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Unit 1 Markets and Market Failure
Topics • • • • • • • • • • • • • • • •
Nature of Economics Economic Objectives Scarcity / Choice / Opportunity Cost Production Possibility Frontiers Positive / Normative Economics Specialisation and division of labour Production Supply Demand Types of Goods Market Equilibrium Interrelationship between markets Elasticity Economies / diseconomies of Scale Inequalities in income / wealth Efficiency
Market Failure • • • • • • • • •
Monopoly Externalities Demerit / Merit goods Public Goods Immobilities of factors of production Government Intervention (price controls, buffer stocks, pollution permits, state provision, regulation Impact of Government Intervention Taxes and Subsidies Government Failure
Basic Economic Concepts Fundamental Economic Problem •
The central theme in economics is the production of goods and services to satisfy consumer needs. Generally, higher levels of production enable a higher level of economic welfare. Economics is concerned with the issue of scarcity. In society, resources are limited. Therefore we have to deal with three issues: o What to produce? o How to Produce? o For Whom to Produce?
Factors of Production • • • •
Land – raw materials. For example, coal, fish, wood Labour – workers able to participate in productive process Capital – machines and equipment used in the productive process to manufacture goods. Enterprise – the human initiative to set up business.
Other Terms • • •
Non-Renewable Resources. Natural resources which are finite. Once used they cannot be replaced. E.g., coal, oil and gas are all finite. Renewable resources. Resources that can be replenished. Examples include wood, fish, solar energy, water. Sustainable resources. Even renewable resources can be depleted, e.g. overfishing can deplete fish stocks. Sustainable use gives time for stocks to replenish. Opportunity cost This is the sacrifice of the next best alternative foregone, e.g. opportunity cost of buying a CD, is a book foregone. Because of scarcity we often face choices. E.g. if we increase production of goods, the opportunity cost may be depletion of the environment.
Positive / Normative Economics Positive economics: This is a statement based on facts and testable theories, e.g. - The inflation rate is 2%. - Labour is a factor of Production Normative economics: This is based on opinion or a value judgement, e.g: - The government should increase taxes on petrol. - The level of income inequality in society is unfair. • Often in economics, we face value judgements which people may disagree upon, e.g. people may disagree about the value of the environment compared to increasing output.
Production Possibility Frontiers (PPF) A PPF shows the maximum output that an economy can produce if the economy is maximising the use of its resources and operating efficiently.
Points on PPF Curve • •
D = inefficient (Within PPF) A or B = Productively efficient. It is impossible to choose more of consumer goods or environment units without an opportunity cost. C = impossible (without economic growth)
Opportunity Cost and PPF •
A PPF can be used to illustrate the concept of opportunity cost. For example, if we move from point A to B, we gain an extra 3 units of the environment. However, the opportunity cost is we have to forego 4 units of consumer goods.
Constant Returns •
The above diagrams show different slopes of PPFs In the first one the opportunity cost of increasing goods is always constant therefore we say it has constant returns.
In the diagram on the right, the opportunity cost increases – we have diminishing returns.
Economic Growth and PPF Economic growth requires an increase in the productive capacity of the economy. This could occur due to: • Discovering more raw materials • Increase in size of work force (e.g. immigration) • Increase in capital stock (machines / factories) • Increase in labour productivity (due to better technology) Economic growth will cause the PPF to shift to the right
Economic Objectives Traditionally, we assume economics is concerned with maximising consumption of goods and services. However, economic welfare includes more factors than just output and consumption. Other objectives for individuals could include • Quality of local environment (e.g. air quality) • Enjoying leisure time and not just working. • Access to amenities like education and health care. • Cultural activities (museums, sport) Firms main objective is to maximise profit. However, firms may also seek to: • Increase market share – gain a large volume of sales in the industry. • Workers in a firm may not be motivated by profit, but objectives such as enjoying work and social / environmental concerns. Governments main objective may be to increase economic welfare for society and overcome market failure, such as providing public services such
7 as health and education. They may have a varying degree of commitment to reducing inequality.
The individual demand curve illustrates the price people are willing to pay for a particular quantity of a good.
A change in price causes a MOVEMENT ALONG the Demand Curve, E.g. if there is an increase in price from p2 to p1 then there will be a fall in demand from Q2 to Q1 P
P1 P2 D2 D1 Q1
Shifts in the Demand Curve •
This occurs when, even at the same price, consumers are willing to buy a higher quantity of goods, e.g. demand shifts from D1 to D2
A shift to the right in the demand curve can occur for a number of reasons: 1. An increase in disposable income; this can occur for a variety of reasons such as higher wages and lower taxes 2. An increase in the quality of the good, e.g. computers are now more powerful. 3. Advertising can increase brand loyalty to the goods and increase demand 4. An increase in the price of substitutes, e.g. if the price of O2 Mobile phone calls increase the demand for Vodafone mobiles will increase. 5. A fall in the price of complements. E.g. a lower price of Play Station 2 will increase the demand for compatible games.
For some luxury goods income will be an important determinant of demand. e.g. if your income increased you would buy more CDs but probably not salt.
Advertising is important for goods in which branding is important, e.g. coca cola but not for bananas
Supply This refers to the quantity of a good that the producer plans to sell in the market. •
As price increases firms have an incentive to supply more because they get extra revenue (income) from selling the goods.
If price changes, there is a movement along the supply curve, e.g. a An increase in price from P1 to P2 causes an increase from Q1 to Q2. P
Shifts in the Supply curve An increase in supply occurs when more is supplied at each price, e.g. a shift in supply from S1 to S2. This could occur for the following reasons: 1. A decrease in costs of production; this means business can supply more at each price. Lower costs could be due to lower wages or lower raw material costs. 2. An increase in the number of producers will cause an increase in supply. 3. Expansion in capacity of existing firms, e.g. building a new factory. 4. An increase in supply of a complementary good, e.g. beef and leather. 5. Climatic conditions are very important for agricultural products 6. Improvements in technology, e.g. computers / internet. 7. Lower taxes reduce the cost of goods. 8. Increase in govt subsidies will also reduce the cost of goods
Market Equilibrium The Price Mechanism refers to how supply and demand interacts to set the market price and the amount of goods sold. â€˘
If price were below the equilibrium at P2 then demand would be greater than the supply. Therefore there is a shortage of (Q2 â€“ Q1)
Therefore firms will put up prices and supply more. As price rises there will be a movement along the demand curve and less will be demanded. P
Therefore price will rise to Pe until there is no shortage and Supply = Demand
Movements to a New Equilibrium If there was an increase in income the demand curve would shift to the right. Initially there would be a shortage of the good, therefore the Price and Quantity supplied will increase leading to a new equilibrium at Q2
The Price Mechanism Example: Factors that could explain a fall in the price of a good The price of a good, such as coffee, would fall if there was a fall in demand and / or an increase in supply.
The demand for coffee could fall for various reasons such as: i) ii) iii) iv) v)
Lower incomes mean that consumers cannot afford to buy as much Less fashionable Decrease in the price of substitutes such as tea Fall in number of coffee shops Health concerns about caffeine
The supply of coffee could increase for various reasons such as: i) ii) iii) iv)
Increase in the number of suppliers Lower costs of production Govt subsidies Higher labour productivity in producing coffee, this will decrease the costs of production
Economic effects of an increase in the Price of Coffee 1.
Q.D. will fall, but it will only be a small amount because demand is inelastic.
Demand for substitutes will increase; however there are not any close substitutes for coffee therefore this will not be very significant. If higher prices are caused by increased demand there will be an increase in income for firms producing and selling coffee.
Impact of New Supplier on Market •
A new supplier will cause supply to shift to the right and depress the market price. This could lead to lower profitability and could cause other firms to leave the market. However, if a new firms enter when demand is increasing, the price may stay the same.
New Supplier Entering the Market when Demand is Increasing
In this case, both supply and demand rise, leaving price unchanged.
• • •
Joint Demand – When a good is bought together with something else. E.g. strawberries and cream, iPad and Application for iPad. The goods are complements to each other. Substitute goods. Two alternative goods. E.g. a substitute for theTimes newspaper is the Guardian. Composite Demand. When a good is demand for two or more purposes. For example, oil can be used for both petrol and diesel. A cow could also be demanded for both milk and leather. Derived Demand. When a good is demanded for another reason. For example, transport is a derived demand. We demand a train in order to get to work. Firms demand workers because there is a demand for the good that they produce. Joint Supply. When two goods are supplied from same source, e.g. a sheep provides both mutton and wool.
Incentives and Price Signals
If a good became increasingly scarce, supply would fall leading to a higher price. This price would act as a signal to consumers to reduce demand and try and find alternatives. If consumers find alternatives, in the long term demand could become more elastic. To firms, the higher price makes production more profitable and therefore acts as an incentive to increase production. E.g. as oil prices rise, it encourages firms to try drilling oil from more difficult places like Siberia and the Antarctic. Therefore, in the long term higher prices may cause increased supply. In the long term, the higher price may encourage more suppliers into the market. The higher price of oil will affect related markets. For example, a rise in the price of oil, could lead to higher demand for bicycles and trains.
Impact of a Fall in Demand A fall in demand will cause a lower price. This lower price will reduce profitability. This may cause some firms to leave the market. Therefore, price will increase in long term as firms leave the market and find more attractive markets.
Government Intervention in Markets 1. Maximum Prices. Under certain circumstances the govt may wish to reduce the price below the market equilibrium. E.g. they could have a maximum price for renting houses. P S
Pe Max P
Problems of Maximum prices â€˘
The lower price will cause a shortage; therefore some tenants will be worse off because they cannot find any houses to rent. Therefore the govt would have to increase supply in order to overcome the shortage.
2. Minimum Prices This occurs when the govt wishes to raise the price above the equilibrium. For example in agricultural markets, the govt often wishes to increase the income of farmers by increasing the price of goods. P S
Min P Pe
Problem of Minimum Prices •
They encourage farmers to increase supply leading to a surplus which is not bought on the market. Therefore the govt is obliged to buy the surplus Q2- Q1 to maintain the target price.
3. Minimum Wages Minimum wages are a policy designed to increase the wages of the lowest paid, reducing relative poverty. In the UK, the NMW is £5.93 for people over 21. (2011) Wage
Min Wage We
If labour markets are competitive then a min wage could cause unemployment of Q2- Q1. However in the real world a minimum wage may not cause unemployment because: • Demand for labour may be very inelastic. (firms willing to pay higher wage) • A higher minimum wage may increase worker productivity. This is because, now wages are higher, workers may feel more loyalty to the company.
4. Buffer Stocks. This is a policy designed to stabilise prices primarily in agricultural markets. The purpose of buffer stocks is: i) ii) iii)
Protect farmers incomes by guaranteeing a min price Protect consumers from high prices by guaranteeing a maximum price level Ensure adequate supplies of food
• • •
Q1 Q2 If there was an increase in supply the equilibrium price would fall below the target price. To maintain the price at the target the govt will need to buy the surplus (Q2-Q1)* TP. This will effectively increase demand and therefore price. This excess supply could be stored in a buffer stock. If there was a shortage in the next year then the govt could sell from its buffer stock to reduce the price.
Problems of Buffer Stocks 1. It is expensive for the govt to buy the surplus and also to store it. 2. Some foodstuffs cannot be stored for a year. 3. The govt may have poor information about how much to buy, e.g. it may be difficult to know whether there is going to be a shortage. 4. A minimum price may encourage over supply amongst farmers.
Why Prices are Volatile In Agricultural Markets S1
i) Demand for agricultural products is inelastic, this is because they are a small % of total income. A lower price of potatoes wouldn’t really encourage people to eat more. ii) Supply is inelastic
iii) Supply can fluctuate due to variable factors such as the weather and disease Q
Advantages of Govt intervention in Agriculture: 1. 2. 3. 4. 5.
Stable prices help maintain farmers incomes. Stability enables investment in agriculture. Farming has positive externalities e.g. helps rural communities. Stable prices prevent excess prices for consumers. Food supplies are assured.
Disadvantages of govt intervention in Agriculture: 1. 2. 3. 4. 5. 6.
Cost of buying excess supply. Min prices and Buffer stocks encourage over supply. Govt subsidy to farmers may encourage inefficiency amongst farmers. Some goods cannot be stored in buffer stocks. Govts may have poor information e.g. what price to set. Administration costs.
Consumer and Producer Surplus
Consumer Surplus. This is the difference between the price consumers’ pay and the price they would be willing to pay. For example, if a book costs £10, but the demand curve shows they would have paid £16, the consumer surplus is £6. •
Monopolies are able to reduce consumer surplus because they charge consumers a higher price.
Producer Surplus. This is the difference between the price suppliers receive and the price they would have been willing to supply the good at. If the market price is £10, and their supply curve shows they would have supplied it at £8, they have producer surplus of £2. •
Monopolies can increase producer surplus because they can charge a higher price.
Elasticity Price Elasticity of Demand (PED) = % change in Quantity Demanded % change in Price
Elastic Demand Demand is elastic if a change in price leads to a bigger % change in demand. The PED will therefore be greater than -1. E.g. PED = -2.5
Elastic Demand PED > 1
Characteristics of Elastic Goods 1. Luxury goods (e.g. organic food) 2. They are expensive and a big % of income (e.g. sports cars and holidays) 3. Goods with many substitutes and a very competitive market. E.g. if Tesco put up the price of its bread there are many alternatives, so people would be more price sensitive. 4. Bought frequently.
Inelastic Demand •
Demand is inelastic if a change in price leads to a smaller % change in Q.D.
PED will be less than -1 e.g. -0.5 P
D D Q
19 Inelastic demand PED <1
Perfectly inelastic PED =0
Characteristics of Inelastic Goods • • • •
They have few or no close substitutes, e.g. alcohol, salt. They are necessities (petrol for cars) They are addictive (cigarettes) They cost a small % of income or are bought infrequently
In the short term demand is usually more inelastic because it takes time to find alternatives
Using Knowledge of Elasticity 1. If demand is inelastic then increasing the price can lead to an increase in revenue. This is why OPEC try to increase the price of oil. S2
Revenue was $15 * 100= $1,500
Revenue is now $30 * 80= $2,400 $15
PED = -20% / 100% = -0.2
D Q 80 100
Income Elasticity of Demand YED This measures the responsiveness of demand to a change in income. e.g. if your income increase by 5 % and your demand for mobile phones increased 20% then the YED = 20 / 5 = 4. Income Elasticity of Demand (YED) = % change in Q.D % change in Income •
Inferior Good This occurs when an increase in income leads to a fall in demand. It will have a negative YED. Examples include clothes from charity shops.
Normal Good This occurs when an increase in income leads to an increase in demand for the good, Therefore YED>0
Luxury Good This occurs when an increase in income causes a bigger % increase in demand, therefore YED >1. (Note a luxury good is also a normal good)
Income inelastic This means an increase in income leads to a smaller % increase in demand. Therefore 0 > YED < 1
Cross Elasticity of demand Cross Elasticity of Demand (XED)
= % change in Q.D good A % change in price good B
Substitute goods These are alternatives to a good. Therefore XED will be positive, Weak substitutes like tea and coffee will have a low XED. Tesco bread and Sainsburys bread are close substitutes so XED is higher
Complements goods These are goods which are used together. Therefore XED is negative. • E.g. If the price of DVD players fall, then there will be a increase in demand for DVD disks,
Price Elasticity of Supply This measures the % change in QS after a change in Price Price Elasticity of Supply PES = % change in QS % change in Price Inelastic Supply. This means that an increase in price leads to a smaller % change in supply. Therefore PES <1 P
Q Perfectly inelastic
Supply could be inelastic for the following reasons 1. Firms operating close to full capacity. 2. Firms have low levels of stocks, therefore there are no surplus goods to sell. 3. In the short term capital is fixed, therefore firms do not have time to build a bigger factory.
21 4. If it is difficult to employ factors of production, e.g. if skilled labour is needed. 5. With agricultural products supply is inelastic in the short run because it takes at least 6 months to grow crops.
Elastic Supply • This occurs when an increase in price leads to a bigger % increase in supply, therefore PES >1
Q Elastic Supply
Q Perfectly Elastic
Supply could be elastic for the following reasons: 1. If there is spare capacity in the factory 2. If there are stocks available 3. In the long run supply will be more elastic because capital can be varied. 4. If it is easy to employ more factors of production.
Multiple Choice Style Question PES is 2.0 for CDS: and the firm supplied 4,000 when the price was £30. Q.
If the price increased from £30 to £36, what will be the new Q? QS increases by 6, therefore as a % 6/30 = 0.2 = 20% •
2.0 = % change in QS 20
40 = % change in QS
Therefore new Q = 4000 *140/100
Specialisation Specialisation occurs when a country or firm concentrates on producing a particular good or service. • Countries will specialise in producing goods where they have a comparative advantage. For example, Japan specialises in producing high-tech electronic goods. Cuba specialised in producing sugar.
Division of Labour This occurs when workers concentrate on different tasks with a certain firm. • Rather than try to master all aspects of production, some workers will specialise in various aspects. • For example, in a car building firm, some will work on design, some on testing and some workers will just do unskilled jobs such as painting the car.
Advantages of Specialisation • • •
Firms can concentrate on producing goods where they are relatively most efficient. It means countries don’t have to produce every good they need, but can trade to increase overall economic welfare. By specialising in production, firms can benefit from economies of scale. This means lower average costs. This is important for industries with high fixed costs.
Problems of Specialisation •
Concentrating on producing a small number of goods can make an economy vulnerable. For example, if the sugar price falls, the Cuban economy suffers. Division of labour can make jobs highly specialised leading to boredom and diseconomies of scale.
Free Market Economy •
A free market economy occurs where there is an absence of government intervention. Firms are privately owned and decisions on what to produce and how to produce goods are left to market forces. Free markets tend to result in an efficient allocation of resources. However, they can also lead to monopoly power and great inequality. In a free market, many public goods will be not be provided
Mixed Economies A mixed economy involves a degree of government intervention. Many firms remain privately owned. However, the government: • Raises taxes e.g. VAT (indirect tax) and income tax (direct tax) • Provides services like health and education • Regulates industries, e.g. monopoly power and environmental laws.
Market Failure Market Failure
This occurs when there is an inefficient allocation of resources in a free market.
These occur when a third party is affected by the decisions and actions of others.
is the total benefit to society = Private Benefit (PMB) + External Benefit (XMB)
is the total cost to society = Private Cost (PMC) + External Cost (XMC)
occurs when resources are utilised in the most efficient way. This will occur at an output where Social Cost (SMC) = Social Benefit. (SMB)
Positive Externalities This occurs when the consumption or production of a good causes a benefit to a third party. •
When you consume education you get a private benefit. But there are also benefits to the rest of society, e.g. you are able to educate other people and therefore they benefit as a result
Therefore with positive externalities the benefit to society is greater than your personal benefit. Social Benefit > Private Benefit
Positive Externality P
S = PMC = SMC
SMB = Social Benefit D = PMB = Private Benefit Q
1 be Q In a free market consumptionQwill at se Q1 because private benefit = private cost.
However this is socially inefficient because Social Cost < Social Benefit. Therefore there is under consumption of the positive externality.
Social Efficiency would occur at Q se where Social Cost = Social Benefit.
For example: In the real world without govt intervention there would be too little education and public transport.
Negative Externalities: • • •
Negative externalities occur when the consumption or production of a good causes a harmful effect to a third party. For example, if you play loud music at night your neighbour may not be able to sleep. If you produce chemicals but cause pollution then local fishermen will not be able to catch fish. This loss of income will be the negative externality. Therefore with a negative externality, Social Cost > Private Cost
Negative Externality P
D = PMB = SMB
25 • • • •
In a free market people ignore the external costs to others therefore output will be Q1 where D=S. This is socially inefficient because at Q1: Social Cost > Social Benefit Social Efficiency occurs at Q se where Social Cost = Social Benefit E.g. In a free market there would be over consumption of cars and cigarettes.
Types of Market Failure 1. Externalities – Goods with negative / positive impacts on other people 2. Public Goods – goods usually not provided because no incentive to provide. 3. Merit / Demerit goods – people have poor information and make illinformed choices. 4. Information Asymmetries. – lack of information by one party. 5. Labour Immobility – difficulty in moving geographical area or retraining. 6. Inequality – inequality resulting from free market. 7. Monopoly – firms with the power to set higher prices to consumers
Information Asymmetries Information asymmetries occur when people lack information that other people possess. This lack of information can lead to poor decisions and market failure. Examples of market failure due to information asymmetries include: • Merit goods. People don’t appreciate or know the value of getting a vaccination or screened for cancer. • Demerit goods. People don’t appreciate or realise the true costs of drinking high quantities of alcohol. • Available jobs. Often people remain unemployed because they are unaware of job vacancies. This leads to frictional unemployment. • People don’t claim benefits that they are entitled to leading to more relative poverty.
Labour Immobilities Often unemployment is due to geographical immobilities. This occurs when it is difficult for workers to move between different regions to take up job vacancies in other parts of the country. Geographical immobilities may occur due to: • Difficult in buying house / renting in other parts of the country. • Family ties to existing area, e.g. children in school.
Occupational Immobilities Occupational immobilities occur when labour is unable to move between different occupations. For example, an unemployed coal miner may lack the skills to take new job vacancies in I.T.
Overcoming Immobilities Education and Training. To some extent workers can gain new skills and qualifications from government sponsored training schemes. • However, there is no guarantee people will be able to understand and pass on the new skills. They may be unable or unwilling to learn skills, especially if they are older. • Also there may be government failure, with the government lacking the right knowledge of which skills and qualifications to offer.
Government Intervention 1. Taxes
Tax on a negative externality P SMC = S + Tax S = PMC P2
P1 P0 D = PMB = SMB Q se • • • •
Tax = P2 –P0 : Supply curve shifts to the left Consumers now pay the social cost SMC Market price increase from P1 to P2 Output will now be Q se where SMC = SMB
DISADVANTAGES of taxes 1. Difficult to measure the level of negative externality e.g. what is the cost of pollution from a car? 2. If demand is inelastic then higher taxes will not reduce demand much. 3. Indirect taxes will cause inequality. (take a bigger % of income from the poor) 4. Cost of administration.
27 5. Possibility of evasion. E.g. with tax on disposing of rubbish there has been an increase in fly tipping (illegal dumping of rubbish)
ADVANTAGES of Taxes 1. Provides incentives to reduce the negative externality such as pollution. e.g. cars have become more fuel efficient 2. Social efficiency, 1st best solution.(where MSC = MSB) 3. Taxes raise revenue for the govt, which can be spent on alternatives
Impact of Tax and Elasticity This diagram shows how the impact of a tax depends on the elasticity of demand.
If demand is price inelastic, then a tax causes only a small % fall in demand. If demand is price elastic, then a tax causes a bigger % fall in demand and a smaller % rise in price.
2. Subsidies This involves the government paying part of the cost to the firm to encourage more consumption, therefore supply shifts to the right.
Subsidy on a Positive Externality P
S = PMC = SMC S2
P1 P0 SMB = Social Benefit D = PMB Q fm
• • •
Subsidy = P2- P0 The supply curve shifts to S2 and Price falls to P0 People will now consume more at Q se
Advantages of Subsidies 1. 2.
Increases social efficiency (increases output to Qse) Provides an alternative to negative externalities e.g. buses for cars
Disadvantages of Subsidies: 1. 2. 3.
Is expensive and the govt will have to increase taxes. Difficult to estimate the benefits of the positive externality and therefore it is difficult for the govt to know how much subsidy to give. Giving subsidies to firms may encourage inefficiency as the firms can rely on government aid.
3. Tradable Pollution Permits • • • •
These involve giving firms a legal right to pollute a certain amount, e.g. 100 units of Carbon Dioxide per year. If the firm produces less pollution it can sell its permits to other firms. However if it produces more pollution it has to buy permits off other firms. Therefore there will be a market for pollution permits. If firms pollute a lot there will be low supply and high demand, therefore the price will be high for permits. Therefore, there is an incentive for firms to cut pollution.
Problems of Tradable Permits • • •
Difficult to know how many permits to give. May be difficult to accurately measure pollution levels. There is an incentive for firms to hide pollution. Requires global co-operation to make it effective, otherwise industry will move to countries with lower environmental legislation.
29 High admin costs of measuring pollution
4. Laws Prohibiting undesirable behaviour E.g. Legal Age for smoking, ban on drink driving
Advantages of legal restrictions • • •
Simple and easy to understand When the danger is great, it may be better to ban it all together When a decision needs to be taken quickly, a tax may be too cumbersome
Disadvantages of legal restrictions There is little incentive for a firm to develop more efficient mechanisms It may be socially inefficient to ban everything
4. Advertising The govt could advertise the dangers of smoking and alcohol; this may overcome problems of poor information consumers may have about demerit goods. However consumers could still ignore the govt
Merit Good: i) ii)
This is a good with 2 characteristics
People do not realise the true benefit of consuming the good Usually these goods have positive externalities
In a free market they will be under consumed. Examples include health, education.
Demerit Good: i) ii)
This also has 2 characteristics:
People don’t realise or ignore the costs of consuming the good e.g. smoking, alcohol Usually these goods have negative externalities.
Therefore they are usually over consumed in a free market
Public Good: i)
These goods have two characteristics:
Non-rivalry: When a good is consumed, it doesn’t reduce the amount available for others. E.g. street lighting ii) Non- excludability: This occurs when it is not possible to provide a good without it thereby being possible for others to enjoy e.g national defence Therefore there is a free rider problem as people can consume without paying for them therefore in a free market they will not be provided.
Benefits of Govt providing Public Services 1. 2.
3. 4. 5.
Merit Goods: people do not realise or underestimate the benefits of education. Positive Externalities. The consumption of health care services has benefits to the rest of society. Therefore will be underprovided in the private sector. Economies of scale in providing National Service. Providing a universal service leads to greater equality of distribution. In a free market some would be unable to afford to pay. Minimum Service Standards: important for public services such as health. The private sector may cut costs by cutting quality of products
Government Failure â€˘
This occurs when govt intervention leads to an inefficient allocation of resources. E.g. it could fail to overcome market failure and / or lead to an inefficient allocation of resources. Govt failure can occur for various reasons: 1. Poor information. The govt may have poor info about the type of service to provide. 2. Political interference, e.g. politicians may take the short term view rather than considering long term effects. 3. Administration costs of govt bureaucracy in running public services. 4. Lack of incentives: There is no profit motive working in the public sector and this can lead to inefficiency. For example there could be overstaffing because there is no incentive to make redundancies.
Advantages of the private sector providing public services 1. Increased demands being placed on the public sector due to demographic changes. If more people went private this would enable the NHS to have shorter waiting lists 2. Provides consumers with more choice. 3. If less people use the NHS it would enable the government to lower taxes and reduce borrowing. 4. Private sector has profit incentive to cut costs and provide a more efficient service, e.g. public bodies may have over staffing because of political fears about job cuts. 5. Diseconomies of Scale in the NHS
Disadvantages of the private sector 1. It is difficult to introduce a profit motive into public services such as Health care, for example it is not practical to give performance related pay to nurses. Also the private sector may cut costs by reducing the quality of service.
31 2. May increase inequality. People on low incomes cannot afford private health. 3. Health is a merit good and will be underprovided in a free market. Therefore there is a justification for government subsidy.
Production and Productivity •
Production refers to goods and services produced by firms. Typically firms will use different factors of production (land, labour, capital and enterprise) to create goods. Productivity means the output per factor input in a certain period of time. For example, labour productivity refers to the output per worker, in a certain time frame.
Efficiency Productive Efficiency: This means it is impossible to produce more of one good than another this occurs on PPF. It will also occur at the lowest point on the firms short run average cost (AC) curve. Allocative Efficiency: This occurs when consumer preferences are met. This involves an optimal distribution of resources i.e. it is impossible to increase the economic welfare of on without reducing it for another. Economies of Scale: This occurs in the long run when increased output leads to lower average costs and therefore increased efficiency. E.g. by increasing output from Q1 to Q2 the firm is able to reduce Average costs from AC1 to AC2
£ LRAC = Total Cost Quantity
AC1 Long run average costs AC2
Types of Economies of Scale: 1. Specialization and division of labour: In large scale operations, workers can do more specific tasks. With little training they can become very proficient in their task; this enables greater efficiency and lower average costs. 2. Technical.
If a firm has high fixed costs, e.g. building a large factory, then the firm will reduce average costs if it makes better use of its existing capacity. Bulk buying: If you buy a large quantity then the average costs will be lower. This is because of lower transport costs and less packaging. Financial economies. A bigger firm can get a better rate of interest from a bank than small firms. Spreading overheads. If a firm merged it could rationalise its operational centres, e.g. it could have one head office rather than two. External economies of scale: This occurs when firms benefit from the whole industry getting bigger. For example, if an industry concentrates in one area, there will be better transport and communication in that area.
Diseconomies of Scale: This occurs when increased output leads to higher average costs. • This can occur due to factors such as difficulty of controlling and monitoring workers in a big firm. • Also in a big firm, which is highly specialised, workers may become alienated and bored with little motive to work hard. • A larger firm may experience difficulties communicating across the different aspects of the business.
Monopoly • This is a market structure with one dominant firm. • Monopoly power occurs when a firm controls over 25% of the market For a monopoly to occur there need to be barriers to entry, these are conditions which make it more difficult for a firm to enter a market: e.g. 1. Economies of Scale. A new firm would find it difficult to compete because its average costs would be much higher than the incumbent who has a higher output and lower average costs. 2. Natural / Geographical Barriers. Only a few countries can produce diamonds because they only occur in small parts of the world. 3. Brand Loyalty. Through advertising firms can differentiate their brand and encourage consumers to be loyal to the product. It makes it more difficult for new firms to enter because they would have to spend a lot of money on advertising which is a sunk cost. (non recoverable) 4. Vertical Integration. By controlling supplies, firms can deter entry. E.g. oil companies can limit supply of petrol to new petrol stations. 5. Legal Barriers. This prevents competition by law. For example a patent or government monopoly (like Royal Mail used to be)
Disadvantages of Monopolies 1. Higher Prices. Consumers have only a limited choice, therefore demand is inelastic. This enables the firm to increase prices, thereby causing a fall in consumer surplus. 2. Allocative inefficiency. Firms don’t respond to consumer needs and preferences. Therefore monopolies tend to be allocatively inefficient. 3. Productive inefficiency. Because competition is limited firms have less incentive to cut costs therefore could be productively inefficient. 4. Monopolies can pay lower prices to suppliers E.g. car companies with monopoly power can pay lower prices to suppliers. 5. Diseconomies of scale. If a firm gets too big and unwieldy, average costs will start to rise
Advantages of Monopolies 1. Economies of Scale. If there are high fixed costs in the industry the firm will be able to benefit from economies of scale and lower average costs as output increases. This enables lower prices for consumers. 2. Research and Development. A firm can use its supernormal profits to invest in new products which will benefit the consumer. This is important for many industries such as pharmaceuticals. 3. Some firms may gain monopoly power because they are efficient and innovative. E.g. Google is considered an innovative company; this gave it monopoly power in search engines. 4. International competition. A domestic monopoly may face competition from abroad.
Evaluation of Monopoly • •
In the real world, firms often have a degree of monopoly power. E.g. Tesco has approximately 32% of market share. Monopolies may face competition from similar industries. For example, Eurotunnel has a monopoly on train services to Paris, but there is competition from alternative types of transport (plane and ferry) which are fairly close substitutes.
Information Asymmetries. Information asymmetries occur when people lack information that other people possess. This lack of information can lead to poor decisions and market failure. Examples of market failure due to information asymmetries include: • Merit goods. People don’t appreciate or know the value of getting a vaccination or screened for cancer.
34 • • •
Demerit goods. People don’t appreciate or realise the true costs of drinking high quantities of alcohol. Available jobs. Often people remain unemployed because they are unaware of job vacancies. This leads to frictional unemployment. People don’t claim benefits that they are entitled to leading to more relative poverty.
Labour Immobilities Often unemployment is due to geographical immobilities. This occurs when it is difficult for workers to move between different regions to take up job vacancies in other parts of the country. Geographical immobilities may occur due to: • Difficult in buying house / renting in other parts of the country. • Family ties to existing area, e.g. children in school.
Occupational immobilities Occupational immobilities occur when labour is unable to move between different occupations. For example, an unemployed coal miner may lack the skills to take new job vacancies in I.T.
Overcoming Immobilities Education and Training. To some extent workers can gain new skills and qualifications from government sponsored training schemes. • However, there is no guarantee people will be able to understand and pass on the new skills. They may be unable or unwilling to learn skills, especially if they are older. • Also there may be government failure, with the government lacking the right knowledge of which skills and qualifications to offer.
In a free market, the ability to purchase goods depends on income and distribution of income. Often in a free market there is inequality, for example, those who are unemployed or have low-income may struggle to purchase sufficient goods and services. This inequality is considered a form of market failure. Income Inequality. Income is known as a flow. It is a payment received per time period, for example, an annual salary or weekly wage. Wealth inequality. Wealth is known as a stock. It is fixed at a certain period of time. Wealth is comprised of assets such as property, stocks and bonds. Assets which can be converted into money. The government may seek to overcome inequality through taxes and benefits, and the provision of public services such as health and education.
Q. Discuss whether govt subsidies to bus companies would increase economic welfare? Subsidies involve the govt paying part of the firms cost therefore Supply shifts to the right and leads to an increase in demand. Buses have positive externalities. This means that when you travel by bus there is a benefit to a third party. For example if you travel by bus rather than car there will be a fall in pollution and congestion. Congestion costs the economy a lot because firms have an increase in costs and there is lost. Therefore the Social Benefit of travelling by bus is greater than the private benefit. However in a free market people ignore the social benefit therefore there is under consumption P
S = PMC Sâ€™ = S+ sub
Subsidy = Ps â€“ P2
Ps P1 SMB
P2 D = PMB
In a free market the equilibrium output will be at Q1 where PMB = PMC. However social efficiency occurs at Q2 where SMC = SMB. Therefore there is a case for subsidising the buses to overcome market failure. A subsidy of (Ps â€“ P2) will shift supply to the right and increase demand to the socially efficient level Another argument for subsidising buses is that it is an important public service and it is important to ensure that all groups of people are able to use it, therefore the govt could subsidise cheap tickets for poor people to ensure greater equality. However the problem with subsidising buses is that giving subsidises to bus firms may encourage them to be inefficient. This is because the company has less need to cut costs because it can get money from the govt. However this may not necessarily occur, it could depend on how competitive the bus industry was. Subsidising buses will mean the govt will have to increase taxes; this could cause disincentives in the economy, because higher taxes may reduce
36 incentives to work. However this problem could be overcome by taxing goods with negative externalities like cars. Another problem with govt intervention is that the govt may have poor information about how much to subsidise and who to give it to. Politicians are usually worse at making economic decisions because they do not have economic pressure but political pressures. A more significant problem is that demand for buses may be very inelastic. Buses only go certain routes therefore it is less suitable for some people, therefore making buses cheaper may not increase demand, it may be necessary to also increase the range of bus services and make them more attractive to consumers. To conclude there is a good economic reason to subsidise buses but the govt will need to be careful that it gives the correct amount and that it is not wasted. Furthermore to reduce congestion, it may be necessary to adopt other measures such as taxing cars.
Unit 2 The National Economy (ECON 2)
Contents Macro economic Objectives Economic Indicators Economic Cycle Aggregate Demand Aggregate Supply Economic Growth Costs and benefits of growth Comparison of Living Standards Measures of Economic Development Inflation and Deflation Supply side policies Unemployment Fiscal Policy Multiplier Effect Monetary Policy Exchange Rates • Balance of Payments on Current Account • • • • • • • • • • • • • • • •
Macro Economic Objectives 1. 2. 3. 4. 5. 6.
Sustainable Economic Growth Low unemployment Control of inflation. (Inflation target is CPI = 2%, +/-1) Satisfactory Balance of Payments Supporting a stable exchange rate Low government borrowing
Lesser objectives include: • Improving the environment • Improving equality of income distribution.
GDP and National Income •
Nominal GDP A Measure of national income, output and expenditure. This is the monetary value of all goods and services produced in the economy
• • •
Real GDP This is National income measured in constant prices. Real GDP = Nominal GDP *100/ price index Real GDP per Capita = This is the Real GDP / population
Common Terms in Macro Economics •
• • • • • •
Investment – spending on capital goods like machines and factories. Note don’t confuse with saving money in a bank. In economics, saving is not considered to be investment. Real Wages – Nominal wages adjusted for inflation Index Numbers – Data is often presented using index numbers. It is a method to show the percentage change in a data index. The index is started in a base year (100). Changes are then shown from this starting point. Labour productivity: This refers to output per worker Output Gap. A positive output gap means output (GDP) is above potential (growth above long run trend rate. A negative output gap means there is spare capacity – output less than potential. Recession – a period of negative economic growth Boom – A period of rapid economic growth Economic Cycle – the cyclical nature of economic growth. Lead variables: Indicators which predict future economic trends Lag Variables: These are indicators, which tend to follow economic cycles Savings Ratio This is the % of a person’s income that is not spent but saved
Aggregate Demand AD = C+I+G+(X-M) : AD is the total demand for goods and services. It includes: • • • • •
C = Consumer expenditure on goods and services. I = Gross Capital Investment (spending on capital goods) G = Government Spending X = Exports M = Imports
An increase in AD (shift to the right) could be caused by a variety of factors: 1. Increased Consumption: due to i) An increase in consumers’ wealth which gives them more confidence to spend. They can also re-mortgage their house ii) Lower Interest Rates. This makes borrowing cheaper and encourages people to spend iii) Higher wages which increase disposable income. iv) Lower Taxes which increase disposable income v) Increased consumer confidence about the future. This encourages people to spend. Consumer Expenditure accounts for about 66% of AD and therefore is a very important component of AD. 2. Increased Investment: Investment is spending on fixed capital like machines. This could increase due to: i) Lower interest rates, this makes borrowing for investment cheaper ii) Increased confidence in the economic outlook. iii) Improved technology making investment more efficient. iv) Increased economic growth. 3. Increased Government spending. E.g. spending on education and transport. 4. Increased exports i) Increased growth in other countries, ii) Lower value of Sterling, this makes exports cheaper 5. Decreased M i) UK more competitive ii) Lower value of sterling which makes imports more expensive.
Aggregate Supply AS Short Run Aggregate Supply curve SRAS. Shifts in the AS can be caused by:
SRAS 1 SRAS 2
1. Changes in Labour costs 2. Changes in Raw Material costs 3. Taxation and subsidies A fall in oil prices would cause SRAS to shift to right (SRAS 1 to SRAS2)
Real GDP Y Long Run Aggregate Supply Curve LRAS In the Long Run, classical economists argue that the productive capacity of the economy is determine by factors other than price and demand. They argue that in the long run AS is determined by: CLASSICAL VIEW 1. 2. 3. 4. 5. 6. 7. 8.
The Labour Force The Capital Stock Available Land Technology Productivity Enterprise Attitudes to work Strength of banking system e.t.c
KEYNESIAN VIEW PL •
Keynesians believe that in the long run there can be spare capacity in the economy
Therefore they argue that the LRAS can be elastic when there is a recession
AD2 AD1 Y
Economic Growth •
• • • •
Economic growth means an increase in real GDP. An increase in GDP means an increase in the volume of goods and services produced in an economy. The rate of economic growth measures the annual % change in real GDP An increase in the productive capacity (LRAS) of an economy is known as an increase in potential growth. The Long Run Trend Rate of Economic Growth: This is the sustainable rate of economic growth in an economy. For example in the UK this is about 2.5%. The trend rate of growth is related to the increase in LRAS.
Benefits Of Economic Growth: 1. 2. 3. 4. 5.
Higher Incomes. Consumers will be able to enjoy more goods and services Lower unemployment: With higher output firms will employ more workers. A sustained period of economic growth will lead to lower unemployment. Lower Government Borrowing. Economic growth creates higher tax revenues and there is less need to spend money on unemployment benefits. This reduces government borrowing. Improved public services. With higher tax receipts more can be spent on health care and education. Firms make more profit. Firms will make higher profit; this may encourage more investment, which leads to a virtuous circle of higher growth.
Costs Of Economic Growth: 1.
2. 3. 4.
Inflation. If AD increases faster than AS then economic growth will be unsustainable and inflationary. There will be a negative output gap and firms will respond by putting up prices. However, if growth is not above the trend rate and AD increases at the same rate as AS, growth will not cause inflation. Boom and Bust Economic Cycles. If economic growth is unsustainable then high inflationary growth may be followed by a recession. This occurred in the late 1980s and recession of 1991. Balance Of Payments Deficit. Higher consumer spending causes an increase in imports therefore causing a deficit on the current account. However, if growth is export led, this will not occur. Environmental Costs. Increased economic growth will lead to increased output and therefore will cause increased pollution and congestion which reduces living standards. However, higher growth may enable more resources to be spent on the environment. Increased Inequality: Higher rates of economic growth have often resulted in increased inequality. Those with wealth and income are often in a position to benefit more from economic growth than others. However this depends upon things such as tax rates and the nature of economic growth. Economic growth can also be a way to reduce relative poverty.
Therefore an increase in income doesn’t necessarily increase living standards.
Circular Flow of Income
The circular flow of income shows how money flows from households to firms (to buy goods). Then firms pay households wages to produce goods. It shows three ways to calculate GDP. 1) Total National income (wages, dividends,) 2) Total National expenditure (consumption and investment) 3) Total National output (value of goods and services produced) Injections This is an increase of expenditure into the circular flow of income, leading to an increase in Aggregate Demand. Injections can include: • • •
Exports – spending from abroad on domestic goods. Government spending. Investment. Spending on capital goods by firms.
Withdrawals A reduction of money in the circular flow. Withdrawals can include: • • •
Saving – depositing money in banks Imports – spending on foreign goods Taxation – Government raising money from consumers and firms.
Causes of Economic Growth. Short Term - Increased AD â€˘ If there is spare capacity in the economy an increase in AD will cause an increase in Real GDP. â€˘ An increase in AD could occur for various reasons such as lower interest rates, increased wages or higher govt spending PL
AD2 AD1 Y Y1
Long Term Economic Growth Long run economic growth requires an increase in the LRAS as well as AD. LRAS or potential growth can increase for the following reasons: 1. 2. 3. 4. 5.
Increased capital e.g. investment in new factories or investment in infrastructures such as roads and telephones. Increase in working population (e.g. immigration or later retirement age) Increase in Labour productivity, through better education and training Producing more raw materials (e.g. discovering oil deposits) Technological improvements to improve the productivity of capital e.g. microchips and the internet have both contributed to economic growth. PL
Long Term Economic Growth P1 AD Y
Trends in Economic Growth
The average sustainable growth rate in the UK is about 2.5% (average quarterly growth rate = 0.7%) In the late 1980s, the UK experienced rapid growth, but this caused inflation and the growth was unsustainable. To reduce inflation, the government increased interest rates and this caused the recession of 1990-91.
Fall in Growth Rate •
Between 1987 Q3 and 1989 Q3 there is a fall in the growth rate. This means Real GDP increased at a slower rate. GDP only falls if there is a negative growth rate, e.g. 1990 and 2008.
Sustainable Growth •
Sustainable economic growth means that the growth can be maintained for a long time. It implies that inflation will remain low and AD increases at a similar rate to AS. It may also refer to environmental sustainability.
Output Gap •
The output gap is the difference between potential GDP and actual GDP.
45 A negative output gap implies that actual GDP is less than potential. (e.g. in a recession, with spare capacity and high unemployment) A positive output gap occurs when actual GDP is above the sustainable potential. A positive output gap leads to inflation.
Long Term Effects on Growth In the long term, economic growth can be influenced by demographic factors (population growth and immigration)
Impact of Immigration on Economic Growth Immigration leads to an increase in the working population. This will lead to: • •
Increase in Aggregate Demand (AD) The new population will increase total spending in the economy. Increase in Aggregate Supply (AS). Immigrant workers will increase the size of the working population and enable more productive capacity.
Net migration will tend to increase Real GDP, but Real GDP per capita is likely to stay the same. The effect of immigration depends on the type of immigration. If the workers are highly skilled then there will be a bigger increase in productive capacity. However, if the immigrants are not of working age, the increase in AS will be less.
Global Nature of Growth •
The UK is affected by the performance of other economies. For example, if the EU entered a recession, it would affect UK exports. It would be quite significant because approx.. 60% of UK exports is to the EU. Therefore, the UK is likely to experience lower growth. Some countries’ economic growth is largely based on exports. For example, China’s economic growth is largely based on exports of
46 manufactured goods. In the UK, exports are typically a much smaller % of AD. In the past, UK growth has often been consumer led.
Inflation â€˘ Inflation means a sustained increase in the general price level â€˘ If there is inflation the value of money declines and there is an increase in the cost of living.
- Consumer Price Index
1. Household expendiure survey - This seeks to measure what people spend their money on. From this we get a typical basket of goods which is used to measure typical prices. 2. This basket of goods gives a relative importance to each different item. E.g. if price of petrol increased this would have more effect than an increase in the price radios because petrol has a higher weighting. 3. The basket of goods is updated each year to take into account changes in expenditure 4. Every month changes in prices of goods and services are monitored and combined into a single figure with using the weights in the basket.
Problems with Calculating CPI 1. Family Expenditure survey does not include everybody, e.g pensioners are excluded, but pensioners have different spending habits e.g. heating is more important. Young people will benefit more from falling prices of mobile phones. 2. Changes in Quality: Computers have many more features than 10 years ago, so it is difficult to compare prices because they are different goods. 3. Ignores housing costs and is often lower than old Retail Price Index (RPI) method.
Costs of Inflation 1.
Cost of reducing inflation: High inflation is deemed unacceptable therefore governments feel it is best to reduce it. This will involve higher interest rates, the reduction in AD will lead to a decline in economic growth and unemployment International competitiveness: Higher prices will make British goods less competitive, leading to a fall in exports. However this may be offset by a decline in the exchange rate Confusion and Uncertainty: When inflation is high people are uncertain what to spend their money on. Also, when inflation is high firms may be less willing to invest because they are uncertain about future profits.
47 4. 5.
Menu Costs. This is the cost of changing price lists Income redistribution. Borrowers will become better off, lenders will become worse off, however it depends on the real rate of interest.
Causes of Inflation 1.Demand Pull inflation â€˘
If AD increases faster than AS inflation will occur LRAS
P2 P AD2 AD1
2. Cost Push Inflation
If there is an increase in the costs of firms then AS will shift to the left causing inflation. This can be caused by:
1. Wage Push Inflation . Trades unions can bargain for higher wages, this will lead to an increase in costs for firms. It may also cause demand-pull inflation as consumers spend more increasing AD.
2. Import prices. One third of all goods are imported in the UK. If there is a devaluation then import prices will become more expensive leading to an increase in inflation. 3. Raw Material Prices If raw materials such as oil prices increase then this will have a significant impact on costs and inflation. 4. Declining productivity. Lower productivity increases costs.
Supply Side Policies Supply side policies are government attempts to increase productivity and shift AS to the right. Supply side policies can help the economy in various ways: 1. 2.
Lower Inflation. Shifting AS to the right will cause a lower price level. Lower Unemployment Supply side policies can help reduce structural, frictional and real wage unemployment. Improved economic growth Supply side policies will increase economic growth by increasing AS Improved trade and Balance of Payments. By making firms more competitive they will be able to export more.
Diagram of Supply Side Policies
If successful, supply side policies will shift the LRAS to the right.
Examples of Supply Side Policies 1. Privatisation. This involves selling state owned assets to the private sector. It is argued that the private sector is more efficient in running businesses because they have a profit motive to reduce costs and develop better services. 2. Deregulation This involves reducing barriers to entry in order to make the market more competitive. For example, UK telecoms markets are now more competitive and this has helped reduce prices and increase efficiency. 3. Reducing Taxes. It is argued that lower taxes (income and corporation) increase incentives for people to work harder, leading to higher output. 4. Increased education and training Better education can improve labour productivity and increase AS. Often there is under provision of education in a free market, leading to market failure. Therefore the govt may need to subsidise suitable training schemes. 5. Reducing State Welfare Benefits Lower unemployment benefits may create a bigger incentive for people to look for work and stay off benefits 6. Providing better information about available jobs. 7. Improving Transport and infrastructure. In a free market there is likely to be under provision of public transport. If transport networks were improved firms would benefit from lower costs. 8. Reduced bureaucracy for Firms. If rules and regulations are removed then firms will have lower costs and be more productive.
Evaluation of Supply side policies 1. They will take time to have effect, e.g. it will take several years to create a more educated workforce. 2. It will cost money to improve information and education and therefore taxes will need to rise. 3. Lower benefits and reduced Minimum wages may cause poverty to increase. 4. Govt failure may occur, this is because the govt may have poor info about what to spend money on, e.g. the govt may finance the wrong kind of scheme. 5. In a recession, increasing AS may be insufficient. It also requires an increase in Aggregate Demand.
Unemployment Economic Costs of Unemployment 1. 2. 3. 4.
Loss of earnings to the unemployed More difficult to get work in the future Stress and Health problems of being unemployed Increased govt borrowing: Tax revenue falls, spending on benefits rises. 5. Lower GDP for the economy, this is Pareto inefficient.
Measuring Unemployment 1. Claimant Count Method. This is the govt official method of calculating unemployment. It counts the number of people receiving benefits (Job Seekers allowance) Problems with Claimant count o The Count excludes those over 60, under 18, those on govt training schemes, and married women looking to return to work o Some people may claim benefits whilst still working in the “black Market” 2. The Labour Force Survey. This is a survey asking 60,000 people whether they are unemployed and whether they are looking for a job. It includes some people not eligible for benefits
Types of Unemployment 1.
Frictional Unemployment: •
This is unemployment caused by people moving in between jobs, e.g. graduates or people changing jobs. There will always be some frictional unemployment.
Also high benefits may encourage people to stay on benefits rather than get work this is sometimes known as “voluntary unemployment”
Structural Unemployment •
This occurs due to a mismatch of skills in the labour market it can be caused by 1. Occupational immobilities. This refers to the difficulties in learning new skills applicable to a new industry, and technological change. 2. Geographical Immobilities. This refers to the difficulty in moving regions to get a job.
Classical or Real Wage Unemployment: •
This occurs when wages in a competitive labour market are pushed above the equilibrium. This could be caused by minimum wages or trades unions. S
Wag e Wtu
D Ql Q1
4. Demand Deficient or “Cyclical Unemployment” •
This occurs when the economy is operating below full capacity. In a recession when AD falls there is a fall in output therefore firms will employ less workers. Some firms will go bankrupt leading to more unemployment. Price Level
Y Y2 â€˘
Demand deficient unemployment is often the biggest cause of unemployment in the UK. E.g. after recession of 1991 and 2009, unemployment rose close to 3 million.
Policies To Reduce Unemployment 1.
Fiscal and Monetary Policy This involves cutting interest rate or taxes to increase AD. Higher output will cause firms to demand more workers. This will be effective for reducing demand deficient unemployment. Price Level
P2 P1 AD2 AD1 Y Y1
However demand side policies may cause higher rates of inflation and will not reduce supply side unemployment.
Lower benefits and taxes. These increase the incentive for the unemployed to look for work rather than stay on benefits. This will reduce frictional unemployment, but will cause a fall in AD and increase relative poverty.
Better job information. This could help reduce frictional unemployment by giving the unemployed better information about available job vacancies.
Education and Training. By improving labour productivity and the skills of the workforce there will be a reduction in occupational immobilities making it easier for workers to switch jobs. However this will cost the govt money, also there could be govt failure with the wrong kind of training subsidised.
53 5. Reform Trades Unions and reduce Minimum Wages This will help reduce real wage unemployment. o However the effect on employment may be small if demand for labour is inelastic. 6.
Regional Grants These can help overcome geographical unemployment by encouraging firms or workers to move. However subsidies may prove ineffective for encouraging workers to move because they may be attached to their local community
Monetary Policy This involves changing the interest rate or manipulation of the Money Supply by the monetary authorities. • In the UK, monetary policy is managed by the Bank of England, Monetary Policy Committee (MPC).
Aim of Monetary policy 1. 2. 3.
Control the rate of inflation. Inflation target for MPC is - 2.0% +/-1 Maintain sustainable economic growth. Influence the Exchange rate
UK Monetary Policy •
Every month, the MPC meet to decide future interest rates. If they feel the inflation rate is likely go above the target (e.g. due to a higher rate of economic growth) then they will increase interest rates to moderate demand and keep inflation low. If the MPC feel inflation is likely to fall below the target and there is slow economic growth, they are likely to decrease interest rates to boost economic growth and prevent unemployment. To determine future inflation, the MPC will look at various statistics such as o The rate of economic growth compared to long run trend rate. – If growth is faster than trend rate, inflation is likely to occur. o Wage growth. Higher wage growth can cause both cost push and demand pull inflation. o Temporary factors like tax rises and commodity price rises will be given less importance because they do not indicate underlying inflation o Unemployment. High unemployment will tend to reduce wage inflation and so the MPC is more likely to cut rates to boost AD.
Effect of Higher Interest Rates. (Tight monetary policy) If inflation is forecast to rise above the inflation target, the MPC are likely to increase interest rates. This will help reduce AD and inflation because higher interest rates:
54 1. 2. 3.
Makes borrowing more expensive, therefore people spend less on credit. Firms will be less willing to invest by borrowing money. The cost of mortgages increases, therefore people have less disposable income causing a fall in consumption. Therefore AD decreases Saving money in a bank is more attractive therefore there is less spending and relatively more saving Exchange rate increases, due to hot money flows into the UK (people take advantage of a better rate of return on UK savings. The appreciation in the exchange rate makes exports more expensive and depresses demand for UK exports
Evaluation of Monetary Policy 1. The effect of higher interest rates depends on the situation of the economy. If the economy is close to full employment, a rise in interest rates is likely to reduce inflation significantly without reducing Real GDP.
However if the economy has spare capacity, (e.g. at Y3 to Y4) reduced AD may not reduce inflation but only reduce GDP
2. The effectiveness of Monetary policy depends upon other variables in the economy e.g. a) If confidence is low, a reduction in interest rates may not increase demand b) If taxes are rising this may counter a fall in interest rates c) If the world economy is slowing this will reduce exports and AD, this would keep spending low even if there was a fall in interest rates 3. There may be time lags for lower interest rates to have an effect. E.g. higher interest rates may not reduce investment in the short term because firms will continue with existing investment projects
4. Monetary policy may conflict with other macro economic objectives. If the MPC reduces inflation this may lead to lower growth or higher unemployment. The below diagram shows the effect of higher interest rates in leading to lower growth.
5. Interest rates may conflict with the exchange rate. If the Bank increased interest rate this would cause a fall in AD but also would cause an increase in the exchange rate (due to hot money flows). This would make exports more expensive and lead to lower demand for exports. 6. Monetary Policy may also affect the Balance of Payments. If AD falls people buy less imports, improving the current account â€˘ However if interest rates increase the exchange rate will and may lead to a worsening of the deficit, because exports are more expensive. 7. Fine Control of Monetary Policy is not possible. It is difficult to get accurate information about the economy. Time lags in policy mean interest rates affect the economy too late 8. Monetary Policy will have a big effect on the housing market. This is because interest rates effect mortgage payments. E.g. an increase in interest rates will reduce the attractiveness of buying a house. Thus interest rates will have a bigger effect on homeowners. 9. Stagflation. In some circumstances there may be higher inflation and higher unemployment. For example, due to a rise in oil prices. This presents the MPC with a dilemma. To reduce inflation, they need to increase interest rates. However, higher interest rates will also cause a further fall in economic growth and unemployment. 10. Redistribution of Income. Higher interest rates improve income of savers but worsen incomes of borrowers.
Fiscal Policy Fiscal Policy involves the government changing the levels of Taxation and Govt Spending in order to influence AD. The purpose of Fiscal Policy is to: 1. Maintain low inflation 2. Stimulate economic growth in a period of a recession • •
Expansionary or loose fiscal policy – involves lower tax, higher spending to increase AD. Deflationary or tight fiscal policy – involves higher tax and lower spending to reduce AD.
Evaluation of Fiscal Policy 1. Poor info may reduce accuracy of forecasting economic growth and inflation 2. It depends on other components of AD, e.g. consumer confidence. For example, if the government cut income tax to increase AD, it may be ineffective if confidence is low and people just save the extra income 3. Higher Taxes can create disincentives to work, reducing productivity and AS. 4. Time lag involved in increasing AD. 5. Expansionary fiscal policy (higher spending, lower tax) will increase government borrowing. This could lead to higher interest rates in the long term. 6. Fiscal policy could be used in association with helping environment. E.g. to stimulate economic growth, the government could build new train lines which help reduce pollution. 7. To reduce inflation, the government may increase tax to reduce disposable income. However, if they increase tax on specific goods (e.g. petrol tax), this will lead to temporary inflation because goods are more expensive. It will reduce inflation in the long term.
The Multiplier This states that if there is an initial injection (e.g. higher govt spending) into the economy, then the final increase in AD and Real GDP will be greater. • The size of the multiplier depends on the marginal propensity to consume. • If people spend a high % of extra income, then the multiplier effect will be bigger.
57 • •
If people save a high % of an increase in income, the multiplier effect will be limited. If there is a large multiplier effect, then an increase in injections (e.g. investment) will cause a bigger % increase in investment.
Evaluation of Multiplier effect 1. 2. 3.
At full capacity an increase in AD may cause inflation and not an increase in Real GDP. There may be significant time lags. E.g. an increase in investment may take time to lead to higher AD. If consumers spend a high % of income on imports, this is a leakage and will not increase AD.
Budget Deficit A budget deficit occurs when government spending is greater than tax revenues. Therefore the government has to make up the shortfall by borrowing from the private sector. • Public sector net Borrowing (PSNB). The annual amount the government needs to borrow • Public Sector Net Debt PSND (The National Debt): This is the total (cumulative) amount of debt that the government owes the private sector at the moment this is over £800bn (or 57% of GDP) • Annual interest payments on the debt are close to £40bn • (N.B. Don’t get a government budget deficit confused with the Trade Deficit which occurs when imports are greater than exports)
Problems of a Government Borrowing 1. 2. 3.
National Debt will increase leading to higher debt payments in the future Govt may have to increase taxes in the future which may create disincentives to work. Govt may have to cut govt spending which leads to deterioration in public services. (for more details see: A2 notes)
Why Borrowing Occurs •
Cyclical Factors. In a recession, government borrowing increases. They receive lower tax receipts (people pay les income tax and less VAT). But, they have to spend more on unemployment benefits Structural Factors. The government may plan to spend more than tax. This could be investment, ev. Spending on public transport or due to aging population.
58 In a recession, government borrowing is helpful in providing an injection into economy and leading to higher AD.
Exchange Rates •
An appreciation in the exchange rate means the currency increases in value. If the £ Pound Sterling appreciates, it means £1 will gain relatively more Euros and dollars. A depreciation means the currency is worth less. It means that £1 will gain relatively fewer Euros and dollars.
Economic Effect of a Devaluation of the Currency 1. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports 2. Imports will become more expensive. This will reduce demand for imports 3. Inflation is likely to occur because: o Imports are more expensive o AD is increasing o With exports becoming cheaper manufacturers may have less incentive to cut costs and become more efficient 4. AD = X-M Therefore higher exports and lower imports will increase AD LRAS
P2 P1 AD2 AD1 Y Y1 • •
Higher AD is likely to cause higher Real GDP and inflation. The size of this increase depends upon factors such as a) Spare capacity in the economy b) Other determinants of AD
59 1. Current Account. There is likely to be an improvement in the current account balance of payments. This is because quantity of exports are increasing and imports are falling Evaluation: The impact on the current account depends upon the elasticity of demand for exports and imports. If demand for exports is inelastic, a depreciation will only cause a small increase in quantity.
Economic Effects of an Appreciation 1. 2. 3. 4.
Exports more expensive, therefore less UK exports will be demanded Imports are cheaper, therefore more imports will be bought. A fall in AD, causing lower growth Lower inflation because: o import prices are cheaper o Lower AD o More incentives to cut costs 5. Current account deficit will tend to deteriorate. In a period of high growth and high inflation, an appreciation may help. In a recession an appreciation is likely to lead to lower growth and higher unemployment.
Balance Of Payments The Balance of Payments is a record of a countryâ€™s transactions with the rest of the world. It shows the receipts from trade. It consists of the current and financial account 1. Current account i) Balance of trade in goods ii) Balance of trade in services insurance iii) Net income flows income) iv) Net current transfers payments to EU)
(visible) (invisibles) e.g. tourism,
(wages and investment (e.g. govt aid,
2. Financial account (note this used to be called the Capital Account) This is a record of all transactions for financial investment. It includes financial flows and net investment
Factors which cause a current account deficit 1.
Overvalued Exchange Rate If the currency is overvalued, imports will be cheaper and therefore there will be a higher Q of imports. Exports will become uncompetitive and therefore there will be a fall in the quantity of exports.
60 If there is an increase in AD and National Income increases, people will have more disposable income to consume goods. If domestic producers cannot meet the domestic AD, consumers will have to imports goods from abroad. 3.
Decline in Competitiveness. If there is high inflation or a decline in productivity there will be less demand for UK exports and British consumers will prefer buying imports.
Policies to reduce a balance of Payments Deficit 1. Devaluation. • This involves lowering the value of the currency against others, making exports cheaper and imports more expensive. • Therefore we would expect a devaluation to lead to an improvement in the current account. However it does depend upon the elasticity of demand for exports and imports. The Marshall Learner Condition (note: ML condition not explicitly required for AS, but could count towards evaluation) This states that a devaluation will improve the balance on the current account, on the condition that the combined elasticity’s of demand for imports and exports is greater than one. •
If (PED x + PED m > 1) then a depreciation will improve current account and an appreciation will worsen the current account A problem with devaluation is that it can lead to imported inflation. This will reduce competitiveness in the long run and will mean the improvement in the current account might only be temporary.
Reduce Consumer Spending. If govt reduces AD by raising interest rates or increasing taxes then people will have less money to spend so they reduce consumption of imports. i)
The UK has a high marginal propensity to import therefore a reduction in AD improves the current account significantly.
Deflationary policies will also put pressure on manufacturers to reduce costs and this will lead to more competitive exports and so exports will increase
However this policy will conflict with other macroeconomic objectives With lower AD, growth is likely to fall causing higher unemployment
Supply Side Policies These can improve the competitiveness of the economy and exporters, but this will take time to have effect
61 This involves restricting trade through tariffs, however it is likely to fail because it will lead to retaliation (other countries place tariffs on UK exports.
International Trade Since 2000, the UK has experienced a current account deficit. This means we import more goods and services than we export.
Benefits of International Trade •
• • •
Comparative advantage. Comparative advantage occurs when a country can produce a good at a lower opportunity cost. If countries specialise in goods where they have a comparative advantage there will be an increase in economic welfare. Lower prices for consumers. Consumers will benefit from lower prices of imports. This is due to competition and gains from comparative advantage. Greater competition. International trade gives firms more competition which helps to reduce costs and increase efficiency. Economies of scale. International trade allows firms to adopt greater specialistion. This can lead to lower average costs of production.
Protectionism This occurs when a government seeks to protect domestic industries from free trade and foreign competition. Protectionism can include: • Tariffs. This is a type of tax on imports. It increases the cost and discourages domestic consumers from buying. • Non-tariff barriers. These are other obstacles to trade. They may include complicated rules and regulations which make it more expensive for foreign companies to adopt.
Reasons for Protectionism • •
Protects domestic industries and allows them to develop. Help countries diversity into new industries. (important for developing countries)
Raise revenue (though tariffs would be a minor source of income)
Conflicts of Macro Economic Objectives Conflicts of Policy Objectives
A period of negative growth (1991 and 2009) caused a rise in unemployment
In practise it is difficult to achieve all policy objectives at once. For example, increasing the rate of economic growth could lead to inflation and a bigger deficit on the current account. Increase In AD
In this diagram an increase in AD leads to an increase in economic growth. However, as the economy gets closer to full capacity, there is an increase in the rate of inflation. Also as consumer spending increases, the level of imports will rise. This tends to cause a deterioration in the current account.
However, higher economic growth will help: 1. Reduce the level of unemployment. Higher output leads to higher employment levels 2. Improved government finances. Tax receipts increase with higher growth. Evaluation • Higher economic growth doesn’t have to cause inflation and a deterioration in current account. If AS increases at same rate as AD, growth can be sustainable and non-inflationary. If growth is export led, (like China), the economy can have a current account surplus.
• • •
The Phillips curve shows a trade off between unemployment and inflation. A rise in AD leads to higher growth. This higher growth causes inflation but helps reduce unemployment. Therefore, in the short term, policy makers face a trade off between unemployment and inflation.
Evaluation Evaluation requires more than knowledge, but also the ability to consider a question in more detail and apply critical distance to the question.
Evaluation questions start with words such as: 1. 2. 3. 4. 5.
Discuss Evaluate To what extent Assess Examine
Usually they will be the longer questions towards the end of the paper, however this isn’t always the case, it is most important to check the key word at the start.
Methods of Evaluation: 1. How important is a factor? For example: Consumption is 66% of AD therefore higher C has a significant effect on AD. If the UK economy experiences a fall in exports to the US, this would have a limited impact on its own. 2. Time lags involved. A cut in govt spending may reduce AD, however it may take time for this to affect the economy. Interest rate changes can take up to 18 months to have an effect on economy, for example, some people may have a two year fixed mortgage and be insulated from the change in interest rates. 3. It depends upon the situation of the economy. An increase in AD will only increase economic growth if there is spare capacity. Therefore the elasticity of AS is important. 4. Conflicts of the policy involved: An increase in taxes may reduce the budget deficit, however it may reduce incentives to work and affect AS. Higher interest rates may reduce inflation, however it may cause the exchange rate to increase reducing demand for exports 5. It depends upon other variables in the economy. An increase in interest rates is likely to reduce AD and inflation, however if consumer confidence is very high and wages are increasing, this is likely to keep AD high despite the increased interest rates. • •
These same concepts can be used for different questions. The most important idea is that you don’t give a simple answer but always consider another viewpoints as well.
Q. Evaluate Policies that the government can use to increase the rate of economic growth. The rate of economic growth measures the annual % increase in Real GDP. To increase economic growth the govt can increase either AD or AS If the economy is below full employment and there is spare capacity within the economy. The govt can use demand side policies to increase the rate of economic growth. Price Level
Increase in AD
AD’ AD Y Y
For example the govt could use fiscal policy to increase the rate of AD. This could involve cutting taxes and increasing the level of govt spending. AD = C+I+G+X-M. Therefore higher G will increase AD and lower taxes will increase disposable income thereby increasing C and AD. Also the MPC could cut interest rates. This reduces the cost of borrowing and reduces monthly mortgage payments. Therefore there will be an increase in the level of borrowing, consumption and investment. However demand side policies do have some problems, firstly there will be time lags between changing taxes or interest rates and having an effect on AD. Also if consumer confidence is lower interest rates may not have much effect on increasing consumption. Also increasing AD can conflict with the govt objective of low inflation. If the economy is close to full capacity higher AD will cause inflation. Classical economists argues that higher AD will always cause inflation, because the LRAS is inelastic. Therefore in the long run there will not be any increase in economic growth
67 Price Level
LRAS LRAS 2
Classical View of Economic Growth
P1 AD2 AD Y1
To increase economic growth in the long run it is necessary to increase productivity and shift the LRAS to the right, this can be done through supply side policies. For example the govt can increase the incentive to work by cutting taxes and reducing benefits. However there is no guarantee that lower taxes do increase work incentives. Also inequality may increase. The govt can overcome market failure by increasing spending on education and training, this will increase labour productivity and therefore efficiency in the economy. However this policy will take time to have effect. Also govt intervention may not be very successful because of poor information leading to subsidising of the wrong types of training. A third type of supply side policy could be to follow a programme of privatisation and deregulation. Privatisation involves selling govt owned industries to the private sector. The advantage of this is that the private sector has a profit incentive to increase efficiency. However there are dangers that a private monopoly may exploit consumers. The example of rail privatisation also showed that privatisation may not be successful, private firms under invested in the network because they took the short term view. Supply side policies may help improve productivity in the long term. However there is a limit to how much the govt can increase productivity, for example it is difficult for the govt to improve technology and working ethics. Also the rate of economic growth is likely to be effected by global events over which the UK govt has no control.
Commentary 1. It is important to consider both the demand and supply side causes of economic growth. 2. To evaluate the policies it is important to give their limitations and disadvantages, alternatively you could say how important the policy was. 3. AD/AS diagrams are very helpful to explain points 4. To get a high marks it is important consider points critically.
Case Study - Housing Market An important element of the AS exam is the ability to use the micro and macro concepts in real life markets. For example, you could get asked about the micro and macro effects of the housing market. These pages are just an example of how the above information can be applied for certain questions.
Factors That Effect House Prices House prices are affected by a combination of supply and demand factors. S
An increase in demand causes a big increase in price because supply is inelastic
D2 D1 Q1
Demand Side Factors Demand for houses can increase for the following reasons 1. An increase in real income. This could be due to higher wages or lower taxes 2. Lower interest rates. This will reduce the cost of having a mortgage. Interest rate are very important, as mortgage repayments are usually the biggest part of a persons monthly spending. 3. An increase in consumer confidence People more willing to take out a mortgage. 4. Lower Unemployment 5. Demographic factors such as an increase in the population or an increase in the number of single people wanting a house. In the UK this has occurred for various reasons such as: o an increase in divorce rates o Increase in life expectancy therefore more old single people o Children leaving home early
69 6. An increase in the price of rented accommodation, which is a substitute to buying a house 7. Inherited wealth. Many people use inherited wealth to buy houses
Supply Side Factors In the short run Supply of housing is fixed because it takes time to build houses. Therefore in the short run demand affects prices more than supply • However if the supply of housing is inelastic then an increase in demand will lead to a big increase in price.
In the long run the supply of housing is affected by many factors o Availability of planning permission. This is difficult to obtain in rural areas o Opportunity cost for builders e.g. are there better returns from other types of investment o Existing houses may be knocked down because they are deemed unfit to live in. o An increase in the cost of building new houses will shift supply to the left
How The Housing Market Impacts the rest of the Economy Housing is the biggest component of most households wealth. Therefore it has a big impact on the economy. The UK has one of the highest rates of property ownership in the UK. It is roughly 77% compared to 50% in France.
1. Effect on AD. If there is a “boom” (or increase) in the housing market then there will be a positive wealth effect as people enjoy capital gains. This will lead to an increase in AD, because people are more confident about the economy and some people will re-mortgage their house (equity withdrawal) to spend more money.
2. Effect on Economic Growth (Real GDP)
An increase in AD is likely to cause an increase in Real GDP, however this depends on the situation of the economy. In the below diagram there is spare capacity in the economy therefore there is an increase in Real GDP LRAS
AD’ AD Y1
However if the economy is close to full capacity then the increase may only be small.
Also the effect on AD depends upon other components of AD. For example if taxes are rising or exports are falling this will keep AD low despite rising house prices
3. Effect on Inflation
An increase in house prices will cause an increase in the cost of mortgages and therefore will lead to an increase in the RPI. Also the increase in AD could cause demand pull inflation, However again it does depend upon the slope of the AS curve and other factors in the economy.
4. The MPC is responsible for setting interest rates. It is committed to keeping inflation within its target of RPIX 2.5% +/-1. • If house prices are rising this may put pressure on inflation therefore they may be more likely to increase interest rates • However house prices are only one factor affecting monetary policy
5. High House prices could cause some workers to be unable to afford to but houses. High property values has caused a shortage of workers in London and the South East.
6. Increased Supply of Houses: With High house prices there is a greater
incentive to build new houses. Therefore house-building firms will do well.
The Housing Market and Market Failure •
Despite the shortage of houses the government has put a limit on building new houses. This is because new houses will cause the loss of “green belt” land. This loss of the environment could be said to be a negative externality
Other negative externalities of new houses include increased traffic on the roads causing congestion and pollution.
Those on low incomes may not be able to afford to buy or rent a house. This has become more of a problem with the boom in housing prices.
Boom and Bust in the Housing Market. This involves rapid movements in the price of housing.
In times of falling house prices, some house owners can experience negative equity causing lower AD.
Rising house prices increase AD maybe causing inflation. Booms encourage speculation and make houses unaffordable for many people
Government Intervention in the Housing Market •
Legislation about building houses on greenbelt land
Govt subsidies for building houses. However this has been quite low in recent years.
Provision of council houses. However in the 1980s many council houses were sold to the occupants at reduced prices. This has reduced the quantity of housing. • Also council houses have often been associated with higher levels of crime and vandalism, especially in many of the new tower blocks built in the 1960s.
To reduce fluctuations in house prices the MPC can change the interest rate. However the problem is that housing prices are only a small effect part of the economy. Despite recent increases in house prices (95-02) interest rates have not been cut because inflation has been low.
Maximum Prices. The aim of this is to reduce the price of rented houses, however this could result in a shortage of houses in the rented sector. Also problem of black market
Housing Benefit. Those on low incomes can apply for housing benefit which enables them to rent housing.
• • •
Policies to reduce speculation in the housing market Stamp Duty (this is a tax on selling a house) Abolition of MIRAS ( this was a tax relief on having a mortgage)
Elasticity and Housing Elasticity of Demand for Housing • The sharp rises in house prices suggest that demand is quite inelastic because the higher prices have not discouraged demand. • There are not many substitutes for housing. Renting is a possibility but in the UK people are keen to buy a house, as it is a form of investment. • Demand is more inelastic in popular areas such as London Elasticity of Supply for Housing: • In the Short run supply will be inelastic because it takes time to build new houses. • In the long run the supply of housing will be more elastic because increased prices will encourage people to buy them • However in certain areas supply will be still inelastic because there is a shortage of space or space is protected by greenbelt land regulations Income Elasticity of demand • •
Demand for housing tends to be income elastic. YED > 1 If incomes increase people tend to spend a higher % of their incomes on housing. This is because people want to get a better (and more expensive house) and some people may buy a 2nd home in the country