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Economics Revision Guide

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Copyright 2013
Last updated March 2013

2

AS Micro Economics
Unit 1 Markets in Action F581
Scarcity / Opportunity Cost
Production Possibility Frontiers
Positive / Normative Economics
Supply and Demand
Consumer and Producer surplus
Market Equilibrium
Labour Markets
Elasticity
Maximum and Minimum Prices
Buffer Stocks
Economies of Scale
Efficiency
Monopoly
Market Failure
Externalities
Demerit / Merit goods
Public Goods
Taxes and Subsidies
Pollution permits
Government Intervention
Government Failure


3
Basic Economic Concepts
Fundamental Economic Problem. This is the issue of scarcity and how
best to produce and distribute scare resources.
Positive economics: This is a statement based on facts and testable
theories - e.g. the inflation rate is 2%
Normative economics: This is based on opinion or a value judgement
e.g. the government should increase taxes
Opportunity cost: This is the sacrifice of the next best alternative
foregone, e.g. opportunity cost of buying a CD, is a book foregone.
Non-Renewable Resources. Natural resources which are finite. Once
used they cannot be replaced. E.g., coal, oil and gas are all finite.
Renewable resources. Resources that can be replenished. Examples
include wood, fish, solar energy, water.
Sustainable resources. Even renewable resources can be depleted,
e.g. overfishing can deplete fish stocks. Sustainable use gives time for
stocks to replenish.
Production Possibility Frontiers:
A PPF shows the maximum output that an economy can produce if the
economy is maximising the use of its resources and operating efficiently.



Points on PPF Curve

D = inefficient (Within PPF)
A or B = Productively efficient. It is
impossible to choose more of
consumer goods or environment units
without an opportunity cost.
C = impossible (without economic
growth)

4
services services
Opportunity Cost
A PPF can be used to illustrate the concept of opportunity cost. For
example, if we move from point A to B, we gain an extra 3 units of the
environment. However, the opportunity cost is we have to forego 4
units of consumer goods.









Constant Returns Diminishing Returns

The above diagrams show different slopes of PPFs In the first one the
opportunity cost of increasing goods is always constant therefore we
say it has constant returns.
In the diagram on the right, the opportunity cost increases we have
diminishing returns.
Economic Growth
Economic growth requires an increase in the productive capacity of the
economy. This could occur due to:
Discovering more raw materials
Increase in size of work force (e.g. immigration)
Increase in capital stock (machines factories)
Increase in labour productivity (due to better technology)

Economic growth will cause PPF to shift to the right

goods goods
5
Q1 Q2

P
Q
D1
P1
P2
D2
Demand
The individual Demand Curve illustrates the price people are willing to pay
for a particular quantity of a good.
A change in price causes a MOVEMENT ALONG the Demand Curve,
E.g. if there is an increase in price from p2 to p1 then there will be a fall
in demand from Q2 to Q1















Shifts in the Demand Curve
This occurs when, even at the same price, consumers are willing to
buy a higher quantity of goods. E.g demand shifts from D1 to D2
A shift to the right in the demand curve can occur for
a number of reasons:
1. An increase in disposable income; this can occur for a variety of
reasons such as higher wages and lower taxes
2. An increase in the quality of the good, e.g. computers are now more
powerful.
3. Advertising can increase brand loyalty to the goods and increase
demand
4. An increase in the price of substitutes, e.g. if the price of O2 Mobile
phone calls increase the demand for Vodafone mobiles will increase.

5. A fall in the price of complements. E.g. a lower price of Play Station 2
will increase the demand for compatible games.
Evaluation:
For some luxury goods income will be an important determinant of
demand. e.g. if your income increased you would buy more CDs but
probably not salt.
Advertising is important for goods in which branding is important,
e.g. coca cola but not for bananas

6
P
P1
S1
Q
P2
Q1 Q2
S2
Supply
This refers to the quantity of a good that the producer plans to sell in the
market.

As price increases firms have an incentive to supply more because
they get extra revenue (income) from selling the goods.

If price changes, there is a movement along the supply curve, e.g. a
An increase in price from P1 to P2 causes an increase from Q1 to Q2.















Shifts in the Supply curve

An increase in supply occurs when more is supplied at each price, e.g. a shift
in supply from S1 to S2. This could occur for the following reasons:

1. A decrease in costs of production; this means business can supply
more at each price. Lower costs could be due to lower wages or lower
raw material costs.

2. An increase in the number of producers will cause an increase in
supply.

3. Expansion in capacity of existing firms, e.g. building a new factory.

4. An increase in supply of a complementary good, e.g. beef and leather.

5. Climatic conditions are very important for agricultural products

6. Improvements in technology, e.g. computers / internet.

7. Lower taxes reduce the cost of goods.

8. Increase in govt subsidies will also reduce the cost of goods




7
P
Pe
S
Q
Q1 Qe Q2
P2
P
P1
S
Q
Qe Q2
P2
D1
D2
Market Equilibrium
Market Equilibrium
The Price Mechanism refers to how Supply and Demand interact to set the
market price and the amount of goods sold.

If price was below the equilibrium at P2 then demand would be greater
than the supply. Therefore there is a shortage of (Q2 Q1)

Therefore firms will put up prices and supply more. As price rises there
will be a movement along the demand curve and less will be
demanded.

















Therefore price will rise to Pe until there is no shortage and Supply = Demand
Movements to a new Equilibrium
If there was an increase in income the demand curve would shift to the right.
Initially there would be a shortage of the good, therefore the Price and
Quantity supplied will increase leading to a new equilibrium at Q2

















8
P
P1
S
Q
Q1
P2
D1
S2
D2
The Price Mechanism
Example: Factors that could explain a fall in the price
of a good
The price of a good, such as coffee, would fall if there was a fall in demand
and / or an increase in supply.

















The demand for coffee could fall for various reasons such as:

i) Lower incomes mean that consumers cannot afford to buy as much
ii) Less fashionable
iii) Decrease in the price of substitutes such as tea
iv) Fall in number of coffee shops
v) Health concerns about caffeine

The supply of coffee could increase for various reasons such as:

i) Increase in the number of suppliers
ii) Lower costs of production
iii) Govt subsidies
iv) Higher labour productivity in producing coffee, this will decrease the
costs of production
Economic effects of an increase in the Price of Coffee
1. Q.D. will fall, but it will only be a small amount because demand is
inelastic.
2. Demand for substitutes will increase, however there are not any
close substitutes for coffee therefore this will not be very significant.
3. If higher prices are caused by increased demand there will be an
increase in income for firms producing and selling coffee.


9
Labour Markets
Demand for Labour depends upon:
Productivity of workers. If workers produce more benefit for firms, they can
be paid more.
Skills and qualifications. Workers with more skills will tend to be better paid
Industry in question. Labour is a derived demand. If there is more demand
to see football games, there will be more money in the sport and footballers
will get paid more than other sportsmen.
Supply of Labour depends upon:
Skills required. If a job is highly skilled, less people will have the necessary
qualifications, therefore supply will be more inelastic
Non-monetary benefits. If a job is dangerous, unpleasant or boring, the
supply will be correspondingly less.
Wage. Higher wages will tend to attract more people to supply their labour.
Tax. Higher income tax may discourage labour supply.
Population and immigration. Immigration has increased supply of labour,
especially for certain jobs like plumbers and nurses.
Trades Unions. Trades unions may be able to restrict supply of labour and
push up wages.
Example of Wage Determination

In the diagram on the left, supply and demand are both elastic. This could
be an unskilled job such as a cleaner. Therefore, wages are relatively low.
On the right, supply and demand are inelastic leading to a higher wage.
This could be a lawyer - where supply and demand are inelastic.
10
P
Max P
Pe
Q
D
S
Q1 Qe Q2
Min P
Pe
Q
D
S
Q1 Qe Q2
P
Government Intervention in Markets
1. Maximum Prices.
Under certain circumstances the govt may wish to reduce the price below the
market equilibrium. E.g. they could have a maximum price for renting houses.













Problems of Maximum prices

The lower price will cause a shortage, therefore some tenants will be
worse off because they cannot find any houses to rent. Therefore the govt
would have to increase supply in order to overcome the shortage
2. Minimum Prices
This occurs when the govt wishes to raise the price above the equilibrium. For
example in agricultural markets, the govt often wishes to increase the income
of farmers by increasing the price of goods.













Problem of Minimum Prices
They encourage farmers to increase supply leading to a surplus which is
not bought on the market. Therefore the govt is obliged to buy the surplus
Q2- Q1 to maintain the target price.

11
Min Wage
We
Q labour
D
S
Q1 Qe Q2
Wage
P
Target Price
Q
D
TP
P1
Q1 Q2
3. Minimum Wages
Minimum wages are a policy designed to increase the wages of the lowest
paid, reducing relative poverty. In the UK, the NMW is 5.93 for people over
21. (2011)













If labour markets are competitive then a min wage could cause unemployment
of Q2- Q1. However in the real world a minimum wage may not cause
unemployment because:
Demand for labour may be very inelastic. (firms willing to pay higher
wage)
A higher minimum wage may increase worker productivity. This is
because, now wages are higher, workers may feel more loyalty to the
company.
4. Buffer Stocks.

This is a policy designed to stabilise prices primarily in agricultural markets.
The purpose of buffer stocks is:
i) Protect farmers incomes by guaranteeing a min price
ii) Protect consumers from high prices by guaranteeing a maximum price
level
iii) Ensure adequate supplies of food
















S2
S1
Buffer Stock
12
P
S2
S1
D

P1

P2
i) Demand for agricultural products is
inelastic, this is because they are a
small % of total income. A lower
price of potatoes wouldnt really
encourage people to eat more!

ii) Supply is inelastic

iii) Supply can fluctuate due to variable
factors such as the weather and
disease
If there was an increase in supply the equilibrium price would fall below
the target price.
To maintain the price at the target the govt will need to buy the surplus
(Q2-Q1)* TP. This will effectively increase demand and therefore price.
This excess supply could be stored in a buffer stock. If there was a
shortage in the next year then the govt could sell from its buffer stock to
reduce the price.
Problems of Buffer Stocks
1. It is expensive for the govt to buy the surplus and also to store it.
2. Some foodstuffs cannot be stored for a year.
3. The govt may have poor information about how much to buy, e.g. it
may be difficult to know whether there is going to be a shortage.
4. A minimum price may encourage over supply amongst farmers.
Why Prices are Volatile In Agricultural Markets














Advantages of govt intervention in Agriculture:

1. Stable prices help maintain farmers incomes.
2. Stability enables investment in agriculture.
3. Farming has positive externalities e.g. helps rural communities.
4. Stable prices prevent excess prices for consumers.
5. Food supplies are assured.
Disadvantages of govt intervention in Agriculture:
1. Cost of buying excess supply.
2. Min prices and Buffer stocks encourage over supply.
3. Govt subsidy to farmers may encourage inefficiency amongst farmers.
4. Some goods cannot be stored in buffer stocks.
5. Govts may have poor information e.g. what price to set.
6. Administration costs.

Q
13
Consumer and Producer Surplus



Consumer Surplus.

This is the difference between the price consumers pay and the price they
would be willing to pay. For example, if a book costs 10, but the demand
curve shows they would have paid 16, the consumer surplus is 6.

Monopolies are able to reduce consumer surplus because they
charge consumers a higher price.

Producer Surplus.

This is the difference between the price suppliers receive and the price
they would have been willing to supply the good at. If the market price is
10, and their supply curve shows they would have supplied it at 8, they
have producer surplus of 2.







14
P
D
D
P
Q Q
P P
Q
Q
D
D
Elasticity
Price Elasticity of Demand (PED) = % change in Quantity Demanded
% change in Price
Elastic Demand
Demand is elastic if a change in price leads to a bigger % change in
demand.
The PED will therefore be greater than -1. E.g. PED = -2.5













Elastic Demand PED > 1 Perfectly Elastic
Characteristics of Elastic Goods
1. Luxury goods (e.g. organic food)

2. They are expensive and a big % of income (e.g. sports cars and holidays)
3. Goods with many substitutes and a very competitive market. E.g. if Tesco
put up the price of its bread there are many alternatives, so people would
be price sensitive.
4. Bought frequently.
Inelastic Demand
Demand is inelastic if a change in price leads to a smaller % change in Q.D.
PED will be less than -1 e.g. -0.5












Inelastic demand PED <1 Perfectly inelastic PED =0
15
P
S1
S2
D
Q
$30
$15
80 100
Characteristics of Inelastic Goods
They have few or no close substitutes, e.g. petrol, cigarettes.
They are necessities
They are addictive
They cost a small % of income or are bought infrequently

In the short term demand is usually more inelastic because it takes
time to find alternatives
Using Knowledge of Elasticity

1. If demand is inelastic then increasing the price can lead to an increase
in revenue. This is why OPEC try to increase the price of oil.













Income Elasticity of Demand YED
This measures the responsiveness of demand to a change in income.
e.g. if your income increase by 5 % and your demand for mobile phones
increased 20% then the YED = 20 / 5 = 4.

Income Elasticity of Demand (YED) = % change in Q.D
% change in Income

Inferior Good This occurs when an increase in income leads to a fall
in demand. It will have a negative YED. Examples include clothes from
charity shops.

Normal Good This occurs when an increase in income leads to an
increase in demand for the good, Therefore YED>0

Luxury Good This occurs when an increase in income causes a bigger
% increase in demand, therefore YED >1. (Note a luxury good is also a
normal good)

Income inelastic This means an increase in income leads to a smaller
% increase in demand. Therefore 0 > YED < 1
Revenue was
$15 * 100= $1,500

Revenue is now
$30 * 80= $2,400

PED = -20% / 100%
= -0.2
16
P P
Q
S
S
Q
Inelastic
Cross Elasticity of demand
Cross Elasticity of Demand (XED) = % change in Q.D good A
% change in price good B

Substitute goods
These are alternatives to a good. Therefore XED will be positive,

Weak substitutes like tea and coffee will have a low XED.
Tesco bread and Sainsburys bread are close substitutes so XED is
higher

Complements goods
These are goods which are used together. Therefore XED is negative.
E.g. If the price of DVD players fall, then there will be a increase in
demand for DVD disks,
Price Elasticity of Supply
This measures the % change in QS after a change in Price

Price Elasticity of Supply PES = % change in QS
% change in Price

Inelastic Supply
This means that an increase in price leads to a smaller % change in supply.
Therefore PES <1












Supply could be inelastic for the following reasons
1. Firms operating close to full capacity.
2. Firms have low levels of stocks, therefore there are no surplus goods
to sell.
3. In the short term capital is fixed, therefore firms do not have time to
build a bigger factory.
4. If it is difficult to employ factors of production, e.g. if skilled labour is
needed.
5. With agricultural products supply is inelastic in the short run because it
takes at least 6 months to grow crops.


Perfectly inelastic
17
S
P
Q
P
Q
S
Elastic Supply
This occurs when an increase in price leads to a bigger % increase
in supply, therefore PES >1










Elastic Supply Perfectly Elastic
Supply could be elastic for the following reasons:
1. If there is spare capacity in the factory

2. If there are stocks available

3. In the long run supply will be more elastic because capital can be
varied.

4. If it is easy to employ more factors of production.
Multiple Choice Style Question
PES is 2.0 for CDS: and the firm supplied 4,000 when the price was 30.

Q. If the price increased from 30 to 36, what will be the new Q?

QS increases by 6, therefore as a % 6/30 = 0.2 = 20%

2.0 = % change in QS
20

40 = % change in QS

Therefore new Q = 4000 *140/100 = 5,600









18
Specialisation

Specialisation occurs when a country or firm concentrates on producing a
particular good or service.
Countries will specialise in producing goods where they have a
comparative advantage. For example, Japan specialises in producing
high-tech electronic goods. Cuba specialised in producing sugar.
Division of Labour
This occurs when workers concentrate on different tasks with a certain firm.
Rather than try to master all aspects of production, some workers will
specialise in various aspects.
For example, in a car building firm, some will work on design, some on
testing and some workers will just do unskilled jobs such as painting the car.
Advantages of Specialisation
Firms can concentrate on producing goods where they are relatively most
efficient.
It means countries dont have to produce every good they need, but can
trade to increase overall economic welfare.
By specialising in production, firms can benefit from economies of scale.
This means lower average costs. This is important for industries with high
fixed costs.
Problems of Specialisation
Concentrating on producing a small number of goods can make an
economy vulnerable. For example, if the sugar price falls, the Cuban
economy suffers.
Division of labour can make jobs highly specialised leading to boredom
and diseconomies of scale.
Free Market Economy
A free market economy occurs where there is an absence of government
intervention. Firms are privately owned and decisions on what to produce
and how to produce goods are left to market forces.
Free markets tend to result in an efficient allocation of resources.
However, they can also lead to monopoly power and great inequality. In a
free market, many public goods will be unprovided
Mixed Economies
A mixed economy involves a degree of government intervention. Many firms
remain privately owned. However, the government:
Raises taxes e.g. VAT (indirect tax) and income tax (direct tax)
Provides services like health and education
Regulates industries, e.g monopoly power and environmental laws.
19
P
Q 1 Q se
Q
SMB = Social Benefit
D = PMB = Private Benefit
S = PMC = SMC
P1
P2
Market Failure
Market Failure: This occurs when there is an inefficient allocation of
resources in a free market.
Externalities: These occur when a third party is affected by the decisions
and actions of others.

Social benefit: is the total benefit to society =
Private Benefit (PMB) + External Benefit (XMB)

Social Cost: is the total cost to society =
Private Cost (PMC) + External Cost (XMC)

Social Efficiency occurs when resources are utilised in the most efficient
way. This will occur at an output where
Social Cost (SMC) = Social Benefit. (SMB)
Positive Externalities
This occurs when the consumption or production of a good causes a benefit
to a third party.

When you consume education you get a private benefit. But there are
also benefits to the rest of society. E.g you are able to educate other
people and therefore they benefit as a result

Therefore with positive externalities the benefit to society is greater
than your personal benefit. Social Benefit > Private Benefit


















Positive Externality
20
Q se Q1
P1
P2
In a free market consumption will be at Q1 because private benefit =
private cost.

However this is socially inefficient because Social Cost < Social Benefit.
Therefore there is under consumption of the positive externality.

Social Efficiency would occur at Q se where Social Cost = Social Benefit.

For example: In the real world without govt intervention there would be too
little education and public transport.

Negative Externalities:

Negative externalities occur when the consumption or production of a
good causes a harmful effect to a third party.
For example, if you play loud music at night your neighbour may not be
able to sleep.
If you produce chemicals but cause pollution then local fishermen will not
be able to catch fish. This loss of income will be the negative externality.
Therefore with a negative externality, Social Cost > Private Cost




















In a free market people ignore the external costs to others therefore
output will be Q1 where D=S.
This is socially inefficient because at Q1: Social Cost > Social Benefit
Social Efficiency occurs at Q se where Social Cost = Social Benefit
E.g. In a free market there would be over consumption of cars and
cigarettes.

SMC
S=PMC
Q
P
D = PMB = SMB
Negative Externality
21
Types of Market Failure
1. Externalities Goods with negative / positive impacts on other people
2. Public Goods goods usually not provided because no incentive to
provide.
3. Merit / Demerit goods people have imperfect information and make ill-
informed choices. These goods may also have externalities.
4. Information Asymmetries. Lack of information by one party.
5. Labour Immobility difficulty in moving geographical area or retraining.
6. Inequality inequality resulting from free market.
7. Monopoly firms with the power to set higher prices to consumers
Information Asymmetries
Information asymmetries occur when people lack information that other
people possess. This lack of information can lead to poor decisions and
market failure.
Examples of market failure due to information asymmetries include:
Merit goods. People dont appreciate or know the value of getting a
vaccination or screened for cancer.
Demerit goods. People dont appreciate or realise the true costs of
drinking high quantities of alcohol.
Available jobs. Often people remain unemployed because they are
unaware of job vacancies. This leads to frictional unemployment.
People dont claim benefits that they are entitled to leading to more
relative poverty.
Labour Immobilities
Often unemployment is due to geographical immobilities. This occurs when it
is difficult for workers to move between different regions to take up job
vacancies in other parts of the country. Geographical immobilities may occur
due to:
Difficult in buying house / renting in other parts of the country.
Family ties to existing area, e.g. children in school.
Occupational immobilities
Occupational immobilities occur when labour is unable to move between
different occupations. For example, an unemployed coal miner may lack the
skills to take new job vacancies in I.T.
Overcoming Immobilities
Education and Training. To some extent workers can gain new skills and
qualifications from government sponsored training schemes.
However, there is no guarantee people will be able to understand and
pass on the new skills. They may be unable or unwilling to learn skills,
especially if they are older.
Also there may be government failure, with the government lacking the
right knowledge of which skills and qualifications to offer.
22
Q se Q1
P1
P2
P0
Government Intervention
1. Taxes






















DISADVANTAGES of taxes
1. Difficult to measure the level of negative externality e.g. what is the
cost of pollution from a car?
2. If Demand is inelastic then higher taxes will not reduce demand much.
3. Indirect taxes will cause inequality. (take a bigger % of income from the
poor)
4. Cost of administration.
5. Possibility of evasion. E.g. with tax on disposing of rubbish there has
been an increase in fly tipping (illegal dumping of rubbish)
ADVANTAGES of Taxes
1. Provides incentives to reduce the negative externality such as
pollution. e.g. cars have become more fuel efficient
2. Social efficiency, 1
st
best solution.(where MSC = MSB)
3. Taxes raise revenue for the govt, which can be spent on alternatives

SMC = S + Tax
S = PMC
Q
P
D = PMB = SMB
Tax on a negative externality
Tax = P2 P0 : Supply curve shifts to the left
Consumers now pay the social cost SMC
Market price increase from P1 to P2
Output will now be Q se where SMC = SMB
23
P
Q fm Q se
Q
SMB = Social Benefit
D = PMB
S = PMC = SMC
P1
P2
P0
S2
Impact of Tax and Elasticity
This diagram shows how the impact of a tax depends on the elasticity of
demand.


If demand is price inelastic, then a tax causes only a small % fall in
demand.
If demand is price elastic, then a tax causes a bigger % fall in demand
and a smaller % rise in price.

2. Subsidies

This involves the government paying part of the cost to the firm to
encourage more consumption, therefore supply shifts to the right.

















Subsidy on a positive externality
24

Subsidy = P2- P0
The supply curve shifts to S2 and Price falls to P0
People will now consume more at Q se
Advantages of Subsidies:
1. Increases social efficiency (increases output to Qse)
2. Provides an alternative to negative externalities e.g. buses for cars
Disadvantages of Subsidies:
1. Is expensive and the govt will have to increase taxes.
2. Difficult to estimate the benefits of the positive externality and therefore it
is difficult for the govt to know how much subsidy to give.
3. Giving subsidies to firms may encourage inefficiency as the firms can rely
on government aid.

3. Tradeable Pollution Permits
These involve giving firms a legal right to pollute a certain amount, e.g.
100 units of Carbon Dioxide per year.
If the firm produces less pollution it can sell its permits to other firms.
However if it produces more pollution it has to buy permits off other firms.
Therefore there will be a market for pollution permits. If firms pollute a lot
there will be low supply and high demand, therefore the price will be high
for permits.
Therefore, there is an incentive for firms to cut pollution.
Problems of Tradeable Permits:
Difficult to know how many permits to give.
May be difficult to accurately measure pollution levels. There is an
incentive for firms to hide pollution.
Requires global co-operation to make it effective, otherwise industry will
move to countries with lower environmental legislation.
High admin costs of measuring pollution

4. Laws Prohibiting undesirable behaviour

E.g. Legal Age for smoking / Ban on drink driving
Advantages of legal restrictions

Simple and easy to understand
When the danger is great, it may be better to ban it all together
When a decision needs to be taken quickly, a tax may be too
cumbersome

25
Disadvantages of legal restrictions

There is little incentive for a firm to develop more efficient mechanisms
It may be socially inefficient to ban everything

5. Advertising

The govt could advertise the dangers of smoking and alcohol; this may
overcome problems of poor information consumers may have about
demerit goods.
However consumers could still ignore the govt
Merit Good This is a good with 2 characteristics:


i) People do not realise the true benefit of consuming the good
ii) Usually these goods have positive externalities

In a free market they will be under consumed. Examples include health,
education.
Demerit Good This also has 2 characteristics:

i) People dont realise or ignore the costs of consuming the good e.g.
smoking, alcohol
ii) Usually these goods have negative externalities.

Therefore they are usually over consumed in a free market
Public Good These goods have two characteristics:

i) Non-rivalry: When a good is consumed, it doesnt reduce the amount
available for others. E.g. street lighting
ii) Non- excludability: This occurs when it is not possible to provide a good
without it thereby being possible for others to enjoy e.g national defence
Therefore there is a free rider problem as people can consume without paying
for them therefore in a free market they will not be provided.
Benefits of Govt providing Public Services
1. Merit Goods: people do not realise or underestimate the benefits of
education.

2. Positive Externalities. The consumption of health care services has
benefits to the rest of society. Therefore will be underprovided in the
private sector.
3. Economies of scale in providing National Service.
4. Providing a universal service leads to greater equality of distribution.
In a free market some would be unable to afford to pay.
5. Minimum Service Standards: important for public services such as health.
The private sector may cut costs by cutting quality of products
26
Government Failure
This occurs when govt intervention leads to an inefficient allocation of
resources. E.g. it could fail to overcome market failure and / or lead to an
inefficient allocation of resources. Govt failure can occur for various reasons:

1. Poor information. The govt may have poor info about the type of
service to provide.
2. Political interference, e.g. politicians may take the short term view
rather than considering long term effects.
3. Administration costs of govt bureaucracy in running public services.
4. Lack of incentives: There is no profit motive working in the public sector
and this can lead to inefficiency. For example there could be
overstaffing because there is no incentive to make redundancies.
Advantages of the private sector providing public
services
1. Increased demands being placed on the public sector due to
demographic changes. If more people went private this would enable
the NHS to have shorter waiting lists
2. Provides consumers with more choice.
3. If less people use the NHS it would enable the govt to lower taxes and
reduce borrowing.
4. Private sector has profit incentive to cut costs and provide a more
efficient service, e.g. public bodies may have over staffing because of
political fears about job cuts.
5. Diseconomies of Scale in the NHS
Disadvantages of the private sector

1. It is difficult to introduce a profit motive into public services such as
Health care, for example it is not practical to give performance related
pay to nurses. Also the private sector may cut costs by reducing the
quality of service.
2. May increase inequality. People on low incomes cannot afford private
health.

3. Health is a merit good and will be underprovided in a free market.
Therefore there is a justification for government subsidy.
Efficiency
Productive Efficiency: This means it is impossible to produce more of one
good than another this occurs on PPF. It will also occur at the lowest
point on the firms short run average cost (AC) curve.

Allocative Efficiency: This occurs when consumer preferences are met. This
involves an optimal distribution of resources i.e. it is impossible to
increase the economic welfare of on without reducing it for another.

27
Q
Long run average costs

Q1 Q2
AC1
AC2
Economies of Scale: This occurs in the long run when increased output
leads to lower average costs and therefore increased efficiency. E.g. by
increasing output from Q1 to Q2 the firm is able to reduce Average costs from
AC1 to AC2









Types of Economies of Scale:
1. Specialization and division of labour:
In large scale operations, workers can do more specific tasks. With little
training they can become very proficient in their task; this enables greater
efficiency and lower average costs.
2. Technical.
If a firm has high fixed costs, e.g. building a large factory, then the firm will
reduce average costs if it makes better use of its existing capacity.
3. Bulk buying:
If you buy a large quantity then the average costs will be lower. This is
because of lower transport costs and less packaging.
4. Financial economies.
A bigger firm can get a better rate of interest from a bank than small firms.
5. Spreading overheads.
If a firm merged it could rationalise its operational centres, e.g. it could
have one head office rather than two.
6. External economies of scale:
This occurs when firms benefit from the whole industry getting bigger. For
example, if an industry concentrates in one area, there will be better
transport and communication in that area.
Diseconomies of Scale:
This occurs when increased output leads to higher average costs.
This can occur due to factors such as difficulty of controlling and
monitoring workers in a big firm.
Also in a big firm, which is highly specialised, workers may become
alienated and bored with little motive to work hard.
A larger firm may experience difficulties communicating across the
different aspects of the business.



LRAC = Total Cost
Quantity
28
Monopoly
This is a market structure with one dominant firm.
Monopoly power occurs when a firm controls over 25% of the market
For a monopoly to occur there need to be barriers to entry, these are
conditions which make it more difficult for a firm to enter a market: e.g.


1. Economies of Scale. A new firm would find it difficult to compete
because its average costs would be much higher than the incumbent
who has a higher output and lower average costs.
2. Natural / Geographical Barriers. Only a few countries can produce
diamonds because they only occur in small parts of the world.
3. Brand Loyalty. Through advertising firms can differentiate their brand
and encourage consumers to be loyal to the product. It makes it more
difficult for new firms to enter because they would have to spend a lot
of money on advertising which is a sunk cost. (non recoverable)
4. Vertical Integration. By controlling supplies, firms can deter entry.
E.g. oil companies can limit supply of petrol to new petrol stations.
5. Legal Barriers. This prevents competition by law. For example a
patent or government monopoly (like Royal Mail used to be)
Disadvantages of Monopolies
1. Higher Prices. Consumers have only a limited choice, therefore
demand is inelastic. This enables the firm to increase prices, thereby
causing a fall in consumer surplus.
2. Allocative inefficiency. Firms dont respond to consumer needs and
preferences. Therefore monopolies tend to be allocatively inefficient.
3. Productive inefficiency. Because competition is limited firms have
less incentive to cut costs therefore could be productively inefficient.
4. Monopolies can pay lower prices to suppliers E.g. car companies
with monopoly power can pay lower prices to suppliers.
5. Diseconomies of scale. If a firm gets too big and unwieldy, average
costs will start to rise.
Advantages of Monopolies
1. Economies of Scale. If there are high fixed costs in the industry the
firm will be able to benefit from economies of scale and lower average
costs as output increases. This enables lower prices for consumers.
2. Research and Development. A firm can use its supernormal profits to
invest in new products which will benefit the consumer. This is
important for many industries such as pharmaceuticals.
3. Some firms may gain monopoly power because they are efficient
and innovative. E.g. google is considered an innovative company; this
gave it monopoly power in search engines.
4. International competition. A domestic monopoly may face
competition from abroad.


29
S = S+ sub
Q
SMB
D = PMB
S = PMC P
Q1 Q2
Q. Discuss whether govt subsidies to bus companies
would increase economic welfare?

Subsidies involve the govt paying part of the firms cost therefore Supply shifts
to the right and leads to an increase in demand.

Buses have positive externalities. This means that when you travel by bus
there is a benefit to a third party. For example if you travel by bus rather than
car there will be a fall in pollution and congestion. Congestion costs the
economy a lot because firms have an increase in costs and there is lost.
Therefore the Social Benefit of travelling by bus is greater than the private
benefit.

However in a free market people ignore the social benefit therefore there
is under consumption
















In a free market the equilibrium output will be at Q1 where PMB = PMC.
However social efficiency occurs at Q2 where SMC = SMB. Therefore there is
a case for subsidising the buses to overcome market failure. A subsidy of (Ps
P2) will shift supply to the right and increase demand to the socially efficient
level

Another argument for subsidising buses is that it is an important public
service and it is important to ensure that all groups of people are able to use
it, therefore the govt could subsidise cheap tickets for poor people to ensure
greater equality.

However the problem with subsidising buses is that giving subsidises
to bus firms may encourage them to be inefficient. This is because the
company has less need to cut costs because it can get money from the govt.
However this may not necessarily occur, it could depend on how competitive
the bus industry was.

Subsidising buses will mean the govt will have to increase taxes; this
could cause disincentives in the economy, because higher taxes may reduce
incentives to work. However this problem could be overcome by taxing goods
with negative externalities like cars.
Ps
P2
P1
Subsidy = Ps P2
30

Another problem with govt intervention is that the govt may have poor
information about how much to subsidise and who to give it to. Politicians are
usually worse at making economic decisions because they do not have
economic pressure but political pressures.

A more significant problem is that demand for buses may be very
inelastic. Buses only go certain routes therefore it is less suitable for some
people, therefore making buses cheaper may not increase demand, it may be
necessary to also increase the range of bus services and make them more
attractive to consumers.

To conclude there is a good economic reason to subsidise buses but
the govt will need to be careful that it gives the correct amount and that it is
not wasted. Furthermore to reduce congestion, it may be necessary to adopt
other measures such as taxing cars.











31
AS Macro Economics
Unit 2 National and International Economy F582
Aggregate Demand
Aggregate Supply
Economic Growth
Inflation
Supply side policies
Unemployment
Fiscal Policy
Monetary Policy
Exchange Rates
Balance of Payments
Conflicts of Macro Objectives

Advice on the Evaluation component of the exam
Model Essay on Economic Growth





32
Macro Economic Objectives of the Government:
1. Sustainable Economic Growth
2. Low unemployment
3. Control of inflation. (Inflation target is CPI = 2%, +/-1)
4. Satisfactory Balance of Payments
5. Supporting a stable exchange rate
6. Low government borrowing
7. Environment
8. Equality

Nominal GDP A Measure of national income, output and expenditure.
This is the monetary value of all goods and services produced in the
economy
Real GDP This is National income measured in constant prices.
Real GDP = Nominal GDP *100/ price index
Real GDP per Capita = This is the Real GDP / population

AD = C+I+G+(X-M) : AD is the Total Demand for goods and services. It
includes
C = Consumer expenditure on goods and services.
I = Gross Capital Investment (spending on capital goods)
G = Government Spending
X = Exports
M = Imports
An increase in AD (shift to the right) could be caused by a variety of
factors:
1. Increased Consumption: due to
i) An increase in consumers wealth
ii) Lower Interest Rate which make borrowing cheaper
iii) Higher wages which increase disposable income.
iv) Lower Taxes
v) Increased consumer confidence about the future
Consumer Expenditure accounts for about 66% of AD and therefore is a
very important component of AD.
2. Increased Investment: due to
i) Lower interest rates, this makes borrowing for investment
cheaper
ii) Increased confidence in the economic outlook.
iii) Improved technology making investment more efficient.
iv) Increased economic growth.
3. Increased Government spending
4. Increased exports
i) Increased growth in other countries,
ii) Lower value of Sterling, this makes exports cheaper
5. Decreased M
i) UK more competitive
ii) Lower value of Sterling

33
Aggregate Supply AS
Short Run Aggregate Supply curve SRAS.

Shifts in the AS can be caused by:

1. Changes in Labour costs
2. Changes in Raw Material costs
3. Taxation and subsidies


A fall in oil prices would cause SRAS to
shift to right (SRAS 1 to SRAS2)


Long Run Aggregate Supply Curve LRAS
In the Long Run, classical economists argue that the productive capacity of
the economy is determine by factors other than price and demand. They
argue that in the long run AS is determined by:


1. The Labour Force
2. The Capital Stock
3. Available Land
4. Technology
5. Productivity
6. Enterprise
7. Attitudes to work
8. Strength of banking system e.t.c




















Price Level
Real GDP Y
SRAS 2
SRAS 1
P L
Y
LRAS
AD
Yf
P L
LRAS
Y
AD2
AD1
CLASSICAL VIEW
KEYNESIAN VIEW
Keynesians believe that in the
long run there can be spare
capacity in the economy

Therefore they argue that the
LRAS can be elastic when there
is a recession
34
Economic Growth
Economic growth means an increase in real GDP. An increase in GDP
means an increase in the volume of goods and services produced in an
economy.
The rate of economic growth measures the annual % change in real GDP
An increase in the productive capacity (LRAS) of an economy is known as
an increase in potential growth.
The Long Run Trend Rate of Economic Growth: This is the sustainable
rate of economic growth in an economy. For example in the UK this is
about 2.5%.
The trend rate of growth is related to the increase in LRAS.
Benefits of Economic growth:

1. Higher Incomes. Consumers will be able to enjoy more goods and
services
2. Lower unemployment: With higher output firms will employ more
workers. A sustained period of economic growth will lead to lower
unemployment.
3. Lower Government Borrowing. Economic growth creates higher tax
revenues and there is less need to spend money on unemployment
benefits. This reduces government borrowing.
4. Improved public services. With higher tax receipts more can be spent
on health care and education.
5. Firms make more profit. Firms will make higher profit; this may
encourage more investment, which leads to a virtuous circle of higher
growth.
Costs Of Economic Growth
1. Inflation. If AD increases faster than AS then economic growth will be
unsustainable and inflationary. There will be a positive output gap and
firms will respond by putting up prices. However, if growth is not above
the trend rate and AD increases at the same rate as AS, growth will not
cause inflation.
2. Boom and Bust Economic Cycles. If economic growth is
unsustainable then high inflationary growth may be followed by a
recession. This occurred in the late 1980s and recession of 1991.
3. Balance Of Payments Deficit. Higher consumer spending causes an
increase in imports therefore causing a deficit on the current account.
However, if growth is export led, this will not occur.
4. Environmental Costs. Increased economic growth will lead to
increased output and therefore will cause increased pollution and
congestion which reduces living standards. However, higher growth
may enable more resources to be spent on the environment.
5. Increased Inequality: Higher rates of economic growth have often
resulted in increased inequality. However this depends upon things
such as tax rates and the nature of economic growth
35
Circular Flow of Income



The circular flow of income shows how money flows from households to firms
(to buy goods). Then firms pay households wages to produce goods. It shows
three ways to calculate GDP.

1) Total National income (wages, dividends,)
2) Total National expenditure (consumption and investment)
3) Total National output (value of goods and services produced)
Injections

This is an increase of expenditure into the circular flow of income, leading to
an increase in Aggregate Demand. Injections can include:

Exports spending from abroad on domestic goods.
Government spending.
Investment. Spending on capital goods by firms.

Withdrawals (leakages)

A reduction of money in the circular flow. Withdrawals can include:

Saving depositing money in banks
Imports spending on foreign goods
Taxation Government raising money from consumers and firms.

36
AD2
AD1
Y2 Y1
P2
P1
P1
LRAS LRAS 2
P L
Causes of Economic Growth
Short Term - Increased AD
If there is spare capacity in the economy an increase in AD will
cause an increase in Real GDP.
An increase in AD could occur for various reasons such as lower
interest rates, increased wages or higher govt spending















Long Term Economic Growth

Long run economic growth requires an increase in the LRAS as well as AD.
LRAS or potential growth can increase for the following reasons:

1. Increased capital e.g. investment in new factories or investment in
infrastructures such as roads and telephones.
2. Increase in working population (e.g. immigration or later retirement age)
3. Increase in Labour productivity, through better education and training
4. Producing more raw materials (e.g. discovering oil deposits)
5. Technological improvements to improve the productivity of capital e.g.
microchips and the internet have both contributed to economic growth.














P L
LRAS
Y
Long Term
Economic Growth
AD
Y
Y1 Y2
37
Trends in Economic Growth

The average sustainable growth rate in the UK is about 2.5% (average
quartely growth rate = 0.7%)
In the late 1980s, the UK experienced rapid growth, but this caused
inflation and the growth was unsustainable. To reduce inflation, the
government increased interest rates and this caused the recession of
1990-91.
Fall in Growth Rate
Between 1987 Q3 and 1989 Q3 there is a fall in the growth rate. This
means Real GDP increased at a slower rate. GDP only falls if there is a
negative growth rate, e.g. 1990 and 2008.
Sustainable Growth
Sustainable economic growth means that the growth can be
maintained for a long time. It implies that inflation will remain low and
AD increases at a similar rate to AS. It may also refer to environmental
sustainability.
Output Gap
The output gap is the difference between potential GDP and actual
GDP.
A negative output gap implies that actual GDP is less than potential.
(e.g. in a recession, with spare capacity and high unemployment)
38
A positive output gap occurs when actual GDP is above the sustainable
potential. A positive output gap leads to inflation.
Inflation
Inflation means a sustained increase in the general price level
If there is inflation the value of money declines and there is an increase in
the cost of living
Measuring Inflation Consumer Price Index (CPI)
1. Household expenditure survey- This seeks to measure what people spend
their money on. From this we get a typical basket of goods which is used to
measure typical prices.
2. This basket of goods gives a relative importance to each different item. E.g.
if price of petrol increased this would have more effect than an increase in
the price radios because petrol has a higher weighting.
3. The basket of goods is updated each year to take into account changes in
expenditure

4. Every month changes in prices of goods and services are monitored and
combined into a single figure with using the weights in the basket.
Problems with Calculating CPI
1. Family Expenditure survey does not include everybody e.g pensioners are
excluded, but pensioners have different spending habits e.g. heating is
more important. Young people will benefit more from falling prices of mobile
phones.
2. Changes in Quality: Computers have many more features than 10 years
ago, so it is difficult to compare prices because they are different goods.
3. Ignores housing costs and is often lower than old RPI method.
Costs of Inflation
1. Cost of reducing inflation:
High inflation is deemed unacceptable therefore governments feel it is
best to reduce it. This will involve higher interest rates, the reduction in
AD will lead to a decline in economic growth and unemployment
2. International competitiveness:
Higher prices will make British goods less competitive, leading to a fall
in exports. However this may be offset by a decline in the exchange rate
3. Confusion and Uncertainty:
When inflation is high people are uncertain what to spend their money
on. Also, when inflation is high firms may be less willing to invest
because they are uncertain about future profits.
4. Menu Costs.
This is the cost of changing price lists
5. Income redistribution.
Borrowers will become better off, lenders will become worse off,
however it depends on the real rate of interest.
39
Y1 Y2
P
P2
Causes of Inflation
Demand Pull inflation
If AD increases faster than AS inflation will occur














Cost Push Inflation



If there is an increase in the costs of firms then AS will shift to the left causing
inflation. This can be caused by:


1. Wage Push Inflation . Trades unions can bargain for higher wages, this
will lead to an increase in costs for firms. It may also cause demand-pull
inflation as consumers spend more increasing AD.
2. Import prices. One third of all goods are imported in the UK. If there is a
devaluation then import prices will become more expensive leading to an
increase in inflation.

3. Raw Material Prices If raw materials such as oil prices increase then this
will have a significant impact on costs and inflation.
4. Declining productivity. Lower productivity increases costs.
Price Level
AD1
LRAS
Y
AD2
40
Supply Side Policies
Supply side policies are government attempts to increase productivity and
shift AS to the right. Supply side policies can help the economy in various
ways:

1. Lower Inflation.
Shifting AS to the right will cause a lower price level.
2. Lower Unemployment
Supply side policies can help reduce structural, frictional and real wage
unemployment.
3. Improved economic growth
Supply side policies will increase economic growth by increasing AS
4. Improved trade and Balance of Payments. By making firms more
competitive they will be able to export more.
Examples of Supply Side Policies
1. Privatisation.
This involves selling state owned assets to the private sector. It is argued
that the private sector is more efficient in running business because they
have a profit motive to reduce costs and develop better services.
2. Deregulation
This involves reducing barriers to entry in order to make the market more
competitive.
3. Reducing Taxes.
It is argued that lower taxes (income and corporation) increase incentives
for people to work harder, leading to more output.
4. Increased education and training
Better education can improve labour productivity and increase AS.
Often there is under provision of education in a free market, leading to
market failure. Therefore the govt may need to subsidise suitable training
schemes.
5. Reducing State Welfare Benefits
This may encourage unemployed to take jobs.

6. Providing better information
7. Improving Transport and infrastructure.
In a free market there is likely to be under provision of public
transport. If this was increased firms would benefit from lower costs
Evaluation of Supply side policies

1. They will take time to have effect.
2. It will cost money to improve information and education.
3. Lower benefits and reduced Minimum wages may cause poverty to
increase.
4. Govt failure may occur, this is because the govt may have poor info about
what to spend money on, e.g the govt may finance the wrong kind of
scheme.
41
Unemployment
Economic Costs of Unemployment

1. Loss of earnings to the unemployed
2. More difficult to get work in the future
3. Stress and Health problems of being unemployed
4. Increased govt borrowing: Tax revenue falls, spending on benefits rises.
5. Lower GDP for the economy, this is pareto inefficient.
Measuring Unemployment
1. Claimant Count Method. This is the govt official method of calculating
unemployment. It counts the number of people receiving benefits (Job
Seekers allowance)

Problems with Claimant count
o The Count excludes those over 60, under 18, those on govt
training schemes, and married women looking to return to work
o Some people may claim benefits whilst still working in the
black Market

2. The Labour Force Survey. This is a survey asking 60,000 people whether
they are unemployed and whether they are looking for a job. It includes some
people not eligible for benefits
Types of Unemployment
1. Frictional Unemployment:

This is unemployment caused by people moving in between jobs, e.g.
graduates or people changing jobs. There will always be some
frictional unemployment.
Also high benefits may encourage people to stay on benefits rather
than get work this is sometimes known as voluntary unemployment

2. Structural Unemployment

This occurs due to a mismatch of skills in the labour market it can be
caused by

1. Occupational immobilities. This refers to the difficulties in
learning new skills applicable to a new industry, and
technological change.
2. Geographical Immobilites. This refers to the difficulty in moving
regions to get a job.



42
Y2
P1
P2
3. Classical or Real Wage Unemployment:

This occurs when wages in a competitive labour market are pushed
above the equilibrium. This could be caused by minimum wages or
trades unions.


















4. Demand Deficient or Cyclical Unemployment

This occurs when the economy is operating below full capacity. In a
recession when AD falls there is a fall in output therefore firms will
employ less workers. Some firms will go bankrupt leading to more
unemployment.


















Demand deficient unemployment is often the biggest cause of
unemployment in the UK. E.g. after recession of 1991 and 2009,
unemployment rose close to 3 million.



Wage
Ql
S
D

Wtu
We
Q1 Qe Q2
Price Level
AD1
LRAS
Y
AD2
Y1
43
LRAS
AD2
AD1
Y1 Y2
P2
P1
Policies To Reduce Unemployment

1. Fiscal and Monetary Policy
This involves cutting interest rate or taxes to increase AD. Higher output
will cause firms to demand more workers. This will be effective for
reducing demand deficient unemployment.
















However demand side policies may cause higher rates of inflation
and will not reduce supply side unemployment.

2. Lower benefits and taxes.
These increase the incentive for the unemployed to look for work rather
than stay on benefits. This will reduce frictional unemployment, but will
cause a fall in AD and increase relative poverty.

3. Better job information.
This could help reduce frictional unemployment by giving the unemployed
better information about available job vacancies.

4. Education and Training.
By improving labour productivity and the skills of the workforce there will
be a reduction in occupational immobilities making it easier for workers to
switch jobs.
o However this will cost the govt money, also there could be govt failure
with the wrong kind of training subsidised.

5. Reform Trades Unions and reduce Minimum Wages
This will help reduce real wage unemployment.
o However the effect on employment may be small if demand for labour
is inelastic.

6. Regional Grants
These can help overcome geographical unemployment by encouraging
firms or workers to move.
o However subsidies may prove ineffective for encouraging workers to
move because they may be attached to their local community

Price
Level
Y
44
Monetary Policy
This involves changing the interest rate or manipulation of the Money Supply
by the monetary authorities.
Aim of Monetary policy
1. Control the rate of inflation. Inflation target for MPC is - 2.0% +/-1
2. Maintain sustainable economic growth.
3. Influence the Exchange rate

Effect of Higher Interest Rates. (Tight monetary policy)

If inflation is forecast to rise above the inflation target, the MPC are likely to
increase interest rates. This will help reduce AD and inflation because higher
interest rates:

1. Makes borrowing more expensive, therefore people spend less on credit.
2. Firms will be less willing to invest by borrowing money.
3. The cost of mortgages increases, therefore people have less disposable
income causing a fall in consumption. Therefore AD decreases
4. Saving money in a bank is more attractive therefore there is less spending
5. Exchange rate increases, due to hot money flows into the UK. The
appreciation in the exchange rate depresses demand for UK exports
Evaluation of Monetary Policy
1. The effect of higher interest rates depends on the situation of the
economy. If the economy is close to full employment, a rise in interest rates
is likely to reduce inflation significantly without reducing Real GDP.



However if the economy has spare capacity, (e.g. at Y3 to Y4) reduced
AD may not reduce inflation but only reduce GDP
45
AD1
LRAS
AD2
Y2
P1
P2

2. The effectiveness of Monetary policy depends upon other variables
in the economy e.g.
a) If confidence is low, a reduction in interest rates may not
increase demand
b) If taxes are rising this may counter a fall in interest rates
c) If the world economy is slowing this will reduce exports and AD,
this would keep spending low even if there was a fall in interest
rates

3. There may be time lags for lower interest rates to have an effect. E.g.
higher interest rates may not reduce investment in the short term because
firms will continue with existing investment projects

4. Monetary policy may conflict with other macro economic objectives.
If the MPC reduces inflation this may lead to lower growth or higher
unemployment. The below diagram shows the effect of higher interest
rates in leading to lower growth.

















5. Interest rates may conflict with the exchange rate. If the Bank
increased interest rate this would cause a fall in AD but also would cause
an increase in the exchange rate (due to hot money flows). This would
harm manufactures who export the most.

6. Monetary Policy may also affect the Balance of Payments. If AD falls
people buy less imports, improving the current account
However if interest rates increase the exchange rate will and may
lead to a worsening of the deficit, because exports are more
expensive.

7. Fine Control of Monetary Policy is not possible. It is difficult to get
accurate information about the economy. Time lags in policy mean
interest rates affect the economy too late.

8. Monetary Policy will have a big effect on the housing market. This is
because they effect mortgage payments. E.g. an increase in interest rates
will reduce the attractiveness of buying a house.
Price Level
Y
Y1
46
Fiscal Policy
Fiscal Policy involves the government changing the levels of Taxation and
Govt Spending in order to influence AD.

The purpose of Fiscal Policy is to:
1. Maintain low inflation
2. Stimulate economic growth in a period of a recession

Expansionary or loose fiscal policy involves lower tax, higher
spending to increase AD.
Deflationary or tight fiscal policy involves higher tax and lower
spending to reduce AD.
The Multiplier
This states that if there is an initial injection (e.g. higher govt spending)
into the economy, then the final increase in AD and Real GDP will be
greater.
Problems of Using Fiscal Policy
1. Poor info may reduce accuracy of forecasting economic growth and
inflation
2. It depends on other components of AD, e.g. consumer confidence.
3. Higher Taxes can create disincentives to work, reducing productivity.
4. Time lag involved in increasing AD.
5. Expansionary fiscal policy will increase government borrowing.
Budget Deficit
A budget deficit occurs when government spending is greater than tax
revenues. Therefore the government has to make up the shortfall by
borrowing from the private sector.
Public sector net Borrowing (PSNB). The annual amount the
government needs to borrow
Public Sector Net Debt PSND (The National Debt): This is the total
(cumulative) amount of debt that the government owes the private
sector at the moment this is over 800bn (or 57% of GDP)
Annual interest payments on the debt are close to 40bn
(N.B. Dont get a government budget deficit confused with the Trade
Deficit which occurs when omports are greater than exports)
Problems of a Government Borrowing
1. National Debt will increase leading to higher debt payments in the future
2. Govt may have to increase taxes in the future which may create
disincentives to work.
3. Govt may have to cut govt spending which leads to deterioration in public
services. (for more details see: A2 notes)

47
Exchange Rates
Factors which influence the exchange rate
1. Inflation
If inflation in the UK is lower than elsewhere, then UK exports will become
more competitive and there will be an increase in demand for s. Also
foreign goods will be less competitive and so UK citizens will supply less
.
2. Interest Rates
If UK interest rates rise relative to elsewhere it will become more attractive
to deposit money in the UK, Therefore demand for Sterling will rise. This
is known as hot money flows. Therefore the value of will appreciate
3. Speculation
If speculators believe the sterling will rise in the future They will demand
more now to be able to make a profit. This increase in demand will cause
the value to rise.
4. Strong Economy
If the British economy is growing strongly interest rates are likely to rise to
keep inflation low. Therefore the is likely to appreciate in value.
5. Current Account.
A large deficit on the current account, is likely to cause a depreciation in
the value of the exchange rate. This is because a deficit implies a flow of
exchange out of the country to buy imports.
Government Intervention in the Foreign Exchange
Market
1. Changing interest rates
Higher interest rates will cause hot money flows, increase demand for
sterling and increase the value of the currency.
2. Reduce Aggregate Demand
By decreasing AD, consumers will spend less and purchase less imports
and so will supply less pounds. This will increase the value of the
currency.
Lower inflation rate will also help as British goods become more
competitive. Thus demand for Sterling will rise.
However this policy has an obvious side effect because lower AD will
cause lower growth and higher unemployment
Economic Effect of a Devaluation of the Currency
1. A devaluation of the exchange rate will make exports more competitive
and appear cheaper to foreigners. This will increase demand for exports
2. Imports will become more expensive. This will reduce demand for imports
3. Inflation is likely to occur because:
o Imports are more expensive
o AD is increasing
o With exports becoming cheaper manufacturers may have less
incentive to cut costs and become more efficient
48
P2
P1

4. AD = X-M Therefore higher exports and lower imports will increase AD

















Higher AD is likely to cause higher Real GDP and inflation.
The size of this increase depends upon factors such as
a) Spare capacity in the economy
b) Other determinants of AD

6. Current Account. There is likely to be an improvement in the current
account balance of payments. This is because quantity of exports are
increasing and imports are falling

Evaluation: The impact on the current account depends upon the elasticity of
demand for exports and imports. If demand for exports is
inelastic, a depreciation will only cause a small increase in
quantity.
Economic Effects of an Appreciation
1. Exports more expensive, therefore less UK exports will be demanded
2. Imports are cheaper, therefore more imports will be bought.
3. A fall in AD, causing lower growth
4. Lower inflation because:
o import prices are cheaper
o Lower AD
o More incentives to cut costs
5. Current account deficit will tend to deteriorate.

In a period of high growth and high inflation, an appreciation may help. In a
recession an appreciation is likely to lead to lower growth and higher
unemployment.

P L
LRAS
Y
AD2
AD1
Y1 Y2
49
Balance Of Payments
The Balance of Payments is a record of a countrys transactions with the rest
of the world. It shows the receipts from trade. It consists of the current and
financial account

1. Current account
i) Balance of trade in goods (visible)
ii) Balance of trade in services (invisibles) e.g. tourism,
insurance
iii) Net income flows (wages and investment
income)
iv) Net current transfers (e.g. govt aid,
payments to EU)

2. Financial account (note this used to be called the Capital Account) This
is a record of all transactions for financial investment. It includes financial
flows and net investment
Factors which cause a current account deficit
1. Overvalued Exchange Rate
If the currency is overvalued, imports will be cheaper and therefore there
will be a higher Q of imports. Exports will become uncompetitive and
therefore there will be a fall in the quantity of exports.

2. Economic Growth
If there is an increase in AD and National Income increases, people will
have more disposable income to consume goods. If domestic producers
cannot meet the domestic AD, consumers will have to imports goods from
abroad.

3. Decline in Competitiveness.
If there is high inflation or a decline in productivity there will be less
demand for UK exports and British consumers will prefer buying imports.
Policies to reduce a balance of Payments Deficit
1. Devaluation.
This involves lowering the value of the currency against others, making
exports cheaper and imports more expensive.
Therefore we would expect a devaluation to lead to an improvement in
the current account. However it does depend upon the elasticity of
demand for exports and imports.

2. The Marshall Learner Condition
(note: ML condition not explicitly required for AS, but could count towards evaluation)
This states that a devaluation will improve the balance on the current account,
on the condition that the combined elasticitys of demand for imports and
exports is greater than one.

If (PED x + PED m > 1) then a depreciation will improve current account
and an appreciation will worsen the current account
50
A problem with devaluation is that it can lead to imported inflation. This
will reduce competitiveness in the long run and will mean the
improvement in the current account might only be temporary.

3. Reduce Consumer Spending. If govt reduces AD by raising interest
rates or increasing taxes then people will have less money to spend so
they reduce consumption of imports.

i) The UK has a high marginal propensity to import therefore a reduction
in AD improves the current account significantly.
ii) Deflationary policies will also put pressure on manufacturers to reduce
costs and this will lead to more competitive exports and so exports will
increase

iii) However this policy will conflict with other macroeconomic objectives
With lower AD, growth is likely to fall causing higher unemployment

4. Supply Side Policies
These can improve the competitiveness of the economy and exporters, but
this will take time to have effect

5. Protectionism.
This involves restricting trade through tariffs, however it is likely to fail
because it will lead to retaliation (other countries place tariffs on UK
exports.
Definitions
Investment: This refers to an increase in the level of the capital stock,
e.g. the purchase of machines. (dont confuse with saving money in bank)

Labour productivity: This refers to output per worker

Output Gap. A positive output gap means output (GDP) is above potential
(growth above long run trend rate. A negative output gap means there is
spare capacity output less than potential.

Economic Cycle the cyclical nature of economic growth.

Economic Stability This refers to sustainable economic growth, low
inflation and low unemployment with low inflation. Macro economic stability
will avoid booms and busts

Savings Ratio This is the % of a persons income that is not spent but
saved

Human Development Index (HDI) A measure of economic welfare that
includes GDP, health care and education standards.


51
International Trade
Since 2000, the UK has experienced a current account deficit. This means we
import more goods and services than we export.


Benefits of International Trade
Comparative advantage. Comparative advantage occurs when a country
can produce a good at a lower opportunity cost. If countries specialise in
goods where they have a comparative advantage there will be an
increase in economic welfare.
Lower prices for consumers. Consumers will benefit from lower prices
of imports. This is due to competition and gains from comparative
advantage.
Greater competition. International trade gives firms more competition
which helps to reduce costs and increase efficiency.
Economies of scale. International trade allows firms to adopt greater
specialistion. This can lead to lower average costs of production.
Protectionism
This occurs when a government seeks to protect domestic industries from
free trade and foreign competition. Protectionism can include:
Tariffs. This is a type of tax on imports. It increases the cost and
discourages domestic consumers from buying.
Non-tariff barriers. These are other obstacles to trade. They may include
complicated rules and regulations which make it more expensive for
foreign companies to adopt.
Reasons for Protectionism
Protects domestic industries and allows them to develop.
52
Help countries diversity into new industries. (important for developing
countries)
Raise revenue (though tariffs would be a minor source of income)
Conflicts of Macro Economic Objectives
Conflicts of Policy Objectives


In practise it is difficult to achieve all policy objectives at once. For example,
increaing the rate of economic growth could lead to inflation and a bigger
deficit on the current account.

Increase In AD



A period of
negative growth
(1991 and 2009)
caused a rise in
unemployment
53
In this diagram an increase in AD leads to an increase in economic
growth. However, as the economy gets closer to full capacity, there is
an increase in the rate of inflation.
Also as consumer spending increases, the level of imports will rise.
This tends to cause a deterioration in the current account.

However, higher economic growth will help:

1. Reduce the level of unemployment. Higher output leads to higher
employment levels
2. Improved government finances. Tax receipts increase with higher
growth.

Evaluation
Higher economic growth doesnt have to cause inflation and a
deterioration in current account. If AS increases at same rate as AD,
growth can be sustainable and non-inflationary. If growth is export led,
(like China), the economy can have a current account surplus.
Phillips Curve


The Phillips curve shows a trade off between unemployment and
inflation.
A rise in AD leads to higher growth. This higher growth causes inflation
but helps reduce unemployment.
Therefore, in the short term, policy makers face a trade off between
unemployment and inflation.
54
Evaluation
Evaluation requires more than knowledge, but also the ability to
consider a question in more detail and apply critical distance to the
question.
Evaluation questions start with words such as:
1. Discuss
2. Evaluate
3. To what extent
4. Assess
5. Examine

Usually they will be the longer questions towards the end of the paper,
however this isnt always the case, it is most important to check the key word
at the start.
Methods of Evaluation:
1. How important is a factor? For example: Consumption is 66% of AD
therefore higher C has a significant effect on AD. A fall in exports to the
US, would have a limited impact on its own.


2. Time lags involved. A cut in govt spending may reduce AD, however it
may take time for this to affect the economy. Interest rate changes can
take up to 18 months to have an effect on economy, one reasons could
be because some people may have a two year fixed mortgage.


3. It depends upon the situation of the economy. An increase in AD
will only increase economic growth if there is spare capacity. Therefore
the elasticity of AS is important.

4. Conflicts of the policy involved: An increase in taxes may reduce the
budget deficit, however it may reduce incentives to work. Higher
interest rates may reduce inflation, however it may cause the exchange
rate to increase reducing demand for exports

5. It depends upon other variables in the economy. An increase in
interest rates is likely to reduce AD and inflation, however if consumer
confidence is very high and wages are increasing, this is likely to keep
AD high despite the increased interest rates.

These same concepts can be used for different questions.
The most important idea is that you dont give a simple answer but
always consider another viewpoints as well.




55
Price Level
AD
LRAS
Y
AD
P
P
Y Y
Q. Evaluate Policies that the government can use to
increase the rate of economic growth.


The rate of economic growth measures the annual % increase in Real GDP.
To increase economic growth the govt can increase either AD or AS
If the economy is below full employment and there is spare capacity
within the economy. The govt can use demand side policies to increase the
rate of economic growth.


















For example the govt could use fiscal policy to increase the rate of AD.
This could involve cutting taxes and increasing the level of govt spending.
AD = C+I+G+X-M. Therefore higher G will increase AD and lower taxes will
increase disposable income thereby increasing C and AD.

Also the MPC could cut interest rates. This reduces the cost of
borrowing and reduces monthly mortgage payments. Therefore there will be
an increase in the level of borrowing, consumption and investment.

However demand side policies do have some problems, firstly there
will be time lags between changing taxes or interest rates and having an
effect on AD. Also if consumer confidence is lower interest rates may not have
much effect on increasing consumption. Also increasing AD can conflict with
the govt objective of low inflation. If the economy is close to full capacity
higher AD will cause inflation.

Classical economists argues that higher AD will always cause inflation,
because the LRAS is inelastic. Therefore in the long run there will not be any
increase in economic growth






Increase in AD
56
Price Level
Y
LRAS LRAS 2
AD
Y1 Y2
AD2
P1

















To increase economic growth in the long run it is necessary to increase
productivity and shift the LRAS to the right, this can be done through supply
side policies. For example the govt can increase the incentive to work by
cutting taxes and reducing benefits. However there is no guarantee that lower
taxes do increase work incentives. Also inequality may increase.

The govt can overcome market failure by increasing spending on
education and training, this will increase labour productivity and therefore
efficiency in the economy. However this policy will take time to have effect.
Also govt intervention may not be very successful because of poor information
leading to subsidising of the wrong types of training.

A third type of supply side policy could be to follow a programme of
privatisation and deregulation. Privatisation involves selling govt owned
industries to the private sector. The advantage of this is that the private sector
has a profit incentive to increase efficiency. However there are dangers that a
private monopoly may exploit consumers. The example of rail privatisation
also showed that privatisation may not be successful, private firms under
invested in the network because they took the short term view.

Supply side policies may help improve productivity in the long term.
However there is a limit to how much the govt can increase productivity, for
example it is difficult for the govt to improve technology and working ethics.
Also the rate of economic growth is likely to be effected by global events over
which the UK govt has no control.
Commentary
1. It is important to consider both the demand and supply side causes of
economic growth.
2. To evaluate the policies it is important to give their limitations and
disadvantages, alternatively you could say how important the policy
was.
3. AD/AS diagrams are very helpful to explain points
4. To get a high marks it is important consider points critically.

Classical View of
Economic Growth
57
P
P1
S
Q
Q1 Q2
P2
D1
D2
Case Study Housing Market

An important element of the AS exam is the ability to use the micro and macro
concepts in real life markets. For example, you could get asked about the
micro and macro effects of the housing market. These pages are just an
example of how the above information can be applied for certain questions.
Factors That Effect House Prices
House prices are affected by a combination of supply and demand factors.


















Demand Side Factors
Demand for houses can increase for the following reasons

1. An increase in real income.
This could be due to higher wages or lower taxes
2. Lower interest rates.
This will reduce the cost of having a mortgage. Interest rate are very
important, as mortgage repayments are usually the biggest part of a
persons monthly spending.
3. An increase in consumer confidence
People more willing to take out a mortgage.
4. Lower Unemployment
5. Demographic factors such as an increase in the population or an
increase in the number of single people wanting a house. In the UK this
has occurred for various reasons such as:
o an increase in divorce rates
o Increase in life expectancy therefore more old single people
o Children leaving home early
6. An increase in the price of rented accommodation, which is a
substitute to buying a house

An increase in
demand causes a
big increase in price
because supply is
inelastic
58
Price Level
AD
LRAS
Y
AD
P
P
Y1 Y2
7. Inherited wealth. Many people use inherited wealth to buy houses

Supply Side Factors
In the short run Supply of housing is fixed because it takes time to build
houses. Therefore in the short run demand affects prices more than supply
However if the supply of housing is inelastic then an increase in
demand will lead to a big increase in price.
In the long Run the supply of housing is affected by
many factors

o Availability of planning permission. This is difficult to obtain in rural areas
o Opportunity cost for builders e.g. are there better returns from other types
of investment
o Existing houses may be knocked down because they are deemed unfit to
live in.
o An increase in the cost of building new houses will shift supply to the left
How The Housing Market Impacts the rest of the
economy.
Housing is the biggest component of most households wealth. Therefore it
has a big impact on the economy. The UK has one of the highest rates of
property ownership in the UK. It is roughly 77% compared to 50% in France.

1. Effect on AD.
If there is a boom (or increase) in the housing market then there will be a
positive wealth effect as people enjoy capital gains. This will lead to an
increase in AD, because people are more confident about the economy
and some people will re-mortgage their house (equity withdrawal) to spend
more money.

2. Effect on Economic Growth (Real GDP)
An increase in AD is likely to cause an increase in Real GDP, however this
depends on the situation of the economy. In the below diagram there is
spare capacity in the economy therefore there is an increase in Real GDP














59

However if the economy is close to full capacity then the increase may
only be small.

Also the effect on AD depends upon other components of AD.
For example if taxes are rising or exports are falling this will
keep AD low despite rising house prices

3. Effect on Inflation
An increase in house prices will cause an increase in the cost of
mortgages and therefore will lead to an increase in the RPI. Also the
increase in AD could cause demand pull inflation, However again it does
depend upon the slope of the AS curve and other factors in the economy.

4. The MPC is responsible for setting interest rates. It is committed to keeping
inflation within its target of RPIX 2.5% +/-1.
If house prices are rising this may put pressure on inflation therefore
they may be more likely to increase interest rates
However house prices are only one factor affecting monetary policy

5. High House prices could cause some workers to be unable to afford to but
houses. High property values has caused a shortage of workers in London
and the South East.

6. Increased Supply of Houses: With High house prices there is a greater
incentive to build new houses. Therefore house-building firms will do well.
The Housing Market and Market Failure
Despite the shortage of houses the government has put a limit on building
new houses. This is because new houses will cause the loss of green
belt land. This loss of the environment could be said to be a negative
externality

Other negative externalities of new houses include increased traffic on the
roads causing congestion and pollution.

Those on low incomes may not be able to afford to buy or rent a house.
This has become more of a problem with the boom in housing prices.

Boom and Bust in the Housing Market. This involves rapid movements in
the price of housing.

In times of falling house prices, some house owners can experience
negative equity causing lower AD.

Rising house prices increase AD maybe causing inflation. Booms
encourage speculation and make houses unaffordable for many people

60
Government Intervention in the Housing Market
Legislation about building houses on greenbelt land

Govt subsidies for building houses. However this has been quite low in
recent years.

Provision of council houses. However in the 1980s many council houses
were sold to the occupants at reduced prices. This has reduced the
quantity of housing.
Also council houses have often been associated with higher levels of
crime and vandalism, especially in many of the new tower blocks built
in the 1960s.

To reduce fluctuations in house prices the MPC can change the interest
rate. However the problem is that housing prices are only a small effect
part of the economy. Despite recent increases in house prices (95-02)
interest rates have not been cut because inflation has been low.

Maximum Prices. The aim of this is to reduce the price of rented houses,
however this could result in a shortage of houses in the rented sector.
Also problem of black market

Housing Benefit. Those on low incomes can apply for housing benefit
which enables them to rent housing.

Policies to reduce speculation in the housing market
Stamp Duty (this is a tax on selling a house)
Abolition of MIRAS ( this was a tax relief on having a mortgage)
Elasticity and Housing
Elasticity of Demand for Housing
The sharp rises in house prices suggest that demand is quite inelastic
because the higher prices have not discouraged demand.
There are not many substitutes for housing . Renting is a possibility but
in the UK people are keen to buy a house as it is a form of investment.
Demand is more inelastic in popular areas such as London

Elasticity of Supply for Housing:
In the Short run supply will be inelastic because it takes time to build
new houses.
In the long run the supply of housing will be more elastic because
increased prices will encourage people to buy them
However in certain areas supply will be still inelastic because there is a
shortage of space or space is protected by greenbelt land regulations

Income Elasticity of demand
Demand for housing tends to be income elastic. YED > 1
If incomes increase people tend to spend a higher % of their incomes
on housing. This is because people want to get a better (and more
expensive house) and some people may buy a 2
nd
home in the country