exchange Rates
• The managed float is basically a flexible exchange rate system in which rates are
permitted to float, but the central bank intervenes on a regular basis to keep the
rate within some agreed upon limits or bounds.
• Government can influence exchange rates, usually through the Central Bank by:
o Buying and selling both domestic and foreign currency
o Altering interest rates in order to influence short term capital flows
o Altering return on investment through tax policies in order to influence long
term capital flows.
• Rather than managing a single currency, for several years the EU has attempted
fixed exchange rates amongst its member countries but a managed external float
as a block against the US$ and the Yen.
o This broke down in the fall of 1992 and was replaced in 1999 by the
European Monetary Union which consists of 11 member countries.
• If interest rates rise in Canada, investors from Britain will buy Can$ money
market instruments until the appreciation in the value of the Can$ which results
is just equal to the differential in the interest rates.
• The expected future depreciation of the Can$ is just enough to bring Canadian
interest rates back down to the international equivalent.
o If interest rates are 5% higher in Canada, investors will keep on investing
until the exchange rate has fallen by 5% (Can$ has appreciated by 5%).
o The extra 5% interest earned is enough to offset the 5% future depreciation
of the Can$.
o The appreciation puts export and import competing industries at a competitive
disadvantage.
4.6.4 Distinction between

4.6.4.1 Depreciation and devaluation
• Under a floating exchange rate system, the exchange rate:
o Depreciates whenever it falls in value against other currencies:
Less foreign currency is needed to purchase a unit of domestic currency
• Under a fixed or adjustable peg system, rates are set every day by the central
bank but are periodically adjusted:
o If the Central Bank devalues the currency it is equivalent to a depreciation in
the currency or an decrease in the exchange rate:
It costs more domestic currency to buy foreign currency.
4.6.4.2 Appreciation and revaluation

• Under a floating exchange rate system, the exchange rate:
o Appreciates whenever if rises in value against other currencies:
More foreign currency is required to purchase a unit of domestic currency.
• Under a fixed or adjustable peg system:
o If the Central Bank revalues the currency it is the equivalent of an
appreciation of the currency or a fall in the exchange rate:
It costs less domestic currency to buy foreign currency.

4.6.5 Effects on Exchange Rates
4.6.5.1 Trade Flows
Appreciation of the Euro: Software Market

• In the figure, Deur and Seur
represent the domestic supply and Appreciation of the Euro
demand for software. The no
D
D
trade point of equilibrium is O with
eu
eu
ur
r+
r+
D
no exports. Se
Ja
eu
Ja
pa
pb
r
• Deur +Japa represents the domestic
European demand plus the A
Price of Software
Pa
Japanese demand for European
Pb B
software. Total European
O
production is Qa of which Qda is
consumed in Europe and Xa is
exported to Japan.
• If the Euro appreciates, the
Xb
foreign price of European software
Xa
will rise:
o Japanese demand will fall to
Japb Qda Qdb Qb Qa
o Exports will fall to Xb Software
o Price will fall from Pa to Pb.
o Domestic consumption rises from Qda to Qdb.
o Exports decrease to Xb.
Appreciation of the Euro: Car Market

represent the domestic supply and
Appreciation of the Euro
demand for cars. The no trade
point of equilibrium is O with no
imports. ur
De
u Se
r
• Seur +Japa represents the domestic
a
European supply of cars plus the J ap
Japanese supply. Total European O u r+
Se pb
consumption is Qa of which Qda is Ja
Price of Cars
+
produced in Europe and Ma is A ur
Pa Se
imported from Japan. B
Pb
• If the Euro appreciates, less Euros
must be paid to obtain the
required amount of Japanese ¥.
Ma
The European price of Japanese
cars will fall: Mb
o The supply curve shifts out
from Seur +Japa to Seur +Jap b. Qdb Qda Qa Qb
o Domestic production of cars Cars
falls from Qda to Qdb.
o Imports of Japanese cars rise to Mb.

Depreciation of the Euro: Software Market
represent the domestic supply Depreciation of the Euro
and demand for software. The
no trade point of equilibrium is O
D
D
eu
eu
ur
r
with no exports.
r+
De
+J
Se
Ja
•
ap
ur
Deur +Japa represents the domestic
pa
b
European demand plus the
Japanese demand for European B
Price of Software
Pb
software. Total European A
Pa
production is Qa of which Qda is O
consumed in Europe and Xa is
exported to Japan.
• If the Euro depreciates, the
foreign price of European Xa
software will fall: Xb
o Japanese demand will rise to
Japb
o Exports will rise to Xb Qdb Qda Qa Qb
o Price will rise from Pa to Pb. Software
o Domestic consumption falls from Qda to Qdb.
o Exports increase to Xb.
Depreciation of the Euro: Car Market

• In the figure, Deur and Seur represent
Depreciation of the Euro
the domestic supply and demand for
cars. The no trade point of
equilibrium is O with no imports. ur
De
ur Se
• Seur +Japa represents the domestic
European supply of cars plus the pb
Ja
Japanese supply. Total European O u r+
Se a
consumption is Qa of which Qda is ap
Price of Cars
J
B u r+
produced in Europe and Ma is Pb Se
imported from Japan. A
Pa
• If the Euro depreciates, more Euros
must be paid to obtain the required
amount of Japanese ¥. The
Mb
European price of Japanese cars will
rise: Ma
o The supply curve shifts in from
Seur +Japa to Seur +Jap b. Qda Qdb Qb Qa
o Domestic production of cars Cars
rises from Qda to Qdb.
o Imports of Japanese cars fall to Mb.
4.6.5.2 Capital Flows & Interest Rate Changes

• In addition to software, the Japanese may be interested in investing in Europe.
o If they buy securities they offer Japanese ¥ to buy Euros to pay for them, an
outward shift of the demand curve.
o This leads to capital inflows into Europe and an appreciation of the Euro.

• If Europeans decide they want to buy more Japanese stocks, they will offer Euros
(equivalent to an outward shift in the supply curve for Euros).
o This leads to capital outflows from Europe and a depreciation of the Euro.
Interest rate effect (two sided):

• A major reason for short term capital movements is differences in interest rates.
• If interest rates are higher in Japan, Europeans with short term funds will buy
short term money market instruments in Japan. .
• For example, if iJapan > iEU ⇒ S€ shifts out, D€ shifts in, €↓
• If return on investment or the interest rate increases in Japan, or if currency
speculators believe the value of the Yen will rise in the future:
o The supply of Euros will shift to the right. More Euros will be offered for sale.
o The Japanese will be less interested in investing in Europe. Fewer Euros will
be demanded.
o The outward shift in supply and inward shift in demand leads to a
depreciation of the Euro.
o To stop the depreciation of the Euros the Central Bank may decide to increase
interest rates.
Return on Investment (ROI) effect (two sided):

• Long term capital movements are more related to expectations about profit
opportunities than to future movements in exchange rates.
• For example, if ROIJapan > ROIEU ⇒ S€ shifts out, D€ shifts in, €↓
• If return on investment is higher in Europe, then money will flow out of Japan
into Europe.
• If rates of return are consistently lower in Europe compared to Japan because
productivity rises more slowly for a number of reasons, then there will be a slow
but steady erosion in the value of the Euro.
• If return on investment is the same in both countries but investors expect the
Euro to appreciate in the future, this may lead to greater long term investment.
o This case is much less likely as it is very difficult to predict exchange rate
movements over the long term.
o Investors are much more sensitive to differences in ROI.
o If the exchange rate is expected to fluctuate greatly in the future, investors
are much less likely to invest for fear of potential loss.
4.6.5.3 Inflation
• If there is inflation in Europe but not in Japan, Japanese cars will appear to be
relatively cheaper, and more cars will be sold in Europe, more Euros will be
offered for sale for Yen.
• For example if If %∆PEU > %∆PJapan ⇒ Px/Pm↑ ⇒ XEU↓ and MEU↑ ⇒ S€ shifts out,
D€ shifts in, €↓
• If inflation is greater in Europe than in Japan, Japanese cars will appear to be
relatively cheaper, and more cars will be sold in Europe, more Euros will be
offered for sale for Yen.
o The supply of Euros will shift out, and the Euro will depreciate in value.
• At the same time, European software will be relatively more expensive in Japan,
o The demand for Euros will shift in to the left, and the Euro will depreciate.
• If both countries have the same amount of inflation, the two sets of shifts offset
each other.
• The country experiencing a more rapid rate of inflation will experience a steady
depreciation of its currency.
Growth or productivity effect (two sided):

• If %∆Q/LEU↑ < %∆Q/LJapan↑ ⇒ Px/Pm↑ ⇒ XEU↓ and MEU↑ ⇒ S€ shifts out, D€ falls,
€↑
• Now it is costs which are falling in the country with the higher growth rate: more
rapid increase in productivity.
• If costs are falling faster in Japan than in Europe, this is equivalent to the
previous case where inflation is faster in Europe than in Japan.
• If productivity rises more slowly in Europe than in Japan, Japanese costs will be
lower and Japanese cars will appear to be relatively cheaper:
o More cars will be sold in Europe, more Euros will be offered for sale for Yen.
o The supply of Euros will shift out, and the Euro will depreciate in value.
• At the same time, European software will be relatively more expensive in Japan,
so the demand for Euros will shift in to the left.
• The outward shift in supply and the inward shift in demand leads to a
depreciation in the exchange rate.
4.6.5.4 Speculation
• Speculation about exchange rates can also lead to short term capital movements:
o If the Euro is expected to appreciate, Japanese investors will buy European
money market instruments in anticipation.
o The increase in the supply of Japanese ¥, equivalent to an increase in the
demand for Euros will force the exchange rate up and lead to an appreciation
of the Euro.
This is an example of self realizing expectations.
4.6.5.5 Use of foreign currency reserves

• The international exchange rate system is highly variable amongst countries but
a rough generalization can be made:
o Large trading areas such as the US and EU tend to have floating exchange
rates
o Smaller trading areas tend to fix the value of their currencies to one of the
larger ones
A good example is Canada which tends to keep the value of the CAD$
within certain bounds compared to the US$ which makes sense as 85% of
Canada’s exports are to the US.
In Europe Croatia which is not yet a member of the EU tends to tie the
value of the Kuna to the Euro very closely because so much trade in both
goods and tourism is with EU members.
• Most of the adjustment is done through interest rates:

o As exchange rates appreciate above the bound, interest rates are lowered and
short term capital flows out of the country
o As exchange rates depreciate below the bound, interest rates are raised and
short term capital flows into the country.

• For those countries which are so small or so risky that no meaningful money
market exists, it may be necessary to adjust through purchases and sales of
foreign currency:
o With downward pressure on the currency, the government will use foreign
exchange reserves to purchase the domestic currency to raise its value
o With upward pressure on the currency, the government will sell domestic
currency and start accumulating foreign exchange.
Recent examples are Taiwan and China which have both offset the upward
pressure on domestic currencies by accumulating US$ which allows them
to remain competitive in international markets.

4.6.H.1 Relative advantages/disadvantages of fixed/floating exchange rates
Fixed exchange rate advantages

• Of particular importance is the uncertainty of production costs in different
locations for TNCs:
o Most have adopted a system of flexible production allocation between plants.
o This is complicated by the volatility of exchange rates between different
countries.
o What appears to be a least cost country location for production may turn out
to be the most expensive if there are major changes in currency values.
• Fixed exchange rates can create much greater stability. Indeed, whenever we
enter a period of floating exchange rates with much volatility, global dispersion of
production and trade tends to fall.
• Most smaller countries have adopted a system of pegging their exchange rates
close to major ones such as the dollar, Euro or Yen. This reduces uncertainty for
TNCs and fosters FDI.
• Fiscal policy tends to be stronger:
o If the government is closing a recessionary gap they will shift AD out to the
right by borrowing
o The rise in interest rates needed to finance the deficit stimulates an inflow of
capital moving the capital account toward a surplus.
o At the same time, rising aggregate demand increases imports which moves
the current account toward deficit.
o If the former is larger than the latter, the whole balance of payments will
move toward surplus.
o To stop the exchange rate from rising (appreciation of the domestic
currency), the central bank intervenes and buys foreign currency from the
commercial banks with Euros.
o This increases the money supply and increases aggregate demand.
Fixed exchange rate disadvantages

• Reserves are needed to offset short term fluctuations.
o Under the gold standard it was found there were not enough reserves to do
the adjusting.
o The US dollar worked quite well until it became unstable.
• A fixed exchange rate system cannot adjust to long term trends.

o If inflation rates are different amongst countries, or there are fundamental
shifts in the supplies and demands for certain goods and services either
because of differences in growth rates or because of major structural changes
such as technological breakthroughs, then the rates must be permitted to
change.
o Over a decade the drift away from the old equilibrium can be quite
substantial.
• Over time as equilibrium rates drift away from the fixed rate, there is more and
more intense speculation as investors try to buy currencies which are expected to
be revalued and sell currencies which are expected to be devalued.
o This drains foreign reserves even more quickly and forces a major adjustment
in the value of the currency.
o This is what eventually destroyed the Bretton Woods system.
• Because of its fixed exchange nature, the adjustable peg system may affect the
domestic economy adversely as domestic policies must be adjusted to maintain
external equilibrium.
• Monetary policy is weakened. If there is a recessionary gap and interest rates are
lowered to shift AD out:
o Investment increases domestically and aggregate demand shifts out
o Lower interest rates lead to capital outflows and the capital account moves
toward deficit.
o At the same time, with rising aggregate demand, imports increase and the
trade balance also moves toward deficit.
o To maintain the fixed exchange rate, the central bank buys domestic
currency. Euros leave the commercial banks and enter official reserves at the
Central Bank reducing the money supply and offsetting the original policy
Floating exchange rate advantages

• The greatest advantage is that adjustments needed to achieve external
equilibrium impact only indirectly on the domestic economy.
o Under a fixed exchange rate system, if there is downward pressure on the
currency and reserves of foreign exchange are exhausted, a recession must
be induced in order to reduce imports and boost exports.
o With flexible exchange rates, downward pressure on the currency leads to
depreciation with a subsequent fall in imports and rise in exports without
having to induce a domestic recession.
• Monetary policy tends to be stronger:

o If the government wants to close an inflationary gap, raising interest rates will
cause AD to shift in and lead to capital inflows.
o This will lead to appreciation, exports fall and imports rise leading to a further
inward shift in AD.
Floating exchange rate disadvantages

• Different Governments try to set their exchange rates at levels which are
inconsistent with each other.
o If central banks try to force their view, there is chaos in exchange markets.

• Countries may become involved in rounds of competitive devaluations in order to
capture a competitive advantage.
o There has been considerable pressure by the US on China to allow an
appreciation of the Yuan to make Chinese goods less competitive in the US.
o When this same policy pressure was applied to Japan 20 years ago, the
Japanese embarked on a program of transplanting production to other
countries to avoid the US border disputes over Japanese made goods.
• It was expected that speculators would stabilize rates close to their PPP normal
exchange rate equivalents.
o In fact, speculators seem no better at predicting than anyone else and there
have been some destabilizing speculations take place.
• Exchange rates have been over and under shooting their PPP normal exchange
rate equivalent often because of interest rate policies and the movement of short
term capital.
o When there has been overshooting, the result has been disruption in
production because of the severe competitive pressures.
• Fiscal policy tends to be weaker.

o Govt runs a surplus budget to close an inflationary gap
o With less crowding out, interest rates fall, capital flows out
o The currency depreciates, exports rise and imports fall shifting AD out.
4.6.H.2 Advantages/disadvantages of single currencies/monetary integration
Single Currency Advantages

• The nation state retains full control over monetary policy with the right to alter
interest rates and money supply to suit the economic circumstances.
Single Currency Disadvantages

• It can act as a depressant to both trade and FDI due to the uncertainties
associated with future currency values.
• Most smaller countries have linked their currencies through some sort of
managed float to a larger currency such as the dollar, Yen or Euro:
o This confers the benefits of stability without limiting their ability to control
monetary policy
o Nevertheless, freedom to adjust monetary policy may be curtailed because of
the need to adjust interest rates to prevent volatility in exchange rate
movements.
Monetary Integration
• Monetary integration occurs when countries fix their currencies against each
other but let the group of currencies float against all other currencies. This is
referred to as a currency block.
o Only if all members agree that there is a fundamental mis-alignment of
currencies can one country make adjustments in its monetary policy.

• Within the European Monetary Union (EMU) control over monetary policy has
been surrendered to the European Central Bank which gives it great influence
over the economies of individual member states.
o EU members have already agreed not to impose tariffs amongst members.
o With a common currency they cannot adjust by changing the exchange rate
or interest rates:
Monetary integration advantages

• Reduced costs and uncertainties associated with having to deal with many
separate currencies within a single market and the overall stability this is
intended to produce.
•
Monetary integration disadvantages
• Individual states are unable to use monetary policy as a stabilization tool during
times of economic crisis.
• The fact that Denmark, Sweden and the UK have stayed outside the group is a
major source of uncertainty.
• The most recent problem is how to integrate the new members of the EU. It may
lead to a core of states which are fully integrated economically and financially
surrounded by various groups of countries with different degrees of integration.
4.6.H.3 Purchasing power parity

• Under a floating system one of the major influences is the purchasing power
parity (what the normal exchange rate should be equal to).
o If a representative basket of goods costs £12 in Britain but Can$20 then the
Canadian PPP for the British pound is equal to
Can$20/£12 = 1.67
o Converting the British pound equivalent to Can$ is equal to:
£12*1.67 = Can$20.
• The PPP rate adjusts for the relative changes in the two countries' price levels. If
the Can$ price of the basket of goods rises to Can$25, then the PPP (normal
exchange rate equivalent) will rise to
o Can$25/£12 = 2.08.
o This is similar to an increase in the exchange rate or a depreciation of the
Can$.
• Thus the PPP (normal exchange rate equivalent) keeps the relative price of the
two nation's goods constant when measured in the same currency.
o As long as the exchange rate remains equal to the PPP rate, the competitive
position of the two nations' producers will not have changed.
o Deviations from the PPP can be substantial in the short run, but over the long
run exchange rates tend toward the PPP.
o It was assumed under the flexible exchange rate system that as speculators
could calculate the PPP, they would work to keep exchange rates equivalent
to their PPP:
Experience has shown that speculators have tended to overshoot or
undershoot the correct PPP.
One of the main reasons for this has been the influence of interest rates
on flows of short term capital.
4.7 Balance Of Payments Problems
4.7.1 Consequences of a current account deficit or surplus
• If we define the current account as C, the capital account as K, and the official
reserves account as F. We will find that:
CR + K R + FR = CP + K P + FP
where
R = receipts (received from foreign country, credit item)
P = payments (paid to foreign country, debit item)
• The sum of all transactions, payments and receipts must be equal. There must
be a zero balance left over otherwise the currency will appreciate or depreciate.
• There does not have to be a balance within an account or between any two
accounts. But there must be balance amongst all three accounts.
• There may be bilateral imbalances between countries, but each country must
have a zero multilateral payments balance with the rest of the world.
Merchandise Account
• If imports of goods exceed exports, we get a deficit on merchandise account.
• This may be offset by a surplus on invisibles.
• If invisibles are in deficit, the current account as a whole will be in deficit.
• In some countries a deficit on the merchandise account is considered to be a bad
thing and is referred to as an unfavourable balance of payments.
o But for developing countries it may be necessary to import machinery and
other capital equipment in order to develop. In the short run there is a deficit
but in the long run the new production may lead to a surplus.
Current Account
• A deficit on the current account can be offset by a surplus on capital account.
o Exports of securities means the country is a net importer of capital (remember
who gets the money), usually associated with a LDC which may experience a
great deal of foreign investment.
• If there is a surplus on the current account, this means there is more foreign
currency being earned than domestic currency being paid out.
o The people who hold this money must do something with it, and presumably
they will hold the foreign currency in the money market in the foreign country
(thus importing financial securities).
o A surplus on the current account is offset by a deficit on the capital.
4.7.2 Methods of Correction

4.7.2.1 Managed Changes in Exchange Rates
Using Official Reserves

• If both the capital account and the current account are in deficit, this can be
offset by a surplus on the official reserves account.

• A balance of payments surplus means the central bank must be adding foreign
exchange reserves to its holdings.
• A deficit means the Central Bank must be reducing its reserves.
• If the central bank did not intervene in the foreign exchange markets, a surplus
or deficit can only be temporary and will be self correcting:
o If holders of Euros are trying to buy more Japanese ¥ than holders of ¥ are
willing to sell because there is a deficit on the balance of payments, the Euros
will depreciate until demand equals supply.
o At that point the balance of payments will also be in balance because imports
look more expensive while exports look cheaper leading to an increase in
exports and a decrease in imports until the balance of payments temporary
deficit is eliminated.
• It is a popular myth that a country's external balance is similar to a firm’s profit

and loss statement.
o If the country is not in surplus it is assumed to be in trouble. However, in
order to keep the balance of payments in surplus, the currency must be
persistently held below its equilibrium level. This requires a deficit in official
reserves which means constant purchases of foreign exchange.
o This view was developed under the mercantilists, a group of economists who
lived 300 years ago.
o The law of comparative advantage shows that average living standards are
maximized by having individuals and regions specialize in the things they can
produce best and trade for things in which they have a comparative
disadvantage.
The more specialization, the more trade. If this leads to a large volume of
trade with a zero balance of trade, then all regions will be better off.
• In most countries, the government is unwilling to allow the currency to float

completely freely and it intervenes. The result is that surpluses will occur if the
currency is persistently held below its equilibrium level or deficits if the currency
is held above its equilibrium level.
• Most governments set target bands around the exchange rate:
o If the exchange rate approaches the upper band, the Central Bank will lower
interest rates:
This discourages short term capital inflows and fosters short term capital
outflows leading to a fall in the exchange rate
o If the exchange rate approaches the lower band, the Central Bank will raise
interest rates:
This encourages short term capital inflows and motivates domestic
investors to stop short term capital outflows.
• A group of countries started meeting in 1975 consisting of: France, the United
States, Britain, Germany, Japan and Italy. Canada joined in 1976 and the EU
joined in 1977. Since 1991 Russia has participated in the discussions but did not
have full rights to participate until 1998. Hence the right to vote. Hence it is
called the G8.
o The main topics of discussion have focused on macro policy, international
trade and development of LDCs.
o While the G8 does not have the power to set exchange rates, policy measures
taken by the members can reduce short term fluctuations by trying to keep
currencies closer to the PPP normal exchange rate equivalence.

• The IMF has also issued guidelines to central bank authorities to ensure an
orderly adjustment process, to establish target zones with other IMF member
countries, and to recognize that it requires team work among the member
countries to ensure stability.
• One major problem still remains and that is the ease with which short term funds
can flow between financial centres.
o These prevent the PPP normal exchange rate equivalents from being
established.
Italy has coped with this by establishing two separate exchange rate
systems, one for the capital account and one for the current account.
Germany has direct controls on overseas borrowing.
• There have also been suggestions that the flow of capital be restricted or slowed
down through heavy taxes on unproductive (that is, speculative) capital flows.
o Problem: how does a central bank identify unproductive from productive flows
of capital?
Inevitably, black markets would form which would allow capital flows to
avoid being tracked for tax purposes.
• Perhaps the most important feature has been the increased international
cooperation which has allowed the international financial system to survive and
weather the temporary crises which inevitably occur every few years. This is why
institutions like the IMF and the G7 are so important for stability.
4.7.2.2 Reduction in Aggregate Demand/Expenditure Changing Policies
Internal and External Balance

• Internal balance is achieved when the level of national income is at the target
level (Y* = Yfe).
o If there is entrenched inflation, the target may be a level of income below the
full employment point (in order to eliminate inflationary expectations).
• External balance is achieved when a target level associated with the external
sector is achieved.
o If the target is a zero trade balance (merchandise (visibles) account and the
services account combined), when it is achieved there is external balance
(this is the target assumed in the examples below).
o If the country is running a surplus in the capital account, the target may be a
certain level of deficit in the trade balance. As long as this deficit is being
achieved, there is external balance.
Conflict between internal and external balance

• A conflict between the internal and external balance occurs if in moving toward
the internal target we move away from the external target.
Case 1: A trade deficit combined with a recessionary gap (Yo < Y*).
• As fiscal or monetary policy are used to move aggregate demand to the right to
close the gap, imports will rise making the trade deficit worse.
• Internal balance is achieved at the cost of moving even further away from
external balance.

• Because unemployment is Case 1: Internal/External Conflict
considered a more serious problem
Trade Account
LRAS
than inflation, and a trade deficit as
a more serious problem than a
surplus, this case is considered the
most serious and is referred to as a
N
et
E
xp
balance of payments constraint on
or
ts
1
domestic stabilization policy.
• In the long term, to prevent an Yo Yfe Real National Income
exchange rate from falling, there is

the possibility of using trade
restrictions. However, under the WTO agreements, the threat of retaliation limits
this policy tool. The main alternative
Case 2: Internal/External Conflict
for government is to deflate the
Trade Account
domestic economy in order to reduce LRAS
import spending.
N
et
Ex
po
rts
Case 2: A trade account surplus
1
together with an inflationary gap (Yo >
Y*).
• As fiscal and monetary policy are Yfe Yo Real National Income
used to move the aggregate demand

curve in to the left, there is a
reduction in imports and an even larger trade surplus.
No Conflict between internal and Case 3: Expenditure Changing

Trade Account
external balance LRAS
Case 3: A trade deficit combined with an

inflationary gap (Yo > Y*).
Ne
tEx
• As fiscal and monetary policy are used to

por
ts
close the gap, imports fall and the trade

deficit is lowered simultaneously Yfe Yo Real National Income
(expenditure reducing).
Case 4: A trade surplus combined with a

Case 4: Expenditure Changing
recessionary gap (Yo < Y*).
Trade Account
LRAS
• As fiscal and monetary policy are used to
increase aggregate demand the gap is
N
et
closed and imports rise lowering the trade

Exp
or
ts
surplus (expenditure increasing).

• The solution to the conflicting situation is to Real National Income
Yo Yfe
shift either the LRAS (supply side policies),
or to shift the net export function.
Expenditure Changing Policies

• Internal balance is achieved when
Y* = C + I + G + ( X − M )

• If we refer to C + I + G = A as domestic absorption, then internal balance is
given by
Y* = A + ( X − M )
o This means that full employment income is equal to aggregate desired

expenditures which is the same as domestic absorption plus net exports.
• Aggregate Demand management policies actually affect the level of aggregate

expenditures (policies that alter aggregate demand).
o Altering aggregate demand leads to shifts along the net export line.
Thus changes in the trade balance and national income are negatively
related.
A rise in Y worsens the trade balance and vice versa.
• In Case 3 and 4 there is no potential conflict: changing aggregate demand in

order to achieve full employment leads to external equilibrium at the same time:
o Case 3: No-Conflict where a trade deficit is combined with an inflationary gap.
In this case an expenditure reducing policy (AD shifted to the left) is
appropriate to achieve both targets:
The inflationary gap is closed while improving the trade deficit.
o Case 4: No-Conflict where a trade deficit is combined with a recessionary gap.

An expenditure increasing policy (AD shifted to the right) will achieve both
targets
The recessionary gap is eliminated while reducing the trade surplus.
4.7.2.3 Change in Supply side policies to increase competitiveness

• Supply side policies attempt to move the LRAS curve to the right by improving
incentives, increasing the productivity of labour and capital, reducing input costs,
and monopoly power.
o Not only does this shift the LRAS to the right but it leads to greater
international competitiveness due to lower costs of production.
o This results in:
A fall in imports and a rise in exports
Upward pressure on the domestic currency.
4.7.2.4 Protectionism/Expenditure Switching Policies

• Expenditure switching policies: do not affect the level of expenditures but switch
the proportions back and forth between domestic absorption and net exports.
• This moves the net export function so that the trade balance is neutral at the full
employment income point (net export line meets LRAS at the Y* point).
o Such policies include changes in exchange rates, tariffs and quotas, and
altering differentials in inflation rates.
Case 1: Expenditure Switching
Trade Account
• Case 1: Conflict: trade deficit with a LRAS
recessionary gap.
N
et
Ex
N
po
o Expenditure increasing policies are not

et
r ts
Ex
2
po
r ts
appropriate.
1
Yo
o What is needed is a switch away from Yfe Real National Income
foreign goods toward domestic goods

which reduces the trade deficit while increasing domestic absorption
o This reduces the recessionary gap (switch from foreign to domestic).
• Case 2: Conflict: a trade account surplus Case 2: Expenditure Switching
Trade Account
together with an inflationary gap LRAS
N
et
Ex
o What is needed is a switch in
po
Ne
rts
tE
1
expenditure away from domestic goods
xp
or
ts
2
toward foreign goods which reduces the
trade surplus. Yfe Yo Real National Income
o At the same time, this decreases

domestic absorption which reduces the
inflationary gap (switch from domestic to foreign).
• The most important problem with expenditure switching policies is that trading
partners are likely to retaliate with such things as exchange rate depreciation or
the imposition of tariffs or quotas.
4.7.3 Consequences of Capital Account Deficit or Surplus

• Capital flows are primarily influenced by interest rates which are part of monetary
policy.
o Expansionary monetary policy leads to an increase in the money supply, a rise
in the price of bonds, a fall in the interest rates, and an increase in domestic
investment.
This leads to an outflow of capital, the capital account moves toward a
deficit.
o Expansionary fiscal policy leads to greater government borrowing which leads
to interest moving up.
Capital flows into the country moving the capital account toward a surplus.
• If we now expand the definition of external balance to include the whole of the
balance of payments, then a deficit in the current account will be matched by a
surplus on the capital account.
• If there is a temporary deficit in the balance of payments, the exchange rate will
fall (depreciation) which will automatically lead to lower imports and greater
exports.
• If the central bank does not want the depreciation to occur, it will intervene and
purchase the domestic currency (the demand curve for Euros shifts out: the
supply of Yen also shifts out).
o The central bank will pay for this by cheques drawn on the commercial banks,
thus there will be a contraction of the money supply.
o Euros leave the commercial banks and enter official reserves at the Central
Bank.
o Interest rates will rise and capital will flow in, the exchange rate will rise
(appreciates) again.
o If the central bank intervenes by increasing the money supply through open
market purchases of bonds, interest rates will remain the same.
The external effect is sterilized and the domestic money supply is
insulated from the external effect.

4.7.H.1 Marshall-Lerner Condition
• If a country wishes to devalue its currency, this will cause a deterioration in the
terms of trade as the price of exports fall in relation to the price of imports:
Px
↓
Pm
.
• The impact on the balance of trade (balance of payments on current account)
depends on the elasticities of the demand for exports and the demand for
imports:
o If both demand curves are elastic, then
Px ↓ ∗Qx ↑↑ − Pm ↑ ∗Qm ↓↓ ⇒ B of T ⇑
That is: export revenues will rise while import expenditures fall, therefore
the Balance of trade improves.
o If both demand curves are inelastic, then:
Px ↓ ∗Q x ↑ − Pm ↑ ∗Qm ↓ ⇒ B of T ⇓
That is: export revenues will fall while import expenditures will rise,
therefore the Balance of trade deteriorates.
o The intermediate case is where one curve is elastic while the other one is
inelastic, and the Balance of trade will:
Improve if the sum of the elasticities is greater than 1
Deteriorate if the sum of the elasticities is less than 1
J Curve
4.7.H.2 J Curve
• This is just another variation of the
Marshall Lerner condition:
Surplus
o When a country devalues its

Balance of Payments
Current Account
currency, the terms of trade

deteriorate:
Px
↓
Pm
Deficit
o Initially there is no change in

quantities as they are often set
by contract for several months or
even a year ahead, therefore:
Time
_ _
Px ↓ ∗ Q x − Pm ↑ ∗ Q m ↓ ⇒ B of T ⇓
That is: export revenues will fall while import expenditures will rise
because there is no change in the quantities of exports and imports (the
bars over top of the Qs indicate no change): therefore the Balance of
trade deteriorates
In the diagram the Balance of Payments, current account falls.
o Over time, contracts can be renegotiated:

If the sum of the elasticities is less than one, the Balance of Trade will
continue to deteriorate
If the sum of elasticities is greater than one, the Balance of Trade will
improve as illustrated in the diagram.
4.8 Terms Of Trade

4.8.1 Definition of the Terms of Trade
• The division of the gains from trade depend on the terms of trade which measure
the quantity of imported goods that can be obtained per unit of good exported:
o The ratio of the price of exports to the price of imports.
• The terms of trade change as the exchange rate changes, and the exchange rate
changes as domestic prices change.
o If foreign inflation is higher, export prices will rise more slowly than import
prices and the terms of trade worsen.
o Countries with higher productivity will produce lower cost goods and their
export prices will rise less quickly than for other countries leading to a
worsening of the terms of trade.
4.8.2 Consequences of a Change in Terms of Trade on B of P

• A country may not experience the gains from trade due to specialization, if the
terms of trade are not in its favour.
• Example: A rise in the price of imports leads to a Opportunity Cost
decline in the terms of trade. Wheat Cloth
o If India specializes in wheat production, 1.67 India 0.6 1.67
bushels of wheat would have to be given up Kenya 2.0 0.5
in order to gain an extra metre of cloth.
o If India can get 1 metre of cloth for 1 bushel of wheat by exporting it, then it
is a good deal. It is better for India to specialize in wheat and trade it for
cloth than it is to move resources out of wheat into cloth production.
o As the terms of trade improve for India, the Balance of trade improves:
They are able to obtain more export revenues as they sell wheat for 1
metre of cloth instead of for 0.6 metres of cloth
Their import expenditures are lower as they pay only 1 box of wheat for a
metre of cloth instead of paying 1.67 boxes of wheat.
o As the terms of trade improve for Kenya, the Balance of Trade improves:
They are able to obtain more export revenues as they sell cloth for 1 box
of wheat instead of for 0.5 boxes of wheat
Their import expenditures are lower as they pay only 1 metre of cloth for a
box of wheat instead of paying 2 metres of cloth for a box of wheat.
4.8.3 The Significance of Deteriorating Terms of Trade for

LDCs
• The term of trade for exporters of manufactured goods (mainly NIEs and MDCs)
have gone from 100 in 1960 to 80 in 2001.
• The terms of trade for exporters of primary goods (mainly LDCs) have gone from
100 in 1960 to 56 in 2001.
• Demand for primary products tends to be very price inelastic:
o Supply also tends to be price inelastic, and primary industries are subject to
frequent supply side shocks for example in agriculture and mining.
o The combination of inelastic demand and supply can mean severe price
volatility.
• Primary commodities tend to be income inelastic:

o Increases in world income put upward pressure on the prices of manufactured
and service imports into LDCs without raising the prices of their exports.

4.8.H.1 Measurement of Terms of Trade
• The division of the gains from trade depend on the terms of trade which measure
the quantity of imported goods that can be obtained per unit of good exported
• This is measured as the ratio of the price of exports to the price of imports.
Index of Export prices
* 100 = Terms of Trade
Index of import prices
where:
o Export prices: a selection of the main export prices are weighted according to
their importance which is determined by their proportion in total export
expenditures.
o Import prices: trade weighted import prices are used.
o This index is set to 100 in the base year. Thus the terms of trade is an index
number
4.8.H.2 Causes of changes in Terms of Trade: short-run and long-run

• The terms of trade change as the exchange rate changes, and the exchange rate
changes as domestic prices change.
o If foreign inflation is higher, export prices will rise more slowly than import
prices and the terms of trade deteriorate.
o Countries with higher productivity will produce lower cost goods and their
export prices will rise less quickly than for other countries leading to a
deterioration in the terms of trade.
o If interest rates or ROI is higher in a country, capital will flow into the country
leading to an increase in exchange rates and an improvement in the terms of
trade as export prices rise relative to import prices.
• If a large country purchases a commodity from several smaller countries it may

be able to use monopsony power to force prices lower.
o One possible example is Starbucks is such a large buyer that is has been
accused of using monopsony power to drive down the price of coffee
• Alternatively a group of sellers can form a cartel and force prices higher through
the use of monopoly power. The best example is OPEC.
• Typically as LDCs develop, they tend to specialize in areas where they have
experience: mainly agriculture and primary processing
o The result is that too many countries export food, cotton, textiles, iron ore,
steel, and the supply curve keeps shifting out to the right as more and more
LDCs join the world trading community
o Obviously this puts continuous downward pressure on prices.

• A country may not experience the gains from trade due to specialization, if the
terms of trade are not in its favour.
4.8.H.3 Elasticity of demand for Imports and Exports

• The terms of trade improve when a given basket of exports will now buy more
imports.
• Note that terms of trade are different from the Balance of Trade which examines
total expenditures on exports and imports.
o An improvement in the balance of trade depends on the elasticities for
exports and imports: check
the Marshall-Lerner Comparative Advantage for India:
conditions above. Consumption & Production Gains
Poduction PossibiltyBoundary
• Consumption gains from trade:
we assume production is not
changed but the terms of trade d Original Terms of trade Terms of
allow the country to export ac Trade
and import cb. Consumers have
Wheat
moved outside the production e f

possibility boundary and there is a
a gain from trade. c b

• Production gains from trade: we
allow the country to re-organize
production to take advantage of
the terms of trade by moving to Cloth
point d. The country exports de
and imports ef for even more
gains.
4.8.5 Elasticities and Short and Long Run changes in Terms of

Trade
• An increase in the terms of trade is favourable for a country: it can import more
per unit of export. Many LDCs tend to produce primary goods and import
manufactured goods. The prices of primary goods tend to cycle quite widely
which means during boom times they are comparatively well off and during world
wide recessions, the terms of trade swing against them.
• For primary goods there are two influences:
o In the short run: both demand and supply elasticities tend to be low which
means that small shifts in the functions can lead to large changes in prices.
In boom times terms of trade improve considerably
During a recessions they deteriorate.
o In the long run:

The income elasticity of demand for primary goods is positive but low: as
world income grow, demand for primary goods does not increase
Income elasticity of demand for manufactured goods is high and as
income increases in LDCs, demand rises leading to a deterioration in the
terms of trade between primary and manufactured goods.
• For manufactured goods:

o Price elasticities tend to be neither high nor low so shifts in demand and
supply cause only moderate changes in the terms of trade.
o Income elasticity tends to be positive and greater than zero for some products
which means terms of trade improve as world income grows.
As income grows in LDCs, not only are the prices of primary goods falling
but LDCs tend to import increasing amounts of manufactured goods
because of high income elasticity
This leads to a deterioration in the terms of trade.
o In the long run, as products reach the end of their life cycle, international
competition has driven the price down and income elasticities are positive but
less than one.
For these goods terms of trade deteriorate.
Production for such goods is often shifted to LDCs which means that it
cannot help to offset the deterioration of terms of trade resulting from
primary goods exports.

SECTION 5: DEVELOPMENT ECONOMICS
5.1 Sources of Economic Growth &/or Development
The diagram on the following page lists the most important sources of growth:
• Entrepreneurs play a key role and grow from small to medium to large
corporations given the right structures and elimination of barriers.
• Multinational or Transnational corporations enter the country and can also
contribute to growth.
• Government policies and programs as they relate to the regulatory regime and
the building of infrastructure play a crucial role.
• Financing can come from the domestic banking system or through loans and
grants from international banks and agencies.
• Trade has been a very important source of growth for Southeast Asian countries.
Latin American countries until 10 years ago attempted to grow domestically by
blocking imports from other, more developed countries.
5.1.1 Natural Factors

• Natural resources:
o It is estimated that more than half the renewable natural resources are being
utilized in the world. This includes arable land, fisheries, forests, and water.
o There are still significant amounts of non-utilized arable land in some African
and Latin American countries and in Central Asia (Mongolia).
• While there is still land to be developed, the bulk of land available to most
populations is limited in size.
• Irrigation, drainage, the use of chemicals for fertilizing, pest and weed control,
and the use of machinery can increase productivity dramatically.
• The green revolution is an example of this.
o The problem is that the damage to the soil can be so extensive, that the
increase in productivity may only last 70 years before the soil is destroyed.
o Already India is starting to seriously question the use of irrigation, machinery
and chemicals as soil degradation is very serious.
5.1.2 Human Factors

• People need to be healthy and educated in order to be productive. Some studies
have shown that a third of the working population in very poor countries are
afflicted with internal parasites which drain energy rapidly.
• Labour: population growth rates in LDCs reduce growth in per capita GDP.
• If 50% to 70% of economic growth arises from improvements in the productivity
of factors, there is a need for better education, greater efficiency in
management, and better training in technology.
• LDCs have made large investments in primary and secondary education.
• Increase in worker skills is essential in order to make use of capital equipment
and new technology, and to provide the services needed for growth in the future.

ECONOMIC GROWTH
Finance
Industrialization
Banking
Mobilize Savings
Entrepreneurs -Safety of capital
-Pay interest on savings
Small stay in community
-Project evaluation
Facilitate Lending:
-Accept risk
-Project evaluation
-Economies of scale
-Keep lending rate low
-Learning by doing
-Reduce risk by diversifying
-Management training
-Geographic, sectoral, industrial
-Backward & forward links
Intermediate move to larger centres

Foreign Aid
-Access to skilled labour Economic Growth
-Subcontract to large firms (Growth oriented)
-Small modern factories Development Position Multilateral
-Agglomeration & external economies -LDC1: primary (iron ore, cotton) -World Bank loans ($6 billion)
-LDC2: primary & processing (steel, textiles)
Large tend to invest in capital -NIC1: manufacturing (toys, shirts) Bilateral ($50 billion)
-Productivity rises with more K but: -NIC2: advanced manuf. (cars, computers) -Tied grants
-Labour often displaced by K -MDC1: manufacturing & services -Political & military
-Jobs are often part time only -MDC2: mostly services (software, financial) -MDCs dictate development priorities
-Invest in R&D: Q/K rises -Lack of complementary inputs
-Trained managers tend to emmigrate Goals
-Increase GDP per capita
-Accelerate economic growth (g = s/k) by:
-Mobilizing savings
-Attracting FDI
Trade
Multinational Firms Problem Example: LDC Debt
Benefits: -1973-79 Low interest rates: Govt. Trade Policy
-Learning by doing -Excess OPEC money from higher oil prices Benefits:
-Management training -MDC started inflating -Gains from trade
-Technology transfer -1979-86 High interest rates: -Economies of scale
-Access to markets -MDC stopped inflating -Technology transfer
-Employment creation -Poor return on LDC investments -Learning by doing
-Higher oil prices raised energy costs
Costs: -MDC recession led to drop in imports from LDC Costs:
-LDC inability to apply technology -Poor project evaluation meant low returns -Foreign enclave
-Labour saving capital displaces jobs -IMF structural adjustment program has failed -Specialization trap
-Poor tax collection due to: -Unbalanced growth
-Transfer pricing -MDC barriers to imports
-Tax concessions
-Creation of foreign enclave
Import Replacement
Goals:
-Vertical integration
-Learning by doing
Govt Industrialization Policy
Problems:
-Reduce price distortions
-Price of intermediate goods rises
-Eliminate urban subsidies
-Exports fall
-Ensure stable government
-Unemployment rises
-Streamline legal & regulatory system
-Supply bottlenecks
-Set up proper tax system
-No technology transfer
-Build public infrastructure
-Slow but even growth
-Set industry standards
-Facilitate technology transfer
Export Promotion
-Tariffs fall, exports rise
-Backward & forward links
-Rapid growth
-Government facilitates:
-Infrastructure & marketing
-Strategic trade policy

UN Millennium Development Goals
• With the agreement of the IMF, the OECD, the WB and most western countries,
the UN has set the following goals to be achieved by 2015:
o Eradicate extreme poverty and hunger
Reduce by half the proportion of people living on less than a dollar a day
Reduce by half the proportion of people who suffer from hunger
o Achieve universal primary education
Ensure that all boys and girls complete a full course of primary schooling
o Promote gender equality and empower women
Eliminate gender disparity in primary and secondary education preferably
by 2005, and at all levels by 2015
o Reduce child mortality
Reduce by two thirds the mortality rate among children under five
o Improve maternal health

Reduce by three quarters the maternal mortality ratio
o Combat HIV/AIDS, malaria and other diseases
Halt and begin to reverse the spread of HIV/AIDS
Halt and begin to reverse the incidence of malaria and other major
diseases
o Ensure environmental sustainability

Integrate the principles of sustainable development into country policies
and programs; reverse loss of environmental resources
Reduce by half the proportion of people without sustainable access to safe
drinking water
Achieve significant improvement in lives of at least 100 million slum
dwellers, by 2020
o Develop a global partnership for development

Develop further an open trading and financial system that is rule-based,
predictable and non-discriminatory.
A commitment to good governance, development and poverty reduction—
nationally and internationally
Address the least developed countries’ special needs. This includes tariff-
and quota-free access for their exports; enhanced debt relief for heavily
indebted poor countries; cancellation of official bilateral debt; and more
generous official development assistance for countries committed to
poverty reduction
Address the special needs of landlocked and small island developing States
Deal comprehensively with developing countries’ debt problems through
national and international measures to make debt sustainable in the long
term
In cooperation with the developing countries, develop decent and
productive work for youth
In cooperation with pharmaceutical companies, provide access to
affordable essential drugs in developing countries
In cooperation with the private sector, make available the benefits of new
technologies—especially information and communications technologies

5.1.3 Physical Capital & Technological Factors
• Diminishing returns is the major cause of low productivity in LDCs.
• There is a scarcity of capital and trained management, ever increasing supplies of
labour combine with relatively fixed supplies of land, capital and management.
o Investment in machinery and equipment add directly to productivity.
o Investment in infrastructure such as roads, bridges, dams, sanitation and
electricity are indirectly productive, but equally as essential.
o The opportunity cost of capital investment is the lower levels of current
consumption which result from saving. Savings present a great hardship for
people who may already be living below the poverty line.
o Technology developed in MDCs is appropriate for labour scarce, rich
countries. Because it is labour saving, it is inappropriate in labour abundant
countries where it is more efficient to use more labour and less capital.
o Capital intensive development often displaces workers and does little to
reduce unemployment.
o Factor rewards go to capitalists or investors from foreign countries. It does
little to relieve poverty.
• 85% of the scientists working in research and development live in the US, Japan,
and Germany. The new ideas and inventions which are applied through the new
technology and capital are dominated by MDC thinking.
• Only modest amounts are invested in research and development in LDCs.
• Higher productivity does not require high tech solutions:
o Billions of dollars in aid for large scale, high tech projects has only increased
dependency for the poor rather than increasing productivity.
o What is needed is technology appropriate for the poor which will allow them
to help themselves.
o Appropriate technology uses local materials, and local labour skills, and capital
that can easily be repaired locally:
Simple clay stoves, pipe wells, pipe latrines, micro hydro power
transformers, better harnesses for oxen etc.
5.1.4 Institutional Factors

• According to the World Bank, rapid growth in Asia is a direct result of policy
guidance rather than just a free market. These policies include:
o Making income distribution more equitable.
o Encouraging savings and making banks more reliable
o Improving primary and secondary education
o Improving agricultural productivity
o Facilitating technology transfer and encouraging FDI
o Streamlining legal and regulatory structures to create a positive business
environment
o Setting industry wide standards and monitoring quality facilitates marketing.
o Targeting key industries for development:
Protecting infant industries in the early stages
Managing resource allocation
Facilitating exports through government assisted marketing
• Is it necessary to substitute for missing institutions in order to enhance the

development process in LDCs?

o Many countries have managed to develop without the need for accumulated
wealth or developed financial sectors (Germany, Russia, Japan).
o Importing foreign experts with knowledge and experience is not as effective
as training and utilizing local talent.
o There is a need to transfer power from old ruling classes with no interest in
promoting development for poorer people:
Landowners block small farm development to prevent competition, and
block growth of industrialists to prevent loss of influence and power,
Rich industrialists try to block small businesses to prevent competition,
'Corporate' unions lobby the government for high minimum wages and
labour protection laws (making it difficult for business to be competitive),
in order to stop erosion of artificially high wages,
Problem: down trodden peasants of one generation become materialistic
consumers of the next generation who prefer imported goods.
5.1.4.1 The Banking System

• Savings are needed for investment in both physical and human capital, but
savings requires a higher income, and higher income requires greater
productivity. This is often referred to as the poverty trap.
• By mobilizing savings a good banking system is essential for economic growth
• Savers: deposit money in the bank and expect to receive a steady interest rate
of, for example, 5%. Savers know that there is no risk attached, and do not mind
earning such a low rate of return.
• Lenders: banks then take the money and lend it out to entrepreneurs. They
charge 10% on the loans for several reasons.
o The bank assesses the investment proposals of various businesses looking for
those which are feasible (can be done) and viable (can support themselves
and repay the loan), and rates them according to risk and return
o Low risk investors pay 10% and higher risk investors pay up to 18%
o The rate differential between savers and borrowers covers the paperwork,
earns a return on invested capital, and covers the loans which may fail
o By diversifying across various sectors in the economy and geographic regions
in the country, banks are able to reduce risk,
o They can also reduce risk through securitization:
Banks grade loans by risk (grade A, B etc.), and group the loans into
standard sized packages such as $5 million)
The packages of loans are sold to domestic and foreign investors.
Entrepreneurs
• Before investing, entrepreneurs analyse the various opportunities available and
rank projects according to the expected rates of return.
o They borrow as long as the project rate of return covers the bank charges
o They can often earn considerably more, but need it to cover the risks of
failure which can be very high for certain projects:
Primary sector projects may find no oil or minerals, manufacturing projects
may face competition from new products or lower cost imports,
The product life cycle may be near exhaustion, or new technology may
render a project obsolete.
• Entrepreneurs earn more because they are prepared to accept the risk of failure
and the consequences of going bankrupt.
• They are willing to take new technology and apply it to a new product, or to
invest in innovative locations or new product areas. Their reward is the high rate
of return.
• Those countries which force the banking system to become entrepreneurs
transfer the risk from the entrepreneur to the banking system:
o The resulting project failures can lead to bank failures.
o People will remove their savings from banks and either send the money
overseas (capital flight) or hide it around their homes.
5.1.4.2 The Education System

• The correlation between education and economic growth is very high:
o Literacy is essential for understanding and applying new technology
o The application of technology is necessary to increase productivity
o Those countries that have experienced rapid economic growth have always
had highly literate populations.
o The difference in growth rates between India and China is often ascribed to
the differences in levels of education.
o Until the population of India achieves the same level of literacy and years of
education, it cannot hope to match the higher economic growth of China.
• The highest ROI from society’s point of view comes from investment in primary
education.
• Remember that the UN definition of literacy is not reached until a person has had
9 years of schooling. Thus the ROI on investment in secondary education is also
high.
o This leads to increased productivity of workers
o Greater productivity leads to greater savings and a wider and deeper tax base
o The correlation between education and health is also strong which means that
people will take better care of themselves and there is less likelihood of
diseases being transmitted because of immunization.
o Fewer children are born to better educated families, and those children that
are born are allowed to go to school and achieve higher levels of education
and productivity.
o Greater levels of political stability are achieved in countries with greater levels
of education.
• It is interesting that the ROI for individuals rises steadily as years of schooling
increase, while the ROI for society actually falls steadily.
o From society’s point of view investment in post secondary education often has
an ROI which is less than the borrowing cost, but for an individual it is very
high.
5.1.4.3 Health Care

• The correlation between spending on health care and life expectancy and
reduced infant mortality is very high.
• There is also a strong correlation between health care and years of schooling:
o Better health care means that children can attend school more regularly and
can learn more effectively
o Better levels of education lead to great care of health.
o Simple techniques such as washing hands after going to the bathroom,
washing breasts before breast feeding a baby, digging a pit latrine downhill or
well away from the village water source, using a mosquito net at night, boiling
or treating drinking water with alum, washing cooking pots thoroughly,
disposing of garbage regularly, and using an enclosed burning device for
cooking (rather than an open fire) can eliminate most of the simple causes of
sickness and ill health.
• Spending on community nurses has a much higher ROI from society’s point of
view than investment in sophisticated hospitals and expensive surgical routines.
o Community nurses can help reduce infant mortality and can educate and
check regularly to minimize TB, Malaria, Hepatitis, and the spread of HIV.
5.1.4.4 Infrastructure
• Generally this refers to public or government regulated private goods and
services and includes:
o Physical
Transportation: roads, bridges, railways, harbours, airports, canals and
dams
Telecommunications: phone systems, TV networks, IT services,
Utilities: water, sewage, electricity, gas pipelines
o Social
Education: primary, secondary, and post secondary
Healthcare: systems of community nursing, hospitals, university research
and medical training centers
• Even in MDCs such as the US, it is estimated that the ROI on investment in
infrastructure is significantly higher than the ROI on investment in private
projects.
• Investment in infrastructure in LDCs can play a critical role in promoting both
economic growth and development:
o Markets open up for more remote communities
o Technology transfer or diffusion is accelerated which enhances productivity
o Health care is improved as community nurses can travel more easily and
there is better access to clean water, sewage is handled more effectively and
health care facilities are more available and accessible.
o Students find it easier to attend school and larger numbers will graduate
o Irrigation resulting from dams and canals can enhance crop production which
leads to better food production, healthier populations and less dependence on
imported food.
5.1.4.5 Political Stability

• Countries with a history of stable government and a developed commercial sector
including merchants, financiers, and businesses familiar with international trade
tend to have fewer problems with development.
• Countries with governments previously dominated by colonial powers and with
commerce controlled by minorities, find it difficult to compete in international
trade and finance.
• Stable government reduces risks for local investors, encourages investment, and
reduces capital flight

• Stable government is more willing to make tough decisions such as devaluation,
reducing urban subsidies, reducing overstaffed bureaucracies, reducing tariffs to
promote competition, and perhaps redistributing income to poorer people
• Stable government is more able to encourage small scale entrepreneurs to:
o Take initiative, develop managerial ability, and undertake risks.
o Train to overcome weaknesses in marketing, finance, and managerial ability.
• For growth to take place without interruption, social legitimacy is required

o When Argentina took off, Juan Peron carried out measures that were popular
with his constituents, such as price control of food grains and enlarged
military expenditures, but that stifled growth and divided society into sharply
contending classes.
o Iran's oil wealth, far from being a source of stability, increased the alienation
of the great majority of the people who felt that the nation's wealth was being
monopolized by a corrupt few.
5.2 Consequences Of Growth

5.2.1 Externalities
Environmental Degradation & Pollution
• Population pressures have led to degradation of the environment:
o Soil erosion is a serious problem in several countries.
o Forest cover is lost by cutting for fuel
o Desertification occurs from domestic animals over-grazing land
o There has been over-fishing of lakes and rivers, and now the oceans.
• Most pollution such as depletion of the ozone layer and the greenhouse gasses
which are causing global warming are a result of industrialization.
• The question becomes: how can we develop indicators which can be used to
adjust national income accounting to alert us when there is a problem and
provide a way of evaluating attempts to reverse the degradation?
o Valuing natural and environmental resources is not simple:
Market values can be subtracted from the flow of income generated by a
country; while not ideal this does provide an indicator
It is usually very difficult to measure changes in quality rather than simple
market values of quantities consumed.
• If we attempt to measure resources which have no market value:

o People may lie about the true value if they think that lying will benefit them
o Market values usually reflect opportunity costs: the value of substitutes. How
do we value a resource for which there is no substitute?
• Crowding in cities usually leads to pollution, health and sanitation problems,

crime and vandalism, and a breakdown in infrastructure
Case Study: China

China tried to copy the Russian model and put all its investment into industry.
Disastrous harvests followed forcing the government to change policy:
• Collectivized farms were abandoned and market driven farmers were encouraged
to invest in machinery and chemicals.
• The government restricted rural urban migration, the resulting migration which
did occur was not enough to eliminate the rural labour surplus, the government
introduced incentives to lower the birth rate,
• Prices to farmers were raised, while input costs were held constant with the
result that the terms of trade turned in favour of the agricultural sector
• Mechanization of farms was slowed down to prevent a drop in demand for
surplus farm labour.
Case Study: Some African Countries

Investment was devoted primarily to industrialization in the cities:
• Low farm productivity was believed to be a result of diminishing returns because
of the limited supply of land, but in fact most African countries had low
population densities (most still do),
• New farm lands were opened up, populations grew rapidly because of the
increases in agricultural productivity,
• Eventually the sharp decline in available arable land and the movement of people
to the cities reduced per capita food production
• Resources have been switched back from the cities to the rural areas.
5.2.2 Income Distribution

• The greatest industrial weakness in LDCs is management which often leads to
labour being displaced by capital:
o Labour is more difficult to manage than capital, and firms use capital instead
of labour to compensate for weak management
o Unionization, minimum wage and labour protection laws motivate firms to buy
labour saving capital
o Foreign investors import labour saving capital equipment.
• Prestige attached to industrialization leads to government pressuring for capital

intense, modern industries and unnecessary infrastructure:
o Paid for with taxes on primary sector exports, impoverishing rural areas
o City infrastructure is heavily subsidized and given priority
Firms lobby for subsidized food in the cities
Rural urban migration explodes.
• This means that the benefits of growth may be experienced by the more wealthy
individuals in society: the ones with education and money to invest.
Income Inequality
• In many countries the bottom 20% of income earners are classified as poor.
o This is a relative concept as the bottom 20% in a Western European country
may live far better than the bottom 20% in an LDC.
• Poverty usually comes about because of unemployment or because a person has

a job but does not have the skills to earn a salary above the poverty level.
• Most MDCs attempt to make income distribution more equal by taxing people
with higher incomes and providing free services and subsidies to those who are
poor.

Redistribution of Assets
• If the most important cause of inequality is an unequal distribution of land,
natural resources and capital, attempts must be made to redistribute at least
some natural resources such as land.
• Land reform can often lead to a dramatic increase in farm productivity and
incomes for the rural poor.
• Children of the elite have greater access to education and to the best jobs:
o Policies to open access to education for the poor, to reduce absenteeism and
improve the quality of education can lead to great increases in productivity.
5.2.3 Sustainability
Ecological Footprint
• Population densities are very low in most African and South American countries,
and are very high in many developed countries.
• If MDC populations are adjusted to include their ecological footprint, the real
populations and population densities are even higher:
o The US with 6% of the population in the world uses 40% of the world’s
resources
Adjusting for 6.7 times the world average of resources per person, the
actual population of the US would be 1,900 million people not 280 million
o India with 17% of the population uses 4% of the world’s resources
Adjusting for 0.25 times the world average of resources per person, the
actual population would be 212 million people not 1 billion
Malthusian approach
The law of diminishing returns suggests that the world will run out of resources in
the face of the rapid increase in population.
• Demographers find that the big increase in population is over. While the long
term effects will lead to increased populations in the future, the growth rate has
already started to stabilize and will reach replacement level by the year 2050.
• While resources have been fixed, the gains from specialization, economies of
scale and learning by doing have more than outweighed diminishing returns in
the last 100 years.
• While there does appear to be an inverse relation between per capita income and
birth rates, death rates have fallen quite independently of incomes.
• It appears that a more equitable distribution of income, greater literacy for
women, and more job opportunities for women results in a lower population
growth rate.
Limits to Growth
• In the 1960s and 1970s some scientists predicted the end of the world based on
physical limits on resources which would restrain economic growth.
• In the 1980s many prominent studies were published which changed the focus:
o The world’s resources are indeed sufficient to meet long term human needs.
o The uneven spatial distribution of the human population relative to the natural
carrying capacity of the environment is of much greater concern.
o There is inefficient and irrational use of natural resources.
o The ability to pollute the world to the point where it is unlivable is likely to
happen far more quickly than the exhaustion of natural resources.
• In the 1990s interest has shifted to applying the knowledge accumulated in the
natural sciences to the economic process:
o The scale and rate of throughput, energy and matter passing through
economic systems, is subject to entropy, the second law of thermodynamics:
Entropy: materials that get used in the economy tend to get dissipated
and it requires energy inputs to make these materials useful again.
Sometimes it is not worthwhile recycling: the cost of transportation
required to bring all the used materials together and the energy required
to return them to a useful state may cost more than the original materials.
o The market is not responsive to certain externalities and so fails to account

for entropy and potentially catastrophic environmental damage.
o Even with government regulation replacing the market, some ecologically
relevant externalities may involve damage to the ecosystem itself, and yet the
signals going to the regulators may be false and sustainability may not be
attainable.
5.3 Barriers To Economic Growth & Development

• There are a number of barriers to economic growth and development which have
been identified over the years:
• Low productivity:
o It has been estimated that 1/3 of economic growth comes from population
increases and industrialization while 2/3s comes from productivity increases
o Productivity increases due to technological change in terms of capital and
human skills, encouraging research and development which can lead to
further growth.
• Problems with social legitimacy of the governments which can come from:
o A colonial past which organized the country to suit the colonial power but
which did not take into consideration the needs of the country
o Many LDCs have not had enough time to adapt to modern concepts such as
science, individualism, economic mobility, and the work ethic.
o Political instability within the country due to tribal, ethnic or religious
differences
o Large minority groups which perform essential functions but tend to dominate
financial and investment sectors of the economy:
These groups offer expertise in commerce, finance and trade.
• Political dependency has been replaced by economic dependency:

o Technological transfer is controlled by TNCs and trade and finance are
dominated by MDCs.
o Many LDC natural resource endowments require western capital and
knowledge to exploit them.
• Problems with trade: the terms of trade have moved steadily against the LDCs
because they export mainly raw materials with little value added.
o LDCs have little scope to develop new products or techniques of production,
the expertise in the MDCs is overwhelming: most R&D is concentrated in
MDCs.

o Most technology is labour saving which may not be of great use in countries
which have a large labour force looking for employment.
o Where LDCs try to add value to raw materials they are faced with high tariff
barriers in the MDCs which are trying to preserve jobs.
• Population:
o Populations are much larger, population densities greater, and education
levels lower than they were for MDCs during their period of industrialization.
o This has acted to reduce per capita incomes as populations grew rapidly with
better health care and more nutrition
o This problem is declining in importance with the reduction in birth rates in
most countries.
• Financial institutions
o Domestic banking systems which are corrupt and do not mobilize savings
o Debt owed to international institutions such as the IMF and the WB as well as
commercial banks: so much money flows out to repay the debt that very little
is left over for investment in infrastructure, education and health care.
• Poverty: many countries or regions within countries are caught in the poverty
cycle where income is low because of low productivity but leads to a lack of
savings which means that very little investment is taking place which is essential
if productivity and incomes are to be raised.
• The rise in income in LDCs has led to increased consumption particularly of

income elastic industrial products while the demand for income inelastic
agricultural goods grew less quickly.
• This led to a rapid rural-urban shift which often destroyed traditional values:
o Many rural communities have lost population to the point where they are no
longer economically viable
o Overuse of urban facilities has led to squalor, disease and crime which have
all prolonged the poverty of large numbers of people in LDCs.
• Environmental sustainability: most of the worst environmental disasters take

place in LDCs due to:
o The cutting down of forests to provide firewood for cooking
o Desertification due to pasturing of sheep and goats in ever increasing
numbers
o Pollution due to a lack of concern for safety or health in factories
5.3.1 Poverty Cycle

Poverty
• Absolute poverty is defined as the inability to meet basic physical needs of food,
clothing and shelter in order to survive. Because this is so hard to measure
accurately, many researchers simply estimate that 20% of the world’s population
falls below this line.
• The WB looks at two measures:
o US$1 per day as the lowest limit and estimates that 1.3 billion people fall
below this line
o US$2 per day as the limit in which case that estimate rises to 2.9 billion
people falling below the absolute poverty line
o It is important to understand that these measures are not strictly comparable
as these amounts of money buy different amounts of goods and services in
different countries
• The UNDP reports that most poor people live in 10 countries, with the
proportions falling below the poverty line in brackets: Bangladesh (80%),
Ethiopia (60%), Vietnam (55%), Philippines (54%), Brazil (49%), India (40%),
Nigeria (40%), Pakistan (29%), Indonesia (24%) and China (10%).
• A characteristic of most LDCs is the unequal distribution of income.
o What is interesting is the middle income LDCs appear to have greater income
inequality than very poor or high income countries.
o Income inequality tends to be greatest in Latin American countries.
Rural Poverty
• Most poor people are found in rural areas. Farmers with small holdings, landless
peasants, artisans, fishermen, nomads and indigenous people. The poor are not
idle, they work hard.
• Those with a traditional way of life are not necessarily poor. For thousands of
years they adequately sustained themselves. It is only recently that they have
become poor due to policies which have deprived them of the means of earning a
living (land, fisheries, hunting ranges, forests).
• Poverty in city slums is highly correlated with poverty in the countryside and is
linked through migration.
• Women are often the poorest of the poor. Men control most of the land, capital
and technology, and receive a better education in most countries. This can have
a major impact on population control.
• Investments in infrastructure, social services, and technology in rural areas can
go a long way to helping these people.
Poverty Cycle
• This concept is based on the idea of inadequate savings:
o Low savings mean low investment
o Low investment means low productivity and thus low income
o Low income means low savings and the cycle of poverty is perpetuated
• This is one of the motivations for Aid programs: by plugging the savings gap it is
hoped that productivity and incomes can be increased to the point where
countries and regions can break out of the poverty cycle and growth can start to
be self-generating.
Kerala State in India

This is a region with low income and yet a reasonably high standard of living
because of the emphasis on human development:
• The society is very international in its approach, and is not afraid of new ideas
and methods of doing things.
• Women have a high status in the society due to the matrilineal system of passing
property from mother to daughter rather than from father to son.
• With greater wealth and income in the hands of women, the child mortality rate
is low, and spending on health, nutrition and education for children has been
very high: the illiteracy rate is very low.
• There is a strong interest in community economic development and the
institutions which promote community welfare such as cooperatives and
community associations.
• The result is strong representation for labour in the workplace, excellent health
standards and low prices on food which result in very little malnutrition.
Reducing Poverty
• The trickle down theory is associated with the concept that inequity is inevitably
a part of economic growth, but after a period of rapid growth, greater equity and
poverty reduction will occur.
o Studies have shown that income distribution does appear to worsen at first.
o However, the evidence indicates that rapid growth does not appear to have
eradicated poverty which is surely the aim of growth in the first place.
o Furthermore, as income rises for the few who are lucky, their consumption
pattern tends to dominate the location on the production possibility curve,
more luxury goods rather than necessities are produced.
• The elite may not contribute that much to growth.

o They often import luxury goods rather than invest domestically. This is very
different from the historical pattern for the MDCs
o Often there is capital flight: elites may invest in overseas bank accounts,
property or investment opportunities.
5.3.2 Institutional and Political Factors

Economic Freedom
• According to the Economic Freedom of the World: 2004 Annual Report the
degree of economic freedom can be measured in five areas:
o Size of government
o Legal structure and protection of property rights
o Access to sound money (low inflation)
o Access to international exchange
o The degree of regulation in the country.
• A number of conclusions can be drawn when the data is collected and studied
across many countries. In countries with more economic freedom:
o Per capita incomes are substantially higher
o Economic growth rates are significantly higher
o Life expectancy rates are 20 years longer than for countries with the least
amount of economic freedom
o Income earned by the poorest 10% in the country is much greater
o Adult literacy is much higher
o Infant mortality is substantially lower
o The incidence of child labour is virtually insignificant
o Access to clean drinking water is substantially greater
o The HDI is much higher
o The opportunities for corruption are substantially lower
o The size of the shadow or parallel economy is significantly lower

5.3.2.1 Ineffective Taxation Structure
• Taxation is often a difficult problem in LDCs:
• In many countries very little tax revenue is collected and government is forced to
raise revenue by printing money or imposing export tariffs which inevitably
reduces the incomes of rural people because most LDCs export raw materials and
agricultural products.
• A proper income tax system can provide the revenue for government and reduce
inequality by making the wealthy pay a fair share for running the country.
• Greater tax revenue also allows the government to provide basic infrastructure
for the poor such as better health care, better schools, provision of clean water,
sanitation, and electricity and more reliable road systems.
5.3.2.2 Lack of Property Rights

• Property ownership, property rights and land tenure are all critical issues when it
comes to fostering growth in an economy.
• Hernando de Soto, a Peruvian economist, is a strong advocate of converting de
facto rights into de jure rights.
o This means that poor people gain the right to use or dispose of the property
on which they live.
o This also means that entrepreneurs can provide collateral in order to obtain
loans from financial institutions.
De facto owners of property cannot participate in the formal economy
Hernando de Soto estimates the value of the “locked up” property at close
to $9 trillion which is a huge sum compared to the amounts sent to LDCs
in the form of loans and aid programs.
5.3.2.3 Political Instability

• Section 5.1.4 above discusses the important role that government can take in
fostering and enhancing economic growth. None of the policies outlined in that
section would be possible without political stability.
o It is not just the building of infrastructure but the rules and regulations which
facilitate the growth of the economy.
o Good governance includes the rule of law and the establishment of clearly
delineated property rights.
Without these, disputes cannot be settled quickly and effectively
Small entrepreneurs cannot provide the collateral needed to obtain a loan
• There is a strong correlation between political instability and wars.

o Armed conflict immediately slows economic growth as money is wasted on
military hardware instead of building infrastructure
o The correlation between the spread of HIV and armed conflict is well
established
o Costa Rica is a perfect example of a country which shut down its military and
spent the money on health care and education instead.
The comparison with Guatemala a close neighbour which has been
involved in armed conflict for many years is quite striking.
• Political instability is very damaging for investment:

o Internally: project evaluations have to include a political risk factor which
artificially increases the required ROI for an investment to be attractive.

Most citizens who have money to invest will often invest in other
countries, called capital flight, and it may take years to restore enough
confidence for them to bring their money home.
o Externally: potential foreign investors are simply not interested in investing

unless they can reach break even very quickly: the point where they pay off
their initial investment quickly.
This means they are simply interested in making money and getting out
before the political situation deteriorates
They will not invest locally in people or physical facilities or technology
transfer which are so vital to the long term growth of the country.
Despite the media fanfare, most FDI today occurs between MDCs and not
between MDCs and LDCs.
• The result is low investment both internally and from external private sources.
o This results in lower productivity growth and slower growth
o The lower tax base and the spending on military means less investment in
infrastructure including education and healthcare
o Often countries will go deeply into debt to pay for the weapons to engage in
armed conflict which reduces the capacity to borrow in the future
o Poverty and political instability persist and economic development is delayed.
5.3.2.4 Corruption
• As noted in Section 5.3.2 above, the greater the economic freedom in a country
the lower the level of corruption.
o Economic freedom means fewer regulations, taxes and tariffs. Thus there are
fewer opportunities for corruption on the part of public officials.
• Corruption in LDCs is thought to arise from a conflict between traditional values

and the imported culture that comes with economic growth.
o Most often it involves the misuse of a public office and government authority
in order to obtain personal gain.
• Corruption does not have to involve money, but it often does as it is usually
market driven: how much is this favour worth to the recipient?
• It can involve bribery to obtain foreign exchange, licenses for exports or imports
or both, licenses to invest in a country, production licenses and tax avoidance.
• Corruption distorts economic signals:
o Inefficient firms can remain in business
o Governments can pursue policies which may be damaging to the environment
or the economy
o Small entrepreneurs who cannot engage in the political game become
discouraged
o Economic growth slows down.
• Typically the more state regulations and the slower the system for obtaining
justice through the courts or through bureaucratic systems, the greater the
potential for corruption.
• Political corruption can also include the non-economic aspects in society such as
vote-rigging, the purchase of votes, and the distorting of election results.

5.3.2.5 Unequal Distribution of Income
• Many theories of economic growth, such as the trickle down theory, have
suggested that income disparities increase in the early stages of development
and improve as the effects of growth “trickle down” to the rest of the population.
o Known as the Kuznets effect, the idea is that as people migrate from rural
areas where income disparity is lower to urban areas where it is higher,
income distribution becomes significantly less equal
o The problem is that it may take 60 years for the poorer groups in urban areas
to catch up with other income groups which have benefited more directly
from economic growth.
• Other theories which have found that increasing productivity through greater
economic development is significantly more important than simply increasing
capital investment, have suggested that an unequal distribution of income can
actually slow down economic growth.
o Research on the available data do indicate that unless economic development
takes place first and the income disparity gap is closed, economic growth is
much slower and the subsequent closing of the income disparity gap takes
much longer.
• One of the problems with measuring income distribution is the lack of good data.
o Often studies are done on small sectors or representatives groups or selected
regions of a country.
o There are very few studies in LDCs which actually measure the income
distribution for the whole population.
o In many cases the Gini coefficient is lower for rural rather than urban
households and yet most of the studies are done using urban data because it
is easier to collect.
o Furthermore, the data are not adjusted for PPP, nor are all sources of income
included in the survey.
The WB has found that this factor alone overstates the Gini coefficient by
as much as 15% for many LDCs because of home production systems.
• Economic freedom studies discussed in Section 5.3.2 above indicate that the
share of income earned by the poorest 10% of the population is unrelated to the
degree of economic freedom in a nation.
o As economic growth rates are positively correlated with economic freedom,
this research indicates that there is no correlation between economic growth
and the income of the lowest 10% of income earners.
5.3.2.6 Formal and Informal Markets

• Those businesses that obtain licenses and declare their income to the
government are considered to be part of the formal economy.
• Businesses that do not obtain a business license and do not declare their income
are considered to be part of the shadow, parallel or informal market.
o Informal businesses are usually small and often home-based
o They tend to be labour intense and utilize simple technology and limited
capital equipment
o They are not subject to government regulation and can lead to serious health,
safety and environmental problems

• The following are considered critical factors leading to the development of
shadow, parallel or informal markets:
o If the opportunity cost for starting a business is high:
The number of procedures required to start a business is excessive
The number of days which elapse before a business can be started is too
long
o Labour market flexibility
The ability to hire workers part time and on limited period contracts
The number of regulations related to minimum conditions of employment
The ability to hire and fire workers easily
o Contracts between firms
The number of procedures required to write contracts
The length of time involved in the procedures required to enforce a
contract including the length of time required to process a contractual
claim through the courts
o Closing a business
The length of time and the involvement of the courts in the insolvency
process.
• As would be expected from the economic freedom study outlined in Section 5.3.2
above, the more the regulations, the more the time involved, and the more
roadblocks thrown up, the greater the size of the informal market.
5.3.2.7 Lack of Infrastructure

• Expenditures on infrastructure are the foundation for achieving many of the
Millennium Development Goals
o 1.2 billion people lack access to safe water today
o 2.4 billion lack access to adequate sanitation
o 2.5 billion lack access to energy supplies
o 900 million people in rural areas today live without any reliable roads to
enable them to access markets, jobs, services
o In Sub-Saharan Africa, less than 8 percent of the population are connected to
a power grid: 92 percent of Africa is in darkness.
o 20 percent of diseases can be attributed to environmental factors associated
with the lack of infrastructure services: waterborne diseases, malaria, indoor
air pollution
o By 2025 most cities in LDCs will have doubled in size and yet the current
infrastructure is not adequate to service existing populations.
• The disappointing results of Aid programs and the poor performance of most LDC
governments have emphasized the following need for change:
o It is the private sector that will have to build the infrastructure which will
mean
Providing a good investment climate to ensure there is no fear of
nationalization
Building a good regulatory climate to regulate the monopolies which will
result
o Infrastructure services must be targeted towards the poor
Roads, water, sewage, electricity and health care have all been identified
by the poorest groups in LDCs as being in critical shortage

o The WB has developed a large number of infrastructure projects which have a
success rate of close to 85% mainly because they have involved the private
sector.
The success rate falls for infrastructure which is more of a public good
such as roads and water supply.
Much of the success is also related to government reform and a better
division of the risk in public-private financing schemes.
5.3.3 International Trade Barriers

5.3.3.1 Overdependence on Primary products
• Low income elasticity of demand for primary goods, the substitution of synthetic
materials and the dramatic reduction in the weight and bulk of manufactured
goods have all led to virtually no growth in demand.
• World demand: tends to be inelastic: there are no substitutes for primary goods:
• World supply: intense competition amongst LDCs lowers price and total revenue.
• Devaluation of the currency can actually lead to lower export revenue:
o If demand for exports is inelastic, when price falls as the value of the
currency falls, there is very little increase in quantity demanded with the
result that export revenue actually falls (see Marshall-Lerner conditions in
section 4.7.H.1).
.
• In farming: supply shocks due to weather and disease combined with inelastic
demand means farm revenues are very unstable.
• Attempts to form cartels have met with opposition from MDCs:
o Cartels that do survive are weak due to cheating amongst members
o Non-members increase supply and reap the benefits of the higher prices.
• Alternatives to cartels are buffer stock management:

o When demand falls: the manager provides a price floor, buying and storing
the excess supply.
o When demand rises: the manager sells from storage and uses the profit to
pay back the costs of the buffer stocks.
o The costs of storage and the interest on the loans to carry the inventory are
very expensive.
• Supply price elasticity problems:

o In mining: shifts in demand for minerals due to MDC economic cycles
combined with inelastic supply means mineral revenues are very unstable.
• Trade protection: MDCs have increased trade protection and subsidies to their
own farmers, effectively blocking imports of food from LDCs.
• Worsening terms of trade: prices of primary goods has fallen relative to the price
of manufactured goods and services, lowering the gains from trade for the
poorest countries which do not have the means to produce anything but raw
materials.
5.3.3.2 Consequences of Adverse Terms of Trade

• Foreign enclave: with wealth and income concentrated in the hands of the rich,
most imports could be luxury goods

• Countries are assumed to be on their production possibility frontier when in fact
most LDCs experience high unemployment and underemployment.
o Technology transfer may be pointless if it is labour saving in countries with
high unemployment rates. What is needed is appropriate technology.
• Risk of permanently slower growth: specialization may lock the LDCs into low
skilled, labour intense production while MDCs benefit from high tech production.
• Prices may not reflect opportunity cost but simply manipulation by government
and firms.
o Taxes, subsidies and the lack of recognition of true social costs (pollution for
example) can lead to serious price distortions.
• Barriers to trade: LDCs may find that MDCs have already achieved economies of
scale, and protect their home industries through export subsidies or import tariffs
and quotas thus effectively blocking imports from LDCs.
o Many LDCs have turned to other LDCs for trade opportunities.
• Displacement of local production by TNCs: in many LDCs the production of cheap

plastic sandals can put shoe makers out of work, backward linkages to suppliers
of leather, fabric, glues, polish and packaging materials lead to even more people
being put out of work.
• Gains from trade will benefit foreign owned plants and factories and the profits
repatriated to home countries.
• High income elasticity for manufactured goods and services means that imports
rise with incomes.
• Price elasticity of demand for capital goods tends to be low because there are
few substitutes.
• Devaluation of the currency can actually lead to a larger import bill.
5.3.3.3 Consequences of a Narrow Range of Exports

• It is important to remember that half the LDCs in the world have a population of
less than 10 million people. As a result it is hard for them to produce a wide
range and variety of goods and services.
• Exporting a narrow range of goods and services results in:
o Greater dependence on importing nations to provide the “hard” currency
needed for development. Some of these nations may decide to impose import
barriers to protect domestic industries which cannot compete
A good example is the cotton industry which is heavily subsidized by the
USA
o It makes the country vulnerable to monopsony power
A good example is the power of coffee shops such as Starbucks to impose
a low price when purchasing coffee
o It also makes the country vulnerable to obsolescence if a new product
becomes available or a competing tourist facility is opened
A good example is Costa Rica which invested heavily in alternative tourism
only to be faced with enormous competition from other LDCs doing the
same
o It means that when prices of natural resources are rising rapidly due to rapid
international economic growth, the country does very well. However, this is
matched by equally depressed prices during years when international
economic growth is sluggish.

5.3.3.4 Protectionism in International Trade
• This is best covered in Section 4.2.2 in the Grand Tour section of the notes.
• Under the World Trade Organization (WTO), tariffs and non-tariff barriers have
been reduced steadily amongst countries to the point where they represent less
than the shipping costs and are not a formidable barrier to trade.
• Unfortunately MDCs have introduced protectionism in other forms to stop the
“flood” of imports from LDCs.
o The most damaging are the huge subsidies given to both US and EU food
producers which make it impossible for LDCs to export to those regions
without special concessions.
o There are a number of “health” issues which MDCs use to prevent imports of
goods which would damage the demand for domestically produced goods
o And the most distasteful has been the erection of trade barriers to goods
produced with “child” labour in LDCs.
The hypocritical nature of these barriers is evident given new studies
showing the extensive use of “child” labour in US agriculture and other
industries.
5.3.4 International Financial Barriers

5.3.4.1 Indebtedness
Economic development has been promoted since 1960 as the best route for LDCs to
follow, justifying borrowing from banks to spend on projects:
• The risky nature of lending to LDCs requires: higher interest rates, much more
expensive than the rate charged by the World Bank or aid agencies
• Stock of debt: the ratio of debts to exports has averaged 125% to 150%.
• Debt servicing flow: includes interest payments and repayments of principal, and
often exceeds 40% of exports for certain poorer LDCs.
Rescheduling & Restructuring

• LDCs were unable to service their debts and were forced to reschedule
• Loans were renegotiated with lenders, extending the terms of repayment.
• LDC govts have been forced to make major structural reforms under instruction
from the IMF in order to qualify for rescheduling
• LDCs which are able to lower their debt servicing experience some benefits:
o Lower inflation which stabilizes the exchange rate and creates enough
confidence that the elite repatriate money lost through capital flight.
o Domestic interest rates fall leading to greater domestic investment and an
improvement in the economy.
• Restructuring simply extends the length of the repayment problem, it does not
eliminate the debt:
o LDCs simply lack the exports needed to earn the foreign exchange required to
service the debt.
o The only hope of getting out of debt is for MDC economies to expand rapidly
leading to major increases in imports from LDCs.
o Most of the debtor nations are faced with years of economic deprivation in
order to meet their debt obligations,
o Domestic policies that lead to overvalued currencies encourage imports and
discourage exports creating strong pressures to seek more loans to support
the country until the next crisis
o If the money had been invested in projects which earned a rate of return
which could have paid the interest plus repaid the principal, there would have
been few problems.
Structural Adjustment Programs

• When there is a financial crisis which will lead to instability in a country’s
currency, it may appeal to the IMF for funding. Loans are made available subject
to certain conditions. It is these conditions which are referred to as a structural
adjustment program for the country.
• It is important to remember that the IMF was created in 1945 at the same time
as the WB but with a very different mandate.
o The WB was created to assist with economic growth and eventually became
more involved in economic development
o The IMF was created to maintain stability in the international payments
system, specifically to lend money to countries experiencing balance of
payments problems which could result in destabilizing devaluations of the
currency.
• The IMF’s main aim is to get it’s money back again:

o It is not interested in helping a country to grow economically
o It wants to ensure that the country experiencing difficulties will not slide back
into the same situation again
o It wants to ensure that the country repays its debt so that money is available
to help the next country experiencing balance of payments difficulties.
• For this reason the IMF imposes SAP conditions on a country. While the list of
conditions is different for each country, they fall into several general categories:
o Cutting government expenditures
This is done to ensure the government no longer runs a deficit budget and
it can use any surplus to repay the loan
Typically it is the economic development programs such as education and
health that get cut first
Often a requirement is that the government must run a balanced budget
Monetary policy is to be tightened, many LDCs with poor systems of
taxation try to pay for things by borrowing from the Central Bank which
leads to inflation. The problem is that this causes interest rates to rise
which can create a recession.
o Export promotion
As most of the countries are LDCs the focus tends to be on the extraction
of natural resources for export to provide the revenue needed to repay the
loan
All export and import tariffs and restrictions are to be removed
o Devaluation of the currency against the US$

As we will see later, if the elasticities of demand for imports and exports
are inelastic, which they are for many LDCs, devaluation will actually cause
the balance of payments problem to deteriorate even further
o Opening of domestic financial and investment markets to foreign direct and

portfolio investment

Promotion of foreign investment is believed to lead to greater economic
growth and the earning of more foreign exchange all of which will
enhance the ability of the country to repay the loan
The rights of foreign investors are to be strengthened, in many cases
stronger than for domestic investors: this has implications in terms of
preventing nationalization in the future or the creation of laws such as for
preserving the environment which may be potentially damaging to a
foreign investor.
o Government intervention into the market must be reduced:

Typically this involves the removal of subsidies and price controls
Usually it involves the privatization of nationalized industries
Supply side policies are promoted to increase output and investment
• Because of the negative effects of the SAP programs, the IMF now requires
countries to develop Poverty Reduction Strategy Papers which are like self-
imposed SAP programs.
Causes of the Debt Crisis

In 1973 and 1979 OPEC increased the price of oil dramatically:
• Oil rich countries looked for the highest rate of return on investments
• The international banking community started lending this money to LDCs,
o While the nominal interest rates charged were high, once inflation had been
taken into account, the real interest rates were very low leading to an
explosion in LDC borrowing.
o Those LDCs which did not have oil, were now faced with vastly higher costs
for fuel, input costs rose dramatically hurting exports.
• Since 1935 most industrialized countries have been off the gold standard.
• Governments started inflating in the early 1960s until 1976 when inflation rates
reached high levels in the MDCs:
o Loanable funds were available at low interest rates to lend around the world.
o LDCs were accustomed to ‘soft’ loans from international agencies such as the
World Bank which lent at low rates of interest.
Commercial banks charged full market rates on ‘hard’ loans
• By 1979 most OECD countries decided to stop inflating:

o Interest rates rose dramatically, particularly for short term loans
o More than 50% of LDC debt is short term in nature, the interest rates being
charged to LDCs reached crisis proportion,
o With the shortage of money, oil rich countries started taking their cash out of
the bank to be used in their own countries,
o No more loans were available for anyone including LDCs.
o As incomes in MDCs fell so did imports from LDCs worsening their balance of
payments difficulties.
o Elite groups in LDCs panicked and there was capital flight:
It is estimated that 30% of all borrowed funds, usually in a hard currency,
ended up in bank accounts outside the borrowing country.
• Poor project evaluation:

o MDC banks were only interested in securing loans through government
guarantees, there was little checking of the projects the money was to be
used for.
o Much of the borrowed money had been wasted on military arms or projects
which did not have any hope of paying interest on the debt or ever repaying
the principal.
o Many LDCs printed money to cover the deficits which led to extremely high
rates of inflation in some countries.
5.3.4.2 Non-Convertible Currencies

• There are several “hard” currencies in the world, the most important for most
people are the US$ and the EU€ and these are most often acceptable in trade.
• There are a number of tradable hard currencies such as the Japanese¥, but most
people do not wish to hold them but they will trade in them as they hold their
value
• Currencies for most LDCs are considered “soft”
o People prefer to trade for products and services from those countries in a
hard currency such as the US$ which means that prices have to be quoted in
US$
o Soft currencies cannot be relied on to hold their value which is why people do
not want to be left holding them after trading
o In many countries there is a significant discount from official exchange rates
when soft currencies are converted into hard currencies
o Many wealthy families in LDCs hold hard currency accounts either
Inside their country if there is no fear of the money being seized
Outside the country (capital flight) if there is fear of financial assets being
seized.
5.3.4.3 Capital Flight

• In a sense “good governance” is the foundation which will enable domestic
investors to develop trust in the economy and the way the government regulates
activity.
• If domestic investors feel that their property will be nationalized or that controls
will be put on the movement of their money, they will simply take their money
out of the country and invest in another, more stable country.
5.3.5 Social & Cultural Factors acting as Barriers

• This refers to a set of values, traditions, and beliefs which make up a social
structure.
o It is what motivates people and determines how they will behave toward each
other and toward those who are not part of the social structure.
• Some of these social and cultural factors can act as barriers to integration into
the world economy and faster economic growth:
o Many traditional societies place great emphasis on the collective good
whereas western society places greater emphasis on the individual and
private property
o The way women are treated in western societies causes many problems in
some cultures

o The approach to finance and charging interest on loans can also be a source
of conflict
o The appointment of civil servants on the basis of merit rather than family
connections can create clashes between western and traditional cultures.
o In many LDCs the structural adjustment programs are viewed as the
imposition of a western business culture which has foreign values to the
culture espoused by traditional culture.
• Social cohesion refers to the ability of a society to work together to promote the
common good including developing greater cooperation and trust amongst its
members.
• For social cohesion to be effective it depends on social capital
o This is the system or network of social values and trust that enables
individuals to work together and includes:
Organizations, usually businesses, to produce what is required by
members of society
Institutions which can provide public benefits from economic activity
through banking, regulation of monopoly, and political parties
The development of dispute resolution mechanisms such as courts
o Members of society who are excluded will not have full access to certain
economic activities including education
This has certainly been the case for women in certain societies such as
India where the illiteracy rate amonst women is substantially higher than
for men.
Exclusion means that these individuals cannot contribute productivity to
economic growth which can hamper the rate of development.
Another group are those who have been marginalized to the point where
they live in the informal economy and participate only sporadically in the
formal economy.
• “Civil society”, a very popular expression today, is an attempt to focus attention

on social cohesion and social capital and indicate how critical social factors can
act as a barrier to economic growth and development.
Population: Policy Options

• Perhaps one of the most contentious areas has been the whole issue of
population control
o The natural increase in population is the birth rate minus the death rate.
o The pre-industrial era was characterized by high birth and high death rates
leading to a slow growing population.
• Birth rates in the LDCs are much higher than they were in the MDCs during the
comparable period of development: a larger proportion of women marry and they
do so at a younger age.
• For many developing countries the birth rate remains high while the death rate
falls. Studies suggest that developing countries today are moving through this
phase more rapidly than the MDCs
• Eventually the birth rate also declines, until low birth and death rates lead to low
and stable population growth again.
o For MDCs population growth rate is 0.5% (below the replacement rate) and
for LDCs it is 2% (the replacement rate is 2.1% per year).
o Studies indicate that more even income distribution contributes to a more
rapid fall in the birth rate.
o In LDCs with high poverty levels, birth rates have remained much higher than
for MDCs: there is a correlation between high birth rates and low GDP per
capita.
• Death rates: as countries develop the death rate drops very quickly due to:
o Sanitation: there is a reduction in infant mortality due to better sanitation,
cleaner water and basic health knowledge,
o Health care: there is a reduction in mortality from disease because of better
health care systems
o Agricultural production: as food production increases deaths resulting directly
or indirectly from malnutrition fall
• Survival rate: as the survival rate for children increases there is a rapid increase
in children as a proportion of the population, savings and investment rates fall:
o This increases dependency rates within families, per capita income falls as
unproductive children are housed and fed,
o Children under 15 form 25% of MDC population and 50% of the LDC
population which leads to a high dependency ratio of non-workers to workers.
Because of the young population, fertility rates are very high
Even though birth rates may have fallen, the large numbers of fertile
women inevitably leads to a second round of population increase
This is particularly so with economic development as healthier, better fed
women have a greater capacity to give birth to a healthy child.
• Although population control policies have been very popular in the last 25 years,
they are no longer a pressing issue:
o After the last ice age, 13,000 years ago, the world population was estimated
to have been 100 million.
o By 1790 this had increased to 1.7 billion, and current estimates place world
population at 6 billion.
o The latest findings show a very rapid decrease in population growth rates to
the point where it is now expected that population will stabilize at about 8
billion by 2050, much lower than the original estimates of 12 billion by the
year 2100.
Optimal Population
Optimal Population Levels
100
•
Per Capita Income
Sub-optimal levels: there is not enough labour to

80
utilize the available resources to the maximum
60
potential,
40
• Above optimal levels: diminishing returns set in 20
as there is too much labour. 0
• However, natural resource discoveries and P*
increases in productivity: will increase the Population
optimal population level.
• Preference for additional children depends on the number of surviving children

and the costs and benefits of those extra children.
o Costs are dependent on feeding, clothing and education, plus the opportunity
cost of the mother’s time.

o Benefits include the need for children to help with the farm or small family
business, the security in old age, and particularly during periods of prolonged
sickness.
• Slower population growth: can be achieved through family planning by women:

o Social security: if there are pensions and support during illness, there is less
need for a large family,
o Effective birth control: whether through chemical or mechanical means or
through birth spacing through extended breast feeding,
o Higher female employment and greater schooling for both men and women
leads to lower fertility rates.
Meaningful work for women: women have an alternative way of achieving
fulfillment in addition to having children
• Financial costs of having children:

o There are reduced opportunities for children to earn income in urban settings
due to enforced schooling and fewer less skilled jobs, plus the opportunity
costs of the parent's time rises
o Higher incomes encourage fewer children with more invested in each child.
o Mass sterilization: created much hatred and severe backlash.
• Slower population growth is better:

o Savings rates rise: families save more and governments spend less on social
services,
o People invest more in human capital: it is more worthwhile if there are fewer
children and they are likely to live longer,
o There is more investment in infrastructure,
o There is less deforestation and erosion of soil
5.3.5.1 Religion
• Family and religious beliefs are some of the strongest motivators in life for most
people as noted in Section 5.3.5 above.
o Religious values can cause resistance to changes which are necessary to the
mobilization of resources for growth
o Alternatively religious beliefs can accelerate the growth process
During the Reformation in the Christian church it became a value to earn
money and promote trade and commerce.
The resulting rapid increase in economic growth has led to the European
and North American economies of today.
• Religion can also lead to the exclusion of certain groups in society

o Certain minority groups such as the Jews of Europe, the Indians in African
countries and the Chinese in Southeast Asia have all contributed greatly to
growth and development in those regions even though they are often treated
poorly
o For example Jews were not permitted to own land in Europe as it was
considered the primary source of wealth.
At the same time Jews were allowed to charge interest on loans which
was forbidden to Christians.
As a result Jewish families became the center of finance and were
instrumental in the formation of banks and the mobilization of savings for
investment in Europe.
o Radical religious exclusion can lead to the types of wars we have seen in the
former Yugoslavia, the Middle East and the Sudan
5.3.5.2 Culture
• In a similar way to religion, culture has a major impact on the “accepted” way in
which societies operate: this is outlined in Section 5.3.5 above.
• While heavily influenced by religion, culture refers more to the way in which
people learn to cooperate together and learn to trust each other.
o One of the best examples is the way in which financial districts operate: huge
amounts of trust are required as millions of dollars worth of securities are
bought and sold on the word of dealers and clients
o Honesty in dealings is fundamental to social cohesion, without it people and
businesses would spend all their time in court fighting for fair trade and
justice.
o Section 5.3.2.4 above discusses corruption and the important link between
the difficulty of executing transactions
The more procedures required and the more time required to follow
procedures, the greater the temptation to cheat
At the same time, a framework of laws and systems which recognize
property rights are essential to the efficient functioning of the market
system.
• Thus there is a dynamic tension at all times between the freedom to operate and
the need for regulation and procedures to ensure justice takes place in the
functioning of the economic system.
o See Section 5.3.2.2 for a discussion of property rights
o See Section 5.3.2 for a discussion about economic freedom.
5.3.5.3 Tradition
• Typically associated with agriculture, fisheries and primitive forestry, this sector
uses traditional methods for harvesting natural resources.
• Often there is common land ownership which can lead to common property
problems which impose externalities on society.
o However, the density of population is often low enough that environmental
damage is minimal.
o Dualism can result if modern commercial farms, fisheries companies and
forestry companies exists side by side the traditional, community based
system.
• Traditional sectors can also exist in urban environments in another type of dual
economy which means that traditional manufacturing, such as food preparation
and clothes tailoring, exist alongside modern manufacturing facilities.
o Many economists label these activities as being part of the informal economy.
5.3.5.4 Gender Issues

• One of the major Millennium Development Goals is greater equality for women
o This has been a very contentious issue in many countries as religious leaders
have expressed deep reservations about allowing the role of women to
change.
o Studies by the UN have indicated that:
Women work 65% of the labour hours
Women do 75% of the farming in the world, most of it by hand
Women receive only 10% of the total wages
Women own less than 1% of the world’s property
65% of women over the age of 25 have never been to school
More than 50% of women are malnourished
• At International Conferences on women’s issues, it has been very difficult for

women from western nations to understand why women from LDCs are often
reluctant to embrace greater equality and freedom
o There is tension between the desire to retain traditional relationships which
foster families and community
Many nations, cultures and religions do not want to embrace the western
way of life which they see as damaging to families and community
relationships.
o At the same time the evidence is overwhelming that if women are educated
to the same level as men and encouraged to participate through careers and
work: the birth rate drops, and economic growth and development can take
place.
5.4: Growth & Development Strategies

5.4.1 Harrod-Domar Growth Model
Industrialization
• If we call real output Y, and the stock of capital K, then output can be related to
the capital stock:
K
Y=
k
where
k = the capital output ratio (the amount of capital required to produce a
unit of output), and is simply a measure of the productivity of capital.
• Growth, g, is simply the rate of change in Y and is related to the investment in

the capital stock K, where investment measures the rate of change in K.
• If we designate S/Y as the percent saving rate in the nation and call it s, then:
s
g =
k
• Capital created by investment is one of the main determinants of growth and it is
savings by people and corporations that pays for that investment.
• Given the formula, planners can decide on the rate of growth, g, and the
equation tells them the savings and investment necessary to achieve that growth
level.
o Alternatively, planners can decide on the rate of savings and investment that
is feasible, and the equation tells them the rate of growth that can be
achieved.
• Often referred to as the savings gap, the ‘s’ tells planners how much they need
to borrow internationally after deducting what the nation saves domestically.

o Poor countries with low savings rates and unemployed labour can achieve
higher growth rates by economizing on capital and utilizing as much labour as
possible.
• As economies grow and per capita income rises:

o Savings rates tend to increase and the labour surplus diminishes.
o Savings become relatively more abundant and hence the price of capital falls
while employment and wages rise.
o As wage rates rise, producers increasingly economize on labour and use more
capital.
• Technological change and learning by doing can play important roles. Both can
contribute to increased productivity of all factors of production.
• Richer nations like the US, Japan and Norway tend to have higher capital output
ratios because capital is less expensive relative to labour than in LDCs.
Growth Through Industrialization

• Manufacturing has been growing faster than GDP in most LDCs, but can only
absorb 30% of the growing workforce.
• In the early stages of development, manufacturing growth often occurs through
backward integration from consumer to producer goods.
• Primary sector growth usually occurs through forward linkages rather than
backward linkages.
• Cities have grown rapidly because:
o There are agglomeration economies (face to face contact with bankers,
government decision makers, lawyers, marketing, and suppliers)
o There are external economies (railroads, ports, airports, communications
utilities, roads, water and sewage)
o Businesses prefer large cities, infrastructure costs can be 15% higher in
smaller cities
Benefits of Industrialization
• Industrialization allows economies of scale (EOS) to be reached in production:
o Exports: access to larger markets allows minimum efficient scale to be
reached more rapidly
o Research and development: costs are more spread out
o Heavy industries: economies of scale are important for steels and chemicals
o Cost savings: size confers concessions and discounts through bulk buying,
and lower interest rates when borrowing money.
o Some economists believe that EOS contribute only 10% to cost reductions.
• Industrialization leads to better firm management:

o In many industries this is more important than economies of scale
o Firms become more efficient through the introduction of: subcontracting
systems, re sequencing of production systems, and just in time delivery; while
the product life cycle can confer temporary monopoly profits.
o The introduction of flexible computer integrated manufacturing has made low
cost labour less important for assembly operations.
o Some economists believe that better management accounts for 50% of cost
reductions.

• Increased productivity enhances the possibilities for import substitution as well as
for export promotion
o Industrialization can ensure that inputs needed to enhance productivity in the
primary sector are available.
• Industrialization can enhance job creation:

o K/L ratios can be as low as 4 to 1 in textiles in LDCs which contrasts with 80
to 1 in MDCs, thus providing 20 times as much employment.
Limitations of Industrialization
• Studies indicate that increases in productivity or efficiency account for a much
higher proportion of growth than was believed to be the case.
o Between 50% and 70% of growth can be attributed to increases in factor
productivity, including mobilization and improvement in the quality of labour
• Industrialization which results from increases in the capital stock frequently
account for much less than half of the increase in output, particularly in rapidly
growing countries.
o This does not mean we can ignore capital investment: capital tends to play a
larger role in growth in today's developing countries.
o Many of the increases in efficiency or productivity involve advances in
technology that is embodied in capital equipment: you cannot have
productivity increases without the capital to work with.
Balanced Industrial Growth

• Balanced growth requires countries to develop a wide range of industries
simultaneously to achieve sustained growth: on the demand side to absorb the
output, on the supply side to prevent bottlenecks
• Balanced growth is very important for centrally planned economies, without price
adjustment, all sectors must be developed simultaneously:
o Information about shortages in one sector cannot be transmitted properly as
prices are not permitted to rise.
o Even if prices were permitted to rise and rates of return were to rise in those
industries in response, there are no entrepreneurs to respond to the profit
opportunities by investing to reduce the shortages
Unbalanced Industrial Growth

• Unbalanced growth typically occurs for a developing country which cannot start
up a wide range of industries simultaneously:
o Import substitution can be followed as a way to ensure a ready market for the
output of a domestic industry
o However, export promotion is likely to foster more rapid growth
Goods which are not available domestically can be imported
There is also access to larger markets which allows domestic firms to
achieve economies of scale more quickly
Through the import of technology and through higher volume output
because of exports to larger markets, workers learn by doing.
• The whole idea behind unbalanced growth is that the market responds to clearly
defined price signals:

o Where there are shortages, prices rise, entrepreneurs can earn super normal
profits until such time as entry into the industry reduces market prices
o Where there are surpluses, prices fall, firms lose money and there is exit from
the industry until market prices rise back to the point where firms earn a
normal profit.
Backward and Forward Linkages

• Shortages and surpluses within markets respond to market signals and the
potential to make super normal profits or lose money
• Shortages and surpluses within and between geographic regions in a country also
respond to market signals.
o In this way the benefits of development can be diffused to other regions of a
country from the leading region.
• Within the production process itself there are various stages:

o Prior to fabrication of the parts and assembly of the parts into a product there
are the following stages:
Research and development of the new idea
Engineering to make the new idea a reality and design to make the
product attractive.
o Then comes the actual fabrication of the parts and the assembly of the parts
into the product
o After the product is complete there are several subsequent stages:
There must be marketing to ensure the product can be sold
There must be physical distribution of the product to stores and
consumers
There must be a system of financing all the stages in the production
process.
• Typically when a new industry is created in response to market signals, it starts

with assembly of parts fabricated in a foreign country.
• Backward linkages can be created as follows:
o Fabrication: as the imported goods are repaired, domestic industries are set
up to supply the parts required rather than importing parts.
• Forward linkages are also created as follows:

o Adding value: rather than exporting raw materials, processing industries are
created to add value to the output, for example iron ore is smelted into steel,
o Once processing is viable, there are opportunities to invest in machinery,
metal processing and eventually car part fabrication and assembly plants.
• Both forward and backward linkages set up pressures that lead to the creation of
new industries, all operating through the profit driven investment process.
• Governments build the infrastructure necessary to service the expanding
industry: roads, railways, harbours, airports, electricity, water and sewage.
• Linkage pressures will eventually lead to balanced growth, provided:
o Free market pricing is permitted to allow the proper signalling to occur to
reflect enhanced profit opportunities,
o A stable banking system is instituted to allow the process of saving and
investing to proceed with low risk,

o An entrepreneurial sector is fostered through training to allow individuals to
respond to the profit signals by investing in areas of the economy where
shortages and profit opportunities are the greatest.
o Super-normal profits are permitted and not taxed away.
Stimulating Growth while Reducing Poverty

• Growth needs to be targeted at those sectors which will reduce poverty.
o Raising the income of the poor will lead to increased consumption of
necessities which are produced within the country.
o This stimulates investment, incomes and jobs and leads to improved health
and education which, in turn, increases productivity.
• Research and development should be directed toward appropriate technology
rather than to the transfer of labour saving technology from MDCs.
Price Distortions
• Prices are often distorted due to subsidies or a strong union sector which is able
to extract high wages from foreign multi-nationals.
o A return to market prices is essential so that correct signals can be sent to
allocate resources according to true scarcity: for example, lower wages would
lead to greater employment.
o Government subsidizes capital through tax breaks, grants and low foreign
exchange. This lowers the price of capital artificially and leads to substitution
of capital for labour.
5.4.2 Structural Change / Dual Sector Model

Agriculture & Rural Urban Migration
• It is estimated that in MDCs, 27% of the population lives in the rural sector with
possibly as much as 5% involved in agriculture.
• In LDCs the figure is 66% living in rural areas, with nearly 50% involved in
agriculture.
• Many of the most severe development problems arise from a weak agricultural
sector. Growth through the agriculture sector has not led to increases in per
capita income.
• On the demand side:
o The growth potential in the agricultural sector is limited because income
elasticity of demand for food is close to zero, growth is much more rapid for
industrial goods and services.
o Primary exports form the major source of foreign exchange earnings for
LDCs, and yet the proportion of primary sector goods in total world trade has
fallen from 33% in 1950 to 21% in 1995.
• On the supply side productivity in agriculture is very low:

o Increased use of machinery and new methods of raising crops have made it
possible for an individual farmer in the US to produce enough food to feed 50
families.
o Farmers in LDCs are hard pressed to support one other family beside their
own.
o Severe droughts and famines occur on a regular basis.

o The oil crisis led to a large increase in energy costs raising the cost of food,
while poor people in urban areas spending 80% of their incomes on food
could not afford a 100% increase in price.
o Government often imposes price controls which help the urban poor but hurt
the farmers.
• The potential for growth through industrialization is much greater, so government

has invested in infrastructure in cities and subsidized capital.
o As a result, food processing can be done much more cheaply by shipping
unprocessed food to the cities: even less value added is left in rural areas.
Unemployment & Rural Urban Migration

• As government pours money into urban housing, education, food subsidies,
health care, and infrastructure, people migrate to the cities, and then
government pours even more money into the cities to prevent rioting.
• The official unemployment rate in LDCs tends to be higher than for MDCs.
However, if disguised unemployment and underemployment figures are included,
there is a very serious unemployment problem in LDCs.
o Disguised unemployment: people are working but producing very little
(marginal product is close to zero), each member of the family is trying to
share in the total output but has very little to add to production.
o Underemployment occurs where people who would like to work full time only
work part time each week, or for only a few months each year.
The Lewis Model

• This approach is based on the notion that structural change requires migration, in
particular from the primary sector, usually rural, to the secondary sector, usually
located in urban areas.
Wages S4 S3 S2 S1 Wages S1 S2 S3
Wurb
Wrural
Wsubst D3
D2
D1
D1
Rural Labour Urban Labour
• If investment has been concentrated in industry, enough capacity may be created

to absorb labour which is surplus to the agricultural sector.
o The increasing productivity of workers in urban areas leads to rising wage
rates:
o Industry only has to pay slightly more than subsistence level to attract labour
to manufacturing jobs in the cities,
o These provide a stark contrast to rural areas where marginal productivity of
workers is very low
o Rural workers will then migrate into the cities in search of work
The supply curve of workers will shift out in the urban area, from S1 to S3
The supply curve of workers will shift left in rural areas: from S1 to S3
o Because there is such a large surplus of unproductive labour in the rural

areas:
Diminishing returns: rural wages equal the average product of farm labour
in the farm household, this is at subsistence level because there is a great
deal of surplus labour and much underemployment or “disguised”
unemployment,
A large part of the population can leave without any reduction in farm
output.
The rural supply of labour can shift inwards for many years before rural
wages start to rise and wages remain at the subsistence level: Wsubst
As disguised unemployment is reduced in rural areas, the amount of food
per family starts to rise and rural populations experience a higher standard
of living
Relatives who have moved to the cities may return on a regular basis and
invest their meager savings in business opportunities in rural towns and
villages.
o The outward shift of the supply of labour in urban areas tends to prevent
manufacturing wages from rising too rapidly even though demand for workers
is increasing steadily from D1 to D3
This encourages FDI and domestic investment in manufacturing industries
which are producing for export
There is pressure on governments to subsidize food, housing and
infrastructure costs in urban areas despite the huge influx of immigrants.
This will hold down the upward pressure on wages in order to maintain
international competitiveness.
Wages will remain at Wurb
• Eventually the supply of rural labour will have shifted in so far, to S4, that wages
will rise to Wrural.
o The supply curve of labour to industry is elastic up to the point at which the
withdrawal of labour can no longer be accomplished without a decline in
agricultural productivity: all the surplus labour has been removed.
o Because China has such a large surplus of rural labour, the rural wages are
not likely to rise for some time. But this has led to rioting in rural areas and
governments have responded by dropping income taxes in rural areas
(demand for labour shifts out).
o In the Pearl River Basin region in southern China, rural populations have been
migrating to the industrial areas for so long that rural wages have started to
increase and manufacturing businesses in this region of China are finding it
increasingly difficult to hire cheap labour and they are starting to lose their
international competitiveness.
• As surplus labour migrates into the urban areas and rural wages rise to equality
with urban wages, the migration process will stop and sectoral change is
complete

Urban Unemployment
• The problem is that in many countries the rural-urban migration has been greater
than the urban manufacturing sector can absorb.
o This occurs if the urban sector is small relative to the large rural sector and
there is not enough capacity to absorb the surplus labour.
o At the most manufacturing can only absorb up to 30% of the workforce after
it is fully developed and that assumes that the output can be sold in export
markets.
o In many countries 70% of the workforce is involved either directly or
indirectly in the primary sector which means that urban poverty and
underemployment has replaced rural poverty and underemployment.
• Often investment has been capital intensive (labour saving) which means there
are few jobs available, particularly for the unskilled rural worker.
• Even if there is only a 20% chance of getting work, or if there is only part time
work available for 20% of the year, young people are still attracted to the city if
the urban wage is five times the rural wage.
• If a rural area suffers from drought every few years, the lifetime income
expected from staying on a farm could be less despite the prospect of many
years of being only partially employed in the city.
• Studies indicate that most migrants do find work within 2 months of reaching the
city: most are young with better education which enhances the prospect of
finding employment in the city.

5.4.3 Types of Aid
Capital goods
• We know where an LDC Potential PPF given K/L

ratio and levels of
Faster economic growth but
E no economic development
could be if it had the productivity (Q/L) in MDCs
same K/L ratio and the C
same level of education, Greater spending on

or Q/L of an MDC. The Current PPF with
leads to greater
good policies &
problem is: how to get good business B
management
there?
o Industrialization is
one route but many A D
Greater economic
economists believe Poor policies & development but less
poor business
that it is limited to management
growth in the future
closing only 30% of

the gap
o Perhaps as much as
50% to 70% could be Public & Merit Goods
closed with greater
productivity of labour, better management and better infrastructure.
o Some economists believe that Aid is of critical importance in addressing the
public goods (infrastructure) and merit goods (education and healthcare)
problems to help increase productivity

5.4.3.1 Bilateral & Multilateral Aid
Official Development Assistance (ODA) in 2003

• ODA is transferred either as bilateral aid between Governments or as multilateral
aid through agencies such as the World Bank (project oriented) or the UN
(program oriented).
• ODA has grown from $1.9 billion in 1955 to $69 billion in 2003
o As a percent of Gross national incomes it has fallen from a peak of 0.5% in
1960 to 0.25% in 2003
• Of the $69 billion in Aid:
o $51 billion was spent on bilateral grants:
Technical cooperation: $18 billion
Food aid: $1 billion
Emergency relief: $6 billion
Debt forgiveness: $8 billion
Administration costs: $3.5 billion
• $19 billion was spent by multilateral agencies

o UN agencies gave $4.7 billion of which the largest programs were:
UNDP: $0.9 billion
WFP: $0.4 billion
UNICEF: $0.5 billion
UNHCR: $0.5 billion
o EC agencies gave: $6.8 billion of which the largest program was:
EDF: $2.3 billion
• Concessional loans are referred to as Aid because the loans are given at much
lower interest rates and for longer periods of time than commercial banks are
prepared to consider.
o The World Bank lent $3.5 billion in 2003: their total loan portfolio is over $20
billion as the WB has been lending money for a long time
o Regional development banks lent $1.7 billion
• Bilateral aid tends to be distributed according to political interests:

o The US mainly directed its aid toward containing communism (now terrorism).
o The EU helps former colonies, especially African countries
o Islamic members of OPEC concentrate on Islamic countries
o Communist bloc countries used to give to communist countries such as Cuba,
Mongolia, and Vietnam, but aid from this source has disappeared.
• LDCs with large populations have received less because donors have a greater
impact by donating to smaller countries which then become more dependent.
• It is estimated that less than 10% of aid goes directly to programs to help the
poor such as health care, basic literacy education, clean water and sanitation.
Major Recipients of Aid in 2003

• All the ODA was received by developing countries ranging from the least
developed to the more developed
• Africa: $26.3 billion of which
o North of Sahara: $2 billion
o South of Sahara: $24 billion

• North and Central America: $2.5 billion
• South American: $3.2 billion
• Middle East: $5.5 billion
• Asia: $20 billion of which:
o South and Central Asia: $8.2 billion
o Far east Asia: $6.2 billion
• Europe: $3.5 billion
• Oceania: $0.8 billion
Unofficial Aid
• NGOs donated $10 billion
o Unlike bilateral grants and multilateral grants which tend to be top down, aid
through NGOs tends to be bottom up.
Foreign Direct Investment

• FDI accounted for $37 billion in 2003.
o Needless to say this money is not grants or loans but investments in
businesses, buildings and capital equipment.
o Investors expect a return on investment otherwise they would not invest.
5.4.3.2 Grant Aid & Soft Loans

• Loans and aid from large agencies is often conditional on changes in government
policy in the recipient country.
• Large donor countries such as the US or Japan or EU tend to dominate
multilateral aid agencies such as the World Bank (created at the Bretton Woods
conference in 1945)
• The World Bank does not give grants (gifts of money) but borrows at the prime
rate from MDCs and relends at a slightly higher rate to LDCs and must be repaid:
o 90% of loans are for projects (physical capital); 10% for programs.
• Large donor countries also tend to dominate the IMF (also created at the Bretton
Woods conference in 1945).
o The IMF is designed to support the system of international currencies
o It only gives loans to countries experiencing balance of payments difficulties,
o The loans are conditional on the imposition of a structural adjustment
program (SAP) which often requires: reductions in government budget
deficits, a slower rate of money expansion (lower inflation), and devaluation.
5.4.3.3 Offical Aid

• Most LDCs have a current account deficit created by the import of high value
added capital goods which cannot be matched by their low value added exports.
Aid provides an alternative to FDI as a way to create a capital account surplus.
• The first aid plan was the Marshall Plan (no longer available) provided by the US
which was motivated by a combination of national security fears, economic
interests and humanitarian concerns.
o This aid was available to European countries with acceptable development
plans for physical capital investment,

o It expanded to include new technical assistance programs: available to invest
in human capital
o Plans and projects were generally excellent making the Marshall plan so
successful that private capital was attracted.
• The success of the Marshall Plan led to the formation of the development
assistance committee of the OECD (25% US) which provided money for:
o Capital and human capital investment (education),
o Improving health and sanitation,
o Relieving poverty through rural regeneration, and assistance to women.
5.4.3.4 Tied Aid

• Aid from these donor is often tied: aid money can only be used to purchase
goods and services from the donor countries
o Historically the proportions were: France 60%, Britain 75%, Italy 90%. While
Japan does not officially tie aid, it often reaches unofficial agreements which
do tie aid.
o The proportions which are tied have dropped steadily and average 25% for
many countries.
o Services are tied in the form of technical assistants being sent out from the
donor country:
They are designed to provide the technical and managerial skills which
may be missing in the LDCs.
An estimated 100,000 consultants from MDCs are working in African
countries, many are doing jobs which could be done by local people.
5.4.4 Export-led growth/Outward Oriented strategies

• About 70% of trade is between MDCs, with the remaining 20% from LDCs and
10% from previously centrally planned economies:
• This situation has not changed significantly for 40 years.
• It is the NICs and the oil exporters which are experiencing rapid growth, the
remaining LDCs have seen their proportion of trade falling steadily.
• Is it better for industrialization to proceed through replacing imported goods with
domestically produced goods, or is export promotion more likely to lead to faster
growth because of the gains from trade through specialization?
Benefits from Trade

• Comparative advantage: the potential gains from trade resulting from economies
of scale and lower consumption prices can be of great potential benefit
• Even large LDCs may have limited domestic markets due to low income
o This is certainly true for Nigeria which is the largest country on the African
continent and yet has a low per capita income.
• Small economies can achieve economies of scale through access to larger
markets
• Growth: technology transfer can occur through the importing of capital goods:
this can promote the rapid spread of technology.
• Learn by doing: best practices in production spread rapidly through trade.
• Domestic monopoly power can be reduced through international competition.

• Trade is essential if the unbalanced growth model is to work: there is a need to
import goods and services which cannot be produced by a less developed
economy.
Import Replacement vs Export Promotion
Domestic or home sector

Domestic
expansion through
Export Promotion regional and
industrial linkage
• Tariffs are reduced or eliminated, adjustment
and imports rise. Domestic

Slow even growth
•
through Import
Import competing domestic investment
replacement
industries are hurt: domestic
production is displaced and Expansion
through
unemployment rises. foreign direct
investment
• Costs for intermediate goods fall
leading to an increase in exports and
a fall in unemployment in the
external sector. Foreign direct investment
• Countries specialize in the sectors in Foreign or export sector
which they have a comparative
advantage.
• Export promotion benefits:

o There is more rapid growth in both GDP and GDP per capita
o Technology transfer takes place through imports of capital goods.
o Exports of manufactured goods rise compared to primary sector exports.
o Gains from trade: lead to a higher standard of living.
o Specialization allows economies of scale and rapid learning by doing.
o Even if growth is uneven, increases in productive capacity lead to rapid
investment and linkage adjustment (backward and forward integration).
• Export promotion costs:

o MDC subsidies to domestic industries, and tariffs and quotas on imports will
block imports of labour intense manufacturing goods even where LDCs have a
comparative advantage.
o Growth is more uneven
o Vertical integration is lost, workers may be confined to assembly and some
fabrication.
o There is a risk that new technology may render a sector obsolete.
o There may be an overemphasis on natural resource exports which could lead
to deteriorating terms of trade.
5.4.5 Import Substitution/inward-oriented

strategies/protectionism
• Tariffs are imposed and imports fall:
o The first to be protected are final stage assembly and simple consumer
goods.
o Over time, parts fabrication and more sophisticated manufacturing is
protected.
o Domestic production increases and unemployment falls.
o Capital and intermediate goods become more expensive, otherwise why
would tariff barriers be needed to promote sales of domestic equivalents?

o Costs rise for exports, exports fall, and unemployment rises in the export
sector.
• The benefits from import substitution:

o There is greater vertical integration within industries (both upstream and
downstream):
Research, development, engineering, design, fabrication, assembly,
marketing, and financing provide a richer variety of jobs
o There is greater integration amongst industries (both backward and forward
linkages)
o Learning by doing takes place.
o There is less dependence on other countries, therefore less specialization and
more evenly distributed development in the economy.
• The costs of import substitution:

o Infant industries never grow up because the lack of international competition
leads to higher costs
o The lack of competition from foreign suppliers can lead to a buildup of
monopoly power domestically which means supernormal profits are extracted
through higher prices with no hope of prices ever coming down
These rich industrialists will be the first to fight lower tariffs and freer
trade.
o With few imports:

Shortages of raw materials and semi-finished goods lead to bottlenecks in
production.
Fewer imports of capital goods reduces the technology transfer.
o The export sector collapses so there are no gains from trade
o Economies of scale cannot be achieved because the market is too small.
o Balance of payments problems lead to a reduction in imported capital which is
often needed for industrialization to proceed:
Producers are cut off from new technology in international markets.
o The poor gain little, the major beneficiaries are the wealthy and the MNCs
operating behind tariff walls.
o Govt . tends to subsidize capital, and currencies are held artificially high to
encourage the use of imported capital and intermediate goods:
Industry becomes less labour intense, leading to unemployment.
Exporters of primary goods (the poor) are hurt: because LDCs face
perfectly elastic demand, they have to lower their prices to compensate for
the higher currency value.
The elite benefit from importing luxury goods more cheaply.
5.4.6 Commercial Loans

• In Section 5.1.4.1 the importance of the banking system as an institution to
mobilize savings in the economy was clearly explained
• Money for loans is always in short supply in LDCs
o People are afraid to save in domestic banks because of past failures or
nationalizations by governments which have simply taken the money
o Governments may not be permitted to print money to pay for expenditures
and so may be the largest borrowers in LDCs which leads to a major crowding
out problem
o What money does remain is often only available for low risk companies which
means there is nothing left for small firms.
• The entry of foreign banks is promoted as part of the movement toward

globalization:
o In countries like Romania and Mexico it has led to the closure of all domestic
banks
o While the foreign banks certainly mobilize savings, often those savings are
sent abroad where risk adjusted ROI may be higher on foreign projects and
investments rather than on domestic ones.
• Governments that have borrowed from foreign commercial banks find that the
interest rates are higher and the terms and conditions much more difficult to
meet than on loans available through the World Bank.
5.4.7 Fair Trade Organizations

• TNCs consist of many divisions located in many countries around the world. If
one division “sells” inputs or semi-finished goods to another division, they use
transfer prices which are not market prices and allow the company to reduce
taxes by declaring the profits in a low income tax country.
• Suppose running shoes are made in the Philippines for $5 and are sold in the US
for $20.
o If the profit is taken in the Philippines, the rate of income tax may be 40%
and the company will pay $6 in tax (0.4*($20 - $5))
o If the company uses a transfer price of $5 out of the Philippines they will take
a profit of $15 in the US where the corporate tax may be 30% in which case
they pay a tax of $4.50 (0.3*$15)
o Alternatively they could stop in Singapore, unload and reload the shoes and
“sell” them to their Singapore division and pay a tax of only $1.50 (0.1*$15).
• Fair trade organizations (FTO) are groups of wholesalers, retailers, and producers
who try to avoid transfer pricing by committing themselves to providing fair
wages to farmers and fair returns to small and home based manufacturing firms
selling their products internationally.
o Of $3.6 trillion of all goods exchanged globally, fair trade accounts for only
.01% or about $400 million.
o Fair trade businesses return 1/3 to 1/4 of profits back to producers in
developing countries.
o Sales for Ten Thousand Villages, the largest fair trade organization in the US
and Canada, amounted to more than $15 million which represents the
creation of the equivalent of 12,500 full-time jobs for disadvantaged artisans
and farmers
• LDC partners must abide by certain principles:

o Paying a fair wage in the local context.
o Offering employees opportunities for advancement.
o Providing equal employment opportunities for all people, particularly the most
disadvantaged.
o Engaging in environmentally sustainable practices.
o Being open to public accountability.
o Providing healthy and safe working conditions within the local context.

5.4.8 Micro-Credit Schemes
• Unemployment is not a result of demand deficient cyclical unemployment:
o In most LDCs it is supply bottlenecks that create constraints on employment
creation.
o There are insufficient savings and investment to create the expensive
workplaces needed to create urban jobs.
• Where there has been technology transfer from MDCs, investment is labour
saving and does not create jobs.
• Capital is often subsidized by a government intent on accelerating growth. Firms
use the cheap capital as a substitute for labour.
• Wages may be too high due to minimum wage laws or MNCs permitting unions to
bid up wages and forcing firms to replace labour with capital.
Micro-enterprise
• There needs to be investment in small scale, labour intense industries in both
urban and rural areas to provide alternatives to low paid farm jobs, and scarce
industrial jobs in cities.
• Small scale businesses in both urban and rural areas have certain characteristics
o People perform all sorts of services and fashion all sorts of products from
recycled materials.
o Capital is scarce, human labour abundant, so production is labour intensive.
o Usually employ 5 workers or less, and yet can account for 30% of the work
force
o Are a wonderful way to flush out entrepreneurial talent,
• Governments favour large firms through price distortions, output controls,

regulations, export licenses, and credit rationing
• To foster small scale businesses, government needs to
o Remove controls and regulations to reduce the bias against small firms.
o Provide a technology extension system to assist in the process of technology
transfer to small entrepreneurs.
• Small, modern factories grow out of small scale businesses:

o They generally employ 50 or less, and yet can account for 50% of the
industrial labour force.
o If they stay in the rural economy, they can provide technology transfer.
o However, they are often forced to move to cities to gain: agglomeration and
external economies, access to pools of skilled workers, cheap transport and
marketing; and access to subcontract work for large firms.
5.4.9 Foreign Direct Investment (FDI)

The Attraction of FDI
• FDI by MNCs usually comes in a bundle including: equity and debt financing,
management expertise, technology transfer, technical skills training, and access
to overseas markets:
• Product life cycles have reinforced the need to maintain technical superiority in
order to advance, thus MNCs are extremely reluctant to un-bundle the package:
they fear the technology will be exposed to a competitor who will reach the life
cycle window faster

• LDC Governments are attracted by the FDI bundle:
o Learning by doing: is accelerated which can enable the country to cope with a
technologically advanced future
o Technology transfer: while embodied in a process, also includes information
and the technical skills needed to adapt, install, operate and maintain capital
equipment systems
o Managerial shortage: LDC governments understand the acute shortage of
local managers capable of organizing and operating large scale industrial
projects,
o Intra firm exclusion: LDC governments realize that access to international
markets is severely limited because markets are dominated by intra and inter
firm transactions (50% of Canada's imports and exports are intra firm sales),
MNCs are needed to gain access to this system.
o Marketing expertise: MNCs have preferential agreements with customers due
to volume, length of time in the business, the use of standardized contracts
and standardized products, it may take years for LDC producers to understand
let alone break into international markets.
o Supply side bottlenecks: can be reduced through FDI by MNCs
• National gaps in savings, foreign exchange, taxes, technology and human skills
can all be filled by MNCs:
o Labour: they can create jobs, develop managerial skills, and provide technical
education of labour,
o Capital: they can transfer technology and provide needed physical capital
o Tax revenue can be earned on the exports of natural resources which can be
used to fund construction of much needed infrastructure.
o Foreign currency flows in from the MNC investments, and from the private
earnings on the exports.
5.4.10 Sustainable Development

Fairness of Access
• Traditional economic growth has attempted to maximize the income per person:
making the pie grow bigger and hoping that poorer people with only tiny slices
will experience some improvement in welfare.
• More recently, economic development has emphasized the need to distribute the
income more evenly amongst persons.
o Everyone receives a fairer slice, even if the pie stays the same size.
• But should economic growth and development have priority over the
environment?
o Without adequate environmental protection, development is undermined.
Without development, resources will be inadequate for needed
investments, and environmental protection will fail.
o Poor people have a high marginal propensity to consume compared to rich
people who have a high marginal propensity to save.
Should we reduce poverty by spreading limited resources thinly and see
them used more rapidly?
Should we allow the rich to accumulate assets knowing they might invest
in and take better care of them?

• People living in poorer countries which are natural resource poor and future
generations impoverished by our overuse of resources do not have political or
economic power to ensure access.
• Uncertainty about environmental systems and their role in our very existence
make us wary of engaging in traditional economic net benefit maximization. This
is especially true for future generations.
Sustainable Development Flow Chart

• The chart on the next page illustrates the three part approach which must be
taken if development is to take place and if that development is to be sustainable
• The center part of the diagram illustrates the Economic Growth flow chart which
was used in Section 5.1
• To the left is a section that deals with human development and most closely
illustrates how economic growth is transformed into economic development.
• What is new is the box on the right which illustrates the factors involved in
making economic growth and development sustainable
o Our current usage of resources is sustainable in most areas but what happens
if the population increases to the 8 or 9 billion level presently forecast?
o The market system does not take into account the costs to future generations
of activities today because they are too distant to have an impact on ROI
calculations today
o What about future generations: everything they will experience is being
filtered through our hands today
o What is the best government policy: low growth or high growth?
Sustainable Economic Development

• Sustainable development is the process which maximizes the net benefits of
economic development while maintaining the services and quality of
environmental and natural resources forever. This involves:
o Using renewable natural resources at rates less than or equal to the natural
rate of regeneration.
o Using non-renewable resources in a manner which permits recycling of
materials and substitutability between natural resources and technological
change.
• Economic development and resource usage are complementary but after a

certain point development will reduce one or more of the functions of certain
resources resulting in a tradeoff. Using forestry as an example:
o The wood can be harvested and sold.
o Or the trees can be left uncut so the forest can act as a waste assimilation
system or a region to absorb rain to prevent flooding.
o Or the trees can be left and the area used as a park for recreation.
• How can we make less use of natural and environmental resources:

o Create a low growth, austerity economy?
o Develop a high tech economy in which growth is based on very low resource
usage and high technological progress?
o Use renewable resources on a sustainable basis and recycle non-renewable
resources?

Human Development
SUSTAINABLE DEVELOPMENT
Goals
-Reduce poverty
-Reduce unemployment Sustainable Development
-Reduce income inequality Goal
-Public goods: build infrastructure -Maximize economic growth while maintaining
-Merit goods: education & health services & quality of environment
Environmental Conservation
Alternative Choices
- Economic growth increases the size of the pie Problems
Govt. Policy
- Human development makes pieces same size -World's resources are sufficient but
Education
- Environmental conservation makes pie smaller -Uncertainty may lead to catastrophe
-Invest in human capital: Q/L rises
-Basic literacy -Waste processing capacity:
-Primary & secondary schools -Ultimate limit on growth
-Energy for cleanup is insufficient
Health Economic Growth -Uneven spatial distribution
-Clean water Trade -Natural carrying capacity is overtaxed
-Safe sanitation Entrepreneurs Benefits: -Current examples
-Basic medical care Small stay in community Goals & Policy -Gains from trade -Overfishing in all world oceans
-Adequate nutrition -Project evaluation lower risk -Increase GDP per capita -Economies of scale -Soil erosion & desertification
-Learn by doing -Accelerate growth by: -Technology transfer -Deforestation
Population Growth Rate -Management training -Mobilizing savings -Learning by doing -Loss of wetland & diversity of species
-Meaningful work for women -Backward and forward links -Attracting FDI -More rapid growth -Greenhouse gasses: global warming
-Social security -Reduce price distortions
-Ecological footprint Medium move to cities -Eliminate urban subsidies Costs: Market failure
-Access to skilled labour -Ensure stable government -Specialization trap -No system to value or measure
Rural Development -Subcontract to large firms -Streamline legal/regulatory -Unbalanced growth -Economic growth for poor leads to:
-Could provide 70% of jobs -Small modern factories -Proper tax system -Barriers to imports -High consumption of resources
-Foster small rural enterprises -Internal, external economies -Build public infrastructure -MDC subsidies -Serious pollution & waste problem
-Land reform -Set industry standards -Child labour & health -Future generations have no input:
-Slow introduction of better crops Large invest in capital -Assist technology transfer -No political or economic power today
-Machinery, irrigation, chemicals -Productivity rises but: Import replacement
-Machines replace jobs -Benefits:
-Jobs are often part time Banking -Vertical integration
Problems -R&D raises productivity -Learning by doing
Government Policy
-Mobilize savings, pay interest Alternatives

-Terms of trade deteriorate -Managers may emmigrate -Keep lending rate low -Problems
-Exports fall -Low growth, austerity
-Income inelastic demand -Reduce risk by diversifying
-Unemployment rises -Renewable: natural regeneration rate
-Rapidly growing LDC supply Multinational Firm benefits -regional, sectoral, industrial -Non-Renewable: recycle resources
-Rural-urban migration -Learning by doing -Project evaluation -Supply bottlenecks
-No technology transfer -High tech, low resource use
-As labour leaves: Q/L rises -Management training
-Slow growth -Appropriate technology
-Price of food rises -Technology transfer
-Innovation to save energy & resources
-Access to markets
Foreign Aid (Project) Export Promotion -Resources left in the hands of the rich
-Employment creation
Foreign Aid (projects) -Benefits: -Monopoly power means slower use
Foreign Aid (Program) -Rich are concerned with conservation
Multinational Firm problems -Multilateral: -Exports rise
-Multilateral ($19 billion)
-World Bank ($6 billion) -Poor people misuse due to poverty
-UN agencies ($5 billion) -LDC unable to absorb & -Backward & forward links
apply new technology -Bilateral ($18 billion) -More rapid growth
-Bilateral ($51 billion)
-Poor tax collection due to: -Tied grants -Problems
-Terms dictated by MDCs
-Transfer pricing -MDC political/military goals -Gains may go to MDCs
-NGOs ($10 billion)
-Tax concessions -Lack complementary inputs -TNCs dominate banking
-Community level
-Small impact, not well coordinated -MDC strategic trade policy
• We need to develop environmentally friendly technologies and ensure they are
made available to developing countries. Top priority must be given to:
o Adequate sewage disposal and safe water.
o The elimination of burning fires for cooking: they cause smoke pollution both
within buildings and around urban areas and contribute to deforestation.
o We must remove subsidies that encourage excessive use of forests, fossil
fuels, irrigation water, and chemical sprays.
o Clarify rights to own resources.
o Help local communities to take ownership of their common resources:
Local participation in setting and implementing environmental policies.
Teach them how to make long term decisions and investments.
o Develop realistic policies and strategies which:
Permit low cost monitoring and enforcement for DCs.
Use market systems of punishments and rewards rather than regulation
Restrict the power of rich resource owners and large institutions.
5.5 Evaluation of Growth & Development Strategies

5.5.1 Evaluation of the following in terms of achieving growth
and/or development
5.5.1.1 Aid and Trade
• Aid is a poor substitute for trade: opening up MDC markets to LDC exports can
enhance the ability of the poor to earn a living and reduce poverty.
• It is estimated that less than half the aid goes to poor countries, instead it is
based on the military, political and business interests of the donors, a reward to
those in power
• The LDC government may be forced to change development policies to suit the
donor's ideas:
o Loans and grants may be contingent on changes in tax laws, wage and price
systems, food subsidy programs, and whether the money is used for rural or
urban development.
o These ideas may be out of touch with reality and do little to contribute to
development in the country
• Aid contributes in direct proportion to the increase in capital investment, but aid
does not appear to have accelerated the growth rates of recipient countries:
o There is a lack of complementary inputs: human technical skills,
administrative capacity, infrastructure, financial institutions, and political
stability,
o The introduction of hard currency inflows may also lead to increases in
consumption rather than just investment:
Supply bottlenecks may discourage investment in physical capital
Rising incomes for the poor may lead to increased consumption rather
than increased saving.
• Aid may displace LDC government spending:

o There is less pressure to provide infrastructure, and necessary reforms
particularly in rural areas

o Resources are then free for consumption instead of investment and may be
used to acquire military hardware
• Famine is often not a result of a lack of food but of the inability to earn enough
to pay for the food:
o Distributing cash instead of food can stimulate the local market:
Local traders know best how to transport supplies
They are often able to reach inaccessible places to provide food.
o Long term food production and employment can increase through investment.
5.5.1.2 Market-Led and Interventionist Strategies
Market Led
• Most economists are impressed with the way free and open markets lead to
productive and allocative efficiency
• For poor countries efficiency is extremely important as it can lead to higher
growth rates and produce a surplus which can be taxed and spent on merit
goods and infrastructure to enhance the process even more.
• Past experience with market planning in the former communist countries and
many socialist countries in Africa and India indicates quite clearly that
government intervention has not worked.
o The intervention does not only have to be socialist, it can also be of the
military dictator type experienced in some Latin American countries.
• This intervention contrasts with the more free market approach of many
southeast Asian countries which have experienced remarkable growth and
development over the last 50 years.
• The Washington Consensus has emerged as a set of principles supported by the
IMF, the WB and most MDCs to replace intervention with a market structure
which will lead to growth and development through unbalanced growth:
o Good governance at the macro level:
Balanced budgets for governments
No more printing money which leads to inflation
o Prices must be free to adjust
All subsidies, price controls and government regulations must be dropped
Privatization of state owned enterprises will lead to lower prices for
essential services such as communications, electricity and transportation
o Free trade:
Eliminating all hindrances to trade
Moving to a floating exchange rate system with minimal government
intervention
Allowing freedom of movement for capital flows and not imposing
restrictions on FDI
• Advocates of the market approach are aware of market failure and do advocate
government intervention in order to correct such failures, but the emphasis
should be on property rights and other means which will allow the market to
operate more effectively.

Government Intervention
• Despite the evidence that market solutions are good, free trade does not
guarantee that countries which have low productivity will be able to compete in a
“fair” way with MDCs
o The huge subsidies paid to farmers in MDCs make it difficult for LDCs to
export food to those countries
o The health barriers, environmental barriers, and child-labour barriers present
major obstacles to LDC producers of such things as textiles, clothing and
footwear to export to MDCs.
• At the same time, there is also ample evidence that while the market may help
those at the top and possibly some in the middle income level, lower income
level groups do not participate effectively in economic growth and development
o The persistence of poverty even in countries with rapid economic growth
indicates quite clearly that the “trickle down” effect does not really operate.
o The diffusion of the benefits of economic growth seems to take place more
effectively in countries with higher levels of education and better healthcare
which indicate the need for government spending on merit goods and
infrastructure.
• However, many studies have indicated that governments are generally not very
good at picking winners, indeed they often seem to support losing industries.
• At the same time, governments can provide a very supportive role in a number of
useful directions:
o By supporting research institutes and universities, technology can be better
understood and applied in the context of that particular country and culture
Perhaps the most powerful examples have been the agricultural extension
and technology extension systems developed by the US, Japan and
Germany.
o By supporting foreign missions to open up new export markets plus helping to

finance exports including insurance until the goods are sold, governments can
provide valuable support for exports
o By building essential infrastructure which is missing, markets can be opened
up through better transportation and communication, better healthcare and
education can lead to higher productivity, cleaner water and sewage can
reduce mortality rates and increase productivity of workers.
• Market led growth based on the Washington consensus can lead to a number of
problems:
o SAP programs have indicated clearly that imposing fiscal austerity usually
leads to governments cutting expenditures on merit goods such as education
and healthcare
o Liberalizing trade can lead to
A painful transition period while import competing domestic industries
close down and workers and capital transfer to more internationally
competitive sectors and industries
Large inflows of FDI can displace local businesses and force the domestic
linkage adjustment to be export oriented rather than promoting the
integration of domestic industries.
o Allowing prices to move freely means that

The poorest groups may not have access to basic food, clothing, and
shelter.
Nor will safety and environmental considerations be taken into account
effectively
Utilities and financial institutions will be owned by foreigners who are the
only ones capable of purchasing large, privatized government enterprises:
in Mexico, not a single bank is owned by Mexicans.
5.5.2 The Role of International Financial Institutions

5.5.2.1 The International Monetary Fund (IMF)
• Created in 1945, the IMF is an international organization of 184 countries which
have agreed to cooperate to stabilize international financial markets:
o It is hoped that such financial stability will promote trade and more rapid
economic growth which will lead to greater employment and less poverty.
o Member countries pay into a fund which is used to lend money to countries
experiencing difficulties in stabilizing exchange rates.
• Loans are given on certain conditions, usually referred to as Structural

Adjustment Programs which require:
o Slower increases in money supply
o Cuts in government spending to balance fiscal budgets
o Devaluation of currencies to promote trade
o The removal of subsidies
o A greater focus on promoting trade through the production and export of
primary commodities
• Structural Adjustment Programs (SAPs) have been renamed as Poverty Reduction

Strategy Initiatives which require the country to come up with its own set of
policies which must conform to the IMF requirements or the country will not
receive the loan
• It is important to remember that the primary focus of the IMF is stabilizing

international financial markets and not economic development
o This means that it is more interested in being repaid the money in order to
replenish the fund and make it available to the next country in need of
assistance
o Money is not lent by the IMF for economic development.
• There is no question that the IMF has been effective in stabilizing international
finance, there have been no competitive devaluations of the type which can lead
to serious depressions.
• On the other hand the damage inflicted by SAPs imposes a heavy cost on
countries moving from Balance of Payments problems to greater financial
stability.
o Many critics claim that the IMF has gone beyond its mandate of stabilizing
international finance to actually restructuring countries along western
capitalistic lines and is dictating economic policy for a significant number of
countries
o There has been little attempt on the part of the IMF to tailor its SAPs to the
needs and conditions of the countries on which they are imposed.

5.5.2.2 The World Bank (IBRD)
• Created at the same time as the IMF in 1945, the International Bank for
Reconstruction and Development (IBRD) was designed to assist countries by
providing low interest loans in order to foster economic growth and development
o The IBRD plus the International Development Association (IDA) were brought
together under the overall title of the World Bank (WB).
• It is a UN specialized agency with 184 member countries which provide funding

and support
o The WB focuses on achieving the UN Millennium Development Goals by
working to reduce poverty in LDCs.
• In 2004 the WB provided $20 billion for 245 projects in nearly 100 LDCs
o $9 billion of the $20 billion was given in the form of grants, interest free
loans, and technical assistance: usually through the IDA to 62 low income
LDCs
Countries have 35 to 40 years to repay the loan with no repayment of
principal for the first 10 years
o $11 billion of the $20 billion was given in the form of low interest loans to 33
higher income LDCs:
Countries have 15 to 20 years to repay the loan with the first 5 years free
of any principal repayment.
• The WB is also involved in lending to high risk countries and providing assistance
in resolving loan disputes between LDCs and commercial banks.
• The WB has also been involved in debt relief for 26 Heavily Indebted Poor
Countries (HIPC)
o The money does not have to be repaid as long as the normal payments which
would have been used for servicing the debt are instead directed toward
housing, education, health, and welfare programs for the poor.
• It is important to remember that despite fresh infusions of cash each year from
member countries and other donors, the WB needs loan recipients to repay their
loans so that money is available for other countries who need to borrow to
finance growth and development
• WB loans were originally designated mainly for infrastructure projects such as
dams, water systems and roads. Over the years, program funding for education,
healthcare and technical training have increased as a proportion of the total loans
given.
• The WB has worked with the IMF to support reform through the imposition of
SAPs as well.
• Studies indicate quite clearly that funding development projects will not work to
enhance economic growth and development unless the governments in those
countries use better economic policies
o Forcing reforms on countries in return for loans may be the only way to bring
about the “good governance” which all now recognize as essential for
economic growth and development to take place
o As with the criticism of the IMF, the SAPs have inflicted so much damage that
it is not clear whether the gains made in terms of growth and development
are adequate compensation

o Many critics believe that grants would be more effective than loans which
have to be repaid
o Although it is easy to blame bad government policies in recipient countries,
the fact remains that many WB initiatives over the last 50 years have done
little to alleviate poverty in many countries.
5.5.2.3 Private Sector Banks

• In Section 5.4.1 the savings gap was used to illustrate the shortage of money in
LDCs for investment in both private capital and public infrastructure.
• In Section 5.1.4.1 the role of the private banking system was explained in terms
of the need to mobilize domestic savings to provide funds needed for bank loans
o Banks must reduce risk as much as possible in order to provide a secure place
to store money for savers
o Banks must diversify their loans geographically, by sector and by industry in
order to reduce risk
o Banks must engage in proper project evaluation when approached by an
entrepreneur with a proposal to borrow money for investment.
o It is the entrepreneur’s job to accept risk, that is why they may be earning
supernormal profit in order to cover the investments which fail
o If governments in LDCs force the banks to invest, this raises the risk
dramatically and lowers the attractiveness of the bank as place to deposit
savings.
• At the same time, governments themselves are aware of the savings gap and
may borrow money from international private banks to invest in infrastructure
o The terms and conditions of the loans are much more exacting than those
required by the WB
Often governments do not earn enough on the investment to pay the
interest let alone repaying any principal
Governments may be forced to meet the conditions of the loan by taking
money from other designated expenditures such as education and
healthcare.
o Typically the loans are short term as the interest charges are lower, however,
if interest rates rise in the world, they do so most rapidly on short term loans
and governments are left trying to renew the loan at higher interest rates.
• In the case of countries such as Mexico and Romania where all the private banks
are owned by foreigners, money may leave the country to be invested in other
countries where the risk adjusted ROI may be higher
o This leaves less money in the domestic economy for both government
borrowing for investment in infrastructure as well as private borrowing for
investment
o Rich citizens may find it easier to hold US$ accounts in those foreign owned
banks which makes capital flight even easier in times of financial stress
o “Hot” money, or short term capital, can flow more easily into an out of LDCs
through foreign owned banks, which may lead to instability in exchange rates
due to speculation.

5.5.2.4 Non-Governmental Organizations (NGOs)
• Although they are called “non-governmental” in fact many NGOs are funded in
part by governments
o This is important because governments are often forced by legislation to
engage in restricted kinds of development assistance
o NGOs funded by the government are free to experiment with new ways of
accomplishing the goals and yet the government is “at arms length” in terms
of being criticized if the new approach fails
• Typically NGOs are non-profit organizations which can be broken into two types
of groups
o By function: the most familiar being environmental groups like the Sierra Club
or economic development groups such as OXFAM
o By social group such as women’s groups or indigenous groups or Amnesty
International
• NGOs provide a wide variety of services including research, data collection,

training, education, providing services such as micro-credit, lobbying and
protesting.
• Most NGOs are staffed with paid management who provide an executive
function, as well as large numbers of volunteers who often receive very small
amounts to cover costs of living.
• In 2004, NGOs donated $10 billion in aid which is larger than the loans given by
the WB in 2004
• Unlike the WB, the IMF and the bilateral Aid system used by MDCs which is top
down, NGOs tend to work at the grass roots (bottom up)
o While this certainly avoids the corruption at the top of LDC governments, it
does lead to inefficiency
o Many NGOs offer similar services to their clients which leads to serious turf
wars
With so many NGOs offering overlapping services, the target group can
“shop around” to get the best deal in terms of food, clothing, healthcare,
education and training
This encourages dependency amongst the poorer groups in society and
does not foster economic growth or much economic development.
o NGOs are always trying to train “nationals” to take over the management, but
can experience serious problems with corruption when the operation is
handed over to nationals
o NGOs raise money from certain interest groups in their home countries and
tend to go with the “flavour of the month” in terms of appealing to those
donors
This can lead to serious disruptions in services to groups which have
become dependent on the NGOs as the focus of the NGO changes to meet
the desires of the donor groups
It can also lead to carelessness in terms of assessing the impact of certain
programs to help target groups. A good example is OXFAM which has
made a public apology for having trained so many poor farmers in growing
coffee without assessing the market implications in terms of a steadily
growing supply of coffee.
• Obviously NGOs are institutions which serve a very important purpose and
contribute significantly in dollar terms to the whole process of development but
there is need for reform, particularly in terms of accountability, transparency and
representation:
o Because they are usually funded by private donors sometimes with
government matching grants, NGOs are not subject to public scrutiny as are
governments or private businesses
o They are often accused of having more impact on global decision making than
citizens of countries with freely elected governments, and yet NGO
management may be largely self-appointed if they have co-opted supervisory
boards.
5.5.2.5 Multinational or Transnational Corporations (MNCs or TNCs)

• MNCs or TNCs are defined as such if they have production and distribution
facilities in more than one country.
• MNCs tend to form for several reasons:
o Trade: with trade barriers in place, it is easier for a producer to set up a plant
in a foreign country and produce for that market rather than producing in the
home country and shipping to the foreign country
o Resources: typically more than half of MNCs are involved in resource
extraction of which oil is the most common
MNCs look for resources all over the world
They also look for cheap labour in order to fabricate and assemble
products or to provide services such as in call centers
o Regulations: many MNCs find the regulations imposed by government for
health, safety and the environment, and the labour agreements enforced by
unions make production too expensive in MDCs and they relocate to LDCs or
countries where regulations are easier
• There are 35,000 MNCs of which 50% are controlled by US, Japanese, German
and Swiss investors.
o 50% of all industrial production is produced by 100 companies.
o These 100 companies control 50% of world trade.
• MNCs have grown for the following reasons:

o They need to secure their supply lines of raw materials.
o The need to sell to ever larger markets where new products are fully
developed and competition increases the price elasticity.
o Locational advantages are important:
They need to locate within restrictive trade barriers
Low wages, low taxes and high education levels are important
They like to locate near markets to reduce transport costs.
• Studies have indicated that MNCs are not good at providing jobs:
o Local firms are displaced by the MNC and the displaced firms often have much
higher labour capital ratios,
o LDC governments may force the MNCs to operate in a highly capital intense
sector of the economy such as natural resource extraction and processing
requiring massive investments in sophisticated equipment and machinery:
The labour that is hired is very highly skilled
Either local labour must be given extensive training or skilled workers
must be imported.

• Labour protection laws: introduced by the government to appease the labour
sector may increase labour costs significantly leading to the substitution of capital
for labour
• MNCs may prefer to take advantage of cheaper labour by using more appropriate
technology but LDC governments anxious for technology transfer insist on the
latest technology being used, once again this lowers the labour capital ratio.
• Technology transfer is severely limited by the country's ability to absorb and
utilize the new technology:
o Workers lack the technical skills
o The LDC system of information dissemination may be non-existent,
o The MNC may be extremely reluctant to accommodate technology transfer for
fear of losing trade secrets.
• Transfer pricing: the setting of internal prices between branches of an MNC such
that goods can be exported at artificially low prices:
o The MNC raises price in the next country to the market level and takes the
profit there if the taxes are very low, thereby saving on income taxes.
o This reduces the ability of the host government to collect taxes and defrauds
them of taxes on work done in their own country.
o 25% of all trade is between branches of the same MNC company.
o The highest value added work is done in the countries with the lowest taxes.
o It is a powerful tool in labour negotiations to demonstrate that the company is
losing money
o Studies indicate that as much as $50 billion is not paid in taxes due to transfer
pricing which means less money is available for LDC governments to spend on
merit goods and infrastructure.
• Competing LDC governments may offer concessions on:

o Reducing taxes while providing subsidies, and tariff or quota protection.
o Allowing monopoly power
o Reducing environmental regulations
• However, concessions are often useless:

o Repatriated profits are simply taxed by home governments
o Tax relief may lead to confiscation of MNC property if the host government
changes in the future
• Foreign enclave: the MNC can increase the inequality between the rich and the
poor by developing a modern high wage sector.
o This sector imports luxury goods
o Inappropriate goods are marketed in the LDC
o It widens the rural-urban wage gap leading to increased migration
o MNC supporters may influence the government to undertake projects or adopt
policies which are growth rather than development oriented.
MNC Policy
• 50 of the top 100 ‘national incomes’ in the world are earned by MNCs.
• MNCs have no loyalty and are happy to produce and sell anywhere, they are
economically powerful and often more influential than the governments they deal
with
• Industrial orientation: 40% of FDI by MNCs is for manufacturing, and 60% is for
extraction and processing of natural resources:
• 500 MNCs control 80% of the FDI, 40% of them are US based, and 30% are
based in the UK, Germany and Japan.
• Most European and US based MNCs tend to invest in other MDCs.
• US owned: US MNCs still account for 50% of total FDI in LDCs. Much of the FDI
from US based MNCs is directed toward the oil industry.
• Japanese owned: 60% of Japanese MNCs investment has been in LDCs,
• LDC owned: MNCs which are LDC based and invest exclusively in other LDCs
have the fastest growth rate.
• Over time, nations and institutions such as labour unions have developed laws
and agreements to control or balance the excess of private companies.
o The problem with MNCs is that there is no global government or global union
to oppose or reduce the worst excesses.
• To achieve their ends LDC governments may:

o Impose a schedule for local value added to be increased and for greater
utilization of local personnel
o Impose bans on the import of used capital equipment with an insistence that
only the latest technology be used
o Insist on joint ventures with local firms, and ceilings on the repatriation of
profits to encourage or force reinvestment of profits in the local economy
o Insist on market pricing rather than transfer pricing on intra firm transactions:
o Many MNC now insist on proper tax payments right from the start:
To provide enough tax revenue for the government to build the
infrastructure needed to service the MNC
To prevent resentment and potential nationalization which can lead to risk
and uncertainty which threaten the long term viability of a project.
5.5.2.6 Commodity Agreements

• See Section 2.1.4.4 for a complete discussion of commodity agreements
• International Commodity agreements are formed amongst producers and
importers in an attempt to stabilize commodity prices.
• Typically a floor price is set and a buffer stock system is set up to purchase
excess supply when prices start to fall below the price floor
o The greatest problem has been disagreement on what the price floor should
be
o Another serious problem is the international producers who refuse to join and
pay the costs of the buffer scheme and yet benefit from more stable prices
o Perhaps the best example is the International Coffee Agreement which was
established in 1962:
Instead of a buffer stock system, members to the agreement used a quota
system which was imposed if prices fell below an agreed to floor price (in
some countries governments or members would purchase the excess
supply)
If prices rose above the floor price, all quotas were suspended
Experience showed that when prices were strong, the agreement fell apart
so that when prices fell again, there was no floor price nor a quota system
to stabilize prices
Attempts were made to move away from quotas towards initiatives to
promote demand rather than attempt to control supply: these met with
only limited success
The most recent round of negotiations in 2001 has led to an agreement
which has focused on improving the conditions of workers, transferring
technology to reduce costs on coffee plantations, promotion of demand
and better quality supply
Experience indicates that without a quota agreement in place, prices fall to
substantially lower levels.
• Alternatively a quota system is set up to control the import of quantities

o Each country to the agreement is assigned a particular quota of exports to
different members of the agreement
o This stabilizes production and usually stabilizes prices
o Those countries which receive generous quotas do well, those with smaller
quotas or who join the agreement too late to gain a quota will suffer.
o Perhaps the best example of this type of agreement is the Multi Fibre
Agreement:
The first version was established in 1962 and dealt with cotton only
It was designed to protect the textile manufacturers in MDCs from the low
cost textiles being exported by LDCs.
The MFA itself was established in 1974 and was expanded to include
textiles made from synthetic and wool as well as cotton
In 1994 the Uruguay round of the WTO agreed that the MFA would be
eliminated in various stages by 2005
Many small textile producers benefited from the stability in the market and
may lose or gain without such an agreement in place.

Economics Book United World College Mostar

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Economics Book United World College Mostar

Hochgeladen von

Copyright:

Verfügbare Formate

UWC IN MOSTAR: BLUE BOOK ECONOMICS NOTES

UWC IN MOSTAR: BLUE BOOK ECONOMICS NOTES TABLE OF CONTENTS........................ 1

UWC in Mostar: Blue Book Economics Notes, page 1

Course Outline for First Year Economics Higher: 2007-08

• Section 4: International Economics

• Section 5: Development Economics

Course Outline for Second Year Economics Higher: 2008-09

• Section 4: International Economics

• Section 5: Development Economics

UWC in Mostar: Blue Book Economics Notes, page 2

UWC in Mostar: Blue Book Economics Notes, page 3

Higher level extension topic

Interaction of demand and supply

Price elasticity of demand (PED)

UWC in Mostar: Blue Book Economics Notes, page 4

Income elasticity of demand

Price elasticity of supply

Applications of concepts of elasticity

Higher level extension topics

2.3 Theory of the firm

Higher level topics

UWC in Mostar: Blue Book Economics Notes, page 5

Reasons for market failure

Possible government responses

Section 4 deals with external equilibrium. Income distribution is introduced here in

The economic strategies available to governments—demand-side policies, supply-

3.1 Measuring national income

3.2 Introduction to development

UWC in Mostar: Blue Book Economics Notes, page 7

3.3 Macroeconomic models

3.4 Demand-side and supply-side policies

Higher level extension topics

3.5 Unemployment and inflation

Higher level extension topics

3.6 Distribution of income

Higher level extension topics

Section 4: International economics

4.1 Reasons for trade

Higher level extension topic

UWC in Mostar: Blue Book Economics Notes, page 9

Definition of free trade

Arguments for protectionism

Arguments against protectionism

4.3 Economic integration

Higher level extension topics

4.4 World Trade Organization (WTO)

UWC in Mostar: Blue Book Economics Notes, page 10

4.6 Exchange rates

Higher level extension topics

4.7 Balance of payment problems

Higher level extension topics

4.8 Terms of trade

Higher level extension topics

UWC in Mostar: Blue Book Economics Notes, page 11

Given the dynamic nature of the international economy, it is problematic to group

5.1 Sources of economic growth and/or development

5.2 Consequences of growth

5.3 Barriers to economic growth and/or development

5.4 Growth and development strategies

5.5 Evaluation of growth and development strategies

UWC in Mostar: Blue Book Economics Notes, page 13

o Management economies: many economists believe that economies of scale

UWC in Mostar: Blue Book Economics Notes, page 14