WJEC AS Economics Revision guide · The fundamental economic problem • The fundamental economic...

WJECASEconomicsRevisionguide

Copyright:TejvanPettinger,Economicshelp.org1stAugust2018

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Table of Contents

Unit1–ASMicroeconomics.......................................................................................4Scarcity,choiceandopportunitycost...............................................................................4Opportunitycost.............................................................................................................................................5

Productionpossibilityfrontiers(PPF)....................................................................6Possibilityfrontierandeconomicgrowth.........................................................................................7Specialisation................................................................................................................................................10

Markets...................................................................................................................................11Demand..........................................................................................................................12

Shiftsinthedemandcurve.....................................................................................................................14Supply.............................................................................................................................15

Shiftsinthesupplycurve........................................................................................................................16Marketequilibrium.............................................................................................................17

Consumersurplus.......................................................................................................21Producersurplus.........................................................................................................................................22

Elasticity........................................................................................................................23Usingknowledgeofelasticity...............................................................................................................25Theimpactofelasticityontax..............................................................................................................27Incomeelasticityofdemand(YED)...................................................................................................29Crosselasticityofdemand.....................................................................................................................30Priceelasticityofsupply.........................................................................................................................30

Tax............................................................................................................................................33Wagedetermination............................................................................................................35Nationalminimumwage....................................................................................................39Flexiblelabourmarkets...........................................................................................................................41ImpactofnetmigrationonUKlabourmarkets..........................................................................43Evaluationofnetmigration...................................................................................................................43

Howresourcesareallocatedinafreemarket.............................................................45MarketFailure..............................................................................................................48

Externalitiesandsocialefficiency......................................................................................................48Negativeexternality...................................................................................................................................49Positiveexternality....................................................................................................................................51Publicgood.....................................................................................................................................................52Informationgaps.........................................................................................................................................53Meritgood.......................................................................................................................................................53Demeritgood.................................................................................................................................................53

Governmentinterventiontocorrectmarketfailure..................................................54Tax......................................................................................................................................................................54Subsidy.............................................................................................................................................................56Maximumprices..........................................................................................................................................58Problemofmaximumprices.................................................................................................................59Minimumprices...........................................................................................................................................60Tradeablepollutionpermits.................................................................................................................60Stateprovisionofpublicservices.......................................................................................................61Advertising/Information......................................................................................................................62Regulation.......................................................................................................................................................62PoliciesofWelshgovernment..............................................................................................................63

Governmentfailure....................................................................................................64

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Unit2TheUKEconomy.............................................................................................65Circularflowofincome.......................................................................................................65Injections.........................................................................................................................................................66Withdrawals(W)(leakages).................................................................................................................66Multipliereffect............................................................................................................................................66

Aggregatedemand......................................................................................................67Consumerspending(C)...........................................................................................................................68Investment......................................................................................................................................................68Governmentexpenditure(G)................................................................................................................69Nettrade(X-M)............................................................................................................................................70

Aggregatesupply(AS)................................................................................................70Equilibriumnationalincome................................................................................................................73Governmentmacroeconomicobjectives.......................................................................................75Conflictsbetweenobjectives.................................................................................................................76

Fiscalpolicy...................................................................................................................78TheNationalDebt.......................................................................................................................................80Governmentspending..............................................................................................................................82Taxation...........................................................................................................................................................84

Supplysidepolicies....................................................................................................86Evaluationofsupplysidepolicies......................................................................................................87

MonetaryPolicy...........................................................................................................89UKmonetarypolicy...................................................................................................................................89

Theroleofthecentralbank..............................................................................................90Exchangerates......................................................................................................................92Factorsthatinfluenceexchangerates..............................................................................................93Appreciationintheexchangerate.....................................................................................................93Evaluationofanappreciation...............................................................................................................94

Trade.......................................................................................................................................96Benefitsoffreetrade.................................................................................................................................97Argumentsforrestrictingtrade..........................................................................................................98

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Unit 1 – AS Microeconomics

Scarcity, choice and opportunity cost

• Scarcity.Theseareresourcesthatarelimited.Withscarceresources,weneedtomakechoicesabouthowtouseanddistributethem.

• Non-renewableresources.Thesearenaturalresourcesthatarefiniteandscarce.Onceused,theycannotbereplaced.Forexample,coal,oil,preciousmetals,andgasareallfinite.

• Renewableresources.Resourcesthatcanbereplenished.Examplesincludewind,wood,fish,solarenergy,andwater.

• Semi-renewableresources.Therearesomeresourcesthat,intheory,arerenewable,butiftheyareover-consumedtheycanbecomeextinctandthusnolongeravailable.Forexample,farmlandshouldberenewable,butifweover-farmanduseextensivequantitiesofchemicals,itcouldcausesoilerosion.

• Economicgood.Agoodwhichhasabenefit(utility)tosociety,andalsoagoodthathassomedegreeofscarcity.

• Freegood.Agoodwhichhasbenefittosociety,butisavailableinanunlimitedquantity.Thereisnoopportunitycostinconsumingit.

Scarcity and choice • Becauseofscarcityandunlimitedwants,weneedtomakechoices.• Forexample,asasociety,ifwecontinuetoover-fish,itmeansfuture

generationsmaynotbeabletotakeanyfishfromtheseaatall.• Asanindividual,weneedtodecidehowtouseourlimitedincometo

purchasegoodsandservices.• Governmentsalsohavescarceresources(limitedtaxincome).Theyneed

tomakedecisionsabouthowtousetaxrevenue.IncreasinggovernmentspendingontheNHSmeanslesspotentialforspendingelsewhere.

The fundamental economic problem • Thefundamentaleconomicproblemistheissueofscarcityandhowbest

toproduceanddistributethesescarceresources.Becauseofscarcityandlimitedresources,economicsisconcernedwith:

• Whattoproduce?• Howtoproduce?• Forwhomtoproduce?

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Opportunitycost• Opportunitycostisthenextbestalternativeforegone.

Examplesofopportunitycost

• Ifthegovernmentspendstaxincomeondefencespending,thenthismoneycannotbespentonhealthcare.

• Ifthegovernmentcutstax,theopportunitycostisthattheyhavelesstospend(orusetoreducebudgetdeficit).

• Ifwespendourtimesurfingtheinternet,wecannotspendthistimestudyingeconomics.

• Iffirmsspendalltheirmoneyonadvertisingtheirnewproduct,theycannotusethatmoneytoinvestindevelopingnewproducts.

Importanceofopportunitycost

• Opportunitycostmeanswehavetomakedecisionsaboutthebestuseoftime,moneyandresources.Sometimestherearetwooptionsthataregood,butweneedtochoosetherelativelybestoption.

Choicebetweenstudyandleisure.Supposewehave12hourstospare.Wecanusethese12hoursforstudyorwecanusethe12hoursforleisure.

IfwemovefromAtoB,wecanspendanextratwohoursonleisure.Theopportunitycostisthatwelose2hoursofstudy.

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Production possibility frontiers (PPF) APPFshowsthemaximumoutputthataneconomycanproduceiftheeconomyismaximisingtheuseofitsresourcesandoperatingefficiently.

Thisisasimplisticproductionpossibilityfrontierthatshowsachoicebetweengoodsandservices.

• Ifweproducemoreconsumergoods,itleadstofewerresourcesavailableforproducingservices.

• Wecoulduseallournaturalresourcesandhavemanyconsumergoods,orwecouldhaveonlyfewgoodsandconcentrateonproducingservices.

Opportunitycostandproductionpossibilityfrontier

• AtpointA,wehave22goods/21services• AtpointB,wehave18goods/27services.• IfwemovefrompointAtoB,wegainanextra6unitsofservices.• However,theopportunitycostisthatwehavetoforego4unitsofgoods.

PointsonPPFCurve

• AorB=Productivelyefficient.• C=impossible

(withouteconomicgrowth)• D=inefficient,belowpotential

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Possibilityfrontierandeconomicgrowth

• Shortruneconomicgrowth.MovingfrompointAtoB.Thisinvolves

makingbetteruseofexistingproductivecapacity.• Longruneconomicgrowth.ThisrequiresashiftinthePPFcurvetothe

right.ThisenablespointCtobeattained.

Causes of long run economic growth AshiftinPPFtotherightcanbecausedby:

• Discoveringmorerawmaterials(e.g.discoveringoilfields)• Increaseinthesizeofworkforce(e.g.immigration)• Increaseincapitalstock(e.g.investmentinnewmachines,factories)• Increaseinlabourproductivity(e.g.duetobettereducatedworkersor

workersbecomingmoremotivated)• Improvementsintechnologywhichincreaseslabourproductivity

Negative economic growth ItisalsopossibleforthePPFcurvetoshiftinwards.Thiscouldoccurdueto:

• Decliningpopulation• Firmsclosingdownandstoppingproduction

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Choice between consumer and capital goods

• Consumergoods.Goodsthatwecanuseandenjoy.Thethingswebuyin

shopslikefood,clothes,etc.• Capitalgoods.Thesearegoodsthatareusedintheproductiveprocess–for

example,amachine.Capitalgoodsinvolveinvestmentinincreasingproductivecapacity.

• IfwemovefromBtoA,thereisamovementalongthePPFcurveenabling

morecapitalgoodstobeproduced(anextra8).Theopportunitycostisthattherearelessconsumergoods(17less).

• Increasingcapitalgoodsleadstolowerlivingstandardsintheshortterm,butinthelongtermwemaybeabletoproducemorebecauseoftheinvestmentinmachinesandfactories,whichenableshigheroutput.

Short term growth or long-term investment

• Devotingahigherproportionofresourcestocurrentconsumptionhasanopportunitycostoflessinvestmentandlessgrowthinthelongrun.

• Devotingahigherproportionofresourcestocapitalinvestmenthasanopportunitycostoflessconsumptionintheshortrun.

• ThereisastronglinkbetweenaPPFandthelongrunaggregatesupplycurve(LRAS).LRASisamajordeterminantofeconomicgrowth(see:unit2macro-economics).

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RotationinPPFCurve

• InthisPPFcurve,weseeashifttotherightofthePPFcurveonthex-axis.• Inthiscase,weseeanimprovementintechnologyrelatingtocapital

goods,butnotconsumergoods.Therefore,wecanproducemorecapitalgoodsrelativetoconsumergoods.

• Iftheeconomyisbecomingmoreskewedtowardscapitalgoods.Itmayenablehighergrowthinthelong-termbecauseofincreasedinvestment.

Diminishing returns vs constant returns

• ThePPFontheleftisconcavetotheorigin.Thisisbecauseofimperfect

substitution,anddiminishingreturnstoincreasinggoods/services.• IfwemovefromAtoB,wegain6services,andtheopportunitycostis

only1good.• But,ifwemovefromCtoD,wegainonly1serviceandlose3goods.

Therefore,theopportunitycostofproducingmoreservicesisincreasing.• APPFcurvecanbestraight(diagramright)ifthereareconstantreturns.

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Specialisation

• Specialisationoccurswhenacountryorfirmconcentratesonproducingaparticulargoodorservice.

• Countrieswillspecialiseinproducinggoodswheretheyhaveacomparativeadvantage.Forexample,Japanspecialisesinproducinghigh-techelectronicgoods.Cubaspecialisesinproducingsugar.

Division of labour

• Divisionoflabouroccurswhenworkersconcentrateondifferenttaskswithinafirm.

• Ratherthantrytomasterallaspectsofproduction,someworkerswillspecialiseataparticularjob.

• Forexample,inacar-buildingfirm,somewillworkondesign,someontesting,andsomeworkerswilljustdounskilledjobssuchaspaintingthecar.

Productivity of labour • Thisisdefinedastheoutputperworker,perperiodoftime.• Forexample,oneworker,maypick100strawberriesperhour.• Specialisationmayenableanincreaseinoverallproductivitybecause

specialisedworkerscanbecomemoreefficient.

Advantages of specialisation in the production of goods • Thedivisionoflabourgivesworkerstimetogainskillsforoneparticular

job.Overall,theyneedlesstimetobetrained.• Withspecialisationandthedivisionoflabour,firmscanbemoreefficient

whenproducingonalargescale;itenableseconomiesofscale,andloweraveragecosts.

• Withoutspecialisationandthedivisionoflabour,onepersonmaybeunabletoproduceacaronhisown.Butthedivisionoflabourmakesabigproductiontaskmanageablebyspreadingtheworkout.

Problems of specialisation • Thedivisionoflabourcanmakejobshighlyspecialisedandrepetitive,

leadingtoboredomandpossiblediseconomiesofscale.• Onanassemblyline,ifonepersonisabsent,thewholeproductionline

mayslowdownifotherpeoplecan’tcovertheirjob.Therefore,thereneedstobesomeflexibility.

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Advantages of specialisation in trade • Worldtradeishighlyspecialised,withthegrowthinworldtradeenabling

higherlivingstandards,agreaterchoiceofgoods,andmorecompetition.• Specialisationmeanscountriesdon’thavetoproduceeverygoodthey

need,whichwouldbeimpracticalforsmallcountries.• Countriescanmakeuseoftheirbestresources(e.g.lowlabourcostsin

IndiaandChinaoradvancedtechnologyinGermany).• Itenablescountriestoimportgoodsthattheyotherwisewouldn’tbeable

toproduce(e.g.youcan’tgrowbananasinUK;Africancountriesdon’tcurrentlyhaveaviablecarindustry).

Problems of specialisation in trade • Concentratingonproducingasmallnumberofgoodscanmakean

economyvulnerable.Forexample,ifsugarpricesfall,countriesthatrelyonsugarexportswillseeafallinincome.

• Itmayhamperdevelopmentifcountriessticktoproducingprimaryproducts,whichhavealow-incomeelasticityofdemand.

Markets • Aproductmarketreferstohowagoodisboughtandsold.Forexample,

farmers(producers)sellpotatoesatthemarketandconsumersbuythem.• Themarketwilldeterminethepriceandquantitysold.

Rationality • Ineconomicsweassumefirmsandconsumersarerational.Thismeans

thattheytrytomaximisetheireconomicwelfareandmakedecisionstoenablethis.

Utility • Thisishowmuchbenefitpeoplegetfromconsumingacertaingood.• Ifwegethighutilityfromeatingatarestaurant,wewillbewillingtopay

alargeamountofmoney.• Weassumeconsumerswishtomaximisetheirutility.Forexample,they

willspendmoneyongoodsonlyiftheybelievetheutilitygainedisgreaterorequaltothecost.

Profit • Thisistheamountofmoneyafirmgainsaftersubtractingcostsfromits

totalrevenue(profit=totalrevenue–totalcosts).• Weoftenassumefirmswishtomaximiseprofit(eitherintheshortrunor

longrun).Thismightinvolvecuttingcostsorsellingprofitablegoods.

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Demand • Theindividualdemandcurveillustratesthepricepeoplearewillingto

payforaparticularquantityofagood.• Themarketdemandcurveillustratesthepriceconsumersinthewhole

economyarewillingtopay.

Movementalongthedemandcurve

Achangeinpricecausesamovementalongthedemandcurve.

• Ahigherpricereducesdemand.• Alowerpriceincreasesdemand.

• Forexample,ifthereisanincreaseinpricefrom9to12,thentherewillbeafallindemandfrom30to22.

• Asthepricefalls,peopleareusuallywillingtobuymoreofthegood.Ifthepriceishigher,thisdiscouragespeoplefrombuyingthegood.

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Demand and diminishing marginal utility Marginalutilityisthesatisfactionthatyougainfromthelastunitofconsumption.

• Thefirstchocolatebarofthedayislikelytogivethehighestutility.Thesecondchocolatebarusuallygiveslessutilitythanthefirst.

• Ifyouhavealreadyeatenthreechocolatebars,youareunlikelytoenjoyafourth.Therefore,theutilityfromthefourthchocolatebarismuchlessthanthefirst.

• Asyouconsumemoregoods,theutilityoftheextragoodsusuallydeclines.Thisiswhythedemandcurveisdownwardsloping.Youwouldn’twanttopayasmuchforthefourthchocolatebarasthefirst.

• Thisiswhyanindividual’sdemandcurveisdownwardsloping.Theyarewillingtopaylowerpricesforahigherquantity.

Toencouragehigherdemand,lowerpricesareneeded.

Income and substitution effect • Ifthepriceofagoodchanges,therearetwofactorswhichaffectdemand.

1.Incomeeffect

• Thislooksattheeffectofapriceincreaseondisposableincome.Ifthepriceofagoodincreases,thenconsumerswillhaverelativelylowerdisposableincome.Forexample,ifthepriceofpetrolrises,consumersmaynotbeabletoaffordtodriveasmuch,leadingtolowerdemand.

2.Substitutioneffect

• Thislooksattheeffectofapriceincreasecomparedtoalternatives.• Ifthepriceofpetrolrises,thenitisrelativelycheapertogobybus.

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ShiftsinthedemandcurveThisoccurswhen,evenatthesameprice,consumersarewillingtobuyahigherquantityofgoods–forexample,demandshiftsfromDtoD2

Ashifttotherightinthedemandcurvecanoccurforanumberofreasons:

1. Anincreaseindisposableincome,suchashigherwagesandlowertaxesgivingconsumersmorespendingpower.

2. Anincreaseinthequalityofthegood.Forexample,mobilephonesarenowmoreversatileandpowerful,makingthemmoreattractive.

3. Advertisingcanincreasebrandloyaltytogoodsandincreasedemand.4. Anincreaseinthepriceofsubstitutes.Forexample,ifthepriceofO2

Mobilephonecallsgoesup,thedemandforVodafonemobileswillincrease.

5. Afallinthepriceofcomplements.Forexample,alowerpriceforAppleappswillincreasedemandforAppleiPhones.

Evaluation

• Itdependsonthetypeofgood.Ariseinincomewillnothaveanyeffectondemandforsalt,butitwillhaveabiggereffectondemandforluxurycars.

• Somegoodswillvaryduetoseasonalfactorsliketheweatherandtimeofyear(e.g.scarvesandairconditioners).

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Supply Thesupplycurvereferstothequantityofagoodthattheproducerplanstosellinthemarket.

Changeinpriceandmovementalongsupplycurve

• Ifpricechanges,thereisamovementalongthesupplycurve.• Forexample,anincreaseinthepricefrom£40to£50causesanincrease

from30to33.

Whysupplycurveslopesupwards

• Aspriceincreases,firmshaveanincentivetosupplymorebecauseatahigherprice,theygetextrarevenue(income)fromsellingthegoods.

• Also,asoutputrises,firmsusuallyhavehighermarginalcostsintheshortrun;itismorecostlytoincreaseoutput.Therefore,firmsrequirehigherpricestoencouragemoresupply.

• Firmsreacttomarketpricesincompetitivemarkets.Ifafarmertriedtosellhisproduceabovethemarketprice,hewouldn’tbeabletosell.Wesayfirmsarepricetakers.

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Shiftsinthesupplycurve

Anincreaseinsupplyoccurswhenmoreissuppliedateachprice,e.g.ashiftinsupplyfromStoS2.Thiscouldoccurforthefollowingreasons:

• Adecreaseincostsofproduction.Thismeansthatbusinesscansupplymoreateachprice.Lowercostscouldbeduetolowerwagesorlowerrawmaterialcosts.

• Anincreaseinthenumberofproducerswillcauseanincreaseinsupply.• Expansioninthecapacityofexistingfirms,e.g.investmenttoextendthe

sizeofafactory.• Anincreaseinthesupplyofacomplementarygood,e.g.beefandleather.• Favourableclimaticconditions,whichareveryimportantforagricultural

products,e.g.goodweatherwillgiveagoodharvest.• Improvementsintechnology,e.g.computersandtheinternetenables

moretobeproducedforalowercost.• Lowertaxesonthegood,e.g.lowerpetroltax.• Governmentsubsidiesonthegood(governmentpayingpartofthecost).

Jointsupply

• Jointsupplyoccurswhentwogoodsaresuppliedtogetherfromthesamesource.

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Market equilibrium Thepricemechanismreferstohowsupplyanddemandinteracttosetthemarketpriceandtheamountofgoodssold.

Marketequilibriumoccurswhensupply=demandandthereisnotendencyforthepricetochange.

Excess demand

Ifthepriceisbelowequilibrium(p2),demandisgreaterthansupply(Q2–Q1)–causingashortage.

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• Therefore,withconsumerswantingtobuymorefirmswillputuppricesandsupplymore.

• Aspricerises,therewillbemovementalongthedemandcurveandlesswillbedemanded.

• Priceswillriseuntilsupplyequalsdemand.

Excess supply

• Ifthepriceisaboveequilibrium(p2),supplyisgreaterthandemand(Q2-Q1)–causingasurplus.

• Toselltheunsoldgoods,firmsreducethepriceandreducesupply(movementalongsupplycurve).Thelowerpricealsoencouragesmoredemand.

• ThepricefallstoP1wheresupplyequalsdemand.

Impact of increase in demand • Ifconsumerssawanincreaseinincome,wewouldseeanincreasein

demandforgoodslikeTV’s;thedemandcurvewouldshifttotheright.• Initiallytherewouldbeashortage,butthehigherdemandwouldcause

thepricetoriseandsupplierstosupplymore.

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Theincreaseindemandcausesanincreaseinprice(P1toP2)andanincreaseinquantity(Q1toQ2).

Inthelong-term,thehigherpricesmayencouragemorefirmstoenterthemarketandthesupplycurvewillshifttotheright.

Fall in supply Iftheavailabilityofoildecreased,wewouldseeafallinsupply.

Thefallinthesupplyofoilcausesthepricetoriseandasmallfallindemand.Sincedemandforoilisinelastic,weseearelativelybiggerincreaseintheprice.

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Impactoffallinsupplyinlongterm

• Ifthepriceofoilincreased,itmaystarttomakeitprofitabletoproduceoilfromnewplaces,suchasAlaskaandAntarctic.Previouslyitwastoocostlytoproduceoilfromhere,butthehigherpricemaymakeitworthwhile.

• Ifthepriceofoilrises,inthelong-termpeoplemayrespondtohigherpricesbyswitchingtootherformsoftransportwhichdon’tusepetrol.

Factors that could explain a fall in the price of a good • Thepriceofagood,suchascoffee,wouldfalliftherewasafallindemand

and/oranincreaseinsupply.

FallinthepricefromP1toP2

Thedemandforcoffeecouldfallforvariousreasonssuchas:• Lowerincomesmeanthatconsumerscannotaffordtobuyasmuch.• Coffeebecomeslessfashionable.

Afallinnumberofcoffeeshops.• Healthconcernsaboutcaffeine.

Thesupplyofcoffeecouldincreaseforvariousreasonssuchas:

• Anincreaseinthenumberofsuppliersorcountriesproducingcoffee.• Lowercostsofproduction,e.g.lowerwageratesincoffee-producing

countries.• Governmentsubsidies,e.g.LatinAmericancountriesmaywishto

subsidiesthecoffeefarmers.• Higherlabourproductivityinproducingcoffee,whichwilldecreasethe

costsofproduction.

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Consumer surplus • Consumersurplusisthedifferencebetweenthepricethatconsumerspay

andthepricethattheywouldbewillingtopay.• Forexample,ifabookcosts£10,butthedemandcurveshowsthatthey

wouldhavepaid£16,theconsumersurplusis£6.

• Consumersurplustendstobehigherwhenmarketsarecompetitiveandpricesarelow.

• Consumerandproducersurpluswillbemaximisedinafreemarketwherepriceisdeterminedbysupplyanddemand.

• Amonopolythatcansethigherpriceswillbeabletoreduceconsumersurplus.

• Forexample,peaktrainfaresareanattempttochargehigherpricestothosecommuterswillingtopaythehigherprice–andcaptureconsumersurplus.

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Producersurplus• Producersurplusisthedifferencebetweenthepricesuppliersreceive

andthepricethattheywouldhavebeenwillingtosupplythegoodat.• Ifthemarketpriceis£10,andtheirsupplycurveshowsthattheywould

havesupplieditat£8,theyhaveaproducersurplusof£2.

Producersurplusafterfallinsupply

• Inthiscase,supplyshiftsfromS1toS2,themarketpricerisesfrom£25to£30.Quantityfallsfrom100to80.

• Inthiscase,weseeadeclineinconsumersurplus.Producersurplusalsofalls.

Calculating consumer surplus Wecancalculatearightangledtriangle,usingformula-1/2xheightxbase

• Price=£30,quantityequals80.• Themaximumconsumersurplus=£50-£30=£20• Tofindtheareaofconsumersurplus=(£20×80)/2=£800

Calculating producer surplus • Themaximumproducersurplusis£30-£15=£15• Theareaofproducersurplus=(£15×80)/2=£600

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Elasticity Thepriceelasticityofdemandmeasurestheresponsivenessofdemandtoachangeinprice.

Priceelasticdemand

• Demandispriceelasticifachangeinpricecausesabiggerpercentagechangeindemand.

Exampleofelasticdemand

• IfthepriceofTescobreadincreases5%anddemandfalls15%,thePEDis(-15/5)=-3.0.Thisispriceelastic.

Characteristics of elastic demand • Luxurygoodsaresensitivetopricebecausetheyrepresentabig

percentageofdisposableincome,suchassportscarsandforeignholidays.• Competitivemarkets.Goodsthathavemanysubstitutesandavery

competitivemarketwillbeelastic-forexample,ifthepriceofTescobreadincreased,consumerscouldswitchtoseveralothervarieties.

• Frequentlybought.Withgoodsthatareboughtfrequently,wearemorelikelytocompareprices,andswitchifnecessary.

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Inelastic demand • Demandispriceisinelasticifachangeinpriceleadstoasmaller

percentagechangeinQ.D.• PEDwillbelessthan-1(e.g.-0.5)

Exampleofinelasticdemand• Ifthepriceoftobaccoincreases10%anddemandfalls2%,thePED=-0.2

Characteristicsofinelasticgoods

• Fewsubstitutes.e.g.petrolandcigaretteshavefewclosealternatives.• Necessities,e.g.ifyouhavetodrivetowork,youneedtobuypetrol.• Addictive.Ifyouareaddictedyouwillpayhigherpricee.g.cigarettes,

coffee.• Smallpercentageofincome–meansyoudon’tworryifpricerises.• Intheshortterm,demandisusuallymoreinelasticbecauseittakestime

forconsumerstofindandswitchtoalternatives.

Evaluation

1. Demandforagoodlikecoffeeislikelytobeinelastic,astherearefewsubstitutestocoffee.Butdemandforindividualbrandsofcoffeeislikelytobemoreelastic,astherearesubstitutestoStarbuckscoffee(e.g.Costa).

2. Elasticitymaychangeovertime.Intheshortterm,demandforpetrolisinelastic,butovertime,peoplemaybemorewillingtoswitchtoalternatives,suchascyclingtowork,sothatdemandforpetrolbecomesmoreelasticwithtime.

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Usingknowledgeofelasticity

1.Revenueandelasticity

Ifdemandisinelasticthenincreasingthepricecanleadtoanincreaseinrevenue.

Inthisexample,thepriceofoilrisesfrom$110abarrelto$190,andthequantityfallsfrom9millionto8million.

• Revenuewas$110×9=$990million• Revenueisnow$190×8=$1,520million• Anincreaseinrevenueof$530million

ThisiswhyOPECtriestoincreasethepriceofoil,becausehigheroilpricesaremoreprofitable.

WhatisthePEDofoilinthisexample?

• %changeinQ.D1/9=-0.11(-11.1%)• %changeinprice80/110=0.727(72.7%)

Therefore,PEDofoil=-11.1/72.7=-0.15(inelastic)

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Ifdemandwaspriceelastic

• Pricerisesfrom£110to£130–(20/110)=18%• Quantityfallsfrom9to4(5/9)=55.5%• Revenuewas110×9=£990• Revenuehasnowfallento4×£130=£520• Afallof£470

PEDofthisexample-55/18=-3.05(elasticdemand)

2.Advertisingandelasticity

• Firmshaveanadvantageifdemandfortheirgoodispriceinelastic.Ifdemandisinelastictheycanincreasepriceandmakemoreprofit.

• Thisiswhymanyfirmsspendmoneyonadvertisingtocreatebrandloyalty.

• Becauseofstrongbrandloyalty,CocaColacanchargeahigherpricethanotherbrandslikeSainsburyCola.

• Firmscanmakedemandmoreinelasticbyofferingmoreadd-onfeaturesandbetterqualityproductsthatstandoutfromthecompetition.

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Theimpactofelasticityontax

• Inthisexample,thetaxis£70perunit.• Aftertaxisplacedonthegood,supplyshiftstoS2.• Demandfallsfrom80to72.Thepricerisesfrom£80to£140.• Thetotaltaxrevenueequals72×£70=£5,040

Consumerburdenoftax

• Thetaxis£70,andconsumersenduppayinganextra£60.• Inthiscase,consumersfacemostofthetaxburden.• Consumerburden=(60×72)=£4,320

Producerburden

• Producersget£10lessafterthetax.• Therefore,producerburdenis(10×72)=£720.

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Elasticity of a demand curve Withastraightlinedemandcurvetheelasticityofdemandvaries.

BetweenpointAandB,demandiselastic.(-3.5)

• Thisisbecausethe%changeinquantity(4to6)is2/4=50%• The%changeinprice(14to12)=-2/14=-14%

BetweenpointsCandD,demandbecomesinelastic.(-0.375)

• The%changeinquantity13to15isjust2/13)=15%• The%changeinpriceisgreater2/5=40%

Withastraightlinedemandcurve,theelasticityisalwayschanging.

• DemandismoreelasticwhenQisclosetozero.• Aspricefallscloserto0,demandbecomesmoreinelastic.• PED=1whenthe%changeindemandisthesameas%changeinprice

(somewhereinmiddleofdemandcurve)

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Incomeelasticityofdemand(YED)Incomeelasticitymeasurestheresponsivenessofdemandtoachangeinincome.

Forexample,ifaverageincomeincreasesby5%andthedemandformobilephonesincreasesby20%,anddemandforTescovaluericefalls2%.

• ThentheYEDformobilephones=20/5=4.0(luxurygood)• TheYEDforTescovaluerice-2/5=-0.4(inferiorgood)

Types of good • Inferiorgood.Thisoccurswhenanincreaseinincomeleadstoafallin

demand.InferiorgoodswillhaveanegativeYED.ExamplesincludeclothesfromcharityshopsandTescovaluerice.Asyourincomeincreases,youbuybetterqualitygoodsinstead.

• Normalgood.Thisoccurswhenanincreaseinincomeleadstoanincreaseindemandforthegood,thereforeYED>0.Mostgoodsarenormalgoods.

• Luxurygood.Thisoccurswhenanincreaseinincomecausesabiggerpercentageincreaseindemand,thereforeYED>1.Itmeansdemandisincomeelastic.Examplesincludejewelleryandsportscars.

• Incomeinelastic.Thismeansanincreaseinincomeleadstoasmallerpercentageincreaseindemand.Therefore0>YED<1.

Importance of income elasticity of demand • Inarecession,withfallingincomes,demandforluxurygoodswillfall

significantly.Demandforinferiorgoodswillincrease.• Budgetpoundshopsmaydowellwithfallingincomes,butluxurycar

saleswillnot.• Supermarketsmayrespondtoarecession(fallingincome)bysupplying

more‘inferior’goodsandcuttingbackonluxurygoods.• Ifincomesarerising,firmsmayseektomaketheirgoodmoreofaluxury

good,e.g.carmanufacturersmayaddmoreluxuryitemstocars,suchasairconditioningtotakeadvantageoftherisingincomes.

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CrosselasticityofdemandCrosselasticityofdemandmeasureshowthedemandforonegoodisaffectedbythepriceofanother.

• Forexample,ifthepriceofmilkfallsby10%,demandforteamayincrease1%.ThereforeXED=(1/-10)=-0.1

Substitutegoods.Thesearetwogoodsthatcouldbeusedasalternatives.Withtwosubstitutegoods,XEDwillbepositive.

• WeaksubstitutesliketeaandcoffeewillhavealowXED.• TescobreadandSainsburysbreadareclosesubstitutessoXEDishigher.

Complementsgoods.Thesearegoodsthatareusedtogether.ThereforeXEDisnegative.

• Forexample,ifthepriceofDVDplayersfall,thentherewillbeanincreaseindemandforDVDdiscs.

Unrelatedgoods.Ifthepriceoflambincreases,wewouldexpectittohavenoeffectonthedemandforbeerorcomputers.Ifthepriceoflambincreasesanddemandchangesforcomputers,itisjustaco-incidenceandnotrelated.

PriceelasticityofsupplyThismeasuresthe%changeinquantitysuppliedafterachangeinprice.

• Ifthepriceofcarsincrease10%,andsupplyincreases5%,o ThePES=5/10=0.5

• Ifthepriceoftomatoesincrease10%andsupplyincreasesonly1%intheshortterm,

o ThePES=1/10=0.1

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Inelastic supply

• Inelasticsupplymeansachangeinpricecausesasmallerpercentagechangeinsupply(PES<1).

• Perfectlyinelasticmeansachangeinpricehasnoeffectonsupply.• Intheexampleontheleft:%changeinQ=3/50=6%• %changeinprice=6/60=10%• Therefore,PES=6/10=0.6(inelasticsupply)

Supplycouldbeinelasticforthefollowingreasons:

1. Operatingclosetofullcapacity.Iffirmsareoperatingclosetofullcapacity,itisdifficulttoincreasesupply.

2. Lowlevelsofstocks;therefore,therearenosurplusgoodstosell.3. Intheshortterm,capitalisfixed,thereforefirmsdonothavetimeto

buildabiggerfactoryandincreasesupply.4. Difficulttoemployfactorsofproduction,e.g.itmaybedifficulttofind

relevantskilledlabourtoincreaseoutput.5. Withagriculturalproducts,supplyisinelasticintheshortrunbecause

ittakesatleast6monthstogrowcrops.

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Elastic supply Thisoccurswhenanincreaseinpriceleadstoabigger%increaseinsupply,thereforePES>1.

• Perfectlyelasticsupplymeansthatatagivenprice,supplyisunlimited.

• Ontheleft:Priceincreasefrom60to63andQincreasesfrom50to60.• %changeinQ=10/50=20%• %changeinprice=3/60=5%• ThereforePES=20/5=4.0(elasticsupply)

Supplycouldbeelasticforthefollowingreasons:

• Ifthereissparecapacityinthefactory.• Iftherearestocksavailable.• Ifitiseasytoemploymorefactorsofproduction.

Difference between long run and short run

• Intheshortrun,supplyismorelikelytobeinelasticbecausethefirmdoesnothavetheabilitytoincreasethesizeofthefactory.

• But,inthelongrun,supplycanbemoreelasticasthefirmisabletoinvestinmorecapacityandthereforeincreasesupply.

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Elasticity calculation SupposePESforcomputersis2.0.Whenthepricewas£30,thefirmsupplied4,000.Ifthepriceincreasedfrom£30to£36,whatwillbethenewQ?

• Priceincreasesby£6.Thereforeasa%,(6/30=0.2)=20%

(PES)2.0=%changeinQS20(%changeinP)

• Therefore40=%changeinQS• ThereforenewQ=4000*140/100=5,600

Tax Taxincreasesthecostofthegoodandshiftsthesupplycurvetotheleft.

• Inthisexample,thespecifictaxis£35perunit(80-45).• Thetaxincreasesthepricefrom£50to£80.Quantityfallsfrom90to82.• Thetotaltaxrevenueforthegovernmentwillbe:82×£35=£2,870

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The burden of tax Theburdenofthetaxissharedbetweenconsumersandproducers.

• Theconsumerburdenshowstheextraamountthattheypay(howmuchtaxraisesprice).

• Producersalsoloseoutfromtaxbecausetheygetalowerpriceafterpayingtaxtothegovernment.

Consumer and producer burden of specific tax

• Ifdemandisinelastic,thenmostofthetaxwillleadtohigherpricesandconsumerburdenofthetaxwillbegreaterthantheproducerburden.

• Inthediagramontheright,demandispriceelasticandthereisaproportionallysmallereffectonpriceandconsumers.Producershaveagreaterburdenfromthetax.Consumerburdenisrelativelyless.

• Governmentsoftenincreasetaxongoodswithinelasticdemandbecausethisleadstothebiggestincreaseintaxrevenue.

• Oftentobaccomanufacturerswillbeabletopass100%ofthetaxincreaseontoconsumersbecausedemandissoinelastic.

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Wage determination

• Incompetitivelabourmarkets,theequilibriumwagerateintheindustryisdeterminedbythemeetingpointofthelaboursupplyanddemandcurves(W1).

Inthisexample,theincreaseindemandforlabour,leadstohigherwages(W1toW2),

andahigherquantityoflabour(Q1toQ2).

Factors affecting demand for labour • Wages.Higherwagescauseamovementalongthedemandcurve.• Productivityofworkers.Ifworkersaremoreproductiveandproduce

more,firmsshouldbewillingtopayhigherwages.• Demandforthegood.Labourisaderiveddemand.Ifthereismore

demandforeconomicstuition,therewillbemoredemandforeconomicstutorsandthiswillpushupthewage.

• Substitutestolabour.Insomeproductionprocesses,firmscouldsubstituteworkersformachines(e.g.assemblylines).

• Non-wagecosts.Thisincludespayingnationalinsurance,healthinsurance,andpotentialredundancypay.

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Elasticity of demand for labour Theelasticityofdemandforlabourmeasureshowresponsivedemandforlabourisafterachangeinwages.Elasticityofdemandforlabourdependson:

• Howessentialistheworker?Canlabourbesubstitutedforcapital?Forexample,withautomatedcheckouts,workerscanbesubstitutedformachinesandlabourdemandwillbemoreelastic.

• Numberofpeoplewithqualificationsandskills.Ifonlyasmallnumberofworkershavequalifications,demandwillbemoreinelastic.

• Timeperiod.Intheshortterm,demandforlabourwillbeinelastic.However,overtime,itbecomeseasiertosubstitutelabourforcapital,sodemandbecomesmoreelastic.

• Proportionofwagecosts.Iflabourisahigh%oftotalwagecosts,thefirmwillbemoresensitivetoariseinwages.

Workerswithinelasticdemandarehardtoreplace.Therefore,theytendtohavegreaterbargainingstrengthandcandemandhigherwages.

ThedemandcurveD2ismoreinelasticthanD1.Thedemandcurve(D2)leadstoahigherwage(W2).Workerswithaninelasticdemandcurvearenoteasilyreplaceableandsogethigherwages.

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Factors that determine supply of labour • Wagerate.Higherwagescauseamovementalongthesupplycurve.• Thenumberofqualifiedpeopleandthedifficultyofgetting

qualifications.Forprofessions,suchaslawyersanddoctors,therearealimitednumberofpeoplewithsufficientqualifications.Thislimitssupplyandpushesupwages.

• Thenon-wagebenefits(non-pecuniary)benefitsofajob.Thisincludesstatus,jobsecurity,dangerofjob,howenjoyablethejobis,thelengthofholidaysandotherfringebenefits.E.g.iftubedrivershavetostartworkingnights,itmayreducesupplyofworkersbecauseitbecomesalessattractivejob.

• Population/demographics.NetimmigrationintotheUKhasincreasedthesupplyofnurses,cleaners,andotherservicesectorworkers.

Elasticity of supply of labour Theelasticityofsupplymeasureshowwageratesaffecttheresponsivenessofthesupplyoflabour.Supplywillbeinelasticif:

• Onlyasmallnumberofworkershavenecessaryqualifications(e.g.doctors).

• Thejobisunpopular/dangerous,makingsupplylower.• Iftakesalongtimetogainqualifications.

• S1ismoreinelastic(e.g.lawyers).ThisleadstoahigherwageofW2.• S2ismoreelastic(e.g.cleaners).ThisleadstolowerwagesofW1.

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Wage inequality between regions • Weoftenseewagedifferentialsbetweendifferentregions.Forexample,

differencesbetweenwagesinWalesandtherestoftheUK.• Alsotherecanbewagedifferentialswithinaregion,e.g.wageshigherin

Cardiff,thanruralpartsofnorthWales.

ExplainingwagedifferentialsbetweenWalesandLondon

• InWalessupplyanddemandarerelativelymoreelastic.• InLondon,supplyismoreinelasticanddemandhigher.

ExplainingrelativelylowerwagesinWalesthanS.E.England

• InLondon,firmsaremoreprofitableandabletopayhigherwages.Forexample,inLondon,manyfinancialfirmsareabletopaylargebonusesduetoprofits.

• HigherunemploymentinWales.Duetotheprocessofde-industrialisationWaleshasexperiencedperiodsofhigherunemployment.Unemploymenttendstopushdownwagesbecausetherearemorepeoplewillingtofillvacancies.

• ShortageofhousinginLondon,limitssupplyofworkers,pushingupwages.

• GreaterconcentrationofworkerswithhighlevelsofskillsandqualificationsinLondoncomparedtoWelshregions.

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National minimum wage Thenationalminimumwageisagovernmentlegislationwhichpreventsfirmsfrompayinglessthanthestatutoryminimum.

• FromOctober2015,thenationalminimumwagewillbe£6.70anhourforworkersagedover21.Therearelowerratesforyoungworkers.

• Thegovernmenthasindicateditwillsignificantlyincreasetheminimumwageforadultworkersto£9anhourby2020.

• Thisisanattempttomatchthelivingwage–aleveldeemednecessarytodealwithcurrentlivingcosts.

Impact of a national minimum wage

1. Potentialunemployment

• AminimumwageabovetheequilibriumcouldcauseunemploymentofQ3-Q1.ThisisbecausetheminimumwageofW2reducesdemandforworkerstoQ1.

• Thisisparticularlyaconcernforsomeindustrieswherewagesareahighpercentageofcosts,e.g.hairdressersorservicesectorworkers,suchascleaners.

• Asubstantialriseintheminimumwagewillbemorelikelytocauseunemploymentinlowwageregions,suchasthenorth.ItwillhavelessimpactinLondonandthesouth.

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2.Minimumwageandmonopsony

• Aminimumwagecouldcounter-acttheeffectofamonopsonyemployer.Amonopsonyisanemployerwhohasmarketpower.Thismarketpowerenableshimtopaylowerwagesandemploysfewerworkers.

• Somejobs,likefiremen,onlyhaveagovernmentemployer,sothatisaclassicexampleofamonopsony.

• Inpractise,manyworkershavelittlebargainingpowerbecauseitisdifficulttomovejobs.

3.Nationalminimumwageandelasticityofdemandandsupply

• Ifdemandforlabourisinelastic,anationalminimumwagewouldcauselittle,ifany,fallindemandforlabour.

• Forexample,ifwagesincreaseforthewholeservicesectorindustry,theycanpassthewagecostsontoconsumers.

• Inthiscase,aNMWonlycausesaverysmallfallindemandforlabour,fromQ1toQ2.

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4.Caseforregionalminimumwages

• AminimumwagemaybeinsufficienttoprovidealivingwageinLondonbecauseofhigherlivingcosts.

• But,inWales,aUKnationalminimumwagemaypotentiallybesignificantlyhigherthancurrentwagelevels.

• Thiswillsignificantlyincreasethewagesofthelow-paid,butalsocouldcauseunemploymentbecauseemployersmaybeunabletoaffordthehigherwages.

5.Doesaminimumwagereducepoverty?

• Aminimumwageincreasestheincomeoflowpaidworkers.• However,theimpactonrelativepovertyisnotclearcut.Thepoorest

sectionsofsocietytendtobeoutofworkandreceivinggovernmentbenefits.Theyarenotaffectedbyanationalminimumwage.

• Also,manywhogetthenationalminimumwagemaybesecondincomeearnersinafamilysotheimpactonreducingpovertyislimited.

FlexiblelabourmarketsFlexiblelabourmarketsarecharacterisedby:

• Wagessetbymarketforces–supplyanddemand• Lowlevelsofregulation• Mobilityofworkers• Easyforfirmstoemployworkers,andeasyforworkerstoswitchjobs

FactorsthathaveincreasedlabourmarketflexibilityintheUK

• Growthinpart-time/temporarycontracts.Thismeansfirmscanemployworkersforthetimeperiodneeded.

• Growthinzerohourcontracts.Thismeanspeopleareemployed,butthefirmisundernoguaranteetoofferafixednumberofhours.Thismeansweeklywagescanfluctuatesignificantly.

• Declineintradeunionsandcollectivebargaining.Thisgivesfirmsmorepowerindeterminingwages.

• Increaseinself-employment.Self-employmentmeansworkersneedtocontinuallygainbusinessinordertogainincome.Thismakesself-employedworkersmoresensitivetochangesinthemarket.

• MigrationofworkersfromEurope.WiththeexpansionoftheEuropeanUnion,manyEasternEuropeanworkershavecometotheUKtofilljobvacancies,oftenjobswhicharenoteasytofill.

• Changesinwelfarebenefits.Thegovernmenthasmadeitharderforworkerstogetbenefits,suchasunemploymentbenefitanddisabilitybenefits.Thishashadanimpactonincreasingthesupplyoflabour.

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Impact of flexible labour markets • Unemploymentfellquicklyafterthe2008recession.Firmsweremore

willingtotakeonnewworkers.Thissuggestsflexiblelabourmarketsmayenablealowerrateofunemployment

• Therehasbeenadegreeofunder-employment,withpeopleworkingfewerhoursthantheywouldlikeinpart-timework.Thismeanslowerincomeformanypart-timeworkers.

• Greaterjobinsecurity.Peoplehavework,buttherearefewerguaranteesthejobwilllast.Thisgreaterjobinsecuritycouldhavenegativeeffects,suchaspeoplebecomingde-motivatedbecausetheyhavelittleattachmenttothefirm.Butitcouldalsoencourageworkerstotryhardertoretaintheirjob.

• Aflexiblelabourmarketcouldbenefitworkerswhoneedtojugglelookingafterchildrenandworkingfromhome.

• Aflexiblelabourmarketcanbenefitthosewhohavetheskillstogainanincomefromnewtechnology,suchastheinternet.However,aflexiblelabourmarketcouldbedamagingtounskilledworkers,whofindithardtogetlong-termjobsecurity.

Government policies to increase labour market flexibility

• Reduceminimumwages.Firmscanpaylowerwages,butitwouldincreaseinequalityandrelativepoverty.

• Makeiteasiertohireandfireworkers.Ifitischeapertohireandfireworkers,firmsmaybemorewillingtoemploypeopleinthefirstplace,butitcanleadtogreaterjobinsecurity.

• Bettereducationandtraining.Trainingschemeswouldgiveworkersmoreskillstobeabletoacceptnewjob.Awelltrainedworkforcewouldreduceoccupationalimmobility.Educationandtrainingisagoodpolicyintheory,butcanbehardtoimplementinpractise;itwoulddefinitelytaketimetohaveaneffect.

• Encourageimmigration.Immigrantscouldtakejobswheretherearelabourshortages,butimmigrationcancreatenewproblems,suchashousingshortagesandcongestion.

• Reduceincometaxrates,e.g.increasingincometaxthreshold.Thiswouldencourageworkerstomoveintotheworkforce,andmakingbenefitsrelativelylessattractive.

• Reducepoweroftradeunions.Ifgovernmentsmakeitdifficultforunionstogoonstrike,thereislesspotentialforworkersdisruptingwagesettlements.Itmayalsoleadtofirmsgainingmonopsonypowerandsettinglowwages.

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ImpactofnetmigrationonUKlabourmarketsInrecentyears,therehasbeenanetinflowofworkersintotheUK.Theeffectofthisnetmigrationincludes:

• Increaseinsupplyoflabour.Theincreasedsupplyoflabourhasoftenfilledgapsinjobswhichfirmshavefounddifficulttofill,e.g.cleaningandfruitpicking.

• Increaseindemandforlabour.Migrantsincreasethepopulationandthereforeincreaseoveralldemandintheeconomy.

• Firstly,migrationcausesanincreaseinlaboursupply.• But,alsointhelong-term,ahigherpopulationshouldincreasedemandfor

labour.• Inthisdiagram,wageswillstayatQ1andquantityoflabourincreasesfromQ1

toQ3.

Evaluationofnetmigration• Skilledlabour.Thegovernmenthassetcriteria,makingiteasierfor

skilledlabourtomigrate.Thishasmeantmigrationhasplayedanimportantroleinfillingvacanciessuchasnursesanddoctors.

• Offsettheimpactofanageingpopulation.TheUKhasanageingpopulation,whichplacesgreaterstrainongovernmentfinances(oldpay,lesstaxandneedmorepensionsandhealthcarespending).Netmigration

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ofyoungworkershelpsthegovernment’sbudgetsituation,becausetheyaremorelikelytopayincometaxanddon’treceivepensions.

• Migrantscanreturntocountryoforigin.Inaperiodofrisingunemployment,migrantsoftenreturnhome.Thus,migrationcanbeacounter-cyclicalfactorinmakingUKlabourmarketsmoreflexible.

• Inrecentyears,manyforeignworkershavebeenattractedintotheUK.

Immigrationaccountedfor46%ofnetpopulationgrowthin2008.

Problems of net migration • Overcrowding.TheUKexperiencesovercrowding,especiallyinpartslike

thesouth-east.Migrationandariseinthepopulationplacesgreaterstrainonalreadylimitedhousingstockandpublicamenities.

• Undergroundeconomy.Migrantsaremorelikelytoworkintheblackmarket,avoidingregulationslikeminimumwages.

o However,thereisabigdifferencebetweenillegalimmigrationandlegalmigration.

• Unemployment.Somepeoplefeelmigrantstakeexistingjobsfromnativeworkersbecausetheyarewillingtoacceptlowerwages.

o However,itshouldberememberedmigrationalsocreatesjobs,throughtheadditionaldemandintheeconomy.

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How resources are allocated in a free market Inafreemarket,pricesandprofitactassignalstoagents.Thisinfluencestheallocationofresources.

Rationing effect • Ifthereisashortageofthegood,thepricewilltendtoincrease.• Thehigherpricecausesmovementalongthedemandcurve.Lessis

demandedatthehigherprice.Thishelpstorationthescarcedemand.

Higherpriceactsasadisincentivetobuy,rationingdemand.

Incentive effect • Iftherewasincreaseddemandforanewgood(likephoneapps),this

wouldpushuptheprice.• Thishigherpricemakesthegoodmoreprofitable.Therefore,inthelong

run,itactsasanincentiveforproducerstoincreaseproduction.

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• Inthelongterm,firmsrespondtohigherprices(andmoreprofit)by

increasingsupply.• Thisisanexampleofhowmarketscanrespondtochangingconditions.• Forexample,therisingdemandformobilephoneshasledtosignificant

increaseinsupply.

Signalling Thepricemechanismcanprovideasignaltofirmsandconsumers.

• Ifweseehigherdemand,priceswillriseandthiscreatesasignaltoproducersthatthereishighdemand.

• Ahighwageforcertaintypesofworkcansignaltoworkersthatfirmsneedtofillthesejobs.

Inter-related markets Deriveddemand.Thisoccurswhenthedemandforagooddependsondemandforanotherproduct/service.

• Forexample,thedemandfortrainsdependsonthedemandforgettingtowork.Iftherewasariseinunemploymentandlesspeopleworking,demandfortravelwouldfall.

Compositedemand.Thisoccurswhenagoodhasmultipledifferentuses.Risingdemandforoneuserationstheavailabilityforuseofanyotherpurpose.

• Forexample,demandforwheatcouldbeduetotheuseofwheatineitherbreadorasabiofuel.

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• Ifthereishigherdemandtousewheatasabiofuel,thiswillaffectthepriceofbread.Withmoredemandforbiofuels,thepriceofwheatwillrisecausingthepriceofwheatforbreadtoalsoincrease.

• Otherexamplesofcompositedemandinclude:• Land-usedforeitherofficesorforbuildinghouses.• Steel-couldbeusedforbuildinggunsoritcouldbeusedforbuilding

bicycles.

Jointdemand.Thisoccurswhentwogoodsarecomplementaryandneededtogether.

• Forexample,ifyoubuyaprinter,youneedtobuyprintinginktoo.• Therefore,higherdemandforhomeprinterswillleadtohigherdemand

forinkcartridges.Otherexamplesofjointdemandinclude:o iPhoneandiPhoneAppso Cameraandmemorystick

Rational behaviour Ineconomics,weusuallyassumefirmsandconsumersarerational.

Thismeansthattheytrytomaximisetheireconomicwelfareandmakedecisionstoenablethis.

• Consumerstrytoplaceavalueonagooddependingonhowmuchtheyenjoythegood/service.Theymaygivethisutilityamonetaryvaluelike£10.

• Weassumeconsumerswishtomaximisetheirutility.Forexample,theywillspendmoneyongoodsonlyiftheybelievetheutilitygainedisgreaterorequaltothecost.

• Thefirstchocolatebarmaygivehighutility,andconsumersarewillingtopay50p.However,thesecondchocolatebarhasalowermarginalutility–youmightfeelsickifyoueattoomany.

Are consumers rational? • Itcanbedifficultforconsumerstoevaluatetheactualutilitytheygetfrom

agood.• Consumersmaynothavethetimetoworkoutthemarginalutility.• Insteadtheymayuse‘rulesofthumb’orbuyaccordingtoprevious

spendingpatterns.• Consumersarenotalwaysrational,butcanbeinfluencedbyfactors,such

asadvertisingandimpulsebuying.• Consumersmayhavepoorinformationorlackthetimetoworkoutthe

bestprice/utility.Inthiscaseconsumersmaymakeuseofhabitbuyingorrulesofthumbtogetthebestestimation.

• Consumerscanbepronetoirrationalexuberance.Forexample,inaperiodofrisinghouseprices,peoplemaythinkthisisagoodonewaybet,sotheybuyhouseshopingpriceswillkeeprising.

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Market Failure Marketfailureoccurswhenthereisaninefficientallocationofresourcesinafreemarket.Marketfailureimpliesthereisadeclineinproducers/consumersurplusandanetwelfareloss.

Marketfailurecanoccurforvariousreasons.

• Externalities–acostorbenefitimposedonathirdparty,leadingtounder-orover-consumption.

• Informationasymmetries–lackofcompleteknowledgebyoneparty.E.g.peoplemayunder-estimatethebenefitsofeducation(meritgood)orunderestimatethecostsofsmoking(demeritgood).

• Monopoly–Whenafirmhasmarketpowerandcansethigherprices.Monopoliesmayalsobemoreinefficientbecausetheyfacelesscompetitivepressures.

• Immobilities–Geographicalimmobilitiesoccurwhenitisdifficultforpeopleorfirmstomovetoanotherarea.E.g.unemployedcoalminersinYorkshirefinditdifficulttomovetoLondonbecauseofhousingcosts.Occupationalimmobilitiesoccurwhenitisdifficultforpeopletoretrainandgetskillsinnewhigh-techindustries.

• Publicgoods–Goodsthatarenon-rivalandnon-excludable.Theytendtobeunder-providedornotprovidedinafree-market.Examplesincludelawandorder,nationaldefenceandstreetlighting.

• Meritanddemeritgoods–Goodswherewemakedecisionsbasedonpoorinformation.

• Volatileprices–Inagriculturalmarkets,pricescanbevolatilecausingproblemsforconsumersandfarmers.

• Incomeinequality–inafreemarket,therecouldbewidespreadinequalitywithsomeunabletoaffordimportantservices.

ExternalitiesandsocialefficiencySocialbenefit

• Socialbenefitisthetotalbenefittosociety.• Socialbenefit=privatebenefit+externalbenefits.• Socialmarginalbenefit(SMB)=theadditionalbenefittosocietyof

producinganextraunit.• SMB=PMB(privatemarginalbenefit)+XMB(externalmarginalbenefit)

Socialcost

• Socialcostisthetotalcosttosociety.• SocialCost=privatecost+externalcosts.• Socialmarginalcost(SMC)=privatemarginalcost(PMC)+external

marginalcost(XMC)

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NegativeexternalityAnegativeexternalityoccurswhenthereisacostimposedonathirdparty.

• Forexample,ifafirmproduceschemicals,theexternalcostisthepollutionthatcausesdamagetotheriverandthelostearningsforfishermen.

• Ifyoudriveintoatowncentre,thenegativeexternalityisthecongestionandpollutionthataffectsotherpeopleinthetown.

• Withanegativeexternality,thesocialmarginalcostisgreaterthantheprivatemarginalcost.

Inafreemarket,theequilibriumwillbeatQ1,P1,wheresupply(S)=demand(D).

• However,atQ1,theSMCisgreaterthanthePMC.• Q1issociallyinefficientbecausetheSMCisgreaterthantheSMB–this

illustratesanareaofdeadweightwelfareloss.• Inthisexample,thereisoverconsumptionofthegoodwithnegative

externalities.• ThesociallyefficientlevelofoutputwouldbeatQ2,whereSMC=SMB.

Diagram:negativeexternalityofproduction

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Negative consumption externality Negativeexternalitiescanalsooccurinconsumption.

• Forexample,ifwedriveinefficientpetrolcars,theconsumptionofpetrolcausesexcessCO2emissionsandpollution.Thisisacosttotherestofsociety.Otherpeoplewillexperiencepollutionandperhapsillhealthbecauseofourdecisiontodrive.

• Ifwedrinkalcoholtoexcess,wemayturnuplatetoworkonMondaymorning,leadingtolowerproductivityandlowereconomicgrowth.

• Withanegativeconsumptionexternality,thesocialmarginalbenefitislessthanyourprivatemarginalbenefit.

• Inafreemarket,theequilibriumwillbeatQ1(D=S).• But,thesociallyefficientlevelisatQ2(whereSMB=SMC).• Therefore,inafreemarket,thereisoverconsumptionofthisgoodwitha

negativeexternality.

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PositiveexternalityApositiveexternalityinconsumptionoccurswhenthereisabenefittoathirdpartyfromyourconsumption.

• Forexample,ifyoucycletowork(ratherthandrive),otherpeoplebenefitfromreducedcongestionandpollution.

Diagramofpositiveexternalityinconsumption

Inafreemarket,theequilibriumwillbeatQ1,P1,whereSupply(S)=Demand(D).

• However,thisissociallyinefficient.• AtQ1,theSMBisgreaterthantheSMC,leadingtoanareaofdeadweight

welfareloss.• Withapositiveexternality,thereisunder-consumption.• SocialefficiencyoccursatQ2,whereSMB=SMC.

Positiveexternalityinproduction

• Whenproducingagoodcausesabenefittoathirdparty.• Forexample,ifyoukeepbees,thenanearbyapplefarmerbenefits

becauseyourbeeshelptopollinatehisappletrees.

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Private good Aprivategoodisagoodwherethebenefitsaccruetotheindividualandothersarepreventedfromconsumingit.

• Theprivategoodisrivalrousandexcludable.Ifyoueatanapple,nooneelsecaneatit.

PublicgoodApublicgood,bycontrast,hastwocharacteristics:

• Non-rivalry.Whenagoodisconsumed,itdoesn’treducetheamountavailableforothers,e.g.streetlighting.

• Non-excludability.Thisoccurswhenitisnotpossibletoprovideagoodwithoutitbeingpossibleforotherstoenjoy,e.g.nationaldefence.

Publicgoodssufferfromthefree-riderproblem.

• Thefreeriderproblemmeansthatpeoplecanenjoythegoodswithoutpayingforit.Therefore,thereisnoincentiveforfirmstoprovidegoodsbecauseitisdifficulttochargeconsumersforusingit.

• Theconsumercanenjoyitforfree.• Publicgoodsusuallyrequirethegovernmenttoprovidethegooddirectly

andpayforitoutofgeneraltaxation.

Quasi—publicgoods.

Somegoodshavepartofthecharacteristicsofpublicgoods,e.groadsaretoanextentnon-rivalrousandnon-excludable,butnotcompletely,e.g.iftoomanypeopleuseroads,itcausescongestion.Somepeoplearenotqualifiedtodrive.

• Somepublicgoodscanbeprovidedbythefreemarket.Forexample,someonemayprovideabeautifulgardenandnotmindifpeopleenjoyitforfree.

Examtip:Becareful-notallgoodsprovidedbythepublicsector(government)arepublicgoods.

• Forexample,theNHSisprovidedbythepublicsector(government).But,itisnotapublicgood,becauseresourcesarelimited(waitinglists)–sothereisrivalryandexcludability.Ifyouseeadoctor,nooneelsecanhaveanappointmentatthatsametime.

• TheNHSwouldbeconsideredameritgood–peoplemayunderestimatethebenefitsofgettingvaccinationsandahealthyworkforcehaspositiveexternalities.

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Informationgaps• Symmetricinformationmeansbothpartiessharethesameknowledge.

Forexample,ifyougotoamarket,youcanseethepriceofapplesandalsolookattheirquality.

• Asymmetricinformationoccurswhenonepartyhasmoreinformationthanotherparties.Forexample,ifsellingacar,acardealermayknowitisafaultyenginethatwon’tlast.But,asaconsumer,youmaynotknowthis.

Problem of asymmetric information • Peoplemaybereluctanttobuysecondhandcarsiftheydon’ttrustwhat

theyarebuying.Thisleadstolowerpricesforallsecondhandcars.• Peoplemakethe‘wrong’decisionsandreducetheireconomicwelfare.

MeritgoodAmeritgoodoccurswherepeoplemayunderestimateorbeunawareofthebenefitsofconsumingagood.

• Forexample,studentsmayunderestimatethebenefitsofstudyingandthereforeleaveschoolearly.Orpeoplemaybereluctanttogetavaccinationfromdiseases.

• Meritgoodsoftenhaveapositiveexternalityaswell.• Meritgoodsareunder-consumedinafreemarket.

DemeritgoodAdemeritgoodoccurswherepeopleunder-estimateorignorethecostsofconsumingagood.

• Forexample,peoplemaynotbeawareofthedangersofsmoking–ortheymaybeaware,butchoosetoignorethem.

• Demeritgoodsoftenhavenegativeexternalitiesaswell(e.g.passivesmokingeffecttoothers).

• Demeritgoodsareover-consumedinafreemarket.

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Government intervention to correct market failure

Tax• Taxshiftsthesupplycurvetotheleftandmakesthegoodmoreexpensive.

Thiswillreducedemand.• Thegovernmentcanusetaxfordemeritgoodsandgoodswithnegative

externalities.

Specific tax

Aspecifictaxplacesacertainperunittaxonthegood.Itisthesamewhatevertheprice,forexample,tobaccodutyoralcoholexciseduty.

Inthiscasethespecifictaxis£15,anditreducesthequantityfromQ1toQ2.Thepricerisesfrom£52to£60.

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Ad valorem tax

Anadvaloremtaxplacesacertainpercentageonthegood.Forexample,VATintheUKis20%.Thehigherthepriceofthegood,themoretaxispaid.

Tax to overcome market failure • Theidealtaxwouldbeequaltotheexternalmarginalcost.• Thismakesconsumerspaythefullsocialmarginalcost.

TaxshiftsthesupplycurvetoS2andreducesdemandtoQ2,whichisthesociallyefficientlevel(SMC=SMB).

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Advantages of taxes • Raisesrevenueforthegovernmenttospendonalternatives.• Internalisestheexternality(taxmakespeoplepaythefullsocialcost).• Createsincentivesinthelong-termtoencouragefirmstoreducepollution

orprovidealternatives.• Taxcanalsoalterconsumerbehaviourinthelong-term.Forexample,

higherpetroltaxmayencourageconsumerstobuyabicycletoavoidfuelduties.

Evaluation of taxes • Ifdemandisveryinelastic,taxwillonlyhaveaminimaleffectinreducing

demand.Thismayoccuriftherearenoalternativestothegood,e.g.petrol,tobacco.

• Hightaxesmayencouragetaxevasion,e.g.cigarettetaxencouragescigarettestobesmuggledontheblackmarket.Ataxonrubbishmayencouragefly-tipping.

• Highspecifictaxeswillberegressive.Theytakeahigherpercentageofincomefromthepoorthanhigh-incomeearners.

• Theremaybeadministrationcostsinimplementingnewtaxes,e.g.itwouldbedifficulttoimplementacongestionchargefordrivingintosmallcities,likeOxfordorCambridge.

• Itcanbedifficulttomeasuretheexternalcostandhowmuchtaxshouldbeincreased.

• Electronicroadpricingisawaytotryandplaceataxequaltotheexternalcostofdriving,e.g.ifyoudriveincitycentresandpeaktimes,thecostsofcongestionarefargreaterthandrivinginoff-peaktimes.

Subsidy• Asubsidymeansthegovernmentpaysapartofthecostofagood.For

everygoodsold,thegovernmentwillgivefirmsaproportionofthecost.• Theaimofsubsidiesistoencourageconsumptionofgoodswhichare

underprovided/under-consumedinafreemarket.• Asubsidyshiftssupplytotherightandreducestheprice.

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Inthiscase,thesubsidyis£10perunit.ThesubsidyincreasesQfrom90to98.

• Thetotalcosttothegovernmentis98×10=£980.

Whysubsidisegoods?

1. Goodsthathavepositiveexternalities(benefitstootherpeople)aresubsidisedtocreatemoresocialefficiency.

a. Forexample,takingthetraintoworkhelpsreducecongestion.Thegovernmentmaywishtomaketrainscheaper,andthereforereducetrafficcongestion.

2. Tomakeimportantpublicservicesavailabletothoseonlowincome,e.g.peoplemaynotbeabletoafforddentaltreatmentwithoutsubsidiesfromthegovernment.

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Subsidy to overcome market failure

• Inthisexample,thefreemarketequilibriumisatQ1,P1(S=D).• AsubsidyofP0-P2shiftsthesupplycurvetoS2andreducespricetoP2.

Atthisprice,thequantitydemandedisQ2.• ThisisasociallyefficientlevelbecauseatQ2,SMB=SMC.

Evaluation of subsidies • Costtothegovernment.Subsidieswillbeexpensiveandwillrequire

highertaxesonothergoods.• Elasticity.Ifdemandisinelastic,asubsidywillbeineffectivein

increasingdemand.Forexample,asubsidyontraintravelmaybeineffectiveifitisapoorsubstitutetodrivingacar.

• Effectofsubsidyonfirm.Afirmthatreceivesasubsidyismorelikelytobeinefficient,astheybecomereliantonthegovernmentsubsidy.Subsidiesmaykeepinefficientfirmsinbusiness.

• Theremaybegovernmentfailure,e.g.thegovernmenthaspoorinformationaboutwhotosubsidise.

• Combinationofpolicies.Subsidiesmaybemosteffectiveifcombinedwithotherpolicies,e.g.taxondrivingandusingmoneytoprovidealternativestodrivingintotown,e.g.cheaperbuses.

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MaximumpricesAmaximumpriceoccurswhenthegovernmentsetsapricelimitandpreventspricesfromrisingabovethatlevel.

Forexample,ifrentingahouseinLondonis£120aweek,thegovernmentmaydecidetohaveamaximumpriceofrentingof£100aweektomakehousingmoreaffordable.

ProblemofmaximumpricesTheproblemofamaximumpriceisthatifthepriceissetbelowtheequilibrium,wegetashortage.AtMaxPrice,demandisgreaterthansupply(Q3-Q1).Thisleadstowaitinglistsandencouragesablackmarket.

• Theextentoftheshortagedependsontheelasticityofdemandandsupply.Ifsupplyisinelastic,therewillbelittlereductioninavailability.

• Note:Ifthemaximumpricewasplacedabovetheequilibrium,itwouldhavenoeffect.

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Minimumprices• Aminimumpriceoccurswhenthegovernmentsetsapricefloor,and

doesn’tallowpricestogobelowthatlevel.• Withminimumprices,thegovernmentmaybecommittedtobuyingthe

surplus.

Theproblemofaminimumpriceisthatwegetasurplus.AtMinprice,supplyisgreaterthandemand(Q3-Q1).TomaintaintheMinprice,thegovernmenthastobuythesurplus.

• Note:Aminimumpricebelowtheequilibriumwouldhavenoeffect.

TradeablepollutionpermitsTheseinvolvegivingfirmsalegalrighttopolluteacertainamount,e.g.100unitsofcarbondioxideperyear.

• Ifthefirmproduceslesspollution,itcansellitspermitstootherfirms.• However,ifitproducesmorepollution,ithastobuypermitsfromother

firms.• Therewillbeamarketforpollutionpermits.Iffirmspollutealot,there

willbelowsupplyandhighdemand;thereforethepricewillbehighforpermits.

• Therefore,thereisafinancialincentiveforfirmstocutpollution.

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Problems of Tradeable Permits • Difficulttoknowhowmanypermitstogiveinthefirstinstance.• Itmaybedifficulttoaccuratelymeasurepollutionlevels.Thereisan

incentiveforfirmstohidepollution.• Inmostmarkets,itrequiresglobalco-operationtomakeiteffective,

otherwisetheindustrywillmovetocountrieswithlowerenvironmentallegislation.Also,pollutionisverymuchaglobalproblemrequiringglobalsolutions.

• Highadministrationcostsofmeasuringpollutionandenforcingpermits.

StateprovisionofpublicservicesForsomemeritgoodsandpublicgoods,themostefficientsolutionformarketfailureisforthegovernmenttoprovideservicesdirectly.

Forexample,thegovernmentcouldsubsidiseprivatedoctorstotreatpeople,butthereareadvantagestothegovernmentpayingforanationalhealthservicedirectly:

• Itensureseveryonehasaccesstothisimportantmeritgoodandprovidesgreaterequalityinsociety.

• Anationalhealthservicemaybeabletobenefitfromeconomiesofscale,leadingtoloweraveragecoststhansmallindependenthospitals.

• Forserviceslikehealthandeducation,workersdonotneedthesameprofitmotiveofaprivatemanufacturingfirm.Therefore,thereislesslikelytobegovernmentfailureduetoalackofincentives.

• Publicgoodslikelawandordermaynotbeprovidedatallinafreemarket.

Advantages of the private sector providing public services 1. Increaseddemandsarebeingplacedonthepublicsectordueto

demographicchanges.Ifmorepeoplewentprivate,thiswouldenabletheNationalHealthServicestohaveshorterwaitinglists.

2. Providesconsumerswithmorechoice.3. IflesspeopleusetheNHS,itwouldenablethegovernmenttolowertaxes

andreduceborrowing.4. Theprivatesectorhasaprofitincentivetocutcostsandprovideamore

efficientservice,e.g.publicbodiesmayhaveover-staffingbecauseofpoliticalfearsaboutjobcuts.

5. PossiblediseconomiesofscaleintheNationalHealthService.

Disadvantages of the private sector 1. Itisdifficulttointroduceaprofitmotiveintopublicservicessuchas

healthcare;forexample,itisnotpracticaltogiveperformancerelatedpaytonurses/doctors.Also,theprivatesectormaycutcostsbyreducingthequalityofservice,e.g.cuttingbackoncleaning.

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2. Mayincreaseinequality.Peopleonlowincomescannotaffordprivatehealth.

3. Healthisameritgoodandwillbeunderprovidedinafreemarket.Thereforethereisajustificationforgovernmentsubsidy.

Advertising/InformationThegovernmentmayseektoovercomemarketfailurethroughprovidinginformationaboutcertaingoods.

• Forexample,thegovernmentmayruncampaignstowarnaboutthehealthdangersoftobaccoandalcohol.Thesearedemeritgoods,wherepeoplemaynotknowthecostsofconsumption.

• Providinginformationcanhelpovercomeinformationasymmetries.

Evaluation

• Governmentadvertisingcampaignswillcostmoneyandrequirehighertaxes.

• Thereisnoguaranteepeoplewilllistenortakenoteofgovernmentcampaigns.Youngpeoplemaychoosetoignorecampaignsaboutthedangersofalcoholbecausetheyenjoyasenseofrebelliousness.

• However,overtime,peoplehavebecomeawareofthedangersoftobaccoandlong-termsmokingrateshavebeenfalling.

RegulationToovercomemarketfailure,thegovernmentmayuselawsandregulationstoprohibitcertainbehaviour.

• Forexample,ratherthantryandtaxcocainetomakepeoplepaythefullsocialcost,theymayjustprohibititsproductionandconsumption.

• Alternatively,thegovernmentmaybancertainchemicalsbecausetheyaretoodangerous.

Evaluation

• Regulationissimpleandcanbeeffectiveinpreventingdamaginggoodsandservicesfrombeingproduced.However,sometimesnopollutionisnotthemostefficientlevelofproductioninsociety.Carscreatenegativeexternalities,butitisnotdesirabletobancarscompletely.

• Itdependsontheenforceability.Forexample,whentheUSprohibitedalcohol,itwasveryhardtoenforce.Peoplekeptdrinkingbutorganisedcrimebecamemorepowerfulandmoresuccessfulbecauseillegalalcoholwasinhighdemand.

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PoliciesofWelshgovernment

Free NHS prescriptions • NHSprescriptionscouldbeconsideredtobeameritgood.Peoplemay

underestimatethebenefitsoftakingaprescriptiondrug.• Iftheyhavetopay,theymaybeunableorunwillingtotake.Free

prescriptions,whichhavebeenintroducedinWaleshelpsovercomethismarketfailure.

• Freeprescriptionsalsomakessureeverybodycanaffordtogetnecessaryhealthcare,andcanhelpreduceinequality.

• However,demandforprescriptionsislikelytobeveryinelasticbecausemostpeoplewouldpaytogetbetterhealth.

• Thereisanopportunitycostofofferingfreeprescriptions.Itwillrequirehighertaxesorlowergovernmentspendinginotherareas.

• Freeprescriptionswillgotoeveryone,includingthequitewealthy,whocouldeasilyafforditanyway.

Charging for plastic bags • Since2011,thereisacompulsorychargeof5pperplasticbag/paperbag.• Whenplasticbagsarefree,consumersuselargequantities,wasting

resources.Chargingforplasticbagsencouragespeopletoreusetheirbagsandcutdownonwastedresources.

• Aplasticbagalsohasnegativeexternalities.Theycauselitter,useupvaluableresourcesandcantakealongtimetodegrade.Bycharging5p,consumersaremadetopaythefullsocialcostoftheplasticbag.

• Thedownsideistheadministrationcostsinchargingforbags.But,makingituniversalmeansshopperscometoexpectthecost.

Policies to reduce inequality • WithinWalesthereissignificantincomeinequalitybetweendifferent

regions.SomeareaslikeCardiffaremoreprosperousthanvalleyregionsinthesouthandareasinthenorthofWales.

• ThereisahighlevelofunemploymentinthesouthWalesformerminingcommunities,whichhavestruggledtoadapttochangeineconomicactivity.

• Inruralareasinthenorth,lowpaidworkismoreofaproblem,withmanyreceivingin-workbenefits.

• Policiestoovercomepovertyincludetaxandbenefitsystem(setforwholeUK,notdevolvedtoWelshgovernment).

• Policiestoattractnewinvestmentandrealignmentoftheeconomy.Forexamplegrantstodepressedareastohelppromoteeconomicdevelopmentanddiversificationintonewindustriesandeconomicsectors,suchastourismandtheservicesector.

• But,onlysomuchthegovernmentcandotoreducepoverty,e.g.privatesectordeterminingwagesandde-industrialisationishardtoreverse.

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Government failure Governmentfailureoccurswhengovernmentinterventionintheeconomycausesanetwelfareloss.Peoplealsorefertogovernmentfailurewheneffortstoovercomemarketfailuredonotsucceed.

Causes of government failure 1.Lackofincentivesworkingforthegovernment.Governmentbodiesdonothavethesameprofitmotivesofprivatecompanies.Thereforemanagersandworkersmayfeelnoincentivetoworkhardorcutcosts.Theresultcanbegovernmentagenciesthatareinefficient,withhighercostsandnotproducingwhatpeopleneed.

• Tosomeextent,thiscanbeovercomebyrewardinggovernmentworkerswithperformancetargets.

• Incentivesmaybelessimportantinserviceslikehealthcare,wheredoctorsvaluepatienthealth.

2.Unintendedconsequences.Oftengovernmentinterventiontriestosolveoneproblem,butanotherproblemiscreated.Forexample:

• Minimumpricesinagriculturewereanattempttostabilisefarmers’incomes.However,theunintendedconsequenceofguaranteedminimumpriceswasthatitencouragedover-production.Farmersusedchemicalstomaximiseyields–knowingthegovernmentwouldbuyanysurplus.Thisprovedexpensiveandinefficient.

• Byincreasingtaxesontobacco,thegovernmentmadeitmoreprofitableforpeopletosmugglecigarettesfromEurope.

• Amaximumpriceonrentingpropertycouldleadtoadeclineinavailablehousingforrenting–worseningthehousingcrisisratherthanhelping.

• Higherincometaxmaydiscouragepeoplefromworking.

3.Lackofinformation.Governmentbodiescansufferfromalackofknowledgeabouthowtointervene,justaswecangetalackofinformationinafreemarket.

• Forexample,itcanbedifficultforagovernmentbodytocalculatethenetexternalcostsofanewairportornuclearpower.

• Governmentsmayfailtopredictfuturetrends,e.g.theimpactofminimumpricesonincentivesinthelong-term.

4.Administrationcosts.Anygovernmentinterventionislikelytohavesomeadministrationcostsandbureaucracy.

• Forexample,settingupacongestionchargeforsmallcitiescouldbedifficultbecausethecostsofadministeringtheschemewillberelativelyhigh.Withsomenewtaxes,thecostofbureaucracymaybeclosetotherevenuegained.

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Unit 2 The UK Economy

Circular flow of income Thecircularflowofincomeisabasicmodeloftheeconomy.Inthecircularflowofincome:

• Moneyflowsfromhouseholdstofirms(tobuygoods).• Thenfirmspayhouseholdswagestoproducegoods.

Moneycanflowoutofthecircularflowofincometoabroadortogovernment.

ThecircularflowofincomeshowsthreewaystocalculateGDP(GrossDomesticProduct).

Three methods of calculating GDP 1. Totalnationalincome(wages,dividends,profit)2. Totalnationalexpenditure(consumptionandinvestment)3. Totalnationaloutput(valueofgoodsandservicesproduced)

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InjectionsThisisanincreaseofexpenditureintothecircularflowofincome,leadingtoanincreaseinaggregatedemand(AD).Injectionscaninclude:

1. Exports(X)–spendingfromabroadondomesticgoods.2. Governmentspending(G).3. Investment(I)–spendingoncapitalgoodsbyfirms.

Withdrawals(W)(leakages)Withdrawalsareareductionofmoneyinthecircularflow.Withdrawalscaninclude:

• Saving(S)–depositingmoneyinbanks.• Imports(M)–spendingonforeigngoods.• Taxation(T)–theGovernmentraisingmoneyfromconsumersandfirms.

MultipliereffectThemultipliereffectoccurswhenachangeininjectionscausesabiggerfinalchangeinrealGDP.

Forexample,ifthegovernmentincreasedG(governmentspending)by£10billion,andthisledtoanincreaseinrealGDPof£16bn,wesaythemultipliereffectis16/10=1.6.

Whydowegetamultipliereffect?

• Supposewehaveadepressedeconomywithsparecapacityandunemployedworkers.Ifthegovernmentspends£10billiononbuildingroads,theywillemployworkers.Incomeandspendingwillriseby£10bn.

• But,theunemployedwillnowhaveextramoneytospend.Theywillbuyproductsfromshops,andshopkeeperswillnowseeimprovedincomesandalsospendmore.

• Inotherwords,theinitialspendingdoesn’tjuststaywithoneperson.Thereareknockoneffects.Higherspendingleadstomoreincomeforothers,andthereforefurtherroundsofspending.

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Aggregate demand Aggregatedemand(AD)isthetotaldemandforgoodsandservicesintheeconomy.AD=C+I+G+(X-M)

• C=Consumerexpenditureongoodsandservices(60%)• I=Grosscapitalinvestment(spendingoncapitalgoods,e.g.machines)• G=Governmentspending• X=Exports • M=Imports

ShiftinADandmovementalongtheADcurve

Anincreaseinthepricelevel(P1toP2)causesmovementalongtheADcurve.

• Atahigherpricelevel,ceterisparibus,consumershavelessdisposableincome(moneytospend).

• Atahigherpricelevel,UKexportswillberelativelylesscompetitive,leadingtolowerexportdemand.

• AshiftintheADcurvewouldoccuriftherewasachangeinfactorslikerealincome;higherincomewouldshiftADtotheright.Consumerswouldbuymoreatthesamepricelevel.

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Shift in AD • Iftherewasanincreaseinincome,theADcurvewouldshifttotheright

(AD1toAD2).• ADcouldshifttotherightiftherewasariseininvestment,exportsor

governmentspending.

Consumerspending(C)ConsumerspendingisthebiggestcomponentofAD(approx.60-65%ofAD).Consumerspendingisdeterminedby:

• Disposableincome.Thisisincomeaftertaxesandbenefits.RisingrealwageswouldincreasedisposableincomeandshiftADtotheright.

• Saving.Thealternativetospendingdisposableincomeistosave.Ifincomestaysconstant,butconsumerswanttoincreasetheirsavings,thenconsumptionwillfall.

• Consumerconfidence.Ifconsumersarepessimisticaboutthefuture,theywillprefertosave,payoffdebtandreducetheircurrentspending.LowconfidencewillshiftADtotheleft.Highconfidencewillencouragespending.

• Houseprices/wealth.Risinghousepricestendtoincreaseconsumerspendingthroughapositivewealtheffect.IntheUK,manypeopleowntheirhouses.Ifhousepricesrise,theycouldgainequitywithdrawal–re-mortgagingthehouseandtakingmoneytospend.Theywillalsofeelmoreconfidentiftheirhouseisworthmore.

• Incometax/VAT.Acuttoincometaxwillincreaseconsumers’disposableincome,encouragingspending.

• Interestrates.Lowerinterestratesreducethecostofborrowingencouragingspending.Lowerratesalsomakeconsumptionmoreattractivethansavinginabank.

• Costofliving.Ifwagesstaythesame,butthecostoflivinggoesdown(e.g.afallinpetrolprices),peoplewillhavemoredisposableincomeandspendmore.(ThisfactorcausesmovementalongtheADcurve.)

InvestmentInvestmentmeansexpenditureoncapitalgoods–factorsthatincreasetheproductivecapacityoftheeconomy,e.g.machinesandfactories.

• Investmentaccountsforabout15%ofAD.• InvestmentaffectsbothADandAS.• Investmentisrelativelymorevolatileandisstronglyinfluencedby

confidenceandchangesintherateofeconomicgrowth.

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Factors that affect investment • Confidence.Ifbusinessesareoptimisticaboutfuturedemand,theywill

needtoincreaseproductivecapacityandstarttoinvestnow.Ifbusinessesfaceuncertainty,theywillcutbackonriskyinvestment.

• Animalspirits.Keynessaidinvestmentwasheavilyinfluencedbythe‘animalspirits’ofbusinessmen–didpeopleexpecttheirbusinesstogrow?Thisconfidencecanquicklychangedependingonthestateoftheeconomy.

• Interestrates.Investmentisoftenfinancedbyborrowingorusingsavings.Lowerinterestratesmakeitcheapertofinanceinvestmentandmakemoreprojectsworthwhile.

• Availabilityoffinance.Businessesmaywishtoborrowandinvest,butaccesstocreditisabigissue.Banksmaybereluctanttogiveasmallbusinessaloanbecauseitisariskyinvestment.Inthiscaseitmaydependonbusinessesfindingothersourcesofcredit,suchasthestockmarketorprivateinvestors.

• Governmentregulation.Somebusinessesmayputoffinvestmentbecauseoftheheavycostofregulation,e.g.theneedtomeetenvironmentalstandardsandlabourregulation.Ontheotherhand,governmentscouldencourageinvestmentthroughofferingregionalsubsidies.

• Economicgrowth.Akeyfactorindetermininginvestmentistherateofeconomicgrowth.ImprovementsintherateofgrowthandADwilltendtoincreaseinvestment.Alsoimportantisthedemandfromoverseasandthedemandforexports.

Governmentexpenditure(G)Governmentspendingincludestransferpayments(e.g.benefits)anddirectspending,suchascapitalinvestmentonpublicroads.

In2013/14,theUKgovernmentspentatotalof£722.9billion(44%ofGDP).Governmentspendingisinfluencedby:

• Fiscalpolicy.ThegovernmentmaychoosetousefiscalpolicytotryandinfluenceAD,e.g.inarecession,thegovernmentcouldborrowmoreandspendoncapitalinvestment,suchasbuildingnewroadsandrailways.

• Economiccycle.Inaperiodofhigheconomicgrowth,taxrevenuestendtorise;thisgivesthegovernmentmoremoneytospendonservicesliketheNHS.

• Politicalcycle.Governmentmaycutspendingafteranelectiontotryandreducebudgetdeficit,butthenincreasespendingshortlybeforeanelection.

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Nettrade(X-M)TheUK’smaintradingpartneristheEU(60%oftrade).Thoughtheproportionoftradewithdevelopingeconomies,likeChinaandIndia,isrising.

Factors that affect (X-M) • Exchangerates.Ifthereisadepreciationoftheexchangerate,exports

willbecheaperandimportsmoreexpensive.Thiswilltendtoincrease(X-M)andincreaseAD.

• Economicgrowth.IfUKgrowthisrelativelyhigherthanothercountries,wewillseeariseinimportspendingandthiswillreducenet(X-M).But,ifthereisstronggrowthinEurope,thiswillleadtohigher(X-M)andhigherAD.

• Competitiveness.IftheUKhasalowerinflationratethanourcompetitors,thenUKexportswillbecomerelativelycheaper.Improvedcompetitivenesscouldbeduetolowerwagesorhigherproductivity.

• Non-pricefactors.Inadditiontoprice,thequalityanddesirabilityofUKgoodsandserviceswillbeimportant.IfUKfirmscanproducebetterqualitygoodsandserviceswithuniquesellingpoints,demandforUKexportswillriseanddemandwillbemoreinelastic.

• Tariffsandprotectionistmeasures.Ifacountryfacedhightariffsonexports,thiswouldreducedemand.Forexample,iftheUKlefttheEU,itmayfindthattherearehighercosts/tariffsonexportstoEurope.

Aggregate supply (AS) Aggregatesupply(AS)isthetotalproductivecapacityoftheeconomy.Itisthesumofalltheindividualsupplycurvesforparticulargoods.

TheAScurveshowsmaximumpotentialoutput;thereisastrongcorrelationwithaProductionPossibilityFrontier(PPF),whichalsoshowsthemaximumpotentialofaneconomy.

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Long run aggregate supply (LRAS)

• InthediagramthereisashiftinAD.Thiscausesahigherpricelevel(P1toP2)andamovementalongtheAScurve.

• IntheshortruntherecanbesparecapacityandLRASiselastic.• But,LRASalsobecomesinelasticatY2.Thismeansthatfirmscannot

increasecapacitybeyondthispointof‘fullemployment’withoutincreasedinvestment.

FactorsaffectingLRAS

Inthelongrun,ASisdeterminedbythequantityoffactorsofproductionandtheproductivityoflabour/capital.(Labourproductivitymeansoutputperworker.)

• Population.Ariseinthenumberofworkingagepeoplewillincreasethelabourforceandincreaseproductivecapacity.Theworkingagepopulationcanbeaffectedbybirthratesandnetmigration.TheUKlabourforcehasincreasedduetonetmigrationinthepastdecade.

• Technology.Technologicalimprovementsareoneofthebiggestfactorsaffectinglabourproductivity,e.g.theInternetmakesiteasierforfirmstocheckcostsandprices.

• Investment.Iffirmsorthegovernmentinvestinincreasingthecapitalstock,wewillseehigherASinthelongrun.

• Educationandskills.Improvededucationandvocationalskillsenablesworkerstobemoreproductiveandofferhigheraddedvalue,increasingproductivecapacity.

• Infrastructure.Improvedtransportlinksreducethecostoftransportandencouragetrade;thisisimportantforboostingproductivecapacity.

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• Governmentpolicies.ThegovernmentcanaffectLRASbyitssupplysidepoliciesoneducation,competitivenessandregulation.Forexample,privatisationandderegulationmayincreaseefficiencyandcompetitivepressureinindustrieslikegasandelectricity.

o Note:Thereisalimittohowmuchthegovernmentcaninfluenceproductivecapacity.Mosttechnologicalimprovementscomefromtheprivatesector.

• Attitudestoenterprise.Astableeconomicandpoliticalclimatemayencourageentrepreneurstoinvestanddevelopbusiness.

Shift in LRAS

Ifthereisanincreaseinproductivityoranincreaseinfactorsofproduction,theLRASwillshifttotheright.ThiscancausehigherrealGDP.

Governmentsupplysidepolicies,suchasprivatisationandderegulation,couldleadtoanimprovementinproductivecapacityandshiftLRAStotheright.

SupplysidepolicieswillalsoshiftthePPFcurvetotheright.

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EquilibriumnationalincomeEquilibriumnationalincomeoccurswhereAD=AS.

• Inthisexample,thereisafallinAD,leadingtoachangeinequilibriumnationalincome.RealGDPfallsfromY1toY2,andthereisafallinthepricelevel.

Rise in AD Ifthereissparecapacityintheeconomy,thenariseinADwillleadtohigherrealGDP.

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Demandsidefactorsthatcanincreaseeconomicgrowthcouldinclude:

• Lowerinterestrates–reducingthecostofborrowingandleadingtohigherinvestmentandhigherconsumption.

• Risinghouseprice–leadingtoapositivewealtheffect,encouragingconsumerspending.

• Lowertaxes–increasingdisposableincome.• Higherconfidenceintheeconomy–encouragingspendingand

investment.

Multiplier effect on AD and GDP

• Inthiscase,wegetariseininjections(e.g.risinginvestmentlevels).• InitiallythiscausesADtoincreasetoAD2.• But,becauseofthemultipliereffectandfurtherroundsinspending,we

getanotherincreaseinADtoAD3causingabiggerfinalincreaseinrealGDP.

• Inthisexample,initially,therewasalotofsparecapacityatY1.AtY3,theeconomyisclosetofullcapacity.

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GovernmentmacroeconomicobjectivesTheprimaryeconomicobjectivesofagovernmentarelikelytobe:

1. Economicgrowth.Mostgovernmentswouldtrytomaximisesustainableeconomicgrowthtoincreaselivingstandardsandhelpcreateemployment.

2. Lowinflation.Thegovernment’sinflationtargetiscurrentlyCPI2%(+/-1).Thegovernmentwishestoavoidbothhighinflationandalsoavoidthethreatofdeflation.Problemsofinflationinclude:

o Createsinstabilityreducinginvestmento HighUKinflationreducesUKcompetitivenesso Canreducetherealvalueofsavings.o Lowinflationisconsideredbestenvironmentforencouraging

investmentandsustainableeconomicgrowth.3. Lowunemployment.Mostgovernmentswillaimforfullemployment.

Unemploymentcreateshighpersonal,socialandeconomiccosts,suchasstressandrelativepovertyfortheunemployed.Governmentsalsolosetaxrevenuefromtheunemployed.

4. Satisfactorycurrentaccount/balanceofpayments.Alargecurrentaccountdeficitcouldbeaneconomicconcern(e.g.weakexportgrowth,relianceoncapitalflows,financedeficit).Therefore,governmentsmaywishtohaveareasonablelowdeficit/surplus,

5. Lowgovernmentborrowing.Governmentsoftencommittofiscaltargetsforbothannualborrowing,andtotaldebt(publicsectornetdebt).

6. Stableexchangerate.Arapiddepreciationintheexchangeratecouldcauseinflationarypressuresandinstability.Therefore,governmentsmaypreferastableexchangerate(e.g.,afixedexchangeratesystem).

Otherminorobjectives

• Issuesofequality.Higheconomicgrowthmaybeattheexpenseofincomeinequality.Makingsuregrowthisfairlydistributedmaybeanobjectiveofsomegovernments.

• Environment.Higheconomicgrowthcouldcauseenvironmentalproblemsandissuesforlong-termsustainability.Lookingafterenvironmentmayrequiresomesacrificeintermsofeconomicgrowth.

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ConflictsbetweenobjectivesAgovernmentwillstruggletomeetallthemacro-economicobjectivesatonce.

Unemploymentvs.inflation

• Ifthegovernmentpursueddemandsidepoliciestoreduceunemployment,wecouldseeafallinunemployment,highereconomicgrowth,butalsoariseininflation.

Diagram:expansionaryfiscalpolicy

• Ifthegovernmentincreasedspending(G),wewouldseeanincreaseinAD.ThisleadstoariseinrealGDP(Y1toY2).

• Asoutputincreases,firmswillhiremoreworkers.• RealGDPrisesfromAtoB,andwegethigherinflation(P1toP2).

Theremaybeothertrade-offsaswell:

• HigherADcouldcauseabiggercurrentaccountdeficitbecauseofhigherimportspending,andhigherinflationreducingthecompetitivenessofexports.

• Expansionaryfiscalpolicy(higherG/lowertax)willleadtoabiggerbudgetdeficit.

Thetrade-offcanworkinreverse.IfwereduceAD(e.g.,higherinterestrates),wecangetlowerinflation,butwemaycauseunemployment.

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Deflationaryfiscalpolicy

FallinADleadstolowerinflation,butalsocauseslowerrealGDPandrisingunemployment.

Evaluation

• Inthelongrun,itmaybepossibletoachievehighergrowthandlowerunemployment,withoutcausinginflation.Forexample,ifADincreasesatthesamerateasLRAS,wecangeteconomicgrowthwithoutinflation.

• Ifwealsousesupplysidepolicies,wecanreducestructuralunemployment,withoutcausinganyinflation.

Other potential policy conflicts • Highereconomicgrowthmaycauseenvironmentalproblems.For

example,theoveruseofscarcelimitedresourcesactsasaconstraintonfuturelivingstandards.

• Lowerincometaxandcorporationtaxmayprovideaboosttogrowth,butmayalsoincreaseinequalitybecausehighearnersbenefitmostfromthesetaxcuts.

• Cuttingdownbenefitsmayprovideanincentivefortheunemployedtogetajob,butitmaycauseincreasedinequality.

• Policiestoreduceacurrentaccountdeficit(deflationaryfiscalpolicy)maycauselowereconomicgrowthandhigherunemployment.

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Fiscal policy Fiscalpolicyreferstochangesintaxationandgovernmentspendingandthefiscalpositionofthegovernment.

Demandsidefiscalpolicyattemptstoinfluenceaggregatedemand(AD).Theaimcouldbeto:

1. Stimulateeconomicgrowthinaperiodofarecession2. Maintainlowinflation

Supplysidefiscalpolicyattemptstoinfluenceproductivityandthesupplysideoftheeconomy,e.g.spendingoneducationtoimprovelabourproductivity.

Expansionary fiscal policy (loose fiscal policy) Thisinvolveslowertaxratesand/orhighergovernmentspending,withtheaimtoincreaseAD.

Effectofexpansionaryfiscalpolicy

• ExpansionaryfiscalpolicywillincreaseADandincreasethesizeofthebudgetdeficit.Itmayalsocauseinflation.

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Deflationary fiscal policy (tight fiscal policy) • Thisinvolveshighertaxratesand/orlowergovernmentspending.• TheaimofdeflationaryfiscalpolicyistodecreaseADandinflation.• Deflationaryfiscalpolicywillalsoimprovethebudgetdeficit.

Evaluation of fiscal policy 1. Poorinformationmayreducetheaccuracyofforecastingfuture

economicgrowthandinflation.Therefore,thegovernmentmaybeunsurewhethertheyneedtoboostADorreduceAD.Inpractise,governmentsfinditdifficultto‘finetune’theeconomywithfiscalpolicy.

2. ItdependsonothercomponentsofAD.Forexample,ifthegovernmentcutincometaxtoincreaseAD,itmaybeineffectiveifconsumerconfidenceislowandpeoplejustsavetheextraincome.

3. Disincentivestowork.Higherincometaxtoreduceinflationcancreatedisincentivestowork,reducingproductivityandAS.

4. TimelaginvolvedininfluencingAD.IfthegovernmentwantedtoincreaseAD,theycouldcommittomoregovernmentspending.But,therewillbedelaysinactuallyimplementinghigherspending,andthendelaysinthisspendingaffectingthewidereconomy.

5. Budgetdeficits.Expansionaryfiscalpolicy(higherspending,lowertax)willincreasegovernmentborrowing.Thiscouldleadtohigherinterestratesinthelongtermorevencausemarketstoloseconfidenceindebtlevels.

6. Crowdingout.Ifthegovernmentspendmorebyborrowingfromprivatesector,itmayreducetheamountofmoneytheprivatesectorhastospend.

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ThenationaldebtNationaldebt(publicsectornetdebt)isthetotal(cumulative)amountofdebtthatthegovernmentowestheprivatesector.

• InJanuary2015,thenetdebtwas£1,483.3 billion, equating to 80%ofGDP.• UKnationaldebtasa%ofGDPpeakedaftertheFirstandSecondWorld

Wars.ItfellduringthepostwarperiodaseconomicgrowthledtohigherGDP,makingdebtasmallerpercentage.

• Netdebtasincreasedsincethefinancialcrisisof2007

Government borrowing • Thebudgetdeficitistheannualamountthegovernmentneedstoborrow

fromtheprivatesector.

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Thepreviousdiagramshowspublicsectornetborrowing(budgetdeficit)intheUK.

• In1999-00and2000-01,theUKranabudgetsurplus.Governmentspendingwaslessthantaxrevenues.

• Borrowingpeakedin2009-10becauseofthefinancialcrisisandrecession.Intherecession,taxreceiptsfellandspendingonunemploymentbenefitsrose.

• In2009/10,thegovernmentalsopursuedexpansionaryfiscalpolicy(cuttingVATratestoboostAD).

Budgetdeficit

• Thebudgetdeficitwillbethedifferencebetweengovernmentspending(G)andtaxrevenue.

• Thebudgetdeficitismeasuredthroughstats,suchasPublicSectorNetCashRequirement(PSNCR)andnetborrowing.

• Thebudgetdeficitisalsoreferredtoasnetborrowing.

Public expenditure Governmentspendingincludesallformsofspendingbycentralandlocalgovernment.Themaintypesofgovernmentspendingare:

• Capitalexpenditure.Thisisgovernmentspendingoncapitalprojectsandcreatingnewassets.Itisinvestmentthatincreasesthecapitalstockoftheeconomy.

o Thistypicallyinvolvesbuildingnewroads,railways,hospitals,andimprovingcommunication.Thiscapitalspendingcanincreasetheproductivecapacityoftheeconomyinthefuture,becauseithelpsshiftlong-runaggregatesupplytotheright.

• Currentexpenditure.Thisisgovernmentspendingonitemsthatarerecurringandonlylastsalimitedtime,e.g.spendingonpublicsectorwagesandconsumableproducts.

o Forexample,buildingaschoolwhichlasts50yearsiscapitalexpenditure.Payingteachers’wagesandpayingelectricbillsiscurrentspending.Botharenecessary.

• Transferpayments.Thesearesimplepaymentsfromthegovernmenttoindividuals.Itrepresentsaredistributionofincomeinsociety.Examplesoftransferpaymentsinclude:• Pensions• Welfarepayments,suchasunemploymentbenefitandhousingbenefit• Transferpaymentscanredistributeincome,butalsowelfarebenefits

riskcreatingdisincentivestowork.

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GovernmentspendingRealgovernmentspending—Spendinglevelsadjustedforinflation.

In2011/12,therewasasmallfallinrealgovernmentspendingduetothepolicyofausterity(cuttinggovernmentspending)

Governmentspendingasa%ofGDProsefrom2000to2009

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Impact of higher government spending Anincreaseinrealgovernmentspendingcouldimply:

• Moreinvestmentineducationandinfrastructure.Thegovernmentcanusetaxrevenuestoovercomemarketfailureinareassuchastransport,education,andhealth.Providinggoodswithpositiveexternalitiescanleadtogreatersocialefficiency.Itcanalsohelpimproveindicesofeconomicdevelopment,suchasliteracyrates.

• Redistribution.Thegovernmentcanspendmoneytoredistributeincomeamongstpeopleonlowincomes.Thiscanhelppromoteamoreequalsocietyandimproveeconomicwelfare.Countrieswiththehighestlevelsofgovernmentspending(Norway,France,UK)havethemostdevelopedwelfarestates,whichprovideasafetynetandhealthcareforthepoorermembersofsociety.

• Fiscalpolicy.Inarecession,governmentspendingmaybeeffectiveinstimulatingtheeconomy,e.g.governmentborrowingcanoffsetariseinprivatesectorsaving,andincreaseAD.

• Automaticstabilisers.Between2007and2010,theincreaseingovernmentspendingasa%ofGDPisaconsequenceoftherecession,causingafallinGDP,buthighergovernmentspendingonunemploymentandhousingbenefits.

Evaluation of higher government spending • Highertaxesmayberequiredtofundhigherspending.Higherincome

taxratescouldcreatedisincentivestowork.Highercorporationtaxcoulddiscouragefirmsfromsettingupinthatcountry,leadingtolowergrowth.

• Potentialinefficiencyofgovernmentspending.Often,governmentbodieslackaprofitincentivetobeefficient.Therefore,governmentspendingcouldbewasteful,misused,andinefficient.Ontheotherhand,itcouldovercomemarketfailure,e.g.lackofeducation.

• Efficiency.Governmentspendingcouldbecomemoreefficientthroughcompetitivetenderingandpublic-privatepartnerships,whichinvolvebothpublicandprivatesectors.Thereisnoreasongovernmentspendinghastobeinefficient.

• Crowdingout.Anincreaseinthegovernmentsectorhasanopportunitycost.Moregovernmentspendingmeansadeclineinthesizeoftheprivatesectorandareductioninprivatesectorenterprise.

• Dependsonthekindofspending.Itdependsonwhatthegovernmentisspendingthemoney:

o Spendingonwelfarebenefits(transferpayments)mayincreaseequality,butbedetrimentaltoefficiencyandproductivity.

o Spendingontransportlinks(capitalspending)canhelptheeconomybecomemoreefficientandcompetitiveinthelongterm.

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TaxationThegovernmentcollectstaxrevenuesfromavarietyofsources.Themaintypesoftaxationare:

• Directtaxation–incometax,NIcontribution.Thesetaxesaretakendirectlyfromaperson’swages.Incometaxisprogressivebecauseittakesabigger%oftaxfrompeoplewithhighincomes.

• Indirecttaxation–VAT,exciseduty.Consumerspaythesetaxesindirectly;whenagoodisbought,thefirmhastopaytheVATratetothegovernment(20%).Indirecttaxesalsoincludeexciseduty(e.g.alcohol,tobacco)andpetroltaxes.

• Progressivetaxoccurswhenthoseonhigherincomelevelspayahigher%oftheirincomeintax,e.g.theUKhasatoprateof45%onmarginalincomeover£150,000;thisisaprogressivetax.

• Regressivetaxoccurswhenanincreaseinincomeleadstoasmaller%oftheirincomegoingonthetax,e.g.excisedutiesandVATtakeabigger%oflowincomeearners.

• Indirecttaxationispaidbyfirmssellinggoods,e.g.VATisincludedinthefinalpriceconsumerspay.

Impact of increasing the rate of income tax • Higherrevenues.Higherincometaxshouldincreasetaxrevenues.

Thegovernmentcanspendmoreonpublicservicesandbenefitstoreduceinequalityandfundcapitalinvestment.

• Taxevasion.Higherincometaxmayencouragetaxevasion,e.g.higherratesofincometaxcouldencouragepeopletoworkinanother

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country.Therefore,anincreaseintaxrevenuesmaybelessthanexpected.

• Incentivestowork.Highermarginaltaxratesmayreduceincentivestoworkanddoovertime.Thesubstitutioneffectstateshigherincometaxwillmakeworkrelativelylessattractive.

• Redistribution.Higherratesofincometaxcanhelpredistributeincomefromhighearnerstolowearnersandcreatemoreequality.

• Aggregatedemand.Highertaxrateswillreducedisposableincomeandleadtolowerconsumerspending.Ceterisparibus,thiscouldleadtolowereconomicgrowthandlowerinflation.

Evaluation of higher income taxes • Disincentives?Somefearhigherincometaxratescouldcreate

disincentivestowork.Butothereconomistssuggestevidenceismixed.Thesubstitutioneffectofataxrisemaymakepeopleworkless,buttheincomeeffectencouragesthemtoworkmore(toachievetargetincome).

• Itdependshowtaxrevenueisused.Ifincometaxrevenueisinvestedinimprovedinfrastructure,itcanthebenefitlong-runproductivecapacity.Ifincometaxrevenueisneededforwelfarepayments,therewillbenoincreaseinproductivecapacity.

• Doesrevenueincrease?TheLaffercurvesuggeststherecomesapointwherehigherincometaxratesleadstoadeclineintaxrevenue,becausepeoplestopworkingiftaxistoohigh.

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Supply side policies Supplysidepoliciesaregovernmentattemptstoincreaseproductivity,maketheeconomymoreefficientandshiftaggregatesupplytotheright.Supplysidepoliciescanbeeither:

1. Interventionist-involvinggovernmentspendingtoovercomemarketfailure,e.g.buildingnewroadstoreducecongestion.

2. Marketoriented-policiestoreduceregulationandallowfreemarketstofunctionmoreefficiently,e.g.reduceminimumwages.

Supplysidepoliciescanhelptheeconomyinvariousways:

1. Lowerinflation.ShiftingAStotherightwillcausealowerpricelevel.2. Lowerunemployment.Supplysidepoliciescanhelpreducestructural,

frictionalandrealwageunemployment.3. Improvedeconomicgrowth.Supplysidepolicieswillincreaseeconomic

growthbyincreasingAS4. Improvedtradeandbalanceofpayments.Bymakingfirmsmore

competitive,theywillbeabletoexportmore.

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Examples of market oriented supply side policies 1. Privatisation.Thisinvolvessellingstateownedassetstotheprivate

sector.Itisarguedthattheprivatesectorismoreefficientinrunningbusinessesbecausetheyhaveaprofitmotivetoreducecostsanddevelopbetterservices.

2. Deregulation.Thisinvolvesreducingbarrierstoentryinordertomakethemarketmorecompetitive.Greatercompetitioncreatesincentivestoreducepricesandcosts.Forexample,UKtelecomsmarketsarenowmorecompetitiveandthishashelpedreducepricesandincreaseefficiency.

3. Reducingtaxes.Itisarguedthatlowertaxes(incomeandcorporation)increaseincentivesforpeopletoworkharder,leadingtohigheroutput.

4. Reducingstatewelfarebenefits.Lowerunemploymentbenefitsmaycreateabiggerincentiveforpeopletolookforworkandstayoffbenefits

5. Reducedbureaucracyforfirms.Ifrulesandregulationsareremovedthenfirmswillhavelowercostsandbemoreproductive.

6. Labourmarketreforms.SomeeconomistsarguethatmanyEuropeanlabourmarketsaretooheavilyregulated.Forexample,removinglawsabouthiringandfiringworkersandfixedhourcontractswouldincreaselabourmarketflexibilityandencouragefirmstohireworkers.Onthedownside,greaterlabourmarketflexibilitymayleadtogreaterjobinsecurityforworkers.

Examples of interventionist supply side policies • Increasededucationandtraining.Bettereducationcanimprovelabour

productivityandincreaseAS.Oftenthereisanunderprovisionofeducationinafreemarket,leadingtomarketfailure.Therefore,thegovernmentmayneedtosubsidisesuitabletrainingschemes.

• Providingbetterinformationaboutavailablejobs.• Improvingtransportandinfrastructure.Inafreemarket,thereis

likelytobeanunderprovisionofpublictransport.Iftransportnetworkswereimproved,firmswouldbenefitfromlowercosts.

Evaluationofsupplysidepolicies• Theywilltaketimetohaveeffect,e.g.itwilltakeseveralyearstocreatea

moreeducatedworkforce.• Itwillcostmoneytoimproveinformationandeducation,andtherefore

taxeswillneedtorise.• Deregulation,suchaslowerbenefitsandreducedminimumwages,may

causesideeffects,suchasincreasedpoverty.• Governmentfailuremayoccur.Forexample,thegovernmentmayhave

poorinformationaboutwhattospendmoneyon.Forexample,the

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governmentmayfinancethewrongkindofscheme,suchasanewtrainlinethatisnotusedverymuch.

• Inarecession,increasingASmaybeinsufficient.Inarecessionthemostimportantthingisnotsupplysidepoliciesbutpoliciestoincreaseaggregatedemand.

Inthisexample,wesuccessfullyincreaseLRAS,buttheeconomyisstuckinarecession,sotheoutputisrelativelysmall.Inthissituation,theeconomyneedsanincreaseinAD(demandsidepolicies).

• Thereisonlysomuchthegovernmentcando.Itisimportanttobearinmindthattechnologicalimprovementsandproductivitygainscomelargelyfromtheprivatesector.

• Itisdifficultforthegovernmenttotransformproductivityandcreatenewtechnology.Atbest,thegovernmentcancreateaclimateforprivatesectorinnovationtooccur.

• TheUK’slastperiodofdemandpullinflationwasthelate1980s.• Inthisperiod,growthwasveryhighat4-5%ayear.Itwasfuelledby

incometaxcuts,risinghousepricesandrelativelylowinterestrates.• Inflationwasclosetothegovernment’stargetof2%between1992and

2008.Thisperiodwasknownasthe‘greatmoderation’becauseeconomicgrowthwassustainableanddidnotcauseinflation.

• Inflationdidnotincreaseuntil2008,whenitreachedover5%.Thiswasduetorisingoilprices.

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Monetary Policy Monetarypolicyinvolveschangingtheinterestrateormanipulationofthemoneysupplybythemonetaryauthorities.

Inflationcomparedtothegovernmentstargetof2%

Aimsofmonetarypolicy

1. Controltherateofinflation.InflationtargetforMPCisCPI-2.0%+/-12. Maintainsustainableeconomicgrowth3. Influencetheexchangerate(notsoimportant)

UKmonetarypolicy• Everymonth,theMPCmeettodecidefutureinterestrates.Iftheyfeelthe

inflationrateislikelytogoabovethetarget(e.g.duetoahigherrateofeconomicgrowth)thentheywillincreaseinterestratestomoderatedemandandkeepinflationlow.

• IftheMPCfeelthatinflationislikelytofallbelowthetargetandthereissloweconomicgrowth,theyarelikelytodecreaseinterestratestoboosteconomicgrowthandpreventunemployment.

Todeterminefutureinflation,theMPCwilllookatvariousstatisticssuchas:

• Therateofeconomicgrowthcomparedtothelongruntrendrate.Ifgrowthisfasterthanthetrendrate,inflationislikelytooccur.

• Wagegrowth.Higherwagegrowthcancausebothcost-pushanddemand-pullinflation.

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• Temporaryfactorsliketaxrisesandcommoditypriceriseswillbegivenlessimportancebecausetheydonotindicateunderlyinginflation.

• Unemployment.HighunemploymentwilltendtoreducewageinflationandsotheMPCismorelikelytocutinterestratestoboostAD.

The role of the central bank CentralBanksplayanimportantroleinamoderneconomy.Theirfunctionsinclude:

1. Monetarypolicy.CentralBanksareusuallyresponsibleformonetarypolicy.Thisinvolveschanginginterestratestomeetthegovernment’stargetforinflation(andothermacro-objectives).

2. Bankertothegovernment.CentralBanksmanagethegovernment’sfinancialaccount.

3. Lenderoflastresort.Animportantroleisactingasthelenderoflastresort,forboththegovernmentandprivatebanks.Ifthegovernmentrunsoutofmoney,theCentralBankscanstepintobuygovernmentdebt,preventingpanicaboutthegovernment’sliquidity.Theycanalsolendmoneytocommercialbanksiftheyaretemporarilyshortofliquidity(money).

Effect of higher interest rates (Tight monetary policy) Ifinflationisforecasttoriseabovetheinflationtarget,theMPCarelikelytoincreaseinterestrates.ThiswillhelpreduceADandinflationbecausehigherinterestrates:

• Makesborrowingmoreexpensive,thereforepeoplespendlessoncreditreducingconsumerspending.Firmswillalsobelesswillingtoinvestbyborrowingmoney.

• Thecostofmortgagesincreases,thereforepeoplehavelessdisposableincomecausingafallinconsumption.ThereforeADdecreases.

• Savingmoneyinabankismoreattractivethereforethereislessspendingandrelativelymoresaving.

• Exchangerateincreases.Withhigherinterestrates,itismoreattractivetosaveinUKbanks.ThisincreasesthedemandfortheBritishPoundandincreasestheexchangerate.Ahigherexchangeratewillreducethedemandfor(X-M)becauseexportsaremoreexpensive,andimportscheaper.

Evaluation of monetary policy 1.Othercomponentsintheeconomy.Theeffectivenessofmonetarypolicydependsuponothervariablesintheeconomy,forexample:

• Ifconfidenceislow,areductionininterestratesmaynotincreasedemand.

• Iftaxesarerising,thismaycounterafallininterestrates.

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• Iftheworldeconomyisslowing,thiswillreduceexportsandAD;thiswouldkeepspendinglow-eveniftherewasareductionininterestrates.

2.Theeffectofinterestratesdependsonthesituationoftheeconomy.Iftheeconomyisclosetofullemployment,acutininterestratesislikelytojustcauseinflationsignificantlywithonlyasmallincreaseinrealGDP.(AD3toAD4)

• Howeveriftheeconomyhassparecapacity,(e.g.atY1toY2)higherADwillincreaseGDP,withonlyasmallamountofinflation.

3.Timelags.Theremaybetimelagsforlowerinterestratestohaveaneffect.Forexample,higherinterestratesmaynotreduceinvestmentintheshorttermbecausefirmswillcontinuewithexistinginvestmentprojects.

4.Conflictsofobjectives.Monetarypolicymayconflictwithothermacroeconomicobjectives.IftheMPCreducesinflation,thismayleadtolowergrowthorhigherunemployment.

5.InterestratesforwholeUK.TheMPCsetinterestratesforthewholeoftheUK,butifregionsaregrowingatdifferentrates,itmaynotbesuitable.Forexample,ifWaleswasdepressed,butrestofUKgrowingstrongly.HighratesmaybedamagingforWelsheconomy.

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Exchange rates • Theexchangeratemeasuresthevalueofacurrencyagainstother

currencies.• Bilateralexchangeratemeasurestheexchangeratefortwocountries,

e.g.thevalueofthePoundSterlingagainsttheDollar.• Nominalexchangeratemeasurestheactualmonetaryvalue,andthe

amountofcurrencyyoucangete.g.£1=$1.5.• Realexchangeratetakesintoaccountinflationandmeasuresthe

amountofgoodsyoucanexchange.Therealexchangerate=nominalexchangerateX(domesticprice/foreignprice).

• Effectiveexchangerate.Theweightedaverageofacurrencyadjustedforinflation,likerealexchangerate.

• Appreciationistheincreaseinvalueofexchangerate.• Depreciation/devaluationisthedecreaseinvalueofexchangerate.• Floatingexchangerateisthevalueofexchangeratedeterminedby

marketforces.• Fixedexchangerateisthegovernmentcommittedtokeepingexchange

rateatsetvalue.• Hybridorsemi-fixedexchangerateisthegovernmentcommittedto

keepingexchangeratewithinacertainband/peg,e.g.£1=€1.1to€1.2.Itisamixtureoffloatingexchangeratesandfixedexchangerates.Itissometimesknownasa‘dirtyfloat’.

ExchangerateindexforthePoundSterling

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• Atrade-weightedindexmeansthatwemeasurethevalueoftheBritishPoundagainstabasketofcurrencies.

• Wegiveaweightingtothemostimportantcurrencies(e.g.theEuroandtheUSDollarwillhavethebiggestweightingbecausemosttradeiswiththeEurozoneandthentheUS).

• Thisexchangerateindexshowsa20%fallinthevalueofthePoundSterlingbetween2007and2009.

Factorsthatinfluenceexchangerates• Inflation.IfinflationintheUKisrelativelylowerthanelsewhere,UK

exportswillbecomemorecompetitive,andtherewillbeanincreaseindemandforPoundSterlingtobuyUKgoods.Countrieswithlowerinflationratestendtoseeanappreciationinthevalueoftheircurrency.Ifacountryengagedinquantitativeeasing(QE)thiscouldcreateinflationandthereforereducethevalueoftheexchangerate.

• InterestRates.IfUKinterestratesriserelativetoelsewhere,itwillbecomemoreattractivetodepositmoneyintheUK.Therefore,thedemandforSterlingwillrise,causing“hotmoneyflows”.Higherinterestratescauseanappreciation.

• Speculation.IfforeigncurrencydealersbecomepessimisticaboutthestateoftheUKeconomy,theymaysellSterling.Theycouldbecomepessimisticaboutprospectsforgrowth,highgovernmentdebt,andfutureinflation.SimilarlyifacountrylikeSwitzerlandwasseenasarelative‘safehaven’forsaving,itcouldleadtoariseindemandforSwissFrancsandcauseanappreciationintheSwissFranc.

• Balanceofpayments.Ifacountryhasalargecurrentaccountdeficit,itmaycausedepreciationbecausethereisanetoutflowofcurrency.

AppreciationintheexchangerateAnappreciationmeansthevalueofacurrencyincreases.Theeffectofthisis:

• Exportsmoreexpensive.Therefore,quantityofexportsfalls.• Importscheaper.Therefore,quantityofimportsrises.• LowerAD.Assumingdemandiselastic,anappreciationwillcauselower

aggregatedemandandlowereconomicgrowth.• Lowerinflation.Thisisdueto3reasons:

o Lowerimportpricese.g.fallingoilpricesfromtheappreciation.o LowerexportsandlowerAD,reducingdemandpullinflation.o Toremaincompetitive,firmshaveabiggerincentivetocutcosts.

• Worseningofcurrentaccount,e.g.biggerdeficit,becauseofdeclineinexportsandriseinquantityofimports.

• Foreigndirectinvestmentmayfall.Ariseintheexchangeratemaydiscourageforeigndirectinvestment(FDI),becauseitisnowmoreexpensiveforforeignfirmstoinvest.

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Evaluationofanappreciation• Dependsontheelasticityofdemandforimportsandexports.If

demandisinelastic,anappreciationwillhavelessimpactonreducingdemand.

• ItdependsonothercomponentsofAD.Anappreciationwon’tcauseafallinAD,ifconsumerspendingisgrowingstrongly.ConsumerspendingisabiggercomponentofADthannetexports.

• Timelags.Often,demandisinelasticintheshorttermandbecomesmoreelasticovertime.Therefore,anappreciationcouldhaveabiggerimpactovertime.

• Itdependsonproductivitygrowth.Iftheexchangerateappreciatesbecausefirmsarebecomingmoreproductive,thentheywillremaincompetitive.Iftheexchangerateappreciatesduetospeculation,firmsaremorelikelytobecomeuncompetitive.

o Forexample,countrieslikeGermanyandJapanhaveprospered,eveninperiodsofanappreciatingcurrency.

• Itdependsonthestateoftheeconomy.Iftheeconomyisgrowingstronglyandisnearfullcapacity,ariseintheexchangeratecouldhelpreduceinflationarypressureandkeepgrowthsustainable.Ifthereisalreadysparecapacity,thenanappreciationcouldleadtoarecession.

Theeffectsofanappreciationdependonthestateoftheeconomy.AfallinADtoAD2reducesinflation,withlittleeffectonrealGDP.

But,afallinADfromAD3toAD4,leadstoabigfallinrealGDP.

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Effects of a depreciation in exchange rate • Exportscheaperandmorecompetitive• Importsmoreexpensive• IncreasedADandhighereconomicgrowth• InflationmayriseduetohigherimportpricesandhigherAD.• Competitivenessimprovesintheshortterm;inthelongtermitmaynot

improveduetohigherinflation.

Government intervention in foreign exchange markets

InthisdiagramagovernmentbuyingPoundSterlinghasincreaseddemand(D1toD2)andincreasedthevalueofthe£.£1nowgivesmoredollars($1.70)

Methodsofgovernmentinterventioninforeignexchangemarkets

1. Buying/sellingcurrency.GovernmentscoulduseforeigncurrencyreservestobuyPoundsandincreasethevalueofthePound.Thoughforeigncurrencyreservesarelimited.

2. Changinginterestrates.ThegovernmentorCentralBankcouldincreaseinterestratestoincreasethevalueofthePound.

3. Improvingcompetitiveness.Thegovernmentcouldusedeflationaryfiscalpolicytoreduceinflationandimprovecompetitiveness.Itcouldalsotrysupply-sidepoliciestoimprovelong-runcompetitiveness.

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Advantages of fixed exchange rates • Providegreaterstabilityforfirmsinvolvedintrade,e.g.exportersdon’t

havetofeararapidappreciationwhichwouldreducetheirprofitability.• Canhelpreduceinflationascountrieshaveanaddeddisciplinetokeep

inflationlow,otherwisethecurrencywouldbeweaker.• Mayreducespeculationifmarketsbelievethecountrywillsticktoan

exchangerate.

Disadvantages of fixed exchange rates • Mayleadtotheexchangeratebeingovervalued,thiscanharmexports

andeconomicgrowth.• Maintainingafixedexchangeratemayrequirehighinterestrates(this

mayconflictwithotherobjectives,suchascausinglowergrowthandhigherunemployment).

• UKforcedoutofERMin1992,becausemarketsfelttheyhadjoinedatthewrongrate.GovernmentunabletomaintainvalueofPoundinERM.

Trade • Internationaltradeallowscountriestospecialiseingoodsandservices

whichtheyarerelativelybestatproducing.• Absoluteadvantage.Thisoccurswhenonecountrycanproduceagood

withfewerresourcesthananother.• Comparativeadvantage.Acountryhasacomparativeadvantageifitcan

produceagoodataloweropportunitycost,e.g.ithastoforegolessofothergoodsinordertoproduceit.

• Thelawofcomparativeadvantage.Thisstatesthattradecanbenefitallcountriesiftheyspecialiseinthegoodsinwhichtheyhaveacomparativeadvantage.

Restrictions on free trade Protectionisminvolvespoliciestorestricttrade.Thiscaninvolve:

• Highertariffs(typeoftaxonimports).• Non-tariffbarriers,e.g.theUShavechargesonpackagesundergrounds

of‘aviationsecurity’,andthisincreasesthecostsofimports.Otherrulesandregulationscanmaketrademoredifficult.

• Voluntaryexportrestraintiseffectivelyatypeofquotawherevoluntarylimitsareplacedonimportsofgoods.

• Embargo,e.g.USembargowithCuba.• Governmentsubsidy.Governmentsubsidieseffectivelygivethefirman

unfaircompetitiveadvantage.Thishasoftenoccurredwithnationalairlines.

• Distortedexchangerate.Keepingyourcurrencyartificiallylowmakesexportsrelativelymorecompetitive.

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Benefitsoffreetrade• Increasedexports.IfUKfirmshaveacomparativeadvantagethen,with

lowertariffs,theywillbeabletoexportmore,andcreatemorejobs.• Economiesofscale.Ifcountriescanspecialiseincertaingoods,theycan

benefitfromeconomiesofscaleandloweraveragecosts.Thisisespeciallytrueinindustrieswithhighfixedcosts,orthosethatrequirehighlevelsofinvestment.

• Tradeisanengineofgrowth.Worldtradehasincreasedbyanaverageof7%ayearsince1945;itisabigcontributortoglobaleconomicgrowth.

• Reducingtariffbarriersleadstotradecreation.Tradecreationoccurswhenconsumptionswitchesfromhighcostproducerstolowcostproducers,enablinganincreaseineconomicwelfare.

• Theremovaloftariffsleadstolowerpricesforconsumers(P1–P2)andanincreaseinconsumersurplus(1+2+3+4).

• Thegovernmentwilllosetaxrevenueofarea3.• Domesticfirmswillselllessandloseproducersurplusofarea1.• Therewillbeanincreaseinoveralleconomicwelfareof:(2+4).

• Increasedcompetition.Withmoretrade,domesticfirmswillfacemorecompetitionfromabroadand,therefore,therewillbemoreincentivestocutcostsandincreaseefficiency.Itmaypreventdomesticmonopoliesfromchargingtoohighprices.

• Makeuseofsurplusrawmaterials.Countrieswithlargereservesofrawmaterialsneedtradetobenefitfromtheirnaturalwealth.

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Argumentsforrestrictingtrade• Infantindustryargument.Ifdevelopingcountrieshaveindustries

thatarerelativelynewthen,atthatmoment,theseindustrieswouldstruggleagainstinternationalcompetition.Therefore,theyneedtariffprotectionwhiletheydeveloptheirindustriestobemorecompetitive.

• Thesenileindustryargument.Ifindustriesaredecliningandinefficient,theymayrequirealargeinvestmenttomakethemefficientagain.Protectionfortheseindustriescouldactasanincentiveforfirmstoinvestandreinventthemselves.

• Needtodiversifytheeconomy.Manydevelopingcountriesrelyonproducingprimaryproducts,inwhichtheycurrentlyhaveacomparativeadvantage.However,relyingonagriculturalproductshasseveraldisadvantages:

o Pricescanfluctuateduetoenvironmentalfactors.o Goodshavealowincomeelasticityofdemand.Therefore,even

witheconomicgrowth,demandwillonlyincreasealittle.

• Protectionagainstdumping.TheEUsoldalotofitsfoodsurplusfromtheCAPatverylowpricesontheworldmarket.Thiscausedproblemsforworldfarmersbecausetheysawabigfallintheirmarketprices.Tariffscanprotectagainstdumping.

• Environmental.Itisarguedthatfreetradecanharmtheenvironmentbecausecountrieswithstrictpollutioncontrolsmayfindthatconsumersimportthegoodsfromothercountrieswherelegislationislaxandpollutionisallowed.

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