OXFORD IB STUDY GUIDES

Constantine Ziogas

Economics
F O R T H E I B D I P LO M A

2nd edition
3
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 Introduction for the student

n This book has been written specifcally or the student studying Higher or
Standard Level Economics or the IB Diploma Programme.

n It may be helpul to any student o Introductory Economics, especially in

the area o understanding the construction and use o diagrams.

n The study guide is organized in boxes and bullet points, and also includes
tips to help your work. Explanations are provided or all points presented.

n The importance o diagrams in Economics in general, and in the IB

examination process in particular, cannot be overemphasized. This guide
has been written to help you realize that diagrams are not just pictures
or you to remember and paste onto your answer sheets, but perectly
logical constructions that once you understand you will never orget.

n Essay-style questions have been included to help you ensure that you have
covered all the material.

n All Higher Level material is clearly marked. Section 5 ocuses on the

mathematical knowledge and skills required by Higher Level students.

n The glossary covers every term ound in the syllabus and will be useul to
you both or reerence and as a revision source.

Constantine H. Ziogas
 Contents

Foundations of Economics 1 4 Development economics

4.1 Economic development 1 44
1 Microeconomics 4.2 Measuring development 1 46
1.1 Competitive markets: demand and supply 5 4.3 The role o domestic actors in the process o
1.2 Elasticity 16 development 1 48
1.3 Government intervention 26 4.4 The role o international trade 1 50
1.4 Market ailures 33 4.5 The role o oreign direct investment and the
1.5 Theory o the frm and market structure 42 multinational corporation 1 53
Microeconomics: Questions 67 4.6 The roles o oreign aid and multilateral
development assistance 1 55
2 Macroeconomics 4.7 The role o oreign debt 1 57
2.1 Macroeconomic goals 71 4.8 The balance between markets and intervention 1 58
2.2 Introducing aggregate demand and aggregate Development economics: Questions 1 59
supply 76
2.3 Macroeconomic objectives 84 5 Quantitative issues in HL Paper 3
2.4 Fiscal policy 98 5.1 Microeconomics 1 60
2.5 Money and monetary policy 1 05 5.2 Macroeconomics 1 67
Macroeconomics: Questions 111 5.3 International economics 1 69

3 International economics Data response sample questions 1 71

3.1 International trade 11 4
3.2 Exchange rates 1 23 Glossary 1 77
3.3 The balance o payments 1 32
3.4 Economic integration and trade liberalization 1 37 Index 1 89
3.5 Terms o trade 1 40
International economics: Questions 1 43
 Foundations of economics
Scarcity
Economics as a discipline would not exist without scarcity.
This is the u nd am ental problem that all societies ace. I t reers
to the excess o hu man wants over what can actu ally be
prod u ced to u l ll these wants. H u man wants are u nlim ited . On
the other hand , the m eans o u l lling these hu man wants are
lim ited becau se the resou rces available are lim ited . As a resu lt,
choices have to be mad e.
For example, society cannot enjoy all the books and all the
tables it wants becau se the nu m ber o trees requ ired to
prod u ce these two good s is lim ited . I t som eh ow has to d ecid e
how many books and how many tables it wants to prod u ce. I
m ore tables are prod u ced then ewer books will be enjoyed and
vice versa. We d e ne as the opportu nity cost o a choice, the
valu e o th e next best alternative sacri ced . I , or exam ple, by
giving (or m ore correctly, allocating) a tree to table prod u ction,
one extra table is prod u ced bu t 2 5 books need to be sacri ced ,
we say that the opportu nity cost o prod u cing one m ore table is
2 5 books.
Resources (factors of production)
Resou rces are also reerred to as actors o prod u ction. They
inclu d e all inpu ts u sed in the prod u ction o a good or service.
They are typically separated into the ollowing ou r categories.
n Land and raw materials (natural resources)
These are inpu ts into prod u ction that are provid ed by
natu re, or example agricu ltu ral and non-agricu ltu ral land ,
orests, pastu res, m ineral d eposits, oil, natu ral gas, lakes
and rivers. The world s land area and raw materials are
lim ited . Som e resou rces, su ch as oil and coal d eposits, are
non-renewable: i they are u sed now, they will not be
available in the u tu re. Other resou rces, or example orests
(tim ber) and the stock o sh, are renewable.
n Labour (human resources)
Labou r inclu d es all orm s o hu man inpu t, both physical
and m ental, into cu rrent prod u ction. The labou r orce is, at
any point in tim e, lim ited both in nu m ber and in skills. The
total nu m ber o people available or work is reerred to as
the labou r orce or working popu lation.
n Capital
Physical capital inclu d es manu actu red resou rces; in other
word s, good s u sed to prod u ce other good s. The world has
a lim ited stock o capital (lim ited su pply o actories,
machines, tools and other equ ipm ent). N ote that the
m eaning o capital in econom ics is d ierent rom that u sed
in ord inary speech where people reer to m oney as capital.
n Entrepreneurship
Entrepreneu rship is related bu t not id entical to
managem ent. When a new ventu re is being con sid ered ,
risks exist. They involve the u nknown u tu re. Som eone m u st
assess these risks and make ju d gm ents abou t whether or
n ot to u nd ertake them . Th e people who d o so are called
en trepren eu rs. Entrepreneu rship reers to the willingness
and ability o certain ind ivid u als to take risks and to
m obilize the remaining actors o prod u ction.
Related concepts
I n ad d ition to the id ea o physical capital alread y m entioned ,
it is u seu l to inclu d e natu ral capital and hu man capital.
n Natural capital
N atu ral capital can be thou ght o as natu ral resou rces
which may be improved u pon or may be d epleted . Thinkin g
in term s o natu ral capital can easily accom m od ate another
related concept, su stainability, which reers to the id ea o
preserving and even increasing or improving u pon the
available stock o natu ral resou rces.
n H uman capital
Labou r may also be improved u pon, in that the labou r orce
may becom e m ore prod u ctive. The term hu man capital
reers to the ed u cation, training and skills em bod ied in the
labou r orce o a cou n try. Even i the size o the labou r orce
o an economy is constant over tim e, th e stock o hu man
capital may increase.
Other useful introductory terms
Social sciences: d isciplines that systematically stu d y hu man
behaviou r rom d ierent perspectives. Econom ics, psychology,
anthropology, political science, sociology and history are all
consid ered social sciences.
Models: sim pli ed and oten simplistic representations o
reality. They are constru cted to stu d y a phenom enon and
throu gh it explain past observations and perhaps pred ict u tu re
ones. Evalu ating the appropriateness or u seu lness o a speci c
m od el is not easy.
N ormative economic statem ents: valu e ju d gm ents, opinions
and statem ents that cannot be alsi ed or proven rig ht or
wrong; statem ents that cannot be tested against act (d ata).
Examples are: I nf ation is rising too ast or I ncom e d istribu tion
is not air. Key phrases in normative statem ents inclu d e ou ght
to be, shou ld be, too m u ch, too little, is air, is u nair, and
so on.
Positive econom ic statem ents: statem en ts that ca n be
alsi ed or proven , at lea st in prin ciple, rig h t or wron g . Th ey
ca n be tested a ga in st a cts (d ata ), or exam ple: A m in im u m
wa g e policy will in crea se u n em ploym en t am on g u n skilled
workers.
Economic goods: good s and services that requ ire scarce
resou rces to be sacri ced in ord er or them to be prod u ced .
Free goods: in contrast to econom ic good s, ree good s have a
zero opportu nity cost o prod u ction. (There are very ew
real-world exam ples, perhaps sea water and air.) N ote that
1
 Foundations o economics
good s available at a zero price are not ree in the econom ists
sense i scarce resou rces have been u sed u p to prod u ce them .
Competitive market: a market where there are very many small
f rm s, the good is hom ogeneou s (it is consid ered id entical
across f rm s by consu m ers) and nothing prevents a new f rm
rom entering the market or an existing f rm rom exiting.
The fundamental questions of economics
Three fundamental questions
Scarcity necessitates choice. As a resu lt all societies,
ind epend ently o their level o econom ic d evelopm ent or the
econom ic system ad opted , m u st answer the ollowing three
qu estions.
n What (which good s and services) will be prod u ced and in
what qu antities?
n H ow will each good or service be prod u ced (u sing, or
exam ple, a labou r-intensive or capital-intensive tech nology)?
n For whom will good s and services be prod u ced ? (H ow will
incom e be d istribu ted ?)
Cou n tries d evelop their own set o institu tions that answer
these three qu estions. H ow these institu tions d o this d epend s
on the econom ic system th e cou ntry has ad opted . An econom ic
system can be broad ly d ef ned as the institu tional ram ework
within which econom ic activity takes place. I t is easy to
distingu ish two extrem e cases bu t in the real world there are
many variations. The two extrem es are market econom ies and
com mand econom ies, and between these extrem es are m ixed
econom ies.
n A market economy is one where households and frm s, each
acting in their own sel-interest and through their interaction
in markets, provide answers to the three questions.
n A command economy is one where the state provid es the
answers.
n A mixed economy is one where both markets and the state
provid e the answers.
Central to the id ea o a market economy is the concept o a
market. A market shou ld be thou ght as a m echan ism that can
The production possibilities curve
Th e prod u ction possibilities cu rve (PPC) also reerred to as the
prod u ction possibilities rontier (PPF) is the f rst econom ic
m od el we will stu d y. Throu gh it, a n u m ber o im portant
econom ic concepts will be illu strated and becom e clear. For
example, the m od el provid es u s with a visu al accou nt o
scarcity, attainable and u nattainable choices, opportu nity cost,
ef ciency and growth.
A PPC reers to an economy with a f xed am ou n t o resou rces,
characterized by a given level o technology as well as som e
institu tional ram ework, and prod u cing only two good s. A PPC
2
Ceteris paribus: a Latin phrase that m eans all other things
remaining constant.
Rationality: in econom ics rationality is taken to imply
pu rposeu l behaviou r and , m ore specif cally, u tility-maxim izing
consu m ers and prof t-maxim izing f rm s.
provid e answers to the three u nd am ental qu estions. For
exam ple, the market can d eterm ine:
n whether this good or that good will be prod u ced and in
what qu antities
n which prod u ction technology a f rm shou ld u se to prod u ce
a good or a service
n how m u ch in com e the owner o each actor o prod u ction
will earn.
Econom ics is th e stu d y o ma rkets: their su ccesses and th eir
ailu res. Qu estion s o resou rce a llocation are in vestigated in
econom ics. Taking th e exam ple given earlier, econom ics
investigates how many workers a nd h ow many trees will be
allocated to the prod u ction o tables, an d h ow many workers
an d how many trees will be allocated to th e prod u ction o
books. Given a set o resou rces (that is, a specif c am ou nt o
labou r a nd trees) th ere a re variou s possible a llocation s. Each
allocation lead s to som e am ou nt o tables an d som e am ou n t o
books prod u ced an d consu m ed . N ot all o th ese allocation s are
best or society. Econom ics stu d ies the allocations that resu lt
rom th e operation o th e ma rket m echan ism and th en
exam ines wh ether they answer th e three u n d am en tal
qu estions in the best possible way or n ot. Som etim es we will
see that th e ma rket as a m echan ism su cceed s and resu lts in
the best possible answers or society to th ese qu estions. M any
other tim es, th e market as a m echanism a ils. When it a ils it
au tomatically creates a role or th e governm ent to step in and
attempt to correct the market a ilu re. H owever, as we will
see, th ere is no a priori g u arantee that the a nswers that
governm ents provid e are n ecessarily better a s g overnm ent
ailu re is also possible.
shows or every am ou nt prod u ced o good X, the maxim u m
am ou nt o good Y that this economy can prod u ce i it u lly
utilizes its lim ited resou rces u sing the available technology.
For exam ple, reerring to Figu re 0.1 , i the economy d ecid es to
prod u ce X1 u nits o good X then it can prod u ce Y1 u nits o
good Y at the m ost, (assu m ing that it u lly u tilizes its lim ited
resou rces with the available technology). A PPC is a
technological relationship and it provid es no inormation abou t
choices. I t shows what an economy can d o, not what it chooses
to d o.
 Fou n d ati on
1 Microeconomics
s o econ om i cs

As sca rce resou rces a re n ot equ a lly well su ited or th e

Units of good Y

prod u ction o a ll g ood s (beca u se resou rces ten d to be

F
Y1
Y2
A (th e ta n g en t at ea ch poin t, su ch a s at poin ts F a n d H )
H
Y3
B m ore u n its o X beca u se resou rces m u ch better su ited or th e
Y4
0 X1 X2 X3 X4
Units of good X
Figure 0.1 The PPC
The existence o a PPC ref ects scarcity: the lim ited resou rces
available constrain any economy in prod u cing only som e
com binations o ou tpu t. Com binations o ou tpu t represented
by points ou tsid e a PPC (su ch as point A in Figu re 0.1 ) are
unattainable given the am ou nt o resou rces available and the
cu rrent level o technology. Points insid e th e PPC (su ch as point
B in Figu re 0.1 ) show attainable but inefcient ou tpu t
com binations in the sense that available resou rces are not u lly
u tilized , or example there is u nemploym ent. Points on the PPC
(su ch as poin ts F and H ) show attainable and efcient
com binations as there is no waste o scarce resou rces and it is
not possible to prod u ce m ore o one good withou t sacri cing
som e o th e other.
The negative slope o the PPC ref ects that, in ord er to prod u ce
m ore o one good , resou rces have to be d iverted away rom the
prod u ction o the other good so that less o the other good can
now be prod u ced : there is an opportu nity cost involved in
prod u cing an extra u nit o a good . This opportu nity cost is the
am ou nt o the other good that has to be sacri ced . The
opportu nity cost o prod u cing X1 X2 extra u nits o good X is
equ al to the Y1 Y2 u nits o good Y that need to be sacri ced .
The opportu nity cost o prod u cing X3X4 extra u nits o X is
equ al to Y3Y4 u n its o good Y that need to be sacri ced .
specia lized ), th e opportu n ity cost o prod u cin g m ore an d m ore
u n its o a g ood in crea ses: ever-in crea sin g am ou n ts o g ood Y
n eed to be sa cri ced to prod u ce m ore a n d m ore u n its o g ood
X. Th is is why th e PPC is bowed towa rd s th e orig in . Th e slope
becom es steeper a n d steeper, ref ectin g that th e opportu n ity
cost o prod u cin g m ore o g ood X is in crea sin g . Prod u cin g
X3 X4 m ore u n its o g ood X is costlier tha n prod u cin g X1 X2
prod u ction o g ood Y m u st n ow be d iverted to th e prod u ction
o g ood X. I , on th e oth er ha n d , resou rces were perectly
su bstitu ta ble th en th e PPC wou ld be a n egatively sloped
stra ig h t lin e ref ectin g con sta n t opportu n ity costs.
Growth o an economy can be shown throu gh an ou tward shit
o the PPC. I t implies that com binations o ou tpu t that were
initially u nattainable can now be prod u ced . For su ch an
ou tward shit to occu r, m ore or better resou rces shou ld becom e
available and /or technology shou ld improve. I t can be argu ed
that ad opting a better in stitu tional ram ework will also
contribu te to growth.
Make sure that the PPC you draw touches the two axes and
TIP
is not foating in mid-air. Draw it bowed (concave) towards
the origin unless you are using it to illustrate constant
opportunity costs. Also note that the axes may be labelled
consumption goods and capital goods to illustrate the
opportunity cost o investment. In this case, the opportunity cost
o producing more capital goods (that is, the opportunity cost o
investment) is the sacrice o current levels o consumption.
Un em ploym ent implies the existence o (labou r) resou rces that
are n ot u tilized . The economy is prod u cing som e com bination
o ou tpu t represented by a point located insid e its PPC. I t
ollows that i u nem ploym ent in creases then the new point will
lie som ewhere closer to the origin as ewer u nits o at least
one o the two good s will be prod u ced . Conversely, i
u nem ploym ent d ecreases there is no shit in the PPC as the
labou r actor o prod u ction has not increased . The economy will
ju st m ove rom som e com bination insid e its PPC to an other
com bination closer to the cu rve itsel (that is, to any point
located to the northeast o the original point).

Points outside the PPC
Points on the PPC
Points inside the PPC
Explanation
These are unattainable combinations o output: more or better resources and/or improved technology would be
necessary to produce such combinations.
These are attainable and ecient combinations as there is no waste o scarce resources.
These are attainable but inecient combinations as scarce resources are not being used, so they are wasted.

3
 Foundations o economics

What the PPC can illustrate

Scarcity The existence o the PPC illustrates scarcity. I scarcity did not exist then all points in the goods space created
when drawing our two axes would be attainable this is obviously unrealistic.
Choice Once the PPC is constructed, a society can choose any combination o output (point) on it, or, i societys
preerences or priorities change, move rom one combination to another one along the curve.
Eciency Eciency is shown at all points on the PPC, as each refects ull use o available resources given the available
technology without any waste.
Ineciency Ineciency is shown at all points inside the PPC, as given the amount produced o one o the two goods, more
o the other could be produced. This implies wasted (idle or unemployed) resources and so ineciency.
Opportunity cost Movement rom one point on the PPC to another implies that more o one o the two goods is produced but less
o the other. So the extra amount produced o one good comes at a cost: this cost is the amount sacriced o
the other good. The opportunity cost o producing more units o the good on the horizontal axis is given by the
slope o the PPC.
Constant opportunity cost A linear PPC refects constant opportunity costs: producing more and more units o one good always requires
the same amount o the other good to be sacriced.
Increasing opportunity cost A concave (bowed in towards the origin) PPC shows increasing opportunity cost, as to produce equal extra units
o one good, increasing amounts o the other good have to be sacriced.
Growth An outward shit o the PPC refects growth as combinations o output previously unattainable become
attainable.

Central themes

n H ow much o a role should markets have and how much
o a role should governm ent have?
M arkets can be consid ered as a m echanism lead ing to
som e allocation o scarce resou rces. There is no gu arantee
that the market ou tcom e is the best ou tcom e rom societys
point o view. For example, markets may lead to too m u ch
pollu tion, or not enou gh libraries; they may lead to
u nacceptably high rates o u nemploym ent or to inad equ ate
health care or lower-incom e hou sehold s; they may lead to
excessively risky lend ing practices by f nancial institu tions
or to not enou gh basic scientif c research. On the other
hand , even i th ere is a role or the governm ent to play, can
we g u arantee that intervention will improve matters? What
is the extent and the type o in tervention that is necessary?
At what cost?
n What is sustainability and why has it emerged as such
an important concept?
The concept is closely bu t not exclu sively related to the
environm ental eects o cu rrent patterns o prod u ction
and resou rce allocation. The World Developm ent Report
2 01 0 states:
Developm ent that is socially, econom ically and
environm entally su stainable is a challenge,
even withou t global warm ing. Econom ic growth
is need ed , bu t growth alone is not enou gh i it
d oes not red u ce poverty and increase the
equ ality o opportu nity. And ailing to
saegu ard the environm ent eventu ally threatens
econ om ic and social achievem ents.
These points are not new. They only repeat what still is,
ater m ore than 2 0 years, perhaps the m ost wid ely u sed
d ef nition o su stainable d evelopm ent: Developm ent that
m eets the need s o the present withou t comprom ising the
ability o u tu re generations to m eet their own need s.
n Given scarcity, should we only care about efciency or
should equity also be a goal?
I s there perhaps a trad e-o between these two g oals? What
d o we m ean in econom ics by the term ef ciency? What
d oes equ ity m ean? There has been m u ch d ebate on
whether policies that prom ote equ ity hu rt or also prom ote
ef ciency. Does the answer d epend on th e types o policy
that are em ployed to ensu re equ ity?
n I an economy grows, is there economic development?
I s there perhaps too m u ch attention being paid to how ast
an econ omy grows? When d oes econom ic growth lead to
d evelopm ent? Can there be d evelopm ent with ou t growth ?
To what extent can one conf d ently claim that an ad vanced
economy is a d eveloped economy? Shou ld we ocu s on
cou ntry totals or shou ld we pay closer attention to
variations within a cou ntry?

4
 1.1 Competitive markets: demand and supply

M icroeconom ics is concerned with the ind ivid u al parts o the economy. I t is concerned with
the d emand an d su pply o particu lar good s, services and resou rces. I n other word s, it ocu ses

S ECTI O N 1 : M I CRO ECO N O M I CS

on ind ivid u al markets.

Markets
A market can be d ef ned as an institu tion which perm its
interaction between bu yers and sellers. I t can also be
consid ered a m echanism that d eterm ines which good s and
services will be prod u ced in an economy and so how scarce
resou rces will be allocated .
Several d ieren t types o market exist beyond prod u ct markets
where g ood s and services are being exchan ged . Factors o
prod u ction are trad ed in actor markets. The labou r market is
an example o a actor market. Th e stock market, the bond
market and the oreign exchange market are exam ples o
f nancial markets.
The interaction o consumers and producers (frms) in product
markets determine the market price o each product. Changes in
market conditions thereore result in changes in market prices.
These set o a chain o events leading to more or less o the good
being produced and so to a new allocation o scarce resources.
To analyse how markets u nction we need to exam ine the
behaviou r o consu m ers and o prod u cers.

Demand: the behaviour of consumers

The d emand or a good su m marizes the behaviou r o bu yers in
Price per unit (P)

a market. I t is the relationship between variou s possible prices

and the correspond ing qu an tities that consu m ers are willing
and able to pu rchase per tim e period , ceteris paribu s. Ceteris
paribu s m eans that all other actors aecting d emand are
assu m ed con stant.
This relationship between price per unit and qu antity P2
d emand ed per period o tim e is inverse (negative), m eaning
that i the price increases then qu antity demanded will decrease
as consu m ers will be willing and able to bu y less per period .
The inverse relationship between price and qu antity d emand ed
is reerred to as the law o d emand . The law o d emand states P1
that i the price o a good rises then qu antity d emand ed per
period will all, ceteris paribu s.
A demand curve shows this inverse relationship between the price
per unit o a good and the quantity o the good demanded per
D
period. Price per unit is measured on the vertical axis; quantity
demanded per period is measured on the horizontal axis.
A d emand cu rve may reer to an ind ivid u al consu m er or to the 0 Q2 Q1
market. The market d emand cu rve is the horizontal su m mation Q u a n tity d em a n d ed p er p erio d (Q d )
o all the ind ivid u al d emand cu rves. This m eans that at each
price we ad d the qu antities d emand ed by each ind ivid u al. So i Figure 1.1.1 A typical market demand curve
a market consists o Joey and Ross, and at a price o 2 .00 Joey
is willing and able to bu y f ve lattes per week while Ross is Goals of typical consumers
willing and able to bu y seven lattes per week, then at th e price
Con su m ers u ti l i ty i s th e sa ti sa cti on d eri ved rom con su m i n g
o 2 .00 the market d emand is 1 2 lattes per week.
a g ood or a bu n d l e o g ood s. Typi ca l con su m ers wi l l try to
For example, in Figure 1 .1 .1 , i the price per unit is P1 then m a xi m i ze th ei r u ti l i ty: th i s m ea n s th a t th ey wi l l ch oose th e
consum ers will be willing and able to buy Q1 units per period, bu n d l e o g ood s wh i ch m a xi m i zes th ei r sa ti sa cti on a n d
whereas i the price increased to P2 per unit then consum ers will wh i ch th ey ca n a ord , g i ven th ei r i n com e a n d th e pri ces
be willing and able to buy Q2 units per period, ceteris paribus. th ey a ce i n th e m a rket.

Why do we expect the law of demand to hold?

The substitution effect If the price of X increases then all other goods automatically become relatively cheaper so consumers will tend to
substitute other goods for X
The income effect If the price of X increases then purchasing power of consumers decreases and they will be able to afford less of X

5
 1 Microeconomics

drink th eir coffee with su gar. We expect that if the price of

A typical demand curve can be drawn as a straight line coffee increases then the d emand for su gar may d ecrease.
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using a ruler or drawn slightly curved and it may or may not M ore generally, if good s X and Y are consid ered as strong
touch the axes. What matters when drawing a typical complem ents then an increase in the price of good Y will
demand curve is that it is negatively sloped. lead to a d ecrease in the d eman d for good X. Demand for
X will shift to the left.
Other factors affecting demand (shift factors)

Price per unit (P)

n Cha n g es i n con su m ers i n com e m ay a ffect d em a n d . For Let D1 be the initial demand for
exam pl e, i f i n com e i n crea ses th en d em a n d for m ost sugar. Assume that the price of
g ood s i s expected to i n crea se, so th e d em a n d cu rve i s coffee, a complement, increases.
expected to sh i ft to th e ri g h t. Th i s i s th e ca se of Demand for sugar is expected
n orm a l g ood s. to decrease.
For som e good s, typically lower-qu ality good s, an increase in It will shift to the left from
incom e will lead to a d ecrease in d emand an d a shift of the D1 to D2.
demand cu rve to the left. This is the case of inferior good s.
The sam e g ood may behave as a normal good in one society or
market and as an inferior good in another. For example, in a
cou ntry with a generally low-incom e popu lation, an increase in
incom e may lead to an increase in the d emand for u sed cars,
D1
wh ereas in another cou ntry where people have higher incom es, D2
a fu rther increase in incom e levels may lead to a d ecrease in
the d emand for u sed cars. 0
Quantity demanded per period (Qd)

A good is a normal good if: A good is an inferior good if: Figure 1.1.3 The effect of an increase in the price of a complement
an increase in income an increase in income There may also be changes in the price of substitutes. Two
leads to an increase in leads to an decrease in
good s are consid ered su bstitu tes if they are in competitive
its demand its demand
consu mption and consu m ers typically bu y one or the other as
or, more generally, or, more generally,
the good s satisfy the sam e need or want. Exam ples are coffee
if income and demand change if income and demand change
in the same direction in opposite directions and tea or Pepsi Cola and Coca Cola. I f a su permarket increases
the price of Pepsi Cola then it is expected that the d emand for
n Changes in the price of other related g ood s will have an Coca Cola will increase. More generally, if g ood X and good Y
impact on d emand . First lets consid er a chan ge in th e price are consid ered close su bstitu tes then an increase in the price of
of complements. Two good s are consid ered complem ents if good Y will lead to an increase in the d emand for X. Demand
they are often consu m ed together. For example, for many for X will shift to the right.
people coffee and su gar are complem ents becau se they
Price per unit (P)

Price per unit (P)

Normal good Inferior good

An increase in income An increase in income
will increase demand: will decrease demand:
it shifts to the right it shifts to the left
from D1 to D2. from D1 to D2.

D2 D1
D1 D2

0 0
Quantity demanded per period (Qd) Quantity demanded per period (Qd)

Figure 1.1.2 The effect of an increase in income on a normal good and on an inferior good

6
 1 Microeconomics
Price per unit (P)

n Changes in the age distribution o the population aect the

Let D1 be the initial demand for pattern o demand. A well-known example reers to an ageing
Coca Cola. Assume that the price population (where the average age is rising) where demand
of Pepsi Cola, a substitute, increases. or alse teeth rises and demand or chewing gum drops.
Demand for Coca Cola is expected
n Expectations o changes in market prices or in incom e will
to increase.
have an eect. For exam ple, i people expect that the price
It will shift from D1 to D2.
o a good will rise in the u tu re, they are likely to bu y m ore
o it now beore prices g o u p (sh iting the cu rrent d emand
cu rve to the right).

Shifts of demand versus movements along a

D2
D1
0
Quantity demanded per period (Qd)
Figure 1.1.4 The eect o an increase in the price o a substitute
Be careul, though, when analysing demand in this way. To take
another example, lets assume that salmonella-tainted chicken is
ound in the supermarkets o a particular country. Demand or
chicken will collapse and so will its price. What do you expect to
happen to the demand or fsh i fsh is considered a sae substitute?
n Changes in tastes aect d emand . The m ore d esirable
people f nd a g ood , the m ore they will d emand it. Tastes are
aected by ad vertising, by ashion, by observing other
consu m ers, by consid erations o health, etc.
n Changes in the size o the market (the num ber o consum ers)
will have an eect. As the size o a market increases, demand
or m ost products will tend to rise and vice versa.
demand curve
Many students make m istakes over this because they do not get
into the habit o distinguishing between demand and quantity
demanded. Demand changes (and on a diagram the demand
curve shits) when any determ inant other than the price o the
good changes. For example, a change in incom e will change
demand and shit the demand curve to the right or to the let.
Quantity demanded changes when the price o the good
changes and results in a m ovem ent along the demand curve. For
example, i the price o a good increases it is quantity demanded
that decreases. Demand and its graphical representation are not
aected. There is only a m ovem ent along the demand curve.
Avoid saying or writing that the demand curve shifts up or
TIP
down. Using these terms very often leads to mistakes. Instead
use the expression the demand curve shifts to the right if you
are describing an increase in demand and the demand curve shifts
to the left if you are describing a decrease in demand.

movement along
if the price of the good changes D(P)
the demand curve
We have a:
shift of the if any of the other factors affecting demand changes D( Y, Ps, Pc, T ) (where Y denotes income,

demand curve Ps stands for price of substitutes, Pc stands for price and T stands for tastes)

Supply: the behaviour of producers

The supply o a good sum marizes the behaviour o prod ucers (or oer 2 00 u nits per m onth at the price o $ 5.00, then the market
frm s) in a market. I t is the relationship between variou s possible supply will be 2 0,000 units per m onth priced at $ 5.00 per unit.
prices and the corresponding quantities that frm s are willing to
Price per unit (P)

oer per period, ceteris paribus. Ceteris paribus m eans that all S
other actors aecting supply are assum ed constant.
The relationship between price per u nit and qu antity su pplied
per period is d irect (positive), m eaning that at higher prices
P2
prod u cers will be willing to oer m ore per period .
This positive relationship between price per unit and quantity
supplied per period o time is oten reerred to as the law o
supply. The law o supply states that i the price o a product
P1
increases then quantity supplied per period is expected to increase.
A supply curve shows the direct relationship between the price per
unit o a good and the quantity supplied per period. It is typically
upward sloping. Price per unit is measured on the vertical axis
and quantity supplied per period on the horizontal axis.
A su pply cu rve may reer to an individu al f rm or to the market.
The market supply curve is the horizontal sum mation o the 0 Q1 Q2
su pply curves o an individual f rm . This m eans that at each Q u a n tity su p p li ed p er p eri o d (Q s)
price we ad d the quantities su pplied by each f rm . So, i a
market consists o 1 00 identical frm s and each is willing to Figure 1.1.5 A typical market supply curve

7
 1 Microeconomics

I n Figu re 1 .1 .5 , i the price is P1 th en prod u cers will be willing

to oer Q1 u nits per period , whereas i the price increased to It should be clear at this point why it is a better idea to
TIP
P2 per u n it then prod u cers will be willing to oer Q2 u nits describe increases in supply as a shit o the supply curve
per period . to the right and decreases in supply as a shit to the let.
I you draw a supply curve and you shit it up you will realize
Why do we expect the law of supply to hold? that now at each price the frms are willing to oer less and
not more.
A simplistic but acceptable because at a higher price, a
explanation is: frms proft margin is greater,
inducing it to oer more units n Changes to technology aect su pply. I mproved technology
per period allows f rm s to oer m ore u nits o the good at the sam e
or, perhaps, more correctly: price, increasing su pply and shiting the su pply cu rve to the
a theoretically sound because i it becomes costlier right. I mproved technology d ecreases the cost o prod u cing
explanation is: or the frm to produce more each extra u n it o the good .
and more units per period o n Cha n g es in prod u ctivity a ect su pply. Prod u ctivity is
time using existing capacity, d ef n ed a s ou tpu t per u n it o inpu t, so labou r prod u ctivity
then it will be willing to do so wou ld be ou tpu t per worker. I , or exam ple, th ose in th e
only at a higher per unit price la bou r orce becom e m ore experien ced , better tra in ed
a n d /or h ea lth ier th en la bou r prod u ctivity will in crea se. I
la bou r prod u ctivity in crea ses th en , ceteris pa ribu s, f rm s
Other factors affecting supply (shift factors)
will be willin g to oer m ore u n its at ea ch price, in crea sin g
n Changes in the cost o actors o prod u ction aect su pply. I su pply a n d sh itin g th e su pply cu rve to th e rig h t. An
inpu t prices increase (or exam ple, i the wages paid to in crea se in la bou r prod u ctivity im plies d ecrea sed
labou r increase or the price o a raw material u sed in the prod u ction costs.
prod u ction o the good increases) then, ceteris paribu s,
su pply is expected to d ecrease. So the su pply cu rve is
expected to shit to the let. At each price, f rm s will be I wages increase by 5% and at the same time labour
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willing to oer less, or they will be willing to oer each u nit productivity increases by 5%, then costs per unit o output
at a higher price than beore. are the same, so supply will neither increase nor decrease.
I wages increase by 15% while labour productivity increases by
Figure 1 .1 .6 illustrates the eect o an increase in the wages
only 5%, then production costs will have increased, so supply
paid. Assum e that the original su pply curve is S1 . In the
will decrease and the supply curve will shit to the let.
let-hand sid e diagram , beore an increase in wages paid, f rm s
were willing to oer Q1 units per period at price P. I wages paid
increase then, as a result o the increased costs o produ ction, n Changes in governm ent policy aect su pply. I nd irect taxes
frm s will be willing to oer only Q2 units per period at price P. and su bsid ies aect the cost o prod u cing an extra u nit o
The sam e holds or all prices so supply decreases, shiting to the a good . An ind irect tax is a paym en t to the g overnm ent by
let to S2 . In the right-hand side d iagram frm s were willing to f rm s per u nit o ou tpu t prod u ced , whereas a su bsid y is a
oer Q u nits per period at price P1 per u nit beore an increase paym ent to f rm s by the governm ent per u nit o ou tpu t
in wages. Ater wages increase, f rm s will be willing to oer Q prod u ced . An ind irect tax will increase prod u ction costs and
units only at the higher price P2 . The sam e hold s or all u nits so lead to a d ecrease in su pply and a shit o the su pply cu rve
supply decreases, shiting let to S2 . to the let, whereas a su bsid y will d ecrease prod u ction
Price per unit (P)

Price per unit (P)

S2 S1

S2

S1

P2
P

P1

0 Q2 Q1 0 Q
Q u a n tity su p p l i ed p er p erio d (Q s) Q u a n ti ty su p p li ed p er p eri o d (Q s)

Figure 1.1.6 The eect on market supply o an increase in wages paid

8

costs and lead to an increase in su pply and a shit o the
su pply cu rve to the right.
The supply decision is predominantly affected by changes in
production costs.
Production costs If the wages paid decrease, production
can change if: costs will decrease and supply will
the price of an increase, shifting the supply curve to the
input changes right (and vice versa)
technology If technology improves, production costs
changes will decrease and supply will increase,
shifting the supply curve to the right
(and vice versa)
productivity If productivity increases, production
changes costs will decrease and supply will
increase, shifting the supply curve to the
right (and vice versa)
an indirect tax If an indirect tax is eliminated,
is imposed or production costs will decrease and
eliminated supply will increase, shifting the supply
curve to the right (and vice versa)
a subsidy is If a subsidy is granted, production costs
granted or will decrease and supply will increase,
eliminated shifting the supply curve to the right
(and vice versa)
n A change in the price o a good that is jointly su pplied will
have an eect on su pply. This is best u nderstood through
an example. I a f rm prod uces m u tton it is jointly produ cing
wool. I the price o m u tton increases in the market this f rm
will have an incentive to increase the qu antity su pplied o
m utton, bu t at the sam e tim e the supply o wool will
increase and its supply curve will shit to the right.
n A change in the price o a good in competitive su pply will
have an eect. This is also best u nd erstood throu gh an
example. Assu m e a arm er with a f xed am ou nt o land u ses
it to prod u ce lem ons and orang es. I the price o oranges
increases then this arm er will have the incentive to
increase th e qu antity su pplied o oranges so the su pply o
lem on s will d ecrease, shiting that su pply cu rve to th e let.
n Changes in the size o the market (the nu m ber o f rm s)
aect su pply. As m ore f rm s join a market, or example,
su pply will tend to increase, sh iting the su pply cu rve to
the righ t.
Equilibrium
Price and output determination in a
competitive market
The price at which a good will be sold in a competitive market
will be determined by the interaction between consumers and
producers; in other words, by the interaction o demand and supply.
I at some price there is excess supply (i quantity supplied per
period exceeds quantity demanded) then the price will tend to drop.
I at some price there is excess demand (i quantity demanded per
period exceeds quantity supplied) then the price will tend to rise.
1 Microeconomics
n Changes in expectations aect su pply. For exam ple, the
expectation that the price will be higher in the u tu re may
cau se su pply o a good to d ecrease now, shiting its su pply
cu rve to the let.
n Changes in other actors can be signifcant. For obvious
reasons, weather conditions aect the supply o arm
products. Floods in Australia, a heat wave in Russia or drought
in Brazil will adversely aect the world supply o wheat,
Supply curves may be drawn as straight lines or curved;
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they may or may not start from the vertical (or horizontal)
axis. Typically, they are upward sloping.
decreasing it and shiting its supply curve to the let. A major
accident, a terrorist act or a war may aect the supply o oil.
Shifts of supply versus movements along a
supply curve
M any stu d ents make m istakes over this becau se th ey d o not
get into the habit o d istingu ishing between su pply and
qu an tity su pplied . Su pply changes (and on a d iagram th e
su pply cu rve shits) when any d eterm inant other than the price
o the good changes, ju st as in the case o d emand . For
example, a change in the price o a raw material will change
su pply and shit the su pply cu rve to the right or to th e let.
Qu antity su pplied changes when the price o the good changes
and resu lts in a m ovem ent along th e su pply cu rve. For example,
i the price o a good increases then it is qu antity su pplied that
increases. Su pply and its graphical representation will n ot be
aected . There is only a m ovem ent along the su pply cu rve.
movement along if the price of the good
the supply curve changes D(P)
if any of the other factors
affecting supply changes D(Pf,
Tech, Prod, Pj, Pc, Tx, Sub, etc.)
We have a: shift of the (where Pf denotes price of factors
supply curve like labour, Tech stands for
technology, Prod for productivity,
Pj for prices of jointly produced
goods, Pc for goods in
competitive supply, Tx for indirect
taxes, Sub for subsidies)
I t ollows that there will be no tend en cy or th e price to chang e
i there is neith er excess su pply n or excess d eman d in the
market. This requ ires that qu antity d eman d ed per period at
that price is equ al to qu a ntity su pplied . Th is price is th e
equ ilibriu m price a nd the correspon d in g qu an tity is the
equ ilibriu m qu a ntity.
A price is an equilibrium price if quantity demanded is
equal to quantity supplied, so there is neither excess
demand nor excess supply.
9
 1 Microeconomics

We say that the market clears or that the market Reerring to Figu re 1 .1 .7, we can answer the ollowing qu estions.
is in equilibrium. n Cou ld P1 be the equ ilibriu m price?
At P1 consumers are willing to buy Qd1 units per period while frms
Price per unit (P)

S are willing to oer Qs1 units per period. Quantity supplied per period
is greater than quantity demanded. There is excess supply equal to
H F Qs1 2 Qd1 5 HF units per period which will create pressure or the
P1 price to all. Since excess supply creates a tendency or the market
price to all, it ollows that P1 is not an equilibrium price.
n Cou ld P2 be the equ ilibriu m price?
E
P At P2 consu m ers are willing to bu y Qd 2 u nits per period while
frm s are willing to oer Qs2 u nits per period . Qu antity
P2 demand ed per period is greater than qu antity su pplied . There is
J V
excess d emand equ al to 0Qd 2 2 0Qs2 5 JV u nits per period
which will create pressu re or the price to rise. Since excess
demand creates a tend ency or the market price to increase, it
ollows that P2 is not an equ ilibriu m price.
Qu antity d emand ed per period is equ al to qu antity su pplied
D
only at price P. At P there is neither excess d emand nor excess
0 Qd1 Q s2 Q Q d 2 Q s1
supply so the market clears. Price 0P is thereore the
Q u a n tity p er p erio d (Q )
equ ilibriu m price. I t is ou nd at the intersection E o the
Figure 1.1.7 The determination o equilibrium price in a competitive market demand and the su pply cu rves.

Changes in equilibrium

Changes in demand conditions
I a actor aecting d emand changes, then d emand will
increase or d ecrease (and on a d iagram the d emand cu rve will
shit to the righ t or to the let). A new equ ilibriu m will resu lt, as
at the original equ ilibriu m either excess d emand or excess
su pply will now exist.
I n Figu re 1 .1 .8, equ ilibriu m is initially at price P1 and qu antity
Q1 . I d emand increases rom D1 to D2 then, at the original
equ ilibriu m price P1 , there will be excess d emand equ al to FH
as qu antity d emand ed (Q9 ) exceed s qu antity su pplied (Q1 ).
Excess d emand in th e market creates pressu re on the price to
increase u ntil a new equ ilibriu m is established at P2 and Q2 .

Demand increases Demand decreases

These are the eects i d emand increases. These are the eects i d emand d ecreases.

n The d emand cu rve shits to the right. n The d emand cu rve shits to the let.

n At the original equilibrium price there will be excess demand. n At the original equ ilibriu m price there will be excess su pply.

n As excess d emand exists there will be a tend ency or the n As excess su pply exists there will be a tend ency or the
price to rise. price to d ecrease.

n Assu m ing typical d emand and su pply cu rves, a higher n Assu m ing typical d emand and su pply cu rves, a lower
equ ilibriu m price and a greater qu antity is expected . equ ilibriu m price and a smaller equ ilibriu m qu antity
is expected .
P/unit

P/unit

S1
S1

P2 J R
P1

F H
P1 P2

D2 D1

D1 D2

0 Q1 Q2 Q 0 Q Q2 Q1
Q / p eri o d Q/period
Figure 1.1.8 Eect o an increase in demand on market equilibrium Figure 1.1.9 Eect o a decrease in demand on market equilibrium

10
 1 Microeconomics

I n Figu re 1 .1 .9, equ ilibriu m is initially at price P1 and qu antity n Assu m ing typical d emand and su pply cu rves, a higher
Q1 . I d emand increases rom D1 to D2 then, at the original equ ilibriu m price and a lower qu antity is expected .
equ ilibriu m price P1 , there will be excess su pply equ al to JR as

P/unit
qu antity su pplied (Q1 ) exceed s qu antity d eman d ed (Q9 ). Excess S2 S1
su pply in the market creates pressu re on the price to d ecrease
u ntil a new equ ilibriu m is established at P2 and Q2 .
I a actor aecting su pply changes, then su pply will increase or
d ecrease (and on a d iagram the su pply cu rve will shit to the
right or to the let). A new equ ilibriu m will resu lt as at th e P2
original equ ilibriu m either excess d emand or excess su pply will
now exist.

Supply increases J R
P1
These are the eects i su pply increases.
n Th e su pply cu rve shits to the right.
n At th e original equ ilibriu m price there will be excess su pply.
n As excess su pply exists there will be a tend ency or the
D1
price to d ecrease.
n Assu m ing typical d emand and su pply cu rves, a lower 0 Q Q2 Q1
equ ilibriu m price and a greater qu antity is expected . Q/period

Figure 1.1.11 Eect o a decrease in supply on market equilibrium

P/unit

S1
S2 I n Figu re 1 .1 .1 1 , equ ilibriu m is initially at price P1 and qu antity
Q1 . I su pply d ecreases rom S1 to S2 then, at the original
equ ilibriu m price P1 , there will be excess d emand equ al to JR as
F H qu antity d eman d ed (Q1 ) exceed s qu antity su pplied (Q9 ). Excess
P1
d emand in the market creates pressu re on the price to increase
u ntil a new equ ilibriu m is established at P2 and Q2 .
P2
Keep in mind that:
excess demand leads to an increase in price
excess supply leads to a decrease in price
also:
D1
an increase in demand increases both equilibrium price
and quantity
0 Q1 Q2 Q a decrease in demand decreases both equilibrium price
Q/period and quantity
Figure 1.1.1 0 Eect o an increase in supply on market equilibrium but:
an increase in supply increases equilibrium quantity but
I n Figu re 1 .1 .1 0, equ ilibriu m is initially at price P1 and qu antity
decreases price
Q1 . I su pply increases rom S1 to S2 then, at the original
equ ilibriu m price P1 , there will be excess su pply equ al to FH as a decrease in supply decreases equilibrium quantity but
qu antity su pplied (Q9 ) exceed s qu antity d eman d ed (Q1 ). Excess increases price
su pply in the market creates pressu re on the price to d ecrease
u ntil a new equ ilibriu m is established at P2 and Q2 . Both demand and supply change
I both d eman d and su pply cond itions in a market change,
Supply decreases it d oes n ot matter which one o th e two eects is hand led
These are the eects i su pply d ecreases. f rst. Either the eect on equ ilibriu m price or the eect on
n Th e su pply cu rve shits to the let. equ ilibriu m qu antity will be ind eterm inate u nless you know
either d iagram matically 2 or, algebraically (H L only) 2 by
n At th e original equ ilibriu m price there will be excess
h ow m u ch d emand and su pply changed . For example, i both
d emand .
d emand and su pply increase and their cu rves shit to the right,
n As excess d eman d exists th ere will be a tend ency or the you know or su re that the equ ilibriu m qu antity will be greater
price to increase. bu t the eect on equ ilibriu m price is u ncertain.

11
 1 Microeconomics

The role of the price mechanism

The signalling and incentive role of relative
price changes
Assu m e that, or a particu lar good , d emand and su pply
cond ition s are su ch that the equ ilibriu m price P1 and the
equ ilibriu m qu antity Q1 are d eterm ined , as illu strated in
Figu re 1 .1 .1 2 . Q1 u nits o the good are prod u ced , with som e
scarce resou rces allocated to its prod u ction.
Assu m e now that preerences in society change an d that, or
example, d emand or the good increases (a sym m etric analysis
hold s or a d ecrease in d emand ). N ow Q9 u nits are d emand ed
bu t only Q1 are su pplied . Why and how will m ore o this good
be prod u ced , and so ad d itional scarce resou rces allocated to
and employed in its prod u ction? What m echan ism s will happen
to gu aran tee that the changed preeren ces o society will be
satisf ed ?
P/unit
The answer lies in the act that an increase in d emand will
au tomatically lead to excess d emand , and so a tend ency or the
market price to increase. This increase in market price is visible
to both prod u cers and consu m ers and each grou p will act in its
own sel-interest. Th e increase in market price has signalling
power as it contains inormation that m ore o the good is
wanted and it also provid es an incentive to f rm s to react to
that inormation an d oer m ore o the good per period .
In Figure 1 .1 .1 2 , quantity supplied increases along the su pply
curve as price increases rom P to P9 . We say that there is an
extension o su pply rom point J to point J9 . At the sam e tim e,
som e consum ers will be dropping out o the market or cutting
back on their purchases as the increase in price lead s to a
decrease in quantity demanded along the new demand
curve D2 . There is a contraction o demand rom point R to
point R9 . As long as excess demand exists, the price will
continue to rise until price P2 is reached . Price P2 is the new

equilibrium price where m ore units o the good (Q2 units) are
S1
produ ced and consu m ed. Since m ore units o this good are
produ ced, it implies that m ore scarce resou rces are channelled
into its produ ction.
The process leading to m ore o the good being produ ced and so
H m ore resou rces being channelled into its prod uction has com e
P2
J R abou t without the governm ent or any other entity intervening.
P
Prod u cers and consu m ers acting in their own sel-interest and
J R
P1 respond ing only to changes in relative prices ad ju st their
behaviour and are responsible or the new ou tcom e. I t is as i
an invisible hand gu id es their behaviou r. We will see later that
D2 this ou tcom e is also the best rom societys point o view, bu t
we m u st also realize that this analysis rests on som e very
restrictive assumptions that oten d o not hold.
D1

0 Q1 Q2 Q
The rationing function of free market prices
Q/period We have seen that prices have a signalling and incentive role
in a market economy. They also have a rationing u nction. I
Figure 1.1.12 The signalling and incentive unction o relative a market is ree then whoever is willing and able to pay the
price changes
market-d eterm ined price will end u p with the good .

Changes in consumer preferences lead to changes in relative prices

which have signalling power and change incentives of market participants
If demand increases, excess demand results, so price increases, leading to an extension of supply along the
original supply curve and a contraction in demand along the new
demand curve
If demand decreases, excess supply results, so price decreases, leading to a contraction of supply along the original
supply curve and an extension of demand along the new demand curve
It follows that the consumer is sovereign in a free competitive market.
The change in price (or, as P. Samuelson wrote, a consumer voting with their dollars)
induces changes in the quantity produced and in the allocation of scarce resources.

12

Market efciency
Consumer surplus
You may be willing to pay $ 1 .00 or a cold sot drink at the
beach bu t it cou ld be that the price is only 75 cents. You will
obviou sly bu y it or 75 cents (as it is worth m ore to you than
the price you have to pay). We say that you gained a consu m er
su rplu s o 2 5 cents. For the sake o the argu m ent, assu m e that
a second u nit is worth 90 cents to you . You wou ld also bu y this
second u nit as it is worth m ore to you than the market price
you have to pay. Th e consu m er su rplu s you gained rom the
second u nit is 1 5 cents. The consu m er su rplu s rom consu m ing
both u nits is thereore equ al to 40 cen ts. You were willin g to
pay at the m ost $ 1 .90 or the two u nits (as m u ch as they were
worth to you ) and you end ed u p paying only $ 1 .5 0.
More generally, we d ef ne con su m er su rplu s as the d ierence
between how m u ch consu m ers are willing and able at the m ost
to pay or som e am ou n t o a good , and what they actu ally end
u p paying. To be able to id entiy the consu m er su rplu s on a
d iagram , it is necessary and u seu l to realize that a d emand
cu rve (and a su pply cu rve) can be read vertically.
P/unit
F su rplu s o 80 cents. The prod u cer su rplu s it gained rom
H
P d iagram , it is necessary and u seu l to realize that a su pply cu rve
F
P
D, MB
0 Q Q
Q/period
Figure 1.1.13 Consumer surplus
For each Q in a d emand d iagram , the vertical d istance to the
cu rve illu strates how m u ch that specif c u nit is worth, at the
m ost, to consu m ers. Unit Q in Figu re 1 .1 .1 3 is worth P d ollars
(or d istance QH ) to con su m ers as they wou ld be willing to pay
P d ollars at the m ost to bu y it, not a cent m ore. I the price was
even slightly higher (say at the level o the grey d otted line),
then they wou ld not have been willing to bu y that last u nit Q.
Equ ivalently, u nit Q9 is worth P9 to consu m ers (or d istance Q9 F)
as that is the m ost they wou ld be willing to pay to acqu ire it.
The vertical d istance to a d emand cu rve m easu res the marginal
benef t (MB) enjoyed rom that u nit.
I it happens that the price in the market is P d ollars th en
consu m ers will bu y all u nits u p u ntil (at the lim it) u nit Q, as
each o these u nits is worth m ore to them than the market price
wou ld requ ire th em to pay. They wou ld not bu y any u nits past
u nit Q. For example, they wou ld not bu y u nit Q9 as it is worth
P9 d ollars (or d istance Q9 F) to them (this is as m u ch as they
1 Microeconomics
wou ld be willing to pay or it at the m ost) and the price (what
th ey wou ld be orced to pay) is higher, at P d ollars.
I t ollows that Q u nits are worth area (0QH F) to consu m ers as
that is the am ou nt they wou ld have been willing to pay to
enjoy all these u nits. Given a market price o P d ollars, they will
end u p paying area (0QH P) to enjoy Q u nits, or the price per
u nit tim es the qu antity consu m ed . Consu m er su rplu s is
th ereore area (PH F), the d ierence between area (0QH F) and
area (0QH P).
On a diagram, consumer surplus is the area below the
demand curve and above the price line for the units of the
good consum ed.
Producer surplus
A f rm may be willing to oer a u nit o a good or $ 2 .00. I the
market price or the u nit is $ 3 .00 then it will certainly d ecid e to
oer it. We say that th e f rm benef ted rom a prod u cer su rplu s
o $ 1 .00. Assu m e that it wou ld have been willing to oer the
next u nit i the price was at least $ 2 .2 0. Since the market price
is $ 3.00 it wou ld also oer this u nit, gaining rom it a prod u cer
oering both these u nits is $ 1 .80 as it requ ired at least $ 4.2 0
to be willing to oer them and it end ed u p earning $ 6.00
rom them .
M ore generally, we d ef ne prod u cer su rplu s as the d ierence
between what f rm s earn rom selling som e am ou nt o a good
and the m inim u m they wou ld requ ire to be willing to oer this
am ou nt. To be able to id entiy the prod u cer su rplu s on a
can be read vertically.
P/unit
S, MC
P F
H
P
J
0 Q Q
Q/period
Figure 1.1.1 4 Producer surplus
For each Q in a supply diagram , the vertical distance to the
curve illustrates the m inim um a frm requires to be willing to
oer that specifc unit. This would be nothing but the cost o
producing that extra unit. A frm would never accept anything
13
 1 Microeconomics
less to be willing to oer an extra unit. The m inim um it would
accept is the cost o producing it. Later you will realize that the
supply curve is nothing but the marginal cost (MC) curve o
the f rm .
So, or a f rm to be willin g to oer u n it Q in Figu re 1 .1 .1 4, the
lowest price requ ired is P d ollars (or d istan ce QH ), n ot a cen t
less. I th e price was even slig htly less (say at th e level o th e
grey d otted line), then th e f rm wou ld n ot have been willing to
oer that last u nit Q. I t wou ld be willin g to oer ewer u n its
per period bu t not u n it Q. Equ ivalently, or the f rm to be
willing to oer u nit Q9 the least paym ent requ ired is P9 (or
d istan ce Q9 F).
I it so happens that th e market price is P d ollars per u nit, then
f rm s will be willing to oer per period all u nits u p u ntil and
inclu d ing u nit Q. They wou ld not be willing to oer u nit Q9 as
they wou ld requ ire m ore (P9 or d istance Q9 F) than they wou ld
get rom the market.
I t ollows that the m inim u m f rm s wou ld requ ire to be willing to
oer Q u nits is area (0QH J), which is the su m o all vertical
d istances u p u ntil u nit Q. Given a market price o P d ollars per
u nit, f rm s will actu ally earn area (0QH P) by selling Q u nits or
the price per u nit (P) tim es the qu antity oered (Q). So,
prod u cer su rplu s is area (JH P), the d ierence between area
(0QH P) and area (0QH J).
On a diagram, producer surplus is the area above the
supply curve and below the price line or the units o the
good produced and sold.
Social or community surplus
Social or com m u nity su rplu s is d ef ned as the su m o the
consu m er su rplu s and the prod u cer su rplu s. I t is a m easu re
o welare.
P/unit
H S
E
P 0
F scarce resou rces have been allocated in the best possible way
D
0 Q
Q/period
Figure 1.1.15 Social or community surplus
I n Figu re 1 .1 .1 5 , given a market price P and an equ ilibriu m
qu antity Q, consu m er su rplu s is equ al to area (FEP) while
prod u cer su rplu s is area (H EP). Given the d ef nition o social
su rplu s it ollows that it is equ al to area (FEH ).
14
Allocative efciency
Th e ol l owi n g q u esti on a ri ses: Gi ven su ppl y a n d d em a n d
con d i ti on s or a g ood i n a m a rket, what i s th e opti m a l
am ou n t prod u ced a n d con su m ed o th i s g ood rom soci etys
poi n t o vi ew? I t wou l d m a ke sen se or soci ety to wa n t a l l
u n i ts o a g ood tha t a re worth m ore tha n what th ey wou l d
cost to prod u ce.
D o we h a ve a m ea su re o wh a t ea ch extra u n i t o a g ood
i s wo rth to so ci ety? Ca n we d eterm i n e th e extra b en ei t
(th e m a rg i n a l ben ei t) th a t soci ety en j oys ro m ea ch extra
u n i t o th e g oo d con su m ed ? Yes, we ca n . I t i s h ow m u ch
a t th e m ost con su m ers wou l d b e wi l l i n g to pa y to
en j oy i t. Th i s i s th e verti ca l d i sta n ce rom ea ch Q to th e
d em a n d cu rve.
Do we have a m easu re o what is th e cost to society o
prod u cing each extra u n it o a good ? Yes, we d o. I t is th e
lowest am ou nt that f rm s wou ld be willin g to accept to oer
each extra u n it o a good . Th is is the vertica l d istan ce rom
each Q to the su pply cu rve, or th e marg ina l cost (M C) o
prod u cing each extra u n it.
P/unit
S, MC
$1 8.00
$1 4.00 A
F
J
P
H
$8.00 B
$6.00
D, MB
Q Q Q Q
Q/period
Figure 1.1.1 6 Allocative efciency: where or the last Q produced, P 5 MC
and social surplus is maximized
We say that allocative ef ciency has been achieved and that
i the optimal am ou nt is prod u ced rom societys point o view.
I neither too m u ch nor too little o a good is prod u ced and
consu m ed then ju st the right am ou nt o labou r and capital are
employed in its prod u ction.
I n Figu re 1 .1 .1 6, the optimal am ou nt o the good rom societys
point o view is Q u nits. Society wou ld like to enjoy all u nits
u p u ntil and inclu d ing u nit Q. For the last u nit Q prod u ced ,
P 5 MC, or, m ore generally, marginal benef t (M B) is equ al to
marginal cost (M C).

Condition or allocative efciency: the price (or marginal
beneft) must be equal to marginal cost (that is,
P (5 MB) 5 MC) or the last unit produced.
I t is easy to u nderstand why. Reerring to Figu re 1 .1 .1 6, society
wou ld want u nit Q9 to be produ ced as it is worth $ 1 8.00 to
consu m ers (this is the m ost they would have been willing to pay
or it) which is m ore than the $ 6.00 it wou ld cost f rm s to
prod u ce (as the m inim u m f rm s wou ld be willing to accept
to oer that u nit is $ 6.00). We cou ld say that i the market did
indeed prod uce that u nit, society wou ld gain a surplus o
$ 1 2 .00 rom unit Q9 . Sim ilarly or unit Q0, as it is worth m ore
($ 1 4.00) than it wou ld cost to prod u ce ($ 8.00); society wou ld
gain a su rplu s o $ 6.00 rom u nit Q0. The sam e argum ent hold s
up u ntil and inclu ding u nit Q which is worth to consu m ers as
m uch as it wou ld cost to prod u ce it; that is, P (5 MB) 5 MC.
What abou t u nit Q09 ? Society wou ld not want that u nit
prod u ced as this wou ld m ean that scarce resou rces wou ld not
1 Microeconomics
be properly u sed . Why? Becau se that u nit is worth to consu m ers
less than it wou ld cost to prod u ce it. I u nit QQ- were
prod u ced , society wou ld have lost su rplu s rom its prod u ction
equ al to FH . I t wou ld have lost su rplu s equ al to area (JH F) rom
th e prod u ction o all u nits QQ-.
What i on ly Q0 u nits were prod u ced and or som e reason u nits
Q0Q were not prod u ced and en joyed by society? Then society
wou ld have lost the su rplu s represented by the area (ABJ) as all
u nits u p u ntil u nit Q are worth m ore than they wou ld have cost
to prod u ce.
I , by prod u cing either less or m ore than Q u nits, a portion o
social su rplu s is lost, it ollows that by prod u cing exactly Q
u nits per period , social su rplu s is maxim ized .
Summary
I , or the last u nit prod u ced , P (5 M B) 5 MC, then allocative
ef ciency is achieved and social su rplu s is maxim ized .
15
 1.2 Elasticity

I n general, elasticity is d ef ned as the responsiveness o som e econom ic variable when

another econom ic variable changes.

Price elasticity of demand

Defnition The responsiveness o qu an tity d emand ed to a
Values are: Terms used are: Given a change in P:
change in price
PED . 1 price elastic demand %DQ is larger
Reerred to as PED
price inelastic
Measure The percentage change in qu antity d emand ed 0 , PED , 1 %DQ is smaller
demand
d ivid ed by the percentage change in price:
unitary price elastic
PED 5 1 %DQ is equal
%DQ d demand
PED 5 ______
%DQP infnitely price elastic
PED ` %DQ is infnite
demand
The above can be rewritten as:
perectly price
DQ PED 5 0 %DQ is zero
___ inelastic demand
PED 5
Q1
____
DP
DP
___
( ) ( )
DQ
DP
P1
, or ___ 3 ___
Q1
PP1 Calculating PED between two points on a
1
demand curve
PED is thereore the ratio o the changes o two variables (price Assu m e that the price o a good increases rom $ 1 2 .00 to
and qu antity d emand ed ) that m ove in opposite directions. $ 1 8.00 and , as a resu lt, qu antity d emand ed d ecreases rom
I the price o the good goes up, then the qu antity demanded 2 00,000 u nits a week to 1 80,000 u nits a week. What is the
goes d own and vice versa. This implies that i the d enom inator PED or this good equ al to?
has a plus sign (the price increased ) then the num erator will
To answer su ch a qu estion it is best to constru ct a small table
have a negative sign (the quantity d emand ed will have
where the in itial price is d enoted P1 and the initial qu an tity
d ecreased ).
d eman d ed Q1 so that m istakes are avoid ed :
As a resu lt, the mathematical valu e o PED in calcu lation s is
always a negative nu m ber. N ote thou gh that the m inu s sign P1 5 $12.00 Q1 5 200,000
is typically ignored and the valu e o PED is treated as i it were
P2 5 $18.00 Q2 5 180,000
a positive nu m ber.
(1 80,000 2 2 00,000)
Ranges o PED The percentage change in qu antity is __________________
2 00,000
2 2 0,000
n I PED . 1 we say that d emand is price elastic. I t m eans 5 ________ 5 2 0.1 0 or 2 1 0%
2 00,000
that the percentage change in qu antity d emand ed is larger (1 8 2 1 2 ) 6
than the percentage change in price, or that a small change The percentage change in price is ________ 5 ___ 5 0.5
12 12
in price lead s to a proportionately greater change in or 1 5 0%
qu antity d emand ed . 2 1 0%
So, PED 5 ______ 5 2 0.2 and , ignoring the m inu s sign,
1 5 0%
n I 0 , PED , 1 we say that d emand is price inelastic. I t
PED 5 0.2 . Demand is price inelastic.
m eans that the percentage change in qu antity d emand ed is
smaller than the percentag e change in price, or that a small
change in price lead s to a proportionately smaller change
PED varies along a typical demand curve
in qu antity d emand ed . Close inspection o the PED orm u la reveals that PED is not the
sam e as the slope o the d eman d cu rve:
n I PED 5 1 we say that d emand is unit elastic. I t m eans
that the percentage change in qu antity d emand ed is equ al
to the percentage change in price, or that a small change in
DQ
( ) ( )
P1
PED 5 ___ 3 ___
DP Q1
price lead s to a proportionately equ al change in qu antity
d eman d ed . ( )
DQ
I t is the prod u ct o two term s. The f rst term ___ is the slope
DP
o the d emand u nction (or the inverse o the d emand cu rve as
n I PED ` we say that d emand is infnitely elastic. I t
illu strated in a graph) which is a constan t i the unction is
m eans that a small change in price lead s to an inf nitely
linear (that is, th e d emand is a straight line). The second
large change in qu an tity d emand ed .
n I PED 5 0 we say that d emand is perectly inelastic. I t ( ) P1
term ___ varies continu ou sly alon g a d emand cu rve (see
Q1
m eans that a change in price lead s to no chang e in Figu re 1 .2 .1 ).
qu antity d emand ed .

16
 1 Microeconomics

P/unit
P/unit

A PED

F PED > 1
P1

Pm PED = 1
M

0 < PED < 1

PED = 0
P1 H 0 Qm B
Q/period
D
Figure 1.2.3 PED along a negatively sloped linear demand curve
0 Q1 Q1
I t makes sense. Responsiveness to a price change (that is, PED)
Q/period
will be higher, the higher the initial price o the good , so the
Figure 1.2.1 PED varies continuously even along a linear demand m ore expensive it is.
Reerring to Figu re 1 .2 .1 , i the initial price P1 is at point F, the
A common mistake is to consider that PED for a linear
P1
Q1 ( )
ratio ___ is bigger than i the initial price P1 was at point H . TIP
demand curve that is at 45 degrees to the axes is constant
I t ollows that even along a linear, negatively sloped d emand and equal to 1. The slope of such a curve is 1 but, as
cu rve, price elasticity varies continu ou sly. explained, slope is not elasticity.
Figu re 1 .2 .3 shows that as point A is approached , PED tend s to
inf nity as Q1 tend s to zero, while at point B price elasticity is Demand curves with constant PED
zero as P1 is zero.
The case of a perfectly inelastic demand curve: PED 5 0
I n this case the d emand cu rve is vertical at som e qu antity. Any
P/unit

A change in price will lead to no change in qu antity d emand ed .

P/unit

Perfectly inelastic
PED = 0

D
0 B
Q/period
Figure 1.2.2 PED takes on all values rom ` to zero
I t can be shown that at the m id poin t M o a linear d emand
cu rve, price elasticity is equ al to 1 . Reerring to Figu re 1 .2 .3:
n within line segm ent AM , correspond ing to prices higher
than Pm within th e segm ent APm , d emand is price elastic
(PED . 1 )
n within line seg m en t M B, correspon d in g to prices lower
tha n Pm with in the seg m en t Pm B, d eman d is price inelastic
(0 , PED , 1 )
0
Q/period
Figure 1.2.4 Perectly inelastic demand curve (PED 5 0)
The perectly inelastic d emand cu rve (PED 5 0) is oten u sed
to d escribe the case o highly ad d ictive good s su ch as dru gs, or
to d escribe the ind ivid u al d emand or pharmaceu tical prod u cts
or which no su bstitu tes exist.
The case of a perfectly elastic demand curve: PED `
I n this case the d emand cu rve is horizontal at som e price. I t is
u sed to d escribe the d emand that a perectly competitive f rm
aces. Su ch a f rm is so tiny in size compared with the market
that it can sell any am ou nt at the going market price. I t is as i
it is acing a perectly elastic d emand at the market price.

17
 1 Microeconomics
P/unit
Perfectly elastic
PED innity
D proportion. The demand curve is a rectangular hyperbola. A
0
Q/period
Figure 1.2.5 Perectly price elastic demand curve (PED ` )
The case of a unitary elastic demand curve: PED 5 1
Th e d emand cu rve in this case is asymptotic to both axes
(that is, it never tou ches either axis). The d emand cu rve is a
rectangu lar hyperbola.
P/unit
Unitary elastic PED = 1
Areas below equal to
total expenditures
D
0 Qm they are at a maxim u m . So, right below th e m id point o the
Q/period
Figure 1.2.6 Unitary elastic demand curve (PED 5 1 )
Al l a rea s bel ow th i s cu rve represen t th e reven u es o f rm s
a n d a re eq u a l i n si ze. I n oth er word s, i n a u n i ta ry ela sti c
d em a n d cu rve, a ch a n g e i n pri ce d oes n ot ch a n g e f rm s
tota l reven u es.
Relationship between PED and total revenues
What will happen to f rm s revenu es (and hence to consu m er
expend itu res) i there is a change in price? The answer d epend s
on PED. Total revenu es (TR) a f rm collects are the prod u ct o
the price per u n it tim es the qu antity sold (TR 5 PQ). I t is not
the sam e as prof ts, which are the d ierence between the TR
collected and the total costs (TC) incu rred .
Con sid er the three possible cases.
Case 1 : A change in price when PED . 1 (demand is price elastic).
A ch a n g e i n pri ce l ea d s to a ch a n g e i n th e opposite
d i recti on i n q u a n ti ty d em a n d ed . Wh en d em a n d i s pri ce
ela sti c, q u a n ti ty d em a n d ed cha n g es proportion ately m ore
tha n pri ce, so th e ch a n g e i n q u a n ti ty h a s a bi g g er eect on
reven u es th a n d oes th e ch a n g e i n pri ce. So, i d em a n d i s
ela sti c, tota l expen d i tu re ch a n g es i n th e sam e d i recti on a s
q u a n ti ty d em a n d ed . I P ri ses th en Q fa lls proporti on a tel y
m ore, so TR wi l l fall. Bu t i P a l l s, th en Q rises
proporti on a tel y m ore, so TR wi l l rise.
Case 2 : A change in price when 0 , PED , 1 (d emand is
price inelastic).
I n th i s ca se, pri ce ri ses proportion ately m ore th a n q u a n ti ty.
Th e ch a n g e i n pri ce h a s a bi g g er eect on TR th a n th e
18
ch a n g e i n q u a n ti ty d oes. TR ch a n g e i n th e sam e d i recti on
a s pri ce. I P ri ses th en Q a l l s proporti on a tel y l ess, so TR
wi l l rise. Bu t i P falls, Q ri ses proporti on a tel y l ess, so TR
wi l l fa ll.
Case 3 : A chan ge in price when PED 5 1 (d emand is
u nitary elastic).
In this case, price and quantity change in exactly the sam e
change in price will have no eect on TR. I we plot TR against Q,
the unction will be a straight line parallel to the horizontal axis.
PED and the shape of the TR curve
I t ollows rom the above that there is a close relationship
between PED and th e shape o the TR cu rve a f rm aces.
Focu sing on Figu re 1 .2 .7 a, which illu strates the typical, linear,
negatively sloped d emand cu rve, we realize that at zero
qu antity (poin t at the origin), TR are zero and at a zero price
(point H ) TR are also zero. As price d ecreases (thinking o
walking d own the price axis) rom point F to Pm , qu antity
d emand ed increases rom 0 to Qm . Since d emand or that price
range is price elastic, the resu lting increase in qu antity
d emand ed is proportionately greater, so TR rise.
Skipping the m id point price Pm , i price continu es to d ecrease
past Pm all the way d own to zero, qu antity d emand ed increases
rom Qm to H . Since d emand is now price inelastic, the
resu lting increase in qu antity d emand ed is proportionately
smaller, so TR d ecrease.
H aving established that TR rise all the way to m id point Qm and
then, right ater Qm , they d ecrease, it necessarily ollows that at
linear d emand cu rve where PED 5 1 , TR are maxim ized .
HL Def ne marginal revenu e (M R) as the extra revenu e
rom selling one m ore u nit o ou tpu t. MR is the
change in TR becau se o a change in Q, so it is the
slope o the TR cu rve. At Qm , where TR are at their
maxim u m , it ollows that M R is zero. I d emand is
a negatively sloped line then MR has d ou ble th e
slope. I n Figu re 1 .2 .8a thereore it will go throu g h
ou tpu t Qm .
Focu sing now on Figu re 1 .2 .7 b, which illu strates a u nitary
elastic demand cu rve, we realize that any change in price will
lead to a percentagewise equ al change in the opposite
d irection o qu antity d emand ed , so that TR remain constant. I n
the bottom part o Figu re 1 .2 .7 b, th e TR cu rve is drawn as a
straight line parallel to the qu an tity axis, illu stratin g that TR d o
not change as ou tpu t varies.
Lastly, Figu re 1 .2 .7 c illu strates the case o a perectly elastic
d emand cu rve. This wou ld be the case o a f rm which cou ld sell
all it wants at the price P9 , say, or exam ple, 3.00 per u nit. I t
ollows that the TR cu rve is a rising straight lin e starting rom
the origin as the revenu es rom one u nit sold will be 3.00, the
revenu es rom two u nits sold will be 6.00, the revenu es rom
three units sold will be 9.00, and so on. I t will becom e clear
that or a f rm to be able to sell as m u ch as it wants at the
sam e price, two cond itions m u st apply. The f rm m u st be tiny
compared to the market in which it operates. I n ad d ition, it
m u st sell a good that consu m ers consid er id entical to the good
sold by all the other f rm s in the sam e market.

(a) (b)
P/unit
P/unit
F
>1
Pm =1
0<<1
D D
0 Qm H 0
TR Q/period TR
MR
TR
0 Qm H 0
Q/period
Figure 1.2.7 PED and the shape o the TR curve
Determinants of PED
n The nu m ber and closeness o available su bstitu tes aect
PED. The m ore su bstitu tes there are or a good , and the
closer th ese are, the m ore easily people will switch to these
alternatives when the price o the good rises; the greater
thereore will be the PED. Also think o how broad ly or
narrowly the good is d ef ned . One example is Pepsi Cola
versu s sot drinks. The broad er the d ef nition, th e ewer the
su bstitu tes available to th e consu m er, so the m ore price
inelastic the d emand is expected to be when small price
changes are mad e.
n The proportion o incom e spent on the good is relevant.
The hig her the proportion o incom e spent on a good , the
m ore consu m ers will be orced to lower consu mption when
its price rises (the big ger the incom e eect will be) and the
m ore price elastic the d emand will be. I we spend a small
proportion o ou r incom e on a good (i it is insignif cant),
then a change in price will not aect ou r spend ing
behaviou r; d emand will be price inelastic.
n The tim e period involved aects PED. When the price
o a prod u ct rises it takes som e tim e or people to f nd
alternatives and ad ju st their consu mption patterns. I t
ollows that th e longer the tim e period ater a price
change, the m ore price elastic the d emand is likely to be.
n PED can be d eterm ined by whether consu m ers consid er
the good or service a necessity. I they d o, a change in its
price will tend to aect it less than a price chan ge aects
other prod u cts.
n I n som e cases, PED depend s upon the nature o the good ,
or example whether or not it is add ictive. Demand or
ad dictive prod ucts, such as cigarettes and alcoholic drinks,
is relatively price inelastic. This has proound implications
on governm ents d ecisions to impose tax on such products.
Students often confuse the factors affecting the demand for
TIP
a product with the factors affecting the PED for a product.
1 Microeconomics
(c)
P/unit
Perfectly
Unitary elastic PED = 1
elastic
Areas below equal to P D
total expenditures
0
Q/period Q/period
TR
TR TR
0
Q/period Q/period
Applications of PED
n PED perm its a f rm to pred ict the d irection o change o its
revenu es given a price change. For example, a f rm wishing
to increase its revenu es will lower the price o a good i
d emand or it is thou ght to be price elastic and it will
increase the price i its d emand is price inelastic.
n PED enables comparison o quantity changes with
monetary (price) changes.
n PED allows a governm ent to estimate the size o the
necessary tax requ ired to d ecrease consu mption o d em erit
good s, su ch as cigarettes or alcoholic drinks.
HL n PED perm its a f rm to employ price d iscrim ination.
The higher price will be charg ed in th e market
with the relatively inelastic d emand .
n PED helps a f rm d eterm ine what proportion o an
ind irect tax can be passed on to the consu m er.
n PED perm its the governm ent to d eterm ine the
incid ence o an ind irect tax.
n PED helps a government predict the eect o currency
devaluation on the trade balance o the country.
PED of primary commodities versus
manufactured products
Primary products include ood and non-ood products. They
include agricultural as well as non-agricultural products (those
provided by nature, such as tim ber and m inerals). In general,
these products do not have close substitutes. Manuactured
goods, on the other hand, are subject to extensive product
dierentiation as producers desperately try to gain an advantage
over competitors. Apples, oranges, peaches and kiwi ruit may be
considered substitutes or consum ers, but they are not as close
substitutes as dierent brands o laptops, DVD players or cell
phones, or example. It ollows that, in general, PED or
com m odities is lower than that or manuactured products.
19
 1 Microeconomics

Cross-price elasticity of demand

Defnition The responsiveness o d emand or one good (x)
to a change in the price o another good (y)
Reerred to as XED (som etim es XPE or CPE)
Measure Th e percentage change in the qu antity
d emand ed o good x d ivid ed by the
percentage change in the price o good y:
d ecrease rom Q1 to Q2 , as som e will consu m ers will stop or
d ecrease their coee consu m ption , lead ing to less d emand or
su gar per period . Again, this is not a demand curve as on one
axis we have the price per u n it o one g ood and on the other
the qu antity d emand ed per period o another.
I instead o a positively or negatively sloped line we had a
vertical line, it wou ld illu strate the case o two totally u nrelated

( )(
DQ x
____ prod u cts where XED is zero. For exam ple, i the price o

( )
1 1
Qx Py cheesecake rises or alls we expect th e d emand or iPhones to
%DQ
%DD y DP y
____
DQ
XED 5 ______x 5 ____ 5 ____x 3 ___1
DP y Qx
) remain u naected .
1
Py
Applications o XED
H ere, the sign d eterm ines how we interpret XED or a prod u ct: XED is u sed by policy makers to delineate (d escribe) markets.
n I XED . 0 then the two goods x and y are substitutes, I t helps to know the size o XED o d ierent produ cts, or
meaning that they are in competitive demand: i one becomes example to d ecid e whether m u fns and eggs shou ld be
more expensive then consumers will switch to the other. considered as belonging in the sam e market as breakast cereal.
n I XED , 0 th en the two good s x an d y a re complem ents, Firms can use XED to guide their pricing policy changes. Assume
m ea nin g that th ey are jointly d emand ed : i one becom es that the price o a substitute product decreases, or example. I
m ore expensive and people bu y it less, they will also bu y frms producing the good do not react, demand or it will probably
less o the other one. decrease. Or, i a complement becomes pricier then, assuming no
n I XED 5 0 then the two good s x and y are u nrelated . reaction, its producer should expect demand or it to contract.
n I t ollows that the u rther away rom zero XED is, the
stronger the relationsh ip between the good s. Conversely, Calculating XED
the closer (absolu tely) to zero XED is, the weaker the Assu m e that the price o good A increases rom $ 1 5 0.00 to
relationship between the two good s. $ 1 80.00 and , as a resu lt, qu antity d emand ed or good B
increases rom 1 .8 m illion u n its a week to 2 .5 2 m illion u nits a
Figu re 1 .2 .8a illu strates th e case o su bstitu tes in which XED is
week. What is the PED or good B when there are changes in
positive. I the price o coee increases rom P1 to P2 then we
the price o good A? H ow are these good s related ?
expect that the qu antity o tea d emand ed per period will
increase rom Q1 to Q2 as som e consu m ers will switch rom Applying the orm u la or XED:
drinking the now m ore expensive coee and will drink tea
( ) ( ) (
1
%DQ B
instead . N ote that this is not a demand curve as on one axis %DD A
DQB
DP A
PA
QB
(2 .5 2 2 1 .8)
1 80 2 1 5 0
1 50
XED 5 ______ 5 ____ 3 ___1 5 __________ 3 ____
1 .8 ) ( )
we have the price per u nit o one good and on the other the
qu antity d eman d ed per period o another good .
Figu re 1 .2 .8b illu strates the case o complem ents in which XED
0.72 1 50
( ) ( )
1 08
5 ____ 3 ____ 5 ____
30 1 .8 54 5 1 2
is negative. I the price o coee increases rom P1 to P2 then Sin ce XED is a positive valu e we conclu d e that A an d B are
we expect that the qu antity o su gar d emand ed per period will consid ered as su bstitu tes.
(a) (b)
Price of coffee

Price of coffee

Coffee and tea Coffee and sugar

substitutes complements
XED > 0 XED < 0

P2 P2

P1 P1

0 Q1 Q2 0 Q2 Q1
Quantity of tea Quantity of sugar
Figure 1.2.8 Substitutes (XED . 0) and complements (XED , 0)

20
 1 Microeconomics

Income elasticity of demand

Defnition The responsiven ess of d emand when increase in incom e lead s to a 5 % increase in qu antity
consu m er incom e changes d eman d ed , for exam ple.
Reerred to as YED We can u se this d iagram as a su m mary.
Measure The percentage change in qu antity d emand ed
Inferior Normal
d ivid ed by the percentage change in incom e:
%DQ d
YED 5 ______
%DY
This can be rewritten as: () 0 1 (+)

DQ
___
Q
____
DY
___
DQ
DY ( ) ( )
Y
YED 5 1 , or ___ 3 ___1
Q1
Y1
Sin ce YED is the ratio of the percentage changes in d emand
and incom e levels, it follows that if both changes are
positive (plu s sign) or if both are negative (m inu s sign) then
YED is a positive nu m ber. For example, if an increase in
in com e lead s to m ore of a good being d emand ed or a drop in
in com e lead s to less being d emand ed , then YED is a positive
nu m ber. I f one change is positive (plu s sign) and the other is
negative (m inu s sign), then YED is a negative nu m ber. For
example, if an increase in incom e lead s to a d ecrease in
qu antity d emand ed , or a d ecrease in incom e lead s to an
in crease in qu antity d emand ed , then YED is a negative
nu m ber.
We can d istingu ish between normal and inferior good s based
on whether YED is positive or negative.
n I f YED . 0 the good is a normal good since d eman d
increases (d ecreases) as consu m er incom e increases
(d ecreases): both incom e and d emand change in the sam e
d irection.
n I f YED , 0 the good is an inerior good since d emand
d ecreases (increases) as consu m er incom e increases
(d ecreases): incom e and d emand chan ge in opposite
d irections.
Focu sing on normal good s, we can state the following.
Income Income
inelastic elastic
Using a graph to illustrate YED
There are two ways to illu strate YED on a graph . Th e ea sy bu t
rath er im precise way is to u se a typical d eman d cu rve d iagram .
I f YED is positive an d so th e good is normal, then an increase
in incom e will increase d eman d an d shift th e d eman d cu rve to
the righ t, while a d ecrease in incom e will d ecrease d ema nd
an d shift th e cu rve to th e left. I f YED is negative and so the
g ood is inferior, th en an increase in incom e will d ecrease
d ema nd an d shift the d ema nd cu rve to th e left, while a
d ecrease in in com e will in crease d eman d and sh ift th e cu rve to
the righ t.
With in th is fram ework, illu stratin g the ca se of a n in com e
elastic good an d a n in com e in ela stic g ood ca n be a problem .
I t may be accepta ble to illu strate th e in com e ela stic case with
a big sh ift to th e rig h t of th e d ema n d cu rve if in com e
increases a n d with a tiny sh ift to the rig h t if d eman d is
incom e in elastic.
A better way to illu strate YED is by u sing an Engel cu rve, which
is ju st a graph with incom e on the vertical axis and qu antity
d emand ed on the horizontal axis. I f the cu rve is positively
sloped then YED is positive and the good is normal. I f the slope
is negative then YED is negative and the good is inferior. I f th e
cu rve is vertical then YED is zero. All three cases are illu strated
in Figu re 1 .2 .9.
Income ( Y)

n I f YED . 1 then the percentage change in d emand is

greater than the percentage change in incom e. We say that Negative slope
d emand is incom e elastic, as a rise in incom e lead s to a YED < 0
faster rise (a proportionately greater in crease) in d emand . Inferior good
Lu xu ry good s (as well as m ost services) are u su ally
consid ered incom e elastic. For example, d emand for plastic
su rgery, spa therapy or hau te cou tu re clothing is incom e
elastic in many markets.
n I f 0 , YED , 1 then the percentage change in d emand is YED = 0
smaller than the percentage change in incom e. We say that (income rises but
d emand is incom e in elastic as a rise in incom e lead s to a Qd stays the same)
slower rise (a proportionately smaller increase) in d emand .
Basic good s (every d ay good s or staple good s) are u su ally
incom e inelastic. For example, d emand for many food
prod u cts is incom e inelastic.
n I f YED 5 0 then d emand for the good is not affected by a Positive slope
change in incom e. I ncom e may increase or d ecrease bu t YED > 0
d emand for the good remains the sam e. Normal good

n I f YED 5 1 then the percentage change in incom e is equ al

0
to the percentage change in qu antity d emand ed : a 5 % Quantity demanded (Yd)
Figure 1.2.9 Illustrating YED through an Engel curve

21
 1 Microeconomics

I t is possible to illu strate the cases o prod u cts with incom e

Income ( Y)
elastic and incom e inelastic d emand as well as the case where Engel curve
YED 5 1 . YED = 1
To illu strate a prod u ct with incom e elastic d emand , draw a (at all points)
straig ht line Engel cu rve that cu ts the vertical axis, as illu strated
in Figu re 1 .2 .1 0.
Income (Y)

F
Y1
Engel curve
YED > 1

F
Y1

0 Q1
H Quantity demanded (Yd)

Figure 1.2.12 YED curve (YED 5 1 )

Optional material
0 Q1 I you are cu riou s why the above resu lts occu r, here is an
Quantity demanded (Yd) easy proo. Lets rearrange the YED orm u la as:
Figure 1.2.1 0 Income elastic demand (YED . 1 )

To illu strate a prod u ct with incom e inelastic d eman d , draw

DQ
( )Y1 Y1
( ) ( ) ( )
DY
YED 5 ___ 3 ___ 5 ___ 4 ___
DY Q1 Q1 DQ

a straight line Engel cu rve that cu ts the horizontal axis, as

illu strated in Figu re 1 .2 .1 1 .
So, we have expressed YED as a ratio. The nu m erator ___
Y1
Q1 ( )
is the slope o the ray (0F ). The d enom inator is the slope
o the Engel cu rve itsel. So:
Income (Y)

Engel curve (slope o the ray 0F)

0 < YED > 1 YED 5 ________________________
(slope o the Engel cu rve itsel )
To check whether YED is greater than, equ al to or smaller
than 1 , you ju st have to compare the two slopes. I n Figu re
1 .2 .1 0 the slope o the ray is steeper so YED is greater
than 1 . I n Figu re 1.2 .1 1 the slope o the ray is f atter so
F
Y1 0 , YED , 1 . I n Figu re 1 .2 .1 2 th e two slopes coincid e so
YED 5 1 .

Some industries are considered cyclical and some acyclical

TIP
as a result o their YED. Overall economic activity, and
thereore incomes, fuctuate and this fuctuation is known as
the trade or business cycle. Short-run fuctuations signicantly
aect auto sales, urniture sales and housing; these industries
are reerred to as cyclical. Sales o ood products in
supermarkets are not aected as much by short-run fuctuations;
0 H Q1
this sector o the ood industry is considered acyclical.
Quantity demanded (Yd)
Figure 1.2.11 Income inelastic demand (0 , YED , 1 )

To illu strate a prod u ct with YED equ al to 1 , draw a straight line

Engel cu rve that goes throu gh the origin, as illu strated in
Figu re 1 .2 .1 2 .

22

Applications o YED
Firms would like to know whether demand or their product is
highly incom e elastic or m oderately incom e inelastic to help
them better plan their investm ents. I an economy is growing and
incom es are increasing ast, then rm s producing highly income
elastic products may have to invest now in expanding their
capacity to be able to m eet the increased demand. Conversely,
arm ers growing, say, potatoes may think o switching to kiwi
ruit or to agro-tourism, which have a higher YED.
A govern m ent may also be in terested in knowing YED
in variou s sectors to plan ahead regard ing training or
d isplaced workers. The econom ic signi cance and viability o
incom e in elastic sectors will shrink in the long ru n so som e
workers in these sectors may lose their jobs and will need
re-training. I n this sense, a growing econom y may su er rom
increased (stru ctu ral) u nemploym ent and m ove away rom u ll
employm ent. Also, as sectors prod u cing highly incom e elastic
prod u cts, or example services, will grow ast, employm en t
need s will also grow ast. This m ean s that governm ents shou ld
plan ahead regard ing changes in school cu rricu la and
vocational schools, so as to avoid employm ent bottlenecks.
Related to the above is the id ea that th e so-called sectoral
composition o ou tpu t o an econ omy changes throu gh tim e as
a resu lt o d iering YEDs. Many ood prod u cts have a low YED
once a certain threshold level o incom e is reached . Any u rther
increases in incom e are m ostly spent on prod u cts rom the
Price elasticity of supply
Defnition The responsiveness o qu antity su pplied when
the price o the good changes
Reerred to as PES
Measure The percentage chang e in qu antity su pplied
d ivid ed by the percentage change in price:
%DQ
PES 5 ______s
%DP
The above can be rewritten as:
DQ s
____
PES 5
Q1
_____
DP
___
DQ
( ) ( )
DP
P
, or ____s 3 ___1
Q1
P1
The sign o PES is positive since su pply cu rves typically have
a positive slope ( rm s oer m ore o a good per period at a
higher price).
Ranges o PES
n I PES . 1 we say that su pply is price elastic. I t m eans that
the percentage change in qu antity su pplied is greater
than the percentage change in price, or that a change in
price lead s to a proportionately greater change in
qu an tity su pplied .
n I 0 , PES , 1 then we say that su pply is price inelastic. I t
m eans that the percentage change in qu antity su pplied is
1 Microeconomics
manu actu ring sector, or example cars, appliances and
u rnitu re, which carry a higher YED. Lu xu ry item s and services
are con sid ered to have an even higher YED so once hou sehold s
have attained a certain stand ard o living, u rther increases
in d iscretionary in com e are spent m ostly on vacation s, spa
treatm ents, expensive clothing and expensive cars. I n this
way the relative size o the primary sector and later o
manu actu ring sh rinks while that o services expand s. This is
the case or many bu t not or all cou n tries, with Germany and
Au stralia being notable exam ples.
Calculating YED
Assu m e that per capita incom e in the preectu re o Corinth
increases rom 2 5 ,000 per annu m to 33,75 0 and , as a
resu lt, qu antity d emand ed or atty grou nd m eat d ecreases
rom 1 5 ,000 kg per week to 1 4,2 5 0 kg per week. What is the
YED or atty grou nd m eat? I s the d emand or atty grou nd
m eat in the area o a normal good ?
Apply the orm u la or YED:
DQ
DY ( )Y1
Q1 ( ) (
1 42 5 0 2 1 5 000
3375 0 2 2 5 000
2 5 000
YED 5 ___ 3 ___ 5 ______________ 3 ______
1 5 000 ) ( )
2 75 0 25 2 1 875 0
5 _____ 3 ___ 5 _______ 5 2 0.1 4
875 0 15 1 31 2 5 0
Since YED has a negative valu e, atty grou nd m eat is
consid ered an inerior prod u ct in that area.
smaller than the percentag e change in price, or that a
chang e in price lead s to a proportionately smaller chang e
in qu antity su pplied .
n I PES 5 1 then we say that su pply is unitary price elastic.
I t m eans that the percentage change in qu antity su pplied is
equ al to the percentage change in price, or that a change
in price lead s to a proportionately equ al change in
qu antity su pplied .
n I PES ` then we say that su pply is perectly elastic.
I t m eans that a small change in price lead s to an in nitely
large change in qu antity su pplied . Eectively, this m eans
that the rm is willing to oer as m u ch as the market
d emand s at the sam e, cu rrent price.
n I PES 5 0 then we say that su pply is perectly inelastic.
I t m eans that a change in price lead s to no chang e in the
qu antity su pplied . Price changes have no eect on the
am ou nt oered per tim e period .
Using graphs to illustrate PES
PES can be illu strated u sing linear su pply cu rves. Bearing in
m ind that a vertical su pply cu rve (see Fig u re 1 .2 .1 3 ) is perectly
inelastic, im plying that a change in price has no eect on
qu an tity su pplied (PES 5 0), while a horizontal su pply cu rve
(see Figu re 1 .2 .1 4) is perectly elastic (PES ` ), it is easy to
rem em ber that as su pply f attens arou nd som e price it
becom es m ore price elastic.
23
 1 Microeconomics

P/unit
P/unit

S
S

Linear supply
Vertical supply
cutting vertical
PES = 0
axis: PES > 1

0
0 Quantity supplied (Qs)
Quantity supplied (Qs)
Figure 1.2.1 6 PES curve (PES . 1 )
Figure 1.2.13 Perectly inelastic supply curve (PES 5 0)
Lastly, i the linear su pply goes throu gh the origin th en PES is
P/unit

equ al to 1 at all points, as illu strated in Figu re 1 .2 .1 7.

P/unit

Horizontal supply,
innitely elastic
Linear supply
through the
origin: PES = 1 S
P S (at all points)

0
Quantity supplied (Qs)

Figure 1.2.1 4 Perectly elastic supply curve (PES `) 0 Q1

Quantity supplied (Qs)
What matters is whether the linear su pply cu ts the horizontal
axis, the vertical axis or goes throu gh the origin. I the su pply Figure 1.2.17 PES 5 1 at all points
cu rve cu ts the horizontal axis (ind epend ently o its slope) then
is price inelastic, as in Fig u re 1 .2 .1 5. Optional material
To convince you rsel why the in tercept o a linear su pply
P/unit

S
cu rve d eterm ines whether PES is smaller than, equ al to
or greater than 1 , u se the sam e logic presented earlier
or YED.

Determinants of PES
n The tim e period d eterm ines PES. I n econom ics, tim e is
d istingu ished into the m om entary period (or market
Linear supply, period ), the short ru n and the long ru n. The d istinction is
cutting horizontal based on the extent to which ad ju stm ents can be mad e.
axis: 0 < PES < 1 I n the m om entary (or market) period no ad ju stm ents are
possible. I n the short ru n som e, bu t not all, ad ju stm ents are
possible. I n the long ru n all ad ju stm ents are possible.

0 The above d ef nitions becom e m ore specif c when applied to

Quantity supplied (Qs)
Figure 1.2.15 Price inelastic supply (0 , PES , 1 )
I the linear su pply cu ts the vertical axis (ind epend ently o its
slope) then it is price elastic, as in Figu re 1 .2 .1 6.
the theory o prod u ction. The m om entary period is when all
actors o prod u ction are consid ered f xed . The f rm is operating
in the short ru n when som e, bu t not all, actors o prod u ction
are consid ered f xed . I n the long ru n all actors o prod u ction
are consid ered variable (no f xed actors exist).

24

I t ollows that in the m om entary ru n, su pply is perectly
in elastic (vertical). I d emand or the prod u ct increases, qu antity
su pplied remains u nchanged . The increased d emand will be
expressed only as a higher price. Su pply is not at all responsive.
I n the short ru n the increased d emand will be partially
expressed as an increase in qu antity su pplied and partially as
an increase in price. I n the long ru n, when all actors are
variable an d the f rm can even increase its scale o operations
(its size), ou tpu t cou ld expand even m ore. So, in the long ru n ,
su pply is typically expected to be m ore price elastic than in th e
short ru n.
Figu re 1 .2 .1 8 illu strates the eect o tim e on the PES o a good .
The longer the tim e period , the greater the PES is expected to
be. I n the m om entary ru n it is vertical so that the PES is zero,
while in the long ru n it may even be perectly elastic with f rm s
willing to oer m ore at the sam e price P9 (althou gh this wou ld
requ ire that cost cond itions d o not change).
P/unit
S1 S2
S3
S4
P S5
0 Q
Quantity supplied (Qs)
Figure 1.2.1 8 The eect o time on PES
n Excess (som etim es reerred to as u n u sed ) capacity is a
d eterm in ing actor o PES. The u rther below u ll ca pacity a
f rm is operating , the greater the PES is expected to be.
n Whether the f rm employs m ostly skilled or m ostly u nskilled
labou r is signif cant. Expand ing ou tpu t in a prod u ction
process that pred om inantly relies on highly skilled labou r
may be m ore d if cu lt than i m ostly u nskilled workers are
requ ired .
n Whether long or short tim e lags characterize the prod u ction
process is also relevan t. The longer the tim e lags involved ,
the lon ger it takes or su pply to ad ju st to new d emand
cond ition s. Agricu ltu ral prod u cts are characterized by long
tim e lags so su pply is oten consid ered perectly inelastic in
the short ru n.
n The speed by wh ich costs rise as ou tpu t expand s need s
consid eration. Firm s will be encou rag ed to expand ou tpu t
1 Microeconomics
by m ore per tim e period to lower the ad d itional (marginal)
cost o d oing so.
n Another d eterm inant o PES is whether it is possible to
store the good . I it is possible to store stocks then it may
be possible to m eet an in crease in d emand by releasing
stocks, so f rm s can be m ore responsive in their su pply than
i their good s are perishable or no stocks are held .
n Mobility o labour is relevant. I, or example, labour is
occupationally or geographically immobile then it will be
more difcult to meet an increase in the demand or a product
than i labour is mobile between occupations or regions.
Applications of PES
PES d eterm i n es th e exten t to wh i ch a n i n crea se i n d em a n d
wi l l a ect th e pri ce a n d /or q u a n ti ty o th e g ood i n a
m a rket. Th e m ore pri ce i n ela sti c su ppl y i s, th e g rea ter th e
i n crea se i n pri ce g i ven a n i n crea se i n d em a n d ; th e m ore
ela sti c su ppl y i s, th e g rea ter th e i m pa ct o a n i n crea se i n
d em a n d on q u a n ti ty.
Primary agricu ltu ral com m od ities, or example wheat and corn,
are characterized by low PES as their prod u ction is su bject to
long tim e lags. Think, or example, o a prod u cer planting at a
particu lar tim e bu t harvesting six m onths later. N on-agricu ltu ral
primary prod u cts, su ch as m etals and m inerals, are also
characterized by low PES becau se o the associated steep
extraction costs. On the other hand , prod u cts rom the
manu actu ring sector are characterized by higher PES becau se
given a prod u ction plant, the extra costs o prod u cing
ad d itional u nits are typically low.
If you are asked to draw the short-run supply curve for a
TIP
farm product, for example wheat or coffee, draw it as a
vertical line (PES 5 0). This also applies if you are asked to
draw the supply curve for a concert, a tennis game or the rooms
offered by a hotel. The short-run supply curve for each example
is also vertical as there is limited, if any, ability to change the
quantity offered (of seats or of rooms) per time period following
a change in demand.
Calculating PES
Assu m e that the price o a particu lar good increases rom
1 6.00 per u nit to 1 8.40 and , as a resu lt, qu antity su pplied
increases rom 2 8,000 u nits per year to 2 8,840 u nits per year.
What is the PES or this g ood ?
Apply the orm u la or PES:
( ) ( ) (
DQ s
DP
P1
Q1
2 8,840 2 2 8,000
1 8.40 2 1 6.00
1 6.00
PES 5 ____ 3 ___ 5 _______________ 3 ______
2 8,000 ) ( )
840 16 1 3,440
5 ____ 3 ______ 5 ______ 5 1 0.2
2 .40 2 8,000 67,2 00
Su pply is price inelastic.
25
 1.3 Government intervention
Indirect taxation
Taxes can be categorized as direct or indirect taxes. Indirect taxes
are taxes on goods and services and can be imposed on a specic
or an ad valorem basis. Specic or unit taxes are a xed am ount
per unit o the good produced or consumed. For example, a tax o
1 00 Indian Rupees per unit o a good is a specic tax. Ad
valorem taxes are a percentage o the price and so o consum er
expenditures. Value added tax (VAT) is an example o an ad
valorem tax which is expressed as a percentage, say 23%, o the
price o the good.
Governm ents impose indirect taxes or a variety o reasons.
Typical reasons include revenue collection or an attempt to
decrease the consumption o goods. Governm ents need revenues
to nance their expenditures and indirect taxation is one source
o revenue. Som e goods are considered harmul and governm ents
oten try to lim it their consumption; examples include cigarettes,
alcoholic drinks and petrol (gasoline). Another reason or
governm ents imposing taxes is that they wish to switch
expend itu res away rom imports toward s d om estically prod u ced
good s. One way o d oing this is by imposing taxes (known as
taris) on imports.
Illustrating indirect tax on a diagram
An indirect tax can be consid ered as an add itional cost o
prod uction. As su ch it will tend to decrease the supply o a rm ,
shiting the su pply cu rve let on a d iagram . I we recall that a
su pply cu rve can also be read vertically and that it ref ects the
extra (marginal) cost o prod ucing an extra u nit, then it shou ld
be clear that an ind irect tax will increase this extra cost, shiting
the su pply cu rve vertically upwards by the am ount o the tax.
P/unit
St
(or, MC = MC + tax)
h harm u l good , su ch as cigarettes.
S, MC
f St
hf = tax/unit
D P
0 Pp
Q/period
Figure 1.3.1 A specic indirect tax
I n Figu re 1 .3.1 a market is illu strated with a d emand cu rve D
and a su pply cu rve S. The su pply cu rve is also the marginal cost
(M C) cu rve. Assu m e a speci c tax equ al to h d ollars per u nit.
Su pply will shit vertically u pward s to St by d istan ce h.
Alternatively, you may think o M C increasing by h d ollars per
u nit so that the new M C cu rve (MC9 ) is equ al to the initial one
(M C) plu s the tax.
26
Consequences o a specifc indirect tax
Assu m i n g typi ca l d em a n d a n d su ppl y cu rves, a n i n d i rect ta x
wi l l m a ke th e g ood m ore expen si ve, wi l l d ecrea se th e
am ou n t con su m ed a n d prod u ced a n d wi l l crea te reven u es
or th e g overn m en t. Prod u cers wi l l be ea rn i n g l ower
reven u es both on a per u n i t ba si s a n d a s a tota l . Con su m er
spen d i n g on th e g ood m a y i n crea se or d ecrea se, d epen d i n g
on PED.
More speci cally, and reerring to Figu re 1 .3.2 , the
ollowing occu rs.
n The market price rises rom P to Pc per u nit while the
equ ilibriu m qu antity d ecreases rom Q to Q9 per period .
Ou tpu t and consu m ption o the good thereore shrink.
n Prod u cers earn only Pp (5 h) per u nit sold , so their new
average revenu e is less than the original, pre-tax price and
average revenu e P.
n Th e tota l reven u es th e prod u cers col lect d ecrea se rom
a rea (0QeP) to a rea (0Q9 Pp). Con su m er expen d itu res m ay
in crea se, d ecrea se or stay th e sam e, d epen d in g on th e
PED between poin t e a n d poin t h , a s th ere is a m ovem en t
a l on g th e d em a n d cu rve oll owin g th e sh it in su ppl y.
Sin ce th e price con su m ers pay in crea ses, th eir
expen d itu res on th e g ood will in crea se i d ema n d is
price in ela stic.
n The governm ent collects tax revenu es equ al to area
(PphPc). This area is ou nd by m u ltiplying the tax per u nit
(h) by the nu m ber o u nits sold (line segm ent 0Q9 , which is
equ al to segm ent Pp).
n Resou rces are m isallocated and a welare loss equ al to area
(eh) resu lts, u nless the tax is im posed to lim it prod u ction
o a pollu ting ind u stry or to cu rtail consu mption o a
P/unit
S
Pc h
H
j
e
f
D
0 Q Q
Q/period
Figure 1.3.2 Consequences o a specic indirect tax
 1 Microeconomics

Consequences of an indirect tax, assuming typical demand and supply conditions

the marke price consumers pay increases
the equilibrium quaniy decreases
the ne ax price producers earn (averae revenue colleced) decreases
toal revenues producers collec decrease
toal expendiures consumers make depends on PED
Social welfare decreases (bu see las bulle above)
governmen revenues increase

HL Tax incidence
Tax incid ence reers to wh o pays what proportion o a tax. For
example, i ater a $ 1 0.00 tax is imposed on a good its market
price increases by $ 9.00, then the incid ence on consu m ers was
$ 9.00, while the incid ence on prod u cers was $ 3 .00 (or 9/1 2
and 3/1 2 respectively).
Figu re 1 .3.2 reveals that the market price d id not increase by
the u ll am ou nt o the ind irect tax im posed . The size o the tax
is line segm ent h (the vertical d istance between the pre-tax
and the post-tax su pply cu rves) while market price increased
only by segm ent hj. I t ollows that the incid ence o this tax is
on both consu m ers and prod u cers: consu m ers and prod u cers
share the tax. Tax incid ence on consu m ers is line segm ent
jh (5 PPc) whereas tax incid ence on prod u cers is line segm ent
j (5 PPp).
Tax incid ence d epend s on PES and PED. The ollowin g
relationship hold s:
(% of tax incidence on consumers)
____________________________ PES
5 ____
(% of tax incidence on producers) PED
To rem em ber the relationship ju st keep in m in d that i incid ence
on consu m ers is in the nu m erator then PED is in the
d enom inator.
Bearing in m ind that the two percentages on th e let raction
m u st ad d u p to 1 00%, the interpretation o the above is
straightorward .
n M arket price will rise m ore and hence the consu m ers share
o the tax will be larg er, the less elastic is d eman d and the
m ore elastic is su pply.
n M arket price will rise less and hence the prod u cers share
will be larger, the m ore elastic is d emand and the less
elastic is su pply.
n Equ ilibriu m qu antity will d ecrease less, the m ore inelastic
d emand and su pply are (the m ore vertical arou nd the initial
pre-tax equ ilibriu m point).
I t ollows that tax revenu e or the governm ent increases as
elasticities d ecrease.
I t is arg u ed that a tax is oten u lly paid by con su m ers. H ow
can that be th e case i the law o d eman d has alm ost u n iversal
applica bility? The a n swer is that su ch cases a re a resu lt o
frm s very oten being a ble to su pply greater qu a n tities per
period at the sam e price 2 later we will reer to th is a s
consta n t retu rns to sca le 2 that is, acing h orizon ta l
(perectly ela stic) su pply cu rves.
I t is a com m on m istake to claim that i d emand is price inelastic
then the incid en ce o an ind irect tax alls m ostly u pon
consu m ers. I PES happens to be lower than PED then it is
prod u cers and not consu m ers who will pay a bigger proportion
o the tax. So i, or example, PED 5 0.8 (price inelastic) while
PES 5 0.2 , then the incid ence on consu m ers will be smaller
(consu m ers will pay 2 0% o th e tax and prod u cers will pay
80% o the tax).

If: then: in other words:

PES . PED ax incidence on consumers is bier han on producers % of ax on consumers . % of ax on producers
PES 5 PED ax incidence is spli beween consumers and producers % of ax on consumers 5 % of ax on producers
PES , PED ax incidence on producers is bier han on consumers % of ax on consumers , % of ax on producers
PES 5 0 producers are burdened by he full amoun of he ax here is 100% of ax on producers and 0% on consumers
PED 5 0 consumers are burdened by he full amoun of he ax here is 100% of ax on consumers and 0% on producers
PES ` consumers are burdened by he full amoun of he ax here is 100% of ax on consumers and 0% on producers

PED ` producers are burdened by he full amoun of he ax here is 100% of ax on producers and 0% on consumers

27
 1 Microeconomics

Analysis of an ad valorem (percentage) tax Figu re 1 .3 .3 illu strates an ad valorem (percentage) tax. I nitially,
market d emand and market su pply are at D and S respectively
What i the tax is an ad valorem (a percentage) tax? Su ch a tax
with P the initial market price and Q the initial qu antity bou ght
is analysed in the sam e way as a specif c tax except that the
an d sold per period . Let an ad valorem (percentage) tax be
shit o su pply is not parallel bu t the wed ge (vertical d istance)
im posed , say, VAT at 2 3%.
wid ens at higher prices. Otherwise, the eects are id entical to
those o a specif c tax. The d ollar am ou nt o th e tax at each possible price is not
constant anym ore. This is why the vertical d istance between the
P/unit

original su pply cu rve S an d the post-tax su pply cu rve St grows

St
as price increases. The wed ge at each ou tpu t level becom es
bigg er and bigger.
The eects o this are that:
n market price that consu m ers will pay rises to Pc
n the average revenu e collected by f rm s d ecreases rom
P to Pp
Pc h S n equ ilibriu m qu antity d ecreases rom Q u nits to Q9 u nits.
Total revenu es collected by f rm s equ al area (0Q9 Pp).
j e
P Consu m ers spend area (0Q9 h Pc), o which tax revenu es
collected by the governm ent equ al area (PjhPc).
Pp
f Assu m ing that th e tax wa s n ot im posed to lim it prod u ction
o a pollu tin g in d u stry or con su m ption o a ha rm u l
good , a welare loss equ a l to a rea (eh ) a n d resou rce
D m isallocation resu lts.

0 Q Q
Q/period
Figure 1.3.3 Eects o an ad valorem (percentage) indirect tax, or
example VAT

Subsidies
A su bsid y is d ef ned as a per u n it paym ent to f rm s by the
P/unit

governm ent aim ed at lowering their costs and the market price, S
and at increasing prod u ction, consu m ption and f rm s revenu es.
I ts analysis is sym m etrical to that o an ind irect tax as once a
h
su bsid y is gran ted the governm ent is payin g (and not getting
paid ) a per u nit am ou nt o m oney to f rm s. Prod u ction costs are
lower by the am ou nt o the su bsid y so su pply shits vertically S(sub)
d ownward by that am ou nt (the marginal cost o prod u cin g
each u nit o ou tpu t is n ow lower). f
Governm ents grant su bsid ies or a variety o reasons. Typically,
they are granted when or som e reason it is consid ered
d esirable to make a particu lar good cheaper so that its hf = subsidy/unit
consu m ption increases and it becom es accessible to lower-
incom e hou sehold s. This inclu d es many health-care and
ed u cation-related prod u cts. Or g overnm ents may wish to
expand ou tpu t and consu mption o prod u cts that are
environm entally riend lier. Oten governm ents grant su bsid ies
to arm ers to increase their incom e becau se o certain D
characteristics o th e agricu ltu ral sector. Or it cou ld be that a 0
Q/period
su bsid y is u sed to make a particu lar good m ore competitive and
attractive abroad so that it penetrates oreign markets, or to Figure 1.3.4 A subsidy
lim it im ports o com petin g good s rom abroad .
In Figure 1 .3.4 the initial demand and supply conditions are Consequences of a subsidy
represented by curves D and S. The new supply ollowing the Assu m ing typical d emand and su pply cu rves, a su bsid y will
granting o the subsidy is at S(sub). The vertical distance h is make the good cheaper, will increase the am ou nt consu m ed
equal to the subsidy per unit and represents the decrease in costs an d prod u ced and will cost the governm ent m oney. Prod u cers
each frm enjoys once the subsidy is granted. I you remem ber will earn m ore revenu es both on a per u nit basis and as a total.
that the supply curve also represents marginal cost (MC) then Consu m er spend ing on the good may increase, d ecrease or
the new supply curve S(sub) is MC9 5 (MC 2 subsidy). remain the sam e, d epend ing on PED.

28
 1 Microeconomics

More specif cally, ocu sing on Figu re 1 .3.5 , the market price
consu m ers pay d ecreases rom P to Pc while the equ ilibriu m
qu antity increases rom Q to Q9 . Ou tpu t and consu mption o
the good thereore in crease.
P/unit
errors. First, locate the new equ ilibriu m qu antity (Q9 in
Figu re 1 .3.5 ). From point Q9 draw a line u p all th e way to the
initial su pply cu rve S. This is line Q9 h. The prod u cers earn
whatever consu m ers are paying (Q9 5 Pc) plus the su bsid y per
u nit h that the governm ent pays. They thereore earn Q9 1 h,

which is equ al to Q9 h or Pp.

S
The governm ent spend s in total area (hPpPc), which is ou nd
by m u ltiplying the su bsid y h by the qu antity prod u ced and
consu m ed Q9 (or 5 Pc).
Pp Both prod u cers and consu m ers o a prod u ct benef t rom a
h
S(sub) su bsid y. Consu m ers pay a lower price wh ile prod u cers earn
e m ore per u nit. I the su bsid y is not granted to encou rage
P
consu m ption o good s that the governm ent consid ers benef cial
to society, a welare loss resu lts 2 here equ al to area (eh) 2
and there is resou rce m isallocation.
Pc f
Consequences of a subsidy, assuming typical demand
and supply conditions
The market price consumers pay decreases
The equilibrium quantity increases
The averae revenue collected increases
by producers
D
Total revenues collected by increase
0 Q Q producers
Q/period
Total consumer expenditures depends on PED
Figure 1.3.5 Consequences o a subsidy Social welfare decreases (but see above)
To id entiy the new average revenu e collected by prod u cers you government expenditures increase
need to be extra careu l as it is a com m on sou rce o stu d ents

Price controls
Price controls reer to cases where or som e reason the
P/unit

governm ent consid ers th e market-d eterm ined (equ ilibriu m ) S

price u nsatisactory and , as a resu lt, intervenes and sets the
price either below or above it. b
Pb

Maximum price (price ceiling)

An au thority, u su ally the governm ent, sets a maxim u m price
(also reerred to as a price ceiling) i it consid ers the market-
d eterm in ed price is too high. I t is a maxim u m price in the sense
that it is the highest price sellers can legally charge. The price
on its own wou ld rise higher toward s its equ ilibriu m level bu t
the governm ent creates a ceiling, restricting the price to the
d esired level. For a maxim u m price to make any sense it
h f M a xi m u m p ri ce
thereore has to be set below the market price. P
(p ri ce cei l i n g )
The aim o setting a price ceiling is to protect the bu yers o the
prod u ct. As su ch it is set on sensitive prod u cts that m ostly
lower-incom e hou sehold s bu y. Typically, price ceilings are set on D
ood prod u cts and petrol (gasoline), as well as in the rental
hou sing market in the orm o rent controls. 0 Qb Q1 Q2
Q / p eri o d
I n Figu re 1 .3.6 the governm ent (or anoth er au thority) has set
the maxim u m price at P9 . Firm s will be willing to oer Q1 u nits Figure 1.3.6 Maximum price (price ceiling)
per period whereas consu m ers will be willing and able to
The price P9 cannot perorm its rationing unction anymore:
pu rchase Q2 u nits per period . So, a shortage resu lts equ al to
individuals may be willing and able to pay the price but it is not
Q1 Q2 u nits per period (or equ al to h).
certain that they will end up with the good as a shortage exists.

29
 1 Microeconomics
A d ierent rationing m echanism is need ed . These are som e
alternative rationing m echanism s.
n Rationing can be on the basis o f rst com e, f rst served .
This is likely to lead to qu eu es d eveloping as people will
ru sh to bu y the price-controlled good beore su pplies are
exhau sted . Firm s may ad opt waitin g lists.
n Ration in g ca n be ba sed on sellers preeren ces. Th e
prod u ct may be a llocated on th e ba sis o wh o th e
con su m er is. I s th e con su m er a reg u la r? I s th e con su m er
attra ctive? I s th e con su m er im porta n t? I th e a n swer is
yes th en th e con su m er will g et th e g ood . I n th is ca se th e
ma rket is n ot im person al a nym ore (wh ich is a major
a d va n ta g e o ree ma rkets) bu t becom es person a l.
Discrim in ation may resu lt.
n The prod u ct cou ld be allocated on a rand om basis, or
example by ballot, as was the case or th e 2 006 FI FA World
Cu p tickets.
n Cou pons cou ld be u sed to ration the good . This alternative
has been u sed in tim es o war.
A major problem with maxim u m prices is the likely em ergence
o parallel (black or shad ow) markets. Consu m ers, u nable to
bu y in legal markets, may well be prepared to pay a m u ch
higher price. Figu re 1 .3.6 inclu d es consu m ers willin g to pay
price Pb to acqu ire u nit Qb. The willingness to pay, m easu red
by the vertical d istance rom the horizontal axis to th e d emand
curve, is greater than the maxim u m price or all prod u ced (and
so available) u nits u p to Q1 .
I n the long ru n ad d itional costs may em erge. The qu ality o
certain prod u cts may worsen as prod u cers may be tempted to
use cheaper inpu ts. Also, i other non-price controlled prod u cts
can be prod u ced u sing the sam e inpu ts then su pply may u rther
shrink, making shortages m ore severe.
To m inim ize shortages and the related problem s, a governm ent
may attempt to encou rage su pply (that is, attempt to shit the
supply cu rve to the right on the d iagram ). I t m ight d o this
throu gh variou s m eans, or example it may draw on stocks,
assu m e d irect prod u ction o the good or grant su bsid ies or tax
relie to prod u cers. Alternatively, governm ents may attempt to
red u ce d emand . For example, it may encou rage prod u ction o
m ore and ch eaper su bstitu tes.
Consequences on stakeholders: the case of rent control
Figu re 1 .3.7 is u sed to illu strate the consequ ences o a price
ceiling on the variou s stakehold ers. The case where ren ts are
controlled in a city is u sed as an example.
Given d eman d D a nd su pply S or ren tal u nits in a city the
equ ilibriu m rent wou ld be at Re with Qe u n its su pplied a nd
dema nd ed . Assu m e now that city au th orities d ecid e that rents
or a typical u nit can not exceed R9 . Lan d lord s (property
owners) are orced to ren t their h ou ses or apartm en ts at a
lower price. Rents a re con trolled at th e level R9 (a price
ceilin g). At that ren t only Q9 u nits are oered or rent while Q2
units are d eman d ed . A shortag e o h ou ses an d apartm en ts or
rent resu lts equ al to Q2 2 Q1 (that is, lin e seg m en t Q2 Q1 ).
The shortag e is d irectly related to the size o th e d ierence
between Re and R9 .
30
Rent per unit
S
1
2 4
Re
3 5
Rent control
R
level
6
D
0 Q1 Qe Q2
Q (Number of rental units)
Figure 1.3.7 Rent control as an application o price ceilings
Since rent R9 is n ot a competitive ree-market d eterm ined rent,
it cannot perorm its rationing role. Being willing and able to
pay rent R9 will not g u arantee that everyone looking or rented
hou sing will f nd it. Land lord s have to u se other rationing
m echanism s, the m ost popu lar being f rst com e, f rst served .
Land lord s also have the power to d iscrim inate against any
grou p they may not like to rent their property to, or exam ple
cou ples with you ng children or with pets, you nger people or
im m igrants. This cou ld create a parallel (black or shad ow)
market, where land lord s may extract u nd er the table paym ents
rom tenants over and above the maxim u m legal rent, or wh ere
land lord s ask or large d own paym en ts.
Are tenants better off or worse off?
Tenants lu cky enou gh to f nd hou sing at the lower rent are
better o, even thou gh land lord s may d ecid e not to maintain
the property. Tenants who wou ld have been able to f nd rented
hou sing at rent Re and who as a resu lt o th e shortage
are let hom eless are d ef nitely worse o. Tenants who are
d iscrim inated against or who end u p paying signif cantly m ore
as a resu lt o th e shortage are also worse o.
Are landlords better off?
I n general, land lord s are worse o as they rent ou t ewer u nits
at a lower rent. Som e may be better o i they take the risk
to rent at an illegal higher rate and they d o not ace any
consequ ences. Oten, many are orced to leave the market (or
example by selling their property) or they may be orced to
witness a lon g-term d eterioration o the valu e o their property
i they cannot aord maintenance.
Welfare analysis
Applyin g welare analysis to this policy issu e will shed light on
its consequ ences to stakehold ers.

Beore th e ren t control wa s im posed , equ ilibriu m ren t wa s at
Re an d th e equ ilibriu m qu a n tity o ren ta l u n its was Qe.
Consu m er su rplu s is equ a l to a rea (1 1 2 1 4) an d prod u cer
su rplu s is equ a l to a rea (3 1 5 1 6). Social (or com m u n ity)
welare (or su rplu s) is thereore equ a l to a rea (1 1 2 1 4 1
3 1 5 1 6).
Ater th e ren t con trol i s i m posed con su m er su rpl u s cha n g es
to a rea (1 1 2 1 3 ). Con su m ers (ten a n ts wh o n d ren ted
h ou si n g ) pay a l ower ren t bu t th e q u a n ti ty o ren ta l u n i ts i s
n ow on l y Q1 . Rem em ber tha t con su m er su rpl u s i s th e a rea
bel ow th e d em a n d cu rve a n d a bove th e pri ce or th e
n u m ber o u n i ts bou g h t. Prod u cer su rpl u s h a s cha n g ed to
a rea (6 ). I t i s th e a rea a bove th e su ppl y cu rve a n d bel ow
th e pri ce or th e n u m ber o u n i ts sol d (i n th i s ca se,
ren ted ou t).
What are the changes?
Land lord s (sellers) are u nam bigu ou sly worse o as they have
lost area (5 ) as well as area (3) which has been transerred to
tenants (bu yers) who enjoy the qu antity available at a lower
rent. Tenants (bu yers) lose area (4) as u nits Q1 Qe are not
available anym ore. H owever, they gain area (3) as they pay only
R9 or the rental u n its available. Social welare d ecreased by
area (4 1 5 ) so n ow there is allocative ine ciency in the
market or rented hou sing. Land lord s (sellers) are worse o as
their su rplu s has shru nk (assu m ing they d o n ot receive illegal
higher paym ents). Tenants who as a resu lt o the rent control
were not able to nd a rental u nit are worse o as they have
lost area (4), bu t tenants who were lu cky en ou gh to nd a
rental u nit at th e lower rent R9 are better o as they gain area
(3). The eect o su ch a policy on lower-incom e hou sehold s
is am bigu ou s.
Lastly, since there is no gu arantee that the apartm ent u nits
0Q1 were rented to the tenants who valu ed these the m ost, it
cou ld be that the social welare loss is actu ally bigger than
area (4 1 5 ).
Remember that, even though its seems counterintuitive, a
TIP
maximum price must be drawn below the equilibrium level.
The shortage created is not an area but the distance
between the quantity demanded and the quantity supplied at
the set price.
It is best to use linear demand and supply curves.
Minimum price (price foor)
An au thority, u su ally the governm ent, sets a m inim u m price
(also reerred to as a price f oor or, som etim es, price su pport) i
it consid ers the market d eterm ined price is too low. A m inim u m
price is set above the market-d eterm ined price and the aim is to
protect prod u cers. I n ord er or a m inim u m price to be eective
it m u st be set above the equ ilibriu m price. I n Figu re 1 .3.8 the
competitive ree-market equ ilibriu m price wou ld have been at
Pe, resu lting in an equ ilibriu m qu antity Qe. The govern m ent
consid ers this price too low and sets the price higher at P9 .
P9 is a m inim u m price.
Typically, m inim u m prices are encou ntered in agricu ltu ral
markets where governm ents set a price f oor to protect
arm ers incom e.
1 Microeconomics
P/unit
S
f h Minimum price
P
(price oor)
e
Pe
j
D
0 Q1 Qe Q2
Q/period
Figure 1.3.8 Minimum price (price foor)
Impact on market outcomes
I n Figu re 1 .3.8 at the price P9 rm s (in th is case arm ers) are
willing to oer Q2 u nits per period whereas bu yers are willing
and able to bu y only Q1 u nits per period . Assu m ing competitive
markets, a su rplu s resu lts equ al to Q2 2 Q1 u n its per period .
This is equ al to line segm ent Q1 Q2 (or h).
The government is orced to buy the resulting surplus as otherwise
the price would collapse. The surplus must be bought at the
promised price P9 so government spends area (Q1 Q2 h) which is
the price it pays, P9 , times the quantity it must buy, Q 1 Q 2 .
Consu m ers are worse o as they enjoy less o the produ ct at a
higher price per u nit. Prod u cers are better o as their revenu es
are higher. Withou t the m inim u m price their revenu es wou ld be
equ al to area (0QeePe), whereas with the m inim u m price their
revenu es are area (0Q2 hP9 ). Governm ent expend itu res increase
(or governm ent spend ing in other areas has to d ecrease). I
spend in g rises then tax payers eventu ally bear the bu rden o
this policy, as they pay or it in the orm o increased taxes. An
incentive to overprod u ce is created , resu lting in resou rce
m isallocation. For exam ple, too m u ch land will be allocated to
the prod u ction o one particu lar arm prod u ct. Units QeQ2 are
valu ed by consu m ers less (see the vertical d istan ce to the
d emand cu rve) than it costs to prod u ce them (see the vertical
d istance to the su pply cu rve). These u nits are now produ ced so
a welare loss equ al to area (ejh) resu lts.
Remember that, even though it seems counterintuitive, a
TIP
minimum price must be drawn above the equilibrium level:
the government creates a foor so that the price does not
drop below the desired level.
The resulting surplus is not an area but a distance (a line
segment) at the set price.
Draw the supply curve rather steep so that the resulting surplus
is not unrealistically large. It is best to use linear demand and
supply curves.
31
 1 Microeconomics

Application: setting a m inim um wage in the labour market
The sam e analytical ram ework can be employed to d escribe
the eects o m inim u m wage legislation . I n Figu re 1 .3 .9 the
vertical axis m easu res the m oney wage rate (W) per worker and
the horizontal axis d epicts the nu m ber o workers (L).
Wage rate (W)
Firm s d ema n d la bou r to prod u ce th e g ood s a n d services th ey
prod u ce. Th e d ema n d or la bou r is a d erived d ema n d . I t is
n egatively sloped a s at h ig h er wag e rates f rm s will try to
su bstitu te ca pita l or la bou r. Workers oer th eir la bou r services
to th e la bou r ma rket. Th e su pply o la bou r is u pwa rd slopin g
a s at h ig h er wa g e rates th e opportu n ity cost o leisu re

S(L)
in crea ses (it becom es m ore expen sive or som eon e to sit
ou tsid e th e la bou r ma rket) so m ore in d ivid u a ls will su bstitu te
work or leisu re. I th e la bou r ma rket is com petitive th en
th e equ ilibriu m wa g e rate will be at We with Le in d ivid u als
h f Minimum em ployed .
W
wage
I th e governm ent n ow consid ers that the market d eterm ined
wage rate We is too low and d ecid es to set a m inim u m wage at
W9 , th en f rm s at W9 will want to hire ewer ind ivid u als than
We the nu m ber o ind ivid u als willin g to oer th eir labou r services.
At the higher wage rate W9 that the governm ent sets, L2
ind ivid u als are looking or a job while f rm s will hire only L1
workers. The excess su pply (su rplu s) o labou r L1 L2 (or line
segm ent h) represents u nemploym ent.
A m i n i m u m -wa g e pol i cy wi l l ben ef t som e workers: th ose
wh o wi l l en d u p wi th a j ob a t W9 i n stea d o We. I t wi l l
typi ca l l y crea te u n em pl oym en t (L1 L2 ) th ou g h , a n d wi l l
D(L) especi a l l y h u rt th e workers wh o wou l d h a ve h a d a j ob
wi th ou t th i s pol i cy bu t a re n ow l et wi th ou t on e, n am el y
0 L1 Le L2
i n d i vi d u a l s L1 Le.
Number of workers (L)
Figure 1.3.9 Minimum wage policy

Maximum price (price ceiling) Minimum price (price foor)

Aim:
Price is set:
Results in:
Impact on consumers is:
Impact on sellers is:
Impact on welfare is:
Example applications are:
to protect vulnerable consumer groups
below market-determined price
a shortage
a situation where price cannot perorm
its rationing role so new rationing
mechanisms o the good are needed, or
example frst come, frst served, sellers
preerences, random rationing or
rationing through use o coupons
the possibility o parallel (black or
shadow) markets orming
worse quality and wider shortages in the
long run
some are better o and some are
worse o
they are worse o as they sell less at a
lower price
inefciency and welare loss
ood price controls
rent control
Aim: to protect vulnerable producers, typically
armers
Price is set: above market-determined price
Results in: a surplus
government being orced to buy the
surplus and having to destroy it, store it
or sell it abroad at a lower price (known
as dumping)
either in taxpayers being burdened by
the cost o the policy or in the sacrifce
o some other government project
Impact on consumers is: they are worse o as they enjoy less at a
higher price
Impact on sellers is: they are better o as they sell more at a
higher price
Impact on welfare is: inefciency and welare loss
Example applications are: price support or armers
minimum-wage policy

32
 1.4 Market ailures
Free markets: successes and failures
The u nd am ental econom ic problem that all societies ace is
scarcity: lim ited resou rces versu s u nlim ited wants. This
necessitates choices (d ecisions abou t which good s will be
prod u ced and in what qu antities). H ow will scarce resou rces be
allocated ? I n a market economy, the answer is given by the
market (the price) m echanism . The interaction o d emand and
su pply, with consu m ers aim ing to maxim ize u tility and rm s
trying to maxim ize pro ts, d eterm ines how m u ch o each good
will be prod u ced and consu m ed . Relative price changes
coord inate econom ic activity as i an invisible hand exists.
Relative price changes provid e the signals and the incentives
or prod u cers and consu m ers to change their behaviou r.
I markets are ree and com petitive th en the ou tcom e is socially
e cient. Allocative e ciency is achieved , as ju st the right
am ou nt o the good rom societys point o view is prod u ced
and consu m ed . I n the real world the necessary cond itions to
HL Case 3: The existence o m onopoly power
M arkets are oten not com petitive as rm s may possess
signi cant m onopoly power. When m onopoly power is present,
less than the socially optimal am ou nt o the good will be
prod u ced and consu m ed so ewer than optimal resou rces will
be employed in its prod u ction.
We shou ld note here that the u nd erlying incom e d istribu tion in
a cou ntry may be very u nair. Since market d emand or any
good ref ects not ju st willingness to bu y a good bu t also the
ability to d o so, hou sehold s with a severe incom e constraint,
living, say, below the absolu te poverty line, may not exist even
in markets where the m ost basic prod u cts, su ch as ood , are
bou ght and sold . Paraphrasing Sam u elsons am ou s expression,
these hou sehold s d o not have any d ollars to vote with. I t
ollows that even i the resu lting ou tpu t m ix is consid ered as
allocative e ciency, it may still be socially u nd esirable.
Externalities as a source o market ailure
An externality is present i an econom ic activity (prod u ction
or consu m ption) im poses costs on, or creates bene ts or,
third parties or which they d o not get compensated or, or
Relevant terms and defnitions
Marginal private costs (MPC)
M PC are d e ned as the costs o prod u cing an extra u nit o
ou tpu t. They inclu d e wages, costs o raw materials and other
costs that a rm takes into consid eration in its d ecision making
regard ing prod u ction. I t ollows that the su pply cu rve ref ects
the M PC o a (competitive) rm .
Marginal social costs (MSC)
These are dened as the costs o producing an extra unit o
output that are borne by society. They refect the value o all
resources that are sacriced in the specic production process.
This means that they include not just the labour and other
arrive at the socially e cient ou tcom e are not oten present.
H ere are som e cases in which market orces may ail.
Case 1 : The case o externalities
I n many circu m stances, the costs and bene ts o econom ic
activity are paid or or enjoyed by third parties ou tsid e the
market. I n su ch cases either m ore or less than the socially
optimal am ou nt is prod u ced and consu m ed .
Case 2 : The case o pu blic good s
The characteristics o certain good s are su ch that consu m ers
have the incentive to hid e their tru e preerences. This may lead
to collapse o the market as pro t-oriented rm s will not have
th e incentive to prod u ce and oer these good s. N ote that the
case o pu blic good s may be consid ered as a special kind o
externality.
Case 4: The case where inormation is asym m etric
I bu yers and sellers share d ierent sets o inormation then
this may also lead to market ailu re. Certain types o
inormational ailu res also involve an externality aspect.
d o not pay or, respectively. Equ ivalently, an externality
exists whenever there is a d ivergence between private and
social costs o prod u ction or between private and social
bene ts o consu m ption. Externalities are also reerred to as
spillover eects.
An extern ality lead s to a market ailu re as either m ore or
less than the socially optimal am ou nt is prod u ced or
consu m ed . M arket orces alone ail to lead to an e cien t
resou rce allocation.
Externalities may arise in the prod u ction process, where they
are known as prod u ction externalities, or in the consu mption
process, in which case they are known as consu mption
externalities. I they im pose costs on third parties th ey are
consid ered negative externalities. I n contrast, i they create
bene ts they are consid ered positive externalities.
resources that are sacriced, the costs o which are taken into
consideration by the rm, but also include any external costs that
are not taken into consideration by rms in the orm o, say,
pollution. In this case the MSC o production exceed the MPC and
should be drawn above the MPC (the supply) curve. This would
be the case o a negative production externality. I, though, a
production process creates benets or a third party (say, another
rm) then the MSC curve lies below the MPC (the supply) curve as
there is an external production beneft involved in the process.
Marginal private benefts (MPB)
MPB are d e ned as the bene ts the in d ivid u al enjoys rom the
consu mption o an extra u nit o a good . The willingness o a
33
 1 Microeconomics

consu m er to pay or an extra u nit is d eterm ined by the extra
bene ts h e or she enjoys rom consu m ing that extra u nit. The
d emand cu rve ref ects the MPB enjoyed rom consu m ing extra
u nits o a good .
Marginal social benefts (MSB)
Th ese a re th e ben e ts tha t soci ety en j oys rom ea ch extra
u n i t con su m ed . M SB i n cl u d e th e pri vate ben e ts en j oyed
by th e i n d i vi d u a l bu t i n a d d i ti on a ny ben e ts oth ers m ay
en j oy a s a resu l t (extern a l ben e ts). I t ol l ows tha t th e M SB
cu rve l i es a bove th e M PB (th e d em a n d ) cu rve. I , th ou g h ,
i n d i vi d u a l s con su m pti on i m poses a cost on oth ers th en th e
M SC cu rve wi l l l i e bel ow th e M PB (th e d em a n d ) cu rve a s
th ere i s a n extern a l cost o con su m pti on g en era ted by
th e process.

Four types o externalities I n Fi g u re 1 .4.1 b we a re l ooki n g at th e ca se o beekeepers

The ou r types o externalities are illu strated in Figu res 1 .4.1 a prod u cin g h on ey a n d l ocated n ext to a pple orcha rd s. Bees
throu gh to 1 .4.1 d . h el p i n th e pol l in ati on o a ppl e f owers, a ll owi n g m ore
eective tra n ser o poll en a n d so i n crea sed cha n ces o
prod u cin g a ppl es a s wel l a s greater g en eti c va ri ati on o a pple
P/unit

MSC
f S, MPC pla n ts. Dem a n d , wh i ch a l ways ref ects th e M PB o bu yers o
h on ey, is id en ti ca l to M SB a s n o extern a l eects in th e
con su m pti on o h on ey a re a ssu m ed . Su ppl y o h on ey ref ects
For each level of output, th e M PC o h on ey prod u cers (that i s, th e costs th ey pay, su ch
h MSC lies above MPC so a s or la bou r a n d bees). Si n ce th e h on ey prod u cers
there is an external cost prod u cti on process en ta i ls extern a l ben e ts to a pple growers
of production equal to fh in th e orm o poll in ati on , it ol l ows that th e socia l costs o
h on ey prod u cti on a re lower tha n th e private costs th e
beekeepers con si d er. Th e M SC o h on ey prod u ction a re
th ereore lower tha n th e M PC by th e am ou n t o th e extern a l
D, M PB = M SB ben e t created .
0
Q/period
P/unit

S, M PC = M SC
Figure 1.4.1 a Negative production externality
For each level of output,
Figu re 1 .4.1 a illu strates the case o a rm in the cem ent MSB lies above MPB so
ind u stry em itting pollu tants into the atm osphere. Demand , there is an external benet
of consumption equal to fh
which always ref ects the M PB o bu yers, is id entical to M SB as f
no external eects in the consu m ption o cem ent are assu m ed .
Su pply o cem ent ref ects the M PC o cem ent man u actu rers
(that is, th e costs they pay, su ch as or wages, energy and MSB
materials). Since the prod u ction process entails external costs in h
the orm o pollu tion, it ollows that society sacri ces in the
prod u ction o cem ent m ore than the rm s consid er. Society D, MPB
sacri ces environm ental assets becau se o the pollu tion. The
M SC o cem ent prod u ction are thereore bigger than the MPC 0
Q/period
by the am ou nt o the external costs created . N ote that there is
no shit involved as many stu d ents incorrectly claim : the two Figure 1.4.1 c Positive consumption externality
cu rves, M PC and M SC, ref ect d ierent inormation.
Fi g u re 1 .4.1 c il l u strates th e m a rket or f u va ccin ati on s. I a
stu d en t vi si ts a d octor a n d g ets va cci n ated a ga in st f u i t i s n ot
P/unit

S, MPC on l y th e stu d en t wh o ben e ts bu t a l so that person s

MSC
f cla ssm ates, tea ch ers a n d oth ers. Th e su pply o va ccin es
a l ways ref ects th e M PC o prod u cers o va cci n es
(pha rma ceu tica l corporation s). Th ey a re i d en tica l to M SC a s
h n o extern a l eects in th e prod u cti on process o va cci n es a re
For each level of output,
a ssu m ed . Dem a n d or va cci n es ref ects th e M PB o th ose wh o
MSC lies below MPC so
there is an external benet a re va cci n ated . Sin ce th ei r va ccin ati on creates extern a l
of production equal to fh ben e ts to oth ers a rou n d th em i n th e orm o a l ower
proba bil i ty that th ose oth ers wi ll catch f u , i t ol lows that th e
soci a l ben e ts o va ccin e con su m pti on a re greater tha n th e
D, MPB = MSB pri vate ben e ts that i n d ivid u a ls ta ke i n to a ccou n t i n d eci d i n g
wh eth er to have a va cci n ation or n ot. Th e M SB o va cci n es a re
0
Q/period th ereore greater tha n th e M PB by th e am ou n t o th e extern a l
ben e t created .
Figure 1.4.1 b Positive production externality

34
 1 Microeconomics

Figure 1 .4.1 d relates to alcohol consumption. Assum e it illustrates

P/unit

S, MPC = MSC the market or vodka. When people consum e alcohol there is
always the risk o increased violence, o drunk driving, o lower
For each level of output, productivity at work and other negative eects. These are all
MSB lies below MPB so
external costs o drinking. The supply o vodka always refects the
there is an external cost
f of consumption equal to fh MPC o vodka producers. The MPC are identical to the MSC as no
external eects in the production process itsel are assum ed.
Demand or vodka refects the MPB o those who consum e the
D, M PB product. Since consumption o alcohol oten creates external
h costs to others in the orm o violence, accidents, lost productivity
at work, and so on, it ollows that the social benets o vodka
M SB consumption are lower than the private benets that individuals
0 enjoy when deciding whether to consum e alcohol or not. The
Q/period
MSB o alcoholic beverages are thereore less than the MPB by
Figure 1.4.1 d Negative consumption externality the am ount o the external costs created.

Demand: Supply:
always refects the MPB enjoyed by consumers: when drawing the always refects the MPC paid by rms: when drawing the supply curve
demand curve instead o simply labelling it D, label it D, MPB. instead o simply labelling it S, label it S, MPC.
I there is no externality in consumption then the benets enjoyed I there is no externality in production then the costs imposed on
by society are not any dierent rom the benets enjoyed by the society are not any dierent rom the costs paid by the rms
individuals consuming the good, so label the demand curve producing the good, so label the supply curve S, MPC 5 MSC.
D, MPB 5 MSB.
I, though, there is an externality in consumption then one o I, though, there is an externality in production then one o
two cases applies: two cases applies:
i there is an external benet then I there is an external cost then I there is an external cost then I there is an external benet then
the MSB curve lies above the D, the MSB curve lies below the D, the MSC curve lies above the S, the MSC curve lies below the S,
MPB curve MPB curve MPC curve MPC curve
(positive consumption externality) (negative consumption externality) (negative production externality) (positive production externality)

Impact of production and consumption
externalities
Impact of a negative production externality
Prod u ction externalities arise on th e prod u ction sid e so we
ocu s on the market su pply in the d iagram . The d emand cu rve
ref ects both the M PB and th e M SB involved . The (competitive)
market ou tcom e is always d eterm ined at the intersection o
market d emand and market su pply.
Reer to Figure 1.4.2 . The market will lead to Q units o cement
produced at a market price o P per unit. The socially optimal level
o cement output is less at Q* . Why? Because at Q* the MSB are
equal to the MSC. For all units past Q* the marginal costs incurred
by society exceed the marginal benets enjoyed by society, so units
Q* Q should not have been produced rom societys point o view.
There is overproduction o cement, which is the market ailure in
this case. Area (eh) represents the welare loss as a result o the
market ailure. Too much cement is produced at too low a price.

Impact of a positive production externality

P/unit

MSC
External cost
P/unit

(of pollution) S, MPC

External benet
S, MPC (of production)
f
MSC
MSB = MSC e
(P*)
e
P
P h
Welfare loss MSB = MSC h
(P*)
Welfare loss
f

D, MPB = MSB
D, MPB = MSB
0 Q* Q
Q/period
0 Q Q* Q/period
Overproduction of cement
(market failure) Underproduction of honey
(market failure)
Figure 1.4.2 Negative production externality
Figure 1.4.3 Positive production externality

35
 1 Microeconomics
Assu m e that Figu re 1 .4.3 illu strates the market or honey. The
d emand cu rve ref ects both the MPB and the MSB that th e
consu mption o honey creates. The (competitive) market
ou tcom e is d eterm ined at the intersection o market d emand
and market su pply so that Q u nits o honey will be prod u ced at
a market price o P per u nit.
The socially optimal level o honey output is more at Q* . Why?
Because at Q* the MSB are equal to the MSC. For all units past
unit Q the marginal benets enjoyed by society exceed the
marginal costs incurred by society, so units QQ* should have been
produced rom societys point o view. The market leads to
underproduction o honey, which is the market ailure in this case.
Area (eh) represents the welare loss as a result o the market
ailure. N ot enough honey is produced rom societys point o view.
Research and d evelopm ent (R&D) activities are con sid ered a
sig ni cant exam ple o a positive prod u ction externality as the
u nd er o the R&D program m e oten captu res only part o the
retu rns generated .
Impact of a positive consumption externality
Figu re 1 .4.4 illu strates the market or f u vaccinations. Th e
su pply cu rve ref ects the MPC as well as the M SC o prod u cing
vaccines. The (competitive) market equ ilibriu m is d eterm ined at
the intersection o the market d emand and the market su pply
so that Q vaccines will be prod u ced and consu m ed at a market
price P per u nit.
P/unit
S, MPC = MSC
h Wel fa re
l o ss
e M SB
MSB = MSC E xtern a l
b en e t
P f
P*
MSB
D, MPB
0 Q Q*
Q/period
Figure 1.4.4 Market or fu vaccinations
Th e socially optimal level o prod u ction and consu m ption is
m ore at Q* . Why? Becau se at Q* the MSB are equ al to the
MSC. For all u nits past Q the marginal bene ts enjoyed by
society exceed the marginal costs o prod u ction incu rred by
society. Units QQ* shou ld thereore have been prod u ced and
consu m ed rom societys point o view bu t they are not: market
orces lead to u nd erconsu m ption and u nd erprovision o
vaccines and this is the market ailu re in this case. Area (eh)
represents the welare loss as a resu lt o the market ailu re. N ot
en ou gh vaccines are consu m ed rom societys point o view.
Merit goods
Merit good s are a special class o good s that are d e ned either
in term s o externalities generated and /or in term s o
inormational ailu res involved . I th e consu mption o a good
creates very signi cant positive externalities then it is reerred
to as a m erit good . Ed u cation and health care are prim e
36
exam ples. Alternatively, m erit good s can be d e n ed as good s
that governm ent wou ld like all m em bers o society to consu m e
in ad equ ate qu antities ind epend ently o their incom e or even
their preerences. I nd ivid u als may not be aware o the bene ts
arising rom the consu m ption o the good becau se o lack o
inormation or myopic behaviou r (resisting change). This is why
ed u cation is com pu lsory in many cou ntries u p to at least a
certain level. N ote the paternalistic role o the state in this case.
Analysis o merit goods is preerably but not necessarily
conducted within the positive consumption externality ramework.
Impact of a negative consumption externality
Fig u re 1 .4.5 illu strates the market or vod ka (bu t cou ld
represent the market or alcoholic drinks in general). The
externality arises when vod ka is con su m ed . The su pply cu rve o
vod ka ref ects the M PC as well as the M SC o prod u cing vod ka.
The (competitive) market equ ilibriu m is d eterm ined at the
intersection o the market d emand and the market su pply so Q
u nits o vod ka will be prod u ced and consu m ed at a market
d eterm ined price P per u nit.
P/unit
S, M PC = M SC
P*
Wel fa re
l o ss
f
P
MSB = MSC e
E xtern a l co st
of co n su m i n g
h
vo d ka
D, M PB
0 Q* Q
eriod
Figure 1.4.5 Market or vodka
The socially optimal level o vod ka consu m ption and prod u ction
is less at Q* . Why? Becau se at Q* the M SB are equ al to th e
M SC. For all u nits past u nit Q* the marginal bene ts to society
o consu m ing vod ka are less than the margin al costs to society
o prod u cing it. Units Q* Q shou ld thereore not have been
prod u ced and consu m ed rom societys point o view bu t they
are: market orces lead to overconsu mption and overprovision
o vod ka and this is the market ailu re in th is case. Area (eh)
represents the welare loss as a resu lt o the market ailu re. Too
m u ch vod ka is consu m ed rom societys point o view.
Demerit goods
Dem erit goods are a special class o goods that are dened
either in term s o externalities generated and/or in term s o
inormational ailures involved. I the consumption o a good
creates very signicant negative externalities then the product is
reerred to as a dem erit good. Alcoholic drinks and tobacco
products are good examples. Alternatively, dem erit goods can be
dened as goods o which governm ents would like to lim it
consumption. Individuals may not be aware o the costs arising
rom the consumption o the good because o lack o inormation
or myopic behaviour and the state takes a paternalistic role.
Analysis o demerit goods is preerably but not necessarily
conducted within the negative consumption externality ramework.

Solutions to externality-related issues
Negative production externalities
Market-based solutions
Indirect taxation
The pioneering work recom m end in g governm ent interven tion in
the case o pollu ting f rm s is attribu ted to Pigou (1 92 0) wh en
he proposed the imposition o an ind irect tax equ al to the size
o the external cost generated by the f rm . The ind irect tax
wou ld in principle internalize th e externality in the sense that it
wou ld raise the f rm s prod u ction costs to the level o the social
costs created by its activity. This wou ld in d u ce the f rm to lim it
ou tpu t o whatever it prod u ced to the socially optimal level.
The principle u nd erlying this solu tion is reerred to as the
pollu ter pays principle and the tax is also known as a Pigovian
tax or carbon tax.
Figu re 1 .4.6 illu strates the eect o im posing a Pigovian tax on
a pollu ting f rm in the cem ent ind u stry.
P/unit
St, MSC
S, MPC
f contractu al agreem ent m u st not be costly to negotiate. The
Pigovian tax imposed is
P*
equal to segment fh which
is the external cost of
production; the tax
P h
increases the rms MPC to
the level of MSC so
that MPC = (MPC + tax)
D, MPB = MSB
0 Q* Q
Q/period
Figure 1.4.6 Eect o a Pigovian tax
The governm ent estimates the size o the pollu tion (external)
costs the f rm s create and im poses a tax equ al to that am ou nt.
The tax will in crease the prod u ction costs to the level o the
MSC, orcing th e f rm s to internalize the externality. Given the
new su pply cu rve St, the market price will rise to P* so that only
Q* u nits o cem ent will be prod u ced and consu m ed , the
socially optimal level.
Estimating the size o the external cost and o the necessary tax is
a difcult task. Many o the costs extend well into the uture. In
addition, even i the tax leads to the optimal rate o output Q* ,
the size o the total level o pollution generated by the activity
(which is equal to the area between the MSC and the MPC curves
or output up to Q* ) is dependent on the PED or the good. I
demand is very price inelastic, the total pollution generated may
be still unacceptably high given all other pollution-generating
activities in the economy. An additional issue is that the eects o
polluting activities extend beyond national borders but taxation
does not. The Dutch governm ent cannot tax a Chinese company.
Assigning and enforcing property rights over assets
Ater the id ea o a Pig ovian tax was introd u ced many
econom ists argu ed that ind ivid u a ls, withou t any governm ent
1 Microeconomics
in tervention , cou ld correct problem s arising rom extern alities
throu g h ba rgain ing and a system o bribes and com pensations
that wou ld make all parties in volved better o. Th e basic id ea
is that i th ere is an opportu nity to a chieve an im proved
situ ation , private agents (people an d f rm s) will have the
in cen tive to ma ke a greem en ts that wou ld lead to the
im provem en t. A hotel own er cou ld bargain an d agree with a
pollu tin g f rm nea rby that the hotel will pay that f rm a certain
am ou n t o m oney per yea r in exchang e or the f rm red u cin g
pollu tan ts to a pre-specif ed level. Both bu sin esses cou ld
ben ef t, or exam ple:
n i the agreem en t allows the h otel owner to charge
higher rates that will cover th e paym ents mad e to the
pollu ting f rm
n i these paym ents are greater than the lost prof t
experienced by the f rm becau se o the lower level o
prod u ction.
For bargaining to be an option there m u st be a set o well-
def ned and enorced property rights over an asset and there
m u st be no transaction costs involved , or example the
Coase theorem (1 960) sh ows that i there are no transaction
costs and i property rights are well d ef ned and enorced ,
ind epend ently o their initial allocation, private parties will
have the incentive to negotiate and reach an improved solu tion
i a possible one exists. Typically thou gh, tran saction costs are
very high and make this kind o bargaining impossible. I n
add ition , it is exceed ingly d if cu lt or impossible to d ef ne
property rights on certain assets, su ch as the atm osphere or the
sea. This issu e is closely related to the topic o com m on access
resou rces (d iscu ssed later).
Tradable (or marketable) pollution permits (cap and trade
schemes)
Th ese a re licen ses or a specif c am ou n t o pollu tion that th e
g overn m en t a llocates to pollu tin g f rm s a n d that a re tra d a ble
in th e open ma rket. Th is creates a n in cen tive system a s clea n er
f rm s wh ich f n d it ch ea per to lower th eir level o pollu tion will
have a n in cen tive to sell u n u sed perm its to old er a n d d irtier
f rm s that f n d it costly to lower pollu tion levels. U n d er su ch a
sch em e, pollu tion perm its a re sca rce a n d a ma rket is created
or th e rig h t to pollu te. Ater a ll tra d in g is com pleted , a n ew
a llocation o perm its will em erg e. Th e tota l pollu tion th e
perm its allow will be equ a l to th e ta rg et level o tota l
pollu tion a n d th e loss o ou tpu t will be sma ller tha n i th e
g overn m en t ha d a ssig n ed th e sam e ma xim u m level o
em ission s or a ll f rm s.
A problem o su ch schem es is that the maxim u m acceptable
level o pollu tion is d if cu lt to d eterm ine. I n ad d ition, the initial
allocation o perm its to f rm s (or cou ntries) is controversial,
while m onitoring com pliance o f rm s is costly.
Command and control solutions
Oten it is not possible or not eective to rely on changing market
signals. Governm ents resort to direct regulation. Governments can
directly regulate output o polluting frms, the prices they can set,
where they can or cannot locate, and the type o machines, flters
37
 1 Microeconomics

and uel they can use, or example. In many cases direct
regulation may be the only realistic and cost-eective solution but
it may also lead to costly and inefcient outcom es.
Advertising (or banning of advertising), moral persuasion or education
Th is is a d ieren t set o solu tion s wh ereby th e g overn m en t
attem pts to cha n g e th e preeren ces a n d pra ctices o
con su m ers a n d o f rm s by in crea sin g th eir awa ren ess o th e
extern a l costs o certa in a ctivities th ey u n d erta ke. By ma kin g
sch ool ch ildren awa re o th e ben ef ts o recyclin g tod ay th e
g overn m en t a im s at creatin g citizen s wh o will ma ke better
ch oices a bou t su ch issu es in u tu re. Wh en pollu tin g f rm s a re
exposed , th e ba d pu blicity th ey receive may orce th em to a lter
th eir pra ctices.

Positive production externalities oth er h a n d , pa ten ts crea te tem pora ry m on opol y a n d so

Market-based solutions h i g h pri ces.

Granting a subsidy Mergers

Granting a su bsid y will d ecrease th e costs o prod u ction
associated with the activity generating the externality and so
ind u ce a greater ou tpu t level. The problem is that it is d if cu lt
to estimate properly the size o the external benef ts generated
and so the correct size o the su bsid y.
Assigning intellectual property rights
I n tel l ectu a l property ri g h ts, su ch a s pa ten ts, a re d esi g n ed to
perm i t a f rm , or exam pl e a ph a rm a ceu ti ca l corpora ti on , to
ca ptu re m ost o th e retu rn s g en era ted rom i ts R&D a cti vi ty.
I n th i s wa y th e f rm wi l l be wi l l i n g to i n vest m ore i n R&D
a s i t wi l l be a bl e to ca ptu re m ost o th e ben ef ts. O n th e
I th e beekeeper and the apple grower in the earlier example
m erge and becom e one f rm then the positive spillover eects
o both activities will be internalized (that is, they will be taken
into accou nt in the d ecisions o the new f rm ).
Command and control solutions
Direct regulation
Basic research is oten pu blicly u nd ed and is u nd ertaken in
research institu tions su ch as u niversities etc. The spillover
benef ts are consid ered so signif cant that it wou ld be again st
societys welare to grant patents to private f rm s.

Positive consumption externalities (merit goods)
Market-based solutions
Granting a subsidy
The governm en t can estimate the size o the external benef t
created an d grant a su bsid y equ al in size that wou ld lower
prod u ction costs and thereore price. The lower price will ind u ce
higher levels o consu mption which cou ld equ al the socially
optimal level, as illu strated in Figu re 1 .4.7.
P/unit
The subsidy increases supply o the good (or example
vaccinations) to S(sub). The market price will consequently drop
to P* . Consumers will be willing to consume Q* at the lower price
P* which is equal to the socially optimal level o consumption.
Again, estimating the proper size o the subsidy is not an easy task.
Command and control solutions
Legislation and direct provision
Wh en a governm ent consid ers that the external ben ef ts are
very sign if cant to the economy and that any positive price may

be prohibitively high or som e, very poor, m em bers o society it

S, MSC A subsidy equal oten d irectly provid es the good or the service ree at poin t o
to the external d elivery. I n many cou ntries this is the case with state ed u cation ,
benet of or with national health-care system s and pu blic hospitals. I n
S(sub) consumption many d eveloping cou ntries the tax revenu es governm ents
MSB = MSC f (segment fh)
collect may be insu f cient to f nance ree ed u cation and health
would increase
supply to S(sub) care and this is one o the areas where aid may prove
P
and lower price instru m ental. Also, many governm ents make ed u cation
to P*, inducing com pu lsory u p to a certain age. Vaccination to im m u nize you ng
P* h a higher level of children is also compu lsory in many cou ntries.
MSB consumption
D, MPB equal to the Advertising and moral persuasion
socially optimal
0 Q Q* A governm ent may resort to ad vertising the benef ts rom
level Q*
Q/period consu mption and u se o su ch good s in an attempt to increase
d eman d (shit the d emand cu rve to the right) to the level o the
Figure 1.4.7 The impact o a subsidy in the case o positive spillover
eects (merit goods)
MSB cu rve.

38
 1 Microeconomics

Negative consumption externalities
(demerit goods)
Market-based solutions
Imposing indirect taxes
An ind irect tax equ al to th e external costs o consu mption will
d ecrease su pply and so increase the price o the good . The
higher price will ind u ce a lower level o consu m ption. I the size
o the tax is correct, the socially optimal level o con su mption
may be achieved . Figu re 1 .4.8 illu strates the case.
P/unit
The specifc tax h will decrease supply to S(tax). As a result, the
market price o the good will increase to P* . The higher price will
lead to a decrease in the quantity consum ed to Q* , the socially
optimal level o consumption. Several issues arise with such a
solution. Again, the optimal tax is difcult to determ ine. Lets
take the examples o drinking and sm oking. Alcohol and tobacco
are addictive so demand is quite price inelastic. This m eans that
i the goal is to curtail consumption a very high tax will be
needed. H owever, not all consum ers are the sam e. Demand by
higher-incom e individuals will even m ore price inelastic so their
consumption may not be aected at all. On the other hand, a

An indirect tax chain o substitutions may start or many poorer addicted

S(tax)
equal to the size
S, MPC = MSC of the external individuals who may switch to lower-priced and lower-quality
costs of substitutes. Consumption may thereore not decrease as
f
P* consumption expected and even worse health-related problem s may result.
(segment fh)
would decrease Command and control solutions
P
supply to S(tax) Direct regulation
MSB = MSC increasing the Oten governments directly regulate consumption o demerit goods
h
price to P* and and the behaviour o those who consume them. For example,
inducing a
smoking may be prohibited inside buildings and cigarettes and
lower level of
consumption alcohol may only be sold to people above a certain age.
D, MPB equal to the
socially optimal Advertising and moral persuasion
MSB
level Q* Governm ents u se ad vertising to inorm the pu blic abou t the
0 Q* Q
Q/period
risks o sm oking and drinking. The goal is to d ecrease d emand
or and con su mption o su ch good s.
Figure 1.4.8 The impact o an indirect tax in the case o negative spillover
eects (demerit goods)

Public goods as a case of market failure
A good is consid ered a pu blic good i it is characterized by the
ollowing two properties.
n I t is non-exclu d able. This m eans that i the good becom es
available to even one consu m er it au tomatically becom es
available to all. N o on e can be exclu d ed rom consu m ing it.
n Consu mption o the good is non-rival (or non-d im inishable).
Th is m eans that each ind ivid u al s consu m ption o the good
d oes not d ecrease the am ou nt available or all others.
N on-excl u d a bi l i ty l ea d s to i n d i vi d u a l s h i d i n g th ei r tru e
preeren ces a n d beh a vi n g a s ree-ri d ers beca u se th ey kn ow
tha t th ey ca n en j oy th e g ood wi th ou t h a vi n g to pa y or
i t on ce i t becom es a va i la bl e or oth ers. N on-ri va l ry i n
con su m pti on i m pl i es th a t th e m a rg i n a l cost o a n
extra u ser i s zero.
The externality aspect o pu blic good s becom es apparent by
realizing that i som eone provid es or maintains a pu blic good ,
even at a cost, he or she cann ot prevent others rom enjoying
the benef ts. So i the private ben ef ts o provid ing a pu blic
good are small compared to th e social benef ts and the private
costs are larger than the private benef ts, then the good will
not be su pplied at all.
More generally, pu blic good s are a case o market ailu re
becau se private prof t-orien ted f rm s will not have the incentive
to prod u ce and oer su ch good s and services throu gh the
market. The market m echanism ails. Even thou gh there may be
suf cient d eman d or su ch a good , it will not be oered .
Few exam ples o pu re pu blic good s exist. A lighthou se, national
d eence and traf c lights are typical examples. I a lighthou se
is bu ilt and maintained on som e island no f sherman can be
exclu d ed rom its benef ts. I the lighth ou se is u sed by one
boat the am ou nt o its service available to other boats
is the sam e (the marginal cost o one m ore boat u sing
the service is zero).
Law and ord er in a town and price stability in an economy are
som ewhat d ierent examples bu t they satisy both criteria o
pu blic g ood s and their im plications are interesting . For
example, i it is sae or M egan to walk at night in a city then,
probably, it is sae or others. Also, i she walks saely there is
no less saety available or others. I price stability exists or one
then it exists or all econom ic agents. Sim ilarly, i one benef ts
rom its existence then law and ord er can even be extend ed to
imply a u nctional institu tional ram ework, which is especially
important or a d eveloping economy and only a governm ent
can provid e it.
A d ieren t exam ple o a pu re pu blic g ood is broa d ca st
television a n d ra d io. Both pu blic g ood properties a re satisf ed .
A broa d ca st television program m e is n orma lly ava ila ble to a ny
h ou seh old with a television (a private, sepa rate g ood ). Also,
i on e person watch es th e program m e th ere is n o less o it
ava ila ble or oth ers to watch . I n terestin gly, television a n d ra d io
broa d ca stin g , d espite its pu blic g ood eatu res, is prod u ced
an d oered by private, or prof t com pa n ies. Th is is possible
beca u se broa d casters a re n ot sellin g th e program m es bu t th e
ad vertisin g tim e, wh ich is both exclu d a ble a n d riva l.

39
 1 Microeconomics
Globa l wa rm in g can an d sh ou ld be th ou gh t o a s perhaps th e
m ost sig n if can t extern a lity-related exam ple o a pu re pu blic
bad . Green h ou se gas (GH G) em ission s d estroy natu ral capita l
(or exam ple coasta l reg ion s) an d a re a lso con sid ered
respon sible or lower agricu ltu ra l prod u ctivity. Firm s em ittin g
green h ou se gases (or even cou n tries which tolerate GH G
em ission s) im pose hu g e costs rom th eir prod u ction a ctivity
that are born e by th e wh ole world (extern a l costs). At th e sam e
tim e, globa l warm ing im poses costs rom wh ich n o on e ca n be
Common-access resources (common-pool
resources)
The traged y o the com m ons was a term introd u ced by Garrett
H ard in (1 968). The id ea was simple. Assu m e a pastu re open to
all (the com m ons) with the ad jacent land own ed by a nu m ber
o herd sm en, as in the ollowing illu stration.
H1 H2
H6 Th e co m m o n s H3
H4
H5
Each herd sman has the incentive to have m ore and m ore o his
animals graze on the com m on s becau se he enjoys the u ll
benef ts o this bu t the costs are shared by all. As a resu lt, there
will be overgrazing and the com m ons will be d estroyed .
Com m on-access resou rces (also known as com m on-pool
resou rces) share two characteristics.
n I t is d if cu lt to exclu d e ind ivid u als rom d eriving benef ts
rom the good or the resou rce.
n There is rivalry in the consu mption o com m on-access
resou rces (one ind ivid u al s consu m ption su btracts rom the
benef ts available to others u sing the resou rces).
Pastu re is one example o a com m on-access resou rce; others
inclu d e f shing grou nd s, orests, irrigation system s, water, the
atm osphere or a city centre. The logic o the traged y o the
com m ons may resu lt in overf sh ing, d eorestation, d epletion o
clean water su pplies, global warm ing, etc.
Analytically, the eect o su ch behaviou r may be illu strated
throu gh a negative externalities d iagram , as in Figu re 1 .4.9,
which illu strates the d ecisions o a f shing f rm .
What is important to notice in Figure 1.4.9 is that the MSC o
fshing exceed the MPC, as the activity o each fshing boat
depletes the stock o fsh available to all other fshing boats.
However, these are costs external to a fshing frms decisions. As a
result, it will tend to fsh more than the socially optimal level Q* .
The d epletion or d egrad ation o com m on- access resou rces
poses a threat to su stainability. Su stainable d evelopm ent is
40
exclu d ed a nd i on e su ers GH G-related costs, th ese d o n ot
d im in ish a n d all the rest su er th e sam e costs. Con versely, the
(clea n ) atm osphere ca n be viewed a s a pu re pu blic g ood as th e
ben ef ts a ccru e to a ll (th ey a re non-exclu d able an d n on-riva l).
Solutions
Compu lsive taxation and provision (bu t not necessarily
prod u ction) by the governm ent is the typical solu tion in the
case o market ailu re relating to many pu blic good s.
P/unit
MSC
S, MPC
P*
P
D, MPB = MSB
0 Q* Q
Overshing Q/period
Figure 1.4.9 Overfshing
said to exist i it m eets the need s o th e present generation
withou t comprom ising the ability o u tu re generations to m eet
their own need s.
Solutions
The logic behind H ard ins traged y o th e com m ons approach
lead s to a rather pessim istic ou tlook. Extend ing property rights
may prove helpu l in certain situ ations, bu t the tim e horizon o
private f rm s and th e specif cs o each situ ation (or example
the operation o m u ltinationals in many cou ntries) may still
prove insu f cient to gu arantee su stainability. A d ierent and
in certain cases prom ising approach is d evising appropriate
institu tional ram eworks. An appropriate institu tion al
ram ework is one that will protect against overexploitation and
perm it su stainable governance o su ch resou rces. This is the
d irection the work o Elinor Ostrom (who won the 2 009 N obel
Prize in Econom ics).
I n certain cases, d irect regu lation by governm ents may prove
eective, or example setting f shing qu otas or perm itting an
activity only on a lim ited -licence basis. I n the case o GH Gs,
trad able pollu tion perm its (d escribed earlier) are a possible
solu tion, althou g h their implem entation carries problem s, the
m ost important being that major pollu ting cou ntries are not
part o the process.
Lastly, ed u catin g (especially the you nger generations) on the
im portance o ad opting environm entally consciou s behaviou r is
consid ered very signif cant.

HL Monopoly power as a source of market failure
Firm s with m onopoly power are able to restrict ou tpu t
below the com petitive id eal and charge a higher price lead ing
to a welare loss. A u ll analysis o m onopoly is given on
pages 5 9-62 .
Possible solutions
The governm ent shou ld en su re that competitive cond itions
prevail in markets. I t shou ld ensu re that:
n n o m ergers or acqu isitions materialize that excessively
increase the m onopoly power o any f rm
HL Asymmetric information
I n many situ ations either the bu yer or the seller possesses
incomplete or inaccu rate inormation When an ind ivid u al on
one sid e o a transaction has m ore or better inormation than
the other, we say that there is asym m etric inormation in the
market. I n su ch situ ations societys scarce resou rces will not be
allocated ef ciently. Assym m etric inormation can lead to the
ollowing problem s.
n Ad verse selection is one problem related to lim itations on
inormation. I n this situ ation, one party possesses m ore
inormation abou t the good being sold than th e other
party. Oten, bu yers cann ot ju d ge the tru e qu ality o the
prod u ct being sold . Consid er the u sed car market. A
proportion o the u sed cars on sale are lem ons, m eaning
that they are d eective. When prices or high-qu ality u sed
cars are high, owners o these cars will join the market and
want to sell their cars to bu y a new one, bu t many bu yers
will shy away. As the price drops thou gh, m ore o the
h igh-qu ality cars will be withdrawn rom the market so that
the proportion o lem ons rises: the qu ality o cars is
ad versely aected . At the lower price the qu antity
d emand ed may even be lower. The market becom es thin
and it may be so thin that it is virtu ally non-existent.
A sim ilar example is the market or health insu rance.
I nd ivid u als seeking insu rance will typically be those m ost
likely to make claim s and receive payou ts, in this case
those in poor health or with a past history o it. I these
people make u p vast nu m bers o a health insu ran ce
com panys cu stom ers, it will be orced to raise prem iu m s,
which will make people in good health withdraw rom
the market. The market will becom e thin and
possibly collapse.
1 Microeconomics
n practices that seem anti-com petitive are m onitored ; it cou ld
tax or f ne f rm s ou nd gu ilty o su ch practices or even break
these f rm s u p into smaller ind epend ent pieces.
A m ost eective way to red u ce d om estic m onopoly power o
frm s is throu gh liberalizing international trad e. Free trad e
automatically increases competition, lead ing to increased
ef ciency and lower prices. Bu t, one shou ld keep in m ind that
there may be very sign if cant d ynam ic benef ts arising rom
the existence o su ch larg e m onopoly f rm s in the orm o
aster rates o inn ovation, technological change an d econom ies
o scale.
n When th ere is a m isalig n m en t o in cen tives then a m oral
haza rd problem a rises. M ora l ha zard exists when on e pa rty
in a contra ct ha s m ore in ormation than the oth er a n d
once th e con tract is sig n ed the pa rty with th e su perior
in ormation chan g es h is or h er behaviou r in ord er to
benef t, while im posin g costs on th e oth er pa rty.
I n d ivid u a ls wh o pu rchase in su ra n ce have less o a n
in centive to avoid th e in su red -a gain st even t. Th ey have
better in ormation rega rd in g th eir behaviou r than th e
in su rers. Th eir behaviou r ca nn ot be easily m onitored . For
exam ple, ater pu rcha sin g car in su ran ce, a driver may sta rt
driving a ster a nd m ore carelessly than beore. Ater
pu rchasin g in su ra n ce th ere is a d ecreased incen tive to
exercise care.
Solu tions to su ch problem s u sed by com panies or ind ivid u als
inclu d e:
n signalling, throu gh which one o the parties tries to convey
inormation abou t itsel that will make it seem cred ible (or
exam ple throu gh issu ing warranties, d isplaying relevant
qu alif cations or u sing expensive showroom s)
n screening, throu gh which ind ivid u als try to iner ad d itional
inormation rom other observable characteristics
n bu ild ing a good repu tation that also conveys in ormation to
bu yers and is too valu able to lose
n writing contracts with contingency clau ses that aim at
ind u cing the d esired behaviou r (or example insu rance
companies oering options or an excess or d ed u ctible).
Governm ents can provid e m ore inormation (or example
labelling and awareness cam paigns), can legislate m inim u m
stand ard s and can regu late f rm s behaviou r to m inim ize
inormation-related market ailu res.
41
 1.5 Theory o the frm and market structure

Production and costs: the short run

HL I n general, the short ru n is d e ned as the tim e period d u ring
which som e, bu t not all, ad ju stm ents can take place. I n the
context o prod u ction theory, the short ru n is d e ned as that
period d u ring which at least one actor o prod u ction is
consid ered xed . Assu m ing two actors o prod u ction, capital
(K) and labou r (L), it is typically capital that is assu m ed
constant in th e short ru n. This m eans that the total prod u ct
(TP), which is another term or ou tpu t (Q), can change by
varying the level o labou r given the level o capital.
I n the short ru n the behaviou r o ou tpu t is d eterm ined by the
law o d im inishing marginal retu rns. Th e behaviou r o short-ru n
costs and the shape o short-ru n cost cu rves (d iscu ssed later) are
a d irect con sequ ence o the behaviou r o ou tpu t and o the law
o d im inishing marginal (and average) retu rns.
The marginal product o labour (MP) is dened as the extra output
produced by employing one more worker or, more generally, as the
change in output induced by a change in labour (L):
DQ
MP L 5 ___
DL
So, or any u nit o ou tpu t Q, M P is the slope o the total
prod u ct (TP) cu rve.
the second worker simply copies the rst worker then d ou ble
the u nits (2 x) will be prod u ced . Bu t since there is so m u ch
capital available to work with compared to labou r there is a lot
o room or labou r specialization to take place. The two
workers may agree that one will be in charge o th e whole
kitchen and the other o all the serving and o taking
cu stom ers paym ents. Ou tpu t will as a resu lt m ore than d ou ble.
Focusing on Figure 1.5.1 (a) output will be initially increasing at
an increasing rate up until some unit o labour, say L1. You should
notice that the tangent on the TP curve at point b is steeper than
at point a. Since we have realized that marginal product is the
slope o total product and this slope is increasing up until L1, it
ollows that the MP curve in diagram 1.5.1 (b) is rising up until L1.
At this point thou gh, ad d ing workers will still help increase
total prod u ct (the TP cu rve in d iagram 1 .5.1 (a) continu es to
rise) bu t now it will rise at a slower rate (it becom es f atter and
f atter). Each extra worker contribu tes to the prod u ction o
TP (Q)
(a) d
e
c
TP

The law o diminishing marginal returns

The law o d im inishin g marginal retu rns states that as m ore Q1
and m ore u nits o a variable actor (labou r) are ad d ed to a
b
xed actor (capital), there is a point beyond which total
prod u ct will continu e to rise, bu t at a d im inishing rate, or
equ ivalently, that marginal prod u ct will start to d ecline. a
N ote that the law o dim inishing marginal returns is a short-run
law as it assum es the existence o at least one xed actor o 0 L1 L2
L
production (usually capital). Technology is assum ed constant
MP

(b)
and the variable actor (labour) is assum ed hom ogeneous. So,
any dierences in returns (output) as m ore units o labou r are
employed are not because o dierences in workers abilities but
a result o the continuously changing ration o capital to labour.
That is why the law is also known as the law o variable
proportions. I capital and labour were perectly substitutable
actors in the produ ction process then the law would not hold.
An example will help you u nd erstand the logic o the law.
I magine a pizzeria equ ipped with ovens and other equ ipm ent,
tables and chairs, etc. The prem ises, ovens, tables, etc. are the
xed capital that exists. With zero workers working in this
pizzeria, ou tpu t per period will be zero. Zero workers will
0 L1 L2
prod u ce zero pizzas. N ow, i one worker is em ployed , then som e L
level o ou tpu t (som e nu m ber o pizzas) will be prod u ced per MP
period , say x u n its. The worker will have to d o everything: take
ord ers, prepare th e pizzas, serve the ood and take the m oney. Figure 1.5.1 Total product, marginal product and the law o diminishing
I two workers are em ployed then it shou ld be realized that i marginal returns

42
 1 Microeconomics

pizzas bu t not as much as the previou s one. The bene ts o
m ore and m ore specialization are slowly exhau sted . The TP
curve still rises bu t now at a decreasing rate. Marginal
product, wh ich is the slope o the TP cu rve, is thereore
positive but decreasing (dropping) between L1 and L2 . N ote
that the slope o the total prod u ct cu rve is f atter at point c
than at point b and that at worker L2 (point d ) its slope is zero
(it is parallel to the horizontal axis) so marg inal prod u ct is zero
in Figu re 1 .5.1 (b).
Ater L2 workers are em ployed , labou r is too m u ch or the
am ou nt o capital available (the size and equ ipm ent o the
pizzeria) so total prod u ct will start d eclining. There are so many
workers that they get in each others way. The contribu tion o
on th e tota l prod u ct cu rve. For exam pl e, th e avera g e prod u ct
o la bou r a t L9 i s eq u a l to ou tpu t (wh i ch i s eq u a l to l i n e
seg m en t L9 H ) d i vi d ed by th e n u m ber o workers em pl oyed
(l i n e seg m en t 0L9 ). Th i s rati o i s th e sl ope o th e ray (0H ). I t
ol l ows th at to d eterm i n e th e beh avi ou r o a vera g e prod u ct
on e n eed s to exam i n e th e beh avi ou r o th e sl ope o th e ray
rom th e ori g i n to su ccessi ve poi n ts on th e tota l prod u ct
cu rve. Th e sl ope o th i s ray i n crea ses u p to L9 a n d th en
d ecrea ses. I t i s steepest a t L9 so AP ha s a m a xi m u m at th at
l evel o workers. N ote th at a vera g e prod u ct ca n n ever cross
th e h ori zon ta l a xi s a n d becom e n ega ti ve a s n ei th er Q n or L
ca n ever be n ega ti ve.

TP (Q)
each extra worker (the workers marginal prod u ct) is negative (a)
ater L2 workers are employed . M arginal prod u ct is negative
ater worker L2 : the marginal retu rns are now negative.
This shows that the law o d im inishing marginal retu rns hold s H TP
between L1 u nits o labou r and L2 u nits o labou r: ater worker
L1 total prod u ct contin u es to rise bu t at a d ecreasing rate; in
other word s, marg inal prod u ct is d ecreasing. N o rm will ever
employ m ore than L2 workers as there wou ld be too m u ch
labou r compared to capital. Sim ilarly, no rm will ever em ploy
ewer than L1 workers as there wou ld be too m u ch capital
compared to labou r. Distance L1 L2 is known as the econom ic
region o prod u ction.
0 L
L
Reer to Figure 1.5.1 (a) and (b). Draw the TP curve in three
AP

TIP (b)
steps: initially with a rising positive slope (rom zero to L1),
then with a decreasing positive slope (rom L1 to L2) then
with a negative slope (past L2). At each switch, drop a line to
the horizontal (labour) axes o both diagrams. You will have
determined points L1 and L2 in the bottom diagram. Here, sketch
the MP curve, remembering that it is the slope o the TP curve.
It rises up to L1 and right above L1 it starts to decrease. At L2
MP is zero so the curve crosses the horizontal axis.
(HL Math and Math Methods students: draw the MP as i you were AP
asked to sketch the frst derivative o the TP unction above it.)

Diminishing average returns
One can also express the law o d im inishing retu rns in term s
o the average prod u ct o labou r: as m ore and m ore u nits o average returns
labou r are ad d ed to a xed am ou nt o capital there is a point
beyond which average prod u ct o labou r d ecreases. I n
Figu re 1 .5.2 this occu rs ater worker L9 .
The average prod u ct (o labou r) is d e ned as ou tpu t per u nit o I n general, the ollowing hold s.
labou r (per worker):
Q
__
AP L 5
L
The average prod u ct o labou r is also reerred to as the
prod u ctivity o labou r.
Focu si n g on Fi g u re 1 .5 .2 , th e averag e prod u ct o la bou r a t
a ny poi n t on th e tota l prod u ct cu rve i s eq u a l to th e sl ope o
a stra i g h t l i n e (th e ray) drawn rom th e ori g i n to th a t poi n t
0 L
L
Figure 1.5.2 Total product, average product and diminishing
The relationship between marginal and
average product
n I marginal is greater than average then average will rise.
I marginal is less than average then average will drop.
n
n I marginal is equ al to average then average will be at
a maxim u m .
To u n d ersta n d th e relation sh ip, th in k o a stu d en t ta kin g a
series o tests in a n econ om ics cou rse. I in th e sixth test (th e
marg in a l test) th e stu d en t ga in s a h ig h er gra d e tha n h is or h er

43
 1 Microeconomics

avera g e gra d e to that poin t (in oth er word s, i M . A) th en

MP, AP
th e stu d en ts avera g e will rise. I th e stu d en t receives a lower
gra d e tha n h is or h er avera g e gra d e to that poin t (in oth er
word s, i M , A) th en th e stu d en ts avera g e gra d e will a ll.
An d i th e stu d en t receives in th e sixth test exa ctly th e sam e
gra d e a s h is or h er avera g e to that poin t, th e stu d en ts avera g e
will n ot cha n g e.
Focu sing on Figu re 1 .5.3, f rst draw the inverse U -shaped
average prod u ct (AP) cu rve and then the marginal prod u ct (MP)
cu rve, making su re that on its way d own, the M P cu rve cu ts the
AP cu rve at its maxim u m point. AP
To th e l et o L9 , M P i s g rea ter th a n AP so AP sh ou l d be
ri si n g . I n d eed i t i s. To th e ri g h t o L9 , M P i s l ess th a n AP so
AP sh ou l d be d ecrea si n g a n d i n d eed i t i s. Si n ce beore L9 AP
0 L
i s i n crea si n g a n d ri g h t a ter L9 AP i s d ecrea si n g , i t ol l ows
Labour (L)
th a t a t L9 AP m u st be a t a m a xi m u m .
MP
Figure 1.5.3 Marginal and average product curves in one diagram

HL The meaning o the term economic costs next best alternative bu siness with the sam e risks, bu siness B,
then the m inim u m retu rn the entrepreneu r requ ires to keep the
To u nd erstand the m eaning o the term it is important to
1 .0 m illion invested in bu siness A wou ld be 80,000 per year,
rem em ber that resou rces are scarce in any economy so
otherwise he or she wou ld pu ll the f nancial capital ou t and
whenever a resou rce is u sed in the prod u ction o a good it is
instead invest it in bu siness B. The am ou nt o 80,000 is a
au tomatically not available to prod u ce other good s. I n oth er
prod u ction cost or bu siness A as withou t this retu rn the
word s, it is sacrif ced . From an econom ists poin t o view, the
entrepreneu r wou ld pu ll ou t his or her scarce u nd s and the
term econom ic costs reers to the valu e o all resou rces that
f rm wou ld not exist.
are sacrif ced d u ring the prod u ction process. I t implies that
econom ic costs inclu d e not only what are d ef ned as the
explicit costs production costs or which
explicit costs o a f rm (the explicit paym ents it makes or the
explicit payments are made,
u se o actors, also known as ou t-o-pocket costs) bu t also
or example wages
implicit costs. This term s reers to the valu e o resou rces the
f rm owns and th ereore it d oes not have to pay or bu t, rom Economic costs implicit costs production costs or actors
include: owned by the frm plus the
the econom ists point o view, these represent sacrif ced
minimum payment required to
scarce resou rces.
secure entrepreneurship
I mplicit costs also inclu d e the m inim u m reward that the scarce (which is known as normal
actor o entrepreneu rship requ ires to remain in that lin e o profts)
bu siness. This m inim u m reward is known as normal prof ts and
is an elem en t o econom ic costs. The id ea is that to secu re
entrepreneu rship in a bu siness activity, som e m inim u m reward Short-run costs
(paym ent) is necessary or the risk that is u nd ertaken. This As m en tioned earlier, the short ru n is a period o tim e d u ring
m inim u m is equ al to what cou ld be earned by the entrepreneu r which at least one actor o prod u ction is f xed . As a resu lt,
in the next best alternative available with the sam e risk. I this f rm s in the short ru n ace both fxed an d variable costs.
m inim u m reward d oes not materialize, then th e f rm will close
Fixed costs are costs that d o not vary when the level o
d own and the f nancial capital tied u p in it will be reed and
prod u ction varies and they are u navoid able. They exist and
m oved into the next best alternative project that com mand s the
have to be paid even i ou tpu t is zero. Examples typically
sam e level o risk. I it is d if cu lt to accept that this m inim u m
inclu d e ren t, interest on loans, insu rance costs, f xed contract
requ ired to attract and secu re the actor o en trepren eu rship is
costs, etc. Figu re 1 .5.4 (a) illu strates f xed costs as a line parallel
an elem ent o econom ic costs, rem em ber that or a f rm to be
to the qu antity axis. Figu re 1 .5.4 (b) below it illu strates average
able to u se the scarce actor o labou r, wages have to be paid
f xed costs. Since average f xed costs are d ef ned as f xed costs
which, o cou rse, are an elem en t o cost. For example, i an
d ivid ed by ou tpu t, it ollows that the average f xed costs
entrepreneu r is contemplating whether to start u p bu siness A
continu ou sly d ecrease as ou tpu t rises bu t they never becom e
by f nancially investing 1 .0 m illion and the entrepreneu r
zero. N ote that the areas beneath the average f xed costs (AFC)
knows that he or she cou ld be earn ing 80,000 a year in the
cu rve are all equ al to the f xed cost the f rm aces.

44
 1 Microeconomics

is initially easy since with d ou ble the u nits o labou r, the rm

Fixed costs
(a)
can prod u ce m ore than d ou ble the ou tpu t. I it wish ed to
prod u ce ju st d ou ble the ou tpu t it wou ld need less than d ou ble
the labou r: variable costs rise bu t they d o not d ou ble.
Va ri a bl e costs (VC) i n Fi g u re 1 .5 .5 (a ) wi l l ri se a t a d ecrea si n g
rate u p u n ti l tha t u n i t o ou tpu t Q 1 at wh i ch d i m i n i sh i n g
m a rg i n a l retu rn s set i n prod u cti on . Beyon d th at l evel o
ou tpu t Q1 va ri a bl e costs wi l l con ti n u e ri si n g bu t a t a n
FC i n crea si n g ra te.
Rem em ber that m a rg i n a l costs a re n oth i n g bu t th e sl ope o
th e VC cu rve: si n ce i n i ti a l l y va ri a bl e costs ri se at a d ecrea sin g
rate a n d a ter ou tpu t Q1 th ey i n crea se a t a n increasin g rate
i t ol l ows th at M C i n i ti a l l y d ecrea se a n d th en at Q1 th ey sta rt
0 to i n crea se, lea d i n g to a sh a pe l i ke th e N i ke-swoosh .
Output (Q)
The ollowing d erivation clearly illu strates the d irect
Average xed costs

(b)
relationship between prod u ction and cost theory and so
between marginal prod u ct and marginal costs. Rem em __
ber that
i labou r is the only variable actor then wage costs ( w 3 L are
the variable costs:
__ __
DVC ( w 3 L) w (DL) __ DL
MC 5 ____ 5 _______ 5 ______
5 w 3 ___
DQ DQ DQ DQ
__
__ 1 __ 1 w
5 w 3 _____5 w 3 ___
5 ___
MP MP
DQ
___
DL ( )
So, MC will d ecrease when M P rises and M C will rise when MP
d ecreases (i.e. wh en d im inishing marginal retu rns start in
AFC prod u ction)
0
Output (Q)
VC

(a)
Figure 1.5.4 Fixed and average xed costs

Variable costs inclu d e costs that vary with the level o ou tpu t,
The output level Q1 here is
or example raw materials, components and labou r. Average equal to the output level Q1
variable costs (AVC) are d e ned as variable costs over the level in Figure 1.5.1 :
o ou tpu t. The average total cost (ATC) o prod u cing som e
When MP starts to decrease
level o ou tpu t is total costs over the level o ou tpu t and it is (i.e. law of diminishing marginal
the su m o the average variable and the average xed costs o returns kicks-in). MC start to
prod u cing that level o ou tpu t: ATC 5 AFC 1 AVC increase as VC start to increase
Marginal cost (MC) is dened as the additional cost o producing at an increasing rate.
an extra unit o output. This m eans it is the change in costs (total 0 Q1
Q
or variable) resulting rom a change in the level o output:
MC

(b)
DTC DVC
MC 5 ____ 5 ____ MC
DQ DQ
I t is the slope o the total cost (or the slope o the variable cost)
cu rve at each level o ou tpu t.

The shape of variable and marginal costs in the short run

The shape o cost cu rves in the short run is a ref ection o the
law o d im inishin g marginal and average retu rns. Ou tpu t (TP
or Q) in the short ru n initially rises at an increasing rate u p
u ntil that u nit o labou r at which d im inishing marginal retu rns 0 Q1
Q
set in. So, as m ore is prod u ced , variable costs rise bu t initially Figure 1.5.5 Variable and marginal costs
they rise at a d ecreasing rate. Prod u cing m ore and m ore ou tpu t

45
 1 Microeconomics

The shape o variable and average variable costs in the
short run
Average variable costs are the ratio o variable costs over the
level o ou tpu t. I n Figu re 1 .5.6 (a) i ou tpu t is Q9 u nits then
variable costs are equ al to line segm ent Q9 H . Averag e variable
Q9 H
costs are thereore equ al to the ratio ____ which is the slope o
0Q9
will becom e smaller and smaller as ou tpu t increases becau se
AFC continu ou sly d ecreases and tend s to zero, as sh own in
Figu re 1 .5.7. As the level o ou tpu t increases the vertical
d istances between th e two cost cu rves becom es smaller and
smaller: (h) , (d e) , (ab).

ATC, AVC
th e ray 0H . So, to d eterm ine the behaviou r o the AVC cu rve
one need s to check the behaviou r o the slope o the rays rom
th e origin to variou s su ccessive points on the VC cu rve. These b
slopes initially d ecrease u p to ou tpu t Q9 and then increase, ATC
giving rise to a U -shaped AVC cu rve. f AVC

h
VC

(a)
VC c

a d

0
Q

Figure 1.5.7 The ATC and AVC curves

Total costs, variable cost and fxed costs in one diagram

0 Q N ow that the shape o the VC cu rve has been explained it is
Q
possible to inclu d e in one d iagram the total cost (TC) cu rve, the
AVC

(b)
VC cu rve and the f xed cost (FC) cu rve. I n Figu re 1 .5.8 the TC
cu rve is shaped ju st like the VC cu rve except it has been shited
u p by the am ou nt o the f xed costs. So, the vertical d istance
between the TC cu rve and the VC cu rve is the sam e at all levels
o ou tpu t. Line segm ent ab 5 h 5 kj 5 u v and they are all
AVC
equ al to the f xed costs 0c.
TC, VC, FC

TC

k
VC
0 Q
Q h
u
Figure 1.5.6 Variable and average variable costs
b
The shape o the AVC cu rve is the m irror image o the average j
prod u ct (AP) cu rve. The ollowing d erivation also illu strates the
d irect relationship between prod u ction and cost th eory and in f
this case between AP and AVC: c FC
__
w 3 L)
(_______
__ __ a
VC L 1
AVC 5 ___ 5 5 w 3 __ 5 w 3 ____
Q Q
__
Q Q
__
L ( )
__ 1
___ w
___ 0
5 w3
AP 5 AP Q/period

Figure 1.5.8 Total, variable and fxed costs

So, AVC will d ecrease when AP rises and AVC will rise when AP
d ecreases (that is, when d im inishing average retu rns occu r in
prod u ction).
N ote that since ATC equ als the su m o AVC and AFC it m u st be
drawn above the AVC cu rve. The vertical d istance between ATC
and AVC is AFC as ATC 2 AVC 5 AFC. The ATC cu rve will also
be U -shaped bu t the vertical distance between ATC and AVC
H ow to draw MC and AC curves in the same diagram
The ru les that have to be ollowed are exactly the sam e as
those explained in Figu re 1 .5.3. Both ATC and AVC cu rves
are U -shaped and marginal cost (M C) is like the N ike-
swoosh shape.

46

ATC, AVC, MC
MC ATC
AVC
0 Q1 Q2
Q your ATC curve. Then draw the AVC curve below it, making
Figure 1.5.9 Marginal and average costs in the same diagram
I t ollows that i average is alling then marg inal m u st be less
than average, while i average is rising then marginal m u st be
Production and costs: the long run
HL The long ru n is d ef ned as that tim e period d u ring which all
ad ju stm ents are possible. Within the theory o prod u ction it is
the period d u ring which all actors are consid ered variable (or,
equ ivalently, no f xed actors exist). The f rm can thereore
change its scale o prod u ction. I t can grow or it can shrink
in size.
I n the long ru n there are three possible eects on ou tpu t rom
an increase in the level o u se o all actors.
n Increasing returns to scale: the percentag e increase in
ou tpu t is greater than th e percentage increase in all inpu ts.
For example, d ou bling all actors o prod u ction m ore than
d ou bles the level o ou tpu t Q. I n other word s, an increase in
all inpu ts by 1 % will lead to a greater than 1 % increase
in ou tpu t.
LAC, SAC
n Constant returns to scale: the percentage increase in
ou tpu t is equ al to the percentage increase in all inpu ts. For
example, d ou bling all actors o prod u ction d ou bles the
level o ou tpu t Q. I n other word s, an increase in all inpu ts
by 1 % will lead to a 1 % increase in ou tpu t.
n Decreasing returns to scale: the percentage increase in
ou tpu t is less than the percentage increase in all inpu ts.
For example, d ou bling all actors o prod u ction less than
d ou bles the level o ou tpu t Q. I n other word s, an increase
in all inpu ts by 1 % lead s to a smaller than 1 % increase in
ou tpu t.
Whether prod u ction in the long ru n is characterized by
increasing, constant or d ecreasing retu rns to scale d eterm ines
the behaviou r o long-ru n average costs. M ore specif cally, the
ollowing applies.
n I prod u ction is characterized by increasing retu rns to scale
then average (u nit) costs are d ecreasing as ou tpu t is
increasing aster than costs. The f rm is benef ting rom
econom ies o scale (EOS).
1 Microeconomics
greater than average. Lastly, on its way u p M C m u st cu t
throu gh average at its m inim u m poin t.
n I M , A then A will drop.
n I M . A then A will rise.
n I M 5 A then A will be at a m inim u m .
I n Figu re 1 .5.9, AVC d ecreases or all u nits o ou tpu t u p to
un it Q1 . MC m u st lie below it. For ou tpu t to the right o
un it Q1 since AVC is rising, M C m u st lie above it. Focu sing
on ATC, it shou ld be clear that or ou tpu t to the let o
un it Q2 , M C shou ld lie below ATC as ATC is d ecreasing. For
outpu t to the right o Q2 , M C shou ld lie above ATC as ATC
is rising.
I you want to draw an ATC and an AVC curve on the same
TIP
diagram frst draw the ATC curve. Note the minimum o
sure that its minimum is to the left o the ATC minimum and
also that they get closer and closer (but do not touch) as you
move to the right.
n I prod u ction is characterized by constant retu rns to scale
then average (u nit) costs are constant, as ou tpu t is
increasing as ast as costs.
n I prod u ction is characterized by d ecreasing retu rns to scale
then average (u nit) costs are increasing, as costs are
increasing aster than ou tpu t. The f rm is experiencing
d iseconom ies o scale.
I n Figu re 1 .5.1 0 a typical long-ru n average cost (LAC) cu rve is
illu strated . Th e LAC cu rve shows the m inim u m average cost
or which level o ou tpu t Q can be prod u ced in th e long ru n;
that is, when th e f rm can change its size and choose the
optimal scale.
SAC1 LAC
SAC2
b
C1
C2 a
0 Q
Q
Figure 1.5.1 0 The LAC curve
Economies o scale (EOS) and diseconomies o scale (DOS)
Figu re 1 .5.1 0 illu strates EOS an d DOS correspond ing to
increasing and d ecreasing retu rns to scale respectively. I nitially,
the LAC cu rve slopes d ownward . Average costs d ecrease as the
47
 1 Microeconomics
size o a rm and ou tpu t increases. The d ownward section o a
LAC cu rve illu strates EOS. Long-ru n average costs are constant
in the horizontal section o the LAC cu rve where the rm is
characterized by constant retu rns to scale. Lastly, i the rm s
size increases m ore then ater som e point, the LAC cu rve slopes
u pward . Average costs increase as the scale o a rm and
ou tpu t increases. The u pward sloping section o a LAC cu rve
illu strates DOS.
N ote at each level o ou tpu t (Q) correspond s the rm s speci c
size (and so a speci c short-ru n average cost cu rve: SAC) with
which the rm can ach ieve the lowest possible average costs.
For example, Q9 u nits o ou tpu t can be prod u ced both by a
small rm with a sh ort-ru n average costs cu rve SAC1 and a rm
that is larger and has a short-ru n average costs cu rve SAC2 . Th e
lowest u n it cost with which this rm can prod u ce Q9 u nits is C2
(equ al to line segm ent Q9 a) and this is achieved i the rm s
size increases. Point a belongs on the rm s LAC cu rve.
Draw the U-shaped LAC curve rather shallow, making sure
TIP
that on its decreasing region the SAC curves are tangent to
it on the let o their lowest points while on its rising section
the SAC curves are tangent to it on the right o their minima. Also
note that the smallest size with which minimum average costs
can be achieved in the long run is the frms minimum optimal
(or minimum efcient) scale.
EOS
These are d e ned as cost savings d u e to increased scale o
prod u ction. They can be d istingu ished into internal EOS and
extern al EOS. I nternal EOS are cost savings d u e to actions o
the rm itsel. External EOS are cost saving s originating rom
d evelopm ents ou tsid e the rm , or example becau se the
ind u stry in which it operates grows.
Sources of EOS
I nternal EOS can resu lt rom technical, marketing,
managem ent, nancial or risk-related reasons. Speci cally,
these can be as ollows.
n Technical EOS may arise:
becau se a rm that is large in size may be able to ad opt
technologies o prod u ction sim ply not available or
smaller rm s, or example capital equ ipm ent (su ch as
an assem bly line) is oten ind ivisible and thereore
u navailable or small rm s
becau se larger rm s oer m ore possibilities or labou r
specialization
as a resu lt o the container principle (or the law o
d im ension s): cost savings may arise becau se volu m es
rise aster than su races. For example, a storage tank
that can store d ou ble the volu m e o som ething costs
less than d ou ble to manu actu re than a smaller tank.
This principle is related to blast u rnaces, pipes, tru cks
and o cou rse shipping transportation.
n Marketing EOS may arise:
becau se, on the inpu t sid e, a larger rm bu ys inpu ts in
bu lk and so may secu re better prices rom su ppliers
(bu lk bu ying)
48
becau se, on the ou tpu t sid e, d istribu tion costs on a per
u nit basis are u su ally lower or larger rm s.
n Financial EOS may arise becau se a large rm can oten
borrow rom banks at lower interest rates.
n M anagem ent EOS may arise becau se larger rm s can
employ specialists in each d epartm ent, or example a large
su permarket will hire nan cial experts to man age its cash
f ow on a d aily basis and a large d epartm ent store will hire
specialist bu yers.
n Risk-related EOS may arise because a larger rm is oten more
diversied, selling not one but many products, in not one but
in many markets (or even in many countries). Risks, and the
associated costs, are thereore better spread and m inim ized.
External EOS
Som etim es, as an ind u stry grows, u nit costs o the rm s
com prising it may d ecrease. Typically this is a resu lt o sim ilar
rm s locatin g together in one area (reerred to also as
agglom eration econ om ies). Why?
H ere are som e reasons.
n A specialized labou r orce may d evelop and technical
schools, catering to rm s need s, may also be established in
the area.
n Complem entary rm s may also be established .
n Better transportation and telecom m u n ications networks
may d evelop.
n M arketing o by-prod u cts may be possible.
DOS
These are d e ned as increases in average costs d u e to
increased scale o prod u ction. Firm s may becom e so big that
u nit prod u ction costs start to rise. DOS can originate within a
rm (internal DOS) or ou tsid e the rm (external DOS).
Internal DOS
Ater a point, size may becom e a problem . When rm s grow
beyond a certain size then u nit costs may start increasing.
Possible reasons or this are as ollows.
n M anagem ent problem s o coord ination, control and
com m u nication associated with hu ge size may d evelop.
n M otivation may d ecrease.
n I n terd epend encies within a hu ge rm may lead to problem s
i there are any hold u ps in any particu lar part o the rm .
External DOS
n Ater a point, congestion costs in an area may d evelop.
n As an ind u stry grows, actor prices (or exam ple or
materials or specialized labou r) may also start increasing as
a resu lt o the higher actor d emand .
Revenues
Total revenu es (TR) are d e ned as the prod u ct o the price per
u nit tim es the nu m ber o u nits sold , or:
TR 5 P 3 Q
The behaviou r o total revenu es as a rm sells m ore u nits o
ou tpu t d epend s u pon whether the rm can sell m ore u nits at
the sam e price or whether in ord er or the market to absorb
m ore u nits it m u st lower the price.
 1 Microeconomics

Case 1 : The frm can sell more per period at the same price

Average revenue
I the f rm is extrem ely small in size compared with the market
and it sells a good that is id entical to the one sold by all the
other f rm s in the market then it will be able to sell m ore u nits
withou t lowering the market price. I n this case it will be as i it
is acing a perectly elastic (horizontal) d emand or its prod u ct,
as illu strated in Figu re 1 .5.1 1 .
P

P d, AR

Demand that such a rm

faces is perfectly elastic
at the market price P

0
Q

P d Figure 1.5.13 AR curve when a frm can sell more units at the same price

Figu res 1 .5.1 3 and 1 .5.1 1 are id entical: the d emand cu rve that a
f rm aces is always id entical to the f rm s AR cu rve.
M arginal revenu e (MR) rom the sale o Q u nits is d ef ned as
0 the extra revenu e earned rom an extra u nit o ou tpu t sold or,
Q
the change in revenu es g iven a change in ou tpu t. So:
Figure 1.5.11 Demand o a frm being able to sell more units at the
DTR
same price P9 MR 5 ____
DQ
Assu m ing that the price at which it can sell its ou tpu t is P9 ,
then its total revenu es will be: There are two ways to u n d erstand what th e M R cu rve will look
like. One way is to realize that i a f rm can sell extra u nits at
TR 5 P9 3 Q
th e sam e price (say, P9 ) then:
For example, i the price at which it can sell its ou tpu t is $ 5.00
n the M R rom selling an extra u nit will be o cou rse equ al to
per u nit then:
the price P9
TR 5 5 Q
n the MR curve will be a straight line at the price P9 , identical to
Figu re 1 .5.1 2 illu strates the total revenu e u nction or su ch a the demand curve it aces and its AR curve, as in Figure 1.5.1 4.
f rm . I t is a straight line that starts rom the origin becau se i it
sells zero u nits it will earn zero revenu es. The other way is to realize that M R is nothing bu t the slope o
the TR cu rve in Figu re 1 .5.1 2 . The slope o TR is a positive and
Total revenues

constant so MR will be a positive nu m ber and constant.

Price, Average revenue, Marginal revenue

TR

P d, AR, MR

0
Output (Q)

Figure 1.5.12 Total revenues when the frm can sell more units at the 0
Q
same price
Figure 1.5.1 4 Marginal revenue when a frm can sell more units at the
Average revenu e (AR) rom the sale o Q u nits is d ef ned as the same price
revenu e per u nit o ou tpu t sold , or:
N ote that since AR in Figu re 1 .5.1 4 is constant it ollows rom
TR(Q)
_____ P3 Q the logic o marginal and average magnitu d es explained earlier
AR(Q) 5 5 _____ 5 P
Q Q that M R m u st equ al AR and m u st thereore also be constant.
It should be clear that AR is always equal to the price at which the
output is sold. Since the demand curve shows at which price each
quantity can be sold it ollows that the AR curve is always the
demand curve that the frm aces, as illustrated in Figure 1.5.1 3.

49
 1 Microeconomics

Case 2: The frm must lower the price to sell more
I the f rm is large in size compared with the market or i it sells
a good that is not consid ered id en tical to those sold by other
f rm s then it aces a n egatively sloped d emand cu rve.
Since AR is always equ al to the price at wh ich the good is sold
(as shown earlier) the d emand cu rve aced by the f rm is also its
Determ ining the shape o the MR cu rve is m ore d if cu lt. I t is
im portant to rem em ber that M R is the slope o TR and that
since AR continu ou sly d ecreases, it m u st be that M R is less
(below on a d iagram ) than AR. So M R m u st cross the horizontal
axis at Q (see Figu re 1 .5.1 7 ).

P, AR, MR
AR cu rve, as illu strated in Figu re 1 .5.1 5 :
P, AR

Output Q will be absorbed at a (PED = 1 )

P
AR = P price P which is also the average
revenue the rm will earn

D, AR
D, AR 0 Q
TR Output (Q)

0 Q
Quantity (Q) MR
Figure 1.5.15 AR curve when a frm must lower price to sell more

As explained earlier, what happens to total revenues in this case,

when the frm lowers price, depends on the price elasticity o
TR
demand (PED). As price drops i demand is price elastic then total
revenues increase while i demand is price inelastic then total
revenues decrease. Total revenues, being the product o price times
quantity, are zero when either quantity or price is zero. They are at
a maximum where PED is equal to 1, which is at the midpoint o a 0 Q
straight line demand curve, as illustrated in Figure 1.5.1 6. Output (Q)
Figure 1.5.17 The MR curve when a frm must lower price to sell more
P, AR

I t can be shown that the M R cu rve when the f rm aces a

negatively sloped straight line d emand cu rve will be also a
straight line, will have the sam e vertical intercept and also
d ou ble the slope.
P (PED = 1 )
AR curve MR curve TR curve
If horizontal Identical to the Identical to the Positively
demand curve demand curve demand curve sloped straight
D, AR faced faced line through
0 Q the origin
Output (Q) If negatively Identical to the Straight line Bell-shaped
TR

sloped demand curve with double (parabola)

demand curve faced the slope and with maximum
same vertical below the
intercept midpoint of
TR
the demand
curve where
PED 5 1
0 Q
Out ut

Figure 1.5.1 6 TR curve when a frm must lower price to sell more

50
 1 Microeconomics

HL The meaning o the term economic profts (p)
Econom ic prof ts are d ef ned as the d ierence between total
revenu es (TR) and total econom ic costs (TC) o prod u ction.
p(Q) 5 TR(Q) 2 TC(Q)
The key to u nd erstand ing econom ic prof ts is to rem em ber th e
m eaning o econom ic costs. Econom ic costs inclu d e not only
explicit costs bu t also implicit costs. Rem em ber that implicit
costs reer to the cost o u sing resou rces owned by a f rm or
which it makes no explicit paym ent as well as the m inim u m
reward that the actor o entrepreneu rship requ ires to remain in
that line o bu siness, known as normal prof ts.
Since econom ic costs inclu d e the m inim u m prof t requ ired to
remain in bu siness, it ollows that i total revenu es are equ al to
total (econom ic) costs and the f rm is making zero econom ic
prof ts it is not that the f rm is making no m oney! I t is making a
prof t 2 the m inim u m it requ ires: normal prof ts.
This means that i a frm is making zero economic profts it will
have no reason to shut down and exit the market as it is making
as much as it would have been making in its next best alternative.
I now it happens that total revenu es exceed total (econom ic)
costs then the f rm is earning m ore than the m inim u m (normal
prof ts) requ ired : it is making su pernormal (or, som etim es,
abnormal) prof ts. These are prof ts over and above normal.
Entrepreneu rs are making in this market m ore than they cou ld
have mad e in the next best alternative available with the sam e
risks. Other entrepreneu rs will want to join this market an d they
will i there is nothing to d eter their entry.
Lastly, i total revenu es are less than total (econom ic) costs
then the f rm is not making the m inim u m it requ ires to remain
in bu siness. I t may be making prof ts bu t these are less than the
entrepreneu r cou ld earn in th e next best altern ative (less than
normal prof ts) so, in the long ru n when no f xed actors tie the
f rm u p, it will certainly exit and try to enter the next best
alternative line o bu siness.
The role o economic profts in a market
economy
Econom ic profts are the reward to entrepreneurship. They dier
rom wages in that profts are not contracted, as wages are, but
are a residual and so they may even be negative (losses).
Supernormal profts attract resources into an industry whereas
losses ree up resources, allowing their use in other industries.
Relative price changes coupled with supernormal profts and
losses drive resource allocation in a market economy. Striving to
achieve profts results in less waste and thereore in greater
(technical) efciency. Supernormal profts provide the incentive
and unding or frms to fnance expansion (investment).
Supernormal profts can also be used to fnance R&D
program mes and so may lead to product and process innovations.

Remember: p 5 (TR 2 TC)

and total costs include normal profts
defned as the minimum required or the frm to remain in the present line o business.
I the frm does not earn normal profts, this will lead to the frm exiting the market.
If p 5 0 If p . 0 If p , 0
The frm is making just normal profts, enough The frm is making supernormal profts 2 The frm is making losses, so even i it is
money to keep it rom exiting the market more than the minimum it requires 2 but making some money it is not enough to keep
because it is making as much as it would other frms will be attracted and, i possible, it operating, as in the next best alternative
make in the next best alternative line o will enter the market. line o business it could make a proft.
business.

Goals o frms

HL Proft maximization
The working assu mption in econom ics is that f rm s aim at
maxim izing econom ic prof ts (that is, maxim izing the d ierence
between total revenu es and total costs).
The condition or proft maxim ization
I t can be shown that i a f rm wishes to maxim ize prof ts it m u st
choose an ou tpu t level Q at which:
MR 5 MC
and the MC curve is rising
Many stu d ents erroneou sly think that this cond ition m eans that
prof ts are zero, orgetting that the term marginal reers to one
m ore u nit, to the extra u nit. To realize why prof ts are maxim u m
when M R 5 M C one m u st consid er the alternatives. There are
two alternatives. M R cou ld be either greater or less than M C.
Case 1 : MR . MC
Assu m e or the sake o the argu m ent that at the chosen level
o ou tpu t Q, M R . MC. Read ing this careu lly m eans that the
extra revenu e collected rom selling one m ore u nit o ou tpu t
exceed s the extra cost o prod u cing that extra u nit. I that is
th e case, then whatever the level o prof ts mad e at Q u nits
o ou tpu t, the f rm will be able to in crease these prof ts by
prod u cing that extra u nit. Bu t i prof ts can be increased , they
are n ot at a maxim u m . I t ollows that i MR . M C then prof ts
cannot be at a maxim u m as they can be increased . N ote that
even i the f rm was making losses at the ch osen level o ou tpu t
Q, it wou ld be able to d ecrease these losses by prod u cin g the
extra u nit, so the chosen Q cou ld not have been the right (the
best or optim u m ) choice o ou tpu t.
Case 2: MR , MC
I th e f rm ha d ch osen a n ou tpu t rate Q at wh ich M R , M C,
th en , by prod u ci n g on e u n i t less it wou ld n ot col lect th e
a ssociated reven u es bu t it wou l d n ot in cu r th e greater
a ssociated cost. I t ollows that, whatever th e level o prof ts,
it wou ld increase th ese (or d ecrea se losses) by prod u cin g
on e less u n it.

51
 1 Microeconomics

I t ollows rom the logic o this analysis that pro ts cannot be maxim ize revenu es is to choose that level o ou tpu t Q or which
at a maxim u m i M R . MC or i M C . M R. MR are zero. I MR are a positive nu m ber at som e level o
A rm shou ld neither increase nor d ecrease its ou tpu t rate i ou tpu t then by selling one m ore u nit the rm cou ld increase
M R 5 M C as at that level o ou tpu t pro ts are maxim ized (or revenu es so they were not at a maxim u m . This m eans that the
losses are m inim ized ). rm shou ld sell all u nits or which M R are positive u p u ntil that
u nit or which M R are zero.
Profts can be increased MR . MC MR , MC
(or losses decreased) Growth maximization
How? By How? By Firm s may also wish to maxim ize the volu m e o ou tpu t sold
i: increasing decreasing su bject to non-negative pro ts. By maxim izing growth the rm
output Q output Q
may be able to lower u nit costs, achieving EOS. A larger rm is
Profts can not be increased (or in better position to d iversiy into d ierent markets as well as
losses decreased); into d ierent prod u cts. The consequ ence o su ch d iversi cation
in other words, profts are MR 5 MC is an overall lowering o associated risks. The cond ition to
maximized and the MC curve is rising maxim ize the volu m e o ou tpu t withou t incu rring losses is that
(or losses minimized) at the chosen level o ou tpu t Q the average revenu e earned
i: shou ld equ al the average costs incu rred .
Why should the MC curve be rising? Satisfcing
To understand why at the chosen level o output Q at which MR The term satis cing was introd u ced by H erbert Sim on (rom
are equal to MC it m ust also be that the MC curve is rising, satisy and su ce). I t d escribes when, becau se o conf icting
consider the alternative (that MC were declining) and assum e objectives o th e variou s stakehold ers within a rm as well as
that the rm decided to produce one m ore unit o output. Prots inormational lim itations, it d oes not aim at maxim izing pro ts
would urther increase as the extra revenue would exceed the or revenu es bu t only strives to achieve at least som e pre-d e ned
extra cost incurred. It ollows that at the chosen output Q not m inim u m level o pro ts or revenu es.
only m ust MR equal MC but also the MC curve m ust be rising.
Corporate social responsibility
Other goals Firm s may d epart rom a strict ree-market, pro t-maxim izing
Goals other than pro t maxim ization inclu d e the ollowing. m od e o operation and pu rsu e objectives that are m ore closely
aligned to the interests o the wid er com m u nity in which th ey
Revenue maximization operate, both the local and global com m u nities. Ethical ways o
I t may be that a rm aim s at maxim izing revenu es. Revenu es d oing bu siness are ollowed and there is a sense o obligation
are d e ned as the prod u ct or the price per u nit tim es the to satisy long-term goals that inclu d e goals involving positive
nu m ber o u nits sold . Reerring to Figu re 1 .5.1 7 it shou ld be im pact on the lives o the workorce and their am ilies as well
clear that the cond ition that need s to be satis ed or a rm to as o society at large.

Market structures

HL I t tu rns ou t that resou rce allocation and e ciency
consid erations are greatly aected by market stru ctu re. The
stru ctu re o a market (whether there are many, ew or one rm )
is important as it d eterm ines the cond u ct o rm s (or exam ple
whether they have the power to set prices) and , consequ ently,
their perormance (that is, whether e ciency is achieved in
resou rce allocation).
Trad itionally, markets are split into ou r types, n am ely:
n perect competition
n m onopoly
n m onopolistic competition
n oligopoly.
Market stru ctu res are d istingu ished on the basis o the nu m ber
o rm s in the market (whether there are many, ew or one
rm ), the type o prod u ct (hom ogeneou s or d ierentiated ) and
whether entry barriers d o or d o not exist.
Perect competition
Characteristics
n I n perect competition there will be very many small rm s in
the market.
n These rm s will prod u ce a hom ogeneou s prod u ct, m eanin g
that consu m ers consid er it identical across sellers. There
are ew exam ples o su ch prod u cts. They are m ostly ou nd
in the primary sector (arm prod u cts and m etals are
examples).
n N o entry (or exit) barriers will exist. An entry barrier is
anything that may d eter entry into a market.
I n ad d ition, we assu m e:
n perect inormation available to all market participan ts
n perect m obility o actors o prod u ction.
Is the perectly competitive m odel realistic?
Very ew markets in the real world share the characteristics
o perect competition. Why? First, EOS are very com m on,
especially in the manu actu ring sector. Very oten large rm s
can prod u ce at a lower u nit cost than smaller rm s can . Firm s
thereore have an incentive to grow either internally (throu gh
investm ent in physical capital) or throu gh m ergers and
acqu isition s. This explains why large rm s are typically ou nd in
m ost ind u stries.
Firm s also have the incentive to d ierentiate their prod u ct, or
exam ple by im provin g qu ality or changing its characteristics, in

52

ord er to acqu ire som e d egree o m onopoly power. Monopoly
power is d ef ned as the ability to raise price (P) above marginal
cost (MC). The Lerner ind ex o m onopoly power is given by the
ratio (P 2 M C) /P. A f rm that manages to prod u ce and sell
even a slightly d ierentiated prod u ct will ace a negatively
sloped d emand cu rve or its prod u ct, so it will be able to
increase price withou t losing all cu stom ers.
Firm s also try to create entry barriers so that they can maintain
any su pernormal prof ts in the long ru n. I n ad d ition , exit
barriers in the orm o su nk costs also are com m on. Su nk costs
are costs that a f rm can not recover when it exits an ind u stry.
I normation in the real world is not perect. There are cases
where inormation is asym m etric, as explained earlier.
Lastly, perect m obility seld om characterizes actors o
prod u ction. Labou r, or exam ple, oten su ers rom
occu pational an d geographical im m obility.
Why is it still useul to study perect competition?
Despite its lim itations perect competition is u seu l. I t is sim ple
and it is capable o su ccessu lly pred icting change. M ost
importantly, its ef ciency properties are consid ered d esirable, so
it serves as a m od el again st which real world markets can be
compared and perhaps, i necessary, corrected .
Short-run equilibrium in perect competition: a case o
supernormal profts
Assum e a perectly competitive market, as illustrated in
Figure 1 .5.1 8 (b). Market orces, in other words market demand
and market supply, determ ine the market price at P. Each frm in
a perectly competitive market is a price taker, m eaning that
the market-determ ined price P is a given or each frm . Since
there are so many other frm s oering an identical product to
perectly inorm ed consum ers, one frm cannot increase the price
above the market-determ ined level as no one would purchase
even a single unit rom it. I t also has no incentive to lower the
(a) A typical rm
P/unit
MC
AC
H d, MR, AR
P P
>0
C
F
0 q*
Q/period
Figure 1.5.1 8 Perect competition
Short-run analysis: a case o supernormal profts
1 Microeconomics
price below the market determ ined level as it is, by assumption,
so small compared with the market that it can sell all it wants at
the going market price. Imagine a sandy beach representing a
market with each grain o sand being a frm . Even i one doubles
its size and becom es as big as two grains o sand it would make
no dierence to the beach (the market). This implies that a
perectly competitive frm can sell m ore output per period at the
sam e price. So, it is as i it is acing a perectly elastic demand
or its product at the going market price P.
As a resu lt o this, the f rm s average revenu e (AR) and marginal
revenu e (MR) are both equ al to the price P so that the AR cu rve,
the MR cu rve and the d emand the f rm aces or its produ ct
coincid e (Case 1 in the analysis o AR presented earlier).
This perectly competitive frm only has to decide how much
output to oer in the market per period given the prevailing
market P. I we assume that the frm is a proft maximizer, we know
the answer. It will choose that level o output q or which:
MR 5 MC and the MC curve is rising.
The M C cu rve in Figu re 1 .5.1 8 (a) intersects the MR cu rve at
point H which is right above ou tpu t q * . I t ollows that the f rm
will choose to sell q * u nits per period at the market price P per
u nit. The cost per u nit (the average cost) when prod u cing q *
u nits is given by the AC cu rve. Going u p rom q * toward the AC
cu rve we f nd point F and rom there we tu rn let and f nd that
the AC o prod u cin g q * u nits is C. Total revenu es collected are
equ al to the nu m ber o u nits sold tim es the price per u nit or
q * tim es P. This is the area o rectangle (0q * H P).
Tu rnin g to the cost sid e, bear in m ind that total costs are equ al
to the nu m ber o u nits prod u ced tim es how m u ch it costs on
the average to prod u ce each, or q * tim es q * F. This is the area
o rectangle (0q * FC). Econom ic prof ts are d ef ned as th e
d ierence between total revenu es collected and total costs o
prod u ction, so geom etrically on Figu re 1 .5.1 8 (a) they are equ al
to shad ed area (CFH P).
(b) The market
P/unit
S
D
0 Q
Q /period
53
 1 Microeconomics
Econom ic prof ts or the typical f rm in this case are positive.
The typical f rm in this market is making su pernormal prof ts.
This m eans that it is making m ore than the m inim u m requ ired
to com pensate or the resou rces employed and the risk taken
(rem em ber this m inim u m requ ired has been d ef ned as
normal prof ts).
A typical mistake students make is when they shade the
TIP
proft area. Make sure you correctly identiy on your diagram
the AC associated with the chosen level o output. Also, line
FC on Figure 1.5.18 (a) cannot be tangent to your U-shaped AC
curve in the short run as MC is shaped like the Nike swoosh.
Short-run equilibrium in perfect competition: a case
of losses
I t is not necessary or the typical perectly competitive f rm to
be making su pernormal or normal prof ts in the short ru n. I t
cou ld be making losses. Figu re 1 .5.1 9 illu strates this case.
I n Figu re 1 .5.1 9 (b) market d emand and market su pply are su ch
that the equ ilibriu m price is d eterm ined at P. The f rm in Figu re
1 .5.1 9 (a) takes the market d eterm ined price P which is equ al to
its MR (an d AR) and selects its optimal level o ou tpu t at the
intersection o M R and M C at q * . AC are equ al to q * F while
AR (price) is only q * H . This f rm is making econom ic losses
equ al to shad ed area (FH CP).
Long-run equilibrium in perfect competition
Resou rces are attracted in to an ind u stry in which f rm s earn
su pernormal prof ts as this implies that these f rm s earn m ore
than they wou ld in the next best alternative. On the other
hand , econom ic losses will ind u ce exit o f rm s rom the
ind u stry as the resou rces they employ cou ld earn m ore in their
next best alternative. I t ollows that i econom ic prof ts in an
ind u stry are zero neither entry nor exit will be observed , as f rm s
in su ch an ind u stry make ju st as m u ch m oney as they wou ld in
(a) A typical rm
P/unit
MC
AC
H
C
>0
d, MR, AR
P P
F
0 q*
Q/period
Figure 1.5.1 9 Perect competition
Short-run analysis: a case o losses
54
their next best alternative. Firm s in perect competition will
neither enter nor exit i each f rm ach ieves its assu m ed
prof t-maxim izing goal by prod u cing at that level o ou tpu t at
which M R 5 MC (and the MC cu rve is rising ) and i the typical
f rm is makin g only n ormal prof ts (that is, zero econom ic
prof ts). I n this situ ation, there is no reason or new f rm s to
enter the market or existing f rm s to exit. Th is requ ires that at
the chosen ou tpu t AR 5 AC.
I n Figu re 1 .5.2 0, the f rm will choose q * u nits to prod u ce as at
that level o ou tpu t it achieves its goal and has no reason to
chang e anything. I n ad d ition, at q * AC and AR are equ al to
q * F so the typical prof t-maxim izing f rm is making normal
prof ts (that is, zero econom ic prof ts). N o n ew f rm s will enter
and no existing f rm s have an incentive to exit. N othin g will
chang e u nless d emand or cost (technology) cond itions change
in this market.
H ow is long-run equilibrium achieved?
Assu m e, as illu strated in Figu re 1 .5.2 0, a perectly com petitive
market in which the typical f rm is making su pernormal prof ts.
As explained , this will ind u ce entry o new f rm s into the
ind u stry. As n ew f rm s enter, market su pply increases, shiting
the market su pply cu rve to the right and pu shing the market
price lower. This process (the entry o f rm s) will stop when
there is no incentive or m ore f rm s to enter; that is, when
econ om ic prof ts are driven to zero. Figu re 1 .5.2 0 illu strates this
situ ation. The market price in Figu re 1 .5.2 0 (a) has been driven
to P. The typical f rm in Figu re 1 .5.2 0 (a) prod u ces q * u nits. At
this level o ou tpu t total revenu es and total costs are equ al to
area (0q * FP).
I n the case o short-ru n losses, illu strated in Figu re 1 .5.1 9,
loss-making f rm s will exit, d ecreasing and shiting to the let
the market su pply cu rve and pu shing market price and AR
hig her. The process (the exit o f rm s) stops when AR becom e
equ al to AC, in other word s when the typical f rm is making
normal prof ts (zero econom ic prof ts); that is, as m u ch as it
(b) The market
P/unit
S
D
0 Q
Q/period

(a) A typical rm
P/unit
MC
AC
F dd, MR, AR
P P
0 q*
Q/period
Figure 1.5.20 Perect competition
Long-run equilibrium
wou ld earn in the next best alternative. There is no reason or
m ore f rm s to exit, as illu strated in Figu re 1 .5.2 0.
The long-run equilibrium condition in perect competition
Long-ru n equ ilibriu m requ ires that at the chosen ou tpu t rate q
the typical f rm is maxim izing prof ts and that these econom ic
prof ts are zero (normal prof ts) so no entry or exit is ind u ced :
MR 5 MC (and the MC curve is rising)
p(q) 5 zero.
Rem em ber that price is always equal to AR and that in this
perectly competitive case (where the frm can sell as m uch as it
wants at the going market price) it is also equal to MR. Also,
since at the chosen output MC and AC are equal, it m ust be
that AC is at a m inim um . So, the long-run equilibrium cond ition
in perectly competitive markets can be written as:
q* : (P 5 AR) 5 MR 5 MC 5 AC
Role o profts and losses in resource allocation
N ote h ere th e role o prof ts a n d losses in a ll ocati n g a n d
re-a l locatin g sca rce resou rces in a ma rket econ om y. Prof ts
attra ct sca rce resou rces a s n ew f rm s en ter th e in d u stry
(a ssu m i n g n o en try ba rriers) wh i l e l osses orce f rm s to exit,
To illustrate long-run equilibrium in perect competition,
TIP
start by drawing a U-shaped AC curve or the typical frm
and then draw, using always a ruler, a horizontal tangent at
its minimum. This line will be the demand (and MR and AR
curves) this frm aces and so determines the price. Make sure
the MC curve is drawn in such a way that it cuts the AC curve
at its minimum. At the intersection o the MR and the MC
curves drop a line to determine the equilibrium output o the
frm. When you then draw the market diagram make sure the
market demand and supply curves intersect at the price you
determined on the frst side diagram. You could start the other
way around by frst determining the market equilibrium price
and extending it all the way to the diagram o a typical frm.
1 Microeconomics
(b) The market
P/unit
D
0 q
Q/period
reein g u p sca rce resou rces. Ba n kru ptcy perorm s a m ost
im porta n t rol e i n a m a rket econ om y a s i t m a kes sca rce
resou rces ava ila bl e a ga i n or u se i n oth er, m ore prod u cti ve
a rea s. O cou rse, wh eth er reed -u p resou rces m ay or m ay
n ot be cha n n el led in to m ore prod u cti ve u ses a l so d epen d s
u pon th ei r m obi l ity. I n a d d ition , th e a ected pa rti es
(workers a n d own ers o ca pita l ) may a ce si g n i f ca n t
a d ju stm en t costs.
Shutting down in perect competition
Assu m e a loss-making f rm . Shou ld it shu t d own im m ed iately?
The answer d epend s on whether it is operating in the long ru n
or in the short ru n.
Long run
I n the long ru n a loss-making f rm will shu t d own and exit the
market. I n the long ru n all possible ad ju stm ents have been
mad e and the f rm has no f xed actors, thereore it aces no
f xed (and so u navoid able) costs.
Short run
Shou ld a loss-making f rm shu t d own in the short ru n? I n
the short ru n som e actors o prod u ction are consid ered
f xed . This im plies that the f rm aces f xed costs. Fixed costs are
u navoid able costs in the sense that the f rm m u st pay them
even i it exits the market and prod u ces zero u nits o ou tpu t.
Th e key to wh eth er a l oss-m a ki n g f rm sh ou l d sh u t d own i n
th e sh ort ru n i s th a t i i t d oes th i s i t wi l l sti l l a ce a n d h a ve to
pay i ts f xed costs, or exam pl e m on th l y pa ym en ts or a n
ou tsta n d i n g ba n k l oa n . Wh eth er th i s f rm sh ou l d sh u t d own
i n th e sh ort ru n or n ot d epen d s on wh eth er th e l osses
i n cu rred wh en th e f rm i s opera ti n g exceed or a re l ower th a n
th e f xed costs i n cu rred i i t sh u ts d own a n d exi ts. I th ese
u n a voi d a bl e f xed costs a re h i g h er th a n th e l osses a ced by
prod u ci n g , th en i t sh ou l d rem a i n i n bu si n ess a s i t wi l l be
l osi n g l ess. O n th e oth er h a n d , i th ese u n a voi d a bl e f xed
costs a re l ower th a n th e l osses i n cu rred by operati n g th en i t
sh ou l d sh u t d own a n d exi t.
55
 1 Microeconomics

Average and marginal revenue (AR and M R) are thereore also

P/unit

MC ATC equ al to P. Given the MC curve illu strated , the prof t-maxim izing
a AVC f rm will choose to prod uce and sell q u nits per period.
AFC at
output q2

P/unit
b MC ATC
C F
H AVC
dd, MR, AR C
P
J
C
H

C J
d, AR, MR
P
F
0 q1 q2
Q /period
Figure 1.5.21 Shut-down rule or a perectly competitive
frm short-run analysis
0 q
Figu re 1 .5.21 illu strates a perectly competitive f rm operating q/period
in the sh ort ru n. As a resu lt, both the ATC and the AVC cu rves
Figure 1.5.22 A loss-making perectly competitive frm shutting down in
are present. The market price is d eterm ined at P which th is f rm
the short run
m u st take an d d eterm ine the optimal, prof t-maxim izing level o
ou tpu t. MR an d M C are equ al exactly above ou tpu t level q 1 . I t will be making a loss as ATC are greater than AR equ al to
This f rm is makin g losses. AR (price) is equ al to line segm ent area (FH CP). I it shu ts d own it will ace the u navoid able f xed
q 1 J while ATC are equ al to line segm ent q 1 F so per u nit losses costs ou nd by m u ltiplying the prof t-maxim izing level o ou tpu t
are equ al to d istance JF. Mu ltiplying this d istance by PJ (which q tim es the correspond ing average f xed cost H J. Fixed costs
is equ al to ou tpu t 0q 1 ) gives the loss area (JFCP), the shad ed aced i it shu ts d own are equ al to area (JH CC). These are less
rectangle. than the losses incu rred by prod u cing. Th is f rm s revenu es
(0q FP) are insu f cien t to cover its variable (operating) costs
We n eed to d eterm ine n ow the size o the (u navoid able) f xed
(0q JC). AR earned 2 P (or q F) 2 is less than the AVC
costs. Given that ATC 5 AVC 1 AFC so that AFC 5 ATC 2
incu rred q J. I t will thereore choose to shu t d own.
AVC it ollows that the vertical d istance at each ou tpu t level
between the ATC and the AVC cu rves is equ al to AFC. Shut-down rule
For example, at ou tpu t level q 2 the correspond ing AFC are
Long I TR , TC Shut down
d istance ab, the d ierence between ATC (q 2 a) and AVC (q 2 b).
run or i AR (5 P) , ATC and exit
We can com pare f xed costs and th e losses incu rred at that is, i p , 0
ou tpu t q 1 by calcu lating the f xed cost area u sing AFC at the
chosen ou tpu t level q 1 . M u ltiplying ou tpu t C9 H (5 0q 1 ) by FH Short i p , 0 Shut down
(the AFC at q 1 ) is area (H FCC9 ), the f rm s f xed costs, the black run and TR , VC and exit
ou tline rectangle. or, equivalently, i AR (5 P) , AVC
I n this case illu strated here, the loss-making f rm shou ld not i p , 0 Do not shut down:
shu t d own in the short ru n as the losses (JFCP) incu rred by but TR . VC wait until no fxed
operating are less than the f xed costs (H FCC9 ) it wou ld still or, equivalently, i AR (5 P) # AVC costs are incurred
ace i it shu t d own.
In the short run the decision to shut down or not boils down to
whether, by producing, the frm is making sufcient revenues to This is a tricky diagram to draw and needs some practice.
TIP
cover its operating (that is, variable costs). I its revenues more Start by drawing the U-shaped ATC and AVC curves ensuring
than cover its variable costs then it should not shut down as it will that their vertical distance (the average fxed costs) becomes
also be able to pay part o its fxed costs, whereas by shutting smaller and smaller as output increases. Make sure the MC curve
down it would be burdened by the ull amount o its fxed costs. (the Nike-swoosh curve) cuts through their minima on its way up.
I you want to illustrate the case o a loss-making perectly
Short-run shut-down rule competitive frm in the short run which will not shut down, choose
A loss-making f rm in the short ru n shou ld shu t d own i total a price between the minima o ATC and AVC and denote the line d,
reven u es are less than (total) variable costs or, equ ivalently AR and MR. Otherwise (i you want to show a frm which will shut
(d ivid ing by Q both sid es), i average revenu e (price) is less than down immediately and exit) choose a price below the minimum o
average variable cost (AVC). the AVC curve you drew. Remember that the vertical distance
So, at any price below the m inim u m AVC a loss-making perectly between ATC and AVC is the AFC corresponding to the chosen
competitive f rm shou ld shu t d own. This case is illu strated in proft-maximizing output so i you multiply it by this output you get
Figure 1 .5.2 2 . The market d eterm ined price is assu m ed to be P. the unavoidable fxed costs incurred.

56

Break-even price
The break-even price is d ef ned as that price at which a f rm
is earning normal (that is, zero econom ic) prof ts. Given a
U -shaped ATC cu rve, the break-even price or a perectly
competitive f rm acing a perectly elastic (horizontal) d emand
is the price that is equ al to the f rm s m inim u m ATC.
I n the short ru n, the break-even price or a perectly competitive
f rm lies above (that is, is greater) than the shu t-d own price
(which is at the m inim u m o the AVC cu rve) as AVC lies below
ATC or all levels o ou tpu t.
I n the long ru n, the break-even price or a perectly competitive
f rm is equ al to the shu t-d own price as both are equ al to the
m inim u m o the AC cu rve. (Rem em ber that in the long ru n
there are no f xed costs so there is no reason to d istingu ish
between ATC and AC.)
N ote, that there is another widely acceptable notion o the
break-even point. It reers to the level o output or which the frm
makes normal (that is, zero econom ic) profts. By setting TR equal
to TC and solving or Q you can fnd the break-even level o
output (that is, the output or which normal profts are earned).
So, or a perectly com petitive f rm :
In the short run:
break-even price is P 5 min ATC
shut-down price is P 5 min AVC
In the long run:
break-even price and shut-down price are P 5 min ATC
Figu re 1 .5.23 illustrates the shu t-d own price as well as the
break-even price in the short ru n or a perectly competitive f rm .
P/unit
MC ATC
AVC
Break-even price:
Pb
P (=AR) = min ATC
Shut-down price:
Ps
P (=AR) = min ATC
0 that they achieve both allocative an d prod u ctive ef ciency.
q /period
Figure 1.5.23 Break-even and shut-down price or a perect competitor in
the short run
The break-even price is at Pb as at any other price th e perectly
competitive f rm wou ld be making either su pernormal prof ts or
losses. The short-ru n shu t-d own price is at Ps as that price is
equ al to the m inim u m AVC.
N ote that i th e f rm i s n ot a perectl y com peti tive f rm a n d
it a ces a n egati vel y sl oped d ema n d th en it d oes n ot m a ke
sen se to con si d er th e m in i m u m o th e ATC cu rve a s th e
brea k-even pri ce, beca u se a n egati vel y sl oped d em a n d
(a n d AR) cu rve ca n on ly be ta n g en t at th e a l li n g portion
o a U -sha ped ATC cu rve.
1 Microeconomics
The supply curve o the perectly competitive frm
I n the short ru n the su pply cu rve o a perectly com petitive f rm
is that portion o its M C cu rve that lies above the m in im u m o
its AVC. I n Figu re 1 .5.2 4, the su pply cu rve is the thick black
segm ent o the M C cu rve. Why?
P/unit
MC, S
j
P3 MR3, AR3
AVC
h
P2 MR2, AR2
f
P1 MR1, AR1
0 q1 q2 q3
q /period
Figure 1.5.24 Short-run supply o a perectly competitive frm
Rem em ber that a su pply cu rve shows how many u nits a f rm
will be willing to oer per period at each price, ceteris paribu s.
Reerring to Figu re 1 .5.2 4, i the market price was at P1 then
the prof t-maxim izing perectly com petitive f rm wou ld oer q 1
u nits per period as its MR cu rve intersects the MC cu rve at
point . Sim ilarly, i the market price was at P2 then the
prof t-maxim izing perectly competitive f rm wou ld oer q2
u nits per period as its new MR cu rve intersects the MC cu rve at
point h. Lastly, i the market price was at P3 then the prof t-
maxim izing perectly competitive f rm wou ld oer q3 u nits per
period as its new MR cu rve intersects the M C cu rve at point j.
Points , h an d j thereore show how many u nits this f rm will
oer at d ierent prices. I t ollows that the M C cu rve is the f rm s
su pply cu rve. H owever, in the short ru n it will on ly be that
segm ent o the MC cu rve above the m inim u m AVC, as at any
lower price we have established that the f rm will n ot oer any
u nits bu t will choose to sh u t d own. By the sam e token, in the
long ru n, the su pply cu rve will be that segm ent o the M C cu rve
that lies above the ATC cu rve as the irm will not oer any u nits
and will shu t d own i price is less than ATC.
Efciency issues and perect competition
Exam ining the ou tcom e o perectly competitive markets shows
As d iscu ssed earlier, allocative ef ciency exists i ju st the right
am ou nt o a good is prod u ced rom societys point o view.
Assu m ing no externalities exist, allocative ef ciency is achieved
i all u nits o a good that are valu ed m ore by con su m ers than
they cost to prod u ce are ind eed prod u ced , u p u ntil that u nit or
which price is equ al to marginal cost. Technical (or prod u ctive)
ef ciency exists i prod u ction takes place with m inimal resou rce
waste (that is, with m inim u m average costs).
Allocative efciency in perect competition
I n Figu re 1 .5.2 5 (b) all u nits that are worth m ore to consu m ers
than it costs to prod u ce them are prod u ced . Unit Q1 is worth to
consu m ers Q1 a (d ollars or eu ro, or example); that is, as m u ch
as consu m ers wou ld have been willing at the m ost to pay or it,
57
 1 Microeconomics
while the marg inal cost o prod u cing it is Q1 b (rem em ber that
the su pply cu rve is the MC cu rve). So u nit Q1 shou ld be
prod u ced and in a perectly com petitive market it will be
prod u ced . I n act, all u nits worth prod u cing rom societys point
o view are ind eed prod u ced . For the last u nit Q* prod u ced in a
perectly competitive market, P 5 M C.
Figu re 1 .5.2 5 (b) shows how social welare, which has been
d e ned as the su m o consu m er and prod u cer su rplu s, is
maxim ized . Consu m er su rplu s is equ al to area (FP* E) and
prod u cer su rplu s is area (H EP* ). Their su m , area (H EF) is at
maxim u m since allocative e ciency is achieved . I any other
qu antity was prod u ced , social welare wou ld be less.
Technical (or productive) efciency in perect competition
I n the long ru n, rm s in perectly competitive markets are
also techn ically e cient as they are orced to prod u ce with
m inim u m average costs. I n Figu re 1 .5.2 5 (a) long-ru n
equ ilibriu m ou tpu t q * is prod u ced by the typical rm with
m inim u m average costs (AC) equ al to d istance q * z. Minimal
waste o scarce resou rces is achieved . I n the long ru n, a rm
incu rring AC higher than q * z wou ld be orced to exit the
ind u stry as it wou ld be making losses. I t ollows that perectly
competitive markets not only lead to the optimal prod u ct m ix
bu t also scarce resou rces are not wasted . This explains why the
perectly competitive market is oten consid ered the m easu rin g
rod against which other market stru ctu res are compared .
Evaluation o perectly competitive markets
Even thou gh, in general, allocative and technical e ciencies
are d esirable properties, there are a nu m ber o caveats to keep
in m ind .
n There is no gu arantee that the good s prod u ced will be
d istribu ted to the m em bers o society in the airest
proportions. There may be consid erable inequ ality o
incom e in a society. So even i the right m ix o good s and
services is prod u ced som e may not enjoy any o them .
(a)
P/unit
MC
AC
z d, AR, MR
P*
0 q*
q /period
Figure 1.5.25 Eciency in perect competition
58
n Since market d emand is d e ned as the willin gness bu t also
the ability to bu y a good at each price, an d ability ref ects
the level o incom e, it may very well be the case that market
d emand ignores very poor hou sehold s. (These will not have
enou gh d ollars or eu ro, or exam ple, to express their
willingness to consu m e even basic good s). So, to take one
exam ple, the market may lead to a very lim ited am ou nt o
low-qu ality bread being prod u ced becau se m ost resou rces
are em ployed in the prod u ction o higher-qu ality whole
wheat bread . There is no gu arantee, thereore, that perect
competition lead s to a truly socially optim u m com bination
o good s prod u ced .
n Perectly competitive rm s d o not have an incentive to
innovate. I t is not only that they may not be able to aord
spend ing on R&D bu t they also know that their innovation
(a new prod u ct or a better process) wou ld be copied by the
other rm s. Su ch investm ent wou ld be a waste o m oney.
n Perectly competitive ind u stries prod u ce u nd ierentiated
prod u cts. This lack o variety m ight be seen as a
d isad vantage to the consu m er.
n Price in competitive markets changes given any change in
d emand or cost (su pply) con d itions. These f u ctu ation s
increase u ncertainty and may d eter long-term investm ent in
an ind u stry. I n contrast, the price stability oten ou nd in
oligopolistic markets may seem d esirable when plannin g
investm ent.
n The perectly competitive m od el is not compatible with
increasing retu rns to scale; that, is with EOS. I EOS were
present then this wou ld m ean that there wou ld be a cost
ad vantage in larger size so the ind u stry wou ld end u p with
ew large rm s. The absence o EOS in perect competition
may imply that, ater all, price is higher than it wou ld have
been i there were ew large rm s involved .
(b)
P/unit
F S, MC
a
E
P*
b
H
D, MB
0 Q1 Q*
Q /period

HL Monopoly
Characteristics
n Monopoly occu rs when one f rm prod u ces a good withou t
close su bstitu tes; the ind u stry coin cid es with the f rm
(a looser d ef nition con sid ers a f rm a m onopoly i it
d om inates the market)
n Monopolies have a u niqu e prod u ct (as there is by d ef nition
only one f rm in the market).
n Th ere are barriers to entry.
The concept o m onopoly is relative since it cru cially d epend s
on how narrowly or broad ly the prod u ct an d the market are
def ned . N ote also the importance o the geographical actor,
or exam ple location in relation to transportation costs.
H ere are som e interesting points abou t m onopoly f rm s.
n A m onopoly f rm can choose either the level o ou tpu t or
the price bu t not both, since the f rm is still constrained by
a negatively sloped d emand cu rve.
n A m onopoly f rm d oes not necessarily make hu ge prof ts. I t
may even make losses; rem em ber that prof ts are a u nction
o the relative position o the d emand cu rve (the AR cu rve)
and the AC cu rve.
n A m onopoly f rm (and , m ore generally, any f rm acing a
negatively sloped d emand cu rve) d oes not have a su pply
cu rve: the MC cu rve is not a su pply cu rve or su ch f rm s;
each ou tpu t rate correspond s to m ore than one possible
price as an inf nite nu m ber o M R cu rves may go throu gh
any point on the M C cu rve. Rem em ber that i we are u sing
a su pply cu rve in a d iagram we are implicitly assu m ing a
perectly com petitive market.
n I t can be shown that i the d emand cu rve (the AR cu rve) is
linear, the MR cu rve is also linear, has the sam e vertical
intercept and double the slope. (H L mathematics stu d ents:
express a lin ear d emand as P 5 a 2 bQ. TR are equ al to
P 3 Q or, su bstitu ting TR 5 (a 2 bQ)Q 5 aQ 2 bQ 2 . MR
DTR
is ____ or, or small changes in Q the f rst d erivative o the
DQ
d TR
total revenu e u nction, ____ 5 a 2 2 Q. The M R cu rve is
dQ
linear, has the sam e vertical intercept with the linear
d eman d cu rve and d ou ble its slope.)
n A m onopoly f rm can set th e price (it is a price setter an d
not a price taker); the d egree o m onopoly power is given
by the d ierence between the price charged and MC
expressed as a proportion o price.
n A prof t-m a xim i zi n g m on opoly f rm wil l n ever ch oose a rate
o ou tpu t Q that correspon d s to th e price in ela sti c
seg m en t o th e d em a n d cu rve it a ces. I t wi ll a l ways locate
below th e ela stic seg m en t. Th is is beca u se or prof t
ma xim ization M R m u st equ a l M C bu t sin ce M C i s
n ecessa rily a positive n u m ber i t ollows that M R m u st a l so
be a positive n u m ber at th e prof t ma xi m izin g ou tpu t. M R
is positive (it lies a bove th e Q a xi s) on ly or that set o
ou tpu t rates that correspon d to th e ela stic reg ion o th e
d ema n d cu rve.
n Th e prof t-maxim izing ou tpu t level is necessarily less than
the reven u e-maxim izing level o ou tpu t (where M R 5 0)
1 Microeconomics
and so the correspond ing price charged is higher. I n other
word s, revenu e maxim ization lead s to m ore u nits being
prod u ced at a lower price.
Equilibrium (in the short run and the long run) o a
monopoly frm
A m onopoly, being the only f rm in the market, aces the
negatively sloped market demand curve. I it is a proft-maxim izing
f rm it will choose that rate o ou tpu t at which M R 5 M C and
MC is rising. I n Figu re 1 .5.2 6 this is the case at ou tpu t Q* .
H aving d eterm ined the prof t-maxim izing ou tpu t will help u s
d eterm ine the price at which this qu antity will be absorbed by
consu m ers. This inormation is given by the d emand cu rve. I t
will set the price at P* . I t cannot set it any higher becau se at
any price above P* ewer than the prof t-maxim izing level o
ou tpu t Q* will be sold .
P/unit
MC
P* F
AC
J
C G
H
D, AR
0 Q* Qr Qsoc
Q /period
MR
Figure 1.5.26 Monopoly: short-run and long-run equilibrium
I n Figu re 1 .5.2 6, at Q* u nits o ou tpu t per period , prof ts are
equ al to area (GFP* C). The d ierence between the average
revenu e Q* F and the average cost Q* G is the prof t per u nit
which, i m u ltiplied by the nu m ber o u nits CG (equ al
to Q* ) gives u s the prof t area (GFP* C).
Th is f rm is making su pernormal prof ts bu t since we can
assu m e that entry barriers exist, no new f rm s will enter th e
ind u stry. I d emand cond itions, cost cond itions and the entry
barriers persist then this equ ilibriu m (P* , Q* ) will not chang e,
so it is also a long-ru n equ ilibriu m cond ition .
N ote that i the monopolist aims at maximizing revenues instead
o profts then it will choose that level o output at which MR 5 0,
which is at Qr where the MR curve crosses the horizontal axis.
Efciency considerations and m onopoly
Allocative ef ciency is not achieved u nd er m onopoly. M onopoly
is a case o market ailu re (as ou tlined earlier). Why?
At th e level o ou tpu t Q* chosen by the m onopoly f rm s, price
exceed s M C. Society wou ld valu e m ore u nits to be prod u ced . I n
Figu re 1 .5.2 6, society wou ld like to enjoy all u nits u p u ntil u nit
Qsoc, which is valu ed as m u ch as it wou ld cost society to
prod u ce (d istance JQsoc). Units Q* Qsoc are not prod u ced , so
society d oes not enjoy welare equ al to area (H JF). Social (or
59
 1 Microeconomics
com m u nity) su rplu s is not maxim ized . Area (H JF) is the
resu lting welare loss reerred to as the d ead weight loss. I t
represents net valu e lost by society. This is a case where market
orces lead to ine cient allocation o scarce resou rces. I t is a
market ailu re.
Prod u ctive ine ciency also resu lts u nd er m onopoly. Why?
Becau se the m onopoly rm is not orced to prod u ce with
m inim u m average costs. At the chosen level o ou tpu t Q*
average costs are equ al to line d istance Q* G, which are greater
than m inim u m .
Lastly, H arvey Leibenstein coined the term X-ine ciency
or a d ierent type o ine ciency that som e very protected
m onopoly positions may lead to. X-ine ciency reers to the
internal slackness that characterizes som e m onopolies. This is
the case wh en , on a d iagram , the AC cu rve is not as low as it
cou ld have been given the available technology.
I s there a case in avou r o m onopoly and m ore generally, in
avou r o large rm s with m onopoly power?
The answer is yes. Assu m e a perectly competitive ind u stry with
a market su pply at S (also the MC cu rve) and market d emand
at D, as in Figu re 1 .5.27. Equ ilibriu m price will be at Pc and
equ ilibriu m qu antity at Qc. We have shown that this ou tcom e is
e cient. Assu m e now that som ehow this perectly competitive
ind u stry is m onopolized , or exam ple one rm bu ys ou t all
perectly competitive rm s, bu t that the prod u ction technology
remains u nchanged . The M C cu rve or the m onopoly rm
remains at M C. The pro t-maxim izing m onopoly rm will now
equ ate its MC with its M R and choose Q* u nits charging a
price P* . We have established that this ou tcom e is ine cient.
The m onopoly rm restricts ou tpu t and raises price. Welare
is red u ced .
H owever, this resu lt rests on the rather u nlikely assu mption that
the larg er in size m onopoly rm employs the sam e technology
that the small perectly competitive rm s employ. I t is very
P/unit
S, MC
MC
P* (with EOS)
Pc
P**
D
0 Q* Qc Q**
Q /period
MR
Figure 1.5.27 Monopoly compared to a perectly competition market
60
probable that the m onopoly rm will enjoy EOS. I ts cost cu rves
may be lower than those the smaller com petitive rm s ace, as
illu strated in Figu re 1 .5.2 8. The technology available to the
com petitive rm s lead to a set o short-ru n cost cu rves su ch as
SACc and MCc. On the other hand , the technology available to
the larger rm s may, as a resu lt o increasing retu rns to scale
and EOS, lead to a d ierent set o cost cu rves, su ch as SACm
and M Cm , located below those the com petitive rm s ace.
LAC, SAC
MCc SACc LAC
MCm SACm
0
Output (Q)
Figure 1.5.28 The lower cost curves enjoyed by the large rm as a result
o EOS
I that is the case (and retu rnin g to Figu re 1 .5.27 ) then the
m onopoly will have a new MC cu rve that cou ld be as low as
MC. MC ref ects the id ea o EOS and is MCm in Figu re 1 .5.2 8.
I th is is the case then the m onopoly may end u p prod u cing
even m ore (Q* * ) than the perectly competitive ind u stry at an
even lower price P* * .
Perhaps, even m ore importan tly, a large rm with m onopoly
power may lead to a aster rate o technological ad vancem ent.
There are two reason s or su ch a d evelopm ent. First, su ch rm s
are in a position to keep their su pernormal pro ts becau se o
the existence o barriers so th ey are in a position to nance
R&D projects which lead to in novations, d e ned as new
prod u cts or n ew processes. I n ad d ition, assu m ing the m onopoly
rm is not entrenched , m eaning that it is not protected by
insu rm ou ntable barriers created by the state su ch as licenses,
then in ord er or it to maintain its position and pro ts it will be
orced to innovate.
I n ad d ition, the su pernormal pro ts su ch rm s enjoy act as bait
that lu res other rm s to innovate in an attempt to d isplace the
m onopoly rm . Think o the cell phone market with N okia,
Apple with its iPhone and Google with Android . Perectly
com petitive rm s wou ld not have the incentive to innovate
becau se ree entry wou ld elim inate the possibility o a
pro table retu rn. These id eas are oten reerred to as d ynam ic
e ciency and are associated with the Au strian econom ist
Joseph A. Schu mpeter.
Barriers to entry
Barriers are d e ned as anything that d eters entry into an
ind u stry or that prevents exit rom an ind u stry. A barrier
increases the u nit cost o a potential entrant above the level
enjoyed by the incu m bent rm .

Types of entry barriers
Barriers can be classi ed into natu ral, state-created and
rm-created barriers, as d escribed below.
Natural barriers: the case of a natural monopoly
Oten, prod u ction technology is su ch that very signi cant EOS
are present. As a resu lt, given market size, only ew or even only
one rm can pro tably co-exist. When only one rm can
pro tably exist in a market it is the case o natu ral m onopoly.
Figu re 1 .5.2 9 illu strates the point. I n this d iagram signi cant
EOS are present as the LAC cu rve slopes d own ward throu ghou t
the length o the d emand cu rve that d e nes the relevant
market. Assu m e that initially there is only one rm in th is
market and that the pro t-maxim izing ou tpu t is at Q while the
price at which these Q u nits will be absorbed is P. This rm is
pro table and it enjoys pro ts equ al to ab per u nit. I now this
market is equ ally shared by two rm s, each prod u cing and
selling (Q/2 ) u nits, then the total am ou nt en tering the market
will still be Q u nits and th e price will remain at P. Each rm now
is making a loss equ al to h per u nit. I t is m u ch too expensive
to prod u ce (Q/2 ) u n its, as the d iagram illu strates.
P/unit
h
f b
P ind u stries in clu d e hairdressers, resta u ra n ts an d DVD renta l
a
LAC
D
0 Q/2 Q
Q/period
Figure 1.5.29 Natural barriers: the case o a natural monopoly
N ote that exclu sive ownership o som e vital inpu t which
cou ld also lead to a m onopoly position is also consid ered a
natu ral barrier.
State-created barriers
Examples are patents, licences and taris.
n Patents are granted by governm ents and are righ ts to
prod u ce exclu sively or a xed period o tim e. Patents aim
at protecting the incentive to spend on R&D.
n Licences are exclu sive perm its that one or ew rm s have.
For example, television and rad io broad casting rm s requ ire
a licence.
n Taris lim it competition rom oreign rm s and create
m onopoly power.
Firm-created barriers
Firm s have every incentive to try to erect barriers in ord er to
enjoy m on opoly power and long-ru n su pernormal pro ts.
Ad vertising, and brand nam e and image creation is one way o
erecting barriers. The stronger the brand nam e in a market the
m ore d i cu lt it is or a newcom er to enter. Also, rm s
1 Microeconomics
d esperately try to d ierentiate their prod u ct. I su ccessu l, this
lowers the PED o their prod u ct and perm its the rm to raise
price. By d ierentiating its prod u ct and by prod u cing many
d ierent varieties the rm makes entry m ore d i cu lt. Kelloggs
cereal prod u cts are a good example.
Lastly, incu m bent rm s may d eliberately maintain excess
prod u ctive capacity. Potential entrants know that the
incu m bent rm can easily increase ou tpu t, d epressing price to
u npro table levels. A typical exam ple o this can be ou nd in
cem ent rm s where, in ad d ition, transportation costs are high.
Monopolistic competition
Characteristics
n Very many small rm s exist in the market (each rm has a
very small share o the market).
n The rm s prod u ce d ierentiated prod u cts. Dierentiation
can be based on qu ality, d u rability, packaging, d esign or
prod u ct service and can be real or imaginary.
n N o entry barriers exist.
I t is th e secon d cha racteristic that g ives su ch rm s a very
small d egree o m onopoly power. Sin ce the prod u ct is not
hom ogen eou s, ea ch rm a ces a n egatively sloped d ema n d or
the prod u ct it sells. I it in creases price it will n ot lose a ll o its
custom ers. I t will lose on ly som e o its cu stom ers so th e
dema n d cu rve or its prod u ct (an d rem em ber th e prod u cts in
m on opolistic com petition are d ieren tiated ) is d own ward
slopin g . Typica l exam ples o m on opolistically com petitive
stores. N ote that oten , especia lly in ma n u a ctu rin g , the
existen ce o many bran d s or con su m ers d oes n ot n ecessa rily
imply m on opolistica lly com petitive ma rkets. For exam ple, in
the d etergen t in d u stry th ere may be very ma ny bra n d s to
choose rom bu t beh in d th ese bran d s th ere are on ly two or
three rm s.
Short-run and long-run equilibrium in monopolistic competition
The illustration o short-run equilibrium in m onopolistic
competition is identical to the m onopoly diagram (Figure 1 .5.2 6).
A m onopolistically competitive rm may enjoy supernormal
prots in the short run. Supernormal prots will induce entry.
Entry is possible in this market structure as no barriers are
assum ed to exist. I hair salons in a market are enjoying
supernormal prots, other such rm s will be attracted. Sooner or
later there will be other hair salons opening up and luring away
custom ers rom the existing rm s.
As entry takes place, the d emand that the typical incu m ben t
rm aces will be aected . N ote that su ch rm s d o not have a
supply cu rve. Only perectly competitive rm s have a su pply
curve. Demand that each m onopolistically com petitive rm
aces or its prod u ct will shrink and tilt. I ts d emand will shrink
(m ean ing that it will d ecrease and shit to the let) becau se
m ore rm s in the market imply a smaller market share or each
rm . At each price the qu antity d emand ed rom each rm
decreases. Demand will tilt (m eaning that it becom es f atter)
becau se i new rm s enter the market, consu m ers will have an
even greater selection o slightly d ierentiated prod u cts to
choose rom , so the d emand each rm aces will becom e m ore
price elastic. Rem em ber that price elasticity increases when
consu m ers ace m ore and closer su bstitu tes.
61
 1 Microeconomics
En try will con tin u e u n til th ere is n o lon g er a n in cen tive or it
to take pla ce. Th is will be th e ca se wh en su pern orma l prof ts
a re com peted away a n d th e typica l m on opolistica lly
com petitive f rm is ma kin g on ly n orma l prof ts (that is, zero
econ om ic prof ts). I , on th e oth er ha n d , th e typica l f rm wa s
ma kin g losses th en exit wou ld ollow, in crea sin g d ema n d
(sh itin g it to th e rig h t a n d ma kin g it m ore price in ela stic)
u n til th ere is n o rea son or m ore f rm s to exit. Th is will be
wh en th e typica l f rm is ea rn in g ju st a s m u ch prof t a s it wou ld
ea rn in its n ext best a ltern ative (that is, wh en it is ea rn in g
n orma l prof ts).
Long-ru n equ ilibriu m will be achieved when the typical f rm in
su ch a market is maxim izing prof ts and these prof ts are zero
(normal prof ts).
P/unit
MC
AC
F Each frm ends up with a scale o operation that orces it to
P*
D, AR
0 Q*
Q/period
MR
Figure 1.5.30 Monopolistic competition: long-run equilibrium
Figu re 1 .5.3 0 illu strates long-ru n equ ilibriu m in m onopolistic
competition as at the chosen level o ou tpu t Q* the f rm not
only equ ates M R and M C, so maxim izing prof ts, bu t also these
econom ic prof ts are zero (normal prof ts) as AR and AC are
tangent and so equ al (to Q* F) right above them . Since the
typical f rm is maxim izing prof ts it is ach ieving its goal, so it
has no reason to change its ou tpu t. Since these prof ts are
HL Oligopoly
Characteristics
Few f rm s operate in the market.
n
n They prod u ce hom ogeneou s prod u cts (su ch as oil, steel or
cem ent) or d ierentiated prod u cts (which inclu d e alm ost
any ind u strial prod u cts, or exam ple cars, d etergents,
appliances, air crat and banking or insu ran ce prod u cts.
n Signif cant entry barriers exist.
To determ ine the extent o concentration in a market a
concentration ratio (CR) is used which m easures the proportion
o total sales accounted by the largest frm s in a market (or an
industry). Typically, m ore than one CR is calculated and
presented. For example, researchers provide 4-frm , 8-frm and
20-frm CRs (or 3-frm , 5 -frm and 1 0-frm CRs) to provide a more
62
normal there is no in centive or new f rm s to enter or or
incu m bent f rm s to exit. This d ef nes long-ru n equ ilibriu m .
Figure 1.5.30 is very tricky to draw. Either start by drawing
TIP
a wide U-shaped AC curve, ollowed by a relatively fat
demand tangent to it and its corresponding MR; determine
the prot-maximizing output Q right below the point o tangency
o AC with AR; lastly careully draw the MC curve, making sure
that not only does it intersect MR right above the chosen output
Q but that it also cuts AC at its minimum. Alternatively, rst draw
a relatively fat demand curve and its corresponding MR;
continue with a relatively fat MC curve and, lastly, the AC curve
that is both tangent to the demand curve above the MR 5 MC
intersection and has also a minimum on the MC curve.
Evaluation of monopolistic competition
In this market structure neither allocative nor technical (or
productive) efciency are achieved. Price exceeds marginal costs or
the last unit o output each frm produces in equilibrium.
Production does not take place with minimal average costs so that
monopolistically competitive frms operate with excess capacity.
produce less output than the one that corresponds to minimum
average costs. Restaurants typically have empty tables and one
does not have to wait long in a queue to rent a DVD or to buy uel.
Free entry and product dierentiation are responsible or this
result. In addition, since these frms cannot maintain profts in the
long run they are not in a position to fnance R&D projects and,
being small in size, they do not enjoy EOS.
On the other hand , as a resu lt o prod u ct d ierentiation and
non-price competition, consu m ers enjoy a greater variety o
prod u cts, increasing the probability that they will f nd a closer
match to their preeren ces. Given ree entry and extensive
prod u ct d ierentiation, consu m ers will have very many, very
close su bstitu tes to choose rom . Price cannot be m u ch higher
than marginal costs, which is another way o saying that the
m onopoly power each f rm enjoys is m inimal. As a resu lt,
ou tpu t will not be too ar below th e socially optimal level.
Firm s are orced to ad vertise and to resort to other m ethod s
o non-price competition, thou gh. The hig her than m inim u m
u nit costs in su ch markets are oten interpreted as the cost
o variety.
complete picture o the market share enjoyed by the largest frm s
in the market. For example, the 5-frm CR (5 CR) is given by:
5
5 CR 5 S i
i =1
wh ere S i i s th e m a rket sha re o th e i th f rm i n th e m a rket (that
i s, th e proportion o m a rket sa les it en joys). Th e m a rket sha re
o a f rm i s th e proporti on o th e tota l m a rket sa les it en j oys.
A 4CR or 5 CR a bove 80% i m pli es a h i g h l y con cen trated
m a rket wh ere a ti g h t oli g opol y (or a m on opoly) is presen t.
CRs provid e n o in orm ati on a bou t th e si ze d i stri bu ti on o
f rm s, so a 5 CR that i s 1 00% cou ld be a m a rket with f ve la rg e
f rm s o equ a l si ze ea ch with a 2 0% ma rket sha re, or a m a rket
wh ere one f rm ha s 96% o th e m a rket a n d ou r f rm s have
th e rem ain i n g 4%.

Optional material
A wid ely u sed m easu re o concentration in a market is the
H irschman-H erf nd ahl ind ex (H H I ) which is ou nd by
squ aring the market share o each f rm in a market an d
su m m ing the resu lting nu m bers, or:
n were able to cooperate and maintain price.
HHI 5 S 2
i v
i =1
where S i is d ef ned as above. Th is ind ex takes into accou nt
the d istribu tion o the f rm s as it gives larger f rm s a
bigger weight. I t approaches zero as the nu m ber o f rm s
o relatively equ al size increases and in the case o a
m onopoly it becom es 1 0,000. Typically, markets with an
H H I in excess o 1 ,800 are consid ered concentrated and i
a m erger between two f rm s signif cantly increases this
H H I then it may be blocked by the competition watchd og.
Game theory and interdependence
The act that ew f rm s exist in an oligopolistic stru ctu re is
responsible or its d isting u ishing characteristic, nam ely
in terd epend ence. I nterd epend ence in a market exists i the
ou tcom e o any action o one f rm d epend s on th e reaction o
the rival f rm s.
A branch o mathematics known as gam e theory is wid ely u sed
to analyse oligopolistic set-u ps. We will exam in e the simplest
orm o a gam e, known as the prisoners d ilem ma. Throu gh it
we will see the interd epend ence that exists in su ch markets
and why oligopolistic f rm s ace the u nd am en tal d ilem ma
o whether to collu d e or to compete.
Assu m e an olig opolistic market with only two f rm s, Gray S.A.
and White S.A. This market is also known as a d u opoly. Each
f rm has two policy options, to maintain the price charged or
to d ecrease it. The ou tcom e to either action d epend s on the
reaction o the rival f rm . The matrix below provid es the pay-os
or each action given the possible reaction o the rival f rm .
Gray S.A.
Maintain price
+ 6.0 million
Maintain price
+ 6.0 million 1 .0 million
White S.A.
1 .0 million
Cut price
+ 1 0.0 million + 3.0 million
Interdependence is evident since the outcome o whichever policy
Gray chooses depends on how White will react, and vice versa. For
example, ocusing on Gray and reading vertically, i it decides to
maintain price it could earn either 6.0 million o supernormal
profts or incur losses equal to 1.0 million depending on whether
White also maintains its price or decides to cut price. I Gray
decides to cut price it could earn 1 0.0 million o supernormal
profts (i White maintains price) or just 3.0 million (i White also
cuts price). Symmetrically, this is true or White.
To determine the dominant strategy, each frm realizes that no
matter what the rival chooses, it is better o cutting price. For
example, Gray realizes that i White maintains price it is better that
Gray cuts price (Gray earns 1 0.0 million instead o only the 6.0
million it would earn it also maintained price) whereas i White
cuts price Grey too should cut price as it would then earn 3.0
1 Microeconomics
million whereas i it maintained price it would lose 1.0 million. In
other words, no matter what White does, Gray is better o i
it cuts price: cutting price is the best strategy. Symmetrically, it is
the best strategy or frm White. Cutting price is thereore the
dominant strategy in this game. The frms will each make only 3.0
million, which is less than the 6.0 million each would make i they
To compete or to collude?
This dilemma characterizes all oligopolistic set-ups. Through
competition these frms may increase their own market share and
their profts at the expense o rivals but at the risk o a price war
which could prove catastrophic. By colluding they decrease
uncertainty and maximize joint profts as i they were a monopoly,
but at the risk o getting caught and acing the consequences.
Collusion
Collu sion exists in a market i f rm s agree to f x price and to
engage in other anti-competitive behaviou r. Agreem ents can be
either ormal or inormal. I the agreem ent is ormal we have
th e case o a cartel. Cartels are generally illegal. I n m ost
cou ntries f rm s can not sign legally enorceable contracts. Firm s
that have mad e ormal agreem ents try to make su re that their
agreem ents remain secret. The Organization o the Petroleu m
Exporting Cou ntries (OPEC) is a case o a ormal agreem ent
between oil-exporting cou ntries in which d eliberations and
d ecisions are pu blicized , as it operates above national laws.
I the agreem ent is inormal then we have the case o tacit
collu sion. I th ere is a d om inant f rm in the market and a ew
smaller competitors (oten reerred to as a competitive ringe)
th en the d om inant f rm may act as a price lead er. I t will set
price at su ch a level to maxim ize its prof ts and the remaining
f rm s will accept it. This d escribes what is known as the
d om inant f rm price lead ersh ip m od el. Th e price lead er d oes
not have to be th e d om inant f rm . I t cou ld be the f rm that has
in the past su ccessu lly pred icted changes in the market or the
position o the lead er may rotate rom f rm to f rm .
To illu strate the ou tcom e o collu sive behaviou r where f rm s
behave as a m onopoly f rm , we can u se a m onopoly d iagram ,
Cut price su ch as Figu re 1 .5.31 . The joint prof t-maxim izing ou tpu t is Q
+ 1 0.0 million
and the price the cartel will set is P, lead ing to joint prof ts
equ al to area (hPC). Som ehow, ou tpu t qu otas and prof t
shares or each m em ber m u st be d eterm ined .
P/unit
+ 3.0 million
MC
P f AC
Joint
prots
h
C
D, AR
0 Q
MR Q/period
Figure 1.5.31 Collusive behaviour where frms behave as a monopoly frm
63
 1 Microeconomics
How likely is it for a collusive agreement to collapse?
Collu sive stru ctu res are u nstable becau se o the inherent
incentive to cheat. Each m em ber wou ld preer others to abid e
by the ou tpu t restricting agreem ent (the qu ota) while it
d oesnt. The logic o this in centive is clear: i all f rm s except
one maintain their ou tpu t qu ota then the price o the g ood will
remain high. To the extent that price is higher than the MC o
the d eector, it has the incentive to cheat and raise ou tpu t
above its qu ota. Since all m em bers have the sam e incentive,
su ch collu sive agreem ents oten collapse.
Collu sive agreem en ts are m ore likely to collapse:
n the greater the nu m ber o m em ber f rm s (as m onitoring
each others behaviou r becom es m ore d if cu lt)
n the smaller the proportion o total ind u stry ou tpu t m em bers
o the agreem ent control (as it becom es m ore d if cu lt to
control market price)
n i the good is d ierentiated and many varieties exist (as any
agreem ent will be m ore d if cu lt to reach and to enorce)
n i prod u ction costs d ier (as this will make agreeing on
qu otas m ore d if cu lt)
n i market d emand is shrinking (as each m em ber will
scram ble to su rvive).
N on2 collusive oligopoly
The term reers to the case where oligopolistic f rm s have
no agreem ent concerning their behaviou r and tactics. Still,
repeated interaction lead s oligopolistic f rm s to avoid changing
outpu t even i cost cond itions change. The kinked d emand
curve m od el illu strates this point. I t was introd u ced by P.
Sweezy in 1 939 and it aim ed at explaining the observed price
stickiness in oligopolistic markets even when cost cond itions
changed . I t is typically consid ered a m od el o non-collu sive
oligopoly.
The kinked demand curve model
Assu m e a d u opoly. Figu re 1 .5.32 illu strates that cu rrently f rm
A is sellin g Q* u nits at a price P* . The behaviou ral assu m ption
in the kinked d emand cu rve m od el is sim ple: the competing
frm will not ollow a price increase initiated by f rm A bu t will
ollow a price cu t. There is thereore an asym m etry in the
expected response. As a resu lt o this asym m etry in the
response o its competitor, the d emand that f rm A aces is
m ore price elastic or prices above the cu rrent price than or
prices below the cu rrent price. Qu antity d emand ed will all by
proportionately m ore i f rm A increases price (since its
competitor d oes not ollow) than it will rise i f rm A d ecreases
price and its competitor ollows. I n the f rst case, f rm As
prod u ct will be m ore expensive, while in the second case both
frm s prod u cts will be cheaper. A kink will orm at the cu rrent
price in the d emand cu rve that f rm A aces.
I n Figu re 1 .5.32 the kink is at point h correspond ing to the
initial price P* and the initial qu antity Q* . Segm ent h o the
demand cu rve is relatively m ore price elastic than segm en t
hg as a consequ ence o the asym m etry in the reaction o the
64
rival. N ote that d emand below the kink d oes not have to be
price inelastic bu t only less price elastic than it is above it, as
the existence o a positive seg m ent or MR illu strates above.
P/unit
MC (upper)
f
MC (lower)
h
P*
b
a c
D, AR
g
0 Q*
Q /period
MR
Figure 1.5.32 The kinked demand model
The kink in the d emand cu rve is responsible or the
discontinuity in the M R cu rve which has to be d ou ble the slope
of each section o the kinked d emand . Given that prof t
maxim ization is the working assu m ption and that prof t
maxim ization requ ires that MR is equ al to M C, it ollows that
the M C cu rve m u st have intersected the M R cu rve right above
the chosen ou tpu t Q* . H owever, this cou ld be the case either
with M C (u pper) or with M C (l ower) and , by inerence, with any M C
within the d iscontinu ou s range o MR.
So, i M C d ecrease below M C(u pper) , the f rm will neither change
ou tpu t nor price charged . Price is sticky at P* in a non-collu sive
oligopoly even i cost con d itions chan ge. The m od el is u seu l as
it illu strates the observed price stickiness in real-world
oligopolies, bu t it ails to explain how the origin al price P*
is orm ed .
N on-price competition
Oligopolistic f rm s avoid com peting throu gh price cu ts. Su ch a
strategy cou ld lead to a competitive d ownward spiral in prices
(a price war) which cou ld leave all f rm s worse o.
N on-price competition can take several orm s, su ch as:
n heavy ad vertising and brand -nam e creation, or example or
Pepsi Cola and Coca Cola
n gits and coupons, or example in newspapers and magazines
n continu ou s prod u ct d ierentiation, or exam ple with cars,
cell phones, DVD players, television sets and television
stations
n excessive prod u ct prolieration to cover all imaginable
market niches, or example with ice cream or breakast
cereal

n extend ed gu arantees (typically in electric appliances,
compu ter hard ware d evices, etc.)
n ater-sale service, or exam ple the cu stom er plans o car
manu actu rers
n volu m e d iscou nts (oten in prod u cts su ch as sham poo and
cond ition ers).
I a price war occu rs in the real world it is u su ally a case where
som e participants (typically with a so-called d eep pocket) are
looking orward to the shake-o eect o nancially weaker
rm s being orced to old and exit the market or be acqu ired .
Market structure Characteristics are:
Perfect very many small frms
competition homogeneous product
no barriers to entry
Monopolistic very many small frms
competition dierentiated product
no barriers to entry
Oligopoly ew interdependent frms, leading to high market
concentration
homogeneous or dierentiated product
high entry barriers
Monopoly single frm
unique product
high entry barriers
HL Price discrimination
Price d iscrim in ation is a pricing policy that certain rm s ad opt
to increase their pro ts u rther. Formally, price d iscrim ination
exists when a rm sells the sam e prod u ct at two or m ore
d ierent prices in two or m ore markets provid ed that the price
d ierences d o not ref ect d ierences in th e cost o prod u ction
or provision. Examples inclu d e airline tickets; train and bu s
ares; theatre and cinema ticket prices; telephone services; and
lawyers, private d octors and consu ltants ees. I n international
trad e, d u m pin g is also consid ered a orm o international price
d iscrim ination as it involves selling abroad at a lower price than
in the protected d om estic market.
Conditions allowing a frm to price discriminate
N ot all rm s can practise price d iscrim ination. The ollowing
cond itions m u st hold or eective price d iscrim ination to
be possible.
n The rm m u st enjoy som e d egree o m onopoly power. I t
m u st ace a negatively sloped d emand cu rve. Thereore,
a perectly com petitive rm cannot practise price
d iscrim ination.
n N o resale o the good (reerred to as seepage) rom the
cheaper to the pricier market shou ld be possible. The two
markets m u st som ehow be separable otherwise arbitrag e
1 Microeconomics
The kinked demand is another tricky diagram to draw
TIP
correctly. Start by frst choosing the kink somewhere in the
upper let corner o the graph space; then draw demand,
making sure that the relatively price inelastic segment is not too
steep. Next draw the MR section corresponding to the relatively
elastic segment o the demand curve, maintaining the rule o
doubling the slope. The MR which corresponds to the lower right
segment hg o the demand curve should start at such a point b
(see Figure 1.5.32) that ab 5 bc and also maintain the rule o
doubling the slope.
Outcomes are:
allocative efciency as or the last unit produced,
P 5 MC
technical efciency as in the long run production takes
place with minimum average costs
neither allocative nor technical efciency
excess capacity
variety
neither allocative nor technical efciency
but, perhaps, dynamic efciency (R&D and aster
innovation; EOS)
neither allocative nor technical efciency
but, perhaps, dynamic efciency (R&D and aster
innovation; EOS)
(bu ying low and selling high) will gu arantee that eventu ally
one price will d om inate in both markets.
n Price elasticities o d emand between markets m u st d ier.
Som e consu m ers m u st be prepared to pay m ore either
becau se ewer su bstitu tes are available to them or becau se
they enjoy a higher level o incom e.
Third-degree price discrimination
There are three types (or degrees) o price d iscrim ination. The
rst degree is only o theoretical interest as it assu m es that the
rm can sell each extra unit at the highest price the consu m er is
willing and able to pay, and so extracts and appropriates the
entire consu m er su rplu s. Block price d iscrim ination, also known
as second-d egree price discrim ination, is when su ccessive blocks
o u nits o ou tpu t are sold at a lower prices. For example, a
parking lot may sell the rst hou r o parking at $ 1 0.00, the
second and third hou rs at $ 5.00 each and extra hou rs at $ 2 .00.
The com m onest type o price d iscrim ination is third d egree,
where the rm segm ents a market across som e characteristic
that on th e one hand takes ad vantage o d iering price
elasticities and on the other hand d oes not allow resale o the
good rom the cheaper to the m ore expensive market. For
exam ple, airlines price tickets bou ght a ew d ays in ad vance
m u ch higher than i they were pu rchased a m onth or so in
advance o a f ight. Since the consu m ers nam e is on the ticket,
65
 1 Microeconomics
resale is not possible. By pricing tickets or the sam e f ight in
this way the company tries to take ad vantage o the act that i
people d ecid e to travel and book a f ight only a ew d ays in
ad van ce, either they have very im portant bu siness to cond u ct
and ace ew i any alternatives or they are very wealthy and
the ticket expense is a small proportion o th eir incom e. On the
other hand , i people book a ticket a m onth in ad vance then
they are m ost probably travelling or pleasu re, so they have
many alternatives to choose rom . Demand or this speci c
f ight is qu ite price elastic.
Figu re 1 .5.3 3 may look a bit com plicated bu t is actu ally a very
straightorward and convenient illu stration o third -d egree price
d iscrim ination. The two markets, A and B, are drawn sid e by
sid e. On the right-hand sid e the d emand or market A is drawn
as relatively price inelastic. This is the grou p o ind ivid u als with
the ewer su bstitu tes available and /or the higher incom es who
are consid ering bu ying a ticket a ew d ays in ad vance o a
f ight. On the let-hand sid e (qu antities are o cou rse not
negative to the let o the origin) the d emand or market B is
drawn as relatively price elastic (f atter). This is the grou p o
ind ivid u als with m ore available su bstitu tes and /or lower
incom es who are consid ering bu ying a ticket a m onth in
ad van ce o a f ight. To avoid the d iicu lty o drawing accu rately
the m irror image o an MC cu rve shaped like the N ike swoosh,
it is assu m ed that the extra cost o an extra ticket or the airline
is constant and equ al to 0h, and we draw the M C cu rve
horizontal to the Q axis. Pro t maxim ization requ ires that in
each market MR is equ al to M C so that:
MR( A) 5 MC and MR(B) 5 MC or MR(a) 5 MR(B) 5 MC
This is the case at Q(A) in market A and Q(B) in market B so
that the rm will charge P(A) in market A and P(B) in market B.
P/unit
Market B:
Tickets purchased
a month in advance
(relatively price elastic demand)
MC
D(B)
Q(B)
Q/period
MR(B)
Figure 1.5.33 Price discrimination: third degree
66
As expected , the rm will charge the higher o the two prices in
the market with the relatively m ore price-inelastic d emand .
When drawing the two demand curves make sure their
TIP
slopes dier substantially so that the resulting prices dier
signifcantly.
Consumers and price discrimination
I n general, a price-d iscrim inating rm extracts and appropriates
part o the consu m er su rplu s. Prod u cers are better o and the
only risk they may ace is the possibility o bad pu blicity in
som e cases. Viewed d ierently, i they were not better o with
price d iscrim ination they wou ld not have ad opted it.
Consu m ers, on th e other hand , are generally worse o as part
o their su rplu s is transerred to prod u cers. There may be
situ ations, thou gh, where at least certain grou ps o consu m ers
d o bene t. One cou ld be the grou p that pays the lower price, i
this is set below the single price that the rm wou ld have
charged withou t price d iscrim ination.
Su ch a pricing policy may allow a rm to sell a greater volu m e
o ou tpu t and so grow in size. For example, rm s oten sell at a
higher price in their d om estic protected market and at a m u ch
lower price in world markets. I su ch a rm grows and enjoys, as
a resu lt, EOS which perm it it to d ecrease all prices charged ,
then even consu m ers in its d om estic market will bene t.
Lastly, there are cases where selling a good wou ld be
u npro table at any sin gle price bu t the rm may becom e
pro table by price d iscrim inating and , throu gh this, allowing
consu m ers to enjoy the prod u ct.
P(A)
Market A:
Tickets purchased
a few days in advance
(relatively price inelastic demand)
P(B)
h
MC
D(A)
0 Q(A)
Q /period
MR(A)
 1 Microeconomics: Questions
Practice part (a) long essay questions (HLP1 and SLP1 )
Command terms: typically AO1 /AO2 but possibly also AO4 (not AO3)
1 . Explain what extern alities are and how they may arise.
2 . Explain u sing d iagram (s) the welare loss arising rom the
prod u ction or consu mption o a good responsible or the
gen eration o negative externalities.
3. Distingu ish between marginal private and social costs as
well as between marginal private and social bene ts.
4. Explain what price, incom e and cross elasticities o d emand
m easu re.
5. Explain why governm ents provid e su bsid ies, and d escribe
examples o su bsid ies.
6. Explain why the price elasticity o d emand or many
primary com m od ities is relatively low while th e price
elasticity o d emand or manu actu red prod u cts is
relatively high.
7. Analyse the con cept o market ailu re as a ailu re o
markets to achieve allocative e ciency.
8. Distingu ish u sing examples between private and
pu blic good s.
9. Explain u sing an appropriate d iagram the possible
consequ ences o rent controls on the market or rental
hou sing in a city o you r choice.
1 0. Explain why a governm ent may choose to establish a
m inim u m wage.
11 . Explain why a governm ent may choose to su pport the price
o an agricu ltu ral prod u ct.
1 2 . Ou tline reasons or which a governm ent may choose to u se
ood price controls.
1 3 . Explain why the price elasticity o su pply or primary
com m od ities is relatively low while or manu actu red
prod u cts it is relatively high.
1 4. Distingu ish between m ovem ents along th e d emand cu rve
and shits o the d emand cu rve, drawing appropriate
d iagram s and provid ing exam ples related to the owner-
occu pied hou sing market o you r cou ntry.
1 5. Distingu ish between m ovem ents along th e su pply cu rve
and shits o the su pply cu rve, drawing appropriate
d iagram s and provid ing exam ples related to a market or
an agricu ltu ral prod u ct o you r choice.
1 6. Distingu ish between speci c and ad valorem taxes u sing
appropriate d iagram s and examples.
1 7. Explain, u sing the term s social su rplu s, marginal bene t
and marginal cost, the m ean ing o the term allocative
e ciency.
1 8. Analyse, u sing an appropriate d iagram , the role that
relative price changes play in the allocation o scarce
resou rces in a ree market economy.
1 9. U sing an appropriate d iagram and examples, explain why
market orces may prove insu cient to ad dress
environm ental concerns.
2 0. Explain, u sing examples and an appropriate d iagram , why
d em erit good s are consid ered a market ailu re.
21 . Explain, u sing appropriate examples an d a d iagram , why
governm ents may choose to im pose price ceilings.
2 2 . Explain why governm ents impose price f oors and d escribe
exam ples o price f oors.
23. Distingu ish between m erit good s, d em erit good s and
pu blic good s.
2 4. Explain u sing examples why com m on access resou rces may
be overu sed and d epleted .
2 5. Explain why the over-exploitation o land or agricu ltu re in
less d eveloped cou ntries may pose a threat to
su stainability.
2 6. Explain, u sing examples, why the global natu re o th e
problem s threatening su stainability and th e lack o
ownership o com m on access resou rces lim it the
eectiveness o in d ivid u al governm ent responses and thu s
requ ire international cooperation.
27. Explain, u sing an appropriate d iagram , why the u se o
ossil u els in prod u ction processes threatens su stainability.
2 8. Describe the term s su stainability and com m on access
resou rces u sing appropriate examples or the latter.
2 9. Explain, with reerence to the ree rid er problem , h ow the
lack o pu blic good s ind icates market ailu re.
30. Explain the role o price elasticity o d emand and cross-
elasticity o d eman d or bu sinesses making d ecisions.
31 . Explain why negative externalities are an example o
market ailu re.
67
 1 Microeconomics: Questions
Higher level only
HL 1. Describe the term tacit collu sion inclu d ing reerence to
price lead ership by a d om inant f rm .
2 . Explain why oligopolistic f rm s ace the d ilem ma to
compete or to collu d e.
3. U sing examples and an appropriate d iagram , explain the
m eaning o the term natu ral m onopoly.
4. Explain the cond itions that need to be satisf ed or a f rm
to su ccessu lly ad opt price d iscrim ination.
5. Explain, u sing d iagram s, u nd er what cond itions and in
which market stru ctu res positive econom ic prof ts are
u nlikely to persist in the long ru n.
6. Explain why the opportu nity cost o entrepreneu rship,
an elem ent o normal prof ts, is part o the econom ic costs
o a f rm .
7. Distingu ish between th e three types o retu rns to scale.
8. Describe ou r actors giving rise to econom ies o scale.
9. Explain why interd epen d ence is responsible or the
d ilem ma aced by oligopolistic f rm s as to whether to
compete or to collu d e.
1 0. Explain, u sing appropriate d iagram (s), how a perectly
competitive market will m ove rom a short-ru n equ ilibriu m
position to long-ru n equ ilibriu m .
11 . Ou tline the ways in which m onopoly power m ight arise.
1 2 . Explain how a m onopoly prod u cer is in a position to earn
positive econom ic prof ts in the long-ru n.
1 3. Explain how a concentration ratio may be u sed to id entiy
an oligopoly.
1 4. Explain, u sing d iagram s, why both price elasticity o
d emand and price elasticity o su pply are necessary to
consid er in ord er to d eterm ine the incid ence o an ind irect
tax on consu m ers and prod u cers.
68
1 5. Explain how f rm s operating in d ierent market
stru ctu res com pete.
1 6. Disting u ish, u sing d iagram s, the short ru n and long ru n
equ ilibriu m positions or a perectly com petitive f rm .
1 7. Disting u ish, u sing examples, between m onopolistic
com petition and oligopoly as market stru ctu res.
1 8. Analyse the d ierences between a collu sive oligopoly and
a non-collu sive oligopoly.
1 9. U sing appropriate d iagram s, d istingu ish between the short
ru n shu t-d own price and the break-even price or a perectly
com petitive f rm .
2 0. Disting u ish between the characteristics o perect
com petition and m onopolistic competition.
21 . Describe how a f rm operating in an oligopolistic market
m ight attempt to increase its market share.
2 2 . Explain the role o barriers to entry in perm itting a f rm to
earn econom ic prof ts.
23 . Explain, u sing examples, why market ailu re may occu r
when one party in an econom ic transaction possesses m ore
inormation than the other party.
2 4. Explain, u sing d iagram s, why the prof t maxim izing choices
o a m onopoly f rm lead to allocative inef ciency and
prod u ctive (technical) inef ciency.
2 5. Disting u ish between short-ru n average total cost cu rves
and long-ru n average cost cu rves u sing appropriate
d iagram s.
2 6. Describe three goals oth er than prof t maxim ization that
f rm s may pu rsu e.

Practice part (b) long essay questions (HLP1 and SLP1 )
Command terms: typically AO3 but possibly AO1 and AO2 or even AO4
1 . Discu ss whether governm ents shou ld always intervene in
markets where signi cant externalities arise.
2 . Evalu ate the u se o two market based policies to correct
the market ailu re arising rom negative externalities o
prod u ction.
3. Evalu ate, u sing appropriate d iagram s wherever possible,
govern m ent responses to correct the market ailu re arising
in the case o m erit good s.
4. Discu ss, u sing d iagram s wherever appropriate, the
sig ni cance o price elasticity o d emand or both rm s and
the governm ent.
5. Explain, with the help o d iagram s, (i) how the market or
beer will be aected by a tax on hard liqu or su ch as whisky
and vod ka, (ii) how the market or oranges will be aected
i arm ers can sell lem ons at a higher price, (iii) how the
d emand or red wine will be aected i its price d ecreases.
6. Discu ss the consequ ences o provid ing a su bsid y on the
stakehold ers in a market.
7. Exam ine the implications or a bu siness o changes in the
prices good s that are related to the one it oers.
8. Evalu ate a policy response ad opted by a governm ent on a
market ailu re o you r choice. U se examples and , i possible,
appropriate d iagram s.
9. Exam ine the implications o d irect provision o pu blic
good s by governm ents.
1 0. To what extent d o tenants (i.e. h ou sehold s who rent an
apartm ent) bene t rom rent controls?
1 1 . Discu ss the possible market ou tcom es o ad opting a
m inim u m wage policy.
1 2 . Discu ss the consequ ences o im posing a price f oor on the
stakehold ers in a market or su ch a prod u ct.
1 3. Discu ss the consequ ences o im posing ood price controls
on the stakehold ers o su ch markets.
1 4. Discu ss, u sing appropriate d iagram (s), the consequ ences on
the stakehold ers involved o provid ing a su bsid y to the
prod u cers o an agricu ltu ral prod u ct.
1 5. An alyse, u sing d iagram s an d with reerence to excess
d emand or excess su pply, how changes in any three
d eterm inants o d emand resu lt in a new market
equ ilibriu m .
1 6. An alyse, u sing d iagram s an d with reerence to excess
d emand or excess su pply, how changes in any three
d eterm inants o su pply resu lt in a new market equ ilibriu m .
1 Microeconomics:
1 Microeconomics
Questions
1 7. Discu ss the im pact o im posing an ind irect tax on market
ou tcom es.
1 8. Discu ss the consequ ences o imposing an ind irect tax on
the stakehold ers in a market.
1 9. Explain, u sing appropriate d iagram s and exam ples, why
social (com m u nity) su rplu s is not maxim ized i either m ore
or less than the allocatively e cient ou tpu t level is
prod u ced .
2 0. Discu ss why national policies may not prove su cient to
ad dress environm ental issu es and thu s why an eective
response to global environ m ental problem s requ ires
internation al cooperation.
21 . Discu ss the econom ic argu m ents relevant to a policy
d ecision to im pose su bstantially higher levels o taxation
on the sale o alcohol, explaining reasons or which it may
not ind u ce signi cantly lower levels o consu mption.
2 2 . Exam ine the possible consequ ences o a d ecision to impose
a price ceiling on basic ood stu .
23. Discu ss the consequ ences o imposing a price ceiling on
the stakehold ers in a market, inclu d ing consu m ers,
prod u cers and the governm ent.
2 4. Exam ine the position that consu m ers are necessarily
worse-o in a m onopoly market.
2 5. Contrast the u se o a market-based policy versu s
governm ent regu lation in markets or good s su ch as
cigarettes and alcohol.
2 6. Discu ss legislation and u nd ing or clean technologies as
possible solu tions to th e threats to su stainability.
27. Evalu ate, u sing d iagram s, two possible governm ent
responses to threats to su stainability.
2 8. Compare and contrast carbon taxes and cap and trad e
schem es as possible solu tions to threats to su stainability.
2 9. Evalu ate carbon taxes and cap and trad e schem es as
possible solu tions to th reats to su stainability.
30. To what extent can the imposition o carbon taxes
encou rage su stainability.
31. Discu ss the im plications o d irect provision o pu blic good s
by governm ents.
32 . Exam ine the view that governm ents can best red u ce
sm oking (or, alcohol con su mption) by su bstantially
increasing taxes on cigarettes.
33. Discu ss three policies that governm ents m ight implem ent
to red u ce negative externalities associated with the
environm ent.
69
 1 Microeconomics: Questions
Higher level only
HL 1. Evalu ate the d esirability o markets in which f rm s enjoy
consid erable market power.
2 . Explain (i) u sing an appropriate d iagram why price rigid ity
is typical in oligopolistic markets, as well as (ii) why
non-price competition is u su ally employed by su ch f rm s.
3. U sing an appropriate d iagram , compare and contrast the
equ ilibriu m positions o a prof t maxim izing m onopoly f rm
and a revenu e maxim izing m onopoly f rm .
4. Draw a d iagram to illu strate 3 rd d egree price
d iscrim ination in airlines, explaining when the prices
charg ed in th e two markets you chose will d ier m ore.
5. Explain, u sing appropriate d iagram (s), why, d espite the
absence o su pernormal prof ts in a m onopolistically
competitive market, f rm s achieve neith er allocative
ef ciency, nor prod u ctive ef ciency.
6. Explain u sing an exam ple why f rm s will ch oose to operate
in the lon g ru n d espite earnin g zero econom ic prof ts.
7. Careu lly d ef ne the long-ru n average total cost cu rve o
f rm s and explain, u sing a d iagram , the reason or its
typical shape.
8. U sing appropriate d iagram s, compare and contrast the law
o d im inishing marginal retu rns with the d ecreasing retu rns
to scale.
9. Explain, u sing a d iagram , the shape o the perectly
competitive f rm s average revenu e and marginal reven u e
cu rves and why, in the long ru n, a perectly competitive
f rm will make only normal prof ts
1 0. Explain, u sing a d iagram , why perectly competitive f rm s
will be prod u ctively ef cient in the long ru n, thou g h not
necessarily in the sh ort ru n.
11 . Shou ld governm ents always intervene to control
m onopoly power?
70
1 2 . Contrast ormal/open an d tacit collu sion in oligopolistic
markets.
1 3. Discu ss the view that the greater the nu m ber o f rm s in a
market the better o society is.
1 4. Contrast the sh ort ru n with the long ru n equ ilibriu m
positions o a f rm in a perectly competitive market.
1 5. Compare and contrast th e characteristics o
m onopolistically competitive markets with perectly
com petitive markets.
1 6. Explain why price rigid ity and n on-price competition are
typically encou ntered in oligopolistic markets. U se a
d iagram and examples to illu strate you r answer.
1 7. U sing appropriate d iagram s, com pare and contrast th e
ef ciency ou tcom es in m onopolistic com petition and in
perect com petition.
1 8. U sing appropriate d iagram s, com pare and contrast th e
short-ru n and long ru n equ ilibriu m o a prof t maxim izing
m onopolistically competitive f rm .
1 9. To what extent d o prod u cers and not consu m ers benef t in
oligopolistic markets?
2 0. Exam ine the view that m onopoly is an u nd esirable market
stru ctu re.
21 . Discu ss two possible governm ent responses to problem s
arising rom asym m etric inormation.
2 2 . Discu ss two possible governm ent responses to the abu se o
m onopoly power.
23 . To what extent is greater econom ic ef ciency achieved in
perect com petition compared to m onopoly?
2 4. Explain why cartels are likely to collapse as well as the
cond itions that make su ch a d evelopm ent m ore likely.
2.1 Macroeconomic goals

Macroeconomics examines issues relating to an economy as a whole, such as unemployment,

ination, growth and the balance o payments. This means that the ocus o macroeconomics

S E CTI O N 2 : M ACRO E CO N O M I CS
is on aggregate economic variables. Whereas microeconomics may be interested in explaining
why the price o corn is rising, macroeconom ics investigates why the average price level may
be rising. I n m icroeconom ics, the ocu s may be on how many workers a f rm will employ bu t
macroeconom ics exam ines the total level o employm ent and u nemploym en t in a cou ntry.
I n other word s, in macroeconom ics we zoom ou t o ind ivid u al markets and f rm s and look
at what is going on in the cou ntry.

Generally, governm ents and policy makers aim at ach ieving
the ollowing.
n Satisactory and su stainable real (m eaning non-in ationary)
growth: total ou tpu t and incom e o the cou ntry or economy
shou ld increase at an annu al rate that is consid ered
acceptable. We have to u se cau tion when evalu ating an
economys perormance with respect to growth rates, as
satisactory growth m eans d ieren t things to d ierent
econom ies at d ierent tim es. I n general, or ad vanced
econom ies, satisactory growth is taken to m ean between
3% and 5 %. Anything less than 3% is typically
characterized as weak growth and anything exceed ing 5 %
is potentially in ationary. For d eveloping econom ies the
range is between 5 % and 1 0% or the sam e reasons. I n
ad d ition, this increase in total ou tpu t shou ld be su stainable
(that is, it shou ld not com e at a heavy environm ental cost).
The central id ea o trad e-os in econom ics shou ld alread y
be apparent. Faster growth may not only prove in ationary
bu t also u n su stainable in term s o the accompanying
environm ental d egrad ation.
n Price stability (which implies low in ation and no d e ation):
or reasons that will becom e clear later, prices on the
average (o good s and services bu t also o assets) shou ld
not increase throu gh tim e too ast. When prices on the
average increase rom one year to the next we say that
there is in ation. Bu t prices on the average shou ld not
d ecrease either as the costs and risks o alling prices
(d e ation) are also u nacceptable. Price stability is u su ally
consid ered to have been achieved i the in ation rate is
between 1 .5 % to 3 % annu ally as the m easu rem ent o
in ation carries the risk o overestimating the tru e rate and
near zero rates o in ation may actu ally be hid in g the
initial stages o d e ation.
n H igh levels o employm ent (low u nemploym ent): ensu ring
that whoever is searching or a job is able to f nd one is
historically consid ered one o the m ost important objectives
o governm en ts. Given that resou rces are scarce, it becom es
clear what a terrible waste u nemploym ent implies.
Unem ploym ent is also responsible or high hu man and
social costs, over and above the associated econom ic costs
it entails. I t is clear that aim ing or zero u nem ploym ent is
u nrealistic in a d ynam ic economy, one that is constantly
changing. Bu t what is consid ered as an acceptable rate o
u nemploym ent d iers rom cou ntry to cou ntry and rom
period to period . As a very rou gh ru le, keep a 5 %
benchmark rate in m ind , rem em bering thou gh that su ch a
rate may be consid ered u n acceptably high or certain
cou ntries and u nrealistically low or others.
n Long-run equilibrium in the balance o payments: the balance
o payments relates to the transactions o a country with the
rest o the world (exports, imports as well as investments to
and rom other countries) and by long-run equilibrium it is
meant that the oreign sector should not impose a constraint
on the countrys ability to achieve the three domestic policy
objectives explained above. This goal is difcult to understand
even on an intuitive basis at this point but the basic idea is
that a country should be in a position to pay or its imports by
maintaining a sufciently competitive export basis.
n Equ itable (m ean ing air) d istribu tion o incom e: it may be
clear that equ itable d oes not m ean equ al bu t its precise
m eaning is elu sive and su bject to interpretation. I the
d istribu tion o incom e is not consid ered by the people
them selves as air then the process is not su stainable. On
the other hand , i the ru its o econom ic growth are enjoyed
by m ore than a ew people, then there are benef ts that
may even help to accelerate the process.
To achieve:
1 Satisfactory and sustainable real growth
2 Low levels of unemployment
Macroeconomic 3 Price stability
goals 4 Long-run equilibrium in the balance of
payments
5 An equitable distribution of income

The level of overall economic activity

The circular fow o income model
The circu lar ow m od el is a simplif ed representation o how
the basic d ecision-making u nits o an economy (hou sehold s,
f rm s, the governm ent and , in an open economy, the oreign
sector) interact. I t d escribes the ows between these u nits.
These ows can be real ( ows o actors o prod u ction, ows o
good s and services) or m onetary ( ows o expend itu res on
good s and services, ows o incom es generated in the
prod u ction process).
At the m ost basic level, where only hou sehold s and f rm s exist,
it is u n d erstood that hou sehold s own all actors o prod u ction
which they oer to f rm s. Firm s u se these actors o prod u ction

71
 2 Macroeconomics
to prod u ce good s and services which they oer back to
hou sehold s. These ows are real ows and are illu strated below
in Figu re 2 .1 .1 .
H ou sehold s
Flow of
Flow of
goods/services
factors
(ou tpu t ow)
Firm s
Figure 2.1.1
I n exchange or the u se o these actors o prod u ction f rm s
oer paym ents to hou sehold s in the orm o wages, rents,
interest and prof ts, the su m o which is d ef ned as incom e. So,
in the opposite d irection o the real ow o actors there is a
m onetary ow o actor paym ents, or o incom e. Th is is reerred
to as the incom e ow. Equ ivalently, in the opposite d irection o
the real ow o good s and services rom f rm s to hou sehold s
there is a m onetary ow o expend itu res rom hou sehold s to
f rm s or the good s and services enjoyed .
H o u seh o l d s
Fl ow of Fl ow of
fa ctor pa ym en ts exp en d i tu res
(i n co m e ow) (exp en d i tu re ow)
Fi rm s
Figure 2.1.2
Th e ows d escribed above m u st be equ al. All the incom e
generated in the prod u ction process is spent on the ou tpu t
prod u ced , so the incom e ow is equ al to the expend itu re ow
which is equ al to the ou tpu t ow.
I a tim e d im ension is ad d ed then the issu e becom es slig htly
m ore complicated , bu t still manageable. I there is a next
period then part o the incom e generated may be saved (a
withdrawal or leakage rom this circu lar ow system ) wh ile not
only hou sehold s spend on d om estic ou tpu t bu t also f rm s
spend on capital g ood s (that is, investm ent spend ing occu rs).
Measures of economic activity
Gross domestic product (GDP) and gross
national income (GNI)
GDP is perhaps the single m ost importan t macroeconom ic
variable and it is d ef ned as the valu e o all f nal good s and
services prod u ced within an economy over a certain period o
72
This latter expend itu re is an injection to the circu lar ow
system . Where this injection com e rom ? The answer is that
banks or f nancial interm ed iaries attract savings and then lend
f rm s the u nd s they need to f nance their investm ents.
I t ollows that the ow in this system will neither increase nor
d ecrease i injections are equ al to withdrawals. I n this
simplif ed version o an economy, withou t governm ent and
withou t a oreign sector, the equ ilibriu m cond ition or national
incom e (Y) becom es:
I5 S
I a governm ent is ad d ed then injections into the circu lar ow
will also inclu d e governm ent expend itu res (G) on d om estically
prod u ced ou tpu t. Dom estic ou tpu t in this m od el can be bou ght
by hou sehold s and f rm s as well as the governm ent. On th e
other hand , part o the incom e generated in this economy may
not be spent as it leaks ou t o the circu lar ow o incom e in the
orm o taxes (T).
The equ ilibriu m cond ition becom es:
I1 G5 S1 T
Lastly, i we make this m od el m ore realistic and ad d a oreign
sector then we have one m ore sou rce o expend itu res on
d om estic ou tpu t, nam ely the expend itu res oreigners make on
it. N ow, not only d o d om estic hou sehold s, f rm s and the
governm ent spend on d om estic ou tpu t bu t also oreigners.
These expend itu res oreigners make on d om estic ou tpu t
constitu te the export revenu es (X) o th e economy and they are
an injection to its circu lar ow system . On the other hand , part
o the incom e generated in this economy may now be spent on
oreign ou tpu t. This spend ing represents ou r imports (M) and is
a leakage (a withdrawal) to the circu lar ow.
The equ ilibriu m cond ition becom es:
X1 I1 G5 M1 S1 T
A sim plif ed representation o the circu lar ow is also illu strated
in Figu re 2 .1 .3.
H o u seh o l d s Sa vi n g s (S)
Ta xes (T)
I m p o rts (M )
H o u seh o l d sp en d i n g
I n co m e
o n d o m esti c o u tp u t
I n vestm en t (I )
G overn m en t exp en d i tu re (G )
E xp o rts (X)
Fi rm s
Figure 2.1.3
tim e, u su ally a year or a qu arter (by actors o prod u ction
resid ing in the cou ntry). Rem em ber the ollowing points.
Only f nal good s and services are inclu d ed . I nterm ed iate good s
(good s u sed in the prod u ction o other good s) are not inclu d ed .
Alternatively, in stead o trying to work ou t which good s are

f nal, inclu d e the valu e-ad d ed contribu ted by each f rm in the
cou ntry, where the valu e ad d ed is d ef ned as the d ierence
between the total revenu es collected by each f rm and the cost
o raw materials, services and components the f rm pu rchased
to prod u ce the good or service. I all prod u ced good s and
services were inclu d ed , d ou ble-cou nting wou ld resu lt and
thereore overestimation o the tru e valu e o ou tpu t.
M easu rem ent o th e GDP o an economy d oes not in clu d e
transactions involving u sed good s, f nancial transactions or
transer paym ents as these d o not represent contribu tions to
cu rrent prod u ction o good s and services.
GDP
The output, expenditure and income approaches
There are three conceptu ally equ ivalent ways o arriving at th e
GDP f gu re or a cou ntry. These are:
n the ou tpu t m ethod , where we ad d all d om estically
prod u ced f nal good s and services
n the expend itu re m ethod , where we ad d all expend itu res
mad e on d om estically prod u ced f nal g ood s and services
n the incom e m ethod , where we ad d all incom es generated in
the d om estic prod u ction process.
Conceptu ally, the three m ethod s are equ ivalent, and with som e
m in or ad ju stm ents the f gu res arrived at throu gh each m ethod
are equ al. Th e valu e o all ou tpu t prod u ced d oes not becom e
thin air bu t end s u p in pockets in the orm o wages, prof ts,
interest or rent (that is, as incom e to th e actors o prod u ction
involved ). This incom e is then spent on ou tpu t.
Each m ethod is u seu l becau se o the breakd own it perm its.
The ou tpu t m ethod , or example, will give u s the share o total
ou tpu t accou nted or by each o the three sectors o an
economy as well as the ou tpu t o d ieren t ind u stries:
output method: primary sector 1 secondary sector
1 tertiary sector, or
industry 1 1 industry 2 1 industry 3 1 1 industry n
The expend itu re m ethod perm its u s to m onitor the level o
investm ent spend ing throu gh tim e or the proportion o
governm ent expend itu res in total econom ic activity:
expenditure method: spending by households 1 spending by
frms 1 spending by the government
1 net spending by oreigners, or
consumption 1 investment 1 government expenditures
1 net exports
The income m ethod provides inormation about the proportion o
total income earned by labour in contrast to owners o capital:
income method: wages 1 profts 1 interest 1 rents
Nominal GDP versus real GDP
N ote that even thou gh we are tru ly interested in an ou tpu t
m easu re, we are orced to ad d valu es (prices tim es qu antities)
which makes ou r GDP m easu re d epend ent not only on ou tpu t
changes (in which we are interested ) bu t also on price changes
(which typically d o not interest u s).
Comparison o GDP f gu res in su ccessive years thereore
becom es a problem since, assu m ing that an increase in GDP is
record ed , we cannot know whether the bigger f gu re is d u e to
2 Macroeconomics
an increase in ou tpu t o good s and services prod u ced or
whether it is d u e to an increase in prices (an increase in the
general or average price level; that is, d u e to in ation). I n other
word s, we cannot know to what extent the increase in the
nom inal (or m oney) GDP f gu re record ed is real an d to what
extent it is in ationary. For exam ple, i GDP m easu red at
cu rrent prices increased rom one year to th e next by 5.5 %, it
cannot be known what proportion o this increase is d u e to an
ou tpu t increase and what proportion is d u e to in ation. I t cou ld
be, or exam ple, that ou tpu t increased by, say, 4% (that is, real
GDP increased by 4%) and that the remainin g 1 .5 % was d u e to
price level increases (that is, to in ation), or it cou ld be that
ou tpu t increased only by 0.5 % and prices by 5.0%.
So, nom inal GDP (m oney GDP or GDP at cu rrent prices) is a
m easu re o ou tpu t o a certain period valu ed at the prices
prevailing in that sam e period .
Real GDP (or GDP at constant prices) is a m easu re o ou tpu t o
a certain year (say, year t) valu ed at the prices prevailing at
som e reerence period (known as the base period or base year).
So, the ou tpu t o each good in year t is m u ltiplied by its price
that prevailed in the base year chosen.
Real GDP is thereore a m easu re o ou tpu t ater having isolated
(or ad ju sted or) the eect o in ation. Real GDP f gu res re ect
the volu m e o prod u ction, not the valu e.
Def ne the GDP d e ator as the ratio o nom inal GDP to real
GDP o a year tim es 1 00:
nominal GDP
GDP deator 5 ___________ 3 1 00
real GDP
By manipu lating the above we arrive at:
nominal GDP
real GDP 5 ___________ 3 1 00
GDP deator
The GDP d e ator is a com prehensive price ind ex which
m easu res the average level o prices o all good s and services
inclu d ed in the GDP o a country.
GN I
A variation o the measure o output given by GDP is given by
GN I. GDP ocuses on what is produced within the boundaries o
an economy independently o the nationality o the actors o
production involved. In contrast, GN I ocuses on the nationality o
the actors o production involved and the incomes they earn
independently o their geographic location. The major dierence
between the two is a result o the operation o multinational
corporations. Lets take two countries, Greece and France. Assume
that in Greece the French bank BN P operates, while in France the
Greek yogurt and ice cream manuacturer DELTA operates.
Focusing on Greece:
GN I 5 GDP 1 DELTA 2 BN P or, m ore generally,
GN I 5 GDP 1 (actor income earned abroad 2 actor
income paid abroad)
where actor income earned abroad reers to the profts o the
Greek frm in France and actor income paid abroad reers to the
profts the French bank earns in Greece. O course, actor income
includes not just profts but also wages, interest and rent.
Per capita fgures
By d ivid ing GDP or GN I by the popu lation o a cou ntry we
arrive at per capita GDP and per capita GN I respectively.
73
 2 Macroeconomics
Per capita f gu res scale the variable or cou ntry size, making
com parisons between cou ntries m eaningu l.
Problems in GDP measurement
GDP m easu rem en t is rau ght with problem s. Of cial GDP
f gu res in many cou ntries u nd erstate the tru e level o econom ic
activity becau se o the existence o a large parallel (black or
shad ow) economy. I nd ivid u als in many cou ntries u nd er-report
their incom es to avoid taxation. A heavy tax bu rd en, especially
high marginal (top) tax rates may be responsible or this
tax-evad ing behaviou r. Som e prod u ctive activity may also be
illegal per se (involvem ent with dru gs, prostitu tion , etc.).
Fu rtherm ore, d o it you rsel activities are not inclu d ed . I
I repair my car instead o taking it to the m echanic, the valu e o
the service I produ ce will not show up in of cial statistics. This
becom es an important issue in the case o many d eveloping
cou ntries becau se su bsistence arm ing (d ef ned as arm ing to
eed ones am ily) is not inclu ded in GDP m easu rem ents and
this leads to und erestimation o per capita incom e levels. Lastly,
data collection in many countries is poor and u nreliable.
Comparisons over time and across countries using national
incom e statistics
For m eaningu l comparisons over tim e it is im portant that the
eect o chan ging price levels is isolated . Real GDP or GN I
m u st be u sed . I n ad d ition, i we are not ju st interested in the
size o an economy then it is ad visable to u se per capita f gu res.
Con version o n ational incom e f gu res to a com m on cu rrency,
u su ally the U S d ollar, shou ld also be mad e u sing pu rchasing
power parity (PPP) d ollars and not market exchange rates.
PPP d ollars in corporate cost o living d ieren ces, making
cross-cou ntry com parisons o th ese variables m ore m eaningu l.
Living standards and GDP/GN I statistics
Per capita GDP or GN I statistics are oten u sed to make
inerences abou t the living stand ard s o a cou ntry. Despite
being a u seu l su m mary m easu re o material welare o the
popu lation o a cou ntry, this m ethod su ers rom major
d ef ciencies and sh ou ld be employed with extra care. The
ollowing is a list o the associated problem s.
n This m ethod ails to incorporate incom e d istribu tion
consid erations. Per capita incom e is a simple average that
provid es no inormation on whether incom e is equ itably or
very u nequ ally d istribu ted .
n I t ails to valu e the environm ental d egrad ation oten
associated with increased prod u ction. Green GDP is an
attem pt to correct this problem as it actors in the
d etrim ental eect o prod u ction on the environm ent. Green
GDP is estimated by su btracting rom GDP the cost o
natu ral resou rce and environm ental d epletion.
n I t ails to inclu d e non-marketed su bsistence prod u ction
which may be relatively signif cant in som e low-incom e
cou ntries. N on-marketed su bsistence prod u ction reers to
ood and other good s and services prod u ced by a am ily or
its own con su mption. M ore generally, it ails to inclu d e the
size o parallel (black or shad ow) econom ies in d eveloping
(and d eveloped ) cou ntries.
n I t ails to reveal the composition o ou tpu t. Two econom ies
with equ al per capita incom e levels may d ier with respect
to living stand ard s becau se o d ierent ou tpu t m ix. A
cou ntry that d evotes a large proportion o its GDP to, say,
74
d eence, sacrif ces resou rces in this area that cou ld
oth erwise have been u sed in the prod u ction o pro-
d evelopm ent good s.
n I t ails to inclu d e the valu e o leisu re, a m ost important
good an ind ivid u al may enjoy. I t makes a big d ierence to
workers i their average workin g week is over 5 0 hou rs and
they can seld om take tim e o, or i the workin g week is
only 35 hou rs.
n I t ails to incorporate the valu e o the stream o services
owing rom the accu m u lated social an d other capital o
an econ omy. Living stand ard s at any point in tim e are
aected not ju st by cu rrent incom e bu t also by the stock o
accu m u lated wealth. For example, the existence o a
high-qu ality and ree pu blic school system implies that
hou sehold s with children may d evote m ore o their incom e
to other good s and services.
The trade (or business) cycle
The trad e or bu siness cycle is d ef ned as the short-term
u ctu ations o real GDP arou nd its long-term trend . Period s o
expansion (boom s) are ollowed by period s o contraction
(recession or bu sts). The d owntu rns major characteristic is
increasing levels o u nemploym ent. I , on the other hand ,
expansion is too rapid it may give rise to in ationary pressu res.
I d eally, stead y, su stainable, non-in ationary long-term growth
is d esirable.
Real GDP
peak
The trend line:
long-term average
annual growth
peak
(potential output)
recession recovery boom
trough
t1 t2 t3
Time
Figure 2.1.4 The trade (or business) cycle
The economy depicted in Figure 2 .1 .4 is a growing economy.
Growth exists when total output, m easured by real GDP, increases
through tim e. It ollows that this economy is growing between
tim e period t2 and t3 but also over the long term as the trend
line is upward sloping. The trend line is equal to the average
annual long-term growth o the economy and is considered to
reect the potential output o the economy. When the economy
is at its potential output we say that there is ull employm ent.
Full employm ent does not m ean that everyone who is looking or
a job has one. In a dynam ic economy, one that continuously
transorm s, this is not possible. Instead, ull employm ent
incorporates what econom ists reer to as natural unemploym ent.
Natural unemployment is usually defned as the unemploym ent
that exists when the labour market is in equilibrium and includes
people in between jobs, people who lack the necessary skills and
are training or re-training, people who are relocating, etc.
 2 Macroeconomics

I n figu re 2 .1 .4, between tim e t1 and t2 the econom y is in
recession. Real GDP is d ecreasing (technically, for at least two
consecu tive qu arters), so the economy is registering negative
growth rates. At t1 it was at a peak (as well as at t3). At t2 it is
at a trou gh and it is abou t to enter recovery.
N ote that if th e growth rate is d ecrea sin g (from , say, 2 .1 % to
0.8%) rea l GDP con tin u es to in crea se bu t at a slower a n d
slower rate. Va riou s expressi on s a re u sed to d escribe th is
pha se, for exam ple th e econ om y i s l osin g steam , it is
pea kin g ou t or i t i s a pproa ch in g recessi on . An econ om y
a bou t to en ter recession is, i n Fi g u re 2 .1 .4, som ewh ere rig h t
before a pea k.
If actual output is greater than potential output then
unemploym ent must be lower than the natural rate.
If actual output falls short of potential output then
unemployment is greater than the natural rate.
When actual output is not equal to potential output an
output gap is present.
Make sure that ater you fnish drawing the trade cycle there
TIP
is only one level o real GDP corresponding to each time
period t. A common error is to draw it in such a way that at
each point t on the horizontal axis there are more than one
corresponding levels o real GDP.

A time line of macroeconomics

n The d istinction between macroeconom ics and
m icroeconom ics d id not always exist. I n fact, it is relatively
new and started to be wid ely recognized only after the
Second World War as a resu lt of the pu blication in 1 936 of
the General Theory of Employment, Interest and Money by
John M aynard Keynes, who transform ed th e theoretical
lan d scape of econom ics.
n The tim e line below serves as a very broad gu id e to the
evolu tion of id eas in macroeconom ics and policy making.

Time line

1 870 1 929 1 936 1 970 1 980 1 990 1 997 2007

Pre-1 929: The Classical School of thought:

Laissez-faire, laissez-passer. Market forces
guarantee that an economy will rest at, or
close, full employment. There is no need for
the government to intervene. (Non-activists)

Keynes' General Theory is published in 1 936. There is no

guarantee that a market economy will rest at full employment
so there is an active role for the government. Through scal
policy the government can stabilize the economy and achieve
full employment. Keynesian interventionist ideas reign after
the Second World War until the mid 1 970s. (Activists)

In the 1 970s, monetarism emerges at the University of

Chicago with Nobel prize laureate Milton Friedman being the
most widely known advocate of monetarist ideas. Monetarists
slowly deconstructed the Keynesian edice, initially doubting
the effectiveness of scal policy and later suggesting that even
monetary policy should be avoided. Markets rule.

In the 1 980s the rational expectations school (new classical)

approach emerges through the work of Lucas, Sargent and
others; the supply side is emphasized. The role of the government
is further questioned and reliance on market forces is further
emphasized.

The East Asian crisis, 1 9971 998, cast doubts on extreme

pro-market policies and on the Washington Consensus.
Many speak of the necessity to manage globalization.
Inequalities within and between countries are rising.

The nancial and economic crisis

that began in 2007 brings back
Keynesian interventionist policies.
The state of macroeconomics is
questioned. Saltwater and
freshwater economists openly
debate issues.

75
 2.2 Introducing aggregate demand
and aggregate supply
Aggregate demand
Ag gregate d ema n d (AD) is a term that reers to total spen d in g
on d om estic g ood s a n d services per period o tim e. M ore
precisely, AD is d ef n ed a s th e pla n n ed level o spen d in g on
d om estic ou tpu t at d ieren t avera g e price levels per period
o tim e.
Spend ing on ou tpu t ca n orig in ate eith er rom th e private
sector (wh ich in clu d es h ou seh old s a n d f rm s) or rom th e
pu blic sector (th e govern m en t). Private sector spend ing
in clu d es consu m ption expen d itu res (C) that h ou sehold s ma ke
a n d in vestm en t expen d itu res (I ) that f rm s make. Th e pu blic
sector expen d itu res are u su ally term ed g overn m en t
expend itu res (G) in wh ich both cu rrent an d capital pu blic
spen d in g are in clu d ed .
Spend ing on d om estic ou tpu t can also origin ate rom abroad
as oreigners bu y d om estic good s an d services. These are the
exports (X) o an economy. Since thou gh part o the spend ing
that hou sehold s, f rm s and the governm ent makes is on oreign
good s, we m u st su btract imports (M ) to arrive at AD. So, AD is
given by the relationship:
AD 5 C 1 I 1 G 1 (X 2 M)
AD 5 C 1 I 1 G 1 N X, where N X 5 (X 2 M)
Wh en pl otted a ga i n st th e avera g e pri ce l evel , AD i s
n egati vel y sl oped i l l u strati n g , a s i n Fi g u re 2 .2 .1 , that a t a
h i g h er avera g e pri ce level , pla n n ed spen d i n g on d om esti c
ou tpu t d ecrea ses.
Average price level (P)
N egatively sloped becau se of th e:
wea lth effect
tra d e effect
in terest rate effect
AD = C + I + G + N X
Real ou tcom e/incom e ( Yr)
Figure 2.2.1 The AD curve
The AD cu rve is d ownward sloping bu t n ot or the sam e reasons
that the d emand or a single good is d ownward sloping as on
the vertical axis we have th e average price o all good s and not
o a single good .
AD is negatively sloped because o the wealth eect, the
interest rate eect and the trade eect. H ere are specif c details.
n The wealth eect: i the average price level increases the
real valu e o the m oney that people have in their pockets or
in bank accou nts, as well as the real valu e o other f nancial
assets su ch as bond s, d ecreases. I people eel poorer they
tend to spend less.
76
n The interest rate eect: i the average price level increases
then m ore m oney will be need ed to eectu ate a given level
o transactions. I the su pply o m oney is f xed bu t the
d emand or m oney increases then interest rates will
increase, which d ecreases both consu mption and
investm ent expend itu res as people an d f rm s borrow to
pu rchase d u rables and capital good s respectively.
n The trade eect: i the average price level increases then exports
become less competitive abroad while imports seem more
attractive at home so net exports, a component o AD, decrease.
As in all d iagram s, the u nction will not shit when a variable
on either o the axes changes. So, i there is a chan ge in th e
average price level there will be no shit in the AD cu rve bu t
on ly a m ovem ent along it. Changes in national incom e cannot
initiate a shit in the cu rve either. AD will shit only i a
non-incom e actor ind u ces a change in any o its components.
Components of AD
Consumption expenditures
Consu mption expend itu res (C) are d ef ned as spend ing by
hou sehold s on d u rables, non-d u rables and services per period
o tim e. Consu mption expend itu res d epend on the level o
interest rates (I R), on the d egree o consu m er conf d ence (CC),
on the level o hou sehold wealth (W), on personal incom e taxes
(PIT), on hou sehold ind ebted ness (H D) etc.
C 5 f (IR, CC, W, PIT, H D, ...)
The above simply states that consu mption expend itu res are a
u n ction o (that is, d epend on) the variables listed insid e the
parentheses.
More specif c d etails are as ollows.
n Interest rates (IR): the interest rate can be simply defned as
the price paid per period or borrowing money on a
percentage basis. I interest rates, or example, increase, then
consumption expenditures are expected to decrease, shiting
AD to the let or three reasons. First, borrowing to fnance
the purchase o consumer durables such as cars, appliances
and urniture will becom e m ore expensive so households will
tend to cut down on such purchases. N ote that the housing
market will also be negatively aected as it will becom e m ore
expensive to fnance the purchase or construction o a house,
but technically this expenditure is classifed under
investm ent. Second, higher interest rates make saving m ore
attractive (saving is defned as incom e not spent). I people
tend to save m ore then it automatically implies that they will
tend to spend less. Lastly, the single largest expenditure o a
typical household is the purchase o its house. H ouseholds
borrow rom banks to fnance this purchase through
specialized very long-term loans known as m ortgages. The
interest rate charged on such loans is oten adjustable,
m eaning that i market interest rates increase, mortgage
rates will also increase and so will the m onthly payments.
People who bought houses in the past with a m ortgage and
still owe m oney will thereore have less m oney available every

m onth to spend on goods and services, as they will need to
pay a higher m onthly mortgage payment to the bank. I, or
example, a amily m ust pay the bank $ 55 0.00 per m onth
instead o $ 5 00.00 then in a year it will have $ 600.00 less
available to spend on goods and services.
n Consu m er conf d ence (CC): hou sehold s eeling secu re and
conf d ent abou t their u tu re will tend to spend m ore.
A stable and growing economy with low in ation and
u nem ploym ent will boost consu m er conf d ence and
avou rably aect hou sehold spend ing, shiting AD to the
right. On the other hand , u ncertainty over u tu re job
prospects and insecu rity abou t ones u tu re incom e
ad versely aect present consu m ption. Spend ing on d u rable
good s, su ch as cars and appliances, as well as on hou sing,
are greatly aected by consu m er m ood s.
n Wealth (W): the total valu e o a hou sehold s assets may
aect the level o its spend ing. I , or example, wealth
increases, then consu m ption will be positively aected .
A stock market boom or rising property valu es tend to
increase spend ing and lower savings. AD will tend to
increase and shit to the right.
n Personal incom e taxes (PIT): I , or example, the governm ent
increases PIT then d isposable incom e (Yd ), d ef ned as
incom e (Y) less su ch taxes (T) plu s transer paym ents (Tr)
will d ecrease (Yd 5 Y 2 T 1 Tr ). Lower d isposable incom e
as a resu lt o higher PIT will tend to d ecrease consu m ption
expend itu res and so d ecrease AD, shiting it to the let.
n The level o household indebtedness (H D): i private
(household) debt (rom taking out loans and /or rom paying
credit card charges) has accumulated, household spending will
to decline as households will need to pay more and more to
service their debt. This will put a damper on consumption
expenditures and so tend to decrease AD, shiting it to the let.
Investm ent expenditures
I nvestm ent expend itu res (I ) are d ef ned as spend ing by f rm s on
capital g ood s per period o tim e. I nvestm ent increases the stock
o capital o an economy. I nvestm ent is important both becau se
o its short-ru n in u ence on AD and becau se in the long ru n it
aects aggregate su pply (AS) and so the rate o (actu al and
potential) growth o an economy. I nvestm ent spend ing is the
m ost volatile component o AD. I nvestm ent expend itu res
d epend on the level o interest rates (I R), on the d egree o
bu siness conf d ence (BC), on technology (T), on bu siness taxes
(BT), on corporate ind ebted ness (CD), etc.
I 5 f (IR, BC, T, BT, CD, ...)
The above simply states that investm ent expend itu res are a
u nction o (that is, they d epend on) the variables listed insid e
the parentheses.
Again, m ore specif c d etails ollow.
n I nterest rates (I R): i interest rates increase, then investm ent
expend itu res by bu sinesses are expected to d ecrease,
shiting AD to the let. Borrowing to f nance the pu rchase
o capital good s su ch as machines, tools, equ ipm en t and
actories will becom e m ore expensive so f rm s will f nd that
ewer possible investm ent projects are now prof table. Even
i a f rm u ses its own u nd s to f nance an investm ent
project, the opportu n ity cost o u sing these u nd s instead o
keeping them tied in banks or as bond s increases.
2 Macroeconomics
n Bu siness conf d ence (BC): the greater the d egree o
bu siness conf d ence in an econom y, the m ore willing f rm s
will be to invest and expand . Econom ic and political
stability are necessary or a positive bu siness climate to
evolve and so or in vestm ents to take place. Keynes
consid ered the behaviou r o entrepreneu rs with respect to
private investm en t d ecisions sim ilar to that o a herd
(im itation ) and , in his opinion, the observed instability o
investm ents was d u e to these animal spirits. Expectations
can be greatly chang ed by many u npred ictable actors,
lead ing to swings in the prevailing bu siness climate and so
to changes in the level o investm ent spend ing.
n Technology (T): ind u stries and sectors where technology
ad vances at a rapid rate will register higher rates o
investm ent spend ing. Firm s in su ch ind u stries will be orced
to u nd ertake su ch spend ing in ord er to remain ahead or
keep u p with rivals.
n Bu siness taxes (BT): changes in bu siness taxes aect the
expected prof tability o an investm ent project. An increase
in bu siness taxes will m ean that ewer investm ent projects
pass the prof tability test and this will tend to d ampen
investm ent and , consequ en tly, d ecrease AD.
n Corporate ind ebted ness (CD): companies that are highly
ind ebted will be very hesitant to take on m ore d ebt in ord er
to make m ore investm ents.
I n add ition to the above actors, th e ollowing are also thou ght
to aect investm ent spend ing in an econom y and so AD.
n Public policy toward investm ent: governm ents oten attempt
to inuence investm ent by oering tax incentives to frm s,
subsidies, preerential loan term s, protection rom oreign
competition, etc. N ote that the size itsel o the public sector
in an economy may inuence the growth o private
investm ent. Also rem em ber that institutions aect private
investm ents. A large bureaucracy (or red tape) and
complicated regulations will burden the operation o frms in
a country and negatively aect the rate o investm ent.
Investm ent levels are, ceteris paribus, higher in countries with
low levels o bureaucracy and with transparent econom ic and
business environm ents. Lastly, corruption adversely aects
investm ent, especially oreign direct investm ent (investm ent
by m ultinational corporations in oreign countries).
n The overall macroeconom ic environm ent: a sou nd
macroeconom ic en vironm ent where policy makers ensu re
low in ation, low bu d get d ef cits, a su stainable pu blic d ebt
an d exible labou r markets u su ally lead s to higher rates o
investm ent spend ing. A sou nd macroeconom ic environm ent
lead s to h igher conf d ence level or bu sinesses.
n I ncom e and its growth : rising incom e lead s to rising
consu mption, which may in d u ce m ore investm ents as f rm s
may be orced to increase their capacity to m eet th e
increased d emand or good s and services.
Government spending
Governm ent spend ing (G) is in many econom ies a large part o
total spend in g on g ood s and services. Governm ent spend ing is
d istingu ished in to current spend ing on good s and services,
capital (pu blic investm ent) spend ing which reers to spend ing
on road s, ports, telecom m u nications, schools and other
inrastru ctu re and also on transfer payments which basically
77
 2 Macroeconomics
reer to pension s and u nemploym ent benef ts. N ote that
transer paym ents are not inclu d ed in national incom e since
they d o not represent reward s to cu rrent prod u ctive eort.
Governm ents spend to ensu re that ad equ ate am ou nts o pu blic
and m erit good s and services are consu m ed , su ch as national
d eence, ed u cational services and health-care services. They
spend to reg u late markets in their attem pt to gu arantee
prod u ct saety, environm ental stand ard s, competitive
cond ition s, etc. They may also spend to red istribu te incom e so
that a socially acceptable m inim u m is gu aranteed . Su ch
spend ing inclu d es u nd ing state pensions, u nemploym ent
benef ts, su bsid ies, d isability benef ts, or example. Lastly,
governm ents spend to aect AD. An increase or d ecrease in
governm ent expend itu res will cau se AD to increase or d ecrease,
shiting to the right or to the let. This is part o what is known
as f scal policy. We may thereore conclu d e that econom ic and
political priorities aect the level o governm ent spend ing .
N et exports
N et exports (N X or X2 M ) a re d ef n ed a s th e d ieren ce
between spen d in g by oreig n ers on d om estic ou tpu t m in u s
d om estic spen d in g on oreig n ou tpu t or, m ore sim ply, a s th e
d ieren ce between export reven u es an d im port expen d itu res
per period o tim e. N et exports d epen d on oreig n in com e (Y ),
th e exchan g e rate (ER ), th e level o tra d e protection or o
com m ercial policy (CP ) etc.
N X 5 f (Yf , ER, CP, ..)
The above sim ply states that net exports are a u nction o (that
is, d epend on) the variables listed insid e the parentheses.
A m ore specif c explanation ollows.
n Foreign incom e (Y ): i, or example, incom e enjoyed by
oreign trading partners increases, their level o consumption
will increase. Part o their increased spend ing will be on
imports. But their imports are our exports. It ollows that the
exports o an economy will tend to increase i the incom e o
its trading partners increases and vice versa.
Consumption expenditures will tend to increase if:
Investm ent expenditures will tend to increase if:
Government expenditures will tend to increase if:
N et exports will tend to increase if:
78
n Exchange rate (ER ): the exchange rate o a cu rrency is its
price expressed in term s o a oreign cu rrency. I , or
exam ple, the exchange rate d ecreases (d epreciates or
d evalu es) then exports becom e ch eaper an d so m ore
competitive abroad while im ports becom e pricier and less
attractive d om estically. As a resu lt, net exports are expected
to increase, shitin g AD to the right.
n Trade protection or changes in commercial policy (CP ): trade
protection or commercial policy reers to any policy that
governments may implement to discriminate against oreign
suppliers. I, or example, trading partners lit trade barriers (or
example i they decrease taris, which are taxes on imports; or
eliminate quotas, which are quantitative restrictions on
imports) then exports will increase and so will AD.
So, i any o these actors change in the d escribed d irection, AD
will ten d to increase and shit to the right. Rem em ber thou g h
that there is no a priori gu arantee that the expected change
will be signif cant or that it will even materialize, as each
component o AD is aected by many variables. So, i, or
example, interest rates d ecrease, we expect that consu mption
expend itu res will be positively aected bu t we cannot be
certain that this will ind eed happen, as perhaps the d ecrease in
interest rates is too small or hou sehold s happen to be very
pessim istic or highly ind ebted . This is why we qu aliy ou r
conclu sion stating that consu mption will tend to increase.
Draw the AD either as a straight line or slightly curved. It is
TIP
easiest, though, to draw it with a ruler. Make sure you label
the axes properly. The vertical is not price but the average
price level as it shows AD and not demand or one good or a
service. The horizontal is oten denoted as Q. This should be
avoided as again it may lead to conusion. GDP should also be
avoided as GDP reers to the actual output produced and not to
planned output. Real output/income and Yr are oten
considered an appropriate choice. Remember that output and
income are conceptually identical terms.
interest rates decrease
consumer confdence increases
wealth increases
personal income taxes decrease
household indebtedness decreases
interest rates decrease
business confdence increases
technology rapidly advances
business taxes decrease
corporate indebtedness decreases
economic priorities change and dictate this
political priorities change and dictate this
oreign income levels increase
the exchange rate decreases
the level o trade protection aced decreases

Aggregate supply
Aggregate su pply (AS) is d ef ned as the planned level o ou tpu t
that d om estic f rm s are willin g to oer at d ierent average
price levels per period o tim e. The shape o the AS cu rve is
rather controversial in macroeconom ics as it re ects the
d ierent assu m ptions u sed by d ierent schools o thou ght.
We will initially discuss what is known as the short-run aggregate
supply (SRAS) curve. The m onetarist or new classical m odel will
ollow and, lastly, we will present the Keynesian m odel.
SRAS
The short ru n is d ef ned in econom ics as the tim e period d u ring
which not all ad ju stm ents have taken place. Within the
ram ework o an AS analysis this is taken to reer to f xed
m oney wages: m oney (or nom inal) wages are assu m ed f xed
over the short ru n and u nable to ad ju st to changes in the
average price level. Why? Two explanations may be oered . The
f rst rests on labou r contracts wh ich f x wages or relatively long
period s o tim e. The second explanation rests on the id ea that
workers are slow to ad ju st th eir expectations o in ation (o a
risin g average price level) and only ater som e tim e d o they
realize that rising prices have aected their pu rchasing power.
Average price level (P)
SRAS
B m oney wages will have ad ju sted and matched the increase in
P2
Money wages are
A
P1 assumed xed in the
short run
0 Y1 Y2
Real outcome/income (Yr)
Figure 2.2.2 SRAS curve
Figu re 2 .2 .2 illu strates a typical SRAS cu rve. I t is u pward
sloping becau se i the average price level rises rom P1 to P2
while m oney wages remain f xed , then f rm s enjoy greater
prof tability which ind u ces them to oer m ore ou tpu t.
Rem em ber that the real wage is the ratio o the m oney wage
d ivid ed by th e average price level so i the latter is rising while
the orm er is constant then the real wage is d ecreasing. There is
a m ovem ent along the SRAS cu rve rom point A to point B
re ecting the d irect (positive) relationship that exists in the
short ru n between the price level an d real ou tpu t.
SRAS will shit to the let or to the right i resou rce prices and ,
m ore specif cally, nom inal wages change, as well as i bu sin ess
taxes or su bsid ies chang e. I n general, across the board changes
in prod u ction costs will tend to shit the SRAS cu rve o an
economy. For example, assu m e that m oney wages increase. The
SRAS cu rve will shit to the let as prod u ction costs or f rm s
will have increased . Or, assu m e that bu siness taxes d ecrease in
2 Macroeconomics
an economy. This is equ ivalent to a d ecrease in prod u ction
costs which will tend to shit the SRAS to the right. N ow
consid er the eect o an increase in th e price o oil. Since oil is
the pred om in ant orm o energy, it will increase prod u ction
costs, shiting the SRAS cu rve to the let.
Lastly, in a principally agricu ltu ral economy, temporary su pply
shocks (su ch as generally poor weather, a d estru ctive hu rricane
or ood s) will have ad verse eects, d ecreasing SRAS and
shiting the cu rve to the let.
Alternative views of AS
The monetarist or new classical AS
Accord ing to the m onetarist or new classical school o thou ght,
an econom y will in the lon g ru n when all ad ju stm ents are
possible and m ore specif cally m oney wages have ad ju sted to
changes in the average price level prod u ce whatever its
resou rces and tech nology allow it to prod u ce. I n the long ru n,
ou tpu t will be at its potential or natu ral level, which is
consid ered the u ll employm ent level o ou tpu t or the
economy. This level o ou tpu t in the long ru n is ind epend ent o
the average level o prices becau se m oney wages are assu m ed
to ad ju st u lly so that the real wage is constant.
Figu re 2 .2 .3 illu strates a m onetarist or new classical long-ru n
aggregate su pply (LRAS) cu rve. I t is drawn vertical to show that
increases in the average price level will not ind u ce any increase
in real ou tpu t in the long ru n. Why? Becau se in th e long ru n,
prices so f rm s prof tability will not have changed .
Average price level (P)
LRAS
Money wages are
assumed to be exible and to
adjust fully to changes in the
average price level
Yf
Real outcome/income (Yr)
Figure 2.2.3 The monetarist or new classical LRAS curve
I t is drawn vertical at the level o potential ou tpu t, Y, to show
that in the long ru n when all ad ju stm ents have been mad e an
economy will prod u ce whatever its resou rces and technology
n ormally allow it to prod u ce. At this level o potential ou tpu t
there is u ll employm ent, bu t that shou ld not be taken to m ean
that there is no u nemploym ent in the economy. At the u ll
em ploym ent level o ou tpu t there is som e u n employm ent,
wh ich is reerred to as natu ral (or normal ) u nemploym ent and ,
as m entioned earlier, is the u nem ploym ent that exists when the
labou r market is in equ ilibriu m .
79
 2 Macroeconomics

The Keynesian version of AS section. Within su ch a set-u p, at u ll employm ent there is som e
Th e Keynesian version o the AS cu rve typically has th ree u nemploym ent, the natu ral or normal rate o u nemploym ent;
d istinct sections, as illu strated in Figu re 2 .2 .4. and ou tpu t can increase beyond that level, im plying that
u nemploym ent may all below that level. I t is perhaps ad visable
Average price level (P)

AS to keep the two m od els separate as their origins and

implications d ier.
I II
Section I I illu strates an u pward sloping AS cu rve. I t d epend s on
the realization that an economy consists o many d ierent
sectors and ind u stries that employ d iering types o resou rces
which d o not reach u ll employm ent cond itions together. Som e
ind u stries may reach u ll em ploym ent earlier than others. Th is
situ ation is reerred to as bottlenecks in prod u ction: spare
I II
capacity may coexist with u ll em ploym ent. Real ou tpu t may
continu e to rise bu t, as a resu lt o the u ll employm ent
cond itions in som e ind u stries, wages and m ore generally
prod u ction costs may also be rising and so will prices.

Shifting AS over the long run

Yf
Real outcome/income (Yr)
Figure 2.2.4 The Keynesian AS curve
Section I is horizontal, im plying that higher levels o ou tpu t can
and will be prod u ced withou t the average price level risin g. The
explanation lies with the realization that the real ou tpu t levels
correspond ing to this region are signif cantly below the u ll
em ploym ent level o real ou tpu t d enoted with Y. Su ch an
economy operates presu mably in d eep recession or d epression-
like cond itions.
Section I I I is vertical at the u ll em ploym ent level o ou tpu t Y.
Th is u ll employm ent level o ou tpu t is typically consid ered
within the Keynesian ram ework o analysis as a wall , im plying
that th ere is no u nemploym ent in the economy. Real ou tpu t
cannot increase beyond Y. I one wishes to inclu d e th e id ea o
natu ral (or normal ) u nemploym ent within this ram ework then
the level o Y m u st be chosen slightly to the let o the vertical
I the LRAS increases and shits to the right it implies that the
u ll employm ent level o real ou tpu t has in creased . I n Figu re
2 .2 .5 the eect o an increase in AS over the long ru n is
illu strated . On the let-han d sid e the m onetarist or new classical
version is d epicted with the LRAS shiting to LRAS. On the
rig h t-han d sid e th e Keynesian version is shown with AS shiting
over the long term to AS.
N ote that, strictly speaking, it is a m istake to reer to long-ru n
Keynesian aggregate su pply as Keynes was not interested in
the long ru n in h is analysis o the workings o an economy. We
show on the right-hand sid e o Figu re 2 .2 .5 an increase in AS
over the long ru n within the Keynesian ram ework.
Which ever approach one chooses to ad opt, the reasons behind
the shit are the sam e. Th ey inclu d e increases in the am ou nt or
the qu ality o the actors o prod u ction available in the
economy and in how ef ciently these are employed , as well as
technological and institu tion al im provem ents.

Monetarist or new classical and Keynesian versions

Average price level (P)

Average price level (P)

LRAS LRAS
AS AS

0 Yf Yf 0 Yf Yf
Real outcome/income (Yr) Real outcome/income (Yr)
Figure 2.2.5 Shiting AS over the long run

80

Equilibrium
Short-run equilibrium
M acroeconom ic equ ilibriu m in the short ru n exists at that level
o real ou tpu t at which AD is equ al to SRAS, as illu strated in
Figu re 2 .2 .6.
Average price level (P)
SRAS
P AD2
AD
0 Ye
Real outcome/income (Yr)
Figure 2.2.6 Short-run equilibrium
Th e eq u i l i bri u m l evel o rea l ou tpu t Ye i s d eterm i n ed a t th e
i n tersecti on o AD wi th SRAS. Th e a vera g e pri ce l evel o th e
econ om y i s a l so d eterm i n ed a t l evel P. I t sh ou l d be cl ea r th a t
a n y sh i t i n AD wi l l i n d u ce a ch a n g e i n th e eq u i l i bri u m
a vera g e pri ce a n d ou tpu t l evel s i n th e sam e d i recti on a s th e
ch a n g e i n AD. For exam pl e, i AD i n crea ses, sa y, a s a resu l t
o l ower i n terest ra tes, th en i t wi l l sh i t to th e ri g h t, l ea d i n g
i n th e sh ort ru n to h i g h er rea l ou tpu t a s wel l a s to a h i g h er
a vera g e pri ce l evel . Sh i ts i n th e SRAS wi l l i n d u ce ch a n g es i n
th e a vera g e pri ce l evel a n d o eq u i l i bri u m ou tpu t th a t a re i n
th e opposi te d i recti on . For exam pl e, i oi l pri ces i n crea se
th en SRAS wi l l d ecrea se, sh i ti n g to th e l et a n d i n d u ci n g a
h i g h er a vera g e pri ce l evel a ccom pa n i ed by l ower eq u i l i bri u m
rea l ou tpu t.
Equilibrium in the monetarist or new
classical model
With i n th e m on eta ri st or n ew cla ssi ca l m od el, eq u il i bri u m in
th e l on g ru n wil l n ecessa ri l y be at th e econ om ys poten ti a l or
u ll em pl oym en t level o ou tpu t, wh il e a ny d evi ation rom th e
poten tia l l evel o ou tpu t ca n on l y exist in th e sh ort ru n a s a
resu lt o th e preva i li n g f xed m on ey wa g es. I t ol l ows that
su ch d eviati on s o sh ort-ru n equ i li briu m rom th e poten tia l
l evel o ou tpu t wil l be tem pora ry a n d th e econ om y wil l a lways
retu rn in th e l on g ru n to th e u ll em pl oym en t level o ou tpu t
a s a resu l t o m on ey wa g es u l ly a d ju sti n g . Fig u re 2 .2 .7
i ll u strates th i s.
2 Macroeconomics
Average price level (P)
LRAS
SRAS2
SRAS1
P2 a2
P a
P1 a1
AD1
0 Yp Y
Real outcome/income (Yr)
Figure 2.2.7 Returning to ull employment ollowing an increase in AD
Assu m e an economy initially in long-ru n equ ilibriu m
d eterm ined at the in tersection o AD1 and SRAS1 on the LRAS
cu rve (point a1 ). Real ou tpu t is at its potential (u ll
em ploym ent) level Yp and the average level o prices is at P1 .
Assu m e now that, or whatever reason, AD increases and the
cu rve shits to the right to AD2 . The average price level will
increase to P and this will ind u ce f rm s to increase real ou tpu t
to Y as m oney wages in the short ru n are f xed , so prof tability
is higher. Short-ru n equ ilibriu m is at point a at the intersection
o AD2 with SRAS1 . Real ou tpu t is above its poten tial (u ll
em ploym ent) level. The economy is characterized by an
infationary gap equ al to the d ierence between the potential
level o ou tpu t and the greater equ ilibriu m level o ou tpu t
YpY9 .
I n the long ru n thou gh, m oney wages within this m od el are
assu m ed to ad ju st u lly and match the increase in prices. I
m oney wages increase to re-establish the original real wage
rate in th e labou r market, then SRAS will d ecrease and the
cu rve will shit to SRAS2 . Rem em ber that an increase in m oney
wages is a actor that shits th e SRAS cu rve to th e let. The real
wage is back to its original level so f rm s will be orced to cu t
back ou tpu t and prod u ce at Yp, the potential (u ll employm ent)
level o ou tpu t. Lon g-ru n equ ilibriu m is re-established with real
ou tpu t at its original u ll em ploym ent level bu t with th e
average price level higher at P2 . The exibility o m oney wages
in the long ru n gu arantee that the economy retu rns to its
normal rate o real ou tpu t.
The sym m etric ad ju stm ent process u nold s with a d ecrease in
AD. M ore specif cally, Fig u re 2 .2 .8 illu strates an economy
initially in long-ru n equ ilibriu m d eterm ined at the intersection
o AD1 and SRAS1 on the LRAS cu rve (point a1 ). Real ou tpu t is
81
 2 Macroeconomics
at its potential (u ll employm ent) level Yp and the average level
o prices is at P1 . Assu m e now that, or whatever reason, AD
d ecreases and th e cu rve shits to the let to AD2 . The average
price level will d ecrease to P and this will ind u ce f rm s to
d ecrease real ou tpu t to Y as m oney wages in the short ru n are
f xed , so prof tability is lower. Short-ru n equ ilibriu m is at poin t a
at the intersection o AD2 with SRAS1 . Real ou tpu t is below its
potential (u ll employm ent) level. The economy is characterized
by a defationary gap equ al to the d ierence between the
potential level o ou tpu t and the lower equ ilibriu m level o
ou tpu t YYp.
Average price level (P)
LRAS
SRAS1
SRAS2
P1 a1
P a
P2 a2
AD1
AD2
0 Y Yp
Real outcom e/incom e (Yr)
Figure 2.2.8 Returning to ull employment ollowing a decrease in AD
I n the long ru n thou g h, m oney wages within the m onetarist or
new classical m od el are assu m ed to be u lly exible. This
m eans that they are assu m ed to ad ju st and match the d ecrease
in prices. I m oney wages d ecrease to re-establish the original
lower real wage rate in the labou r market, then SRAS will
increase and the cu rve will shit to SRAS2 . Rem em ber that an
d ecrease in m oney wages is a actor that shits th e SRAS cu rve
to the right. The real wage is back to its original level, so f rm s
will be ind u ced to increase ou tpu t and prod u ce at Yp, the
potential (u ll employm ent) level o ou tpu t. Long-ru n
equ ilibriu m is re-established with real ou tpu t at its original u ll
em ploym ent level, bu t with the average price level lower at P2 .
The d ownward exibility o m oney wages assu m ed by the
m onetarist or new classical school gu arantees that in the long
ru n the economy will retu rn to its normal rate o real ou tpu t.
The market economy in this m od el is capable o retu rning to its
potential rate o real ou tpu t with exible m oney wages d oing
the trick.
An infationary gap exists when actual equilibrium output is
greater than potential (ull employment) output.
A defationary gap (also reerred to as a recessionary gap)
exists when equilibrium output is below the potential (ull
employment) level o output.
Equilibrium in the Keynesian model
The major dierence between the monetarist or new classical
model described above and the Keynesian model is that the latter
is not equipped with an automatic adjustment mechanism. Within
82
the Keynesian ramework an economy may fnd itsel stuck at an
equilibrium level o real output with less than ull employment.
N o endogenous orces exist that will restore ull employment.
More specifcally, money wages are assumed sticky downwards
(the ratchet eect: money wages may increase but they do not
easily adjust downwards). It ollows that within the Keynesian
world, AD is the driving orce behind economic activity. Instead o
believing in supply creating its own demand (Says law rom the
classical school o thought, which included the intellectual athers
o monetarism and the new classical school), Keynes turned things
inside out, postulating that it is eective demand (which we call
AD) that determines the equilibrium level o real output in an
economy. I, or whatever reason, AD proves insufcient to
establish ull employment then a market economy will suer a
system-wide ailure as it will be unable on its own (that is, without
the help o the government) to restore ull employment
conditions. Figure 2 .2 .9 illustrates equilibrium in a Keynesian
model o national income determination.
Average price level (P)
AS
Section II Section III
AD
0 Ye Yf
Real outcome/income (Yr)
Figure 2.2.9 Equilibrium in a Keynesian macroeconomic model
Assum e that AD is at an extrem ely low level (as on Figure 2 .2 .9)
perhaps becau se o extrem ely low consum er and business
confdence and a general wave o pessim ism in the country.
Equilibrium real ou tput will be determ ined at the intersection o
AD with the Keynesian AS curve at the level o output Ye. In this
m odel, and as a result o the assum ed downward stickiness o
m oney wages (perhaps as a result o labou r unions), equilibrium
below ull employm ent may persist or an unacceptable period
o tim e, orcing the governm ent to intervene and attempt to
increase AD by increasing its own spending levels, as will be
explained later. N ote that i AD increases it is not necessary or
the economy within this Keynesian ram ework o analysis to
experience rising price levels (that is, in ationary pressures) at
least u ntil it reaches section II o the AS curve.
Again, when equ ilibriu m ou tpu t is less than u ll employm ent
ou tpu t a d e ationary (or recessionary) gap exists, equ al to YeY.
An in ationary gap is m ore cu m bersom e to illu strate within a
Keynesian d iagram as Keynesian analysis was originally not
interested in investigating in ationary cond itions. I n any case,
i AD increases within the vertical section o a Keynesian AS
cu rve (section I I I ) then an in ationary gap is said to be created ,
as illu strated in Figu re 2 .2 .1 0.
 2 Macroeconomics

Assu m e that AD is originally at AD1 , lead in g to an equ ilibriu m

Average price level (P)

AS
level o real ou tpu t equ al to the u ll employm ent level o real
ou tpu t Y. I , or som e reason, AD increases and the cu rve shits
to AD2 then the economy will remain at its u ll employm ent
b
level o ou tpu t Y bu t the average price level will rise, proving
pu rely inf ationary. Distance ab in Figu re 2 .2 .1 0 is oten
AD2 consid ered to illu strate an inf ationary gap within the
a
Keynesian m od el.

AD1

0 Yf
Real outcome/income (Yr)
Figure 2.2.1 0 An infationary gap within a Keynesian AS diagram

83
 2.3 Macroeconomic objectives
Low unemployment
An ind ivid u al is consid ered u nemployed i h e or she is actively
searching or a job an d cannot f nd one. The u nemploym ent
rate is the ratio o the nu m ber o u nem ployed over the size o
the labou r orce (also reerred to as the workorce or the
working popu lation) tim es 1 00. The labou r orce inclu d es the
employed and the u nemployed :
number of unemployed
Unemployement rate 5 ___________________ 3 1 00
labour force
Measurement problems
It is difcult to get an accurate estimate o the unemployment rate.
The ofcial unemployment rate may underestimate or overestimate
the true level o unemployment in a country, as ollows.
It may understate the true level o unemployment because o
the existence o discouraged workers and o underemployed
individuals. The frst category o discouraged workers includes
individuals who would like to work and would happily accept a
job oer but who have stopped actively searching or one because
they have remained unemployed or too long and their past search
eort was unsuccessul. Since they are demonstrating no eort in to hire individuals currently employed elsewhere as not only will
seeking employment they are not considered unemployed, so they
are not included in the ofcial unemployment rate. The second
category, the underemployed individuals, includes people who do
have a job (so are considered employed) but who are working as
part-time employees ewer hours per week than desired. These are
involuntary part-time workers.
The of cial u nem ploym ent rate may overstate the tru e level o
u nem ploym ent as som e ind ivid u als may inten tionally conceal
their tru e employm en t statu s eith er earing loss o transer
paym ents, su ch as u nem ploym ent benef ts, that are granted
only to the u nemployed or becau se they are em ployed in illegal
activities su ch as gam bling or prostitu tion.
In general, during recessions the num ber o part-time workers and
o discouraged workers increases. Also, som e who were alsely
claim ing to be unemployed in order to collect benefts may
actually becom e unemployed. As a result, actual or true
unemploym ent is m ore likely to be higher during the downturn o
the business cycle than the ofcial fgure suggests. Sym m etrically,
during a boom actual unemploym ent may be lower than the
reported ofcial fgure as ewer people will become discouraged
or will be orced into accepting part-time positions when jobs are
plentiul. In addition, m ore people may continue reporting as
unemployed even though they have actually ound a job.
Remember that the reported ofcial unemployment rate does not
reveal any inormation pertaining to age, gender, ethnic or regional
disparities. Concerning demographic groups, unemployment
among young workers and minorities is typically the highest. It is
thereore important to examine disaggregated unemployment data
to get a better picture o the labour market o a country.
Consequences of unemployment
Perhaps the biggest cost o unemployment is the opportunity cost
o lost output. Goods and services that could have been produced
84
are sacrifced. One way o viewing this cost is by examining the
size o the distance between actual output and potential output
in a business cycle diagram. This is reerred to as the output gap.
Another way o visualizing this cost is through a diagram showing
a production possibilities curve (PPC) also known as a
production possibilities rontier (PPF) as unemployment implies
that the economy is operating inside the curve.
The governm ents f nances are also aected by u nemploym ent.
Tax revenu es collected are lower becau se o the lower incom es
and the resu lting d ecreased private spend ing. Governm ent
spend ing increases becau se o the u nem ploym ent benef ts paid
to the u nemployed and the increased nu m ber o trainin g and
re-training program m es that need to be implem ented .
For individuals who lose their jobs, the single m ost important
cost incurred is the lost income. Living standards o the
unemployed are adversely aected, especially i wages were the
only source o incom e. Another cost or individuals is the loss o
up-to-date skills. In certain proessions this may be very important
and the longer people remain unemployed the less employable
they become as their human capital is eroded. Employers preer
their skills be up to date but also the risks created by asymm etric
inormation are avoided as the employer cannot know why the
unemployed lost their jobs in the frst place. Other possible
private costs o unemploym ent include the loss o sel-esteem
that oten results and the increased probability that the person
will resort to alcohol or drug abuse.
I u nem ploym ent is high and prolonged , society may experience
a higher incid ence o crim e and violence and other negative
externalities resu lting rom dru g and alcohol abu se. I
u nemploym ent is heavily concentrated in regions or in age
grou ps su ch problem s may becom e even m ore pronou nced .
There may be som e benef ts arising rom m od erate
u nemploym ent. Many qu ote that u nion power weakens, so
there is red u ced wage in ation in the economy. I the real wage
d ecreases then prof tability and com petitiveness o d om estic
f rm s increases. I ncreased geographical and occu pational
m obility is also m ention ed as a possible positive sid e eect o
u nemploym ent as workers are orced to relocate or change
occu pation. These benef ts m u st be viewed in context thou gh,
otherwise the harsh reality o u nem ploym ent may be d istorted .
Types and causes of unemployment
and policies to lower it
There are three main types o u nem ploym ent.
n Seasonal unemployment is a resu lt o pred ictable
variations in the d emand and su pply o labou r. Weather
patterns are responsible or constru ction workers being laid
o in th e winter and snow ski instru ctors in the su m m er.
Labou r su pply su rges in Ju ne every year as college and
second ary school grad u ates start lookin g or a job. This
type o u nem ploym ent is expected and there is not m u ch a
governm ent can d o abou t it. Unemploym ent statistics
thou gh are oten corrected (season ally ad ju sted ) so that

policy makers can d eterm ine tru e changes in
u nemploym ent, not th ose d u e to the changing seasons.
n Frictional unemployment reers to people in-between jobs
as it takes tim e to match a job seeker with an available job
vacancy. This is u nemploym ent o a short-term natu re and is
largely also u navoid able in an economy since people will
always volu ntarily switch jobs, searching or better ones or
relocating. Faster and better inormation abou t the labou r
market will d ecrease bu t not elim inate rictional
u nemploym ent. Governm ents can m inim ize rictional
u nemploym ent by ensu ring that job vacancies as well as
the prof les o those available or work becom e kn own
wid er and aster.
n Structural unemployment is perhaps the most serious type o
unemployment since it is o a long-term nature. It represents
those remaining unemployed long ater recovery is under way
in an economy. An economy may be booming but structural
unemployment will not decrease. It is the result o the
evolving structure o an economy because o rapid
technological advancement or shiting comparative
advantage. The changing structure o an economy results in a
mismatch between the skills available among the
unemployed and the skills required by the labour market. N ew
technologies render certain proessions obsolete but at the
same time create new job opportunities. For example, in some
cases the Internet may have decreased the demand or shop
assistants but it has created new jobs or web designers and
sotware engineers. But i the redundant shop assistant is not
trained in computer science then he or she may fnd it difcult
to get a job. Or, consider the case o an industry in a country
losing its export markets to lower-cost oreign frms. I Korean
shipyards become more competitive then specialized workers
in other countries will lose their jobs. Lastly, the mismatch can
also be geographic, with the unemployed clustered in one
region o the country while job vacancies exist elsewhere.
Fig ure 2 .3.1 is an illu stration o the stru ctu ral u nemploym ent
resulting in som e specif c ind u stry i, or example, som e o the
f rm s are orced to shu t d own as a resu lt o increased oreign
competition or becau se o som e f rm s switching to au tomated
processes that rend er som e o the workers red u nd ant.
Money wage
LS
w The governm ent may also try to elim inate m inim u m wage laws
f h
LD1
LD2
0 as it will be less costly to f re them in a d owntu rn.
Labour
Figure 2.3.1 Structural unemployment in a specifc industry as a result o
a shit in comparative advantage or the introduction o new technology
2 Macroeconomics
N ote that labou r d eman d (LD) shows how many workers f rm s
are willin g to hire at each wag e rate while labou r su pply (LS)
shows how many workers are willing to oer their labou r
services at each wage rate. I nitially, we assu m e equ ilibriu m in
this specif c labou r market with the wage rate d eterm ined at
the intersection o LD1 with LS. I au tomated processes or
shiting com parative ad vantage d ecrease labou r d emand to
LD2 and m oney wages are sticky then d istance h may be
thou ght o representin g the resu lting stru ctu rally u nemployed .
Stru ctu ral u nem ploym ent, thou gh, may n ot be a resu lt o
m ismatches bu t o what are known as labou r market rigid ities.
M inim u m wage laws and wages set throu gh collective
bargaining between ind u stries and labou r are examples o
labou r market rigid ities. They both resu lt in high er
u nemploym ent as wage rates are set above their equ ilibriu m ,
market clearing level. I pension plans in one ind u stry are not
easily transerred to another ind u stry then occu pational
m obility is hampered . Consid er a worker losing his job in
ind u stry A bu t prevented rom taking a job oer in ind u stry B
becau se he can not transer his pension rights. H e will end u p
u nemployed . Lastly, in stitu tional d isincentives are consid ered as
cau ses o stru ctu ral u nemploym ent. Laws preventing f rm s
d ism issing employees except in certain circu m stances and high
u nemploym ent benef ts are examples.
Elim inating stru ctu ral u nemploym ent is not possible in a
d ynam ic econ omy as its stru ctu re is con stantly changing bu t
there are policies consid ered helpu l in red u cing it. Perhaps the
m ost important o these policies are related to acilitating the
training and re-training o those with non-marketable skills.
Governm ents may d irectly provid e training program m es or they
may su bsid ize private provision o su ch program m es. They may
also provid e low-interest loans to ind ivid u als willin g to enroll in
su ch skill-creating cou rses who otherwise lack the necessary
f nancing, as well as assistance to ind ivid u als willing to relocate
to ease their ad ju stm ent costs. Governm ents oer incentives in
the orm o tax breaks or wage su bsid ies to f rm s hiring
stru ctu rally and long-term u nemployed ind ivid u als. They also
revise school cu rricu la to prepare ind ivid u als better or the
labou r market.
I labou r market rigid ities are responsible or som e o the
stru ctu ral u nemploym ent in a cou ntry then th e obviou s solu tion
is to rend er the labou r market m ore exible, bu t this is d if cu lt.
At th e top o the list o policies to achieve this are those that
red u ce the power o labou r u nions. This is becau se labou r
u nions are responsible or the increased power insid ers (workers
with jobs) hold that increase tu rnover costs or f rm s and
prevent ou tsid ers (workers looking or a job) rom getting hired .
as well as collective bargaining since both create excess su pply
o labou r in particu lar labou r markets. Red u cing non-wage
labou r costs, su ch as national insu rance con tribu tions that f rm s
are obliged to pay, cou ld increase d emand or labou r. Red u cing
the level o u nemploym ent benef ts and the length o tim e or
wh ich benef ts can be collected will orce som e workers to
accept a job oer instead o remaining u nem ployed and
collecting benef ts. Lastly, elim inating legislation relating to job
secu rity may m ean that f rm s are m ore willing to hire workers
H owever, the red u ction in stru ctu ral u nem ploym ent that som e
o these m easu res may bring abou t may com e at a signif cant
85
 2 Macroeconomics
cost to society. Decreasin g workers protection may lead to
labou r and social u nrest which may hamper growth instead o
accelerating it. Segm ents o the popu lation may becom e
marginalized and incom e d istribu tion m ore u nequ al, again with
ad verse eects on growth and d evelopm ent.
I t is worth noting that the policies that shou ld be em ployed to
lower stru ctu ral u nem ploym ent are o a m icroeconom ic natu re.
Cyclical (or Keynesian or demand-defcient)
unemployment
This type o u nemploym ent is d irectly related to the bu siness
cycle. H igher u nemploym en t will necessarily accompany a
recession becau se o the lower level o econom ic activity. A
d ecrease in AD will orce som e bu sinesses to shrink and others
to close d own.
On the let-hand sid e o Figu re 2 .3.2 the d ecrease in AD is
shown rom AD1 to AD2 which resu lts in lower level o
econom ic activity and lower real ou tpu t Y2 . The economy has
entered a recession. As a resu lt o the lower o econom ic
activity, f rm s d ecrease their d emand or labou r. Som e f rm s may
shrink, others may even shu t d own becau se o the recession. On
Average price level (P)
SRAS
AD1
AD2
0 Y2 Y1 Yf
Real outcome/income (Yr)
Figure 2.3.2 Illustrating cyclical unemployment
Low and stable rate o infation
I n ation is d ef ned as a su stained increase o the average level
o prices. The in ation rate is the percentage by which the price
ind ex has risen between two period s. For example, i annu al
in ation in I nd ia in 2 01 0 was at 1 0.9% this m eans that prices
in I nd ia increased in 2 01 0 compared with 2 009 by 1 0.9%.
De ation is d ef ned as a su stained d ecrease in the average
price level. I t im plies a negative rate o in ation. For example,
in Febru ary 2 01 0 the Japanese in ation rate was 2 1 .2 % on a
year-on-year basis, m eaning that on average prices in Febru ary
2 01 0 were lower than in Febru ary 2 009 by 1 .2 %.
Disin ation characterizes an economy experiencing a d ecrease
in in ation. The in ation rate remains positive bu t it is lower
than it was in the previou s period . I n oth er word s, prices
86
the right-hand sid e o Figu re 2 .3 .2 the economys labou r market
is illu strated . N ote that in Figu re 2 .3.2 the labou r market as a
whole o a cou ntry is d epicted whereas Figu re 2 .3 .1 ocu sed on
the labou r market relating to a specif c ind u stry. I n Figu re 2 .3.2 ,
labou r d eman d d ecreases rom DL1 to DL2 . M oney wages are
assu m ed sticky d ownward and so remain at w. Excess su pply
o labou r in the cou ntry resu lts equ al to d istance ab, re ecting
the resu lting cyclical u nem ploym ent.
Unemploym ent d u e to cyclical reasons is d ealt with u sing what
are called expansionary d emand -sid e policies. Eectively,
throu gh these policies the governm ent will attempt to close the
d e ationary gap. The policies aim at increasing AD. They
inclu d e interest rate cu ts in the hope that hou sehold s and f rm s
will be convinced to spend m ore, as well as lower taxes and
increased governm ent expend itu res.
Even though it sounds counterintuitive, a growing economy
TIP
may over the long term suffer from higher structural
unemployment. This is because the different income
elasticities of demand of the different industries and sectors of
an economy will change its structure.
Money wage
SL
a b
w
DL2 DL1
0
Labour
continu e to in crease bu t at a slower rate. For example, in ation
in I nd ia in 2 004 was at 3.8% while in 2 003 it was at 5.4%.
Since in ation in 2 004 d ecreased com pared with 2 003, this
m eans that there was d isin ation in I nd ia. Prices continu ed to
rise in 2 004 bu t at a slower rate than in the previou s year.
Measuring ination
The average level o prices is m easu red throu gh a price ind ex
which is a weighted average o the prices that the typical
consu m er aces expressed as an ind ex nu m ber. I t is reerred to
as the consu m er (or retail) price ind ex (CPI ). Statisticians
d eterm ine the CPI throu gh su rveys o the basket o good s and
services that the typical hou seh old bu ys. The average is a

weighted average as good s and services are not o equ al
signif cance to the typical consu m er. The weight or each good
is the expend itu re on it expressed as a proportion o total
expend itu res mad e. The cost o pu rchasing the basket is
record ed and then expressed as an ind ex nu m ber. This m eans
that u sing statistical criteria som e year is chosen to be the
base (or reerence) year and all other years are expressed as a
percentage o it. I t ollows that the price ind ex or the base year
will be equ al to 1 00. By expressin g a variable as an ind ex
nu m ber we get rid o its u nits o m easu rem ent which makes
comparisons throu gh tim e easier. I we have constru cted the
consu m er price ind ex or period t and the consu m er price ind ex
or period (t 1 1 ) then the in ation rate o period (t 1 1 ) is
given as the percentage change o these two price ind ices.
N ote that a negative percentage change implies d e ation.
CPI(t 1 1 ) 2 CPI(t)
Infation (t 1 1 ) 5 % D(CPI) 5 ________________ 3 1 00
CPI(t)
Problems o measurement
The typical con su m er is a f ctitiou s person. This person is both
you ng and old , lives both in a city and on a arm and is both
well o and relatively poor. As a resu lt, it is problematical to
u se the in ation rate f gu re to d eterm ine, or example, by how
m u ch a governm ent shou ld increase pension s, as old er people
consu m e m ore health care an d less entertain m ent than a
you nger ind ivid u al. Since the patterns o consu mption across
d ierent d em ographic grou ps d ier, the price d ierences
experienced by each grou p will not be accu rately re ected by
the nation al or of cial in ation rate o the cou ntry.
Th ere a re a l so severa l oth er m ea su rem en t probl em s o a m ore
tech n ica l n atu re. Th e wei g h ts u sed to con stru ct th e avera g e
price l evel a re f xed . As a resu lt, th e eect on th e i n ati on
rate o a n i n crea se i n th e pri ce o a pa rti cu la r g ood i s
overestim ated . Even th ou g h con su m ers wi ll swi tch away rom
i t a n d pu rcha se oth er ch ea per su bsti tu tes, i ts si g n i f ca n ce (i ts
weig h t) in th e con stru cti on o th e avera g e wi l l be th e sam e. I n
th i s way, th e of cia l i n ation rate m ay overestim ate tru e
i n ation . Th i s i s reerred to a s th e su bsti tu ti on bia s. N ew
prod u cts a re n ot im m ed iatel y ta ken i n to a ccou n t i n th e
con stru cti on o th e avera g e pri ce l evel. I t took a ew yea rs or
th e pri ce o m obil e ph on e servi ces to en ter th e typica l ba sket
o g ood s a n d services in ma ny cou n tri es. Th i s i s reerred to a s
th e n ew prod u ct bi a s. Pri ces rom n ew reta i l ou tlets su ch a s
on li n e stores (or exam ple Am a zon ) or m ega a n d d i scou n t
stores m ay n ot be su f ci en tly sam pl ed . Sin ce th ese reta i l
ou tlets u su a ll y have l ower pri ces, th e of cia l in ati on rate
m ay overestim ate tru e i n ation . Th i s i s reerred to a s th e n ew
reta il ou tlet bia s. I m proved qu a li ty o g ood s a n d servi ces m ay
n ot be properl y a ccou n ted or i n th e con stru ction o th e
avera g e pri ce level . A better version o a prod u ct m ay be 1 0%
m ore expen sive bu t m ay la st 5 0% m ore tha n th e old er
versi on , ren d eri n g i t eecti vely ch ea per. Aga i n , th e of cia l
i n ation rate m ay overestim ate tru e i n ati on . Th i s is reerred
to a s th e qu a li ty bia s.
Core (or underlying) infation
The CPI is aected signif cantly by changes in (resh) ood
prices and energy prices. Spend ing on ood item s together with
spend ing on gasoline and heating oil represent a signif cant
2 Macroeconomics
ch u nk o the typical consu m ers bu d get. Food prices, thou gh,
are aected by weather and other rand om actors. For exam ple,
a bad season will increase the price o m ost ood prod u cts
while a good crop will d ecrease it. Oil prices are aected by
d ecisions mad e by the Organization o th e Petroleu m Exportin g
Cou ntries (OPEC), political d evelopm ents in cou ntries prod u cin g
and exporting oil and by specu lators. Oil prices may thereore
increase and d ecrease signif cantly or reasons u nrelated to the
u nd am entals o an economy. This is why what is known as core
in ation is estimated and reported . The core or u nd erlying rate
o in ation simply exclu d es ood and energy prices rom the set
o prices comprising the basket o good s that the typical
consu m er pu rchases. As a resu lt, swings in ood and energy
prices that are u nrelated to the u nd am entals o an economy
are isolated , perm itting a m ore accu rate interpretation o the
working s o an econom y.
The producer price index
An alternative price ind ex that has certain ad vantages over the
CPI is the prod u cer price ind ex (PPI ). The PPI inclu d es the prices
that prod u cers receive or good s (services are not inclu d ed ) at
all stag es in the prod u ction process, inclu d ing not ju st f nished
g ood s (su ch as price-scanning d evices and tractors) bu t also
sem i-f nished and interm ed iate good s (su ch as ou r and steel)
as well raw or cru d e materials (su ch as coal and cru d e oil). The
main ad vantage o the PPI over the CPI is that it picks u p and
sign als price chang es that the typical consu m er will ace beore
those changes actu ally materialize. I n this sense chan ges in the
PPI are consid ered lead ing ind icators o u tu re consu m er
in ation rates.
The GDP defator used as a comprehensive
measure o price movements
Th e GDP d e ator (see pa g e 69) m ea su res pri ce cha n g es o a l l
g ood s a n d servi ces i n clu d ed i n a cou n trys GDP. I t i s i n th i s
sen se broa d er a n d m ore u seu l tha n th e CPI or th e PPI or
m ea su ri n g th e overa l l cha n g es i n th e pri ce l evel. I t i n clu d es
n ot on l y con su m er g ood s a n d services bu t a lso i n vestm en t
g ood s a n d servi ces, g overn m en t g ood s a n d servi ces a s wel l a s
g ood s a n d servi ces sol d to orei g n ers. I t d oes n ot, th ou g h ,
i n clu d e pri ces o i m ported g ood s a n d servi ces wh i ch d o
eatu re i n th e ba sket o g ood s a n d servi ces that th e typi ca l
con su m er bu ys, a n d th i s is con si d ered a d isa d va n ta g e. Th e
G DP d e ator i s typica ll y u sed to a d ju st m on ey (or n om i n a l )
G DP or price cha n g es.
Consequences o infation
n I n a ti on i n crea ses u n certa i n ty i n bu si n ess, m a ki n g i t
even m ore d i f cu l t or f rm s to ju d g e a n d d eci d e wh eth er
a n i n vestm en t proj ect wi l l or wi l l n ot be prof ta bl e. Th i s
i s m ore so th e ca se i i n a ti on i s va ri a bl e. H ow a st wi l l
wa g es a n d prod u cti on costs ri se i n th e u tu re? H ow
m u ch wi l l i t be possi bl e to sel l th e g ood or i n on e, two
or th ree yea rs ti m e? H ow a st wi l l pri ces o su bsti tu tes
a n d com pl em en ts i n crea se? Th e i n crea sed u n certa i n ty
m ea n s th a t f rm s wi l l u n d erta ke ewer i n vestm en ts.
Sl ower ra tes o i n vestm en t spen d i n g wi l l sl ow d own
econ om i c g rowth a n d so, i n th e l on g ru n , em pl oym en t
ra tes m a y d ecrea se.
87
 2 Macroeconomics
n I n ation also rend ers exports less competitive in oreign
markets. As a resu lt, the export sector shrinks, making it
m ore d if cu lt to earn the necessary oreign exchange to
pay or imports, which will tend to increase as oreign
good s will also becom e m ore attractive. Trad e im balances
will wid en. Pressu re on the cu rrency to d epreciate will be
exerted which cou ld u rther aggravate in ation as imports
will becom e m ore expensive.
n H ou sehold s on f xed m on ey incom es (su ch as wage earners
and pensioners) su er a d ecline in their pu rchasing power.
I ncom e d istribu tion may worsen.
n I actu al in ation proves higher than expected in ation
then borrowers will gain at th e expense o lend ers. The
m oney they will be paying back to lend ers will be worth
less than expected at the tim e o the loan.
n I n a ti on a l so tra n sers pu rcha si n g power rom th e peopl e
to th e g overn m en t, a cti n g a s a n a d d i ti on a l ta x i th e ta x
bra ckets o a progressi ve i n com e ta x system d o n ot a d ju st
i n l i n e wi th i n a ti on . Assu m e th a t som eon e ea rn s 1 0%
m ore i n com e wi th i n a ti on a l so at 1 0%. I n rea l term s
th i s i n d i vi d u a l i s n ot better o bu t h e or sh e m ay be
m oved to a h i g h er ta x bra cket wi th a m u ch h i g h er
m a rg i n a l ta x ra te, so i n rea l term s wi l l pa y proporti on a l l y
m ore ta x th a n beore.
n I n ation, in general, may red istribu te national incom e rom
the poor to the rich since the orm er have ewer choices to
hed ge against in ation and , in ad d ition, they cannot
borrow easily. The wealthy have the necessary collateral to
borrow rom the banking system and proceed to invest in
assets (or example land or gold ) the valu e o which is
expected to rise aster than in ation. On the other han d ,
the real valu e o m oney d eposited in a typical savings
accou n t d ecreases.
n Th e ef cien cy o th e price m echa n ism is lost beca u se
in ation d i storts th e sig n a llin g a n d in cen tive power o
relati ve price cha n g es. A con su m er or a f rm witn essin g
th e price o g ood X risin g ca n n ot be su re that it tru ly is
becom in g relatively m ore expen sive a s th e person or f rm
ca n n ot kn ow wh eth er th e prices o oth er sim ila r g ood s
have in crea sed by th e sam e percen ta g e or n ot. I th ey
have, th en th e relative price o th e g ood in qu estion ha s
n ot cha n g ed a n d n o su bstitu tion process sh ou ld kick in .
With in ation (wh ich is u n ba la n ced , m ea n in g that prices
a re n ot a l l ri sin g at th e sam e rate) th is becom es
im possible to d eterm in e, con u sin g d ecision s o con su m ers
a n d o f rm s a n d lea d in g to in ef cien cy in th e a llocation
o sca rce resou rces. I n th i s sen se, in ation i s n oise.
n Keep in m ind that m ild in ation red u ces the real wage
costs o f rm s, so it may help their competitiveness. This is
especially important in a world where m oney wages d o not
easily ad ju st d ownward s becau se o contracts an d
resistance o labou r u nions.
Remember that the costs o infation may easily be
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re-written in an essay as the benets o price stability.
88
Consequences o defation
n The biggest risk o d e ation is that the economy may enter
a d e ationary trap. A viciou s circle may start, with d e ation
creating m ore d e ation.
n De ati on in d u ces con su m ers to d elay pu rcha ses sin ce th ey
com e to expect u rth er pri ce d ecrea ses. As a resu l t, AD
d ecrea ses even m ore, pu sh in g even l ower th e avera g e
pri ce level .
n De ation d ecreases f rm s revenu es, squ eezing their prof t
margins and orcing them to cu t d own on costs. Wages all
and red u nd ancies ollow. Som e f rm s are orced to go
bankru pt. AD shits u rther to the let.
n The real valu e o ou tstand ing d ebt increases. I nd ebted
consu m ers becom e hesitant to make pu rchases and
ind ebted f rm s h esitan t to make investm ents. AD d ecreases
even m ore and so d oes the average price level.
n Since the real valu e o ou tstand ing d ebt increases, som e
hou sehold s and som e f rm s cannot service their loan s.
Banks accu m u late bad loans (loans that are not repaid ),
so the risk o a banking crisis with repercu ssions on th e real
economy increases.
n As AD alls it is not only the average price level that alls
bu t also real ou tpu t, lead ing to higher u nem ploym ent.
n Easy m onetary policy is a policy u sed by a central bank to
stim u late econom ic growth by lowering interest rates bu t,
when there is d e ation, the central bank cannot u se this
policy to re ate the economy as (nom in al) interest rates
cannot d ecrease below zero. Expansionary f scal policy may
also prove ineective as hou sehold s may preer to save and
postpone spend ing. Even sitting on cash earn s a real rate
o retu rn, m eaning that with alling prices it will bu y m ore
in the u tu re.
n H owever, exports becom e m ore competitive abroad and AD
may increase as a resu lt o a rise in net exports.
Types and causes o infation and o defation
Throu gh th e AD/AS d iagram it shou ld be clearly realized that
any actor that persistently increases AD or lead s to an ad verse
shit in AS may lead to an increasin g price level (that is, to
in ation). The orm er is known as d emand -pu ll in ation and th e
latter as cost-pu sh in ation, even thou gh once an in ationary
process begins it is d if cu lt in practice to d istingu ish between
the two.
Demand-pull infation
I n the case o d emand -pu ll in ation the extent o the
in ationary eect resu lting rom the increase in AD d epend s on
how steep the AS cu rve is, in other word s on how close to the
u ll employm ent or potential level o real ou tpu t the economy is
operating. The closer to the potential level o real ou tpu t (that
is, the steeper AS is) the greater the eect on the average price
level o AD increasing.

Average price level (P)
SRAS
P2
P1
AD2
AD1
0 Y1 Y2
Real outcome/income (Yr)
Figure 2.3.3 Demand-pull ination
I n Figu re 2 .3.3 d emand -pu ll in ation is illu strated , employing a
generic SRAS cu rve. Keep in m ind that, in the lon g ru n, any
increase in AD is pu rely in ationary as the LRAS cu rve is
vertical at the potential level o ou tpu t. Within the m onetarist
or new classical m od el any increase in real ou tpu t and
correspond in g d ecrease in u nemploym ent will be short lived
since m oney wages will ad ju st. Within the vertical section o a
typical Keynesian-style AS cu rve an increase o AD will also
prove pu rely in ationary. I n the Keynesian m od el an increase in
AD may not prove in ationary i the economy is in a d eep
recession and is operating on the horizontal section o the
AS cu rve.
Causes o demand-pull infation
An increase in any component o AD may prove responsible or
d emand -pu ll in ation. Demand -pu ll in ationary pressu re may
originate rom a rapid increase in consu m ption and investm ent
expend itu res cau sed by excessively optim istic and con f d ent
hou sehold s and f rm s. Su rging exports may also exert u pward
pressu re on prices. Export growth may accelerate, as a
resu lt o an u nd ervalu ed or d epreciating cu rren cy or aster
growth abroad .
M ost oten, governm ents are responsible or d emand -pu ll
in ation. Pro igate governm ent spend ing and poorly d esigned
tax-cu ts, especially beore elections, may increase AD too ast
and create in ation.
I n ationary expectations them selves are a com m on cau se o
continu ing in ation. I prices are expected to continu e clim bing
then f rm s and workers with pricing power will increase their
prices and wages to keep ahead o the gam e, ad d ing to the
in ationary spiral.
Perhaps the single m ost important cau se o ination is excessive
m onetary growth. The easiest way to understand this is by
qu oting Milton Fried mans am ous saying that ination exists
when too m uch m oney chases ater too ew goods and so
ination is a purely m onetary phenom enon. I the m oney supply
increases aster than output then part o the resulting increased
spending will maniest itsel in the orm o rising prices.
2 Macroeconomics
Remember that increases in AD will aect not only the
TIP
average price level but also real output. A rise in real output
and in employment may accompany demand-pull infation.
Cost-push infation
Figu re 2 .3.4 illu strates cost-pu sh in ation as the average price
level is shown to increase rom P1 to P2 ollowing a shit to the
let o AS (an ad verse su pply shock) rom AS1 to AS2 .
Average price level (P)
AS2 AS1
P2
P1
AD
0 Y2 Y1
Rea l ou tcom e/in com e (Yr)
Figure 2.3.4 Cost-push ination
Causes o cost-push infation
Any actor that is responsible or a d ecrease in AS and a shit o
the AS cu rve to the let may lead to cost-pu sh in ation. Perhaps
the m ost com m on cau se o cost-pu sh in ation is a rise in the
price o oil. Oil is still the pred om inant orm o en ergy or f rm s
so a su stained and sharp increase in its price will increase
prod u ction costs across the board and so increase prices. More
g en erally, rising com m od ity prices can create cost-pu sh pressu re
as com m od ities are prod u cts u sed as inpu ts in manu actu ring .
Poweru l labou r u nions may also create cost-pu sh pressu re as
they may be in a position to achieve or their m em bers m oney
wage increases higher than any prod u ctivity gains. Eectively,
this increases prod u ction costs or f rm s and so increases prices.
A d eva lu ation (or a sha rp d epreci ation ) o th e cu rren cy
ren d ers im port pri ces h ig h er. Th e avera g e price level wil l
a u tom atica lly i n crea se a s th e typica l ba sket o g ood s a n d
services con su m ed in clu d es im ported prod u cts. Th is may lea d
workers to d ema n d h ig h er wa g es, in i ti atin g a wa g e-pri ce
spira l. Also, i d om estic f rm s rely or th eir prod u ction process
on i m ported raw m ateria ls a n d in term ed iate prod u cts th en
prod u ction costs will i n crea se, wi th th e sam e eect on pri ces.
An increase in ind irect taxation will increase prod u ction costs
and so increase prices. This wou ld be a one-o increase in the
average price level so it wou ld hard ly qu aliy as a cau se o
in ation (a sustained increase in prices) u nless it led to
d emand s or higher wages and an in ationary spiral began.
89
 2 Macroeconomics
Lastly, a prod u ctivity slow-d own may initiate cost-pu sh in ation
as prod u ction costs wou ld increase. Su ch a d evelopm ent wou ld
typically requ ire som e u navou rable institu tional change.
Stagnant GDP or even alling GDP will accompany cost-push
TIP
infation.
Causes o defation
Figu re 2 .3 .5 illu strates a case o d e ation since the average
price level is shown to d ecrease rom P1 to P2 as a resu lt o
d ecreasing AD rom AD1 to AD2 .
Average price level (P)
AS
P1
P2
AD1
AD2
0 Y2 Y1
Real outcome/income (Yr)
Figure 2.3.5 Deation
De ation can be cau sed by continu ing d ecrease in AD, oten
the resu lt o a signif cant d om estic crisis, su ch as a banking
crisis or a crisis related to governm en t d ebt. Typically, interest
rates have alread y been driven d own to zero as a resu lt o
u nsu ccessu l attem pts by the central bank to in crease private
spend ing and the governm ent has little room to spend m ore
and boost AD.
De ation may also resu lt rom AD rising slower than originally
expected . Optim istic f rm s may have overinvested in new
capacity, lead ing to a large shit to the right o AS. I AD ails
to rise as ast then a d ecreasing average price level may resu lt.
Policies to deal with demand-pull infation
I n the case o d emand -pu ll in ation , policy makers m u st
attempt to d ecrease (or, m ore correctly, slow d own the increase)
o AD in the econom y. Spend ing in the economy m u st be
restrained . I t ollows that the governm ent may d ecrease its own
expend itu res (f scal restraint). Governm ent expend itu res are
a com ponen t o AD, so i they d ecrease then AD will also
d ecrease. Taxation may also increase as higher d irect taxes will
d ecrease d isposable in com e and so consu mption expend itu res.
The policy m ix o d ecreasing governm ent expend itu res and
increasing taxation is reerred to as contractionary or
d e ationary f scal policy and will be evalu ated later.
Policy makers cou ld try to restrain private spend ing
(consu mption expend itu res by hou sehold s and investm ent
expend itu res by f rm s) throu gh an increase in interest rates.
90
I nterest rates are set by the central bank o a cou ntry and
chang es o interest rates (and /or o the m oney su pply) are
reerred to as m onetary policy. An increase in interest rates
(known as tight m onetary policy) makes borrowing rom banks
m ore expensive or hou sehold s and bu sinesses. I t also makes
saving m ore attractive and it leaves am ilies with ad ju stable
m ortgage loans with less to spend every m onth as their
m onthly bank installm ent to pay o their m ortgage will be
hig her. The bottom line is that private spend ing is expected to
d ecrease (or to slow d own). Figu re 2 .3 .6 illu strates the eect o
con tractionary policies on in ation.
Average price level (P)
AS
P2
P
P1
AD2
AD
AD1
0 Y1 Y Y2
Real outcome/income (Yr)
Figure 2.3.6 Dealing with demand-pull ination
Given AD1 and AS the average price level is at P1 . As a resu lt
o d emand -pu ll in ation, AD wou ld increase rom AD1 to AD2
an d the price level all the way to P2 . I contractionary f scal
an d /or tight m onetary policies are ad opted then the hope is
that AD will not increase as ast all the way rom AD1 to AD2
bu t wou ld increase on ly to AD. The price level will rise bu t not
as m u ch. I n ation will be lower.
N ote thou gh that whereas real ou tpu t wou ld rise to Y2 it will
now, as a resu lt o the contractionary policies employed , rise
on ly to Y9 . Ou tpu t will increase bu t not as ast, so the
cost o d ecreasing in ation is slower econom ic growth,
even recession.
Policies to deal with cost-push infation
Th e pol i cy respon se i s l ess obvi ou s i n th e ca se o cost-pu sh
in ati on . I t m ay seem that pol ici es that a i m at i n crea si n g
AS (su ppl y-si d e poli cies) a re i n ord er bu t th ese poli cies a re
d if cu lt to a d opt a n d i m plem en t a n d ta ke a l on g ti m e to have
a ny eects. For exam ple, pol icy m a kers m ay try to d ecrea se
th e power o la bou r u n i on s or th ey may i n i tiate pol ici es that
a i m at m a ki n g prod u ct m a rkets m ore com petitive. Th ere i s n o
d ou bt that a ppropriate su pply-si d e poli cies a re a l ways h elpu l
to con ta i n i n ation sin ce by sh iti n g AS to th e rig h t a ny
in crea se in AD wi ll be a bsorbed with ou t th e avera g e
pri ce l evel ri si n g . N on-in ati on a ry growth wi ll th ereore
be a ch i eved .
Becau se o the d if cu lties related to policy initiatives that
try to increase AS even i in ation is cost-pu sh in ation, it is

contractionary d emand managem ent policies that are
employed by policy makers. The typical im m ed iate real-world
response to any in ationary pressu res em erging in an economy
is or policy makers to tighten m onetary policy (that is, to
increase interest rates, making borrowing m ore costly).
Average price level (P)
AS2
AS1
P2
P1
AD1
AD
0 Y Y2 Y1
Real outcome/income (Yr)
Figure 2.3.7 Dealing with cost-push ination
Figu re 2 .3.7 illu strates the situ ation. I nitially, AD and AS are
su ch that real ou tpu t is at Y1 and the average price level at P1 .
Assu m e an ad verse su pply shock (or example a lasting rise in
oil prices) shiting AS rom AS1 to AS2 and lead ing to a higher
price level P2 . Cost-pu sh in ation is even m ore costly than
d emand -pu ll in ation as real ou tpu t d ecreases rom Y1 to Y2
and u nemploym ent rises.
HL The Phillips Curve
The original Phillips Curve
Sin ce the early 1 960s and u ntil the m id -1 970s econom ists
relied on an em pirical resu lt that Alban W. Phillips, a N ew
Zealand econom ist at the Lond on School o Econom ics, mad e
in 1 95 8. H is work, th e Phillips cu rve, becam e one o the m ost
am ou s relationships in macroeconom ics. I t showed that there
was a stable trad e-o between the in ation rate and the
u nemploym ent rate o an economy.
H is original empirical (statistical) work exam ined U K data on the
annual percentage change in m oney wages and the annual
unemployment rate over a period o 96 years (rom 1 861 to
1 957). The let-hand side o Figure 2 .3.8 shows what he ound:
that the percentage change in m oney wages and the
unemployment were inversely related. I unemploym ent was low
(reerred to as a tight labour market) then m oney wages rose a
lot as employers were orced to bid up wages to fnd employees,
In contrast, i unemployment was high (a slack labour market),
then m oney wages increased by just a little, or even decreased,
as frm s could hire workers without having to oer m ore or even
by oering less than last years prevailing m oney wage.
Moving rom wage ination to price in ation was the next step.
Since wages typically orm a big proportion o production costs
and since frm s in the real world oten set prices as a percentage
2 Macroeconomics
Policy makers respon d by in crea sin g in terest rates (tig h t
m on eta ry policy) in a n attem pt to keep th e avera g e price level
at P1 . I th e policy is su ccessu l a n d th e in crea sed borrowin g
costs lea d to a d ecrea se in spen d in g by h ou seh old s an d f rm s
th en AD will d ecrea se an d sh it let rom AD1 to AD9 ,
ma in ta in in g th e price level sta ble at P1 . I n ation will have
been elim in ated . N ote th ou g h that th e n egative eect on
econ om ic activity (that is, on rea l ou tpu t) will be m ore severe.
Th is will u rth er d ecrea se to Y9 an d u n em ploym en t will
in crea se even m ore. Oten , th is is con sid ered a sh ort-ru n cost
worth su erin g a s th e resu ltin g price sta bility h elps accelerate
econ om ic growth a n d , con sequ en tly, em ploym en t g en eration
in th e lon g ru n .
Increased exposure to international competition also exerts
TIP
a dampening eect on infation. Not only are domestic rms
orced to become more ecient and lower their prices but
also they may benet rom cheaper sources o supply.
H ow to deal with defation
De ation is a d if cu lt problem to d eal with. Japan, a major
ad vanced economy, has su ered the consequ ences o d e ation
or many years. De ation creates a viciou s circle o d ecreasing
prices lead ing to d ecreasing AD, lead in g in tu rn to d ecreasing
prices that is extrem ely d if cu lt to break (a d e ationary trap).
Monetary policy is ineective and f scal policy is weakened .
Som ehow policy makers have to convince the pu blic that
in ation shou ld be expected . Governm en ts have resorted to
printing d ated vou chers to orce recipients to spend them and
not save them . De ation is oten corrected throu gh the increase
in AD that resu lts rom ch eaper exports.
o their unit costs (mark- up pricing) it seem ed sensible to
explore how the annual in ation and unemploym ent rate were
related. The right-hand sid e o Figure 2 .3.8 illustrates what was
ound by many empirical studies in the 1 960s. I nation and
unemploym ent were inversely related. I unemploym ent
decreased then ination increased, while i ination d ecreased
unemploym ent would increase. The negatively sloped curve on
the right-hand side o Figure 2 .3.8 is the original Phillips curve.
I this inverse relationship was stable then g overnm ents cou ld
perhaps exploit it. The Phillips cu rve was consid ered as
presenting policy makers with a m enu o choices. They cou ld
achieve a lower u nem ploym ent rate bu t at the cost o higher
in ation, or they cou ld achieve lower in ation bu t at the cost o
higher u nem ploym ent. The issu e was to d eterm ine the
politically d esired com bination o the two variables and then
throu gh d emand -sid e policies policy makers cou ld achieve it.
This statistically d eterm in ed relation ship was compatible with
the ru ling Keynesian theory. Rem em ber that the Keynesian
perspective stressed the importance o AD in the d eterm ination
o equ ilibriu m incom e. I AD increased then real ou tpu t wou ld
increase and so u nem ploym ent wou ld d ecrease. Bu t this rise in
AD wou ld also lead to in ationary pressu res. So, as shown on
the righ t-hand sid e o Figu re 2 .3.8, i policy makers were to
su cceed in red u cing u nem ploym ent rom U 1 to U 2 then
in ation wou ld increase rom p1 to p2 .
91
 2 Macroeconomics
Percentage change in money wages (%W)
+
0 U2
Unemployment
rate (%)
Figure 2.3.8 The original Phillips curve
The breakdown of the Phillips curve
Since the late 1 960s the original Phillips curve relationship suered
both empirical and theoretical setbacks. Ination and
unemployment were both increasing in the 1 970s in the USA
and in other advanced economies. The term stagation was
coined, implying recession together with rising ination. The
original inverse relationship had collapsed and traditional
Keynesian analysis, relying on the importance o shits in AD to
explain movements in output and prices, ound it hard to explain
what was going on. Stagation implied higher ination and higher
unemployment and this suggested that the Phillips curve was not
stable but shited out and to the right, as illustrated in Figure 2.3.9.
I n Figu re 2 .3 .9 the Phillips cu rve is shiting ou tward s throu gh
tim e. Point A2 on Phillips cu rve PC2 illu strates a both a hig her
rate o u nem ploym ent and a h igher rate o in ation compared
with Phillips cu rve PC1 and point A1 .
H ow could this happen? One explanation was that AS had shited
let in the 1 970s. The oil price shocks at this time increased
production costs o frms across the board. Back then the US
economy relied much more on manuacturing than it does these
days. The price shocks shited AS on the let-hand side diagram o
Figure 2 .3.1 0 rom AS1 to AS2 . Equilibrium has shited rom point
Ination rate ()
A2
A1
PC2
PC1
Unemployment rate (%)
Figure 2.3.9 Stagation and the outward shiting o the Phillips curve
92
Ination rate ()
2
1
Phillips
curve
U1
Unemployment rate (%)
A1 to point A2 which is characterized by rising prices and by
lower real output and higher unemployment as the same point
illustrated on the right-hand side diagram o Figure 2 .3.1 0. The
adverse supply shock resulted in stagation and analytically this
is shown with a shit to the right o the Phillips curve.
But beyond this empirical reutation o the original Phillips curve
there came a theoretical attack. Milton Friedman and Ed Phelps
(both Nobel Laureates; 1 976 and 2 006 respectively)
independently made a distinction between a short-run Phillips
curve (SRPC) and a long-run Phillips curve (LRPC) and claimed that
in the long run the Phillips curve was vertical at the equilibrium
rate o unemployment (the natural rate introduced earlier which
corresponds to the potential level o real output o an economy
where the LRAS is vertical). Thereore, they claimed, any trade-o
between ination and unemployment could exist only in the short
run. This became known as the PhelpsFriedman critique and the
theory as the expectations-augmented Phillips curve.
I a governm ent tried to lower unemploym ent below its natural
or equilibrium rate using expansionary policies (that is, by
increasing AD) it would succeed only temporarily and at the cost
o permanently higher ination. The short run trade-o between
ination and unemploym ent was only because workers suer
Average Price Level (P)
AS2 AS1
P2 A2
P1 A1
AD
0 Y2 Y1
Real Output/Income (Yr)
Figure 2.3.1 0 Stagation as a result o adverse supply shocks

rom m oney illusion: they orm their expectations about ination
adaptively (m eaning that they orm their expectations about
next years ination by looking at past ination rates) so they are
slow to realize that ination accelerates and does not remain the
same as a result o the expansionary policies pursued.
Ination rate (%)
LRPC
6.5%
A4 A5
4.0%
2.0% A3 SRPC (4.0%)
A2
SRPC (2.0%)
1.0% A1
SRPC (1.0%)
0 4.5% NRU
(e.g. 5.2%) Unemployment rate (%)
Figure 2.3.11 The LRPC
(The expectations-augmented Phillips curve or the PhelpsFriedman critique)
In Figure 2.3.11 it is assumed that the natural rate o
unemployment (NRU) is at 5.2% and that the economy has been
experiencing ination equal to 1.0% or some time now so that
workers again expect 1.0% ination next year (point A1 ). Assume
now that the government adopts expansionary policies to try to
lower unemployment to 4.5% below the equilibrium (natural) level.
It is essentially trying to expand output beyond its potential level.
As a result o the higher AD, ination accelerates to 2 .0%. The real
wage rate decreases and frms hire more workers. We are moving
along the economys SRAS curve where the average price level is
higher and real output greater. Unemployment decreases to 4.5%
Economic growth
Econom ic growth exists i a countrys real GDP increases through
tim e. It can be illustrated in several ways. In Figure 2 .3.1 2
econom ic growth is depicted by the m ovem ent towards the
northeast rom point A to point B (closer to the rontier within a
countrys production possibilities curve or PPC) as this m ovement
illustrates an increase in the economys actual output.
Point B re ects prod uction o m ore o good X and m ore o good
Y compared to point A (as X2 . X1 and Y2 . Y1 ). This increase
in actual output (real GDP) represents econom ic growth. It can
be a result o lower unemploym ent in the country and , m ore
generally, better (m ore ef cient) use o existing resources.
Lower unemployment does not imply in this set-up more labour
becoming available but that, given the existing amount o labour,
ewer individuals remain unemployed. I you think about it, strictly
speaking, you could have a movement rom point A to point B
2 Macroeconomics
and the economy has moved to point A2 on the fgure. Workers are
slow to realize that ination is actually higher than previously at
2 .0%, so the real wage is lower. But when their expectations adjust
they will demand higher money wages, increasing the real wage
or frms back to its original equilibrium level. The SRAS curve o
the economy will have decreased and shited to the let. Firms will
fre workers so unemployment returns to its natural rate at 5.2%
(point A3) and real output to its potential level Yp.
I the governm ent insisted on trying to d ecrease unemploym ent
below its natural rate using expansionary demand-side policies it
wou ld need to engineer higher and higher ination rates so
that workers would be temporarily ooled and accept job oers.
I n Figure 2 .3.1 1 , ination would have to accelerate to 4.0% or
u nemploym ent to drop below the natural rate again and or the
economy to m ove to point A4 beore adjusting back to A5 ,
while workers would expect in ation still to be at 2 .0%.
The policy implication predominantly associated with the
monetarist or new classical school is clear: governments should
not try to lower unemployment below its natural rate using
expansionary demand-side policies because it is utile. Any
decrease in unemployment will be temporary and at the cost o
higher ination. Equivalently, in terms o real output, the
implication is that it is utile to try to expand real output beyond
its potential level by employing expansionary demand-side policies
as any increase will be short lived and will in the long run prove
purely inationary. In the long run, when expectations have
adjusted and there is no money illusion, there is no trade-o
between ination and unemployment. There is only one rate o
unemployment and it is compatible with any rate o ination as
long as this rate o ination does not accelerate. In the long run
the Phillips curve is vertical at the NRU which is also known or
this reason as the non-accelerating ination rate o unemployment.
Units of good Y
Y2 B
Y1 A
0 X1 X2
Units of good X
Figure 2.3.12 Economic growth as an increase in actual output
93
 2 Macroeconomics
with the unemployment rate remaining the same i the number o
unemployed increases at the same rate as the labour orce. In this
case, though, there would also be a shit o the curve outwards.
Econom ic growth can also be illu strated throu gh an ou tward s
shit o the PPC, as illu strated in Figu re 2 .3.1 3.
Units of good Y
H
F
0 F H Econ om ic growth has many benef ts and this may explain why
Units of good X
Figure 2.3.13 Economic growth as an increase in the production
possibilities o a country
The production possibilities o this economy have expanded and
the PPC has shited rom FF to H H . Rem em bering that each
point in this space represents a specifc com bination o output it
should be clear that this economy is now in a position to produce
and enjoy com binations o good X and o good Y that were
previously unattainable. I we recall the assumptions made to
construct the PPC it should be clear that such a shit is possible i
the quantity or quality o available resources increases or
improves and/or i the available technology advances.
An altern ative visu alization o econom ic growth employs th e
concept o the LRAS cu rve with the economys potential ou tpu t
increasing. I t wou ld n ot be technically correct, thou gh, to
consid er the level o potential ou tpu t as being the sam e with
any point on a PPC: the orm er is not a technological bu t an
econom ic concept; the latter are pu rely technological as they
are d ef ned solely on the basis o what th e technological
capabilities o an economy are with som e specif c set o
resou rces and technology.
Figu re 2 .3.1 4 illu strates an econom y which experiences a shit
to the right o its LRAS and a correspond ing increase in its level
o potential ou tpu t.
Average price level (P)
LRAS1 LRAS2
Yp1 Yp2
Real outcome/income (Yr)
Figure 2.3.1 4 Economic growth as an increase in potential output
and a shit to the right o the LRAS
94
Poten tial ou tpu t has increased rom Yp1 to Yp2 , shiting the
economys LRAS cu rve rom LRAS1 to LRAS2 . The actors that
cou ld be respon sible or su ch d evelopm ents inclu d e all the
actors that cou ld sh it a PPC ou tward s bu t, in ad d ition, any
actor that may d ecrease the natu ral rate o u nemploym ent.
I n the long ru n , econom ic growth is achieved when the
economy experiences improved labou r prod u ctivity as im proved
prod u ctivity m eans great ou tpu t per u nit worker. For su ch
prod u ctivity gains to be achieved , investm ents in natu ral
capital, physical capital and hu man capital are prerequ isites.
I m provem ents in the institu tional ram ework shou ld also not be
overlooked . These are the sam e actors responsible or a shit
ou tward s o the PPC. The single m ost important drivin g orce in
prod u ctivity growth is technology thou gh.
Consequences of economic growth
it is consid ered the single m ost important macroeconom ic goal,
bu t it may also entail seriou s costs. The ollowing consequ ences
o econom ic growth are signif cant.
n Econom ic growth has an eect on living stand ard s. I t
allows m ore ou tpu t to be enjoyed per person, assu m ing o
cou rse that the econom ic growth is greater than popu lation
growth. I ou tpu t per person increases then increased levels
o consu mption o g ood s and services are possible.
Assu m ing a d irect relationship between welare and
consu m ption it ollows that growth may im prove living
stand ard s. Econom ic growth is consid ered a prerequ isite or
poverty red u ction.
n A growing economy will aect u n employm ent. Econom ic
growth is typically, bu t not necessarily positively, correlated
with employm en t creation. U su ally, in a growing economy
m ore jobs are created and u nemploym ent d ecreases.
Su ccessu l policies that accelerate growth also d ecrease
u nem ploym ent so that a secon d macroeconom ic objective
is achieved . I t is possible, thou gh, or a cou ntry to
experience jobless growth. This cou ld be the case i growth
is achieved u sing inappropriate technologies, which in the
case o d eveloping cou ntries m eans that they d o not rely on
labou r, the relatively abu nd ant actor o prod u ction. Also,
growth may n ot lead to a red u ction o u nem ploym ent i it is
not ast en ou gh so that the net in crease in the labou r orce
exceed s th e jobs that are created .
n A growing economy aects in ation. Econom ic growth can
both alleviate and create in ationary pressu res. I the
growth in the prod u ctive capacity o the economy is not
aster than the growth in d emand that rising incom e levels
create then the economy may overheat. This will m ean that
prices (the average level o prices) will start risin g. Whether
econom ic growth is responsible or (d emand -pu ll) in ation
d epen d s on how ast AD rises compared to LRAS. I n
ad d ition, i th e growth process pu ts pressu re on inpu t prices
(wages or labou r, raw material prices, etc.) it may also
initiate a cost-pu sh in ationary spiral. The ip sid e o this is
that i the growth process increases LRAS at least as ast as
AD increases then the economy will be able to enjoy
non-in ationary growth.
n Econom ic growth has consequ ences or governm ent
f nances (the f scal d ivid end ). A growing economy im plies

higher incom es and m ore spend ing. Tax revenu es rom both
d irect and ind irect taxation will thereore au tomatically
increase (that is, withou t the governm ent imposing any new
taxes). M ore m oney owing into the governm ents coers
perm its f nancin g o m ore governm ent projects, not only
withou t the governm ent resorting to higher taxation bu t
also withou t it incu rring any ad d itional borrowing costs.
n Econom ic growth can both im prove and worsen incom e
d istribu tion. I t can alleviate incom e inequ ality as it perm its
govern m ent a red istribu tion o incom e rom the wealthy to
the poor. Red istribu tion can be d irect by perm itting the
establish m ent o a social welare net su ch as pensions and
u nemploym ent benef ts or perm itting an increase in su ch
benef ts. I t can also be ind irect throu gh spend ing on
poverty alleviation program m es (to increase agricu ltu ral
prod u ctivity; to im prove sanitation; to improve basic
inrastru ctu re, etc.) as well as on im proved health an d
ed u cation acilities that increase hu man capital and labou r
prod u ctivity. Unortu nately, econom ic growth oten lead s to
higher incom e inequ ality. There is no gu arantee that he
benef ts o growth will be airly d istribu ted . I growth is
driven by only a hand u l o ind u stries; i it is concentrated
in certain regions; i it relies only on certain skills or i it is
jobless then many may be let ou t and incom e inequ ality
in the cou ntry may wid en.
n Econom ic growth aects trad e. I the growth is export
driven (that is, i it is a resu lt o growing exports as in the
case o China) then it will d ecrease any trad e d ef cit or lead
to a trad e su rplu s. I , thou gh, it is driven by d om estic
d emand then the resu lting higher incom e levels may be
respon sible or a wid ening trad e d ef cit as part o the
higher incom es will be spent on imports.
n Th ere are also consequ ences or su stainability: the eect o
econom ic growth on th e environm ent may entail certain
Equity in the distribution of income
The ou rth macroeconom ic goal is to ensu re that incom e
d istribu tion is equ itable. Equ itable d oes not m ean equ al. I t
m eans air. Bu t airness is an elu sive concept and it m eans
d ierent things to d ierent people. Unequ al ownership o The Lorenz curve and the Gini coefcient
actors o prod u ction may be responsible or incom e inequ ality
as well as a d istorted institu tional ram ework that is tilted in
avou r o certain social grou ps and grants them exclu sive
privileges and preerences.
Indicators o income inequality
Inequality ratios
I n com e in equ a lity ca n be d escribed u sin g in equ a lity ratios.
Th ese exam in e th e ratio o (d isposa ble) in com e o th e top
1 0% (d ecile) over th e bottom 1 0% o th e popu lation (a lso
kn own a s th e in terd ecile P90 to P1 0 in com e ratio) or o th e
top 2 0% (qu in tile) over th e bottom 2 0% (qu in tile). I n com e
in equ a lity ratios in th e world o th e h ig h est to th e lowest
d ecile ra n g e ca n ra n g e between rou g h ly 5 to 40: th e top 1 0%
may ea rn 5 to 40 tim es m ore tha n th e bottom 1 0% o th e
popu lation . I n Den m ark th e f g u re in th e m id -2 000s wa s th e
lowest at 2 .72 .
2 Macroeconomics
benef ts bu t it also creates very signif cant costs. The
possible benef ts can best be u nd erstood throu gh the
so-called environm ental Ku znets cu rve (associated with
Gene Grossman) which shows that there is an inverted
U -shaped relation ship (that is, a hu mp-shaped cu rve)
between certain environm ental costs (su ch as water
pollu tion, air pollu tion and d eorestation) and per capita
incom e levels o cou ntries. Th e basic id ea is that as per
capita incom es increase, pollu tion increases, bu t som e
threshold level o incom e exists. Beyond this thresh old , not
only is there sign if cantly increased d emand or a cleaner
environm ent by the popu lation, bu t there are also m ore
resou rces available to expend on clean er technologies. The
issu e here is that ou tpu t growth not only requ ires the u se o
m ore natu ral resou rces bu t also lead s to m ore em issions
and wastes that may exceed the earths carrying capacity,
rend ering growth u nsu stainable. The environm ental
Ku znets cu rve provid es an optim istic view in the sense that
it claim s that econom ic growth d oes not u navoid ably harm
the natu ral habitat bu t it is strongly criticized in many
respects. First, it may empirically hold or local externalities
(that is, or ind oor hou sehold pollu tion which d oes d ecrease
ater som e relatively low per capita in com e level) bu t it
d oes not seem to hold or many d ispersed externalities su ch
as carbon em issions. Also, d ierent pollu tants behave
d ierently across cou ntries and across incom e levels. I n
ad d ition, with global pollu tion levels still rising, wealthier
cou ntries may choose not to prod u ce bu t to import
pollu tion-intensive good s. I n general, the eect o econ om ic
growth on the environm ent is a u nction o the scale o
prod u ction , the composition o prod u ction (whether
changing tastes lead to the prod u ction o ewer pollu tion-
intensive good s) and the techniqu es o prod u ction (whether
less pollu tion-intensive technologies are em ployed ).
Income inequality can also be described through the Lorenz curve
and its degree can be measured through the Gini coefcient.
I n Figu re 2 .3 .1 5 popu lation (incom e recipients) is plotted on
the horizontal axis in cumulative percentages (that is, rom
poorest to richest hou sehold s). So at, say, the 2 0% point, we
have the poorest 2 0% o th e popu lation and at the 40% point,
we have the poorest 40% o the popu lation. On the vertical
axis we m easu re the percentag e o incom e received by each
percentage o the popu lation.
The Lorenz cu rve shows the proportion o national incom e
earned by each incom e grou p. For example, the poorest 2 0%
o people in Figu re 2 .3.1 5 receive only 5 % o national incom e.
N ote that 1 00% o the popu lation will o cou rse receive 1 00%
o national incom e. Also note that the d iagonal is th e line o
equ ality (perectly equ al incom e d istribu tion).
The u rther away rom the d iagon al, the m ore u nequ al the
d istribu tion o in com e is. The closer to the d iagonal, the m ore
equ al the d istribu tion o incom e is. I incom e d istribu tion
worsens in a cou ntry it m eans that the Lorenz cu rve m oves
u rther away rom the d iagonal.
95
 2 Macroeconomics
1 00%
National income (cumulative)
55%
40% A B
20%
1 0%
5%
0% 20% 40% 80% 1 00%
Population (cumulatively ranked)
poorest to richest
Figure 2.3.15 The Lorenz curve and the Gini coefcient
The Gini coefcient measures the degree o incom e inequality in
a population. It is the ratio o the area between the Lorenz curve
and the diagonal over the area o the hal square in which the
curve lies. The Gini coefcient is the ratio o the area between the
Lorenz curve and the diagonal over the area o the hal-square or,
ocusing on Figure 2 .3.1 5, area (A) divided by area (A1 B):
area (A)
Gini coeicient 5 ___________
area (A 1 B)
The Gini coef cient can vary rom 0 (d enoting perect equ ality:
each person gets the sam e incom e) to 1 (d en oting perect
inequ ality: all incom e goes to the share o the popu lation with
the highest incom e).
Range o values o Gini: (0,1 )
Typically, highly unequal incom e distributions are distributions
with a Gini coefcient between 0.50 and 0.70. Som e
representative values o this coefcient are: Brazil 0.57, Zim babwe
0.50, Argentina 0.49, U ganda 0.46, the U SA 0.38, the U K 0.34,
Australia 0.30, Austria 0.27, and Denmark and Sweden at 0.23.
The Organisation or Econom ic Co-operation and Developm ent
(OECD) average in the mid-2 000s was around 0.31 .
Keep in m ind that oten what matters m ost is not the level o
incom e d istribu tion bu t the d irection o chang e (that is,
whether incom e d istribu tion is becom ing m ore or less u nequ al).
Poverty
Absolute poverty is defned by the minim um incom e necessary to
satisy basic physical needs; the 2 008 World Bank international
poverty line is set $ 1 .2 5 (purchasing power parity PPP) per day.
Relative poverty m easu res the extent to which a hou sehold s
incom e alls below the national average.
Causes and consequences of poverty
Poverty locks ind ivid u als into a viciou s poverty cycle or trap.
Low incom e is both a cau se and a consequ ence o poverty. As a
resu lt o their low incom e, these ind ivid u als hu man capital is
very low. They cannot aord the opportu nity cost o schooling.
Th eir savings are non-existent, so they are not in a position to
invest in physical capital and (in d eveloping cou ntries) they are
orced in their eort to su rvive to d eplete or d estroy any natu ral
capital they may have access to. Low hu man, physical and
natu ral capital implies low prod u ctivity, which in tu rn lead s to
low incom e, closing the cycle.
96
Possible benefts and costs o a more equitable
income distribution
A m ore equ itable d istribu tion may help accelerate growth and
prom ote hu man and econ om ic d evelopm ent in many ways.
n The very poor will be able to aord access to cru cial
resou rces, su ch as ed u cation and m ed ical care, so the
am ou nt and qu ality o prod u ctive resou rces available to
a cou n try increases. Better ed u cation and health improves
labou r as prod u ctivity will be hig her.
n The propensity o the poor to consu m e is higher than that
o the rich so red istribu tion will increase AD, especially or
basic good s and services.
n Social tensions will be lower, so governm ents can m ore easily
undertake important econom ic reorm s requiring a high
degree o consensus within the population. I people eel
that they enjoy the ruits o econom ic growth then they will
be willing to work harder and sacrifce m ore now in order or
them or their children to enjoy m ore at a later date. They will
be willing and able to save m ore, allowing higher rates o
investm ent and so growth. Fewer social tensions decrease
uncertainty and risks or dom estic and oreign investors.
Tru st increases am ong the popu lation so the cost o
n
econom ic transactions d ecreases. More econom ic activity
will take place so growth will accelerate.
On the other hand , consid er the ollowing.
n An excessively equ al incom e d istribu tion cou ld lower
econom ic ef ciency. I t cou ld lower the incentives or people
to work hard and or risk taking. I n this way, growth may be
u nd erm ined .
The role o taxation in promoting equity
Direct and indirect taxes
Direct ta xes are ta xes on in com e, on prof ts an d on wea lth .
The chara cteristic o a d irect ta x is that its bu rd en can n ot be
sh ited on to an other en tity. I n d irect ta xes in clu d e taxes on
g ood s a nd on expen d itu res a nd th ey have been d iscu ssed
earlier. Th e bu rd en o a n ind irect tax ca n be sh ited on to a
d ieren t en tity.
Progressive, proportional and regressive taxation
To explain the d ierence between these types o taxes it is
important to d ef ne the marginal tax rate (MTR) and the
average tax rate (ATR).
The M TR is the percentage taken by the governm ent on the last
d ollar earned , or the extra tax paid as a resu lt o extra incom e
earned .
The ATR is the ratio o the tax collected over incom e earned or,
m ore generally, the ratio o the tax collected over the tax base.
The tax base reers to whatever is taxed , or example incom e,
spend ing, prof ts and wealth.
MTR ATR
DT
MTR 5 ___
T
ATR 5 _
DY Y
A progressive tax system is one in which ind ivid u als with
higher incom es pay proportion ately m ore so the ATR rises as
 2 Macroeconomics

incom e rises. I n a progressive incom e tax system the M TR is
greater than the ATR. (Rem em ber that i the average increases
it ollows that the marginal is greater than the average.)
A proportional tax system is one in which all individuals pay the
sam e proportion o their incom e independently o the level o
their incom e. In a proportional tax system the ATR remains
constant as incom e rises so the MTR is equal to the ATR. A at
rate (proportional) incom e tax exists in several countries, such as
Latvia, Russia, and Estonia, and is being considered by many
others. I t presents many ad vantages to the progressive incom e
tax system s that m ost countries have. Disincentives are lower,
adm inistrative costs are lower, the system is simple and m ore
transparent and it is potentially even airer, as loopholes do not
exist which usually higher-incom e household s take advantage o.
A regressive tax system is one in which poorer ind ivid u als pay
a greater proportion o their incom e. I n a regressive tax system
the ATR d ecreases as incom e rises so the MTR is less than the
ATR. I nd irect taxes are proportional with respect to expend itu re
bu t regressive with respect to incom e. This is why ind irect
taxation on ood and basic good s is lower than in other
system s, or set at zero.
In Figure 2 .3.1 6 the horizontal axis m easures the tax base (say,
incom e) and the vertical the am ount o tax paid. A proportional
tax system is illustrated by any straight line through the origin. In
a progressive tax system the slope o the line is increasing while
in a regressive tax system the slope o the line is decreasing.
Tax paid
Measures to promote equity
Short-run solutions
U su ally governm ents resort to a m ixtu re o progressive incom e
taxes cou pled with a system o transer paym en ts. Transer
paym ents inclu d e pensions, u nemploym ent benef ts, d isability
ben ef ts, child allowances and su bsid ies. By taxing hou sehold s
with higher incom es m ore heavily than those with lower
incom es and spend ing m ore on transer paym ents, nation al
incom e may be red istribu ted in an attempt to satisy the equ ity
g oal. Social health insu rance and a system o pu blic ed u cation
is u su ally part o a package that aim s at eectively increasing
the incom e o the lower-incom e strata.
Long-run solutions
I n the long ru n, the m ost eective rou te to a m ore equ itable
incom e d istribu tion is by im proving the qu ality and access to
ed u cation an d health-care services or the m ost d eprived
incom e grou ps. Schools, health-care centres, im proved
inrastru ctu re that inclu d es better road s, as well as sanitation
and clean water su pplies will all contribu te to an increase in
h u man capital. A healthier popu lation with better ed u cation,
training and skills will increase labou r prod u ctivity and lead to
h igher incom es. The importance o a air ju d icial system , better
institu tions in general and lower corru ption shou ld not be
u nd erestimated .
Progressive tax Proportional tax Regressive tax
A tax is progressive: A tax is proportional: A tax is regressive:

Progressive

if the ATR constant

if the ATR if the ATR

that is, MTR . ATR that is, MTR 5 ATR that is, MTR , ATR
which means which means that which means that
that higher income higher income higher income
Proportional individuals pay individuals pay individuals pay
proportionately proportionately proportionately less,
Regressive
more, the same,
or, more generally, or, more generally, or, more generally,
that tax paid rises that tax paid rises that tax paid rises
faster than the as fast as the slower than the
tax base. tax base. tax base.

Tax base (income)

Figure 2.3.1 6 Progressive, proportional and regressive taxation

97
 2.4 Fiscal policy

Fiscal policy is a d emand -sid e policy. Demand -sid e policies attempt to increase or d ecrease
AD (or, m ore precisely, to slow d own the increase o AD) in ord er to aect real ou tpu t
(growth), employm ent an d the in ation. Later we will see that these sam e policies are also
u sed to correct a trad e im balance and are reerred to as expend itu re-changing policies.
Fi sca l pol i cy reers to th e m a n i pu la ti on o th e l evel o g overn m en t expen d i tu res (G )
a n d /or g overn m en t reven u es (T) i n ord er to i n u en ce AD a n d , th rou g h th i s, econ om i c
va ri a bl es su ch a s rea l ou tpu t a n d g rowth , em pl oym en t a n d i n a ti on .

The government budget

Sources of revenue and types of expenditures
Governm ents typically earn m ost revenu es rom d irect and
ind irect taxation. They may earn also revenu es rom the sale o
good s and services (or example, revenu es rom the sale and
export o oil are a major sou rce o governm ent reven u es or
cou ntries prod u cing and exporting oil). The proceed s rom the
sale o governm ent-owned assets, su ch as state-owned
enterprises that are then privatized or governm ent land , are
also one-o revenu es.
Spending is classif ed into current spending, capital expenditures
and transer paym ents. Current expenditu res include wages and
salaries o public sector employees as well as spending on
consu mables (day-to-day item s) such as stationery. Capital
expenditures reer to public investm ent spending. These
expenditures inclu de all spending on inrastructure, or example
spending on the construction o roads, harbou rs, hospitals and
schools. Transer paym ents represent transers o m oney rom
one grou p to another and as such are not inclu ded in the
calculation o GDP bu t are part o incom e redistribution policies.
Transer paym ents inclu de social security (welare) expenditures,
or example pensions, unemploym ent benefts, disability
paym ents and scholarship grants.
The budget outcom e
The relationship between the size o governm ent expend itu res
and governm ent incom e (tax revenu es) d eterm ines whether
there is a bu d get d ef cit, a bu d get su rplu s or a balanced
bu d get. H ere are specif c d ef nitions.
n A bu d get d ef cit exists i governm ent expend itu res (G)
exceed governm ent revenu es or incom e (T).
n A bu d get su rplu s exists i governm ent revenu es or incom e
(T) exceed governm ent expend itu res (G).
n A balanced bu d get exists i governm en t expend itu res (G)
are equ al to governm ent revenu es or incom e (T).
The public (national or government) debt
Assum e the ormation o a n ew cou ntry in, say, 2 006. Assu m e
that its governm ent in 2 006 had spent 1 5 0 m illion o its own
d ollar cu rrency and had collected 1 2 0 m illion d ollars. I t
incurred a bu d get d ef cit equ al to 3 0 m illion d ollars. Assu m e
now that in 2 007 it had spent 1 80 m illion d ollars and had
collected in tax and other revenu es 1 70 m illion d ollars. I n 2 007
it record ed a bu d get d ef cit equ al to 1 0 m illion d ollars. I ts
pu blic d ebt is at 40 m illion d ollars. I in 2 008 it spent
21 0 m illion d ollars and collected in tax and other revenu es
21 5 m illion d ollars, it record ed in 2 008 a bu d get su rplu s
o 5 m illion d ollars. I ts pu blic d ebt will now stand at 35 m illion
d ollars. The pu blic d ebt is d ef ned as the the cu m u lative total
o all governm ent borrowings less repaym ents or the su m o all
m oney owed by a governm ent at a point in tim e. Bu d get
d ef cits or su rplu ses and the pu blic d ebt are thereore n ot the
sam e bu t they are linked , as the pu blic d ebt grows when the
governm ent ru ns a bu d get d ef cit and shrinks wh en it ru ns a
bu dget su rplu s.
The public (national or government) debt should not be
TIP
conused with a countrys external debt. The external debt
reers to what a country (public and private sector) owes to
oreigners and is denominated in oreign exchange.

If: then: and:

G.T a budget defcit is recorded the national debt grows
T.G a budget surplus is recorded the national debt shrinks
G5T the budget is balanced the national debt is unchanged

98
 2 Macroeconomics

Expansionary and contractionary fscal policy

Expansionary (or reationary) fscal policy i n a ti on . I n Fi g u re 2 .4.2 th i s ri sk i s sh own to d epen d
cru ci a l l y on th e sh a pe o th e AS cu rve a n d , m ore preci sel y,
Keyn es i n trod u ced th e i d ea th a t th e (eq u i l i bri u m ) l evel o
on h ow cl ose or a r rom u l l em pl oym en t th e econ om y
ou tpu t wa s d em a n d -dri ven . Th e l evel o AD (eecti ve
i s opera ti n g .
d em a n d ) d eterm i n es th e l evel o overa l l econ om i c a cti vi ty.
Th ere wa s n o g u a ra n tee, a ccord i n g to th i s sch ool o th ou g h t,

Average price level (P)

th a t eq u i l i bri u m ou tpu t a n d u l l em pl oym en t ou tpu t wi l l AS
coi n ci d e. Th ere cou l d very wel l be a d e a ti on a ry (or
recessi on a ry) ga p. AD cou l d be i n su f ci en t i , or wh a tever P6
rea son , th e pri va te sector (h ou seh ol d s a n d f rm s) d eci d ed to
h ol d ba ck on th ei r spen d i n g . A recessi on cou l d resu l t. So, P5
th rou g h th i s, Keyn es i n trod u ced th e i d ea o expa n si on a ry
f sca l pol i cy.
Expansionary (or, re ationary) f scal policy aim s at increasin g AD5 AD6
P4
AD in ord er to increase national incom e (real ou tpu t) and
P3
employm ent and so close a d e ationary gap.
P
I t req u ires a n in crea se in g overn m en t spen d i n g (G) a n d /or a AD3 AD4
d ecrea se in ta xati on (T). Si n ce g overn m en t spen d i n g i s a
com pon en t o AD, a rise i n G wi l l d i rectl y in crea se AD, sh iti n g
i t to th e ri g h t. I n oth er word s, i pri vate spen d i n g (C 1 I ) i s AD1 AD2
n ot su f ci en t to g en erate u l l em pl oym en t, th en th e
g overn m en t sh ou l d i n crea se i ts spen d i n g (G) by borrowi n g Y1 Y2 Y3 Y4 Yf
rom th e pri vate sector (d ef cit spen d in g : G . T). A d ecrea se i n Real outcom e/incom e (Yr)
ta xati on (T) wi ll i n d i rectl y a l so i n crea se AD a s it wil l in crea se
Figure 2.4.2 The shape o AS and the eects o expansionary fscal policy
d i sposa bl e i n com e that peopl e have (d ef n ed a s in com e m i n u s
d i rect ta xes) a n d wi l l in d u ce m ore spen d i n g . I th rou g h a n Assu m ing that the econom y was in equ ilibriu m at Y1 , the
i n crea se i n g overn m en t expen d i tu res a n d /or a d ecrea se i n increase in AD rom AD1 to AD2 lead s to an increase in real
ta xes, AD i n crea ses (that is, sh its to th e ri g h t) th en a ou tpu t withou t the average price level being ad versely aected .
d e ati on a ry (or recessi on a ry) ga p ca n be cl osed , a s I , thou gh, the d e ationary gap was smaller and the economy
Fig u re 2 .4.1 il lu strates. was in equ ilibriu m at Y3, then the increase in AD rom AD3 to
AD4 wou ld lead not only to an increase in real ou tpu t bu t also
Average price level (P)

AS to som e increase in prices (that is, it wou ld be responsible or

som e in ation). I the econom y is at u ll employm ent and
g overnm ent expend itu res increase and /or taxes d ecrease, the
resu lting increase in AD will prove only in ationary.
I we employ a m onetarist or new classical AD and AS
ram ework then the eects are sim ilar, as shown in Figu re 2 .4.3 .
Average price level (P)

LRAS

SRAS

AD2
AD1
Y1 Y2 Yf
Real outcome/income (Yr)
Figure 2.4.1 Expansionary fscal policy

Assu m e a n econ om y i n eq u i l i bri u m a t rea l ou tpu t l evel Y1 . AD4

G i ven th a t th e u l l em pl oym en t (or poten ti a l ) l evel o ou tpu t AD3
i s a t Y, th ere i s a d e a ti on a ry (or recessi on a ry) g a p eq u a l to
d i sta n ce Y1 Y. Lets sa y th e g overn m en t d eci d es to em pl oy
expa n si on a ry f sca l pol i cy i n a n a ttem pt to cl ose th i s ga p. AD2
AD1
Th e i n crea se i n g overn m en t expen d i tu res (G ) a n d th e
d ecrea se i n ta xes (T) wi l l i n crea se AD (a s expla i n ed a bove), Yp
i n th i s ca se, sa y, rom AD 1 to AD 2 . Th e n ew eq u i l i bri u m Real ou tcom e/incom e (Yr)
l evel o rea l ou tpu t i s a t Y2 , wh i ch i s cl oser to th e u l l Figure 2.4.3 Expansionary fscal policy in a monetarist or new
em pl oym en t l evel Y. I t sh ou l d be rea l i zed th ou g h th a t th e classical ramework
opportu n i ty cost o su ch a pol i cy i s th e ri sk o a ccel era ti n g

99
 2 Macroeconomics
I there is a d e ationary gap then expansionary f scal policy will
increase AD rom AD1 to AD2 . The resu lt is higher real ou tpu t
bu t also in ationary pressu res. I , thou gh , the economy is at its
potential ou tpu t and AD increases as a resu lt o re ationary
f scal policy rom AD3 to AD4, then no lastin g increase in real
ou tpu t will resu lt. Any increase in real ou tpu t will be temporary.
I n the long ru n, real ou tpu t will retu rn at its poten tial rate at
the cost o higher in ation. Expansionary f scal policy will not
have su cceed ed in increasing real ou tpu t.
Contractionary (deationary) fscal policy
On the other hand , an overheating economy, d ef ned as an
economy where AD is rapid ly increasing, creating in ationary
Expansionary fscal policy
To refate a ailing economy increasing real output and
Goal decreasing unemployment
(to help close a defationary gap)
How? G and/or T
Why is AD An increase in G directly increases AD;
aected? a decrease in T will increase Yd and so C and AD
Possible Higher infation;
costs wider trade decit; crowding out
Note: The shape o the AS curve is crucial in evaluating the impact on an economy
HL The multiplier eect
Expansionary f scal policy accord ing to the Keynesian school is
very poweru l tool to lit an economy ou t o a recession, as a
resu lt o the operation o the m u ltiplier eect.
Average price level (P)
G on imports, or saved or paid as taxes to the governm ent, k is
Multiplier effect
AD3
AD2
AD1
0
Real outcome/income (Yr)
Figure 2.4.4 The Keynesian multiplier eect
Assu m e that a governm ent wishing to close a d e ationary gap
em ploys expansionary f scal policy and d ecid es to increase its
expend itu res by som e am ou nt, say, DG (the d ierence between
the new level o spend ing and the original level o spend ing).
AD will au tomatically increase by DG and shit rom AD1 to
AD2 , as in Figu re 2 .4.4. Bu t accord ing to the m u ltiplier eect,
the process will not end there. AD will continu e to increase and
shit to the righ t all the way to AD3 .
The m u ltiplier eect states that an increase in governm ent
expend itu res will lead to a greater chang e in incom e:
1 00
pressu res, requ ires contractionary f scal policy. The governm ent
m u st d ecrease governm ent expend itu res and increase taxes so
that AD d ecreases.
The d ecrease in governm ent expend itu res (G) will d irectly
d ecrease AD (or slow d own its increase) while an increase in
d irect taxes will d ecrease d isposable incom es, lowering
con su mption (C) and so AD.
I n a d ia gram , AD will sh it let, a lleviatin g in ation a ry
pressu res (sh own a s a d ecrea se in th e avera g e price level) bu t
a lso riskin g a con traction o th e econ om y (that is, a lower level
o ou tpu t a n d a h ig h er rate o u n em ploym en t). Th e risk o
con tra ction d epen d s on th e sha pe o th e AS cu rve a cin g th e
econ om y.
Contractionary fscal policy
To cool o an overheating economy
(to help close an infationary gap)
G and/or T
A decrease in G directly decreases AD;
an increase in T will decrease Yd and so C and AD
Slow down in growth or even a recession; increased
unemployment
DY 5 kDG
where DY is the resu lting chang e in national incom e, DG is the
chang e in governm ent spend ing and k is the m u ltiplier.
I t can be shown that the m u ltiplier k is equ al to:
1
k 5 _________
(1 2 MPC)
where M PC is the marginal propen sity to consu m e d ef ned as
the extra spend ing ind u ced by extra incom e:
DC
MPC 5 ___
DY
Since whatever is not spent on d om estic ou tpu t is either spent
also equ al to:
1
k 5 __________________
(MPM 1 MPS 1 MRT)
MPM is the marginal propensity to import, M PS is the margin al
propen sity to save and M RT is the marginal rate o tax. They
are d ef ned respectively as the extra spend ing on im ports, the
extra savings and the extra taxes paid rom extra incom e
earned and th ey represent th e withdrawals (leakages) in ou r
circu lar ow o incom e m od el.
The logic o the Keynesian m ultiplier
Why will national income increase by m ore than the increase in
governm ent expenditures? The explanation rests on two ideas.
First o all, one persons spending is automatically som eone elses
income. In addition, as the circular ow diagram (see Figure 2 .1 .3
on page 68) clearly illustrates, econom ic activity takes place in
successive rounds. An example will help clariy the point. Assum e
that the governm ent decides to increase expenditures by 1 0
m illion and hires unemployed workers to dig holes and bury

bottles, and other unemployed workers to dig them up. National
incom e has directly increased by 1 0 m illion the incom e that
these workers earned or the service they produced. Spending by
the governm ent is incom e or the workers. But, econom ic activity
will not stop there. There is a 2 nd and a 3rd and an nth round
that ollow. Why? Because these workers will spend part o this
extra incom e on dom estic goods and services that others produce
and the process will continue.
Let the M PC be constant and equ al to b; or example, b cou ld
be equ al to 0.8 which m eans that ou t o every extra pou nd
earned in in com e, 0.80 o it will be spent on d om estic good s
and services. The increase in governm ent expend itu res by 1 0
m illion pou nd s will lead to an eventu al increase in national
incom e equ al to 5 0 m illion i the M PC is equ al to 0.8 as k,
1 1
the m u ltiplier, is equ al to ________ 5 ___ 5 5 and so the
(1 2 0.8) 0.2
resu lting chang e in incom e DY is equ al to 5 3 1 0 m illion 5
5 0 m illion.
Since only 8 m illion ou t o the 1 0 m illion was spent on
d om estic good s it ollows 2 m illion was not spent on d om estic
ou tpu t. This incom e m u st have been spent on oreign good s
(imports) or paid in taxes or simply saved .
I mport expend itu res, tax paym ents and savings are all
withdrawals in the circular ow m odel. It ollows that (1 2 MPC)
is the marginal propensity to withdraw (MPW) as shown above.
The m u ltiplier eect is thereore greater, the greater the
proportion o any increase in in com e that is spent on d om estic
ou tpu t; or the smaller the proportion o any increase in incom e
that is saved , spent on imports or taxed by the governm ent.
The multiplier can be generalized or all injections, namely
TIP
not just or G but also or I (investments) and X (exports).
According to the Keynesian multiplier, an increase in any
injection will lead to a greater increase in national income.
Note that one mechanism through which trade cycles are
transmitted internationally is the export multiplier. A recession in
the US economy will lead to lower US imports and so lower
European and, say, Japanese exports. Depending on the size o
this decrease, as well as on the openness o these economies,
economic activity in Europe and Japan will be adversely aected
(their AD will shrink) and this eect will be magnifed through the
export multiplier, which is the change in national income resulting
rom a change in export revenues.
Also, note that the eect is not instantaneous as there is a time
lag between receipt o income and subsequent spending.
2 Macroeconomics
Optional material
Algebraically the ollowing hold s:
(1 ) DY 5 DG 1 bDG 1 b 2 DG 1 b 3 DG 1 b 4 DG 1 ...
(2 ) DY 5 (1 1 b 1 b 2 1 b 3 1 b 4 1 ...)DG
(
1
(3 ) DY 5 _____ DG
1 2 b )
(4) DY 5 k DG,
where k is the m u ltiplier
Since b is the marginal propensity to consu m e (M PC)
d om estic good s and services the m u ltiplier k can be
rewritten as:
1
k 5 _________
(1 2 M PC)
I n (1 ) th e cha n g e in in com e DY is equ al to th e in itia l
cha n g e in g overn m en t spen d in g (DG) wh ich workers
ea rn ed a n d is th e d irect, frst-rou n d eect a n d th e f rst
term in th e equ ation . Th e secon d term (bDG) is th e
proportion b o th is in com e that wa s spen t on oth er
d om estic g ood s by th ese workers a n d wh ich is in com e to
oth ers in th e econ om y. For exam ple, i I ea rn ed rom th e
g overn m en t 1 00 pou n d s or f xin g a win d ow in a
g overn m en t bu ild in g an d m y M PC is 0.8 th en I will spen d
80 pou n d s, say on lu xu ry cakes that th e ba ker Roxa n n e
a cross th e street baked . N ow, in com e has in crea sed by
1 80 a n d represen ts th e service (win d ow f xin g ) a n d th e
g ood (ca kes) prod u ced u p to th is poin t. I Roxan n e in
tu rn spen d s 0.8 o h er extra in com e on say, ch ed d a r
ch eese that Bob prod u ces, th en h is in com e will have
in creased by 64 pou n d s (th is th e th ird term , b 2 G)
represen tin g th e extra ch ed d a r prod u ced . U p to th is
poin t, n ation al in com e ha s in crea sed by 1 00 1 80 1 64
or, g en era lizin g , by DG 1 bDG 1 b 2 DG. Bob will th en
spen d a portion b o h is extra in com e b 2 DG or, b 3 DG on
som e oth er g ood s, an d so on .
I n (2 ) the term DG is actored ou t and it shou ld be
realized that insid e th e parentheses we have the sum o
inf nite term s o a geom etric progression which converges
1
(as 0 , b , 1 ) to _______.
(1 2 b)
1 01
 2 Macroeconomics
The crowding out eect
Crowd ing-ou t is a m onetarist criticism o Keynesian-inspired
expansionary f scal policy. I the governm en t increases
govern m ent spend ing then, as a resu lt o the m u ltiplier eect,
AD will increase by m ore than the original increase in
govern m ent expend itu res. Fiscal policy thereore seem s,
accord ing to the Keynesian sch ool o thou ght, like a very
poweru l tool to re ate an economy in a recession.
N ot so, cla i m th e m on eta ri sts. Th e i n crea sed g overn m en t
spen d i n g a n d resu l ti n g g rea ter bu d g et d ei ci t n eed s to be
som eh ow i n a n ced . For exam pl e, i a g overn m en t d eci d es to
spen d $ 7 87 bi l l i on m ore wi th ou t resorti n g to i n crea sed
ta xa ti on , th en i t m u st borrow. I th e g overn m en t borrows by
sel l i n g bon d s to th e n on -ba n k pri va te sector, th en i n terest
ra tes m a y ri se a s th ere i s g oi n g to be g rea ter d em a n d or
l oa n a bl e u n d s i n th e l oa n a bl e u n d s m a rket. I n Fi g u re
2 .4.5 th e m a rket wh ere u n d s a re borrowed a n d l en t i s
i l l u stra ted . I n i ti a l l y, d em a n d or l oa n a bl e u n d s (by
bu si n esses a n d oth ers pla n n i n g to spen d m ore th a n th ey
h a ve a va i la bl e) a n d su ppl y o l oa n a bl e u n d s (by pa rti es
th a t wi sh to spen d l ess th a n th ey h a ve a va i la bl e) i s su ch
th a t i n terest ra tes a re a t r1 .
Interest rate (r)
S of
loanable funds
r2
r1
D2 for
loanable funds
D1 for
loanable funds
Loanable funds (per peroid)
Figure 2.4.5 The loanable unds market and the eect o government
borrowing on interest rates
Automatic fscal stabilizers
Ta x reven u es a s well a s som e g overn m en t expen d itu res chan g e
a u tomatica lly a s th e level o n ation al in com e chan g es with ou t
th e g overn m en t havin g to in itiate any leg islative cha n g es.
M ore specif ca lly, a progressive in com e ta x system a n d th e
existen ce o socia l in su ra n ce in th e orm o u n em ploym en t
ben ef ts will exert a sta bilizin g eect on th e econ om y, makin g
th e bu sin ess cycle sm ooth er. With th ese system s in pla ce,
recession s will be slig h tly m ild er wh ile a n overh eatin g
econ om y will som ewhat cool o, alleviatin g in ation a ry
pressu res.
1 02
I th e g overn m en t en ters th i s m a rket a n d a l so a sks to borrow,
th en d em a n d or l oa n a bl e u n d s m ay i n crea se to D2 . I n terest
ra tes a re sh own to i n crea se rom r1 to r2 . Pri va te sector
i n vestm en t spen d i n g i s th ereore expected to d ecrea se a s
l on g a s i t i s i n versel y rela ted to i n terest ra tes. Con su m pti on
expen d i tu res m ay a l so d ecrea se. Fi g u re 2 .4.6 sh ows th a t
si n ce AD i n cl u d es n ot on l y G bu t a l so C a n d I i t m ay n ot
i n crea se to AD2 a ter a l l bu t on l y (i , at a l l ) to AD3 .
Averag price level (P)
As a resu lt
of crowd i n g ou t
As a resu l t of th e
m u l ti pli er effect
AD 2
AD I
AD 3
0
Rea l ou tcom e/in com e (Yr)
Figure 2.4.6 The crowding-out eect
I n this way, expansionary f scal policy is sh own to be not as
poweru l as Keynesians thou ght.
The eects o crowding out also depend on the type o
TIP
government expenditures fnanced. I capital (investment)
expenditures are fnanced then, given that inrastructure
investments may create substantial positive externalities to
private frms, economic growth may even accelerate. This is an
especially valid argument or developing countries where
improved inrastructure is much needed and is considered
complementary to market orces. Also, i the budget is fnanced
by oreigners then domestic interest rates may not increase (but
other problems may result: or example, the external debt, which
has to be paid o in oreign exchange, will increase).
H ow do automatic fscal stabilizers work?
For example, assu m e an economy entering recession. As the
econ omy contracts and real ou tpu t/incom e (Y) d ecreases, tax
revenu es collected by the governm ent will au tomatically all
proportionately by m ore so d isposable incom es will not
d ecrease as ast. At the sam e tim e, as a resu lt o people losing
their jobs, u nem ploym ent benef ts will au tomatically kick in,
provid ing the u nemployed with at least som e d isposable
incom e to spend . The eect o what has ju st been d escribed is
to m itigate the d owntu rn o the economy: au tomatic stabilizers

will not allow d isposable incom e to d ecrease as ast in a
recession, slowing d own the d ecrease in con su mption and AD.
Figu re 2 .4.7 illu strates the point.
Real GDP
Th e d own tu rn i s n ot a s
steep a s a resu l t of th e
Y
a u tom a ti c sca l sta bi li zers
Y
0 t1 t2
Tim e
Figure 2.4.7 How automatic stabilizers mitigate an economic downturn
The economy enters recession at tim e t1 . Real GDP begins to
d ecrease. At tim e t2 , as a resu lt o the au tomatic stabilizing
eect o u nem ploym ent benef ts and progressive taxes, real
ou tpu t alls on ly to Y whereas it wou ld have d ecreased to Y
withou t their existence. Th e d owntu rn is m ild er.
Assu m e now an economy starting to overheat as AD is growing
aster than AS. An in ationary gap is em erging. Real ou tpu t is
growing above potential ou tpu t. H ere, progressive taxes will d o
their trick as they increase aster than incom e, slowing d own
the in crease in d isposable incom es and so the spend ing power
o hou sehold s and f rm s. AD will not be in creasing as ast as it
wou ld have had taxes not been progressive. The existence o a
progressive tax system cools o the economy, relieving it to an
extent rom the bu ild -u p o in ationary pressu res. The u ptu rn o
the bu siness cycle is m ild er, as Figu re 2 .4.8 illu strates.
Impact o fscal policy on potential output
and LRAS
N ot all governm ent expend itu res are the sam e. A d istinction
in trod u ced earlier was between cu rrent spend ing, capital
spend ing and transer paym ents. An increase in cu rrent
spend ing and transer paym ents is u nlikely to have an im pact
on potential ou tpu t bu t that d oes not hold tru e or pu blic
in vestm ent (capital) spend ing. Lets take the exam ple o
governm ent expend itu res on inrastru ctu re, which can be
d ef ned as physical capital that creates signif cant positive
externalities in lowering the overall cost o econom ic activity
and so potentially having a h igh social rate o retu rn. This type
o expend itu re can increase an economys potential ou tpu t and
shit its vertical LRAS to the right. The constru ction o an
im proved road system , o a necessary brid ge or harbou r, or o a
better system o telecom m u nications has the potential to
expand the prod u ctive capacity o an economy. O cou rse, we
shou ld keep in m ind thou gh that a brid ge to nowhere is ju st a
waste o scarce resou rces.
Expend itu res on schools and health care can increase and
im prove the stock o h u man capital an economy has available.
More and better primary schools, second ary schools and
colleges as well as m ore an d better health -care centres are
2 Macroeconomics
At tim e t1 the economy starts to recover. At tim e t2 real ou tpu t
has grown above the (thick black) trend line that re ects
potential ou tpu t. An in ationary gap em erges. Real ou tpu t
wou ld have grown to Y withou t the au tomatic stabilizing eect
o progressive taxation. The stabilizing eect allows ou tpu t to
grow only to level Y, in this way d ecreasing the size o the
in ationary gap the econ omy experiences. The u ptu rn is m ild er.
Figu re 2 .4.8 can also illu strate why au tomatic stabilizers can
retard recovery. As, right ater tim e t1 , the economy begins to
recover, growth wou ld have been aster and potential ou tpu t
cou ld have been attained earlier were it not or the d ecrease in
governm ent ou tlays (paym ents or u nemploym ent benef ts will
d ecrease as the u nem ployed f nd jobs) an d the proportionately
aster increase in tax revenu es. This problem is known as
f scal drag.
Real GDP
The upturn is milder as a result of
the automatic stabilizing effect of
progressive taxes
Y
The trend line
Y (potential output)
0 t1 t2
Time
Figure 2.4.8 How automatic stabilizers cool-o an overheating economy
cru cial in increasing labou r prod u ctivity. An increase in labou r
prod u ctivity translates to aster long-ru n growth and so a higher
level o potential ou tpu t.
I t can be argu ed that a d ecrease in tax rates may u nleash m ore
work and investm ents as incentives cou ld be positively aected .
To the extent that lower taxes provid e the incentive or m ore
work and investm ents, potential ou tpu t can also increase. On
th e other hand , tax revenu es have to be su f cient and
equ itably shared so that the f nancing o necessary governm ent
expend itu res d oes not requ ire m ore and m ore borrowing which
may prove u nsu stainable.
Lastly, pru d ent f scal managem ent may ind irectly aect
potential ou tpu t and long-ru n growth . The term is elu sive bu t it
is generally consid ered to m ean that bu d get d ef cits are not
excessive and that the national d ebt d oes not grow at
u nsu stainable rates. As explained earlier, high-bu d get d ef cits,
especially i they are not incu rred in a d eep recession, can lead
to in creased interest rates and the crowd ing ou t o private
sector investm ent and consu mption. An u nsu stain able national
d ebt, as a resu lt o pro igate governm en t spen d ing and an
ineective tax system , may lead to d eau lt with hu ge costs on
th e real econom y.
1 03
 2 Macroeconomics

Evaluating fscal policy

Possible strengths o expansionary fscal policy
n Fiscal policy is d irect: any increase in governm ent spend ing
will au tomatically increase national in com e by at least as
m u ch, i not m ore, as it is a component o AD.
n A d ecrease in taxes to re ate an economy as part o an
expansionary stim u lu s plan may also have benef cial su pply-
sid e eects as lower taxes may im prove the incen tives to
work and to invest.
n I n an economy in d eep recession (or d epression ) in terest
rates may be at or close to zero, so m onetary policy is
totally ineective; in su ch a case policy makers have only
f scal policy to tu rn to.
n I the institu tional ram ework o the economy is equ ipped
with u nem ploym ent benef ts and a progressive incom e tax
system then policy makers have the benef ts o bu ilt-in
stabilizers.
n I the increased governm ent expend itu res o a stim u lu s
package in clu d e spend ing on in rastru ctu re (or example
road s, brid ges, harbou rs or telecom m u nication s; that is,
physical capital typically f nanced by governm ents that
create very signif cant positive externalities d ecreasing
transaction costs across the board ), along with health and
ed u cation then a positive su pply-sid e eect will also resu lt.
n I th e in crea sed g overn m en t expen d itu res o a stim u lu s
pa cka g e in clu d e spen d in g on th e d evelopm en t o green
tech n olog ies th en an a d d ition a l lon g -ru n ben ef t will be
th e im provem en t o th e en viron m en t, a llowin g su sta in able
growth .
HL n I the governm ent expend itu re m u ltiplier is greater
than one then it is also a very poweru l tool to
help a lagging economy recover. The Chie
Econom ist o Presid ent Obamas Cou ncil o
Econom ic Ad visors, Christina Rom er, estimates the
U S governm ent expend itu re m u ltiplier at 1 .6. I n
general, the size o f scal m u ltipliers d epend s on
specif c characteristics o each economy with m ore
open econom ies (those, or example, with ew
restrictions on trad e) having larg er m u ltipliers
than less open econom ies.
Possible weaknesses o fscal policy
n There are signif cant tim e lags associated with f scal policy
that may even en d u p d estabilizing instead o stabilizing an
economy. Specif cally, we can break d own the overall lag
rom the m om ent an econom ic problem is encou ntered to
the m om ent the policy switch has an im pact into:
the d etection lag (it takes tim e to collect and evalu ate
d ata in ord er to d etect a problem )
the ad m inistrative lag (it takes tim e or the governm ent to
d ecid e, or exam ple, exactly how m u ch it need s to spend
and on exactly what projects, as well as to have the
package approved by the parliam ent or congress)
the execu tion or impact lag (it takes tim e or whatever
policy response was chosen to have eects on the
economy, especially since the cu m u lative im pact o the
m u ltiplier is long).
n Large defcit spending may increase national debt to
unsustainable levels and may orce signifcant tax increases
in the uture (so, in a sense, the cost o such a policy is
shited on to uture generations) or may even lead to deault.
n There is also the chan ce that i an expansionary f scal eect
continu es or longer than requ ired th en in ationary
pressu res may arise.
n Expansionary f scal policy and d ef cit spend ing may end u p
crowd ing ou t private investm ent and thereore be less
eective. The resu lting bu d get d ef cit m u st som ehow be
f nanced . Governm ent borrowing rom f nancial markets
may drive interest rates u p and , as a resu lt, private
investm ent will d ecrease (and so will consu m ption
expen d itu res). I this d ecrease in private spend ing matches
the increased governm ent spend ing, the crowd ing ou t is
said to be com plete and f scal policy is totally ineective.
n Fiscal policy su ers rom an expansionary bias becau se
politicians are oten irresponsible and preer to spend m ore
and tax less rather than spend ing less and taxing m ore
becau se the orm er maxim izes their sh ort term re-election
chances.
n Expansionary f scal policy may also lead to a wid ening
trad e d ef cit. A higher level o in com e will lead to m ore
imports absorbed . I the average price level increases then
exports will shrink as they becom e less competitive and
imports will rise as they becom e relatively m ore attractive
than d om estic good s.
n Contractionary f scal policy to f ght in ationary pressu res is
oten d if cu lt to employ. Societies u su ally d o not welcom e
d ecreases in spend ing related to social welare or in
ed u cation and health or even in d eence program m es.
I n creasing taxation beyon d a point will ad versely aect
incentives in the economy.
n An increase in governm ent expend itu res as part o an
expan sionary f scal policy cannot be easily reversed i policy
makers realize that it lead s to overheating: or exam ple, it is
not easy to stop the constru ction o a brid ge.
HL n The governm ent expend itu re m u ltiplier may even
be less than one as som e econom ists claim .

1 04
2.5 Money and monetary policy
Money
Money is d ef ned as anything generally acceptable as a m eans
o paym ent. I nothing serves this u nction, then we have a
barter economy, where good s are exchanged or g ood s. Barter
requ ires d ou ble coincid en ce o wants and implies extrem ely
high transaction costs or ind ivid u als who will thereore preer
to avoid specialization in ord er to m inim ize d epend ency on
exchange. I ntrod u cing m oney perm its specialization to take
place, expand ing dramatically the prod u ction possibilities in
both a static and d ynam ic sense.
Functions of money
n M on ey is a m ed iu m o exchange: it is acceptable as a
m eans o paym ent in market transactions.
n I t is a u nit o accou nt: it serves as a yard stick, with which
valu es can be m easu red , expressed and com pared .
n I t is a store o valu e: people may hold their wealth throu gh
tim e in the orm o m oney (m oney at rest).
n M on ey provid es a stand ard o d eerred paym ents: it allows
inter-temporal con tracts; it serves as a link between the
past, present an d u tu re.
The banking system
The m od ern banking system is known as a two-tier system
since it comprises com m ercial banks and a central bank.
The role of a central bank
The role o central banks has evolved a lot over tim e and their
im portance has changed . A central bank is consid ered as the
ban ker to the governm ent an d the banker o com m ercial banks.
n I t is the sole note-issu ing au thority in a cou ntry. Rem em ber,
thou gh, that the su pply o notes is a small percentage o
the m oney su pply which inclu d es at the least d emand
d eposits (also known as sight d eposits, chequ ing accou nts
or cu rrent accou nts).
n I t issu es and red eem s governm ent bond s.
n I t manages the governm ents banking accou nt.
n I t carries ou t m onetary policy by in u encing interest rates
and banks lend ing practices. For many econom ists, the
single m ost im portant d u ty o a central bank is to ensu re
price stability throu gh m onetary policy.
n I t has responsibility or exchange rate policy.
n I t is the lend er o last resort; it stand s read y to provid e any
requ ired liqu id ity to th e banking system in case o an
em ergency (a cred it cru nch).
n I t regu lates and su pervises com m ercial banks to ensu re that
bank lend ing is pru d en t and that banks are su f ciently
liqu id to m eet their obligations to d epositors.
Comm ercial banks
These are prof t -maxim izing f rm s specializing in bringing
borrowers and lend ers together. They belong to the larger class
o so-called f nancial interm ed iaries. These prof t-oriented f rm s
accept peoples m oney and lend to those wishing to invest.
They pay interest to savers and are paid interest rom borrowers.
Their prof tability to a large extent d epend s on the d ierence
(the spread ) between the two interest rates. I nterest is what is
earned when lend ing m on ey and what it costs to borrow m oney
and typically is expressed on an annu al basis and as a
percentage. There are very many interest rates d epen d ing on
who borrows or lend s, how m u ch is borrowed or lent, the level
o risk involved , etc. The central ban k, as will be explained later,
can in u ence market interest rates.
I t is im portant to u nd erstand that lend ing by com m ercial banks
is perorm ed by the stroke o a pen. N owad ays, its actu ally
m ore like a compu ter click o a m ou se. The bank issu es a loan
to a bu siness by opening u p a accou nt allowing chequ es to be
written or the bu siness (that is, a cu rrent accou nt). N ote
thou gh that or every $ 1 .00 cash d eposited by a cu stom er in a
bank, cred it can be extend ed by a m u ltiple which is greater, the
smaller the cash drainage (the u se o cash ) in the econ omy.
This is known as a ractional reserve system : com m ercial banks
need on ly to keep as reserves (in their vau lts or in th eir d eposits
at the central bank) a raction o the total valu e o loans
(cred it) they have issu ed . This is becau se at any point in tim e
only som e cu stom ers will requ ire to be paid in cash (by cash ing
their chequ es); m ost transaction s (in term s o valu e) involve the
transer o ch equ es, the compu ter cred iting o one accou nt
and the d ebiting o another.
Demand for money: the concept
The term d emand or m oney seem s strange as m ost people
wou ld claim that the d emand is inf nite. Bu t the term makes
sense once you realize that h old ing m oney will not earn you
interest while hold ing bon d s will. The term m oney d emand
reers to the case where an agent (an ind ivid u al or a f rm ) has a
choice to hold bond s (an interest-bearing asset) and m oney (a
non-interest bearing asset; that is, cash and an accou nt on
which chequ es can be drawn). I t becom es clear that there is no
reason to hold m oney and sacrif ce interest u nless there is a
d esire to pu rchase good s or services. Accord ing to Keynes there
are three m otives or hold ing m oney (he term ed this liqu id ity
preerence, m eaning d emand to be liqu id , to hold cash).
n Th e transactions m otive: you need m oney (liqu id ity) to bu y
g ood s and services. The transactions d emand or m oney is a
positive u nction o national incom e as at higher levels o
incom e, m ore transactions will take place.
n Th e precau tionary m otive: you need to hold m oney to m eet
u nexpected expenses. The precau tionary d emand or m oney
is also a positive u nction o incom e.
n Th e specu lative m otive: the specu lative d emand is inversely
related to the interest rate since the opportu nity cost o
h old ing cash rises as interest rates rise and people will
preer to hold bond s in stead .
Fig ure 2 .5.1 illu strates the d emand or m oney. As the interest
rate increases, d emand or hold ing m oney in stead o bond s
d ecreases as the opportu nity cost o hold ing cash rises. I the
level o incom e increases rom Y1 to Y2 then the d emand to
1 05
 2 Macroeconomics
hold m oney at each level o interest rates will increase, shiting
the d emand or m oney to the right.
Interest rate (r)
Note that if interest rates drop very
low, money demand may become
innitely elastic (the Keynesian
liquidity trap)
Md2
Md1
(when Y = Y2>Y1 )
(when Y = Y1 )
0 m ore orange ju ice bu t 80 m illion less eu ros, (that is, the
Money (M)
Figure 2.5.1 Demand or money (liquidity preerence)
Money supply
Money su pply is consid ered at this level to be exogenou s,
m eaning that it is not aected by the level o AD and interest
rates bu t that it is f xed at som e level by the central bank. The
m oney su pply inclu d es cash (coins and notes) as well as cu rrent
accou nt d eposits (also known as sight accou nt d eposits). The
d ef nition may be expand ed to inclu d e m ore assets.
Figu re 2 .5.2 illu strates the typical shape o the m oney su pply
provid ed by the cen tral bank.
Interest rate (r)
Ms
Money (M)
Figure 2.5.2 The money supply (exogenous and fxed by the central bank)
Th e central bank can aect the size o the m oney su pply as
ollows.
n I t can change the requ ired reserve ratio. Com m ercial banks
need to keep only a raction o the m oney d eposited in
their vau lts and can lend ou t the rest. They need to d o that
to ensu re that they are su f ciently liqu id to m eet their
obligations to d epositors. I the central bank increases the
requ ired reserve ratio then they will be able to lend ou t less
so the m oney su pply will d ecrease, shiting the cu rve in
Figu re 2 .5.2 to the let.
n The central ban k can change the d iscou nt rate. There are
very many interest rates in an economy. One su ch rate is the
1 06
d iscou nt rate which is the interest rate at which com m ercial
banks can borrow i they need to rom the central bank.
I the central bank wants to d ecrease the m oney su pply and
shit the cu rve to the let then it cou ld increase this
d iscou nt rate, making it m ore costly or com m ercial banks
to get hold o extra cash to lend ou t to their cu stom ers.
n The central bank can cond u ct open market operations.
I it d ecid es to bu y orange ju ice on the open market costing
1 00 m illion eu ros then its vau lts will f ll u p with orange
ju ice and the market will have an extra 1 00 m illion resh
eu ros. The m oney su pply will have increased and shited to
the right. I the central bank d ecid es to sell som e o the
orange ju ice or 80 m illion eu ros then the market will have
m oney su pply will have d ecreased ). The central bank d oes
not bu y and sell orange ju ice becau se, f rst, this wou ld
signif cantly d isru pt the price o a basic good that many o
u s bu y and also the good wou ld be costly to store. I nstead
it bu ys and sells (ou tstand ing) bond s in the open market. I
it bu ys bond s it can increase the m oney su pply and i it
sells bond s it can d ecrease it.
Interest rate determination by the central bank
The interaction o the su pply and the d emand or m oney will
d eterm ine, as in any market, the interest rate which in u ences
all other market interest rates. Figu re 2 .5.3 illu strates the point.
Interest rate (r)
Ms3 Ms1 Ms2
r3
r1
r2
Md
Money (M)
Figure 2.5.3 Interest rate determination by the central bank
Given a m on ey d eman d M d a n d m on ey su pply at M s1 th e
ma rket in terest rate will be d eterm in ed at r1 . I th e cen tra l
ba n k wish es or som e reason to lower in terest rates it ca n
in crea se th e m on ey su pply to M s2 . I t ca n d o th is by d ecrea sin g
th e requ ired reserve ratio, lowerin g its d iscou n t rate or
con d u ctin g open market pu rcha ses o (ou tsta n d in g ) bon d s.
Th e in terest rate in th e m on ey market will d ecrea se to r2 . On
th e oth er ha n d , i or som e rea son th e cen tra l ba n k wish es to
in crea se in terest rates it ca n d ecrea se th e m on ey su pply to
M s3 . Th is ca n be d on e by in crea sin g th e requ ired reserve ratio,
ra isin g its d iscou n t rate or con d u ctin g open ma rket sales o
(ou tsta n d in g ) bon d s. Th e in terest rate in th e m on ey ma rket will
in crea se to r3 .

Monetary policy
Monetary policy is, together with fscal policy, a demand-side
policy. It aims to aect economic variables such as real output
and growth, employment and ination. I the goal is to increase
AD then the central bank will adopt easy or loose (expansionary)
monetary policy, increasing the money supply and, through this,
lowering interest rates. This would typically be the policy choice
or an economy in recession or about to enter one (that is, when a
deationary or recessionary gap is present). I the goal is to
decrease AD (or to slow down its increase) then the central bank
will adopt tight or contractionary monetary policy, decreasing the
money supply and, through this, increasing interest rates. This
would typically be the policy choice or an overheating economy
(that is, when an inationary gap is present).
Easy or loose monetary policy
I an economy is abou t to enter recession or i it alread y is
su ering negative growth rates and a d e ationary gap then the
central bank may d ecrease interest rates (r) (or, equ ivalently,
d ecrease the m oney su pply) in an attem pt to increase AD and
so ou tpu t and employm ent. H ow d oes it work? H ow are lower
interest rates expected to re ate a ailing economy? I t is hoped
that AD will increase becau se consu mption expend itu res,
investm ent expend itu res and net exports will tend to rise.
Consu m ption expend itu res o hou sehold s may in crease as
borrowing to f nance the pu rchase o d u rables (or exam ple cars
or hou sehold appliances) becom es cheaper so hou sehold s may
spend m ore on these good s. Also, m onthly paym ents on
ad ju stable m ortgage loans will d ecrease so hou sehold s will
have m ore available to spend in general. Lastly, the lower rate
o retu rn will make saving a less attractive option so
hou sehold s will tend to spend m ore.
I nvestm ent spend ing by f rm s may also increase as borrowin g
costs to f nance pu rchases o capital good s (or example
machin es, tools and other equ ipm ent) and expansions (su ch as
new actories) are lower. Also, lower interest rates im ply that
the opportu nity cost to f rm s o u sing their own past retained
prof ts to f nance investm ents is also lower.
Lastly, as a resu lt o lower interest rates, the exchange rate will
tend to d epreciate (see the section on exchange rates later) so
exports will becom e m ore com petitive abroad and imports less
attractive d om estically, increasin g net exports and so AD.
Tight monetary policy
Assu m e an overheating econom y in which in ation is becom ing
a problem and an in ationary gap is orm ing. The cen tral bank
may increase interest rates (or, equ ivalently, increase the m oney
su pply) in an attempt to d ecrease AD. AD is expected to
d ecrease as higher interest rates will work in the opposite
d irection to the one d escribed when an easy or loose m onetary
policy is ad opted . With tight m onetary policy, borrowing costs
will increase or both hou sehold s and f rm s, m onthly loan
repaym ents or many types o loans will increase and saving
will becom e m ore attractive. Spend ing by hou sehold s and f rm s
is thereore expected to slow d own or even d ecrease. The
exchange rate will also tend to appreciate, rend ering exports
2 Macroeconomics
pricier and th ereore less competitive abroad and imports m ore
attractive d om estically, d ecreasing net exports.
N ote that the term qu antitative easing reers to pu rchases
by the central bank o long-term bond s so that the m oney
su pply increases.
Evaluation of monetary policy
Central banking is both an art and a science: the tim ing o an
interest rate chang e, the statem ents issu ed by the central
banker and the size o the interest rate change are all cru cial
or the su ccess o any policy change. There are very many
actors that d eterm ine the extent to which a policy response
will or will not be su ccessu l. I n general, m onetary policy is
extensively u sed throu ghou t the world to regu late the strength
o total spend ing on d om estic good s and services.
n I t is consid ered rather exible as the central bank can alter
interest rates oten.
n I nterest rates can be altered grad u ally or increm entally (by
0.2 5 % at a tim e).
n The central bank can also easily reverse any d ecision i it
becom es clear that a policy reversal is in ord er.
On the other hand , it is also characterized by several problem s.
n M ost importantly, spend ing o both hou sehold s and f rm s
d oes not only d epend on interest rates. Consu m ption and
investm ent expend itu res d epend on a host o other actors.
The d egree o con su m er and bu siness conf d ence is
extrem ely im portant in d eterm ining the response o
hou sehold and bu siness spend ing to a change in in terest
rates. The d egree o hou sehold and f rm ind ebted n ess is
also o param ou nt im portance. For example, lets say the
central bank lowers interest rates in an attempt to prevent
a recession. I bu sinesses are pessim istic and /or i
hou sehold s are alread y bu rd ened by heavy d ebts there is
no gu arantee that they will be convinced to borrow and
spend m ore, and the policy may ail.
n Also, i the borrowing rate is alread y too low (close to zero)
then it can not be lowered any u rther as negative interest
rates d o not make any sense (see Figu re 2 .5.1 and consid er
the liqu id ity trap case where m oney d emand becom es at,
that is, inf nitely elastic).
n Ju st like f scal policy, m onetary policy is characterized by
potentially d estabilizing tim e lags. Th ese tim e lags may be
shorter than those characterizing f scal policy bu t they are
still variable in length, creating u ncertainty as to the
su ccess o any policy change.
n Und er a f xed exchange rate system m on etary policy is
ineective. I nterest rate changes have to be u sed only to
ensu re that the exchange rate remain s f xed at the chosen
level. This will becom e clear in a later section.
n Tod ay, f nancial markets are largely global so m ost f rm s
and even hou sehold s can and d o borrow rom anywhere in
the world . These d evelopm ents weaken the eectiveness o
any d om estic m onetary policy ch oice.
1 07
 2 Macroeconomics

Easy or loose monetary policy Tight monetary policy

To increase AD o an economy that is in or about to enter To decrease AD o an economy suering rom infationary
Goal
recession (to close a defationary gap) pressures (to close an infationary gap)

By r (or, by Ms through open market purchases o bonds, By r (or, by Ms through open market sales o bonds,
How?
lower required reserves or a decrease in the discount rate) higher required reserves or an increase in the discount rate)
Why is AD By lowering interest rates the central bank hopes that C and I By increasing interest rates the central bank hopes that C and

aected? and NX will and so AD will I and NX will and so AD will
other variables also aect the decision to spend; nancial markets are global; there is a lower interest rate limit beyond which it
But
is ineective (the liquidity trap); it is ineective under a xed exchange rate regime, etc.
On the monetary policy is fexible, gradual and easily reversible; in addition, i the central bank is independent, monetary policy is less
other hand yielding to political pressure and manipulation

Supply-side policies
Su pply-sid e policies are policies that aim at increasing the
prod u ction sid e o an economy and so aggregate su pply,
shiting the LRAS cu rve to the right.
Su pply-sid e policies attem pt to enhance the institu tional
ram ework o an economy, increase the qu an tity and improve
the qu ality o actors o prod u ction, as well as im prove
incentives. They may be d istingu ished into interventionist and
pro-market policies. I n th e orm er, the governm ent takes on an
active role, whereas in the latter the role o the governm ent is
su pposed to be m inim ized in ord er to u nleash the powers o
the ree market.
Interventionist supply-side policies
n I nvestm ents in hu man capital, inclu d ing investm ents in
ed u cation and health care, are one example. I nvestm ents in
primary and second ary ed u cation yield the high est social
rate o retu rn, the resu lting external benef ts are the h ighest
and investm ent ensu res that all children have access to
ed u cation. I nvestm ents in better h ealth-care services mad e
available to the general popu lation also help increase the
stock o hu man capital o an economy. An increase in
hu man capital lead s to increased labou r prod u ctivity, so to
an increase in the prod u ctive capacity and th e potential
ou tpu t o an economy. The LRAS will sh it to the righ t.
n I nvestm ents in in rastru ctu re will also boost the su pply sid e.
Bu ild you rsel a road to get rich is not an exaggeration as
a better transportation system creates massive positive
externalities. I nrastru ctu re reers to physical capital that
governm en t typically bu t not necessarily f nances which
d ecreases the costs o econom ic activity and creates sizable
external benef ts. Road s, railways, harbou rs, airports and
telecom m u nications all serve to lower prod u ction costs o
all econom ic agents in a cou ntry.
n Investm ents in technology are another example. In their
attempt to increase AS, governm ents und R&D projects.
Provision o basic R&D is responsible or signifcant positive
externalities that a private frm would not be able to capture.
Markets alone would lead to ewer R&D projects being
undertaken, which implies a slower rate o technological
progress. Labour productivity does not only depend on the
level o human capital (education and training) but also on
the quality and the level o technology em bodied in the
physical capital that employees work with. It ollows that a
aster rate o technological advancem ent will increase labour
productivity and so the LRAS o an economy.
N ote that all o the above public investments imply an increase
in governm ent expenditures and as such will also have a
short-run eect on AD, increasing it and shiting it to the right
beore the LRAS is positively aected and also shits to the right.
n I m proving the institu tional ram ework is a su pply-sid e
policy. The institu tional ram ework o an economy inclu d es
the laws, the regu lations, the cu stom s and trad itions within
which econom ic activity takes place. They d ef ne th e ru les
o the gam e. I m provin g the in stitu tional ram ework o an
economy im plies improving the capacity o the economy to
prod u ce. Unortu nately, there is no u niqu e set o laws, ru les
and regu lations that can be transplan ted to any economy
and prove optimal. Movem ents that red u ce bu reau cracy,
increase transparency and accou ntability, simpliy processes
and proced u res, and red u ce corru ption are, in general,
consid ered to be steps in the right d irection.
n I n d u strial policies are cham pioned by policy makers who
consid er governm ent intervention and gu id ance necessary
or the prod u ctive capacity o an economy to increase. This
grou p consid ers market orces inad equ ate to gu id e f nancial
capital and investm ents to their m ost prod u ctive u ses and
so believe that governm en t is necessary to d o the job and
pick winners (that is, ind u stries and f rm s to su pport as
they are thou ght to have the m ost potential or growth).
Su bsid ized low interest loans, tax breaks an d tax
allowances and protection rom oreign com petition are
som e o the m easu res employed . Som e su ccessu l as well as
u nsu ccessu l d eveloping cou ntries have ad opted su ch
m easu res. M any, i not all, ad vanced econom ies have also
employed su ch policies in varying d egrees.
Pro-market supply-side policies
The m easu res inclu d ed in this grou p are m easu res that the
su pply-sid ers espou se. Su pply-sid ers are a grou p o econom ists
who are known or their oten extrem e pro-market id eas and
biases. Their basic principle is less governm ent and m ore ree
an d u nettered markets. Their id eas inclu d e the ollowing .
n Policies related to the labou r market inclu d ing polices that
try to make it m ore exible. Som e examples are policies
aim ed at:
lowering or even abolishing the m inim u m wage

1 08

d ecreasing the power o labou r u nions
red u cing non-wage labou r costs to employers (su ch as
national insu rance contribu tions) so that labou r becom es
cheaper to f rm s and m ore labou r is hired
making hiring and f ring o workers easier so that
managers d o not hesitate to hire m ore labou r when
d emand rises
making pension plans transerable across occu pations (so
that labou r m obility in creases)
red u cing u nemploym ent benef ts to make job acceptance
aster or f rm s searching or labou r.
n Th eir policies related to prod u ct markets inclu d e ones that
aim to in crease the extent o competition and d ecrease the
d egree o any m onopoly power in markets so that the
economy reaps the resu lting benef ts rom increased
ef ciency and lower prices. Deregu lation and privatization
as well as trad e liberalization are typical cand id ates.
Deregu lation reers to the d ecrease in regu lation s related to
cond u cting bu siness in a certain market. I n many cou ntries
there are many laws that prevent competition rom working.
For example, in Greece only pharmacists have the right to
open u p a pharmacy and they may not open a new
pharmacy less than a 1 00 m etres rom an existing one.
Dismantling su ch regu lations is consid ered to increase
com petition and , throu gh this, improve ef ciency and lower
prices. Privatization reers to the transer o state-owned
assets (m ost oten this reers to state-owned f rm s) to the
private sector. The id ea is that the private sector, as a resu lt
o the prof t m otive, will cu t costs and improve ef ciency
and this will lead to lower prices. Trad e liberalization reers
to the d ecrease or elim ination o trad e barriers and is
consid ered the astest way to d ecrease any d om estic
m onopoly power.
n Supply-siders incentive-related policies decrease tax rates to
improve the incentive to work, save and invest. A decreased
marginal tax rate will increase the opportu nity cost o leisure
so individuals will supposed ly have a greater incentive to
work. The increase in labour supply will exert a positive
eect on LRAS. A lower capital gains tax or business proft
tax aim s at increasing the incentive to invest.
2 Macroeconomics
Evaluation of supply-side policies
Overall, the benef ts expected rom im plem enting su pply-sid e
policies are a resu lt o:
n increased levels o com petition and the expected enhanced
ef ciency
n ewer d istortions to the price m echanism
n ewer bu ilt-in d isincen tives
n increased exibility in labou r markets.
There is no qu estion that in many econ om ies prod u ct markets
are severely d istorted as a resu lt o years o governm ent
intervention an d that an institu tional overhau l can create real
long-term benef ts or society. I n many econom ies labou r
markets may also be d istorted , with privileged grou ps o
workers reaping rents that increase inef ciencies, create
u nemploym ent and d ecrease overall com petitiveness. Reorm
can im prove social welare in the long term .
On the other hand , pro-market su pply-sid e policies can be
criticized on the ollowin g grou nd s.
n Benef ts u su ally take a long tim e to materialize. Pro-market
su pply-sid e policies are eective in the long ru n bu t
incapable o d ealing with short-ru n problem s.
n Tax cu ts may ind u ce m ore leisu re and less labou r and
investm ent, proving m ore o a g it to the better-o
segm ents o the popu lation and u rther skewing an
inequ itable incom e d istribu tion.
n Privatization oten has led , at least in the short ru n, to
increased u nemploym ent and it may lead to m onopoly
pricing an d related inef ciencies.
n Deregu lation may prove u nsu ccessu l in raising com petition
and lowering prices. The d eregu lation o the banking sector
in the U SA is consid ered by many prom in en t econom ists
the cau se o the 2 00809 f n ancial and econom ic crises.
n The smaller saety net that resu lts rom lower and stricter
u nemploym ent benef ts an d other welare-related cu ts, as
well as the squ eeze o real wages (especially or the
u nskilled ), may lead to increased incom e inequ ality as
segm ents o the popu lation may get marginalized . This may
create signif cant econ om ic and social costs in the u tu re.
1 09
 2 Macroeconomics
Optional material
Schools of economic thought: a very brief outline of ideas
Classical school
n Given that scarcity is the u nd am en tal econom ic problem ,
an economy will always u lly u tilize its scarce resou rces. An
economy will thereore prod u ce whatever its scarce
resou rces and its technology allow it to prod u ce.
n Su pply creates its own d emand is known as Says Law (Say
was a French econom ist). Says Law m eans that prod u ction
creates incom e and this incom e will n ecessarily be u sed to
pu rchase whatever was prod u ced .
n Overprod u ction was ru led ou t in this school o thou ght, as
overprod u ction im plies excess su pply which in competitive
markets lead s to lower prices and so to the market clearing
(reaching equ ilibriu m ).
n Prolonged u nemploym ent was also ru led ou t as it implies
excess su pply in labou r markets. Excess su pply lead s to
lower wages, orcing the labou r market to clear (that is, or
d emand or labou r to equ al su pply o labou r).
n Fl exi bil ity o prices a n d wa g es g u a ra n tees that th e
prod u ct a n d la bou r ma rkets wou l d clea r (that d em a n d
wou l d equ a l su ppl y).
n The economy will tend to operate at or near the u ll
employm ent equ ilibriu m . Any d eviation rom this wou ld be
temporary.
n I t ollows that there wou ld be no n eed or the governm ent
to intervene. This is known as laissez-aire, laissez-passer.
Keynesian school
n Demand or output creates the supply o output. It is
eective demand that determines equilibrium output and
income. An economys total output depends on the level o
eective demand, later reerred to as aggregate demand (AD).
n There is no gu arantee that an economy will f nd itsel (will
be in equ ilibriu m ) at the u ll employm ent level o ou tpu t.
Equ ilibriu m may occu r below u ll em ploym ent (a
d e ationary or recessionary gap may exist).
n I the private sector (which inclu d es hou seh old s and f rm s)
or whatever reason perhaps ju st psychological is u nable
to express su f cient d emand or good s and services in an
economy to lead to u ll employm ent o resou rces, then the
governm en t can act. I t can raise its own spend ing on good s
and services (as well as lower taxation) to increase the level
o total d emand to that level that all resou rces are u lly
employed . This is kn own as expansionary (or re ation ary)
f scal policy.
n The inherent instability o a market (a capitalist) economy
lead s to the observed short-ru n u ctu ations o ou tpu t
arou nd its long-ru n trend . This instability is a resu lt o
consu mption and investm ent being u nstable, as well as the
existence o the m u ltiplier eect and the interaction o the
m u ltiplier and the accelerator.
n I nstability (the bu siness or trad e cycle) requ ires g overnm ent
intervention. Cou ntercyclical d emand -sid e stabilization
policies need to be introd u ced . These inclu d e f scal and
m onetary policies.
n Fiscal policy is consid ered m ost eective in tim es o d eep
recession s.
11 0
Monetarist or new classical school
Two major d evelopm ents in the 1 970s were responsible or the
change in d irection in econom ics: the great in ation o the
1 970s and the d econstru ction o the Keynesian interventionist
approach by M ilton Fried man and the Chicago School (or, m ore
generally, by the m onetarists). Fried mans pro-market id eas
began to d om inate econom ic theory and with Margaret
Thatcher in 1 979 in the U K and Ronald Reagan in 1 980 in the
U SA they also started to d om inate policy making.
In 1 973, the frst oil crisis erupted, leading to the quadrupling o
the price o a barrel o oil in one day. The eect was stagation,
the coexistence o rising unemploym ent and rising in ation. This
was a blow to Keynesian econom ics as the two were thought as
being inversely related through the Phillips curve.
n M onetarists are consid ered the intellectu al heirs o the
classical school o thou ght.
n Fried man an d the m onetarist school tried to show that a
market economy is inherently stable, so there is no need or
an active role or the governm ent. Consu mption
expen d itu res were n ot thou ght to d epend on the cu rrent
level o incom e and the role o expectations on the bu siness
investm ent spend ing d ecision was d im inished . Private
spend ing was m ore stable.
n M onetarists f rst pointed ou t the possibility o crowd ing-
ou t, in this way weakening d ef cit spend ing as a tool to
re ate a agging economy.
n I n ation or Fried man was a pu rely m onetary ph enom enon
with too m u ch m oney chasing ater too ew good s.
M onetary policy was even consid ered potentially
d estabilizing and this school o thou ght preerred to rely on
pro-market su pply-sid e policies.
n The m onetarists d iscred ited the Phillips cu rve in ation
u nemploym ent trad e-o, trying to show that in the long ru n
the Phillips cu rve is vertical at the natu ral rate o
u nemploym ent, a term that Fried man him sel coined .
n Extrem e m onetarists consid ered that anything the
governm ent can d o the market can d o better. Governm ent
ailu re was even m ore likely than market ailu re.
n Several id eas related to m onetarism are the basic ingred ien t
o what is known as the Washington Consensu s which
pu sh ed stabilization, liberalization and stru ctu ral
ad ju stm ent onto d eveloping n ations, oten with very
d ebatable resu lts.
n N ew classical econom ists (Bob Lu cas, Thomas Sargent, N eil
Wallace, Ed Prescott, et al.) tried to bu ild macroeconom ic
theory on the basis o neoclassical m icroeconom ic theory.
They consid ered agents aim ing at maxim izing u tility and
possessing rational expectations so that no systematic
errors were mad e. Their analysis conclu d ed that only
u nanticipated policy changes cou ld temporarily aect real
econom ic variables (policy ineectiveness). Real bu sin ess
cycle theorists regard changes in prod u ctivity as the driving
orce o bu siness cycles.
 2 Macroeconomics: Questions
Practice part (a) long essay questions (HLP1 and SLP1 )
Command terms: typically AO1 /AO2 but possibly also AO4 (not AO3)
1 . Describe the circu lar ow m od el o an open econom y and
explain the m eaning o the term s incom e ow and
expend itu re ow.
2 . Explain how the size o the incom e ow within th e circu lar
ow m od el d epend s on the relative size o the with drawals
(or, leakages) and the injections.
3. Ou tline the d ierence between GDP and GN I as well as
between nom inal and real valu es o these m easu res o
econom ic activity.
4. Explain why the in com e approach, the ou tpu t approach
and the expend itu re approach in m easu ring national
incom e are equ ivalen t.
5. Explain the m eaning and signif cance o the term
green GDP.
6. U sing an appropriate d iagram , d istingu ish between the
phases o the bu siness (or, trad e) cycle and explain th e
m eaning o the term long term growth tren d , id entiying
it on you r d iagram .
7. What is th e d ierence between the d emand or a prod u ct
and aggregate d emand ? Explain two reasons or which
aggregate d emand is negatively sloped .
8. Def ne any three o the ou r components o aggregate
d emand and explain, or each o these three components
chosen , one actor that may increase it and thu s lead to a
rightward shit in the AD cu rve.
9. Def ne the term consu m ption expend itu res and explain
three actors that may increase their level in an economy
and thu s increase aggregate d emand .
1 0. Def ne the term investm ent expend itu res and explain
three actors that may increase their level in an economy
and thu s increase aggregate d emand .
11 . Def ne the term governm ent expend itu res and explain the
three types that these expend itu res are typically classif ed
into as well as actors that may increase their level in an
economy and thu s increase aggregate d emand .
1 2 . Def ne the term net exports and explain three actors that
may increase their level in an economy and thu s increase
aggregate d emand .
1 3 . Explain why the short ru n aggregate su pply within the
M onetarist /N ew Classical ram ework is u pward sloping
and su ggest two reason s it may shit to the let.
1 4. Explain the d istinction between the short ru n aggregate
su pply and the long ru n aggregate su pply within th e
M onetarist /N ew Classical ram ework.
1 5. Explain each o the three d iscreet sections o a typical
Keynesian aggregate su pply cu rve.
1 6. Explain actors that may shit the Monetarist /N ew Classical
long run aggregate supply curve right. Are these exactly the
same actors that are responsible or shiting the production
possibilities curve (or, rontier) o an economy outwards?
1 7. Distingu ish between the reasons the Keynesian
aggregate su pply cu rve is u pward sloping (section I I )
and the reasons the M onetarist short ru n aggregate
su pply is u pward sloping .
1 8. Explain the impact o an increase in aggregate d emand
within the M onetarist /N ew Classical an d the Keynesian
analytical ram ework.
1 9. U sing appropriate d iagram (s), explain the m echanism that
gu arantees, within the Monetarist /N ew Classical
ram ework, how any gap (in ation ary or d e ationary) will
au tomatically close.
2 0. Explain the role o aggregate d emand within the Keynesian
ram ework o analysis and contrast it with its long ru n role
in th e M onetarist /N ew Classical ram ework.
21 . Compare and contrast the sign if cance o shits o the
aggregate d emand within the Keynesian and the
M onetarist /N ew Classical ram ework.
2 2 . Explain what prevents real ou tpu t retu rning to its u ll
employm ent (or, potential) level ollowing a d ecrease (or,
an increase) in aggregate d emand within the Keynesian
ram ework.
23. Explain why a d e ationary gap requ ires governm ent
intervention within the Keynesian perspective bu t d oes not
within the M onetarist /N ew Classical perspective.
2 4. Explain how th e u nemploym ent rate is calcu lated as well
as the d if cu lties in m easu ring u nemploym ent.
2 5. Describe u sing examples the types o u nemploym ent
d istingu ishing between the cau ses o each type.
2 6. Explain u sing d iagram (s) the cau se o cyclical
u nemploym ent.
27. Explain u sing d iagram (s) the cau se o stru ctu ral
u nemploym ent.
2 8. Distingu ish between in ation, d isin ation and d e ation.
2 9. Explain how in ation and d e ation are m easu red .
30. Explain the problem s o m easu ring in ation.
31 . Explain why core in ation is importan t to m onitor.
32 . Explain what a producer price index m easu res and why it
is u seu l to m easu re it.
33. Explain the cau ses o both d emand pu ll and cost pu sh
in ation.
34. (H L only) Explain the view that the short ru n Phillips cu rve
may shit ou tward s.
35. Explain the m ean ing o the term natu ral rate o
u nemploym ent and its relationship to the M onetarist /
N ew Classical id ea o potential ou tpu t.
111
 2 Macroeconomics: Questions
36. Def ne econ om ic growth and , u sing appropriate d iagram s,
d escribe variou s ways it may be achieved .
37. Explain the signif cance (or, role) o d ierent types o 55. Ou tline the typical role and responsibilities o a Central
investm ent (in natu ral, physical and hu man capital) or
econom ic growth and illu strate u sing an appropriate
d iagram .
38. Explain the role o prod u ctivity gains in the process o
econom ic growth.
39. Does equ ity and equ ality in the d istribu tion o incom e
m ean the sam e thing? Explain.
40. Explain why markets may lead to increased incom e
inequ ality.
41 . Explain two ways th e d istribu tion o incom e may be
d escribed .
42 . Explain how inequ ality in the d istribu tion o incom e is
typically m easu red .
43. Distingu ish between absolu te an d relative poverty.
44. Explain possible cau ses o poverty.
45. Explain possible consequ ences o poverty.
46. U sing examples, d istingu ish between d irect and
ind irect taxation and explain the role o each type in
d istribu ting national incom e (or, ... o d irect taxation in
red istribu ting incom e).
47. Distingu ish between progressive, proportional and
regressive taxes, provid ing examples o each and
illu strating with an appropriate d iagram (last point not in
syllabu s).
48. Explain, u sing examples, how governm ent expend itu res
and transer paym ents may be u sed to red istribu te incom e.
49. Distingu ish, u sing examples, the sou rces o governm ent
revenu e and the types o expend itu res a governm en t makes
and com m ent on the possible bu d get ou tcom e.
50. Explain u sing a nu m erical example the relationship
between bu d get d ef cits/su rplu ses that a governm ent ru ns
and the pu blic d ebt o a cou ntry.
51 . Explain u sing appropriate d iagram (s) how expansionary
f scal policy can in u ence macroeconom ic aggregates
su ch as in ation, employm ent and ou tpu t, with special
emphasis on the shape o ag gregate su pply (n ote that this
cou ld easily be also a part (b) long essay qu estion as it is
qu ite d emand ing ).
52 . Explain u sing appropriate d iagram (s) how contractionary
f scal policy can in u ence macroeconom ic aggregates su ch
as in ation, employm ent and ou tpu t (note that this cou ld
easily be also a part (b) long essay qu estion as it is qu ite
d emand ing).
53. Explain how au tomatic stabilizers may help to stabilize
overall econom ic activity. U se a d iagram to illu strate
you r analysis.
11 2
54. Explain both the d irect and ind irect channels throu gh
which f scal policy may impact on long term growth.
Bank.
56. Explain how the level o interest rates in an economy is
d eterm ined , d escribing how the Central Bank can aect
the m oney su pply.
57. Explain u sing appropriate d iagram (s) how easy m onetary
policy can in u ence macroeconom ic aggregates su ch as
in ation, employm ent and ou tpu t, with special emphasis
on the shape o aggregate su pply (note that this cou ld
easily be also a part (b) long essay qu estion as it is qu ite
d emand ing).
58. Explain u sing appropriate d iagram (s) how tig ht m onetary
policy can in u ence macroeconom ic aggregates su ch as
in ation, employm ent and ou tpu t (note that this cou ld
easily be also a part (b) long essay qu estion as it is qu ite
d emand ing).
59. Describe the channels throu gh which looser (easier)
( / tigh ter) m onetary policy can help close a d e ationary
( / in ationary) gap.
60. Explain what is m eant by the expression in ation
targeting when reerring to the mand ate o a Central
Bank.
61 . Su ppl y sid e pol ici es m ay be o a n i n terven ti on ist n atu re
or m ay be m a rket ori en ted . Ou tl i n e th e m ea n i n g o th i s
statem en t, expla in i n g th rou g h a n a ppropriate d ia gram
th ei r a im .
62 . Def ne the term inrastru ctu re and explain the im pact o a
d ecision to improve a cou ntrys inrastru ctu re both in the
short term and in the long term .
63. Def ne the term hu man capital and explain why many
cou ntries make signif cant investm ents to increase its stock.
64. What d o we m ean by the expression ind u strial policies?
List three exam ples that may be consid ered part o an
ind u strial policy initiative and explain their impact on
aggregate d eman d and long ru n aggregate su pply.
65. Ou tline any two interventionist su pply sid e policies
explaining both th eir short term impact on aggregate
d emand and their potential im pact on long ru n impact on
aggregate su pply.
66. Explain how two d ierent types o market-based su pply-sid e
policies are expected to aect the long ru n aggregate
su pply o an economy.
67. Analyze how labou r market reorm s may aect the
su pply-sid e o an economy.
68. Analyze how policies to encou rage com petition may aect
the su pply-sid e o an economy.
69. Analyze how incentive-related policies may aect the
su pply-sid e o an economy.

Practice part (b) long essay questions (HLP1 and SLP1 )
Command terms: typically AO3 but possibly AO1 and AO2 or even AO4
1 . To what extent can national incom e statistics be u seu l in
d eriving conclu sions concerning changes in living
stand ard s o a cou ntry throu gh tim e or comparisons o
living stand ard s between cou ntries at a point in tim e?
2 . Exam ine the impact o an increase (and , separately, a
d ecrease) in aggregate d emand on short ru n an d long ru n
equ ilibriu m within the Monetarist /N ew Classical.
3. Exam ine the impact o an increase (and , separately, a
d ecrease) in aggregate d emand within the Keynesian
analytical ram ework.
4. Exam ine why an increase in aggregate d emand may have
d ierent implications concerning in ation ary pressu res
within the Keynesian and the M onetarist /N ew Classical
ram eworks o analysis.
5. (H L only) Explain, u sing an appropriate d iagram , the
m eaning and signif can ce o the Keynesian m u ltiplier
ou tlining the actors that may increase its size.
6. Discu ss econom ic consequ ences o u nem ploym ent.
7. Discu ss personal and social consequ ences o
u n employm ent.
8. Evalu ate policies to d eal with d ierent types o
u n employm ent.
9. Discu ss possible con sequ ences o in ation.
1 0. Discu ss possible con sequ ences o d e ation.
11 . Evalu ate policies to d eal with d ierent types o in ation.
1 2 . (H L only) To what extent (or, d iscu ss whether) a trad e-o
exists between in ation and u nemploym ent u sin g
appropriate d iagram (s).
2 Macroeconomics: Questions
1 3. Discu ss the consequ ences o econom ic growth on living
stand ard s, u nemploym ent, in ation, incom e d istribu tion,
the balance o paym ents and su stainability.
1 4. Evalu ate possible governm ent policies employed to
red istribu te incom e with special reerence to how ef ciency
issu es are aected .
1 5. Evalu ate the eectiveness o expansionary f scal policy,
taking into consid eration the Keynesian Monetarist/N ew
Classical viewpoints as well as short ru n versu s long ru n
consid erations.
1 6. Evalu ate the eectiveness o contractionary f scal policy,
taking into consid eration the Keynesian Monetarist/N ew
Classical viewpoints as well as short ru n versu s long ru n
consid erations.
1 7. Evalu ate the eectiveness o easy m on etary policy, taking
into consid eration the Keyn esian Monetarist/N ew
Classical viewpoints as well as short ru n versu s long ru n
consid erations.
1 8. Evalu ate the eectiveness o tight m onetary policy, taking
into consid eration the Keyn esian Monetarist/N ew
Classical viewpoints as well as short ru n versu s long ru n
consid erations.
1 9. Discu ss the strengths and weaknesses o market-based
su pply-sid e policies.
2 0. Discu ss the strengths and weaknesses o interventionist
su pply-sid e policies.
11 3
 3.1 International trade
th bfs d
S e cti o n 3 : i n te r n ati o n al e co n o m i cS
n I t perm its specialization o scarce resou rces wh ich lead s to
high er levels o ou tpu t and so higher levels o consu m ption.
Throu g h trad e cou ntries can consu m e com binations o
good s ou tsid e their prod u ction possibilities cu rve (PPC).
n Free trad e d ecreases the power o d om estic m onopolies by
exposing them to international competitive orces. The
increased level o competition increases ef ciency and
orces d om estic f rm s to lower prices.
n I t may allow d om estic f rm s to achieve econom ies o scale
(EOS) by increasing the size o the markets they sell or
export their prod u cts. This is especially signif cant or small
cou n tries with small d om estic markets.
n I t allows f rm s to import capital good s (machinery,
equ ipm ent, tools and in term ed iate prod u cts) that m eet
m u ch m ore closely their exact specif cations and this u rther
increases their prod u ctivity and prof tability.
n I t enables transer and d iu sion o technology and id eas
across bord ers.
n I t stim u lates growth by increasing prod u ctive resou rces, by
accelerating techn ological change and by spu rring
com petition, as well as throu gh the m u ltiplier eect
resu lting rom the increased export revenu es.
n The resu lting growth in real incom es allows higher savings,
increasing the availability o d om estic u nd s or investm ent.
n I t presents consu m ers with a greater variety o g ood s to
choose rom .
Free trade: summary of key points
allows specialization o resources
increasing output
increases competition, lowering domestic
monopoly power
leads to greater efciency
leads to lower prices which beneft buyers
and keep the cost o living lower
may induce domestic frms to grow and
Free trade achieve EOS
allows domestic frms to import exactly
what they need
enables technology and ideas to spread
aster
stimulates aster growth
allows higher savings that may be used to
fnance investments
presents consumers with more options
11 4
Figu re 3.1 .1 may be u sed to illu strate the welare gains rom
ree trad e. The market or good X is shown and initially no
trad e is assu m ed . This cou ld be the resu lt o prohibitive trad e
barriers that perm it no imports rom abroad (known as th e
au tarky case).
Price per unit
Supply
E
P
(1 ) (2) (3)
F H Sw
P
Demand
0 Q1 Q Q2
Q /period
Fgu 3.1.1 Benefts o ree trade
The equilibrium market price will be determined at P and the
equilibrium quantity at Q. N ow assume trade barriers are
eliminated and trade becomes ree. I the world price o the good
is at P9 then the world price would prevail in the domestic market.
HL N ote that since Fig u re 3.1 .1 is a d emand and su pply
d iagram we are im plicitly consid ering a perectly
competitive market where the good is hom ogeneou s;
so one price will prevail, the lower world price P9 ; we
are also consid ering a small cou ntry case which
m eans that the cou ntry is so small that the world
price o the good is not aected by how m u ch the
small cou ntry d emand s.
At the lower world price P9 domestic frms will produce
less (Q units instead o Q) and consumers will consume
1
more (Q 2 units instead o Q). As a result, consumer
surplus increases by area (1 , 2 , 3) whereas producer
surplus decreases by area (1 ). Area (EFH ) or area (2 , 3)
thereore represents the net welare gain resulting rom
ree trade. The additional consumer surplus is greater
than the lost producer surplus. Consumers can, in
principle, ully pay (compensate) producers and still be
better o.

HL Absolute and comparative advantage
The qu estion that arises is in which good s shou ld each cou ntry
specialize? Accord in g to Ad am Sm ith, m u tu ally bene cial trad e
is based on the principle o absolu te ad vantage. A cou ntry may
be m ore e cient in the prod u ction o som e com m od ities and
less e cient in the prod u ction o others relative to an other
nation. Each cou ntry shou ld specialize in the prod u ction o the
good in which it has an absolu te ad vantage.
A cou ntry has an absolu te ad vantage in the prod u ction o a
good i it can prod u ce m ore o it with the sam e resou rces or,
equ ivalently, i it can prod u ce a u nit o it with ewer resou rces
than another cou ntry. I n absolu te ad vantage the absolu te
resou rce cost o prod u cing a good is relevant.
Units of good Y
20
8 I n Figu re 3.1 .3, Cou ntry G rey can prod u ce 1 8 u nits o good X
0 14 18
Units of good X
Figure 3.1.2 Absolute advantage
O n a d i a g ram , th e cou n try wi th th e PPC u rth er ou t on a n
a xi s h a s th e a bsol u te a d va n ta g e i n th e prod u cti on o th e
g ood m ea su red on th a t a xi s. I n Fi g u re 3 .1 .2 Cou n try G rey
h a s a n a bsol u te a d va n ta g e i n th e prod u cti on o g ood X
(i t ca n prod u ce 1 8 u n i ts wi th th e sam e resou rces wh i l e
Cou n try B la ck ca n prod u ce on l y 1 4 u n i ts). Cou n try Bla ck h a s
a n a bsol u te a d va n ta g e i n th e prod u cti on o g ood Y
(2 0 u n i ts i n stea d o 8 ). Cou n try G rey sh ou l d th ereore
speci a l i ze i n a n d export g ood X a n d i m port g ood Y, a n d
vi ce versa or Cou n try B la ck.
I a cou ntry happens to be absolu tely m ore e cient in the
prod u ction o both good s then, accord ing to the principle o
absolu te ad vantage, there is no reason or it to specialize and
engag e in trad e. This wou ld be the case in a d iagram where the
PPCs d o not intersect.
I n 1 81 7, David Ricard o showed that absolu te ad vantage is not
necessary or m u tu ally ben e cial specialization and trad e to
take place. Even i a cou ntry is absolu tely at a d isad vantage in
the prod u ction o every g ood com pared with an other cou ntry
(that is, its PPC is insid e th e other cou ntrys PPC) there is still
room or m u tu ally bene cial trad e.
Accord ing to Ricard o only comparative ad vantage is necessary.
Each cou ntry shou ld specialize an d export those g ood s that it
can prod u ce at relatively lower cost. Relative costs are what
matter and not absolu te costs.
3 International economics
A country has a comparative advantage in the production o a good
i it can produce it at a lower opportunity cost (that is, by sacricing
ewer units o another good compared to another country).
Units of good Y
20
9
0 18 20
Units of good X
Figure 3.1.3 Comparative advantage
or 9 u nits o good Y at the m ost, whereas Cou n try Black can
prod u ce 2 0 u nits o good X or 2 0 u nits o good Y. Cou ntry
Black has an absolu te ad vantage in the prod u ction o both
good s as it can prod u ce m ore o both.
Since their PPCs are not parallel, their opportu nity cost ratios
d ier. This m eans there is room or specialization and m u tu ally
bene cial exchange.
Cou ntry G rey has a comparative ad vantage in th e prod u ction o
good X an d Cou ntry Black has a comparative ad vantage in the
prod u ction o good Y. G rey shou ld specialize and export good X
while Black shou ld specialize and export good Y.
H ow d o we know that Cou ntry G rey has a com parative
ad vantage in the prod u ction o good X?
First, we can see this as Cou ntry G rey's PPC is f atter. On a
gu re with two linear PPCs, the cou ntry with the f atter PPC has
the com parative ad vantage in the prod u ction o th e good on
the horizontal axis, while the other cou ntry has the
comparative ad vantage in the prod u ction o the other good .
We can also calcu late the opportu nity cost o prod u cing good X
by each cou ntry.
For Cou ntry G rey: I it prod u ces 1 8 u nits o good X it cannot
prod u ce (that is, it m u st sacri ce) 9 u nits o good Y, so (d ivid ing
both sid es by 1 8) in prod u cin g 1 u nit o X it m u st sacri ce
9
___ 1
or __ u nits o good Y.
18 2
For Cou ntry Black: I it prod u ces 2 0 u nits o X it cannot prod u ce
(that is, it m u st sacri ce) 2 0 u nits o Y, so (d ivid ing both sid es
by 2 0) in prod u cin g 1 u nit o X it sacri ces 1 u n it o Y.
M ore generally, the opportu nity cost o prod u cing the good on
the horizontal axis is the slope o the PPC:
Y
Opportunity cost of producing the good on the horizontal 5 ___
X
11 5
 3 International economics
N ote that i the PPCs are parallel, as in Figu re 3.1 .4, then there
is no room or specialization and m u tu ally bene cial trad e
becau se the opportu nity cost ratios are equ al.
Units of good Y
20
10
0 10 20
Units of good X
Figure 3.1.4 No room or mutually benecial specialization and trade
Sources of comparative advantage
The ultimate determ inants o a countrys comparative advantage
include dierences in actor endowm ents and dierences in
technology. Dierences in the quantity and quality o actors o
production available include dierences in the stock o natural
capital and its productivity, dierences in the stock o human
capital and its productivity and dierences in the stock o
physical capital and its productivity. Dierences in technology
are maniested indirectly as technology is embodied in the
physical capital available (it is inside the machines available)
and aects the productivity o human capital.
In addition, comparative advantage and trade fows can be aected
by movements in the exchange rate (the price o a currency
expressed in terms o another). For example, i the exchange rate
rises (appreciates) then exports become less competitive. Changes
in the relative infation rates also aect competitiveness. For
example, i average infation in country X is 8% while in country B
it is 4%, the goods and services produced by country X will become
relatively more expensive over time. This worsens their
competitiveness and causes a loss in comparative advantage.
Export subsidies can also be used to create an articial comparative
advantage or a countrys products US cotton producers,
recipients o massive state subsidies, provide a good example.
Lastly, non-price actors can lead to the creation or the loss o
comparative advantage and competitiveness (such as product
design, reliability, quality o ater-sales support). Export sales o
German capital goods, or example, are not easily aected by an
appreciating euro as their reputation is excellent in oreign markets.
Assumptions on which the principle of comparative
advantage rests
These assu m ptions are:
n constant (average and marg inal) costs o prod u ction
ref ected in the linear PPCs we draw
n perect actor m obility within each cou ntry (bu t, im m obility
between cou ntries)
11 6
n no tran sport costs
n perect competition in all markets
n ree trad e (n o trad e barriers).
Criticisms of the principle of comparative advantage
The above assu mptions d o not accu rately ref ect real world
cond itions. These assu mptions are the basis or the criticism s
o the com parative ad vantage m od el an d its pred ictions. The
criticism s are as ollows.
Costs o prod u ction need not be constant. They may be
decreasing, in which case the gains rom specialization may
even be greater. I ncreasing retu rns to scale in prod u ction and
the resu lting EOS are very oten the case in the real world .
Labour and the other actors o production suer rom both
occupational and geographical immobility. It may not be costless
or even possible or a country to specialize. Real adjustment costs,
such as unemployment or certain regions or groups, will result
when a country responds to a shit in its comparative advantage.
Transportation costs do exist in the real world and, depending on
the ratio o weight to value, will decrease the scope o oreign trade
opportunities. Note though that transport costs have dramatically
decreased since the advent o the container in shipping.
Perect com petition is not com m on at all. Large rm s with
monopoly power and EOS d om inate world trad e.
Trade barriers are also a reality which prevents world trade fows
rom refecting comparative advantage conditions among nations.
For these and other reasons the actu al pattern o trad e f ows
does not u lly ref ect com parative ad vantage. Still, comparative
advantage is a m ost u seu l concept in u nd erstand ing and
explaining m u ch o what is going on in the world o trad e.
Limitations of the theory of competitive advantage: summary
increasing returns to scale and so EOS exist
Limitations labour suffers from occupational and geographical
of the immobility so it may be costly to specialize
theory of
transportation costs exist, limiting the scope for trade
comparative
advantage perfectly competitive conditions are rarely
are that approximated
trade barriers exist, limiting the scope for trade
Comparative advantage is a dynamic concept
Comparative ad vantage is a d ynam ic concept as it can and
d oes change over tim e. Governm ents can and historically have
prom oted policies that help to create a com parative ad vantage
in speci c ind u stries. A governm ent cou ld invest in ed u cation,
increasing the stock o hu man capital and raising labou r
prod u ctivity and lowerin g average costs in speci c ind u stries.
I t cou ld create avou rable investm en t cond ition s or private
rm s by ensu ring price stability (low inf ation), long-ru n
equ ilibriu m in the exchange rate and , m ore generally, a
cond u cive bu siness environm ent. I t cou ld also import
technology by attracting oreign d irect investm ent (FDI ) in
high -tech sectors.
An example o a cou ntry that d id not rely on a static
interpretation o comparative ad vantage bu t instead created a
com parative ad vantag e in several other areas is Korea. I it had
relied on its original com parative ad vantage, it wou ld have still
been an exporter o rice.
 3 International economics

The World Trade Organization The WTO is criticized on several grou nd s. I t is accu sed that it is
controlled by the rich nations, especially the U SA, and that it
The World Trad e Organization (WTO) was set u p in 1 995 and
d oes not su ciently consid er the need s and problem s o th e
has 1 53 m em ber cou ntries, replacing another international
d eveloping world . For example, agricu ltu ral prod u cts rom
organization known as the General Agreem ent on Taris and
d eveloping cou ntries d o not have ree access to the U S market
Trad e (GATT). GATT was orm ed in 1 948 when 23 cou ntries
bu t the U SA insists that the poor open u p their markets to U S
signed an agreem ent to red u ce taris.
good s and , especially, services. I t is claim ed that the WTO is too
The WTO is an international in stitu tion aim ing at prom oting poweru l, trying to orce nations to change policies, laws and
ree trad e by persu ad ing cou ntries to abolish im port taris and regu lations by d eclaring them in violation o its ru les. I t is
other barriers. I t has becom e closely associated with charged that d oes not consid er th e possible ad verse eects o
globalization. I t ensu res that trad e ru les are ad hered to, it trad e liberalization on workers, on the environm ent and health
settles trad e d ispu tes between cou ntries and it organizes trad e or on child labou r. Lastly, som e consid er that it lacks
negotiations. WTO d ecisions are nal and every m em ber m u st transparency in its d ecision making on trad e d ispu tes as it is
abid e by its ru lings. So, when the U SA and Brazil are in d ispu te closed to the m ed ia and the pu blic.
over rozen orange ju ice, it is the WTO wh ich acts as ju d ge and
On the other hand, even i the benets o reer trade have not been
ju ry. The WTO empowers its m em bers to enorce its d ecisions by
shared equally, many believe that the trade liberalization eorts o
im posing trad e sanction s against cou ntries that have broken
the WTO have improved living standards across the globe.
the ru les.
The WTO: summary of key points
was set up in 1995 as a successor o the GATT (1948).
has 153 member countries.
The WTO promotes trade liberalization.
sets trade rules and ensures that they are ollowed.
is the arbitrator o trade-related disputes.
biased in avour o US and European Union interests.
inconsiderate to the needs o developing countries.
Criticisms of the WTO include that it is
paying insufcient attention to increasingly important issues such as child labour, health,
the environment and workers rights.

restictions on fee tade: tade potection

Does trade protection make sense? in the case o a war; in other word s, or strateg ic reasons.
The weapons and aerospace ind u stries as well as the ood
I the bene ts rom ree trad e are so many and , as shown
ind u stry are oten classi ed as being o su ch strategic
earlier in Figu re 3.1 .1 , n et welare increases with ree trad e, why
im portance. The valid ity o this argu m ent is d ou btu l, at
d o so many cou ntries restrict trad e and em ploy variou s d egrees
least or cou ntries belonging in wid e strategic and /or
o trad e protection? Why is managed trad e so com m on?
political alliances.
The sim ple answer is that not all parties involved gain rom ree
n Trad e barriers are also em ployed to restrict im ports o dru gs
trad e. There are grou ps that are worse-o. Free trad e creates
an d other harm u l su bstances or to pu t pressu re on and
winners and losers.
weaken politically u nriend ly cou ntries (em bargoes).
In Figure 3.1.1 the increase in the consumer surplus exceeds the
n Som e cou ntries resort to trad e protection to preserve a way
decrease in the producer surplus. The winnings o the winners are
o lie or cu ltu ral id entity as part o a broad er social
greater than the losses o the losers. The problem in the real world
strategy. For exam ple, the television stations in many
is that there is no guarantee that the losers will be compensated.
cou ntries ace restrictions on the hou rs o program m es
I n ad d ition, the winnings rom ree trad e are spread over a very broad cast in oreign langu ages.
large nu m ber o people (consu m ers) each getting a very small
n Trade barriers also exist to ensure that certain minimum saety
ad d ition to his or her incom e while the resu lting losses are
and health standards are met. The goal is purportedly to
spread over a m u ch smaller nu m ber o ind ivid u als (prod u cers)
protect the public but oten such standards are a pretence
each su ering a signi cant cu t in their incom e. I t ollows that
losers have a big incentive to pu t u p a ght again st ree trad e. through which domestic producers are protected.

To ensu re that th e ad ju stm ent costs or the losers are small,
governm ents oten ju d ge that som e level o trad e protection
is necessary.
N on-economic arguments in favour of trade protection
n Governm ents oten erect trad e barriers to ensu re that a
cou ntry is sel-su cient in the prod u ction o cru cial good s
Economic arguments in favour of trade protection
n A very com m on argu m ent in avou r o restricting trad e is to
protect d om estic jobs. M any claim that ree trad e d ecreases
employm ent as ch eaper and better-qu ality oreign prod u cts
f ood the d om estic market, orcing d om estic rm s to shu t
d own. Foreign cheap labou r is oten blam ed or in creasing
rates o u nemploym ent.

11 7
 3 International economics
These claim s m u st be careu lly evalu ated . First, higher
d om estic wages d o not necessarily imply higher labou r
costs as labou r prod u ctivity is important. I d om estic wages
are higher becau se o hig her labou r prod u ctivity then
labou r costs may be lower than abroad , so there is no
reason to ear imports. I , thou gh, the higher d om estic
wages are not a ref ection o higher labou r prod u ctivity
then the d om estic ind u stry has a comparative
d isad vantage. Theory then su ggests that labou r and other
resou rces sh ou ld be channelled to other, m ore e cient
u ses. Workers and owners o capital, and perhaps whole
regions, will have to ace real ad ju stm ent costs and o
cou rse will resist these changes. They will try to blam e
oreigners or their pligh t and will d emand protection.
I nstead o protection thou gh, which will red u ce the
incentive to restru ctu re and ad ju st, other policies cou ld be
ad opted to sm oothen the transition, especially or d isplaced
workers. N ote that in the case o poorer d eveloping
cou n tries shiting resou rces rom one u se to another may be
alm ost im possible withou t som e governm ent assistance
which itsel cou ld be too costly to implem ent. I n su ch a
case, trad e liberalization shou ld proceed grad u ally. Also,
i employm ent in a whole region relies on the d istressed
ind u stry with ew or no employm ent alternatives or the
popu lation, then the liberalization process m u st be grad u al.
n Another com m on argu m ent in avou r o protection is to
im prove a trad e d e cit. A trad e d e cit exists i the valu e o
im ports o good s and services (the im port bill) is greater
than export revenu es. The id ea is that trad e protection will
rend er imports m ore expensive and thereore less attractive.
Spend in g on imports will thereore d ecrease, shrinking and
correcting the trad e im balance.
There are several potential problem s with th is argu m ent.
First, it invites retaliation rom trad ing partners as any
im provem en t in the trad e balance com es at their expense.
Second , restricting oreign prod u cts into the cou ntry lowers
oreign incom es and , consequ ently, oreign consu m ers
ability to bu y ou r exports. Third , and m ost importantly, su ch
a policy d oes not treat the root cau se o a wid ening trad e
d e cit problem . The ballooning trad e d e cit may be the
resu lt o d om estic prod u cts being u ncom petitive: d om estic
good s and services are u nable to penetrate oreign markets
(so that exports d ecrease) and th ey are not the choice o
d om estic hou sehold s which nd it cheaper to bu y imports
instead (so that imports rise). H igh inf ation, stru ctu ral
rigid ities and u ncompetitive d om estic markets, as well as
issu es o poor qu ality, reliability, d elivery, d esign or
marketing may be the real reasons behind a growing trad e
im balance. I n these cases trad e protection will not prove
helpu l bu t may possibly prove d etrim ental as it will d elay
the ad option o appropriate ad ju stm ent policies.
n Governm ents may decid e to erect import barriers to assist
the growth o certain indu stries in their initial stages o
developm ent. Once these industries acquire the necessary
know-how and achieve EOS they will be able to m eet
international competition. At this point protection should be
rem oved. This is the well-known inant industry argum ent.
This argu m ent also n eed s to be careu lly evalu ated . I t is
ind eed theoretically sensible and the policy has been u sed
by all d eveloped econom ies in the past, inclu d ing the U SA,
11 8
as well as by all Asian export achievers, in varying d egrees.
Bu t it also su ers rom potential major drawbacks. H ow
d oes a governm ent pick a winner? I t may be d i cu lt to
d eterm ine which ind u stry qu ali es or su ch treatm en t. I a
m istake is mad e, will it be possible or the governm ent to
reverse its cou rse and withdraw its su pport? Rem oving the
protection cou ld be ercely resisted by the in d u stry
stakehold ers. I trad e protection is not lited th en we have
the case o the perpetu al inant. There is an inherent risk
o making the in d u stry over-reliant on state su pport,
slu ggish and ine cient.
n I d u mping is su spected (which is selling abroad at a price
below average costs or lower than the d om estic price) then
even the WTO allows a cou ntry to impose taris (taxes on
imports which in this case are reerred to as anti-d u mping
d u ties) on the exporting ind u stry. An investigation ollows
and i d u mping is proved th en trad e protection is perm itted
to ensu re a level playing eld .
Du mping is not easy to prove, thou gh. The qu estion arising
relates to rm s average costs. I t cou ld be that the oreign
rm is m u ch m ore e cient, so it has m u ch lower u nit costs
o prod u ction. Or it cou ld be that the oreign rm is illegally
being su bsid ized by its governm ent, creating an arti cial
cost ad vantage. I n the orm er case there is no case o
d u m ping whereas in the latter there is. As anti-d u mping
d u ties are au tomatically im posed when d u mping is
su spected u ntil the issu e is investigated and a verd ict is
reached , many ind u stries cry d u m ping to gain tim e in
ord er to restru ctu re and , they hope, becom e m ore e cient.
n Another argu m ent is the strategic trad e policy argu m ent.
Accord ing to this, in a ram ework o international
oligopolies (where ew large rm s d om inate world markets)
a governm ent can tilt the balance and the pro ts away
rom oreign com petitors and toward s d om estic rm s by
u sing trad e policies. The governm ents assistance can be in
the orm o su bsid ies, grants, loans at below market interest
rates and taris. The classic example is the aircrat
manu actu ring in d u stry, with Boeing and Airbu s
m onopolizing the world market and where each sid e
accu ses the other o massive governm en t assistance. I n
other cases (typically in high-tech ind u stries), where there
are rst m over ad vantages (implying that rm s that are
rst to su cceed will d om inate th e world ind u stry), the
assistance cou ld take the orm o setting ind u stry stand ard s
in avou r o d om estic rm s.
The problem with strategic trad e policy is that it carries the
risk o d estabilizing trad e d ispu tes an d retaliation as it is a
beggar thy neighbou r policy. I one cou ntry su cceed s then
another cou ntry necessarily ails. There is also the risk o
protecting the wrong ind u stries.
n Ta ri s (ta xes on i m ports) provi d e a g overn m en t wi th
reven u es. Ta x system s i n certa i n d evel opi n g cou n tri es
a re i n eecti ve, m a ki n g i t d i cu l t or th ei r g overn m en ts
to col l ect su ci en t reven u e to n a n ce pro-d evel opm en t
a cti vi ti es. Si n ce poi n ts o en try i n to a cou n try a re ew,
ta xi n g i m ports to col l ect reven u e m ay be a la st resort
th a t ca n n ot be g i ven u p. I th i s i s th e ca se th en tra d e
l i bera l i zati on m u st be g ra d u a l to en su re th a t th e
provi si on o ba si c g overn m en t servi ces i s n ot i n terru pted .

Arguments in favour of trade protection: summary
Economic it will protect jobs rom oreign competition.
arguments in
it can correct a trade defcit.
favour of trade
it will protect against possible dumping.
protection
are that it can enhance government revenues.
Other arguments in the inant industry argument.
favour are the strategic trade policy argument.
Arguments against trade protection
n Trad e protection breed s ine ciency as d om estic rm s are
exposed to less competition and are aced with captive
d om estic markets.
n Less com petition im plies greater d om estic m onopoly power.
n Greater m onopoly power or d om estic rm s implies higher
prices, d istortion o the signalling power o the price
m echanism and m isallocation o scarce resou rces.
n H igher prices or im ported and d om estically prod u ced
consu m er good s imply a d ecrease in consu m er su rplu s and
lower pu rchasing power or hou sehold s and so constrained
ability to express d emand or all other good s and services
in the economy. Th is cou ld have negative eects on ou tpu t
and employm ent levels.
n H igher prices or d om estic rm s importing interm ed iate
prod u cts (prod u cts u sed in their own prod u ction process)
imply higher prod u ction costs and so a d ecrease in
aggregate su pply and cost-pu sh inf ationary pressu res. I
these d om estic rm s happen to be export-oriented their
competitiveness in international markets will be erod ed ,
hu rting their sales and ad versely aecting overall
employm ent levels in the economy. Trad e protection u su ally
d estroys m ore jobs than it preserves or creates.
n Trad e protection may ind u ce retaliation (tit or tat). I the
trad e rictions escalate then a trad e war may resu lt, in the
long term , in hu rting all parties involved .
Types of trade protection
Trad e protection can take variou s orm s. The m ost com m on
orm s are: taris, qu otas, volu ntary export restraints, su bsid ies
and regu latory barriers (prod u ct stand ard s), as well as a host o
other m easu res su ch as antid u mping d u ties, exchange controls,
non-au tomatic im port au thorization (import licenses) etc.
Rem em ber that non-tari barriers inclu d e those barriers that
d o not d irectly aect the price o the good .
Tariffs
A tari is d e n ed as a tax imposed on imports aim ed at
restricting their f ow into the cou ntry and at protecting
d om estic prod u cers. I t has been the m ost com m on orm o
protection. I t may be speci c or ad valorem . A tari will tend to
raise the d om estic price and d om estic prod u ction while
lowering the am ou n ts consu m ed and imported . These eects
are illu strated in Figu re 3 .1 .5.
3 International economics
n Dom estic rm s will not be exposed to the technological
ad vancem ents em bod ied in im ported capital good s.
n Only special interest grou ps bene t rom trad e protection,
with society at large worse o in the long ru n. Owners and
workers o protected ind u stries an d their stakehold ers are
better o at the expense o all others.
n Trad e protection is responsible or d irectly u nprod u ctive
pro t-seeking (DU P) activities, a term introd u ced by
Bhagwati (1 989), which inclu d es activities su ch as rent and
revenu e seeking and tari and qu ota evasion that take
place in response to an existing trad e barrier and lead to
the u se and waste o real resou rces.
n Consu m ers an d rm s are aced with lim ited options to
choose rom . The red u ction in choice is a cost as bu yers
(consu m ers as well as rm s) have to settle or their second
or third choice. U tility d ecreases or hou sehold s while
com petitiveness d ecreases or rm s.
Arguments against trade protection: summary
it breeds inefciency.
it limits competition and increases
monopoly power.
it is responsible or misallocation o scarce
resources.
it leads to higher prices or consumers.
Arguments against
it increases the production costs o frms
trade protection are
importing intermediate goods.
that
it increases the possibility o retaliation.
it limits awareness o frms to technological
progress embodied in imported capital
goods.
it is responsible or DUPs.
it limits options to consumers and frms.
Price per unit
S
B C
P Sw
1 2 3 4 J
A
P Sw
F H
D
0 Q1 Q3 Q4 Q2
Q /period
Figure 3.1.5 Eects o a tari (small country case)
11 9
 3 International economics

Assu m e th e m a rket or a pa rti cu la r g ood a n d l et th e worl d Tariffs: summary of effects

pri ce be a t P. At th e pri ce P, d om esti c rm s wi l l oer Q 1
u n i ts per peri od wh i l e d om esti c con su m pti on wi l l be Q 2
u n i ts per peri od . I m ports wi l l m a ke u p th e d i eren ce (th a t i s,
Q 1 Q 2 u n i ts per peri od ).
Let a ta ri eq u a l to t d ol la rs or eu ros be n ow i m posed .
Th e ta ri wi l l ra i se th e d om esti c pri ce to P9 . Th e ta ri t i s
eq u a l to P9 d ol la rs or eu ros per u n i t. N ote th a t th e ta ri wi l l
n ot a ect th e worl d pri ce a s i t i s a ssu m ed th a t th e cou n try i s
sm a l l . Th i s m ea n s th a t th e worl d pri ce P i s n ot a ected i Tariffs
th e cou n try, a s a resu l t o th e ta ri , d em a n d s l ess. Th e
cou n try i s sm a l l i n th e sen se th a t i ts prod u cti on a n d
con su m pti on d eci si on s a re i n si g n i ca n t, so th ey d o n ot
a ect th e worl d pri ce.
Given the new price P9 established in the d om estic market,
d om estic prod u ction will rise to Q3 u n its per period while
d om estic consu mption drops to Q4 u nits per period . The
volu m e o imports shrinks to Q3Q4 u nits per period .
Th e higher price implies that the consu m er su rplu s d ecreases by
area (P9 PJC) or area (1 , 2 , 3 , 4) while the prod u cer su rplu s
increases by area (PABP9 ) or area (1 ).
Area (FH CB) (area (3 )) is the tari reven u e collected . This is the
case becau se tari revenu es are th e prod u ct o the tari per
increase the domestic price o the protected good.
increase domestic production o the good.
decrease consumption o the good.
decrease consumer surplus by area (1 1 2 1 3 1 4) in
a typical tari diagram.
increase producer surplus by area (1) in a typical tari
diagram.
create tari revenues equal to area (3) in a typical tari
diagram (but the eect on total government tax revenues
collected is ambiguous).
lead to production inefciency equal to area (2) in a
typical tari diagram.
lead to consumption inefciency equal to area (4) in a
typical tari diagram.
are responsible or a welare loss equal to area (2 1 4) in
a typical tari diagram.
Quotas
A qu ota is d e ned as a qu antitative restriction on the volu m e
o imports. Figu re 3 .1 .6 illu strates the eect o a qu ota.
Price per unit

u nit tim es that nu m ber o u nits imported . The tari per u nit is Sd
line segm en t P9 P (equ al to segm ent BF) and th e volu m e o
imports is Q3Q4 (or segm ent FH ). S = (Sd + Quota)
Exam ining the changes in social welare that resu lt rom the Su pply of th e g ood in th e
Quota = d om estic m a rket d id n ot
imposition o the tari we realize that: in crea se! I t wa s in n itely
250 units ela stic at Sw a n d n ow it is
D(producer surplus) 5 plus area (1 )
on ly S. Rem em ber th e
D(consum er surplus) 5 minus area (1 1 2 1 3 1 4) qu ota restricts im ports.
H E The qu ota d ecrea ses
Area (3 ) represents the tari revenu es collected , so it cannot be P
su pply in th e d om estic
consid ered a welare loss as this m oney can be spent on 1 2 3 4 m arket from Sw to S.
schools and health care centres, or example. P Sw
B C F R J
So: D(social welfare) 5 minus area (2 1 4)
D
A tari lead s to a net welare loss equ al to areas (2 ) and (4). A

Area (2 ) represents the resu lting prod u ction ine ciency while 0 Q1 Q3 Q4 Q2
area (4) represents the resu lting consu mption ine ciency. 200 700 Q /period
units units
Area (2 ) ref ects prod u ction ine ciency becau se the cost o
d om estically prod u cing u nits Q1 Q3 (which is equ al to area Figure 3.1.6 Eects o a quota
Q1 Q3BA, th e su m o all the margin al costs o prod u cing these
Let the world price or som e good be at P. At price P, d om estic
u nits) is greater than what it wou ld have cost the cou ntry to
rm s are willin g to oer Q1 u nits per period (say, 2 00
import these u nits at the world price 0P (which is equ al to area
thou sand tons o rozen orange ju ice per period ) while d om estic
(Q1 Q3FA), the prod u ct o u nits Q1 Q3 tim es the world price).
consu mption will be Q2 u nits (say, 700 thou sand tons). The
Area (4) ref ects consu mption ine ciency. U nits Q4Q2 are now volu m e o im ports will be Q1 Q2 u nits or, in this example, 5 00
not consu m ed by d om estic consu m ers as a resu lt o the tari thou sand tons o rozen orange ju ice).
even thou gh these u nits are valu ed by consu m ers m ore than
Let the governm ent now impose a qu ota o 2 5 0 thou sand tons
what it wou ld cost them to import. These u nits are worth area
o rozen orange ju ice in an attem pt to protect d om estic
(Q4CJQ2 ) to consu m ers, which is the su m o how m u ch
prod u cers. N o m ore than 2 5 0 thou sand tons o imported rozen
consu m ers wou ld be willing to pay or each o these u nits. They
orange ju ice may enter the d om estic market.
wou ld have cost only area (Q4Q2 JH ) to im port.
Prior to the qu ota, d om estic consu m ers aced an in nitely
elastic su pply o rozen orange ju ice Sw as they were oered
Remember that despite the welare loss a tari may make
TIP whatever am ou nt they wished at the world price. We are
sense. It is a source o government revenue that may be
again assu m ing a small cou ntry so that the world price remains
impossible to replace. Also, the adjustment costs or the
u naected no matter how m u ch the small cou ntry d ecid es
displaced workers may in some cases be prohibitively high.
to bu y.

1 20

Ater th e im position o th e qu ota , at th e u n chan g ed world
price P, a s well a s at a ny oth er price a bove it, su pply o rozen
ora n g e ju ice in th e d om estic market will be con stra in ed to
whatever am ou n t d om estic prod u cers o rozen oran g e ju ice
a re willin g to oer plu s th e 2 5 0 th ou san d ton s o rozen
ora n g e ju ice that can n ow on ly be im ported .
I t ollows that the new eective su pply o rozen orange ju ice is
at S, which is parallel to the right o the d om estic su pply cu rve
Sd by the am ou nt o the qu ota, in th is case by 2 5 0 thou sand
tons (m ore precisely, the new su pply is the line ABFS). At each
price above P, the am ou nt o rozen orange ju ice available to
d om estic consu m ers will equ al to whatever qu antity d om estic
prod u cers are willing to oer plu s the 2 5 0 thou sand tons qu ota
o rozen orange ju ice.
At price P, the total qu antity su pplied will equ al Q1 u nits o
d om estic rozen orange ju ice plu s the 2 5 0 thou sand tons o the
qu ota equ al to d istance BF. At that price P thou gh, qu antity
d emand ed is greater an d equ al to Q2 u n its. Excess d emand
equ al to d istance FJ u nits per period will resu lt. Since we are
im plicitly assu m ing perectly competitive markets, the d om estic
market price or rozen orange ju ice will rise u ntil it reaches P9 .
Price P is the new equ ilibriu m price in the d om estic market
becau se at that price the total am ou nt su pplied to the market
by both d om estic and oreig n prod u cers is equ al to the qu antity
d om estically d emand ed by consu m ers. M ore specif cally, at P 9
d om estic prod u cers oer Q3 tons (or d istan ce P9 H ), consu m ers
bu y Q4 tons (or d istance P9 E) and the d ierence o Q3Q4 tons
(or d istance H E) is mad e u p o the im ported rozen orange ju ice
which is equ al to the 2 5 0 thou sand tons qu ota.
A qu ota thereore increases the d om estic price o the protected
good as well as d om estic prod u ction while it red u ces d om estic
con su mption and , o cou rse, the volu m e (qu antity) o imports.
Exam ining the changes in social welare that resu lt rom the
im position o the qu ota we realize that:
D(producer surplus) 5 plus area (1 )
D(consumer surplus) 5 minus area (1 1 2 1 3 1 4)
D(social welfare) 5 m inus area (2 1 3 1 4)
Area (3) is known as qu ota rents and represents m oney
typically earned by the oreign exporting f rm s wh ich can now
export the prod u ct at a h igher price. Area (3 ) may also end u p
in the hand s o oreign governm ents. I t is even possible that the
m oney that area (3) represents end s u p in the hand s (th e
coers) o the d om estic governm ent i, or example, it au ctions
o the qu ota licenses.
Area (2 ) again represents the resu lting prod u ction inef ciency
while area (4) represents the resu ltin g consu mption in ef ciency,
as explained in the case o a tari.
The eects o a qu ota are the sam e as those o an equ ivalen t
tari with one exception: the tari revenu es area (3 ) now
represents qu ota rents which are u su ally collected by oreigners
and represent an ad d itional welare loss.
Th e exi sten ce o q u ota ren ts h el ps expla i n wh y q u ota s a re
oten i m posed i n stea d o ta ri s even th ou g h th e a ssoci a ted
wel a re l oss i s bi g g er. Forei g n ers a re ha ppi er a s th ey u su a l l y
pocket th ese ren ts. I th e orei g n exporti n g f rm s pocket th e
q u ota ren t, th en th ei r export reven u es (a n d eq u i va l en tl y, th e
3 International economics
i m port bi l l rom th e poi n t o vi ew o th e i m porti n g cou n try)
a re bi g g er th a n i a n eq u i va l en t ta ri wa s i m posed a n d m ay
even be g reater th a n wh a t th ey wou l d ha ve been u n d er ree
tra d e. Wi th ree tra d e th ei r export reven u es were eq u a l to
a rea (Q 1 Q2 J B) wh erea s wi th a q u ota a ppropri ated by th e
orei g n exporter th ey a re a rea (Q3 Q4EH ), wh i ch cou l d be
g rea ter. Th i s possi bi l i ty m i n i m i zes th e proba bi l i ty o
reta l i ati on .
The quota diagram is one o the most difcult to draw and
TIP
is a source o many avoidable mistakes. An easy way to do
the job is to draw a ree trade diagram, determine the
amount o imports under ree trade (Q1Q2 in Figure 3.1.5) and
fnd the midpoint o this segment (conveniently assuming that
the quota is set at hal the ree trade level o imports). Do not
label this new point! Very lightly trace with your pencil (so that
you can erase it later) a line up to Sw to determine the point
rom which you draw a parallel to the domestic supply curve Sd
(in Figure 3.1.5 the point you determine on Sw is point F). This is
the new eective supply curve S9 . Lastly, rom the intersection o
S9 and your demand curve D (point E in Figure 3.1.5) determine
the new equilibrium price P9 .
Quotas: summary of effects
increase the domestic price o the protected good.
increase domestic production o the good.
decrease consumption o the good.
decrease consumer surplus by area (1 1 2 1 3 1 4) in
a typical quota diagram.
increase producer surplus by area (1) in a typical quota
diagram.
create quota rents equal to area (3) which are typically
Quotas pocketed by oreign frms (but the domestic government
may also collect these).
lead to production inefciency equal to area (2) in a
typical quota diagram.
lead to consumption inefciency equal to area (4) in a
typical quota diagram.
are responsible or a welare loss equal to area (2 1 3 1 4)
in a typical quota diagram (assuming that the quota rents are
collected by oreigners).
Voluntary export restraints (VERs)
Setti n g u p VERs i s a orm o tra d e protection that is a sl ig h tl y
d i eren t versi on o i m posin g q u ota s. VERs a re a greem en ts
between a n exportin g a n d a n im porti n g cou n try li m iti n g th e
m a xi m u m am ou n t o exports i n a g i ven peri od . Th e d om esti c
(im porti n g ) g overn m en t a sks th e oreig n g overn m en t to
restrict th e exports o th e g ood ; th e term vol u n ta ry i s
m islea d in g sin ce th e req u est i s rea ll y a d ema n d a n d i t i s
m a d e clea r that u n l ess th e oreig n g overn m en t vol u n ta ri ly
com pli es, m ore restri cti ve protecti on ist ba rri ers wi ll be
i m posed . Th e eects a re si m ila r to that o a q u ota so a rea (3 )
m ay sti ll en d u p in th e pockets o orei g n ers, m a ki n g i t l ess
costl y tha n i a ta ri wa s i m posed .
1 21
 3 International economics
Subsidies
Su bsid ies lower prod u ction costs o f rm s and thereore
artif cially increase their competitiveness. As a resu lt, su bsid ies
will d ecrease imports and may even lead to exports. The U S
cotton ind u stry is the recipient o hu ge governm ent su bsid ies
and ranks n u m ber one in world cotton exports. The eects o a
su bsid y are illu strated in Figu re 3 .1 .7.
Price per unit
S, MC
S = (MC subsidy)
subsidy/
F unit
Pp
J H R
P Sw
D requ irem ents), sanitary stand ard s (to protect the d om estic
0 Q1 Q3 Q2
Q /period
Figure 3.1.7 The eect o a subsidy to domestic producers on imports
I nitially, assu m e ree trad e with the world price o the prod u ct
at P. Th e d om estic ind u stry will be willing to prod u ce and oer
Q1 u nits per period whereas consu m ption (qu antity d emand ed )
will be at Q2 u nits per period lead ing to Q1 Q2 u nits o imports.
I a su bsid y is granted to the d om estic f rm s then their
prod u ction (marginal) costs will d ecrease by the am ou nt o the
su bsid y. Su pply will in crease, shiting vertically d ownward by
the am ou nt o the su bsid y to S9 .
Th e world price P is not aected (assu m ing again a small
cou ntry case) bu t now at the world price P, d om estic f rm s are
willing to oer m ore. Dom estic prod u ction at P is n ow, as a
resu lt o the su bsid y, at Q3 u nits per period . Consequ ently, the
volu m e o imports will shrink rom Q1 Q2 to Q3Q2 u nits.
Dom estic f rm s will earn P per u nit plu s the per u nit su bsid y
which is the vertical d istance H F between the two su pply cu rves
(that is, their new average revenu e is Pp).
Total reven u es or the d om estic ind u stry have increased rom
area (0Q1 JP) to area (0Q3FPP). Consu m ers enjoy the sam e
Why have cries for trade protection been
increasing?
A growing number o developing countries (especially China) have
achieved rapid, export-led growth. Export success by these
countries means deep import penetration in Europe and the USA.
Protectionist response is expected rom those groups most
aected.
Large trad e im balances between large trad ing nations (the
m ost prom inent example being that between the U SA and
China) have strained relationsh ips between these cou ntries and
have led to variou s protectionist m easu res. The U SA, or
1 22
am ou nt at the sam e price bu t the governm ent and so,
eventu ally, taxpayers are bu rd ened by the cost o the su bsid y
which is equ al to area (PH FPP).
Subsidies: summary of effects
do not affect the domestic price of the protected good.
do not affect consumption of the good.
increase domestic production of the good.
do not affect consumer welfare.
Subsidies make domestic producers better-off.
lead to wasteful domestic production and resource
misallocation.
lead to increased government spending burdening
taxpayers.
can create trade frictions.
Administrative or regulatory barriers
Perhaps this is the m ost com m on orm o protection. Regu latory
barriers inclu d e prod u ct stand ard s (to m eet certain d om estic
consu m ers), pollu tion stand ard s, etc.
Oten these stand ard s are set to protect d om estic prod u cers
rather than d om estic consu m ers by making it m ore d if cu lt
(and costly) or oreign f rm s to comply.
Perhaps the m ost am ou s example o an ad m inistrative barrier
is the one related to the city o Poitiers in France. I n 1 981 , the
Fren ch governm ent ord ered that all Japanese vid eo imports
were to be inspected and pass cu stom s there. Poitiers is located
inland , is ar rom ports an d was staed with only a ew of cers
ord ered to inspect u lly each and every tru ck. The d elays were
hu ge and the volu m e o im ports entering France per period was
eectively red u ced . Following complaints this absu rd
requ irem ent was withdrawn.
Anti-dumping duties
Dom estic f rm s may f le a complaint that oreign f rm s are
d u mping their good s in the d om estic market. Du mping is said
to exist i a f rm sells abroad at a price below u nit (average)
costs or below its d om estic price. A d u ty (a tax) is au tomatically
imposed that raises the oreign f rm s price and the issu e is
investigated and resolved by the WTO.
Very oten, f rm s f le su ch claim s only to bu y tim e to restru ctu re
and , they hope, becom e m ore ef cient.
example, has accu sed the Chinese o achieving export
penetration as a resu lt o keeping their cu rrency (the yu an or
renm inbi) u nd ervalu ed .
Exchange rate instability has ad d ed risk and u ncertainty to
trad e and since it can lead to su d d en shits in comparative
ad vantages it may lead to calls or protection or d om estic
ind u stry. M any claim that the choice is between managed trad e
or managed exchange rates.
O cou rse, risin g u nemploym ent has always been a reason or
d emand ing increased trad e protection. Recessions and
u nem ploym ent always pu t political pressu re on governm ents to
lim it job threatening im ports.
3.2 Exchange rates
The exchange rate o a cu rrency is d e ned as the price (or the valu e) o a cu rrency
expressed in term s o another cu rrency.
For exam ple, on 7 April 2 01 1 , 1 .00 EU R 5 1 .38 U SD. One need ed 1 .38 U S d ollars to
pu rchase 1 eu ro. This au tomatically m eans that one need ed 0.73 eu ro to bu y 1 U S d ollar
as 0.73 is the inverse o 1 .3 8.
Foreign exchange markets
A oreign exchange market is a market in which cu rrencies are
exchanged or other cu rrencies. An example is the market where
eu ros and d ollars are trad ed . This is a 2 4-hou r, 3 65 -d ays-a-year
world market that is a good approximation o a perectly
competitive market, as ollows.
n Th e good is hom ogeneou s as it makes no d ierence
whether a d ollar is bou ght in Franku rt or in Singapore or
in Lond on.
n Th ere are very many bu yers and sellers o cu rrencies (all
major world banks participate, non- nancial corporations as
well as nancial corporations su ch as pension u nd s,
insu rance companies, hed ge u nd s, etc.) N o single player is
large en ou gh to inf u ence the market price o a cu rrency.
n N o entry barrier into the market exists as any new bank
or corporate nancial or non- nancial major can enter and
participate.
A d istinctive characteristic o this market is that all bu yers are
at the sam e tim e also sellers, and vice versa. Also, i the price o
currency A expressed in term s o cu rrency B is e then the price
o cu rrency B expressed in term s o cu rrency A is __( )
1
e .
Floating, fxed and managed exchange
rate systems
A cu rrency is trad ed in a f oatin g (or f exible) exchange rate
system i market orces alone withou t any governm ent or
central bank intervention d eterm ine its valu e. The d ollar, th e
eu ro and the British pou nd all f oat against each other.
A xed exchange rate system reers to the case where the
exchange rate is set and maintained at som e level by the
governm ent (or the central bank) o a cou ntry.
A managed exchange rate system is one where th ere is no
annou nced level or band bu t either the exchange rate is
allowed to f oat with in som e implicit u pper and lower bou nd
or au thorities intervene whenever they consid er the d irection or
the speed o ad ju stm ent o the cu rrency u nd esirable.
Appreciation and depreciation
These term s reer to changes in the price (the valu e) o a
cu rrency in a f oating (or f exible) exchange rate system . More
speci cally, a cu rrency appreciates i its price increases within a
f oating exchang e rate system . A cu rrency d epreciates i its
price d ecreases with in a f oating exchan ge rate system .
I t shou ld be clear that i cu rrency A d epreciates in term s o
cu rrency B it ollows that cu rrency B appreciated in term s o
cu rrency A, as the one exchange rate is the inverse o the other.
I n a f oating exchange rate system exchan ge rate changes are
continu ou s and even i the trend is u pward , there is a lot o
short-term volatility.
Revaluation and devaluation
The term s reer to o cial changes in the price o a cu rrency in a
xed exchange rate system . More speci cally, a cu rrency
d evalu es i its o cial price d ecreases within a xed exchange
rate system . A cu rrency revalu es i its o cial price increases
with in a xed exchange rate system .
Who demands (and supplies) a currency in the oreign
exchange market and why?
Con sid er or example the d emand or the British cu rrency:
pou n d s sterling. Wh o will d emand pou nd s in the oreign
exchan ge market and or what reason?
n Demand or pounds sterling arises rom the demand or UK
exports o goods and services. For example, Koreans
purchasing British engines or measuring instruments will need
to pay in pounds sterling so the Korean currency, the won, will
have to be exchanged or pounds sterling at some point in the
oreign exchange market. The equivalent will happen when an
American spends her holiday in London.
n Demand or pounds sterling also arises when oreigners want
to make deposits in this currency or to purchase UK bonds or
shares o UK rms. Demand or the British currency also arises
when multinational corporations want to establish a presence
in the UK. These are all investment (capital) fows (portolio
investments and oreign direct investment; FDI, respectively)
into the UK.
n Lastly, specu lators may bu y British cu rrency not to bu y a
good , a service or som e asset bu t instead hoping to sell it
at a higher price at a later d ate an d so make a pro t.
Rem em ber that the d eman d or a cu rrency is at the sam e tim e
the su pply o another cu rrency. I n the market or British
currency the su pply o pou nd s sterling will originate rom
hold ers o that cu rrency who oer it in the market, wishing to
bu y another cu rrency in ord er to:
n pu rchase oreign good s and services (that is, U K imports)
n make investm en ts (portolio and FDI ) abroad (that is,
investm ent or capital ou tf ows rom the U K)
n bu y oreign cu rrencies as part o pu re specu lative activities.
1 23
 3 International economics
I t shou ld be ad d ed that central banks may also bu y or sell a
cu rrency as part o th eir exchange rate policy.
Demand and supply of currency: summary
The demand and the supply o a currency in the oreign
exchange market refects international trade fows as well as
cross-border investment and speculative fows
Demand or the Supply o the currency
currency refects refects
the value o its exports the value o its imports
More
o goods and services o goods and services
specically:
as well as the infow o as well as the infow o
investments into the investments into the
country. country.
I n Figu re 3 .2 .1 the market or British pou nd s sterling (GBP) is
illu strated against the U S d ollar (U SD).
Price of GBP
(in USD; $/GBP)
S of GBP
(UK imports and
investment outows)
e1
($1.63)
D for GBP
(UK exports and
investment inows)
0 happen when the exchange rate reaches e* . At e* , d emand or
GBP per period
Figure 3.2.1 What the demand and the supply o a currency refect
I n Figu re 3 .2 .1 the vertical axis is the price o the pou nd
sterling and we choose to express it in U S d ollars. So, it is U S
d ollars per one pou nd sterling or $ y. Since th e vertical axis is
the price o the pou nd sterling it ollows that the horizontal
axis will be qu antity o pou nd s sterling trad ed per period or
m ore sim ply pou nd s sterling () per period . I n g eneral, and to
avoid a com m on m istake, rem em ber that whatever is below on
the ratio o the vertical axis is the label on the horizontal axis.
Th e d emand or pou nd s sterling ref ects the valu e o U K exports
as well as inf ows o capital rom abroad to bu y U S assets. Th e
su pply o pou nd s sterling ref ects the valu e o U K im ports as
well as ou tf ows o capital rom the U K to bu y oreign (U S in
this case) assets. Rem em ber that we also have specu lators on
both sid es and perhaps central banks.
Th e interaction o the d aily or hou rly d emand and su pply o a
cu rrency d eterm in es the exchange rate in a f exible exchange
rate system .
Exchange rate adjustments in a fexible
exchange rate system
To simpliy the analysis lets assu m e that there are no cross-
bord er investm ents so that only exports and im ports o good s
and services (trad e f ows) create a need to exchange cu rrencies.
I n a U SEU 1 7 ram ework, Am ericans d eman d eu ros to bu y
EU 1 7 good s and services and Eu ropeans su pply eu ros to bu y
d ollars (and so U S good s and services). (EU 1 7 reers to the
m em bers o the eu rozone. See page 1 31 or m ore on this.
1 24
A tra d e d e cit creates pressu re
for th e exchan g e rate to
d epreciate as it lea d s to excess
su pply for th e cu rren cy
S for euros
($/euros)
Price of euros expressed in $
Dista n ce AB represen ts th e
(M of EU1 7)
EU 1 7 tra d e d e cit at e1
A B a n d th e resu ltin g excess
e1 su pply of eu ros
E Dista n ce H F represen ts th e
e* EU 1 7 trad e su rplu s at e2
e2 an d th e resu ltin g excess
H F
d em a n d for eu ros
D for euros A tra d e su rplu s creates pressu re
(X of EU1 7) for th e excha n g e rate to
0 appreciate as it lea d s to excess
Euros per period dema n d for th e cu rren cy
Figure 3.2.2
At the exchange rate e1 the su pply o eu ros is equ al to d istance
e1 B and ref ects the valu e o imports into the EU 1 7 while the
d emand or eu ros is d istance e1 A and ref ects the valu e o
EU 1 7 exports to the U S. I m port expend itu res exceed export
revenu es at e1 so the EU 1 7 has a trad e d e cit and in the
oreign exchange market an excess su pply o eu ros exists equ al
to d istan ce AB. This excess su pply creates pressu re or the eu ro
to d epreciate.
This d epreciation has two eects: EU 1 7 exports becom e
cheaper and m ore competitive abroad while im ports becom e
pricier and thereore less attractive within th e EU 1 7. Eventu ally,
the valu e o EU 1 7 exports will increase and the expend itu res on
imports will shrink, tend ing to balance ou t trad e f ows. This will
eu ros is equ al to su pply o eu ros per period and trad e balance
is restored . Rem em ber we are assu m ing there are no
cross-bord er investm ent f ows or central bank intervention.
At the exchange rate e2 the su pply o eu ros is equ al to d istance
e2 H and ref ects th e valu e o im ports into the EU 1 7 while the
d emand or eu ros is equ al to d istance e2 F and ref ects the
valu e o EU 1 7 exports to the U SA. Export revenu es exceed
import expend itu res at e2 so the EU 1 7 has a trad e su rplu s and
in the oreign exchange market an excess d emand or eu ros
exists equ al to d istance H F. The excess d emand creates pressu re
or the eu ro to appreciate.
This appreciation has two eects: EU 1 7 exports becom e m ore
expensive and thereore less competitive abroad , while im ports
becom e cheaper and m ore attractive d om estically. Even tu ally
the valu e o EU 1 7 exports will d ecrease and the expend itu res
on imports will increase, tend ing to balance ou t trad e f ows.
This will happen wh en the exchange rate reaches e* . At e* ,
d emand or eu ros is equ al to su pply o eu ros per period and
trad e is balan ce is restored .
I t ollows that a trad e d e cit (m ore generally, a cu rrent accou nt
d e cit) creates pressu re or the exchange rate to d epreciate
whereas trad e su rplu s (m ore generally, a cu rrent accou n t
su rplu s) creates pressu re or the exchange rate to appreciate.
In the real world though there are a num ber o issues that
complicate matters. First, exchange rates are very m uch aected
by cross-border investm ents (the buying and selling o bonds and
stocks and speculation) and not only by trade fows. For example,
any change in interest rates or in investors' expectations may
prevent the adjustm ent process described above.

Second, whether a depreciating currency will increase the value o
exports (that is, export revenues) depends on the price elasticity o
exports. The lower-priced exports will denitely increase the volume
(quantity) o exports per period but whether their value (revenues)
actually increases or not depends on their PED.
Causes o changes in the exchange rate
The demand and the supply o a currency in the oreign exchange
market refect trade fows and investment fows between
countries. Trade fows reer to exports and imports o goods and
services. This means that the rst actor that may change the
exchange rate o a currency is a change in exports or in imports.
Changes in trade fows
n One example is a change in the oreign demand or a
countrys exports. Assu m e that a cou ntry is experiencing
growing d emand or its exports. To simpliy the analysis
lets u rther assu m e that d emand or its imports remains
constant. Growing exports im plies that d emand or the
cu rrency by oreigners will be increasing, sh iting to the
right. At the original exchange rate a trad e (cu rrent
accou nt) su rplu s will be created as well as excess d emand
or the cu rrency. Excess d emand or the cu rrency will create
pressu re or the cu rrency to appreciate. N ote that a
d ecrease in the oreign d emand or a cou ntrys exports will
exert d ownward pressu re on its cu rrency.
n Another example is a change in the domestic demand
or imports. Assu m e that d om estic d emand or im ports
increases, with d emand or exports remaining constant.
Su pply o the cu rrency will increase as there will be growin g
n eed to bu y with it oreig n exchange. The su pply or the
cu rrency will be shiting to the right. At the original
exchange rate a trad e (cu rrent accou nt) d e cit will orm as
well as excess su pply or the cu rrency. Excess su pply or the
cu rrency will create pressu re or the cu rrency to d epreciate.
N ote that a d ecrease in d om estic d emand or a cou ntrys
imports will exert u pward pressu re on its cu rrency.
Fig u re 3.2 .3 illu strates the rst point ocu sing on th e Au stralian
dollar (AU D) and assu m ing that Au stralia experien ces
increased d emand or its exports.
S of AUD
Price of AUD (in USD) USD/AUD
(M of Australia)
e relative growth rates. A higher growth rate implies that
A B
e
D for AUD
(because of increasing
exports X > X)
D for AUD
(X of Australia)
AUD per period
Figure 3.2.3 Growing demand or a countrys exports and its eect
on the currency
3 International economics
I nitially, assum e that demand and supply or the Australian
d ollar are equal so that the exchange rate against the U S dollar
is at point e on the vertical axis. Australias trade in good and
services is balanced (we are assum ing there are no investm ent
f ows). I there is growing demand or Australian exports then
d emand or AU D will shit to D ref ecting the growth in export
d emand (X X). At the original exchange rate e there is a trade
(current account) surplus equal to distance AB and excess
d emand or Australian dollars in the market. This m eans there is
pressure on the Australian dollar to appreciate all the way to e.
I n Figu re 3 .2 .4 we assu m e increased d emand in Au stralia or
imported good s and services.
S of AUD
Price of AUD (in USD) USD/AUD
(M of Australia)
S for AUD
(because of increasing
imports M>M)
F H
e
e
D for AUD
(X of Australia)
0
AUD per period
Figure 3.2.4 The eect o increased domestic demand or imports
on a currency
The increased d emand or oreig n good s and services (imports)
in Au stralia will increase su pply or th e Au stralian d ollar to S.
At th e original exchange rate, e, a trad e (cu rrent accou nt)
d e cit will appear as well as excess su pply o Au stralian d ollars
in the oreign exchange market (equ al to d istance FH ) which
will exert pressu re on the Au stralian d ollar to d epreciate to e.
Since changes in the oreign d emand or a cou ntrys exports
and changes in the d om estic d emand or imports aect the
exchange rate, it ollows that any actor that aects a cou ntrys
trad e f ows will in tu rn aect its exchan ge rate.
n Factors that may aect trade fows include changes in
incom es in the cou ntry are rising aster. Since rising
incom es imply rising consu mption expen d itu res, and
hou sehold consu m ption inclu d es spend ing on not only
d om estic bu t also oreign good s and services, it ollows that
in a growing economy d emand or im ports will rise. I
incom es are risin g then m ore im ports will be absorbed .
1 25
 3 International economics
in dollars ($/rupiah)
Price of Indonesian rupiah expressed
S1 for rupiah
(M1 )
S2 for rupiah
(M2 > M1 )
e1
e2
D for rupiah
(X)
0
Rupiah traded per period
Figure 3.2.5 Eect o a growing economy on the exchange rate
In Figure 3.2 .5 the price o the Indonesian rupiah is initially
assumed at e1. I Indonesian growth accelerates then Indonesians
incomes are rising so their consumption expenditures will rise. This
means that they will also buy more oreign products.
I nd onesians will have to su pply m ore o their cu rrency, th e
ru piah, in the oreign exchange market to bu y th e necessary
d ollars they need to bu y m ore im ports. Su pply o the ru piah will
shit to the righ t to S2 as imports are now greater (M2 M1 ).
As a resu lt, the ru piah will tend to d epreciate to e2 . This is a
very interesting resu lt that is seem ingly cou nterintu itive.
A growing economy may witness a d epreciatin g cu rrency.
n Factors that may aect trade fows include changes in
relative infation rates. I inf ation in a cou ntry accelerates
it m eans that prices in that cou ntry are rising on the
average aster than previou sly. As a resu lt, its prod u cts
will be less com petitive abroad while imported good s and
services will seem m ore attractive d om estically.
Foreign d emand or its exports will d ecrease and so will the
d emand or its cu rrency in oreign exchange markets. I n
ad d ition, d om estic d emand or oreign prod u cts (imported
good s and services) will increase, increasing the su pply o
its cu rrency in oreign exchange markets (as m ore oreign
exchange will be need ed to pay or these im ports).
in dollars ($/rupiah)
Price of Indonesian rupiah expressed
S1 for rupiah
(M1 ) S2 for rupiah
(M2 > M1 )
e1
e2
D1 for rupiah
(X1 )
D2 for rupiah
(X2 < X1 )
0
Rupiah traded per period
Figure 3.2.6 Eect o higher infation on the exchange rate
1 26
Figu re 3.2 .6 illu strates the eect o higher inf ation in
I nd onesia on its cu rrency, the ru piah. I n itially, the ru piah
against the d ollar is at e1 .
Th e h ig h er in f ation in I n d on esia will have a n a d verse eect
on its exports a s th ey will becom e less com petitive abroa d a n d
th ereore d ecrease, d ecreasin g th e d ema n d or th e ru pia h rom
D1 to D2 .
At the sam e tim e inf ation will m ean that I nd onesians nd
oreign prod u cts m ore attractive. I mports will tend to increase,
lead ing to m ore ru piahs being su pplied in the oreign exchang e
market, shiting the su pply o ru piahs rom S1 to S2 . The ru piah
will ten d to d epreciate to e2 .
I nf ation in an economy will tend to d epreciate a cu rrency.
Changes in cross-border investment (capital) fows
Th e excha n g e rate is also a ected by cross-bord er in vestm en t
an d specu lative f ows. For Am erican s to bu y EU 1 7 bon d s or to
set u p a n ew rm in th e EU 1 7 rst th ey n eed to g et th eir
han d s on eu ros. I , on th e oth er ha n d , EU 1 7 bon d s d o n ot
seem a s attra ctive a nym ore th en h old ers o EU 1 7 bon d s will
wa n t to g et rid o th em to switch to, say, British bon d s. Th ey
will sell eu ros to bu y pou n d s sterlin g , so th e su pply o eu ros
will in crea se.
I nvestm en t f ows in clu d e portolio investm ents (the bu ying and
selling o bond s and stocks and o other nancial assets) and
FDI , which reers to investors establishing a presence in a
oreign cou ntry either by setting u p a new rm or by acqu iring
controlling share o an existing d om estic rm .
Mu ch o these capital f ows are short term and specu lative in
natu re. Cu rrency specu lation is also inclu d ed in this section.
These transactions are inclu d ed in the nancial accou nt o the
balance o paym en ts o a cou ntry.
Bea r in m in d that n ot a ll cou n tries have u lly libera lized th eir
n a n cia l a ccou n t. Th is m ea n s that oreig n in vestm en t may be
con strain ed . M any econ om ies lim it th e types o oreig n
in vestm en t f ows th ey perm it a s som e o th ese in vestm en ts
may prove very d estabilizin g . Sh ort-term specu lative ca pita l
may su d d en ly be with drawn , lead in g to a su d d en sharp
d epreciation a n d , con sequ en tly, to ad verse rea l eects on th e
econ om y. Th ere is a lot o d iscu ssion on th e d esirability o su ch
private ca pita l in f ows (reerred to also as h ot m on ies or
ootloose u n d s, or obviou s rea son s) especia lly or
d evelopin g cou n tries.
Factors aecting cross-bord er capital f ows are explained below.
n Factors that may aect investment fows include changes
in relative interest rates. I in terest rates in a cou ntry
d ecrease, then d om estic bond s as well as savings d eposits
d enom in ated in the d om estic cu rrency will be less attractive
to oreign investors. As a resu lt, not only will d emand or
that cu rrency d ecrease bu t also there will be an increase
in the su pply or that cou ntrys cu rrency as investors will
sell their assets to bu y cu rrencies and bond s o other
cou ntries. The eect o lower interest rates will be a
tend ency or the cu rren cy to d epreciate.
 3 International economics

S1 for euros I the u tu re prospects o this growing economy are good (i, in
in dollars ($/euro)
Price of euros expressed

(when r = r1 in EU1 7) other word s investors expect it to continu e growing in the

S2 for euros
(when r = r2 < r1
in EU1 7)
e1
e2 D1 for euros
(when r = r1 in EU1 7)
D2 for euros
(when r = r2 < r1 in EU1 7)
0
Euros traded per period
Figure 3.2.7 Eect o a decrease in interest rates on a countrys currency
I n Figu re 3.2 .7 we assu m e that the d ollar price o the eu ro is
initially at e1 . Lets say the Eu ropean Central Bank d ecreases
interest rates. N ow the rate o retu rn on Eu ropean bond s as
well as on d eposits in eu ros is lower, so these assets are less
attractive to investors. Demand or the eu ro will d ecrease rom
D1 to D2 , ref ecting the lower d emand or Eu ropean bond s and
eu ro d eposits. Also, som e hold ers o su ch assets will d ecid e to
sell them , increasing the su pply o eu ros rom S1 to S2 as they
switch to m ore attractive bond s issu ed by other cou ntries. The
eu ro will tend to d epreciate rom e1 to e2 .
A note o cau tion here: i interest rates rise there will be a
tend ency or the exchange rate to appreciate assuming that
oreign in vestors d o not expect the cu rrency to d epreciate. For
exam ple, i interest rates in cou n try A rise then in vestors will
not all f ock into that cou ntry i they expect its cu rrency to
d epreciate. So interest rates d o matter, bu t so d oes the
expectation abou t the u tu re path o th e exchange rate itsel.
n Factors that may aect investm ent fows include
expectations about uture growth. A growing economy
u tu re) then they will want to bu y stocks and /or establish a
bu siness presence them selves in the cou ntry so that they can
receive the expected pro ts. Demand or the cou ntrys cu rrency
will tend to increase, pu shing the exchange rate u pward .
Rem em ber that a growing econom y implies growing and
pro table rm s and plentiu l bu siness opportu nities which
oreigners will also want to take ad vantage o.
In Figure 3.2.8 the Korean currency, the won, is illustrated. Initially,
the equilibrium exchange rate is assumed at e1. I data projections
point out strong and continuing growth or the Korean economy,
then growing interest will be expressed in Korean company stocks
as well as FDI into Korea.
Th ese increased portolio investm ents an d FDI into Korea imply
an increase in the d emand or Korean won in the oreign
exchang e markets. Demand or won will in crease rom D1 to
D2 , so the won will tend to appreciate rom e1 to e2 .
n Factors that may aect investment fows include
expectations concerning the uture path o the exchange
rate. Oten a cu rrency is d emand ed in oreign exchange
markets not to bu y oreign good s or services or to bu y
oreign bond s, stocks or companies bu t ju st to sell it at a
later d ate, perhaps even in a matter o hou rs, at a higher
price, making a pro t ou t o the price d ierence.
M arket participants who act in this way are known as
cu rrency specu lators. Their d emand or the cu rrency is
pu rely specu lative. Obviou sly, the driving orce behind
their d emand is the expected u tu re path o the exchange
rate itsel.
I n the simplest scenario i they expect the exchange rate to
appreciate they bu y the cu rrency now, hoping to sell it later
at a higher price, making a pro t. I others believe and
d o th e sam e thin g then the d emand or the cu rrency
will increase.
in dollars ($/TL)
Price of Turkish lira expressed

will tend to absorb m ore and m ore imports, pu tting S of TL

pressu re on the exchange rate to d epreciate, as illu strated
in Figu re 3.2 .8. At the sam e tim e, thou gh, there will be
oth er orces in the oreign exchange market that will tend
to appreciate the cu rrency. e2
in dollars ($/won)
Price of Korean won expressed

S of won e1
(Korean imports
and outows of
capital from Korea)
e2 D2 for TL
D1 for TL
e1
0
Turkish lira traded per period
D2 for won
Figure 3.2.9 Currency speculation and the exchange rate
D1 of won (Korean exports
I n Figu re 3 .2 .9 cu rrency specu lation increases the d emand or
and investments into Korea)
the Tu rkish Lira rom D1 to D2 , lead ing it to appreciate rom e1
0 to e2 . I n this way, expectations can oten be sel-u l lling.
Won traded per period

1 27
 3 International economics

Exchange rate appreciation and depreciation: summary

I oreign demand or a countrys exports increases and/or domestic demand or imports
decreases, creating or widening a trade (current account) surplus, then
I domestic interest rates increase (or, oreign interest rates decrease) then the exchange rate will tend to appreciate.
I it is expected that the country will continue to grow then
I speculators expect the exchange rate to appreciate then
On the other hand , the ollowing applies.
I domestic demand or imports increases and/or oreign demand or its exports decreases,
creating or widening a trade (current account) decit, then
I domestic infation increases then the exchange rate will tend to depreciate.
I domestic interest rates decrease (or oreign interest rates increase) then
I speculators expect the exchange rate to depreciate then

Government intervention

Fixed exchange rate systems Remember that in a fxed exchange rate system we use the
H ow does a fxed exchange rate system work? terms devaluation and revaluation.
A xed exchange rate system is dened as a system in which the The exchange rate will be maintained at the d esired level e*
exchange rate is set by the government at some desired level only i au thorities som ehow manage to in crease d emand or
(usually against a major currency, say, the US dollar) and is then the cu rrency to D2 . H ow cou ld they d o this? One obviou s
maintained at that level through intervention in the oreign option is or the central bank o cou ntry A to enter th e oreign
exchange market by the central bank. H ow is the exchange rate exchange market an d start bu ying FH u nits o its cu rrency per
maintained at the set level? What can and should the government period u sing its oreign exchange reserves, or example pou nd s
or the central bank do to maintain the rate at the desired level i, sterling or eu ros. What this really m eans is that the central
or example, there are pressures or it to devalue? bank is increasin g d emand or cu rrency A rom D1 to D2 .
H ow d o they work? To d eend the cu rrency, the central bank can also increase
interest rates. This wou ld be the next lin e o d eence as oreign
Currency A pegged
against the dollar at e* exchange reserves are lim ited and the central bank cannot go
on sellin g, or exam ple, eu ros orever to bu y its own cu rrency:
S of A rises to S2 because
ination makes imports
there will com e a point when it has no m ore eu ros let to sell.
in terms of currency B)
Price of currency A (expressed

seem more attractive, The higher interest rates in cou ntry A will attract nancial
S1 of A creating an excess capital rom abroad as d om estic bond s and d eposits in cu rrency
S2 of A
supply that will push A
below e* , unless: A will earn a higher rate o retu rn, so will be m ore attractive.
Foreigners will bu y cu rrency A in the oreign exchange market
central bank of A
starts buying HF units
in ord er to bu y cou ntry As bond s or make d eposits in cu rrency
e* H F
of A per period articially A. H igher interest rates im pose a real cost on the economy,
increasing demand for thou gh, as growth in cou ntry A will slow d own and
it to D2
u nemploym en t will increase.
or instead the central
The governm ent may also resort to o cial borrowing o oreign
D2 for A bank could increase
interest rates inducing exchange in an attempt to maintain the cu rrency at e* . This
D1 for A greater demand borrowing to d eend the cu rrency cannot con tinu e or long,
for A by investors
0 (i.e. inducing capital thou gh, as repaym ent will impose sig ni cant u tu re costs on an
Units of currency A inows). econ omy. Alternatively, the governm ent may try to lim it
traded per period pressu re on the cu rrency to d evalu e by restricting imports into
Figure 3.2.1 0 Fixed exchange rates the cou ntry and in this way restricting the su pply o its cu rrency
in the oreign exchange market.
I n Figure 3.2 .1 0 it is assum ed that currency A is pegged against, Lastly, it can also restrict access to oreign exchange, reducing the
say, the U S dollar at e* . I demand and supply orces are at D1 supply o its currency in the oreign exchange market. Exchange
and S1 the exchange rate will be at e* so there is no reason or
controls may lead to a parallel (black or shadow) market.
the authorities to intervene. Assum e now that supply or
currency A increases to S2 , perhaps as a resu lt o accelerating On th e oth er ha n d , i th ere a re orces pu sh i n g u p th e
dom estic infation which induces residents to switch to m ore cu rren cys va l u e th e cen tra l ba n k wi l l sell i ts cu rren cy, bu yin g
attractive imports. As m ore o the currency will be supplied in U S d olla rs i n th e oreig n excha n g e m a rket, or i t m ay l ower
the oreign exchange market (supply o A, say, shits to S2 ) there d om esti c i n terest rates. N ote that both opti on s in crea se th e
will be excess supply or the currency equal to FH per period at m on ey su pply, so m ay lea d to a ccelerati n g in f ati on a ry
e* , putting pressure on the currency to devalue. pressu res in cou n try A.

1 28
 3 International economics

Fixed exchange rate system: summary

In a fxed exchange rate system
then the central bank must start buying it using oreign exchange reserves (but these are limited).
I there are or the central bank must increase interest rates to attract oreign capital infows (but high interest rates choke o
pressures or the economic activity).
currency to devalue or the country must resort to ocial borrowing o oreign exchange (but borrowing imposes uture costs).
or the government may restrict imports and access to oreign exchange (but ineciencies and black markets will emerge).
The ollowing applies in relation to revalu ation.
In a fxed exchange rate system
I there are pressures then the central bank must start selling it to buy dollars (oreign exchange).
or the currency to or the central bank must decrease interest rates to create an outfow o oreign capital.
revalue (but both options increase the risk o infation).

Managed exchange rate systems
Managed foat
I n a managed exchang e rate system the govern m ent tries to
d ecrease exchange rate m ovem ents withou t keeping exchange
rates rigid ly xed . The central bank period ically intervenes i
au thorities consid er the exchange rate m oving in a d irection or
a speed that is consid ered u nd esirable. U su ally there is an
implicit targeted band within which exchange rate m ovem ents
are consid ered acceptable, bu t it is not annou nced .
I ntervention involves bu ying and selling the cu rrency in oreign
exchange markets or o manipu lating interest rates to ind u ce
the d esired capital f ows, as d escribed earlier when d iscu ssing
xed exchange rates.
Maintaining disequilibrium exchange rates
Keeping the currency overvalued
Sometimes countries try to keep the exchange rate o their currency
overvalued. This means that they try to maintain it at a level above
the ree market equilibrium level. Why would policy makers decide
on something like this and what are some o the consequences?
M any d eveloping cou ntries have in the past tried to keep their
cu rrency overvalu ed as part o an im port su bstitu tion strategy
which will be explained in m ore d etail later. The basic id ea is
that they were trying to shit ou t o agricu ltu re and into
manu actu ring by su bstitu ting d om estic prod u ction or imports.
They erected trad e barriers to protect their inant ind u stries
and at the sam e tim e kept their exchang e rate overvalu ed . This
sou nd s absu rd becau se when the exchang e rate increases then
imports becom e cheaper. Bu t the goal was to lower the price o
imported machines and other inpu ts (that is, the price o
capital good s and raw materials that wou ld d ecrease the
prod u ction costs o the new ind u stries). The trad e barriers
wou ld be u sed to keep ou t o the cou ntry any good s that cou ld
be consid ered su bstitu tes in the eyes o d om estic bu yers,
allowing the growth o the d om estic inant ind u stries.
This may make sense but at the same time the overvaluation o
the currency acted as a tax on exports because exports became
more expensive abroad. In the case o traditional primary export
commodities (or example coee) or which the price was
determined in commodity markets and was quoted in US dollars,
armers earned ewer units o domestic currency or each US dollar
o their exports as a result o the overvaluation. The bottom line
was that an overvalued exchange rate hurts the export sector.
On the other hand, keeping the currency overvalued may be part
o a policy to com bat infationary pressures. Export demand,
which is part o aggregate demand (AD), will decrease, cooling
o the economy. I n addition, cheaper imports also help. First,
the cost o living o the popu lation is lower (as the typical
consum ers basket o goods includ es imports). Also, it orces
dom estic import-competing industries to cut costs, increasing
their eciency and keeping their own prices low. Lastly,
prod uction costs o dom estic rm s using imported inputs remain
low. With infation contained, the country can keep interest rates
low, which spu rs investm ent and growth. These are som e o the
benets the U S economy has enjoyed as a result o the U S dollar
being overvalu ed in relation to the Chinese yuan (as the Chinese
have been accused o keeping their currency undervalued). U S
export demand may have been hurt but there have been also
som e very signicant side-bene ts that cannot be overlooked.
Keeping the currency undervalued
Som etim es cou ntries try to keep the exchange rate o their
cu rrency u nd ervalu ed . This m eans that they try to maintain it at
a level below the ree market equ ilibriu m level. Why wou ld
policy makers d ecid e on som ething like this and what are som e
o the consequ ences?
An u nd ervalu ed cu rrency au tomatically im plies cheaper exports.
This is the biggest ad vantage o su ch a policy. The oreig n price
o a cou ntrys good s and services is pu shed lower. Exports gain
a competitive ad vantage. The increased export penetration an d
resu lting export revenu es increase AD and , throu gh the export
m u ltiplier, accelerate growth. Und ervalu ed cu rrencies have
sign i cantly contribu ted to the spectacu lar exportled growth
that several d evelopin g cou ntries have ach ieved .
Su ch a bene t d oes have its costs. First, the export su ccess rom
keeping the cu rrency u nd ervalu ed creates trad e rictions with
trad ing partners. One cou ntrys export su ccess m eans that
import-competing ind u stries o the trad ing partner will su er
and the d istress cau sed will increase the cries or retaliation
and trad e protection. Another risk o su ch a policy is that it
may resu lt in inf ationary pressu res. To keep the cu rrency
u nd ervalu ed in the ace o growing export d emand requ ires
massive selling o a cu rrency in the oreign exchange market. To
keep the yu an u nd ervalu ed , China m u st sell yu an bu ying U S
d ollars. The resu lting increase in the m oney su pply may prove
inf ationary and in the lon g term u nd erm ine the export su ccess
and growth o the cou ntry.

1 29
 3 International economics
Comparing and contrasting fexible and xed
exchange rates
I n general, the ad vantages o one system can be consid ered
d isad van tages o the other.
Advantages o fexible exchange rates
n Policy makers are ree to u se m onetary policy. For example,
they can u se easy m on etary policy to boost th e economy as
not only is the cu rrency allowed to d epreciate bu t
d epreciation may lead to an increase in net exports, a
com ponent o AD.
n A trad e (m ore generally, a cu rrent accou nt) d e cit or
su rplu s may be au tomatically corrected . A trad e d e cit
im plies that m ore o the cu rrency is su pplied than
d eman d ed in the oreign exchange market. The excess
su pply will d epreciate the cu rrency and , assu m ing proper
elasticities, the valu e o exports will rise and import
expend itu res will drop. There is thereore less need or the
governm ent to ad opt costly contractionary d eman d -sid e
policies which slow d own growth and increase
u nemploym ent i there is a wid ening trad e d e cit.
n Exchang e rate ad ju stm ents throu gh tim e are u su ally
sm ooth and continu ou s, so cu rrency crises are avoid ed .
n On the one hand , there is less specu lation as there is no
exchange rate target that may be perceived by specu lators
as u nd am entally u nd ervalu ed or overvalu ed and thereore
eventu ally impossible to d eend . Bu t, i the u nd am entals o
an economy (or example inf ationary pressu res) point to a
weakening cu rrency, specu lators may start selling th e
cu rrency en masse, lead ing to a u nnecessarily sharper
d ecrease in its valu e.
n There is less need or the central bank to carry large oreign
exchange reserves as there is no need or it constantly to
intervene to maintain the exchange rate at a xed parity.
Advantages o oating exchange rates: summary
policy makers can use monetary policy to
achieve domestic goals.
trade imbalances are in principle automatically
Advantages o corrected.
oating
exchange rate adjustments are smooth and
exchange rates
continuous.
are that
typically, less speculation exists.
there is less need or the central bank to keep
oreign exchange reserves.
Disadvantages o fexible exchange rates
n Since in a foating system the exchange rate bobs up and
down, oten in an very unpredictable manner with any world
economic or political development capable o aecting it,
there is a lot o uncertainty in the oreign exchange market.
Exporters and importers as well as investors ace signicant
exchange rate risks against which they can only partially
hedge. As a result, both the volume o international trade in
goods and services and the volume o cross-border portolio
investments are negatively aected. Smaller rms especially,
with ewer resources available to protect themselves against
such risks, will drop out o the market.
1 30
n Governm ents lack the policy d iscipline that a xed
exchange rate system imposes. A cou ntry may thereore be
m ore prone to inf ation. For example, easy m onetary policy
to accelerate growth cou ld be m ore easily ad opted by a
governm ent even i it m eans that the resu ltin g growth will
be inf ationary.
Disadvantages o exible exchange rates: summary
Disadvantages increased uncertainty hurts trade and
o exible cross-border investment fows.
exchange rates a government may be more prone to adopt
are that infationary policies or short-term gains.
Advantages o fxed exchange rates
n Less u n certainty and exchange rate risk m eans that rm s
engaged in in tern ational trad e can easier pred ict th eir
export revenu es or import bill. Portolio investors avoid
exchange rate risk which cou ld lower their retu rn rom any
investm ent. A xed exchange rate regim e may even lead to
m ore FDI as the valu e o repatriated pro ts d epend on
exchange rate m ovem ents. This will m ean that the volu m e
o exports and im ports is higher and m ore cross-bord er
investm ents will resu lt.
n Since infation is not compatible with a xed exchange rate
system, governments cannot easily pursue expansionary scal
policy that may prove infationary: xed exchange rates impose
scal discipline on governments. In addition, rms are orced
to be ecient and keep their costs and prices down to
maintain whatever competitive advantage they have.
n Fixing the exchange rate has oten been a policy choice or
governm ents d eterm ined to cu rb inf ation in high-inf ation
econom ies.
Advantages o fxed exchange rates: summary
there is less uncertainty and exchange rate risk
increases the volume o trade and cross border
Advantages o investments.
fxed exchange policy discipline on governments as infationary
rates are that growth is not an option.
they provide a policy option to curb high
infation.
Disadvantages o fxed exchange rates
n The governm ent is d eprived o m onetary policy as a tool to
aect d om estic econom ic activity. M onetary policy may be
u sed only to ensu re that th e exchange rate remains xed .
n The governm ent is also d eprived o exchange rate policy to
d eal with d om estic objectives.
n Even the u se o ref ationary scal policy is constrained as
bu d get d e cits need to be som ehow nanced and a
nancing a large bu d get may lead to either a aster growth
in the m oney su pply or hig her interest rates.
n Devalu ation or revalu ation can prove d isru ptive as they
imply an abru pt realignm ent o th e cu rrency.
n To avoid the need to resort to d evalu ation a trad e d e cit
m u st be corrected by ad opting contractionary scal policy
to lower national incom e and import absorption. Bu t this
m eans slower growth or even ind u cing a recession with
u nemploym ent increasing.
 3 International economics

n Central banks m u st maintain large oreign exchange market and maintain the parity. This involves a high
reserves to be able to intervene in the oreign exchange opportu n ity cost as reserves earn either no or low interest.
Disadvantages o fxed exchange rates: summary
the government cannot use monetary policy to achieve domestic goals.
the government is deprived o an exchange rate policy.
the use o expansionary fscal policy is restrained as fnancing a defcit may aect the money supply
Disadvantages o fxed or interest rates.
exchange rates are
exchange rate adjustments are abrupt and potentially disruptive.
trade defcits are not automatically corrected requiring use o painul contractionary fscal policy.
the central bank may maintain large oreign exchange reserves.

Purchasing power parity (PPP)
Econom ists oten use the concept o PPP to help predict long-run
m ovem ents in the oreign exchange value o a currency. PPP is a
m easure o the equilibrium value o a currency, dened as the
exchange rate towards which the currency will m ove over tim e.
The PPP rate is the rate that will equate the cost o purchasing
the sam e basket o goods in two countries.
I a currencys market exchange rate is presently below its PPP
value, PPP advocates will argue that the currency is undervalued
and will thereore tend to appreciate in the uture. For example,
consider a basket o goods and services purchased by the typical
consumer in two countries. Assum e that it can be bought in
Europe (EU 1 7 ) with 1 00.00 whereas one needs $ 1 60.00 to
buy it in the U SA and that the market exchange rate is 1 .00 5
$ 1 .47. One may argue that the dollar is overvalued and will tend
to depreciate (or, equivalently, that the euro is undervalued and
will tend to appreciate). An Am erican could go to the oreign
exchange market and purchase 1 00.00 with only $ 1 47.00 and
buy the sam e basket o goods and services in Europe or which
he or she would need $ 1 60.00 to buy in the U SA. The theory
thereore suggests that in such a case U S imports o goods and
services will rise. But, as m ore U S dollars will be oered in the
oreign exchange market to buy the necessary euros, the U S
dollar will be pushed down (and the pushed euro up) until the
U S dollar alls (the euro rises) to 1 .00 5 $ 1 .60.
PPP theory may be helpu l to orecast the lon g-ru n valu e o a
cu rrency bu t its u seu lness to pred ict short-ru n variations is very
strongly d ou bted . N ot only will it take a long tim e or the
equ ilibriu m valu e as d e ned to be reached bu t, in ad d ition,
there are many oth er econ om ic orces that may keep the valu e
away rom equ ilibriu m .
Overall, empirical su pport or PPP is m ixed , as exchange rates
d o not n ecessarily m ove toward s their long-ru n equ ilibriu m
valu e. Why? The basket o good s and services consu m ed by the
typical con su m er in each cou ntry d iers su bstantially and also
inclu d es non-trad ed good s (su ch as haircu ts or real estate). I
given the market exchange rate, real estate is cheaper in the
other cou ntry we cannot import land , bu ild ings and hou sing
rom it. Trad e barriers and transport costs also d ecrease the
scope o trad e bu t, m ost importan tly, exchange rates are highly
inf u enced by capital f ows.
PPPs are still u sed as conversion actors. PPPs shou ld be u sed
instead o market exchange rates as conversion actors (to a
single cu rrency, u su ally th e U S d ollar) o GN I and per capita
GN I gu res, in ord er to incorporate cost o living d ierences
that will make cross-cou ntry com parisons o these variables
m ore m eaningu l. Care shou ld be taken that the PPP valu e u sed
in the conversion accu rately ref ects recent and tru e cost o
living d ierences.

1 31
 3.3 The balance o payments
The balance o paym ents is d e ned as a record o all
transactions o a cou ntry with the rest o the world over a
period o tim e, u su ally a year.
Transactions which lead to an inf ow o cu rrency en ter the
accou nt with a plu s sign and are known as cred it item s whereas
those that lead to an ou tf ow o cu rrency enter with a m inu s
sign and are called d ebit item s.
The balance o paym ents is d ivid ed into three major
components, the cu rrent accou nt, the capital accou nt and the
n ancial accou nt. The su m o these by constru ction equ als zero.
The balance o paym ents balances.
For the same reason a households monthly budget must balance:
Assume Zoi earned $2,000 and spent $ 2,300 in January. This is
not possible unless she drew on her savings and/or borrowed a
total o $ 300. I these $ 300 dollars are added to her income then,
since all her expenditures were necessarily somehow nanced, her
budget or January was balanced. I more currency fowed out o a
country to pay or imports and investments than fowed in rom
exports and investments then this dierence must have been
somehow nanced. Foreign exchange reserves decreased and/or
ocial borrowing took place in sucient amounts to balance her
external account.
The current account
The cu rren t accou nt inclu d es the ollowing three accou nts.
n The goods and services account which inclu d es exports
and imports o good s (physical m erchand ise) and exports
and imports o services. The d ierence between export
revenu es and import expend itu res is the balance o trad e in
good s and the balance o trad e in services respectively.
Trad able services inclu d e transport, constru ction, postal and
cou rier services, insu rance and pension services, nancial
services, com m u nication services, compu ter services,
personal and bu siness travel, etc.
n The primary incom e account which inclu d es the
d ierences between primary incom e received rom abroad
and payable abroad . Primary incom e inclu d es pro ts,
interest and d ivid end s (PI Ds) rom portolio and d irect
investm ents, compensation o employees (wages and
salaries) and the retu rn s rom renting natu ral resou rces (or
example rom granting shing, grazing, m ining, and orestry
rights). N ote that this d ierence (net incom e rom abroad ) nancial accou nts. I t is th e inclu sion o changes in reserve
is what d istingu ishes GDP rom GN I in macroeconom ics.
n The secondary income (or current transers) account which
includes unilateral current transers with nothing received in
return, or example workers remittances, donations, transers
related to international cooperation between governments
(such as receipts and paym ents to EU institutions), ood aid
and emergency aid ater natural disasters.
The sum o net exports o goods and services, net incom e and
net current transers over a period is d ened as the current
account balance. I this is positive we say that there is a current
account surplus. I it is negative we say that there is a
current account decit. I we ocus only on the exports and
imports o goods and services we can say that i export revenu es
1 32
rom the sale o goods and services is greater or smaller than
import expenditures on goods and services over a period then
we have a current account surplus or de cit respectively.
The capital account
The capital accou nt inclu d es the ollowing.
n I t inclu d es capital transers receivable and payable, su ch as
the provision o resou rces or capital pu rposes by one party
withou t anything o econom ic valu e being su pplied as a
d irect retu rn to that party. Debt orgiveness is also inclu d ed
in capital transers.
n I t also inclu d es the acqu isition and d isposal o non-
prod u ced , non- nancial assets su ch as sales and pu rchases
o intangible assets (patents, copyrights, trad emarks,
ranchises and leases, etc.).
Typically, the capital accou nt is small and o m inor importance.
The fnancial account
The nancial accou n t inclu d es investm ents and assets, as
ollows.
n FDI exists when a resid ent in one cou ntry acqu ires control
or a sig ni cant d egree o inf u ence on the manag em ent o
a rm in another economy. I t m ostly reers to m u ltin ational
corporations.
n Portolio and other investments reer to the acqu isition
and sale o stocks and bond s as well as changes in loans
and d eposits. When a resid ent o Egypt bu ys stocks o
Tu rkish companies or bu ys Tu rkish bond s then an ou tf ow o
m oney is record ed in the Egyptian nancial accou nt and an
equ al inf ow o m oney in the Tu rkish on e. N ote that the
next year, when the Egyptian resid ent receives d ivid end s
and interest paym ents rom the investm ents, the inf ow o
m oney will be record ed in the Egyptian cu rrent accou n t as
a receipt o in com e and the equ al ou tf ow o m oney in the
Tu rkish cu rrent accou nt as a paym ent o incom e.
n Reserve assets (ofcial reserves) inclu d e assets that the
central bank hold s to nance balance o paym en ts n eed s
and to intervene in the oreign exchange market in ord er to
aect the exchange rate.
The cu rrent accou nt is equ al to th e su m o the capital and
assets (that is, in o cial reserves that orce the balance o
paym ents always to balance). I t wou ld be impossible over a
speci c period o tim e (say, a year) or m ore cu rrency to f ow
out o a cou n try than had f owed in the sam e period u nless
som ehow this d e cit was nanced : either by drawing on oreign
exchange reserves and /or by o cial borrowing. Since we ad d
the nan cing o a d e cit as a d ecrease in oreign exchange
reserves assets (and /or as o cial borrowing) in the nancial
accou nt, the balance o paym ents accou nt will necessarily
balance. Con versely, i over a period m ore cu rrency had f own
into a cou ntry than f own ou t o a cou ntry then o cial reserves
wou ld in crease and /or o cial lend ing wou ld take place or th e
overall balance o paym ents to balance.

U n ortu n a tel y th ere a re a l wa ys errors a n d /or om i ssi on s.
N ot on l y i s esti m a ti on o cred i ts a n d d ebi ts i n to a n d ou t o a
cou n try i m preci se bu t th ere a re a l wa ys u n record ed i l l eg a l
cross-bord er a cti vi ti es, or exam pl e i n vol vi n g d ru g s or
wea pon s. As a resu l t, th e ba la n ce o pa ym en ts a ccou n t d oes
n ot ba la n ce d espi te th e i n cl u si on o th e o ci a l n a n ci n g
(reserves) i tem . To ba la n ce th e a ccou n ts a rti ci a l l y th e
ba la n ci n g i tem i s i n cl u d ed wi th th e sam e m a g n i tu d e bu t
th e opposi te si g n o th e error i tem . I th e ba la n ci n g i tem
i s la rg e th en th i s i s a n i n d i ca ti on o poor d a ta col l ecti on
a n d sta ti sti ca l servi ces a n d /or o i l l eg a l sa l es or pu rch a ses.
Is a current account defcit a problem?
As explained earlier, a rising cu rrent accou nt d e cit will exert
pressu re on the exchange rate to d epreciate (in a f oating
exchange rate system ) or d evalu e (in a xed system ). Why?
Becau se rising oreign import d emand m ean s that resid ents are
oering in the oreign exchange market m ore o th eir cu rrency
while d ecreasing export revenu es m eans that oreigners are
d emand ing less o the cu rrency in the market. I su pply o a
cu rrency increases and /or d emand or it d ecreases the cu rrency
will tend to d ecrease in valu e.
Beyon d th i s eect on th e exch a n g e ra te th e q u esti on
rem a i n s wh eth er a cu rren t a ccou n t d e ci t i s or i s n ot a
probl em . Th e a n swer i s i t d epen d s. Fi rst o a l l , i t d epen d s on
th e si ze o th e d e ci t. To d eterm i n e th e i m porta n ce o a
cu rren t a ccou n t ba la n ce (d e ci t or su rpl u s) we a l ways express
i t a s a proporti on o G DP so th a t th e si ze o th e econ om y i s
sca l ed ou t. Typi ca l l y a cu rren t a ccou n t d e ci t i s con si d ered
HL Implications o a persistent current
account defcit
A cu rren t accou nt d e cit m u st be som ehow n anced and
it is this nancing that may create u tu re problem s in the
economy. The bottom line is that the economy is not
earning enou gh oreign exchange rom its exports and
incom e earnings rom abroad to nance its imports.
Ru nning d own oreign exchang e reserves may only
continu e or short period s o tim e becau se these reserves
are lim ited . The remaining options are ew. A su rplu s is
requ ired in the com bined capital and nancial accou nts
and it may resu lt either rom the sale o d om estic assets
(su ch as bu sinesses, stocks or property) to oreigners or
rom borrowing rom abroad .
Selling assets requires willing buyers. Bu yers are willing to
buy dom estic assets i the u ture prospects o the economy
look good and/or i the selling price is exceptionally low. I
the uture growth prospects o the economy look good then
the sale o assets does not have to signal a problem . For
example, oreigners will buy shares or acquire companies
because they expect growth in sales and thereore high
dividend s and high prots. But since we are d iscussing here
a persistent current account de cit problem , any sale o
assets m ust be a result o very low sale prices. The assets
sold to oreigners can be both sizeable and o signicance
(or example sale o signi cant natural resources, sale o
banks or o large industries) so such a developm ent carries
the threat o loss o econom ic sovereignty.
3 International economics
a poten ti a l probl em i i t i s wi d en i n g a n d exceed s between
5 % a n d 6 % o th e cou n trys G DP.
I t also d epend s on the reason s or which it exists. More
speci cally it d epend s on whether it is temporary or persistent
(also reerred to as u nd am ental).
Tem porary d e cits are short term being either o a transitory
natu re (or example becau se o a crop ailu re) or o a reversible
natu re (or example as a resu lt o a boom ing economy). I n the
latter case, a short-term cu rrent accou nt d e cit implies an
im provem ent in living stand ard s as the nation is consu m ing
m ore than it is prod u cing. A strong and growing econom y
typically record s trad e d e cits as a resu lt o the increased
im port absorption (assu m ing o cou rse that growth was n ot
export led in the rst place, as in the case o, say, China). Also,
a d eveloping economy in the process o establishing certain
ind u stries may initially be orced to rely on imported capital
good s, lead ing to trad e d e cits.
On the other hand , u nd am ental or persistent im balances are
ch ronic. They tend to last or a long tim e and they are the
resu lt o stru ctu ral problem s o the economy. These are ind eed
seriou s as they ref ect a sick econ omy. To u nd erstand the issu e,
consid er an economy with chronic inf ation, u ncompetitive
prod u ct markets an d rigid labou r markets. Export
com petitiveness will be erod ed and export revenu es will shrink
while spend ing on im ports will in crease as many d om estic
hou sehold s will tu rn to better and cheaper imports. A
balloon ing cu rrent accou nt d e cit will resu lt.
On the other hand , borrowing in volves u tu re repaym ent o
the capital plu s interest. This implies that in the u tu re
part o national incom e m u st be d iverted away rom
d om estic u ses toward s the repaym ent o past borrowing.
This incom e cou ld have been u sed to nance increased
consu mption expend itu res, increased investm ent
expend itu res or increased governm ent spend ing on, say,
social capital ormation. I n ad d ition, since repaym ent o
su ch borrowing m u st be mad e in oreign exchang e it
m eans that u tu re oreign exchange earnings rom exports
will need to be d iverted away rom the pu rchase o imports
o consu m er and capital good s. I the economy is not
growing ast enou gh to nance these obligations then
these d evelopm ents will jeopard ize any u tu re growth
prospects o the economy. Living stand ard s o the
popu lation will d ecrease. Also, i the lend ing is o a
short-term natu re (rom hot m oney inf ows) then there is
the risk o a su d d en exod u s o th is capital with the
resu lting sell-ou t sharply d epreciating the cu rrency.
More importantly, a m ou ntin g oreign d ebt creates
snowballin g eects on an economy. Foreigners will be
willin g to lend only at higher and higher interest rates to
com pensate or the ad d ition al risk they ace. H igher
interest rates imply su rging interest costs thou gh,
worsening th e oreign d ebt problem . As the risk o the
cou ntry d eau lting increases, its cred it rating by
international cred it rating ag en cies su ch as M ood ys cou ld
be d owngrad ed . This tighten s th e squ eeze on the cou ntry
as su ch a d evelopm ent will u rther increase interest rates.
1 33
 3 International economics
I t shou ld be clear that an u n su stainable cu rrent accou nt
d e cit cannot and will not last orever. Som e ad ju stm ent
process eventu ally will restore balance. Bu t ad ju stm ent may
be abru pt and very u npleasant. Correcting a cu rrent accou nt
d e cit may requ ire expend itu re-red u cing or expend itu re-
switching policies an d /or su pply-sid e policies.
Methods to correct a persistent current
account defcit
Expenditure-reducing policies
These inclu d e policies that d ecrease the level o AD. The goal
is to red u ce the level o national incom e and so d ecrease
spend ing on im ports.
Policies that d ecrease the level o AD inclu d e contractionary
scal policy and tight m onetary policy. Since th e d ecrease in
AD will also d ecrease inf ation, the export sector may bene t
rom increased competitiven ess. All in all, shrinking imports
and perhaps rising exports will help narrow the cu rrent
accou nt d e cit.
N ote thou gh that su ch an ad ju stm ent policy com es at a high
cost. Growth will su rely slow d own or even tu rn negative.
I ncom es and ou tpu t will d ecrease. Firm s will contract or shu t
d own and u nem ploym ent will su rge.
Expenditure-switching policies
These are policies aim ing at switching spend ing away rom
im ported good s and services toward s d om estically prod u ced
good s and services. To ind u ce su ch a switch, imports have to
becom e m ore expensive and thereore less attractive.
A d evalu ation (or a rapid d epreciation) o the exchange rate
is one su ch policy choice. I the price o a cu rrency d ecreases
then oreign good s and services (imports) becom e m ore
expensive in d om estic cu rrency. I n ad d ition, exports will
becom e ch eaper abroad and may rise in valu e. Both eects
will tend to correct the oreig n d e cit.
A potential risk o a rapid d epreciation or d evalu ation o the
cu rrency is that inf ation may accelerate. Why? First, a rise in
export d emand will tend to increase AD, shiting it to the
right. The rapid d epreciation will also increase im port prices
and increase the cost o living. I this d evelopm ent initiates a
rise in wages then a wage-price inf ationary spiral may ollow.
I n ad d ition, d om estic prod u ction processes that requ ire the
u se o im ported raw materials and /or interm ed iate prod u cts
will experience an increase in their prod u ction costs so
cost-pu sh inf ation may ollow.
1 34
Alternatively, policy makers cou ld in stead resort to trad e
protection which will rend er imports m ore expensive. Taris
and qu otas, or exam ple, increase the price o imports and
lower import spend ing. Dom estic hou sehold s and rm s will
su bstitu te d om estic prod u cts or imports, d ecreasing the
cou ntrys import bill.
Su ch protectionist policies create trad e rictions and invite
retaliation rom aected exporting nations. I n ad d ition, they
ru n again st WTO m em bership ru les. I they are implem ented
then ine ciency increases as resou rces are m isallocated . The
cou ntry su ers the costs o trad e protection.
N ote that certain expend itu re-red u cing policies may also end
u p switching expend itu res. For example, a tight m onetary
policy will d ecrease national incom e and so d ecrease
im ports, ind u ce capital inf ows which cou ld help nance the
cu rren t accou nt d e cit bu t also d ecrease inf ation, lead ing to
increased international competitiveness. On the other hand ,
it may lead to an appreciation o the cu rrency, hu rting
exporting ind u stries.
Supply-side policies
Solu tions o a m ore long-ru n natu re inclu d e certain su pply-
sid e policies aim ing at increasing the com petitiveness o the
economy and especially o the export sector. Rem em ber that
a persistent cu rrent accou nt d e cit may be a resu lt o
u ncompetitive prod u ct markets characterized by a h igh
d egree o m onopoly power and o rigid labou r markets with
hig h labou r costs and low labou r prod u ctivity. Su pply-sid e
policies can prove u seu l to restore the competitiveness o an
ailing economy and cu re a u nd am en tal d isequ ilibriu m in the
cu rren t accou nt.
On the other hand , su pply-sid e policies have their drawbacks,
which have been d iscu ssed earlier (see page 1 08).
Policies to correct a persistent current account defcit: summary
include policies that decrease AD,
Expenditure-reducing
or example contractionary scal
policies
and monetary policies.
include devaluation, as well as
Expenditure-switching
increased trade protection that
policies
renders imports more expensive.
include decreasing domestic
monopoly power, increasing labour
Supply-side policies
market fexibility and improving
incentives.

HL Is a current account surplus a problem?
Rem em ber a cu rrent accou nt su rplu s exists i the su m o net
exports o good s and services plu s net incom e and net cu rrent
transers is positive. I t is acceptable, even th ou gh not strictly
speaking correct, to say that it exists when export revenu es
rom the sale o good s and services over a period o tim e
exceed s the im port bill.
I n general, one may argu e that i the su rplu s is small or
transitory it is not consid ered an issu e. Also, i it is part o a
growth and d evelopm ent strategy known as export-oriented
growth its bene ts may exceed its costs bu t, still, a persistent
cu rrent accou nt su rplu s d oes involve risks or an economy
which shou ld be ad dressed .
First, a persistent su rplu s implies that the economy is
consu m ing insid e its prod u ction possibilities. From a static
point o view th is implies that living stand ard s are lower than
they need be bu t rom a d ynam ic point o view this argu m ent
may be tu rned on its head . Foreign markets can and have
proved an engine o long-ru n growth and d evelopm ent or
many cou ntries. The m ost prom inent recent examples inclu d e
Japan, the ou r East Asian Tigers (H ong Kong, Taiwan,
Singapore and Sou th Korea), Malaysia, Thailand , Vietnam and ,
o cou rse, China and I nd ia.
M ore im portantly, large bilateral trad e su rplu ses carry the risk o
retaliatory protection ist m easu res by the d e cit cou ntry. To the
extent that the su rplu s cou ntry relies on oreign d emand or its
HL The Marshall-Lerner condition and
the J-curve eect
Devalu ation im plies that the oreign price o exports d ecreases
and the d om estic price o im ports increases. This o cou rse
assu m es that the d om estic price o exports d oes not change nor
d oes the oreign price o imports. So i, or example, Germany
exports BM W cars to the U SA and imports Abercrom bie and
Fitch shirts rom the U SA, we are assu m ing that the eu ro price
o BM W cars d oes not change nor d oes the U S d ollar price o
an Abercrom bie and Fitch shirt.
With exports more competitive abroad and imports less attractive
domestically, we expect that export revenues will increase and
import expenditures will decrease. So i a country has a current
account decit this will improve. Such a development rests though
on the size o the PED or exports and the PED o imports. Why?
Because the behaviour o revenues and expenditures when price
changes depends on PED.
The Marshall-Lerner cond ition states that or d evalu ation or a
sharp d epreciation o a cu rrency to improve, a cu rrent accou nt
d e cit the su m o the PED or imports and the PED or exports
m u st be (absolu tely) greater than 1 .
The Marshall-Lerner condition: summary
Marshall-Lerner condition:
devaluation (sharp depreciation) will improve a trade defcit
i: PED (X) 1 PED (M) > 1
3 International economics
growth this may pose a seriou s risk. The d e cit cou ntry may
su d d enly ad opt highly protectionist policies, blockin g ou t
imports which cou ld grind growth o the exporting su rplu s
cou ntry to a halt.
I t is also argu ed that i the cu rrent accou nt su rplu s is the resu lt
o trad e barriers erected in key markets o the econ omy then the
su rplu s cou n try is not u lly exploiting its comparative
ad vantage and is ine ciently employing its scarce resou rces.
On the other hand , given that comparative ad vantage is not a
static bu t a d ynam ic concept that cou ntries can, and shou ld try
to change, this argu m ent is signi cantly weakened . The trad e
protection policies employed may help the cou ntry d evelop
competitive ind u stries.
Perhaps the m ost seriou s problem associated with a persistent
and wid ening cu rrent accou nt su rplu s is that it pu ts pressu re on
the exchange rate to appreciate. This is even m ore seriou s i the
trad e su rplu s is m ostly d u e to one export, or exam ple oil or
natu ral gas. The appreciation m eans that all other exports
becom e less and less competitive in oreign markets and as
resu lt su er (this is reerred to as the Du tch d isease). On the
other hand , the appreciation pu ts pressu re on rm s to cu t d own
on waste and becom e m ore e cient.
Lastly, i the cu rrent accou nt su rplu s is the resu lt o the cou n try
keeping its cu rrency u nd ervalu ed then , as explained earlier, the
cou ntry ru n s th e risk o inf ation.
The proo need s som e elem entary calcu lu s bu t this may serve to
illu m inate the cond ition.
I we express the German trad e balance in U S d ollars, then a
sharp d epreciation o the eu ro will make U S Abercrom bie and
Fitch shirts pricier in eu ros even thou gh their U S d ollar price is
constant. Let PED(M ) 5 0 so that exactly the sam e qu antity o
Abercrom bie and Fitch shirts is bou ght in Germany. With their
U S d ollar price the sam e and the qu antity d emand ed and
imported the sam e, im port expend itu res expressed in U S d ollars
will necessarily remain the sam e.
Germanys trad e balance will im prove i export revenu es
(expressed in U S d ollars) increase. Since the d epreciation o the
eu ro mad e the U S d ollar price o BM W cars in N ew York lower,
Germanys export revenu es in U S d ollars will increase i the
qu antity o cars d emand ed by Am ericans increase by
proportionately m ore, so that PED(X) 1 .
The su m o the two elasticities wou ld thereore exceed 1 . I t
ollows that i the M arshall-Lerner cond ition is satis ed then the
German trad e balance, ollowing a sharp d epreciation o the
eu ro, will improve.
1 35
 3 International economics

Why are PED for exports and PED for imports low

Trade balance (X-M)

in the short run?
Firm s and especially hou sehold s may not even be aware o the
new prices. A sharp d epreciation o the eu ro will m ean that
Eu ropean cars are now cheaper in the U SA. Will the average U S +
hou sehold im m ed iately realize that Eu ropean cars are cheaper?
N ot really. Access to new in ormation is n ever instantaneou s.
Bu t even i it becom es wid ely known that Eu ropean cars are
now cheaper in the U SA, the typical Am erican may n eed som e
tim e to switch away rom bu ying Am erican cars i all his or her
t1 t2
lie the person has bou ght Ford s bu ying habits also need tim e
Time
to be overcom e. $250m
M ost i m porta n tl y, i t i s com m ercia l con tra cts between
exporti n g a n d i m porti n g f rm s that slow d own th e respon se to
a cu rren cy cha n g e. I m porters o orei g n ca rs m ay have sig n ed
lon g -term con tra cts wi th orei g n f rm s that a re d i f cu lt to
term in ate or cha n g e. It takes tim e to change business contracts.
Figure 3.3.1 : The J-curve eect
The J-curve effect
Since PED o exports and PED o im ports are low in the short larger becau se the Marshall-Lerner cond ition is not satisf ed :
ru n the Marshall-Lerner cond ition will not be im m ed iately PED or exports and PED or imports are very low and d o not
satisf ed . I t will take som e tim e beore the su m o the two exceed u n ity.
elasticities exceed u nity. So, in a f gu re with tim e on the Only ater tim e t2 in Figu re 3 .3 .1 is the cond ition satisf ed and
horizontal axis and the trad e balance (X-M ) on the vertical, the the trad e d ef cit shrinks below the $ 2 5 0 m illion mark.
path throu gh tim e o th e trad e balance ollowing d evalu ation
N ote that an inverted J-cu rve resu lts ater a revalu ation
traces a J-shaped cu rve. This is known as the J-cu rve eect.
(appreciation), where the su rplu s initially becom es bigger and
I n Figu re 3 .3 .1 assu m e an economy with a trad e d ef cit equ al only later it starts to shrink.
to $ 2 5 0 m illion d ecid ing to d evalu e its cu rrency (or let it
sharply d epreciate). I nitially, the d ef cit becom es larger and

1 36
3.4 Economic integration and trade liberalization
Preferential trade agreements
Globalization implies greater interconnected ness o cou ntries in
the world . This greater interconnected ness is also expressed in
the area o international trad e. Econom ies are becom in g m ore
open, m eaning that the size o exports and imports as a
proportion o GDP is increasing. The volu m e and valu e o
annu al trad e f ows has been rising in the past d ecad es as a
resu lt o trad e liberalization.
Trad e liberalization, d e n ed as a process o red u cing or even
elim inatin g trad e barriers, may be achieved throu gh preerential
trad e agreem ents (on a bilateral or m ore generally, regional
basis) or m u ltilaterally throu gh the WTO. The WTO has been
d iscu ssed earlier see page 1 1 0.
Preerential trad e agreem ents are the weakest orm o
econ om ic integration where tari red u ctions are only oered to
som e prod u ct categories rom certain cou ntries. The term ,
thou gh, may also reer to all orm s o regional trad ing blocs.
Regional trading blocs or agreements
The regional approach to trad e liberalization reers to
agreem ents am ong governm ents o two (bilateral) or m ore
cou ntries to liberalize trad e. They d o this by red u cing or
elim inatin g taris and other trad e barriers and perhaps
coord inating other trad e-related activities while keeping
protectionist barriers with ou tsid ers. There are ou r types o
regional trad ing arrangem ents: ree trad e areas, cu stom s
u nions, com m on markets and econom ic (and m onetary) u nions.
n Two or m ore cou ntries can orm a free trade area i taris
and non-tari barriers between m em bers are abolished or
agreed to be phased ou t, bu t each m em ber cou ntry
maintain s its own taris on imports rom n on-m em ber
cou ntries so that no com m on trad e policy exists toward s
non-m em bers. N AFTA (the U SA, M exico and Canad a) are
EFTA (I celand , N orway, Liechtenstein and Switzerland ) and
the best kn own examples.
n A customs union is a ree trad e area where m em bers
ad d itionally establish a com m on tari and agree to oth er
trad e policies with non-m em ber cou ntries. Examples
inclu d e:
n MERCOSU R, set u p in 1 991 , in which Argentina, Brazil,
Paragu ay and U ru gu ay are u ll m em bers
n the 1 996 agreem ent between the EU and Tu rkey
n the East Arican Cu stom s Union between Ethiopia,
Su d an, Kenya, Tanzania, U gand a and Zam bia.
n I, in addition, unrestricted actor fows are agreed then the
m em ber countries have orm ed a common market. Free fow
o labour and capital m eans that ind ivid uals have the right
to work in any o the m em ber countries without any special
perm its and that cross-border investm ent is liberalized. A
com m on market can be sum marized as an agreem ent or
the ree fow o goods, services, people and capital.
n Lastly, an economic union is orm ed when m em bers o a
com m on market make ad d itional provisions or the
harm onization o certain macroeconom ic and regu latory
policies. I they also ad opt a com m on cu rrency they have
orm ed a m onetary u nion. The Eu ropean Un ion and the
eu rozone are the only su ch exam ples.
Dismantling o trad e-related barriers within a trad ing block will
increase competition between the rm s o m em ber cou ntries,
which is consid ered a positive ou tcom e, bu t at the sam e tim e
certain ine ciencies may arise as a resu lt o taris being
lowered or elim inated only between m em bers. Rem em ber that
preerential trad ing agreem ents are d iscrim inatory while WTO
m u ltilateral agreem ents are non-d iscrim inatory.
Regional trading blocs: summary
members eliminate or agree to phase out
A ree trade area trade barriers between them but each
is ormed i member country maintains its own external
tari to nonmembers.
A customs union is ree trade area members agree to adopt a
ormed i common external tari.
members o a customs union additionally
A common market
agree to permit the ree fow o actors o
is ormed i
production.
members o a common market additionally
An economic
harmonize certain macroeconomic and
union is ormed i
regulatory policies.
members o an economic union agree to
A monetary union
adopt a common currency and establish a
is ormed i
common central bank.
1 37
 3 International economics
HL Evaluation of trading blocs
The big question is whether preerential trade agreements are a
stumbling block or a building block to multilateral trade
liberalization through the WTO. Since almost all WTO members are
also members o at least one preerential trade agreement but, at
the same time, non-members o most agreements, the signicance
o evaluating the role o trading blocs becomes apparent.
The static analysis o trad ing blocs rests on the work o Jacob
Viner in 1 95 0, who introd u ced the term s trad e creation and
trad e d iversion.
Trade creation reers to an increase in imports that displace
less-ecient domestic production. The elimination o the internal
trade barriers will lead members to import rom one another goods
and services that were previously produced domestically. This
increases eciency since production shits away rom a higher-cost
domestic producer to a lower-cost oreign producer, leading to
ewer scarce resources being wasted.
Trad e d iversion arises when im ports shit rom an e cient
non-m em ber to a less-e cient m em ber d u e to the preerences
the latter enjoys. The remaining external tari only or
non-m em bers may rend er som e m em ber arti cially cheaper in
the prod u ction o a good . Another m em ber will then switch
importing rom the tru ly e cient and lowest-cost non-m em ber
to the arti cially cheaper m em ber. This is ine cient since it
implies prod u ction against what comparative ad vantage wou ld
d ictate, bu t it is still possible that the eect is to improve
welare, as both consu m ers and prod u cers within the importing
cou ntry ace prices closer to th e tru e world price levels. I t
ollows that by exam ining trad e creation and trad e d iversion it
is not simple to d eterm in e whether the preerential agreem ent
enhances or d ecreases welare. The relative size o trad e
creation and trad e d iversion will vary rom case to case and
d eterm in e whether the agreem ent enhances or d im inishes
static e ciency. Whether a particu lar trad ing bloc prom otes
global welare is an empirical qu estion.
Monetary union
I m em bers o an econom ic u nion ad opt a single cu rrency and
tran ser the responsibility o m on etary policy to a com m on
central bank then they have also established a m onetary u nion.
I n 1 999 a su bset o cou ntries o the Eu ropean Union ad opted a
com m on cu rrency, the eu ro. The eu rozone in 2 01 1 has 1 7
m em ber cou ntries.
Ad vantages are m ostly o a m icroeconom ic natu re and inclu d e
the ollowin g.
n There are lower transaction costs as cu rrency conversions
are not necessary. Every tim e an ind ivid u al or a bu siness
has to exchange one cu rrency or another, a ee has to be
paid to the bank. This cost is elim inated or any
transactions within a m onetary u nion.
n There is greater price transparency, wh ich makes
comparisons o prices o good s, services and resou rces
m u ch easier. Bu yers (consu m ers a well as rm s) are able to
spot qu ickly the lowest price available in the market or
1 38
I n a d d i ti on to th e a bove sta ti c a n a l ysi s, th e expected
d yn am i c eects sh ou l d be wei g h ed i n . O n th e pl u s si d e, a
tra d i n g bl oc expa n d s th e si ze o th e m a rket so a ster a n d
h i g h er i n vestm en t ra tes wi l l ol l ow, a l l owi n g rm s to g row i n
si ze so EO S m a y resu l t. Th i s h a s been a n a rg u m en t u sed or
d evel opi n g cou n tri es. By orm i n g a tra d i n g bl oc th ey cou l d
a ccel era te th e process o i n d u stri a l i za ti on . Protecti on rom
d evel oped econ om i es wou l d be reta i n ed a n d m em bers
wou l d en j oy a bi g g er m a rket, a ster i n vestm en t a n d EO S.
Seam l ess bord ers a l so en a bl e a ster tech n ol og y tra n ser.
La stl y, th e ba rg a i n i n g power o m em bers i n crea ses, so th ey
ca n exerci se g rea ter econ om i c l evera g e th a n i th ey a cted
i n d i vi d u a l l y.
Are there any potential long-run disadvantages of such
trading blocs?
Firm s cou ld grow to su ch sizes that they su er rom
d iseconom ies o scale (DOS). This is rather u nlikely thou gh.
What is m ore likely is that trad ing blocs may orm by sel-
interested m em ber prod u cers hoping to ben e t rom any
resu lting trad e d iversion eects.
M ost importan tly, the role o the WTO is u nd erm ined .
M u ltilateral agreem ents which are su perior to any regional
trad ing agreem ent may becom e m ore and m ore d i cu lt to
achieve. There is a risk that the world may end u p split into
major blocs, each a potential ortress to the others.
An ad d itional risk arises rom a large economy (or example the
U SA, China or the Eu ropean Union) signing a sequ ence o
preerential agreem ents with smaller ind ivid u al cou ntries which
allows it to u se its hu g e bargaining power m ore eectively than
en gaging in sim u ltaneou s bargaining (throu gh the WTO).
Th ere were 474 reg ional agreem ents in Ju ly 2 01 0 accord ing to
the WTO. This prolieration o preeren tial trad e agreem ents has
also resu lted in a spaghetti bowl o taris that complicates
trad e as it increases bu siness and ad m inistration costs o
ad hering to ru les.
whatever good or service they are looking or. This increases
competition, orces ine cient prod u cers to becom e m ore
e cient and prices gravitate toward s the lowest oered in
the u nion.
n Exchange rate risk and o the resu lting u ncertainty costs are
elim inated . Flexible exchange rates are oten very volatile
and even i an exchange rate is pegged it may always
revalu e or d evalu e. This implies increased u n certainty or
rm s engaged in exports and imports o good s and services
as well as or investors bu ying and selling stocks and
bond s. They cannot be su re what the exchange rate will be
at a u tu re d ate and even thou gh there are nancial
instru m ents that help them hed ge against exchange rate
volatility they are still costly, especially or smaller rm s.
A single cu rrency encou rages m ore trad e and a greater
volu m e o investm ent within m em ber cou ntries.
n A grou p o cou ntries with a com m on market and a com m on
cu rrency will enjoy greater inf u ence and bargaining power
in world aairs.
 3 International economics

On the other hand , here are som e possible d isad vantages,
m ostly o a macroeconom ic natu re, o m onetary u nion.
n M em ber cou ntries are d eprived o an ind epend ent
m onetary policy. Since there is one cu rren cy and on e central
bank there is one m onetary policy or all m em bers. This
one size ts all approach may make thing s very d i cu lt or
som e m em bers i bu siness cycles are asynchronou s. This is
a ancy term that ju st m eans that when one economy is
boom ing and overheating another may be losing steam
and abou t to enter recession. Theory d ictates that the
orm er shou ld tighten m onetary policy, in creasing interest
rates, while the latter sh ou ld loosen m onetary policy,
d ecreasing interest rates. I they are m em bers o a m onetary
u nion, m ost probably the smaller cou ntry will su er.
n M em bers a re d epri ved o a n i n d epen d en t exch a n g e ra te
pol i cy. A cen tra l ba n k i s respon si bl e or con d u cti n g
m on eta ry a n d exch a n g e ra te pol i cy. B ei n g a m em ber o a
si n g l e cu rren cy a rea d epri ves a cou n try th e possi bi l i ty to
d eva l u e or sh a rpl y d epreci a te i ts cu rren cy to boost i ts
exports i n a recessi on , or to d o th e opposi te i n th e a ce
o m ou n ti n g i n f a ti on a ry pressu res. N ot on l y i s th ere n o
exch a n g e ra te to m a n i pu la te between m em bers (wh en
tra d e between m em bers i s proba bl y th e bi g g est), bu t
on e m em ber a l on e ca n n ot i n f u en ce th e extern a l va l u e
o th e com m on cu rren cy a s th ere i s a n i n d epen d en t
cen tra l ba n k.
n There is lim ited room or pu rsu ing ind epend ent scal policy.
Even thou gh each governm ent can manipu late its own
expend itu res and taxes, the available d egrees o reed om
are lim ited as scal irresponsibility within a m onetary u nion
can create havoc. Rem em ber that bu d get d e cits and
pu blic d ebts have to be nanced som ehow so that scal
and m onetary policies are not ind epend ent as they may at
rst seem .
n Mem bers lose econom ic sovereignty. I a cou ntry is d eprived
o an ind epend ent m onetary policy, i it cannot exercise an
ind epend ent exchange rate policy and i its scal nances
have to be aligned with other m em bers, th en it has
transerred at least part o its econom ic sovereignty ou tsid e
the cou ntry. This has been a major argu m ent or many
Eu ropean Union cou ntries again st ad opting the eu ro.
Advantages and disadvantages of monetary union: summary
lower transaction costs as currency conversions
are unnecessary.
Possible greater price transparency, acilitating price
advantages of a comparisons.
monetary union no exchange rate risks and associated
include uncertainty costs.
greater negotiating and bargaining power in
world aairs.
no independent monetary policy.
Possible
disadvantages no exchange rate policy.
of a monetary limited room or independent fscal policy.
union include
loss o economic sovereignty.

1 39
 3.5 Terms of trade

HL Meaning and measurement
The term s o trad e (TOT in the equ ations below) o a cou ntry
are d e ned as the ratio o the average price o exports over
the average price o imports, expressed as ind ex n u m bers
tim es 1 00.
Average price of exports expressed as an index number
____________________________________________
TOT 5 Average price of exports expressed as an index number 3 the cou ntry can attain a greater volu m e o imports with the
TOT = Average price of imports expressed as an index number 3 1 00
Average price of imports expressed as an index number
1 00
The term s o trad e thereore m easu re the volu m e o im ports
attainable by a u nit o exports. They show the volu m e o
oreign good s that can be bou ght by a cou ntry by exporting a
given am ou nt o d om estic ou tpu t. They ref ect the rate at which
one cou ntrys good s exchange or those o another cou ntry.
A cou ple o examples will illu strate the above points. On a
personal everyd ay basis, i the price o a pizza is $ 1 2 .00 and
the price o a cheesebu rger is $ 2 .00 then the ratio
Price o a pizza
__________________ 12
5 ___ 3 6
Price o a cheesebu rg er 2
shows that you can exchange 6 cheesebu rgers or 1 pizza. You
shou ld realize im m ed iately that even thou gh it is a ratio o
prices, it shows the rate at wh ich qu antities can be exchanged .
N ow assu m e that we are reerrin g to international trad e and
that a cou ntry exports coee and imports a certain type o
machine. Fu rther assu m e that th e price o a ton o coee is
$ 2 0,000 and the price o these machines is $ 1 0,000 each. Th e
cou ntrys term s o trad e are
2 0,000
2 5 2
TOT 5 ______ 3 __
1 0,000 1
showing that this cou ntry can import two o the machines by
exporting one ton o coee.
Changes in the terms of trade
I the term s o trad e increase throu gh tim e it is reerred to as a
avou rable m ovem ent (an improvem ent) in the sense that now
sam e exports (or, equ ivalently, the sam e volu m e o imports with
a smaller volu m e o exports). For example, i the price o a ton
o coee increases to $ 3 0,000 then the term s o trad e
increase to 3/1 m eaning that a ton o coee bu ys three o
the machines in world markets and not ju st two.
I the term s o trad e d ecrease over tim e this is reerred to as an
u navou rable m ovem ent (a d eterioration or a worsening) in the
sense that now the cou ntry can attain a smaller volu m e o
imports with the sam e exports (or, equ ivalently, the sam e
volu m e o imports with a greater volu m e o exports). For
example, i the price o a ton o coee d ecreases to $ 1 0,000
then the term s o trad e d ecrease to 1 /1 m eaning that a ton
o coee now bu ys one o the mach ines in world markets
and not two.
An i n crea se in th e term s o tra d e (a avou ra ble m ovem en t)
wi ll occu r i th e avera g e price o exports ri ses relativel y to th e
price o i m ports, a n d vi ce versa . An d ecrea se i n th e term s o
tra d e (a n u n avou ra bl e m ovem en t) wi ll occu r i th e avera g e
price o exports ri ses relativel y to th e price o i m ports, a n d
vi ce versa . By u si n g th e word relati vel y we avoi d havin g to
m en tion a l l th e possi ble ways that a ra cti on m ay in crea se or
d ecrea se in va lu e.

Volume refers to the quantity of exports or imports. Think

TIP
of Qx and Qm respectively.

HL Causes of changes in the terms of trade
One m u st be careu l as to the cau se o any change in the term s
o trad e as it aects the interpretation o the eects. For
exam ple, it makes a big d ierence whether export prices rise as
a resu lt o increased d emand or a cou ntrys exports, or as a
resu lt o an appreciation o the exchange rate.
n Take the case o changes in the world d emand or a
cou ntrys exports or imports. I the world d emand or a
cou ntrys exports increases (d ecreases) then, ceteris paribu s,
its term s o trad e will increase (d ecrease): there will be a
avou rable (u navou rable) m ovem ent. I th e world d emand
or a cou ntrys imports increases (d ecreases) then, ceteris
paribu s, its term s o trad e will d ecrease (increase): there will
be an u navou rable (avou rable) m ovem ent.
Let's, consider Australia. I t predom inantly exports
com m odities (they make up 80% o goods it exports).
A su rge in the world demand or com m odities
(raw materials) will lead to an increase in the average price
o Australian exports. Australias term s o trade will increase
(assum ing no change in the average price o its imports).
This is a avourable m ovem ent. On the other hand , or
cou ntries importing raw materials, their term s o trade will
decrease (deteriorate; experience unavourable m ovem ent)
to the extent that the average price o all imports is aected.
n N ow lets look at changes in the world su pply or a
cou ntrys exports or imports. A change in the world su pply
will aect the price o a prod u ct. For example, i
technological progress or higher prod u ctivity or red u ced
inpu t costs increase the su pply o a good that a cou ntry
exports then its price will drop and its term s o trad e will
d ecrease (worsen). N ote that we are implicitly reerring to a
cou ntry with signi cant concentration o its exports in one
or ew prod u cts or prod u ct grou ps, or example agricu ltu ral
prod u cts. For importers o the prod u ct or prod u ct grou p
their term s o trad e increase (im prove).

1 40

Or, consider a decrease in the world supply o an export (or
an import). A good example is the case o commodity
agreements which aimed at restricting exports to increase
their world price. Oil is in a similar category as the
Organization o the Oil Producing and Exporting Countries
(OPEC) is a cartel which typically, but not always, restricts oil
exports o members to push the world price o oil up. The
terms o trade o oil exporters increase (a avourable
movement) but given oils signicance as an energy input, the
terms o trade o importing countries will decrease (worsen).
n Changes in the exchange rate will result in changes in the
terms o trade. I a the external value o the currency changes
then the terms o trade are aected as export prices and
import prices change. For example, assume an appreciation (or,
in a xed exchange rate system, a revaluation). Since exports
become pricier and imports cheaper, the terms o trade are
aected. They will increase (that is, a avourable movement
will take place); conversely, or a depreciation (or devaluation).
Consequences o changes in the terms o trade
Consequences or the trade balance in goods and services
(current account)
A change in the term s o trad e will aect the trad e balance o a
cou ntry as it im plies that export and /or import prices have
changed . For example, to d eterm ine whether a trad e d e cit will
improve or wid en it is importan t to d eterm ine whether the
cau se o the change in the term s o trad e has aected the
average price o exports and the volu m e o exports in the sam e
or opposite d irections (or, sym m etrically, whether the average
price o imports and the volu m e o im ports have m oved in the
sam e or opposite d irections).
The d iscu ssion is sim ilar to the d iscu ssion in m icroeconom ics o
whether an increase in th e price o a good will increase or
d ecrease the revenu es o a rm . I the increased price is a resu lt
o an increase in the d eman d or the good , then both th e price
and the qu an tity (volu m e) increase, so revenu es u nam bigu ou sly
increase. I the increased price is a resu lt o a d ecrease in
su pply (and so a m ovem ent along the d emand cu rve), then
qu antity (volu m e) will d ecrease and price elasticity will
d eterm in e the answer. I d emand is price elastic then the
increase in price will d ecrease reven u es whereas i it is price
inelastic the in crease in price will d ecrease revenu es.
Retu rning to trad e f ows, i an improvem ent in the term s o
trad e is the resu lt o an increase in world d emand or th e good
then price and qu antity (volu m e) m ove in the sam e d irection,
so export reven u es increase. A trad e d e cit (ceteris paribu s) will
narrow (or a trad e su rplu s will grow). I the improvem ent is a
resu lt o a d ecrease in world su pply that increased export prices
then qu antity (volu m e) o exports d ecreases so the eect on
export revenu es (or the import bill) d epend s on PED. I it is
price inelastic, as in the case o oil, then export revenu es o
OPEC m em bers will increase and their trad e su rplu ses will grow
(and the import bill o oil importers will also increase, with their
trad e d e cits wid ening).
A change in the term s o trade as a result o exchange rate
m ovem ents aects prices and volum es (quantities) o tradables
in the opposite direction, so again price elasticities are important
3 International economics
n Changes in the relative rates o in f ation will aect the
term s o trad e. I prices in an economy are increasing aster
than th ey are abroad , then the average price o its exports
will be increasing aster than the average price o its
im ports. Ceteris paribu s, this m eans that the term s o trad e
o the cou n try with the h igher inf ation are improving.
n When a large cou ntry imposes taris and other trad e
barriers this can improve its term s o trad e. A large cou n try
is d e ned as a cou ntry that is in a position, throu gh its
d ecisions, to aect the world price o a prod u ct. Assu m e
that a large cou ntry imposes a tari on a prod u ct it im ports.
The d om estic price o this prod u ct will rise bu t at the sam e
tim e the resu lting d ecreased d emand or it will tend to
d ecrease its world price. The d ecrease in the d emand in the
im porting cou ntry was big en ou gh to ad versely aect world
d emand or the prod u ct. The large cou ntry has managed to
im prove its term s o trad e as the average price o its imports
has d ecreased .
in determ ining the eect on the trade balance. For example,
i the term s o trade o a country have increased because o an
appreciation, then prices o exports rise. Exports becom e less
competitive abroad and m ore dicult to sell. The volum e o
exports alls. The country will earn m ore oreign currency only
i the volum e o exports drops by proportionately less (that is, i
the demand or its exports is price inelastic; sim ilarly or imports).
The Marshall-Lerner condition enters this discussion.
n I the su m o the Price elasticity o d emand (PED) or
exports an d the PED or imports o a cou ntry exceed u nity
then an appreciation will d ecrease a trad e su rplu s (that
is, narrow it).
n On the other hand , a d epreciation wh ich lowers export
prices and makes imports m ore expensive will d ecrease
(worsen) the term s o trad e. H owever, i the su m o the
PED or exports and the PED or imports o a cou ntry
exceed u n ity, then the d epreciation will d ecrease a trad e
d e cit (that is, narrow it).
Lastly, an im port tari imposed by a large cou ntry will, ceteris
paribu s, tend to improve its trad e balance as both the world
price o the good will d ecrease and the volu m e o its imports.
Long-term consequences
A long-term d eterioration in a cou ntrys term s o trad e m eans
that the cou ntry will have to export ever-increasing volu m es o
good s to attain the sam e volu m e o im ports. I t implies that a
unit o its exports com mand s a smaller slice o world ou tpu t.
The d istribu tion o world incom e (ou tpu t) changes against the
cou ntry experiencing the worsening term s o trad e.
Terms o trade and developing countries
Short-term fuctuations
M any d eveloping cou ntries specialize and export a narrow set
o primary prod u cts, while they import m ostly manu actu ring
sector prod u cts. Su pply in the short ru n o primary agricu ltu ral
com m od ities is typically very low and can be consid ered or
analytical pu rposes as perectly inelastic (that is, vertical). This
is the resu lt o the lon g tim e lags that characterize th eir
prod u ction. Demand or m ost com m od ities is also very price
1 41
 3 International economics
inelastic as they lack close su bstitu tes. Given that ou tpu t o
agricu ltu ral prod u cts is aected by rand om and u ncontrollable
actors, su ch as weather cond itions, it ollows that prices o
su ch exports are qu ite volatile.
The resulting short-term fuctuations o the term s o trade o
developing countries exporting a narrow range o agricultural
com m odities creates high uncertainty both or producers and the
governm ent. Uncertainty over export prices and, consequently,
export revenues hurt planning and deter productivity, enhancing
investments as arm ers are araid that they may not be in a
position to pay back any bank loans they take.
Flu ctu ating export revenu es m eans that oreign exchange may
not always be enou gh to nance the pu rchase o necessary
imports o ood , capital or interm ed iate prod u cts.
Foreign d ebt paym ents may be impossible to make, requ iring
m ore borrowing. Growth and d evelopm ent becom e even m ore
d i cu lt to achieve.
Long-term deterioration
Developing cou ntries specializing in and exporting a narrow
range o agricu ltu ral com m od ities have over th e long term
su ered a d eterioration o their term s o trad e. World prices o
su ch prod u cts have in general d ecreased over the long term
becau se su pply has in general grown aster than d emand .
World su pply has dramatically increased , both as a resu lt o
1 42
technological ad vancem ents in agricu ltu re and as a resu lt o
massive su bsid ies granted to arm ers in d eveloped cou ntries
by their governm ents.
On the other hand , world d emand or agricu ltu ral com m od ities
has not increased as ast. The reason or this is that incom e
elasticity o d emand (YED) or ood prod u cts is low.
This long-term d ecline o the term s o trad e o many d eveloping
cou ntries signi ed a shrinking slice o world ou tpu t and incom e
or these cou ntries to enjoy. Distribu tion o world incom e
becam e m ore u nequ al. Developm ent based on primary sector
exports was consid ered a d ead -end . Decreasing export earnings
orced these cou ntries to try to prod u ce m ore and m ore which,
given th e competitive stru ctu re o these markets, pu shed prices
even lower.
Short-ru n instability and long-term d ecline in export earnings
were responsible or low rates o investm ent, u nstable
employm ent and increased poverty, as well as environm ental
d egrad ation becau se o m ore intensive cu ltivation o land ,
d eorestation and soil erosion.
The long-term d ecline in the term s o trad e o many d eveloping
cou ntries is the principal argu m ent in avou r o ind u strialization
and d iversi cation. The logic behind import su bstitu tion,
in d u strialization and export prom otion as growth and
d evelopm en t strategies rests on the long-term d eterioration o
the term s o trad e o many d eveloping cou ntries.
 3 International economics: Questions
Variations on the foowing may be asked in questions (b) and (c)
of Hl/Sl Paper 2
1 . Explain the gains rom trad e that a cou ntry may expect.
2 . Explain u sing appropriate d iagram s absolu te and
com parative ad vantage.
3. Describe the possible sou rces o com parative ad vantage or
cou ntry X.
4. Describe the objectives and u nctions o the WTO as well
as som e o the criticism s it aces.
5. Explain, u sing an appropriate d iagram , the eects on
d ierent stakehold ers o a tari imposed on g ood X.
6. Explain, u sing an appropriate d iagram , the eects on
d ierent stakehold ers o a qu ota (or, o a VER) im posed on
good X.
7. Explain, u sing an appropriate d iagram , the eects on
d ierent stakehold ers o the governm ent granting a
su bsid y to the d om estic prod u cers o good X.
8. Describe ad m inistrative (regu latory) barriers to trad e.
9. Discu ss argu m ents in avou r o trad e protection.
1 0. Discu ss argu m ents against trad e protection.
1 1 . Explain, u sing an appropriate d iagram and an example,
how the valu e o a cu rrency is d eterm ined in a f oating
(f exible) exchan ge rate system .
1 2 . Describe, u sing an appropriate d iagram , two actors that
may be consid ered responsible or an appreciation/
d epreciation (or, revalu ation/d evalu ation) o cu rrency X.
Variations on the foowing may be asked in part (d) of Hl/Sl Paper 2
1 . Com pare and contrast a xed exchange rate system with a
f oating exchange rate system .
2 . Com pare and contrast the d ierent types o trad ing blocs.
3. (H L only) Discu ss the real-world relevance and lim itation s
o the theory o comparative ad vantage.
4. Discu ss the argu m ents in avou r o trad e protection.
5. Discu ss the argu m ents against trad e protection.
6. (H L only) Discu ss the implications o a persistent cu rrent
accou nt d e cit.
7. (H L only) Discu ss the possible consequ ences o a rising
cu rrent accou nt su rplu s.
8. Discu ss the possible ad vantages and d isad vantages o a
m onetary u nion or its m em bers.
1 3. Distingu ish, u sing real world exam ples, between an
appreciation an d a revalu ation o a cu rrency (or, between a
d epreciation and a d evalu ation o a cu rrency).
1 4. Describe a xed exchange rate system and explain the
actions requ ired to maintain cu rrency X xed .
1 5. Explain how a man aged exchange rate system operates.
1 6. Ou tline (or, d escribe) the role o th e balance o paym ents.
1 7. Distingu ish between cred its and d ebits in th e balance o
paym ents, illu strating with examples (rom the extract).
1 8. Explain th e ou r components o the balance o paym ents
provid ing an example rom each.
1 9. Explain th e d ierence between a cu rrent accou nt d e cit
and a cu rrent accou nt su rplu s.
2 0. Explain (u sing examples rom the extract) two components
o th e capital accou nt.
21 . Explain th e three (main) components o the nancial
accou nt provid ing an exam ple or each.
2 2 . Explain th e m eaning o the expression cu rrent accou nt
balance.
23. Exam ine how the cu rrent and the nancial accou nts are
interd epend ent.
2 4. Explain th e pressu re on the exchange rate o a cu rrency o
a sizeable cu rrent accou nt d e cit (or, su rplu s).
9. Evalu ate the eect o d ierent types o trad e protection.
1 0. Evalu ate the possible econom ic consequ ences o a chang e
in the valu e o a cu rrency.
1 1. (H L only) Evalu ate the eectiveness o the policies to
correct a persistent cu rrent accou nt d e cit.
1 2 . Exam ine the possible consequ ences o overvalu ed and
u nd ervalu ed cu rrencies.
1 3. Exam ine how the cu rrent accou nt and the nancial
accou nt are interd epend en t.
1 4. (H L only) Exam ine the eects o changes in the term s o
trad e on a cou ntrys cu rrent accou nt.
1 43
 4.1 Economic development
Dfg grwh ad d
S ecti o n 4 : D evelo pm en t eco n o m i cS
Developm ent is a m u ltid im ension al qu alitative concept that
reers to an improvem ent in living stand ard s in an economy
encom passing material consu mption, ed u cation and health, as
well as environm ental concerns. Developm ent involves poverty
red u ction, in creased employm en t opportu nities or the
ind ivid u al and a m ore equ itable d istribu tion o incom e.
Developm ent ocu ses attention on the ind ivid u al and on the
three d im ension s o well-bein g, which are:
health: the ability to live a long and healthy lie
ed u cation: the ability to read , write and acqu ire knowled ge
incom e: com mand over the incom e need ed or a d ecent lie.
The term su stainable d evelopm ent ocu ses attention on
intergenerational equ ity alon g with environm ental, social and
econom ic issu es. A wid ely accepted d e nition is: d evelopm ent
which m eets the need s o the present withou t comprom isin g
the ability o u tu re generations to m eet th eir own need s.
A d evelopm ent process is typically consid ered u nsu stainable
when insu cient attention is paid to the environm ental
consequ ences as well as to th e resu lting changes in the
d istribu tion o in com e. I gnoring these d im ensions threatens to
reverse any progress mad e.
Surs g-r grwh
A u seu l way o rem em bering the sou rces o growth is to realize
that ou tpu t may grow i all o the ollowing cond itions apply.
The am ou nt o available resou rces increases.
The qu ality o available resou rces increases.
The available technology improves.
The ram ework within which econom ic activity takes place
(reerred to as the institu tional ram ework) improves.
Growth may take place as a resu lt o the ollowing actors.
More or im proved natu ral resou rces (land ) becom es
available. This u su ally implies either the d iscovery o new
m ineral or oil d eposits or the im provem ent o existin g land .
I rrigation, ertilization and improved land managem ent may
all improve the qu ality o existing land an d contribu te to
growth. An increase in the natu ral capital may lead to
growth. Rem em ber, thou gh, that many poor cou n tries rich
in natu ral resou rces have grown spectacu larly while several
rich cou ntries with abu nd ant natu ral resou rces have
m iserably ailed to grow.
There is investm ent in physical capital. N ew actories,
machinery and equ ipm ent increase the physical stock o
capital. As a resu lt, labou r prod u ctivity (d e ned as ou tpu t
per worker) increases. Also, increased pu blic investm ents in
inrastru ctu re su ch as road s, ports, com m u nications, power
su pplies, water and sanitation acilitate and also lower the
cost o econom ic activity.
The labou r orce grows. A larger labou r orce m eans m ore
manpower while a larger popu lation increases the d emand
1 44
Econom ic growth, on the oth er hand , is a pu rely qu antitative
concept. Growth reers to increases in the real GDP (total
ou tpu t) o an economy throu gh tim e. Growth and d evelopm ent
are related bu t at the sam e tim e very d ierent. Growth d oes not
necessarily imply d evelopm ent. A cou ntry may grow withou t
any d evelopm ent objective being achieved . The United N ations
Developm ent Program m e (U N DP) has d escribed ou r types o
growth to avoid , d e ned as:
jobless, where employm ent opportu nities or the poor d o
n ot expand
ru th less, where incom e inequ ality wid ens
u tu reless, where natu ral resou rces are wasted and the
impact on the environm ent is neglected
voiceless, where ind ivid u al empowerm ent lags behind .
On the other hand , d evelopm ent typically necessitates growth.
Even thou gh som e lim ited improvem ent in living stand ard s may
be achieved withou t any growth taking place, long-term
progress on the d evelopm ent ront requ ires that d eveloping
cou ntries grow.
sid e o d om estic markets. H owever, a larger labou r orce
may not be able to nd prod u ctive employm ent. I n
ad d ition, short-term growth may resu lt rom better
u tilization o existing id le hu man (and oth er) resou rces.
I n vestm ent in hu man resou rces can exert a m ost poweru l
eect on growth as it has a d irect positive eect on labou r
prod u ctivity. I mproving health services and increasing the
stock o hu man capital, d e ned as the experience, skills
and ed u cation em bod ied in the labou r orce o a cou ntry,
are consid ered the best policy choices to achieve growth
and d evelopm ent.
Technological progress is a very infuential determ inant o
growth. I labour is the relatively abundant resource then
labour-saving technologies where higher output levels are
achieved with the sam e quantity o labour are considered
inappropriate as this leads to the U N DPs category o
jobless growth. Employing the appropriate technology
(which relies on the relatively abundant actor) to accelerate
the growth and developm ent process is a highly complex
issue, especially i environm ental considerations are included.
An institutional ramework conducive to growth and
development is devised. The institutional ramework o a
country reers to the set o rules and laws, norms and
conventions within which economic activity is conducted.
There is no unique set o institutions that singularly promotes
growth. H owever, some institutions have worked better than
others. Attempts to transplant a template o westernized
institutions into developing countries may not prove ruitul.

charaerisis of developing eonoies
Developing cou ntries in ou r world are many and d iverse. Their
initial cond itions, geography, climate, history, political system s,
institu tions and available resou rces vary signi cantly. This
m eans that the list o characteristics that ollows d oes not
apply to all d eveloping cou ntries, or to the sam e extent or
them all. I t is very d angerou s to generalize as there are hu ge
d ierences in these characteristics between d eveloping
cou ntries and within each one.
Per capita real income levels
Extremely low per capita real income levels characterize many
developing countries. Low per capita real income levels result in
low saving and so low investments. Low investments in natural,
human and physical capital lead to low productivity gains and so
low incomes, creating a vicious circle o poverty that extends across
generations and which may require some kind o intervention.
The degree o incom e inequality is generally greater in
developing than in developed econom ies. I ncom e distribution is
oten highly unequal, with the top qu intile (2 0%) o people
oten receiving 1 0 to 5 0 tim es m ore than the bottom 40%.
The percentage o people in absolute poverty, dened as the
specic m inim um incom e needed to satisy the basic physical
needs to assure continued survival , is also high in developing
countries. Interestingly enough, there is recent research showing
that oten an increase in incom e will not lead to m ore ood
purchased. There may be households at or even below poverty
line who will instead choose to spend any extra incom e earned
on a television or a cell phone (Banerjee and Dufo, 2 01 1 ).
I n ad d ition, as a resu lt o very low per capita incom e levels,
large segm ents o th e popu lation su er rom ill h ealth,
malnu trition and d ebilitating d iseases and inant m ortality
rates are also very high. Rem em ber that there are signi cant
variations both between and within d eveloping cou ntries.
Population growth rates and/or size
Many developing econom ies are still characterized by high
population growth rates or, i the population growth rates are
the millenniu Developen Goals
In 2000, world leaders promised to improve living standards in the
developing world by achieving eight UN Millennium Development
Goals (MDGs) by 201 5. These goals encompass education, health,
gender and the environment and are stated as ollows.
Erad icate extrem e poverty and hu n ger.
Ach ieve u niversal primary ed u cation.
Prom ote gend er equ ality and empower wom en.
Red u ce child m ortality.
I mprove maternal health.
Com bat H I V/AI DS, malaria and other d iseases.
Ensu re environm ental su stainability.
Develop a global partnership or d evelopm ent.
4 Development economics
not very high, the size o their population may be very high.
This may be the resu lt o high birth rates (ertility) coupled with
a reduction in death rates (m ortality) because o improved
health conditions. A major implication o high birth rates is that
children under the age o 1 5 oten make up alm ost one hal o
the total population. This m eans that the active labour orce has
to support alm ost twice as many children as it typically does in
richer cou ntries. I n som e developing cou ntries a large proportion
o the population is attracted to cities (urban centres) where
m ost econom ic activity takes place in the inormal sector (that
is, where it is neither ocially registered nor regulated ).
Unemployment and underemployment
H igh unemployment is a common eature o most developing
countries. Unemployment, especially in urban areas, may aect
1 020% o the labour orce. On the other hand, the
underemployed include those working less than they would like to
as well as those who have near zero contribution to total output. In
rural areas unemployment suers rom large seasonal variations.
Unemployment is a much more complex problem in developing
economies and the necessary policy approaches go beyond
traditional demand-side or pro-market supply-side prescriptions.
Dependence on the primary sector
Agricu ltu re in d eveloping cou ntries con tribu tes arou nd 3 0% o
GDP compared to less than 2 % in high-incom e cou ntries. As
per capita in com e levels rise the stru ctu re o d emand changes,
lead ing rst to a rise in manu actu ring and then to a rise in
services. The share o services in high-incom e cou ntries is
arou nd 70% o GDP. O cou rse, there are variations in the
stru ctu re o ou tpu t within each in com e grou p.
Dependence on exports of primary commodities
Since a signicant proportion o output in low-income countries
originates rom the primary sector, primary commodities oten also
orm the basis o their exports to other nations. Some countries
may even depend on exporting a single non-oil primary commodity.
Progress has been mad e on several issu es bu t or very many
cou ntries and regions these goals remain ou t o reach. The best
way to m onitor u p-to-d ate progress on each o these goals is to
visit www.u n.org/m illenniu m goals/reports.shtm l. The World
Developm ent Report also inclu d es u seu l inormation on the
MDGs. Check, or exam ple, Table 3 (M illenniu m Developm ent
Goals: Erad icating poverty and improving lives) on page 3 82 o
the 2 01 0 report.
Bear in m ind that one important drawback o these goals is
that th ey overlook inequ ality and process reed om s. I n ad d ition,
accord ing to the World Bank, climate change and con f ict may
com prom ise the eorts to im prove stand ard s o living and to
achieve these goals.
1 45
 4.2 Measuring development
indcators used to measure development
Per capita income fgures
Per capita GN I or per capita GDP represent m easu res o per
capita incom e. The d ierence between GDP and GN I is that
GN I exclu d es in com es earned d om estically by oreign actors
(which are paid abroad , or example the pro ts o m u ltinational
corporations) bu t it inclu d es incom es earn ed abroad by
nationals o the cou ntry. Per capita incom e gu res are
compu ted by d ivid ing GN I or GDP o a cou ntry by the m id -year
total popu lation o the cou ntry. U su ally, per capita incom e
gu res are in so called PPP (pu rchasing power parity) d ollars,
som etim es reerred to as international d ollars, which have the
sam e pu rchasing power over GDP as a U S d ollar in the U S. The
id ea behind u sin g PPP as a conversion actor, and n ot the
market exchange rate, is that cost o living may d ier
su bstantially between cou ntries and market exchange rates d o
not necessarily ad ju st to captu re these d ierences.
The World Bank u ses per capita GN I to d eterm ine the
ollowing incom e classi cations: low incom e was d e ned as
$ 975 or less in 2 008; m id d le incom e was $ 976 to $ 1 1 ,905 ;
and high in com e was $ 1 1 ,906 or m ore. A u rther d ivision at
GN I per capita $ 3 ,85 5 is mad e between lower-m id d le
incom e and u pper-m id d le incom e econom ies.
This classi cation is u seu l and may provid e u s with som e
inormation on the level o d evelopm en t o a cou ntry as there is
a positive correlation between per capita incom e and social
welare. Few wou ld qu estion that N orway is m ore d eveloped
than Zim babwe. Bu t since growth in per capita incom e d oes
not necessarily imply improved living stand ard s, classi cation
based on per capita incom e is also rau ght with problem s.
U sing per capita incom e may mask very signi cant d ierences
between cou ntries.
These are some issues to be aware o when using per capita
income gures to determine the level o development o countries.
Per capita incom e ails to incorporate incom e d istribu tion
consid erations. Per capita incom e is ju st a simple average
provid ing no inormation on whether incom e is equ itably or
very u nequ ally d istribu ted .
U sin g per capita incom e gu res d oes not take into accou nt
the valu e o the environm ental d egrad ation oten
associated with increased prod u ction. The pressu re on
agricu ltu re to prod u ce m ore ood prod u cts is responsible or
soil erosion and the bu rn ing o orests. I nd u strialization is
also oten accom panied by massive m igration rom ru ral to
u rban areas, lead ing to heavily pollu ted and congested
cities. Em issions rom ind u stry and increased energy
requ irem ents also d ecrease the qu ality o lie.
Per capita incom e gu res ail to inclu d e non-marketed
su bsistence prod u ction which may be relatively signi cant
in som e low-incom e cou ntries. N on-marketed su bsistence
prod u ction reers to ood s and other good s and services
prod u ced by a am ily or its own consu m ption . More
g enerally, per capita incom e gu res ail to inclu d e th e size
o parallel (black or shad ow) econom ies in d eveloping
cou ntries.
1 46
Relying on per capita incom e also conceals useul
inormation on the composition o output. Two econom ies
with equal per capita incom e levels may dier with respect to
living standards because o dierent output m ix. A country
that spends a large proportion o its GDP on, say, deence,
devotes resources there that could have been used otherwise
in the production o pro-developm ent goods. The value o
leisure, a very important good an individual may enjoy, is
not included in the calculation o GN I or GDP. As pointed out
in Section 2 , it makes a big dierence to workers i the
average working week is over 5 0 hours and they can seldom
take a holiday, or i the working week is only 35 hours and
everyone enjoys our weeks paid leave every year.
Lastly, per capita incom e d oes n ot inclu d e the valu e o the
stream o services f owing rom the accu m u lated social and
other capital o an economy that ind ivid u als enjoy. Living
stand ard s at any point in tim e are n ot aected ju st by
cu rrent incom e bu t also by the stock o accu m u lated
wealth. For exam ple, as m entioned in Section 2 , the
existence o a high-qu ality and ree pu blic school system
implies that hou sehold s with children may d evote m ore o
their incom e to good s an d services not related to ed u cation.
Despite these and oth er shortcom ings, per capita incom e
remains the best single ind icator o d evelopm ent available bu t
m u st be employed with cau tion in any analysis.
Other single indicators
Single ind icators o the level o d evelopm ent o a popu lation
inclu d e the ollowing.
H ealth-related ind icators may be u sed , su ch as health
expend itu re per capita; lie expectancy at birth (years);
inant m ortality (per 1 ,000 live births); m ortality o children
aged u nd er ve years (per 1 ,000); malnu trition prevalence,
weight and /or height or age (o children u nd er ve years
old ); birth s attend ed by skilled health sta (% o total);
maternal m ortality ratio (per 1 00,000 live births);
im m u nization, DPT and m easles (% o children aged
between 1 2 and 23 m onths); im proved sanitation acilities
(% o popu lation with access); prevalence o H I V (% o
popu lation aged between 1 5 and 49 years); physicians (per
1 0,000 people); hospital bed s (per 1 0,000 people).
Ed u cation-related ind icators may be taken into accou nt,
su ch as literacy rate (% o people aged 1 5 years and old er);
m ean years o sch ooling (o people aged 2 5 years and
old er); expected years o schooling (years); expend itu re per
stu d ent, primary, second ary and tertiary (% o GDP, per
capita); pu pilteach er ratio, primary; ratio o girls to boys in
primary and second ary ed u cation (%); school enrolm ent,
primary, second ary and tertiary (%); trained teachers in
primary ed u cation (% o total teachers).
Other ind icators inclu d e newspaper circu lation per 1 ,000
popu lation, energy con su mption per capita, percentage
o GDP d erived rom each sector o the economy and
u rban popu lation.

An excellent sou rce o cu rrent d ata on health, ed u cation and
other d evelopm ent-related ind icators are the statistical tables at
the en d o th e World Developm ent Report pu blished annu ally
by the World Bank (www.d ata.world bank.org).
Composite indicators
N o single ind icator is powerul enough to illustrate satisactorily
the complex issue o developm ent. It is thereore preerable to
rely on several indicators synthesized into a single variable.
A nu m ber o com posite ind ices have been d evised . They
in tegrate econom ic, social and even political aspects o
d evelopm en t. The m ost wid ely qu oted and u sed composite
in d icator is the hu man d evelopm ent ind ex (H DI ). The H DI
m easu res average achievem ents o a popu lation in term s o
health, ed u cation and access to good s and services and was
d evised as a simple rival to GN P concentrating only on
longevity, basic ed u cation and m inimal incom e. The H DI
su cceed ed in challenging the hegem ony o growth-centric
thinking (that is, it was su ccessu l in d isplacing per capita
in com e as a su m mary m easu re o d evelopm ent).
The health dim ension o the H DI is captured by lie expectancy
at birth. In 2 01 0 the indicators used to m easure progress in
education have been revised and now include the m ean years o
schooling o people aged 2 5 and older and the expected years
o schooling that a child o school entrance age could expect to
receive i prevailing patterns o enrolm ent were to stay the sam e
(instead o adult literacy and gross enrolm ent rate). Access to
goods and services is m easured by per capita incom e which in
2 01 0 has also been revised and now reers to GN I per capita in
PPP dollars, replacing GDP per capita. The reason or the change
to GN I is that in a globalized world it is preerable to ocus on
the incom e o the residents o a country as this incom e may
signifcantly dier rom dom estic production.
Major drawbacks o the H DI inclu d e:
a reliance on national averages which conceals skewed
d istribu tions in the variables inclu d ed within a popu lation
the absence o a qu antitative m easu re o hu man reed om
4 Development economics
(U N DP, 2 01 0).
Being an average it may conceal important d ierences within a
cou ntry. Wom en and ru ral popu lations as well as the very old
and the very you ng oten su er d isproportionately bu t this is
not illu strated throu gh the H DI . I n ad d ition, environm ental
concerns are not ad dressed . I t is possible or a cou ntry to have
a high H DI and be u nsu stain able, u nd em ocratic and u nequ al .
N ote that three new composite ind icators were introd u ced by
th e U N DP in 2 01 0 captu ring m u ltid im ensional inequ ality (the
inequ ality-ad ju sted H DI , known as th e I H DI ), gend er d isparities
(the gend er inequ ality ind ex) and extrem e d eprivation (the
m u ltid im ensional poverty ind ex).
The I H DI is a m easu re o hu man d evelopm ent that takes
into consid eration the extent o inequ ality in the cou ntry.
Und er perect equ ality the H DI and th e I H DI are equ al.
I nequ ality in the d istribu tion o health, ed u cation and
incom e lowers the H DI o an average person in a society
below the aggregate H DI o the cou ntry (based on the
U N DP H u man Developm ent Report, 2 01 0).
The gend er inequ ality ind ex attempts to reveal d ierences
in the d istribu tion o achievem ents between wom en and
m en in a cou ntry. Oten wom en and girls are d iscrim inated
against in health, ed u cation and in the labou r market,
which negatively aects their reed om s.
The m u ltid im ensional poverty ind ex replaces the hu man
poverty ind ex. I t complem ents m oney-based m easu res o
poverty by consid ering m u ltiple d eprivations and their
overlap. Low level o incom e is bu t one d im ension o the
poverty experienced by people in many cou ntries o the
world poverty extend s to other d im ensions su ch as poor
health and nu trition, low ed u cation and skills, inad equ ate
livelihood s, bad hou sing cond itions, social exclu sion and
lack o participation. The m u ltid im en sional poverty ind ex
shows th e nu m ber o people wh o are poor (su ering a
given nu m ber o d eprivations) and the nu m ber o
d eprivations with which poor hou sehold s typically stru ggle.
1 47
 4.3 The role of domestic factors in the process
of development
Domestic factors

Education and health Microcred it, on the other hand , ocu ses on making available
very small loans to the very poor, helping them to start a small
Labour productivity is dened as output per worker, or the
bu siness or expand an existing one or m eet an em ergency
quantity o goods and services a worker can produce per hour o
arising rom d isease, thet or bad weather. The pioneer o
work. It critically depends on the education, skills and training o
m icro nance is Banglad eshi econom ist Mu ham mad Yu nu s who
workers as well as on the type o capital they use in the
created the Gram een Bank several d ecad es ago. Yu nu s won the
production process. Growth in productivity is the key to long-term
N obel Peace prize or his eorts in 2 006. The N obel Com m ittee
growth which in turn is a prerequisite or developm ent.
ad opted the view that red u cing the gap between the rich and
I nvestm ents in hu man capital ormation are necessary to the poor is necessary to d ecrease conf ict in the world .
achieve higher labou r prod u ctivity, aster long-term growth and
Many m icro nance loans have been oered to wom en who
improved living stand ard s. Better health and ed u cation
have not only shown that th ey spend the m oney careu lly and
increase labou r prod u ctivity and allow ind ivid u als to have
prod u ctively bu t also that they are m ore likely to pay the loans
m ore, better and higher-paid employm ent opportu nities. Better
back. Lend ing m oney to wom en has helped them in their
ed u cation and health are also responsible or n u m erou s
empowerm ent. Their participation in su ch program m es gives
extern al bene ts (both are the m ost im portant exam ples o
them greater bargaining power and enables them to take part
m erit good s). Rem em ber too that achieving better health and
in am ily d ecision making while it also increases their m obility.
ed u cation are them selves d evelopm ent goals.
Micro nance has been consid ered to play a signi cant bu t
Appropriate technology rather lim ited role in the d evelopm ent process o nation s.
Microcred it has lately com e u nd er attack: m ost borrowers d o
Growth is necessary or any long-term progress in d evelopm ent
not appear to be clim bing ou t o poverty, and a sizable
bu t not all types o growth d o lead to d evelopm ent. The
m inority is getting trapped in a spiral o d ebt, accord ing to
technology employed d eterm ines whether any acceleration in
stu d ies and analysts ( New York Times , 2 01 1 ).
growth will translate into hu man d evelopm ent gains or not.
I n general, technologies can be d istingu ished into capital- Women and their empowerment
intensive or labou r-intensive. Capital-inten sive prod u ction
Policies that aim at improving gend er equ ity have been ou n d
processes rely m ostly on the u se o physical capital (on
to improve hu man d evelopm ent. N ot on ly will d eprived girls
machines) whereas labou r-intensive prod u ction processes rely
an d wom en bene t rom su ch policies bu t also the growth and
m ostly on the u se o labou r (on workers). Rem em ber that in
d evelopm ent process will accelerate: H u man d evelopm en t i
many prod u ction processes there is no choice: you cannot
not engend ered , is end angered .
constru ct a labou r-intensive oil re nery.
There are numerous routes through which this can be
Since in m ost d eveloping cou ntries labou r is the relatively
accomplished. Educating girls is considered one o the most
abu nd ant actor o prod u ction, it ollows that appropriate
signicant investments or a developing country as it results in
technologies are labou r-intensive. A labou r-intensive technology
even greater, gender-specic benets. An educated mother
translates to in creased employm ent and incom e generation or
will enjoy higher earning ability outside the home or each extra
the popu lation o the cou ntry and an exit rom poverty. On the
year o schooling. She will have ewer children so will create
other hand , capital-intensive technologies lead to what is
conditions or capital deepening (which means more capital will
reerred to as jobless growth, which is a type o growth that
be available per worker), resulting in even higher long-term
d oes not lead to improved living stand ard s.
productivity and output gains. H er children will be healthier and
she will make sure that her children are also educated, creating a
Credit and microcredit virtuous circle. Educating women decreases mortality in children
The im portance o cred it and m icrocred it institu tions lies in the younger than ve years old, decreasing the costs o health-care
simple act that typically, i you cannot borrow, you cannot intervention.
make any investm ent in physical, natu ral or hu man capital. I t
Lastly, better and m ore ed u cated wom en can lead to higher
ollows that a u n ctional cred it system is vital in breaking the
wom ens participation in the labou r orce as well as in politics,
poverty cycle explained earlier.
allowing them to inf u ence policy.
Cred i t i n sti tu ti on s i n d u ce peopl e to save, a s th ey oer n ot
on l y sa ety or wh atever i n com e peopl e d o n ot spen d bu t
a l so a ra te o retu rn . Ba n ks a l l ow peopl e to borrow m on ey
th a t ca n be u sed to i n crea se th ei r h u m a n ca pi ta l or to sta rt a
sm a l l bu si n ess, wh i ch m ay en a bl e th em to brea k th e poverty
cycl e. U n ortu n a tel y, a u n cti on a l cred i t system i s n ot en ou g h
a s very oten i t i s a l so th e a bsen ce o wel l-d e n ed property
ri g h ts th at preven ts poor peopl e rom borrowi n g rom
com m erci a l ba n ks.

1 48

The distribution of income
H igh and risin g incom e in equ ality is consid ered a major barrier
to econom ic d evelopm ent. I t ollows that policies aim ing at
red u cing incom e inequ ality and making growth inclu sive will
encou rage d evelopm ent. Poverty red u ction d epend s not only on
incom e growth bu t also on how incom e is d istribu ted : poverty is
red u ced and d evelopm ent is ach ieved i there is growth
accompanied by narrowing incom e inequ ality.
A m ore equ itable d istribu tion o incom e will make it easier to
reach consensu s am ong d ierent popu lation grou ps. This is a
necessary cond ition or a governm ent to be willing and able to
u nd ertake su ccessu lly the requ ired institu tional and econ om ic
reorm s that accelerate growth. Lower incom e inequ ality
d ecreases the prevalen ce o corru ption in a cou ntry and
4 Development economics
corru ption is consid ered a major obstacle to the d evelopm ent
process as it increases the costs o d oing bu siness an d it
d istorts ef ciency. Tru st between econom ic agents increases,
also d ecreasing the cost and increasing the likelihood o d oing
bu siness, another necessary con d ition or growth to accelerate.
A m ore equ itable d istribu tion o incom e will d ecrease the
nu m ber o the very poor so that m ore people will have access
to ed u cation and health resou rces and so becom e m ore
prod u ctive m em bers o society. The probability o civil u n rest
will be lower, d ecreasing the risks or investors and lead ing to
m ore d om estic an d oreign in vestm ent spend ing in the cou ntry.
Lower incom e inequ ality may accelerate savings and resu lt in
m ore investm ent and greater d emand or locally prod u ced
good s and services, which may increase incom e and u rther
d ecrease inequ ality.
1 49
 4.4 The role of international trade
trade-relaed barriers
Barriers to primary export-led growth
Overspecialization on a narrow range o primary exports cannot
eectively lead the way to econom ic d evelopm ent. H ere are
som e o the reason s or this.
Demand or m ost primary exports is incom e inelastic and, as
a result, markets or such products in high-incom e countries
do not grow ast enough to help accelerate growth.
HL The term s o trade o cou ntries exporting primary
products will deteriorate in the long run. They will
need to export a greater volu m e o primary
exports to be able to import one u nit o
manuacturing goods. H owever, this will only lead
to a urther decrease in the price o these primary
products as m ost o these markets are competitive.
Export earnin gs may exhibit signi cant year-to-
year f u ctu ations as prices o arm prod u cts are
aected by the weather an d other rand om
actors. This may m ean that d om estic aggregate
d eman d becom es u nstable and investm en t
spend ing is m ore risky.
Primary exports may be dom inated by a ew
m ultinationals and m iddlem en so that linkages
with the rest o the economy may prove ineective.
trade-relaed sraegies for growh and developmen
The strategy of protection: import-substitution
industrialization (ISI)
I n the 1 95 0s it was thou ght that the problem o d evelopm ent
was a stru ctu ral problem in that d eveloping cou ntries relied
too heavily on the primary sector and d id not have a
manu actu ring sector. The creation o an ind u strial base to
su bstitu te d om estically prod u ced manu actu red good s or
imports becam e known as I SI . The good s targeted were
non-d u rable manu actu red good s (or example textiles) that
were simple to prod u ce and were or d om estic consu mption.
Trad e barriers were erected to protect the newly established
d om estic rm s. These barriers wou ld stay in place u ntil the
rm s grew su ciently in size and acqu ired the necessary
know-how to lower average costs. Trad e barriers were red u ced
when the rm s were able to compete with imports and su rvive
within the d om estic markets.
Typically, the exchange rate was kept overvalu ed so that prices
o necessary im ported materials and interm ed iate prod u cts
(machines and other manu actu red inpu ts) u sed by the in ant
ind u stries were arti cially low.
Several problem s a re a ssociated with a n in wa rd -orien ted
strategy. Sin ce th e d om estic in d u stry had its own ca ptive
ma rket to sell its prod u cts, it n ever ha d th e in cen tive to
becom e e cien t. Th e price a n d cost d isciplin es that
1 50
Prices received or many primary prod u cts have d ecreased
throu gh tim e. For exam ple, technology and an increase in
the nu m ber o coee-prod u cing cou ntries have pu shed
d own the world price or coee.
Agricu ltu ral exports have to ace the trad e protection that
ad vanced econom ies (the U SA, the Eu ropean U nion an d
Japan) grant their arm ers in the orm o su bsid ies. The
resu lting inability to access these markets is a m ore general
barrier d eveloping cou ntries ace. This statem ent d oes not
ind iscrim inately apply to all d eveloping cou ntries, thou gh,
as many alsely believe. I t mainly applies to the so called
Cairns Grou p o d eveloping cou ntries, which inclu d es
Argentina, Brazil, Chile, Colom bia, Costa Rica, I nd onesia,
M alaysia, Philippin es, Sou th Arica, Thailand and U ru gu ay
which are m ostly m id d le-incom e cou ntries with a strong
comparative ad vantage in agricu ltu re. I t ollows that th e
main bene ciaries o liberalizing trad e in agricu ltu re wou ld
be this grou p o cou ntries. The least d eveloped cou ntries as
d e ned by the U N (which inclu d e all cou ntries in Su b-
Saharan Arica; Aghanistan, Banglad esh, Bhu tan,
Cam bod ia, Lao, Mald ives an d N epal in Asia; and H aiti in
Cen tral Am erica) will actu ally be hu rt by this liberalization,
the main reason or th is being that m ost o these cou ntries
are net ood importers and elim ination o agricu ltu ral
su bsid ies will translate into higher ood prices or them .
com petition im poses on rm s were totally absen t. I n
som e ca ses, low-qu a lity, h ig h -cost a n d h ig h -priced g ood s
were prod u ced .
The overvalu ed exchange rate acted as a tax on trad itional
primary exports as arm ers earned less d om estic cu rrency or
each d ollar o primary exports. Poverty or larg e segm ents o
the popu lation thereore in creased . I n som e d eveloping
cou ntries the I SI strategy created a privileged lite which
becam e m ore and m ore poweru l as the ind u strial sector grew.
I n many cases, the protective trad e barriers were never
elim inated . I n ad d ition, the newly established ind u stries were
oten capital-intensive, employing inappropriate technologies
which led to jobless growth as m inimal employm ent
opportu nities were created . Rem em ber that jobless growth is a
type o growth to avoid as d evelopm ent d oes not ollow.
Export promotion: outward-oriented strategies
I n som e East Asian cou ntries, inclu d ing those known as the
ou r East Asian Tigers (Korea, Taiwan, H ong Kong and
Singapore), the stru ctu ral change that the I SI strategy
represented was ollowed by an attempt to export the simple,
non-d u rable, manu actu red good s these cou ntries had been
prod u cing or their d om estic market. These, and later other
d eveloping cou ntries, ad opted an ou tward orientation.

I n this process, the role o the state varied am ong cou ntries bu t,
in all o them , it played a signi cant, com plem entary role. I t
provid ed gu id ance and assistance to the private rm s bu t only
i they achieved speci c perormance stand ard s typically
associated with export targets. These rm s were orced to
prod u ce low-price, high-qu ality good s in ord er to continu e to
enjoy any state su bsid ies or cheaper loan s rom banks.
Export prom otion is not su cient to prom ote d evelopm ent and
to ensu re the su stainability o the process. The state in these
cou ntries invested heavily in ed u cation, slowly creating a m ore
prod u ctive labou r orce with higher skills. The state also
ensu red that th e ru its o econom ic growth were enjoyed by all.
This m eant that these cou ntries avoid ed the costs associated
with rising incom e inequ ality.
The rst Asian cou ntry to initiate su ch an approach to the
growth and d evelopm ent problem was Japan. I t was ollowed
by the ou r East Asian Tig ers (and other cou ntries, su ch as
Malaysia, I n d onesia, Thailand and Vietnam , have been ad d ed
to th is list). China and I nd ia are th e cu rrent stars o the export-
or ou tward -oriented strategy.
Advantages of outward-oriented strategies
Focu sing initially on the prod u ction and export o simple,
manu actu red non-d u rable good s changed the stru ctu re
o these econom ies. Employm en t opportu nities increased
or the ru ral m igrants, as th ese ind u stries were m ostly
labou r -intensive.
The export revenu es earned alleviated problem s with the
balance o paym ents as they were u sed to nance the
importation o necessary interm ed iate and capital good s.
There was less d anger o the economy ru n ning into oreign
exchange and oreign d ebt problem s. Rising export
reven u es also increase aggregate d emand (AD), so they can
u el growth in ou tpu t and incom es.
Focu sing on the larger export markets orced rm s to grow
in size and acqu ire econom ies o scale (EOS). This is
especially important or small cou ntries.
Firm s were orced to learn m ore abou t manu actu ring their
prod u cts m ore e ciently. I nternational competition
provid ed the stim u lu s. The state also invited technical
assistance rom abroad bu t it u su ally lim ited contracts so
that they lasted no m ore than three years, orcing d om estic
rm s to learn the necessary technology. Operating
su ccessu lly in world markets enabled rm s to acqu ire the
marketing, nancial, managerial and , m ost importantly,
entrepreneu rial skills. Exposu re to world competition
allowed a local entrepreneu rial class to evolve and matu re.
Throu gh varying d egrees o state gu id ance these econom ies
slowly shited their comparative ad vantage and prod u ction
to m ore sophisticated and com plex manu actu red prod u cts
and later to knowled ge-based an d technology-intensive
prod u cts. Their econ om ies thereore d iversi ed and were
m ore insu lated rom ind u stry-speci c risks.
Possible disadvantages of outward-oriented growth
Since the growth process is driven by exports, it d epend s on
how ast the ad vanced econom ies are growing. I th eir
incom es are rising ast then they will be absorbing m ore
4 Development economics
im ports which are the exports o the d eveloping cou ntries.
A d eep recession in the U SA or in Eu rope, thou gh, will be
costly as it will slow d own the process, especially i
d om estic d emand is weak an d the governm ent is not in a
position to ad opt expansionary scal policy. I n response to
the 2 008 global crisis China was able to ad opt a hu ge
scal stim u lu s program m e, bu t not all cou ntries were able
to d o the sam e.
Ou tward -oriented growth m u st su ccessu lly overcom e the
barriers created by trad e protection in d eveloped cou ntries.
Outward-oriented strategies may lead to worsening incom e
distribution as the rural sector may be let behind. A larger
share o national incom e will accru e to those involved in the
export sector. It ollows that only i there are redistributive
policies in place will d evelopm ent ensue (u sing the term
redistributive policies in its broad sense here that is,
including spend ing on better health and education).
The drive to produ ce cheaply or export markets may lead
policy makers to ignore the costs o environm en tal
d egrad ation. This is very evid ent in China where export-
driven growth is seriou sly d amaging the natu ral resou rce
base o the cou ntry and generating major environm ental
costs, u nd erm ining the su stainability o the cou ntrys
long-term growth and d evelopm ent prospects.
Achieving outward-oriented growth orces policy makers to
keep the exchange rate articially undervalued to provide an
extra competitive edge to their exports, risking not only rising
protectionist sentim ent abroad but also infation at hom e.
Focu sing on ou tward -oriented growth may lead policy
makers to postpone the creation o a social saety net that
wou ld inclu d e state pensions and health insu rance, as the
growth process d oes not rely on the ability o the
popu lation to spend on d om estic good s and services.
Preferential trading agreements
Regional integration am ong d eveloping cou ntries is oten
reerred to as sou thsou th in tegration. Originally, in the 1 960s
and 1 970s, d eveloping cou ntries had attempted to create a
nu m ber o preerential trad ing agreem ents as a way o red u cing
the cost o I SI throu gh opening their markets to other
d eveloping cou ntries. A bloc wou ld increase the size o the
potential market or each exporting rm and so it wou ld lead
to EOS. Any complem entarities in prod u ction wou ld also help
red u ce costs and allow specialization. The regional agreem ents
since the 1 990s are reerred to as new regionalism and are
part o a broad er trad e liberalization schem e where export
prom otion is eatu red as the growth and d evelopm ent strategy
o choice.
Exam ples o preerential trad ing agreem ents am ong d eveloping
cou ntries inclu d e the Latin Am erica Free Trad e Association
(LAFTA), orm ed in 1 961 ; MERCOSU R, a cu stom s u nion am ong
Argentina, Brazil, U ru gu ay, and Paragu ay orm ed in 1 991 ; the
Asia-Paci c Econ om ic Cooperation (APEC), a grou p o 21
nations that bord er the Paci c Ocean, established in 1 989 and
prom oting reer trad e and cooperation am ong its m em bers; the
Econom ic Com m u nity o Central Arican States (ECCAS),
established in 1 983 and inclu d in g Bu ru nd i, Cam eroon, Central
1 51
 4 Development economics
Arican Repu blic , Chad , Congo, Equ atorial Gu inea, Gabon ,
Rwand a, So Tom and Prin cipe; and the Econom ic Com m u nity
o West Arican States (ECOWAS), established in 1 975 , with 1 6
m em ber cou ntries.
Possible benef ts o increased regional cooperation am ong
d eveloping cou ntries inclu d e:
increased trad e creation as a resu lt o the resu lting
expand ed market
the possibility o EOS that may lead to m ore exports ou tsid e
the bloc
greater political and bargaining power in negotiations with
d eveloped econom ies
a d ecreased level o d epend ence on d eveloping cou ntries
markets.
1 52
H ere are som e reasons many attempts at regional cooperation
am on g d eveloping cou ntries have ailed or have resu lted in
lim ited su ccess.
The stru ctu re o prod u ction and o trad e in d eveloping
cou ntries lacks a su f cient complem entary natu re. The
sim ilarity o their econom ies has resu lted in m ore trad e
d iversion than trad e creation.
M any attem pts have encou ntered sign if cant organizational
and ad m inistrative problem s.
Political rivalry both between and within cou ntries and lack
o com m itm ent have also prevented progress.
Transaction costs are oten high d u e to the high share o
raw materials and non-d u rables in these cou ntries m u tu al
trad e. There are high tran sport costs, especially since
inrastru ctu re is poor (or example, th ere are ew road s).
 The role of foreign direct investment
4.5 and the multinational corporation
Foreign direct investment (FDI)
FDI is long-term investm ent where a rm based in one cou ntry
establishes a presence in another cou ntry. I t may either reer to
investm ent in new acilities (d e novo or green eld
investm ent) or it may reer to acqu iring controlling percentage
o the shares o existing local companies. The key characteristic
o FDI is that the investor has control o the acqu ired asset.
FDI lead s to the creation o m u ltinational corporation s.
A m u ltinational corporation is a rm which has established ,
throu gh FDI , prod u ction or other operations in m ore than
one cou ntry.
Why do multinational corporations invest
in developing countries?
The obviou s reason or corporations to expand into other
cou ntries is that by d oing so they are able to increase their
sales and /or d ecrease their costs so that they increase their
pro ts.
M ost FDI f ows into d eveloped cou ntries (abou t 70% o the
total in 2 009) and m ost o it f ows ou t o d eveloped cou ntries
(abou t 88% in 2 009). Flows into d eveloping cou ntries have
been alm ost stead ily increasin g thou gh. Som e o the m ost
important explanations or the expansion o a m u ltinational
corporation into d eveloping cou ntries are listed below.
Th e m u ltinational corporation is involved in extraction o
natu ral resou rces su ch as oil, copper or bau xite, which m u st
be d one at location.
I t is attem pting to lower its prod u ction costs. For example,
or many prod u ction processes (especially stand ard ized
ones) labou r costs are oten lower in d eveloping cou ntries
than the m u ltinational corporations hom e cou ntry.
Th e m u ltinational corporation is attem pting to bene t rom
slacker regu latory ram eworks.
M u lti n ation a l corporati on s d o n ot expa n d in d i scri m in ately
i n to d evelopi n g cou n tri es. A d eta il ed exam i n ati on o a n n u a l
FDI i n f ows revea l s that som e d evelopi n g cou n tri es recei ve a r
m ore FDI tha n oth ers. Ch in a , Bra zi l a n d M exi co attra ct th e
m aj ori ty.
So, why d o som e d evel opi n g cou n tri es attra ct m u ch m ore FDI
tha n oth ers? What a ctors a ct a s pu ll a ctors i n to a speci c
d evel opi n g cou n try? Th e ol lowin g li st h el ps to a n swer th ese
qu esti on s. N ote that som e o th ese a ctors m ay a l so expla i n
why com pa n ies expa n d a n d becom e m u lti n ation a l. Th e
a ctors a re:
stable macroeconom ic environm ent
stable political environm ent
pu blic policy, inclu d in g tax treatm ent and ease
o pro t repatriation
weak regu latory system s
en vironm ental laws, regu lations and their enorcem ent
clearly d e n ed property rights and a secu re legal ram ework
extent and power o labou r u nions
high levels o hu man capital and labou r prod u ctivity
low labou r costs (low wages cou pled with high labou r
prod u ctivity)
qu ality o physical inrastru ctu re (or example road s and
ports) and inormational inrastru ctu re
proxim ity to a major and growing market area with high
and or growing levels o incom e
m em bership in wid er ree trad e areas or trad ing blocs;
avoid ance o taris
natu ral resou rce end owm ents (and their geographical
d istribu tion) inclu d ing climate
cu ltu ral sim ilarities.
Does the presence of multinational
corporations accelerate growth
and development?
Arguments in support of multinational corporations
FDI can be seen as a way o llin g in gaps between:
the target level o investm ent spend ing in a cou ntry and
the actu al level o investm ents that d om estic savings can
nance
the target level o oreign exchange and the actu al level
d erived rom net export earnings, oreign aid and private
rem ittances not only will the inf ow o private oreign
capital partly nance a cu rrent accou nt d e cit bu t i the
oreign-owned enterprise generates a f ow o export
earnings it can also help over tim e
the target tax revenu es requ ired to nance projects aim ed
at growth and d evelopm ent and the actu al revenu es
collected .
I n add ition, m u ltinational corporations may:
create greater levels o employm ent, provid ing job
opportu nities to the local popu lation
provid e training and skill creation to the local workorce
help by provid ing access to managem ent and
organizational skills
prove to be a vehicle or aster transer and d iu sion o
technology.
Arguments against m ultinational corporations
M u ltinational corporations may hu rt d om estic rm s by
elim inating competition and by im porting interm ed iate
prod u cts rom overseas a liates instead o bu yin g these
rom d om estic su ppliers
Repatriation o pro ts, paym ent o royalties an d
importation o interm ed iate good s may lead to problem s
with the balance o paym ents as m ore oreign exchange
f ows ou t o the cou ntry.
The tax contribu tion o m u ltinational corporations may be
consid erably less than it shou ld be as a resu lt o tax
concessions, investm ent allowances and transer pricing
(which arti cially red u ces their incom e).
1 53
 4 Development economics
The technology employed may be inappropriate i it is
capital intensive and employm ent positions may not be
generated.
The skills o the local workorce may not improve i workers
are u sed to ll on ly the low-skill positions and no training is
provid ed .
M u ltinational corporations may generate d om estic incom es
or higher incom e grou ps with a high propensity to bu y
imports and a low propensity to save d om estically.
They may worsen the im balance between ru ral and u rban
opportu nities and contribu te to m ore u nequ al incom e
d istribu tion .
They may u se their econom ic power to inf u ence
governm ent policies in d irections u navou rable to the
d evelopm ent process.
1 54
Overall
The net eects on growth are u nam bigu ou s, at least in the
short ru n, bu t the eects on the long-ru n d evelopm ent
prospects o the host cou ntry are not.
The conditions and stipulations o the contracts signed,
as well as the ability o the dom estic governm ent to
enorce these and to regulate the behaviour o m ultinational
corporations, are critical in determ ining whether the
long-run eect on the host country will be positive
or negative.
I n cou ntries where the state ensu red that the m u ltinational
corporations mad e a d irect contribu tion to its goals and
that their activities were complem en tary and not at the
expense o d om estic prod u ction processes, the d evelopm ent
process was accelerated .
 The roles of foreign aid and multilateral
4.6 development assistance
Foreign aid
Foreign aid is the ou rth major sou rce o oreign exchange or
the d eveloping world , behind export earnings, investm ent
inf ows and m igrants rem ittances. Foreign aid inclu d es any
f ow o capital to d eveloping cou ntries which is granted on
concessionary term s and is non-com m ercial rom the point o
view o the d onor. Foreign aid inclu d es both ou tright grants
(where no repaym ent is expected ) and loans, as long as the
interest rate charged on these loans is lower than that charged
on com m ercial loans and the repaym ent period is longer. Su ch
long -term loans are reerred to as concessional loans and
inclu d e a 2 5 % grant elem ent.
Aid granted by governm ents (public aid) is also reerred to as
ocial developm ent assistance (ODA). Aid, especially
humanitarian aid (which consists o ood aid, m edical relie and
em ergency relie aid), can also be extended by non-governm ental
organizations (N GOs). It is typically small (but growing) in scale.
Types of aid
Aid can be classi ed in many ways. I t can be bilateral or
m u ltilateral. Aid is:
Some aid-related facts
The total annu al f ow o aid in 2 01 1 am ou nts to 0.31 % o
d onors GN I . This is d own rom 0.3 4% in 1 990 and
signi cantly lower than the 0.7 % target which was rst set
in 1 970 and has been repeated ly re-end orsed .
I n 2 01 0 the largest d onors by volu m e were the U SA, the
U K, France, Germany an d Japan. Denmark, Lu xem bou rg,
the N etherland s, N orway and Swed en continu ed to exceed
the U N s ODA target o 0.7 % o GN I .
The largest rich cou ntries give less per person than smaller
cou ntries.
Only six d eveloped cou ntries (I reland , Lu xem bu rg, the
N etherland s, Swed en, N orway and the U K) provid ed nearly
1 00% u ntied aid . (Tying aid is consid ered to lim it the
eectiveness o aid .)
I n 2 008 total o cial aid f ows rom OECD cou ntries
(inclu d ing d ebt relie) reached a record high o $ 1 2 8.7
billion (OECD d ata) while since 1 95 0 it has totalled $ 2 .3
trillion 2 006 d ollars (Easterly and Pgu tze, 2 008).
M ost aid goes to those who need it least; the rich er 40% o
the d eveloping world s people get twice as m u ch aid per
person than the poorer 40%.
Accord ing to the U N DP, d evelopm ent aid is inad equ ate in
am ou nt and oten inappropriate in orm .
Evaluating the impact of aid on development
The debate on the role o aid in the development process is highly
polarized. Jerey Sachs, UN adviser and director o Columbia
Universitys Earth Institute, argues that massive inusions o aid are
needed to break the poverty cycle and considers aid a powerul
determinant o long-term growth. Poor countries are poor because
bilateral when the f ow is rom one ad vanced economy to a
poorer nation
m u ltilateral when it f ows to the d eveloping nation throu gh
an international lend ing agency and organization su ch as
the U N , the World Ban k or the I MF.
Aid is also d istingu ished into:
tied aid, when the u nds m ust be used to buy imports rom
the donor country or m ust be linked to a specic project (or
example the donor may build a highway and be paid in oil
or iron ore which orm the inrastructure or com m odities)
project aid , with the u nd s u sed to nance the constru ction
o a particu lar project (or example a d am , a road or a
hospital) typically project aid u nd s d evelopm ent o
econom ic inrastru ctu re and environ m ental im provem ent
program m e loans, in which case the u nd ing is d epend ent
on the recipient ollowing speci c ad vice and ad hering to
speci c cond itions (cond itional or stru ctu ral ad ju stm ent
len d ing) an d /or a loan is given to u nd speci c
program m es, in health or ed u cation or example.
they are hot, inertile, inested with malaria and oten landlocked,
making it hard to increase productivity without help to deal with
such endemic problems. N either ree markets nor democracy, in
Sachs opinion, will do very much or them.
On the other side o the debate, William Easterly, co-d irector o
the Developm ent Research Institute and Proessor o Econom ics
at N ew York University, argues that aid does m ore harm than
good. It is oten wasted instead o being spent productively. It
may prevent people rom devising their own solutions to the
speci c problem s they ace. Aid oten corrupts or is granted to
corrupt autocrats and underm ines local institu tions. I t is
typically ragm ented am ong too many donor countries and is
thinly spread over too many sectors with a lot o overlapping
and conusion.
Som e aid program m es help m ore than others. I t is not easy to
d eterm ine which ones prom ote d evelopm ent goals and which
ones u nd erm ine them . One recent approach ad opted by J-PAL
(Poverty Action Lab) at Massachu setts I nstitu te o Technology
(M IT), u nd er the d irection o Esther Du f o an d Abhijit Banerjee,
is to try to nd ou t by u sing rand om ized control trials, ju st as
the eectiven ess o a dru g is evalu ated in m ed icine.
The ollowing points provid e a platorm or d iscu ssing the
eectiveness o aid .
Effectiveness of aid
Aid can be eective:
when it is narrowly targeted to speci c pro-d evelopm ent
projects and objectives
when it is not tied to bu ying prod u cts rom d onor cou n tries
m ost importantly, when it is reinorced by appropriate
d om estic policies and institu tions in a non-corru pt
governm ent environm ent.
1 55
 4 Development economics
Aid can be ineective:
when it is given to cou ntries with corru pt governm ents
when it ind u ces cou ntries to postpone improvem ents o
macroeconom ic cond itions
when it replaces d om estic saving s and trad e f ows as
vehicles or d evelopm ent
Motives for offering aid
There are three main m otives or provid ing aid to d eveloping
cou ntries.
H u ma n ita rian m otives a re th e m oral or eth ica l reason s or
provid in g a id . Th e U S respon se to th e 2 01 0 H a itia n
earth qu ake is a n exam ple o em erg en cy assista n ce, with
aid to H a iti risin g in that yea r by 2 41 % to U S $ 1 .1 billion .
Political m otives or strategic reasons may exist, in that aid
has been u sed in an eort to bu ild closer political an d
strategic relations with other cou ntries. H u ge am ou nts o
d evelopm ent loan s have been provid ed by several
d eveloped d onor cou ntries to secu re riend ly relationships.
Donor cou n tries have also u sed aid program m es as a
bargaining chip or international negotiations. Aid
sanction s are u sed as a d iplomatic instru m en t to prod u ce a
d esirable policy shit in the aid s recipient.
Economic m otives, such as to develop markets and dispose o
surpluses, may exist. Aid has oten been directed to prom ote
a countrys exports o manuactured goods and imports o
raw materials. Aid program m es oten tied loans or grants to
the purchase o the donor countrys exports so that the
country could expand its export market. Aid can be granted
(usually as tied aid) to cover the need to import industrial
raw materials, oodstus and other primary com m odities.
Chinas post-2 000 astonishing growth o aid in Sub-Saharan
Arica and elsewhere is considered to be driven by such a
m otive. Deals are oten quasi-barter. For example, donor
construction and engineering companies might design and
build inrastructure acilities in a developing country and ask
the recipient to repay in com m odity term s, say in oil or iron
ore (this would be a case o tied project aid).
1 56
when it is given on the basis o strategic and political
consid erations
when the technologies transerred and the ad vice given are
inappropriate.
Aid and NGOs
The term N GOs u su ally d escribes an array o grou ps and
organizations which pu rsu e som e kind o pu blic interest or
pu blic good and aim at provid ing services to the pu blic,
d irectly or ind irectly. Oxam , Friend s o the Earth and WWF
are well-known N GOs bu t there are very many other smaller,
grassroots organizations that serve sim ilar pu rposes.
N GOs have had an increasing signi cance in eorts toward
su stainable d evelopm ent at the international level.
They try to aect inter-governm ental negotiations that
range rom the regu lation o hazard ou s wastes and a global
ban on land m ines to increasing access to AI DS dru gs or
aected people in d eveloping cou n tries.
M any N GOs work closely with the people they wish to help,
which increases their eectiveness.
N GOs have oten exposed the social and environmental
externalities that the practices o many multinational
corporations result in. Many act as watchdogs o
multinational corporations. Labour, environmental and human
rights records are scrutinized and activists have in many
instances orced change upon multinational corporations.
Bu sinesses have been orced to care abou t the eects o
their activities and not ju st the eects on their share price
bu t also on workers, com m u nities and th e world at large.
M any companies n ow allocate signi cant resou rces to
environm ental and social aairs.
4.7 The role o oreign debt
Foreign or external d ebt is u su ally d e ned as d ebt owed to non-resid ents o a cou ntry. I t is
the total am ou nt o m oney that a cou ntry owes to oreign entities which is repaid in oreign
exchange. Foreign entities inclu d e oreign governm ents, com m ercial banks and m u ltilateral
institu tions.
The frst debt crisis
I n the m id -and late -1 970s many non-oil d eveloping cou ntries
began accu m u lating large trad e d e cits. On the other han d ,
oil-exporting cou ntries were accu m u lating hu ge cu rrent accou nt
su rplu ses and were d epositin g in the banks o ad vanced
econom ies the oil export earn ings they cou ld not spend . The
banks then lent this m oney to the d eveloping cou n tries which
had problem s with their balance o paym ents. As a resu lt, these
cou ntries began to accu m u late hu ge oreign d ebts.
I n 1 982 Mexico annou n ced that it was not able to service its
d ebt. M exico was not alone. Du e to th e actors listed below, 1 5
Latin-Am erican nations and som e Su b-Saharan Arican
cou ntries were orced to requ est em ergency aid rom the I M F.
Causes o the frst debt crisis
World interest rates increased as a resu lt o the extrem ely
tigh t m onetary policy ad opted by the U S Fed eral Reserve
Bank to ght o inf ation . As a resu lt, interest paym ents on
existing loans (the ou tstand ing d ebt) o these cou ntries
increased an d new borrowing becam e m ore expensive.
As a resu lt o the higher interest rates, the U SA ell into
recession, dragging other cou ntries with it. World d emand
or the primary exports o these d eveloping cou ntries
thereore d ecreased , lowering th eir prices, their volu m es
and , consequ ently, the export earnings o these cou n tries.
Th e higher U S interest rates led to an appreciation o the
U S d ollar and so to an increase in the real valu e o the
d ebt, as som e o the export earnings o these cou ntries
were in other hard cu rrencies.
Worse still, the u nd s that had been borrowed by many
govern m ents o d eveloping cou n tries were oten u sed
wasteu lly so that th e prod u ctive capacity o these
econom ies was not enhanced .
The d ebt crisis inf icted trem end ou s pain on the people o the
d eveloping cou ntries and led the I M F and the World Bank to
assum e a new role. Cond itional lend ing program m es were
initiated , with recipient cou ntries agreeing to implem ent
stru ctu ral ad ju stm ent policies. There now seem s to be a
consensu s that these policies u su ally d id not ad vance the
d evelopm ent cau se.
Costs o high levels o indebtedness
H igh levels o oreign d ebt still bu rd en many d eveloping
cou ntries. H igh levels o ind ebted ness hold back the
d evelopm ent process in many ways.
Since oreign exchange earnings are drained to service the
d ebt, paying or n ecessary imports o capital good s and
ood prod u cts becom es m ore d i cu lt.
The state is d eprived o u nd s to spend on necessary
inrastru ctu re.
The state is d eprived o u nd s to spend on health care and
ed u cation. I n many Su b-Saharan cou ntries the am ou nt
spent to service d ebt exceed s the am ou nt spent on primary
ed u cation and primary health care com bined .
Debt overhang ad versely aects d om estic and oreign
investm ent as investors ear h igher taxes and the econom ic
instability o these econom ies.
N ecessary reorm s are m ore d i cu lt or the governm ent to
initiate. The econom ic problem s associated with d ebt
servicing complicate attem pts to reach consensu s within
the popu lation.
The H eavily Indebted Countries Initiative (H IPC)
For the poorest an d m ost ind ebted cou ntries, the accu m u lated
d ebt bu rd en obstru cts any possibility or d evelopm ent. Debt
becom es u nsu stainable i it exceed s the capacity o the cou ntry
to service it. Viewed in this way, d ebt relie (that is, d ebt
red uction) becom es necessary. This is why the H I PC and
M u ltilateral Debt Relie I nitiative (M DRI ) were d esigned and
lau nched in 1 996 and 2 006 respectively.
The goal o the H I PC was to ensu re d eep, broad and ast d ebt
relie and thereby contribu te toward growth, poverty red u ction,
and d ebt su stainability in the poorest, m ost heavily ind ebted
cou ntries. The goal o the MDRI was to provid e ad d itional
su pport to H I PCs to reach the M DGs.
I n 2 01 0, or the 36 heavily ind ebted cou ntries that have
ben e ted rom relie, the ratio o the present valu e o their d ebt
to their exports d eclined rom 457 % to 78%, the present valu e
o debt to GDP ratio d ecreased rom 1 1 4% to 1 9% and the
d ebt service to exports ratio d ecreased rom 1 8% to 3 %.
1 57
 The balance between markets
4.8 and intervention
Development as a separate sub-discipline o economics did not exist beore the 1 950s. Beore
that little attention was paid to poor countries. The League o Nations 1 938 World Economic
Su rvey inclu d ed one paragraph on Sou th Am erica. This was a m ore complete coverage than
poor countries in Arica or Asia had, since there was no reerence to them at all. The
industrialization o the Soviet Union (through planning, orced saving and investment)
changed all this.

The role of the state and of the market
The role o the state in the d evelopm ent process resem bles a
pend u lu m . I t shited rom the heavy-hand ed intervention in the
1 95 0s and 1 960s when the problem o d evelopm ent requ ired
state planning and was red u ced to the solu tion o a system o
equ ations. I t swu ng all the way to the grad u al d im inu tion o
the role o the state in the 1 970s and 1 980s, when markets
were conerred a central role (or example with privatization
and trad e liberalization) with increased attention paid to
getting the u n d am entals right (achieving, or exam ple, low
bu d get d e cits and low inf ation).
A growing consensu s is now being orm ed which consid ers the
role o th e state and o the market complem entary. As the ocu s
has been shiting toward s hu man d evelopm ent any policy,
wheth er macroeconom ic or m icroecon om ic in natu re, has to be
ju d ged with respect to its eect on the least privileged
seg m ents o society.
M arkets and prices are important or these reasons.
On the other hand , an eective state is requ ired to achieve
d evelopm ent or these reasons.
I n rastru ctu re, which is necessary or growth and
d evelopm ent, is a pu blic good in the sense that the private
sector will not provid e it.
An appropriate institu tional environm ent is necessary or
markets to operate. At the very least the state has to protect
property rights and gu arantee the ru le o law.
Basic ed u cation and health care create very signi cant
positive externalities and wou ld be u nd erprovid ed i let to
the market.
The market cannot gu arantee an equ itable d istribu tion o
incom e between ind ivid u als, grou ps, regions or tim e.
The market cannot gu arantee eective protection o the
environm ent.
I t is necessary to create a stable macroeconom ic
environm ent or econom ic activity to grow.

They provid e signals or the allocation o resou rces. Markets and the state shou ld be partners in the process o
They create incentives. growth and d evelopm ent. The private sector shou ld provid e the
necessary vigou r and the state the ram ework within which
They perm it choice.
econom ic activity can take place, rectiying market ailu res and
Pro t-oriented entrepreneu rs can spot opportu nities and au gmenting the resou rces available.
u se resou rces e ciently.
Competition lead s to lower prices and better qu ality and
orces rm s to innovate.

1 58
 4 Development economics: Questions
variations on the foowing may be asked in questions (b) and (c)
of Hl/Sl paer 2
1 . Distingu ish between econ om ic growth and econom ic
d evelopm ent explaining that d evelopm en t is broad er
than growth.
2 . Explain actors that may assist accelerating the growth
process o an economy.
3. Explain why growth is typically a necessary bu t not a
su cient cond ition or a cou ntry to d evelop.
4. Su g gest two characteristics that many d eveloping
cou ntries share.
5. Explain the m eaning o the term poverty trap
(or, poverty cycle).
6. Ou tline the cu rrent statu s o the Millenniu m
Developm ent Goals.
7. Explain the d ieren ce between GN I and GDP as well as
between GDP (or, GN I ) g u res and GDP (or, GN I ) at
PPP d ollars.
8. Explain the components o the H DI and why the later is
a better ind icator o d evelopm ent than per capita
incom e levels.
9. Explain how (i) overspecialization, (ii) price volatility o
com m od ities and (iii) inability to access international
markets may obstru ct the process o growth and
d evelopm ent.
variations on the foowing may be asked in art (d) of Hl/Sl paer 2
1 . Com pare and contrast the GDP per capita gu res an d the
GN I per capita gu res or econom ically m ore d eveloped
cou ntries an d econom ically less d eveloped cou ntries.
2 . Com pare and contrast two health ind icators or
econom ically m ore d eveloped cou ntries and econom ically
less d eveloped cou ntries.
3. Com pare and contrast two ed u cation ind icators or
econom ically m ore d eveloped cou ntries and econom ically
less d eveloped cou ntries.
4. Com pare and contrast the H DI gu res or econom ically
m ore d eveloped cou ntries and econom ically less
d eveloped cou ntries.
5. Com pare and contrast the extent, natu re and sou rces o
o cial d evelopm ent assistance to two econom ically less
d eveloped cou ntries.
6. Com pare and contrast the roles o aid and trad e in
econom ic d evelopm ent.
7. Discu ss the positive ou tcom es on d evelopm ent o
market-orien ted policies.
8. Discu ss the negative ou tcom es on d evelopm ent o
market-orien ted strategies.
9. Discu ss the streng ths o interventionist policies on
d evelopm ent.
1 0. (H L only) Explain why the long term path o the term s o
trad e o a cou ntry may act as a barrier in its growth and
d evelopm ent process.
11 . Describe the natu re o FDI and o MN Cs.
1 2 . Explain why MN Cs expand into d eveloping cou ntries.
1 3. Describe the characteristics o d eveloping cou ntries that
rend er FDI inf ows m ore likely.
1 4. Explain the m ean ing o the term oreign aid making
reeren ce to the variou s types and orm s o aid that exist.
1 5. Describe the role o N GOs in the d evelopm ent process.
1 6. Explain reasons or which a d eveloped cou ntry may extend
aid to a d eveloping cou ntry.
1 7. Ou tline the m eaning o oreign d ebt and explain the
constraints it may impose in the d evelopin g process.
1 8. Explain why good governance is consid ered a necessary
precond ition or a cou ntry to d evelop.
1 0. Discu ss the lim itations o interventionist policies on
d evelopm ent.
11 . Discu ss the view that econom ic d evelopm ent may best be
achieved throu gh a complem entary approach, involving a
balance o market oriented policies and governm en t
intervention.
1 2 . Evalu ate each o the ollowing as a m eans o achieving
econom ic growth and econom ic d evelopm ent. a. I m port
su bstitu tion b. Export prom otion c. Trad e liberalization
d. The role o the WTO e. Bilateral and regional preerential
trad e agreem ents f. Diversi cation.
1 3. Evalu ate the impact o oreign d irect investm ent (FDI ) or
econom ically less d eveloped cou ntries.
1 4. Evalu ate the eectiveness o oreign aid in contribu tin g to
econom ic d evelopm ent.
1 5. Exam ine, u sing appropriate d iagram s where relevant, how
the ollowing actors contribu te to econom ic d evelopm ent.
a. Ed u cation and health b. The u se o appropriate
technology c. Access to cred it and m icro-cred it d. The
empowerm ent o wom en e. I ncom e d istribu tion .
1 6. Exam ine the cu rrent roles o the I MF and the World Bank in
prom oting econom ic d evelopm ent.
1 59
 5.1 Microeconomics
Remember that you are allowed to use a graphic display calculator (GDC) and this can
be very useful.
S e cti o n 5 : Q u an ti tati ve i S S u e S i n H L PaP e r 3
1.1 cmp mks: dmd d spply
Linear demand functions
A linear d emand cu rve has the orm : Q d 5 a 2 bP
This simply states that qu antity d emanded per period is
inversely related to price re ecting the law o d emand , and that
the d emand cu rve is a straight line rom the northwest to the
sou theast on you r paper.
The term a is a constant while the term 2 b is the slope o th e
u nction.
I the term a increases, the d emand cu rve shits to the right,
ind icating that d emand has increased . I the term a d ecreases,
the d emand cu rve shits to the let, ind icating that d emand has
d ecreased .
I the absolu te valu e o the coef cient o price increases then
the d emand cu rve you will have plotted on the graph paper
becom es atter, whereas i the absolu te valu e o the coef cien t
o price d ecreases the d emand cu rve becom es steeper. I this
seem s su rprising rem em ber that the convention we have, since
the work o Alred Marshall, is or the ind epend ent variable
(price) to be on the vertical axis.
I you are asked to plot a d emand u nction, f rst f nd the P
intercept by pu tting in zero or qu antity d emand ed in you r
u nction, and then f nd the Q intercept by pu tting in zero or
price. Connect the points. I nitially, u se a sot pencil and once
you are su re you have d one it right, go over the lin e with a
black pen. Th e qu estion paper will provid e you with the two
axes or the graph with nu m bers on them , so you au tomatically
have the relevan t range o valu es or su ch u nctions. I , or
example, the horizontal axis (qu an tity demand ed ) on you r exam
paper goes u p to 1 2 0 and you have calcu lated the horizontal
intercept to be 5 00, you have probably mad e a m istake! Also
rem em ber that only positive nu m bers or price and qu antities
make sense.
Also keep in m ind that you are allowed to u se a GDC
calcu lator. M ost, or example the Casio x9860GI I , allow you
to enter th e d emand (or any) u nction and ask to plot its
inverse. (Rem em ber that the axes are inverted with P on the
vertical and Q on the horizontal.) M ake su re you practise u sing
a GDC calcu lator a lot to avoid errors.
Linear supply functions
A linear su pply cu rve has the orm : Q s 5 c 1 d P
This simply states that qu antity su pplied per period is d irectly
related to price re ecting the law o supply, and that the su pply
cu rve is a straig ht line rom the sou thwest to the northeast on
you r paper.
Th e term c i s a con sta n t wh i l e 1 d i s th e sl ope o th e u n cti on .
I c increases, the su pply cu rve shits to the right, ind icating
that su pply has increased . I c d ecreases, the su pply cu rve shits
to the let, ind icating that su pply has d ecreased .
I the coef cient o price in creases, the su pply cu rve plotted on
th e graph paper becom es atter. Whereas i the coef cient o
1 60
price d ecreases, the su pply cu rve becom es steeper. Rem em ber
the convention to place the ind epend ent variable (price) on the
vertical axis.
The question paper will provide the two axes with numbers on
them. Choose any two convenient prices within the range given
on the vertical axis and fnd the quantity supplied or each. Just
substitute the values or P in the supply unction. You will have
determined two points on your paper which you simply connect.
Use a sot pencil and then go over the line with a black ink pen.
Remember that you are allowed to use a GDC calculator but plot
the inverse o the linear supply unction you are given. Only
positive numbers or price and quantities make sense.
Equilibrium price and quantity
The equ ilibriu m cond ition requ ires that qu antity d emand ed per
period is equ al to qu antity su pplied per period . You will have
three equ ations: the d eman d equ ation, the su pply equ ation
an d the equ ilibriu m cond ition (given below as (1 ), (2 ) and (3 )
respectively) and you will have three u nknowns (the price, th e
qu antity d emand ed and the qu antity su pplied ):
(1 ) Q d 5 a 2 bp
(2 ) Q s 5 c 1 d p
(3) Q d 5 Q s
Pu t (1 ) and (2 ) into the equ ilibriu m con d ition (3 ) and solve or
price. Pu t the equ ilibriu m price you f nd into either the d emand
or the su pply equ ation to f nd equ ilibriu m qu antity.
For example:
Q d 5 60 2 2P
Q s 5 4P (here, the constant c is zero)
Qd 5 Qs
Su bstitu ting the d emand and the su pply equ ations in the
equ ilibriu m cond ition:
60 2 2 P 5 4P
60 5 6P
P 5 10
By putting the equilibrium price 1 0 into the supply equation we
fnd that the equilibrium quantity is 40. Double check your answer
by also substituting the value 1 0 or P into the demand equation.
I you pu t into the d eman d and su pply u nctions any price
greater than 1 0 (the equ ilibriu m price), qu antity su pplied will
be greater than qu antity d emand ed and their d ierence will be
the excess su pply resu lting at that price. For exam ple, i you pu t
the price 2 0 into the d emand u nction, qu antity d emand ed will
equ al to 2 0 u nits, wh ereas i you pu t 2 0 into the su pply
u n ction, qu antity su pplied will be 80 u nits. Qu antity su pplied
exceed s qu antity d emand ed by 60 u nits, which is the excess
su pply resu lting at a price o 2 0.
 5 Quantitative issues in HL Paper 3

I you pu t into the d emand and su pply u nctions any price less Rem em bering that in the post-tax su pply u nction we su bstitu te
than 1 0 (the equ ilibriu m price), qu antity d emand ed will be (P 2 t) or the term P we m u st solve now the equ ation s:
greater than qu antity su pplied and their d ierence will be the
Q d 5 60 2 2 P
excess d emand resu lting at that price. For exam ple, i you pu t
the price 5 into the d emand u nction, qu antity d emand ed will Q s 5 4(P 2 3)
equ al 5 0 u nits, whereas i you pu t 5 into the su pply u nction,
Solving the system will yield the new market price that
qu antity su pplied will be 2 0 u nits. Qu antity d emand ed exceed s
consu m ers will pay Pc 5 1 2 and the new equ ilibriu m qu antity
qu antity su pplied by 3 0 u nits, which is the excess d emand
Q9 5 36.
resu lting at a price o 5.
This is how the table m ight look:
Indirect taxes
P0 10
An indirect tax is a tax on goods or services. For the quantitative
part o the exam you need to ocus only on specifc taxes (that Q0 40
is, a specif c dollar am ou nt per unit o the good). I you do not Pc 12
care about the logic o the problem , the easiest way to deal with
Q9 36
such a tax is to rewrite you r supply equation substituting the
term P with (P 2 tax). So, i the su pply equation is: Pp 5 (Pc 2 tax) 5 9
2
Q s 5 4P 12 2 10 5 2 (consumers pay __3
Incidence on consumers
of the tax)
and a $ 3.00 tax per u nit is imposed , rewrite it as:
1
10 2 9 5 1 (producers pay __
3 of
Q s 5 4(P 2 3) Incidence on consumers
the tax)
The n ext step is to equ ate the d emand with the new su pply Initial revenues and P0 3 Q 0 5 10 3 40 5 400
cu rve to f nd the n ew market price. Su btracting the tax rom the expenditures TR0
new market price you ju st calcu lated will give you the new, net
o tax, price that prod u cers earn. N ote that beore the tax was Post-tax producer revenues Pp 3 Q9 5 9 3 36 5 324
imposed , the market price was also the average revenu e earned Post-tax consumer Pc 3 Q9 5 12 3 36 5 432
by f rm s whereas ater the tax is imposed , the average revenu e expenditures
earned is the net o tax market price ou nd by su btracting the
Tax revenues collected by t 3 Q9 5 3 3 36 5 108
tax rom the new market price.
government
I you have alread y plotted the original d emand and su pply
cu rves on graph paper, you can ju st shit the su pply cu rve Area of a triangle is
1
__
vertically u pward s by the am ou nt o the tax to f nd the new 2 (base 3 height).
market price and the new market qu antity and to answer a lot Since the vertical intercept of the
o other related qu estions. Initial consumer surplus demand curve is 30, the height of
Rem em ber that an ad valorem tax (say a 1 5 % VAT or sales tax) the consumer surplus triangle is
will not lead to a parallel shit o the su pply cu rve bu t the new (30 2 10) 5 20. The base is the
su pply cu rve will create a wed g e with th e original one (their quantity 40 so CS 5 400.
vertical d istance will be increasing). (10 3 40)
Initial producer surplus Similarly: _________
2 5 200
H ere is som e ad vice on solving ind irect tax problem s.
Solve algebraically beore plotting on the graph paper to (30 2 12) 5 18 is the new height
en su re that you r calcu lations are precise. New consumer surplus and 36 is the base so consumer
(18 3 36)
Avoid ing u sing P1 and P2 . I nstead ad opt m ore m eaningu l surplus is _________ 5 324
2
sym bols like Pm or Pc or the new higher market price (9 3 36)
New producer surplus ________
consu m ers pay ater the tax, and Pp or the net o tax price 2 5 162
prod u cers earn (their new average reven u e). Initial social welfare 400 1 200 5 600
Write d own all the relevant inormation in a table as this
New social welfare 324 1 162 1 108 5 594
will help you with any ad d itional calcu lations you are asked
to make. 600 2 594 5 6 or
(40 2 36) 4
For exam ple, assu m e that d emand and su pply are given by: Welfare loss (12 2 9) 3 _________
2 5 3 3 __
2
Q d 5 60 2 2 P 5 6 (the area of the triangle)
Q s 5 4P
Denoting the orig inal equ ilibriu m price by P 0 and the original Subsidies
equ ilibriu m qu antity by Q 0 we have alread y ou nd that: A su bsi d y i s a paym en t to prod u cers a i m ed a t l oweri n g
prod u cti on costs a n d so m a rket pri ce a n d i n crea si n g
P0 5 1 0
prod u cti on a n d con su m pti on o th e g ood . Th e ea si est way to
Q 0 5 40 d ea l wi th su ch a su bsi d y i s to rewri te you r su ppl y eq u a ti on

1 61
 5 Quantitative issues in HL Paper 3

su bsti tu ti n g th e term P wi th (P 1 subsidy). So, i th e su ppl y 2

10 2 8 5 2 (consumers enjoy __
3 o
eq u a ti on i s: Beneft to consumers
the subsidy)
Q s 5 4P 1
11 2 10 5 1 (producers enjoy __
3 o
Beneft to producers
and a $ 3.00 su bsid y per u nit is granted , rewrite it as: the tax)
Initial revenues and P0 3 Q 0 5 10 3 40 5 400
Q s 5 4(P 1 3 )
expenditures TR0
The next step is to equ ate the d emand with th e new su pply Post-subsidy producer Pp 3 Q9 5 11 3 44 5 484
cu rve to f nd the new market price. Ad d ing the su bsid y to the revenues
new market price will give you the new price, inclu sive o the
su bsid y, that prod u cers earn. N ote that beore the su bsid y was Post-subsidy consumer Pc 3 Q9 5 8 3 44 5 352
granted , the market price was also the average revenu e earned expenditures
by f rm s. Whereas ater the su bsid y is granted , the average Total cost o subsidy to s 3 Q9 5 3 3 44 5 132
revenu e earned is inclu sive o the su bsid y market price ou nd by the government
ad d ing the su bsid y to the new market price consu m ers pay. Area o a triangle is
I you have alread y plotted the original d emand and su pply 1
__
2 (base 3 height).
cu rves on graph paper, you can ju st sh it the su pply cu rve
Since the vertical intercept o
vertically d ownward s by the am ou nt o the su bsid y to f nd the the demand curve is 30, the height
Initial consumer surplus
new market price and the new market qu antity and to answer a o the consumer surplus triangle
lot o other related qu estions. is (30 2 10) 5 20. The base is
The sam e ad vice g iven or ind irect tax problem s hold s or the quantity 40 so consumer
su bsid y problem s, as ollows. surplus 5 400.
Solve alg ebraically beore plotting on the graph paper to (10 3 40)

Initial producer surplus Similarly: _________
2 5 200
ensu re that you r calcu lation s are precise.
Avoid ing u sing P1 and P2 . I nstead ad opt m ore m eanin gu l (30 2 8) 5 22 is the new height
sym bols like Pm or Pc or the new lower market price New consumer surplus and 44 is the base, so consumer
(22 3 44)
consu m ers pay ater the su bsid y, and Pp or the inclu sive o surplus is _________
2 5 484
su bsid y price prod u cers earn (their new average revenu e).
(11 3 44)
_________
Write d own all the relevant inormation in a table as this New producer surplus 5 242
2
will help you with any ad d itional calcu lations you are asked Initial social welare 400 1 200 5 600
to make.
484 1 242 5 726 minus the cost
For example, assume that demand and supply are again given by: New social welare
o the subsidy 132 5 594
Q d 5 60 2 2 P 600 2 594 5 6 or
(40 2 36) 4
Q s 5 4P Welare loss (12 2 9) 3 _________ 5 3 3 __
2 2
Denoting the original equ ilibriu m price by P 0 and the original 5 6 (the area o the triangle)
equ ilibriu m qu antity by Q 0 we have alread y ou nd that:
P0 5 1 0 Price ceilings
A price ceiling or maxim u m price (or rent control in the case o
Q 0 5 40
hou sing) is a price set by the governm ent below the equ ilibriu m
Rem em bering that in the post-su bsid y su pply u nction we price. This implies that qu antity d emand ed is greater than
su bstitu te (P 1 s) or the term P we m u st solve now the qu antity su pplied so that excess d eman d , reerred to in this
equ ations: case as a shortage, resu lts.
Q d 5 60 2 2 P You may be asked to calcu late the resu lting shortage. You
wou ld ju st have to su btract the qu antity su pplied rom the
Q s 5 4(P 1 3 ) qu antity d emand ed at the maxim u m price by pu ttin g it into
Solving the system will yield the new market price that consumers both th e su pply and then the d emand equ ations.
will pay Pc 5 8 and the new equilibrium quantity Q9 5 44. U sing the sam e d emand and su pply cond ition s:
This is how the table m ight look: Q d 5 60 2 2P
Q s 5 4P
P0 10
with
Q0 40
P0 5 1 0
Pc 8
Q9 44 Q 0 5 40
pp 5 (Pc 1 subsidy) 5 11 d ef ning the original market equ_ilibriu m price and qu an tity,
assu m e that a maxim u m price P 5 7 is im posed . Su bstitu tin g

1 62

this price into the d emand and then into the su pply u nctions
helps u s d eterm ine the qu antity d emand ed Q d and the qu antity
su pplied Q s :
Q d 5 46
Qs 5 2 8
so that a shortage equ al to Q d 2 Q s 5 1 8 u nits resu lts.
You may be a sked to ca lcu late th e chan g e in con su m er
expen d itu res. Con su m er expen d itu res a re ou n d by m u ltiplyin g
th e price pa id tim es th e a ctu al n u m ber o u n its bou g h t.
Rem em ber that th e sh ort en d o th e ma rket always preva ils, so
that i on ly 2 8 u n its were ma d e availa ble by f rm s at th e
ma xim u m price set it is im materia l that con su m ers were
d ema n d in g 46 u n its.
I nitially consu m er expen d itu res were 1 0 3 40 5 400 whereas
ater the maxim u m price is set they will be 7 3 2 8 5 1 96.
The change is thereore 1 96 2 400 5 2 2 04. This m eans that
consu m er expend itu res d ecreased by 2 04 (or example d ollars
or eu ros) which makes sense as both the price is lower and the
qu antity consu m ed is less. Consu m er expend itu res in this case
are equ al to total revenu es prod u cers collect.
Price foors
A pri ce oor or m i n i m u m pri ce (or pri ce su pport) i s a pri ce
set by th e g overn m en t a bove th e eq u i l i bri u m pri ce. Th i s
i m pl i es th a t q u a n ti ty d em a n d ed i s l ess th a n th e q u a n ti ty
su ppl i ed so th a t excess su ppl y, reerred to i n th i s ca se a s a
su rpl u s, resu l ts.
You may be asked to calcu late the resu lting su rplu s. You wou ld
ju st have to su btract the qu antity d eman d ed rom the qu antity
su pplied at the m inim u m price by su bstitu ting it into both the
su pply and the d emand equ ations.
U sing the sam e d emand and su pply cond itions:
Q d 5 60 2 2 P
Q s 5 4P
with
P0 5 1 0
Q 0 5 40
th e orig in a l ma rket equ_ilibriu m price an d qu a n tity, a ssu m e
that a m in im u m price P 5 1 4 is im posed . Su bstitu tin g th is
1.5 theory o he frm and marke srucures
Total, marginal and average product
You may be asked to calcu late rom a table (with em pty cells)
or rom a graph, total, marginal and average prod u cts. This is
an easy task i you rem em ber exactly what each concept m eans
and the orm u la one can u se.
To calcu late average prod u ct (o, say, labou r) you need to d ivid e
total prod u ct (TP, or in other word s, Q) by the nu m ber o
workers u sed (L) or:
TP
AP L 5 ___ (1 )
L
5 Quantitative issues in HL Paper 3
price in to th e d ema n d an d th en in to th e su pply u n ction s
h elps u s d eterm in e th e qu an tity d ema n d ed Q d a n d th e
qu a n tity su pplied Q s :
Q d 5 32
Qs 5 5 6
so that a su rplu s equ al to Q s 2 Q d 5 2 4 u nits resu lts.
You may be asked to calcu late the change in consu m er
expend itu res. Consu m er expend itures are ou nd by m u ltiplying
the price paid tim es the actu al nu mber o u nits bou gh t.
Rem em ber that the short end o the market always prevails, so
that i only 32 u nits were d emand ed by consu m ers at the
m inim u m price set it is im material that f rm s were oering in
the market 5 6 u nits.
I nitially, consu m er expend itu res were 1 0 3 40 5 400 while
ater the m inim u m price they were equ al to 1 4 3 32 5 448
(or exam ple d ollars or eu ros). N ote that these expend itu res are
greater than the expend itu res made at the lower price. Since
the price paid increased , the qu an tity pu rchased will have
d ecreased (law o d emand ) so that consu m er expend itu res may
have increased , d ecreased or remained the sam e d epend in g on
the price elasticity o d emand (PED) or the good . What we
have here is a m ovem ent along a demand cu rve. Since in this
example th e higher price paid resulted in higher expend itu res
by consu m ers, it im plies that PED is less than one (d emand is
price inelastic).
I n the case o a m in im u m price, the governm ent m u st intervene
and bu y rom prod u cers at the prom ised m inim u m price the
su rplu s created . I t ollows that produ cers earn not only what
consu m ers spend on the good bu t also what the governm ent
spend s to bu y the su rplu s. Rem em ber prod u cers sell all o what
they have prod u ced : som e to consum ers and th e rest to the
governm ent. So prod u cers earn the prod u ct o the price set
($ 1 4 or whatever) tim es the total am ou nt su pplied (5 6 u nits),
that is, $ 1 4 3 5 6 5 $ 784. The governm ent expend itu res in
the case o a m inim u m price are the prod u ct o the su rplu s
(2 4 u nits) pu rchased tim es the m inim u m price prom ised ($ 1 4),
or $ 1 4 3 2 4 5 $ 33 6.
To d ou bl e ch eck rem em ber th a t th e reven u es col l ected
m u st eq u a l th e su m o th e expen d i tu res con su m ers m a d e
pl u s th e am ou n t o m on ey th e g overn m en t spen t to bu y
th e su rpl u s rom prod u cers or, i n th i s exam pl e,
$ 448 1 $ 3 3 6 5 $ 784.
N otice that equ ation (1 ) has three term s so i you know any
two you can solve or the third . For example, i f ve workers can
prod u ce an average o 1 2 0 shirts per d ay then each worker can
prod u ce on average 2 4 shirts per d ay. Average prod u ct
120
is ____ 5 2 4 shirts per worker per d ay. Or, i you know that the
5
average prod u ct per worker per d ay is 2 4 shirts and that the
f rm employs f ve workers you can f nd the total averag e
produ ct which is 5 3 2 4 5 1 2 0 shirts per d ay.
To calcu late marginal prod u ct (o, say, labou r) you need to
rem em ber that marginal m eans extra (ad d itional) so that
1 63
 5 Quantitative issues in HL Paper 3

marginal prod u ct (MP) is the change in ou tpu t ind u ced by a to the total product o two workers to calculate the total product
change in the n u m ber o workers employed . I t is equ al to the o three workers (which is equal to 300 1 2 00 5 500 units).
ratio o the change in ou tpu t prod u ced over the change in N ow that you have the total product or three workers it is easy
labou r employed . I the chan ge in th e nu m ber o workers is to calculate the average product when three workers are
1 (that is, you have d ata on the ou tpu t o 0, 1 , 2 , 3, 4, etc. employed by dividing total product by the num ber o workers,
workers) then marginal prod u ct is ju st the change in ou tpu t: 5 00
or ____ 5 1 66.67 u nits per worker per period .
DQ 3
DTP
MP L 5 ____ 5 ___ ,
DL DL
Total, marginal and average cost
and , i DL is always 1 , then M P 5 DQ 5 Q 2 2 Q 1 (2 ). Th e sam e l og i c expla i n ed a bove or th e ca l cu la ti on o tota l
N ote rom equ ation (2 ) that it ollows that M P 1 Q 1 5 Q 2 , so prod u ct, m a rg i n a l prod u ct a n d a vera g e prod u ct h ol d s
i we kn ow that th e ma rg in a l prod u ct o, say, th e f th worker or ca l cu la ti n g tota l , m a rg i n a l a n d a vera g e costs (TC,
is 2 5 a pples (per period ) an d that with ou r workers total M C a n d AC).
prod u ct is 1 00 apples, th en tota l prod u ct with f ve workers will The d ef nitions (orm u las) to rem em ber inclu d e:
be 2 5 1 1 00 5 1 2 5 a pples. Th is is very u seu l to rem em ber
wh en com pletin g su ch ta bles. TC 5 FC 1 VC (1 )
For example, consid er the table below. ATC 5 AFC 1 AVC (2 )
TC FC VC
Labour or Output (Q) or Average Marginal ATC 5 ___, AFC 5 ___, AVC 5 ___ (3)
Q Q Q
number of total product product (AP) product (MP)
workers (TP) DTC DVC
MC 5 ____ or, since DFC 5 0 M C 5 ____ (4)
(L) DQ DQ
0 0 2 2 i DQ 5 1 then :
1 (0 1 120) 5 ( ____
1 ) 5 120
120 120 MC 5 TC2 2 TC 1 TC 1 1 M C 5 TC 2 (5 )
120 MC 5 VC2 2 VC 1 VC 1 1 M C 5 VC 2 (6)
2 (2 3 150) 5 150 (300 2 120) 5
300 180 These may look d if cu lt bu t they are extrem ely easy. Equ ation
(1 ) states that total costs (TC) are the su m o f xed and variable
3 (300 1 200)5 ( ____
3 ) 5 166.67
500 200 costs (FC and VC). I n the lon g ru n, sin ce there are no f xed costs
500 total costs are variable costs.
4 640 ( ____
4 ) 5 160
640
(640 2 500) 5 You d erive equ ation (2 ) by d ivid ing all term s o equ ation (1 ) by
Q (the level o ou tpu t) to arrive at per u nit o ou tpu t (that is,
140
average) costs. I t states that average total cost (ATC) is the su m
5 (5 3 135) 5 135 (675 2 640) 5 o average f xed costs (AFC) plu s average variable costs (AVC).
675 35
The equ ations labelled (3) are u seu l as each has three term s
6 (675 1 0) 5 ( ____
6 ) 5 112.5
675 0 so, i two o them are known you can solve or the third term .
675 Rem em ber that f xed costs are f xed as the level o ou tpu t
increases bu t average f xed costs continu ou sly d ecrease as the
Assume that the table originally contains only the cells given in level o ou tpu t increases.
black on white above and that you are asked to calculate the The equ ations labelled (4) state that marginal cost (MC) is the
remaining (shaded) cells. The calculation required and the result change in either total or variable costs d ivid ed by the change in
or each cell is given in shaded cells. N ote two things: i no (zero) ou tpu t.
workers are employed neither the marginal nor the average can
Equ ations (5 ) and (6) are m ost u seu l as they state that i we
be calculated as they are m eaningless concepts; also, in each
know that the total costs (or variable costs) o produ cing, say,
row, only one number is needed to calculate the other two. For
eight u nits is $ 2 00.00 and that the marginal cost o the ninth
example, or three workers you are only given that the marginal
u nit is $ 2 2 .00 then the total costs (or variable costs) o
product o the third worker is 2 00 units o output. But since you
prod u cing nine u nits is $ 2 00.00 1 $ 2 2 .00 5 $ 2 2 2 .00. This is
have calculated that the total product o two workers is 300
m ost u seu l when asked to complete cost tables.
units, you just need to add the extra output rom the third worker

1 64
 5 Quantitative issues in HL Paper 3

I n the table below you are g iven only the total cost o
prod u ction (in black on white) and you may be asked to f ll in
the rest o the table. The answers are in the shad ed areas.

Q TC FC VC AVC ATC AFC MC

0 100 100 0 2 2 2 2
(150 2 100) or
1 150 100 50 ( ___
1 ) 5 50
50
( ____
1 ) 5 150
150
( ____
1 ) 5 100
100
(50 2 0) 5 50
(180 2 150) or
2 180 100 80 ( ___
2 ) 5 40
80
( ____
2 ) 5 90
180
( ____
2 ) 5 50
100
(80 2 50) 5 30
(190 2 180) or
3 190 100 90 ( ___
3 ) 5 30
90
( ____
3 ) 5 63.33
190
( ____
3 ) 5 33.33
100
(90 2 80) 5 10
(200 2 190) or
4 200 100 100 ( ____
4 ) 5 25
100
( ____
4 ) 5 50
200
( ____
4 ) 5 25
100
(100 2 90) 5 10
(220 2 200) or
5 220 100 120 ( ____
5 ) 5 24
120
( ____
5 ) 5 44
220
( ____
5 ) 5 20
100
(120 2 100) 5 20
(260 2 220) or
6 260 100 160 ( ____
6 ) 5 26.67
160
( ____
6 ) 5 43.33
260
( ____
6 ) 5 16.67
100
(160 2 120) 5 40
(320 2 260) or
7 320 100 220 ( ____
7 ) 5 31.43
220
( ____
7 ) 5 45.71
320
( ____
7 ) 5 14.29
100
(220 2 160) 5 60
(420 2 320) or
8 420 100 320 ( ____
8 ) 5 40
320
( ____
8 ) 5 52.5
420
( ____
8 ) 5 12.5
100
(320 2 220) 5 100
(570 2 420) or
9 570 100 470 ( ____
9 ) 5 52.22
470
( ____
9 ) 5 63.33
570
( ____
9 ) 5 11.11
100
(470 2 320) 5 150
(770 2 570) or
10 770 100 670 ( ____
10 ) 5 67
670
( ____
10 ) 5 77
770
( ____
10 ) 5 10
100
(670 2 470) 5 200

Or, consid er the table below where only a ew entries were Total, marginal and average revenue
provid ed (th ose in the white cells). H ere are a ew hints to help. The log ic behind the calcu lations o total, average and
When ou tpu t is zero, variable costs are zero as no variable marginal revenu es is once again exactly th e sam e as the logic
actors are u sed . I the marginal cost o the f rst u nit is 1 5 0 beh ind prod u ct and cost u nctions. The orm u las are:
(d ollars) the variable cost o prod u cing one u nit is 1 5 0 (d ollars)
TR P3 Q
and by d ivid ing by 1 all average costs are ou nd . I the average AR 5 ___ 5 ______ 5 P (1 )
Q Q
total cost when prod u cing 2 u nits is 2 2 5 then the total cost is
(2 3 2 2 5 ) or 45 0 and given that the f xed costs are 1 00, the DTR
MR 5 ____ (2 )
variable cost o two u nits is 35 0. I the variable cost o DQ
prod u cing two u nits is 35 0 and the variable cost o prod u cin g
And , i DQ 5 1 , then :
1 u nit is 1 5 0 then the marginal cost o prod u cing the second
u nit is (35 0 2 1 5 0) 5 2 00 (d ollars) and so on. M R 5 DTR 5 TR 2 2 TR 1 so TR 1 1 MR 5 TR 2

Equ ation (1 ) states that AR is the ratio o total revenu e over

Q FC VC ATC AFC AVC MC
ou tpu t. Since TR is the prod u ct o price tim es ou tpu t it ollows
0 100 0 2 2 2 that AR is always equ al to price or any level o ou tpu t Q
(150 1 100) ____ ind epend ent o market stru ctu re. This is labelled on the
(0 1 150) 5 ___________ 150
100 ____
1 100 1 1 150 d emand cu rve as D, AR.
150 1
For exam pl e, con sid er th e ta bl e on th e n ext pa g e wh ere th e
(2 3 225) 2 350 (350 2 150) 5
100 ____
____ d em a n d sch ed u le or a prod u ct i s g i ven (that i s, th e q u a n ti ty
2 100 225
2 2
100 5 350 200 d em a n d ed or ea ch price). Th e avera g e reven u e (AR) col u m n
(650 1 100) ____ a s a resu lt o eq u ation (1 ) a bove i s i d en tica l to th e pri ce
___________ 650 (650 2 350) 5
100 ____
3 100 650 3 3 col u m n (P). Th e tota l reven u e (TR) col u m n i s th e prod u ct o
3 300
ea ch price tim es th e qu a n tity d em a n d ed . Th e m a rg in a l
(850 1 100) ____ 850 (850 2 650) 5
100 ____ reven u e (M R) i s th e extra reven u e coll ected rom ea ch extra
4 100 850 ___________
4 4 4 200 u n i t sol d so it is th e d i eren ce between su ccessi ve tota l
reven u e f g u res (sin ce th e d i eren ce i n Qs i s a lways eq u a l to
1 ). N ote that si n ce TR col lected rom sell in g zero u n its a re
zero (d olla rs) wh erea s wh en 1 u n i t is sold TR col lected a re 80
(d olla rs), i t oll ows that M R col l ected rom sell i n g th e f rst u n i t
i s 80 (d olla rs).

1 65
 5 Quantitative issues in HL Paper 3

Q P AR TR MR MC, prof ts are rising so choose that level o ou tpu t Q or which

MR 5 M C or the largest level ou tpu t Q or which M R is still
1 80 (80) (1 3 80) 5 80 (80 2 0) 5 80 greater than M C.
2 70 (70) (2 3 70) 5 140 (140 2 80) 5 60 I n a d iagram , d eterm ine the level o ou tpu t or which MR an d
3 60 (60) (3 3 60) 5 180 (180 2 140) 5 40 MC intersect and then f nd TR by m u ltiplying that ou tpu t with
4 50 (50) (4 3 50) 5 200 (200 2 180) 5 20 price. Find TC by d eterm ining or the ch osen level o ou tpu t the
correspond ing ATC and m u ltiplying the two f gu res.
5 40 (40) (5 3 40) 5 200 (200 2 200) 5 0
6 30 (30) (6 3 30) 5 180 (180 2 200) 5 2 20 Issues in market structures
7 20 (20) (7 3 20) 5 140 (140 2 180) 5 2 40 You may be asked to calcu late the short-ru n shu t-d own price
8 10 (10) (8 3 10) 5 80 (80 2 140) 5 2 60 an d the break-even price rom a set o d ata or a graph.
The break-even price is that price or which total revenu es are
Rem em ber that the revenu e-maxim izing level o ou tpu t is that equ al to total costs and thu s econom ic prof ts are zero (that is,
at which M R is zero. I n the above case you shou ld choose f ve normal; the m in im u m requ ired or the f rm to remain in
u nits as or the f th u nit M R 5 0. As a resu lt o the act that bu siness). For a perectly competitive f rm the break-even price
the table above d oes not correspond to a continu ou s u nction can be ou nd on a d iagram at the m inim u m o the U -shaped
bu t is ju st a collection o d iscrete d ata, maxim u m revenu es o ATC cu rve it aces. Rem em ber that a perectly competitive f rm
2 00 (d ollars) are also collected when ou r u nits are sold . I n aces a horizontal d emand (and so AR) cu rve. For all other
an exercise when this happens, choose that level or which types o f rm s acing a negatively sloped d emand cu rve the
M R 5 0. break-even price is ou nd where the negatively sloped d emand
(and AR cu rve) is tangent to the U -shaped ATC cu rve. I given a
Economic profts table with TR and TC f gu res (or AR and ATC f gu res) it is that
Econom ic prof ts or each level o ou tpu t Q is given by the level o ou tpu t or which the two are equ al.
equ ation: The shu t-d own price an d the break-even price are id entical
in the long ru n.
p(Q) 5 TR(Q) 2 TC(Q)(1 )
I n the short ru n, when f xed costs exist and on a d iagram both
To maxim ize prof ts choose that level o ou tpu t or wh ich: ATC and AVC cost cu rves are d epicted , the shu t-d own price or
MR 5 M C a perectly competitive f rm is at the m inim u m o the AVC
cu rve. I provid ed with a table with d ata to d eterm ine the
You may be given a table with cost and revenu e d ata to shu t-d own price you ju st have to d eterm ine the lowest AVC
complete an d d eterm in e the level o ou tpu t at which maxim u m f gu re. At any price below that price the f rm will im m ed iately
prof ts are achieved . Rem em ber that as long as M R exceed s shu t d own.

1 66
5.2 Macroeconomics

2.1 the level of overall economic aciviy

Measures o economic activity I t also ollows that the remaining 2 0 cents were paid in tax,
saved and /or spent bu t on imports. The m u ltiplier may
You may be asked to calcu late nom inal GDP rom sets o
th ereore be written as:
nation al incom e d ata, u sing the expend itu re approach. I n this
case you ju st ad d (C 1 I 1 G 1 X) and then su btract im ports 1 1
k 5 __________________ 5 _____ , where
(M). Oten in su ch exercises stu d ents are given ad d ition al d ata (M RT 1 M PS 1 MPM ) M PW
as sm oke to conu se them . I gnore the ad d itional d ata. I asked
M RT is the marginal tax rate (the extra tax paid ou t o an extra
to f nd the per capita GDP (or GN I ) ju st d ivid e GDP (or GN I ) by
d ollar earned ), MPS is the ad d itional savings ou t o an
popu lation.
ad d itional d ollar earned and MPM is the ad d itional spend ing
You may be asked to calcu late GN P or GN I rom d ata. GN P is on imports ou t o an ad d itional d ollar earned :
GDP plu s incom e rom abroad m inu s actor (or property)
in com e rom abroad or plu s net actor (or property) incom e DT DS DM
MRT 5 ___, M PS 5 ___ and MPM 5 ____
rom abroad . DY DY DY
DW
Lastly, you may be asked to calcu late real GDP or GN I u sing a and MPW is the marginal propensity to withdraw, or ____.
DY
price d e ator. A price d e ator is a price ind ex. Divid e GDP (or
GN I ) by the GDP d e ator and m u ltiply the resu lt by 1 00. Once Continu ing the previou s exam ple, i people are taxed 1 2 cents,
again, the relationship has three term s so i any two are save 3 cents and spend on imports 5 cents ou t o each
provid ed you can solve or the third one. ad d itional d ollar earned then:
M RT 5 0.1 2 , M PS 5 0.03 and MPM 5 0.05
The Keynesian multiplier
so that MPW 5 0.2 0 (their su m ).
The Keynesian m u ltiplier states that the change in incom e is a
m u ltiple o the change in any injection: The m u ltiplier k is thu s equ al to:
1
__________ 1 1
D Y 5 k D J, where J 5 (G, I , X) 5 ________ 5 ___ 5 5
(1 2 MPC d ) (1 2 0.8) 0.2
I t ollows that i any two term s are given you can solve or the
third one. or u sing the MPW f gu re d irectly:

I n ad d ition, 1
___
5 5
0.2
1 D Cd
k 5 __________ , where MPC d 5 ____
(1 2 M PC d ) DY I th e g overn m en t in crea ses spen d in g by 1 5 0 billion , th en
n ation al in com e will in crea se by (5 3 1 5 0) 5 75 0 billion .
MPCd is the ad d itional spend ing on d om estic good s rom
Or i, or exam ple, th e g overn m en t wa n ts n ation a l in com e to
ad d itional incom e. So, i you are told that rom an extra d ollar
in crea se by 1 .2 trillion th en g overn m en t expen d itu res sh ou ld
(wh ich has 1 00 cents) people spend 80 cents it ollows that
1 .2
rise by ___ 5 2 40 billion .
80 5
MPC d 5 ____ 5 0.8.
1 00

2.3 Macroeconomic objecives

The unemployment rate
You may be asked to calcu late the u nemploym ent rate rom a
set o d ata. Th e u nemploym ent rate is a percentage. I t is the
nu m ber o u nem ployed expressed as a proportion o the labou r
orce:
nu m ber o u nem ployed
Unem ploym ent rate 5 __________________ 3 1 00
labou r orce
Again, you have a relationship with three term s so i any two
are given you can solve or the third one. The labou r orce is not
the sam e thing as th e popu lation o a cou ntry. I t inclu d es the
employed and the u nemployed individ u als, so given a total
popu lation f gu re, the nu m ber o those u nwilling and /or
u nable to work are exclu d ed . Babies, old er people as well as
people within the working age popu lation who are neither
working nor actively searching or a job are not part o the
d en om inator in th e calcu lation o the u nem ploym ent rate as
they are not inclu d ed in the labou r orce.
The infation rate
You may be asked to calcu late the in ation rate rom a set o
d ata. The in ation rate is also a percentage. I t is the
percentage change in the average price level between two
period s o tim e, u su ally between two years. The average price
level is given by a price ind ex.
Typical price ind ices inclu d e the consu m er price ind ex (CPI or
retail price ind ex) and the prod u cer price ind ex (PPI ). I we
d en ote by P t the CPI at period t and by P (t 2 1 ) the CPI the
previou s period (so that i t is 2 009 then (t 2 1 ) is 2 008) th en :
Pt2 P (t2 1 )
I n ation rate in t 5 % DP 5 _______ 3 1 00
P (t2 1 )

1 67
 5 Quantitative issues in HL Paper 3
So i the CPI or 2 008 was calcu lated at 1 5 8.2 and the CPI or
2 009 was at 1 65.6 then in ation in year-on-year in ation in
2 009 was:
1 65.6 2 1 58.2
____________ 7.4
3 1 00 5 _____ 3 1 00 5 0.0467 3 1 00 5 4.68%
1 58.2 1 58.2
N ote that i th is percen ta g e wa s n egative th en th ere was
d e ation . Rem em ber that i you were to ca lcu late in ation or,
say, two con secu tive years a n d th e resu lts were positive bu t
th e rate wa s sma ller in th e secon d yea r th en th ere wa s
d isin ation (that is, prices con tin u ed to in crease bu t at a
d ecrea sin g rate).
You m a y be a sked to con stru ct a wei g h ted pri ce i n d ex u si n g
a set o d a ta provi d ed . Th i s i s very ea sy. You wi l l be g i ven a
l i m i ted n u m ber o g ood s (say, th ree to f ve), th ei r pri ces i n
two or m ore peri od s (typi ca l l y m on th s or yea rs) a n d th e
n u m ber o u n i ts o ea ch g ood th at th e typi ca l h ou seh ol d
(con su m er) pu rcha sed in th e ba se peri od or reeren ce peri od
(m on th or yea r). Th ese a re th e wei g h ts o ea ch g ood .
Rem em ber th at g ood s d o n ot ca rry th e sam e wei g h t i n th e
ca l cu lati on o th e avera g e pri ce l evel or o th e ca l cu la ti on o
th e cost o th e ba sket o g ood s pu rch a sed . Th e wei g h t o
ea ch g ood i n you r si m pl e ca l cu lati on o th e wei g h ted
a vera g e i s th e n u m ber o u n i ts o ea ch g ood pu rch a sed .
So, to calcu late the cost o each basket o good s in each period
you ju st m u ltiply the price o each good d u ring the period
tim es the nu m ber o u nits consu m ed by the typical consu m er
and ad d the expend itu res across good s. To convert the cost
(say, d ollars) arrived at to a price ind ex d ivid e the cost o the
basket in each year by its cost in the base year chosen and
m u ltiply by 1 00. To calcu late the in ation rate o a year f nd
th e percentage between the two price ind ices compu ted .
Rem em ber it is the percentag e change o the price ind ex o one
period with respect to its valu e in the previou s period . The next
example will help you und erstand .
The ollowing table has the prices o three good s in som e
economy between 2 01 2 and 2 01 4.
Year Price of X Price of Y Price of Z
2012 6.00 0.50 3.00
2013 6.60 0.60 3.10
2014 6.80 0.75 3.40
We assu m e that the basket o the typical consu m er con tains
1 0 u nits o good X, 3 0 u nits o good Y and 2 0 u n its o good Z.
Constru ct a weighted price ind ex or all three years assu m ing
that 2 01 0 is th e base year and calcu late the in ation rate or
2 01 3 and 2 01 4.
First calcu late the cost o the basket in each year. Th e cost or
2 01 2 will be:
(6.00 3 1 0) 1 (0.5 0 3 30) 1 (3 .00 3 2 0)
5 60.00 1 1 5.00 1 60.00 5 1 35.00
The cost or 2 01 3 will be:
(6.60 3 1 0) 1 (0.60 3 30) 1 (3 .1 0 3 2 0)
5 66.00 1 1 8.00 1 62 .00 5 1 46.00
The cost or 2 01 4 will be:
(6.80 3 1 0) 1 (0.75 3 30) 1 (3.40 3 2 0)
5 68.00 1 2 2 .5 0 1 68.00 5 1 5 8.5 0
1 68
You cou ld ca lcu late th e in ation rate in 2 01 3 a s th e
percen ta g e cha n g e in th e cost o livin g between 2 01 3 an d
(1 46 2 1 3 5 )
2 01 2 : ___________ 3 1 00 5 8.1 5 % an d , sim ila rly, th e
1 35
(1 5 8.5 2 1 46)
in ation rate in 2 01 4: ____________ 3 1 00 5 8.5 6%
1 46
Or you cou ld constru ct the consu m er price ind ex u sing 2 01 2 as
the base year:
1 35
price ind ex or 2 01 2 (base year) 5 ____ 3 1 00 5 1 00
1 35
1 46
price ind ex or 2 01 3 5 ____ 3 1 00 5 1 08.1 5
1 35
1 5 8.5
price ind ex or 2 01 4 5 _____ 3 1 00 5 1 1 7.41
1 35
a n d th en ca lcu late th e in ation rate or 2 01 2 a s th e
percen ta g e cha n g e in th e price in d ices between 2 01 3 a n d
1 08.1 5 2 1 00
2 01 2 : ____________ 3 1 00 5 8.1 5 %
1 00
an d then the in ation rate or 2 01 4 as the percentage
change in the price ind ices between 2 01 4 and
1 1 7.41 2 1 08.1 5
2 01 3: _____________ 3 1 00 5 8.5 6%
1 08.1 5
Growth
You may be asked to calculate the rate o econom ic growth
between two years rom a set o data. This is a straightorward
percentage change calculation assum ing proportional growth in
discrete tim e. Denoting the growth rate in year t as g t and real
GDP o year t as yt we arrive at:
(yt 2 y(t 2 1 ) )
g t 5 ___________
yt
Rem em ber that to calcu late real GDP rom nom inal (or m oney)
GDP or GN I d ata you ju st d ivid e nom inal GDP by the GDP
d e ator and m u ltiply by 1 00.
Equity
The role of taxation in promoting equity
You may be asked to calcu late the margin al tax rate (MRT) and
the average tax rate (ATR) rom a set o d ata. Rem em ber that
the M RT is the extra (ad d itional) tax paid rom an extra d ollar
o incom e (or, rom an extra d ollar o the tax base; that is,
whatever is taxed , or example expend itu re, wealth and
bu siness prof ts). The ATR is the ratio o the tax paid over
incom e (or, m ore generally, the tax base). Assu m ing the typical
case o an incom e tax:
DT T
M RT 5 ___ and , ATR 5 __
DY Y
I the ATR is increasing as incom e (or, m ore generally, the tax
base) is increasing then the tax is progressive. I t ollows that
MRT . ATR.
I the ATR is constant as income (or, more generally, the tax base) is
increasing then the tax is proportional. It ollows that MRT 5 ATR.
I the ATR is d ecreasing as incom e (or, m ore generally, the tax
base) is increasing then the tax is regressive. I t ollows that
MRT , ATR.
5.3 International economics
3.1 inrnaonal rad
Comparative advantage and opportunity costs
You may be asked to calcu late opportu nity costs rom a set o
d ata in ord er to id entiy comparative ad vantage. I n an example
eatu ring two good s, the opportu nity cost o prod u cing m ore o
one good is the am ou nt o the other good that need s to be
sacrif ced . The prod u ction possibilities cu rve (PPC) that you will
be presen ted with will be linear. Assu m ing that good X is
m easu red on the horizontal axis and good Y on the vertical
then the opportu nity cost o prod u cing an extra u nit o good X
DY
is given by ___, which o cou rse is the slope o the PPC.
DX
Rem em ber that Y 5 Y2 2 Y1 .
3.2 exchang ras
Floating exchange rates
H ere you may be asked to calcu late the valu e o one cu rrency in
term s o another cu rrency.
Keep in m ind that i the exchange rate o currency in term s o
currency is e, then the exchange rate o currency in term s o
1 $
will be __
e . For example i 1 .00 5 $ 1 .44 then $ 1 .00 5 0.69.
You may be asked to calcu late the exchan ge rate or linear
d emand and su pply u nctions and to plot th e cu rves. The
process is id entical to th e d eterm ination o the equ ilibriu m
price and ou tpu t or a good an d the plotting o the linear
d emand and su pply u nctions.
Or, you may be asked to calcu late the price o a good in
d ierent cu rrencies u sing exchange rates. For example, i you
are given the price o an item in, say, U S d ollars and you want
to calcu late it in I nd ian ru pees (I N R) you m u ltiply the price o
INR
the item in d ollars tim es the ____ exchange rate.
$
3.3 th balanc of paymns
The structure of the balance of payments
H ere you m ay be a sked to ca l cu late el em en ts o th e ba la n ce
o paym en ts rom a set o d ata . You ju st n eed to rem em ber a
ew th i n g s.
To f nd the balance on any item you m u st su btract paym ents
(d ebits) rom receipts (cred its). I the resu lt is a positive nu m ber
you have a su rplu s in that item , while i it is negative you have
a d ef cit.
To f nd the cu rrent accou nt rom its com ponents you ad d net
exports o good s, net exports o services, net incom e an d net
cu rrent transers together.
Restrictions on trade: tariffs, quotas
and subsidies
You may be asked to calcu late rom d iagram s the eects o
imposing a tari on imported good s on d ierent stakehold ers,
inclu d ing d om estic prod u cers, oreign prod u cers, consu m ers
and the governm ent. These can all easily be calcu lated rom
linear u nctions bu t the syllabu s specif es that you will be asked
to make calcu lations rom d iagram s. Beyond being able to read
a d iagram properly you will need to rem em ber that
base 3 height
the area o a triangle is given by ____________
2
the area o a rectangle is a 3 b
(B 1 b)
and that the area o a trapezoid is _______ 3 h.
2
Assu m e that U S$ 1 .00 5 I N R44.69 and the item is an
Abercrom bie and Fitch shirt that sells or U S$ 70.00. I ts price in
INR INR
I N R is its price in U S d ollars tim es ____ or, $ 3 ____ so that the
$ $
$ cancels ou t:
INR
the price o the shirt in U S d ollars 5 $ 70.00 3 44.69 ____
5 I N R3,1 2 8.3
Lastly, you may be asked to calculate the change in the value o
a currency rom a set o data. H ere keep in m ind that i currency
depreciates by x% compared with cu rrency then currency
has not appreciated by x% compared with currency . I the
dollar d epreciates against the euro by 1 0% then the euro has
not appreciated against the dollar by 1 0%. You will need to
calculate the inverse o the exchange rates given and then fnd
the percentage change. I the euro was $ 1 .00 and appreciated
to $ 2 .00 it appreciated by 1 00%. The dollar depreciated by
5 0% as it was 1 .00 and it went down to 0.5 0.
To f nd the f nancial accou n t balance rom its com pon ents you
ad d net d irect investm ent abroad , net portolio investm ent and
net other investm ents and reserve assets together.
The su m o the capital and f nancial accou nts m u st equ al the
cu rrent accou nt balance.
Thereore, the su m o the capital, f nancial and cu rrent
accou nts m u st equ al zero. I the su m is not zero it is becau se o
errors and om issions.
1 69
 5 Quantitative issues in HL Paper 3

3.5 terms of rade

The meaning of terms of trade
You may be asked to calcu late the term s o trad e o a cou ntry.
The term s o trad e (TOT in the equ ation below) are the ratio o
th e average price o exports over the average price o im ports o
a cou ntry expressed as ind ex nu m bers tim es 1 00.
average price o exports
TOT 5 ___________________ 3 1 00
average price o im ports
An index num ber is a num ber that has no units o m easurem ent
and because o this it allows comparisons. You may be given the
average price o exports and o imports o a cou ntry or a
nu m ber o years or you may be told that a cou ntry exports only
one product, say oil or coee, and imports only one good, say
tractors or computers, to make things simpler.
To convert each average exports price into an ind ex nu m ber you
will need to d ivid e it by the average export price or the what is
chosen as the base year (or reerence year) and m u ltiply the
resu lt by 1 00. You will d o the sam e to convert each average
imports price into an ind ex nu m ber. Throu gh this you are
expressing the average price o exports (or o imports) or each
year as a percen tage o its average price in the chosen base
year. I t ollows that the ind ex nu m ber valu e or any variable in
the base year is equ al to 1 00.
For example, assu m e a cou n try that exports only coee and
imports only laptops. You are given the price o coee and the
price o laptops between 2 01 0 and 2 01 4 as well as the
revenu es in m illions o U S d ollars rom its coee exports. You
are also told that 2 01 1 is the base year. You may be asked to
calcu late the term s o trad e and to express export revenu es as
an ind ex nu m ber (to f ll in the colu m ns in grey in the table).
First you calcu late export prices as an in d ex nu m ber by d ivid ing
the export price in each year by the export price o the base
year (2 01 1 ) and then m u ltiplying by 1 00. Do exactly the sam e
calcu lation to d eterm ine import prices as an ind ex nu m ber.
Rem em ber that in the base year the valu e o an ind ex nu m ber
is 1 00. To f nd the term s o trad e in each year d ivid e the ind ex
o export prices by the ind ex o import prices and m u ltiply by
1 00. Rem em ber that the term s o trad e in the base year are
equ al to 1 00.
To express export revenu es as an ind ex nu m ber d ivid e export
revenu es in each year by export revenu es in the base year and
m u ltiply the resu lt by 1 00.

Year Price of Average exports price Price of Average imports Terms of trade (TOT) Export Export revenues as an
coffee as an index number a laptop price as an index PX
___ revenues index number
per ton (USD) number PM 3 100 (USD
(USD) millions)

2010 1500 1500

_____ 450 450
____ 90.91
_____ 36.5 36.5
____
1650 3 100 5 90.91 500 3 100 5 90 90 3 100 5 101 35.7 3 100 5 102.24
2011 1650 1650
_____ 500 500
____ 100
____ 35.7 35.7
____
1650 3 100 5 100 500 3 100 5 100 100 3 100 5 100 35.7 3 100 5 100
2012 1770 1770
_____ 540 540
____ 107.27
______ 34.8 34.8
____
1650 3 100 5 107.27 500 3 100 5 108 108 3 100 5 99.32 35.7 3 100 5 97.48
2013 1850 1850
_____ 575 575
____ 112.12
______ 34.3 34.3
____
1650 3 100 5 112.12 500 3 100 5 115 115 3 100 5 97.5 35.7 3 100 5 96.08
2014 1920 1920
_____ 610 610
____ 116.36
______ 33.2 33.2
____
1650 3 100 5 116.36 500 3 100 5 122 122 3 100 5 95.38 35.7 3 100 5 92

Summary
I you know:
X2 2 X1
(1 ) that the percentage change in X is _______ 3 1 00
X1

(2 ) that i Total X is TX and Marginal X is MX (so that MX 5 X2 2 X1 ) then X2 5 X1 1 M X

base 3 height
(3) that the area o a triangle is given by ____________
2

the area o a rectangle is a 3 b and

(B 1 b)
the area o a trapezoid is _______ 3 h
2

(4) and how to solve a system o two linear equ ations

you shou ld be u lly prepared or the calcu lations part o H L Paper 3.

1 70
 5 Data response sample questions
HLP2 & SLP2
Question 1
Study the extract below and answer the questions that follow.
Chinese and US trade negotiators convene in
Washington
1 . I n a U S-Chinese trad e d ispu te over tire imports the World
Trad e Organization (WTO) recently ru led in avou r o the
U S. The d ecision conclu d ed that the U S had complied with
global trad e ru les when last year it imposed taris as h igh
as 35 percent on Chinese tires that are u sed in both
passenger cars and light tru cks. The WTO ru ling relied on
a special provision that the U S trad e negotiators had
secu red when China joined the WTO. Specif cally, the U S
reserved the right to impose taris i it consid ered that U S
jobs were at risk as a resu lt o a su d d en and sharp increase
in imports rom China.
2 . The WTO verd ict was hailed as a major victory or the U S
and especially or Am erican companies and workers. The
2 009 d ecision to impose taris on tires im ported rom
China was also a consequ ence o signif cant pressu re rom
th e United Steelworkers Union and several other U S
lobbying grou ps.
3. The ru ling coincid ed with the preparations or a
Washington m eeting o U S and Chinese trad e of cials to
d iscu ss trad e and exchange rate issu es. Trad e rictions
between the two cou ntries inclu d e everything rom steel,
tires and pou ltry to Chinese taris on raw materials exports
(a) (i) Def ne the term recession ind icated in bold in the text
(paragraph 4). [2 marks]
(ii) Def ne the term trade defcit ind icated in bold in the
text (paragraph 4). [2 marks]
or:
(b) Explain u sing an appropriate d iagram why the tari
ru ling o the WTO is consid ered a major victory or the
United States and particu larly or Am erican workers and
bu sinesses (paragraph 2 ). [4 marks]
(c) Explain u sing an appropriate d iagram how the Chinese
are maintaining their cu rrency artif cially u n d ervalu ed .
[4 marks]
or:
(d) U sing inormation rom the text/d ata and you r
knowled ge o econom ics, evalu ate possible consequ ences
o China maintaining the yu an u nd ervalu ed . [8 marks]
or:
as well as concerns over the qu ality and saety o Chinese
mad e toys, ood s and other prod u cts. The latter, accord ing
to Chin ese manu actu rers, are nothing m ore that an excu se
or U S trad e protection .
4. Tension is also hig h as a resu lt o the U S complaint that
China is maintaining its cu rrency, the Yu an, artif cially
undervalued in ord er to u nairly assist its exporting f rm s.
Since m id -2 008 the Yu an had been u nof cially f xed to the
U S d ollar. I n 2 009 the valu e o U S exports to China
am ou nted to $ 7 7.4 billion whereas Chinese exports to the
U S, its second biggest trad ing partner, were signif cantly
higher reaching $ 2 2 0.8 billion . The U S trade defcit has
recently narrowed as a resu lt o the recession ind u ced
d ecrease in U S d emand .
5. On the other hand , the Chinese governm ent has its own
grievances over U S econom ic policy. I t claim s that th e
loose m onetary policy that the U S Fed eral Reserve Bank
(the U S Central Bank) has ad opted to help re ate the
Am erican economy has erod ed the valu e o Chinas hu ge
d ollar reserves.
Lastly, Chinas massive selling o its own cu rrency in th e
oreign exchange market, to help keep the Yu an low, has
increased in ationary pressu res at hom e as the m oney
su pply is increasing ar too ast.
(a) (i) Def ne the term undervalued (cu rrency) ind icated in
bold in the text (paragraph 4). [2 marks]
(ii) Ou tline two objectives o the WTO (paragraph 1 ).
[2 marks]
(b) Explain how easy U S m onetary policy is consid ered
responsible or d ecreasin g the valu e o the d ollar reserves
China is hold ing (paragraph 6). [4 marks]
(c) Explain how a U S recession may narrow the U S trad e
d ef cit (paragraph 4). [4 marks]
(d) U sing inormation rom the text/d ata and you r
knowled ge o econom ics, exam ine possible econom ic
eects on the U S and China o a d ecision to perm it the
yu an to rise. [8 marks]
1 71
 5 Data
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questions
Question 2
Study the extract below and answer the questions that follow.
Brazils current account defcit widens in 201 0
1 . I n 2 01 0 Brazil s current account defcit increased to
$ 47.5 billion as a resu lt o rising imports, a rapid ly
appreciating Real (Brazil s cu rrency) and its ad verse eect
on the cou ntrys exports. Years o stable and continu ou s
growth is responsible or higher import absorption while
oreign m u ltinational corporations with an established
presence in Brazil repatriate their prof ts taking ad vantage
o the higher valu e o the Real.
2 . Rising in ows rom oreign direct investm ent in to Brazil
u lly f nanced the cu rrent accou nt d ef cit. I n 2 01 0
m u ltinationals invested $ 48.5 billion into Brazil u p rom
$ 2 5.9 a year earlier.
3. Decreasing exports and rising imports o good s as a resu lt
o the strengthening o the cu rrency narrowed Brazil s
trade surplus rom $ 2 5.3 billion in 2 009 to $ 2 0.7 billion
this year. The cu rrency has appreciated rou ghly by 30%
against the U S d ollar since th e beginning o 2 009.
4. In the m eantim e, oreign direct investm ent inows continue
to increase and are predicted to rise to over $ 5 0 billion in
2 01 1 . A $ 7.1 billion investm ent involving the Chinese group
Sinopec and Brazil s Repsol is responsible or the increased
fgure this m onth. This trend in direct investm ent inows
m ust continue as the current account defcit is projected
to urther widen to $ 64 billion in 2 01 1 . This fgure is
(a) (i) Def ne the term current account defcit ind icated in
bold in the text (paragraph 1 ). [2 marks]
(ii) Describe a managed exchange rate system
(paragraph 6). [2 marks]
or:
(b) U sing an appropriate d iagram explain how a d ecision
by Brazil s Central Bank to increase interest rates may
aect the Real (paragraph 6). [4 marks]
(c) Exam ine the relationship d escribed between Brazil s
cu rrent and f nancial accou nts (paragraph 2 ). [4 marks]
or:
(b) Explain u sing an exchange rate d iagram how weakening
cu rrencies may boost exports and improve trad e balances
(paragraph 6). [4 marks]
(c) Explain the expected eect on Brazil s term s o trad e o
the appreciation o the Real (paragraph 3). [4 marks]
or:
(d) U sing inormation rom the text/d ata and you r
knowled ge o econom ics, evalu ate th e possible
econom ic consequ ences o the appreciation o the
Real on Brazil s economy. [8 marks]
or:
1 72
estimated to be the equivalent o about 3% o Brazil s GDP.
5. Brazil s Central Bank annou nced in its qu arterly report that
GDP grew by 7.3 percent last year as a consequ ence o
increased d eman d , cheap loans and investm ents. A su rvey
o econom ists expects Brazil s growth to slow d own to
4.5 percent this year. The Central Bank signaled that it
may also start tightening m onetary policy next m onth
as in ation is projected to increase aster than orig inally
expected .
Brazil ears international currency war
6. Brazilian Finance Minister Ed u ard o M antega claim ed in an
interview that an international cu rrency war has begu n as
g overn m ents are intervening in oreign exchange markets
manipu lating their cu rrencies. Mantega consid ers this
tactic a d irect threat to Brazil as it erod es its
com petitiveness. Governm ents d eliberately weaken their
cu rrencies to improve trad e balances by rend ering their
exports m ore competitive and red u cing the attractiveness
o im ported prod u cts. The ad vanced cou ntries are seeking
to d evalu e their cu rrencies, said the Finance M inister,
pointing u nm istakably to the United States, Japan and
Eu rope. Su ch policies artif cially strengthen trad e
com petition and risk an abru pt policy reversal toward s
increased trad e protection.
(a) (i) Def ne the term oreign direct investment ind icated in
bold in the text (paragraph 2 ). [2 marks]
(ii) Def ne the term trade surplus ind icated in bold in the
text (paragraph 3). [2 marks]
(b) Explain whether each o the ollowing is registered as a
cred it or a d ebit item in Brazil s Balance o Paym ents:
g reater oreign travel by Brazilians (paragraph 1 )
the $ 7.1 billion transaction involvin g the Chinese
grou p Sinopec and Repsol Brazil (paragraph 4)
i ncreased overseas prof ts rem ittances by
m u ltinationals (paragraph 1 )
consu mption o m ore im ports (paragraph 1 )
[4 marks]
(c) (H L only) U sing a proper J-cu rve eect d iagram , explain
whether ollowing the appreciation o the Real the
Marshall-Lerner cond ition or Brazil has com e into eect
(paragraph 3 ). [4 marks]
(d) U sin g inormation rom the text/d ata and you r
knowled ge o econom ics, exam ine possible reasons or
which oreign d irect investm ent has been owing in to
Brazil. [8 marks]

Question 3
Study the extract below and answer the questions that follow.
The East African Community strategy to
accelerate growth
1 . Bu ru nd i, Kenya, Rwand a, Tanzania and U gand a are
m em bers o the East Arican Com m u nity (EAC) which rom
Ju ly 2 01 0 has evolved rom a cu stom s u nion to a com m on
market. The total popu lation o this regional trad ing bloc
exceed s 1 2 5 m illion people while com bined GDP is rou ghly
$ 75 billion.
2 . As a resu lt o the ormation o a com m on market, trad e
and investm ent ows insid e the bloc will increase while
foreign direct investment will also be attracted . By 2 01 2
m em bers also plan to establish a m onetary u nion ad opting
th e East Arican Shilling as a com m on cu rrency. The
Com m on M arket agreem ent signed at the end o 2 009 has
alread y attracted signif cant investm ents rom Japan,
China and I nd ia.
3. Establishing an East Arican M on etary Union will prove
ad van tageou s to investors who are expected to actively
seek bu siness opportu nities in the region. As there will be
(a) (i) Def ne the term infrastructure ind icated in bold in th e
text (paragraph 4). [2 marks]
(ii) Def ne the term GDP ind icated in bold in the text
(paragraph 1 ). [2 marks]
(b) Explain two possible reasons or which signif cant
investm ents rom Japan, Chin a and I nd ia are alread y
attracted into the EAC (paragraph 2 ). [4 marks]
(c) Explain u sing appropriate d iagram (s) the possible short
term an d long term impact o increased and im proved
inrastru ctu re in any o the EAC econom ies (paragraph 4).
[4 marks]
(d) U sing inormation rom the text/d ata and you r knowled ge
o econom ics, evalu ate the prospect o the East Arican
Com m u nity establishing a m onetary u nion as a m eans o
achieving econom ic growth and econom ic d evelopm ent.
[8 marks]
55Quantitative
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Paper 3
no need to convert cu rrencies in the oreign exchange
market tran saction costs will be signif cantly red u ced . The
elim ination o taris and other trad e barriers has alread y
enhanced trad e ows between the f ve m em ber states.
Greater tran sparency will perm it d irect price comparisons
boosting com petition and ef ciency. M em bers are also
expected to benef t rom the greater bargaining power they
will enjoy in political and econom ic negotiations.
4. On the other hand , d oing bu siness in the region has n ever
been easy. Poor infrastructure as well as high levels o
corru ption bu rd en bu sin esses with ad d itional costs. Sizable
investm ents in u pgrad ing road s and transport system s as
well as in d evelopin g su f cient and reliable power
generation acilities are expected to red u ce prod u ction
costs and thu s to accelerate growth or all f ve m em ber
states. On the other hand , erad icating corru ption may
prove m u ch m ore complex. For exam ple, even thou gh
region al taris have been elim inated since 2 005 m ore
than 2 0% o cu rrent shipping costs rom Rwand a to Kenya
are attribu ted to bribes an d corru ption.
Or:
(a) (i) Def ne the term foreign direct investment (paragraph 2 ).
[2 marks]
(ii) Ou tline th e d ierences between a cu stom s u nion and a
com m on market (paragraph 1 ). [2 marks]
(b) Explain u sing an appropriate d iagram h ow elim inating
taris aects trad e ows o the cou ntries involved
(paragraph 3). [4 marks]
(c) U sing an appropriate d iagram explain the expected eect
on an econ omy o a d ecrease in the level o corru ption
(paragraphs 4 and 5 ). [2 marks]
(d) U sing inormation rom the text and you r knowled ge o
econom ics d iscu ss the possible ad vantages and
d isad vantages o signing a m onetary u nion or the EAC
m em ber cou ntries. [8 marks]
1 73
 5 Data
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response
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questions
Question 4
Study the extract below and answer the questions that follow.
A. India: Time to rethink crutches or exports
1 . I nd ias export perormance in Decem ber 2 01 0 highlights
several interesting d evelopm ents. First o all, it
d em onstrates that the exchange rate is not anym ore the
single m ost important d eterm inant o the cou ntrys export
perormance. Whether I nd ian exports penetrate oreign
markets d oes not only d epend on a cheap cu rrency.
I nternational competitiveness relies m ore on increased
prod u ction ef ciency o I nd ian f rm s as well as on several
im proved non-price actors.
2 . Second ly, I nd ias export su ccess d oes not anym ore rely on
the perormance o a ew commodities or on low valu e-
ad d ed manu actu res. Past governm ent policies to d iversiy
the composition o exports as well as their d estination
(su ch as the Look East policy initiative or the ocu s on
Arican and Sou th Am erica) are paying o. And even
thou gh growth in ad vanced econom ies is slu ggish many
em erging econom ies are growing ast.
3. Third ly, rapid ly increasing export revenu es are narrowing
I nd ias trad e and cu rren t accou nt d ef cits. The gap between
export revenu es and import expen d itu res had wid ened
d u ring the f rst hal o the cu rrent year to $ 3 5.4 billion or
3.7 % o I nd ias GDP as a resu lt o a sharp rise in imports.
The size o this d ef cit was then consid ered by many
analysts as increasingly u nsu stainable.
4. Thu s, the recently registered strong perormance o export
revenu es which are now growing aster than im port
expend itu res is a m ost welcom e d evelopm ent. I t also
points to the sig nif cance o the export sector an d su gg ests
(a) (i) Def ne the term exchange rate ind icated in bold in
the text (paragraph 1 ). [2 marks]
(ii) Def ne the term growth ind icated in bold in the text
(paragraph 5 ). [2 marks]
or:
(a) (i) Def ne the term appreciation ind icated in bold in the
text (paragraph 6). [2 marks]
(b) Explain u sing an appropriate d iagram how econom ic
recovery in the western world may aect I nd ias
aggregate d emand (paragraph 2 ). [4 marks]
(c) Explain how greater prod u ction ef ciency and improved
non-price actors may increase the competitiveness o
I nd ias exports (paragraph 1 ). [4 marks]
or:
(b) Explain the implication or I nd ias term s o trad e o the
ru pee appreciation m ention ed in paragraph 5. [4 marks]
(c) Distingu ish the term s trad e and cu rren t accou nt d ef cits
m entioned in paragraph 3 . [4 marks]
or:
(b) Explain u sing an appropriate d iagram how I nd ias
expected growth ou tlook and its im pact on oreign
1 74
that not only shou ld inrastru ctu re im prove to allow
exporting f rm s bu t also that the governm ent shou ld
sim pliy proced u res and cu t d own on red tape. Will it m ove
in the right d irection?
B. Rupee rises on und infows
5. Expectations that I nd ias economy will continu e to register
strong growth as well as relatively high interest rates have
been responsible or increased oreign investm ent as well
as or the appreciation o the I n d ian ru pee. The Reserve
Bank o I nd ia (its central bank) orecasts that the economy
will grow this year by 8.5 %. The interest rate has been set
at 6.2 5 % by the RBI and is th e second highest ater
I nd onesia in the region . Analysts thu s expect that oreign
appetite or I nd ian assets will remain strong as the interest
rate d ierential will attract d ollar investors.
C. Cotton prices to hit clothing exports
this year
6. Accord ing to a recent report, rising cotton prices as well as
the appreciation o the ru pee cou ld harm exports o the
I nd ian clothing sector. As a resu lt o these d evelopm ents
export revenu es o clothing exporters cou ld d ecrease
lowering their prof tability. The report ad d s that d espite
improving export d emand in key markets the U S and
Eu rope ru pee appreciation has im paired the competitive
ad vantage previou sly enjoyed by the I nd ian clothing
exporters against their Asian rivals.
(ii) Outline two typical unctions o a Central Bank, such
as the Reserve Bank o India (paragraph 5 ). [2 marks]
or:
(a) (i) Def ne the term commodities ind icated in bold in th e
text (paragraph 2 ). [2 marks]
(ii) Def ne the term GDP ind icated in bold in the text
(paragraph 3). [2 marks]
investm ents may have aected the I nd ian ru pee
(paragraph 5 ). [4 marks]
(c) With reerence to the concept o price elasticity o
d emand , explain how I nd ias cotton export revenu es may
d ecrease ollowing an appreciation o the ru pee
(paragraph 6). [4 marks]
or:
(b) Explain u sing an appropriate d iagram how relatively
high interest rates have aected the Indian rupee
(paragraph 5 ). [4 marks]
(c) U sin g an appropriate d iagram explain how the
d evelopm ent in cotton prices aects the d om estic
(I nd ian) price o clothing (paragraph 6). [4 marks]
 55Quantitative
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Paper 3

(d) U sing inormation rom the text/d ata and you r or:
knowled ge o econom ics, d iscu ss the view that econom ic (d) U sing inormation rom the text/d ata and you r
d evelopm ent may best be achieved throu gh a knowled ge o econom ics, evalu ate export prom otion as a
com plem entary approach involving a balance o market m eans o accelerating growth and econom ic
oriented policies and governm ent intervention. d evelopm ent. [8 marks]
[8 marks]
or:
(d) U sing inormation rom the text/d ata and you r
knowled ge o econom ics, exam ine d iversif cation as a
m eans o accelerating growth and econom ic
d evelopm ent. [8 marks]

1 75
 5 Data
Data response
response
sample
sample
questions
questions
Question 5
Study the extract below and answer the questions that follow.
More Kenyans to access banking service
1 . A new agent banking m od el is soon to be introd u ced by
the Central Ban k o Kenya (CBK) which will hopeu lly
su cceed in bringing banking services closer to the
popu lation. Fou r commercial banks have been granted a
license to cond u ct agent banking bu siness. A physical
presence accord ing to the agent banking m od el is not
requ ired in the areas where these banks are planning
to oer their services. This signif cantly lowers the
costs o expand ing.
2 . The services oered by an agent ban k are the sam e as
those oered by a real bank and inclu d e, am ong others,
cash d eposits and withdrawals, transer o u nd s as well as
loans. Petrol station owners, villag e town wholesalers,
su permarket owners and post of ces are examples o the
prof les o banking agents in this m od el. Micro credit
institu tions are also expected to becom e agents, as not
only d o they satisy the requ irem ents bu t they also have
the experience.
3. Access to banking institu tions is consid ered highly
benef cial, especially since this m od el wou ld perm it a
banking presence in ru ral and rem ote areas o the cou ntry.
At this point only 23 percent o the cou ntrys ad u lt
popu lation hold s a bank accou nt while 34 percen t has no
access to ormal f nancial services with many orced to
resort to the inormal banking sector. These are exactly the
ind ivid u als targeted by the proposed agent banking
m od el and by m icro cred it institu tions. I ncreasing access to
banking institu tions will in crease savings and investm ents.
As a resu lt, growth and d evelopm en t o poverty stricken,
ru ral and rem ote areas will hopeu lly accelerate.
(a) (i) Def ne the term commercial bank ind icated in bold in
the text (paragraph 1 ). [2 marks]
(ii) Def ne the term micro credit ind icated in bold in the
text (paragraph 2 ). [2 marks]
(b) Su ggest two strategies that may improve the capacities o
benef ciaries to earn incom es and repay their loans
(paragraph 6). [4 marks]
1 76
Philippines: Micro credit gains ground
4. Th e poor who need to borrow oten pay extrem ely in ated
interest rates as they are orced to resort to the inormal
banking system . An alternative or these people are m icro
cred it institu tions. N ot only d o the very poor in cases o
m ed ical or other em ergencies u se su ch in stitu tions, bu t
also many small hou sehold based entrepreneu rs who
borrow to f nance short term need s o their small
bu sinesses.
5. M icro cred it may help alleviate poverty bu t it is not a
cu re-all an swer. Despite aim ing to help the very poor, loan
recipients still m u st satisy som e m inim u m requ irem ents.
For example, poor ind ivid u als hoping to set u p a small
bu siness m u st d em onstrate that they are capable to
manage it.
6. I n the Philippines, the market or su ch m icro cred it
institu tions d ef nitely exists as abou t 40 percent o ru ral
h ou sehold s are very poor. Su ccess o su ch institu tions
involves signif cant risks sin ce the prod u ctivity o the
targeted poor larg ely d epend s on agricu ltu re. I t ollows
that targeted in rastru ctu re su ch as arm to market road s
and irrigation system s are necessary to increase their
capacity to repay their loans. Micro cred it and improved
inrastru ctu re thu s go hand in hand : both are need ed to
increase agricu ltu ral prod u ctivity and incom es and the one
withou t the other is inad equ ate to ad dress the problem o
ru ral poverty. M ore generally, m icro cred it requ ires
com plem entary strategies that aim to increase the incom e
earning capacity o the loan recipients. Only then will it
becom e eective and su stainable in the long ru n.
(c) Explain two possible problem s associated with the u se o
inormal banking system s (paragraphs 3 and 4).
[4 marks]
(d) U sing inormation rom the text/d ata and you r knowled ge
o econ om ics, exam ine how expand ed access to cred it may
contribu te to econom ic d evelopm ent. [8 marks]
 Glossary
Abnormal prots (see Supernormal prots)
Absolute advantage A country is said to
have an absolute advantage in the
production o a good i it can produce
more o it with the same resources; or, the
same amount using ewer resources.
Absolute poverty Measures the number o
people living below the minimum income
necessary to satisy basic physical needs;
the 2008 World Bank international poverty
line is set at $1.25 purchasing power parity
(PPP) per day. (See also Purchasing
power parity (PPP) theory.)
Accounting costs Production costs or which
a rm makes explicit monetary payments.
Actual and potential growth Actual
growth reers to increases in real GDP
through time; potential growth reers to a
shit outwards o the production
possibilities rontier or curve.
Ad valorem tax An indirect tax expressed
as a percentage o the price o a product,
or example VAT.
Administrative trade barriers
(or, regulatory trade barriers)
Government or administrative regulations or
requirements that result in a lower level o
imports into a country.
Adverse selection A problem arising when
inormation in a market is asymmetric and
the seller knows more about the
characteristics o the good being sold than
the buyer. The buyer would be better o
trading with someone selected at random
rom the general population than with
this seller.
Aggregate demand (AD) Total planned
spending on domestic goods and services
at various possible average price levels per
period o time.
Aggregate supply (AS) The planned
level o output at various possible price
levels that rms are willing to oer per
period o time.
Aid Any fow o capital (grants or loans)
rom developed to developing countries
that is non-commercial rom the point o
view o the donor and or which the terms
are concessional (that is, the interest rate
is lower than the market rate and the
repayment period longer).
Allocative eciency Exists when just the
right amount rom societys point o view
has been produced. It requires that or the
last unit produced, price is equal to its
marginal cost (MC) or, more generally,
that marginal social benet (MSB) is equal
to marginal social cost (MSC).
Anti-dumping duties Taxes (taris) that
bring the import price o the good that is
being dumped closer to the price
charged by domestic rms in order to
avoid injury to the domestic industry in
the importing country.
Anti-monopoly regulation Laws and
regulations that aim to restrict monopoly
power and monopoly practices in markets.
Appreciation An increase in the exchange
rate within a fexible (foating) exchange
rate regime.
Appropriate technology Technology that
employs the relatively abundant actor o
production o a country.
Asymmetric inormation Exists when one
side o a market knows more than the
other side does.
Automatic stabilizers Reers to the
income-induced changes o progressive
income taxes and o unemployment
benets on the governments budget that
tend to stabilize the business cycle.
Average xed costs (AFC) Fixed costs
on a per unit o output basis; xed
costs divided by the level o output;
average xed costs continuously decrease
as output increases. (See also Fixed costs.)
Average household A ctitious household
determined through surveys that possesses
the average characteristics o the population
and that is used in the construction o the
consumer price index (CPI).
Average product (o labour) Output per
worker and used as a common measure o
labour productivity.
Average revenue (AR) Total revenues (TR)
divided by output; AR is always equal to
price and diagrammatically is identical to
the demand curve a rm aces.
Average tax rate The ratio o the tax
paid over the tax base, or example
income or spending.
Average total costs The total costs
incurred on a per unit o output basis.
(See also Total costs.)
Average variable costs (AVC) Variable
costs on a per unit o output basis;
variable costs divided by the level o
output. (See also Variable costs.)
Balance o payments (BOP) A record o
all transactions o a country with the rest
o the world over a period o time. It is
broken down into the current account, the
capital account and the nancial account.
Balance o trade Reers to the dierence
between the value o exports and the
value o imports o goods (physical
merchandise) over a period o time
(sometimes services are also included).
Balanced budget When government
expenditures (G) are equal to government
tax and other revenues/income (T)
Barrier to entry Anything that deters
entry o a new rm into a market, or
example a patent.
Basic economic questions The what,
how and or whom questions that all
economies must somehow answer.
Bilateral agreements Preerential trade
agreements between two countries.
Bilateral aid Aid rom one government to
another through some kind o national
aid agency.
Birth rate The average number o live
births in a year or every 1,000 population.
Bottlenecks (in production) Used to
explain the upward sloping section o the
Keynesian aggregate supply (AS) curve
(section 2) which reers to the act that as
aggregate demand (AD) increases, some
industries being characterized by very low
price elasticity o supply (PES) reach their
capacity level o output beore others .
Branding A type o rm-created barrier to
entry which reers to the eorts rms make
to establish the brand name image o their
goods in order to render demand or those
goods more price inelastic and deter entry
o new rms.
Break-even output That level o output or
which the total revenues (TR) o a rm are
equal to the total costs (TC) o production
so that prots are zero.
Break-even price The price at which a rm
is earning zero economic prots (that is,
normal prots) which or a perectly
competitive rm is the minimum o its
average total costs (ATC).
Budget decit Exists i government spending
(G) exceeds government (tax) revenues (T).
Budget surplus Exists i government (tax
and other) income (T) exceeds government
expenditures (G) .
Business condence The degree o
optimism or pessimism characterizing
businesses which aects their decisions
on investment spending.
Business cycle The short-run fuctuations
o real GDP around its long-run trend.
Business taxes Taxes on rms prots.
Cap and trade schemes A solution to
pollution externalities that aims at
creating a market or pollution permits by
limiting (capping) the number issued
(making them scarce and valuable) and
then permitting rms to trade these in the
open market.
Capital Produced means o production
(tools, machines, equipment, actories, etc.).
Capital account o the balance o
payments (BOP) An account o the
BOP which records unilateral transers
o capital, such as the orgiveness o
a countrys debt by the government
o another country as well as transers
o non-produced, non-nancial assets
such as natural resources, contracts,
leases and licences, marketing assets
(and goodwill).
Capital fight Reers to nancial capital
exiting a country legally or illegally and
fowing into saer and more protable
nancial centres.
1 77
 Glossary
Capital fows Investment fows per period o
time into and out o a country. These include
portolio and oreign direct investments.
Capital gains tax A tax on the gains rom
the sale o stocks (shares).
Capital (government expenditures)
Reers to public investment spending, or
example spending by the government on
inrastructure such as on the construction
o roads, harbours, hospitals and schools.
Carbon tax A tax on polluting emissions
that aims at orcing polluters to pay the cost
o their action (polluter pays principle); a tax
on the carbon content o ossil uels.
Cartels Formal collusion o oligopolistic
rms agreeing to behave as i they were a
monopoly by restricting output in order to
x price at a higher level.
Central bank An institution responsible or
monetary and exchange rate policy which
provides banking services to the government
and to commercial banks and which is
considered the lender o last resort.
Centrally planned (command) economy
Reers to an economy in which the state
determines prices and output o goods and
services.
Ceteris paribus All other actors remaining
constant.
Circular fow model An economic model
showing the major interrelationships and
fows, real and monetary, between the
major players (decision-making units) o
an economy.
Closed economy An economy that does
not engage in international trade (exports
and imports).
Collusive oligopoly When oligopolistic
rms ormally or tacitly agree to x price or
to engage in other anti-competitive
practices.
Commodities Primary sector agricultural and
non-agricultural products used as inputs in
the manuacturing process and traded in
international markets, or example coee,
cotton, tin, zinc and copper).
Commodity agreements Agreements
between producers to coordinate
commodity exports in order to stabilize
prices. Either a production (export) quota
system is operated (such as the
I nternational Coee Agreement) where
producers (exporting countries) agree to
limit the amount exported, eectively
orming a cartel; or a buer stock system
(or example or cocoa or rubber) may be
operated. Commodity agreements usually
collapse because o nancing problems.
Commodity concentration o exports
When one or very ew products are
responsible or a large percentage o the
export revenues o a developing country,
or example copper and nitrates or Chile.
Common-access resources Common-access
(or pool) resources are resources or which
1 78
it is dicult to exclude individuals rom
deriving benets rom their use and which
are rival in consumption, or example
shing grounds and orests.
Common market A orm o economic
integration whereby members move orward
to establish not only ree trade in goods and
services but also ree movement o actors o
production.
Common-pool resources (see
Common-access resources)
Comparative advantage A country is said
to have a comparative advantage in the
production o good X i it can produce it at a
lower opportunity cost (that is, by sacricing
ewer units o good Y) compared with
another country.
Competitive supply I a rm can produce
dierent goods with the same inputs then
these goods are in competitive supply.
Complementary goods or
complements Goods that are consumed
jointly, or example coee and sugar.
Composite indicators o development
Indicators o development that are based
on more than one economic variable, or
example the Human Development Index.
Concentration ratio A measure o
concentration based on ratio (CR) in an
industry where typically the sales o the
largest n rms are expressed as a percentage
o total industry sales; or example the
our-rm CR expresses the sales o the scal policy was not as eective as
largest our rms as a proportion o total
industry sales.
Concessional loans Loans granted to a
country usually by a multilateral institution,
or example the IMF, with a longer
repayment period and with an interest rate
below the market rate (known as sot loans).
Constant returns to scale A production
technology where a 1 % increase in all
inputs leads to a 1 % increase in output (so
that unit costs are constant).
Consumer condence The degree o
optimism or pessimism characterizing
households which aects their spending
decisions.
Consumer expenditures Spending by
households on durable and non-durable
goods and services per period o time.
Consumer price index (CPI) A weighted
average o the prices o the goods and
services that the typical consumer aces,
expressed in index number orm.
Consumer surplus The dierence between
how much a consumer is willing and able to
pay at the most or some amount o a good
and what he or she actually ends up paying.
Consumption (see Consumer expenditures)
Consumption externality When the
consumption o a good imposes costs or
creates benets or third parties or which
the latter do not get compensated or do
not pay or.
Contractionary scal policy Decreases in
government spending and/or increases in
taxes aimed at decreasing aggregate
demand (AD).
Contractionary monetary policy (see
Tight monetary policy)
Core infation A measure o infation that
excludes volatile oil and ood prices.
Corporate social responsibility A possible
objective o rms that aims at creating and
maintaining an ethical and environmentally
responsible image or them.
Corporate indebtedness The total
amount o money that rms owe to banks
and other holders o their debt and which
is considered a actor that may aect their
decision to undertake additional
investment spending.
Cost-push infation Infation resulting
rom adverse supply shocks shiting
aggregate supply (AS) to the let; usually,
rising commodity prices are responsible,
especially oil prices.
Credit item (in the BOP) Any item that
leads to an infow o money into a country,
or example exports o goods and services
or oreigners purchasing domestic bonds.
Cross-price elasticity o demand
(XED) The responsiveness o the demand
or a good to a change in the price o
another good.
Crowding-out The idea that expansionary
Keynesian theory claimed because decit
spending required nancing which would
lead to increased interest rates and so
reduced private sector spending.
Current government expenditures
Spending by the government on wages and
salaries o public sector employees as well
as spending on consumables (day-to-day
items) such as stationery.
Current account (o the BOP) Records
the value o exports and imports o goods
and services o a country in a period o
time. A current account surplus exists i the
value o exports o goods and services
exceeds the value o imports. This applies
conversely or a decit. More precisely, the
current account includes visible trade and
invisibles. The latter include trade in
services and net investment income as well
as net transers.
Current account decit When import
expenditures on goods and services exceed
export revenues over a period o time; more
precisely, when the sum o net exports o
goods and services plus net income rom
investments plus net transers is negative.
Current account surplus When export
revenues exceed import expenditures on
goods and services over a period o time;
more precisely, when the sum o net exports
o goods and services plus net income rom
investments plus net transers is positive.

Customs unions A orm o regional
economic integration whereby two or more
countries abolish taris (and other
barriers) between them and establish a
common external barrier toward non-
member countries.
Cyclical (demand-decient or Keynesian)
unemployment Unemployment that is a
result o insucient aggregate demand
(AD) and o sticky money wages. Cyclical
unemployment rises as an economy moves
deeper into recession.
Death rate The average number o deaths
in a year or every 1,000 population.
Debit item (in BOP) Any item that leads to
an outfow o money rom a country, or
example imports o goods and services or
domestic residents purchasing oreign bonds.
Debt burden Signies the impediment to
the growth and development process o a
country that a high external debt creates.
Debt rescheduling Reers to agreements
between a debtor country and its creditors
to deer debt service payments, to extend
maturities on all outstanding debt and
perhaps even to reduce debt-service
obligations in order to provide the debtor
with debt relie.
Debt servicing Payment o interest and
principal o a debt (o a country or an
individual).
Decile One o the ten equal parts o a
requency distribution.
Decreasing returns to scale A production
technology where a 1 % increase in all inputs
leads to a smaller than 1 % increase in
output (so that unit costs rise; diseconomies
o scale DOS).
Defation Reers to the case where the
average level o prices is decreasing
through time. Defation implies negative
infation rates.
Defationary gap A defationary gap is
present i equilibrium (actual) real output
alls short o the level corresponding to the
ull employment level o output as a result
o insucient aggregate demand (AD).
Demand The relationship between various
possible prices and the corresponding
quantities that an individual or the market
is willing and able to buy per period o time,
ceteris paribus. The individual demand
reers to an individual consumer whereas
the market demand reers to the whole
market and diagrammatically it is the
horizontal summation o the individual
demand curves.
Demand-pull infation Infation resulting
rom aggregate demand (AD) rising aster
than aggregate supply (AS).
Demand-side policies Policies aimed at
infuencing the level o aggregate demand
(AD) in order to aect growth, employment
and infation. They include scal and
monetary policy.
Demerit goods Consumption o such goods
creates very signicant negative externalities
on society so governments try to decrease or
prohibit their consumption. Typical examples
include alcohol, tobacco and illegal drugs.
Demographic actors Factors pertaining
to the characteristics o a population in a
country, or example the average age o a
population.
Depreciation (o a currency) A decrease
in the exchange rate within a foating
(fexible) exchange rate system.
Deregulation Policies that lower or eliminate
government regulations on the operation o
an industry and which may have a positive
supply-side eect on the economy. Economic loss A rm is making economic
Determinants o demand Factors other
than the price o a good that may aect its
demand and shit it, such as changes in
income, tastes and prices o related goods.
Determinants o supply Factors other
than the price o a good that may aect
its supply and shit it, such as changes in
the price o inputs or the level o
technology available.
Devaluation (o a currency) A decrease
in the exchange rate within a xed
exchange rate system.
Dierentiated product Products which are
similar but not identical across sellers in an
industry. They are considered by consumers
as close but not perect substitutes.
Direct taxation Taxation on income
and wealth.
Diseconomies o scale (DOS) Reers to
increases in average costs (AC) as a result o
increased size o the rm; see also
decreasing returns to scale.
Disguised unemployment (see Hidden
unemployment)
Disinfation Disinfation exists when the
rate o infation decreases which means
that prices continue to rise but at a
decreasing rate.
Disposable income Income ater
subtracting direct taxes and adding transer
payments which can be spent or saved.
Distribution o income A representation
o what proportion o national income is
enjoyed by dierent segments o a
population; a requency distribution
showing groups o people classied by
levels o national income.
Diversication (o exports) A policy
initiative to move away rom commodity
concentration o exports. When a country,
instead o relying on only a ew
commodities to export, tries to export a
bigger variety o goods and services.
Dominant rm Typically the largest in size
rm in an oligopoly which may set prices
that other tacitly ollow.
Dynamic eciency When a rm enjoys
economies o scale (EOS), leading to aster
rates o innovation (new products and
new processes).
Glossary
Easy monetary policy When the central
bank decreases interest rates (or increases
the money supply) to increase aggregate
demand (AD) in an economy and thereore
overall economic activity.
Economic costs The value o all resources
sacriced to produce a good.
Economic development A sustainable
increase in living standards that implies
increased per capita income, better
education and health as well as
environmental protection.
Economic good Goods whose production
involves the sacrice o scarce actors o
production.
losses i its revenues are insucient to
cover all economic (that is, both implicit
and explicit) costs; negative economic
prots.
Economic models Simplied representations
o economic reality, typically but not
necessarily expressed in mathematical orm,
aiming at acilitating comprehension o
complex economic phenomena and at
deriving alsiable hypotheses.
Economic prots The reward o
entrepreneurship. They are dened as the
(positive) dierence between total revenues
(TR) and total economic costs (TC).
Economic union A orm o regional
economic integration where members o a
customs union decide to integrate urther
by harmonizing taxation and other
economic policies and even establishing a
common currency.
Economies o scale (EOS) Economies o
scale exist i average costs decrease as the
size (scale) o the rm increases.
Education indicators Single variable or
composite indicators that aim at
summarizing an aspect or the level o
education o a country, or example the
adult literacy rate or primary education
completion rate.
Eciency Reers, in general, to non-
wasteul use o scarce resources. (See also
Allocative eciency, Productive eciency
and Technical eciency.)
Elasticity Generally, the responsiveness o
an economic variable to a change in some
other economic variable. For example,
price elasticity o demand (PED).
Emergency relie aid (see Humanitarian
aid)
Empowerment o women In the US
denition the term has ve components:
womens sense o sel-worth; their right to
have and to determine choices; their right
to have access to opportunities and
resources; their right to have the power to
control their own lives, both within and
outside the home; and their ability to
infuence the direction o social change to
create a more just social and economic
order, nationally and internationally.
1 79
 Glossary
Entrepreneurship The willingness and
ability o certain individuals to organize
the other three actors o production and
to take risks.
Equilibrium A market is considered to be in
equilibrium i there is no tendency or
change. This will be the case i quantity
demanded per period equals quantity
supplied and the market clears (that is,
quantity demanded equals quantity
supplied and so neither excess demand
nor excess supply exist).
Equilibrium price The price at which a
market clears (that is, at which quantity
demanded equals quantity supplied and
so neither excess demand nor excess
supply exist).
Equilibrium quantity The quantity that
corresponds to the equilibrium price in a
market.
Equity Reers to airness in the distribution
o income.
Excess demand Excess demand exists when
at some price the quantity demanded is
greater than the quantity supplied, exerting
pressure on the market price to increase.
Excess supply Excess supply exists when at
some price the quantity supplied is greater
than the quantity demanded, exerting
pressure on the market price to decrease.
Exchange rate The price o a currency
expressed in terms o another currency.
The number o units o a oreign
currency required to buy a unit o the
domestic currency.
Excise tax An excise tax is an indirect tax
(that is, a tax on goods or on expenditure);
strictly speaking it is a tax levied on a
specic commodity or group o
commodities in contrast to a sales tax
which is levied on all commodities (US use).
Exit (rom a market) When a rm or rms
shut down and cease operations in a market.
Exit barriers Costs that a rm incurs
upon exit.
Expansionary scal policy Reers to
increases in government expenditures
and/or decreases in taxes aiming at
increasing aggregate demand (AD) and
economic activity.
Expansionary monetary policy (see Easy
monetary policy)
Expectations The present perception o
decision-making units concerning the uture
state o aairs in an economy, a market or
the value o an economic variable.
Expected variables The uture value o a
variable as perceived presently.
Expenditure approach Reers to one o the
three ways o measuring national income
whereby expenditures by households, rms,
oreigners and the government on domestic
goods and services over a period o time
are added (the other two methods are the
output method and the income method).
1 80
Expenditure-changing and expenditure-
switching policies Expenditure changing:
demand management policies that will
lower aggregate demand (AD) and thereore
national income and so reduce imports and
a trade decit. Expenditure switching:
policies that will try to switch expenditure
away rom imports and towards domestic
products by making imports relatively more
expensive and thereore undesirable, or
example through devaluation or through
the imposition o taris.
Expenditure fow Within the circular fow
diagram o a closed economy without
government it reers to the monetary fow
rom households to rms that refects their
spending on domestic output per period.
Explicit costs Also reerred to as out-o-
pocketcosts o production. (See also
Accounting costs.)
Export promotion A growth policy that
aims at using export demand as the
vehicle o growth and that is oten
contrasted to import substitution.
Export subsidy A payment granted by a
government to domestic rms to
strengthen their competitiveness against
oreign producers.
Export-led/outward-oriented growth
A strategy stressing export markets in the
belie that the resulting increase in
aggregate demand (AD) and in oreign
exchange earnings, together with the
aster transer and diusion o technology Free goods Goods that do not have an
and all other trade-related eciency
benets, will accelerate the growth and
development process o an economy.
Externalities When an economic activity
creates benets or imposes costs or
third parties or which these do not pay
or, or do not get compensated or,
respectively.
Factor endowments The actors o
production (land, labour, capital and
entrepreneurship) o a country.
Factors o production The land (natural
capital), labour, human capital, physical
capital and entrepreneurship an economy
has at its disposal.
Fertility rate The average number o live
births per 1,000 or all women between
1 5 and 44 years old.
Financial account Records the portolio
and oreign direct investment (FDI) into
and out o a country over a period o time
as well as changes in reserve assets.
Fiscal policy Reers to the manipulation o
the level o government spending (G) and
o taxation (T) in order to aect aggregate Full employment The term has come to
demand (AD).
Fixed costs Production costs refecting the
use o xed inputs which are independent
o the level o output and exist even i
output is zero; their existence signals that
the rm operates in the short run.
Fixed exchange rate system A system
where the exchange rate is set at a level or
within a range by the government and is
then maintained there through central
bank intervention (specically, through
buying and selling the currency in the
oreign exchange market and/or
manipulating the interest rate).
Floating (fexible) exchange rate
system A system where the exchange
rate is determined solely through the
interaction o demand and supply or the
currency with no government (central bank)
intervention.
Food price controls Maximum prices
imposed by some governments on ood
items which are set below the ree-market
equilibrium prices and which aim at
protecting the vulnerable.
Foreign debt The amount o money that a
country owes to oreign entities that
include oreign governments, commercial
banks and multilateral institutions and
which is repaid in oreign exchange.
Foreign direct investment (FDI) When
multinational corporations establish a new
rm or acquire controlling interest in an
existing one in a oreign country. It is
distinct rom portolio investment as in FDI
the investor has control over the asset.
Foreign exchange reserves The value o
oreign exchange holdings at the central
bank o a country.
opportunity cost, or example sea water.
Free market economy Reers to an
economy in which markets alone, in other
words the interaction o buyers and sellers,
determine prices and output.
Free rider problem A consequence o
non-excludability in the case o public
goods: it reers to the ability o all
individuals to benet rom a good or
service once it becomes available to one.
Free trade Reers to international trade that
is not subject to any type o trade barriers.
Free trade area (agreement) An
agreement that is ormed when two or
more countries abolish taris (and other
barriers) between them while maintaining
existing barriers to non-members.
Frictional unemployment Reers to
people in between jobs. It is a orm o
unavoidable unemployment as people are
constantly moving between jobs in search
o better opportunities. Better and aster
inormation concerning the labour market
can lower this type o unemployment.
reer to the situation where there is
equilibrium in the labour market and so any
unemployment remaining is not demand-
decient. Any increase in total output
beyond the ull employment level will prove
infationary and temporary.

Game theory A branch o mathematics with
many applications in economics that
analyses in a stylized orm situations where
interdependence o outcomes exists.
Gini coecient A measure o income
inequality within a population that ranges
rom zero (perect equality) to 1 (or 1 00) in
the case o absolute inequality.
Goals o rms Prot maximization is the
working assumption but several other
behavioural assumptions have been also
proposed by theorists. Sales (revenue)
maximization, growth maximization,
satiscing theories, corporate social
responsibility as well as managerial
theories are among the alternatives.
Government budget (or national
budget) An estimate o government
expenditures and government (tax and
other) income or a uture period.
Government debt (see Public debt)
Government ailure When government
policies aiming at correcting a market
ailure ail to do so as a result o
unintended consequences, measurement
problems, biases, etc.
Government revenue Also reerred to as
government income; it includes tax and
other revenues a government collects.
Grants (aid) Flows o nancial aid to
developing countries that do not have to
be repaid to the donor country.
GDP The value o all nal goods and
services produced within an economy over
a period o time, usually a year.
Green GDP An attempt to correct GDP by
accounting or the detrimental eect o
production on the environment. Green GDP
is estimated by subtracting rom GDP the
cost o natural resource and environmental
depletion.
Gross national income (GNI) (see Gross
national product)
Gross national product (GNP) GNP equals
GDP plus income rom abroad minus income
paid abroad.
Growth Reers to increases in the real GDP
(the total output) o a country through
time. Can be distinguished into actual and
potential.
Growth maximization An alternative to
the short-term revenue maximization goal
where managers are assumed to seek to
maximize the growth in sales revenue
(that is, the growth rate o demand or the
rms output) and the capital value o the
rm over time.
Health indicators Single variable or
composite indicators that aim at
summarizing an aspect or the level o health
o a country, or example lie expectancy at
birth, incidence o tuberculosis per 1 00,000
people.
Heavily indebted countries Developing
countries acing an unsustainable debt
burden.
Hidden unemployment Unemployment that
is not refected in ocial unemployment
statistics which includes, or example,
discouraged workers, involuntary part-time
employees and workers orced into early
retirement and which causes the ocial
unemployment statistic to understate the
true level o unemployment in an economy.
Homogeneous product A product that
consumers consider identical (a perect
substitute) across all rms o an industry.
Household indebtedness The amount o
money households owe typically to banks
rom past borrowing.
Human capital The education, training and
experience embodied in the labour orce o
an economy.
Human development Expanding peoples
choices and the level o wellbeing they
achieve: material consumption as well as
better health and better education.
Human development index A composite
measure o development that ocuses on
three dimensions: health, education and
income. It uses lie expectancy; mean years
o schooling o people aged 25 and older;
expected years o schooling that a child o
school entrance age can expect to receive i
prevailing patterns o enrolment stay the
same; and per capita GNP based on
purchasing power parity dollars (PPP$). (See
also Purchasing power parity (PPP) theory.)
Humanitarian aid Aid provided or
humanitarian reasons to countries
suering rom a natural disaster (or Industrial policy A set o interventionist
example an earthquake), amine or war.
Implicit costs Production costs or which
no explicit payment is made by the rm
and which include the opportunity cost o
using resources the rm owns as well as
normal prot, the minimum return required
or the rm to remain in business.
Import substitution/inward-oriented
growth A growth strategy in which
domestic production is substituted or
imports in an attempt to shit production
away rom the primary sector and
industrialize.
Incentive unction o prices Reers to the
idea that changes in the relative price o a
good will induce producers to oer more or
less o it in the market as their prot
margin will be aected.
Incidence (burden) o taxation Reers to
who ends up paying a tax (tax shiting). An
indirect tax imposed on a rm may eventually
be partially or wholly paid by consumers.
Income approach Reers to one o the
three ways o measuring national income
whereby incomes earned by all our actors
o production (namely, wages, prots,
interest and rents) over a period o time are
added together to arrive at an estimate o
national income or GNP. The other two
methods are the output method and the
expenditure method.
Glossary
Income elasticity o demand
(XED) The responsiveness o demand
to a change in income.
Income, expenditure and output
method Three conceptually equivalent
methods o measuring overall economic
activity. The output method includes all
nal goods and services produced within a
period o time; the income method adds all
incomes that this production process
generates (wages, prots, interest and
rents); the expenditure method sums all
the expenditures made or the purchase o
these nal goods and services produced.
Income fow Within the circular fow diagram
o a closed economy without government it
reers to the monetary fow rom rms to
households that refects payments by the
rms to households or the use o actors o
production.
Increasing returns to scale A production
technology where an increase in all inputs
by 1 % leads to an increase in output by
more than 1 %; increasing returns to scale
lead to economies o scale (EOS).
Indebtedness Within a development
ramework the external (oreign) debt o
a country. The money a developing
country owes to oreigners including
governments, multinational institutions
and commercial banks.
Indirect taxation A tax on goods or on
expenditure on a per unit basis or as a
percentage o the price.
supply-side policies whereby the
government supports with subsidized
loans, preerential tax treatment as well as
other methods certain specic industries
thought to exhibit high growth potential
and to create signicant positive spillovers
or the whole economy.
Inant industry argument The argument
that the only way a developing country can
create a competitive domestic industrial
sector is i it blocks all competing imports
with prohibitive taris until it becomes
suciently ecient.
Inerior goods Goods or which demand
decreases ollowing a rise in consumers
income.
Innitely price elastic demand
A limiting value o price elasticity o
demand (PED) which implies that the rm
is a price taker and aces a horizontal
demand or its product at the going
market-determined price.
Innitely price elastic supply A limiting
value o price elasticity o supply (PES) which
implies that the rm is willing to oer as
much as the market demands at some price
and that the rm is characterized by constant
returns to scale so that average costs (AC) are
constant and equal to marginal costs (MC).
Infation Reers to a sustained increase in
the general price level.
1 81
 Glossary
Infation rate The percentage change in
the average price level, measured by some
price index, between two time periods; or
example i the infation rate o a country
or 2011 is 3.2% it means that prices in
2011 increased on the average by 3.2%
rom 201 0. I it is negative it implies
defation. I it is positive but decreasing
through time there is disinfation.
Infationary gap A gap is present i
equilibrium (actual) real output (temporarily)
exceeds the level corresponding to the ull
employment level o output.
Inormal markets Markets in which
economic activity is not ocially registered,
recorded or regulated by the government.
Street vendors in many cities are typically
part o the inormal sector o an economy.
Inormal sector (see Inormal markets)
Inrastructure Physical capital, typically
nanced by governments, which acilitates
economic activity as it lowers production
and transaction costs and is responsible or
the creation o sizable positive externalities.
The road system, the rail system, harbours,
airports and telecommunications that a
country has are typical examples.
Injections Within the circular fow model the
term reers to spending on domestic output
that is exogenous (that is, independent o
the level o domestic income). It includes
private investment spending, government
spending and exports.
Innovations Reers to new or improved
products or processes as well as new
marketing and organizational methods.
Institutional actors Reers to the laws and
regulations o product, labour and capital
markets in a country; more generally reers
to the legal and regulatory ramework
within which economic activity is conducted.
Interdependence In an oligopolistic
setting the term reers to the act that the
outcome o any action o a rm depends
on the reaction o rival rms.
Interest The reward o the actor o
production capital. The payment made or
using borrowed money over a period o time.
Interest rate The price paid or borrowing
money over a specied period expressed
as a percentage (or, the reward or lending
or parting with money).
International credit rating An evaluation
o a countrys credit worthiness (that is, its
ability to repay debt) prepared by
specialized agencies such as Moodys.
Investment Spending by rms on capital
goods, or example machines, tools,
equipment and actories; the change in
the stock o capital o an economy through
time. Investment expenditures in national
income accounts include not only xed
capital expenditures by rms but also
inventory investment and residential
housing investment.
1 82
Invisible balance Invisibles in the balance
o payments include exports and imports o
services, net income rom investments
(prots, interest and dividend receipts and
payments) and net transers (ocial and
private remittances).
J-curve eect Following devaluation, a
trade decit will typically worsen beore it
starts improving (tracing the letter J
through time) as the Marshall-Lerner
condition is not satised in the short run.
Joint prots The prot measure that cartel
members aim at maximizing, behaving as i
they were a monopoly.
Joint supply Two goods are jointly supplied
i the production o one automatically is
responsible or the production o the other.
Kinked demand curve An oligopolistic
model developed by P. Sweezy where in a
(usually non-collusive) set-up it is assumed
that i one rm decreases price the rival
rm will ollow but i it raises price the
rival will not ollow. This asymmetric
response gives rise to a kinked demand
curve. The model shows that in an
oligopoly, even i cost conditions change,
prices remain sticky.
Labour The human eorts used in the
production o goods and services.
Labour market fexibility The ability o a
labour market to adjust ast and ully to
changes in labour demand and labour
supply conditions.
Labour market reorms Reorms related to
the operation o labour markets that aim at
increasing labour orce participation,
lowering unemployment and improving
overall fexibility o the labour market. These
reorms are oten but not exclusively centred
around the labour unions, minimum wage
laws, employment protection legislation,
size and duration o unemployment
benets, etc.
Land Natural resources that an economy is
endowed with.
Law o demand As the price per unit o a
product rises, quantity demanded per time
period decreases, ceteris paribus.
Law o diminishing marginal returns
A short-run law o production which states
that as more and more units o a variable
actor (or example labour) are added to a
xed actor (or example capital) there is a
point beyond which total output will
continue to rise but at a decreasing rate or,
equivalently, that marginal product will
start to decrease.
Law o supply As the price per unit
increases, the quantity that a rm is willing
to oer per period rises, ceteris paribus.
Leakages Within the circular fow model
the term reers to income not spent on
domestic output but being withdrawn
rom the circular fow, namely savings,
taxes and spending on imports.
Legal barriers (to entry) Reers to
state-created barriers to entry, or
example patents and licenses.
Linear demand When demand is a
straight line (and not a curve) as price is
raised to the rst power; the general orm
is Qd 5 a 2 bP.
Long run (in macroeconomics) When
money wages can ully adjust to a change
in the average price level so that the real
wage remains xed at its equilibrium level.
Long run (in market structure) When
not only are incumbent rms achieving
their prot-maximizing goal but in addition
there is no entry or exit o rms as either
prots are normal or because o the
existence o barriers.
Long run (in production and cost
theory) When all actors o production
are considered variable so no xed actors
exist. The rm can thereore change its
scale o operations.
Long-run aggregate supply (LRAS) Within
the monetarist or new classical perspective,
the LRAS is a vertical line at the economys
potential level o output illustrating that in
the long run (when money wages are
assumed fexible and can ully adjust to
price level changes) the level o real output
is independent o prices.
Long run average cost curve (LRAC)
A locus o points that show the minimum
unit costs a rm will incur to produce a
certain level o production when it can
change all actors o production.
Long-run Phillips curve A vertical line at
the non-accelerating infation rate o
unemployment suggesting the idea that
there is a rate o unemployment
compatible with any rate o infation as
long as this does not accelerate and that
in the long run there is no trade-o
between infation and unemployment that
policy makers can exploit.
Loose monetary policy (see Easy
monetary policy)
Lorenz curve A diagrammatic illustration
o how national income is distributed
within the population o a country.
Luxury goods Usually reers to goods with
a high income elasticity o demand (YED);
that is, with YED greater than 1.
Managed exchange rate system
Usually reers to a foating system in
which authorities (central banks)
intervene whenever they consider the
movement o the exchange rate
undesirable.
Managerial theories o the rm
A collection o alternatives to the
prot-maximizing behavioural assumption
stemming rom the separation o
ownership rom management in the
modern corporation. Here managers are
assumed to pursue their own objectives

such as power and prestige, salaries, status
and job security. This approach is mostly
connected to Baumol, Marris and
Williamson.
Marginal benet The extra benet enjoyed
rom consuming an extra unit o a good.
Marginal cost The extra cost incurred rom
the production o an extra unit o a good.
Marginal private benet (MPB) The
extra benet enjoyed by the consumer rom
consuming an extra unit o a good.
Marginal private cost (MPC) The extra
cost incurred by a rm rom producing an
extra unit o a good.
Marginal product (o labour) Marginal
product o labour is the extra output rom
one more unit o labour. It is thus the
change in output rom a change in labour.
This is the slope o the total product curve.
Marginal propensity to consume The extra
consumption induced rom extra income.
Marginal propensity to import The extra
spending on imports induced rom extra
income.
Marginal propensity to save The extra
savings induced rom extra income.
Marginal propensity to tax (see Marginal
tax rate MTR)
Marginal revenue (MR) The extra revenue
rom selling one more unit o output: it is
the change in total revenues (TR) rom a
change in output. This is the slope o the
TR curve.
Marginal social benet (MSB) The
extra benet enjoyed by society rom the
consumption o an extra unit o a good.
Marginal social cost (MSC) The extra
cost incurred by society rom the
production o an extra unit o a good.
Marginal tax rate (MTR) The tax paid on
the last dollar o income earned.
Marginal utility The extra satisaction a
consumer derives rom consuming an extra
unit o a good.
Market A process or an institution through
which potential buyers and sellers o a
product interact.
Market clearing price That market price
or which quantity demanded is equal to
quantity supplied per period. No excess
demand or supply exists at such a price.
Market equilibrium Exists when there is
no tendency or the market price to
change; it requires that neither excess
demand nor excess supply exists so that
quantity demanded equals quantity
supplied per period.
Market ailure When market orces
(demand and supply conditions) alone ail
to allocate scarce resources eciently,
meaning that either too much or not
enough o a good is produced or consumed.
Typical cases include the existence o
monopoly power; o externalities and o
public, merit and demerit goods.
Market success When market orces
(demand and supply conditions) alone lead
to socially ecient outcomes meaning that
just the right amount o a good is
produced rom societys viewpoint and so
scarce resources are allocated in the best
possible way.
MarshallLerner condition A condition
stating that devaluation will improve a trade
decit i the sum o the price elasticities o
demand or exports and imports exceeds
unity. Since this condition is typically not
satised in the short run the trade decit
initially worsens, giving rise to the J-curve
eect.
Maximum price (price ceiling) A price set
by an authority (the government) below the
equilibrium determined price (the market
price) aiming at protecting (low-income)
consumers.
Merit goods Goods whose consumption
creates very signicant positive externalities
to society. As a result, governments oten
want even the poor or the ignorant to
consume sucient amounts o these
goods. Typical examples include basic
education, basic health care, museums, etc.
Microcredit schemes Very small loans to
the very poor in developing countries that
are used to help them start or grow small
businesses and meet emergency expenses.
Microcredit pioneer Muhammad Yunus and
the Grameen Bank in Bangladesh won the
2006 Nobel Peace Prize.
Millennium development goals
(MDG) Following the 2000 Millennium
Summit these are eight development goals
that all UN member states have agreed to
achieve by 201 5. The MDG are: ending
extreme poverty and hunger; achieving
universal primary education; promoting
gender equality; reducing child mortality;
improving maternal health; combating
HIV/AIDS, malaria and other diseases;
ensuring environmental sustainability;
developing a global partnership or
development.
Minimum price (price foor) A price set
by an authority (the government) above
the equilibrium determined price, usually
in order to protect producers. Note that the
expression is also used in cases o collusive
oligopoly and it reers to the minimum
price at which these rms have agreed to
sell the product.
Minimum wage A wage set by the
government above the equilibrium ree
market money wage that aims at protecting
workers; the lowest money wage employers
can legally pay.
Mixed economy Reers to an economy in
which economic decisions are determined
by both market orces and by the state.
Monetary policy The manipulation o
interest rates in order to aect aggregate
Glossary
demand (AD) and so infation, output and
employment.
Monetary union An economic union where
members also adopt a common currency
and monetary policy conducted by a
common central bank, or example the
1 7 eurozone countries.
Money demand A relationship showing at
each interest rate how much money
(non-interest bearing assets) economic
agents wish to hold given the level o
national income (also reerred to as
liquidity preerence).
Money supply The total amount o money
in circulation in a country; money supply
includes all coins and notes plus money in
current (chequing) accounts
Monopolistic competition Exists when
there are very many small rms in a
market, no entry or exit barriers and a
dierentiated product.
Monopoly Exists when there is one rm, a
unique product and high entry barriers.
Monopoly power The ability o a rm to
raise price above marginal cost (MC): that
is, the level that would prevail in
competition; the Lerner index o monopoly
power is given by the ratio o the dierence
o price charged less MC expressed as a
proportion o price (P). This is equal to zero
in perect competition as in perect
competition, P = MC.
Moral hazard Moral hazard arises when
economic agents, consumers or rms, as a
result o asymmetric inormation do not
bear the ull cost o their actions and so
become more likely to take such actions.
Movement along a curve The case in any
diagrammatic representation o an economic
relationship between two variables when one
o these two variables changes.
Multilateral aid Aid dispensed through
multilateral organizations, such as the IMF
or the World Bank.
Multilateral development
assistance (see Multilateral aid)
Multinational (or transnational)
corporations (or enterprises)
Corporations that have established a
presence and manage acilities in more
than one country. A result o oreign direct
investment (FDI).
Multiplier eect (expenditure
multiplier) The (Keynesian) idea that a
rise in injections (G, I, X) will lead to a
greater increase o national income. Fiscal
policy is thus a powerul tool to lit an
economy out o a recession.
National debt (see Public debt)
National vs. domestic (output or income)
National aggregates ocus on the nationality
o actors independently o their location,
whereas domestic aggregates ocus on
location independently o the nationality o
the actors o production involved.
1 83
 Glossary
Nationalization The transer o privately
owned rms (assets) to the state.
Natural capital Reers to the resource o
land but it implies that land is not a xed
endowment but that it can both increase
or improve, or decrease or be destroyed by
human activities and policies.
Natural monopoly A natural monopoly is
said to exist i the available production
technology in relation to the size o the
market is such that two rms cannot
protably coexist; typically, a result o very
signicant economies o scale (EOS).
Natural rate o unemployment (NRU)
or non-accelerating infation rate o
unemployment (NAIRU) The natural
rate o unemployment is dened as the
equilibrium rate o unemployment, that is,
the unemployment that exists at the real
wage rate that equates the number o
workers that rms are willing to hire with
the number o workers who are willing to
accept a job oer. It is also the
unemployment compatible with any rate
o infation as long as it does not
accelerate. The long-run Phillips curve is
vertical at this rate o unemployment.
Necessities A loose term reerring to basic,
day-to-day goods and services with a low
income elasticity o demand (YED).
Negative externalities Arise when an
economic activity, production or
consumption, imposes costs on third parties
or which these do not get compensated.
Net exports The dierence between the
value o exports and imports o goods and
services over a period o time.
Net investment Gross investment minus
capital consumption (depreciation).
Net national product Gross national
product (GNP) minus depreciation.
Nominal variable (or value) Nominal
variables are measured in monetary units
and the eect o infation has not been
accounted or.
Non-collusive oligopoly When
oligopolistic rms compete through price
or non-price competition.
Non-excludability A characteristic o
public goods which means that i a good
or service becomes somehow available to
one individual it automatically becomes
available to all.
Non-governmental organizations (NGOs)
Organizations usually independent o
governments and typically aiming at
designing and implementing development-
related projects. An example is Oxam which
is concerned with poverty alleviation.
Non-price competition Competition
typically ound in oligopolistic markets
that is not based on price cutting but on
other methods such as advertising,
provision o volume discounts or o
extended guarantees.
1 84
Non-price rationing Rationing mechanisms
that are not based on the use o a ree
market price but on other methods such as
sellers preerences or rst come-rst served. Perect competition Exists when there are
Non-produced non-produced assets
Non-nancial, non-produced assets include
land, patents, leases as well as transerable
contracts and Internet domains.
Non-rivalness A characteristic o public
(and quasi public) goods which means that
i a good or service is consumed by one, the
amount available or the rest does not
diminish; also a characteristic o common-
access (pool) resources (non-subtractability).
Normal goods Goods or which demand
increases ollowing an increase in
consumer income.
Normal prots The minimum reward
required by a rm to remain in business
that compensates or the risk incurred by
the entrepreneur (normal prot is thereore
an element o economic costs as without it
the rm would not secure the actor o
production entrepreneurship).
Normative (economic) statement
A value judgement, an opinion; usually
spotted by words such as ought to be,
air or unair.
Ocial aid Aid rom governments or
multilateral institutions (organizations)
such as the World Bank.
Ocial development assistance (see
Ocial aid)
Oligopolistic interdependence
Interdependence exists when the outcome
o any action o an oligopolistic rm
depends on the reaction o the rival rm(s).
Oligopoly Exists when there are ew
interdependent rms, entry barriers and
either a homogeneous or a dierentiated
product.
Open economy An economy that engages
in trade (that is, it exports and imports
goods and services). The degree o
openness is measured by the ration o the
sum o exports and imports expressed as a
proportion o GDP.
Opportunity cost (o an action) The
value o the next best alternative sacriced.
Output approach Reers to one o the
three ways o measuring national income
whereby production (output) is summed
across all industries over a period o time.
The other two methods are the expenditure
method and the income method.
Output fow Within the circular fow
diagram o a closed economy without
government, it reers to the real fow o
goods and services rom rms to
households over a period o time.
Overspecialization A case where a
country concentrates production and
exports in only one or in a very limited
range o products which exposes it to
higher risks.
Per capita (GDP or income) or per
head The GDP (or national income) o a
country divided by its population.
very many small rms, no entry or exit
barriers and a homogeneous product; also,
perect inormation and perect actor
mobility. There are ew examples, mostly
ound in agriculture.
Perect resource mobility When nothing
hinders the fow o actors o production
rom one use to another.
Perectly inelastic demand A limiting
case when price elasticity o demand (PED)
is equal to zero, implying that a change in
price leads to no change in quantity
demanded so that the demand curve is
vertical at some quantity.
Perectly inelastic supply A limiting case
when price elasticity o supply (PES) is
equal to zero, implying that a change in
price leads to no change in quantity
supplied so that the supply curve is vertical
at some level o output; quantity oered is
thereore independent o demand and
price. Typically, this is the case or many
agricultural products in the (very) short run
or when a service is constrained by the
amount o capital available, or example in
the case o hotel services, or seating
available in a sports stadium or concert hall.
Personal income taxes A direct tax levied
on the income o a person.
Phases o the business (or trade) cycle)
The alternating periods o growth and
contraction o an economy (o real GDP);
usually, our phases are distinguished: the
upturn (expansion or boom), the peak, the
downturn (recession or contraction) and the
trough. Recovery and slow down may be
included as separate phases.
Phillips curve An empirically derived
inverse relationship between the rate o
infation and the rate o unemployment: a
decrease in unemployment will result to an
increase in infation and vice versa.
Physical capital The term is used to
distinguish the term capital rom the terms
human capital and natural capital and reers
to so-called produced means o production.
Pigovian tax Taxes levied on polluters
(polluter pays principle) equal to the
external cost o pollution which not only
internalize the externality but also
generate revenues or the government.
Polluter pays principle The idea behind
Pigovian taxes; the principle according to
which polluters should pay the cost o
their actions or the cost o measures to
reduce pollution, according to the size o
the damage inficted on society.
Portolio investments (in the nancial
account o the BOP) Reers to the
acquisition o stocks and bonds and o
other nancial assets by oreign investors

which do not provide them with ownership
or management rights; international
investment that covers investment in equity
and debt instruments.
Positive (economic) statement An
(economic) statement that can (at least in
principle) be tested against data. For
example, unemployment in Australia has
decreased since 2006.
Positive externalities A positive externality
arises i an economic activity creates a
benet to a third party or which it does not
pay. They can arise either in the production
or in the consumption o a good.
Potential output The level o output an
economy can produce in the long run when
money wages are fexible and the labour
market is in equilibrium so that only
natural unemployment is present. At the
potential level o output, the long-run
aggregate supply (LRAS) is vertical. The
long-term growth trend line in a business
cycle diagram also illustrates potential
output. It is also reerred to as the ull
employment level o output.
Poverty (cycle) A vicious circle in which
low incomes leading to poverty are
responsible or low savings which are able
to nance limited investments, leading to
low income levels.
Price ceiling Reers to a maximum price
(that is, a price usually set by the
government below the ree market price
and above which sellers cannot charge).
Price controls Reers to both maximum and
minimum prices (that is, cases where the
government intervenes and sets the price
because it considers the market-determined
price as either too high or too low.
Price defator A price index used to convert
nominal GDP or nominal GNP/GNI to real
GDP/GNI which is based on the prices o
all domestically produced goods and
services; more generally price defators
permit comparisons o the true change in a
variable such as GDP ree rom the
infuence o price changes.
Price discrimination When a rm
charges or the same product two or
more dierent prices in two or more
markets and the price dierence is not a
result o dierences in production or
provision costs.
Price elasticity o demand (PED) The
responsiveness o demand to a change
in price.
Price elasticity o supply (PES) The
responsiveness o supply to a change
in price.
Price foor (see Minimum price)
Price leadership When in oligopolistic
markets tacitly colluding rms ollow the
price changes initiated by some industry
leader (known as dominant rm or
barometric price leadership).
Price maker (or price searcher) Any
rm acing a negatively sloped demand
curve.
Price mechanism A mechanism that
impersonally and with minimum cost
conveys under certain assumptions all the
necessary inormation to market
participants and allocates societys scarce
resources to their best use.
Price rigidity (in oligopoly) A eature o
oligopolistic markets where rms oten do
not change prices even i market demand
or cost conditions change, preerring to
adjust quantities or ear o initiating a
price war.
Price support (see Minimum price)
Price taker A perectly competitive rm
which who is so small compared to the
market that it cannot infuence market
price by its output decisions.
Price war Reers to the case where
oligopolistic rms compete through
successive price cuts.
Price-elastic demand Demand is
considered price elastic i a change in price
leads to a proportionately greater change
in quantity demanded.
Price-inelastic demand Demand is
considered price inelastic i a change in
price leads to a proportionately smaller
change in quantity demanded.
Primary products Agricultural and
non-agricultural products traded in world
markets and used as inputs in
manuacturing.
Primary/secondary/tertiary sector The
primary sector reers to agriculture, mining,
orestry and shing; the secondary sector
reers to manuacturing (industry) and
construction whereas the tertiary sector
reers to services.
Prisoners dilemma A simple non-
cooperative game illustrating strategic
interdependence and that lack o
coordination leads to suboptimal
solutions.
Private sector The private sector o an
economy includes households and rms.
Privatization The transer o state-owned
assets (rms) to the private sector.
Producer price index (PPI) A price index
that tracks the selling prices received by
domestic producers or their output.
These prices are also reerred to as
wholesale prices.
Producer surplus The dierence between
what a rm earns and the minimum it
requires to oer a given amount o a good.
Production costs The value o resources
sacriced or the production o a good or
service.
Production externalities Externalities
arising in the process o production. These
could be either positive or negative
externalities.
Glossary
Production possibilities curve (rontier
or boundary) Shows the maximum
amount o good Y an economy is able to
produce or each amount o X it chooses to
produce i it ully and eciently employs
all o its scarce resources with its given
level o technology.
Productive eciency When production
takes place with minimum average (unit)
costs, implying that production takes place
with minimal resource waste (also
technical eciency).
Prot maximization The assumed goal o
the typical rm. Firms will choose that
level o output or which economic prots
are maximum, which requires that
marginal revenue (MR) is equal to
marginal cost (MC) and that MC is rising.
Prot repatriation Prots earned by
multinationals and sent back home.
Progressive, proportional and
regressive taxation Progressive tax
system: when a higher-income household
pays proportionately more than a
lower-income household. Proportional tax
system: when a higher-income household
pays proportionately the same as a
lower-income household. Regressive tax
system: when a higher-income household
pays proportionately less than a lower-
income household.
Project aid Flows o aid targeting the
realization o specic projects, such as
the construction o public
inrastructure capital.
Property rights Legal ownership rights
over an asset. Property rights are part o
the institutional ramework o an economy.
Public debt The sum o all past
(accumulated) budget decits less surpluses;
the total o what a government owes.
Public goods Goods which are non-
excludable and non-rival. Since they are
non-excludable consumers have the
incentive to conceal their preerences and
behave as ree riders. Public goods are a
case o market ailure and typical examples
include national deence, law and order,
trac lights, lighthouses, etc.
Public sector The state, the government.
Purchasing power parity (PPP) theory
A theory o long-run equilibrium exchange
rate determination: in the absence o trade
barriers, transportation costs and
cross-border capital fows and i all goods
were tradable then the market exchange
rate would gravitate towards its PPP value
(that is, it would refect cost-o-living
dierences).
Quintile One o the ve equal parts o a
requency distribution.
Quota A quantitative restriction o imports.
The term is also used to reer to the
amount o output a cartel member is
assigned when joint prots are maximized.
1 85
 Glossary
Rationality The assumption that all
consumer behaviour is purposeul and obeys
certain assumptions concerning preerences.
Rationing unction o equilibrium
prices The ability o ree-market
equilibrium prices to ration the available
quantity to whoever values it the most and
is willing and able to pay the price.
Rationing system A mechanism employed
to allocate goods to consumers. The price
mechanism is an example o a rationing
system.
Real GDP GDP ater adjusting or infation.
Real GDP measures the volume o output
produced in an economy over a year.
Real variable An economic variable
expressed in terms o goods and so
adjusted or infation.
Recession An economy is in recession i
real GDP is decreasing or at least two
consecutive quarters (negative growth
rate); in the USA the NBER determines
when the economy enters recession and its
decision is based on more variables.
Refationary scal policy (see
Expansionary scal policy)
Regional economic integration When
countries become members o regional
trading blocs; more generally, the
elimination o trade and investment
barriers among a group o countries.
Regional preerential trade agreements
Trade agreements among a group o oten
but not necessarily geographically
neighbouring countries that reduce trade
barriers on a reciprocal and preerential
basis or only the members o the group.
Regulation Direct government intervention
in the operation o markets aimed at
infuencing the behaviour o rms with
respect to decisions on pricing, market
entry and exit, competition, product
standards, etc.
Regulatory ramework The set o
regulations within which a market, an
industry or the economy as a whole
operates.
Relative poverty Reers to households
with income below the national average;
the proportion o a population that is poor
in comparison with the consumption or
income level o the general population.
Rent The income or the services o a piece
o land collected by its owner.
Rent control A maximum price or rent
ceiling on what landlords can demand or
payment on residential housing set below
the ree-market determined rent.
Resource allocation The appointment o
scarce resources to dierent uses or the
production o dierent goods and services.
Revaluation An increase in the exchange
rate (the price o a currency) within a xed
exchange rate system.
Revenue maximization An alternative to
prot maximization where the rm is
1 86
assumed to maximize revenues (sales)
choosing that rate o output or which
MR = 0.
Sales maximization (see Revenue
maximization)
Satiscing An alternative to prot
maximization where, because o conficting
objectives o the various stakeholders
within a rm and inormational limitations,
rms only strive to achieve at least some
pre-dened minimum level o prots or
revenues.
Scarcity The idea that human wants exceed
the ability to produce goods and services
rom our limited resources to satisy these
wants; illustrated by the mere existence o
a production possibilities rontier.
Seasonal unemployment Unemployment
due to seasonal variations o demand, or
example construction workers who are
unemployed because o extremely cold
weather.
Shit o a curve A curve in a diagram may
shit i there is a change in a variable that
is not represented in either o the two
axes; or example, in a demand curve
diagram with price and quantity
demanded on the two axes, the curve may
shit i income changes.
Short run (in macroeconomics) When
money wages are assumed xed so that a
change in the average price level aects
the real wage and induces a change in
real output by rms.
Short run (in market structure) The time
period during which the number o rms in
a market is not xed but may change as a
result o supernormal prots or losses.
Short run (in production and cost
theory) The time period during which
some but not all adjustments are possible;
in production, it is when at least one xed
actor o production exists.
Short-run aggregate supply (SRAS)
Within the monetarist or new classical
perspective, SRAS is an upward sloping
curve illustrating that i the average price
level increases rms will be oering more
output because money wages are assumed
xed and so prot margins increase.
Shortage When, as a result o price being
xed by an authority below the competitive
ree-market equilibrium level, quantity
demanded exceeds quantity supplied.
Shut-down-rule A loss-making rm in the
short run will shut down and exit only i
the price (average revenue, AR) is less than
the average variable cost (AVC). In the
long run it will shut down i it is making
losses.
Signalling unction o relative price
changes Relative price changes within a
ree competitive market set-up convey
inormation to participants concerning the
existence o excess demand or supply
which induces a change in their behaviour.
Slope o a demand curve Assuming a
linear demand unction it is the coecient
o the term P; note that i this coecient
becomes absolutely larger the curve
becomes fatter as the axes in economics
are reversed.
Slope o a supply curve Assuming a
linear supply unction it is the coecient
o the term P; note that i this coecient
becomes absolutely larger the curve
becomes fatter as the axes in economics
are reversed.
Social (or community) surplus The sum
o the consumer surplus and the producer
surplus.
Social science The set o scientic
disciplines that systematically study
human behaviour rom dierent
perspectives.
Sot loans Loans granted at concessionary
terms. The interest rate charged is lower
than market interest rates and the
repayment period is longer. An example o
such loans is oreign aid.
Specialization When a actor o production
is employed in the production o only one
good or even a part o a good.
Specialization results in increased levels o
output.
Specic tax An indirect tax (a tax on a
good) that is set as a xed amount per unit.
Speculation The buying and selling o
oreign exchange (or more generally an
asset) in order to prot rom dierences in
its price.
Stagfation Stagnation (zero or negative
growth) and rising or high unemployment
at the same time.
Stagnation Stagnation exists when growth
in real GDP is either negative or negligible
or a number o years.
Stakeholders All parties that have a direct
or indirect interest in an organization or
who could be aected by its actions and
decisions.
State-owned enterprises (SOE)
Nationalized rms (that is, rms whose
ownership rests with the state).
Strategic interdependence In a game
theoretic ramework, the act that each
players welare and pay-o depends not
only on his or her actions but also on the
actions o other players.
Structural unemployment Unemployment
that persists way past recovery and is a
result o the changing structure o an
economy as well as a result o labour-
market rigidities.
Subsidy A payment made by the government
to rms aiming at lowering costs and price
and thus raising production and
consumption o the product as well as rms
revenues.
Substitute goods Two goods that can
satisy the same need or a consumer
which are thus in competitive consumption

and or which cross price elasticity o
demand (XED) is positive.
Supernormal (abnormal) prots
Anything above the minimum prot
required by a rm to remain in a certain
business.
Supply The quantity that a rm is willing to
oer per period o time at a given price,
ceteris paribus.
Supply shocks Reers to sudden changes
and shits in the short-run aggregate
supply (SRAS) typically as a result o a
sudden change in the price o oil (as oil is
the predominant orm o energy or rms)
or, more generally, o commodities.
Surplus When, as a result o price being
xed by an authority above the competitive
ree-market equilibrium level, quantity
supplied exceeds quantity demanded.
Sustainable development Development
that meets the needs o the present
generation without decreasing the ability
o uture generations to meet their own
needs. Typically it implies development
that does not result in environmental
degradation.
Tacit collusion Tacit or inormal collusion is
said to exist when oligopolistic rms
coordinate their behaviour (without any
communication between the parties being
necessary) so that it resembles that o a
single dominant rm and the outcome that
o explicit collusion.
Tari A tax on imports as a result o which
the domestic price o the product rises, the
level o domestic production rises, the level
o domestic consumption drops and the
volume o imports is restricted. A tari also
generates revenues or a government.
Tax incidence (See Incidence (burden)
o taxation)
Technical eciency (see Productive
eciency)
Terms o trade The ratio o the average
price o exports over the average price o
imports expressed as an index number
times 1 00. It shows the volume o imports
attainable with a unit o exports.
Terms o trade: improving I the terms o
trade ratio rises it shows that a greater
volume o imports is now attainable by a
unit o exports.
Terms o trade: worsening
(or deteriorating) I the terms o trade
ratio decreases it means that ewer imports
can now be attained by a unit o exports.
Tied aid Aid that has to be used to buy the
donors products (oten unnecessary or low
priority and/or more expensive);
considered a actor partially explaining the
weak link between aid and development.
Tight monetary policy A central bank is
employing tight monetary policy i it
increases interest rates (decreases the
money supply) in order to decrease (or slow
down the increase in) aggregate demand
(AD) and so decrease infationary pressures
in the economy.
Time lags (in economic policy) Reers to
the time that elapses rom the moment a
problem arises in an economy to the time a
policy choice has an eect; can be
distinguished into the detection lag, the
administrative lag and the impact or
execution lag.
Total costs The costs incurred or the
production o Q units o output. Total costs
are equal in the short run to xed costs
plus variable costs.
Total product Total product is the output
derived rom a specic combination o
inputs.
Total revenues (or sales revenue)
The product o the price per unit times the
number o units sold by a rm in a time
period.
Tradable (marketable) permits (or
licences) A market-based solution to the
problem o pollution-emitting rms where
the government determines the maximum
acceptable level o pollution and then
issues to rms permits (rights to pollute a
certain amount) which are tradable. Firms
have the incentive to engage in active
trading until a new allocation o permits
emerges with the total level o pollution
the same but with minimal amount o
production sacriced.
Trade balance The dierence between the
value o exports and imports o goods (and
services) per period. I the value o exports
exceeds the value o imports then a trade
surplus is recorded. Conversely, a trade
decit is the case i the value o imports o
goods (and services) exceeds that o exports.
Trade creation The increased trade as a
result o lower trade barriers in a regional
trading bloc where a less-ecient member
now imports a good rom a more-ecient
member instead o producing it itsel.
Trade cycle (see Business cycle)
Trade diversion The inecient rise in trade
within a regional trading bloc whereby a
less-ecient member imports a good rom
another member, instead o importing it
rom a truly more-ecient non-member.
Trade fows Exports and imports o goods
and services per period.
Trade liberalization Reers to policies
aiming at decreasing or eliminating trade
barriers.
Trade protection Reers to policies that
aim at restricting the fow o imports into a
country and/or creating an articial
advantage to exporting rms.
Trading blocs A orm o economic
integration where a group o countries
decreases trade barriers among them while
maintaining barriers to non-members. The
arrangement may take the orm o a ree
trade agreement, a customs union, a
common market or an economic union.
Glossary
Tragedy o the commons A term
introduced in 1 968 by Garrett Hardin that
reers to users o a commons (a common-
pool resource, or example a pasture)
where in his original analysis the process
inevitably leads to the destruction o the
resource (or example overgrazing o the
pasture) on which the users depend.
Transer payments Payments o the
government to individuals that do not
refect contribution to current production.
Examples o transer payments include
unemployment benets and pensions.
Typical consumer (see Average
household)
Underemployment When individuals are
employed but are working less than they
would have wanted to or in positions
below their skills.
Underlying infation (see Core infation)
Underprovision and overprovision o
merit and demerit goods When market
orces lead to less than the socially optimal
amount being produced or consumed (in
the case o merit goods) or to more than the
socially optimal amount being produced or
consumed (in the case o demerit goods).
Unemployment Exists when individuals
who are actively searching or a job cannot
nd one.
Unemployment rate The number o
unemployed individuals expressed as a
proportion o the labour orce.
Unitary price elasticity o demand
When a change in price leads to a
proportionally equal change in quantity
demanded so that price elasticity o
demand (PED) is 1. I PED is 1 throughout
the length o a demand curve then the
demand curve is a rectangular hyperbola.
Unitary price elasticity o supply When
a change in price leads to a proportionally
equal change in quantity supplied so that
price elasticity o supply (PES) is 1. I PES is
1 throughout the length o a supply curve
then the supply curve is linear and goes
through the origin.
Variable costs Production costs that refect
the use o the variable actors o production;
to produce more the rm needs more
variable inputs so variable costs increase.
Voluntary export restraints A orm o
trade protection which is similar to a
quota as it also reers to a quantitative
restriction but in this case the exporting
rms agree to limit the volume o exports
o a good, typically to avoid worse trade
protection.
Wage stickiness A eature o labour
markets where money wages do not easily
decrease because o labour unions
and contracts.
Wages The reward o the actor o
production labour.
Wealth The value o all assets owned by an
individual minus whatever he or she owes.
1 87
 Glossary
Weighted average An average where
each element does not carry the same
signifcance in the calculation.
Welare (or deadweight) loss Reers to
decreases in producer and/or consumer
surplus as a result o either more or less
than the socially optimal level o output
produced and consumed.
Withdrawals (see Leakages)
World Trade Organization (WTO) An
international organization with 1 53 member
1 88
countries which aims at urther liberalizing
trade through conducting multilateral trade
negotiations and at regulating trade and
which is the arbitrator o all trade-related
disputes. It was established in 1 995
and grew out o the General Agreement
on Taris and Trade (GATT).
X-inefciency Reers to the internal
slackness that oten characterizes
entrenched monopoly frms. The term was
introduced by Harvey Leibenstein.
Zero economic profts Exist when total
revenues are equal to total (economic)
costs. Since normal profts are included in
(economic) costs, it ollows that a frm
earning zero economic profts is making
just enough to remain in business (that is,
it is making as much as it would have been
making in its next best alternative).
 Index
absolu te ad vantage 1 1 5 1 6, 1 69 costs
ad valorem (percentage) taxes 2 8 d im inishing average retu rns 43
ad vertising 3 8, 3 9 econom ic costs 44, 51
aggregate d emand (AD) 76 law o d im inishing marginal retu rns 423
consu mption expend itu res 767 long-ru n costs 4751
governm ent spend ing 7 78 opportu nity costs 1 69
investm ent expend itu res 7 7 short-ru n costs 427
net exports 78 cred it 1 48
see also d emand cross-price elasticity o d emand (XED) 2 0
aggregate su pply (AS) 79 cu rrent accou nt 1 32
alternative views o AS 7980 d e cit 1 33 4
shits in long-ru n aggregate su pply (LRAS) 80 expend itu re-red u cing policies 1 34
short-ru n aggregate su pply (SRAS) 79 expend itu re-switching policies 1 34
see also su pply su pply-sid e policies 1 34
allocative e ciency 1 41 5 , 578 su rplu s 1 35
assets 37 cu stom s u nions 1 37
reserve assets 1 3 2
asym m etric inormation 33 , 41 d ebt
oreign d ebt 1 57
balance o paym ents 1 3 2 , 1 69 pu blic (national or governm ent) d ebt 98
capital accou nt 1 3 2 d ef ation 86, 88, 91
cu rrent accou nt 1 32 cau ses 90
cu rrent accou nt d e cit 1 33 4 d emand 5 6
cu rrent accou nt su rplu s 1 35 changes in d emand cond itions 1 01 1
nancial accou nt 1 3 23 law o d emand 5
J-cu rve 1 35 , 1 36 shit actors 67
Marshall-Lerner cond ition 1 3 5 6 see also aggregate d emand
banking system 1 05 d em erit g ood s 36, 38
interest rate d eterm ination by central bank 1 06 d eveloping cou ntries
break-even price 57 d epen d ence on exports o primary com m od ities 1 45
bu siness cycle 745 d epen d ence on primary sector 1 45
per capita incom e levels 1 45
cap and trad e schem es 37 popu lation 1 45
capital 1 term s o trad e 1 41 2
capital accou nt 1 32 u n employm ent and u nd erem ploym ent 1 45
circu lar f ow o incom e m od el 71 2 d im inishing retu rns 423
com mand econom ies 2 d iseconom ies o scale (DOS) 47, 48
com m on access resou rces 401 d isinf ation 86
com m on markets 1 37
com m u nity su rplu s 1 4 East Arican Cu stom s Union (EACU ) 1 37
comparative ad vantage 1 1 5 1 6, 1 69 econom ic activity 71 2
competitive markets 2 m easu res o econom ic activity 725 , 1 67
d emand and su pply 1 01 1 , 1 603 econom ic costs 44, 51
market e ciency 1 31 5 econom ic d evelopm ent 1 44
price and ou tpu t d eterm ination 91 0 composite ind icators 1 47
price m echanism 1 2 d eveloping econom ies 1 41 2 , 1 45
complem ents 6 d om estic actors 1 489
consu m er price ind ex (CPI ) 867 single ind icators 1 467
consu m ers 5 sou rces o long-term growth 1 44
consu m er su rplu s 1 3 econom ic good s 1
price d iscrim ination 66 econom ics 1
corporate social responsibility (CSR) 5 2 central them es 4
u nd am ental qu estions 2

1 89
 Index

econom ies o scale (EOS) 47, 48 m u ltiplier eect 1 001

ed u cation 1 46, 1 47, 1 48 potential ou tpu t and LRAS 1 03
elasticity 1 6 oreign aid 1 5 5
cross-price elasticity o d emand (XED) 2 0 evalu ation o im pact 1 5 5 6
incom e elasticity o d eman d (YED) 21 3 m otives or oering aid 1 5 6
price elasticity o d emand (PED) 1 61 9 non-governm ent organizations (N GOs) 1 5 6
price elasticity o su pply (PES) 2 35 types o aid 1 5 5
entrepreneu rship 1 oreign d ebt 1 57
equ ilibriu m 91 0 rst d ebt crisis 1 57
changes in equ ilibriu m 1 01 1 H eavily I nd ebted Poor Cou ntries I nitiative (H I PC) 1 57
long-ru n equ ilibriu m 5 45 M u ltilateral Debt Relie I nitiative (M DRI ) 1 57
m onetarist or new classical m od el 81 2 Foreig n Direct I nvestm ent (FDI ) 1 32 , 1 53
m onopolistic com petition 61 2 m u ltin ational corporations 1 53 4
m onopoly 5 9 oreign exchange markets 1 2 37
price and qu antity 1 601 governm ent interven tion 1 2 831
short-ru n equ ilibriu m 53 4, 81 ree good s 1 2
equ ity 95 ree trad e 1 1 4
incom e d istribu tion 96 absolu te and comparative ad vantage 1 1 5 1 6
ind icators o incom e inequ ality 95 6 argu m ents against trad e protection 1 1 9
m easu res to prom ote equ ity 97 ree trad e areas 1 37
role o taxation 967, 1 68 trad e protection 1 1 71 9, 1 2 2
Eu ropean Free Trad e Association (EFTA) 1 37 types o trad e protection 1 1 92 2
Eu ropean U nion (EU ) 1 37
exchange rates 1 23 gend er 1 47, 1 48
ad ju stm ents 1 2 45 Gen eral Agreem ent on Taris and Trad e (GATT) 1 1 7
cau ses o changes 1 2 5 8 Gini coe cient 95 6
xed exchange rate system s 1 23 4, 1 2 8, 1 2 9, 1 3 01 good s 1 2 , 6, 33, 36, 38, 39 40
f exible exchange rate system s 1 2 45 , 1 3 0 good s and services accou nt 1 32
f oating exchange rate system s 1 23 4, 1 69 governm ent intervention 2 6, 1 5 8
managed exchang e rate system s 1 2 3 4, 1 2 9 externalities 378
pu rchasing power parity (PPP) 1 31 ind irect taxation 2 68, 37, 39, 96
exports 1 36 price controls 2 932
export prom otion 1 5 01 su bsid ies 2 89, 38, 1 2 2 , 1 61 2
externalities 33 governm ents
negative consu mption externality 35 , 36, 3 8 bu d get 98
negative prod u ction externality 3 4, 35 , 378 scal policy 98
positive con su mption externality 34, 36, 38 m onetary policy 1 078
positive prod u ction externality 3 4, 3 5 6, 38 su pply-sid e policies 1 089
gross d om estic prod u ct (GDP) 723
actors o prod u ction 1 comparisons between cou ntries 74
nancial accou nt 1 323 living stand ard s 74
rm s 51 2 problem s in m easu rem ent 74
econom ic pro ts 1 66 trad e (bu siness cycle) 745
long-ru n prod u ction and costs 4751 GDP d ef ator 87
short-ru n prod u ction and costs 427 Gross N ational I ncom e (GN I ) 72 , 73 4
shu tting d own 5 5 6 growth 93 4, 1 2 5 6, 1 68
total, average and marginal prod u ct 1 63 4 consequ ences 945
total, marginal and average cost 1 645 growth maxim isation 5 2
total, marginal and average revenu e 1 65
scal policy 98 health 1 46, 1 47, 1 48
au tomatic scal stabilizers 1 023 H eavily I nd ebted Poor Cou ntries I nitiative (H I PC) 1 57
contractionary (d ef ationary) policy 1 00 hu man capital 1
crowd ing ou t eect 1 02 H u man Developm ent I nd ex (H DI ) 1 47
evalu ation 1 04 inequ ality-ad ju sted H u man Developm ent I nd ex (I H DI ) 1 47
expansion ary (ref ationary) policy 981 00, 1 04 H u man Poverty I nd ex (H PI ) see M u ltid im ensional Poverty I nd ex

1 90
 Index

hu man resou rces 1 marginal private costs (M PC) 33

imports 1 2 5 , 1 3 6 marginal social bene ts (MSB) 3 4
import-su bstitu tion ind u strialization (I SI ) 1 5 0 marginal social costs (M SC) 3 3
incom e 95 market ailu re 3 3
circu lar f ow o in com e m od el 71 2 asym m etric inormation 33, 41
Gini coe cient 95 6 com m on-access resou rces 401
incom e d istribu tion 96, 1 489 d em erit good s 36, 38
Lorenz cu rve 95 6 externalities 33, 345
incom e elasticity o d emand (YED) 21 3 impact o extern alities 3 5 6
applications 2 23 m erit good s 36, 38
graphs 21 2 m onopoly 3 3, 41
ind irect taxes 2 6, 37, 39, 96, 1 61 pu blic good s 33, 3940
ad valorem (percentage) tax 2 8 solu tions to externality-related issu es 37 41
consequ ences 2 67 market stru ctu res 5 28
illu strating on d iagram 2 6 econom ic pro ts 1 66
tax incid ence 27 issu es 1 66
inequ ality ratios 95 m onopoly 5 961
inf ation 86, 1 2 6 oligopoly 625
consequ ences 878 price d iscrim ination 65 6
core (u nd erlying) inf ation 87 total, average and marginal prod u ct 1 63 4
cost-pu sh in f ation 8990, 901 total, marginal and average cost 1 645
d emand -pu ll inf ation 889, 90 total, marginal and average revenu e 1 65
GDP d ef ator 87 markets 5 , 1 2 , 1 5 8
inf ation rate 1 678 com m on markets 1 37
m easu ring in f ation 867 market econom ies 1
Phillips cu rve 91 3 market e ciency 1 31 5
prod u cer price ind ex (PPI ) 87 see competitive markets; oreign exchange markets
intellectu al property rig hts 38 Marshall-Lerner cond ition 1 35 6
interest rates 1 2 67 Mercosu r 1 37
international trad e see trad e m ergers 38
investm ent 1 2 6, 1 2 7 m erit g ood s 36, 38
Foreign Direct I nvestm ent (FDI ) 1 32 , 1 53 4 m icro-cred it 1 48
portolios 1 32 m icroeconom ics 5
Millenniu m Developm ent Goals (M DGs) 1 45
J-cu rve 1 3 5 , 1 36 m ixed econom ies 2
m od els 1
Keynes, John Maynard 75 circu lar f ow o incom e m od el 71 2
Keynesian m u ltiplier 1 67 m onetary policy 1 07
evalu ation 1 078
labou r (hu man resou rces) 1 m onetary u nion 1 37, 1 389
land 1 m oney 1 05
law o d emand 5 banking system 1 05
law o d im inishing retu rns 423 d emand or m oney 1 05 6
linear d emand u nctions 1 60 u nctions 1 05
linear su pply u nctions 1 60 interest rate d eterm ination by central bank 1 06
lon g-ru n aggregate su pply (LRAS) 80, 1 03 m oney su pply 1 06
lon g-ru n average cost (LAC) cu rves 478 m onopolistic competition 61
lon g-ru n costs 4751 equ ilibriu m 61 2
Lorenz cu rve 95 6 evalu ation 62
m onopoly 5 9
macroeconom ics 71 barriers to entry 601
macroeconom ic objectives 1 678 e ciency consid erations 5 960
tim eline 75 equ ilibriu m 5 9
marginal and averag e prod u cts 43 4 market ailu re 33 , 41
marginal private bene ts (M PB) 33 4 m oral persu asion 38, 39

1 91
 Index

M u ltid im ensional Poverty I nd ex (MPI ) 1 47 primary com m od ities versu s manu actu red prod u cts 1 9
M u ltilateral Debt Relie I nitiative (M DRI ) 1 57 ranges o PED 1 6
m u ltinational corporations (M N Cs) 1 53 4 TR cu rves 1 81 9
price elasticity o su pply (PES) 2 3 4
natu ral capital 1 applications o PES 2 5
natu ral resou rces 1 calcu lating PES 2 5
non-governm ent organizations (N GOs) 1 5 6 d eterm inants 2 45
non-price competition 645 graphs 23 4
normative econom ics statem ents 1 ranges o PES 23
N orth Am erican Free Trad e Area (N AFTA) 1 37 price f oors 31 2 , 1 63
price m echanism 1 2
o cial d evelopm ent assistance (ODA) 1 5 5 6 primary incom e accou nt 1 32
oligopoly 623 prod u cer price ind ex (PPI ) 87
collu sive and non-collu sive oligopoly 63 4 prod u cers 78
gam e theory and interd epen d ence 63 prod u cer su rplu s 1 3 1 4
kinked d emand cu rve m od el 64 prod u ction possibilities cu rves (PPCs) 2 4
non-price com petition 645 pro t
opportu nity costs 1 69 econom ic pro ts 51 , 1 66
pro t maxim isation 51 2
per capita incom e 1 45 , 1 46 property rights over assets 37
perect com petition 5 23 pu blic (national or governm ent) d ebt 98
allocative and prod u ctive e ciency 578 pu blic good s 33, 39 40
break-even price 57
evalu ation o markets 5 8 qu estions 67, 69, 1 1 1 1 3, 1 43, 1 5 9
long-ru n equ ilibriu m 5 45 higher level qu estions 68, 70
short-ru n equ ilibriu m 53 4 qu otas 1 2 01
shu tting d own 5 5 6
su pply cu rves 57 raw materials 1
see also com petition reserve assets 1 32
Phillips cu rve 91 3 resou rces 1
Phillips, Alban William s 91 com m on access resou rces 401
popu lation 1 45 retu rns to scale 47
positive econom ic statem ents 1 revenu es
poverty 96 PED and total revenu es 1 8
M u ltid im ensional Poverty I nd ex (M PI ) 1 47 revenu e maxim isation 5 2
preerential trad e agreem ents 1 379, 1 51 2 total revenu es (TR) 1 81 9, 485 0, 51
price break-even 57 total, marginal and average revenu e 1 65
price ceilings 2 931 , 1 623
price controls 2 9 satis cing 5 2
maxim u m price (price ceiling) 2 931 scarcity 1 , 33
m inim u m price (price f oor) 31 2 second ary incom e (cu rrent transers) accou nt 1 3 2
price d iscrim ination 65 sh ort-ru n aggregate su pply (SRAS) 79
cond itions allowing price d iscrim ination 65 sh ort-ru n costs 427
consu m ers 66 shu t-d own ru le 5 6
th ird -d egree price d iscrim in ation 65 6 sh u tting d own 5 5 6
price elasticity o d emand (PED) 1 61 9 social sciences 1
applications o PED 1 9 social su rplu s 1 4
cross-price elasticity o d emand (XED) 2 0 su bsid ies 2 8, 38, 1 61 2
d emand cu rves 1 61 7 consequ ences 2 89
d emand cu rves with constant PED 1 71 8 trad e protection 1 2 2
d eterm inants o PED 1 9 su bstitu tes 67
exports 1 36 su pply 78
imports 1 3 6 changes in su pply cond itions 1 1
incom e elasticity o d eman d (YED) 21 3 shit actors 89
PED and total revenu es 1 8 see also aggregate su pply

1 92
 Index

su pply cu rves 9 trad e protection 1 1 71 9, 1 2 2

su pply-sid e policies 1 089, 1 34 ad m inistrative or regu latory barriers 1 2 2
econom ic schools o thou ght 1 091 0 anti-d u mping d u ties 1 2 2
evalu ation 1 09 argu m ents against 1 1 9
interventionist policies 1 08 qu otas 1 2 01
pro-market su pply-sid e policies 1 089 su bsid ies 1 2 2
su rplu s 1 31 4 taris 1 1 92 0
volu ntary export restraints (VERs) 1 21
taris 1 1 92 0 trad in g blocs 1 37
taxes com m on markets 1 37
ad valorem (percentage) taxes 2 8 cu stom s u nions 1 37
d irect taxes 96 econom ic u nion 1 37
ind irect taxes 2 68, 37, 39, 96, 1 61 evalu ation 1 38
progressive taxes 967 ree trad e areas 1 37
proportional taxes 97 m onetary u nion 1 37, 1 389
regressive taxes 97
technology 1 48 u nemploym en t 84
term s o trad e (TOT) 1 40, 1 70 cau ses 846
cau ses o chan ges 1 401 consequ ences 84
changes in term s o trad e 1 40 cyclical (or Keynesian or d emand -d ef cient) u nemploym ent 86
consequ ences o change 1 41 d eveloping cou ntries 1 45
d eveloping cou ntries 1 41 2 riction al u nemploym ent 85 6
see also trad e m easu rem ent problem s 84
total revenu es (TR) 485 0, 51 seasonal u nemploym ent 845
TR cu rves 1 81 9 u nemploym ent rate 1 67
trad e 1 2 5 United N ations Developm ent Program (U N DP) 1 47
barriers to primary export-led growth 1 5 0
comparative ad vantage 1 69 volu ntary export restraints (VERs) 1 21
export prom otion 1 5 01
import-su bstitu tion ind u strialization (I SI ) 1 5 0 wom en 1 48
see also term s o trad e World Trad e Organization (WTO) 1 1 7

1 93
OXFORD IB STUDY GUIDES

Economics
Author
F O R T H E I B D I P LO M A 2nd edition Constantine Ziogas

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How to get in contact:

1 web www.oxfordsecondary.co.uk/ib
email schools.enquiries.uk@oup.com
tel +44 (0)1 536 452620
fax +44 (0)1 865 31 3472