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WJECASEconomicsRevisionguide
Copyright:TejvanPettinger,Economicshelp.org1stAugust2018
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Table of Contents
Unit1–ASMicroeconomics.......................................................................................4Scarcity,choiceandopportunitycost...............................................................................4Opportunitycost.............................................................................................................................................5
Productionpossibilityfrontiers(PPF)....................................................................6Possibilityfrontierandeconomicgrowth.........................................................................................7Specialisation................................................................................................................................................10
Markets...................................................................................................................................11Demand..........................................................................................................................12
Shiftsinthedemandcurve.....................................................................................................................14Supply.............................................................................................................................15
Shiftsinthesupplycurve........................................................................................................................16Marketequilibrium.............................................................................................................17
Consumersurplus.......................................................................................................21Producersurplus.........................................................................................................................................22
Elasticity........................................................................................................................23Usingknowledgeofelasticity...............................................................................................................25Theimpactofelasticityontax..............................................................................................................27Incomeelasticityofdemand(YED)...................................................................................................29Crosselasticityofdemand.....................................................................................................................30Priceelasticityofsupply.........................................................................................................................30
Tax............................................................................................................................................33Wagedetermination............................................................................................................35Nationalminimumwage....................................................................................................39Flexiblelabourmarkets...........................................................................................................................41ImpactofnetmigrationonUKlabourmarkets..........................................................................43Evaluationofnetmigration...................................................................................................................43
Howresourcesareallocatedinafreemarket.............................................................45MarketFailure..............................................................................................................48
Externalitiesandsocialefficiency......................................................................................................48Negativeexternality...................................................................................................................................49Positiveexternality....................................................................................................................................51Publicgood.....................................................................................................................................................52Informationgaps.........................................................................................................................................53Meritgood.......................................................................................................................................................53Demeritgood.................................................................................................................................................53
Governmentinterventiontocorrectmarketfailure..................................................54Tax......................................................................................................................................................................54Subsidy.............................................................................................................................................................56Maximumprices..........................................................................................................................................58Problemofmaximumprices.................................................................................................................59Minimumprices...........................................................................................................................................60Tradeablepollutionpermits.................................................................................................................60Stateprovisionofpublicservices.......................................................................................................61Advertising/Information......................................................................................................................62Regulation.......................................................................................................................................................62PoliciesofWelshgovernment..............................................................................................................63
Governmentfailure....................................................................................................64
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Unit2TheUKEconomy.............................................................................................65Circularflowofincome.......................................................................................................65Injections.........................................................................................................................................................66Withdrawals(W)(leakages).................................................................................................................66Multipliereffect............................................................................................................................................66
Aggregatedemand......................................................................................................67Consumerspending(C)...........................................................................................................................68Investment......................................................................................................................................................68Governmentexpenditure(G)................................................................................................................69Nettrade(X-M)............................................................................................................................................70
Aggregatesupply(AS)................................................................................................70Equilibriumnationalincome................................................................................................................73Governmentmacroeconomicobjectives.......................................................................................75Conflictsbetweenobjectives.................................................................................................................76
Fiscalpolicy...................................................................................................................78TheNationalDebt.......................................................................................................................................80Governmentspending..............................................................................................................................82Taxation...........................................................................................................................................................84
Supplysidepolicies....................................................................................................86Evaluationofsupplysidepolicies......................................................................................................87
MonetaryPolicy...........................................................................................................89UKmonetarypolicy...................................................................................................................................89
Theroleofthecentralbank..............................................................................................90Exchangerates......................................................................................................................92Factorsthatinfluenceexchangerates..............................................................................................93Appreciationintheexchangerate.....................................................................................................93Evaluationofanappreciation...............................................................................................................94
Trade.......................................................................................................................................96Benefitsoffreetrade.................................................................................................................................97Argumentsforrestrictingtrade..........................................................................................................98
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Unit 1 – AS Microeconomics
Scarcity, choice and opportunity cost
• Scarcity.Theseareresourcesthatarelimited.Withscarceresources,weneedtomakechoicesabouthowtouseanddistributethem.
• Non-renewableresources.Thesearenaturalresourcesthatarefiniteandscarce.Onceused,theycannotbereplaced.Forexample,coal,oil,preciousmetals,andgasareallfinite.
• Renewableresources.Resourcesthatcanbereplenished.Examplesincludewind,wood,fish,solarenergy,andwater.
• Semi-renewableresources.Therearesomeresourcesthat,intheory,arerenewable,butiftheyareover-consumedtheycanbecomeextinctandthusnolongeravailable.Forexample,farmlandshouldberenewable,butifweover-farmanduseextensivequantitiesofchemicals,itcouldcausesoilerosion.
• Economicgood.Agoodwhichhasabenefit(utility)tosociety,andalsoagoodthathassomedegreeofscarcity.
• Freegood.Agoodwhichhasbenefittosociety,butisavailableinanunlimitedquantity.Thereisnoopportunitycostinconsumingit.
Scarcity and choice • Becauseofscarcityandunlimitedwants,weneedtomakechoices.• Forexample,asasociety,ifwecontinuetoover-fish,itmeansfuture
generationsmaynotbeabletotakeanyfishfromtheseaatall.• Asanindividual,weneedtodecidehowtouseourlimitedincometo
purchasegoodsandservices.• Governmentsalsohavescarceresources(limitedtaxincome).Theyneed
tomakedecisionsabouthowtousetaxrevenue.IncreasinggovernmentspendingontheNHSmeanslesspotentialforspendingelsewhere.
The fundamental economic problem • Thefundamentaleconomicproblemistheissueofscarcityandhowbest
toproduceanddistributethesescarceresources.Becauseofscarcityandlimitedresources,economicsisconcernedwith:
• Whattoproduce?• Howtoproduce?• Forwhomtoproduce?
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Opportunitycost• Opportunitycostisthenextbestalternativeforegone.
Examplesofopportunitycost
• Ifthegovernmentspendstaxincomeondefencespending,thenthismoneycannotbespentonhealthcare.
• Ifthegovernmentcutstax,theopportunitycostisthattheyhavelesstospend(orusetoreducebudgetdeficit).
• Ifwespendourtimesurfingtheinternet,wecannotspendthistimestudyingeconomics.
• Iffirmsspendalltheirmoneyonadvertisingtheirnewproduct,theycannotusethatmoneytoinvestindevelopingnewproducts.
Importanceofopportunitycost
• Opportunitycostmeanswehavetomakedecisionsaboutthebestuseoftime,moneyandresources.Sometimestherearetwooptionsthataregood,butweneedtochoosetherelativelybestoption.
Choicebetweenstudyandleisure.Supposewehave12hourstospare.Wecanusethese12hoursforstudyorwecanusethe12hoursforleisure.
IfwemovefromAtoB,wecanspendanextratwohoursonleisure.Theopportunitycostisthatwelose2hoursofstudy.
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Production possibility frontiers (PPF) APPFshowsthemaximumoutputthataneconomycanproduceiftheeconomyismaximisingtheuseofitsresourcesandoperatingefficiently.
Thisisasimplisticproductionpossibilityfrontierthatshowsachoicebetweengoodsandservices.
• Ifweproducemoreconsumergoods,itleadstofewerresourcesavailableforproducingservices.
• Wecoulduseallournaturalresourcesandhavemanyconsumergoods,orwecouldhaveonlyfewgoodsandconcentrateonproducingservices.
Opportunitycostandproductionpossibilityfrontier
• AtpointA,wehave22goods/21services• AtpointB,wehave18goods/27services.• IfwemovefrompointAtoB,wegainanextra6unitsofservices.• However,theopportunitycostisthatwehavetoforego4unitsofgoods.
PointsonPPFCurve
• AorB=Productivelyefficient.• C=impossible
(withouteconomicgrowth)• D=inefficient,belowpotential
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Possibilityfrontierandeconomicgrowth
• Shortruneconomicgrowth.MovingfrompointAtoB.Thisinvolves
makingbetteruseofexistingproductivecapacity.• Longruneconomicgrowth.ThisrequiresashiftinthePPFcurvetothe
right.ThisenablespointCtobeattained.
Causes of long run economic growth AshiftinPPFtotherightcanbecausedby:
• Discoveringmorerawmaterials(e.g.discoveringoilfields)• Increaseinthesizeofworkforce(e.g.immigration)• Increaseincapitalstock(e.g.investmentinnewmachines,factories)• Increaseinlabourproductivity(e.g.duetobettereducatedworkersor
workersbecomingmoremotivated)• Improvementsintechnologywhichincreaseslabourproductivity
Negative economic growth ItisalsopossibleforthePPFcurvetoshiftinwards.Thiscouldoccurdueto:
• Decliningpopulation• Firmsclosingdownandstoppingproduction
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Choice between consumer and capital goods
• Consumergoods.Goodsthatwecanuseandenjoy.Thethingswebuyin
shopslikefood,clothes,etc.• Capitalgoods.Thesearegoodsthatareusedintheproductiveprocess–for
example,amachine.Capitalgoodsinvolveinvestmentinincreasingproductivecapacity.
• IfwemovefromBtoA,thereisamovementalongthePPFcurveenabling
morecapitalgoodstobeproduced(anextra8).Theopportunitycostisthattherearelessconsumergoods(17less).
• Increasingcapitalgoodsleadstolowerlivingstandardsintheshortterm,butinthelongtermwemaybeabletoproducemorebecauseoftheinvestmentinmachinesandfactories,whichenableshigheroutput.
Short term growth or long-term investment
• Devotingahigherproportionofresourcestocurrentconsumptionhasanopportunitycostoflessinvestmentandlessgrowthinthelongrun.
• Devotingahigherproportionofresourcestocapitalinvestmenthasanopportunitycostoflessconsumptionintheshortrun.
• ThereisastronglinkbetweenaPPFandthelongrunaggregatesupplycurve(LRAS).LRASisamajordeterminantofeconomicgrowth(see:unit2macro-economics).
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RotationinPPFCurve
• InthisPPFcurve,weseeashifttotherightofthePPFcurveonthex-axis.• Inthiscase,weseeanimprovementintechnologyrelatingtocapital
goods,butnotconsumergoods.Therefore,wecanproducemorecapitalgoodsrelativetoconsumergoods.
• Iftheeconomyisbecomingmoreskewedtowardscapitalgoods.Itmayenablehighergrowthinthelong-termbecauseofincreasedinvestment.
Diminishing returns vs constant returns
• ThePPFontheleftisconcavetotheorigin.Thisisbecauseofimperfect
substitution,anddiminishingreturnstoincreasinggoods/services.• IfwemovefromAtoB,wegain6services,andtheopportunitycostis
only1good.• But,ifwemovefromCtoD,wegainonly1serviceandlose3goods.
Therefore,theopportunitycostofproducingmoreservicesisincreasing.• APPFcurvecanbestraight(diagramright)ifthereareconstantreturns.
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Specialisation
• Specialisationoccurswhenacountryorfirmconcentratesonproducingaparticulargoodorservice.
• Countrieswillspecialiseinproducinggoodswheretheyhaveacomparativeadvantage.Forexample,Japanspecialisesinproducinghigh-techelectronicgoods.Cubaspecialisesinproducingsugar.
Division of labour
• Divisionoflabouroccurswhenworkersconcentrateondifferenttaskswithinafirm.
• Ratherthantrytomasterallaspectsofproduction,someworkerswillspecialiseataparticularjob.
• Forexample,inacar-buildingfirm,somewillworkondesign,someontesting,andsomeworkerswilljustdounskilledjobssuchaspaintingthecar.
Productivity of labour • Thisisdefinedastheoutputperworker,perperiodoftime.• Forexample,oneworker,maypick100strawberriesperhour.• Specialisationmayenableanincreaseinoverallproductivitybecause
specialisedworkerscanbecomemoreefficient.
Advantages of specialisation in the production of goods • Thedivisionoflabourgivesworkerstimetogainskillsforoneparticular
job.Overall,theyneedlesstimetobetrained.• Withspecialisationandthedivisionoflabour,firmscanbemoreefficient
whenproducingonalargescale;itenableseconomiesofscale,andloweraveragecosts.
• Withoutspecialisationandthedivisionoflabour,onepersonmaybeunabletoproduceacaronhisown.Butthedivisionoflabourmakesabigproductiontaskmanageablebyspreadingtheworkout.
Problems of specialisation • Thedivisionoflabourcanmakejobshighlyspecialisedandrepetitive,
leadingtoboredomandpossiblediseconomiesofscale.• Onanassemblyline,ifonepersonisabsent,thewholeproductionline
mayslowdownifotherpeoplecan’tcovertheirjob.Therefore,thereneedstobesomeflexibility.
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Advantages of specialisation in trade • Worldtradeishighlyspecialised,withthegrowthinworldtradeenabling
higherlivingstandards,agreaterchoiceofgoods,andmorecompetition.• Specialisationmeanscountriesdon’thavetoproduceeverygoodthey
need,whichwouldbeimpracticalforsmallcountries.• Countriescanmakeuseoftheirbestresources(e.g.lowlabourcostsin
IndiaandChinaoradvancedtechnologyinGermany).• Itenablescountriestoimportgoodsthattheyotherwisewouldn’tbeable
toproduce(e.g.youcan’tgrowbananasinUK;Africancountriesdon’tcurrentlyhaveaviablecarindustry).
Problems of specialisation in trade • Concentratingonproducingasmallnumberofgoodscanmakean
economyvulnerable.Forexample,ifsugarpricesfall,countriesthatrelyonsugarexportswillseeafallinincome.
• Itmayhamperdevelopmentifcountriessticktoproducingprimaryproducts,whichhavealow-incomeelasticityofdemand.
Markets • Aproductmarketreferstohowagoodisboughtandsold.Forexample,
farmers(producers)sellpotatoesatthemarketandconsumersbuythem.• Themarketwilldeterminethepriceandquantitysold.
Rationality • Ineconomicsweassumefirmsandconsumersarerational.Thismeans
thattheytrytomaximisetheireconomicwelfareandmakedecisionstoenablethis.
Utility • Thisishowmuchbenefitpeoplegetfromconsumingacertaingood.• Ifwegethighutilityfromeatingatarestaurant,wewillbewillingtopay
alargeamountofmoney.• Weassumeconsumerswishtomaximisetheirutility.Forexample,they
willspendmoneyongoodsonlyiftheybelievetheutilitygainedisgreaterorequaltothecost.
Profit • Thisistheamountofmoneyafirmgainsaftersubtractingcostsfromits
totalrevenue(profit=totalrevenue–totalcosts).• Weoftenassumefirmswishtomaximiseprofit(eitherintheshortrunor
longrun).Thismightinvolvecuttingcostsorsellingprofitablegoods.
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Demand • Theindividualdemandcurveillustratesthepricepeoplearewillingto
payforaparticularquantityofagood.• Themarketdemandcurveillustratesthepriceconsumersinthewhole
economyarewillingtopay.
Movementalongthedemandcurve
Achangeinpricecausesamovementalongthedemandcurve.
• Ahigherpricereducesdemand.• Alowerpriceincreasesdemand.
• Forexample,ifthereisanincreaseinpricefrom9to12,thentherewillbeafallindemandfrom30to22.
• Asthepricefalls,peopleareusuallywillingtobuymoreofthegood.Ifthepriceishigher,thisdiscouragespeoplefrombuyingthegood.
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Demand and diminishing marginal utility Marginalutilityisthesatisfactionthatyougainfromthelastunitofconsumption.
• Thefirstchocolatebarofthedayislikelytogivethehighestutility.Thesecondchocolatebarusuallygiveslessutilitythanthefirst.
• Ifyouhavealreadyeatenthreechocolatebars,youareunlikelytoenjoyafourth.Therefore,theutilityfromthefourthchocolatebarismuchlessthanthefirst.
• Asyouconsumemoregoods,theutilityoftheextragoodsusuallydeclines.Thisiswhythedemandcurveisdownwardsloping.Youwouldn’twanttopayasmuchforthefourthchocolatebarasthefirst.
• Thisiswhyanindividual’sdemandcurveisdownwardsloping.Theyarewillingtopaylowerpricesforahigherquantity.
Toencouragehigherdemand,lowerpricesareneeded.
Income and substitution effect • Ifthepriceofagoodchanges,therearetwofactorswhichaffectdemand.
1.Incomeeffect
• Thislooksattheeffectofapriceincreaseondisposableincome.Ifthepriceofagoodincreases,thenconsumerswillhaverelativelylowerdisposableincome.Forexample,ifthepriceofpetrolrises,consumersmaynotbeabletoaffordtodriveasmuch,leadingtolowerdemand.
2.Substitutioneffect
• Thislooksattheeffectofapriceincreasecomparedtoalternatives.• Ifthepriceofpetrolrises,thenitisrelativelycheapertogobybus.
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ShiftsinthedemandcurveThisoccurswhen,evenatthesameprice,consumersarewillingtobuyahigherquantityofgoods–forexample,demandshiftsfromDtoD2
Ashifttotherightinthedemandcurvecanoccurforanumberofreasons:
1. Anincreaseindisposableincome,suchashigherwagesandlowertaxesgivingconsumersmorespendingpower.
2. Anincreaseinthequalityofthegood.Forexample,mobilephonesarenowmoreversatileandpowerful,makingthemmoreattractive.
3. Advertisingcanincreasebrandloyaltytogoodsandincreasedemand.4. Anincreaseinthepriceofsubstitutes.Forexample,ifthepriceofO2
Mobilephonecallsgoesup,thedemandforVodafonemobileswillincrease.
5. Afallinthepriceofcomplements.Forexample,alowerpriceforAppleappswillincreasedemandforAppleiPhones.
Evaluation
• Itdependsonthetypeofgood.Ariseinincomewillnothaveanyeffectondemandforsalt,butitwillhaveabiggereffectondemandforluxurycars.
• Somegoodswillvaryduetoseasonalfactorsliketheweatherandtimeofyear(e.g.scarvesandairconditioners).
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Supply Thesupplycurvereferstothequantityofagoodthattheproducerplanstosellinthemarket.
Changeinpriceandmovementalongsupplycurve
• Ifpricechanges,thereisamovementalongthesupplycurve.• Forexample,anincreaseinthepricefrom£40to£50causesanincrease
from30to33.
Whysupplycurveslopesupwards
• Aspriceincreases,firmshaveanincentivetosupplymorebecauseatahigherprice,theygetextrarevenue(income)fromsellingthegoods.
• Also,asoutputrises,firmsusuallyhavehighermarginalcostsintheshortrun;itismorecostlytoincreaseoutput.Therefore,firmsrequirehigherpricestoencouragemoresupply.
• Firmsreacttomarketpricesincompetitivemarkets.Ifafarmertriedtosellhisproduceabovethemarketprice,hewouldn’tbeabletosell.Wesayfirmsarepricetakers.
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Shiftsinthesupplycurve
Anincreaseinsupplyoccurswhenmoreissuppliedateachprice,e.g.ashiftinsupplyfromStoS2.Thiscouldoccurforthefollowingreasons:
• Adecreaseincostsofproduction.Thismeansthatbusinesscansupplymoreateachprice.Lowercostscouldbeduetolowerwagesorlowerrawmaterialcosts.
• Anincreaseinthenumberofproducerswillcauseanincreaseinsupply.• Expansioninthecapacityofexistingfirms,e.g.investmenttoextendthe
sizeofafactory.• Anincreaseinthesupplyofacomplementarygood,e.g.beefandleather.• Favourableclimaticconditions,whichareveryimportantforagricultural
products,e.g.goodweatherwillgiveagoodharvest.• Improvementsintechnology,e.g.computersandtheinternetenables
moretobeproducedforalowercost.• Lowertaxesonthegood,e.g.lowerpetroltax.• Governmentsubsidiesonthegood(governmentpayingpartofthecost).
Jointsupply
• Jointsupplyoccurswhentwogoodsaresuppliedtogetherfromthesamesource.
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Market equilibrium Thepricemechanismreferstohowsupplyanddemandinteracttosetthemarketpriceandtheamountofgoodssold.
Marketequilibriumoccurswhensupply=demandandthereisnotendencyforthepricetochange.
Excess demand
Ifthepriceisbelowequilibrium(p2),demandisgreaterthansupply(Q2–Q1)–causingashortage.
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• Therefore,withconsumerswantingtobuymorefirmswillputuppricesandsupplymore.
• Aspricerises,therewillbemovementalongthedemandcurveandlesswillbedemanded.
• Priceswillriseuntilsupplyequalsdemand.
Excess supply
• Ifthepriceisaboveequilibrium(p2),supplyisgreaterthandemand(Q2-Q1)–causingasurplus.
• Toselltheunsoldgoods,firmsreducethepriceandreducesupply(movementalongsupplycurve).Thelowerpricealsoencouragesmoredemand.
• ThepricefallstoP1wheresupplyequalsdemand.
Impact of increase in demand • Ifconsumerssawanincreaseinincome,wewouldseeanincreasein
demandforgoodslikeTV’s;thedemandcurvewouldshifttotheright.• Initiallytherewouldbeashortage,butthehigherdemandwouldcause
thepricetoriseandsupplierstosupplymore.
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Theincreaseindemandcausesanincreaseinprice(P1toP2)andanincreaseinquantity(Q1toQ2).
Inthelong-term,thehigherpricesmayencouragemorefirmstoenterthemarketandthesupplycurvewillshifttotheright.
Fall in supply Iftheavailabilityofoildecreased,wewouldseeafallinsupply.
Thefallinthesupplyofoilcausesthepricetoriseandasmallfallindemand.Sincedemandforoilisinelastic,weseearelativelybiggerincreaseintheprice.
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Impactoffallinsupplyinlongterm
• Ifthepriceofoilincreased,itmaystarttomakeitprofitabletoproduceoilfromnewplaces,suchasAlaskaandAntarctic.Previouslyitwastoocostlytoproduceoilfromhere,butthehigherpricemaymakeitworthwhile.
• Ifthepriceofoilrises,inthelong-termpeoplemayrespondtohigherpricesbyswitchingtootherformsoftransportwhichdon’tusepetrol.
Factors that could explain a fall in the price of a good • Thepriceofagood,suchascoffee,wouldfalliftherewasafallindemand
and/oranincreaseinsupply.
FallinthepricefromP1toP2
Thedemandforcoffeecouldfallforvariousreasonssuchas:• Lowerincomesmeanthatconsumerscannotaffordtobuyasmuch.• Coffeebecomeslessfashionable.
Afallinnumberofcoffeeshops.• Healthconcernsaboutcaffeine.
Thesupplyofcoffeecouldincreaseforvariousreasonssuchas:
• Anincreaseinthenumberofsuppliersorcountriesproducingcoffee.• Lowercostsofproduction,e.g.lowerwageratesincoffee-producing
countries.• Governmentsubsidies,e.g.LatinAmericancountriesmaywishto
subsidiesthecoffeefarmers.• Higherlabourproductivityinproducingcoffee,whichwilldecreasethe
costsofproduction.
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Consumer surplus • Consumersurplusisthedifferencebetweenthepricethatconsumerspay
andthepricethattheywouldbewillingtopay.• Forexample,ifabookcosts£10,butthedemandcurveshowsthatthey
wouldhavepaid£16,theconsumersurplusis£6.
• Consumersurplustendstobehigherwhenmarketsarecompetitiveandpricesarelow.
• Consumerandproducersurpluswillbemaximisedinafreemarketwherepriceisdeterminedbysupplyanddemand.
• Amonopolythatcansethigherpriceswillbeabletoreduceconsumersurplus.
• Forexample,peaktrainfaresareanattempttochargehigherpricestothosecommuterswillingtopaythehigherprice–andcaptureconsumersurplus.
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Producersurplus• Producersurplusisthedifferencebetweenthepricesuppliersreceive
andthepricethattheywouldhavebeenwillingtosupplythegoodat.• Ifthemarketpriceis£10,andtheirsupplycurveshowsthattheywould
havesupplieditat£8,theyhaveaproducersurplusof£2.
Producersurplusafterfallinsupply
• Inthiscase,supplyshiftsfromS1toS2,themarketpricerisesfrom£25to£30.Quantityfallsfrom100to80.
• Inthiscase,weseeadeclineinconsumersurplus.Producersurplusalsofalls.
Calculating consumer surplus Wecancalculatearightangledtriangle,usingformula-1/2xheightxbase
• Price=£30,quantityequals80.• Themaximumconsumersurplus=£50-£30=£20• Tofindtheareaofconsumersurplus=(£20×80)/2=£800
Calculating producer surplus • Themaximumproducersurplusis£30-£15=£15• Theareaofproducersurplus=(£15×80)/2=£600
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Elasticity Thepriceelasticityofdemandmeasurestheresponsivenessofdemandtoachangeinprice.
Priceelasticdemand
• Demandispriceelasticifachangeinpricecausesabiggerpercentagechangeindemand.
Exampleofelasticdemand
• IfthepriceofTescobreadincreases5%anddemandfalls15%,thePEDis(-15/5)=-3.0.Thisispriceelastic.
Characteristics of elastic demand • Luxurygoodsaresensitivetopricebecausetheyrepresentabig
percentageofdisposableincome,suchassportscarsandforeignholidays.• Competitivemarkets.Goodsthathavemanysubstitutesandavery
competitivemarketwillbeelastic-forexample,ifthepriceofTescobreadincreased,consumerscouldswitchtoseveralothervarieties.
• Frequentlybought.Withgoodsthatareboughtfrequently,wearemorelikelytocompareprices,andswitchifnecessary.
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Inelastic demand • Demandispriceisinelasticifachangeinpriceleadstoasmaller
percentagechangeinQ.D.• PEDwillbelessthan-1(e.g.-0.5)
Exampleofinelasticdemand• Ifthepriceoftobaccoincreases10%anddemandfalls2%,thePED=-0.2
Characteristicsofinelasticgoods
• Fewsubstitutes.e.g.petrolandcigaretteshavefewclosealternatives.• Necessities,e.g.ifyouhavetodrivetowork,youneedtobuypetrol.• Addictive.Ifyouareaddictedyouwillpayhigherpricee.g.cigarettes,
coffee.• Smallpercentageofincome–meansyoudon’tworryifpricerises.• Intheshortterm,demandisusuallymoreinelasticbecauseittakestime
forconsumerstofindandswitchtoalternatives.
Evaluation
1. Demandforagoodlikecoffeeislikelytobeinelastic,astherearefewsubstitutestocoffee.Butdemandforindividualbrandsofcoffeeislikelytobemoreelastic,astherearesubstitutestoStarbuckscoffee(e.g.Costa).
2. Elasticitymaychangeovertime.Intheshortterm,demandforpetrolisinelastic,butovertime,peoplemaybemorewillingtoswitchtoalternatives,suchascyclingtowork,sothatdemandforpetrolbecomesmoreelasticwithtime.
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Usingknowledgeofelasticity
1.Revenueandelasticity
Ifdemandisinelasticthenincreasingthepricecanleadtoanincreaseinrevenue.
Inthisexample,thepriceofoilrisesfrom$110abarrelto$190,andthequantityfallsfrom9millionto8million.
• Revenuewas$110×9=$990million• Revenueisnow$190×8=$1,520million• Anincreaseinrevenueof$530million
ThisiswhyOPECtriestoincreasethepriceofoil,becausehigheroilpricesaremoreprofitable.
WhatisthePEDofoilinthisexample?
• %changeinQ.D1/9=-0.11(-11.1%)• %changeinprice80/110=0.727(72.7%)
Therefore,PEDofoil=-11.1/72.7=-0.15(inelastic)
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Ifdemandwaspriceelastic
• Pricerisesfrom£110to£130–(20/110)=18%• Quantityfallsfrom9to4(5/9)=55.5%• Revenuewas110×9=£990• Revenuehasnowfallento4×£130=£520• Afallof£470
PEDofthisexample-55/18=-3.05(elasticdemand)
2.Advertisingandelasticity
• Firmshaveanadvantageifdemandfortheirgoodispriceinelastic.Ifdemandisinelastictheycanincreasepriceandmakemoreprofit.
• Thisiswhymanyfirmsspendmoneyonadvertisingtocreatebrandloyalty.
• Becauseofstrongbrandloyalty,CocaColacanchargeahigherpricethanotherbrandslikeSainsburyCola.
• Firmscanmakedemandmoreinelasticbyofferingmoreadd-onfeaturesandbetterqualityproductsthatstandoutfromthecompetition.
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Theimpactofelasticityontax
• Inthisexample,thetaxis£70perunit.• Aftertaxisplacedonthegood,supplyshiftstoS2.• Demandfallsfrom80to72.Thepricerisesfrom£80to£140.• Thetotaltaxrevenueequals72×£70=£5,040
Consumerburdenoftax
• Thetaxis£70,andconsumersenduppayinganextra£60.• Inthiscase,consumersfacemostofthetaxburden.• Consumerburden=(60×72)=£4,320
Producerburden
• Producersget£10lessafterthetax.• Therefore,producerburdenis(10×72)=£720.
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Elasticity of a demand curve Withastraightlinedemandcurvetheelasticityofdemandvaries.
BetweenpointAandB,demandiselastic.(-3.5)
• Thisisbecausethe%changeinquantity(4to6)is2/4=50%• The%changeinprice(14to12)=-2/14=-14%
BetweenpointsCandD,demandbecomesinelastic.(-0.375)
• The%changeinquantity13to15isjust2/13)=15%• The%changeinpriceisgreater2/5=40%
Withastraightlinedemandcurve,theelasticityisalwayschanging.
• DemandismoreelasticwhenQisclosetozero.• Aspricefallscloserto0,demandbecomesmoreinelastic.• PED=1whenthe%changeindemandisthesameas%changeinprice
(somewhereinmiddleofdemandcurve)
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Incomeelasticityofdemand(YED)Incomeelasticitymeasurestheresponsivenessofdemandtoachangeinincome.
Forexample,ifaverageincomeincreasesby5%andthedemandformobilephonesincreasesby20%,anddemandforTescovaluericefalls2%.
• ThentheYEDformobilephones=20/5=4.0(luxurygood)• TheYEDforTescovaluerice-2/5=-0.4(inferiorgood)
Types of good • Inferiorgood.Thisoccurswhenanincreaseinincomeleadstoafallin
demand.InferiorgoodswillhaveanegativeYED.ExamplesincludeclothesfromcharityshopsandTescovaluerice.Asyourincomeincreases,youbuybetterqualitygoodsinstead.
• Normalgood.Thisoccurswhenanincreaseinincomeleadstoanincreaseindemandforthegood,thereforeYED>0.Mostgoodsarenormalgoods.
• Luxurygood.Thisoccurswhenanincreaseinincomecausesabiggerpercentageincreaseindemand,thereforeYED>1.Itmeansdemandisincomeelastic.Examplesincludejewelleryandsportscars.
• Incomeinelastic.Thismeansanincreaseinincomeleadstoasmallerpercentageincreaseindemand.Therefore0>YED<1.
Importance of income elasticity of demand • Inarecession,withfallingincomes,demandforluxurygoodswillfall
significantly.Demandforinferiorgoodswillincrease.• Budgetpoundshopsmaydowellwithfallingincomes,butluxurycar
saleswillnot.• Supermarketsmayrespondtoarecession(fallingincome)bysupplying
more‘inferior’goodsandcuttingbackonluxurygoods.• Ifincomesarerising,firmsmayseektomaketheirgoodmoreofaluxury
good,e.g.carmanufacturersmayaddmoreluxuryitemstocars,suchasairconditioningtotakeadvantageoftherisingincomes.
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CrosselasticityofdemandCrosselasticityofdemandmeasureshowthedemandforonegoodisaffectedbythepriceofanother.
• Forexample,ifthepriceofmilkfallsby10%,demandforteamayincrease1%.ThereforeXED=(1/-10)=-0.1
Substitutegoods.Thesearetwogoodsthatcouldbeusedasalternatives.Withtwosubstitutegoods,XEDwillbepositive.
• WeaksubstitutesliketeaandcoffeewillhavealowXED.• TescobreadandSainsburysbreadareclosesubstitutessoXEDishigher.
Complementsgoods.Thesearegoodsthatareusedtogether.ThereforeXEDisnegative.
• Forexample,ifthepriceofDVDplayersfall,thentherewillbeanincreaseindemandforDVDdiscs.
Unrelatedgoods.Ifthepriceoflambincreases,wewouldexpectittohavenoeffectonthedemandforbeerorcomputers.Ifthepriceoflambincreasesanddemandchangesforcomputers,itisjustaco-incidenceandnotrelated.
PriceelasticityofsupplyThismeasuresthe%changeinquantitysuppliedafterachangeinprice.
• Ifthepriceofcarsincrease10%,andsupplyincreases5%,o ThePES=5/10=0.5
• Ifthepriceoftomatoesincrease10%andsupplyincreasesonly1%intheshortterm,
o ThePES=1/10=0.1
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Inelastic supply
• Inelasticsupplymeansachangeinpricecausesasmallerpercentagechangeinsupply(PES<1).
• Perfectlyinelasticmeansachangeinpricehasnoeffectonsupply.• Intheexampleontheleft:%changeinQ=3/50=6%• %changeinprice=6/60=10%• Therefore,PES=6/10=0.6(inelasticsupply)
Supplycouldbeinelasticforthefollowingreasons:
1. Operatingclosetofullcapacity.Iffirmsareoperatingclosetofullcapacity,itisdifficulttoincreasesupply.
2. Lowlevelsofstocks;therefore,therearenosurplusgoodstosell.3. Intheshortterm,capitalisfixed,thereforefirmsdonothavetimeto
buildabiggerfactoryandincreasesupply.4. Difficulttoemployfactorsofproduction,e.g.itmaybedifficulttofind
relevantskilledlabourtoincreaseoutput.5. Withagriculturalproducts,supplyisinelasticintheshortrunbecause
ittakesatleast6monthstogrowcrops.
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Elastic supply Thisoccurswhenanincreaseinpriceleadstoabigger%increaseinsupply,thereforePES>1.
• Perfectlyelasticsupplymeansthatatagivenprice,supplyisunlimited.
• Ontheleft:Priceincreasefrom60to63andQincreasesfrom50to60.• %changeinQ=10/50=20%• %changeinprice=3/60=5%• ThereforePES=20/5=4.0(elasticsupply)
Supplycouldbeelasticforthefollowingreasons:
• Ifthereissparecapacityinthefactory.• Iftherearestocksavailable.• Ifitiseasytoemploymorefactorsofproduction.
Difference between long run and short run
• Intheshortrun,supplyismorelikelytobeinelasticbecausethefirmdoesnothavetheabilitytoincreasethesizeofthefactory.
• But,inthelongrun,supplycanbemoreelasticasthefirmisabletoinvestinmorecapacityandthereforeincreasesupply.
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Elasticity calculation SupposePESforcomputersis2.0.Whenthepricewas£30,thefirmsupplied4,000.Ifthepriceincreasedfrom£30to£36,whatwillbethenewQ?
• Priceincreasesby£6.Thereforeasa%,(6/30=0.2)=20%
(PES)2.0=%changeinQS20(%changeinP)
• Therefore40=%changeinQS• ThereforenewQ=4000*140/100=5,600
Tax Taxincreasesthecostofthegoodandshiftsthesupplycurvetotheleft.
• Inthisexample,thespecifictaxis£35perunit(80-45).• Thetaxincreasesthepricefrom£50to£80.Quantityfallsfrom90to82.• Thetotaltaxrevenueforthegovernmentwillbe:82×£35=£2,870
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The burden of tax Theburdenofthetaxissharedbetweenconsumersandproducers.
• Theconsumerburdenshowstheextraamountthattheypay(howmuchtaxraisesprice).
• Producersalsoloseoutfromtaxbecausetheygetalowerpriceafterpayingtaxtothegovernment.
Consumer and producer burden of specific tax
• Ifdemandisinelastic,thenmostofthetaxwillleadtohigherpricesandconsumerburdenofthetaxwillbegreaterthantheproducerburden.
• Inthediagramontheright,demandispriceelasticandthereisaproportionallysmallereffectonpriceandconsumers.Producershaveagreaterburdenfromthetax.Consumerburdenisrelativelyless.
• Governmentsoftenincreasetaxongoodswithinelasticdemandbecausethisleadstothebiggestincreaseintaxrevenue.
• Oftentobaccomanufacturerswillbeabletopass100%ofthetaxincreaseontoconsumersbecausedemandissoinelastic.
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Wage determination
• Incompetitivelabourmarkets,theequilibriumwagerateintheindustryisdeterminedbythemeetingpointofthelaboursupplyanddemandcurves(W1).
Inthisexample,theincreaseindemandforlabour,leadstohigherwages(W1toW2),
andahigherquantityoflabour(Q1toQ2).
Factors affecting demand for labour • Wages.Higherwagescauseamovementalongthedemandcurve.• Productivityofworkers.Ifworkersaremoreproductiveandproduce
more,firmsshouldbewillingtopayhigherwages.• Demandforthegood.Labourisaderiveddemand.Ifthereismore
demandforeconomicstuition,therewillbemoredemandforeconomicstutorsandthiswillpushupthewage.
• Substitutestolabour.Insomeproductionprocesses,firmscouldsubstituteworkersformachines(e.g.assemblylines).
• Non-wagecosts.Thisincludespayingnationalinsurance,healthinsurance,andpotentialredundancypay.
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Elasticity of demand for labour Theelasticityofdemandforlabourmeasureshowresponsivedemandforlabourisafterachangeinwages.Elasticityofdemandforlabourdependson:
• Howessentialistheworker?Canlabourbesubstitutedforcapital?Forexample,withautomatedcheckouts,workerscanbesubstitutedformachinesandlabourdemandwillbemoreelastic.
• Numberofpeoplewithqualificationsandskills.Ifonlyasmallnumberofworkershavequalifications,demandwillbemoreinelastic.
• Timeperiod.Intheshortterm,demandforlabourwillbeinelastic.However,overtime,itbecomeseasiertosubstitutelabourforcapital,sodemandbecomesmoreelastic.
• Proportionofwagecosts.Iflabourisahigh%oftotalwagecosts,thefirmwillbemoresensitivetoariseinwages.
Workerswithinelasticdemandarehardtoreplace.Therefore,theytendtohavegreaterbargainingstrengthandcandemandhigherwages.
ThedemandcurveD2ismoreinelasticthanD1.Thedemandcurve(D2)leadstoahigherwage(W2).Workerswithaninelasticdemandcurvearenoteasilyreplaceableandsogethigherwages.
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Factors that determine supply of labour • Wagerate.Higherwagescauseamovementalongthesupplycurve.• Thenumberofqualifiedpeopleandthedifficultyofgetting
qualifications.Forprofessions,suchaslawyersanddoctors,therearealimitednumberofpeoplewithsufficientqualifications.Thislimitssupplyandpushesupwages.
• Thenon-wagebenefits(non-pecuniary)benefitsofajob.Thisincludesstatus,jobsecurity,dangerofjob,howenjoyablethejobis,thelengthofholidaysandotherfringebenefits.E.g.iftubedrivershavetostartworkingnights,itmayreducesupplyofworkersbecauseitbecomesalessattractivejob.
• Population/demographics.NetimmigrationintotheUKhasincreasedthesupplyofnurses,cleaners,andotherservicesectorworkers.
Elasticity of supply of labour Theelasticityofsupplymeasureshowwageratesaffecttheresponsivenessofthesupplyoflabour.Supplywillbeinelasticif:
• Onlyasmallnumberofworkershavenecessaryqualifications(e.g.doctors).
• Thejobisunpopular/dangerous,makingsupplylower.• Iftakesalongtimetogainqualifications.
• S1ismoreinelastic(e.g.lawyers).ThisleadstoahigherwageofW2.• S2ismoreelastic(e.g.cleaners).ThisleadstolowerwagesofW1.
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Wage inequality between regions • Weoftenseewagedifferentialsbetweendifferentregions.Forexample,
differencesbetweenwagesinWalesandtherestoftheUK.• Alsotherecanbewagedifferentialswithinaregion,e.g.wageshigherin
Cardiff,thanruralpartsofnorthWales.
ExplainingwagedifferentialsbetweenWalesandLondon
• InWalessupplyanddemandarerelativelymoreelastic.• InLondon,supplyismoreinelasticanddemandhigher.
ExplainingrelativelylowerwagesinWalesthanS.E.England
• InLondon,firmsaremoreprofitableandabletopayhigherwages.Forexample,inLondon,manyfinancialfirmsareabletopaylargebonusesduetoprofits.
• HigherunemploymentinWales.Duetotheprocessofde-industrialisationWaleshasexperiencedperiodsofhigherunemployment.Unemploymenttendstopushdownwagesbecausetherearemorepeoplewillingtofillvacancies.
• ShortageofhousinginLondon,limitssupplyofworkers,pushingupwages.
• GreaterconcentrationofworkerswithhighlevelsofskillsandqualificationsinLondoncomparedtoWelshregions.
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National minimum wage Thenationalminimumwageisagovernmentlegislationwhichpreventsfirmsfrompayinglessthanthestatutoryminimum.
• FromOctober2015,thenationalminimumwagewillbe£6.70anhourforworkersagedover21.Therearelowerratesforyoungworkers.
• Thegovernmenthasindicateditwillsignificantlyincreasetheminimumwageforadultworkersto£9anhourby2020.
• Thisisanattempttomatchthelivingwage–aleveldeemednecessarytodealwithcurrentlivingcosts.
Impact of a national minimum wage
1. Potentialunemployment
• AminimumwageabovetheequilibriumcouldcauseunemploymentofQ3-Q1.ThisisbecausetheminimumwageofW2reducesdemandforworkerstoQ1.
• Thisisparticularlyaconcernforsomeindustrieswherewagesareahighpercentageofcosts,e.g.hairdressersorservicesectorworkers,suchascleaners.
• Asubstantialriseintheminimumwagewillbemorelikelytocauseunemploymentinlowwageregions,suchasthenorth.ItwillhavelessimpactinLondonandthesouth.
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2.Minimumwageandmonopsony
• Aminimumwagecouldcounter-acttheeffectofamonopsonyemployer.Amonopsonyisanemployerwhohasmarketpower.Thismarketpowerenableshimtopaylowerwagesandemploysfewerworkers.
• Somejobs,likefiremen,onlyhaveagovernmentemployer,sothatisaclassicexampleofamonopsony.
• Inpractise,manyworkershavelittlebargainingpowerbecauseitisdifficulttomovejobs.
3.Nationalminimumwageandelasticityofdemandandsupply
• Ifdemandforlabourisinelastic,anationalminimumwagewouldcauselittle,ifany,fallindemandforlabour.
• Forexample,ifwagesincreaseforthewholeservicesectorindustry,theycanpassthewagecostsontoconsumers.
• Inthiscase,aNMWonlycausesaverysmallfallindemandforlabour,fromQ1toQ2.
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4.Caseforregionalminimumwages
• AminimumwagemaybeinsufficienttoprovidealivingwageinLondonbecauseofhigherlivingcosts.
• But,inWales,aUKnationalminimumwagemaypotentiallybesignificantlyhigherthancurrentwagelevels.
• Thiswillsignificantlyincreasethewagesofthelow-paid,butalsocouldcauseunemploymentbecauseemployersmaybeunabletoaffordthehigherwages.
5.Doesaminimumwagereducepoverty?
• Aminimumwageincreasestheincomeoflowpaidworkers.• However,theimpactonrelativepovertyisnotclearcut.Thepoorest
sectionsofsocietytendtobeoutofworkandreceivinggovernmentbenefits.Theyarenotaffectedbyanationalminimumwage.
• Also,manywhogetthenationalminimumwagemaybesecondincomeearnersinafamilysotheimpactonreducingpovertyislimited.
FlexiblelabourmarketsFlexiblelabourmarketsarecharacterisedby:
• Wagessetbymarketforces–supplyanddemand• Lowlevelsofregulation• Mobilityofworkers• Easyforfirmstoemployworkers,andeasyforworkerstoswitchjobs
FactorsthathaveincreasedlabourmarketflexibilityintheUK
• Growthinpart-time/temporarycontracts.Thismeansfirmscanemployworkersforthetimeperiodneeded.
• Growthinzerohourcontracts.Thismeanspeopleareemployed,butthefirmisundernoguaranteetoofferafixednumberofhours.Thismeansweeklywagescanfluctuatesignificantly.
• Declineintradeunionsandcollectivebargaining.Thisgivesfirmsmorepowerindeterminingwages.
• Increaseinself-employment.Self-employmentmeansworkersneedtocontinuallygainbusinessinordertogainincome.Thismakesself-employedworkersmoresensitivetochangesinthemarket.
• MigrationofworkersfromEurope.WiththeexpansionoftheEuropeanUnion,manyEasternEuropeanworkershavecometotheUKtofilljobvacancies,oftenjobswhicharenoteasytofill.
• Changesinwelfarebenefits.Thegovernmenthasmadeitharderforworkerstogetbenefits,suchasunemploymentbenefitanddisabilitybenefits.Thishashadanimpactonincreasingthesupplyoflabour.
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Impact of flexible labour markets • Unemploymentfellquicklyafterthe2008recession.Firmsweremore
willingtotakeonnewworkers.Thissuggestsflexiblelabourmarketsmayenablealowerrateofunemployment
• Therehasbeenadegreeofunder-employment,withpeopleworkingfewerhoursthantheywouldlikeinpart-timework.Thismeanslowerincomeformanypart-timeworkers.
• Greaterjobinsecurity.Peoplehavework,buttherearefewerguaranteesthejobwilllast.Thisgreaterjobinsecuritycouldhavenegativeeffects,suchaspeoplebecomingde-motivatedbecausetheyhavelittleattachmenttothefirm.Butitcouldalsoencourageworkerstotryhardertoretaintheirjob.
• Aflexiblelabourmarketcouldbenefitworkerswhoneedtojugglelookingafterchildrenandworkingfromhome.
• Aflexiblelabourmarketcanbenefitthosewhohavetheskillstogainanincomefromnewtechnology,suchastheinternet.However,aflexiblelabourmarketcouldbedamagingtounskilledworkers,whofindithardtogetlong-termjobsecurity.
Government policies to increase labour market flexibility
• Reduceminimumwages.Firmscanpaylowerwages,butitwouldincreaseinequalityandrelativepoverty.
• Makeiteasiertohireandfireworkers.Ifitischeapertohireandfireworkers,firmsmaybemorewillingtoemploypeopleinthefirstplace,butitcanleadtogreaterjobinsecurity.
• Bettereducationandtraining.Trainingschemeswouldgiveworkersmoreskillstobeabletoacceptnewjob.Awelltrainedworkforcewouldreduceoccupationalimmobility.Educationandtrainingisagoodpolicyintheory,butcanbehardtoimplementinpractise;itwoulddefinitelytaketimetohaveaneffect.
• Encourageimmigration.Immigrantscouldtakejobswheretherearelabourshortages,butimmigrationcancreatenewproblems,suchashousingshortagesandcongestion.
• Reduceincometaxrates,e.g.increasingincometaxthreshold.Thiswouldencourageworkerstomoveintotheworkforce,andmakingbenefitsrelativelylessattractive.
• Reducepoweroftradeunions.Ifgovernmentsmakeitdifficultforunionstogoonstrike,thereislesspotentialforworkersdisruptingwagesettlements.Itmayalsoleadtofirmsgainingmonopsonypowerandsettinglowwages.
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ImpactofnetmigrationonUKlabourmarketsInrecentyears,therehasbeenanetinflowofworkersintotheUK.Theeffectofthisnetmigrationincludes:
• Increaseinsupplyoflabour.Theincreasedsupplyoflabourhasoftenfilledgapsinjobswhichfirmshavefounddifficulttofill,e.g.cleaningandfruitpicking.
• Increaseindemandforlabour.Migrantsincreasethepopulationandthereforeincreaseoveralldemandintheeconomy.
• Firstly,migrationcausesanincreaseinlaboursupply.• But,alsointhelong-term,ahigherpopulationshouldincreasedemandfor
labour.• Inthisdiagram,wageswillstayatQ1andquantityoflabourincreasesfromQ1
toQ3.
Evaluationofnetmigration• Skilledlabour.Thegovernmenthassetcriteria,makingiteasierfor
skilledlabourtomigrate.Thishasmeantmigrationhasplayedanimportantroleinfillingvacanciessuchasnursesanddoctors.
• Offsettheimpactofanageingpopulation.TheUKhasanageingpopulation,whichplacesgreaterstrainongovernmentfinances(oldpay,lesstaxandneedmorepensionsandhealthcarespending).Netmigration
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ofyoungworkershelpsthegovernment’sbudgetsituation,becausetheyaremorelikelytopayincometaxanddon’treceivepensions.
• Migrantscanreturntocountryoforigin.Inaperiodofrisingunemployment,migrantsoftenreturnhome.Thus,migrationcanbeacounter-cyclicalfactorinmakingUKlabourmarketsmoreflexible.
• Inrecentyears,manyforeignworkershavebeenattractedintotheUK.
Immigrationaccountedfor46%ofnetpopulationgrowthin2008.
Problems of net migration • Overcrowding.TheUKexperiencesovercrowding,especiallyinpartslike
thesouth-east.Migrationandariseinthepopulationplacesgreaterstrainonalreadylimitedhousingstockandpublicamenities.
• Undergroundeconomy.Migrantsaremorelikelytoworkintheblackmarket,avoidingregulationslikeminimumwages.
o However,thereisabigdifferencebetweenillegalimmigrationandlegalmigration.
• Unemployment.Somepeoplefeelmigrantstakeexistingjobsfromnativeworkersbecausetheyarewillingtoacceptlowerwages.
o However,itshouldberememberedmigrationalsocreatesjobs,throughtheadditionaldemandintheeconomy.
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How resources are allocated in a free market Inafreemarket,pricesandprofitactassignalstoagents.Thisinfluencestheallocationofresources.
Rationing effect • Ifthereisashortageofthegood,thepricewilltendtoincrease.• Thehigherpricecausesmovementalongthedemandcurve.Lessis
demandedatthehigherprice.Thishelpstorationthescarcedemand.
Higherpriceactsasadisincentivetobuy,rationingdemand.
Incentive effect • Iftherewasincreaseddemandforanewgood(likephoneapps),this
wouldpushuptheprice.• Thishigherpricemakesthegoodmoreprofitable.Therefore,inthelong
run,itactsasanincentiveforproducerstoincreaseproduction.
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• Inthelongterm,firmsrespondtohigherprices(andmoreprofit)by
increasingsupply.• Thisisanexampleofhowmarketscanrespondtochangingconditions.• Forexample,therisingdemandformobilephoneshasledtosignificant
increaseinsupply.
Signalling Thepricemechanismcanprovideasignaltofirmsandconsumers.
• Ifweseehigherdemand,priceswillriseandthiscreatesasignaltoproducersthatthereishighdemand.
• Ahighwageforcertaintypesofworkcansignaltoworkersthatfirmsneedtofillthesejobs.
Inter-related markets Deriveddemand.Thisoccurswhenthedemandforagooddependsondemandforanotherproduct/service.
• Forexample,thedemandfortrainsdependsonthedemandforgettingtowork.Iftherewasariseinunemploymentandlesspeopleworking,demandfortravelwouldfall.
Compositedemand.Thisoccurswhenagoodhasmultipledifferentuses.Risingdemandforoneuserationstheavailabilityforuseofanyotherpurpose.
• Forexample,demandforwheatcouldbeduetotheuseofwheatineitherbreadorasabiofuel.
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• Ifthereishigherdemandtousewheatasabiofuel,thiswillaffectthepriceofbread.Withmoredemandforbiofuels,thepriceofwheatwillrisecausingthepriceofwheatforbreadtoalsoincrease.
• Otherexamplesofcompositedemandinclude:• Land-usedforeitherofficesorforbuildinghouses.• Steel-couldbeusedforbuildinggunsoritcouldbeusedforbuilding
bicycles.
Jointdemand.Thisoccurswhentwogoodsarecomplementaryandneededtogether.
• Forexample,ifyoubuyaprinter,youneedtobuyprintinginktoo.• Therefore,higherdemandforhomeprinterswillleadtohigherdemand
forinkcartridges.Otherexamplesofjointdemandinclude:o iPhoneandiPhoneAppso Cameraandmemorystick
Rational behaviour Ineconomics,weusuallyassumefirmsandconsumersarerational.
Thismeansthattheytrytomaximisetheireconomicwelfareandmakedecisionstoenablethis.
• Consumerstrytoplaceavalueonagooddependingonhowmuchtheyenjoythegood/service.Theymaygivethisutilityamonetaryvaluelike£10.
• Weassumeconsumerswishtomaximisetheirutility.Forexample,theywillspendmoneyongoodsonlyiftheybelievetheutilitygainedisgreaterorequaltothecost.
• Thefirstchocolatebarmaygivehighutility,andconsumersarewillingtopay50p.However,thesecondchocolatebarhasalowermarginalutility–youmightfeelsickifyoueattoomany.
Are consumers rational? • Itcanbedifficultforconsumerstoevaluatetheactualutilitytheygetfrom
agood.• Consumersmaynothavethetimetoworkoutthemarginalutility.• Insteadtheymayuse‘rulesofthumb’orbuyaccordingtoprevious
spendingpatterns.• Consumersarenotalwaysrational,butcanbeinfluencedbyfactors,such
asadvertisingandimpulsebuying.• Consumersmayhavepoorinformationorlackthetimetoworkoutthe
bestprice/utility.Inthiscaseconsumersmaymakeuseofhabitbuyingorrulesofthumbtogetthebestestimation.
• Consumerscanbepronetoirrationalexuberance.Forexample,inaperiodofrisinghouseprices,peoplemaythinkthisisagoodonewaybet,sotheybuyhouseshopingpriceswillkeeprising.
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Market Failure Marketfailureoccurswhenthereisaninefficientallocationofresourcesinafreemarket.Marketfailureimpliesthereisadeclineinproducers/consumersurplusandanetwelfareloss.
Marketfailurecanoccurforvariousreasons.
• Externalities–acostorbenefitimposedonathirdparty,leadingtounder-orover-consumption.
• Informationasymmetries–lackofcompleteknowledgebyoneparty.E.g.peoplemayunder-estimatethebenefitsofeducation(meritgood)orunderestimatethecostsofsmoking(demeritgood).
• Monopoly–Whenafirmhasmarketpowerandcansethigherprices.Monopoliesmayalsobemoreinefficientbecausetheyfacelesscompetitivepressures.
• Immobilities–Geographicalimmobilitiesoccurwhenitisdifficultforpeopleorfirmstomovetoanotherarea.E.g.unemployedcoalminersinYorkshirefinditdifficulttomovetoLondonbecauseofhousingcosts.Occupationalimmobilitiesoccurwhenitisdifficultforpeopletoretrainandgetskillsinnewhigh-techindustries.
• Publicgoods–Goodsthatarenon-rivalandnon-excludable.Theytendtobeunder-providedornotprovidedinafree-market.Examplesincludelawandorder,nationaldefenceandstreetlighting.
• Meritanddemeritgoods–Goodswherewemakedecisionsbasedonpoorinformation.
• Volatileprices–Inagriculturalmarkets,pricescanbevolatilecausingproblemsforconsumersandfarmers.
• Incomeinequality–inafreemarket,therecouldbewidespreadinequalitywithsomeunabletoaffordimportantservices.
ExternalitiesandsocialefficiencySocialbenefit
• Socialbenefitisthetotalbenefittosociety.• Socialbenefit=privatebenefit+externalbenefits.• Socialmarginalbenefit(SMB)=theadditionalbenefittosocietyof
producinganextraunit.• SMB=PMB(privatemarginalbenefit)+XMB(externalmarginalbenefit)
Socialcost
• Socialcostisthetotalcosttosociety.• SocialCost=privatecost+externalcosts.• Socialmarginalcost(SMC)=privatemarginalcost(PMC)+external
marginalcost(XMC)
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NegativeexternalityAnegativeexternalityoccurswhenthereisacostimposedonathirdparty.
• Forexample,ifafirmproduceschemicals,theexternalcostisthepollutionthatcausesdamagetotheriverandthelostearningsforfishermen.
• Ifyoudriveintoatowncentre,thenegativeexternalityisthecongestionandpollutionthataffectsotherpeopleinthetown.
• Withanegativeexternality,thesocialmarginalcostisgreaterthantheprivatemarginalcost.
Inafreemarket,theequilibriumwillbeatQ1,P1,wheresupply(S)=demand(D).
• However,atQ1,theSMCisgreaterthanthePMC.• Q1issociallyinefficientbecausetheSMCisgreaterthantheSMB–this
illustratesanareaofdeadweightwelfareloss.• Inthisexample,thereisoverconsumptionofthegoodwithnegative
externalities.• ThesociallyefficientlevelofoutputwouldbeatQ2,whereSMC=SMB.
Diagram:negativeexternalityofproduction
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Negative consumption externality Negativeexternalitiescanalsooccurinconsumption.
• Forexample,ifwedriveinefficientpetrolcars,theconsumptionofpetrolcausesexcessCO2emissionsandpollution.Thisisacosttotherestofsociety.Otherpeoplewillexperiencepollutionandperhapsillhealthbecauseofourdecisiontodrive.
• Ifwedrinkalcoholtoexcess,wemayturnuplatetoworkonMondaymorning,leadingtolowerproductivityandlowereconomicgrowth.
• Withanegativeconsumptionexternality,thesocialmarginalbenefitislessthanyourprivatemarginalbenefit.
• Inafreemarket,theequilibriumwillbeatQ1(D=S).• But,thesociallyefficientlevelisatQ2(whereSMB=SMC).• Therefore,inafreemarket,thereisoverconsumptionofthisgoodwitha
negativeexternality.
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PositiveexternalityApositiveexternalityinconsumptionoccurswhenthereisabenefittoathirdpartyfromyourconsumption.
• Forexample,ifyoucycletowork(ratherthandrive),otherpeoplebenefitfromreducedcongestionandpollution.
Diagramofpositiveexternalityinconsumption
Inafreemarket,theequilibriumwillbeatQ1,P1,whereSupply(S)=Demand(D).
• However,thisissociallyinefficient.• AtQ1,theSMBisgreaterthantheSMC,leadingtoanareaofdeadweight
welfareloss.• Withapositiveexternality,thereisunder-consumption.• SocialefficiencyoccursatQ2,whereSMB=SMC.
Positiveexternalityinproduction
• Whenproducingagoodcausesabenefittoathirdparty.• Forexample,ifyoukeepbees,thenanearbyapplefarmerbenefits
becauseyourbeeshelptopollinatehisappletrees.
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Private good Aprivategoodisagoodwherethebenefitsaccruetotheindividualandothersarepreventedfromconsumingit.
• Theprivategoodisrivalrousandexcludable.Ifyoueatanapple,nooneelsecaneatit.
PublicgoodApublicgood,bycontrast,hastwocharacteristics:
• Non-rivalry.Whenagoodisconsumed,itdoesn’treducetheamountavailableforothers,e.g.streetlighting.
• Non-excludability.Thisoccurswhenitisnotpossibletoprovideagoodwithoutitbeingpossibleforotherstoenjoy,e.g.nationaldefence.
Publicgoodssufferfromthefree-riderproblem.
• Thefreeriderproblemmeansthatpeoplecanenjoythegoodswithoutpayingforit.Therefore,thereisnoincentiveforfirmstoprovidegoodsbecauseitisdifficulttochargeconsumersforusingit.
• Theconsumercanenjoyitforfree.• Publicgoodsusuallyrequirethegovernmenttoprovidethegooddirectly
andpayforitoutofgeneraltaxation.
Quasi—publicgoods.
Somegoodshavepartofthecharacteristicsofpublicgoods,e.groadsaretoanextentnon-rivalrousandnon-excludable,butnotcompletely,e.g.iftoomanypeopleuseroads,itcausescongestion.Somepeoplearenotqualifiedtodrive.
• Somepublicgoodscanbeprovidedbythefreemarket.Forexample,someonemayprovideabeautifulgardenandnotmindifpeopleenjoyitforfree.
Examtip:Becareful-notallgoodsprovidedbythepublicsector(government)arepublicgoods.
• Forexample,theNHSisprovidedbythepublicsector(government).But,itisnotapublicgood,becauseresourcesarelimited(waitinglists)–sothereisrivalryandexcludability.Ifyouseeadoctor,nooneelsecanhaveanappointmentatthatsametime.
• TheNHSwouldbeconsideredameritgood–peoplemayunderestimatethebenefitsofgettingvaccinationsandahealthyworkforcehaspositiveexternalities.
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Informationgaps• Symmetricinformationmeansbothpartiessharethesameknowledge.
Forexample,ifyougotoamarket,youcanseethepriceofapplesandalsolookattheirquality.
• Asymmetricinformationoccurswhenonepartyhasmoreinformationthanotherparties.Forexample,ifsellingacar,acardealermayknowitisafaultyenginethatwon’tlast.But,asaconsumer,youmaynotknowthis.
Problem of asymmetric information • Peoplemaybereluctanttobuysecondhandcarsiftheydon’ttrustwhat
theyarebuying.Thisleadstolowerpricesforallsecondhandcars.• Peoplemakethe‘wrong’decisionsandreducetheireconomicwelfare.
MeritgoodAmeritgoodoccurswherepeoplemayunderestimateorbeunawareofthebenefitsofconsumingagood.
• Forexample,studentsmayunderestimatethebenefitsofstudyingandthereforeleaveschoolearly.Orpeoplemaybereluctanttogetavaccinationfromdiseases.
• Meritgoodsoftenhaveapositiveexternalityaswell.• Meritgoodsareunder-consumedinafreemarket.
DemeritgoodAdemeritgoodoccurswherepeopleunder-estimateorignorethecostsofconsumingagood.
• Forexample,peoplemaynotbeawareofthedangersofsmoking–ortheymaybeaware,butchoosetoignorethem.
• Demeritgoodsoftenhavenegativeexternalitiesaswell(e.g.passivesmokingeffecttoothers).
• Demeritgoodsareover-consumedinafreemarket.
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Government intervention to correct market failure
Tax• Taxshiftsthesupplycurvetotheleftandmakesthegoodmoreexpensive.
Thiswillreducedemand.• Thegovernmentcanusetaxfordemeritgoodsandgoodswithnegative
externalities.
Specific tax
Aspecifictaxplacesacertainperunittaxonthegood.Itisthesamewhatevertheprice,forexample,tobaccodutyoralcoholexciseduty.
Inthiscasethespecifictaxis£15,anditreducesthequantityfromQ1toQ2.Thepricerisesfrom£52to£60.
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Ad valorem tax
Anadvaloremtaxplacesacertainpercentageonthegood.Forexample,VATintheUKis20%.Thehigherthepriceofthegood,themoretaxispaid.
Tax to overcome market failure • Theidealtaxwouldbeequaltotheexternalmarginalcost.• Thismakesconsumerspaythefullsocialmarginalcost.
TaxshiftsthesupplycurvetoS2andreducesdemandtoQ2,whichisthesociallyefficientlevel(SMC=SMB).
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Advantages of taxes • Raisesrevenueforthegovernmenttospendonalternatives.• Internalisestheexternality(taxmakespeoplepaythefullsocialcost).• Createsincentivesinthelong-termtoencouragefirmstoreducepollution
orprovidealternatives.• Taxcanalsoalterconsumerbehaviourinthelong-term.Forexample,
higherpetroltaxmayencourageconsumerstobuyabicycletoavoidfuelduties.
Evaluation of taxes • Ifdemandisveryinelastic,taxwillonlyhaveaminimaleffectinreducing
demand.Thismayoccuriftherearenoalternativestothegood,e.g.petrol,tobacco.
• Hightaxesmayencouragetaxevasion,e.g.cigarettetaxencouragescigarettestobesmuggledontheblackmarket.Ataxonrubbishmayencouragefly-tipping.
• Highspecifictaxeswillberegressive.Theytakeahigherpercentageofincomefromthepoorthanhigh-incomeearners.
• Theremaybeadministrationcostsinimplementingnewtaxes,e.g.itwouldbedifficulttoimplementacongestionchargefordrivingintosmallcities,likeOxfordorCambridge.
• Itcanbedifficulttomeasuretheexternalcostandhowmuchtaxshouldbeincreased.
• Electronicroadpricingisawaytotryandplaceataxequaltotheexternalcostofdriving,e.g.ifyoudriveincitycentresandpeaktimes,thecostsofcongestionarefargreaterthandrivinginoff-peaktimes.
Subsidy• Asubsidymeansthegovernmentpaysapartofthecostofagood.For
everygoodsold,thegovernmentwillgivefirmsaproportionofthecost.• Theaimofsubsidiesistoencourageconsumptionofgoodswhichare
underprovided/under-consumedinafreemarket.• Asubsidyshiftssupplytotherightandreducestheprice.
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Inthiscase,thesubsidyis£10perunit.ThesubsidyincreasesQfrom90to98.
• Thetotalcosttothegovernmentis98×10=£980.
Whysubsidisegoods?
1. Goodsthathavepositiveexternalities(benefitstootherpeople)aresubsidisedtocreatemoresocialefficiency.
a. Forexample,takingthetraintoworkhelpsreducecongestion.Thegovernmentmaywishtomaketrainscheaper,andthereforereducetrafficcongestion.
2. Tomakeimportantpublicservicesavailabletothoseonlowincome,e.g.peoplemaynotbeabletoafforddentaltreatmentwithoutsubsidiesfromthegovernment.
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Subsidy to overcome market failure
• Inthisexample,thefreemarketequilibriumisatQ1,P1(S=D).• AsubsidyofP0-P2shiftsthesupplycurvetoS2andreducespricetoP2.
Atthisprice,thequantitydemandedisQ2.• ThisisasociallyefficientlevelbecauseatQ2,SMB=SMC.
Evaluation of subsidies • Costtothegovernment.Subsidieswillbeexpensiveandwillrequire
highertaxesonothergoods.• Elasticity.Ifdemandisinelastic,asubsidywillbeineffectivein
increasingdemand.Forexample,asubsidyontraintravelmaybeineffectiveifitisapoorsubstitutetodrivingacar.
• Effectofsubsidyonfirm.Afirmthatreceivesasubsidyismorelikelytobeinefficient,astheybecomereliantonthegovernmentsubsidy.Subsidiesmaykeepinefficientfirmsinbusiness.
• Theremaybegovernmentfailure,e.g.thegovernmenthaspoorinformationaboutwhotosubsidise.
• Combinationofpolicies.Subsidiesmaybemosteffectiveifcombinedwithotherpolicies,e.g.taxondrivingandusingmoneytoprovidealternativestodrivingintotown,e.g.cheaperbuses.
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MaximumpricesAmaximumpriceoccurswhenthegovernmentsetsapricelimitandpreventspricesfromrisingabovethatlevel.
Forexample,ifrentingahouseinLondonis£120aweek,thegovernmentmaydecidetohaveamaximumpriceofrentingof£100aweektomakehousingmoreaffordable.
ProblemofmaximumpricesTheproblemofamaximumpriceisthatifthepriceissetbelowtheequilibrium,wegetashortage.AtMaxPrice,demandisgreaterthansupply(Q3-Q1).Thisleadstowaitinglistsandencouragesablackmarket.
• Theextentoftheshortagedependsontheelasticityofdemandandsupply.Ifsupplyisinelastic,therewillbelittlereductioninavailability.
• Note:Ifthemaximumpricewasplacedabovetheequilibrium,itwouldhavenoeffect.
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Minimumprices• Aminimumpriceoccurswhenthegovernmentsetsapricefloor,and
doesn’tallowpricestogobelowthatlevel.• Withminimumprices,thegovernmentmaybecommittedtobuyingthe
surplus.
Theproblemofaminimumpriceisthatwegetasurplus.AtMinprice,supplyisgreaterthandemand(Q3-Q1).TomaintaintheMinprice,thegovernmenthastobuythesurplus.
• Note:Aminimumpricebelowtheequilibriumwouldhavenoeffect.
TradeablepollutionpermitsTheseinvolvegivingfirmsalegalrighttopolluteacertainamount,e.g.100unitsofcarbondioxideperyear.
• Ifthefirmproduceslesspollution,itcansellitspermitstootherfirms.• However,ifitproducesmorepollution,ithastobuypermitsfromother
firms.• Therewillbeamarketforpollutionpermits.Iffirmspollutealot,there
willbelowsupplyandhighdemand;thereforethepricewillbehighforpermits.
• Therefore,thereisafinancialincentiveforfirmstocutpollution.
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Problems of Tradeable Permits • Difficulttoknowhowmanypermitstogiveinthefirstinstance.• Itmaybedifficulttoaccuratelymeasurepollutionlevels.Thereisan
incentiveforfirmstohidepollution.• Inmostmarkets,itrequiresglobalco-operationtomakeiteffective,
otherwisetheindustrywillmovetocountrieswithlowerenvironmentallegislation.Also,pollutionisverymuchaglobalproblemrequiringglobalsolutions.
• Highadministrationcostsofmeasuringpollutionandenforcingpermits.
StateprovisionofpublicservicesForsomemeritgoodsandpublicgoods,themostefficientsolutionformarketfailureisforthegovernmenttoprovideservicesdirectly.
Forexample,thegovernmentcouldsubsidiseprivatedoctorstotreatpeople,butthereareadvantagestothegovernmentpayingforanationalhealthservicedirectly:
• Itensureseveryonehasaccesstothisimportantmeritgoodandprovidesgreaterequalityinsociety.
• Anationalhealthservicemaybeabletobenefitfromeconomiesofscale,leadingtoloweraveragecoststhansmallindependenthospitals.
• Forserviceslikehealthandeducation,workersdonotneedthesameprofitmotiveofaprivatemanufacturingfirm.Therefore,thereislesslikelytobegovernmentfailureduetoalackofincentives.
• Publicgoodslikelawandordermaynotbeprovidedatallinafreemarket.
Advantages of the private sector providing public services 1. Increaseddemandsarebeingplacedonthepublicsectordueto
demographicchanges.Ifmorepeoplewentprivate,thiswouldenabletheNationalHealthServicestohaveshorterwaitinglists.
2. Providesconsumerswithmorechoice.3. IflesspeopleusetheNHS,itwouldenablethegovernmenttolowertaxes
andreduceborrowing.4. Theprivatesectorhasaprofitincentivetocutcostsandprovideamore
efficientservice,e.g.publicbodiesmayhaveover-staffingbecauseofpoliticalfearsaboutjobcuts.
5. PossiblediseconomiesofscaleintheNationalHealthService.
Disadvantages of the private sector 1. Itisdifficulttointroduceaprofitmotiveintopublicservicessuchas
healthcare;forexample,itisnotpracticaltogiveperformancerelatedpaytonurses/doctors.Also,theprivatesectormaycutcostsbyreducingthequalityofservice,e.g.cuttingbackoncleaning.
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2. Mayincreaseinequality.Peopleonlowincomescannotaffordprivatehealth.
3. Healthisameritgoodandwillbeunderprovidedinafreemarket.Thereforethereisajustificationforgovernmentsubsidy.
Advertising/InformationThegovernmentmayseektoovercomemarketfailurethroughprovidinginformationaboutcertaingoods.
• Forexample,thegovernmentmayruncampaignstowarnaboutthehealthdangersoftobaccoandalcohol.Thesearedemeritgoods,wherepeoplemaynotknowthecostsofconsumption.
• Providinginformationcanhelpovercomeinformationasymmetries.
Evaluation
• Governmentadvertisingcampaignswillcostmoneyandrequirehighertaxes.
• Thereisnoguaranteepeoplewilllistenortakenoteofgovernmentcampaigns.Youngpeoplemaychoosetoignorecampaignsaboutthedangersofalcoholbecausetheyenjoyasenseofrebelliousness.
• However,overtime,peoplehavebecomeawareofthedangersoftobaccoandlong-termsmokingrateshavebeenfalling.
RegulationToovercomemarketfailure,thegovernmentmayuselawsandregulationstoprohibitcertainbehaviour.
• Forexample,ratherthantryandtaxcocainetomakepeoplepaythefullsocialcost,theymayjustprohibititsproductionandconsumption.
• Alternatively,thegovernmentmaybancertainchemicalsbecausetheyaretoodangerous.
Evaluation
• Regulationissimpleandcanbeeffectiveinpreventingdamaginggoodsandservicesfrombeingproduced.However,sometimesnopollutionisnotthemostefficientlevelofproductioninsociety.Carscreatenegativeexternalities,butitisnotdesirabletobancarscompletely.
• Itdependsontheenforceability.Forexample,whentheUSprohibitedalcohol,itwasveryhardtoenforce.Peoplekeptdrinkingbutorganisedcrimebecamemorepowerfulandmoresuccessfulbecauseillegalalcoholwasinhighdemand.
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PoliciesofWelshgovernment
Free NHS prescriptions • NHSprescriptionscouldbeconsideredtobeameritgood.Peoplemay
underestimatethebenefitsoftakingaprescriptiondrug.• Iftheyhavetopay,theymaybeunableorunwillingtotake.Free
prescriptions,whichhavebeenintroducedinWaleshelpsovercomethismarketfailure.
• Freeprescriptionsalsomakessureeverybodycanaffordtogetnecessaryhealthcare,andcanhelpreduceinequality.
• However,demandforprescriptionsislikelytobeveryinelasticbecausemostpeoplewouldpaytogetbetterhealth.
• Thereisanopportunitycostofofferingfreeprescriptions.Itwillrequirehighertaxesorlowergovernmentspendinginotherareas.
• Freeprescriptionswillgotoeveryone,includingthequitewealthy,whocouldeasilyafforditanyway.
Charging for plastic bags • Since2011,thereisacompulsorychargeof5pperplasticbag/paperbag.• Whenplasticbagsarefree,consumersuselargequantities,wasting
resources.Chargingforplasticbagsencouragespeopletoreusetheirbagsandcutdownonwastedresources.
• Aplasticbagalsohasnegativeexternalities.Theycauselitter,useupvaluableresourcesandcantakealongtimetodegrade.Bycharging5p,consumersaremadetopaythefullsocialcostoftheplasticbag.
• Thedownsideistheadministrationcostsinchargingforbags.But,makingituniversalmeansshopperscometoexpectthecost.
Policies to reduce inequality • WithinWalesthereissignificantincomeinequalitybetweendifferent
regions.SomeareaslikeCardiffaremoreprosperousthanvalleyregionsinthesouthandareasinthenorthofWales.
• ThereisahighlevelofunemploymentinthesouthWalesformerminingcommunities,whichhavestruggledtoadapttochangeineconomicactivity.
• Inruralareasinthenorth,lowpaidworkismoreofaproblem,withmanyreceivingin-workbenefits.
• Policiestoovercomepovertyincludetaxandbenefitsystem(setforwholeUK,notdevolvedtoWelshgovernment).
• Policiestoattractnewinvestmentandrealignmentoftheeconomy.Forexamplegrantstodepressedareastohelppromoteeconomicdevelopmentanddiversificationintonewindustriesandeconomicsectors,suchastourismandtheservicesector.
• But,onlysomuchthegovernmentcandotoreducepoverty,e.g.privatesectordeterminingwagesandde-industrialisationishardtoreverse.
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Government failure Governmentfailureoccurswhengovernmentinterventionintheeconomycausesanetwelfareloss.Peoplealsorefertogovernmentfailurewheneffortstoovercomemarketfailuredonotsucceed.
Causes of government failure 1.Lackofincentivesworkingforthegovernment.Governmentbodiesdonothavethesameprofitmotivesofprivatecompanies.Thereforemanagersandworkersmayfeelnoincentivetoworkhardorcutcosts.Theresultcanbegovernmentagenciesthatareinefficient,withhighercostsandnotproducingwhatpeopleneed.
• Tosomeextent,thiscanbeovercomebyrewardinggovernmentworkerswithperformancetargets.
• Incentivesmaybelessimportantinserviceslikehealthcare,wheredoctorsvaluepatienthealth.
2.Unintendedconsequences.Oftengovernmentinterventiontriestosolveoneproblem,butanotherproblemiscreated.Forexample:
• Minimumpricesinagriculturewereanattempttostabilisefarmers’incomes.However,theunintendedconsequenceofguaranteedminimumpriceswasthatitencouragedover-production.Farmersusedchemicalstomaximiseyields–knowingthegovernmentwouldbuyanysurplus.Thisprovedexpensiveandinefficient.
• Byincreasingtaxesontobacco,thegovernmentmadeitmoreprofitableforpeopletosmugglecigarettesfromEurope.
• Amaximumpriceonrentingpropertycouldleadtoadeclineinavailablehousingforrenting–worseningthehousingcrisisratherthanhelping.
• Higherincometaxmaydiscouragepeoplefromworking.
3.Lackofinformation.Governmentbodiescansufferfromalackofknowledgeabouthowtointervene,justaswecangetalackofinformationinafreemarket.
• Forexample,itcanbedifficultforagovernmentbodytocalculatethenetexternalcostsofanewairportornuclearpower.
• Governmentsmayfailtopredictfuturetrends,e.g.theimpactofminimumpricesonincentivesinthelong-term.
4.Administrationcosts.Anygovernmentinterventionislikelytohavesomeadministrationcostsandbureaucracy.
• Forexample,settingupacongestionchargeforsmallcitiescouldbedifficultbecausethecostsofadministeringtheschemewillberelativelyhigh.Withsomenewtaxes,thecostofbureaucracymaybeclosetotherevenuegained.
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Unit 2 The UK Economy
Circular flow of income Thecircularflowofincomeisabasicmodeloftheeconomy.Inthecircularflowofincome:
• Moneyflowsfromhouseholdstofirms(tobuygoods).• Thenfirmspayhouseholdswagestoproducegoods.
Moneycanflowoutofthecircularflowofincometoabroadortogovernment.
ThecircularflowofincomeshowsthreewaystocalculateGDP(GrossDomesticProduct).
Three methods of calculating GDP 1. Totalnationalincome(wages,dividends,profit)2. Totalnationalexpenditure(consumptionandinvestment)3. Totalnationaloutput(valueofgoodsandservicesproduced)
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InjectionsThisisanincreaseofexpenditureintothecircularflowofincome,leadingtoanincreaseinaggregatedemand(AD).Injectionscaninclude:
1. Exports(X)–spendingfromabroadondomesticgoods.2. Governmentspending(G).3. Investment(I)–spendingoncapitalgoodsbyfirms.
Withdrawals(W)(leakages)Withdrawalsareareductionofmoneyinthecircularflow.Withdrawalscaninclude:
• Saving(S)–depositingmoneyinbanks.• Imports(M)–spendingonforeigngoods.• Taxation(T)–theGovernmentraisingmoneyfromconsumersandfirms.
MultipliereffectThemultipliereffectoccurswhenachangeininjectionscausesabiggerfinalchangeinrealGDP.
Forexample,ifthegovernmentincreasedG(governmentspending)by£10billion,andthisledtoanincreaseinrealGDPof£16bn,wesaythemultipliereffectis16/10=1.6.
Whydowegetamultipliereffect?
• Supposewehaveadepressedeconomywithsparecapacityandunemployedworkers.Ifthegovernmentspends£10billiononbuildingroads,theywillemployworkers.Incomeandspendingwillriseby£10bn.
• But,theunemployedwillnowhaveextramoneytospend.Theywillbuyproductsfromshops,andshopkeeperswillnowseeimprovedincomesandalsospendmore.
• Inotherwords,theinitialspendingdoesn’tjuststaywithoneperson.Thereareknockoneffects.Higherspendingleadstomoreincomeforothers,andthereforefurtherroundsofspending.
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Aggregate demand Aggregatedemand(AD)isthetotaldemandforgoodsandservicesintheeconomy.AD=C+I+G+(X-M)
• C=Consumerexpenditureongoodsandservices(60%)• I=Grosscapitalinvestment(spendingoncapitalgoods,e.g.machines)• G=Governmentspending• X=Exports • M=Imports
ShiftinADandmovementalongtheADcurve
Anincreaseinthepricelevel(P1toP2)causesmovementalongtheADcurve.
• Atahigherpricelevel,ceterisparibus,consumershavelessdisposableincome(moneytospend).
• Atahigherpricelevel,UKexportswillberelativelylesscompetitive,leadingtolowerexportdemand.
• AshiftintheADcurvewouldoccuriftherewasachangeinfactorslikerealincome;higherincomewouldshiftADtotheright.Consumerswouldbuymoreatthesamepricelevel.
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Shift in AD • Iftherewasanincreaseinincome,theADcurvewouldshifttotheright
(AD1toAD2).• ADcouldshifttotherightiftherewasariseininvestment,exportsor
governmentspending.
Consumerspending(C)ConsumerspendingisthebiggestcomponentofAD(approx.60-65%ofAD).Consumerspendingisdeterminedby:
• Disposableincome.Thisisincomeaftertaxesandbenefits.RisingrealwageswouldincreasedisposableincomeandshiftADtotheright.
• Saving.Thealternativetospendingdisposableincomeistosave.Ifincomestaysconstant,butconsumerswanttoincreasetheirsavings,thenconsumptionwillfall.
• Consumerconfidence.Ifconsumersarepessimisticaboutthefuture,theywillprefertosave,payoffdebtandreducetheircurrentspending.LowconfidencewillshiftADtotheleft.Highconfidencewillencouragespending.
• Houseprices/wealth.Risinghousepricestendtoincreaseconsumerspendingthroughapositivewealtheffect.IntheUK,manypeopleowntheirhouses.Ifhousepricesrise,theycouldgainequitywithdrawal–re-mortgagingthehouseandtakingmoneytospend.Theywillalsofeelmoreconfidentiftheirhouseisworthmore.
• Incometax/VAT.Acuttoincometaxwillincreaseconsumers’disposableincome,encouragingspending.
• Interestrates.Lowerinterestratesreducethecostofborrowingencouragingspending.Lowerratesalsomakeconsumptionmoreattractivethansavinginabank.
• Costofliving.Ifwagesstaythesame,butthecostoflivinggoesdown(e.g.afallinpetrolprices),peoplewillhavemoredisposableincomeandspendmore.(ThisfactorcausesmovementalongtheADcurve.)
InvestmentInvestmentmeansexpenditureoncapitalgoods–factorsthatincreasetheproductivecapacityoftheeconomy,e.g.machinesandfactories.
• Investmentaccountsforabout15%ofAD.• InvestmentaffectsbothADandAS.• Investmentisrelativelymorevolatileandisstronglyinfluencedby
confidenceandchangesintherateofeconomicgrowth.
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Factors that affect investment • Confidence.Ifbusinessesareoptimisticaboutfuturedemand,theywill
needtoincreaseproductivecapacityandstarttoinvestnow.Ifbusinessesfaceuncertainty,theywillcutbackonriskyinvestment.
• Animalspirits.Keynessaidinvestmentwasheavilyinfluencedbythe‘animalspirits’ofbusinessmen–didpeopleexpecttheirbusinesstogrow?Thisconfidencecanquicklychangedependingonthestateoftheeconomy.
• Interestrates.Investmentisoftenfinancedbyborrowingorusingsavings.Lowerinterestratesmakeitcheapertofinanceinvestmentandmakemoreprojectsworthwhile.
• Availabilityoffinance.Businessesmaywishtoborrowandinvest,butaccesstocreditisabigissue.Banksmaybereluctanttogiveasmallbusinessaloanbecauseitisariskyinvestment.Inthiscaseitmaydependonbusinessesfindingothersourcesofcredit,suchasthestockmarketorprivateinvestors.
• Governmentregulation.Somebusinessesmayputoffinvestmentbecauseoftheheavycostofregulation,e.g.theneedtomeetenvironmentalstandardsandlabourregulation.Ontheotherhand,governmentscouldencourageinvestmentthroughofferingregionalsubsidies.
• Economicgrowth.Akeyfactorindetermininginvestmentistherateofeconomicgrowth.ImprovementsintherateofgrowthandADwilltendtoincreaseinvestment.Alsoimportantisthedemandfromoverseasandthedemandforexports.
Governmentexpenditure(G)Governmentspendingincludestransferpayments(e.g.benefits)anddirectspending,suchascapitalinvestmentonpublicroads.
In2013/14,theUKgovernmentspentatotalof£722.9billion(44%ofGDP).Governmentspendingisinfluencedby:
• Fiscalpolicy.ThegovernmentmaychoosetousefiscalpolicytotryandinfluenceAD,e.g.inarecession,thegovernmentcouldborrowmoreandspendoncapitalinvestment,suchasbuildingnewroadsandrailways.
• Economiccycle.Inaperiodofhigheconomicgrowth,taxrevenuestendtorise;thisgivesthegovernmentmoremoneytospendonservicesliketheNHS.
• Politicalcycle.Governmentmaycutspendingafteranelectiontotryandreducebudgetdeficit,butthenincreasespendingshortlybeforeanelection.
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Nettrade(X-M)TheUK’smaintradingpartneristheEU(60%oftrade).Thoughtheproportionoftradewithdevelopingeconomies,likeChinaandIndia,isrising.
Factors that affect (X-M) • Exchangerates.Ifthereisadepreciationoftheexchangerate,exports
willbecheaperandimportsmoreexpensive.Thiswilltendtoincrease(X-M)andincreaseAD.
• Economicgrowth.IfUKgrowthisrelativelyhigherthanothercountries,wewillseeariseinimportspendingandthiswillreducenet(X-M).But,ifthereisstronggrowthinEurope,thiswillleadtohigher(X-M)andhigherAD.
• Competitiveness.IftheUKhasalowerinflationratethanourcompetitors,thenUKexportswillbecomerelativelycheaper.Improvedcompetitivenesscouldbeduetolowerwagesorhigherproductivity.
• Non-pricefactors.Inadditiontoprice,thequalityanddesirabilityofUKgoodsandserviceswillbeimportant.IfUKfirmscanproducebetterqualitygoodsandserviceswithuniquesellingpoints,demandforUKexportswillriseanddemandwillbemoreinelastic.
• Tariffsandprotectionistmeasures.Ifacountryfacedhightariffsonexports,thiswouldreducedemand.Forexample,iftheUKlefttheEU,itmayfindthattherearehighercosts/tariffsonexportstoEurope.
Aggregate supply (AS) Aggregatesupply(AS)isthetotalproductivecapacityoftheeconomy.Itisthesumofalltheindividualsupplycurvesforparticulargoods.
TheAScurveshowsmaximumpotentialoutput;thereisastrongcorrelationwithaProductionPossibilityFrontier(PPF),whichalsoshowsthemaximumpotentialofaneconomy.
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Long run aggregate supply (LRAS)
• InthediagramthereisashiftinAD.Thiscausesahigherpricelevel(P1toP2)andamovementalongtheAScurve.
• IntheshortruntherecanbesparecapacityandLRASiselastic.• But,LRASalsobecomesinelasticatY2.Thismeansthatfirmscannot
increasecapacitybeyondthispointof‘fullemployment’withoutincreasedinvestment.
FactorsaffectingLRAS
Inthelongrun,ASisdeterminedbythequantityoffactorsofproductionandtheproductivityoflabour/capital.(Labourproductivitymeansoutputperworker.)
• Population.Ariseinthenumberofworkingagepeoplewillincreasethelabourforceandincreaseproductivecapacity.Theworkingagepopulationcanbeaffectedbybirthratesandnetmigration.TheUKlabourforcehasincreasedduetonetmigrationinthepastdecade.
• Technology.Technologicalimprovementsareoneofthebiggestfactorsaffectinglabourproductivity,e.g.theInternetmakesiteasierforfirmstocheckcostsandprices.
• Investment.Iffirmsorthegovernmentinvestinincreasingthecapitalstock,wewillseehigherASinthelongrun.
• Educationandskills.Improvededucationandvocationalskillsenablesworkerstobemoreproductiveandofferhigheraddedvalue,increasingproductivecapacity.
• Infrastructure.Improvedtransportlinksreducethecostoftransportandencouragetrade;thisisimportantforboostingproductivecapacity.
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• Governmentpolicies.ThegovernmentcanaffectLRASbyitssupplysidepoliciesoneducation,competitivenessandregulation.Forexample,privatisationandderegulationmayincreaseefficiencyandcompetitivepressureinindustrieslikegasandelectricity.
o Note:Thereisalimittohowmuchthegovernmentcaninfluenceproductivecapacity.Mosttechnologicalimprovementscomefromtheprivatesector.
• Attitudestoenterprise.Astableeconomicandpoliticalclimatemayencourageentrepreneurstoinvestanddevelopbusiness.
Shift in LRAS
Ifthereisanincreaseinproductivityoranincreaseinfactorsofproduction,theLRASwillshifttotheright.ThiscancausehigherrealGDP.
Governmentsupplysidepolicies,suchasprivatisationandderegulation,couldleadtoanimprovementinproductivecapacityandshiftLRAStotheright.
SupplysidepolicieswillalsoshiftthePPFcurvetotheright.
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EquilibriumnationalincomeEquilibriumnationalincomeoccurswhereAD=AS.
• Inthisexample,thereisafallinAD,leadingtoachangeinequilibriumnationalincome.RealGDPfallsfromY1toY2,andthereisafallinthepricelevel.
Rise in AD Ifthereissparecapacityintheeconomy,thenariseinADwillleadtohigherrealGDP.
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Demandsidefactorsthatcanincreaseeconomicgrowthcouldinclude:
• Lowerinterestrates–reducingthecostofborrowingandleadingtohigherinvestmentandhigherconsumption.
• Risinghouseprice–leadingtoapositivewealtheffect,encouragingconsumerspending.
• Lowertaxes–increasingdisposableincome.• Higherconfidenceintheeconomy–encouragingspendingand
investment.
Multiplier effect on AD and GDP
• Inthiscase,wegetariseininjections(e.g.risinginvestmentlevels).• InitiallythiscausesADtoincreasetoAD2.• But,becauseofthemultipliereffectandfurtherroundsinspending,we
getanotherincreaseinADtoAD3causingabiggerfinalincreaseinrealGDP.
• Inthisexample,initially,therewasalotofsparecapacityatY1.AtY3,theeconomyisclosetofullcapacity.
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GovernmentmacroeconomicobjectivesTheprimaryeconomicobjectivesofagovernmentarelikelytobe:
1. Economicgrowth.Mostgovernmentswouldtrytomaximisesustainableeconomicgrowthtoincreaselivingstandardsandhelpcreateemployment.
2. Lowinflation.Thegovernment’sinflationtargetiscurrentlyCPI2%(+/-1).Thegovernmentwishestoavoidbothhighinflationandalsoavoidthethreatofdeflation.Problemsofinflationinclude:
o Createsinstabilityreducinginvestmento HighUKinflationreducesUKcompetitivenesso Canreducetherealvalueofsavings.o Lowinflationisconsideredbestenvironmentforencouraging
investmentandsustainableeconomicgrowth.3. Lowunemployment.Mostgovernmentswillaimforfullemployment.
Unemploymentcreateshighpersonal,socialandeconomiccosts,suchasstressandrelativepovertyfortheunemployed.Governmentsalsolosetaxrevenuefromtheunemployed.
4. Satisfactorycurrentaccount/balanceofpayments.Alargecurrentaccountdeficitcouldbeaneconomicconcern(e.g.weakexportgrowth,relianceoncapitalflows,financedeficit).Therefore,governmentsmaywishtohaveareasonablelowdeficit/surplus,
5. Lowgovernmentborrowing.Governmentsoftencommittofiscaltargetsforbothannualborrowing,andtotaldebt(publicsectornetdebt).
6. Stableexchangerate.Arapiddepreciationintheexchangeratecouldcauseinflationarypressuresandinstability.Therefore,governmentsmaypreferastableexchangerate(e.g.,afixedexchangeratesystem).
Otherminorobjectives
• Issuesofequality.Higheconomicgrowthmaybeattheexpenseofincomeinequality.Makingsuregrowthisfairlydistributedmaybeanobjectiveofsomegovernments.
• Environment.Higheconomicgrowthcouldcauseenvironmentalproblemsandissuesforlong-termsustainability.Lookingafterenvironmentmayrequiresomesacrificeintermsofeconomicgrowth.
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ConflictsbetweenobjectivesAgovernmentwillstruggletomeetallthemacro-economicobjectivesatonce.
Unemploymentvs.inflation
• Ifthegovernmentpursueddemandsidepoliciestoreduceunemployment,wecouldseeafallinunemployment,highereconomicgrowth,butalsoariseininflation.
Diagram:expansionaryfiscalpolicy
• Ifthegovernmentincreasedspending(G),wewouldseeanincreaseinAD.ThisleadstoariseinrealGDP(Y1toY2).
• Asoutputincreases,firmswillhiremoreworkers.• RealGDPrisesfromAtoB,andwegethigherinflation(P1toP2).
Theremaybeothertrade-offsaswell:
• HigherADcouldcauseabiggercurrentaccountdeficitbecauseofhigherimportspending,andhigherinflationreducingthecompetitivenessofexports.
• Expansionaryfiscalpolicy(higherG/lowertax)willleadtoabiggerbudgetdeficit.
Thetrade-offcanworkinreverse.IfwereduceAD(e.g.,higherinterestrates),wecangetlowerinflation,butwemaycauseunemployment.
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Deflationaryfiscalpolicy
FallinADleadstolowerinflation,butalsocauseslowerrealGDPandrisingunemployment.
Evaluation
• Inthelongrun,itmaybepossibletoachievehighergrowthandlowerunemployment,withoutcausinginflation.Forexample,ifADincreasesatthesamerateasLRAS,wecangeteconomicgrowthwithoutinflation.
• Ifwealsousesupplysidepolicies,wecanreducestructuralunemployment,withoutcausinganyinflation.
Other potential policy conflicts • Highereconomicgrowthmaycauseenvironmentalproblems.For
example,theoveruseofscarcelimitedresourcesactsasaconstraintonfuturelivingstandards.
• Lowerincometaxandcorporationtaxmayprovideaboosttogrowth,butmayalsoincreaseinequalitybecausehighearnersbenefitmostfromthesetaxcuts.
• Cuttingdownbenefitsmayprovideanincentivefortheunemployedtogetajob,butitmaycauseincreasedinequality.
• Policiestoreduceacurrentaccountdeficit(deflationaryfiscalpolicy)maycauselowereconomicgrowthandhigherunemployment.
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Fiscal policy Fiscalpolicyreferstochangesintaxationandgovernmentspendingandthefiscalpositionofthegovernment.
Demandsidefiscalpolicyattemptstoinfluenceaggregatedemand(AD).Theaimcouldbeto:
1. Stimulateeconomicgrowthinaperiodofarecession2. Maintainlowinflation
Supplysidefiscalpolicyattemptstoinfluenceproductivityandthesupplysideoftheeconomy,e.g.spendingoneducationtoimprovelabourproductivity.
Expansionary fiscal policy (loose fiscal policy) Thisinvolveslowertaxratesand/orhighergovernmentspending,withtheaimtoincreaseAD.
Effectofexpansionaryfiscalpolicy
• ExpansionaryfiscalpolicywillincreaseADandincreasethesizeofthebudgetdeficit.Itmayalsocauseinflation.
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Deflationary fiscal policy (tight fiscal policy) • Thisinvolveshighertaxratesand/orlowergovernmentspending.• TheaimofdeflationaryfiscalpolicyistodecreaseADandinflation.• Deflationaryfiscalpolicywillalsoimprovethebudgetdeficit.
Evaluation of fiscal policy 1. Poorinformationmayreducetheaccuracyofforecastingfuture
economicgrowthandinflation.Therefore,thegovernmentmaybeunsurewhethertheyneedtoboostADorreduceAD.Inpractise,governmentsfinditdifficultto‘finetune’theeconomywithfiscalpolicy.
2. ItdependsonothercomponentsofAD.Forexample,ifthegovernmentcutincometaxtoincreaseAD,itmaybeineffectiveifconsumerconfidenceislowandpeoplejustsavetheextraincome.
3. Disincentivestowork.Higherincometaxtoreduceinflationcancreatedisincentivestowork,reducingproductivityandAS.
4. TimelaginvolvedininfluencingAD.IfthegovernmentwantedtoincreaseAD,theycouldcommittomoregovernmentspending.But,therewillbedelaysinactuallyimplementinghigherspending,andthendelaysinthisspendingaffectingthewidereconomy.
5. Budgetdeficits.Expansionaryfiscalpolicy(higherspending,lowertax)willincreasegovernmentborrowing.Thiscouldleadtohigherinterestratesinthelongtermorevencausemarketstoloseconfidenceindebtlevels.
6. Crowdingout.Ifthegovernmentspendmorebyborrowingfromprivatesector,itmayreducetheamountofmoneytheprivatesectorhastospend.
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ThenationaldebtNationaldebt(publicsectornetdebt)isthetotal(cumulative)amountofdebtthatthegovernmentowestheprivatesector.
• InJanuary2015,thenetdebtwas£1,483.3 billion, equating to 80%ofGDP.• UKnationaldebtasa%ofGDPpeakedaftertheFirstandSecondWorld
Wars.ItfellduringthepostwarperiodaseconomicgrowthledtohigherGDP,makingdebtasmallerpercentage.
• Netdebtasincreasedsincethefinancialcrisisof2007
Government borrowing • Thebudgetdeficitistheannualamountthegovernmentneedstoborrow
fromtheprivatesector.
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Thepreviousdiagramshowspublicsectornetborrowing(budgetdeficit)intheUK.
• In1999-00and2000-01,theUKranabudgetsurplus.Governmentspendingwaslessthantaxrevenues.
• Borrowingpeakedin2009-10becauseofthefinancialcrisisandrecession.Intherecession,taxreceiptsfellandspendingonunemploymentbenefitsrose.
• In2009/10,thegovernmentalsopursuedexpansionaryfiscalpolicy(cuttingVATratestoboostAD).
Budgetdeficit
• Thebudgetdeficitwillbethedifferencebetweengovernmentspending(G)andtaxrevenue.
• Thebudgetdeficitismeasuredthroughstats,suchasPublicSectorNetCashRequirement(PSNCR)andnetborrowing.
• Thebudgetdeficitisalsoreferredtoasnetborrowing.
Public expenditure Governmentspendingincludesallformsofspendingbycentralandlocalgovernment.Themaintypesofgovernmentspendingare:
• Capitalexpenditure.Thisisgovernmentspendingoncapitalprojectsandcreatingnewassets.Itisinvestmentthatincreasesthecapitalstockoftheeconomy.
o Thistypicallyinvolvesbuildingnewroads,railways,hospitals,andimprovingcommunication.Thiscapitalspendingcanincreasetheproductivecapacityoftheeconomyinthefuture,becauseithelpsshiftlong-runaggregatesupplytotheright.
• Currentexpenditure.Thisisgovernmentspendingonitemsthatarerecurringandonlylastsalimitedtime,e.g.spendingonpublicsectorwagesandconsumableproducts.
o Forexample,buildingaschoolwhichlasts50yearsiscapitalexpenditure.Payingteachers’wagesandpayingelectricbillsiscurrentspending.Botharenecessary.
• Transferpayments.Thesearesimplepaymentsfromthegovernmenttoindividuals.Itrepresentsaredistributionofincomeinsociety.Examplesoftransferpaymentsinclude:• Pensions• Welfarepayments,suchasunemploymentbenefitandhousingbenefit• Transferpaymentscanredistributeincome,butalsowelfarebenefits
riskcreatingdisincentivestowork.
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GovernmentspendingRealgovernmentspending—Spendinglevelsadjustedforinflation.
In2011/12,therewasasmallfallinrealgovernmentspendingduetothepolicyofausterity(cuttinggovernmentspending)
Governmentspendingasa%ofGDProsefrom2000to2009
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Impact of higher government spending Anincreaseinrealgovernmentspendingcouldimply:
• Moreinvestmentineducationandinfrastructure.Thegovernmentcanusetaxrevenuestoovercomemarketfailureinareassuchastransport,education,andhealth.Providinggoodswithpositiveexternalitiescanleadtogreatersocialefficiency.Itcanalsohelpimproveindicesofeconomicdevelopment,suchasliteracyrates.
• Redistribution.Thegovernmentcanspendmoneytoredistributeincomeamongstpeopleonlowincomes.Thiscanhelppromoteamoreequalsocietyandimproveeconomicwelfare.Countrieswiththehighestlevelsofgovernmentspending(Norway,France,UK)havethemostdevelopedwelfarestates,whichprovideasafetynetandhealthcareforthepoorermembersofsociety.
• Fiscalpolicy.Inarecession,governmentspendingmaybeeffectiveinstimulatingtheeconomy,e.g.governmentborrowingcanoffsetariseinprivatesectorsaving,andincreaseAD.
• Automaticstabilisers.Between2007and2010,theincreaseingovernmentspendingasa%ofGDPisaconsequenceoftherecession,causingafallinGDP,buthighergovernmentspendingonunemploymentandhousingbenefits.
Evaluation of higher government spending • Highertaxesmayberequiredtofundhigherspending.Higherincome
taxratescouldcreatedisincentivestowork.Highercorporationtaxcoulddiscouragefirmsfromsettingupinthatcountry,leadingtolowergrowth.
• Potentialinefficiencyofgovernmentspending.Often,governmentbodieslackaprofitincentivetobeefficient.Therefore,governmentspendingcouldbewasteful,misused,andinefficient.Ontheotherhand,itcouldovercomemarketfailure,e.g.lackofeducation.
• Efficiency.Governmentspendingcouldbecomemoreefficientthroughcompetitivetenderingandpublic-privatepartnerships,whichinvolvebothpublicandprivatesectors.Thereisnoreasongovernmentspendinghastobeinefficient.
• Crowdingout.Anincreaseinthegovernmentsectorhasanopportunitycost.Moregovernmentspendingmeansadeclineinthesizeoftheprivatesectorandareductioninprivatesectorenterprise.
• Dependsonthekindofspending.Itdependsonwhatthegovernmentisspendingthemoney:
o Spendingonwelfarebenefits(transferpayments)mayincreaseequality,butbedetrimentaltoefficiencyandproductivity.
o Spendingontransportlinks(capitalspending)canhelptheeconomybecomemoreefficientandcompetitiveinthelongterm.
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TaxationThegovernmentcollectstaxrevenuesfromavarietyofsources.Themaintypesoftaxationare:
• Directtaxation–incometax,NIcontribution.Thesetaxesaretakendirectlyfromaperson’swages.Incometaxisprogressivebecauseittakesabigger%oftaxfrompeoplewithhighincomes.
• Indirecttaxation–VAT,exciseduty.Consumerspaythesetaxesindirectly;whenagoodisbought,thefirmhastopaytheVATratetothegovernment(20%).Indirecttaxesalsoincludeexciseduty(e.g.alcohol,tobacco)andpetroltaxes.
• Progressivetaxoccurswhenthoseonhigherincomelevelspayahigher%oftheirincomeintax,e.g.theUKhasatoprateof45%onmarginalincomeover£150,000;thisisaprogressivetax.
• Regressivetaxoccurswhenanincreaseinincomeleadstoasmaller%oftheirincomegoingonthetax,e.g.excisedutiesandVATtakeabigger%oflowincomeearners.
• Indirecttaxationispaidbyfirmssellinggoods,e.g.VATisincludedinthefinalpriceconsumerspay.
Impact of increasing the rate of income tax • Higherrevenues.Higherincometaxshouldincreasetaxrevenues.
Thegovernmentcanspendmoreonpublicservicesandbenefitstoreduceinequalityandfundcapitalinvestment.
• Taxevasion.Higherincometaxmayencouragetaxevasion,e.g.higherratesofincometaxcouldencouragepeopletoworkinanother
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country.Therefore,anincreaseintaxrevenuesmaybelessthanexpected.
• Incentivestowork.Highermarginaltaxratesmayreduceincentivestoworkanddoovertime.Thesubstitutioneffectstateshigherincometaxwillmakeworkrelativelylessattractive.
• Redistribution.Higherratesofincometaxcanhelpredistributeincomefromhighearnerstolowearnersandcreatemoreequality.
• Aggregatedemand.Highertaxrateswillreducedisposableincomeandleadtolowerconsumerspending.Ceterisparibus,thiscouldleadtolowereconomicgrowthandlowerinflation.
Evaluation of higher income taxes • Disincentives?Somefearhigherincometaxratescouldcreate
disincentivestowork.Butothereconomistssuggestevidenceismixed.Thesubstitutioneffectofataxrisemaymakepeopleworkless,buttheincomeeffectencouragesthemtoworkmore(toachievetargetincome).
• Itdependshowtaxrevenueisused.Ifincometaxrevenueisinvestedinimprovedinfrastructure,itcanthebenefitlong-runproductivecapacity.Ifincometaxrevenueisneededforwelfarepayments,therewillbenoincreaseinproductivecapacity.
• Doesrevenueincrease?TheLaffercurvesuggeststherecomesapointwherehigherincometaxratesleadstoadeclineintaxrevenue,becausepeoplestopworkingiftaxistoohigh.
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Supply side policies Supplysidepoliciesaregovernmentattemptstoincreaseproductivity,maketheeconomymoreefficientandshiftaggregatesupplytotheright.Supplysidepoliciescanbeeither:
1. Interventionist-involvinggovernmentspendingtoovercomemarketfailure,e.g.buildingnewroadstoreducecongestion.
2. Marketoriented-policiestoreduceregulationandallowfreemarketstofunctionmoreefficiently,e.g.reduceminimumwages.
Supplysidepoliciescanhelptheeconomyinvariousways:
1. Lowerinflation.ShiftingAStotherightwillcausealowerpricelevel.2. Lowerunemployment.Supplysidepoliciescanhelpreducestructural,
frictionalandrealwageunemployment.3. Improvedeconomicgrowth.Supplysidepolicieswillincreaseeconomic
growthbyincreasingAS4. Improvedtradeandbalanceofpayments.Bymakingfirmsmore
competitive,theywillbeabletoexportmore.
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Examples of market oriented supply side policies 1. Privatisation.Thisinvolvessellingstateownedassetstotheprivate
sector.Itisarguedthattheprivatesectorismoreefficientinrunningbusinessesbecausetheyhaveaprofitmotivetoreducecostsanddevelopbetterservices.
2. Deregulation.Thisinvolvesreducingbarrierstoentryinordertomakethemarketmorecompetitive.Greatercompetitioncreatesincentivestoreducepricesandcosts.Forexample,UKtelecomsmarketsarenowmorecompetitiveandthishashelpedreducepricesandincreaseefficiency.
3. Reducingtaxes.Itisarguedthatlowertaxes(incomeandcorporation)increaseincentivesforpeopletoworkharder,leadingtohigheroutput.
4. Reducingstatewelfarebenefits.Lowerunemploymentbenefitsmaycreateabiggerincentiveforpeopletolookforworkandstayoffbenefits
5. Reducedbureaucracyforfirms.Ifrulesandregulationsareremovedthenfirmswillhavelowercostsandbemoreproductive.
6. Labourmarketreforms.SomeeconomistsarguethatmanyEuropeanlabourmarketsaretooheavilyregulated.Forexample,removinglawsabouthiringandfiringworkersandfixedhourcontractswouldincreaselabourmarketflexibilityandencouragefirmstohireworkers.Onthedownside,greaterlabourmarketflexibilitymayleadtogreaterjobinsecurityforworkers.
Examples of interventionist supply side policies • Increasededucationandtraining.Bettereducationcanimprovelabour
productivityandincreaseAS.Oftenthereisanunderprovisionofeducationinafreemarket,leadingtomarketfailure.Therefore,thegovernmentmayneedtosubsidisesuitabletrainingschemes.
• Providingbetterinformationaboutavailablejobs.• Improvingtransportandinfrastructure.Inafreemarket,thereis
likelytobeanunderprovisionofpublictransport.Iftransportnetworkswereimproved,firmswouldbenefitfromlowercosts.
Evaluationofsupplysidepolicies• Theywilltaketimetohaveeffect,e.g.itwilltakeseveralyearstocreatea
moreeducatedworkforce.• Itwillcostmoneytoimproveinformationandeducation,andtherefore
taxeswillneedtorise.• Deregulation,suchaslowerbenefitsandreducedminimumwages,may
causesideeffects,suchasincreasedpoverty.• Governmentfailuremayoccur.Forexample,thegovernmentmayhave
poorinformationaboutwhattospendmoneyon.Forexample,the
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governmentmayfinancethewrongkindofscheme,suchasanewtrainlinethatisnotusedverymuch.
• Inarecession,increasingASmaybeinsufficient.Inarecessionthemostimportantthingisnotsupplysidepoliciesbutpoliciestoincreaseaggregatedemand.
Inthisexample,wesuccessfullyincreaseLRAS,buttheeconomyisstuckinarecession,sotheoutputisrelativelysmall.Inthissituation,theeconomyneedsanincreaseinAD(demandsidepolicies).
• Thereisonlysomuchthegovernmentcando.Itisimportanttobearinmindthattechnologicalimprovementsandproductivitygainscomelargelyfromtheprivatesector.
• Itisdifficultforthegovernmenttotransformproductivityandcreatenewtechnology.Atbest,thegovernmentcancreateaclimateforprivatesectorinnovationtooccur.
• TheUK’slastperiodofdemandpullinflationwasthelate1980s.• Inthisperiod,growthwasveryhighat4-5%ayear.Itwasfuelledby
incometaxcuts,risinghousepricesandrelativelylowinterestrates.• Inflationwasclosetothegovernment’stargetof2%between1992and
2008.Thisperiodwasknownasthe‘greatmoderation’becauseeconomicgrowthwassustainableanddidnotcauseinflation.
• Inflationdidnotincreaseuntil2008,whenitreachedover5%.Thiswasduetorisingoilprices.
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Monetary Policy Monetarypolicyinvolveschangingtheinterestrateormanipulationofthemoneysupplybythemonetaryauthorities.
Inflationcomparedtothegovernmentstargetof2%
Aimsofmonetarypolicy
1. Controltherateofinflation.InflationtargetforMPCisCPI-2.0%+/-12. Maintainsustainableeconomicgrowth3. Influencetheexchangerate(notsoimportant)
UKmonetarypolicy• Everymonth,theMPCmeettodecidefutureinterestrates.Iftheyfeelthe
inflationrateislikelytogoabovethetarget(e.g.duetoahigherrateofeconomicgrowth)thentheywillincreaseinterestratestomoderatedemandandkeepinflationlow.
• IftheMPCfeelthatinflationislikelytofallbelowthetargetandthereissloweconomicgrowth,theyarelikelytodecreaseinterestratestoboosteconomicgrowthandpreventunemployment.
Todeterminefutureinflation,theMPCwilllookatvariousstatisticssuchas:
• Therateofeconomicgrowthcomparedtothelongruntrendrate.Ifgrowthisfasterthanthetrendrate,inflationislikelytooccur.
• Wagegrowth.Higherwagegrowthcancausebothcost-pushanddemand-pullinflation.
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• Temporaryfactorsliketaxrisesandcommoditypriceriseswillbegivenlessimportancebecausetheydonotindicateunderlyinginflation.
• Unemployment.HighunemploymentwilltendtoreducewageinflationandsotheMPCismorelikelytocutinterestratestoboostAD.
The role of the central bank CentralBanksplayanimportantroleinamoderneconomy.Theirfunctionsinclude:
1. Monetarypolicy.CentralBanksareusuallyresponsibleformonetarypolicy.Thisinvolveschanginginterestratestomeetthegovernment’stargetforinflation(andothermacro-objectives).
2. Bankertothegovernment.CentralBanksmanagethegovernment’sfinancialaccount.
3. Lenderoflastresort.Animportantroleisactingasthelenderoflastresort,forboththegovernmentandprivatebanks.Ifthegovernmentrunsoutofmoney,theCentralBankscanstepintobuygovernmentdebt,preventingpanicaboutthegovernment’sliquidity.Theycanalsolendmoneytocommercialbanksiftheyaretemporarilyshortofliquidity(money).
Effect of higher interest rates (Tight monetary policy) Ifinflationisforecasttoriseabovetheinflationtarget,theMPCarelikelytoincreaseinterestrates.ThiswillhelpreduceADandinflationbecausehigherinterestrates:
• Makesborrowingmoreexpensive,thereforepeoplespendlessoncreditreducingconsumerspending.Firmswillalsobelesswillingtoinvestbyborrowingmoney.
• Thecostofmortgagesincreases,thereforepeoplehavelessdisposableincomecausingafallinconsumption.ThereforeADdecreases.
• Savingmoneyinabankismoreattractivethereforethereislessspendingandrelativelymoresaving.
• Exchangerateincreases.Withhigherinterestrates,itismoreattractivetosaveinUKbanks.ThisincreasesthedemandfortheBritishPoundandincreasestheexchangerate.Ahigherexchangeratewillreducethedemandfor(X-M)becauseexportsaremoreexpensive,andimportscheaper.
Evaluation of monetary policy 1.Othercomponentsintheeconomy.Theeffectivenessofmonetarypolicydependsuponothervariablesintheeconomy,forexample:
• Ifconfidenceislow,areductionininterestratesmaynotincreasedemand.
• Iftaxesarerising,thismaycounterafallininterestrates.
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• Iftheworldeconomyisslowing,thiswillreduceexportsandAD;thiswouldkeepspendinglow-eveniftherewasareductionininterestrates.
2.Theeffectofinterestratesdependsonthesituationoftheeconomy.Iftheeconomyisclosetofullemployment,acutininterestratesislikelytojustcauseinflationsignificantlywithonlyasmallincreaseinrealGDP.(AD3toAD4)
• Howeveriftheeconomyhassparecapacity,(e.g.atY1toY2)higherADwillincreaseGDP,withonlyasmallamountofinflation.
3.Timelags.Theremaybetimelagsforlowerinterestratestohaveaneffect.Forexample,higherinterestratesmaynotreduceinvestmentintheshorttermbecausefirmswillcontinuewithexistinginvestmentprojects.
4.Conflictsofobjectives.Monetarypolicymayconflictwithothermacroeconomicobjectives.IftheMPCreducesinflation,thismayleadtolowergrowthorhigherunemployment.
5.InterestratesforwholeUK.TheMPCsetinterestratesforthewholeoftheUK,butifregionsaregrowingatdifferentrates,itmaynotbesuitable.Forexample,ifWaleswasdepressed,butrestofUKgrowingstrongly.HighratesmaybedamagingforWelsheconomy.
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Exchange rates • Theexchangeratemeasuresthevalueofacurrencyagainstother
currencies.• Bilateralexchangeratemeasurestheexchangeratefortwocountries,
e.g.thevalueofthePoundSterlingagainsttheDollar.• Nominalexchangeratemeasurestheactualmonetaryvalue,andthe
amountofcurrencyyoucangete.g.£1=$1.5.• Realexchangeratetakesintoaccountinflationandmeasuresthe
amountofgoodsyoucanexchange.Therealexchangerate=nominalexchangerateX(domesticprice/foreignprice).
• Effectiveexchangerate.Theweightedaverageofacurrencyadjustedforinflation,likerealexchangerate.
• Appreciationistheincreaseinvalueofexchangerate.• Depreciation/devaluationisthedecreaseinvalueofexchangerate.• Floatingexchangerateisthevalueofexchangeratedeterminedby
marketforces.• Fixedexchangerateisthegovernmentcommittedtokeepingexchange
rateatsetvalue.• Hybridorsemi-fixedexchangerateisthegovernmentcommittedto
keepingexchangeratewithinacertainband/peg,e.g.£1=€1.1to€1.2.Itisamixtureoffloatingexchangeratesandfixedexchangerates.Itissometimesknownasa‘dirtyfloat’.
ExchangerateindexforthePoundSterling
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• Atrade-weightedindexmeansthatwemeasurethevalueoftheBritishPoundagainstabasketofcurrencies.
• Wegiveaweightingtothemostimportantcurrencies(e.g.theEuroandtheUSDollarwillhavethebiggestweightingbecausemosttradeiswiththeEurozoneandthentheUS).
• Thisexchangerateindexshowsa20%fallinthevalueofthePoundSterlingbetween2007and2009.
Factorsthatinfluenceexchangerates• Inflation.IfinflationintheUKisrelativelylowerthanelsewhere,UK
exportswillbecomemorecompetitive,andtherewillbeanincreaseindemandforPoundSterlingtobuyUKgoods.Countrieswithlowerinflationratestendtoseeanappreciationinthevalueoftheircurrency.Ifacountryengagedinquantitativeeasing(QE)thiscouldcreateinflationandthereforereducethevalueoftheexchangerate.
• InterestRates.IfUKinterestratesriserelativetoelsewhere,itwillbecomemoreattractivetodepositmoneyintheUK.Therefore,thedemandforSterlingwillrise,causing“hotmoneyflows”.Higherinterestratescauseanappreciation.
• Speculation.IfforeigncurrencydealersbecomepessimisticaboutthestateoftheUKeconomy,theymaysellSterling.Theycouldbecomepessimisticaboutprospectsforgrowth,highgovernmentdebt,andfutureinflation.SimilarlyifacountrylikeSwitzerlandwasseenasarelative‘safehaven’forsaving,itcouldleadtoariseindemandforSwissFrancsandcauseanappreciationintheSwissFranc.
• Balanceofpayments.Ifacountryhasalargecurrentaccountdeficit,itmaycausedepreciationbecausethereisanetoutflowofcurrency.
AppreciationintheexchangerateAnappreciationmeansthevalueofacurrencyincreases.Theeffectofthisis:
• Exportsmoreexpensive.Therefore,quantityofexportsfalls.• Importscheaper.Therefore,quantityofimportsrises.• LowerAD.Assumingdemandiselastic,anappreciationwillcauselower
aggregatedemandandlowereconomicgrowth.• Lowerinflation.Thisisdueto3reasons:
o Lowerimportpricese.g.fallingoilpricesfromtheappreciation.o LowerexportsandlowerAD,reducingdemandpullinflation.o Toremaincompetitive,firmshaveabiggerincentivetocutcosts.
• Worseningofcurrentaccount,e.g.biggerdeficit,becauseofdeclineinexportsandriseinquantityofimports.
• Foreigndirectinvestmentmayfall.Ariseintheexchangeratemaydiscourageforeigndirectinvestment(FDI),becauseitisnowmoreexpensiveforforeignfirmstoinvest.
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Evaluationofanappreciation• Dependsontheelasticityofdemandforimportsandexports.If
demandisinelastic,anappreciationwillhavelessimpactonreducingdemand.
• ItdependsonothercomponentsofAD.Anappreciationwon’tcauseafallinAD,ifconsumerspendingisgrowingstrongly.ConsumerspendingisabiggercomponentofADthannetexports.
• Timelags.Often,demandisinelasticintheshorttermandbecomesmoreelasticovertime.Therefore,anappreciationcouldhaveabiggerimpactovertime.
• Itdependsonproductivitygrowth.Iftheexchangerateappreciatesbecausefirmsarebecomingmoreproductive,thentheywillremaincompetitive.Iftheexchangerateappreciatesduetospeculation,firmsaremorelikelytobecomeuncompetitive.
o Forexample,countrieslikeGermanyandJapanhaveprospered,eveninperiodsofanappreciatingcurrency.
• Itdependsonthestateoftheeconomy.Iftheeconomyisgrowingstronglyandisnearfullcapacity,ariseintheexchangeratecouldhelpreduceinflationarypressureandkeepgrowthsustainable.Ifthereisalreadysparecapacity,thenanappreciationcouldleadtoarecession.
Theeffectsofanappreciationdependonthestateoftheeconomy.AfallinADtoAD2reducesinflation,withlittleeffectonrealGDP.
But,afallinADfromAD3toAD4,leadstoabigfallinrealGDP.
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Effects of a depreciation in exchange rate • Exportscheaperandmorecompetitive• Importsmoreexpensive• IncreasedADandhighereconomicgrowth• InflationmayriseduetohigherimportpricesandhigherAD.• Competitivenessimprovesintheshortterm;inthelongtermitmaynot
improveduetohigherinflation.
Government intervention in foreign exchange markets
InthisdiagramagovernmentbuyingPoundSterlinghasincreaseddemand(D1toD2)andincreasedthevalueofthe£.£1nowgivesmoredollars($1.70)
Methodsofgovernmentinterventioninforeignexchangemarkets
1. Buying/sellingcurrency.GovernmentscoulduseforeigncurrencyreservestobuyPoundsandincreasethevalueofthePound.Thoughforeigncurrencyreservesarelimited.
2. Changinginterestrates.ThegovernmentorCentralBankcouldincreaseinterestratestoincreasethevalueofthePound.
3. Improvingcompetitiveness.Thegovernmentcouldusedeflationaryfiscalpolicytoreduceinflationandimprovecompetitiveness.Itcouldalsotrysupply-sidepoliciestoimprovelong-runcompetitiveness.
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Advantages of fixed exchange rates • Providegreaterstabilityforfirmsinvolvedintrade,e.g.exportersdon’t
havetofeararapidappreciationwhichwouldreducetheirprofitability.• Canhelpreduceinflationascountrieshaveanaddeddisciplinetokeep
inflationlow,otherwisethecurrencywouldbeweaker.• Mayreducespeculationifmarketsbelievethecountrywillsticktoan
exchangerate.
Disadvantages of fixed exchange rates • Mayleadtotheexchangeratebeingovervalued,thiscanharmexports
andeconomicgrowth.• Maintainingafixedexchangeratemayrequirehighinterestrates(this
mayconflictwithotherobjectives,suchascausinglowergrowthandhigherunemployment).
• UKforcedoutofERMin1992,becausemarketsfelttheyhadjoinedatthewrongrate.GovernmentunabletomaintainvalueofPoundinERM.
Trade • Internationaltradeallowscountriestospecialiseingoodsandservices
whichtheyarerelativelybestatproducing.• Absoluteadvantage.Thisoccurswhenonecountrycanproduceagood
withfewerresourcesthananother.• Comparativeadvantage.Acountryhasacomparativeadvantageifitcan
produceagoodataloweropportunitycost,e.g.ithastoforegolessofothergoodsinordertoproduceit.
• Thelawofcomparativeadvantage.Thisstatesthattradecanbenefitallcountriesiftheyspecialiseinthegoodsinwhichtheyhaveacomparativeadvantage.
Restrictions on free trade Protectionisminvolvespoliciestorestricttrade.Thiscaninvolve:
• Highertariffs(typeoftaxonimports).• Non-tariffbarriers,e.g.theUShavechargesonpackagesundergrounds
of‘aviationsecurity’,andthisincreasesthecostsofimports.Otherrulesandregulationscanmaketrademoredifficult.
• Voluntaryexportrestraintiseffectivelyatypeofquotawherevoluntarylimitsareplacedonimportsofgoods.
• Embargo,e.g.USembargowithCuba.• Governmentsubsidy.Governmentsubsidieseffectivelygivethefirman
unfaircompetitiveadvantage.Thishasoftenoccurredwithnationalairlines.
• Distortedexchangerate.Keepingyourcurrencyartificiallylowmakesexportsrelativelymorecompetitive.
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Benefitsoffreetrade• Increasedexports.IfUKfirmshaveacomparativeadvantagethen,with
lowertariffs,theywillbeabletoexportmore,andcreatemorejobs.• Economiesofscale.Ifcountriescanspecialiseincertaingoods,theycan
benefitfromeconomiesofscaleandloweraveragecosts.Thisisespeciallytrueinindustrieswithhighfixedcosts,orthosethatrequirehighlevelsofinvestment.
• Tradeisanengineofgrowth.Worldtradehasincreasedbyanaverageof7%ayearsince1945;itisabigcontributortoglobaleconomicgrowth.
• Reducingtariffbarriersleadstotradecreation.Tradecreationoccurswhenconsumptionswitchesfromhighcostproducerstolowcostproducers,enablinganincreaseineconomicwelfare.
• Theremovaloftariffsleadstolowerpricesforconsumers(P1–P2)andanincreaseinconsumersurplus(1+2+3+4).
• Thegovernmentwilllosetaxrevenueofarea3.• Domesticfirmswillselllessandloseproducersurplusofarea1.• Therewillbeanincreaseinoveralleconomicwelfareof:(2+4).
• Increasedcompetition.Withmoretrade,domesticfirmswillfacemorecompetitionfromabroadand,therefore,therewillbemoreincentivestocutcostsandincreaseefficiency.Itmaypreventdomesticmonopoliesfromchargingtoohighprices.
• Makeuseofsurplusrawmaterials.Countrieswithlargereservesofrawmaterialsneedtradetobenefitfromtheirnaturalwealth.
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Argumentsforrestrictingtrade• Infantindustryargument.Ifdevelopingcountrieshaveindustries
thatarerelativelynewthen,atthatmoment,theseindustrieswouldstruggleagainstinternationalcompetition.Therefore,theyneedtariffprotectionwhiletheydeveloptheirindustriestobemorecompetitive.
• Thesenileindustryargument.Ifindustriesaredecliningandinefficient,theymayrequirealargeinvestmenttomakethemefficientagain.Protectionfortheseindustriescouldactasanincentiveforfirmstoinvestandreinventthemselves.
• Needtodiversifytheeconomy.Manydevelopingcountriesrelyonproducingprimaryproducts,inwhichtheycurrentlyhaveacomparativeadvantage.However,relyingonagriculturalproductshasseveraldisadvantages:
o Pricescanfluctuateduetoenvironmentalfactors.o Goodshavealowincomeelasticityofdemand.Therefore,even
witheconomicgrowth,demandwillonlyincreasealittle.
• Protectionagainstdumping.TheEUsoldalotofitsfoodsurplusfromtheCAPatverylowpricesontheworldmarket.Thiscausedproblemsforworldfarmersbecausetheysawabigfallintheirmarketprices.Tariffscanprotectagainstdumping.
• Environmental.Itisarguedthatfreetradecanharmtheenvironmentbecausecountrieswithstrictpollutioncontrolsmayfindthatconsumersimportthegoodsfromothercountrieswherelegislationislaxandpollutionisallowed.