Economics Unit 4 Notes

Definitions
Definition of law of diminishing returns (2 marks) if increasing quantities of a variable factor are
applied to a given quantity of a fixed factor, the marginal product of the variable factor will
eventually decrease.
In economics, the marginal product of labor(MPL) is the change in output that results from
employing an added unit of labor
Free Market- an economic system in which prices are determined by unrestricted competition
between privately owned businesses.
Capitlism- private ownership of resources
Income inequality refers to the extent to which income is distributed in an uneven manner among a
population.
Relative poverty Where individual or household income falls below some national average or median
income

Capital Flight' A large-scale exodus of financial assets and capital from a nation due to
events such as political or economic instability, currency devaluation or the imposition
of capital controls.

Absolute poverty was defined as: a condition characterised by severe deprivation

of basic human needs, including food, safe drinking water, sanitation facilities,
health, shelter, education and information. It depends not only on income but also on
access to services.

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Essay Marking
Examination length: 2 hours One essay question with two parts from a choice of three topic areas.
Worth 50 marks. One data response question out of a choice of two questions. Worth 50 marks.
use and evaluate more complex models involving more variables, for example pricing and output
decisions under different market structures (see Unit 3)
apply models to a wider range of contexts, for example students should consider the causes and
consequences of inequality in developed and developing countries (see Unit 4)
develop the ability to apply and evaluate economic models as represented in written, numerical
and graphical form, for example in Unit 3 students will need to be able to draw a cost curve and
explain its shape in terms of diminishing marginal returns and economies of scale
be able to propose possible solutions to problems, for example in Unit 4, students have to apply
concepts and theories which may be appropriate to promote growth and development in a
particular economy
understand the relationships and linkages which underpin macro-economic models, for example in
Unit 4, students should understand global factors which influence a countrys exchange rate
be able to predict the possible impact of policy changes on local, national and international
economies, for example in Unit 4 the AD/AS model is applied in analysing and evaluating the use of
policies to achieve economic objectives

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 be able to evaluate the effectiveness of government policies across a range of contexts, for
example in Unit 4, students have to examine government policy to increase international
competitive
Unit 4 students have to identify constraints on growth and development in different economies and
reasons for their different growth rates.
30 marks- 4 kaa and 3 eval maybe diagram
10 marks definition, 2 application, reference and evaluation

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Globalisation
Rowstow model
J curve
Harrod domar model
Budget deficit
Prebisch singer
Infrant industry argument for eval of globaltion
Phillps curve

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Globalisation

Globalisation has involved:

Greater free trade.
Greater movement of labour.
Increased capital flows.
Growth of Multi-national companies.
Increased integration of global trade cycle.
Increased communication and improved transport, effectively reducing barriers between
countries.

Benefits of Globalisation

1.
2.
3.
4.
5.

1. Free Trade Free trade is a way for countries to exchange goods and resources. This
means countries can specialise in producing goods where they have a comparative
advantage (this means they can produce goods at a lower opportunity cost). When
countries specialise there will be several gains from trade:
Lower prices for consumers
Greater choice of goods
Bigger export markets for domestic manufacturers
Economies of scale through being able to specialise in certain goods
Greater competition
See: Benefits of Free Trade

2. Free Movement of Labour

Increased labour migration gives advantages to both workers and recipient countries. If
a country experiences high unemployment, there are increased opportunities to look for
work elsewhere. This process of labour migration also helps reduce geographical
inequality. This has been quite effective in the EU, with many Eastern European workers
migrating west.
Also, it helps countries with labour shortages fill important posts. For example, the UK
needed to recruit nurses from the far east to fill shortages.
However, this issue is also quite controversial. Some are concerned that free movement
of labour can cause excess pressure on housing and social services in some countries.
Countries like the US have responded to this process by actively trying to prevent
migrants from other countries.
3. Increased Economies of Scale.

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Production is increasingly specialised. Globalisation enables goods to be produced in

different parts of the world. This greater specialisation enables lower average costs and
lower prices for consumers.
4. Greater Competition
Domestic monopolies used to be protected by lack of competition. However,
globalisation means that firms face greater competition from foreign firms.
5. Increased Investment
Globalisation has also enabled increased levels of investment. It has made it easier for
countries to attract short term and long term investment. Investment by multinational
companies can play a big role in improving the economies of developing countries.

Costs Of Globalisation
1. Free Trade can Harm Developing Economies.
Developing countries often struggle to compete with developed countries, therefore it is
argued free trade benefits developed countries more. There is an infant industry
argument which says industries in developing countries need protection from free trade
to be able to develop. However, developing countries are often harmed by tariff
protection Western economies have on agriculture. Paradox of Free Trade
2. Environmental Costs
One problem of globalisation is that it has increased the use of non renewable
resources. It has also contributed to increased pollution and global warming. Firms can
also outsource production to where environmental standards are less strict. However,
arguably the problem is not so much globalisation as a failure to set satisfactory
environmental standards.
3. Labour Drain
Globalisation enables workers to move more freely. Therefore, some countries find it
difficult to hold onto their best skilled workers, who are attracted by higher wages
elsewhere.
4. Less Cultural Diversity
Globalisation has led to increased economic and cultural hegemony. With globalisation
there is arguably less cultural diversity, however it is also led to more options for some
people.
5. Tax Competition and Tax avoidance.
Multinational companies like Amazon and Google, can set up offices in countries like
Bermuda and Luxembourg with very low rates of corporation tax and then funnel their
profits through these subsidiaries. This means they pay very little tax in the countries

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where they do most of their business. This means governments have to increase taxes
on VAT and income tax. It is also seen as unfair competition for domestic firms who
dont use same tax avoidance measures.
The greater mobility of capital, means that countries have sought to encourage inward
investment by offering the lowest corporation tax. (e.g. Ireland offers very low tax rate).
This has encouraged lower corporation tax, which leads to higher forms of other tax.
(see: Tax competition)
Globalization and inequality
Accept analysis of different types of inequality e.g. income and wealth. Analysis that inequality
between countries has decreased: Closer integration of countries e.g. through trade liberalisation
has resulted in increased living standards in developing countries But: monopsony power of TNCs in
developed economies might keep people in developing countries relatively poor Increased trade
has resulted in rapid growth rates in countries such as China and India which have lifted large
numbers of people out of poverty But: some countries left behind e.g. those with civil wars such as
Mali or wars with neighbours Sudan/South Sudan Differences in levels of foreign direct investment
Differences in the take up of technology/internet/broadband/mobile phones Increased demand
for commodities has resulted in an increase in prices so leading to an improvement in the terms of
trade and higher living standards of some developing countries. But: problem that supplies of some
non-renewable commodities will be exhausted in the future so the decrease in inequality might be
temporary; fluctuating commodity prices so reduction in inequality might be emporary Analysis that
inequality within countries has increased: (these points may be used as evaluation) Unskilled
workers in developed countries have been priced out of the market by outsourcing of work to low
wage countries But: with rising transport and wage costs in developing countries, some companies
are moving factories back to developed countries In developing countries, workers moving to
industrialised areas likely to see their wages rise relative to those remaining in rural areas Evidence
that earnings of top 1% of workers has increased relative to those on middle incomes related to
global market for top executives/footballers/entertainers Relative poverty within countries has
increased e.g. because of fall in demand for unskilled labour in developed countries; industrialisation
in developing countries But governments can take measures to redistribute incomes. Further
evaluative point: Consideration of the difference between inequality of income and wealth

Current Account deficits and surplus

Number of policies that the government can use to reduce the current account deficit.
1. Demand management: Reductions in government spending, higher interest rates
and higher taxes could all have the effect of dampening consumer demand
reducing the demand for imports. This leads to an increase in spare productive
capacity which can then be allocated towards exporting.
2. Natural effects of the economic cycle: One would expect to see a trade deficit fall
during a recession so some of the deficit is partially self-correcting but this
does little to address the problems of a structural balance of payments problem.
3. A lower exchange rate:

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a. The central bank of a country might decide that a lower exchange rate
provides a suitable way of improving competitiveness, reducing the
overseas price of exports and making imports more expensive
b. For those countries operating with a managed exchange rate, the
government may decide to authorise intervention in the currency markets
to manipulate the value of the currency
4. Supply-side improvements:
a. Policies to raise productivity, measures to bring about
more innovation and incentives to increase investment in industries with
export potential are supply-side measures designed to boost exports
performance and compete more effectively with imports. The time-lags
for supply-side policies to have an impact are long.
b. Policies to encourage business start-ups successful small businesses
with export potential
c. Investment in education and health-care to boost human capital and
increase competitiveness in fast-growing and high value industries such
as bio-technology, engineering, finance, medicine
d. Investment in modern critical infrastructure to support businesses and
industries involved in international markets
5. Protectionist measures such as import quotas and tariffs are rarely used because
of our commitments to the World Trade Organisation and our membership of the
European Union.

Increasing competitiveness Firms can increase their international competitiveness by:

Rationalisation output to get rid of high cost plants

Relocating to places where labour costs are lower

Process innovation

Product innovation

Incorporating the latest technology into investment

Sourcing from abroad where appropriate

Seeking out new market opportunities

Improving relationships with suppliers and customer

Governments role to improve international competitiveness Governments seek policies

which aim to:

Encourage R&D spending (e.g. through tax breaks)

Improve the skills base

Improve the economic infrastructure

Promote competition between firms

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Operate macro-economic policies favourable to business expansion

Reduce interest rates to stimulate investment

Reduce tax rates to stimulate enterprise, effort and investment

Deregulation to promote competition

Reduce bureaucracy

Encourage sharing of ideas and best practice

Reduce protectionist barriers to stimulate competition

Encourage investment in human capital

Potential benefits of a budget deficit

1. Government borrowing can benefit growth: A budget deficit can have positive
effects if it is used to finance capital spending that leads to an increase in
the stock of national assets. For example, spending on transport infrastructure
improves the supply-side capacity of the economy. And increased investment in
health and education can boost productivity and employment.

2. The budget deficit as a tool of demand management: Keynesian economists

support the use of changing the level of government borrowing as a legitimate
instrument of managing aggregate demand. An increase in borrowing can be
a useful stimulus to demand when other sectors of the economy are suffering
from weak or falling spending. If crowding out is not a major problem - fiscal
policy can play an important counter-cyclical role leaning against the wind of
the economic cycle.
Economic growth is a long-term expansion of a countrys productive potential

Reasons for current account deficit.

There are various factors which could cause a current account deficit:
1. Fixed 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 national income, people will tend to have more disposable
income to consume goods. If domestic producers can not meet the domestic demand,
consumers will have to import goods from abroad. In the UK we have a high Marginal
propensity to imports mpm because we do not have a comparative advantage in the

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production of manufactured goods. Therefore if there is fast economic growth there

tends to be a significant increase in the quantity of imports.
3. Decline in Competitiveness.
In the UK there has been a decline in the exporting manufacturing sector, because it has
struggled to compete with developing countries in the far east. This has led to a
persistent deficit in the balance of trade.

Higher inflation
This makes exports less competitive and imports more competitive. However this factor
may be offset by a decline in the value of sterling.

Recession in other countries.

If the UKs main trading partners experience negative economic growth then they will
buy less of our exports, worsening the current account.
However
Trade in goods balance is just one part of the current account and may be balanced by surplus in
trade in services account or in investment income Deficit might be financed by inflows into the
Financial Account
Significance depends on deficits/surplus as a percentage of GDP
Debt forgiveness will mean that the country has to stop paying interest on the loan meaning that
outflows from the investment income section of the current account decreases leading to a
improvement on the current account.

Savings gap is the difference between private investment and savings.

A free trade area is a group of countries that agree to have free trade between themselves.

Customs union is an agreement between a group of countries to set a common external trade

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Strategies to promote growth and development

Microfinance
Fair trade schemes
Aid
Debt CancellationTo reduce absolute poverty: no more interest payments on debt More resources available for
health care leading to increased life expectancy More resources for education leading to increased
school enrolment and higher literacy rates To provide resources for investment: multiplier effects:
link to increased growth and more resources for health, education. Effective as an immediate
way to fill savings gap Helps to fill foreign exchange gap enabling LEDCs to buy capital equipment;
oil etc Opportunity cost of debt servicing More resources for public services
Eval
Danger of corruption: money saved not spent e.g. to improve health and education Misuse of
money saved e.g. for defence purposes Creation of a dependency culture Moral hazard May be
used to generate political influence
Developing different sectors of the economy
Agriculture
Manufacturing industry
Tourism
Trade Liberalisation
Case for trade liberalisation: LEDCs have access to markets in developed countries: increased
exports and higher GDP, the proceeds of which may be used for health, education, improved access
to clean water Increased competition might promote increase efficiency in LEDCs Incentive for
multinationals to establish production plants in the country so contributing to industrialisation
Consumers benefit from lower prices and more choice More efficient use of resources based on
law of comparative advantage leading to increased growth Enables LEDCS to become less
dependent on aid Use of tariff diagram to illustrate impact of cut in tariffs e.g. on (30 ) consumer
surplus, producer surplus, welfare gains
However: Domestic firms in LEDCs may be unable to compete with TNCs from developed
economies Infant industries may be unable to survive Monopsony power of TNCs might result in
exploitation of resources of LEDcs Environmental arguments against free trade Problems of
overspecialisation Dumping by developed countries
Other evaluative comments: It could be argued that without individual freedom, democracy and
the rule of law, economic development is not possible Difficulty of defining economic development
precisely

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Factors which cause growth and development to slow down

Primary product dependency
But less of an issue if prices of primary products are
rising; some countries have developed on the basis
of specialisation in primary products
Savings gap
But could be offset by FDI or aid;
Foreign exchange gap
But could be offset by debt cancellation
Protectionism by developed economies
But WTO active in bringing about a reduction in tariffs
Debt
But could be offset by debt cancellation
Rapid population growth: creating a high dependency ratio
But: larger markets will be created in the future and larger workforces
Poor education and health care
Poor/inadequate infrastructure; land-locked countries
Corruption; poor governance
Political instability; Civil war
Disease e.g. AIDS
Other evaluative comments could include:
Prioritisation of factors
Problem of defining economic development precisely
Some problems may be of a short term nature only

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Quantative easing will mean that exhcnage rates decrese

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Policies include: Monetary policy: discussion of transmission mechanism; AD/AS analysis

Evaluation: consideration of whether it is appropriate to target inflation or asset prices; adverse
effects on other variables of changing interest rates e.g. on exchange rate; time lags; Negative
impact on growth and employment Inappropriate to raise interest rates when inflation is caused
by cost push factors
Supply side policies: discussion of those which impact on the price level i.e. measures to increase
competition and productivity; transmission mechanism; education and training
Evaluation: some policies will have implications for public finances; time lags
Fiscal policy: discussion of transmission mechanism; AD/AS analysis (30 )
Evaluation: ineffective if consumers reduce savings following a rise in taxes; very blunt instrument
adverse impact on other variables e.g. unemployment. In the case of oil, governments might react
by cutting the tax on petrol

The interest rate transmission mechanism

Interest rates transmit their way to aggregate demand in the following ways:
1. Household demand is affected because changes in interest rates affect savings,
which indirectly affect spending.
2. For households or firms with existing debt, such as a mortgage, a change in rates
affects repayments, and hence individuals have more (or less) cash after servicing
their debts. Changes in rates affect the cash-flow of firms and households.
3. In the case of new debt to fund spending, borrowing is also encouraged (or
discouraged) following interest rate changes.
4. Interest rates also affect consumer and business confidence, which in turn affects
spending.
5. Asset values are also affected by interest rates. A fall in rates will tend to increase
the profitability of firms and they may pay higher dividends to shareholders. This can
trigger an increase in household spending. Similarly, a rate fall makes savings less
attractive and property more attractive, increasing the value of property and
household wealth.
6. Finally, interest rates may affect the exchange rate, which can also influence export
demand. For example, a rise in interest rates may raise the exchange rate, pushing
up export prices and reducing overseas demand. Changes in the exchange rate also
affect the price of imports, which also affect the inflation rate.

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Cancellation of debt
Case for debt cancellation: To reduce absolute poverty: no more interest payments on debt
More resources available for health care leading to increased life expectancy More resources for
education leading to increased school enrolment and higher literacy rates To provide resources for
investment: multiplier effects: link to increased growth and more resources for health, education.
Effective as an immediate way to fill savings gap Helps to fill foreign exchange gap enabling
LEDCs to buy capital equipment; oil etc Opportunity cost of debt servicing More resources for
public services
eval
Danger of corruption: money saved not spent e.g. to improve health and education Misuse of
money saved e.g. for defence purposes Creation of a dependency culture Moral hazard May be
used to generate political influence

The Prebisch-Singer Hypothesis (PSH) is more of an observation rather than a complex

theory. It suggests that over the long run the price of primary goods such as coal,
coffee cocoa declines in proportion to manufactured goods such as cars, washing
machines and computers.
The income elasticity for demand of manufactured goods is greater than that for
primary products. So as income increase than manufactured goods rise at a faster pace
then primary.
However it has been criticised
If a countries has comparative advantage in producing primary products then it will be
more efficient of them to do so.
There was a greater price growth of primary goods in 2008 then secondary goods.

Rowstow model

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BY TAYMOOR KHAWAR

Duel sector model

The model assumes that a developing economy has a surplus of unproductive labour in the
agricultural sector. These workers are attracted to the growing manufacturing sector where higher
wages are on offer. It is also assumed that the wage on offer in the manufacturing sector is fixed.
Entrepreneurs in the manufacturing sector will make a profit because they charge a price above the
fixed wage rate. The model then assumes that these profits will be reinvested in the business in the
form of more fixed capital.
Firms productive capacity is thus increased and entrepreneurs will demand a greater amount of
labour. More workers will be employed from the surplus found in the agricultural sector. The
process continues until all surplus labour from the agricultural sector has been employed. The
manufacturing sector has grown and the economy has moved from a traditional to industrialized
one
If wages are 30% higher than rural wages (1 mark), workers will move to the modern urban industrial
sector where the marginal product of labour is much higher. (1 mark) The industrial sector will then
employ these extra workers without pushing up wages. (1 mark) This allows firms to make large
profits (1 mark) which are then reinvested. (1 mark) Growth means more jobs for surplus rural
labour (1 mark) and the additional workers increase output, and thus also incomes and profits,
further. (1 mark) Extra incomes will also increase demand for domestic products (1 mark) while
increased profits fund increased investment. (1 mark) Hence ruralurban migration offers selfgenerating growth.

Criticisms of the Model

Model assumes that all profits made by the entrepreneurs will be reinvested, this may not always
be the case
Reinvestment may take place in the form of fixed capital but it may be capital that is labour saving
and thus demand for labour may in fact fall.
The model also assumes that there is a surplus of labour in the agricultural sector that can easily
move to the manufacturing sector.
Wage levels may not always be fixed. There may be upward pressure on wages for example
through trade union activity and profits may therefore fall.

Harrod domar model

The Harod Domar Model suggests that economic growth rates depend on
two things:
1. Level of Savings (higher savings enable higher investment)
2. Capital Output Ratio (efficiency of investment)

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g=s/c
where
g is the economic growth rate
s=S/Y is the ratio of saving S to income,Y,
c is marginal capital-output ratio
It is argued that in developing countries saving rates are often low, if left to the
free market. Therefore, there is a need for governments to increase the savings
rate in an economy. Alternatively, developed countries could step in and transfer
capital stock to the developing countries, which would increase the productive
capacity.

Warranted Growth Rate

Roy Harrod introduced a concept known as the warranted growth rate.

This is the growth rate at which all saving is absorbed into investment. (e.g. 80bn of
saving = 80bn of investment.
Let us assume, the saving rate is 10%. the Capital output ratio is 4. In other words
10bn of investment, increases output by 2.5bn
In this case the economys warranted growth rate is 2.5 percent (ten divided by four).
This is the growth rate at which the ratio of capital to output would stay constant at four.

The Natural Growth Rate

The natural growth rate is the rate of economic growth required to maintain full
employment.
If the labor force grows at 3 percent per year, then to maintain full employment, the
economys annual growth rate must be 3 percent.
This assumes no change in labour productivity which is unrealistic.

Criticisms of Harod Domar Model

Developing countries find it difficult to increase saving. Increasing savings ratios may be
inappropriate when you are struggling to get enough food to eat.
Harod based his model on looking at industrialised countries post depression years. He
later came to repudiate his model because he felt it did not provide a model for long term
growth rates.
The model ignores factors such as labour productivity, technological innovation and
levels of corruption. The Harod Domar is at best an oversimplification of complex factors
which go into economic growth.
There are examples of countries who have experience rapid growth rates despite a lack
of savings, such as Thailand.

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It assumes the existences of a reliable finance and transport system. Often the problem
for developing countries is a lack of investment in these areas.
Increasing capital stock can lead to diminishing returns. Domar was writing during the
aftermath of the Great Depression where he could assume there would always be
surplus labour willing to use the machines, but, in practice this is not the case.
The Model explains boom and bust cycles through the importance of capital,
(seeaccelerator theory) However, in practice businesses are influenced by many things
other than capital such as expectations.
He assumed there was no reason for the actual growth to equal natural growth and that
an economy had no tendency to full employment. However, this was based on
assumption of wages being fixed.

J curve

Phillps curve

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The curve suggested that changes in the level of unemployment have a

direct and predictable effect on the level of price inflation. The accepted
explanation during the 1960s was that a fiscal stimulus, and increase in
AD, would trigger the following sequence of responses:
1. An increase in the demand for labour as government spending
generates growth.
2. The pool of unemployed will fall.
3. Firms must compete for fewer workers by raising nominal wages.
4. Workers have greater bargaining power to seek out increases in
nominal wages.
5. Wage costs will rise.
6. Faced with rising wage costs, firms pass on these cost increases in
higher prices.

Using AD/AS to demonstrate the Phillips Curve effect

This process can also be explained through AD-AS analysis.
Assume the economy is at a stable equilibrium, at Y. An increase
in government spending will shift AD from AD to AD1, leading to a
rise in income to Y1, and a fall in unemployment, in the short term.

However, households will successfully predict the higher price

level, and build these expectations into their wage bargaining.

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 As a result, wage costs rise and the AS shifts up to AS1 and the
economy now moves back to Y, but with a higher price level of P2.
It is argued that the effectiveness of supply side policies has
meant that the economy can continue to expand without inflation.

It is argued that the effectiveness of supply side policies has meant that the
economy can continue to expand without inflation.

Expansionary (or loose) Fiscal Policy

This involves increasing AD.

Therefore the government will increase spending (G) and / or cut taxes (T). Lower taxes
will increase consumers spending because they have more disposable income (C)
This will tend worsen the government budget deficit and the government will need to
increase borrowing.

Deflationary (or tight) Fiscal Policy

This involves decreasing AD.

Therefore the government will cut government spending (G) and / or increase taxes.
Higher taxes will reduce consumer spending (C)
Tight fiscal policy will tend to cause an improvement in the government budget deficit.

Marshal learners condition

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Lorenz curve
A Lorenz curve shows the % of income earned by a given % of the
population.
A perfect income distribution would be one where each % received the
same % of income.

Perfect equality would be, for example, where 60% of the population gain
60% of national income. In the above Lorenz curve, 60% of the population
gain only 20% of the income, hence the curve diverges from the line of
perfect equality of income.
The further the Lorenz curve is from the 45 degree line, the less equal is
the distribution of income.

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Changes in the position of the Lorenze curve indicates changes in the

distribution of income.
The Gini co-efficient or index is a mathematical device used to compare
income distributions over time and between economies. The Gini coefficient can be used in conjunction with the Lorenz curve. It is calculated
by comparing the area under the Lorenz curve and the area from the
450 line to the right hand and 'x' axis. In terms of the Gini index, the
closer the number is to 100 the greater the degree of inequality.

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