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AS Econom i cs
U ni 1: The market system t U ni 2: Market f l t aiure U ni 3: The nati t onaland i nternati onaleconomy

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Contents
Uni 1:The m arket system ...................................................................................................... 4 t Choice and its consequences ...............................................................4 ............................................................... The economi probl c em..................................................................................................................................4 Resources ............................................................................................................................................................4 O pportuni cost ..............................................................................................................................................4 ty PPC/PPF ...............................................................................................................................................................4 Com petitive m arkets and how they w ork....................................................6 .................................................... Demand ...............................................................................................................................................................6 Consumer surpl ............................................................................................................................................6 us PED ........................................................................................................................................................................7 YED ........................................................................................................................................................................8 XED ........................................................................................................................................................................9 Suppl ..................................................................................................................................................................9 y Producer surpl ........................................................................................................................................... 10 us PES ...................................................................................................................................................................... 10 Equii um ...................................................................................................................................................... 11 lbri Firm s and how they operate...............................................................11 ............................................................... Costs................................................................................................................................................................... 11 Economi ofscal ....................................................................................................................................... 13 es e Proft maxi sati ...................................................................................................................................... 14 i mi on O ther obj ves ............................................................................................................................................ 14 ecti Market structure ............................................................................................................................................ 15 Barri to entry ............................................................................................................................................. 16 ers Uni 2:M arket fai ure ............................................................................................................ 17 t l Econom ic ef iciency w ithin com petitive m arkets............................................17 f ............................................ Producti ef i ency ................................................................................................................................... 17 ve f ci Alocati ef i ency ..................................................................................................................................... 17 l ve fci Pareto ef i ency............................................................................................................................................ 18 f ci Ef i ency and the PPC/PPF........................................................................................................................ 18 f ci Ef i ency and competi on........................................................................................................................ 18 f ci ti W hy m arkets m ay not w ork ef icientl .....................................................18 f y...................................................... Externalti i es..................................................................................................................................................... 18 Market domi nance and X-i f ci nef i ency................................................................................................... 21 Publc,quasi i -publc and pri i vate goods................................................................................................. 22 De/meri goods.............................................................................................................................................. 23 t Factor i mmobii lty.......................................................................................................................................... 24 Inequalty ......................................................................................................................................................... 24 i Governm ent intervention and f urtherm arket f ure........................................26 ail ........................................ Fi nanci i al nterventi (taxes and subsi es)....................................................................................... 26 on di State provi on ............................................................................................................................................... 27 si Redi buti stri on................................................................................................................................................. 27 Cost benef t anal s .................................................................................................................................... 27 i ysi Uni 3:The nati t onaland i nternati onaleconom y ................................................................ 29 M acroeconom ic obj ectives................................................................29 ................................................................ U nempl oyment.............................................................................................................................................. 29 Inf ati l on............................................................................................................................................................. 32 Bal ance ofpayments.................................................................................................................................... 32 GDP (and the three measures) ................................................................................................................. 33 Economi growth.......................................................................................................................................... 33 c

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Gareth Jones - http://cyro.cs-terri es.com/ tori Confi i macroeconomi polci ..................................................................................................... 34 lcts n c i es AD/AS m odeling .........................................................................35 l ......................................................................... Aggregate demand ...................................................................................................................................... 35 The mul pler ef ect..................................................................................................................................... 41 ti i f Aggregate suppl y.......................................................................................................................................... 42 AD/AS Di agrams............................................................................................................................................ 44 The instrum ents ofm acroeconom ic pol .................................................45 icy.................................................. Fi scalpolcy ..................................................................................................................................................... 45 i Monetary polcy............................................................................................................................................. 45 i Exchange rates............................................................................................................................................... 46 Suppl si polcy......................................................................................................................................... 49 y de i Free trade and protectionism ..............................................................52 .............................................................. Types oftrade................................................................................................................................................. 52 Why does trade take pl ace?....................................................................................................................... 52 Gai f ns rom trade............................................................................................................................................ 52 Tari f ................................................................................................................................................................. 53 fs Non-tarifprotecti sm............................................................................................................................. 54 f oni Arguments f and agai protecti sm........................................................................................... 54 or nst oni W hat com e up i past exam papers (Jan 01 Jan 04)...................................................... 56 s n U nit 1....................................................................................56 .................................................................................... U nit 2....................................................................................56 .................................................................................... U nit 3....................................................................................57 ....................................................................................

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Uni 1:The m arket system t


Choice and its consequences
The econom i probl c em

The economi probl scarce resources i rel on to unlmi wants. c em: n ati i ted Thi l s eads to these questi (f rst three are standard): ons i o What to produce? Goods/servi ces? Consumer/capi goods? tal o H ow to product? Labour/capi i tal ntensi ve? o For whom to produce? Equalty? Abii to pay? i lty o When to produce? Now,or i the f n uture?

Resources

Resources can be categori as: sed o Land: Naturalresources. o Labour: H uman resources (workf orce). The f actors ofproduction or o Capi : Man-made ai to producti tal ds on. IN PU TS o Enterpri O rgani on and ri taki se: sati sk ng. Combi ned,vi producti they produce: a on o Consumabl es OU TPU TS o Consumer Durabl es o Capi Goods tal o Servi ces O utput can be i ncreased vi speci i on. Speci i on l a alsati alsati eads to the need f trade. or Money acts as a medi ofexchange to alow trade to occur. um l Speci i on i producti of i alsati n on ten nvol the di si ofl ves vi on abour.

O pportuni cost ty
Scarce resources and unlmi wants mean that choi have to be made. The true cost of i ted ces any choi between al ce ternati i the opportuni cost The next best al ves s ty ternati f ve orgone.

PPC/PPF
The choi a soci has to make can be shown vi a producti possi lty f ce ety a on bii ronti (PPF) (or er producti possi lty curve (PPC)). The maxi on bii mum output an economy or soci can produce ety usi al i resources wi n the current state oftechni knowl ng l ts thi cal edge.

The axes show the two possi lti bii es. Poi A shows al resources produci capi goods so no consumer goods are made. nt l ng tal Any poi on the PPC means al resources are f l used (A,B,C). nt l uly Any poi i de the PPC means some resources are empl nt nsi oyed (D). K A B C

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Gareth Jones - http://cyro.cs-terri es.com/ tori A PPC can show opportuni cost. ty A strai lne shows constant opportuni cost,i You gi up the same quanti of ght i ty .e.: ve ty capi goods f each addi onaluni ofconsumer goods. tal or ti t A = B,C = D. A curved PPC shows i ncreasi opportuni cost,i f each extra uni ofcapi ng ty .e.: or t tal goods you gi up more and more consumer goods. ve A = B,C > D. Capitalgoods Capitalgoods

Consum ergoods

Consum ergoods

C D C D To move producti f on rom capi goods to consumer goods i tal nvol realocati of ves l on resources. Ifthere was perf f ect actor mobii (i resources were j as good at lty .e. ust produci capi goods as consumer goods) we woul have a strai lne PPC. Thi ng tal d ght i s assumpti i not realsti so we have the curved PPC demonstrati i on s i c ng mperf f ect actor mobii lty. The PPC wilshi t i you: l f f A. H ave more/l f ess actors ofproducti on. B. The f actors ofproducti become more/l producti on ess ve. C. The state oftechni knowl cal edge advances. An i mprovement i A,B or C wilshi t the PPC outwards. Thi i caled economi n l f s s l c growth;the soci has the potenti to produce more. ety al Capitalgoods Increase in potentialproduction ofcapitalgoods onl y

Capitalgoods

Shif ofPPC t = SR Econom ic grow th

Consum ergoods Consum ergoods Ifyou j have i ust mprovement i the abii to produce one type ofgood (e.g. capi ) n lty tal then the PPC wilshi t onl i that axi l f y n s. Page 5

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Com petitive m arkets and how they w ork


D em and
Def ni on has three el i ti ements: Pri Quanti and Ti It i the amount ofgoods that ce, ty me. s consumers are wilng and abl to purchase at a gi pri over a certai ti peri li e ven ce n me od. Demand has a schedul and a curve drawn on the assumpti that al other f e on l actors (other than pri remai unal ce) n tered;the ceteris paribus assumpti on. Price Pri ce 1 2 3 4 5 Q uanti ty/ti e m 5 4 3 2 1 P2 P1 D Q2 Q1 Quantity/tim e

A change i pri causes a movement al n ce ong the demand curve. An i ncrease i pri f n ce rom P1 to P2 l eads to a decrease i quanti demanded (or contraction i demand) f n ty n rom Q1 to Q2. There i s an i nverse rel onshi between pri and the quanti demanded per uni ofti As pri ati p ce ty t me. ce decreases the quanti demanded wili ty l ncrease (or an extension ofdemand),and vi versa. ce These are movements al ong the demand curve. A shi t i the demand curve i caused by a change i any ofthe f f n s n actors that i l nfuence demand, otherthan the price ofthe good orservice. o Fi nanci abii to pay,i l al lty nfuenced by: Di sposabl i e ncome i ncome af tax. ter The avaiabii and cost ofcredi (af ected by i l lty t f nterest rates). o Atti tudes toward the product,i l nf uenced by: Adverti ng. si Taste. Fashi on. Brand i mage/l ty. oyal Peer pressure o Pri avaiabii and attracti ce, l lty veness ofrel ated products,i l nfuenced by: Compl ements. Substi tutes. o O ther f actors,specii to a certai products i ude: fc n ncl Weather. Future expectati ons.

Consum er surpl us
Consumer surpl i the dif us s f erence between what consumers w oul pay f a product (shown d or by the demand curve) and what they actualy pay (shown by the market pri It i the l ce). s di f f erence between the totalval consumers pl on what they consume and the payments ue ace they actualy make to purchase those uni Thi i represented by the shaded area on the l ts. s s

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Gareth Jones - http://cyro.cs-terri es.com/ tori di agram. Exampl ofgoods wi hi consumer surpl es th gh uses i ude paracetamoland f ncl ootbal l ti ckets. Price

Market pri ce D Quantity/tim e Consumer surpl us decreases as equii um pri i lbri ce ncreases i ncreases as equii um pri decreases lbri ce decreases as demand becomes more el c asti i ncreases as demand becomes more i asti nel c

PED
Al measures ofel ci measure the change i one vari e f l ng a change i another l asti ty n abl olowi n vari e. Where a smal change i one vari e has a more than proporti abl l n abl onate ef ect on f another vari e the rel onshi are el c. Where the change i l than proporti abl ati ps asti s ess onate i i t s i asti nel c. Pri El ci ofDemand (PED) = ce asti ty

% Change i quanti demanded n ty % Change i pri n ce

Pri El ci ofdemand i al ce asti ty s ways negati (as an i ve ncrease i pri causes a decrease n ce i the quanti demanded per uni ofti n ty t me),so the negati si i generaly not ve gn s l wri tten. The determi nants ofPED are: o The avaiabii ofsubsti l lty tute goods: Many substi tutes H i PED (El c) gh asti Few substi tutes Low PED (Inel c) asti o The proporti ofi on ncome spent on the good or servi ce: H i proporti ofi gh on ncome usualy i i el c PED. l mples asti o The ti peri consi me od dered: O ver a short ti peri most goods are reasonabl i asti me od y nel c. O ver a l onger ti peri many goods are more el c. me od asti o H abi tualconsumpti on: Addi ve products have very i asti PEDs. cti nel c Some i mportant val ofPED: ues i Perf y el c . ectl asti P D Q/t Page 7 P D Q/t i. Perf y i asti i ectl nel c

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ii PED > 1,El c i. asti

i PED = 1,U ni v. tary el ci ofdemand asti ty P


16 Area bel dem and ow curve is constant ( e.TR constant) i.

v. PED < 1,Inel c asti P

D
8 4 2

D
2 4 8 16

Q/t

Q/t

Q/t

PED and Totalrevenue (TR = P * Qsold ): o Ifa f rm knows i PED i can see the ef ect ofa change i pri on i total i ts t f n ce ts revenue usi thi di ng s agram: PED i el c s asti

PED = 1 o PED i i asti s nel c o Q/t IfPED i el c: s asti An i ncrease i pri causes a n ce decrease i totalrevenue. n A decrease i pri causes an n ce i ncrease i totalrevenue. n IfPED i i asti s nel c: An i ncrease i pri causes an n ce i ncrease i totalrevenue. n A decrease i pri causes a n ce decrease i totalrevenue. n Revenue i theref maxi sed when s ore mi PED = 1.

Revenue

Totalrevenue

Q/t

Y ED
Income El ci ofDemand (YED) = asti ty % Change i quanti demanded n ty % Change i i n ncome

The si ofthe YED shows: gn o Posi ve YED demonstrates that that product i a ti s normalgood, i that as i .e.: ncome i ncreases the quanti demanded per uni ofti i ty t me ncreases (peopl buy more ofthi e s type ofgood when they have a hi gher i ncome). These are generaly branded products. l

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Gareth Jones - http://cyro.cs-terri es.com/ tori Negati YED demonstrates that that product i an nf or good, i that as i ve s i eri .e.: ncome i ncreases the quanti demanded per uni ofti decreases (peopl buy l ofthi ty t me e ess s type ofgood when they have a hi gher i ncome). These are generaly un-branded l products. The l arger the number the l arger the i l nfuence a change i i n ncome has. o

X ED
Cross El ci ofDemand (XED) = asti ty % Change i quanti demanded ofone good n ty % change i pri ofanother good n ce

The si ofthe XED shows: gn o Posi ve XED shows the goods are substi ti tutes. o Negati XED shows the goods are compl ve ements. The l arger the number the cl oser the rel onshi between the two goods. ati p

Suppl y
ty me. y e Def ni on has three el i ti ements: Pri Quanti and Ti Suppl has a schedul and a curve ce, drawn on the assumpti that al other f on l actors (other than pri remai unal ce) n tered;the ceteris paribus assumpti on. Price Pri ce 1 2 3 4 5 Q uanti ty/ti e m 2 4 6 8 10 P2 S

P1

Q1

Q2

Quantity/tim e

A change i pri causes a movement al n ce ong the suppl curve,i an i y .e.: ncrease i pri f n ce rom P1 to P2 l eads to an i ncrease i quanti suppled f n ty i rom Q1 to Q2. Pri and Quanti demanded are ce ty di rectl proporti y onal as Pri i , ce ncreases Quanti demanded per uni ofti al i ty t me so ncreases. A shi t i the suppl curve i caused by: f n y s o Changes i the f rms costs ofproducti n i on: Increased costs make the suppl curve shit to the l t. y f ef Decreased costs make the suppl curve shi t to the ri y f ght. o The nature ofthe i ndustry: Easy access (i l barri to entry) shi t suppl to the ri i the .e. ow ers f y ght f company i i a prof tabl i s n i e ndustry. o Indi rect taxes and subsi es: di Increase i i rect tax shits the suppl curve to the l t. n ndi f y ef Increased i subsi es shi ts the suppl curve to the ri n di f y ght. o O ther f actors: Weather (f agri turalproducts). or cul

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Gareth Jones - http://cyro.cs-terri es.com/ tori The ease wi whi producers can shi t producti f th ch f on rom one good or servi to another,f exampl potatoes to carrots. ce or e

Producer surpl us
Producer surpl i the di f us s f erence between the pri they woul suppl thei product at ce d y r (shown by the suppl curve) and the pri they actualy get (i the market pri It i the y ce l .e.: ce). s di f f erence between the revenue requi by frms to suppl and what they recei red i y ve. Price Market pri ce S

Producer surpl us

Quantity/tim e i ncreases as pri i ce ncreases. decreases as pri decreases. ce i ncreases as suppl becomes more i asti y nel c. decreases as suppl becomes more el c. y asti

PES

Pri El ci ofSuppl (PED) = ce asti ty y

% Change i pri n ce

Pri el ci ofsuppl i al ce asti ty y s ways posi ve as an i ti ncrease i pri bri about an n ce ngs i ncrease i the quanti suppled per uni ofti n ty i t me. i Perf y el c,PES = . ectl asti P P i. Perf y i asti PES = 0 i ectl nel c,

Q/t ii PES > 1,El c i. asti i PES = 1,U ni v. t el c or uni asti tary el ci ofsuppl asti ty y P S S S
Any straight l ine going through the origin

Q/t v. PES < 1,Inel c asti P S

S Q/t Page 10 Q/t Q/t

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The determi nants ofPES are: o The l evelofstocks avaiabl l e: H i stock l s gi el c PES val gh evel ve asti ues. Low stock l s gi i asti PES val evel ve nel c ues. o The ease wi whi producti can be i th ch on ncreased: Spare capaci (easy to i ty ncrease producti gi el c PES val on) ves asti ues. No spare capaci (hard to i ty ncrease producti gi i asti PES on) ves nel c val ues. o The ti peri consi me od dered: Duri a short ti peri most suppl curves are reasonabl i asti ng me od y y nel c, i not perf y i asti s ectl nel c. O ver a l onger ti peri suppl curves are generaly more el c. me od y l asti

Equi i um l bri
The pri the f market sets,where there i nei ce ree s ther excess suppl or excess demand and y there i no tendency to change,ceteris paribus. Thi i the pri at whi the suppl and s s s ce ch y demand curves cross.

Firm s and how they operate


Costs
George rents hal a soccer pi f 50,and deci to grow vegetabl Ini aly he has to do f tch or des es. ti l everythi hi ng msel ;di ng,sowi wateri f lsi and harvesti f ggi ng, ng, ertii ng ng. George empl Jack to hel both take a wage of10. Speci i on becomes possi e as oys p; alsati bl Jack i parti arl good at di ng and thei totalproduce more than doubl s cul y ggi r es. H annah i empl s oyed next and i a worl wateri champi and f s d ng on urther speci i on alows alsati l thei produce to grow stilf r l urther. Gaz i empl s oyed as an extra worker but totalproduce di t i dn ncrease by as much as bef as ore thei work starts to overl r ap. As addi onalworkers are empl ti oyed totalproduce actualy f l as they overwork the l l als and due to the l ofdi ni ng returns,a short run concept. aw mi shi Labour 0 1 2 3 4 5 6 7 Totalproduce 0 20 50 90 120 140 150 140 Producti ty per vi w orker (Average product) 0 20 25 30 30 28 25 20 M argi product nal 0 20 30 40 30 20 10 -10

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Thi wilgenerate a graph whi can be generalsed by the f l ng: s l ch i olowi

U nits ofoutput

M arginal Product

Average Product

W orkers The margi product cuts the average product at i hi nal ts ghest poi i where each worker i nt, .e.: s produci the hi ng ghest capaci ty. To summari as more ofthe vari e f se, abl actor,l abour,was added to the fxed f i actors ofl and and capi the addi ons to output i tal ti ncreased bef decreasi and eventualy becomi ore ng l ng negati Thi i the l ofdi ni ng returns. ve. s s aw mi shi Average Product = TotalProduct Number ofworkers

Change i totalproduct ari ng f n si rom the addi on ofan ti Margi Product = extra worker nal

The costs i ncurred on George f s arm can be broadl categori i two groups,fxed costs y sed nto i and vari e costs. abl

Fi costs are costs that remai constant i xed n rrespecti ofoutput. Exampl i ude: ve es ncl o Rent f the l or and. o Capi (i tool tal .e. s). Vari e costs are costs that change dependi on the l abl ng evelofoutput. Exampl es i ude: ncl o Wages f l or abour. o Seeds. o Water.

The f arm operates by addi vari e uni ofa vari e f ng abl ts abl actor (i thi case l n s abour) to fxes i amounts offxed f i actors (i thi case l n s and and capi ). H ere we expect the l ofdi ni ng tal aw mi shi returns to happen. Thi i a short run si s s tuati on.

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O utput 0 1 2 3 4 5 6

Fi costs xed 60 60 60 60 60 60 60

Average f xed i cost (AFC) 60 30 20 15 12 10

Vari e costs abl 0 50 80 105 152 225 330

Average vari e cost abl (AVC) 50 40 35 38 45 55

Totalcost 60 110 140 165 212 285 390

Average total cost (ATC) -

Margi nal cost (MC) 50

110 30 70 25 55 47 53 53 57 105 65

AFC =

Totalfxed cost i O utput

AVC =

Totalvari e cost abl O utput

ATC =

Totalcost O utput

When pl otted a generalsati ofthe AFC,AVC,ATC and MC gi i on ves:

Cost ofoutput ( )

MC ATC AVC

AFC

U nits ofoutput The MC curve cuts the AVC and ATC curves at thei mi mum poi r ni nts.

Econom i of scal es e
Economi ofscal are the advantages of ng bi As the si ofproducti pl i es e bei g. ze on ant ncreases, uni costs f l Economi ofscal i a l t al. cs e s ong run concept,where no resources are fxed. i Economi ofscal can take the f l ng f cs e olowi orms:

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Purchasi k buyi ng bul ng Marketi domi ng nance over adverti ng si Techni more complcated machi cal i nery and capi f use i producti tal or n on Manageri frms attracti hi y skil speci i staf al i ng ghl led alsed f Fi nanci abii to borrow money f al lty rom banks at a l ower cost.

Di seconomi ofscal are the di es e sadvantages ofbei too bi and cause the uni cost to ri ng g t se af a gi l ter ven evelofoutput (the MES,mi mum ef i ent scal the l ni f ci e, owest poi on the LRATC nt curve). Thi can happen due to: s

Lack of /poor communi on cati Lack of /poor organi on sati Low moral e/moti on among workers vati

Profi m axi i on t m sati


Pri vate frms are i busi i n ness to gai the reward f entrepreneurshi proft. Proft i n or p, i i s maxi sed at the poi where there i the greatest dif mi nt s f erence between the totalcost of producti and the totalrevenue recei f on ved rom seli what has been produced. lng Proft maxi sati occurs when a f rm i alocati y ef i ent,that i MR (P) = MC,the cost of i mi on i s l vel f ci s produci the l good or servi i equalto the amount the consumer i wilng to pay. H ere ng ast ce s s li no proft i made,so totalprof ts have been maxi sed. i s i mi

O ther obj ves ecti


In practi many frms do not maxi se thei prof ts f a number ofreasons. se i mi r i or

For many f rms i i si y i i t s mpl mpossi e to know where thi output l bl s evelles,to ai f i m or sal revenue maxi sati i much easi to quantiy. es mi on s er f Supernormalprofts i an i i n ndustry can attract other compani i enteri the es nto ng i ndustry and so reduce market share. Al ternati y a frm may ai to i vel i m ncrease market share by ai ng f sal maxi sati mi or es mi on, operati at a l i the short run. Thi can of be seen when a l ng oss n s ten arge company branches out to of eri dif f ng f erent goods and servi and i used to gai market share. ces s n Sati i ng;a state where a company ai to keep share hol sf ci ms ders happy and other parti i es nvol i the economi transacti Large frms can choose to gi money to ved n c on. i ve chari and take care ofthe envi ty ronment at the expense ofsome proft. i

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M arket structure
Features N um b er of fi s rm Perfect Com p eti on ti Large number M onopol sti i c Com p eti on ti Large number O l gopol i y A f bi frms ew g i domi nate the market Consi derabl e barri to ers entry/exi t Li e ttl contestabii lty Possi y;barri bl ers to entry prevent new entrants but competi on may ti l ower them May or may not be prof t i maxi sers;may mi persue other obj ves; ecti sati i ng sf ci Pri MAKER ce Dif f erenti ated Very hi gh M onopol y Si e frm i ngl i n theory,>25% of market i n practi se Very hi gh barri to entry ers No contestabii lty Yes,i both the n short run and l ong run (due to abii to prevent lty new entrants) Proft maxi sers i mi

Ab i i to l ty enter/l eave Contestab i i l ty Abnorm alp rofi ts

Compl ete f reedom ofentry Hi y ghl contestabl e O nl i the short yn run then they are competed away Proft maxi sers i mi

Few barri to ers entry/exi t Hi y ghl contestabl e O nl i the short yn run then they are competed away Proft maxi sers i mi

M oti on vati

Pri ng ci Products Concentrati on rati (3 or 5 fi ) o rm Typ e of com p eti on ti

Pri TAKER ce H omogenous Very,very l ow

Pri MAKER ce Dif f erenti ated Very,very l ow

Pri ce competi on onl ti y

Pri and nonce pri ce competi on ti Lots of substi tutes but not exact due to brandi ng Yes,f rom l of ots si l but not miar, i denti cal products

Avai ab i i of l l ty sub sti tutes

Lots ofother products whi ch are exact substi tutes Yes,f rom l of ots i denti cal products

Consum er choi ce? O ther

Mai y non-pri nl ce competi on (e.g. ti adverti ng, si brand prolf ierati on) A f substi ew tutes avaiabl but l e consumers may have hi brand gh l ty oyal Li ted choi mi ce f rom a f ew supplers i The frms are i inter-dependent and labl to i e coli lde

Pri MAKER ce Si e product ngl wi l ofcl th ack ose substi tutes not applcabl i i e n theory (1 frm); i very hi i gh n practi se No competi on ti i theory n

No substi tutes avaiabl l e

No choi a ce; si e product ngl whi i uni ch s que

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B arri to entry ers


Barri to entry reduce contestabii i a market,the ease wi whi frms can enter and ers lty n th ch i l eave the market. Barri to entry,the di fcul es f ers f i ti aced by a f rm enteri a market,can be i ng categori as f l sed olows:

Legal Where the l prevents f rms enteri the market enti y (such as the Royal : aw i ng rel mai i delveri mai under 60g) or restri ons on enteri the market i vari n n i ng l cti ng n ous f orms ofregul on i udi patents prohi ti the manuf ati ncl ng bi ng acturi ofsome goods ng and servi by more than one company. ces H i costs ofcapi necessary f the i gh tal or ndustry,f exampl aeropl or e anes are very expensi as i mi ng equi ve s ni pment. There i a l s arge ri i sk nvol i buyi thi capi ved n ng s tal f the entrepreneur. or Large f rms taki advantage ofeconomi ofscal can have much l i ng es e ower costs so new entrants operati at break-even poi cannot compete wi the pri ofthe l ng nt th ce arger producers (i udi adverti ng economi ofscal where a frm may have an ncl ng si es e i adverti ng monopol si y). Strong brand alegi l ance by consumers to an exi ng producer. sti

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Gareth Jones - http://cyro.cs-terri es.com/ tori

Uni 2:M arket fai ure t l


Econom ic ef iciency w ithin com petitive m arkets f
Any economy i sai to be worki ef i entl s d ng f ci y Ifscarce resources are alocated i a way that maxi ses househol s utii l n mi d lty/welare. f Ifthe economy i produci the ghtgoods and servi to sati y as many consumer s ng ri ces sf wants as possi e. bl

Producti effi ency ve ci


Price MC AC Where MC = AC,at the l owest poi on the AC curve. H ere nt goods and servi are bei ces ng produced as cheapl as y possi e. As f rms produce at a bl i l ower pri thi causes an ce s i ncrease i suppl Excess n y. suppl causes the pri to drop y ce and so demand i ncreases, i ncreasi the consumer ng surpl At the l us. owest poi on nt the AC curve consumer surpl us i maxi sed so the economy s mi i al alocativel ef icient. s so l y f

Output

Al ocati effi ency l ve ci


Price A S There i an equii um pri at s lbri ce P.H ere consumer surpl i us s PAB and producer surpl i us s PBC. At the equii um consumer lbri surpl and producer surpl us us are maxi sed. Thi i mi s s alocative ef iciency. l f At thi poi P = MC,i the s nt .e. pri the l consumer val ce ast ues a good or servi at i equalto ce s the extra cost ofproduci ng that good or servi Ifal ce. l markets are i equii um (thi n lbri s i a hi y theoreti si s ghl cal tuati on) then the economy i s alocati y ef i ent,but we l vel fci don know i the goods are t f bei di buted evenl ng stri y.

C Q

D QS & D p.u.t.

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Gareth Jones - http://cyro.cs-terri es.com/ tori

Pareto effi ency ci


When no one i soci can be made better of wi n ety f thout maki someone el worse of the ng se f economy i sai to be Pareto ef i ent. It i hard to measure Pareto ef i ency as the rel ve s d fci s fci ati worth ofone good i hard to quanti y agai another. s f nst

Effi ency and the PPC/PPF ci


Y C At any poi on the PPC the nt economy i perf s ormi ng ef i entl (A,B,C). f ci y Poi A demonstrates Pareto nt ef i ency a move to produce f ci more ofX or Y wilresul i a l t n greater than proporti onate l oss ofproducti ofthe other. on At poi i de the PPC (D,E) the nts nsi economy i worki i f ci y. s ng nef i entl

A D B E

Effi ency and com peti on ci ti


Perf competi on throughout the economy shoul l to maxi sed ef i ency as i ect ti d ead mi f ci denti cal products,no barri to entry,l ers arge numbers ofbuyers and selers coupl wi perf l ed th ect knowl edge l eads to the f rms bei pri takers. i ng ce Thi theref dri the pri down to where P = MC (where the cost ofproduci the l s ore ves ce ng ast good or servi i the same as the val the l consumer i wilng to pay) and as MC = MR, ce s ue ast s li thi l s eads to profts bei maxi sed so perf competi on wilcreate alocati ef i ency. i ng mi ect ti l l ve fci

W hy m arkets m ay not w ork ef icientl f y


External ti i es
An externalty i a thi party ef ect ari ng f i s rd f si rom the producti or consumpti ofa good or on on servi ce. Pri vate cost costs i ncurred by the suppler. i Externalcosts costs i ncurred by anyone other than the suppler. i Soci costs = PC + EC al Pri vate benefts benef ts enj i i oyed by the consumer. Externalbenefts benef ts enj i i oyed by anyone other than the suppler. i Soci benefts = PB + EB al i

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Gareth Jones - http://cyro.cs-terri es.com/ tori O besi and fatty foods ty Impendi government report ng Mars bar provencettes at H RSFC 66% ofmal and 53% off es emal are cl fes as overwei or obesi es assi i ght ty

There i a market f l as f s aiure atty f oods are over consumed. Faii to achi economi ef i ency lng eve c f ci In parti ar,we seem to have alocative inef iciency as resources are bei alocated to cul l f ng l uses that bri about an i f ci overal outcome ng nef i ent l Arguabl the market al f l Pareto ef i ency y so ais f ci

Causes and consequences ofobesi ty Possi e causes bl O vereati ng Fatty f oods and i nappropri di ate et Lack ofexerci se Fewer pl areas f chidren ay or l Greater avaiabii ofj l lty unk f ood Increasi popul ty ofsedentary ng ari pasti mes More adverti ng si Polti l i cal obbyi ng Changi consumer pref ng erences and i ncreasi i ng ncomes Lower f ood pri i realterms ces n Lower pri di ces ctated by supplers i Fatty foods m arket Price P1 Possi e consequences bl Greater i dence ofcancer, nci di abetes,weak bones and blndness i whi costs the NH S 500m a year; ch opportuni cost coupl wi ty es th greater l s ofauti and il evel sm lness. Devel opment ofnew products.

P2

S1

S2

D1 D2 Q1 Q2 Quantity/tim e

Al arge i ncrease i suppl f n y rom S1 to S2 i caused by supplers demandi l s i ng ower pri f ces rom supplers. A smaler decrease i demand,caused by adverti ng,hi i l n si gher i ncomes and consumers havi convi ng nced themsel they have l ti to cook so they buy prepared ves ess me meal that are generaly hi s l gher i f Thi causes a decrease i equii um pri f n at. s n lbri ce rom P1 to P2 Page 19

Gareth Jones - http://cyro.cs-terri es.com/ tori and an i ncrease i equii um quanti demanded f n lbri ty rom Q1 to Q2. Thi i overproducti s s on, causi a heal probl or Q2 - Q1. ng th em, Supplers onl consi the pri i y der vate costs ofproducti Addi onalexternalcosts exi such as on. ti st i ncreasi obesi putti supplers out ofbusi ng ty, ng i ness. Taki al costs i account causes ng l nto suppl to shi t to the l t,f y f ef rom S2 to S1. Thi reduces overproducti O ne way ofmaki the s on. ng f rm pay f externalti i through taxati Al i or i es s on. coholand ci garettes are good exampl of es where the government ai to get the frms to i rectl pay the externalcosts i the f ms i ndi y n orm of duti Fat tax i bei consi es. s ng dered as a way f the government to shi t suppl f or f y rom S2 to S1 f f or atty f oods. H eal foods m arket thy Price P2

P1

S2

S1

D2 D1 Q2 Q1 Quantity/tim e

Decrease i demand as consumers buy f n atty f oods i nstead,and a l arger decrease i suppl i n y s caused as consumers l eave the market. Thi causes a hi s gher equii um producti and a lbri on l ower quanti demanded,under producti Q1 - Q2. ty on Consumers onl consi pri y der vate benef ts ofconsumpti addi i the soci benef ts woul i on, ng n al i d i ncrease demand f rom D2 to D1 and under producti woul be reduces. H eal f on d thy oods are subsi sed and the government i contempl ng a scheme to i di s ati ntroduce f heal f ree thy ood i nto school s. Controli the spendi ofconsumers causes polti i lng ng i cal ssues as thi i a movement away f s s rom posi ve economi dealng wi f ti cs i th acts to dealng wi opi ons. i th ni Meri goods are goods or servi that are better f us than we realse. t ces or i Demeri goods are goods or servi that are worse f us than we realse. t ces or i The market f l here i i terms ofi ormati there i an overproducti ofdemeri goods aiure s n nf on; s on t (f atty f oods) and underproducti ofmeri goods (heal f on t thy oods).

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Gareth Jones - http://cyro.cs-terri es.com/ tori External ti i Sw eden i es n The producti ofti on nned herri i Sweden causes externalti as detaied bel ng n i es l ow. Ari ng f si rom producti on Creati ofj i the l on obs n ocalarea. Cheap f f l uel or ocalpublc i transport reduci consumpti ng on off lf s. ossi uel Cl eaner sea wi new waste th di sposal . Posi ve ti externalti i es P S(PC) S(SC) Ari ng f si rom consumpti on H eal popul on l thy ati owers costs ofheal spendi and creates a th ng more producti work f ve orce.

D(PB)

D(SB)

Q/t Di sea usi ol waste di rty ng d sposal .

Q/t Di sposalofpackagi ng. Smels f l rom openi f ng ermented f sh products. i P D(SB) D(PB)

P Negati ve externalti i es

S(SC)

S(PC)

Q/t

Q/t

M arket dom i nance and X -i neffi ency ci


Mi crosof i the best current exampl ofx-i fci t s e nef i ency occurri wi n a monopol The ng thi y. market f l i caused by: aiure s Economi ofscal whi gi es e, ch ves: Lower costs. Hi gher prof ts. i Barri to entry ers More competi ve i the past. ti n Aspects ofmarket f l observed i Mi aiure n crosof t: Alocati i fci l ve nef i ency as P > MC. Market domi nance whi causes a l ofcompeti on. ch ack ti

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Gareth Jones - http://cyro.cs-terri es.com/ tori Producti i f ci ve nef i ency due to the l ofpressure to cut costs (no competi on), ack ti ref erred to as X-i fci nef i ency.

X-i f ci nef i ency i a si s tuati where costs are hi on gher than necessary,f unknown reasons or (hence the ). Theref many governments have competi on polci to ensure frms do not x ore ti i es i expl t monopol power. oi y

Publ c,quasi i -publ c and pri i vate goods


PU BLIC GO O DS QU ASI-PU BLIC GO O DS PRIVATE GO O DS

Mi l def ssie ence system Polce f i orce,a beach Banana Publc goods have two characteri cs: i sti 1. Non excl udabl one person cannot stop another f e rom consumi that good or ng servi ce. 2. Non-ri i consumpti the consumpti ofan i vi val n on on ndi dualdoes not lmi the i t amount avaiabl f others. l e or Pri vate goods have the opposi characteri cs to publc goods: te sti i 1. Compl y excl etel udabl e. 2. Compl y ri i consumpti etel val n on. For pri vate goods the pri vate benef ts are l i arge. Thi means that consumers are wilng to pay s li a pri f the provi on ofpri ce or si vate goods and so pri vate f rms enter the market to provi the i de consumer wi the good or servi th ce. Publc provi on ofpublc goods i more lkel than pri i si i s i y vate provi on as i a f market publc si n ree i goods are severel under produced or not produced at al. Thi can be expl ned usi game y l s ai ng theory. The pri soner di em m a s l You are one oftwo pri soners bei hel i separate cels. Soon,you must ei ng d n l ther pl ease guity l or not guity to a cri you have been arrested f wi l me or, thout knowi the pl ofyour f l ng ea elow pri soner. The j udge and j know that at l ury east one ofyou i guity but aren sure whether you s l t both are. Ifyou both pl guity,you wileach recei a 5-year ead l l ve j lsentence as acknowl ai edgi your guit wilbe vi ng l l ewed sympatheti l by the court. Ifone ofyou pl caly eads guity l and the other pl eads not guity,the outcomes wilbe an l l 8-year sentence and f reedom respecti y. Ifboth ofyou vel pl ead not guity you wilrecei sentence of7 years as l l ve the courts wilsee that you both need a f l orm of puni shment even though your guit may be uncertai l n. There i no way that you can contact the other pri s soner to fnd out how they are goi to pl i ng ead. The pri soner f aces opti that can be expressed i the ons n Jack Guity l Al i 5 5 8 0 7 8 7 Not Guity l

Guity l

Not Guity l

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Gareth Jones - http://cyro.cs-terri es.com/ tori gri to the ri d ght. Not guity i the domi l s nant strategy. By choosi the opti that i best f ng on s or themsel the fnaloutcome i worse f them overal. Thi i what game theory sti ates; ves i s or l s s pul that choosi the best opti f onesel wilresul i a fnaloutcome that i worse f ng on or f l t n i s or everyone. Thi can be used to expl n the l ofprovi on ofpublc goods i a f market as consumers s ai ack si i n ree are unwilng to pay. The f ri ef ect sti ates that the mentalty ofthe i vi li ree der f pul i ndi duali that s everyone el wilpay so the i vi se l ndi dualdoes not need to. As everyone takes the atti tude the good or servi i not provi ce s ded i the f market,so publc goods are usualy provi n ree i l ded by the publc sector,fnanced through taxati i i on.

D e/m eri goods t


Meri goods: t H ave posi ve externalti ti i es. H ave addi onalpri ti vate benef ts that the consumer i unaware of i s . Are associ ated wi a tendency to under consume. th Good exampl ofmeri goods i ude heal and educati es t ncl th on. Price D D (PB)

P2 P1 S

H eal and educati are th on under consumed by Q2 Q1.

Q1 Q2 Quantity/tim e Demeri goods: t H ave negati externalti ve i es. H ave addi onalpri ti vate costs that the consumer i unaware of s . Are associ ated wi a tendency to over consume. th An exampl ofa demeri good i smoki e t s ng. Price D (PB) D Ci garettes are over consumed by Q1 Q2.

P1 P2 S Q2 Q1 Quantity/tim e

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Factor i m obi i m l ty
Where the i nabii off lty actors ofproducti to be moved f on rom one use to another bri ngs about market f l aiure.

I nequal ty i
Why i thi a probl s s em?

It depends on val j ue udgements,some peopl may not vi equi as a probl e ew ty em. H owever i can be argued that equi i t ty ssues are a probl as some cannot earn em enough money to obtai access to basi goods and servi n c ces. These i vi ndi dual can s be regarded as lvi ow the poverty lne. i ng bel i Absol poverty i when i vi ute s ndi dual earn l than a speci i sum ofmoney s ess fc requi f a basi standard oflvi red or c i ng. Rel ve poverty i i ati s ncome rel ated i rel on to some measure ofi n ati ncome. Generaly the medi i l an ncome i used as the mean i easiy skewed by l s s l arge earners. Earni 50% ofthe medi i ng an ncome may be vi ewed as rel ve poverty, ati f exampl or e. O thers may not have access to certai goods and servi n ces,certai aspects of n heal care and i th nsurance,f exampl or e. U nequalvotes castthrough spendi patters (e.g. Jacuzzi vs. operati ng s ons).

Sol ons to the probl uti em 1. Redi buti of i stri on ncom e

Requi a taxati system; res on Progressi i ve ncome tax systems (i those that take a hi .e. gher % ofi ncome f or hi gher earners). Regressi expendi ve ture tax system as those on l ower i ncomes spend more of thei i r ncome so a greater proporti ofi on ncome goes i tax. Zero-rati on n ng chidren cl l s othes,f ood and l ower rates on domesti f make the system l c uel ess regressi ve. Requi a beneft/wel are system; res i f Ifunempl oyment beneft i set too hi i may di i s gh t stort the worki ofthe ng l abour market especi l i a poverty trap exi (where an i vi aly f sts ndi dualrecei ves more i benefts than they coul earn by worki n i d ng). Thi causes a f s urther market f l aiure. There i no controlover what peopl spend the benef ts money on (i i s e i t s debateabl as to i controlhere i ri or wrong) as some may choose to e f s ght gambl thei benefts or spend i on al e r i t coholor ci garettes. O ther benef ts are n-ki such as a f pl i schooland chid care i i nd ree ace n l vouchers. Some benefts are gi to al i i ven l ncome groups,other benef ts are targeted at i speci i groups such as f prescri ons f the unempl fc ree pti or oyed and students.

So here government i nterventi can l to a f on ead urther market f l aiure.

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Gareth Jones - http://cyro.cs-terri es.com/ tori 2. Set a m i m um w age ni


A mi mum wage bel W1 woul have no ef ect as W1 i al ni ow d f s ready the equii um lbri wage. A mi mum wage at Wmin will ni l ead to redundanci ofL1 L2 and an excess suppl es y ofl abour (i unempl .e. oyment) ofL3 L2.

W age Wmin W1

SL (househol ds)

DL (f rms) i L2 L1 L3 LS & LD p. t u.

U nempl oyment can be seen as market f l so government i aiure nterventi i the f on n orm ofa mi mum wage can cause a f ni urther market f l aiure. The extent ofthi wildepend on the s l el ci ofboth suppl and demand. asti ty y 3. Set a m axi um pri (e.g. rent control m ce s) Price ( rent) SRA

R1 Rmax DRA A2

A1

A3

AS & AD p. t u.

A maxi mum rent above R1 woul have no ef ect as the equii um i the f d f lbri n ree market i R1. s A maxi mum rent at Wmax will to excess demand. l ead

Theref another market f l i created i the f ore aiure s n orm ofexcess demand,so f rom al three l exampl above government i es nterventi to sol one market f l can cause another. on ve aiure

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Gareth Jones - http://cyro.cs-terri es.com/ tori

Governm ent intervention and f urtherm arket f ure ail


Market i nterventi by the government can be broadl cl fed i fve categori on y assii nto i es: Fi nanci i al nterventi (e.g. taxes and subsi es). on di State provi on (ofpublc and meri goods). si i t Redi buti (through taxati and government spendi stri on on ng). Regul on (break up monopoles,do not alow gamblng unti 18 years,dri ng ati i l i l vi unti 17 years). l Inf ormati on.

Fi nanci i al nterventi (taxes and subsi es) on di


An exampl offnanci i e i al nterventi i the 2004 budget i the i on n s ncreased duty on ci garettes. Thi i an i s s ncreased manuf acturi cost. The duty causes a decrease i the quanti suppled ng n ty i ncrease i pri f n ce rom P1 to P2. Thi duty ai to reduce consumpti by s ms on f rom Q1 to Q2 and an i shi ti the suppl curve as recent government i ormati campai ai f ng y nf on gns med at shi ti f ng demand i nward were no ef ecti enough. f ve In the di agram beneath AC demonstrates the cost ofthe i ncreased tax,so the i ncrease i total n government revenue i P2ACE,P2ABP i pai by the consumer and P1BCE by the f rm. s s d i Price P2 A
TAX

P1 E

B C

STAX

S Q2 Q1

D QD & QS p. t. u.

The outcome here I i ncreased tax revenue f the government and decreased consumpti or on. Part ofthe externalcost ofproduci and consumi ci ng ng garettes has been i nternalsed,that i i s that i has become part ofthe pri t vate cost. Smaler i l ncreases i the duty on envi n ronmentaly f endler f may swi consumpti away l ri i uel tch on f rom l eaded petrol . An exampl ofa subsi i the budget i i the i e dy n s n ncreased subsi on chidcare. dy l Externalbenefts are lkel f i i y rom suppl ng more chid care at a cheaper pri Subsi si yi l ce. di ng shoul l d ead to a l ower pri and a hi ce gher quanti consumes. O ne argument agai the ty nst i ncreased subsi i that i benef ts al i dy s t i l rrespecti ofi ve ncome. A sol on has been to gi uti ve chidcare l vouchersto speci i targeted groups. fc

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Gareth Jones - http://cyro.cs-terri es.com/ tori

Thi shoul i s d ncrease suppl as shown bel causi an i y ow ng ncreased quanti demanded at a ty l ower pri ce.

Price P1
SU BSIDY

P2

SSU BSIDY Q1 Q2

D QD & QS p. t. u.

State provi on si

Increased educati and heal care servi provi on are exampl ofstate provi on i the on th ces si es si n Budget. Arguabl subsi sed chid care i al state provi on,these are quasi y di l s so si -publc goods. i

Redi buti stri on


An exampl i the 100 payment to over 70 to hel wi counci tax. Fi e s s p th l scaldrag,not i ncreasi tax bands i lne wi i l on and i ng n i th nf ati ncreasi i ng ncomes,causes a redi buti stri on ef ect f f rom tax payers to pensi oners. Income Tax f alowance ree l Taxabl i e ncome M ain rate oftax is 22% Actualtax pai d 3, 300 Tax as % ofi ncome 16.5% Pre-budget 20, 000 5, 000 15, 000 +4% +2% Post-budget 20, 800 5, 100 15, 700 3, 454 16.6%

Cost benefi anal s t ysi


Thi approach i used f hel ng to assess the nature and extent ofmarket f l s s or pi aiure,to enabl e deci ons to be made concerni those i si ng ssues. Shoul the government i d ntervene? What f orm shoul the i d nterventi take? on Step 1: Identiy al costs and benefts (pri f l i vate and external associ ) ated wi an i th ssue. Step 2: Assi monetary val to the costs and benef ts i gn ues i dentii fed. Step 3: Forecast f uture costs and benefts. i

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Step 4: Anal and i yse nterpret al i ormati on costs and benefts. l nf on i Step 5: Deci on maki si ng: Yes i soci benef t are greater than soci costs; f al i al No i soci costs are greater than soci benefts. f al al i

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Gareth Jones - http://cyro.cs-terri es.com/ tori

Uni 3:The nati t onaland i nternati onaleconom y


M acroeconom ic obj ectives
The government has f key macroeconomi obj ves. These are: our c ecti A hi sustai gh, nabl rate ofeconomi growth, e c Low,stabl i l on, e nfati Bal ance ofpayments equii um and lbri Low unempl oyment. The government i ai ng f 1-2% i l on usi the H ICP measure,3% growth,l s mi or nfati ng ow unempl oyment and equii um i the bal lbri n ance ofpayments. Currentl the U K i experi ng y s enci a bal ance ofpayments defci very l unempl i t, ow oyment (~5% ),l growth and l i l on. ow ow nf ati

Unem pl oym ent


W hat i unem pl s oym ent? An economi defni on ofunempl c i ti oyment i when resources are not utii to thei f l s lsed r ul potenti . Thi i udes resources such as l al s ncl and not j l ust abour. U nempl oyment i more commonl used to descri al those wilng and abl to work but s y be l li e unabl to fnd a j Thi means al members ofthe U K l e i ob. s l s abour f orce ages 16-65 years ol d. H ow i unem pl s oym ent m easured? There are two key ways i whi unempl n ch oyment i measured. s Cl ant count aim The frst i the cl mant count. Thi measures those who are wilng and abl to work and i s ai s li e elgi e to cl m unempl i bl ai oyment beneft. It i used as a cheap and easy way f the government i s or to obtai fgures ofboth the enti economy and ofdi f n i re f erent regi ons. The government has power to change regul ons ati The cl mant count can under esti ai mate unempl oyment because: Excl on ofthose wi savi and those wi a worki partner. usi th ngs th ng Potenti applcants bei put of by l ofpaper work and onl a smal chance of al i ng f ots y l gai ng any benef t. ni i and can al over esti so mate unempl oyment because: Some cl m benef t who are not acti y seeki work,or who parti pate i the bl ai i vel ng ci n ack market. Labourf orce survey The second way that unempl oyment can be measured i the l s abour f orce survey. It defnes i unempl oyment as those acti y seeki empl vel ng oyment. To cal ate the f gures a proporti of cul i on the work f orce are asked i they consi themsel to be unempl f der ves oyed. Compii thi survey i more costl so i i perf lng s s y t s ormed l f ess requentl onl once per quarter (3 y, y month peri and does not demonstrate a regi od) onalbreak-down off gures. The l i abour f orce survey i i s ndependent ofthe government and i the standard f i s or nternati onalcompari sons.

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Gareth Jones - http://cyro.cs-terri es.com/ tori The l abour f orce survey generaly over esti l mates unempl oyment because ofthe defni on i i ti t uses. D oes an i ncrease i em pl n oym ent m ean that there m ust be a decrease i unem pl n oym ent? Not necessariy,a vari off l ety actors can alow empl l oyment to i ncrease wi thout unempl oyment decreasi ng: Increased parti pati (parti arl ofwomen over recent years). ci on cul y School l /colege l eavers taki up empl ng oyment. Empl oyment ofmi grant workers. Part-ti worker adopti a portf i career or si y worki more than one j me ng olo mpl ng ob. Both measures ofunempl oyment are i naccurate. Types of unem pl oym ent Invol untary Demand-defci or cyclcalunempl i ent i oyment: when i the busi n ness cycl there i a e s recessi There i a sl down a recessi i the enti economy there wilbe on. s ow on n re l l ower i ncomes i the economy,so consumpti wilbe l n on l ower,and so f ewer workers wilbe requi to produce these goods. There i usualy a ti l red s l me-l between the ag busi ness cycl and empl e oyment as there i a l s arge cost to busi nesses associ ated wi th f ri workers and hi ng new workers. i ng ri Vol untary Fri onalor search unempl cti oyment: when a worker l eaves one j (ei ob ther vol untariy l or i nvol untariy) and moves to a new j there i a peri ofunempl l ob s od oyment. Thi i s s not a probl as l em ong as thi peri i short lved and the worker has adequate s od s i i ormati about getti a new j In the U K thi nf on ng ob. s naturalrateofunempl oyment i s ~2-3% . Structuralunempl oyment: when an i ndustry has moved on through technol cal ogi devel opment or tastes have changed so a good or servi i no l ce s onger requi red. Good exampl i the U K i ude mi ng and shi es n ncl ni pbuidi i l ng ndustri Seasonal es. unempl oyment i a subcategory ofthi f exampl Santa Cl s s, or e ausare not requi to red work i the summer. Structuralempl n oyment depends on: o Mobii ofl lty abour to move f rom one occupati i a declni i on n i ng ndustry to an occupati i a growi i on n ng ndustry and to move f rom one geographi l cal ocati on to another area where there may be empl oyment. o The pace ofchange. Ifthi i very qui structuralunempl s s ck oyment i lkel to be s i y hi gher. o Regi onalconcentrati ofa declni i on i ng ndustry,f exampl coalmi ng may or e ni mean a parti ar regi suf ers more severel cul on f y. W hat probl s face the unem pl em oyed? There i a cl correl on between percei j securi and psychol calwel bei s ose ati ved ob ty ogi l ng. Many ofthose i l pai and i n ow d nsecure j suf ered si l psychol calprobl obs f miar ogi ems to those out ofwork. Some ofthe psychol calef ects caused by unempl ogi f oyment i ude depressi and ncl on depreci ated soci skil Many peopl out ofwork f nd themsel di al ls. e i ves vorci thei partners and ng r do not have access to i ormati about new j so have dif cul fndi new empl nf on obs f i ty i ng oyment. Page 30

Gareth Jones - http://cyro.cs-terri es.com/ tori

Women were more seri y af ected by the prospect ofthere bei no work avaiabl ousl f ng l e. W hy m i ght these probl s gi ri to costs not j for the unem pl em ve se ust oyed but al for so soci as a w hol ety e? U nempl oyment i a broad term used to descri those wilng and abl to work but unabl to s be li e e f nd a j Economi l unempl i ob. caly oyment causes a probl as the i vi em ndi duali not acti i the s ve n producti ofa good or servi wi n the economy. Thi means the economy perf on ce thi s orms bel ow the producti capaci ofthe economy. Thi can be best il ve ty s lustrated on a PPF,a Producti on Possi lty Fronti a di bii er, agram that demonstrates al combi ons oftotaloutput that an l nati economy can produce,usi al ofi resources i the most ef i ent manner. ng l ts n fci Consum ergoods C A E

D Capitalgoods

The possi e producti capaci ofthe economy i il bl ve ty s lustrated by the lne. Poi encl i nts osed wi n the area represent an i f ci use or waste ofresources. Year on year the producti thi nef i ent ve capaci ofthe economy grows f ty rom AB to CD. Typi l f the U K thi growth rate has been caly or s ~2.5% . H owever,unempl oyment causes the economy to be at poi E,whi i bel the nt ch s ow producti capaci ofthe economy,due to the wasted resource,l ve ty abour. The gap between poi E and the lne i caled the output gap. nt i s l As the potenti output ofthe economy conti al nues to grow at ~2.5% unempl oyment (ceteris paribus) means that even i the economy managed to grow at 2.5% i woul stilf lshort of f t d l al the possi e i bl ncrease i output. It i ni i n s gh mpossi e to recover thi l output,caused by bl s ost unempl oyment. The cost ofunempl oyment to tax payers i hi as the government l s gh oses revenue i tax that n the i vi ndi dualwoul have pai had they been i empl d d, n oyment and al i transf payments so n er made to the i vi ndi duali the f n orm ofbenef ts. The l i osses through taxes are hi f gh rom the VAT on the i ncreased goods and servi that an i vi ces ndi dualwoul have purchased wi thei d th r i ncreased i ncome to the NI contri ons and i buti ncome tax. Theref the tax payers have to pay ore f both the f or undi f the transf payments and the addi onaltaxes the unempl ng or er ti oyed person woul have pai had they been i empl d d n oyment. There are many f urther costs to the i vi ndi dualand to the communi as detaied above. ty, l U nempl oyment decreases the i ncome ofan i vi ndi dualwhi l ch eads to decreased spendi In ng. areas ofhi unempl gh oyment thi can cause many busi s nesses to cl ose. H ousehol have lttl ds i e Page 31

Gareth Jones - http://cyro.cs-terri es.com/ tori spare money to spend on thei gardens and property and an i r ncrease i burgl es and n ari vandalsm of f l i ten olows. Furthermore unempl oyment makes many f lke aiures.Thi can l to a vari ofef ects eel i f l s ead ety f i udi marri break-up,sui de and mentalstabii Death rates are generaly hi ncl ng age ci lty. l gher amongst those unempl oyed than those who have not been out ofwork. As peopl are out ofwork f l e or onger workers become deskil and thei skil may be out of led, r ls date. Thi can cause probl s ems fndi work and can cause a downward spi . The i ng ral government ai to hel peopl i thi si ms p e n s tuati by thei on r new deal where trai ng i of ered ni s f f ofcharge. ree

I ati nfl on
Inf ati i a sustai l on s ned change i the overal pri l n l ce evelwi n the economy over a peri of thi od ti me. Generaly the term i l on i associ l nf ati s ated wi a posi ve change,a ri i the pri l th ti se n ce evel and the term def ati wi a f li the pri l . Inf ati i usualy expressed as a l on th al n ce evel l on s l percentage change. The ol measure ofi l on i the U K was the RPI,the RPIX excl ng mortgages and the RPIY d nf ati n udi excl ng mortgages and taxati Thi was cal ated usi a wei udi on. s cul ng ghted basket ofgoods ai med at representi the average consumer. No consumer however i represented by the ng s averageconsumer as some goods are mutualy excl ve such as al three f lf s. l usi l ossi uel The measure that the government has now adopted i the H ICP (harmoni i s sed ndex of consumer pri or CPI the consumer pri i ces, ce ndex) whi makes some modii ons on the RPI. ch f cati These i ude excl ng housi depreci on,counci tax and dentalcharges whist i udi ncl udi ng ati l l ncl ng uni versi f and new car pri The wei ngs are dif ty ees ces. ghti f erent,pensi oners i uded and the ncl top 4% ofspenders excl uded. The geometri (not ari c thmeti mean i used to cal ate the c) s cul mean and thi generaly gi a l s l ves ower resul f i l on than the RPI,whi i i beleved to be t or nf ati ch t s i more accurate i keepi wi the way other countri measure thei i l on. n ng th es r nf ati

B al ance of paym ents


The bal ance ofpayments i a record oftransacti between those i one economy and those s ons n i other economi over a gi ti peri usualy one year. There are f ve secti to the n es ven me od, l i ons bal ance ofpayments,onl the current count needs to be understood i detai: y n l Current account Made up ofthe trade i goods and servi i l n ces, nfows and outfows ofi l nvestment i ncomes and current transf When goods are exported thi l ers. s eads to an i l and when goods are nfow, i mported thi l s eads to an outf ow. Investment i l ncomes are the rewards f i or nvestment i n f gn economi (rent,i orei es nterest and proft). i Current transf are usualy negati on the U K bal ers l ve ance ofpayments as they of represent ten ai gi to devel ng countri (a net outfow f the U K). d ven opi es l or Capitalaccount The trade i capi goods,a very mi part ofthe bal n tal nor ance ofpayments. Financialaccount A record ofi nvestment made by U K economi abroad and by abroad economi i the U K. es es n

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Gareth Jones - http://cyro.cs-terri es.com/ tori N et errors and om issions Stati calerrors made i the gatheri ofdata are noted here. sti n ng Internationalinvestm ent position A secti outlni the ownershi ofassets owned by the U K abroad and by abroad on i ng p economi i the U K. es n

G D P (and the three m easures)


GDP i an acronym f Gross Domesti Product,the totalval ofgoods and servi s or c ue ces produced i an economy over a gi ti peri usualy one year. Si money spent on n ven me od, l nce goods and servi i equalto the val ofthose goods and servi ces s ue ces,GDP can be measured usi totalspendi (totalexpendi ng ng ture) i the economy. n The expenditure m ethod There are f key groups ofpeopl who may spend money i an economy. Fi y the our e n rstl consumers wi n the economy (Consumpti and busi thi on) nesses based i that economy n (Investment). The government wilal spend money (Government expendi l so ture),as wil l consumers and busi nesses f rom other economi (Net exports). es Thus,GDP can be cal ated as the sum ofthese components,where net exports are denoted cul as (X M),the val ofgoods and servi exported l the val ofthose i ue ces ess ue mported. GDP = C + I + G + (X M) The incom e m ethod Thi cal ates GDP at f s cul actor cost. It i cal ated by summi the rewards f s cul ng rom f actors of producti rent,wages,prof ts and i on; i nterest. Transf payments are excl er uded as they are not a reward f the producti ofa good or servi GDP measured by the expendi or on ce. ture method l ess tax and addi on subsi es gi the same val as GDP measured by the i ng di ves ue ncomes method (l transf payments). ess er The output m ethod A f gure obtai i ned by summi the val added (to avoi doubl counti by f rms i the U K ng ue d e ng) i n to goods and servi ces. GN P Gross Nati onalProduct i a more accurate fgure f the i s i or ncome generated f the domesti or c economy. Rewards f f or actors ofproducti fow both i and out ofthe U K economy,GNP on l n takes thi i account,whereas GDP does not. s nto

Econom i grow th c
In the short run economi growth can be defned as a measure ofthe change i GDP. Most c i n of thi i a posi ve i ten s s ti ncrease,si l to trend growth. Short run economi growth i a miar c s growth i output. Thi can be represented on a PPC as a movement al n s ong or around the PPC,a movement f rom any ofthe poi on the PPC to any other poi nts nt. Growth i output fuctuates around the trend growth f the economy. When thi fgure i n l or s i s negati f two or more quarters the economy i sai to be i a recessi and when the ve or s d n on, economy i produci at hi s ng gher than i producti capaci ts ve ty

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Gareth Jones - http://cyro.cs-terri es.com/ tori Long run economi growth i the growth i potenti output,the rate the economy coul c s n al d grow by i the l n ong run. O n a PPC thi i shown as a shi t outwards f s s f rom the sold lne to the i i dotted lne. i

Consumer goods

Capi goods tal

Confl cts i m acroeconom i pol ci i n c i es


Probl em Inf ati l on Fi scalpol cy i tax rates di sposabl i e ncome C, I (AD ) government di screti onary spendi ng G (AD ) M onetary pol cy i Interest rates C ( di Income) sc. I ( opp. cost) Money suppl y credi l t ess avaiabl l e. C . Interest rates C ( di Income) sc. I ( opp. cost) Money suppl y credi more t avaiabl l e C Exchange rate pol cy i Appreci ate Rai i se nterest rates. Spend f gn. orei currency reserves f GBP. or Lower i mported i l on. nf ati Depreci ate Lower i nterest rates. Sel GBP f l or f gn orei currency. Increased demand f or U K exports U . Imports more expensi so U K ve f rms i setup i the n domesti c economy U . Depreci ate Exports cheaper so X ,but I as opp. cost i hi s gher so there i s a conf i lct. Suppl de pol cy y-si i AS i LR n Increase pri vate or publc i i nvestment. Increases competi on, ti i ncenti and ves competi veness. ti (short run probl of em i l on) nf ati AS i LR n As above f ocusi ng on trai ng of ni workf orce to i ncrease occupati onal mobii lty and af ordabl f e housi ng to i ncrease geographi cal mobii lty.

U nempl oyment

tax rates di sposabl e i ncome. C, I (AD ) U . di ncenti to si ves work. government di screti onary spendi ng G (AD ) U .

Bal ance ofpayments def ci i t

Lack ofgrowth

tax rates di sposabl i e ncome C ofl uxury i mports government di screti onary spendi ng G AD U . totalNY . C ofl uxury i mports. tax rates di sposabl e i ncome. C, I (AD ) U di ncenti to si ves

Interest rates C ( di Income) sc. I ( opp. cost coul d cause l ong run probl ems) Money suppl y credi l t ess avaiabl l e. C . Interest rates C ( di Income). sc. I ( opp. cost). Money suppl y credi more t

AS i LR n Increase competi veness ti abroad by i nvestment and by pri vate frms i and government.

Depreci ate O veral i l ncrease i n economi acti ty c vi causes an i ncrease i n growth.

AS i LR n Increase AS so AS expands by LR potenti . U se i al n combi on wi nati th

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Gareth Jones - http://cyro.cs-terri es.com/ tori


work government di screti onary spendi ng G (AD ) U . GDP . avaiabl l e. C . demand management polci to alow the i es l UK to achi i LR eve ts potenti . al

and a vari ofsi ety tuati to consi (note the conf i above i polci ons der lcts n i es):
Probl em 3% Growth 2% Inf ati l on 4% U nempl oyment Fi scalpol cy i M onetary pol cy i Exchange rate pol cy i Suppl de pol cy y-si i To decrease the natural rate ofunempl oyment i ncrease trai ng and ni cheaper housi to ng reduce occupati onal and geographi cal i mmobii ( p.40 of lty. See the study guide) AS i LR n Increase occupati onal and geographi cal mobii lty U . Make U K busi nesses more competi ve. ti Increase l abour parti pati ci on. AS i LR n (See p. 40 ofthe study gui de) Ai f f m or reer trade.

10% U nempl oyment BoP Defci i t

Expansi onary.

Expansi onary.

Depreci ate X more competi ve ti so X . M more expensi ve so M .

4% Inf ati l on 1% Growth BoP Surpl us 8% U nempl oyment

In the short run onl grow th orinfation can be targeted,a priority choice needs to y l be m ade.Suppl side pol y icies w il hel in the l run but w il not cure short run l p ong l probl s. em Change tarif f s.

AD/AS m odeling l
Aggregate dem and
Aggregate demand i the totalamount ofdemands (or expendi s tures) i the economy at any n gi pri l . It i cal ated by the f ven ce evel s cul ormul a: AD = C + I + G + X M W here: C: Consumer expendi ture;spendi on durabl goods,non-durabl goods and servi ng e e ces. I: Investment or spendi by f rms on capi goods. ng i tal G: Government spendi on current goods and servi ng ces. X: Exports,spendi by overseas buyers ofU K goods and servi ng ces. M: Imports,spendi by U K buyers ofoverseas goods and servi ng ces. Consum pti on Consumpti wi n the U K economy has i on thi ncreased at a reasonabl steady rate f y rom ~170bn per annum i 1955 to ~500bn per annum i 1998 at constant (1995) pri Spendi on n n ces. ng essenti i al tems such as f ood and energy has remai ned rel vel constant whist spendi on ati y l ng durabl goods has i e ncreased dramati l Reali caly. ncome has i ncreased approxi matel 4-f d y ol

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Gareth Jones - http://cyro.cs-terri es.com/ tori and consumpti has i on ncreased to match thi meani that generaly the extra money s ng l i vi ndi duals gai i di n n sposabl i e ncome i spent on durabl goods and not i s e nvested. MPC,Margi Propensi to Consume = nal ty Change i consumpti n on Change i i n ncome Change i savi n ngs Change i i n ncome Consumpti on APC,Average Propensi to Consume = ty Income APC,Average Propensi to Save = ty Savi ngs Income

MPC,Margi Propensi to Save = nal ty

APS + MPS = 1,APC i i s nversel proporti y onalto APS;MPC i i s nversel proporti y onalto MPS. An i vi ndi dualcan have an APC or an MPC greater than one as they can ei ther borrow money (a l oan,f exampl or spend money that they have previ saved,so meani that they are or e) ous ng spendi more money than they are earni ng ng. The si f x actors that af ect consumpti and savi i the economy are: f on ng n Weal the val ofstocks i a househol s portf i may i th ue n d olo ncrease so maki them ng f ri eel cher and more abl to spend on consumpti Ri ng house pri alow e on. si ces l consumers to borrow more agai the (now hi nst gher) val ofthei home and so they ue r can spend the borrowed money. Inf ati In the short run a hi rate ofi l on may cause peopl to purchase now l on gh nf ati e i nstead ofi the f n uture when they know the same good wilcost more. l The rate ofi nterest To buy expensi i ve tems househol borrow money and what i ds s more i mportant to the consumer than the pri ofthe i ce tem such as a car or ki tchen i s the cost ofthe repayments. H i i gh nterest rates cause these rates to ri and so se consumpti to f l on al. The avaiabii ofcredi Credi i now wi y avaiabl yet bef the earl 1980s the l lty t t s del l e ore y market was hi y restri ghl cted by the government. Now the mai f n actor af ecti the f ng avaiabii ofcredi i the rate ofi l lty t s nterest. Expectati Expected i ons ncreases i the pri ofgoods and servi wilcause the n ce ces l consumer to spend now. Expected i ncreases i thei i n r ncome wilalow the consumer l l to f more secure i borrowi l eel n ng arger sums ofmoney. The composi on ofhousehol Generaly ol and younger peopl spend a greater ti ds l der e proporti ofthei i on r ncome than those i mi e age. For the n ddl APC M PC young thi i due to the costs i s s nvol i setti up a home. ved n ng 1.02 1.50 For the ol they may run down savi as thei pensi d ngs r on 0.98 1.49 gi them a much more lmi i ves i ted ncome. 0.95 0.71 1.01 1.43 APC tels us the proporti ofi l on ncome bei spent on consumpti ng on, 0.96 132.0 MPC tels us how much ofan i l ncrease i i n ncome i bei spent,i s ng .e.

1958 1968 1978 1988 1998

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Gareth Jones - http://cyro.cs-terri es.com/ tori f every 1 i or ncrease how much ofthat 1 i bei spent on consumpti s ng on. 1958 H ousehol are spendi more than thei i ds ng r ncome. In thi peri househol are s od ds di ssavi that i spendi thei savi ng, s ng r ngs. In the 1950s most househol were abl to own thei ds e r own property f the f rst ti and l or i me abour savi devi were wi y avaiabl f the frst ng ces del l e or i ti Many houses al had tel si sets. There were prosperous expectati and an me. so evi on ons average growth f the decade of3% . or 1968 2% ofi ncome i saved. For every extra 1 earnt 1.49 i spent as the consumer f l s s els prosperous. 1978 5% ofi ncome i saved. For every extra 1 earnt onl 70p i spent on comsumpti s y s on. U ncertai f many househol about j securi af two oi cri s nty or ds ob ty ter l si . 1988 H ousehol spendi slghtl more than thei i ds ng i y r ncome. H i gher expectati f the ons or f uture. For every 1 spent 1.43 i spent. Fi s nanced by di ssavi and now i ng ncreasi y ngl borrowi whi i a rel vel new i f purchases ofconsumer durabl ng ch s ati y dea or es. 1992 Duri a recessi so probabl si l to the 1978 f gure. ng on y miar i 1998 The U K has a hi APC and so a l APS. Low savi mean l i gh ow ngs ow nvestment. H owever there have been very l i ow nterest rates so i i easi to borrow and f nance l t s er i arge l oans i the n current economi clmate. Bri expectati wi n the economy as unempl c i ght ons thi oyment reaches the naturalrate wi n the economy af a steady declne f many years. The MPC i thi ter i or s extorti onatel l y arge pri mariy due to house pri l ces,f every 1 i or ncrease i i n ncome the consumer spends an extra 132 on consumpti on!

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Gareth Jones - http://cyro.cs-terri es.com/ tori Changes i consum pti over recent years i the UK econom y n on n
D i osab l sp e i ncom e Increased steadiy over l the peri od f rom ~320bn i 1980 to n ~520bn i n 1998. W eal th I ati nfl on Rate of i nterest Avai ab i i of l l ty credi t Fewer restri ons on cti borrowi ng money and payi on ng credi has l t ead to a massi ve boom i n borrowi ng. Avaiabii has l lty i ncreased vastl over y recent years. Exp ectati ons H i U caused gh l ow expectati so ons Cl ow. Al ti hi l me gh consumer confdence i caused a vast i ncrease i C. n Consumer confdence i very l so C ow decreased. Consum p ti on of househol ds An agi ng popul on has ati caused an i ncrease i C as n ol peopl der e generaly l spend more than thei r i ncomes as they use up savi ngs. Thi s has i ncreased throughout the peri od.

Earl 80s y

Late 80s

H i house pri cause C gh ces to i ncrease. Strong stock market i ncreases weal so th Ci ncrease. Negati equi causes a ve ty decrease i C. Af bl n ter ack Monday i 1987 there i a n s weak stock market,causes C to decrease.

Earl 90s y

H i i l on gh nf ati (doubl e f gures). As i val ofmoney ue f l als househol ds tend to save APC decreases and APS i ncreases.

15% i l on nf ati pushed the roiup. C of durabl es generaly on l credi t. Less di screti onal i ncome as mortgage payments ri and se, l ower borrowi ng so C decreases.

Late 90s

Earl 00s y

Increasi ng house pri ces, f les amii f eel weal er thi so C i ncreases.

Strong stock market perf ormance, Ci ncreases. Weaker stock market perf ormance, C decreases. Very l and ow stabl causes e APC to i ncrease. Low and stabl causes e APC to i ncrease.

Growi ng consumer confdence i causes an i ncrease i C. n Confdent i consumers and l U caused C ow to ri se.

Is measured usi the Gf confdence i ng K i ndex,cal ated f cul rom surveys ofthe publc. i Average U K ci zen now owes ~4, ti 500.

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Gareth Jones http://cyro.cs-terri es.com/ tori I nvestm ent Tax ef ects the amount of f money frms have avaiabl i l e f i or nvestment. Exchange rates - A weak pound encourages demand f rom abroad,so compani es i nvest i machi n nery to create goods to sati y thi demand. sf s Previous nationalincom e the accel erator theory suggests the change i i n nvestment wilecho l the change i nati n onali ncome, and that thi echo wilbe a s l more than proporti onal response3. Pri vate f ons Expectations i expectati are f the economy to grow or and demand to i ncrease compani wili es l nvest i an ai n m to meet thi demand. Low s expectati have the opposi ons te ef ect and cause l f ow i nvestment.

Technol ogicalchange f ast paced devel opment i a n i ndustry requi i res nvestment to keep up wi competi th tors. Cost ofcapitalgoods. Prof the number and its sui lty ofproj tabii ects to i nvest i n.

Factors affecti I ng nvestm ent

gh Rate ofinterest A hi rate of i nterest makes i nvestment l ess attracti as many proj ve ects wil l return a l ower rate than that whi ch savi the money i a bank woul ng n d return. Thi means i s nvesti has a ng hi opportuni cost associ gh ty ated wi i A l rate ofi th t. ow nterest makes savi l attracti and ng ess ve i nvestment more attracti as there ve i al s ower opportuni cost i ty nvol ved i i n nvesti ng. Publ c i i nvestm ent (by the governm ent)

H ousehol i d nvestm ent Interest rates are the f oremost f actor ef ecti f ng househol i d nvestment i fxed assets,such as nto i houses.

Less vol e generaly pl atil l anned many years i n advance,however hi i gh nterest rates may di scourage excessi borrowi and duri a ve ng ng recessi the government may i on nvest to revi ve the economy.
3

See Al n Anderton,Economi AS Level pp.207-208 ai cs

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Gareth Jones http://cyro.cs-terri es.com/ tori G overnm ent spendi ng Discretionary spending (thi i i the AD f s s G n ormul a) i udes spendi on goods and servi (such as ncl ng ces heal care and educati and empl th on) oyment i both n centraland l ocalgovernment servi ces. In ti mes ofl ow AD/recessi the government may choose to spend on more to revi the economy. ve

Autom atic expenditure (does not count toward i the AD f G n ormul such as a) benef ts wilvary wi the state ofthe i l th economy.

Factors affecti governm ent ng expendi ture Pol iticaldecisions. I ports and Exports m Exchange rate a l pound makes U K ow Standard ofl iving i the U K we enj n oy exports more competi vel pri f ti y ced or l uxury goods f rom abroad,as our overseas compani so i es, ncreases exports standard oflvi i i ng ncreases i mports wil l but makes i mports more expensi yet ve, al i so ncrease. demand wilnot f lby as much l al proporti onaly as i l mports are not Qual ofgoods produced. ity pri el c goods. ce asti Factors affecti net ng Innovation the abii to lty spendi on i ports and ng m create new i deas. Whist many l exports Business cycl in m aj m arkets. e or i deas are created i the U K n they are of devel ten oped Overal l ofdem and we know the U K l evel overseas. has a hi MPC,and l gh uxury goods are i mported so an i ncreased i the overal n l Rel ative productivity perw orker l evelofdemand causes an i ncrease i n f the U K thi i very l or s s ow. i mports. The reverse i al true. s so Raw m aterial or f s actors ofproducti that an on economy has can alow i to become a net l t exporter. Interesti y Japan has become a net ngl exporter wi very f naturalresources. th ew

Infation hi i l on rel ve to other l gh nf ati ati countri makes the U K goods and servi es s ces l competi vel pri so exports decrease. ess ti y ced Comparati y l i l on causes an i vel ow nf ati ncrease i net exports. n

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Gareth Jones http://cyro.cs-terri es.com/ tori

H i pri l gh ce evel(hi i ati gh nfl on) C decreases as i l on pushes i nf ati nterest rates up and makes savi more attracti 4. ng ve I decreases as savi i more attracti f ng s ve or busi nesses too. O nl proj of eri a hi y ect f ng gher rate ofreturn than the i nterest rate wilbe l consi dered as the opportuni cost of ty i nvestment has i ncreased. G lttl change al i e though m ay decrease slghtl i y as the repayments on any pl anned borrowi ng wilbe much hi l gher. X - M decreases as exports become l ess competi ve overseas and f gn goods ti orei become more competi ve i U K markets. ti n H i pri theref cause AD to decrease. gh ces ore

Low pri l ce evel(l i ati ow nfl on) Ci ncreases as savi i l attracti and ng s ess ve repayments on borrowed money are l ower. Ii ncreases as savi i made l attracti ng s ess ve and the repayments on borrowed money are cheaper f busi or nesses too. The opportuni ty cost ofi nvestment has decreased so i seems t more attracti ve. G lttl change al i e though m ay i ncrease slghtl i y as the government chooses to borrow more. X-M i ncreases as exports become more competi ve overseas and f gn goods ti orei become l competi ve i U K markets. ess ti n H i pri theref cause AD to increase. gh ces ore

Thi theref gi the demand curve a downward sl ng shape: s ore ves opi Price l evel

N ationalincom e
4

Consumers al desi to keep the r val ofthei savi the same. To thi they must save more. so re eal ue r ngs s

The m ul pl er effect ti i
The U K has a very hi MPC so money gi to f gh ven actors ofproducti as a reward f on or parti pati i the producti ofgoods and servi i very lkel to be consumed. The ci ng n on ces s i y average U K MPC i approxi s matel 0.9,so i thi y n s second roundofconsumpti about 90% of on the i ncome recei wilbe consumed. In consecuti spendi rounds the amount ofmoney ved l ve ng spent wildecrease as the MPC i l than 1. The overal i l s ess l ncrease i consumpti (and so GDP) n on f rom an i ti i ni al nvestment of1, 000m i the U K economy woul be ~10, nto d 000m.

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Gareth Jones http://cyro.cs-terri es.com/ tori


Ini ali ti nvestment Fi round rst Second round 1000m 900m 810m 729m 656m 590m 531m 478m

Studi ofthe U K economy have shown thi fgure to be nearer to es s i 1.3 ti mes the i ti i ni al nvestment due to much ofthe money spent by househol s fows out ofthe U K economy by buyi i d l ng mports,payi ng taxes or savi money. Theref an i ng ore nvestment of1000m i lkel s i y to cause an i ncrease i GDP ofapproxi n matel 1300m. y Price l evel

Thi round rd Fourth round Fi th round f Si round xth Seventh round

Total

10000m

The shi t f f rom AD1 to AD2 demonstrates the i ti ni al i nvestment i the economy, nto causi an i ng ncrease i I,and n rounds ofspendi cause C ng to i ncrease causi an ng eventualshit to AD3. f 1 1 - MPC

AD1

AD2 AD3

Mul pler = ti i

N ationalincom e

Aggregate suppl y
Aggregate suppl i the totalsuppl ofgoods and servi i the economy. It i measured i y s y ces n s n pounds and i the equi ent ofrealnati s val onali ncome,or output. In the short run aggregate suppl i upward sl ng as f rms f they can i y s opi i eel ncrease output and so prof t at a hi i gher pri In realty thi j causes i l on. ce. i s ust nfati Price l evel P2 P1

NY 1

NY 2

N ational incom e

At a l output (up to NY 1) the suppl curve i perf y el c. Thi i because the economy i ow y s ectl asti s s s produci f i de i PPC. At thi l ng ar nsi ts s evelthere i an excess suppl ofl s y abour (due to hi gh

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Gareth Jones http://cyro.cs-terri es.com/ tori unempl oyment ofresources at an equii um up to NY 1) so al frms can i lbri li ncrease suppl y wi thout rai ng the pri as there i lttl extra cost i si ce s i e nvol i them doi so. ved n ng nesses must pay i ncreasi y more f resources as they become ngl or Between NY 1 and NY 2 busi i ncreasi y harder to obtai as the economy gets nearer to f lcapaci Fi have to pay ngl n ul ty. rms hi gher pri to obtai resources as they become more scarce and thi i ces n s ncrease i cost i n s passed on to the consumer,causi i l on both cost push and demand pul i l on. As the ng nfati l nf ati economy output i s ncreases nearer to f lcapaci the negati output gap i ul ty ve mproves. When the economy reaches NY 2 there i onl a naturalrate ofunempl s y oyment wi n the thi economy. The economy i worki at i f lcapaci so any shi t ofthe market equii um s ng ts ul ty f lbri s ng outward wilcause onl demand pul i l on. At pri l l y l nf ati ce evelP1 the economy i produci on i PPC,at pri l s above P1,such as P2,the economy i overheati ts ce evel s ng.

At NY 2 the economy i s operati at f lcapaci ng ul ty, on i PPC (equalto any of ts the poi on the l t hand nts ef PPC).

K An i ncrease ofrealoutput i an economy can be seen on a PPC as a shi t outwards. Thi can n f s al be shown as a shi t outwards ofthe aggregate suppl curve. Whereas a shi t i aggregate so f y f n demand i caused by a change i C,I,G or net exports a shi t i suppl i caused by a change s n f n y s i ei n ther the qualty ofquanti ofresources avaiabl i an economy. i ty l e n Qual ity Fertii lsers or conservati on. Trai ng and educati ni on. Quantity Di scovery ofnew naturalresources or recl amati on. Immi grant l abour,i ncreasi the ng pensi age,l on oweri the compul ng sory schoolng age or part ti and the i me unempl oyed worki ng. Investment. Trai ng. ni C

Land Labour

Capi tal Enterpri se Price l evel

Research and devel opment. Ini ati ti ves.

N ational incom e Page 43

Gareth Jones http://cyro.cs-terri es.com/ tori The macroeconomi obj ves ofthe government are: c ecti Low and stabl i l on. e nfati Low unempl oyment. Sustai nabl economi growth, e c Equii um i the bal lbri n ance ofpayments.

H owever,to achi al ofthese obj ves i i eve l ecti s mpossi e so the government must make bl tradeof s between obj ves. Targeti unempl f ecti ng oyment i lkel to cause a ri i i l on as s i y se n nf ati the aggregate suppl curve shows;i y ncreasi y scarce resources cause f rms costs to i ngl i ncrease and so i l on. nf ati Economi growth wilbri about a ri i nati c l ng se n onali ncome,and as most ofthe U K l s uxury goods are i mported thi i lkel to cause a worseni defci on the bal s s i y ng i t ance ofpayments. There i al a trade of between the bal s so f ance ofpayments equii um and i l on as a lbri nfati depreci ng exchange rate makes exports most competi ve i f gn markets so the bal ati ti n orei ance ofpayments wilwork toward an equii um l . H owever a depreci ng exchange rate wil l lbri evel ati l al cause i so mports to become more expensi and so i l on i the U K economy. ve nfati n To manage these changes i suppl the government has f key tool (expl ned f n y our s ai rom p.45 onwards). o Fi scalpolcy the use ofgovernment expendi i ture and taxati to i l on nfuence the l evel ofeconomi acti ty. c vi Monetary polcy. i Suppl de polcy. y-si i Exchange rate polcy. i

AD /AS D i agram s
Anal ng si ysi tuati usi aggregate suppl and demand di ons ng y agrams to expl n changes i ai n output and i l onary pressures i i nf ati s mportant. For exampl a substanti i e, al ncrease i the worl n d pri ofoi may bri about the f l ng ef ect. ce l ng olowi f O i has very pri i asti l ce nel c demand i the U K economy n so an i ncrease i the pri n ce ofoi will onl to a l l ead y smal f li quanti l al n ty demanded per uni ofti t me so the val ofi ue mports wil l i ncrease,causi a decrease ng i AD f n rom AD1 to AD2. Thi s causes a decrease i n nati onali ncome f rom NY 1 to NY 2 and a decrease i pri n ce l evelf rom P1 to P2.

Price l evel

AD2

AD1

AS

P1 P2

NY 2 NY 1 Realnationalincom e ( Output)

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Gareth Jones http://cyro.cs-terri es.com/ tori

The instrum ents ofm acroeconom ic pol icy


Fi scalpol cy i
Fi scalpolcy i the mani ati ofgovernment spendi and taxati to achi i s pul on ng on eve macroeconomi obj ves. c ecti

M onetary pol cy i
Monetary polcy i the attempt by the government or centralbank to mani ate the money i s pul suppl suppl ofcredi i y, y t, nterest rates or any other monetary vari es to achi the abl eve f fl uliment ofpolcy goal such as pri stabii i s ce lty. The government has f key macroeconomi polcy obj ves;to have l and stabl our c i ecti ow e i l on,l unempl nf ati ow oyment,hi and stabl economi growth and to mai n a current gh e c ntai account equii um. lbri To achi these obj ves i the U K economy the Bank ofEngl eve ecti n and mani ates i pul nterest rates and the money suppl y. The i pact of l i m ow nterest rates on the econom y Aggregate dem and,in the short run: Consumpti i on ncreases as credi i more avaiabl di t s l e, screti onali ncome i ncreases and savi i ng s l attracti to consumers. Investment wilal i ess ve l so ncrease as the opportuni cost of ty i nvestment i l s ower. Government spendi i lkel not to ng s i y Year GDP Base rate of G row th i nterest change as much spendi i pl ng s anned i advance however n 1985 3.6 12.5 l i ow nterest rates make payments on the nati onaldebt 1986 3.9 11.0 l ower so wilgi the government a budget surpl l ve us.
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 4.5 5.2 2.2 0.8 -1.4 0.2 2.5 4.7 2.9 2.6 3.4 2.9 2.4 3.1 1.9 9.3 9.1 14.0 13.9 11.9 8.4 5.6 5.6 6.4 5.9 6.7 6.9 5.4 5.8 5.0 4.0 3.6 4.0

Ifthe rate ofi nterest i the U K i l n s ower than i other n economi hot money wilfow out ofthe U K whi wil es l l ch l cause depreci on i the val ofthe pound. Thi wil ati n ue s l make exports more expensi and exports cheaper abroad. ve Thi wilcause net exports to i s l ncrease,al though i mports are lkel to decrease by a proporti i y onaly smal val as l l ue i mports to the U K are pri i asti ce nel c. Aggregate suppl in the l run: y, ong As i nvestment becomes more attracti i the short run ve n f busi or nesses i the l n ong run the economy shoul benef t d i f rom thi by i s ncreasi the producti capaci ofthe ng ve ty economy. Li betw een econom i grow th and i nk c nterest rates Si 1997 the goalofmonetary polcy has been sol y nce i el pri stabii The target of2.5% i l on 1% i the goal ce lty. nf ati s the government sets the Bank ofEngl and.

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Gareth Jones http://cyro.cs-terri es.com/ tori Duri the U K ti i the ERM the goalwas to mai n the exchange rate wi n the ng s me n ntai thi restri ons ofthe ERM. Bef the ERM the mai goalwas to mai n the avaiabii ofcredi cti ore n ntai l lty t. To do thi the government can lmi the proporti ofthei f s i t on r unds banks can l end out. H as the econom y been m ore stabl si e nce the Bank of Engl and took over m onetary pol cy i i 1997? n The goalthe Bank ofEngl and has been set by the government i pri stabii to control s ce lty i l on has been achi nf ati eved. Whereas when the government was i controlofi n nterest rates typi l an expansi caly onary fscalpolcy woul be used bef an el on to i i i d ore ecti mprove polti i cal popul ty duri the governments term a def ati ari ng l onary polcy woul need to be i emented i d mpl to curb the i l on resul ng f nf ati ti rom the earler polcy thi i no l i i s s onger true. It has been suggested that the government controlcaused i nstabii i the busi lty n ness cycl however now e i nterest rates are controled by an i l ndependent body thi shoul not be the case. s d

GDP and i nterest rates 16 14 12 10 8 6 4 2 0 -2 -4

% rate

19 85

19 87

19 89

19 91

19 93

Low erdarkerl represents yearon yearincrease in GDP perannum ,upperl ine ighterl represents base rate ofinterest. ine

Exchange rates
The exchange rate i the val ofthe pound i rel on to that ofother currenci It i s ue n ati es. s determi ned by suppl and demand. The demand f pounds comes f y or rom: Forei i gn nvestors (hot money) movi i the U K. ng nto Purchase ofexports (i udi vi tors on holday i the U K). ncl ng si i n Specul ators who beleve the pound wilri i val i l se n ue. Government seli f gn currency reserves to buy pounds. lng orei UK i nvestors movi f ng unds i the domesti economy f nto c rom abroad.

and the suppl f pounds comes f y or rom: U K ci zens/f rms i ti i mporti goods (i udi buyi overseas holdays). ng ncl ng ng i

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19 95

Year

19 97

19 99

20 01

20 03

Gareth Jones http://cyro.cs-terri es.com/ tori Specul ators who expect the val ofthe pound to decrease. ue Government seli pounds to buy f gn currency f reserves. lng orei or Forei i gn nvestors wi thdrawi f ng unds f rom the U K. UK i nvestors movi f ng unds abroad.

W hat tool can be used to controlthe exchange rate and how do they w ork? s Interest rate Ifthi i hi s s gher than other economi then i vi es ndi dual wi hot money may move thei money s th r i the U K. Thi wilcause an i nto s l ncrease i demand f pounds (Figure 1). Thi wilcause a shi t n or s l f f rom D1 to D2,an i ncrease i quanti demanded per uni ofti f n ty t me rom Q1 to Q2 whi resul i ch ts n an i ncrease i pri f n ce rom P1 to P2. Thi i ref s s erred to as appreci on ofthe pound. Ifthe i ati nterest rate i l s ower than i other economi the opposi wilhappen (Figure 2). Funds wilfow out n es te l l l ncrease i quanti n ty ofthe U K economy and cause an i ncrease i suppl f n y rom S1 to S2,an i demanded per uni ofti f t me rom Q1 to Q2 whi resul i a decrease i pri f ch ts n n ce rom P1 to P2. Thi s drop i the pri ofthe pound i caled depreci on. n ce s l ati Figure 1 Price P2 P1 S Price P1 P2 D D1 Q1 Q2 D2 Q S&D p.u.t. S1 Q1 S2 Q2 Q S&D p.u.t. Figure 2

Governm ent spending The onl controlthe government now has on exchange rates i through exchangi i y s ng ts f gn currency reserves f pounds,or seli pounds f i reserves. Thi has a very smal orei or lng or ts s l ef ect and i not sustai f s nabl (such as duri the ERM peri and due to the vast amount of e ng od) currency traded daiy any ef ect caused by the government tradi i reserves woul be l f ng ts d mi mal ni . Usi the exchange rate to achi ng eve m acroeconom i obj ves c ecti M acroeconom i c obj ve ecti Low and stabl e i l on nf ati
Aim to el inate im ported im infation ifl ofraw l ots m aterial goods and services s, are im ported f rom abroad

Change to exchange rate Appreci ate.

H ow w oul i w ork? Any probl s? d t em By i ncreasi the base rate ofi ng nterest rel ve to other ati economi and the government seli i f gn es lng ts orei currency reserves to buy pounds the demand f or pounds wili l ncrease. Thi wilcause appreci on whi s l ati ch wilmake i l mports l expensi and as the U K i very ess ve s

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Gareth Jones http://cyro.cs-terri es.com/ tori relant on i i mports thi wilease the pressure ofi l on. s l nfati S Price P2 P1

D1 Q1 Q2

D2 Q S&D p.u.t.

Low unempl oyment and sustai nabl e growth

Depreci ate.

The ef ect depends on the exchange rate and f proporti ofconsumer goods that are i on mported. By decreasi the rate ofi ng nterest or the government i ncreasi i f gn currency reserves U K exports ng ts orei become cheaper f overseas ci zens,whi causes an or ti ch i ncrease i demand f U K exports whi wilutii n or ch l lse more resources i the U K economy whi shoul cause n ch d a shi t i aggregate demand a l f n ower unempl oyment i n the short run. AD1 AD2 AS Price l evel P2 P1 NY 1 NY 2 Realnationalincom e ( Output) Thi wilcause the probl s l ems associ ated wi i l on as th nf ati the economy nears i producti capaci whi ts ve ty ch causes i l on as shown above and the i nfati ncrease i the n pri ofexports causes i ce mported i l on as U K nf ati consumers now wi an i th ncreased nati onali ncome buy more l uxury i mported goods. In the l ong run new frms i shoul enter the market i the U K to provi the goods d n de and servi whi are expensi i ces ch ve mported l uxuri es. Thi shoul cause l s d ong run sustai nabl growth. e For the U K i mports woul become more expensi and d ve exports more competi ve. Thi will ti s l ead to probl ems of i l on i the short run as demand f i nf ati n or mports i very s i asti but shoul encourage new U K based f rms to nel c d i enter the market to suppl to the domesti economy. y c For Japan i mports become cheaper and more competi ve than home produced goods and servi ti ces so i mports i ncrease and exports become l ess competi ve so exports decrease. ti

Bal ance ofpayments equii um lbri


U K reduce the def icit Japan reduce the surpl us

Depreci ate f the U K, or appreci ate f Japan. or

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Gareth Jones http://cyro.cs-terri es.com/ tori For both economi there wilbe a ti l whist f rms es l me ag l i enter the market f the U K and l or eave the market or adapt i Japan. In the U K there wilal be the short run n l so probl ofhi em gher i l on. nf ati The two tool that the government can theoreti l use to bri about changes i the s caly ng n exchange rate are i nterest rates and government spendi H owever,i the U K the ng. n government does not controlthe rate ofi nterest. Thi i the j ofthe Bank ofEngl s s ob and (whose mai goali pri stabii and the government adj ng i f gn currency reserves i n s ce lty), usti ts orei s polti l unpopul The U K i of i aly a f foati currency,meani the exchange rate i i caly ar. s f ci l ree l ng ng s governed enti y by suppl and demand. U se ofgovernment f gn currency reserves to rel y orei di stort the exchange rate the market sets woul be regarded and rty foati d di l ng. There are three ways a currency can be exchanged on currency markets. Ei ther f foati ree l ng, lke the U K pound where the rate i determi i s ned enti y by suppl and demand,managed rel y f oati where a target i ai l ng s med f such as the U K economy duri the ERM i preparati or, ng n on f the EMU . For those economi that entered the Euro the exchange rates were i or es rrevocabl y f xed,ref i erred to as a fxed exchange rate. i

Suppl si pol cy y de i
Suppl si polci are government polci desi y de i es i es gned to i ncrease the producti capaci of ve ty the economy,so shi ti the LRAS curve outwards. These can be broadl categori i f ng y sed nto: Encouraging com petition:Through pri sati ofstate owned assets and deregul on of vati on ati i ndustri Thi happened l duri the ti Thatcher was Pri Mi ster and most es. s ots ng me me ni i ndustri that have been pri sed have al been deregul es vati so ated. The NH S has not been pri sed,al vati though the i ndustry regul ons alow other provi ati l ders ofheal care. Water th servi i probabl the onl exampl ofan i ces s y y e ndustry that has been pri sed but not vati deregul ated. Providing incentives: Removi or decreasi di ncenti to work such as unempl ng ng si ves oyment benef ts. It i debateabl as to how ef ecti decreasi benef ts i at i i s e f ve ng i s ncreasi parti pati ng ci on i the work f n orce. Increasing com petitiveness: Investment i educati research and devel n on, opment maki the ng U K competi ve wi overseas economi ti th es. Effects i the short run n The ef ects here are mi mal The government may i f ni . ncrease i government di ts screti onary capi expendi tal ture as more i spent on i s nvesti Fi ng. rms may al be encouraged to i so ncrease thei i r nvestment by bei of ered subsi es or tax releff doi so. Theref i the short run ng f di i or ng ore n there may be a smal i l ncrease i aggregate demand whi may,i the economy i near f l n ch f s ul empl oyment cause i l on. nf ati Long run effects Suppl si polci ai to i y de i es m ncrease aggregate suppl by i y ncreasi ei ng ther the quanti or ty qualty ofthe resources i the economy. Pri i n mariy thi takes the f l s orm ofi ncreasi capi ng tal through i nvestment,encouragi entrepreneurshi and i ng p mprovi the qualty ofl ng i abour.

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Gareth Jones http://cyro.cs-terri es.com/ tori Labour: Ai pri m mariy to i l ncrease occupati onalmobii through i lty mprovi skil ofthe ng ls workf orce. Remove trade uni ons. Reduce wel are benefts. f i Reduce mi mum wage. ni Decrease tax rates on i ncome. Reduce taxes on l abour. Reduce costs ofchangi j ng obs. Increase trai ng and educati ni on. Capital : Decrease taxes to i ncrease profts,so encourage more entrepreneurshi and i p i nvestment. Encourage l endi to pri ng vate f rms f i i or nvestment. Remove tari f to i fs ncrease ef i ency. f ci Encourage smal frms to enter the market to encourage competi on and keep li ti pri l ces ow. Pri se state owned assets and deregul i vati ate ndustri l ng the f market es etti ree alocate scarce resources. l

In the recent budget the government has chosen to i ement the f l ng suppl si mpl olowi y de polci i es: Increased chid care subsi es,thi wilhopef l l to i l di s l uly ead ncreased parti pati i ci on n the work f orce. Rai the mi mum wage,arguabl thi may act as an i sed ni y s ncenti to enter the ve workf orce whi will to i ch l ead ncreased parti pati H owever,some ofthose who ci on. are unempl oyed may be wilng to work f l than the mi mum wage and so li or ess ni ch s the mi mum wage creates an excess suppl ofl ni y abour ofQ3-Q2,whi i unempl oyment. S W ages PMin. wage PE

D Q2 Q1
U nempl oyment

u. Q3 QS&D p. t.

More spendi on research,through a 10 year f ng ramework to boost research and devel opment wi n the U K. Increased i thi nvestment i mproves the quanti and ty qualty ofresources. Increased research and devel i opment i hi val output nto gh ue wilhel resol the bal l p ve ance ofpayments si tuati as when eastern European on countri j n the EU the U K wilhave f es oi l urther cheap competi on f ti rom abroad.

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Gareth Jones http://cyro.cs-terri es.com/ tori Increase housi i the short run thi wili ng, n s l ncrease the demand f buiders and so or l i ncrease aggregate demand a smal amount but i the l l n ong run thi polcy i s i s ai med at i ncreasi the geographi mobii ofl ng cal lty abour wi n the economy. thi Changes i taxes and duti may change busi n es ness practi ses. Improvi the U K i rastructure shoul make the U K more competi ve as f ng s nf d ti ewer hours wilbe wasted traveli and delvery wilbecome cheaper. l lng i l Ref orms to regul ons on busi ati nesses wilreduce costs to busi l nesses and f up ree scarce resources used i regul on f another applcati n ati or i on. More Bri sh fl bei made through subsi es. Thi may hel exports. ti ims ng di s p Ref orms to l ocalgrowth authori es gi ng them more power to achi thei own ti vi eve r goal s.

H ow effecti i governm ent fundi at i ve s ng ncreasi grow th? ng Governm ent f unding has a l arge ef ect if f More j are created i the l obs n ocalarea. Localmul pler ef ect causes thi to i ti i f s ncrease and so cause a shit outwards i f n aggregate suppl f y rom AS1 to AS2. AS1 Price l evel AS2

Realnationalincom e ( Output) Lower busi nesses costs as More use ofl abour. More i nvestment. More trai ng. ni

Governm ent f unding has l ofan ef ect if ess f Profts are repatri i ated abroad rather than rei nvested l l i the i ocaly f nvestment i FDI s (f gn di orei rect i nvestment). Requi more than money. Localcouncis need to agree wi the expansi If res l th on. l ocalpl anni permi on f exampl i not granted the move may be unpopul ng ssi or e s ar. May be lmi government f i ted undi splt between many regi ng i ons. A f racti ofthe on money alocated may reduce i l ncenti to compani ves es. For those who want to trade wi Europe a base anywhere other than the south th easy i not an opti they woul consi s on d der. Europe accounts f ~50% ofthe U K or s trade so compani want to si es tuate themsel near the channeltunnel ves .

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Free trade and protectionism


Types of trade
Inter-industry trade: Where di f f erent economi speci i i produci dif es alse n ng f erent goods and servi then trade,e.g. France makes bread and the U K meat. ces Intra-industry trade: Where one economy i both an exporter and an i s mporter ofthe same good or servi For exampl the U K exports cars and unref ned oi but i ce. e, i l mports dif f erent model ofcars and refned oi. s i l

W hy does trade take pl ace?

Di f f erent countri have dif es f erent avaiabii ofresources (f l lty actor endowments), f exampl Indi has excess l or e a abour whereas the U K has a shortage. Economi es wi l th arge resources can speci i f exampl agri ture f an economy wi alse, or e cul or th l ofl ots and. Access to di f f erent l s oftechnol evel ogy alows easi producti ofsome goods l er on and servi ces. Di f f erenti ated products are of ered by di f f f erent economi so goods are i es mported to i ncrease consumer choi f di f ce or f erent types ofappl and cars. es To expl t economi ofscal to create l oi es e ower uni costs. Very l t arge compani may es choose a vari ofsmaler f ety l actori around the worl i es d nstead ofone l arge f actory so as not to exceed thei MES (mi mum ef i ent scal output at whi the uni r ni f ci e ch t cost i l s owest).

U nit cost Tradi alows U K compani ng l es to i ncrease demand f rom DU K to DWO RLD and so decrease thei uni cost f r t rom PU K to PWO RLD. LRAC

PU K PWO RLD

DU K

DWO RLD Output

G ai from trade ns
( Anderton p.263 and study guide p.67) See Free trade i the i s nternati onalexchange ofgoods and servi wi ces thout barri such as quotas ers and tari f f s.

Special isation: Economi speci i i produci what they are best at. es alse n ng Econom ies ofscal As above,alow an extensi i the LRAC curve whi causes a e: l on n ch f li uni costs. al n t Choice: Consumers can choose f rom di f f erenti ated products produced i di f n f erent economi es.

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Innovation: Increased competi on (f ti rom supplers i other economi l i n es) eads to pressure to i nnovate and i ncrease ef i ency. f ci

Under free trade,Adam Sm i sai that econom i shoul speci i accordi to th d es d al se ng absol advantage. ( Anderton p. ute See 88) Absol advantage i when a country can produce a good more cheapl i absol terms ute s y n ute than another country. That i what a country can produce gi i f s, ven ts actor endowment. Ifan economy i sai to have an absol advantage thi means that i can produce more than s d ute s t another economy or produce the same output at a l ower absol cost. ute In realty one economy may be better at produci many goods than another economy the i ng economy may have an absol advantage i the producti ofal goods. Trade can stilbe ute n on l l worthwhie i one economy has a comparati advantage. A comparati advantage i the l f ve ve s opportuni cost ofproduci that i ty ng tem,the producti ofanother good or servi f on ce orgone. If one economy can produce good A by sacrii ng the producti ofgood B,yet another fci on economy can onl produce good A by sacrii ng the producti oftwo good B the f rst y f ci on s i economy i sai to have a comparati advantage over the second. s d ve The terms oftrade and pri rati (the rati ofexport pri to i ce o o ces mport pri ces) wildetermi l ne whether trade i benef ci . H owever whist speci i on bri rewards ofi s i al l alsati ngs ncreased producti ty f al i vi or l nvol the benef ts,the extra producti may appear predomi ved i on, nantl or y excl vel i a si e economy or a mi ty ofeconomi i usi y n ngl nori es nvol i the trade. As l ved n ong as no economy i worse of through tradi i i stillkel though that trade wiltake pl s f ng t s l i y l ace.

Tari ffs
Cl othi i K enya:Usi tari on i ported cl ng n ng ffs m othi ng Price SDO MESTIC

PN PT PW QM QMT D SWO RLD

Q1 Q2 QN

Q3

Q4

QS & QD p. t. u.

Cl ng i produced i Kenya,but the market equii um i a hi othi s n lbri s gher pri than worl suppl ce d y. Worl suppl i modeled as bei perf y el c as there are l d y s l ng ectl asti arge stocks ofcl othes.

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By alowi f worl trade the suppl curve shits to SWO RLD,and so the equii um pri l ng ree d y f lbri ce decreases f rom PN to PW and quanti consumed wi n the economy i ty thi ncreases f rom QN to Q4. ty agram as H owever domesti producti f l f c on als rom QN to Q1,and the quanti marked on the di QM represents the l evelofi mports i f trade i i emented. f ree s mpl Thi can be undesi e f an economy that has i ant i s rabl or nf ndustri A tari fi one f es. f s orm of protecti sm. For i oni ndustri wi hi fxed costs a reducti i output menti es th gh i on n oned above due to worl trade wilcause a proporti d l onaly l l arge i ncrease i uni costs as il n t lustrated to the l t ef the movement f rom O 1 to O 2 causes a proporti onaly l l arger i ncrease i uni costs f n t rom U 1 to U 2. Thus a tari fcan be vi f ewed as desi e to protect i ant i rabl nf ndustri and so rai domesti es se c producti to a hi on gher output,l oweri uni costs. Increase domesti producti wilcreate ng t c on l more j and l obs ower unempl oyment,whi may hel to achi macroeconomi obj ves i ch p eve c ecti n the short run. The si ofthe tari fcan vary,but as il ze f lustrated above a tari fofmagni f tude PWPT causes a decrease i totalquanti demanded and suppled f n ty i rom Q4 to Q3,an i ncrease i n ower i mports down to Q2Q3 f rom Q1Q4. So,whist the tarif l f domesti producti ofQ1Q2 and l c on benef ts domesti producers as i i i c t ncreases thei producti totalconsumpti i l r on on s ower and the consumer i payi a hi s ng gher pri The consumer surpl i al l ce. us s so ower when a tari fi f s i mposed so the consumer i Kenya i worse of . n s f

N on-tari protecti sm ff oni


Bri l these i efy, nvol ve: Quotas Al egalrestri on on the val or amount ofa good or servi that can be i cti ue ce mported. Subsidies Reduci the cost ofdomesti producti ofa good or servi through fnanci hel ng c on ce i al p. Exchange control s Li ti the avaiabii off gn currency,yet si 1979 thi i not an opti f the mi ng l lty orei nce s s on or government as al restri ons were removed. l cti Vol untary Export Restraints Agreements between two economi to lmi trade. es i t

Argum ents for and agai protecti sm nst oni


Free trade i the unrestri s cted exchange ofgoods and servi between economi whist ces es l protecti sm i where restri ons are pl oni s cti aced on these exchanges. Ifan economy adopts f trade,economi l they stand to gai many benefts. When there ree caly n i are no restri ons on trade compani compete gl cti es obaly. Competi on bri about ef i ency l ti ngs f ci and i nnovati as consumers have choi over a vari ofdif on ce ety f erenti ated products produced i dif n f erent economi Consumers are al lkel to pay a l es. so i y ower pri and so wilhave an ce l i ncreased consumer surpl us. Further ef i ency can be gai f ci ned as speci i on occurs. Economi wilproduce accordi to alsati es l ng absol and comparati advantage where an economy produced goods at a l ute ve ower f actor cost or a l ower opportuni cost. Thi wilcause worl output to i ty s l d ncrease and so the overal l

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Gareth Jones http://cyro.cs-terri es.com/ tori standard oflvi i the worl to i i ng n d ncrease. As i totalmore goods and servi are bei n ces ng produced. As economi trade gl es obaly and speci i they can benef ts f l alse i rom economi ofscal as the es e f rms can i i ncrease thei output to sati y demand i the gl r sf n obaleconomy not j the domesti ust c economy. The reducti i uni costs as output i on n ts ncreases. Thi means consumers can pay a s l ower pri and/or the entrepreneur gets more prof t,a greater reward f the ri taki ce i or sk ng whi encourages f ch urther entrepreneurshi p. An economy i ementi f trade polci can theref stand to gai i mpl ng ree i es ore n ncrease ef i ency f ci brought about by i ncreased competi on. ti H owever a sudden i ementati off trade polci can cause probl mpl on ree i es ems f an economy or as f actor i mmobii may cause hi unempl lty gh oyment and frms encounter hi barri to i gh ers entry i the f n orm ofeconomi ofscal f frms i other economi al es e or i n es ready tradi gl ng obaly or l i l n arger domesti economi c es. Arguabl theref protecti st polci can be very usef i the short run and certai y y ore oni i es ul n nl cause the government to be more popul domesti l ar caly. Protecti declni i ng i ng ndustri and new start up i es ndustri can hel keep unempl es p oyment at manageabl l s and l to i e evel ead ncrease i nternati onalcompeti veness. Protecti sm i the ti oni s rai ng oftrade barri agai i si ers nst mports and can take a vari off ety orm i udi tari f ncl ng f s, subsi es and quotas. di Af urther case f protecti sm i f def or oni s or ence i ndustri and those i es ndustri rel on to es ati def ence f the case ofnati or onalsecuri These i ty. ndustri shoul be protected by l alowi es d aw l ng operati onl by frms di on y i rectl under the controlofthe state or state authori es themsel y ti ves. In concl on theref whies protecti st polci have some temporary applcati there usi ore l oni i es i ons are f economi gai f ew c ns rom protecti st polci For the domesti economy consumers wil oni i es. c l pay hi gher pri and suf er a l ces f ower consumer surpl and f rms may suf er retalati f us i f i on rom f gn countri and so may f nd i hard to exports thei goods and servi The worl orei es i t r ces. d market wilal suf er as worl output wilbe l l so f d l ower than the potenti as barri prevent al ers economi speci i ng accordi to absol and comparati advantage. es alsi ng ute ve

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W hat com e up i p ast exam p ap ers (Jan 01 Jan 04) s n


U nit 1
5.1.1 Economi c probl em Resources O pportuni cost ty PPC 5.1.2 Demand Consumer surpl us PED YED XED Suppl y Producer surpl us PES Equii um lbri 5.1.3 Costs Economi of es scal e Revenue Proft i maxi sati mi on O ther obj ves ecti Market structure Barri to entry ers Jan 01 Jun 01 Jan 02 Jun 02 Jan 03 N ew Spec. Jun 03 Jan 04

U nit 2
5.2.1 Producti ef i ency ve f ci Alocati ef i ency l ve fci Pareto ef i ency f ci Ef i ency and a PPC f ci Ef i ency and competi on f ci ti 5.2.2 Externalti i es Market domi nance
(and X-i f ci nef i ency)

Jan 01

Jun 01

Jan 02

Jun 02

Jan 03

N ew Spec.

Jun 03

Jan 04

Publc goods i De/meri goods t (M) Factor i mmobii lty Inequalty i 5.2.3 Page 56 (M)

Gareth Jones http://cyro.cs-terri es.com/ tori Pri vate/externalcosts and benef ts i Taxes/subsi es di Pri control (max/mi ce s n) Regul on ati Inf ormati provi on on si Competi on polcy ti i Cost benef t anal s (CBA) i ysi Government f l aiure

U nit 3
5.3.1 U nempl oyment Inf ati l on Bal ance ofpayments Economi growth c GDP (+ 3 measures) Confi i macro lct n polci i es 5.3.2 Aggregate demand Aggregate suppl y AD/AS di agram Mul pler ti i Equalty i 5.3.3 Fi scalpolcy i Monetary polcy i Exchange rates Interest rates Suppl si polci y de i es 5.3.4 Gai f ns rom trade Tari f fs Non-tarif f protecti sm oni For/agai nst protecti sm oni Jan 01 Jun 01 Jan 02 Jun 02 Jan 03 N ew Spec. Jun 03 Jan 04

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