AS level

Economics
 Basic economic ideas and resource allocation

Economics as a social science

Model → a simpli ed view of reality used to explain economic problems. They can be used again and again
to test a theory in di erent contexts.

positive and normative statements

Positive statements → based on facts or actual evidence
Normative statements → based on an economist’s opinion or value judgement and which cannot be
proven

meaning of the term ceteris paribus

Latin phrase meaning ‘other things are equal / unchanged.’ This is used by economists to model the e ects
of one change at a time.
‘The margin’ (the current level of any activity: consumption/production of g/s) → involves analysing
microeconomic decisions. It suggests that a small change in one variable will lead to further (small) changes
in other variables. Used to predict what the impact of a change might be. Decision making by consumers,
rms and governments is based on choices at the margin.

importance of time periods

Short run → when a rm can change at least 1 but not all factor inputs
Long run → all FOP are variable but with 1 constant, such as the state of technology
Very long run → all key inputs into production are variable.

factors of production

Land - natural resources in an economy. ● reward → rent

● surface of the earth, lakes, rivers, ● Quantity: depends on geographical region
forests, mineral deposits, climate ● quality: depends on soil type, fertility, weather
etc. ● mobility: geographically immobile, occupationally mobile

Labour - human resources ● reward → wages/salaries.

● skills of workers/labourers. ● quantity: depends on num. of workers available (in uenced by
population, age structure, number of hours they work.)
● quality: depends on skills, education, quali cation of labour.
● mobility: occupationally mobile if they have the right quali cations.
geographically mobility depends on transport facilities, costs, housing
facilities, family and personal priorities etc

Capital - all the man-made resources used ● reward → interest

to nish making economic goods ● quantity: depends on demand for goods and services, how well
● Machinery, buildings, tools businesses are doing, the economic state of the country
● quality depends on how many good quality products can be produced
using the given capital. E.g - using mechanisation and technology
rather than manual labour
 ● mobility depends on nature and use of the capital.
an o ce building is geographically immobile but occupationally
mobile. But a pen is geographically and occupationally mobile.

Enterprise - involves taking risks and ● reward → pro t (from business)

organising FOPs ● quantity: dependents on entrepreneurial skills (risk-taking,
● Entrepreneur- individual seeking innovation, e ective communication), education, corporate taxes,
business opportunities who’s regulations
willing to take risks to make a rm ● Quality: depends on how well it is able to satisfy & expand
run successfully demand in cost-e ective and innovative ways.
● Mobility: highly mobile.

the difference between human capital and physical capital

Physical capital → FOP like machinery, buildings, infrastructure. Quality + quantity is considered the
most important source of economic growth in low + lower - middle income countries.
Human capital → value of labour in contributing to the productive potential or future growth in an
economy. Covers skills, knowledge, experience and anything else that can contribute to an inc. in growth.

specialisation and the division of labour

Specialisation → process by which individuals, rms and economies concentrate on producing those g + s
where they have an advan over others.

Advantages Disadvantages

More is produced at a high quality and - no one is self-su cient, meaning relying on one-another to satisfy
more e ciently. needs is inevitable.
- Pace of tech advancement means that specialist skills may become
redundant, so individuals must be multi-skilled and exible to move
between occupations.
- Changes in consumer wants can mean a country’s goods are no
longer required in the same quantity → unemployment

Division of labour
Where a manufacturing process is split into a sequence of individual tasks

Advantages Disadvantages

- Faster, cheaper production - Dissatisfaction and monotony. Workers may also

- Workers become more specialised → inc in become deskilled.
output per worker
- Improved quality of product

the role of the entrepreneur →

the market economy
- Market (price) mechanism → resource allocation decisions are taken by individual producers and
consumers with no govt. intervention.
- How the price mechanism works: excess supply → fall in price → rms less willing to
supply → increase in price → more rms willing to supply → increase in supply
- economic system where decisions are taken through the market mechanism. Allocation driven by
forces of demand and supply. In a market economy, there is little to no government intervention.
The government is involved ONLY when the price mechanism fails to allocate resources e ectively
(market failure). They seek to regulate situations to prevent rms using their power to control the
market for excessive gain.

the planned economy

- Resources are state owned and allocated by a central body. Price mechanism is not used; basic foods
are highly subsidised by the govt. to maintain low prices, which consequently leads to a shortage.
The objective is to achieve a high rate of growth, and reach a maximum productive potential. This
is done through production targets which focus mainly on the growth of agriculture and
manufacturing. E.g - Cuba, North Korea

the mixed economy

- Privatisation → change in ownership from public to private sector
- Emerging economy → making quick progress towards becoming a high income economy
- Asian tiger economy → export-led, high growth economies
- Both market forces and government are involved in resource allocation decisions mainly through
the market mechanism.
- E.g - Privatisation has been the key for emerging economies. The restructuring of the
economy (perestroika) of former soviet states led to huge inward ows of foreign
investment, esp. in manufacturing + retail sectors.
- E.g - Asian Tiger economies (Singapore, Hong Kong, China): Focus strongly on the
market to allocate resources. Free enterprise encouraged. China’s growth can be linked to
controlled management of the economy yet the clear opportunities for foreign investors +
domestic companies to in uence allocation of resources.

the production possibility curve

- Quality and quantity of fop determines an economy’s production possibilities.
- PPC → maximum level of output an economy can achieve, given its current resources + state of
technology.

the shape of the PPC

- Steep PPC → in order to produce more of good A, an inc. amount of
productive capacity for making good B is sacri ced.
- Flat PPC → each good B that is sacri ced gives a much smaller increase in
 the number of good A’s produced
Constant opportunity costs are due to fops being equally well suited to the production of both goods. Inc
opp. Cost → di fops.

Trade-o - deciding whether to give up some of one good in order to obtain more of another good. E.g
producing 300 televisions at the cost of 200 cars.
- Numerical trade-o s obtained by comparing inc. or dec. in production for each of the two goods.

Changes in the availability of resources

When there are technological advancements in the production of one good
(A), the productive capacity of A increases, shifting it to the right. So, for
any quantity of good B produced, it is possible to produce more of A. The
PPC changes because there has been no change in the conditions a ecting
car production.

shifts in the PPC

2 main reasons why shifts occur
- More resources become available, improvement in quality of resources → productive capacity inc.
Such changes could happen due to inc. in FOP such as labour via immigration. Overpopulation on
the other hand, could result in fewer available resources.
- Technological changes / advancements → productive capacity inc. as more of both products can be
produced. In some cases, technological progress may fall.

PPC is used to make choices. Its di culty is particularly proven in low-income economies. Scarce resources
need to be allocated to meeting present needs (i.e consumer goods) at the expense of investing in a range
of capital goods that would have inc. economic potential in the longer term.

6.1 excludability and rivalry - Classification of goods and services

An individual's consumption of g+s is limited by people’s income and whether the govt. Is able to fund
people’s wants and needs.
- Excludability → where it is possible to stop someone from consuming a g / s. E.g - smartphones
- Non excludable → freely available and nothing prevents its consumption.
- Rivalry → consumption by 1 person of a g/s reduces the availability of the g/s for others (majority
of g/s) E.g - sneakers
- Non-rival → consumption by 1 person does not
reduce consumption by someone else.

Private goods
Goods that can be consumed by one person and not available to anyone
else. They have a cost in terms of the resources used and are scarce, so a
price must be charged. E.g - food, clothes, petrol
- Excludability: through charging a price, it's possible to exclude some people from consuming.
 - Rivalry: consumption by one person reduces the availability for others
Free goods on the other hand have 0 opportunity cost since consumption is not limited by scarcity. There is
no FOP used. There is no price charged. E.g - air!

public goods
Must be both non-excludable (impossible to stop anyone else from bene ting from the good) and
non-rival (bene t to those already consuming must not be reduced). E.g - police, re protection, national
security. Everyone should have the same accessibility to its support.

Quasi-public goods
Lighthouses for e.g are known as pure public goods as it meets both characteristics. A quasi - public good
however has some but not all the full characteristics of a public good. E.g - toll station road is non rivalrous
but excludable like a private good as anyone not paying the toll is excluded from using it.

The problem caused by public goods

- Problem caused in the free market by the existence of public goods: markets may not produce them
if they don’t have the mechanism for guaranteeing their production.
- The free rider problem is associated with the provision of public goods. People enjoy its bene ts
without having paid for it. For example, a non-toll road that would be funded by the regional
government. Tourists and locals alike can use it for free. Private businesses have a pro t motive and
would never consider building one.
- The very existence of public goods may mean that scarce resources are not used in a way that would
be desirable.

merit goods, demerit goods and information failure

- Merit goods → desirable for consumers but which is underprovided by the market because of
information failure. Governments tend to provide this as it tends to be underproduced and
underconsumed.
- Demerit goods → are undesirable for consumers and are overproduced by the market because of
information failure. Tends to be over consumed as well because they tend to be habit forming,
cheap and readily available.

Information failure and the underconsumption of merit goods

Information failure → a situation where consumers don’t have full or complete information when
making decisions.

Examples of information failure

1. When consumers aren’t aware of the bene ts or harmful e ects of consuming a product.
2. Persuasive advertising results in consumption levels that aren’t in the best interest of consumers
3. Producers know more about the product than consumers
Preventing information failure. The ever inc. info to consumers enables them to take rational decisions
that maximise their welfare. Like this, the market works e ciently. If not, there’s an ine cient allocation of
resources.
1. large quantities of information on the internet to help consumers
2. Better labelling on products such as food, drink, and non-prescription medicine also helps.
3. On goods such as tobacco, labelling may contain reasons to limit consumption.

Low income and underconsumption of merit goods

Another reason for the underconsumption of merit goods is low income, particularly in the education and
healthcare sectors. Consumers may recognise the bene ts but lack disposable income.
- All forms of education and training produce bene ts to the individual (improved / new skills,
better pay, new employment opportunities) and the country (better quali ed workforce→
economic growth and improves competitiveness of the economy overall)
- A healthy population bene ts both individuals and the economy. If people must pay for access to
doctors and hospitals, there will be underconsumption among low-income families. This is why
governments try to provide a minimum level of health care for their people.

However, consumers may just be ignorant of the harmful e ects of demerit goods on themselves and on
others. E..g -
- obesity can be attributed to the overconsumption of cheap junk food in low - income households.
- Smoking. Despite the government's attempts at reducing its consumption, it's an addiction and
may be di cult for low-income individuals to distribute this amount spent on cigarettes elsewhere.

Some economists even believe that there is no such thing as merit and demerit goods. It should be the
individual, not the govt. who decides what is best for them. This contradicts the underlying assumption that
governments have more information on products than consumers.
2 The price system and the microeconomy
7.1 The price mechanism and markets
- In a market economy, price mechanism is essential to the allocation of resources
- It sends out signals from consumers to producers:
- Surplus → fewer resources should be allocated to the product
- Shortage → more resources should be allocated to the product
- Price mechanism is self-regulating - does not require any involvement from the gov while the
mechanism is working e ciently
- Economists take a broader view of the term 'market.' At the core of any market is trade. Whenever
people come together for the purpose of trade or exchange - there is a market. Examples →
● Housing market - people rent, buy and sell property
● Labour market - individuals' services are 'bought and sold' (i.e i sell my service as a worker)
● Global markets - for wide range of agricultural products (co ee, tea, cotton)
● Market for oil - closely monitored by governments, transport companies and individuals (ups and
downs of oil market have an important in uence on our lives and economies)
● Stock market - shares are bought and sold
● Foreign exchange market - currencies are bought and sold
● Internet - huge range of products are traded by thousands of companies as well as millions of
individuals (unique market bc buyers are in a strong position where they can compare goods and
search for the best price)

Demand
the quantity of a product that consumers are willing and able to buy at di erent prices per period of time
(ceteris paribus)
- Notional d→ where buyers may want to purchase a product but are not always backed up by the
ability to pay
- E ective d → demand that is supported by the ability to pay
- Market d → total demand
NOTE: e ective demand is determined by price where as notional demand is more likely to be a ected by
non-price factors

7.3 The demand curve:

● Must collect statistical data about consumers' preferences and the quantity of product x that people
are willing and able to buy at various prices per period of time, ceteris paribus
● The data set in the table is known as a demand schedule
● Consider the di culty of collecting real-world data for a demand schedule, especially when there is
a wide range of prices to consider
● Inverse relationship between price and quantity demanded
● Δ price → Δ in quantity demanded (shown by movements ALONG the
curve i.e contraction + extension), ceteris paribus.
Main features of a demand curve are:
 ● A linear relationship - acceptable for price and quantity demanded to be related in a non-linear
manner and be drawn as a curve
● A continuous relationship - can nd what price would be at 1259 pcs
● A time based relationship - here, the time period is weekly
● Ceteris paribus

The (other) factors that a ect demand

*** Think about who the good is intended for (ex. For someone on high income it might be considered
inferior but for someone on low income it can be considered normal)

Income Ability to pay is vital when considering the importance of e ective demand. Demand for goods and
services depends upon income (disposable). In terms of market demand, income refers to the income of
all consumers and is closely related to the state of the macroeconomy (growth/ boom or recession)
● Normal g have a proportional/+ve relationship between y + d. Most products are normal
goods like cars, housing, restaurant meals
● Inferior g have an indirect/-ve relationship. packet noodles, low-grade rice, used clothing

Price and availability of ● Substitutes → alternative goods that satisfy the same want or need. -ve relationship between
related products substitutes (Δ price) + d Extent of Δ in d depends on the degree of substitutability
● Complements → goods that have joint demand as they add to the satisfaction that consumers
get from another product. +ve relationship between compliments (Δ price) and demand

Fashion, taste and attitudes ● More di cult factors to explain bc they are largely a matter of individual choice and behavior
● An individual's attitude may change and be in uenced by what they have read or what
advertisers would like consumers to believe about their product

7.4 Supply
Quantity of a product that suppliers are willing and able to sell at di erent prices within a time period
(ceteris paribus)
- Supply chain → all the stages of a product's progress from raw materials, production and
distribution until it reaches the consumer
7.5 The supply curve:
We collect statistical data about companies' selling intentions and represent it as a supply schedule
Supply curve shows:
● +ve relationship between price and quantity supplied
● Δ price → Δ in quan s - shown by movements ALONG the supply curve i.e
contraction + extensions, ceteris paribus.
Main features of a supply curve are:
● causal relationship - price Δ cause the Δ in quant s
● linear relationship
● continuous relationship - look at curve to nd out how many PCs rms are
willing to supply at $1150
● time-based relationship
 NOTE: the areas underneath the s and d curves show total consumer expenditure/ total revenue.

7.6 The (other) factors a ecting supply:

Costs Supply decisions are driven by the cost of producing and distributing their products to customers. E.g: :
labour costs, cost of energy and transport, capital costs

Size and nature of the - An industry that is growing in size means more products will be supplied to the market
industry - Growth may attract new entrants - competition increases - prices fall - rms leave industry
- In some industries supply is deliberately restricted to keep up prices

Change in the price of Being aware of competitors. If competitors lower prices, less of the product may be supplied by other rms.
other products (vice versa)

Government policy - Taxes reduce supply, subsidies inc it

- Subsidies → direct payments made by governments to producers of g and s

Other factors In agricultural markets, s is a ected by uncertain weather conditions: storms, frost, drought

7.7 Causes of a shift in the demand curve:

When the assumption that all other factors remain unchanged is relaxed, the outcome is a shift to the right
or left of the demand curve

7.8 Causes of a shift in the supply curve:

NOTE: a movement or shift takes place over two time periods. Meaning if there is an
unexpected increase in quantity demanded leading to an increase in price, it will take
time for suppliers to produce more to meet this increase

8.2 Price elasticity of demand:

● -ve gure bc of inverse relationship between price and quant demanded (ignore)
● When numerical value is less than 1 then demand is price inelastic
● When numerical value is more than 1 then demand is price elastic
 ● Price elasticity of demand (PED): measures of the responsiveness of the
quantity demanded for a product following a change in the price of the
product
● Price elastic: relative change in quantity demanded is greater than the
change in price of the product
● Price inelastic: relative change in quantity demanded is less than the
change in the price of the product

Special PED values →

Perfectly inelastic Regardless of price charged, consumers are willing and able to buy
the same amount. Demand is completely unresponsive to changes in
0 price.

Perfectly elastic where all that is produced is sold at a given price

Unitary elastic Change in price is relatively the same as the change in quantity
demanded
1

Factors a ecting price elasticity of demand:

Three main factors that determine whether, over a particular price range, demand for a product is likely to
be price elastic or inelastic.

Availability and attractiveness of substitutes: Important to distinguish between substitutability of products

More subs + the more closely substitutable ● Products can be organised in categories. Example: di types of orange
products are → the more elastic juice are a group of products in their own right. Also part of a larger
group of fruit juices and an even bigger group of 'drinks.' Drinks will have
high PED because of the range of subs
● As we classify products into groupings, demand starts to become more
price inelastic (lower substitutability). The narrower the de nition of the
market, the more likely it is that PED will be greater
 Other substitutability issues to consider:
- Quality and extent to which info is available to consumers - internet for example
provides consumers with a tool for comparison - can nd the cheapest products
locally or globally
- Extent to which product is considered a necessity (inel) or a luxury (el) Addictive
properties of the product - if product is habit-forming, d = inelastic
- Brand image of the product - some products are sold to consumers solely bec of
the brand + how it is superior to similar products from competitors - such
products are likely to be price inelastic.

Relative expense of the product - Rise in prices red purchasing power of a person's income + their ability to pay
- The larger the proportion of income this price represents, the larger the impact
on consumers' income as a result of a change in the products' price (so the greater
PED is)

Time period such as short run or long run - short run (weeks/months), ppl may nd it hard to change their spending patterns
- longer run, if price of a product goes up and stays up, over time, people will adapt
and adjust
- Therefore PED goes from price inel to price el as cons look at what else is
available in the market

8.3 Income elasticity of demand:

● YED measures responsiveness of quant demanded due to a change in income (ceteris paribus)
● If demand is responsive to an income change, % in q demanded will be greater than % in income
(YED is greater than 1). Opposite for income inelastic (YED is less than 1)

The classi cation of goods in relation to income:

- Classi cation is based on size (numerical terms) and the sign (positive or negative)
- Size indicates strength of relationship between a change in income and q demanded
- Classi cations depend on the level of income of consumers or households. (a necessity good for one
family could be a normal good for a better o family)
● Normal g - quan d inc as y inc. Most products are like this - e.g cars. YED is +ve & between 0 and 1
● Inferior g - quan d dec as y inc (and vice versa). When y rises, consumers use inc y to buy better
quality goods to replace inferior subs - e.g poor quality rice and packet noodles. YED is negative
● Necessity good - type of normal good for which q demanded is unlikely to change when income
changes- e.g Rice, our (regularly consumed). YED +ve & close to 0
● Superior or luxury goods - normal g where quan d is responsive to changes in y - e.g jewellery.
YED +ve & greater than 1. Higher size of YED, greater change in q demanded
8.4 Cross elasticity of demand:
● XED measures the responsiveness of the quantity demanded for one product due to a change in
price of another product (ceteris paribus)
● Can be both elastic and inelastic. Demand is cross elastic when quan d for 1 product responds more
than proportionately (to a greater degree) to a change in the price of another product (XED is
greater than 1). Opposite for cross inelastic where XED is less than 1. The value indicates the
strength of the relationship

Sign of XED indicates the relationship between two goods →

+ve = substitutes
● Inc in price of one inc the quan d for the other (and vice versa) (Assumed that
consumers act switching their demand to the cheaper product)
-ve = compliments (Aka jointly demanded)
● Increase in price of one causes a decrease in quan d for another (assuming the
price of that product remains unchanged)

NOTE: when XED = 0, there is no relationship between the two products

All elasticity values are estimates due to the problems associated with the collection of data
NOTE: elasticity measurements are estimates because of the di culty of collecting data. Di cult to identify
and single out the many in uences and ensure that the data remains reliable. (take into account rapid
change (technological) and time spans)

8.5 How price, income and cross elasticities of demand can a ect decision-making:
PED can be used to explain →
1. Price variations in the market
● Prices vary according to PED. When more elastic, prices tend to be cheaper (vice versa inelastic).
Firms do this to maximise revenue
2. The e ects of changes in indirect taxes on government income
3. Expenditure in relation to time
● The di between peak and o -peak rail travel in some countries
● Why it is cheaper to purchase airline tickets a few months rather than a few days ahead of travel
● Why restaurant meals are more expensive during religious festivals
4. Impact of changing prices on consumer expenditure and sales revenue
PED helps us understand how total spending by consumers changes as price rises or falls
● Total expenditure/ revenue = price x quantity
● If we assume there are two products each priced $10 and quantity traded is 100 units per day (total
rev/ expenditure =$1000)
- De is relatively price elastic so when price rises to $11 quantity traded falls
to 80 units. Making total rev= $880 (PED=2).
- Di is relatively price inelastic so when price rises to $11 quantity traded only
falls to 95 units. But this causes total expenditure/ rev to rise to $1045.
(PED=0.5)
Basically:
● When demand is price inelastic, a business can increase price in order to increase revenue
● When demand is price elastic, a business should decrease price to increase the quantity demanded
and therefore inc revenue
○ EVAL: However, if the rm has no or little excess capacity or if rival rms follow suit in
order to avoid losing sales to the rst rm, a fall in its price may not lead to an increase in its
total revenue. However, the product may be inelastic as it has distinctive features
○ EVAL: Although PED may be useful for increasing total revenue, this is not true for
increasing pro t due to the omission of total cost. For example, if demand is price elastic, a
fall in price will lead to a larger proportionate increase in quantity demanded resulting in
an increase in total revenue. However, if total cost rises by a larger extent, pro t will fall.
○ EVAL: PED and XED do not take production capacity into consideration. For example, if
demand is price elastic, a fall in price will lead to a larger proportionate increase in quantity
demanded resulting in an increase in total revenue. However, total revenue will not rise if
there is no excess capacity to increase production.

An objective of rms is to make PED for their product more inelastic in order to inc revenue.
● Using persuasive advertising - in uence consumers to buy product - highlights bene ts of product
compared to subs - may emphasise health bene ts or use a celeb who endorses the product - this
results in a shift to the right of the demand curve - increases sales with no change in price
● Creating a brand image - makes products appear superior to competitors' - often used by
multinational companies to persuade consumers to buy their brand
● Firm takes over or merges with a competitor to increase market share - greater control over market
● Firm creates a monopoly product - where rm is only producers - protected by a patent or
regulations
NOTE: when product is price elastic and sale promotion is used - policy is risky as competitors are likely to
do the same and then all producers lose out

Income elasticity of demand:

● Bene cial to rms and gov for forecasting future d for a range of consumer g and s
● In many emerging economies, demand for cars rises as incomes increase
○ Gov spending then must be reallocated towards building more roads to accommodate the
increased demand for personal mobility
If YED for normal g is <1 (superior g), d is expected to grow more quickly than consumer incomes, rms
that produce these can expect their sales to inc when the economy is doing well (like China, India in recent
years) and vice versa for recession.

If YED is -ve (inferior goods), rms that produce these can expect their sales to decline when the economy is
doing well and vice versa for recession.
 Cross elasticity of demand (XED):
● Size of XED is important - allows rms to determine how much of an impact a change in price of
a sub or comp might have on demand for their product
● XED also helps rms identify compliments and introduce a pricing strategy that generates
more revenue ( rms want consumers to buy whole range of complimentary products from same
manufacturer)
○ EVAL: However, if this is likely to lead to a price war, the rm may consider engaging in
non-price competition such as product promotion and product development instead of
decreasing its price.
● Market research can identify spending patterns - help rms adopt pricing structures that looks at
the relationships between the demand for all the products a rm o ers

Limitations of the concepts of elasticity

The data that are used to calculate elasticities of demand may be irrelevant or unreliable. Data from past
records may no longer be relevant to calculating elasticities of demand as some of the determinants of
demand may have changed. Although data from current market surveys are relevant to calculating
elasticities of demand, they may not be reliable as the respondents may not be truthful in their responses.
Furthermore, if the sample sizes of the market surveys are small, the results may not be reliable as they may
not be re ective of the actual markets for the goods. The assumption of ceteris paribus that is made in
calculating elasticities of demand is unlikely to hold in reality. In reality, many factors such as the level of
income, the price of goods and the prices of related goods are changing simultaneously.

9.1 Price elasticity of supply:

● PES measures responsiveness of quantity supplied to changes in price (ceteris paribus)
● Supply could be that of an individual business or producer or the market supply of an industry
● Since supply curve is upward sloping, PES is always positive

Price elastic s: quan s responds more than proportionately to a change in its price (PES <1)
Price inelastic s: quan s responds less than proportionately to a change in its price (PES >1
Special PES values →
● perfectly price inelastic (PES=0) - not possible for producer to increase or decrease
supply regardless of any change in price (examples are ower production where
perishable products have to be supplied once they are ready for sale)
● perfectly price elastic (PES= in nity) - producer may only be willing to supply a
product for a given price and no less - supply can be varied but the price remains at P

9.2 Factors in uencing price elasticity of supply:

Businesses and industries try to be more exible in the way they operate. This is a ected by:

Availability of stocks - - Stock allows companies to meet variations in demand through changing output rather than changing
Ease with which business the price of the product
can accumulate or reduce - Not possible with services - supply is perishable and xed in the short run e.g PES=0 in stadiums where
stocks of goods a ects supply is xed to number of seats available
PES - Not possible with perishable goods either

Time period - a ects ease ● In short run, businesses and industries with spare productive capacity tend to have higher PES
with which producers are ● Shortages of critical factor inputs (skilled workers, components, fuel) → inelastic PES
able to increase ● ^^Particularly the case with agricultural products - takes time to alter the type of crop produced.
production
Takes a while for producers to switch from a poor-performing to a more saleable crop

Productive capacity ● Over time, rms can inc productive capacity by investing in more capital equipment
● Can take advantage of technological advantages

9.3 Implications of PES for the ways in which businesses react to changing market conditions:
● In short run, PES for agricultural products is more price inelastic than manufactured products (bus
can hold stock to release quickly and without too many problems when demand increases)
● In long run, if the increase in demand is expected to be persistent, the scale of the business can be
expanded to inc productive capacity - takes time depending on scale of change required
○ In agricultural markets, case is di erent. Price inelastic & unstable supply- Crop yields
are not easy to predict due to external forces: natural disasters, growing e ects of climate
change, health scares, inc scale of protection of agricultural markets by developed econs

● Stability of global markets is also a ected by changes in d for manufactured and

agricultural goods
● Changes in demand have a greater e ect in agriculture than manufacturing markets
○ PES inelastic = any Δ in d has a big impact on agricultural prices and
farmers' incomes PES elastic = e ect of Δ in d are not as great
10.1 Market equilibrium and disequilibrium:
● Market is in equilibrium when q supplied is equal to q demanded
● A balanced situation with no tendency to change (ceteris paribus)
● Consumers and suppliers are satis ed with the current situation

Real-world markets are invariably in disequilibrium

● Often excess supply or excess demand in the market
● Key feature of market mechanism is that it adjusts supply or demand to reach
the equilibrium position

Excess supply = clearing price is too high → Response for suppliers is to reduce prices
→ more consumers will start buying the product → New equilibrium point is reached
and market clears
Excess demand = signals to suppliers to increase price of product → fewer customers will buy the product
→ Price will continue to increase until market reaches its new equilibrium position and clears
NOTE: as rms cut prices, they reduce the quantity they supply (and vice versa). Cutting prices ---
disequilibrium starts to narrow

Adjustment
NOTE: time taken for changes to come about is dependent on the price elasticity of supply
● The process of market adjustment may not happen instantly as there will be time lags (if rms
cannot react quickly to increase or decrease production)
● In agriculture - time to adjust will be subject to delay (geographical considerations)
● Even so, there will always be a tendency for the market to move back to its equilibrium position
(where the underlying motives and plans of consumers and suppliers are driving it)
- Speed of adjustment is also a ected by how long it takes consumers and producers to make known
the price they are prepared to pay or sell a product for when the market is in disequilibrium
- At basic level - consumers compare prices in street markets, convenience stores, online etc. with no
di culty

10.2 The e ects of shifts in demand and supply curves on equilibrium price and quantity:
- Equilibrium price and quantity changes when there are changes in the demand and supply for a
product. These changes occur due to non price factors.
- when demand shifts to the right, consumers are willing to pay a higher price for the same quantity
- in uences on someone's ability to pay include the availability of loans or credit and interest rate
- when supply shifts to the right, suppliers are willing to supply more at lower prices

1. Costs associated with supply:

Wage rates, Worker productivity (output per worker), Raw material and component prices, Equipment
maintenance costs, Distribution costs, Changes in technology

2. Competitors prices:
Think of cross elasticity + how it a ects demand and therefore a ects supply of the other product
● Competitor lowers price - lower demand for product - lower supply
● Competitor increases price - higher demand for product - higher supply

3. Size and nature of industry:

When it's made clear that substantial pro t will be made by selling the product …
● Firms within industry will invest in capital and attempt to grow bigger + take advantage of situation
● Firms outside industry will try to enter market - new local competitors may emerge
● Supply curve shifts to the right as size of industry increases
● If comp is high, supply curve will shift to the right (e ects of price competition start to a ect the
price that all rms are willing to accept for their products)
 4. Government policy:
● Excise duties is imposed on the output of rms (speci c tax that is levied on g such as cigarettes)
● Ad valorem tax on particular g and s
● Gov policy in agriculture may involve the release of stocks (to calm the volatility (unpredictable
nature) of markets associated with a poor harvest)

A change in supply AND demand →

● Increase in demand puts upward pressure on price
● Simultaneous increase in supply puts downward pressure on price
● Equilibrium price remains unchanged
● Quantity traded increases from Q to Q1

10.3 Relationships between markets:

● Relationship between two products (subs and compliments) is extended to show how market
conditions change when there is a change in the price of either of them

Alternative demand → A substitute is an

alternative good
- A rise in the price of one product will
lead to an increase in demand and a rise in
the price of the substitute

Joint demand → Compliment is in joint demand

- consumed with another product
● Increase in supply - causes price of one
product to fall
● Prompts an increase in demand for the
compliment

Derived demand → d for g or s depends upon

the use that can be made from it
● Applies when something is required bc it
is needed for the production of other g
and s. E.g - inc in d for hotel services, inc
d for labour
Joint supply → When two goods are produced
together but for dif purposes e.g - sheep for wool,
meat etc
● Increase in demand for sheep for wool -
increase in supply and fall in price of
meat.

10.4 The functions of price in resource allocation:

Rationing → Price system can limit products in the market
● Process of rationing is automatic
● Producer may wish to limit supply of products so they remain exclusive (likely to have higher price)
in the market. Demand is limited + ensures it is in line with q supplied to the market
Signalling → where decisions taken by buyers or sellers are determined by price
● Rise in quan d → inc in price, signalling to producers they should inc their products in the market
● If consumers withhold demand, prices can be expected to fall → signals to producers that less
should be produced
Price mechanism works in a way so outcome is a new equilibrium position with consumers' d = producers' s
Transmission of preferences → the automatic way in which the market allows the wants of consumers to
be made known to producers
● If consumers do not buy product bc it is not liked or too expensive, message is transmitted back to
producers
● Wish to stay in business - producers react by improving product, reducing price or both
The provision of incentive → where low or high prices in uence consumption and production by
encouraging buyers to consume and sellers to produce
● Low prices, special o ers - encourage consumers to buy more goods bec they get more satisfaction
from consuming a product when they think they are getting a good deal
● High prices stop consumer purchasing a good - but encourage suppliers to produce more
● Low prices can discourage willingness to supply
○ If low prices persist, suppliers may well decide to exit a market

11.1 The signi cance of consumer surplus:

● Demand curve can be used to explain how much consumers are willing to pay for dif quantities of
products they want to consume
● Those who receive most satisfaction will be willing to pay a higher price than those receiving very
little satisfaction (concept of marginal utility)
Consumer surplus → di between the price a consumer is willing to pay for a product and its market price
● For any good or service, there are likely to be people who are willing to pay above the market price
● Some may want the product at almost any price ( nal world cup match, world famous singer)

- Consumer surplus is shown by the area above the price line P

- Some consumers may be willing to pay as much as P1 to consume the product.
This is because they do not want to miss out on consuming it
- As price increases above P, consumer surplus decreases as less people are
prepared to pay the higher prices

- In contrast, a fall in market price will lead to an increase in consumer surplus

since consumers who were previously paying above the market price are now
paying less. Fall in price also = more demand and inc consumers.
- When price falls, Δ in cons surplus applies to new (willing to pay a price
between p1 and p) and existing customers

Impact of price change on consumer surplus depends on:

● The extent of the price change (the larger the Δ in price,
the greater the Δ in consumer surplus)
● Price elasticity of demand → inelastic = inc in price will
see less of a fall in consumer surplus than if demand is
price elastic

11.2 The signi cance of producer surplus:

Producer surplus → the di between the price a producer is willing to accept and what is actually paid
● In general, producers are keen to supply to consumers willing to pay above that which they would
normally be prepared to accept
● Additional revenue above baseline price is producer surplus (will always be passengers willing to pay
above the market price + provide additional revenue)

- Extent of producer surplus is shown by shaded area (above P below p1)

- Anything rms sell below P1 is because they are willing to sell to
consumers at a discounted price
- Under P, costs of production would not be covered and therefore
supplier is unwilling to supply anything

Impact of a price change on producer surplus depends on:

● Extent of the price change (the greater the price change, the greater the change in producer surplus)
● Price elasticity of supply: elastic = inc in price will see a much greater increase in producer surplus.
This is bc there are already producers in the marker willing to supply at a lower price
NOTE: where there is a consumer surplus or producer surplus there is an ine cient allocation of resources.
A market is only e cient when consumers and producers are satis ed with the market price

NOTE: to calculate, work out area of triangle =1/2 bh

Producer surplus triangle is re ected triangle of consumer surplus
 3 Government microeconomic intervention

Reasons for government intervention in markets

Market failure → free market fails to e ciently allocate scarce resources to their most productive uses.

Situations which require government intervention:

1. Lack of public goods
E.gs: police force, national defence, lighthouses. They are consumed collectively and are both non - exclusive
and non rival. The free rider problem means that people can enjoy the use of a public good without
contributing towards its cost. The private sector would be unwilling to provide public goods as they’d make
no pro t, so they must be funded by the government. Opportunity cost is an issue here as it competes with
other types of government spending.
2. Underproduction of merit goods
When supplied by the private sector, the quantity needed is less than required. Access restricted to those
who can a ord to pay. To correct market failure: 1. Government takes over x (whether its healthcare,
education etc.) Resources will then be allocated to meet expectations without private sector involvement.
However, a less expensive way is to 2. Allow the private sector to provide, but the government provides the
di erence until the required amount is reached. That way everyone can a ord it.
3. Overconsumption of demerit goods
Considered undesirable for consumers and tend to be over-provided in the free market. The main rsn for
this is that consumers invariably lack full and proper info. Manufacturers may be required to put written
warnings and graphic photos on packaging to reduce consumption. This could lead to a more productive
and healthy workforce + savings in the healthcare budget as less patients need to be treated due to smoking.
4. Information failure
- Compulsory information on cigarette packets warning of dangers of smoking
- Public health announcements and campaigns
- Advice on non-prescription medicines
- Nutrition and allergy info on food packaging

The impact and incidence of specific indirect taxes

Indirect taxes → widely used to discourage the production and consumption of demerit goods
- Taxes tend to be passed on to consumers through increased prices in the market (technically
imposed on producer)
- When indirect tax is imposed - must be paid to gov by retailers, wholesalers, manufacturers
Types of indirect taxes:
- Ad valorem taxes → proportion of % of the price charged by the retailer (eg VAT) - may be
included in published retail price or added to price at nal transaction stage
- Speci c taxes → xed amount per unit purchased - tax is based on a measurable quantity like per
litre (fuel for e.g)
Key terms:
● Incidence → the extent to which the tax burden is borne by the producer or the consumer or both
● Tax return → a form with personal circumstances + income that's used to assess liability for tax.
 A speci c tax is represented by a shift to the left of the supply curve by the amount of tax (vertical distance
bet s curves)

● Market price - now higher at P1 compared to previous equilibrium price P

● Quantity traded is less at Q1
● Shows the incidence of the indirect tax: Producer bears a higher burden here
● Producer now receives P2 for product (p2 is where new equilibrium is on old s
curve)

● Extent to which the producer can pass on tax by raising price depends on PED
● price inelastic = easier (vice versa elastic)
● When elastic, consumers invariably buy less of product as price rises → producer
absorbs more of the tax.
● Explains why essential products like petrol are heavily taxed in most economies

In low/ lower-middle income economies, there is a struggle when it comes to collecting

taxes. Cash is still main form of money (a lot of the working population do not submit a
tax return). In emerging market economies, govts feel more con dent collecting indirect
taxes than direct taxes

The impact and incidence of subsidies

subsidies → Direct payments made by governments to the producers of g and s

Reasons for provision Limitations

- Keep down market prices of essential goods - Allocation of subsidies from limited gov revenue is
- Reduce & remove -ve externalities controversial→ interferes with market mechanism + opportunity
- Encourage greater consumption of merit goods cost (Comes out of tax revenue)
- Contribute to a more equitable distribution of income - Estimating the size of a subsidy is a further di culty → govts
- Provide services that would not be provided by the free market don’t know the precise size of the externality in the market. This is
- Raise producers' incomes, especially in the case of farmers because externalities are di cult to value and so govts attempts are
- Provide an opportunity for exporters to sell more goods just estimates of the value of the externality.
- Reduce dependence on imports by paying subsidies to domestic - Blanket or 'lump sum' payments
producers of close substitutes - Shortages can also exist if demand exceeds supply
E.g → Public transport is heavily subsidised in all parts of the - If subsidy is paid to producers - no incentive for ine cient
world. This is done to give low earner access to employment producers to improve. It's also not certain that money received as a
opportunities, provide social mobility to elders, red road subsidy payment will be used for its intended purpose
congestion & -ve environmental impact of tra c → bene ts - Unlike taxes on consumers - cannot be easily linked to incomes
individuals and community as a whole and ability to pay
^E.g → Staple foods (rice, bread, cooking oil) are subsidised in
some low and lower middle-income econs → provides relief for the
lowest income groups in the economy as world food prices continue
to rise→ Yet subsidised prices are paid by all income groups (many
of whom can a ord to pay more) → necessary to assess who
bene ts from a particular subsidy.

Impact of subsidies → opposite e ect of indirect tax bec it's equivalent to a fall in costs for the producer
→ rightward shift in the market s curve. Results in reduced price and an increase in quan traded.

When evaluating the e ectiveness of subsidies it is important to consider PED.

- inelastic = greater price fall in the market.
- elastic = price fall is smaller as producers do not pass a large percentage of
the subsidy on consumers.

Incidence of subsidies is shared between consumers and producers

● Consumers bene t from a reduced price
● *Producers bene t from receiving a higher price than they would selling an increased s on the
market (Ps is the price received by sellers)

PED also a ects who bene ts MORE from the subsidy.

- inelastic = greater bene t for consumers as a large percentage of the
subsidy is passed onto consumers via a lower market price.
- elastic = smaller the price falls and the smaller the subsidy gain for
consumers as a result of a smaller price fall. Conversely, producers take most
of the subsidy bene t when the demand curve is elastic, as they keep hold of
much of the cost savings from the subsidy.

The direct provision of goods and services

Govts provide certain important services free of charge at the point of use or consumption. They are
nanced through the tax system: merit & public goods. If services are used equally by all citizens - those on
lowest incomes gain most as a percentage of their income - thereby lowering inequality

1. Merit goods like healthcare and edu - are provided for free in some economies.
● Common model is for there to be part free provision - other parts being paid for at points of use
● Justi cation of free provision must be on the grounds of equity i.e everyone should have access to a
certain level of education and healthcare regardless of income.
Major di erences in the provision of healthcare between economies:
● UK - free National Health Service for more than 70 years
● US - free healthcare is limited - those who can a ord to pay are obliged to take out medical
insurance
● In most low income countries (Cuba being an exception) a charge is usually made for most types of
healthcare provision. E.g → countries in Sub-Saharan Africa have a very basic system of healthcare
is provided free of charge

2. Characteristics of public goods means they are not provided by the market mechanism and consumers
won’t be willing to pay for them.

Limitations of direct provision:

● Mer g → healthcare and edu markets are subject to various forms of market failure, therefore direct
provision of merit g is not enough. A combination of this + info for e.g can solve market failure.
● Pub g (+ mer g)→ leads to ine ciency bec market overproduces - especially where no direct
charge is made → resources are not allocated e ciently
● If a charge is made or introduced - demand is likely to fall
● Could also be argued that many consumers can a ord to pay a charge, so reducing the tax burden or
allowing funding saved in this way to be put to alternative uses.

Maximum and Minimum prices

Key terms:
- Maximum price (price ceiling)→ a price that is xed; the market price must not exceed this price.
(below equilibrium)
- Minimum price (price oor)→ a price that is xed; the market price must not go below this price
(above equilibrium)
● Market failure occurs when the price of a good in the free market is too high
● This prompts the gov to pass legislation to impose a maximum price on a particular g or s
● Seen as a way of assisting families on low incomes, reducing inequalities in income, recognising the
wider bene ts of consuming a particular product that aren’t fully appreciated (mer g)

Governments use legislation to enforce maximum prices for:

● Staple food items such as rice and cooking oil
● Petrol and diesel fuel
● Rents in certain types of housing
● Services provided by utilities (water, gas, electricity)
● Transport fares (especially where a subsidy is being paid)
E ect of maximum price
Since prices are forced down, producers are only willing to supply Q1 → Lower price makes ‘x’ g/s more
a ordable - Q2 is now demanded → shortage (Q2-Q1)→ production not su cient to satisfy everyone who
wishes to buy the product. Only consumers who purchase bene t from cheaper products.
Since price cannot rise - available supply has to be allocated in other way via 2 means of restricting d
● Queuing → form of control in the former planned economies of Central, Eastern Eur
● Rationing → inevitably leads to an informal or underground market for products involved.
Consumers then have to pay in ated prices well above the maximum price. Such markets inevitably
arise when there are dissatis ed people who have not been able to buy the goods they want bc not
enough has been produced

Why governments may impose a minimum price control

● Demerit goods such as high-sugar sport drinks to prev consumption
● Agricultural products to encourage supply and provide a living income for farmers
● Wages in certain occupations (usually low skilled to avoid employers exploiting their employees)
● Certain types of imported goods where close substitutes produced by domestic producers are
available
E ect of minimum price
Suppliers willing to s more products than are d by cons → Min price red d from OQ
to OQ1 → increases supply from OQ to OQ2 → results in excess supply of Q2-Q1
● As price cannot fall, supply is restricted to Q1 (this is what cons can a ord
to buy at P1) → red quan traded than (what would’ve) at equilib price

Limitations:
● Producers may become ine cient
○ Firms with high costs have little incentive to reduce costs - high minimum price protects
them from lower-cost competitors
● Informal market development (especially for products like imported cigarettes)
○ High indirect tax + high minimum price → products attractive for non-market trading
○ Consumers will buy from dealers o ering these g at less than the regulated minimum price

Buffer stock schemes

Bu er stock scheme → designed to smooth price rises and falls by buying and selling stocks of products
depending on market conditions. (Basically combines the principles of minimum and maximum price
controls). USed for agricultural products as supply can be volatile.

1. Bu er stock schemes start by setting a minimum price for a particular product

If market price looks like going below this minimum - bu er stock scheme will buy up stocks from growers
Stocks are then stored in warehouses
Action should then raise the price of the product since supply has now fallen
2. Scheme can also set a maximum price
E ect will be to increase supplies from growers which in time will reduce the price of the product
● For many years - EU's Common Agricultural Policy (CAP) - was an example of this type of
intervention. Yet CAP was heavily criticised for its ine ciency. Resulted in CAP focusing instead
on implementing structural reform to make agricultural production more e cient.
Income and Wealth
- Income is a ow of payments to factors of production over a given time period. For labour, income
is paid in wage, salaries and bonuses. For other FOPS incomes take the form of rent, interest and
pro ts.
- Wealth is a stock of assets that has been built up over time. They are there to provide security and in
some cases, an income stream for the future.

Measuring income and wealth inequality

Gini coe cient → numerical measure of income inequality. 0 = economy is equal and 1 = all income occurs
to one person. Most economies lie somewhere between these two extremes.

Economic reasons for inequality of income and wealth

- A lack of formal employment opportunities
- Poor vocational training: local industries cannot obtain the labour needed to maintain a viable
operation in national and international markets.
- Lack of investment in the education and health sectors
- Poor infrastructure like roads, railways, power and water
- Inability to obtain credit to fund small business and personal education
- Low rate of savings, which hold back priv and public sector investment

Policies to redistribute income and wealth

Many of the policies depend on funds generated from tax revenue for their implementation and regulation.
Collection of taxes causes di culties in low and middle income countries, where the informal economy is
huge with only a very small % of the pop. paying direct as opposed to indirect. Corruption and tax evasion
are common too.
- Informal economy → not regulated, protected or taxed by the government.

1. Minimum wage rate

De ned as the legal requirement of what employers must pay an employee per hour. It is a rate before tax
and any social security deductions are made.
- Less poverty
- Might only apply to a minority of poorly-paid workers
- Doesn’t have impact on informal sectors, self-employed, small businesses sta ed by family
- Its introduction leads to unemployment as demand for employment decreases.
2. Transfer payments
Payments made by the government to vulnerable members of the community. Examples include:
unemployment bene ts, old age pensions, housing allowances, child bene ts, food coupons. The extent to
which they can be paid is dependent on how much tax is collected and how many people pay tax.
- Less poverty
- Equitable distribution of income
- Unemployment bene ts → disincentive to work → reduced output + ine ciency
3. Progressive income taxes, inheritance and capital taxes
Progressive → rate of taxation increases as income increases
- Results in reduced income di erentials, however also the disincentive to work and even refuse to
move to a high tax country.
Inheritance → percentage of inheritance given as tax
Capital → paid annually on the nancial gain a person may have made in the time that an asset (property)
has been owned.
4. State provision of essential goods and services
If the goods and services are used equally by all citizens, then those with the lowest income gain most as a %
of their income. Inequality is therefore lowered. The market failures that occur as a result of provision of
these goods must be justi ed on the grounds of equity and not free provision to the consumer.
 4 The Macroeconomy
National income statistics
National income → a country’s total output.
- People earn an income ((FOP rewards) from producing the output → income is spent on the
output → total output = total income = total expenditure.
National income statistics → measures of the total output (+ income + expenditure) of an economy
- Governments’ measure their total output to assess the performance of the economy and compare to
other countries. Economists examine both the level and rate of growth of a country’s output.

Gross domestic product and gross national income

Gross domestic product (GDP) → total output produced in an economy
Gross national income (GNI) → GDP + net income from abroad (consumers + rms) (in ow - out ow)
- Net property income from abroad → receiving pro ts, rent, interest due to the ownership of
foreign assets (in ows) - pro t, rent and interest to foreigners (out ows).
- Compensation of employees → income of workers who work in another country temporarily
- Some tax rev can be paid to other countries/international organisations and subsidies may be
received by them.
Gross national disposable income → GNI + net transfers of workers’ income to their relatives to and
from other countries (in ow - out ow in terms of transfer of wage)

GDP > GNI → Due to MNCs, as foreign workers make an important contribution to output + Ability to
attract foreign investment. However this has resulted in an out ow of pro ts and other income. E.g Ireland
GNI > GDP → Due to net in ow of property income from abroad. E.g Germany as rms have invested in
other countries and now receive an in ow of pro ts from their MNCs operating in other countries +
signi cant in ow of income from their citizens working abroad.

Methods of measuring GDP

Each method should give the same value because they’re all measures of…
circular ow of income → how income ows around the economy
1. Output method (production method)
- Measures the value of output produced by industries.
- Double counting must be avoided. This can be done by →
- Totalling value of nal g/s
- Adding the value added at each stage of production. This gure should give the market
value of the nished product produced.
2. Income method
- Value of the output produced by adding all the incomes (rent, wage, interest, pro t) earned in
producing a g/s
- Include only payments received in return for providing a g/s, transfer payments NOT included
3. Expenditure method
- Totalling all the spending on the country’s output (cons spending, govt spending on g/s, total
investment, change in stocks, di between ex, imp). Transfer payments NOT included
 - *What's produced in a year will either be sold or added to stocks. So, if additions to stocks are added
to expenditure on g/s, a measure is obtained that will = output and income.
- Must add expenditure on exports and deduct expenditure on imports because exp creates income
and imp created income for people in those countries.

Market prices and basic prices

GDP and GNI are both measures in market prices and basic prices.
- Market price →price given to consumers. Includes any taxes and the deducting of subsidies
- Basic prices (factor cost) → prices that would be charged without govt intervention and which =
income paid to the FOP for making the output.
To go from market to basic prices taxes are deducted and subsidies on products are added

Gross values and net values

- Gross investment → total spending on capital goods
- Net domestic product (NDP) → GDP - depreciation
- Net national income (NNI) → GNI - depreciation
- Net investment → additions to the capital stock
- Depreciation (of cap g) → value of cap g have worm out / become out of date
GDP + GNI includes gross investment. This includes the output of cap g both used to replace existing ones
and those required to expand capacity. NDP and NNI only include net investment. They deduct the value
of the replacement cap g. This value is referred to as depreciation or capital consumption. Net investment
indicates whether the country’s ability to produce g/s in the future will inc/dec/same.

The circular flow of income

The difference between an open and closed economy

Open economy → engages in international trade
Closed economy → does not engage in international trade (neither exp nor imp)
Circular ow of income in a closed economy:
- Outer circle → money ow of spending + incomes
- Inner circle → real ow of products and factor services
The impact of injections and leakages on the circular flow
Leakages → withdrawals from the circular ow of income
- Some income is saved, some is taxed and some is spent on imports
Injections → additions to the circular ow of income
- Some expenditure is additional to the spending that comes from the
incomes generated by domestic output (households, rms):
investment, govt spending, spending by foreigners on a country’s
exports.
*Injections add to spending in an economy whereas leakages reduce it.
Circular ow of income in an open economy →

Links between injections and leakages

An injection will cause GDP to inc until, after time, leakages rise to match the
higher total injections.
In the long run, links can occur between changes injections and leakages.
- Inc investment → inc income → more saving → nance more investment
- Inc govt spending → inc tax rev by inc incomes
- Inc exports → inc incomes → inc cons spending on domestic + foreign products

Equilibrium and disequilibrium income

For income to be unchanged, injections = leakages
- Injections > leakages → extra spending → inc income
- Leakages > injections → more spending will leave the circular ow → dec income

1. Equilibrium income in a 2 sector economy (closed econ): households + rms

2. A rise in investment will cause a rise in GDP → inc production → income + spending

3. Equilibrium income in a 4 sector economy (open econ): households + rms + govt + international
econ
4. Income will move to a higher equilibrium level if any injection rises or any withdrawal falls. If tax
rates rise w/o changes in govt spending → more tax rev collected from households will reduce
amounts they have to spend. A rise in saving or imports will also cause GDP to fall, at least in the
short run.
Aggregate demand
AD → total demand for an economy’s g and s at a given price in a given time period.

Determinants of the components of AD

1. Consumer expenditure → spending by households on g/s
* amount and the proportion of income are not the same thing.
a) Disposable income → ∝ to spending.
- Poor peoples’ disposable income is spent on current needs
- Dissaving → cons exp exceeding income with ppl/countries drawing on past savings or borrowing
- Saving → disposable y - cons exp
b) Distribution of income → when y becomes more equally distributed due to: inc direct taxes +
state bene ts → ppl on low y inc spending, while the rich aren’t that a ected and cont spending.
c) Low interest rates (on spending) → ∝ to spending → return from saving dec, buying goods on
credit cheaper, easier to obtain loans
d) Expectations about the future + wealth → optimistic ab job security and inc income → inc
spending. Also an inc in wealth is ∝ to spending.

2. Investment → private sector spending by rms on cap g like factories, o ces, machinery
a) Δ in cons demand → ∝ to investment as they’d want to expand capacity
b) Low interest rates → inc investment → rms who borrow to buy cap g will nd it cheaper →
rms using retained pro ts will nd opp cost to fall → expect higher sales as low int rates = inc d
c) Advances in tech → ∝ to inv → raise productivity of cap g → stimulate more investment
d) Low price of cap equip/installation prices → inc investment
e) Expectations ab future → when rms are optimistic ab economic conditions improving and inc
d → more investment
f) Govt policy → cutting corporate tax + subsidising for investment→ inc investment. Only
applicable to an open economy.

3. Government spending → expenditure on merit g like education and healthcare and public
goods like defence. More e.gs: medicines, skl equip, military aircraft, investment in infrastructure.
a) Govt policy → depends on economic situation and whether it wants to stimulate econ activity
b) Inc tax rev → ∝ to govt spending
c) Demographic Δ → like an inc num of children → pressure to spend on education
 4. Net Exports → exports - imports
a) Country’s GDP → When it rises, demand for imports will inc. This could also mean that products
may be diverted from the export market to the domestic market.
b) Other countries GDP → when y rises abroad, demand for their exports will inc.
c) Relative price + quality competitiveness of the country’s products → Exports when inc when
competitiveness increases. This can happen due to inc productivity or improved marketing
d) Exchange rate → If exchange rate falls, the country’s exports will be cheaper and imports will be
more expensive. If d for ex + imp are elastic… exp rev will rise, while imp expenditure will dec → net
exports dec.

The aggregate demand curve

- Shows the relationship between total demand for the economy’s products at di prices.
- Relationship di to demand because in a d curve, price of the individual product is Δ but assumes
that the price of other products haven’t. In AD curves, prices of most products Δ in same direction
Why does AD fall when price inc (vice versa)?
1. Wealth e ect → rise in price reduces amount of g/s cons can buy → reducing purchasing power
2. International e ect → rise in price reduces d for net exports as esports will become less competitive
3. Interest rate e ect → rise in price inc d for money to pay for higher prices → inc interest rate →
reduction in consumption + investment

Shifts in the AD curve

(following examples cause a shift to the right, opposite for left)
1. Cons spending → rise in cons con dence, red income tax, inc wealth, inc
money supply, inc pop
2. Investment → rise in business con dence, red corporate tax, advances in
tech
3. Govt spending → desire to stimulate economic activity, desire to win
political support
4. Net exports → dec exchange rate, inc quality of domestic products, inc
incomes abroad

Aggregate supply
AS → total output (real GDP) that producers in an econ are willing and able to supply at a given price level
in a given time period.

The short run aggregate supply curve

SRAS → total output of an economy that will be supplied when the prices of FOP have not had time to
adjust to changes in AD and price level.
Average cost → cost per unit of output
Supply side shocks → large + unexpected Δ in SRAS
As price level (of g & s) rises, producers are willing and able to supply more g & s. 3 possible reasons why →
Change in price level = movement along the curve
- Pro t e ect → as price level inc, the prices of FOP like wages does not change. So, the gap
between output and input prices widens and pro t inc.
- Cost e ect → (it’s assumed that wage rates, raw material costs and other input prices remain
unchanged along an SRAS curve.) Average costs may rise as output rises. This is bec for e.g:
overtime payments may have to be paid and costs will be involved in recruiting more workers. To
cover extra costs, producers will require higher prices.
- *Misinterpretation e ect → producers may confuse changes in the price level with changes in
relative prices. They may think that a rise in the price level indicates greater d for their product →
encouraged to produce more.

Shifts in the SRAS

1. Δ price of FOP → inc wage rate not matched by inc in labour productivity,
and raw mat costs → left shift
2. Δ quantity of resources → in the short run, supply of inputs may be
in uenced by supply-side shocks. This can have adverse e ects on
productive potential in the long run
NOTE: factors causing inc quantity in long run will also inc SRAS
3. Δ taxes on rms → reduction in corporate tax → right shift
4. Δ quality/productivity of resources → rise in labour / capital productivity → right shift

The shape of the long-run aggregate supply curve

LRAS → total output of an econ that will be s when there's time for input prices to adjust to Δ in AD
Keynesians → ppl who agree w economist John Maynard Keynes that govt intervention is needed to
achieve full employment.
New classical economists → believe LRAS curve is a vertical line and the econ will move towards full
employment w/o govt intervention.
1. A group of economists called Keynesians represent the LRAS curve as perfectly
elastic at low rates of output, then upward sloping over a range of output, then
perfectly inelastic.
NOTE: to analyse macroeconomic issues, draw this curve. Enables me to make
comments about the e ect on output and the price level of Δ in AD.
- To emphasise that in the long run, an econ can operate at any level of output
and not necessarily at full capacity. From 0 - Y, output can be raised w/o inc
price level.
- When output and hence employment are low, rms can attract more resources w/o raising prices.
There’s time for input prices to Δ but, due to the low level of AD, they don’t. E.g: when
unemployment is high, the o er of a job may be su cient to attract new workers.
- As output rises from Y - Y1, rms begin to experience shortages of inputs and bid up wages, raw
material prices and the price of capital equip. When output reaches Y1,
the econ is producing max output w its existing resources.
 1. New classical economists illustrate LRAS as a vertical line.
- They believe that in the long run, the economy will operate at full capacity.
- A rise in AD may inc output in the short run by encouraging rms to make more intensive
use of their existing resources. Workers may be asked to work overtime and capital equip
may be operated for long periods.
- However, in the long run, this more intensive use of resources will
raise costs of production→ The economy will move onto a new
SRAS curve and back to the LRAS curve. Output will return to
initial level, at a higher price.

Shifts in the LRAS curve

Both Keynesian and new classical economists agree that the causes of a shift are
changes in the quantity and or quality of resources. Both will inc productive
capacity of an economy.
1. Causes of an inc in quantity of resources
- Net immigration: inc labour force IF they are of working age
- Inc in retirement age (by raising the age in which they can receive state pensions): inc labour force
- More woman in labour force: E.g - 42% Saudi vs 72% Norway
- Net investment: if gross (total) investment exceeds depreciation (cap g that have to be replaced bec
they are worn out) will inc capital stock
- Discovery of new resources
- Land reclamation (creation of new land from sea): E.g Dubai building houses / hotels / beaches
2. Causes of an inc in quality of resources
- Improved education and training
- Advances in tech: reduce costs of production + inc productive capacity

Macroequilibrium and disequilibrium

Macroeconomic equilibrium → output and price level achieved where AD = AS

Δ in AD and AS will move the econ to a new macroeconomic position. Where,

depends on the direction of the Δ, the size of the Δ and the initial level of economic
activity.

Economic growth
Economic development → an inc in welfare and quality of life
- Economic growth is an increase in an economy’s output. It's the key measure of progress in an
economy.
- For people to enjoy greater variety of g & s, output must inc by more than any growth in
population (GDP per head)
 - Economic growth does not result in a rise in living standards for everyone in an econ. Improvement
of life is possible w/o econ growth. E.g → reduced pollution or equal distribution of income. So,
economic development is related to, but distant from economic growth

Measurement of economic growth

- Economic growth rate is the annual % change in output from one period of time to another.
- Econ growth is measured in terms of real GDP

Nominal GDP and Real GDP

Nominal GDP → total output measured in current prices. It does not take into consideration the e ect of
in ation. It's unreliable because the value of nominal GDP may have risen not because of more output, but
simply due to inc price levels.
Real GDP → total output measured in constant prices (prices operating in base year). This ensures the
e ect of in ation that distorts nominal is removed.
- Base year→reference to a point in time. It's the starting year in an index and is given a value of 100.
- Real GDP → nominal GDP x (price index in base year / price index in current year)
- Price index → a way of measuring in ation. The value of the base year in the index is 100 and the
value of each following year is a % of it.
The price index used to convert nominal into real GDP is the GDP de ator → price index of all
domestically produced g & s. Includes capital g, cons g, price of exports but NOT imports.

Causes and consequences of economic growth

- If there is spare capacity - output can increase as a result of an inc in agg d → more
FOP being employed and output rising
- Making more use of existing resources can be shown on a PPC
● an inc in agg d in an econ with spare capacity can also be shown on an AD/AS curve:
Inc in agg d uses previously unemployed resources → output inc from Y to Y1

long term sustainable econ growth = productive capacity and agg s MUST inc:
1. Increase in quantity of resources:
Things that would increase the supply of labour, entrepreneurship, capital and land
- natural increase in population (long term)
- More immediately - net immigration of people of working age
- Govt policy measures. E.g - rise in retirement age (raises supply of labour) and
deregulation and privatisation (promotes entrepreneurship)
- Supply of capital goods will increase if there is net investment
- Quantity of land may increase through discovery e.g - new oil elds or gold mines

2. Increase in the quality (thus productivity) of resources:

- labour, entrepreneurship: education and better quality healthcare
- capital goods: technology advances
- Land: Fertilisers, irrigation and drainage schemes
 ● With the PPC it is now possible to produce a higher maximum combination of
the two types of goods
● The LRAS curve shifts to the right to show an inc in productive capacity

Economic growth in low-income countries

- Main obstacle to increase quantity and quality of resources - opportunity cost of
allocating resources away from their current use
- Allocating more resources to education may mean that fewer resources can be
allocated to healthcare
- Producing cap g may mean having to sacri ce some cons g in the short run (which
would lead to a decrease in living standards)
- Research and development that can result in advances in technology also use
resources that have alternative uses

Economic growth in China and India

China and India have witnesses particularly rapid economic growth
- China has become 1 of the 2 largest economies in the world
- 2012 - 2019, Accounted for 30% of global economic growth
- China's increase in output has been driven by increases in investment and exports
- High rates of saving in China have freed up some resources for investment
- The relatively low value of the Chinese currency has contributed to the rise in d for its exports
● India's econ growth rate has boosted by an inc in the size of the labour force + advances in IT
● 2012 - 2019, India accounted for 16% of global economic growth

Economic growth may be negative…

- Recession → A decline in real GDP over two consecutive quarters (six months) or more
A country's output may decline as a result of a dec in agg d or agg s

● For an increase in productive capacity to lead to higher output, the rise in

productive capacity must be put to use
● Both diagrams above show an increase in aggregate demand and aggregate supply
● With the PPC we can see an increase in output yet the new point is still inside the
curve and represent ine ciency
● In both cases - the econ is not producing as much as it is capable of making (it's
wasting resources - unemployed workers and unused machines
● Second diagram shows that both AD and AS have increased
● Yet the economy is not operating at maximum capacity
● Maximum output would be achieved if the AD curve cuts the LRAS curve on the
vertical part of the LRAS curve
 The costs and bene ts of economic growth:
● Some economists in high income countries debate whether the bene ts of economic growth
outweigh the costs
● For those in low income countries - economic growth is seen as essential to bring people out of
poverty

Bene ts Costs

- In the long run - inc investment will inc output of both capital goods - Short run - To inc the country's productive capacity
and consumer goods and services (through a greater production of capital goods) resources
- inc in g and s that become available for the country's citizens to enjoy will have to be moved from the production of consumer
goods to cap g → dec consumption + spending → lower
- raise living standards
living standards
- makes it easier to help the poor - higher incomes and more spending
- if the econ is operating at full capacity - opp cost
inc tax rev and some of this extra rev may be given to the poor in the - Inc stress and anxiety -
form of higher bene ts (better housing, education, healthcare). W/o an ● growing econ is dynamic and undergoes
inc in income and output - govts may have to raise the tax rates on structural changes - some industries expand and
higher income groups (which reduces their living standards) to help some decline - workers may have to learn new
the poor skills + may have to change their occupation and/
or where they live
- Economic growth may also be accompanied by a rise in employment
● Inc working hours, pressure to come up w new
● A rise in real GDP caused by higher AD is likely to create ideas and improvements
extra jobs (derived demand) - depletion of natural resources → damage to
- Inc agg s → products more internationally competitive and so may environment
generate more jobs (if accompanied by d) - rms using more oil, depleting sh stocks, building on
- stable rate of econ growth→ inc bus + cons con dence (encourages areas of natural beauty and creating more pollution
investment)
- inc a country's prestige and power (e.g china)

Unemployment and the labour force

- Unemployment → the state of being willing and able to work but not having a job
- Homemakers → people who look after the household of their own families
- Economically inactive → ppl who are not in the labour force (those not of working age)
- Labour force → the employed and unemployed
- Economically active → people in the labour force

- labour force in an economy is de ned as the total number of workers who are available for work
- Refers to all people who can contribute to the production of goods and services
- Size of a country's labour force depends upon a wide range of demographic, economic, social and
cultural factors:
- school leaving age
- number of people who remain in full time education above the school leaving age
- retirement age
- proportion of women who join the labour force
 - It's not always the case that the greater the number of people of working age, the greater the labour
force. The labour force is a ected by the labour force participation rate:
- Labour force participation rate → % of the total population of working age who are actually
classi ed as being part of the labour force
- Rate may be low due to a higher participation rate in higher education and a relatively large
proportion of workers deciding to take early retirement

Level of unemployment and rate of unemployment

- Level of unemployment → workers who are unemployed
- Unemployment rate → unemployed workers as a percentage of the labour force

-
- Employment rate → employed workers as a percentage of the population of working age
NOTE: employment rate and unemployment rate do not add up to 100%
NOTE: Level and rate may move in the same direction, but they aren't the same: labour force inc by a
greater % than the level of unemployment - unemployment rate will fall

19.4 The stock and ow of unemployment:

● A ow is measured over time
● A stock is measured at a particular time period
○ Level and of unemployment show unemployment at a particular time period, NOT the
exact situation as people move into and out of unemployment
● Unemployed ppl may stay the same over a few months but it doesn’t mean it's the same ppl:
○ some will have become unemployed over the time period while others will have found jobs
or will have left the labour force
● Discouraged worker → workers who would like a job but who have given up actively seeking
work after a period of trying to nd work
NOTE: don’t assume that if there are 1 million fewer unemployed people, that there are 1 million ppl in
work as there are reasons as to why workers may stop being unemployed:

On the left= why the enter

On the right=why they leave

Measures of unemployment
Governments use two main methods of measuring unemployment:
1. Claimant count measure: based on those claiming unemployment bene ts
- Relatively quick and cheap to calculate bec based on info the govt collects as it pays out bene ts
● gure obtained not be entirely accurate because:
 ○ May overstate or understate true gure
○ Some of those receiving unemployment bene ts may not be actively seeking employment
○ Some may be working and claiming bene ts illegally
○ groups who are actively seeking employment but do not appear in o cial gures: too
young / old to claim unemployment bene ts, choose not to, full-time students looking for
work, non-employment income is too high.

2. Labour force survey measure: based on a survey that identi es people who are actively seeking a job:
employed, unemployed or economically inactive. More widely used than the claimant count measure.
Involves conducting a survey usually using the International Labour Organization (ILO) de nition of
unemployment: all people of working age who, in a speci ed period, are without work but are available for
work in the next two weeks and who are seeking paid employment
- This measure picks up some groups that the other doesn’t
- Also has the advantage that its based on internationally agreed concepts and de nitions (makes
international comparisons easier)
- More info is found on (ex. Quali cations job seekers have)
● Data are more expensive and time consuming to collect than the other measure
● Data are based on a sample survey - so they are subject to sampling error and to the practical
problems of data collection
Sampling error → ppl being surveyed having di characteristics / experiences to the rest of the pop

The causes of unemployment

1. Frictional unemployment → temporary and arises when workers are in-between jobs
a) voluntary unemployment - occurs when workers are not willing to accept jobs at the current wage
rate and working conditions
● This form of unemployment is also in uenced by how the level of unemployment bene ts
compares to low wages
○ If amount earned in employment is less than what is received in bene ts - some workers
may decide to stay unemployed
○ In most countries - amount of unemployment bene ts received falls after a period of time
b) search unemployment - workers do not accept the rst job or jobs on o er and spend some time
looking for a better paid job
● The provision of more and better quality information may reduce search unemployment
c) Casual unemployment - workers who are out of work between periods of employment (actors,
construction workers)
d) Seasonal unemployment - demand for workers uctuates according to the time of year (tourism,
hospitality, building, farming)

2. Structural unemployment → caused as a result of the changing structure of economic activity

- Over time - the pattern of d & s Δ → d for some products dec while for others inc → industries
expand or contract
 - During this time - there may be a mismatch between job vacancies and the skills, quali cations,
experience and geographical location of those who have lost their jobs
- If workers cannot move from one industry to another (due to lack of geographical or occupational
mobility) they may stay structurally unemployed for some time
a) Regional unemployment - declining industries may be concentrated in a particular area of the
country
b) Technological unemployment - introduction of labour saving techniques (like the development
of drones and robots delivering shopping is resulting in some delivery drivers losing their jobs)
c) International unemployment - occurs when workers lose their jobs because demand switches
from domestic industries to more competitive foreign industries

Frictional and structural arise largely due to problems on the supply side of the economy

3. Cyclical unemployment → unemployment that results from a lack of aggregate demand. AKA demand
- de cient unemployment. It a ects the whole economy (job loses over a range of industries)
- This diagram shows the labour market:
- A fall in agg d means rms will dec output and agg d for labour shifts left
- If workers resist wage cuts - there will be cyclical unemployment XQ
- But even if wages fall - cyclical unemployment will persist
- a cut in wages would red d for g and s bc people have less to spend →
rms dec output and make more workers redundant

The consequences of unemployment

Workers ● Experience a fall in income

● Unemployed people nd it more di cult to get another job the longer they have been out of work
● ^^ miss out on training, will become out of touch with advances in tech, may lose con dence
● Unemployed people may also witness a decline in physical and mental wellbeing
- For a small number of people - chance that a period of frictional or structural unemployment may give
them the chance to search for a job they may enjoy more and is better paid

Firms - Greater choice of potential workers

- Firms may also bene t from workers not requesting wage rises for fear of losing their jobs
 ● su er from lower demand for their goods and services

Economy - structural unemployment allows the econ to respond quicker to changes in d and s conditions (workers
move from declining to expanding industries)
● Output will be below its potential level (if the unemployed were still working - more g and s would be
produced and living standards would be higher)
● Tax rev will be lower than with a higher level of employment
● Econ experiences an opp cost: inc in gov spending on unemployment bene ts

How significant is unemployment

E ects of unemployment depend signi cantly on its rate, duration and type
- High rate = economy producing well INTO its PPC and are forgoing a large quantity of output
- The longer workers are unemployed - the lower their income will be - may su er from poor mental
health bc of the stress of being without work - less likely to be employed

- Frictional is considered the least serious type - Some level is unavoidable in a changing econ
- Whereas cyclical can cause serious problems - may be of high rate and last a long time

- Low unemployment is not always a sign of a strong economy

- Some workers may be in low paid and insecure jobs
- Other working may be experiencing underemployment
- Underemployment → situation where ppl are working fewer hours than they would like
or working in jobs that they are overquali ed for

- Reasons for the fall in a country's unemployment rate must be closely monitored
- Bene cial if fall results from previously unemployed gaining good quality jobs
- not bene cial when rate falls bec unemployed have given up on trying to nd jobs

- Unemployment rates vary bet genders, age groups, ethnic background, regions and skills

In ation, de ation and disin ation

Price level → the average of all prices in an economy
Price stability → prices rise by only a small % and there is avoidance of uctuations in the price
- Encourages rms to expand. Higher national output can create employment, as well as increasing
the g/s available for governments to spend on education and healthcare.
In ation → a sustained increase in an economy's price level over a period of time
- In ation does not mean that EVERY price is rising or that all prices are rising at the same rate
- On av. prices are rising at a particular rate: Some prices may rise by more and some may fall
- When the price level (aka general price level) increases - the value of money falls and its purchasing
power declines
Degrees of in ation:
- A low and stable in ation rate (creeping in ation) (about 2%) is not regarded as a problem for an
econ. It may even encourage rms to produce more
- Hyperin ation → very high rate of in ation which may result in people losing con dence in the
currency. It is generally considered to be an in ation rate that exceeds 50% a month
- It occurs when in ation gets out of control and sometimes results in people resorting to barter

De ation and disin ation:

- De ation → sustained fall in the price level (-ve in ation rate). Results in a rise in the value of
money (each currency unit has greater purchasing power)
- Disin ation → in ation rate falls but is still positive. Price level is still rising but at a slower rate

Calculating the inflation rate:

In ation rate → % Δ in price level from one period to another
- % Δ can be Δ in av prices from one month to the next or from one quarter to another
Two comparisons most used by economists:
1. Annual average method: a way of calculating the in ation rate by comparing the average level of
prices during a twelve month period with the average level in the previous twelve months
2. The year on year method: a way of calculating the in ation rate by comparing the percentage
change in the price level for a given month with that of the same month of the previous year

Measurement of inflation and deflation:

● A country's price level indicated how much it costs to live in that country
● Rise in price level = cost of living has increased
● To assess changes in cost of living - governments construct a consumer price index (CPI)
○ CPI → measure that shows the average change in the prices of a representative basket of
products purchased by households

Limitations of CPI
Summary: accuracy of country's CPI is a ected by:
- Sampling errors
- How often basket of goods and services is updated
- The extent to which govt statisticians can avoid substitution and quality bias
The base year Di cult to select a base year that's representative of the economic conditions of a country

The survey - 2 key problems: whether people selected are representative of the whole population or whether they
complete the survey accurately
- Even if survey is representative - doesn't mean the in ation rate represents the price changes that each
person experiences
- Dif groups have dif spending patterns so e ectively have dif in ation rates
- old people spend more on medication so more a ected by price Δ (there) than younger people
- People might make mistakes when recording their spending or may deliberately leave items out

The basket of 1. The weights might become out of date

goods and ● EVAL: Most govs update the content of the basket regularly to ensure the weights remain
services representative of current household expenditure patterns
● EVAL: within the period before updating to the new basket, it remains xed. So, consumers may
react during this time to changes in relative prices by altering their purchases.
1. Govts take into consideration substituting from one relatively expensive brand or product to a less
expensive one, but they DONT account substitution between di types of products (bus travel and car
travel) → CPI does not fully re ect how consumers react to changes in relative prices
2. Basket takes time to include new products and to remove old ones that are now less popular
3. basket may have quality bias - like a washing machine price may be 4% higher but may have improved in
quality with additional features and a longer life.
● EVAL: Could be argued that in such a case consumers are getting better value for money
4. Also possible that while prices may not change, quality and size of products may decline
● E.g: Price of ight may stay the same but quality of meals served may decline, or price of chocolate bar
may not change but size becomes smaller (aka shrink ation)
● EVAL: Some govs seek to overcome potential quality issue by putting a monetary value on the
quality changes in products
● If a product has improved or it has additional features - value of changes is removed from price of
product
● If product has a diminished or removed feature - value is added to the price
● EVAL: In practice - it can be di cult to estimate the value of quality changes

The difference between money values and real data

Money values (nominal values) → values of the prices operating at the time
Real data → is data in real terms - has been adjusted for in ation
- To convert money values into real data - gures are multiplied by the price index in the base year and
divided by the price index in the current year
- E.g - worker may experience a 'pay rise' but due to in ation - no real increase has occurred
- Changes in real data can be estimated by - the Δ in inf rate from the Δ in the money value
○ If nominal interest rate is 5% and in ation rate is 6% real interest rate is -1%
The causes of inflation
Cost-push in ation → in ation caused by inc in costs of production
Figure shows a decrease in aggregate supply caused by higher costs of production →
contraction in agg d and reduces real GDP

There are a number of costs that may rise:

- Wages may increase more than labour productivity → inc labour costs
○ Higher wages can cause a wage-price spiral → Workers gain a wage
raise - causes price to rise - workers seek higher wages to restore their
real value and so on
- Inc in raw material costs and fuel can also push up prices
- In some cases - increases may be caused by a fall in the exchange rate
- When value of currency falls - price of imported products rises - results in higher transport
and production costs - higher price
- Increase in rms' pro t margins will also increase costs of production
- lead to longer term investments and cash-out to investors (via dividends or sale of the rm
shares), which increase the demand for raw materials. This increased demand of raw
materials (e.g. Oil) leads to cost-push in ation.
- Costs may also be pushed up by damage and depletion of resources (ex. Period of bad weather may
reduce fertility of land and supplies of oil may be reduced)

Demand-pull in ation → caused by inc in agg d not matched by equivalent inc in agg s
- Can be caused by an inc in consumer expenditure, govt spending, investment, rise in net exports

- Rise in agg d will have a greater impact on the price level the closer the econ comes to full capacity
- Increase in some forms of gov spending and investment may not be in ationary in the long run
○ Gov spending on education may inc labour productivity and so inc productive capacity

All economists agree that there is a clear link between changes in the money supply and changes in the price
level. The debate is which causes which
- Monetarists: economists who consider that in ation is caused by an excessive growth in the money
supply
○ They suggest that if the money supply grows more rapidly than output - greater supply of
money will drive up price level
○ Some economists view 'monetary in ation' as a speci c cause of in ation
- Keynesians argue that it is in ation that causes an increase in the money supply
○ if costs rise - rms may borrow more from banks → increase in the quantity of money

Link between demand pull in ation and cost push in ation:

● Some changes both increase aggregate demand and increase costs of production
● E.g fall in country's foreign exchange rate may both raise the price of imported raw materials and
increase export revenue
 ● Also once in ation occurs - risk that an in ationary spiral may occur → Demand pull and cost
push factors may interact together and reinforce each other
● Higher govt spending on state pensions may increase aggregate demand - resulting in higher prices
may encourage workers to call for higher wages - wage-price spiral occurs (but also higher wage =
more spending = higher aggregate demand = high prices etc.)
NOTE: di cult to determine cause of in ation (demand pull or cost push)

The consequences of inflation

Possible costs of in ation:
● Balance of payments problems: Reduction in net exports → reduces international
competitiveness of country's products → inc expenditure on imports → low export rev
● Unplanned redistribution of income: some gain and some lose as a result of in ation → if rate
of interest does not rise in line with in ation → borrowers gain and lenders lose (pay back less in
real terms and lenders receive less) → savers lose out bc real value of their savings falls
● Menu costs: costs to rm of having to change prices because of in ation (a ect rms like with
catalogues, price tags, bar codes and advertisements) - involves sta time and is unpopular with
customers
● Shoe leather costs: costs involved in moving money from one nancial institution to another in
search of the highest rate of interest
● Fiscal drag (bracket creep) → the income of people and rms being pushed into higher tax brackets
as a result of in ation
○ EVAL: can be argued is a cost of an ine cient tax system not a cost of in ation
● Discouragement of investment: unanticipated in ation can create uncertainty and so make it
more di cult for rms to plan ahead → adverse e ect on economic growth
● In ationary noise: 'money illusion' arises when in ation causes consumers and rms to confuse
price signals → hence they make wrong decisions because of incorrect assumptions about price
changes like a misallocation of resources
● In ation causing in ation: consumers, workers, rms will expect prices to rise and act in a way
that will cause in ation → workers call for higher wages → rms raise prices to cover expected
higher costs → consumers may seek to purchase products now before prices rise further → di cult
for gov to change in ationary expectations

Potential bene ts of in ation:

● Stimulates output: low and stable in ation rate caused by increasing demand may make rms feel
optimistic about the future. If prices rise by more than costs then pro ts will increase which will
provide funds for investment - investment also encouraged as real rates of interest fall and consumer
expenditure may rise as higher money incomes will make people feel better o even if they aren’t in
real terms
● Reduces the burden of debt: real interest rates fall due to in ation or may even become negative -
bc money interest rates do not tend to rise with in ation - fall in debt burden may stimulate
expenditure which in turn could lead to higher output and employment
 ● Prevents some unemployment: struggling rms may have to reduce their costs to survive - for
many wages form a signi cant part of total costs - with zero in ation rms may have to cut their
labour force - in ation would help them reduce real costs of labour by keeping wage costs the same
or by not raising them in line with in ation

Factors a ecting the consequences of in ation:

● The cause of in ation (demand pull is likely to be less harmful than cost push) one is associated
with rising output while the other is associated with falling output
● Rate of in ation - high rate likely to cause more damage especially if it turns into hyperin ation
→ households and rms losing faith in their currency and this may bring down the govt
● Whether rate is accelerating or stable - accelerating or even uctuating will cause uncertainty
and may discourage rms from investing - need to devote more time and e ort to estimating future
in ation rates will increase costs
● Whether in ation rate is expected - unanticipated in ation also creates uncertainty and
discourages some consumer expenditure and investment - but if it was accurately estimated by
households, rms and governments then they can take measures to adapt to it and avoid its
potential harmful e ects. For instance:
- Firms adjust prices
- money interest rates may be changed to maintain real interest rates
- Government may adjust tax brackets - raise pensions - public sector wages
- How rate compares with other countries - if rate is below that of competing countries it
may become more internationally competitive

Recent reductions in global in ation:

● In most countries - rate has been relatively low
● One reason thought to be responsible is advancements in tech (keep costs down and enable higher
agg d to = higher agg s)
● Another reason is increased international competition
● Also changes in labour markets like trade union membership falling and a growth in casual
employment (such changes have reduced ability of workers to call for wage rises)

Extension: causes and consequences of deflation:

Causes and consequences of de ation:
Good de ation occurs as a result of an inc in aggregate supply (fall in price level and rise
in real GDP)
● Cause: advances in tech - create new methods of production and lower costs of
production
● Bene t: inc output, employment and can raise international competitiveness
of country's products

Bad de ation however occurs when the price level is driven down by a fall in agg d
● In this case output falls which may result in higher unemployment
 ● Bad de ation runs the risk of developing into a de ationary spiral
● Consumers may delay purchases (expecting prices to fall further in future)
● Firms may not invest and reduce the number of workers they employ (because of low demand)
● Some debtors may get into di culty and this may cause banks to get into di culty with the risk of
some going out of business and losing their customers' money
○ Debtors → people, rms or govts who owe money
● All these e ects reduce demand further and economic activity will decline again

In ation versus de ation:

● Most govs aim for a low and stable rate of in ation rather than a fall in the price level
● Two key reasons for this:
○ a low rate of demand pull in ation may promote economic growth
○ Measures of in ation tend to overstate the in ation rate bc they tend to take into account
quality improvements and the e ect of consumer switching to lower priced products
 5 government macroeconomic intervention
Government macroeconomic policy objectives →
Price stability
- Aim for low and stable in ation rate, NOT 0 because:
a) Any measure of in ation tends to overstate any rise in prices
b) May result in de ation
c) Low and stable in ation caused by inc spending → rms inc output
- Govts set in ation targets for their central banks: 3% - 6% or w a margin on either side 2% +/- 1%
- An in ation target holds a central bank accountable. It may even reduce in ationary expectations: if
households, rms, workers have con dence in a central bank’s ability to meet its target, they may act
in a way that DOESN’T inc prices. E.g - workers believe there will be price stability so they don’t
demand higher wages.

Low unemployment
- Results in high output, high tax rev, low expenditure on unemployment bene t.
- Govts hope to ensure any unemployment is short term so that workers don’t lose their skills and
work habits. They seek to achieve this by promoting labour mobility. E.g: training schemes

Economic growth
- If a country’s output is falling, unemployment may inc and living standards may decline.
- Govts also want to avoid a high rate of econ growth bec it could result in the economy overheating.
- Agg d > agg s
- Pressure on resources and inc in ation
- Entrepreneurs become overoptimistic and set up rms that don’t have a long term future
- Households may expect incomes to cont rising and so take out loans that they will struggle
to repay if their expectations are wrong
- In determining a good growth rate, govts must take into account several factors. Including: changes
in labour size, changes in productivity, advances in technology

Fiscal policy and the Budget

Government policy that uses taxation and govt expenditure to manage agg demand to achieve the
macroeconomic aims.
The budget → an annual statement in which the govt outlines its plans for spending and tax rev. It's an
indicator of both scal policy intentions and economic performance.
- Budget surplus → tax revenue > govt expenditure
- Budget de cit → govt expenditure > tax revenue
- Balanced budget → govt expenditure = tax rev

A budget de cit tends to decline in the short run IF there’s a rise in tax and a dec in govt expenditure.
- EVAL: However, there's a possibility that a rise in govt spending and or a cut in tax could reduce a
budget de cit, bec such changes could inc economic activity. E.G inc spending on training
 In the short run, a govt may aim for a budget de cit if
there's low levels of economic activity. This is called a
cyclical de cit. It tends to fade when GDP rises. A de cit
can occur due to both deliberate govt action (cut taxes, inc
spending) and automatic stabilisers (changes in govt
spending and tax that occur to reduce uctuations in agg d
w/o alteration in govt policy). A govt should worry about a
structural de cit. This arises when a govt is committed to
spending too much relative to its tax revenue. The de cit
won’t disappear when GDP inc.

National Debt
National debt is often expressed as a % of GDP. It's connected to budget de cits (adds to debt) + surpluses
(can be used to pay o debt).
- Tends to inc during economic downturns + military con icts
- Tendency to inc spending during economic booms too (structural de cit)
- Disadvantages: opportunity cost of paying o the debt. Also there's a reluctance to lend as
households, rms and nancial institutions may have doubts about the govts ability to pay them
back w interest.

Taxation
Indirect taxes → Taxes on the sale of g/s. Largely paid by consumers, but are collected by rms that supply
the products. Firms will try to pass on as much of the tax onto consumers via higher prices. (extent of
burden depends on PED)
- Ad valorem taxes: VAT (value added tax) and GST (general sales tax) are the 2 most common
types. This means that they are taxes based on the % of the price of a product.
- Speci c indirect taxes: taxes charged as a set amount per unit
- Excise duties / sin taxes: taxes on products considered to be harmful to consumers

Advantages Disadvantages

- They can be changed quickly and easily - Makes income less evenly distributed as its regressive
- Cheaper to collect as rms do part of the administrative - Contribute to cost - push in ation as an extra cost is
work placed on suppliers → higher prices
- Discourage consumption of demerit goods - Encourages the illegal smuggling of imported goods to
- They don’t discourage e ort, innovation, saving and avoid paying import tari s
investment

Progressive, regressive and proportional taxes

- Progressive → as income rises, a higher % is paid in tax
- Regressive → takes a larger % of the income / wealth of those on low incomes
- Proportional → takes the same % of the income and wealth of all income groups (regressive)
 Direct taxes → taxes on income and wealth
- Income tax → tax on personal income
- Corporate tax → tax on pro ts
- Tax evasion → illegal non - payment or underpayment of a tax
- Tax avoidance → legal bending of rules of the tax system to pay less tax

Advantages Disadvantages

- Some workers amy decide to work more hours to keep - Puts o ppl from joining the labour force
their level of disposable income - Stop ppl from working overtime
- Encourage ppl to cut standard working hrs
- Acts as a disincentive to save as it means their income will
be cut TWICE: once when earned, once w interest
- Stops rms introducing new methods and products
- Encourage tax evasion and avoidance

Marginal and average rates of taxation

- Marginal rate of taxation → proportion of extra income taken in tax
- If a person earns an extra $100 and $30 is taken in tax, marginal tax rate = 30/100 = 0.3
(30%)
- Average rate of taxation → proportion of income that's taxed (tax / income)
- progressive tax: the marginal tax rate > average tax rate. Proportion of tax people pay on extra
income > proportion they pay on the total amount they earn.
- regressive tax: the marginal tax rate < average tax rate.
- proportional tax: marginal tax rate = average tax rate

The reasons for taxation

- In uence aggregate demand based on the economic situation of a country
- Raise revenue to nance govt spending on public goods and merit goods
- Distribute income more evenly (progressive only). Gap could be narrowed further by using some of
the tax taken from the rich to provide cash bene ts to lose on low incomes.
- Discourage the consumption of certain products: imports, demerit goods

Government spending
Reasons for government spending
- In uence agg d and therefore the level of economic activity
- Inc agg s (supply-side) to raise the econ’s productive potential
- Avoid poverty and to reduce income inequality: transfer payments and unemployment bene ts to
- Overcome market failure: merit goods and public goods
- Win political popularity and remain in power
- Pressure from the public to spend on the environment and becoming sustainable

Expansionary and contractionary scal policy

- Expansionary → inc agg d by inc govt spending and cutting tax. A govt may even aim to inc an
existing budget de cit to make a larger net injection into the circular ow of income?? why
- Contractionary → reduce agg d by dec govt spending and inc taxes. Govts aim for a budget surplus
- Δ in govt spending may be a result of Δ in govt policy or Δ in economic activity. Discretionary
scal policy → deliberate changes in government spending and taxation.

Automatic stabilisers
- Govts can also allow automatic stabilisers to in uence agg d. They are forms of govt spending and
taxation that change w/o any deliberate govt action to o set changes in GDP.
- E.g: during a recession, govt spending on unemployment bene ts automatically rises because there
are more unemployed people. Tax rev from corporate, income and indirect
taxes will automatically fall as pro ts, income and expenditure decline.
- The Figure shows how total tax rev and govt expenditure change
automatically as GDP changes: Initially, the econ is operating below full
employment at Y w a signi cant gap between govt spending and taxation. As
GDP rises, govt spending on bene ts falls while tax revenue rises with more
people in employment or receiving more income

The impact of expansionary and contractionary scal policy on the macroeconomy

- Contractionary scal policy may be used to reduce demand - pull in ation, as lower govt spending
(good for countries like Pakistan where the majority of the population don't pay income tax) and
higher taxes are likely to decrease agg d.
- EVAL: workers may seek higher wages to maintain their disposable income → higher costs
of production for rms → cost - push in ation. Some workers may even leave the labour
force and emigrate to other countries → reducing the econ’s productive potential & agg s
- Expansionary scal policy may be used to inc a country's output and raise
employment. (particularly if its cyclical unemployment)
- EVAL: the success of this will depend on… how worried households
and rms are about the future (consumers may save most of their
disposable income) and how much spending the govt injects into
the econ. Too much = demand - pull in ation.
Monetary Policy
A demand - side policy used to in uence aggregate demand. They are applied by the central bank

The main tools of monetary policy are:

- Interest rates (the cost of borrowing money and the reward for saving) → its main objective is to
control in ation and in uence economic activity. Households and rms who borrow money have
to pay interest. While if they lend money they are paid interest.
- Money supply (total amount of money in a country) → changes in the quantity of money in an
economy can in uence agg d. A central bank can electronically print more money, but the main
cause of changes in money supply is lending by commercial banks.
- Exchange rate → central banks may manipulate this to raise / lower agg d to in uence price
stability
- Credit regulations (rules a ecting bank lending) → central banks may also impose credit
regulations on commercial banks to help maintain nancial stability. Most central banks require the
country’s commercial banks to hold a proportion of their assets in a form that can be quickly sold
and converted into cash so that they can meet consumers’ demand for cash even during a nancial
crisis.

The impact of expansionary and contractionary monetary policy

Monetary policy and the price level
- reduces demand-pull in ation (contractionary): If the in ation rate is rising outside its target
range, the central bank is likely to raise the rate of interest to reduce demand → cost of borrowing
inc → discourages large scale purchases (cars, houses) → savings may be increased as the return for
it increases.
- EVAL: however, monetarists argue that the only way to red in ationary pressure is to lower
the growth of money supply. If inc money s do not exceed inc in output, they suggest there
won't be an increase in price levels.
- EVAL: a rise in interest rates may not discourage spending IF consumers are optimistic
about their incomes in the future
- EVAL: inc interest rates can have an adverse a ect on investment: inc cost of borrowing
funds to invest and will inc opp cost of using pro ts to invest → capital stock will decline if
investment falls below depreciation → decrease in agg supply which can push up price level
- EVAL: if central banks raise interest above other countries, they may attract an in ow of
money into their nancial institutions from abroad, inc their exchange rates (appreciation)
- Correct bad de ation (expansionary): done by decreasing interest rates and / or inc money supply
- EVAL: rms and households may be pessimistic during de ation and so may not speed
more even if there's more money in circulation and it becomes cheaper to borrow
- EVAL: may not be possible to red the interest rate further and any cut will have little e ect
on stimulating inc borrowing and spending
Monetary policy and equilibrium national income, the real level of output and employment
1. Expansionary monetary policy → higher national income → more cons expenditure and
investment and therefore inc agg d → inc real output → inc employment to meet demand
2. Contractionary monetary policy may red national income, output and employment. However, if
it's used when the econ is operating with all resources employed, it may red in ation rate. W/o
downward pressure on the growth of consumer spending and investment, the price level would rise
to p2 rather than p1.

The di erence between expansionary and contractionary monetary policy

- Expansionary → inc agg d: inc money s, red interest rates and red restrictions on bank lending
- Contractionary → dec agg d: dec money s, inc interest rates and restrictions on bank lending

The e ectiveness of monetary policy

- Di cult to control money supply because commercial banks have a strong incentive to try and inc
their lending and may seek to get round any limits a central bank seeks to palace on the growth of
their lending. Trying to control certain forms of money can lead to new forms of (illegal) money
being used.
- There may be a time lag between changing interest rates and the full e ect being transmitted to the
macroeconomy. Some economists estimate that it takes as long as 18 months for its full impact.
However this is less time than in the case of some scal policy measures.
- Interest rates are also blunt and uncertain as households and rms can react di erently. E.g: inc
interest rates harms borrowers but bene ts savers.

Supply side policy objectives and tools

Govt policy tools designed to inc agg supply, main way is by increasing productivity of FOP. Some tools will
reduce govt intervention while others will inc it.

1. Education and training: inc spending can inc the quality of education and training → skills +
productivity of workers inc → exibility and mobility → more e cient labour force. Same size, yet
more g/s can be produced. A better educated workforce → inc quality of entrepreneurship → inc
innovation
2. Promoting infrastructure development: e cient transport, power, energy keeps the costs of
rms low → easier transport of products to market. E.g less power outages means production is not
interrupted as frequently. E.g improving the rail network → reduced costs of moving products to
 and from rms → workers aren’t late. Govts can also encourage priv sector to provide infra, like a
motorway which charges motorists a fee for using it.
3. Support for technological improvement: enables capital equip to produce a greater output at a
lower cost. Govts can subsidise unis and priv sector to encourage such development.
4. Cuts in corporate tax: encourages investment as rms will keep more of the pro t they earn
5. Cuts in income tax: encourage workers to inc working hours, accept promotion + greater
responsibilities. Some workers may stay in the labour force for longer and persuade others to join.
6. Trade union reform: inc workers exibility and mobility and cut down the num of days lost
through strikes. A fall in industrial action → mnc more willing to invest → inc both productivity
and production
7. Privatisation and deregulation: rms operate more e ciently in priv sector due to their pro t
motive. Deregulation is done by removing barriers of entry + laws that inc rms’ costs of
production
8. Encouragement of immigration: particularly of skilled workers, to inc both quantity and quality
of labour in a country

The impact of supply-side policy tools on the macroeconomy

The impact on national income and real output (will inc IF productivity of labour + cap inc)
- Improved training → more g/s produced
- Govt spending on infra → inc quan of resources that can be used in the production and transport
of products → more g/s produced at a faster rate
- Tech improvement → raises quality and productivity of cap g. E.g robots used to pick fruits→ inc
output + red costs of production

The impact on the price level

- Over time, agg d tends to inc. IF agg s can keep up w this inc, a country can
enjoy a higher output (inc in real GDP) w/o experiencing demand-pull in ation.
- Inc spending on training → inc labour productivity → reduce labour costs →
correct cost-push in ation

The impact on employment

- Improved education + training → inc workers’ skills, geo + occu mobility → reduce both frictional
and structural unemployment
- Technological improvement → capital replaces workers. EVAL: however, this could inc
employment as it lowers costs of production for rms → may inc sales → more workers hired to
produce the higher output

The e ectiveness of supply - side policies

Education and training:
- e ective in the long run as it may directly inc the quality of labour and productive capacity
- Not e ective in the short run bec it can take a long time to have an e ect. It may also contribute to
in ation as inc govt spending on training results in inc employment → inc agg demand
 - Not e ective if it isn’t of high quality or if training develops unnecessary skills
- Inc spending on training may be successful in raising skills, but if their pay inc because of this, costs
of production inc and agg s will not inc
Infrastructure development:
- Expensive and takes a long time to build
- Demand for a particular means of transportation may have changed
- Harmful e ects on the environment
Technological development
- New products, new jobs and new methods of production are created
- Labour substitution → unemployment

NOTE: any supply - side policy tool which inc agg s may not raise output if the economy is initially
operating w spare capacity This is bec while it will inc productive potential, that potential will not be used
if there isn’t enough agg d. Firms may be capable of producing more, but they will not do so if they don’t
expect to sell extra output.
 6 international economic issues
The reasons for international trade
Absolute and comparative advantage
- Factor endowment → the availability of FOP in an economy
International trade occurs because countries have di erent factor endowments. These di erences a ect the
types of products countries produce and the quality and quantity of the products, as well as
their costs of production.
Absolute Advantage → a situation where, for a given set of resources, 1 country can
produce more of a particular product than another country.
E.g indonesia has an absolute advantage in producing rice while Brazil in co ee ———>
- Opportunity cost ratio → quantity of 1 product compared to the quantity of
another product that has to be sacri ced to produce it.
If each country specialises in producing the product in which it has an aa and then trades,
based on the opp cost ratio, total output will rise for both countries.

Comparative advantage → a situation where a country can produce a product at a lower opportunity cost
than another country
- E.g - France and Italy can produce Wine or Cheese with the same resources. France can produce 20
units of wine and 10 units of cheese while Italy can produce 30 units of wine and 22 units of cheese.
- Italy has the absolute advantage of both (same resources but produce more).
- By calculating the opportunity cost of each (10:5 France 15:11 Italy); the outcome is that Italy
has the comparative advantage of producing cheese while France has the comparative advantage of
producing wine.

- Comparative advantage can also be illustrated in terms of the FOP needed to produce a given
number of units of a product

-
- Vietnam has the aa in producing both as it can produce both more quickly. It has the ca in
producing smartphones as it takes ½ the time to produce 20 shoes but only ⅓ to produce 20
smartphones.
The benefits of specialisation and free trade (trade liberalisation)
Free trade → international trade not restricted by taxes on imports and other policy tools designed to give
domestic producers protection from competition from imports
- This allows an e cient allocation of resources with countries being able to specialise in producing
products in which they have a ca in. This should inc world output, employment and living
standards.
- Competition that may arise from free trade → pressure on rms to keep prices and costs down and
raise the quality of their products. They may also be able to BUY resources at lower prices as rms
have a wide variety to choose from (raw mats and cap g)
- Firms may produce a higher output if they sell in an international market → economies of scale →
consumers have a wide variety of products.

Trading possibility curve

Exports, imports and the terms of trade

The bene ts a country can gain from engaging in international trade are in uenced by how many imports
the country is able to purchase w the rev it gains from the esports it sells. This, in turn, is in uenced by the
prices it receives for the exports and the prices it pays for the imports.

Measurement of the terms of trade

Terms of trade → a numerical measure of the relationship between export and import prices
- Terms of trade index = (index of export prices / index of import prices) x 100
 - A favourable movement means that the index number has inc; fewer exports have to be sold to buy
a given quantity of imports.
- An unfavourable movement means that the index number has fallen; more exports will have to be
exchanged to gain the same quantity of imports.

Causes of changes in the terms of trade

Favourable movement caused by: rise in export prices relative to imports / imports fall while exports = same
Unfavourable movement: fall in exports prices relative to imports
1. Demand and supply
- Inc d for exports → inc prices of exports
2. In ation rate
- Inc → export prices higher
3. Exchange rate
- A govt reducing its exchange rate can be referred to as a deliberate deterioration of its terms
of trade → attempt to reduce export prices and raise import prices to make country’s
products more internationally competitive
The Prebisch-Singer hypothesis suggests that the terms of trade tends to move against countries producing
primary products (agriculture). This is based on the view that d for manufactured g / s rises by more than d
for primary products when income inc.

The impact of changes in the terms of trade

EVAL: impact of an inc in terms of trade index depends on the cause of the favourable movement
- Inc demand for exports leading to higher prices = bene cial as the domestic products will be sold
- Inc costs of production leading to higher prices = d for country’s products and export rev will fall
An unfavourable movement in the terms of trade may reduce a de cit on the current account of the BOP. If
demand for exports and imports is elastic, a fall in export prices relative to import should inc export rev
relative to import expenditure.

Limitations of the theory of absolute and comparative advantage

They do not provide a full explanation of the pattern of international trade:
- Some govts want to avoid overspecialisation
- High transport costs amy o set the comparative advantage
- Exchange rate may not lie between the opportunity cost ratios
- Other govts may impose trade restrictions
Theory of comparative advantage assumes that resources are mobile and that there are constant returns. If
they cannot achieve specialisation → structural unemployment will occur. Even if they are able to do so, it
does not necessarily mean that the extra resources will be as productive as those rst employed and so using
double the resources may not lead to double the output of one product.

In a world with many countries and a vast number of products, it may be di cult to determine where a
country’s comparative advantage lies. E.g: 2 countries are specialising in steel. They must persuade their
govts to impose trade restrictions on imported steel so that their country gains a competitive advantage.
NOTE: link to margin and decision making: countries have a limited amount of resources. The theory of
comparative advantage could help them allocate resources more e ciently

Protectionism, its tools and their impact

Protectionism → protecting domestic producers from foreign competition through restricting free trade.

1. Tari s (custom duties) → a tax imposed on imports or exports

- Import tari s
1. Discourage consumption of imports (successful if d for imports = elastic)
2. Increase tax revenue (successful if demand for imports is inelastic)
3. Make domestic products more price competitive (EVAL: however, not
successful if the price of the import + tari is still below domestic price or
if rms absorb the tari and do not raise their prices)
A tari imposes an extra cost on the supplier which usually inc price. Bene ts
domestic production, consumers lose out.
- Export tari s
1. Raise tax revenue (if d for exports is inelastic. E.g - Belarus’s tari on timber hasn’t stopped the vol
of timber exports increasing)
2. Ensure an adequate supply of the product on the home market. E.g - on food to reduce the risk of
absolute poverty (income too low to enable them to meet their basic needs) as the price will
remain low for the home market.
3. Act as a form of protectionism - E.g on raw materials to protect domestic industries using them. If
Australia put an exp tari on iron ore to Japan, it would inc costs of Japan’s steel producers and
make them less internationally competitive.

2. Import quotas → limits on imports, usually its quantity.

- Drives up their prices → sellers of the imports that gain the extra amount per unit paid by
consumers
NOTE: a REDUCTION in the size of a quota means that its inc its trade protection by allowing fewer
units of the good to come into the country.

3. Export subsidies
- Lowers costs for domestic producers → encourages them to inc output and keep costs low
- Losers will be foreign rms and domestic taxpayers (opportunity cost of govt spending)
- Consumers will bene t in the short run. EVAL: however, in the long run, if foreign rms are
driven out of business, subsidised domestic rms may inc their prices.

4. Embargoes → a complete ban on imports or on trade with a particular country

5. Voluntary export restaurants → an agreement by an exporting country to restrict the amount of a

product that it sells to the importing country
6. Excessive administrative burdens (‘red tape’) → discourage imports by requireming importers to ll
out lengthy forms

7. Exchange control → restrictions on the purchases of foreign currency

The arguments for protectionism

1. Protect infant (sunrise) industries → new and have a low output, high average costs and may struggle
to survive due to high competition from foreign rms taking advan of economies of scale + brand image
- Gives time to grow and establish an international reputation
- EVAL: however, very di cult to estimate long-run average cost curves for rms in the industry

2. Protect declining (sunset) industries

- To prevent a sudden rise of unemployment, add protection and gradually remove so that as it
reduces its output, some workers may retire and some may leave for jobs in other industries
- EVAL: however, this may a ect other industries that still have a comparative advantage as they’ll
have to buy from the declining industry for a higher price → loss of sales at home and abroad

3. Protect strategic industries

- Weapons, fuel and food - govts don’t want to be dependant n foreign supplies of these products in
case something shifts international relations.

4. Prevent dumping → selling products in a foreign market at below their cost of production
- Short run: consumers enjoy lower prices
- Long run: foreign rms may establish a monopoly (1 rm dominates the market due to having a
large market share) and raise their prices. They could have the speci c objective of gaining control
of a market in another country by destroying existing competition and preventing new domestic
rms from becoming established.
- Foreign rms can do this by covering losses w previous pro ts, by charging high prices in
their home markets or because they receive subsidies

5. Improve the terms of trade

- Trade restrictions on another countries’ exports→ reduced demand → lower prices → purchase
more imports for the same quantity of exports
- Restricting the supply of exports → inc prices → inc purchasing power of exports
- EVAL: distorts trade and can reduce global output

6. Improve the balance of payments

- Encourages consumers to switch from buying imports to domestic products
- EVAL: may lead to retaliation: foreign govts impose their own trade restrictions, the exports of the
country will fall too → international trade decline → global output falls.
- EVAL: may only bene t BOP short term if the country’s products are not internat competitive
7. Provide protection from cheap labour
- Trade restrictions should be imposed on products from countries where wages are low because costs
of production are low so their prices are low → more internationally competitive
- EVAL: Weak argument as low wage → low productivity → low output → higher labour costs
- EVAL: moral argument of imposing trade restrictions on products produced using children

8. Other reasons
- Persuade other govts to remove trade restrictions EVAL: could lead to trade war
- Increase revenue EVAL: only works if demand is inelastic
NOTE: advans of free trade are the disads of protectionism (vice versa)

The arguments against protectionism

- Cannot bene t from advantages of free trade
- Prevent countries from specialising in the products they have a comparative advantage in → lower
global output + living standards
- Reduce international competition → inc prices and lower the quality of products
- Reduce the choice of products available to consumers
- Lower the size of rms’ markets → reduce ability to take advantage of economies of scale
- Reduce rm’s choice of raw mats and cap g → inc costs of production

What is a country’s balance of payments

- Balance of payments account → a record of a country’s economic transactions with the rest of
the world over a year
- Capital account → within the BOP, a record of the sale and purchase of copyrights, patents,
trademarks, and money brought into the country by immigrants and taken out by emigrants.
- Financial account → within the BOP, a record of the transfer of nancial and capital assets
between the country and the rest of the world

Components of the current account of the balance of payments

Credit → in ow of money
Debit → out ow of money
Trade in goods → exports and imports of goods such as cars, TVs and clothing.
- Exports give rise to credit items
- Imports give rise to debit items
- Trade in goods surplus = export revenue > import expenditure
Trade in services → trade in exp and imp of services (‘invisibles’) such as shipping, tourism, banking
- Trade in services de cit = rev from exp of services < expenditure on services brought from abroad
Primary income → income in the forms of pro t, interest, dividends earned on direct investment abroad
and foreign earnings on investment in the country. Also includes employees’ compensation: wages earned by
the country’s residents working in other countries and paid for by residents of those countries.
- E.g: dividends paid on foreign shares by residents in the country appear as credit items
- Interest paid to foreigners on bank accounts they hold in the country = debit items
Secondary income → payments made and receipts received for which there is no corresponding exchange
of an actual g/s: foreign aid, govt transfers, transfers made by private individuals, workers’ remittances
(credit): transfer of money from ppl working abroad to their relatives at home.

Balance and imbalances in the current account of the BOP

Current account balance
- Current account balance: overall balance of the trade in goods, trade in services, primary income
and secondary income.
- De cit: combined debit items on the 4 parts > combined credit items
- Surplus: combined credit items > combined debit items
- Balanced = credit items = debit items

Current account balance calculations

- Trade in goods balance / visible balance / merchandise balance: revenue earned from exports -
expenditure on imports
- Trade in services balance: value of exports - value of imports
- Balance of trade in goods and services: balance of trade in goods + balance of trade in services
- Current account balance: balance of primary income + balance of secondary incomes + balance
of trade in goods and services

Causes of imbalances in the current account of the balance of payments

Causes of a current account de cit
1. Growing domestic econ → When rms inc output, may buy more raw amts + cap g from abroad.
Export rev may also decline bec exports are being diverted from the foreign to the domestic market.
- Considered to be short term and self - correcting: likely to sell more products both abroad
and at home → export rev may rise to = import expenditure.
2. Declining economic activity in a country’s trading partners (cyclical de cit)→ if countries that
buy this country’s imports experience a recession, their import expenditure may fall. Also
considered a cyclical de cit if there are changes in the economic cycle of the domestic economy.
(short term)
3. Structural problems → long term and not self - correcting. Indicates that domestic rms are not
internationally competitive: overvalued exchange rate, low labour and capital productivity
(indicates bad quality products) → low levels of investment and innovation.

Causes of a current account surplus

1. Declining domestic economy → not bene cial: experiencing a recession → demand for imports
decreases → less spending by consumers → reduced output
2. Increasing economic activity in the country’s trading partners → likely to buy more of the
country’s exports
3. Structural advantages → a country’s rms may be internationally competitive because: good
education and training, high levels of investment and innovation, low exchange and in ation rate
Consequences of imbalances in the current account on the economy
A current account de cit…
- Allows residents to consume more products than the country produces
- HOWEVER, they’ll have to nance the de cit via attracting investment or by borrowing
- This involves an out ow of money in the form of investment income
- De cit may also reduce agg d → slow down economic growth → unemployment
A current account surplus…
- Bene cial as its earning more than its spending
- EVAL: however, means that the country isn’t enjoying as high a standard of living as
possible.
- High demand + additions to money supply → in ation
*NOTE: the signi cance of the size of a current account de cit or surplus can be assessed more e ectively by
considering it as a % of the country’s GDP rather than seeing it in monetary terms. E.G - UK has a de cit of
108 billion while Albania 940 million. However, Albania’s de cit is a cause for concern as it accounts for
7.4% of GDP while the UK accounts for 4.2%.

The exchange rate and how a floating exchange rate is determined

Foreign exchange rate → the price of one currency in terms of another currency
Floating exchange rate → determined by the market forces of demand and supply

Depreciation and appreciation of a floating exchange rate

Depreciation → a fall in the value of a currency caused by market forces. (inc s / dec d)
- Reduction in export prices in terms of foreign currencies
- Rise in import prices in terms of the domestic currency
Appreciation → rise in the value of a currency caused by market forces (dec s / inc d)
- Exports more expensive in terms of foreign currencies
- Imports cheaper in terms of the domestic currency

Causes of changes in a floating exchange rate

DEMAND for the currency will rise if a higher value of exports is being sold.
1. More exports will be sold if →
- Relative in ation rate has fallen
- Relative productivity has inc
- Quality of the products inc
- Incomes abroad inc

2. Currency bought to →
- Purchase shares in the country’s rms due to the economic prospects improving (investing)
- Open accounts in their banks because of higher interest rates
- Hot money ows → ows of money moved around the world to take advantage of
changes in interest rates and exchange rates
- Speculate on making pro t if the value of the currency is to rise in the future
3. Foreign rms purchase if →
- Rise in labour productivity
- Growing market
- Get around trade restrictions

Why is currency sold?

- Buy imports
- Travel abroad
- Invest abroad
- In expectation that the value of the currency will fall in the future / fall in interest rates

The impact of exchange rate changes on the domestic economy

The impact of a depreciation on the domestic economy’s →
1. National income and real output
Fall in the value of the exchange rate → exports cheaper in terms of foreign
currencies + imports more expensive in terms of domestic currency → enables
domestic rms to sell more products both at home and abroad → foreigners may
now buy country’s exports rather than products in other countries → rise in net
exports → increased aggregate demand → rise in output and national
income

2. Price level
Inc agg d → demand pull in ation
Firms still need to purchase imported materials for production → inc costs of prod → cost - push in ation
- Domestic rms may also feel less competitive pressure to keep prices low

3. Unemployment
inc agg d → rms hire more workers to expand output → decrease cyclical unemployment

The impact of an appreciation on the domestic economy’s →

1. National income and real output
Exports more expensive in terms of foreign currencies + imports cheaper in terms of domestic currency →
dec d for domestic products → slowed economic growth → recession → lower real output → incomes fall

2. In ation
Can also reduce in ationary pressure by shifting agg s
curve to the right → lower costs of imported raw mats
Increased competitive pressure on domestic rms to
restrict price rises to maintain sales abroad + at home.

3. Unemployment
If agg d decreases → Increase unemployment
Government policy objective of stability of the current account
- Money entering the country = money leaving the country
- In the short run, a good de cit may arise: purchasing raw materials and cap g from abroad + allows
consumers to have a wider variety of products to choose from
- A govt may encourage a surplus to: inc agg d and provide funds to repay external debt

The effect of fiscal policy on the current account

- De cit: contractionary policy → inc tax → less disp income → less spending → less d for imports
- EVAL: however, reduces agg d and s → slowed economic growth → unemployment
- Surplus: expansionary policy → lower tax → more disposable income → inc spending
EVAL: scal policy measures amy alter current account in the short run, but once the policy measures are
stopped, households and rms will go back to their old spending patterns → not a long term solution

The effect of monetary policy on the current account

- Reducing the growth of the money supply may be used to reduce growth in spending on imports.
- EVAL: di cult to control the money supply
- De cit (and low in ation): reduce interest rates to reduce oating exchange rate → more
internationally competitive
- EVAL: risk of in ationary pressure
- De cit: inc interest rates → cut consumer expenditure → reduce demand for imports
- EVAL: may raise the oating exchange rate which could reverse the fall in d for imports
- Surplus: expansionary policy → raise money supply and cut the rate of interest and encourage
appreciation → inc cons expenditure
EVAL: most monetary policy tools are not e ective long term: does not tackle the structural weaknesses in
the economy, such as low productivity, which are causing a current account de cit.

The effect of supply-side policy on the current account

- De cit: deregulation + privatisation → inc competitive pressure on domestic rms to keep costs
and prices low → improve quality → become more responsive to changes in demand
- De cit: inc spending on education, training and investment subsidies → more skilled workers +
better capital equip → inc quality → inc demand for exports. ALSO, attracts MNCs to set up a
local branch → contribute to exports
- De cit: trade union reform → fall in industrial action + more motivated workers → better quality
+ improved productivity → foreign rms more willing to buy the country’s exports
EVAL: has the potential to reduce a de cit in the long run. However, not designed to reduce a surplus as the
policies aim to increase the quality and quantity of the country’s resources.

The effect of protectionist policy on the current account

- De cit: impose import tari s → encourage domestic consumers and rms to switch to buying
domestic products
- EVAL: may provoke retaliation and may reduce pressure on domestic rms to be e cient.
NOTE: take into account the size, duration, cause of the imbalances before choosing a policy to correct it.