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155195918 igcse-economics-revision-notes

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Muhammad Talha

The document provides information on key economic concepts including opportunity cost, factors of production, productivity, and different types of market systems. It defines opportunity cost as the next best alternative forgone when making a choice. The four factors of production are land, labor, capital, and entrepreneurship. Productivity is defined as a measure of efficiency and is increased by using fewer resources to produce the same output or using the same resources to produce more output. The summary discusses the different types of market systems including free markets, mixed economies, and planned economies along with their advantages and disadvantages.

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1 IGCSE Economics Opportunity cost and the basic economic problem Definition Opportunity cost: the cost of any activitymeasuredintermsof the value of the nextbest alternative forgone(thatisnotchosen) Production: the act of creatingoutput,a goodor service whichhasvalue contributesto the utilityof others Producer: people whomake andsell goods/services Consumption:The final purchase of goodsand servicesbyindividuals Consumer:Individualswhopurchase the good/servicestosatisfytheirwantsandneeds ConsumptionExpenditure : Spendingof consumers Exchange: A marketplace inwhichsecurities,commodities,derivativesandotherfinancial instrumentsare traded Trade: An economicactivitythatinvolvesmultiple partiesparticipatinginthe voluntary negotiationandthenthe exchange of one'sgoodsandservicesfordesiredgoods and servicesthatsomeone else possesses. Entreprenuers:individualswho,ratherthanworkingasanemployee,runs asmall business and assumesall the riskandrewardof a givenbusinessventure,idea,goods, or service offeredforsale. Human resources:the companydepartmentchargedwithfinding,screening,recruiting and trainingjobapplicants,aswell asadministeringemployee- benefitprograms.Alsoknownas Labor. Natural resources:resourcesoccurringin nature thatcan be usedto create wealth Alsoknownas Land. Examplesinclude,seasandrivers. Factors of Production; Definition:inputsthat are usedin the productionof goodsor servicesinthe attempttomake an economicprofit. The factors of productionincludeland,labor,capital andentrepreneurship. Factors 1. Land Land referstothe resourcesavailable includingthe seasnadrivers,forestsanddesertsall mannerof mineralsfromthe ground;chemicalsfromthe airand earth’scrust.
2 2. Labor Labor referstothe physical andmental effortproducedbypeople tomake goods/services.The size and abilityof a economy’slaborforce are veryimportantindeterminingthe quantityandqualityof the goods/servicesproduced.The greaterthe numberof workersthe bettereducatedandskilledtheyare,the more an economycan produce. 3. Enterprise Enterprise referstothe abilitytoruna productionprocess,employandorganize resourcesinafirm(an organizationthatownsa factoryor a numberof factoriesandevenshops,where goods/servicesare produced). 4. Capital Capital referstoalready-produceddurablegoodsthatare usedinproductionof goodsor services.Itisnot wantedforitself butforitsabilitytohelpinproducingothergoods. Itis alsoknownas man-made resources. Divisionof labor/Specialization Definition: A system whereby workers concentrate on performing a few tasks (instead of finishing the entire product by themselves) andthenexchange theirproductionforothergoods/services Advantages 1. More goods/servicescan be produced When workers become specialists in the jobs they do, repetition of the same operation increases the skill and speedof the workerandas a resultmore isproduced. 2. Full use ismade of everyone’sabilities With the division of labor there is greater chance that people will be able to do those things at which they are bestand whichinterestthemthe most. 3. Time issaved Time is wasted when a worker has to switch from one task to another. Time can also be saved when training people. It would take many years to train someone to be able to build a car, for example, but a person can be trainedquicklytofulfill one operationinthe productionprocess. 4. It allows the use of machinery As laborisdividedupintospecialisttasks,itbecomesworthwhiletouse machinerywhichallowsa further savingintime andeffort.Forexample,carsare paintedbymachinesinsteadof byhand.This,inturn,allows machinerytotake overpeople’sjobsleavingmanyunemployed. Disadvantages 1. Work may become boring A workerwhoperformsthe same operationeverydayislikelytobe unsatisfied/low morale.Tocombatthis, manyfirmsplaymusicto theirlaborforces,or allow themtohave a restduringpart of each hour.Longer rest hoursand annual holidaysmayalsobe introducedalthoughthiswill shortenthe workingweek. 2. People become toodependentoneach other
3 Specialisationanddivisiolof labourmeansthatpeople come torelyonothersforthe provisionof goods/services.Forexample,people whoproduce foodrelyonthe provisionof tractors,fertilizers,etc. 3. Workersmay feel alienated Workersmay feel unimportantbecause theycannolongersee the final resultof theirefforts.Some firmsare tryingto reverse thisbyintroducingworkerstoagreatervarietyof tasks 4. Standardization of goods Goodsproducedundera systemof specializationare usuallyturnedoutinvastnumbersandshare the same design.Whetherthisisadisadvantage dependsonpeople’sopinion.Forexample,there isprobablyvariation inthe colorand designinclothestoplease mostpeople.However,itisnotpossibletoplease everyone because inmostfactoriesitwouldbe difficultandexpensive tochange the productionprocesstosuitone person’swantssince mostfactoriespractice massproductioninordertoproduce the greatestnumberof goodsin the lowestcostpossible. What is economics? Economicsisthe social science thatanalyzesthe production,distribution,andconsumptionof goodsandservices.It studieshowindividuals,governments,firmsandnationsmake choicesonallocatingscarce resourcestosatisfytheir unlimitedwants.Economicscangenerallybe brokendowninto:macroeconomics,whichconcentratesonthe behaviorof the aggregate economy;andmicroeconomics,whichfocusesonindividualconsumers. Market Systems Definition: Market: One of manyvarietiesof systems, institutions,procedures,social relationsand infrastructureswherebypartiesengage inexchange.Itconsistsof all those people or firmswhowishto exchange agivengoodor service. Market system: Anysystematicprocessenablingmanymarketplayerstobidandhelping biddersandsellersinteractandmake deals.Itisnot justthe price mechanismbutthe entire systemof regulation,qualification,credentials, reputationsandclearingthatsurroundsthatmechanismandmakesit operate ina social context. Price mechanism: Referstothe consumersandproducerswhonegotiate pricesof goodsor servicesdependingondemandandsupply.Thisisalsoknownas market forces. Types ofmarket systems Market system Free economy Mixedeconomy Plannedeconomy Definition An economyinwhich An economicsysteminwhich An economicsysteminwhich
4 decisionsregarding investment,productionand distributionare basedon supplyanddemandandthe pricesof goodsand services are determinedinafree price system. boththe state and private sector directthe economy,reflecting characteristicsof bothmarket economiesandplanned economies. decisionsregardingproduction and investmentare embodied ina planformulatedbya central authority,usuallybya governmentagency. Advantages  Capital return. Capital flowstowhere itwill get the greatestreturn, expandingthe total size of the economytoits maximumlevel.  Supplyand Demand. Supplyanddemandare closelylinked:Someone whohas a good ideaor productcan quicklyputit intothe marketso that it isavailable tothose who wantit. Conversely, whena certaintype of productis desiredby enoughpeople,itisa simple matterfor someone toprovide it.  Economic freedom. In a marketeconomy,itis easierforsomeone with initiativeandvirtue to create a betterlife for themself andtheir family;economic freedommakesiteaiser to transformhard work and perseverance into material wealth.  Providesfair competition. The presence of private enterprise ensuresthatthere isfair competitioninthe market,andthe qualityof productsand servicesare not compromised.  Well regulated.Market pricesare well regulated.The governmentwithits regulatorybodiesensure that the marketprice do not go beyonditsactual price.  Efficientuse of resources. Optimumutilizationof national resources.Inamixed economy,the resourcesare utilizedefficientlyasboth governmentandprivate enterprisesare utilizingthem.  It doesnotallow monopolyat all. Barring a few sectors,a mixedeconomydoesnot allow anymonopolyasboth governmentandprivate enterprisesenterevery sectorfor business.  Stability.Long-term infrastructure investment can be made withoutfear of a marketdownturn leadingtoabandonmentof a project.  Meetingcollective objectives.Planned economiesmaybe intendedtoserve collective rather thanindividual needs.The governmentcan harnessFOPto serve the economicobjectivesof the state.  Advantages overfree economy.It is notsubject to majorpitfallsof market economiesandmarked- orientedmixedeconomies. A plannedeconomydoes not sufferfrombusiness cycles,doesnotexperience crisesof overproduction.It doesnotresultinasset bubbles –massive misallocationsof resources. Disadvantages  Unequal wealth distribution.a small percentage of societyhas the wealthwhile the majoritylivesinpoverty.  No economicstability. greedand overproductioncause the economyto have wildswingsrangingfrom timesof robustgrowth to cataclysmic recessions.  Inefficient.It'sefficiency propertyreducesin progressivelyhigherdegree, the more its mixednature embracesmore andmore of government/state interventionandState planningandreducesthe reliance oncompetitive marketeconomy managementmechanisms.  Less reliance on competition.Mixedeconomy  Inefficientresource distribution.Planners cannot detectconsumer preferences,shortages,and surpluseswithsufficient accuracy and therefore cannot efficientlyco- ordinate production.  Suppressionofeconomic democracy and self- management. Without economicdemocracythere can be troubleswiththe
5 The ownershipof the factorsof productioncontrols:  What isproduced  Where toproduce  How to produce – the methodof production(labourintensive/capital intensive)  How much goodsandservicestoproduce Production – Productivity & Wealth Creation Definition Productivity:A measure of the efficiencyof production.Itisthe amountof outputthat can be producedfroma givenamountof resources Labor productivity:the amount of goodsand servicesthata workerproducesina givenamountof time Production PossibilityFrontier:A graph thatcomparesthe productionratesof twocommodities thatuse the same fixedtotal of the factorsof production. Profit= Revenue –Cost (Productivity(↑ CELL;FOP) ↓ Cost) Productivity  Labor productivity= Output ÷ No. of workers o E.g. FirmA: 10 unitsof labor & 20 unitsof output FirmB: 20 unitsof labor& 60 unitsof output  Ways to increase productivitymaymean:  Usingsame number of Factors of Production to produce more output  UsinglessFactors of Production to produce same amount of output.  What isincreasedproductivity=lowerbusinesscost  Too competitive.A competitiveenvironment createsan atmosphere of survival of the fittest. Thiscausesmany businessestodisregard the safetyof the general publictoincrease the bottomline. systemhasa natural tendencytomove further and furtherawayfrom reliance oncompetitive marketmechanismtogreater and greaterbureacratic controlsand interventions.  Encourage state monopolies. Mixedeconomysystemstend to encourage more state monopolies,higherand highertax to GDP ratio and dominantpublicfinances, makingthe governmenta large economicplayeras comparedto corporate or individualentities. flow of knowledgeasis shownwiththe initiative for backyardfurnacesand othereffortsinthe Great Leap Forward. Examples USA, Japan,Brazil Canada,Germany,UK China,Cuba,NorthKorea
6  Increased productivity means greater wealth for owners of firms and the economy (in general)  PPF shift outwards(economicgrowth) How to improve productivityof land  Increaseduse of fertilizers –Fertilizersallow previouslybarrenlandto produce crops,and fertile landstoimprove higheryields  Improveddrainage –Reducessoil erosionandassistsinthe reduction of phosphorusin  streams. It allowscropssuch as hay,corn and soybeanstoproduce higher yields.  Improvedirrigation –Indry areas,improvedirrigationwill allow plantstoreceivemore  waterandproduce a higheryield.  Increaseduse of machinery –Machinerysuch as tractors helptake inthe yieldsmuchmore quickly.  Introduced genetically-modifiedhigh-yieldcrops – Genetically-modifiedcropsproduce higheryieldastheycanbe alteredto fightagainstpests,herbicides,cold,disease or drought.  Buildmulti-functionedbuildings(e.g.skyscrapers) - Bybuildingmulti-functionedbuildings, landcan be allocatedmore efficientlyas buildingssuchasskyscraperscan accommodate a wide range of business activities How to improve productivityof labour  Implementdivisionof labor–Divisionof laborallowsproductiontobe more efficient.  Increase use of machinery(to aid tasks) – Machineryallowsthe increase of productionas well asthe qualityof the finishedproducttobe better.  Specialization– There isa higheroutput.Total outputof goodsandservicesisraisedand qualitycanbe improved.A higheroutputatlowercostsmeansmore wants and needsmightbe satisfiedwithagivenamountof scarce resources.
7  Skill training–Skillstrainingincrease productivity.Inadditiontolearninghow tocomplete newtasksand take on more responsibility,employeescanlearnadvanced techniquestohelpthose complete everydaytasksmore efficiently.Also,it improvesjob satisfactionof the employee.Investingtime andmoneyin employees’skillsmake themfeel valuedandappreciated,anditchallenges those to learnmore andget more involvedintheirjobs.Higherjob satisfaction ultimatelyresultsinreducedturnoverandhigherproductivity.  Motivate workers with financial incentives (pay raises, profit sharing), increase job satisfaction (better workingenvironment) Nationalization Definition:The processof takingan industryorassetsintogovernmentownershipbya national governmentorstate.Itusuallyreferstoprivate assets,butmayalsomeanassets ownedbylowerlevelsof government,suchasmunicipalities,beingtransferredtothe publicsectorto be operatedandby the state. Advantages  The abilityof the state to directinvestmentinkeyindustries  The distributionof state profitsfromnationalizedindustriesforthe overall national good  The abilitytodirectproducersto social ratherthan marketgoals  Greatercontrol of the industriesbyandforthe workers  The benefitsandburdensof publiclyfundedresearchanddevelopmentare extendedtothe widerpopulace Disadvantages  Costly management. The management of the nationalized industry is complicated and unwieldy. There are numerousdepartmentsandpaidpersonsi.e.directorate,regional office conductitsmanagement.  Lack of decision making. All the necessary matters are decided by various official and committees. In case of conflictingviews,quickdecisioncannotbe made forthe urgentmatterswhichare dangerousinbusiness.  Lack of efficiency. Nationalized industries are managed by salaried persons who are generally found less efficient as compared with privately owned concerns. There is also lack of flexibility and adaptability which are assetof private ownership.  Bureaucracy. There is extensive and rigid procedure of the state machinery by which event is dealt. Such stipulatedruleshas made the processof workverycomplicatedwhichresultsindelayandlossof initiative.  Absence of profit motive. The salaried persons are not concerned with profit. Therefore, nationalized undertakinghardlyrunsuccessfullydue tolackof personal interest  Chances of loss. The loss of the nationalizedenterprises is regarded as the loss of the nation. So the structure of nationalizedeconomywill greatlyaffectedbythe failure of suchscheme.  Limited investment. Investors hesitate to invest large sum of money due to risk of nationalization. Therefore the volume of investmentremainslimitedinprivatesector.
8 Economic sectors Primary: The extractionof natural resourcese.g.oil drilling,quarrying,forestry Secondary: The manufacturingof goodsusingnatural or man-made resourcese.g.carassembling, propertyconstruction,toymanufacturing Tertiary: The provisionof servicestoconsumersorproducerse.g.education,accounting,marketing Quaternary: The provisionof R&D,software developmentand informationprocessinge.g.research intofiberoptics,developmentof searchengines. Privatization Definition:The incidence orprocessof transferringownershipof abusiness,enterprise,agency,public service propertyfromthe publicsector(the state orgovernment) tothe private sector (businessesthatoperate fora private profit) ortoprivate non-profitorganizations. Advantages  Increased efficiency. Private companies and firms have a greater incentive to produce more goods and services for the sake of reaching a customer base and hence increasing profits. A public organization would not be as productive due to the lack of financing allocated by the entire government's budget that must considerotherareasof the economy.  Specialization. A private business has the ability to focus all relevant human and financial resources onto specific functions. A state-owned firm does not have the necessary resources to specialize its goods and servicesasa resultof the general productsprovidedtothe greatestnumberof people inthe population.  Improvements. Conversely, the government may put off improvements due to political sensitivity and special interests—evenincasesof companiesthatare runwell andbetterserve theircustomers'needs.  Capital. Privately held companies can sometimes more easily raise investment capital in the financial markets. While interest rates for private companies are often higher than for government debt, this can serve as a useful constraint to promote efficient investments by private companies, instead of cross-subsidizing them with the overall credit-risk of the country. Investment decisions are then governed by market interest rates. State-owned industries have to compete with demands from other government departments and special interests.Ineithercase,forsmallermarkets,political riskmayaddsubstantiallytothe costof capital. Disadvantages  Job Loss. Due to the additional financial burden placed on privatized companies to succeed without any governmenthelp,unlike the publiccompanies,jobscouldbe losttokeepmore moneyinthe company.  Natural monopolies. Privatizationwill notresultintrue competitionif anatural monopolyexists.  Profit. Private companies do not have any goal other than to maximize profits. A private company will serve the needsof those whoare mostwilling(andable)topay,as opposedtothe needsof the majority.  Goals. The government may seek to use state companies as instruments to further social goals for the benefitof the nationasa whole.
9 Demand theory Definitions Demand: The abilityandwillingnesstopaya price to purchase a good/service Quantity demanded:The total amountof goods or servicesthatare demandedatany givenpointintime. CeterisParibus:The relationshipbetweenboththe price andthe quantitydemandedof an ordinarygood. Effective demand:the demandfora productor service whichoccurswhenpurchasersare constrainedina differentmarket Notional demand: The demandthat occurs whenpurchasersare notconstrainedinanyother market Individual demand:The abilityandwillingnessof aconsumertopurchase a good/service Deriveddemand: Demandforone goodor service occursas a resultof the demandforanother intermediate/final goodorservice Types ofincome  Real. Income of an individual or group after taking into consideration the effects of inflation on purchasing power.  Disposable. Amount of money that households have available for spending and saving after income taxes have been accounted for. Disposable personal income is often monitored as one of the many key economic indicatorsusedtogauge the overall state of the economy.  Discretionary. Amount of an individual's income that is left for spending, investing or saving after taxes and personal necessities (such as food, shelter, and clothing) have been paid. Discretionary income includes moneyspentonluxuryitems,vacationsandnon-essential goodsandservices. Factors that affect the demand for goods/services  Good's own price. The basic demand relationship is between potential prices of a good and the quantities that would be purchased at those prices. Generally the relationship is negative meaning that an increase in price will induce a decrease in the quantity demanded. This negative relationship is embodied in the downward slope of the consumer demand curve. In other words, the lower the price, the higher demand, ceterisparibus  Price of related goods. The principal related goods are complements and substitutes. A complement is a good that is used with the primary good. Examples include hotdogs and mustard, beer and pretzels, automobiles and gasoline. If the price of the complement goes up, the quantity demanded of the other good
10 goes down. The other main category of related goods is substitutes. Substitutes are goods that can be usedin place of the primary good. If the price of the substitute goes down, the demand for the good in question goesdown.  Personal Disposable Income. In most cases, the more disposable income (income after tax and receipt of benefits) you have the more likely you buy. Any changes in the level of income tax rates and allowances are therefore likely to result in a change in the quantity of goods/services demanded. In a normal good, demand for a product tends to rise as incomes rise. If the demand tends to fall as incomes rise the product is said to be an inferiorgood.  Tastes, preference or habits. The greater the desire to own a good the more likely you is to buy the good. There is a basic distinction between desire and demand. Desire is a measure of the willingness to buy a good based on its intrinsic qualities. Demand is the willingness and ability to put one's desires into effect. It is assumed that tastes and preferences are relatively constant. For example,if consumers around the world are demanding good/services that are environmentally-friendly, the derived demand for those goods/services will increase. Advertising also plays a part. Persuasive and informative advertising tends to increase brand awarenessandas a result,increase the demandforthe good/service.  Consumer expectations about future prices and income. If a consumer believes that the price of the good will be higher in the future he is more likely to purchase the good now. If the consumer expects that her income will be higher in the future the consumer may buy the good now. In other words positive expectationsaboutfuture income mayencourage presentconsumption.  Seasonal demand. A hot summer can boost sales of cold drinks and ices while a cold winter can boost the demandforfuel forheating.  Higher interest rates can increase the demand for savings schemes but reduce the amount of money people wantto borrow,includingmortgagesforhouse purchases.  Population change. An increase in population tends to increase the demand for many goods and services in a country. For example, in a country where there is an aging population, demand for walking sticks and retirementhomesmayincrease.  Location of consumers. There is unequal distribution of income and wealth in different areas of the country. In a richerarea of the country,the demandforsuperiorgoodswill be higherinanareaof low income. Price Elasticity of Demand Definition: PED. A measure usedtoshow the responsiveness,orelasticity,of the quantity demandedof agood or service toa change in itsprice. The elasticityof the demand curve will alsoaffecttheamountof revenue asthe price changes Formula PED = % change in Quantity Demanded PED = (NewQD – Old QD) x100 % change in Price , (NewP – Old P) x 100
11 Inelastic : The PED value isbetween0and -1. Ittendsto have few substitutes,isnecessities,and/orcanbe addictive,e.g.,alcohol,cigarettes,orpetrol. Elastic : The PED value isbetween -1and-∞.It has a lotof substitutesandmaybe an inferiorgood. Revenue Definition: Revenue is the amount received by the producer from the sale of the goods or service. It is calculated by the multiplying the price charged by the quantity sold (R = P x Q). The only difference between revenue and profit isthe costs Price elasticity of Supply Definition: PES: A measure usedtoshowthe responsiveness,orelasticity,of the quantitysuppliedof agood or service toa change initsprice.The PESis alwaysa positive number Formula PED = % change in Quantity Supplied PED = (NewQS – Old QS) x100 % change in Price , (NewP – Old P) x 100 Inelastic :The PED value isbetween0and1. It tendstohave few substitutesandtakestime toalterthe quantityof production. Elastic : The PED value isbetween1and ∞. Note:The amount suppliedisnot always equal to supply and may create shortages and surplus. Economies of scale Definition: Economiesof scale: The cost advantagesthat an enterprise obtainsdue toexpansion. Diseconomiesofscale: The forces that cause larger firms and governments to produce goods andservices at increasedper-unitcosts. Advantages of large-scale production Internal  Lower average unit costs. Scale of production because of a change in the way a firm is run. For example, larger firms can afford more effective advertising. They can spread the cost of advertising over a larger numberof products.
12  Efficiency. For example companies can shut down small firms and open one large firm and paying fewer managers to run it. Another is technological economies, meaning that larger firms can buy more efficient and largermachineryandequipment,leadingtoloweraverage unitcosts  Research and Development.Firmscanaffordto spendlarge amountsonresearchand development  Purchasing. They can afford to buy materials in bulk and therefore the unit costs are cheaper as they may be givendiscountsforbuyinginlarge quantities. External `  Geographical advantage. An area has an excellent reputation for producing a particular good/service or a pool of skilled labour may develop in an area where many firms are concentrated. This helps reduce training costs andprobablymakesrecruitmenteasier.  Risk-bearing economies. When borrowing from a large loan, the company can use assets from profitable firmsare collateralsandspreadthe riskof the loanoverseveral firms.  Firms may cooperate witheach other.  Similar and related firms. There may be firms in the area in related industries with similar expertise and knowledge. Disadvantages of large-scale production  Managerial deos. Breakdown of communicationas firms get too large. This can lead to a delay in making decisions.  Labor deos. Decrease in staff morale as it is difficult to retain close personal contact with staff because of the size of the organization  Jobsmay be brokendownintospecialistpartsandthe workersmayfindtheirjobs toorepetitive and boring. Advantages of small firms  Flexibility. Small firms can adapt readily to consumer needs, designing products to meet individual requirements,whilstsome productscannotbe massproduced.  Industrial relations. The boss of the small firms tends to have a wide general knowledge of the performance of their employees, and may have a friendly relationship. This could increase morale and motivation. There is alsolesschance of poorproductivityasthere are lesspeople insmall firms.  Customer relations. Likewise, small firms are more likely to know their customers and to be able to offer personalized services to their customers. Personal attention is more feasible in small businesses, such as private music/sportstuition.  Local monopoly. Some firms supply only to a small market, and specialist businesses are not interested in these markets.
13 Public and Merit Goods In a mixedeconomythe governmentexistsalongside the freemarkettoprovide certaingoodsandservices.These tendto be publicgoodsand meritgoodsbecause afree market wouldeitherfail toprovidethemornotprovide theminsufficientquantities. PublicGoods These are thingslike streetlighting,coastguard,police,firebrigade,andthe army. Itis clearthat people want streetstobe litandto be keptsafe fromattack so whydoesn’tthe marketreactand satisfythese wants?Whydoyou believethatprivate firmswouldbe reluctanttoprovide these?Theyhave twodistinctive features:Theyare non- rivalry, meaningthatanyone can use it,and theyare non-excludable,meaningthattheycan’tstoppeople fromusing it andit isdifficulttoprevent“free riders”. MeritGoods Merit goodsare not providedenoughby the private sectors because it is not profitable. Theyare thingslike healthcare,education,libraries,sportscenters,countryparks,publichousing,andpublichospitals.Publichousing and hospitalsare publicbecause the people whouse thesefacilitieshave noorlow income toaffordit. Again, people wanttobe keptwell andwantto be educated.The marketcan provide these goods;ESFisa private educationproviderwhilstinthe USA healthcare isalmostexclusivelycarriedoutbythe private sector.Whythenin manycountriesdogovernmentsstepinandprovide healthcare? Trade Unions Definitions Trade Unions: Anorganizationof workersthathave bandedtogethertoachieve common goals,promote andprotectthe interestsof theirmember. Collective bargaining:a processof negotiationsbetweenemployersandagroup of employees aimedat reachingagreementsthatregulate workingconditions andpay. Openshop :A firmthat can employunionizedandnon-unionizedlabour Closedshop :All workersinaplace of workhave to be unionmembers.The closedshopis outlawedinsome countriesbecauseitgave unionstoomuchpowertodictate whoa firmcouldemploy Shop Steward: One of the firm’semployeeswhoisgrantedtime off,duringworkinghours, to deal withtrade unionmatters. Insome largercompanies,ashopsteward may be employed full-time on industrialrelations. Hisor her Wage Councils:These organisationssetminimumwages(notNational)fortheirrelevant industries.Wage councilshave declineddramaticallyinnumberssince 1979. EmploymentLaws: Lawspassedby the governmentorthe EuropeanUnionthat setoutrulesof behaviourforworkers,employersandtrade unionswithregardtoemployment Single unionagreement:Anagreementbetweenanemployeranda unionsuchthat the unionwill
14 representall the workersat a particularworkplace.Thismeansthatone unioncan representall the workers,whatevertheiroccupation,inthe same workplace. Industrial relations: The relationshipsbetweenemployeesand employers Trade UnionsPast and Present– The change of trade unions Since their establishment, the membership and influence of trade unions continued to grow until the early 1980s. The Conservative government at that time responded to public anger over strikes by introducing laws that restricted the unions’ activities. In addition, rising unemployment and the decline in the manufacturing industries (that formed the traditional base of the unions) have reducedunionmembership. The increase in part-time jobs and the increased number of women working have also had an impact on union membership. In the past, neither of these groups have been strong supporters of trade unions. In addition, the 1980s and 1990s have seen a dramatic increase in the number of self-employed people - who are not usually unionized. In response, unions have tried to improve their image by making their services more appealing and relevant to today’s world - e.g. the ATL union (Association of Teachers and Lecturers) has a “no strike” policy. Many unions now offertheirmembersloans,mortgages,insurance,creditcards,discountholidayvouchersanddiscountcarhire. Today, some trade unions also provide grants for college courses, or arrange retraining programmes (the process of developing new skills), for their members who have been made redundant. In addition, they also provide representatives for members in cases of redundancy, grievance, disciplinary hearings and legal action (e.g. on equal pay). Trade UnionMembershipAround the World According to the International LabourOrganisation, only 25% of the world’s 1.3bn workers were members of trade unions in November 1997. However, since the ILO also concluded that trade unions are adjusting to the realities of today,it islikelythattrade unionmembershipwill increase overthe nexttenyears. In a recent ILO survey of 92 countries, only 14 had a unionised workforce of over 50% (and 48 countries had less than 20%). Resultsof selectedcountriesare shownbelow Trade Union Densityin selected countries(ILO): Country 1995 density % change since 1985 Sweden 91.1 +8.7 Italy 44.4 -7.4 SouthAfrica 40.9 +130.8 Australia 35.2 -29.6 UK 32.9 -27.7 Germany 28.9 -17.6 NewZealand 24.3 -55.1 Japan 24.0 -16.7 USA 14.2 -21.1 SouthKorea 12.7 +2.4
15 France 9.1 -37.2 Source:adapted fromILOLabourReport1997 Types ofTrade Unions Although the number of trade unions and the number of members in unions have declined steadily since 1979, we can still distinguishbetweenfourdifferenttypesof trade unions: 1. Craft Unions These are the oldest type of unions, which were formed originally to organize workers according to their particular skill. For example, engineers and printers formed their own respective unions. Today, the GPMU (Graphical, Paper and Media Union) has members working in the printing, paper, publishing and media industries. The decline in the demandforsome particularcrafts hasledto many of the olderunionstorecruitsemi-skilledandunskilledworkers. 2. Industrial Unions These unions attempt to organise all workers in their industry, irrespective of their skills or the type of work done. The National Union of Mineworkers (NUM) is an example. National Union of Teachers (NUT), Trade Union Congress (TUC) 3. General Unions These unions are usually prepared to accept anyone into membership - regardless of the place they work, the nature of work, or industrial qualifications. These unions have a very large membership of unskilled workers. The TGWU (Transport and General Workers Union) is a very large General Union in the UK. Their members include drivers, warehouse workers,hotel employeesandshopworkers. 4. ‘White Collar’Unions Also called non-manual unions and professional associations, these recruit professional, administrative and clerical staff (salaried workers) and othernon-manual workers. They are very strong in teaching, banking, the civil service and local government. The Role/Functions/AimsofTrade Unions The primaryrole of Trade Unionsis to protectthe workers’ interests. Examplesinclude:  Collective pay bargaining – trade unions are able to operate openly and are recognized by employers, they may negotiate withemployersoverwagesandworkingconditions.  Subscription – Early trade unions, like Friendly Societies, often provided a range of benefits to insure members against unemployment, ill health, old age and funeral expenses. In many developed countries, these functions have been assumed by the state; however, the provision of professional training, legal advice, support for members that are mad redundant and representation for members is still an important benefit of trade unionmembership.  Political activity – Trade unions may promote legislation favorable to the interests of their members or workers as a whole. To this end they may pursue campaigns, undertake lobbying, or financially support individualcandidatesorparties(suchasthe Labour Party inBritain) forpublicoffice.
16  Industrial action– Trade unions may enforce strikes or resistance to lockouts in furtherance of particular goals. Aims ofthe Trade Union  Defendingtheiremployee rightsandjobs  Securingimprovementsintheirworkingcondictions,includinghoursof workandhealthandsafetyof work  Improvingtheirpayandother benefits,includingholidayentitlements  Improvingsickpaypensionsandindustrialinjurybenefits  Encouragingfirmsto increase workerparticipationinbusinessdecisionmaking  Developingandprotectingthe skillsof Unionmembers. Aims ofthe workers: Workerswill aimtomaximize:  HigherWages – matchinginflation(index-linksalariestoCPI)  Jobsecurity – no sackingwithoutnotice orreasons  Workingconditions - Health&Safety;workinghours  Careerprogressionopportunities:Trainingandup-to-date information  Healthand Safetyatwork  Perks,Healthinsurance,pensions,car,educationallowance Aims ofthe employers For the employer,targetstomaximisemayinclude:  Profits  Sales  Lowercosts Industrial disputes Definition: Disputeswiththe workforce and/ortheirrepresentatives - andanyresultingindustrial action - are costly and damagingtoboth the businessandworkers. Causes 1. Economic Cause  Demand for increase in wages on account of increase in all-India Consumer Price Index for Industrial Workers.  Demandforhighergratuityand otherretirementbenefits.
17  Demand for certain allowances such as: House rent allowance, medical allowance, demand for paid holidays and reductionof workinghours,Betterworkingconditions,etc. 2. Personnel Causes. Sometimes, industrial disputes arise because of personnel problems like dismissal, retrenchment,layoff,transfer,promotion,andmore vacationsetc. 3. Indiscipline. Industrial disputes also take place because of indiscipline and violence on the part of the workforce. The managementstocurb indisciplineandviolence resorttolock-outs 4. Misc. causes. Some of the other causes of industrial disputes can be workers' resistance to rationalization, introduction of new machinery and change of place, non-recognition of trade union, rumors spread out by undesirable elements, working conditions and working methods, lack of proper communication behaviour of supervisorstointer-tradeunionrivalry. How collective bargainingis organized Definition:the processwherebyrepresentativesof the workers(inaparticularindustry) negotiate say paysettlements - withrepresentativesof the employers(inthatindustry). Generally, an individual worker is in a weak bargaining position - the main purpose of a trade union is to remove this weaknessby“forcing”the employertonegotiate withthe representativesof his/herworkforce. Trade unions are autonomous bodies - they have complete freedom to act in their own interests. Most unions, however, are affiliated to the Trade Union Congress (TUC), which is the largest trade union. It has an important role in bringing trade unions’ points of views on a national scale, possibly affecting government decisions - e.g. the TUC have beenat the forefrontof the National MinimumWage negotiations. If the more powerful unions make full use of their bargaining strength, they could succeed in getting larger and/or more frequent wage increases than the weaker unions. This highlights the importance of “unionisation” within trade unions - the largerand more unitedthe union,the betterthe bargainingposition,ceterisparibus. How is it organized Collectivebargainingisorganizeddependingonthe relationshipbetweenaunion andfirmsthat employunionized labor.  In a openshop,a firmcan employunionizedandnon-unionizedlabor  In a closedshopall workersina place of work have to be unionmembers.The closedshopisoutlawedin some countriesbecause itgave unionstoomuchpowertodictate whoa firmcouldemploy.A unioncould alsocall the entire workforce inafirm/industryoutonstrike.Inthese ways,aunionmayact like amonopoly and restrictthe supplyof labourso as to force upthe marketwage fora job/occupation.  A single unionagreementallowsauniontorepresentall the workers,whatevertheiroccupation,inthe same workplace.Thisisusuallyinreturnforcertaincommitmentsfromthe uniononpayor productionlevels,and for agreeingnottotake strike action.Negotiatingwithasingle unionratherthanseveral ata time ismuch easierfora firm. The ChallengesfacingTrade Unions
18  Decline of manufacturingindustries  Growth inpart-time employment  Switchfrommale to female employment(intermsof percentage increases.  Co-operationwithmanagement  Governmentlegislation(whichseekstoreduce unioninfluence) The Basis for Wage Claims Trade uniondemandsforhigherwagesare normallybasedonone ormore of the following: 1. A rise inthe cost ofliving(e.g.due to inflation) hasreducedthe real income of theirmembers. 2. Workersincomparable occupationshave receivedawage increase. 3. The increasedprofitsinthe industry justify ahigherreturnto labour. 4. The productivityof labourhasincrease How can Trade Unionsraise wages? 1. Restrictingthe Supplyof Labour Unions can restrict the supply of labour in an industry, for instance, by pushing for longer apprenticeships or tough examination(entry)requirements. Thisincreasesthe wage rate inthe industryfrom W1 toW2 inthe diagrambelow. S2 S1 W2 W1 D Q2 Q1 Employment However,aproblemhasarisen - the quantityof labourable to enterthe industryisrestrictedby Q1 to Q2.
19 2. Increasingthe Demand for Labour Unions can influence the demand for labour by use of productivity deals. They try to persuade workers to increase productivity (which in turn helps to increase the Marginal Revenue Product of Labour - recall that the MRPL is the demand for labour). In return, trade unions negotiate wage increases for their members, justified by their increased productivity. SL W2 W1 D2 = MRPL2 D1 = MRPL1 Q1 Q2 Employment Externalities Calculations Social Costs= Private + External Costs Social Benefits = Private + External Benefits Definition  Social costs and benefits are therefore the costs and benefitsincurred by the entirety of society (producer, consumerand third party) as a resultof the production and/or consumptionof a good or service.  Privatecosts and benefits are the costs and benefits incurred by individuals directly involved in the production and/or consumption ofa good or service.  Where no marketfailure existssocial costswouldbe equal toprivate costs.  If external benefits exist more of the said good should be produced and consumed (it is being under- consumedorunder-produced)thusthe marketsystemisnotsupplyingthe optimumresource allocation.  If external costs exist than less of the said good should be produced and consumed (it is being consumed or producedinexcessivequantities) thusthe marketsystemisnotsupplyingthe optimumresource allocation.  Firms and individuals will not consume/produce any good or service unless the private benefit of their activityexceeds the privatecostincurredintheiractivity. The governmentwill make sure that:  Merit goods (goods with external benefits) are encouraged (to prevent under-consumption or under- productionfromoccurring.)  Demerit goods (goods with external costs) are discouraged (to prevent over-consumption or over- productionfromoccurring.)  Demeritgoods do not have priceswhich account for theirexternal costs. Productivity deals have the effect of raising the MRPL curve from D1 to D2, thereby raising wages from W1 to W2. The advantages of this method are that productivity deals help to increase the supply of and demand for labour.
20  Smokingandalcohol are examplesof demeritgoods. The governmentwill:  Subsidize merit good producers to reduce the costs of production and thereby encourage production of such goods whilst causing prices to be lowered as a result of the increase in supply and the decrease in prices of productioncausedbysubsidization.  Tax demerit good producers to increase the costs of production and thereby discourage production of such goods whilst causing prices to increase as a result of the decrease in supply caused by taxations as well as by the increase inthe price of production.  Sometimes the government may choose to nationalize certain industries that are producing externalities to regulate andcontrol themand soforce themtoproduce at the sociallyoptimumlevel.  Laws and regulations –Limits on the level of emissions of certain chemicals through use of the law and a finingsystemtopunishfirmsforinfringement.  Ban on the use of certain chemicals which may result in significant external costs through use of the law and a finingsystemtopunishanyinfringement.  Forcing firms to internalize all costs: Pollution permits (these can be traded to firms who can then pollute more at a reasonable price). Pollution permits are given out to firms by the government before any trading is done. (Equivalent and derived from the Carbon Credits used internationally to restrict national pollution). But this scheme is costly (administration costs are high) to implement, it is difficult to measure pollution levels accurately, rich firms may simply buy their permits off poorer firms and so pollution may not have been decreasedatall,itis hard to calculate how manypollutionpermitstogive out.  If external benefits exist then the public would be willing to pay more for a certain good to assure that it is producedat the sociallyoptimumlevel.(Increase indemand,extensionalong the supplycurve).  If external costs exist that the public would be willing to pay more to assure that it is produced at the socially optimumlevel.(Decrease insupply,contractionalongthe demandcurve.) Government Regulation These are used to:  Promote competition.  Resolve externalitieswhere marketfailure exists:  Provisionof publicgoods.  Taxingdemeritgoods.  Enforce law andorder. Influence the location offirms:  Preventovercrowdingincities.  Preventregionsfrombeingneglected. Governments do not desire oligopolistic or monopolistic markets as such markets areuncompetitive when compared with competitionbasedmarkets. Often,a governmentwill restrictthe formation of such markets by:  Breakinguplarger firmsintosmallerones  Providingincentive forotherfirmstosetupinthe market  Preventingmergesthatmayprove detrimentaltocompetition How does the governmentregulate private enterprises?  Investigate existing monopolies and suggesting ways in which competition may be introduced into these monopolist-dominatedmarkets.  Investigate proposed mergers and prevent such merges from taking place if they are believed to be detrimental tocompetition.
21 Influencingthe Location of Firms: Whyis this done?  o Some regions may be economically depressed, usually due to the decline of a traditional industry (this may leadto regional unemployment).  o Some regions may be overcrowded with too much pollution, traffic congestion, insufficient housing and publicservicesasa resultof toomany firmschoosingtosetup inthe said regions. How is this done? Give firmsincentivesto set up indepressedregions:  Lowloan interestrates.  Grants forthe constructionof infrastructure.  Grants forthe trainingof workers.  Tax holiday/allowance.  Lowrent/free premises.  By buildingandimprovingthe infrastructure presentinthe saiddepressedregion.  Persuade firms in congested regions to move to depressed regions (stop granting licenses to operate in a congestedregion). Monopoly Definition:A monopolyisasituationwhere the marketisdominatedessentiallybyone firm.The legal definitionof “monopoly”isa firmthathas 25% or more marketshare inthe market. Advantages and Disadvantages of Monopolies Advantages  Firmsusuallymakeshigherprofits  The firmcan use profitstoinvestinnew or improve uponexistingproducts  Price Maker because doesnotface any competitors  Economies of Scale: Increased output will allow average unit prices of production to drop. This can be passed onto consumers in the form of lower prices, so customers may be more inclined to buy the firms products in the future.  A firmmay become amonopolythroughefficiency;A monopolyisthusasignof successand not inefficiency. Disadvantages  Consumersmayhave to payhigherpricesdue tolack of competition  Consumershave lesschoice because marketisdominatedbythe monopolisticfirm.  Lessinnovationof products  Firms may not be efficient with allocation and utilization of resources because they do not have any pressure to reduce costs. Oglipoly What is it?  An oligopolyexistswhenthereare several dominate firmsinone market.  If there are only two sellers in one market than that the market structure of the said market is a duopoly whichis a special case of an oligopolisticmarket.  Examples include the petroleum industry, TV broadcasting industry (duopoly in HK), supermarket industry and the bankingindustry.
22  Please note that, as a general rule of thumb, even if a market has hundreds of providers, if the top 3 –7 providers together possess 50% or more of the market’s total market share then that market is said to be oligopolistic. Main Features  A few sellers dominate market supply/or a few sellers supply a major part of the total market supply irrespectiveof the total numberof smallersuppliersinthe market  The same goodsbutwhichare heavilydifferentiatedbyuse of advertising,brandingandothersuchmethods.  These firms produce similar but heavily differentiated products; this differentiation makes the goods look differenttothe consumer.(Heterogeneousgoods)  These firms engage in many forms of non-price competition but rarely deign to involve themselves in price based competition as such competition can lead to price wars which only benefit the consumers and no one else.  Brand image isoftenveryimportantforsuchfirms.(Coke andPepsi test). 1. Oligopolistic firms will advertise a lot more than monopolists in the attempt to build a strong brand image and to differentiatetheirgoodsfromthe productsof theircompetitors. 2. If one firm has a better brand image, even with an inferior product, the said firm may be able to sell more of its productthan anotherfirmwitha worse brandimage.  Entry into such markets is restricted either because of governmental decrees or because of the huge startup capital or technology requirements needed in order to open shop in the said market. Furthermore, because of the furious level of competition between existing oligopolistic firms, these firms generally produce at a very low price, a feat which would be very difficult for smaller firms which do not wield the same level of economiesof scale asthe largeroligopolisticfirms.  Market information is restricted and often incomplete as no firm knows what another competitor will do. To combat this, such firms often collude to form cartels (trade agreements) and conduct themselves with all the advantages,anddisadvantages,of monopolists.These agreementsare generallyillegal.  The actions of one firm will affect what the other competing oligopolistic firms will do as such firms will react veryquicklytothe actionsof a competitor.(Sellersare highlyinterdependent). Barriers to Entry  Existingfirmsare well establishedandhave strongbrandimages.  Existingfirmsenjoyeconomiesof scale andare much more efficient.  Existingfirmsenjoycustomerconfidence.  The government may have issued rules that govern entry, sometimes for a certain number of years, into a certain market. These rules would have been put in place to encourage entrepreneurs to enter into a market where one wouldrequire large startupcapitals.(Mobilephone industryinChina). Pricing Strategies:  Price wars.  Price Leadership:  When the dominate firm in a market determines the price of a good other firms have no choice but to follow their example or lose market share unless they choose to lower their prices even further and risk a price war.  Sometimestheywill evencollude topreventprice warsfromhappening. Price collusion:  Forminga cartel.  Predatorypricingotherwiseknownasdestructionpricing.
23 Advantages  Economiesof scale (lowaverage costachievedonaccountof a highlevel of output).  Excess(abnormal orsupernatural) profits.  Promotes research and development because these firms can spread the potential costs involved in R&D overa much largerrange of income sourcesthusloweringthe riskof R&D. Disadvantages  Loweroutputlevelsandhigherpricesasthese firmscontrol suchthings  Lesschoice for consumers.  The needforgovernmentregulationtopreventoligopolyfirmsfromoverusingtheirpowers. Economic growth Definition Recovery: The periodwhere the economymovesbetweenarecessionanda boom. Boom: This periodisfasteconomicgrowth.Outputisvery highdue toincrease indemand,and unemploymentisverylow.Additionally,consumersmay be confidentaboutthe economy so thismay leadtoextraspending Recession:EconomicGrowthslowsdownandlevel of outputmayhave a negative impact. Unemploymentincreasesandconsumersare likelytosave insteadof spend,sothere is lessmoneycirculatinginthe economy. Slump: A periodwhere outputstartsto decrease.Consumerconfidence mayalsobegintodeplete. GDP: The total or national outputof a country overa periodof time. GDP  It measuresthe total amountof income earnedina macro economy – national income.  Changesusedtomeasure economicgrowth – Real change in GDP over time.  National Output = National Income = National Expenditure  Total value of outputproducedbyall domesticfirmswithineconomy.  GDP = Consumption+ GovernmentExpenditure +Investment+ Net imports  Some of the output income will flow overseas, as people from other countries may achieve output in your economy  GDP ismeasuredintermsof money.  However, money is subject to change in its value and inflation. To solve this problem, the real value of output or GDP is adjusted for inflation so we know how much is really generated from economic growth and howmuch issimplydue to risingprices. Inflation Definition Inflation:A general andsustainedrise inthe level of pricesof goodsandservices –prices of vast majorityof goodsand servicesonsale toconsumerskeepsrisingovertime. Stagflation: Persistenthighinflation combinedwithhighunemploymentandstagnantdemandin a country's economy.
24 Hyperinflation:Pricesrise atphenomenal ratesinshortperiodsof time,renderingmoney worthless. Usually,the inflationrate isindouble digits Deflation:The pricesof goodsand servicesfall. Thisisusually negative inflation. Disinflation:Fall inthe rate of inflation. Ideas  Price change overtime (inflation) isalwaysgivenperperiodof time.  Deflation can be a cause for concern – deflation will usually occur when demand for goods and services are falling,causingfirmstolose profits,profitsandreduce workforce.  This will reduce household incomes, causing further reduction in goods and services. The value of debts heldbypeople andfirmswill rise inreal terms aspricesfall andburdenof makingloanrepaymentsrises.  Eventuallythe economygoesintorecession. How to measure inflation Measuredby • CPI (ConsumerPrice Index) • RPI (Retail Price Index) 1. A base yearor startingpointis chosen.Thisbecomesthe standardagainstwhichprice changesare measured. 2. A listof itemsboughtbyan average familyisdrawnup.Thisis facilitatedbythe LivingCostsandFoodSurvey. 3. A setof weightsare calculated,showingthe relative importance of the itemsinthe average familybudget- the greaterthe share of the average householdbill,the greaterthe weight. 4. The price of each itemismultipliedbythe weight,adjustingthe item'ssizeinproportiontoitsimportance. 5. The price of each itemmustbe foundinboththe base yearand the year of comparison(ormonth). Thisenablesthe percentage change tobe calculatedoverthe desiredtime period. Calculating the CPI/RPI:  Indicesexpresschange inpricesof anumberof differentproductsasa movementinasingle number.  Average of ‘basket’of productsinfirstyearcalculationor base year isgiventhe number100.  If on average the basketrisesoverall by25% nextyear,thenindex becomes125.  If in second year it rises another 10%, then 125 x 1.1 = 137.5 – 37.5 becomes average price rise in two year period.  To construct a CPI, a sample of households are taken and surveyed – their spending patterns observed for 12 monthswhichisthe base year. The proportion of income spenton each category is recorded.  Average prices of differentgoodsandservices(minusfuel andfood) are recordedfromasample of shops.  The proportion of income spent on each category is used to weight average prices of each type of good/service tofindtheirweightedaverage prices.  This shows how big an impact a change in price of a particular type of good or service will have on cost of livingforthe average household.  The proportional of household income spent on a certain type of good/service is multiplied by the average price of the good/service purchasedin the category, to generate its weighted average price – these weighted pricesare thenall addedtogether,whichisthe overall average price forgoodsandservicesinthe basket.
25  The weighted total price of the basket can be compared each year to work out percentage changes in average consumerprices. Uses of CPI/RPI Data: 1. As economic indicator – CPI is widely used measure of price inflation, and therefore is measure of changesin cost of living. Governments try to control inflation using macro-economic policies. The CPI will be used by workers to seek wage increases, and used by entrepreneurs in business making concerning purchases and settingwage andprices. 2. As a price deflator – Rising prices reduce purchasing power, value, of money. Rising prices can therefore affect real value of wages, profits, pensions, savings, interest payments, tax revenues and other economic variables important to people and decision making. CPI therefore used to deflate other economic series to calculate real inflation-free values. i.e. wages go up 10% but inflation is 15%, therefore real wages fallen by almost5% less. 3. Indexation – involves tying certain payments to rate of increase in CPI. E.g. pensions may be indexed. Similarly, savings may be index-linked, meaning interest rate is set equal to CPI, protecting real value of people’s savings. Many workers may also be covered by collective bargaining agreements that tie wage increases to CPI changes. Government may alsoindex threshold at which people start to pay tax or higher tax ratesto stop people payingmore orlesstax. Problems with Price Indices:  Overtime typical householdbasketof goodsandserviceswill change.  CPIneedstotake account of this,butdecidinghow andwhento make themcan be difficult.  Changesdue to: o Fashionandtaste o Introductionof newgoodsandservices o Change in population and household size due to migration, birth/death rates, marriage timing and numbersetc. o Similarly CPI needs to take into account changes in quality of goods and services over time, how and where householdsbuygoodsandservicessuchasinternetandnew shops. o International comparisons of CPIs are hard to make due to different household compositions and spendingpatterns. o Argued that exclusion of food, energy, house prices and income taxes means CPI cannot accurately measure change of livingcost. Inflation  Economiststodaytendto agree maincause of inflationis ‘toomuchmoneychasing too fewgoods.’  This means people are able to increase spending on goods and services faster than producers can supply goodsand services,boostingaggregate demandandforcingpricesup.  A government can allow supply of money to increase in an economy by issuing more money or allowing bankingsystemtocreate more credit – lendingmore topeople andfirms.  A governmentmaydosoto : o Increase total demandineconomytoreduce unemployment. o In response toincrease indemandforgoodsandservicesforgoods. o In response toworkersdemandforhigherwages,orrise inotherproduction costs. o As moneysupplyrises,people’spurchasingpowersrise andinflationcanoccur. o To stop excessive inflation, a monetary rule government’s should follow is to only allow supply of moneytoexpandat same rate as increase inreal outputorreal GDP overtime. o If moneysupplyincreasesfasterthanoutput,theninflationwill occur. o Stagflation – when inflation and unemployment are both high and increasing – often due to rising livingcostscausingincreaseddemandforhigherwagesandlesslabourdemand. Causesof inflation  Increase in MoneySupply – an increase inmoneysupplywouldincrease the spending
26 power of the average consumer, thus increasing demand and hence pushing up prices. This then causes inflation.  Demand Pull Inflation– Whenaggregate demandisincreased,firmsare nolongerable to meet demand in production and thus prices inflate. To finance this, firms may borrow more or money supply increased.  Cost Pull Inflation – When the cost of producing goods is increased, firms may want tooffset these increased costs to consumers to keep a certain level of profit, thus the extra cost is added to price of the good or service,causing inflation. Wage Price Spiral is when workers demand higher and higher wages, causing cost pushinflationandpromptingthemtoaskfor higherwagesagain.  Imported Inflation – rising prices in one country may be exported to another country through international trade in many different goods and services. Many countries have been able to enjoy stable inflation as China’slarge supplyof goodsandservicesisproducedthroughcheaplabour. Consequences and Costs of Inflation:  Personal Costs: o Reduce purchasingpower o Real income falls o People likepensionersandstudentsonfixedincomeswillsufferfrominflation. o Low paidand non-unionizedworkersoftenfailtogetsufficientrisestostopreal income falling. o Professionalworkersmayaskforwage increasesthatprotector cause increasesinreal wage levels. o Saversand lendersmaybe hurtby inflationrate if interestisless. o People whoborrowedmaybenefit. o Demand-pull inflation increased spending can boost company profits, while cost-push may reduce profits. Rising profits could yield more tax, however government may have to pay more for goods and services. o Economical Costs:  Possible unemployment –purchasingpowerdrops,lessdemand  Some people save more,reducingeconomicactivityandoverall output  Causesgoodsand servicestobecome uncompetitive internationally  Benefits:  Economicgrowth  Reduce debtvalues –fallingvalue of moneyreducesreal debtvalues  Higherstockvalue  Valuesof fixedassetscouldrise –financial security  Possible increasedemployment  Stimulate technological advancement Economic Growth and Inflation Most governments hope that they can achieve steady economic growth without it causing acceleration in demand- pull and / or cost-push inflationary pressures. The dangers of a booming economy is that inflationary pressures build and that the economymustslowdownorfall intorecessionforthese inflationriskstobe controlled.
27  During the early part of the last decade, the British economyenjoyed a period of steady growth and relatively lowand stable inflation  In 2007-08 the trade-off betweengrowthandinflationworsened  Inflationsurgedhigher–mainlybecause of external factorssuchashighfoodand oil prices  The economysufferedasteepdescentintorecessionfollowingthe global financial crisis  In early 2009 the economy experienced recession and higher inflation – some economists warned of a lengthyphase of “stagflation”conditions  Inflation fell back largely because of the recession. But in 2010 and into 2011, inflation has been rising again whilstGDPgrowthhas beenweakwiththe riskof a seconddownturn(a“double-dip”) Stagflation Stagflation is a period of economic stagnation accompanied by rising inflation. In other words, both of these key macro objectives are worsening. It can happen when an economy goes into a downturn or a recession but when other external forces are bringing out higher inflation. The obvious example of this is when recession is afflicting a country but the prices of imported products are surging causing prices to rise and real incomes and profits to fall. The rise in the cost of imports can be shown by an inward shift in the short run aggregate supply curve leading to a contractionin real national outputandan increase inprices. One of the dangers of stagflation is that the fall in real incomes causes consumer and investment spending to fall and thus the rate of economic growth suffers too (a deterioration in a third objective of policy). Wage demand may also pick up as people experience rising prices. The central bank needs to consider appropriate policy responses to this. Too severe a tightening of monetary policy for example will help to curb inflation but risk causing a deep recession. The combinationof deflationandasustaineddropineconomicoutputistermedaneconomicdepression An improvement in aggregate supply can help to resolve the growth – inflation trade off. We see in the diagram how aggregate supply has moved outwards and this allows aggregate demand (C+I+G+X-M) to operate at a higher level withoutthreateningapersistentincrease inthe general price level (inflation).
28 Overcominga conflictbetweeneconomicgrowth and inflation – increasesin AD and AS Conflictsbetweenobjectives –the economicsofdeflation Deflation is a sustained fall in the prices of goods and services, and thus the opposite of inflation. Increased attention has focused on the impact of price deflation in several countries in recent years – notably in Japan (inflation -0.3% in 2010) and in some Euro Area countries such as Ireland Greece where prices have been falling, national output has droppedand unemploymenthasbeenrising.
29 It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can be caused by rising productive potential, which leads to an excess of aggregate supply over demand. Greece has suffered from a severe rise in unemployment (right hand scale) and is now seeing her relative living standardsfall.A deflationary depression isa risk for Greece Possible damagingconsequencesofpersistentprice deflation  Holding back on spending: Consumers may postpone demand if they expect prices to fall further in the future.  Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people’s willingness to spend. This isespecially the case withmortgage debtsandotherbig loans.  The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. If inflation is negative, the real cost of borrowing increases and this can have a negative effect on investmentspendingbybusinesses  Lower profit margins: Lower prices hit revenues and profits for businesses - this can lead to higher unemploymentasfirmsseektoreduce theircostsbysheddinglabour.  Confidence and saving: Falling asset prices including a drop in property values hits wealth and confidence – leadingtodeclinesinADandthe threatof a deeperrecession. Resolvingthe threat ofprice deflation  UsingexpansionaryMonetary Policy o Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and therebyboostconsumption o Quantitative Easing – printing money in the hope that, by injecting it into the economy, people and companieswill be more likelytospend.  UsingexpansionaryFiscal policy o Keynesian economists believe that fiscal policy is a more effective instrument of policy when an economyisstuckin a deflationaryrecessionandaliquiditytrap o The key Keynesian insight is that a market system does not have powerful self-adjustments back to full-employment after there has been a negative economic shock. Keynes talked of persistent under- employment equilibrium – an economy operating in semi-permanent recession leading a persistent gap betweenactual demandandthe potentiallevel of GDP.
30 Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to get aneconomy onthe path back to full(er) employmentandtopreventdeflation. Unemployment Definition Frictional Unemployment:Occursas workerschange jobsand spendtime withoutjobsduringthis period. Seasonal Unemployment: Occurs when consumer demand for certain goods and services are seasonal, and as a resultpeople are onlyemployedduringperiodsof time. Cyclical Unemployment:Occurswhenthere istoolittle demandforgoodsandservicesinthe economyduringa recession,andfirmsare producinglessasaresult, employinglesslabourasa result. Structural Unemployment:Occurswhenthe labourmarketisunavailabletoprovide jobsforall workersbecause of a mismatchbetweenthe worker’sskillsandthe skill requirementof the jobs.Itarisesfromlong-termchangesinthe structure of the economy,asentire industriesclose downdue tolackof demandforgoodsand servicestheyproduce.Workerswhobecome unemployedandhave skillsnolongerneededare occupationally immobile. Voluntary Unemployment:Voluntaryunemploymentincludesworkerswhorejectlow wage jobs whereasinvoluntary unemploymentincludesworkersfireddue toan economiccrisis,industrial decline,companybankruptcy,or organizational restructuring. International labour organization The International Labour Organization (ILO) measure of unemployment assesses the number of jobless people who want to work, are available to work and are actively seeking employment. It is used internationally so comparisons can be made between countries. It also enables consistent comparisons over time. The ILO measure is calculated using data from surveys of a country’s labour force; it can therefore be subject to sampling differences betweenone country and another. It differs from the claimant count unemployment tmeasure, which only includes people claiming unemployment-related welfare benefits. The ILO measure gives a higher figure than the claimant count measure as it includes those who are classified as available for work but who are not claiming jobless benefits. The ILO measure may include students who are actively seeking work but may not qualify for jobless benefits. Similarly, second earners within a household may be reluctant to claim jobless benefits but would be classified as unemployed underthe ILO measure astheyare available forwork. Government Policy Definition Monetary policy:The processbywhichthe government,central bank,ormonetaryauthorityof a countrycontrolsthe supplyof money,availabilityof money,andcostof money or rate of interest,inordertoattain growthand stabilityof the economy. Fiscal policy: Governmentpolicythatattemptstoinfluence the directionof the economythrough changesingovernmenttaxesorthroughsome spending.
31 Expansionary policy: Contractionary policy: Government macroeconomic objectives and policies Most of the governmentsroundthe worldhave fourmainobjectives.These are  Keepinflationundercontrol  Maintaina lowlevel of unemployment  Achieve ahighlevel of growthrate  Maintaina healthybalance of payments. GovernmentEconomicPolicies Governmentinfluencesthe economythroughitseconomicpolicies.These are Fiscal Policy It is related with taxes and government spending. This policy is there to control inflation and demandin the economy. Usually government collects money in the form of taxes and spends money through its development expenditure such as building roads, bridge, defense, transports etc. Government constantly monitors the aggregate demand in the economy.Inflationrate givesthe correctmeasure of the aggregate demandinthe economy. When the aggregate demand in the economy is high, prices rise, this shows that the economy is spending too much. In this case, the government will lower is expenditure budget and cut back on investment spending, such as on road construction and hospital equipment. On the other hand the government might also increase the taxes, which would take spending power out of the economy by leaving consumers and businesses with less income to spend. In the opposite scenario, when the economy is heading for a recession and unemployment is rising, the government might increase its expenditure plans. There might be a reduction in taxes so as to leave consumers and businesses withhigherdisposable incomes. Monetary Policy Monetary Policy is related with a change in interest rates by the government or the Central bank. When the forecast for inflation is that it will rise above the targets set by government, then the Central Bank will raise its base rate and all other banks and lending institutions will follow. It is usually done when the economy is at the boom stage of the businesscycle. A higher interest rate will resultin…businesswillnotbe able toexpandastheyhave to pay more interesttothe bankfor theirloansandtheyhave lessprofitleft.Businessesthatare planningtotake loanfor expandingmay postpone theirdecisionsandwaitfora cut ininterestrates.Consumersdemandwillalsofall astheywill notbe gettingcheaploanstopay for the buyingnewhousesandluxuryitems. If inflationislowandisforecastedtoremainbelow governmentstargets,thenthe Central Bankmaydecide to reduce interestrates. Supplyside policies It includesall those policieswhichaimatimprovingthe efficientsupplyof goodsandservices.These mightinclude:  Privatization  Impartingtrainingandimprovingthe educationlevel of the workforce resultinginhigherskills.  Increase competitioninall industriesbyremovingentrybarriers,thusleadingtomore efficiency.
32 Factors causing a change incomponents ofAD Change in consumption A change inconsumptioniscausedbyany of the followingfactors  Changesin income:Income increasesconsumptionincreasesandvice versa.  Changes in interest rates: Fall in interest rates will make borrowing money cheaper. Consumers will now be tempted to take loans and purchase goods and services. Consumption will rise. On the other hand if the interest rates increase, borrowing becomes expensive. Consumers will be more tempted to save rather than spend.Consumptionwillfall.  Changes in wealth: A rise in house prices or the value of stock and shares makes a person feel wealthy. Consumersfeel more confidentandtendtospendmore .  Changesin consumer confidence:Higherconsumerconfidence islikelyleadtoincreasedconsumption. Change in Investment  Interest Rates: If interest rates are low firms will find it easy to borrow funds for investment. Investment increase wheninterestratesfall.  Changes in National Income: If the national income increases, firms will have to invest further to increase output(inducedinvestment).  Technological change: Regular changes in technological front demand firms to invest in order to keep up withthe changesand remaincompetitive.  Business Confidence: The economic environment in an economy is a major factor in determining the investment level. When an economy is showing signs of healthy growth, firms will have positive expectation and will invest in expanding their facilities and to meet higher demands in the future. During troughs firms will be more conservativeintheirinvestmentsandthusADwill be affected. Change in GovernmentExpenditure GovernmentExpendituredependson  Macroeconomics objectives: If the government is considering increasing employment then it might increase itsspendingonpublicprojects.  Condition of the economy: During phases of slow economic growth, government is more likely to increase its spendinginordertostimulate the economy. Changesin net exports Exports are domesticgoodsboughtbyforeigners.Exportswillrise when  Foreignersincome rise  Exchange rate of the exportingcountryisfalling.  The economyfollowsamore liberal trade policyi.e.free trade increase  Inflationrate inthe economyiscomparativelylowerthanitstradingpartners. Imports are the goodsboughtfrom foreigncountry.Importswillrise when  Domesticincome rises.Thisisbecause peoplewillincreasetheirconsumptionandthusimportswillincrease.  Exchange rate of the importing country increase. Now it becomes cheaper for the country to purchase from outside astheircurrencyisstrongerthan theirtradingpartners.  If the economyisfollowingaliberal trade policyi.e.free trade increases.  Inflationrate ishigh Possible conflictbetweenmacroeconomicobjectives  It israre for a country to achieve all of itsmainobjectivesatthe same time  Frequently conflicts appear between the different aims and as a result, choices might have to be made about whichobjectivesare tobe givengreatestpriority.
33  This will vary from one country to another since the needs of different nations will differ according to their stage of economicdevelopment. Here are some possible policyconflicts:  Inflation and unemployment: Falling unemployment might create demand-pull and cost-push inflationary pressuresleadingtoa fall inthe value of money  Economic growth and environmental sustainability: Rapid economic growth and development frequently puts extra pressure on scarce environmental resources threatening the sustainability of living standards in the future  Economic growth and inflation – an overheating economy may suffer accelerating inflation which then has negative effectsontrade performance,businessprofitsandjobs  Economic growth and the balance of payments: Strong GDP growth fuelled by high levels of consumer demand for goods and services might lead to a worsening of the trade balance. This is particularly true when an economyhasa highmarginal propensitytoimport. Unemploymentandinflation – the PhillipsCurve concept  Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemploymenttorise  If a Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the productmarkets. The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product marketsfroman increase innational income,outputandemployment.
34  The labour market: As unemployment falls, labour shortages may occur where skilled labour is in short supply. This puts pressure on wages to increase and prices may rise as businesses pass on these costs to their customers.  Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so doesthe deriveddemandforcomponentsandraw materials. Product markets: Rising demand can lead to suppliers raising prices to increase their profit margins. The risk of rising pricesisgreatestwhendemandisout-strippingsupply-capacityleadingtoexcessdemand(i.e.apositive outputgap.) Fiscal policy The two maininstrumentsof fiscal policyare governmentspendingandtaxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:  Aggregate demandandthe level of economicactivity.  The patternof resource allocation.  The distributionof income. How fiscal policywork High rate of inflation High rate of inflation is caused by too much aggregate demand in the economy. Government will use deflationary fiscal policy. Government will try to influence aggregate demand by reducing its public spending. The government will spend less on construction of roads, bridges and other public spending and thus aggregate demand will fall. On the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable income outpeople’spocketresultinginalowerdemand.
35 Low rate ofinflation In an economic recession, aggregate demand, output and employment all tend to fall.Now the Government wants to increase employment in the economy, it can attempt to do so by increasing aggregate demand. The Government will increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so that people have more disposableincome tospendandinstigate demandinthe economy. Role of fiscal policies The two maininstrumentsof fiscal policyare governmentspendingandtaxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:  Aggregate demandandthe level of economicactivity.  The patternof resource allocation.  The distributionof income. AD=C+G+I+(X-M)
36 As we can see in the above equation that G (Government Expenditure) is a component of AD, it can be used by Government to influence AD in the economy. The government can use expansionary or deflationary fiscal policy to getthe desiredresults.Let’sdiscusseachpolicyindetail. Expansionary fiscal policy Expansionary fiscal policy is used to increase the Aggregate demand in the economy. If the economy is having a deflationarygap,the governmentcanuse expansionaryfiscal policytoreduce the gapor totallyeliminate it. Deflationarygap Deflationary gap is the difference between full level of employment and the actual level of output of the economy. We can see inthe diagrambelow,thatthe economyisoperatingalevel ‘a’below the Yf (full levelof employment). The consequence is that due to deflationary gap all the resources of the economy are not being usedin the optimum level and they are idle. This results in unemployment and low level of output. This is not desirable for any government.Inordertoreduce/eliminatethe deflationarygap,the governmentuses expansionaryfiscal policy. Government will either increase its spending or reduce taxes (or both) in order to stimulate the aggregate demand. Increase Government spending will result me more projects being funded by the government and thus employment and output will increase. Even a lower tax rate will result in more disposable income for households and encourage consumption. Increased G and C will leadtohigherAD.However,thismightalsoleadtohigherprices/inflationinthe economy. Contractionary fiscal policy Contractionary fiscal policy involves the reduction of government spending and increase taxes as a measure to control inflation/AD in the economy. With reduced government spending, the AD will fall and thus reduce pressure on the economic resources and the average price level in the economy will come down. Similarly, increased taxes will take away the excess disposable income from the households and result in a fall in AD. Contractionary fiscal policy is thususedto reduce the inflationarygap. Inflationarygap Inflationary gap is when the Aggregate demand exceeds the productive potential of the economy. As we can see through the diagram, the economy is operating at a level above the full employment level of the output. Due the
37 limitation of the economy to fulfil this increased demand the average price level in the economy increases resulting ininflation. Problemsof fiscal policy Reduce incentive to work Raising taxes on income and profits reduce work incentives, employment and economic growth. An effort to reduce aggregate demand may cause disincentives to work, if this occurs there will be a fall in productivity and Aggregate supplycouldfall. Adverse effectofloweringPublicSpending Reduced government spending to Increase Aggregate demand could adversely affect public services such as public transportand educationcausing marketfailure andsocial inefficiency. ‘Crowdingout’ effect With an increase in government expenditure, there will be greater competition for limited resources. This will offset private investmentsresultinginshrinkingof the private sector. Inaccurate forecasting If the Government’s estimate or forecasting is wrong or inaccurate the fiscal policy will suffer. For example, if a recession isexpected and the government practices deficit budget, and yet the recession turns out to be a boom,this will cause inflation. Implementationofthe Policy Planning for the spending is done once by most of the governments. If there is a delay in the implementation of the fiscal policy,itmightreduce the effectivenessof the policy. Thusthe time lagisimportant. Poor Information Fiscal policy will suffer if the government has poor information. e.g. If the government believes there is going to be a recession, they will increase AD, however if this forecast was wrong and the economy grew too fast, the government actionwouldcause inflation.
38 Time Lags If the government plans to increase spending this can take a long time to filter into the economy and it may be too late.Spendingplansare onlysetonce ayear. There isalsoa delayinimplementinganychangestospendingpatterns. Budget Deficit Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget deficit which has many adverse effects.Higherbudgetdeficitwill require highertaxesinthe future andmaycause crowdingout(see below Other ComponentsofAD If the government uses fiscal policy its effectiveness will also depend upon the other components of AD, for example if consumerconfidence isverylow,reducingtaxesmaynotleadtoan increase inconsumerspending. Dependson Multiplier Change ininjectionsmaybe increasedbythe multipliereffect;thereforethe size of the multiplierwill be significant. Monetary Policy Monetarypolicyisgenerallyreferredtoaseitherbeingan expansionarypolicy,or a contractionary policy. An expansionary policy increases the total supply of money in the economy and is traditionally used to combat unemployment in a recession by lowering interest rates. Lowered interest rates encourage the household and the firms to increase their consumption and investment respectively. This will shift the AD to the right and result in higherreal outputandmore employment. Contractionary policy decreases the total money supply and involves raising interest rates in order to combat inflation. The result will be that investment will fall, and consumption will fall. All of these changes will shift the AD to the left.
39 It is argued that an increase in the money supply causes an increase in the rate of inflation. Maintaining a low and stable inflation is one of the main macroeconomic objectives of the Government. Government does so by controlling the supplyof moneytothe economy.Thispolicyisknownas monetarypolicy. Monetary policy in any country is usually controlled by the Central Bank of that country. The Central bank alters the interestratesinthe economyafterassessingthe inflationarypressuresinthe market. Monetary Policytools Central Bankhas three toolsof monetarypolicy: Openmarket operations  Openmarket purchases:The central bankbuysgovernmentsecuritiestoincrease the monetarybase.  Openmarket sales:The central bank sellsgovernmentsecuritiestodecrease the monetarybase. Openmarketoperationshave anumberof advantages:  Theyare underthe directand complete control of the central bank  Theycan be large or small.  Theycan be easilyreversed.  Theycan be implementedquickly Discount loans When a bank receives a discount loan from the central bank, it is said to have received a loan at the “discount window.”The Central Bankcan affectthe volume of discountloansbysettingthe discountrate:  A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discountloans.  A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discountloans. Discountlendingismostimportantduring?nancial panics:  Whendepositorslose con?dence inthe ?nancial system, theywill rushtowithdraw theirmoney.  Thislarge depositout?owputsthe bankingsystemingreatneedof reserves.  The central bank stands ready to supply these reserves by making discount loans. In such situations, the central bankacts as a lenderof lastresort. Changesin reserve requirements The portion (expressed as a percent) of depositors' balances banks must have on hand as cash. This is a requirement determined by the country's central bank. It affects the money multiplier; changes in the required reserve ratio can leadto changesin the moneysupply.Thisisalsoreferredtoasthe "cashreserve ratio" (CRR).
40 How money supplyworks Money supply includes all the notes and coins in circulation with the public plus the money with banks. It also includes the deposits in banks and building societies. The later is more significant supply of money and is usually the target of Governmentsmonetarypolicy.The waysthroughwhichGovernmentcontrolsthe moneysupplyare: Openmarket operations Government usually sells treasury bills and bonds to raise money. Private individuals invest in these bonds and bills in orderto get a healthyrate of interest.Thisreducesthe depositswithbanksandthe moneysupply. Variation of legal reserve requirements Usually, the commercial banks have to maintain a certain percentage of their assets as depositwith the Central Bank. When the Central Bank wants to reduce money supply it will increase the limit of the deposit kept by the banks. The commercial banksare leftwithlessmoneytolendtotheircustomers. Central banks Central Banks are charged with regulating the size of a nation’s money supply, the availability and cost of credit, and the foreign-exchange value of its currency. Regulation of the availability and cost of credit may be designed to influence the distribution of credit among competing uses. The principal objectives of a modern central bank in carrying out these functions are to maintain monetary and credit conditions conducive to a high level of employment and production,areasonablystable levelof domesticprices,andanadequate levelof international reserves. Functionof a Central Bank A central bankusuallycarriesoutthe followingresponsibilities:  Implementationofmonetary policy.  Controlsthe nation'sentire moneysupply.  The Government'sbankerandthe bankers'bank("Lenderof Last Resort").  Manages the country'sforeignexchange andgoldreservesandthe Government'sstockregister;  Regulationandsupervisionof the bankingindustry  Setting the official interest rates- used to manage both inflation and the country's exchange rate - and ensuringthatthisrate takeseffectviaa varietyof policymechanisms Role of taxation in promoting equity Tax isa fee charged("levied") byagovernmentonaproduct, income,oractivity. Whytaxes are imposed? There are differentreasonsforimposingtaxes.  To finance government expenditure. One of the most important uses of taxes is to finance public goods and services,suchasstreetlightingandstreetcleaning.  To reduce consumptionof goodsthatcreatesnegative externalities.  To control the amountof importedgoodsi.e.tariffs  Usedas a part of fiscal policytocontrol aggregate demandinthe economy.  To control income inequality. Classificationoftaxes Progressive taxes A progressive tax isatax imposedsothatthe tax rate increasesasthe amountsubjecttotaxationincreases.Insimple terms,itimposesagreaterburden(relative toresources)onthe richthan on the poor.It can be appliedtoindividual taxesor to a tax systemas a whole.Progressive taxesattempttoreduce the tax incidence of peoplewithalower ability-to-pay,astheyshiftthe incidencedisproportionatelytothose withahigherability-to-pay.The resultispeople withmore disposable income payahigherpercentage of thatincome intax than do those withlessincome.
41 Regressive Tax The opposite of a progressive tax isa regressive tax,where the tax rate decreasesasthe amountsubjectto taxation increases.Itimposesagreaterburden(relative toresources) onthe poorthanon the rich.Regressive taxesattempt to reduce the tax incidence of people withhigherability-to-pay,astheyshiftthe incidence disproportionatelyto those withlowerability-to-pay. Proportional Tax A proportional tax isone thatimposesthe same relative burdenonall taxpayers—i.e.,where tax liabilityandincome grow inequal proportion.Insimple terms,itimposesanequal burden(relativetoresources) onthe richand poor. Proportional taxesmaintainequal tax incidence regardlessof the ability-to-payanddonotshiftthe incidence disproportionatelytothose withahigheror lowereconomicwell-being. Types oftaxes Direct Taxes It isa tax paiddirectlytothe governmentbythe personsonwhomitisimposed. Examples  Tax imposedonpeoples’income-Incometax  Tax on wealth –wealthTax  Tax on firm’sprofits.- corporate tax IndirectTaxes Indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the consumer). The intermediary later files a tax return and forwards the tax proceedstogovernmentwiththe return. Indirect taxes are generally included in the price of goods and services, so are less obvious to those paying the taxes than directlevies. Thusindirecttaxesare alsoknownasexpendituretax orconsumptionbasedtax. Examples  GST (Goodsand service tax)  VAT(Value addedtax)  Consumers are charged a percentage of tax while purchasing a good/service and then the seller pays the tax collectedtothe Government. Other measuresto promote equity The governmentsalsoundertake expenditurestopromote income equity.Theseinclude Subsidies Provide directly, or to subsidize, a variety of socially desirable goods and services. These include health care services, education,andinfrastructure thatinclude sanitationandcleanwatersupplies. Transfer payments Government provides various kind of assistance to low income groupsin the society. The objective is to support them in maintaining a reasonable standard of living and to lower inequality. These payments are given directly to these groups in the form of monetary help. Examples include Social Security, unemployment compensation, welfare, and disabilitypayments. Government policy to control inflation Governmentusesanumberof policiestodeal withthe differenttypesof inflation.These are:
42 Demand Side policies-tocontrol demandpull inflation Deflationary fiscal policy: This involves an increase in taxes and lowering of government spending. Increasing taxes will result inlower disposable income for household and thus less consumption. Moreover, increased taxeswill result inlowerprofitsforfirmsandthus lessinvestmentbyfirms.Allthese factorswill lowerthe ADin the economy. Deflationary monetary policy: It involves rising of interest rates and reducing money supply. Higher interest rates mean higher loan and mortgage repayments. This will deter households and firms to borrow, leading to fall in consumptionand investmentrespectively. Supplyside policies-tocontrol cost pushinflation It includesall those policieswhichaimatimprovingthe efficientsupplyof goodsandservices.These mightinclude:  Privatization  Impartingtrainingandimprovingthe education level of the workforce resultinginhigherskills.  Increase competitioninall industriesbyremovingentrybarriers,thusleadingtomore efficiency. Exchange rate policiesto control importedinflation This involves increasing the value of currency to reduce importedinflation. Increase currency rate will alsolead to fall indemandfor exports(componentof AD). International aspects Definition Exchange rate: The price of one’scurrencyintermsof anothercurrency Foreignexchange market: The marketwhere currenciesare boughtandsold. Exchange control: Limitsonthe amountof foreigncurrencyavailabletoimporters,which consequentlylimitimports Appreciation:The rise in value of a currencyagainstothers.Exportswill become more expensive abroad andimportscheaperat home. Depreciation:The fall invalue of a currencyagainstothers.Exportswill become cheaperabroad and importsexpensiveathome. Devaluation:Depreciationbroughtaboutthe government,normallybyagovernmentwhich fixes the value of itscurrency. Exports: The movementof goodsorcommoditiesoutof the country. Imports: The movementof goodsorcommoditiesintothe country. Protectionism:Policyof protectingdomesticindustriesagainstforeigncompetitionbymeansof tariffs,subsidies,importquotas,orotherhandicapsplacedonimports. Free trade: A systemof trade policythat allowstraderstotrade across national boundaries withoutinterference fromthe respective governments.
43 Globalisation What is it?  It is the increasingintegrationof countries’individual economies.  It is the global movement towards trade, financial and communications integration through the development of free trade, free flow of capital, and the freedom to tap into cheaper foreign factor markets. (Official definition) Benefits  Most efficientformof production:  Because firmswill choose toproduce where costsare lowest.  Stimulatesthe economy,particularlythatof LEDCs, bydrawinginmore foreigndirectinvestment.  Employmentopportunities  Openingjobs. Training • Introducesskillsandtechnologytonationsthroughacompany’simplementationsof such:  Thisincreasesthe productivityof anation’sworkforce,etc. • OpeningnewindustriesinLEDCssuchas the white phosphorusminingindustryinYemen. • Increasescompetition:  Lowers prices  Lessinflation.  Betterqualitygoods.  Betterefficiency. Costs • Environmental damage.  Because the companyis sopowerful thatitcan affordto operate inefficientlyforconveniencessake. • Creates uncertainty:  Foreignfirmsownmostof the marketshare ina country,notdomesticfirms. • May choose to source theirresourcesfromabroadandnot fromlocally:  Thus local resource producerswill gooutof business. • Human rightsabuses.  Infringementsonindigenousrights. • Terrorism. • Investmentsinnationsfacingpolitical sanctionsasaresultof theirwrong-doings. • Leaching from governmentfunds:  Large MNCs may be too important for a government to allow to go bankrupt thus whenever said MNC is facingtroublestheywill be givenaidbytheirgovernment. • Price manipulation. • Labour abuse:  Childlabour.  Bad workingconditions.  Poor healthcare.  Sweatshops.  Bad wages.  Restrictionstorestinghours.  Anti-Labour-Unionpolicies. • Usingtactics detrimental to competition:  Predatorypricing.  Monopolypower.
44 • Tax evasion:  Through transferpricing. • Using illegal methodsandmaterialstoproduce goodsandservices.  Or to force people tobuytheir goodsor services:  Great AmericanStreetcarscandal. • Blockingof technologies:  Bribery.  Blockingbatterytechnologyforhybridcarssoone can sell more oil.  Concealmentof imports.  Causingtrade deficit:  Wal-Mart is accusedof beingone of the largestsourcesof the trade deficitinthe USA. Objections Third world debt.  Debt in the developing, less developed or least developed third world countries in Africa, Asia, Latin America and the Middle East.  Globalizationis leaching resourcesfrom these countries and the revenue generated from this leaching is not fed back into these countries. Furthermore, with population growth causing the needs and wants of these countriestoalsogrow, these countriesare fallingintodebtinordertopay forthese needsandwants. • Animal rights. • Childlabour. • Anarchism. • Anti-capitalist Exchange rates Demand for and Supply of a currency Thisis whatdeterminesexchange rate inafree-floatingexchangerate system:  Whena currencyhas strong demanditwill appreciate invalue.  In contrast,whenthere isa large scale sellingof acurrency itwill depreciate. Demand for a currency:  Exportsand importsof goods/services o If a country has a decline in export industries and earnings, yet its people continue buying imports, the exchange rate islikelytofall.  This is possibly not true for countries such as Hong Kong which are dependent on imports of oil and food. o Fewer exports will mean less demand for the currency to pay for them, so the demand for the currency will decrease. o Thiswill leadtodepreciation o Whena currency has depreciated,thismakesthe countries’exportscheaperabroad. o Thus,exportsshouldbecome more competitive overseas.  Price elasticityof demandforimports o Whena currency depreciates,importsbecomemore expensive. o If the demandforimportsisprice elastic,thisshouldleadtoafall inexpenditure onimports o Thissituationisfoundwhere importscompetewithhome-producedalternatives. o When countries import necessities, such as food and oil, demand tends to be price inelastic so expenditure riseswhenthe currencyfalls. • Pure speculative demand. o Speculatorsoftenpurchase currenciesthattheythinkwill appreciate invalueagainsttheirowncurrency. • Official buyingof the currencybythe central bank. o Thismightbe done forinvestmentorspeculationorsecurityorotherreasons.
45 • Comparativelyhigherdomesticinterestrate. o Thus savers will be likely to convert their own money into your currency to save in your nation and enjoy the comparativelyhigherdomesticinterestratesyouoffer. Supplyof a currency  Importsof goodsand services.  Outflowsof directinvestment.  Outflowsof portfolio investment.  Speculative sellingof the currency.  Official sellingofthe currency by the central bank.  Rate ofinterestabroad. Appreciationand Depreciation • Foreignerswilltendtosave moneyinone’snation.  Thus the demandforone’scurrency riseswhichcan cause one’scurrencyto appreciate ingeneral. • Depreciationmeansthatthe value of the currencyintermsof othercurrenciesgoesdown: • If the USD depreciatesagainstthe RMB thenitwill take fewerRMBto buyeach USD. • If 1 Euro was worthHKD 10.2 at the start of the year. • It may depreciate if the Greek government declared that it would withdraw from the Eurozone and go back to usingthe Drachma in orderto depreciate theircurrency. • Thiswill cause otherstolose confidence inthe Euroandspeculationwillcause people tosell the Euro. • Thismay endupcausingthe Euro to depreciate toHKD7 perEuro. • In this case the Euro has depreciated against the HKD because it now takes more Euros to purchase each HKD. • But the HKD has appreciatedagainstthe Eurobecause itnow takesfewerHKDto buy1 euro Advantages of a Strong Currency  Lowerimportprices – This boostslivingstandardsof consumers.  An increase in the real purchasing power of HK residents traveling overseas for business and leisure purposes.  Cheaper to import raw materials, components and capital inputs – causes an outward shift in short-run aggregate supply.  Improvementinthe termsof trade (lowerimportprices).  Helps to control RPI inflation – Domestic producers face stiff international competition and must keep their prices down. Lower inflation allows the MPC/HKMA to keep nominal interest rates at a lower level than if the exchange rate wasweak.  An increase in a country’s relative position in international league tables showing real GDP per capita when expressedinacommoncurrency:  Even if one’s GDP, as measured in one’s own currency, is no more than previously, because one’s currency has appreciated in value, the GDP of one’s nation will also increase when it is translated into another currency. Disadvantages of a Strong Currency • Cheaperimportsleadtorisingimportpenetrationandlarge trade deficit: • Import penetration means that a larger portion of the goods and services provided by a nation’s firms is now providedbyforeignfirms. • Exportersalsolose price competitivenessandmarketshare thuscausinga trade deficit. • Damagedprofitandemploymentinsome sectorstowhichexportingisthe keymeansof generatingrevenue. • Negative impact on economic growth (exports – injections of aggregate demand, imports - leakages of wealth formthe circularflowof income).
46 • Some regions which have a higher than average dependency on exporting industries are more affected than others. Balance of Payments on Current Accounts What is it?  It is a set of accounts that record a country’s international transactions and which (because double entry bookkeepingisused) isalwaysinbalance withnosurplusordeficitshownonthe overall basis.  It serves to highlight a country’s competitive strengths and weaknesses and helps in achieving balanced economicgrowth.  Because the international market isso large it is unlikelytoadhere to the businesscycle.  Therefore, a country which has a healthy BoP account will likely have balanced growth because the levels of investment, consumption and capital of the international market is unlikely to fluctuate much and will grow steadily.  The demand from the international market is unlikely to fluctuate much and will grow steadily therefore investment and capital will also grow steadily (this growth happens because people are getting richer, world populationisgrowing,etc.).  Capital inthiscase shouldindicate the moneyinvestedinbusinessesto generate income:  If investments grow so too will capital because capital is the money already invested and investments are the source of capital. The Balance of PaymentsAccount  The currentaccount, capital accountand financial account.  The capital and financial accountsusedtoknown collectivelyasthe capital account. The BoP is always balanced  When the news talks about a BoP surplus or deficit they are usually referring to the net transactions of the CurrentAccountor just the Balance of Trade.  Calculatedbysubtractingthe total value of importsfromthe total value of exports BoT isBalance ofTrade  Positive figure (surplus)–Value of imports< Value of exports.  Negative figure(deficit) –Value of imports>Value of exports.  A negative BoP indicates that a country’s exports are not competitive enough to compete with those producedbyothercountries:  Thus there isa net leakage of wealthfromthe country. Correctingtrade imbalances Large trade imbalances,whetherabigdeficitora bigsurplus,can cause problemsfora national economy. Problemswith a trade surplus  There may be political and economic pressure on the government from other countries to reduce its trade surplussotheycan reduce theirtrade deficits  Exporting firms will enjoy significant overseas revenues – profits and wages may rise – but the increase in demandmaycause demand-pushinflation  A surplus causes the value of the currency to appreciate or stay high, and may eventually reduce demand for exportsandcause a lossof jobs.
47 Problemswith a trade deficit  If more money is paid out for imports than is earned from exports then this loss of money from an economy may mean less can be spent on domestic goods and services. Domestic firms facing a fall in demand for their productsmay cut back productionandtheirdemandforlabourresultinginhigherunemployment.  The value of the exchange rate will fall, causing imports to become more expensive and resulting in imported inflation. If demand for price-inelastic goods or services falls, more money will be paid out for imports and the demandfordomestically-producedgoods/serviceswill decrease.  The trade deficit might be a symptom of a declining industrial base, with fewer firms in the economy over time producinggoodsandservicesforexport. Economic growth and trade balance A period of fast growth may come into conflict with the balance of payments. Much depends on the income elasticity of demand for traded goods and services. In the case the UK, the evidence is that consumers have a high propensity to consume imports; the income elasticity of demand is strongly positive. Say for example, real disposable incomes grow by 3% and that the income elasticity for imports = +2.5. That would lead to a 7% rise in the volume of imports. Unless there is a corresponding rise in exports, we expect to see a worsening of the balance of trade (i.e. a widening trade deficit). In a recession, this effect works in reverse as demand for imported products including raw materials, components and ready to consume goods and services declines. The trade balance will improve although the root cause is a drop ineconomicactivity. Correctingtrade balances 1. Do nothing,asa floatingexchangerate will correctit. Trade deficitsandsurplusescanbe self-correctingif allowedtoadjustfreely. 2. Fiscal policy A contractionary fiscal policy is when the government may cut public expenditure and raise taxes to reduce the total demand in their economy so people have less to spend on imports. This will help reduce the trade deficit. However, a fall in demand may also affect domestic firms, who may cut output and employment in response tothe fall indemand An expansionary fiscal policy is when the government lowers tax rates and raise public expenditure. This boosts spending on imports and help to correct a trade surplus. However, it may also help domestic firms if demandfortheirgoodsand servicesalsorises,andmayhelptohaltany decline inthe industrial base. 3. Monetarypolicy An expansionary monetary policy is when the government attempt to attract more inwards investments to their economy to help offset a trade deficit by raising interest rates. Higher interest rates will also make borrowing more expensive and reduce the demand for loans by consumers and firms that may be used to pay forgoodsand servicessuppliedoverseas. A contractionary monetary policy is when the government lowers interest rates to help correct for a trade surplus by lowering the cost of borrowing from firms and consumers, and will lower the return overseas investorscanexpect ontheirinwardinvestmentsinthe economysothattheyinvestelsewhere instead. 4. Protectionism This is when a country uses trade barriers such as tariffs to make imports more expensive or limit the amount of importsinorderto correct a trade deficit.
48 Visible and Invisible Visible Trade Visibletrade involvestradingof goodswhichcanbe touchedandweighed.Examplesincludetrade ingoodssuchas Oil,machinery,food,clothesetc. VisibleTrade consistsof  Visible exports:Sellingof tangible goodswhichcanbe touchedandweighedtoothercountries.  Visible imports:Buyingof tangible goodswhichcanbe touchedandweighedfromothercountries. Balance of trade It isthe difference betweenthe value of visible exportsand value of visibleimportsof acountry. If the value of visibleexportsismore thanvisible importsthe countrywill have asurplusbalance of trade. If the value of visibleimportsismore thanvisibleexportsthe countrywill have anUnfavourablebalance of trade. Invisible trade Invisibletrade involvesthe importandexportof servicesratherthangoods. Example include servicessuchas insurance,banking,tourism,education. If a UK studentcomesto Singapore tostudy,itwouldbe invisibleexportforSingapore asitisearningforeign exchange byprovidingeducationalservices. If a Singapore citizentravelstoUKfor a holiday.Itwill be invisible importforSingapore andinvisibleexportforUK. Balance of invisible trade It isthe difference betweenthe value of invisible exportsandvalue of invisible importsof acountry. Comparative advantage The theory of comparative advantage states that a country should specialise in the production of good or service in which it has lower opportunity cost and it should import commodities which have a higher opportunity cost of production. Example Suppose for example we have two countries of equal size, Northland and Southland. Both produce and consume two goods, Food and Clothes. The productive capacities and efficiencies of the countries are such that if both countries devotedall theirresourcestoFoodproduction,outputwouldbe asfollows:  Northland:100 tonnes  Southland:200 tonnes If all the resourcesof the countrieswere allocatedtothe productionof clothes,outputwouldbe:  Northland:100 tonnes  Southland:100 tonnes Assuming each has constant opportunity costs of production between the two products and both economies have full employment at all times. All factors of production are mobile within the countries between clothing and food industries, but are immobile between the countries. The price mechanism must be working to provide perfect competition. Southlandhasan absolute advantage overNorthlandinthe productionof Food.Bothcountriesare equallyefficient inthe productionof clothes.There seemstobe nomutual benefitintrade betweenthe economies.The opportunity costs showsotherwise.Northland'sopportunitycostof producingone tonne of Foodisone tonne of Clothesandvice versa.Southland'sopportunitycostof one tonne of Foodis 0.5 tonne of Clothes.The opportunitycostof one tonne of Clothesis2 tonnesof Food.Southlandhasa comparative advantage infoodproduction,because of itslower opportunitycostof productionwithrespecttoNorthland.Northlandhasa comparative advantage overSouthlandin the productionof clothes,the opportunitycostof whichishigherinSouthlandwithrespecttoFoodthan in
49 Northland. To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, considerthe countriesproduce andconsume onlydomestically.The volumesare: Food Clothes Northland 50 50 Southland 100 50 Worldtotal 150 100 Production and consumptionbefore trade Thisexample includesnoformulationof the preferencesof consumersinthe twoeconomieswhichwouldallow the determinationof the international exchangerate of ClothesandFood.Giventhe productioncapabilitiesof each country,inorder fortrade to be worthwhile Northlandrequiresaprice of at leastone tonne of Food inexchange for one tonne of Clothes;andSouthlandrequiresatleastone tonne of Clothesfortwotonnesof Food.The exchange price will be somewhere betweenthe two.The remainderof the exampleworkswithaninternational tradingprice of one tonne of Foodfor 2/3 tonne of Clothes. If both specializeinthe goodsinwhichtheyhave comparative advantage,theiroutputswill be: Food Clothes Northland 0 100 Southland 200 0 Worldtotal 200 100 Production aftertrade World production of food increased. Clothing production remained the same. Using the exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level of consumption: Food Clothes Northland 75 50 Southland 125 50 Worldtotal 200 100 Consumptionafter trade Northlandtraded50 tonnesof Clothingfor75 tonnesof Food.Both benefited,andnow consume atpointsoutside theirproduction possibilityfrontiers. Assumptionsin Example 2  Two countries,two goods o The theory is no different for larger numbers of countries and goods, but the principles are clearer and the argumenteasiertofollow inthissimplercase.  Equal size economies o Again,thisisa simplificationtoproduce aclearerexample.  Full employment
50 o If one or other of the economies has less than full employment of factors of production, then this excesscapacitymustusuallybe usedupbefore the comparative advantagereasoning canbe applied.  Constant opportunity costs o A more realistic treatment of opportunity costs the reasoning is broadly the same, but specialization of production can only be taken to the point at which the opportunity costs in the two countries become equal. This does not invalidate the principles of comparative advantage, but it does limit the magnitude of the benefit.  Perfectmobilityof factors of production withincountries o This is necessary to allow production to be switched without cost. In real economies this cost will be incurred: capital will be tied up in plant (sewing machines are not sowing machines) and labour will need to be retrained and relocated. This is why it is sometimes argued that 'nascent industries' should be protected from fully liberalised international trade during the period in which a high cost of entryintothe market(capital equipment,training) isbeingpaidfor.  Immobilityof factors of productionbetweencountries o Why are there different rates of productivity? The modern version of comparative advantage (developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes these differences to differences in nations' factor endowments. A nation will have comparative advantage in producing the good that uses intensively the factor it produces abundantly. For example: suppose the US has a relative abundance of capital and India has a relative abundance of labor. Suppose further that cars are capital intensive to produce, while cloth is labor intensive. Then the US will have a comparative advantage in making cars, and India will have a comparative advantage in making cloth. If there is international factor mobility this can change nations' relative factor abundance. The principle of comparative advantage still applies, but who has the advantage in whatcan change.  Negligible TransportCost o Cost isnot a cause of concernwhencountriesdecidedtotrade.Itis ignoredandnotfactoredin.  Assume that halfthe resourcesare used to produce each goodin each country. o Thistakesplace before specialization  Perfectcompetition o This is a standard assumption that allows perfectly efficient allocation of productive resources in an idealizedfree market. Absolute advantage A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resourcesthananothercountry. For example if one unit of labor inAustralia can produce 80 units of wool or 20 units of wine; while in France one unit of labor makes 50 units of wool or 75 units of wine, then Australia has an absolute advantage in producing wool and France has an absolute advantage inproducingwine. Australia can get more wine with its labor by specializing in wool and trading the wool for French wine, while France can benefitbytradingwine forwool. Example 1  CountryA can produce one widgetusingone unitof labour.  CountryB can produce one widgetusingtwounitsof labour.  CountryA has an absolute advantage overCountryBinproducingwidgets. Example 2  CountryA has 100 unitsof labour.It uses20 to produce 80 unitsof Parachutes,and80 to produce 20 unitsof Barbie dolls.
51  CountryB has 100 unitsof labour.It uses40 to produce 100 unitsof Barbie dolls,and60 to produce 20 units of Parachutes.  If the countriesmaximizedtheirpotential,CountryA couldproduce 400 unitsof Parachutes,andcountryB couldproduce 250 unitsof Barbie dolls.Throughtrade,the twocountrieswouldachieve amore efficient allocationof resourcesandincrease theirprosperity. Free trade Definition:International trade lefttothe mechanismsof demandandsupplywithoutinfluence of protectionist methods. Reasons for Free Trade  DomesticNon-availability o A nation trades because it lacks the raw materials, climate, specialist labour, capital or technology neededtomanufacture aparticulargood.Trade allowsagreatervarietyof goodsand services.  Cost effectiveness o It ischeaperto buyfrom othercountriesratherthanproducingthemselves. BenefitsofTrade  Lower pricesfor consumers o When there is free trade, consumers can free to buy goods from the producer who is willing to sell at the lowestprices.Hence consumersgainfromlowerprices.  Greaterchoice for consumers o With free trade, consumers have access to variety of goods and services from different producers across the globe.Thismeansmore choice.  Abilityof producersto benefitfromeconomiesofscale o Producers have access to a larger market thus they can produce more at lower cost and benefit from economiesof scale.  Abilitytoacquire neededresources o Through free trade producers can not only sell in a large market but also gain from purchasing from suppliersacrossthe world.  More efficientallocationofresources o When there is free trade, the most efficient producers get the opportunity to produce due to their cost efficiency.Thisleadstoproductiveefficiency.  Increasedcompetition o In free trade producers from different regions can compete with each other in terms of price, quality and variety.Increasedcompetitionleadstoefficientallocationof resources.  Source of foreignexchange o Free trade involves the transaction of goods and services between nations. In order to purchase goods from abroad (imports), we need foreign currency. This is possible through exporting of goods to othercountries.
52 Free Trade diagrams Protectionism methods The chief protectionist measures, government-levied tariffs, raise the price of imported articles, making them less attractive to consumers than cheaper domestic products. Import quotas, which limit the quantities of goods that can be imported,are anotherprotectionistdevice. Tariffs A tariff is a tax on foreign goods upon importation. Tariff rates vary according to the type of goods imported. Import tariffs will increase the cost to importers, and increase the price of imported goods in the local markets, thus loweringthe quantityof goodsimported.
53 Quotas An import quota is a type of protectionist that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time. This leads to a reduction in the quantity imported and therefore increases the market price of imported goods. Quotas, like other trade restrictions, are used to benefit the producers of a good ina domesticeconomyatthe expenseof all consumersof the goodinthat economy. Administrative Barriers Countries are sometimes accused of using their various administrative rules (eg. regarding food safety, environmental standards,electrical safety,etc.) asa way to introduce barrierstoimports. Embargo An embargo is the prohibition of commerce and trade with a certain country, in order to isolate it and to put its government into a difficult internal situation, given that the effects of the embargo are often able to make its economysufferfromthe initiative. Subsidies Government subsidies (in the form of lump-sum payments or cheap loans) are sometimes given to local firms that cannot compete well against foreign imports. These subsidies are purported to "protect" local jobs, and to help local firmsadjustto the worldmarkets. Anti-dumpinglegislation Supporters of anti-dumpinglaws argue that they prevent "dumping" of cheaper foreign goods that would cause local firms to close down. However, in practice, anti-dumping laws are usually used to impose trade tariffs on foreign exporters. Externalities,MarketFailure and Import Controls Protectionism can also be used to take account of externalities and dealing with de-merit goods. Goods such as alcohol, tobacco and narcotic drugs have adverse social effects and are termed de-merit goods. Protectionism can safeguard society from the importation of these goods, by imposing high tariff barriers or by banning the importation of the goodaltogether.
54 Non-EconomicReasons Countries may wish not to over-specialise in the goods in which they possess a comparative advantage. One danger of over-specialisation is that unemployment may rise quickly if an industry moves into structural decline as new international competitionemergesatlowercosts. The government may also wish to protect employment in strategic industries, although clearly value judgments are involved in determining what constitutes a strategic sector. The recent trade dispute arising from the decision bythe United States to introduce a tariff on steel imports is linked to this objective. The US steel tariff was declared unlawful by the WTO in July 2003 and eventually the United States was pressurized into withdrawing these tariffs in the late autumnof 2003. Tariffs are not usually a major source of tax revenue for the Government that imposes them. In the UK for example, tariffs are estimated to be worth only £2 billion to the Treasury, equivalent to only around 0.5% of the total tax take. Developingcountriestendtobe more reliantontariffsforrevenue. Economic Argumentsagainst Import Controls Protectionism– hurting customers Tariffs,non-tariff barriersandotherformsof protectionserve asa tax on domesticconsumers.Moreover,theyare veryoftena regressive formof taxation,hurtingthe poorestconsumersfarmore thanthe betteroff.Inthe EU for instance,the nature of existingprotectionmeansthatthe heaviesttaxestendtofall onthe necessitiesof life suchas food,clothingandfootwear. According to Professor JagdishBhagwati, “the fact that trade protection hurts the economy of the country that imposesitisone of the oldestbutstill moststartlinginsightseconomicshastooffer.” The folly of protection has been confirmed by a range of studies from around the world. These indicate that that it has brought few benefits but imposed substantial costs. Among the main criticisms of protectionist policies are the following:  Market distortion:Protectionhasprovedan ineffective andcostlymeansof sustainingemployment. a. Higher prices for consumers: Trade barriers in the form of tariffs push up the prices faced by consumers and insulate inefficient sectors from competition. They penalise foreign producers and encourage the inefficient allocation of resources both domestically and globally. In general terms, import controls impose costs on society that would not exist if there was completely free trade in goods and services. It has beenestimated for example that the recent tariff and other barriers placed on importsof steel intothe US increasedthe price of everycarproducedthere byan average of $100 b. Reduction in market access for producers: Export subsidies, depressing world prices and making them more volatile while depriving efficient farmers of access to the world market. This is a major criticism of the EU common agricultural policy. In 2002 the EU sugar regime lowered the value of Brazil, Thailand and South Africa’s sugar exports by over $700 million – countries where nearly 70 millionpeoplesurviveonlessthan$2 a day.  Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus arising from a lossof allocative efficiency.Welfare isreducedthroughhigherpricesandrestrictedconsumerchoice.  Regressive effect on the distribution of income: It is often the case that the higher prices that result from tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on those products that lower income families spend a higher share of their income. Thus import protection may worsen the inequalities in the distribution of income making the allocation of scarce resources less equitable  Production inefficiencies: Firms that are protected from competition have little incentive to reduce productioncosts.Governmentsmustconsiderthese disadvantagescarefully  Little protection for employment: One of the justifications for protectionist tariffs and other barriers to trade is that they help to protect the loss of relatively low skilled and low paid jobs in industries that are coming under sever international competition. The evidence suggests that, in the long term, tariffs are a costly and
55 ineffective way of protecting such jobs. According to the DTI study on trade published in 2004, since 1997 UK employment in textiles manufacturing has fallen by 45%, in clothing manufacture by nearly 60%, and in footwear manufacturing by around 50% - and this despite the protection afforded to European Union textile manufacturers. The cost of protecting each job runs into hundreds of thousands of Euros for the EU as a whole. Might that money have been spent more productively in other ways? Often there is a huge opportunitycostinvolvedinimposingimporttariffs.  Trade wars: There is the danger that one country imposing import controls will lead to “retaliatory action” by another leading to a decrease in the volume of world trade. Retaliatory actions increase the costs of importingnewtechnologies  Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in total trade will have a negative multiplier effect affecting many more countries because exports are an injection of demand into the global circular flow of income. The negative multiplier effects are more pronouncedwhentrade disputesboil overandleadtoretaliation. The diagram below shows the welfare consequences of imposing an import tariff In a newstudyof the benefitsof global trade andinvestmentpublishedinMay2004, the UK Departmentof Trade of Industry outlinedtheiroppositiontoimportcontrols(protectionism) Higher taxesand higherprices Protectionismimposesadouble burdenon tax payers and consumers.Inthe case of Europeanagriculture,the cost to tax payersisabout€50 billionayear,plusaround€50 billionayearto consumersviaartificiallyhighfoodprices – togetherthe equivalentof over£800 a yearon the annual foodbudgetof an average familyof four. Furthermore huge distortionsininternational agriculture marketspreventthe world’spoorestcountriesfromtrading inthe productstheyare bestable to produce.Continuingbarrierstotrade are costingthe global economyaround $500 billionayearinlostincome. Protectionistpoliciesrarelyachieve theiraims.Theycanbe costly to administerandtheynearlyalwaysprovide domesticsupplierswithaprotectionistshieldthatencouragesinefficienciesleadingtohighercosts. Protectionismisa‘secondbest’approachtocorrectingfor a country’sbalance of paymentsproblemorthe fearof risingstructural unemployment.Andimportcontrolsgoagainstthe principlesof free trade enshrinedinthe theories of comparative advantage.Inthissense,importcontrolscanbe seenasexamplesof governmentfailure arisingfrom intervention inmarkets.
56 Economic nationalism Economicnationalismisatermthat has become usedmore frequentlyinrecentyears.Itisusedtodescribe policies whichare guidedbythe ideaof protectingacountry's home economy,i.e.protectingdomesticconsumption,jobs and investment,evenif thisrequiresthe impositionof tariffsandotherrestrictionsonthe movementof labour, goodsand capital.Economicnationalismmayincludesuchdoctrinesasprotectionismandimportsubstitution. Examplesof economicnationalismincludeChina'scontrolledexchangeof the yuan,andthe UnitedStates'use of tariffstoprotect domesticsteel production.The termgainedamore specificmeaningin2005 and 2006 afterseveral EuropeanUniongovernmentsintervenedtopreventtakeoversof domesticfirmsbyforeigncompanies.Insome cases,the national governmentsalsoendorsedcounter-bidsfromcompatriotcompaniestocreate 'national champions'.Suchcasesincludedthe proposedtakeoverof Arcelor(Luxembourg) byMittal Steel (India).Andthe Frenchgovernmentlistingof the foodanddrinksbusinessDanone(France) asa'strategicindustry'to pre -empta potential takeoverbidbyPepsiCo(USA). Sample IGCSE Questions 1. When the exchange rate of a currency depreciates, the balance of trade improves. Do you agree with this statement?Give reasonsfor your answer.(6) Depreciation is referred to as the decrease in the value of currency relative to another country. It is often linked with the balance of trade, the amount of exports subtracted by the amount of imports. When the balance of the trade improves, this means the value of exports is greater than the value of imports; a trade surplus. This means that the value of exports is cheaper overseas so people are able to buy more of the country’s exports so demand for the good increases and thus they would have higher purchasing power to buy your good. This causes the country to export more. Another reason is that because of depreciation, importsbecome more expensive sodemandforimports decreasesaspricesforimportsrise. However, exports may not rise if another country has depreciated its currency even further or produced that good at a lower cost. Exports may not even increase if there are a lot of substitutes for the good, such as coffee beans. If the exports are inelastic, there is little change in quantity demanded. Countries like Hong Kong are dependent on food and oil, they are forced to pay a higher price and quantity demanded will not fall toomuch. In general,currency depreciationshouldimprove the balance of trade. 2. Apart from depreciation of the currency, identify and briefly explain twomeasures that a government may use to increase exports.(4) a. Demand-side policy  promotion of products made in the country, for example, The British Council has an annual trade fair on British goods to attract more buyers. Similarly, for Hong Kong, it is the Hong KongTrade andDevelopmentCouncil (HKTDC). b. Supply-side policy  Subsidies to export companies to lower production cost and increase supply. For example,China’ssubsidiestosolarpanel producers. 3. To what extent is international borrowing by a developing country likely to lead to an increase in the standard ofliving?Give reasonsfor your answer.(6) International borrowing is when countries or government borrowing money from banks overseas. Standard of living is the welfare of individuals. One example of international borrowing is when the Chinese government borrowed from the International Monetary Fund (IMF) to build the Three Gorges Dam. By building this dam, it allows people in China to have access to clean water which reduces cholera and other water-borne diseases outbreaks and increases their health. Another added benefit of building this dam is
57 that it is a hydroelectric plant and produces a large supply of electricity to power businesses and therefore increase productivity. Irrigation can also be provided by the dam to improve the marginal agricultural areas. Thus, farmers in these areas can produce more agricultural products and increase their standard of living. Another important benefit is that by building this dam, it creates jobs for construction workers as well as engineers,architectsandmanyothers. However, international borrowing results in high interest rates and in the long-term, debt. The disadvantage of building a dam is that the surrounding wildlife and habitat will be destroyed and some people will be relocatedandthus,thiswill decrease theirstandardof living. In conclusion, for the majority of the people, the standard of living will increases due to international borrowing. 4. How does combatting inflationaffectthe exchange rates?(6) Raising benchmark interest rates is the preferred plan of action when it comes to the central bank's fight against inflation. It's the easiest and simplest strategy, and the results can sometimes be quicker compared to other methods. All a monetary body does, in this instance, is increase the benchmark that most commercial and retail banks refer to when creating client loans. These products include mortgage, student and car loans, along with commercial loans for businesses. Once these rates rise, the cost of money increases. This isn't a good thing for customers or companies. (For more on the relationship between interest rates and inflation. Global investors constantly search for high interest rate returns combined with relatively low risk. The same goes for foreign exchange investors. So, when a central bank elects to raise rates, you can be sure that demand for that currency will rise. For example, the Australian dollar benefited from this phenomenon beginning in June 2010. The central bank of Australia raised rates several times between late 2009 and early 2011. By January 2011, the Australian dollar had risen by 26% compared to the U.S. dollar in response As the Australian economy rebounded quickly amid a slumping global economy, the country's central bank was forced to raise rates more than once – by 25 basis points each time – in order to fight inflation. The decisions led to higher demand for the Aussie, especially against the U.S. dollar, during that time. An equally effective strategy for central banks is to raise the reserve requirements of banking institutions. When a central bank elects to raise the reserve requirements, is limiting the amount of money or cash in the system - referred to as the monetary base. An increase in the reserve requirement increases the minimum cash reserve that a commercial bank is governed to hold, so this adjustment prevents the bank from lending out that cash. This restriction of money will slow the rise in prices as there will be less money chasing the same expensively priced goods (hopefully suppressing demand). The Chinese government favors this policy due toits own semi-fixed currency policy. Since the beginning of 2011, the People's Bank of China haselected to raise the reserve requirementthree times –increasingthe rate by50 basispointseachtime. The decision to raise reserve requirements should eventually slow down the inflation of a nation's currency. More often than not, such a decision also helps to fuel the foreign exchange rate's upward trend in value due to speculators.So,the central bank'sdecisionholdssignificanceforthe foreignexchange investor. By increasing the reserve requirement, the central bank is acknowledging that inflation is a problem and is aggressively dealing with it. However, this could increase a currency's attractiveness to forex investors, as they anticipate another round of reserve requirement increases. As the supply of money thins - a result of higher reserves held by banks - speculation helps to support and even propagate a higher currency valuation (thuslowering inflation). Referring back to the Chinese yuan, the effects of speculative demand are apparent: The currency gained by almost 4% following a series of reserve rate increases from June 2010 to January 2011, as speculatorsanticipatedfurtherreserve quotaincreasesforChinese domesticbanks.
58 5. Changes in rate of exchange meant that exports of good from Egypt decreased a they became more expensive inothercountries a. Explainwhat is meantby a rate of exchange.(3) A rate of exchange is the rate at which one currency can be exchanged for another on the global foreign exchange market. It is therefore the market price of one currency in terms of another currency,for example,the price of eurosintermsof US dollars b. If exports from Egypt become more expensive, how might that affect production and employment both in Egypt and in countries importingEgyptian goods? (7) If exports from Egypt become more expensive, global demand for them is likely to fall. Unless global demandisprice inelasticthiswill lose revenue and their profits will fall. In response, exporters may cut back their production and reduce their employment of labour. If exports are a major source of revenue forEgypt,thiscouldresult inasignificantlossof income andhighunemployment. In the country importing Egyptian goods there could be inflation, especially if the Egyptian goods make up a significant proportion of total imports and are used by firms in the production of other goods and services. However, consumers in this country may be able to buy similar products from domestic producers instead. Domestic firms are likely to respond by increasing their output and demand for labour rise. However, if consumers also switch some of their demand to other imported goods from other countries then the potential for growth and employment in their country will be reduced. c. Describe the structure of balance of payments on current account of a country (4) The balance of payments of a country records international transactions with other countries. The current account within the balance of payments records payments made to other countries for visible and invisible imports and payments received from overseas from the sale of visible and invisible exports. The balance of trade is therefore the difference between the value of goods exported and the value of goods imported by a country. The balance of invisibles is the difference between the value of services purchased by overseas firms and residents and the value of services purchasedfromby domesticfirmsandresidents. The current account also records income flows into and out of a country including wages earned by residents working overseas or paid out to migrant workers from overseas, and any international payments of interest, profits and dividends. It also records current transfers including payments of taxesandexcise dutiesbyvisitingresidentsof othercountries,orsimilarpaymentsmadoverseas. d. Discuss what might leadto an improvementinthe current account of a country (6)

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155195918 igcse-economics-revision-notes

  • 1. 1 IGCSE Economics Opportunity cost and the basic economic problem Definition Opportunity cost: the cost of any activitymeasuredintermsof the value of the nextbest alternative forgone(thatisnotchosen) Production: the act of creatingoutput,a goodor service whichhasvalue contributesto the utilityof others Producer: people whomake andsell goods/services Consumption:The final purchase of goodsand servicesbyindividuals Consumer:Individualswhopurchase the good/servicestosatisfytheirwantsandneeds ConsumptionExpenditure : Spendingof consumers Exchange: A marketplace inwhichsecurities,commodities,derivativesandotherfinancial instrumentsare traded Trade: An economicactivitythatinvolvesmultiple partiesparticipatinginthe voluntary negotiationandthenthe exchange of one'sgoodsandservicesfordesiredgoods and servicesthatsomeone else possesses. Entreprenuers:individualswho,ratherthanworkingasanemployee,runs asmall business and assumesall the riskandrewardof a givenbusinessventure,idea,goods, or service offeredforsale. Human resources:the companydepartmentchargedwithfinding,screening,recruiting and trainingjobapplicants,aswell asadministeringemployee- benefitprograms.Alsoknownas Labor. Natural resources:resourcesoccurringin nature thatcan be usedto create wealth Alsoknownas Land. Examplesinclude,seasandrivers. Factors of Production; Definition:inputsthat are usedin the productionof goodsor servicesinthe attempttomake an economicprofit. The factors of productionincludeland,labor,capital andentrepreneurship. Factors 1. Land Land referstothe resourcesavailable includingthe seasnadrivers,forestsanddesertsall mannerof mineralsfromthe ground;chemicalsfromthe airand earth’scrust.
  • 2. 2 2. Labor Labor referstothe physical andmental effortproducedbypeople tomake goods/services.The size and abilityof a economy’slaborforce are veryimportantindeterminingthe quantityandqualityof the goods/servicesproduced.The greaterthe numberof workersthe bettereducatedandskilledtheyare,the more an economycan produce. 3. Enterprise Enterprise referstothe abilitytoruna productionprocess,employandorganize resourcesinafirm(an organizationthatownsa factoryor a numberof factoriesandevenshops,where goods/servicesare produced). 4. Capital Capital referstoalready-produceddurablegoodsthatare usedinproductionof goodsor services.Itisnot wantedforitself butforitsabilitytohelpinproducingothergoods. Itis alsoknownas man-made resources. Divisionof labor/Specialization Definition: A system whereby workers concentrate on performing a few tasks (instead of finishing the entire product by themselves) andthenexchange theirproductionforothergoods/services Advantages 1. More goods/servicescan be produced When workers become specialists in the jobs they do, repetition of the same operation increases the skill and speedof the workerandas a resultmore isproduced. 2. Full use ismade of everyone’sabilities With the division of labor there is greater chance that people will be able to do those things at which they are bestand whichinterestthemthe most. 3. Time issaved Time is wasted when a worker has to switch from one task to another. Time can also be saved when training people. It would take many years to train someone to be able to build a car, for example, but a person can be trainedquicklytofulfill one operationinthe productionprocess. 4. It allows the use of machinery As laborisdividedupintospecialisttasks,itbecomesworthwhiletouse machinerywhichallowsa further savingintime andeffort.Forexample,carsare paintedbymachinesinsteadof byhand.This,inturn,allows machinerytotake overpeople’sjobsleavingmanyunemployed. Disadvantages 1. Work may become boring A workerwhoperformsthe same operationeverydayislikelytobe unsatisfied/low morale.Tocombatthis, manyfirmsplaymusicto theirlaborforces,or allow themtohave a restduringpart of each hour.Longer rest hoursand annual holidaysmayalsobe introducedalthoughthiswill shortenthe workingweek. 2. People become toodependentoneach other
  • 3. 3 Specialisationanddivisiolof labourmeansthatpeople come torelyonothersforthe provisionof goods/services.Forexample,people whoproduce foodrelyonthe provisionof tractors,fertilizers,etc. 3. Workersmay feel alienated Workersmay feel unimportantbecause theycannolongersee the final resultof theirefforts.Some firmsare tryingto reverse thisbyintroducingworkerstoagreatervarietyof tasks 4. Standardization of goods Goodsproducedundera systemof specializationare usuallyturnedoutinvastnumbersandshare the same design.Whetherthisisadisadvantage dependsonpeople’sopinion.Forexample,there isprobablyvariation inthe colorand designinclothestoplease mostpeople.However,itisnotpossibletoplease everyone because inmostfactoriesitwouldbe difficultandexpensive tochange the productionprocesstosuitone person’swantssince mostfactoriespractice massproductioninordertoproduce the greatestnumberof goodsin the lowestcostpossible. What is economics? Economicsisthe social science thatanalyzesthe production,distribution,andconsumptionof goodsandservices.It studieshowindividuals,governments,firmsandnationsmake choicesonallocatingscarce resourcestosatisfytheir unlimitedwants.Economicscangenerallybe brokendowninto:macroeconomics,whichconcentratesonthe behaviorof the aggregate economy;andmicroeconomics,whichfocusesonindividualconsumers. Market Systems Definition: Market: One of manyvarietiesof systems, institutions,procedures,social relationsand infrastructureswherebypartiesengage inexchange.Itconsistsof all those people or firmswhowishto exchange agivengoodor service. Market system: Anysystematicprocessenablingmanymarketplayerstobidandhelping biddersandsellersinteractandmake deals.Itisnot justthe price mechanismbutthe entire systemof regulation,qualification,credentials, reputationsandclearingthatsurroundsthatmechanismandmakesit operate ina social context. Price mechanism: Referstothe consumersandproducerswhonegotiate pricesof goodsor servicesdependingondemandandsupply.Thisisalsoknownas market forces. Types ofmarket systems Market system Free economy Mixedeconomy Plannedeconomy Definition An economyinwhich An economicsysteminwhich An economicsysteminwhich
  • 4. 4 decisionsregarding investment,productionand distributionare basedon supplyanddemandandthe pricesof goodsand services are determinedinafree price system. boththe state and private sector directthe economy,reflecting characteristicsof bothmarket economiesandplanned economies. decisionsregardingproduction and investmentare embodied ina planformulatedbya central authority,usuallybya governmentagency. Advantages  Capital return. Capital flowstowhere itwill get the greatestreturn, expandingthe total size of the economytoits maximumlevel.  Supplyand Demand. Supplyanddemandare closelylinked:Someone whohas a good ideaor productcan quicklyputit intothe marketso that it isavailable tothose who wantit. Conversely, whena certaintype of productis desiredby enoughpeople,itisa simple matterfor someone toprovide it.  Economic freedom. In a marketeconomy,itis easierforsomeone with initiativeandvirtue to create a betterlife for themself andtheir family;economic freedommakesiteaiser to transformhard work and perseverance into material wealth.  Providesfair competition. The presence of private enterprise ensuresthatthere isfair competitioninthe market,andthe qualityof productsand servicesare not compromised.  Well regulated.Market pricesare well regulated.The governmentwithits regulatorybodiesensure that the marketprice do not go beyonditsactual price.  Efficientuse of resources. Optimumutilizationof national resources.Inamixed economy,the resourcesare utilizedefficientlyasboth governmentandprivate enterprisesare utilizingthem.  It doesnotallow monopolyat all. Barring a few sectors,a mixedeconomydoesnot allow anymonopolyasboth governmentandprivate enterprisesenterevery sectorfor business.  Stability.Long-term infrastructure investment can be made withoutfear of a marketdownturn leadingtoabandonmentof a project.  Meetingcollective objectives.Planned economiesmaybe intendedtoserve collective rather thanindividual needs.The governmentcan harnessFOPto serve the economicobjectivesof the state.  Advantages overfree economy.It is notsubject to majorpitfallsof market economiesandmarked- orientedmixedeconomies. A plannedeconomydoes not sufferfrombusiness cycles,doesnotexperience crisesof overproduction.It doesnotresultinasset bubbles –massive misallocationsof resources. Disadvantages  Unequal wealth distribution.a small percentage of societyhas the wealthwhile the majoritylivesinpoverty.  No economicstability. greedand overproductioncause the economyto have wildswingsrangingfrom timesof robustgrowth to cataclysmic recessions.  Inefficient.It'sefficiency propertyreducesin progressivelyhigherdegree, the more its mixednature embracesmore andmore of government/state interventionandState planningandreducesthe reliance oncompetitive marketeconomy managementmechanisms.  Less reliance on competition.Mixedeconomy  Inefficientresource distribution.Planners cannot detectconsumer preferences,shortages,and surpluseswithsufficient accuracy and therefore cannot efficientlyco- ordinate production.  Suppressionofeconomic democracy and self- management. Without economicdemocracythere can be troubleswiththe
  • 5. 5 The ownershipof the factorsof productioncontrols:  What isproduced  Where toproduce  How to produce – the methodof production(labourintensive/capital intensive)  How much goodsandservicestoproduce Production – Productivity & Wealth Creation Definition Productivity:A measure of the efficiencyof production.Itisthe amountof outputthat can be producedfroma givenamountof resources Labor productivity:the amount of goodsand servicesthata workerproducesina givenamountof time Production PossibilityFrontier:A graph thatcomparesthe productionratesof twocommodities thatuse the same fixedtotal of the factorsof production. Profit= Revenue –Cost (Productivity(↑ CELL;FOP) ↓ Cost) Productivity  Labor productivity= Output ÷ No. of workers o E.g. FirmA: 10 unitsof labor & 20 unitsof output FirmB: 20 unitsof labor& 60 unitsof output  Ways to increase productivitymaymean:  Usingsame number of Factors of Production to produce more output  UsinglessFactors of Production to produce same amount of output.  What isincreasedproductivity=lowerbusinesscost  Too competitive.A competitiveenvironment createsan atmosphere of survival of the fittest. Thiscausesmany businessestodisregard the safetyof the general publictoincrease the bottomline. systemhasa natural tendencytomove further and furtherawayfrom reliance oncompetitive marketmechanismtogreater and greaterbureacratic controlsand interventions.  Encourage state monopolies. Mixedeconomysystemstend to encourage more state monopolies,higherand highertax to GDP ratio and dominantpublicfinances, makingthe governmenta large economicplayeras comparedto corporate or individualentities. flow of knowledgeasis shownwiththe initiative for backyardfurnacesand othereffortsinthe Great Leap Forward. Examples USA, Japan,Brazil Canada,Germany,UK China,Cuba,NorthKorea
  • 6. 6  Increased productivity means greater wealth for owners of firms and the economy (in general)  PPF shift outwards(economicgrowth) How to improve productivityof land  Increaseduse of fertilizers –Fertilizersallow previouslybarrenlandto produce crops,and fertile landstoimprove higheryields  Improveddrainage –Reducessoil erosionandassistsinthe reduction of phosphorusin  streams. It allowscropssuch as hay,corn and soybeanstoproduce higher yields.  Improvedirrigation –Indry areas,improvedirrigationwill allow plantstoreceivemore  waterandproduce a higheryield.  Increaseduse of machinery –Machinerysuch as tractors helptake inthe yieldsmuchmore quickly.  Introduced genetically-modifiedhigh-yieldcrops – Genetically-modifiedcropsproduce higheryieldastheycanbe alteredto fightagainstpests,herbicides,cold,disease or drought.  Buildmulti-functionedbuildings(e.g.skyscrapers) - Bybuildingmulti-functionedbuildings, landcan be allocatedmore efficientlyas buildingssuchasskyscraperscan accommodate a wide range of business activities How to improve productivityof labour  Implementdivisionof labor–Divisionof laborallowsproductiontobe more efficient.  Increase use of machinery(to aid tasks) – Machineryallowsthe increase of productionas well asthe qualityof the finishedproducttobe better.  Specialization– There isa higheroutput.Total outputof goodsandservicesisraisedand qualitycanbe improved.A higheroutputatlowercostsmeansmore wants and needsmightbe satisfiedwithagivenamountof scarce resources.
  • 7. 7  Skill training–Skillstrainingincrease productivity.Inadditiontolearninghow tocomplete newtasksand take on more responsibility,employeescanlearnadvanced techniquestohelpthose complete everydaytasksmore efficiently.Also,it improvesjob satisfactionof the employee.Investingtime andmoneyin employees’skillsmake themfeel valuedandappreciated,anditchallenges those to learnmore andget more involvedintheirjobs.Higherjob satisfaction ultimatelyresultsinreducedturnoverandhigherproductivity.  Motivate workers with financial incentives (pay raises, profit sharing), increase job satisfaction (better workingenvironment) Nationalization Definition:The processof takingan industryorassetsintogovernmentownershipbya national governmentorstate.Itusuallyreferstoprivate assets,butmayalsomeanassets ownedbylowerlevelsof government,suchasmunicipalities,beingtransferredtothe publicsectorto be operatedandby the state. Advantages  The abilityof the state to directinvestmentinkeyindustries  The distributionof state profitsfromnationalizedindustriesforthe overall national good  The abilitytodirectproducersto social ratherthan marketgoals  Greatercontrol of the industriesbyandforthe workers  The benefitsandburdensof publiclyfundedresearchanddevelopmentare extendedtothe widerpopulace Disadvantages  Costly management. The management of the nationalized industry is complicated and unwieldy. There are numerousdepartmentsandpaidpersonsi.e.directorate,regional office conductitsmanagement.  Lack of decision making. All the necessary matters are decided by various official and committees. In case of conflictingviews,quickdecisioncannotbe made forthe urgentmatterswhichare dangerousinbusiness.  Lack of efficiency. Nationalized industries are managed by salaried persons who are generally found less efficient as compared with privately owned concerns. There is also lack of flexibility and adaptability which are assetof private ownership.  Bureaucracy. There is extensive and rigid procedure of the state machinery by which event is dealt. Such stipulatedruleshas made the processof workverycomplicatedwhichresultsindelayandlossof initiative.  Absence of profit motive. The salaried persons are not concerned with profit. Therefore, nationalized undertakinghardlyrunsuccessfullydue tolackof personal interest  Chances of loss. The loss of the nationalizedenterprises is regarded as the loss of the nation. So the structure of nationalizedeconomywill greatlyaffectedbythe failure of suchscheme.  Limited investment. Investors hesitate to invest large sum of money due to risk of nationalization. Therefore the volume of investmentremainslimitedinprivatesector.
  • 8. 8 Economic sectors Primary: The extractionof natural resourcese.g.oil drilling,quarrying,forestry Secondary: The manufacturingof goodsusingnatural or man-made resourcese.g.carassembling, propertyconstruction,toymanufacturing Tertiary: The provisionof servicestoconsumersorproducerse.g.education,accounting,marketing Quaternary: The provisionof R&D,software developmentand informationprocessinge.g.research intofiberoptics,developmentof searchengines. Privatization Definition:The incidence orprocessof transferringownershipof abusiness,enterprise,agency,public service propertyfromthe publicsector(the state orgovernment) tothe private sector (businessesthatoperate fora private profit) ortoprivate non-profitorganizations. Advantages  Increased efficiency. Private companies and firms have a greater incentive to produce more goods and services for the sake of reaching a customer base and hence increasing profits. A public organization would not be as productive due to the lack of financing allocated by the entire government's budget that must considerotherareasof the economy.  Specialization. A private business has the ability to focus all relevant human and financial resources onto specific functions. A state-owned firm does not have the necessary resources to specialize its goods and servicesasa resultof the general productsprovidedtothe greatestnumberof people inthe population.  Improvements. Conversely, the government may put off improvements due to political sensitivity and special interests—evenincasesof companiesthatare runwell andbetterserve theircustomers'needs.  Capital. Privately held companies can sometimes more easily raise investment capital in the financial markets. While interest rates for private companies are often higher than for government debt, this can serve as a useful constraint to promote efficient investments by private companies, instead of cross-subsidizing them with the overall credit-risk of the country. Investment decisions are then governed by market interest rates. State-owned industries have to compete with demands from other government departments and special interests.Ineithercase,forsmallermarkets,political riskmayaddsubstantiallytothe costof capital. Disadvantages  Job Loss. Due to the additional financial burden placed on privatized companies to succeed without any governmenthelp,unlike the publiccompanies,jobscouldbe losttokeepmore moneyinthe company.  Natural monopolies. Privatizationwill notresultintrue competitionif anatural monopolyexists.  Profit. Private companies do not have any goal other than to maximize profits. A private company will serve the needsof those whoare mostwilling(andable)topay,as opposedtothe needsof the majority.  Goals. The government may seek to use state companies as instruments to further social goals for the benefitof the nationasa whole.
  • 9. 9 Demand theory Definitions Demand: The abilityandwillingnesstopaya price to purchase a good/service Quantity demanded:The total amountof goods or servicesthatare demandedatany givenpointintime. CeterisParibus:The relationshipbetweenboththe price andthe quantitydemandedof an ordinarygood. Effective demand:the demandfora productor service whichoccurswhenpurchasersare constrainedina differentmarket Notional demand: The demandthat occurs whenpurchasersare notconstrainedinanyother market Individual demand:The abilityandwillingnessof aconsumertopurchase a good/service Deriveddemand: Demandforone goodor service occursas a resultof the demandforanother intermediate/final goodorservice Types ofincome  Real. Income of an individual or group after taking into consideration the effects of inflation on purchasing power.  Disposable. Amount of money that households have available for spending and saving after income taxes have been accounted for. Disposable personal income is often monitored as one of the many key economic indicatorsusedtogauge the overall state of the economy.  Discretionary. Amount of an individual's income that is left for spending, investing or saving after taxes and personal necessities (such as food, shelter, and clothing) have been paid. Discretionary income includes moneyspentonluxuryitems,vacationsandnon-essential goodsandservices. Factors that affect the demand for goods/services  Good's own price. The basic demand relationship is between potential prices of a good and the quantities that would be purchased at those prices. Generally the relationship is negative meaning that an increase in price will induce a decrease in the quantity demanded. This negative relationship is embodied in the downward slope of the consumer demand curve. In other words, the lower the price, the higher demand, ceterisparibus  Price of related goods. The principal related goods are complements and substitutes. A complement is a good that is used with the primary good. Examples include hotdogs and mustard, beer and pretzels, automobiles and gasoline. If the price of the complement goes up, the quantity demanded of the other good
  • 10. 10 goes down. The other main category of related goods is substitutes. Substitutes are goods that can be usedin place of the primary good. If the price of the substitute goes down, the demand for the good in question goesdown.  Personal Disposable Income. In most cases, the more disposable income (income after tax and receipt of benefits) you have the more likely you buy. Any changes in the level of income tax rates and allowances are therefore likely to result in a change in the quantity of goods/services demanded. In a normal good, demand for a product tends to rise as incomes rise. If the demand tends to fall as incomes rise the product is said to be an inferiorgood.  Tastes, preference or habits. The greater the desire to own a good the more likely you is to buy the good. There is a basic distinction between desire and demand. Desire is a measure of the willingness to buy a good based on its intrinsic qualities. Demand is the willingness and ability to put one's desires into effect. It is assumed that tastes and preferences are relatively constant. For example,if consumers around the world are demanding good/services that are environmentally-friendly, the derived demand for those goods/services will increase. Advertising also plays a part. Persuasive and informative advertising tends to increase brand awarenessandas a result,increase the demandforthe good/service.  Consumer expectations about future prices and income. If a consumer believes that the price of the good will be higher in the future he is more likely to purchase the good now. If the consumer expects that her income will be higher in the future the consumer may buy the good now. In other words positive expectationsaboutfuture income mayencourage presentconsumption.  Seasonal demand. A hot summer can boost sales of cold drinks and ices while a cold winter can boost the demandforfuel forheating.  Higher interest rates can increase the demand for savings schemes but reduce the amount of money people wantto borrow,includingmortgagesforhouse purchases.  Population change. An increase in population tends to increase the demand for many goods and services in a country. For example, in a country where there is an aging population, demand for walking sticks and retirementhomesmayincrease.  Location of consumers. There is unequal distribution of income and wealth in different areas of the country. In a richerarea of the country,the demandforsuperiorgoodswill be higherinanareaof low income. Price Elasticity of Demand Definition: PED. A measure usedtoshow the responsiveness,orelasticity,of the quantity demandedof agood or service toa change in itsprice. The elasticityof the demand curve will alsoaffecttheamountof revenue asthe price changes Formula PED = % change in Quantity Demanded PED = (NewQD – Old QD) x100 % change in Price , (NewP – Old P) x 100
  • 11. 11 Inelastic : The PED value isbetween0and -1. Ittendsto have few substitutes,isnecessities,and/orcanbe addictive,e.g.,alcohol,cigarettes,orpetrol. Elastic : The PED value isbetween -1and-∞.It has a lotof substitutesandmaybe an inferiorgood. Revenue Definition: Revenue is the amount received by the producer from the sale of the goods or service. It is calculated by the multiplying the price charged by the quantity sold (R = P x Q). The only difference between revenue and profit isthe costs Price elasticity of Supply Definition: PES: A measure usedtoshowthe responsiveness,orelasticity,of the quantitysuppliedof agood or service toa change initsprice.The PESis alwaysa positive number Formula PED = % change in Quantity Supplied PED = (NewQS – Old QS) x100 % change in Price , (NewP – Old P) x 100 Inelastic :The PED value isbetween0and1. It tendstohave few substitutesandtakestime toalterthe quantityof production. Elastic : The PED value isbetween1and ∞. Note:The amount suppliedisnot always equal to supply and may create shortages and surplus. Economies of scale Definition: Economiesof scale: The cost advantagesthat an enterprise obtainsdue toexpansion. Diseconomiesofscale: The forces that cause larger firms and governments to produce goods andservices at increasedper-unitcosts. Advantages of large-scale production Internal  Lower average unit costs. Scale of production because of a change in the way a firm is run. For example, larger firms can afford more effective advertising. They can spread the cost of advertising over a larger numberof products.
  • 12. 12  Efficiency. For example companies can shut down small firms and open one large firm and paying fewer managers to run it. Another is technological economies, meaning that larger firms can buy more efficient and largermachineryandequipment,leadingtoloweraverage unitcosts  Research and Development.Firmscanaffordto spendlarge amountsonresearchand development  Purchasing. They can afford to buy materials in bulk and therefore the unit costs are cheaper as they may be givendiscountsforbuyinginlarge quantities. External `  Geographical advantage. An area has an excellent reputation for producing a particular good/service or a pool of skilled labour may develop in an area where many firms are concentrated. This helps reduce training costs andprobablymakesrecruitmenteasier.  Risk-bearing economies. When borrowing from a large loan, the company can use assets from profitable firmsare collateralsandspreadthe riskof the loanoverseveral firms.  Firms may cooperate witheach other.  Similar and related firms. There may be firms in the area in related industries with similar expertise and knowledge. Disadvantages of large-scale production  Managerial deos. Breakdown of communicationas firms get too large. This can lead to a delay in making decisions.  Labor deos. Decrease in staff morale as it is difficult to retain close personal contact with staff because of the size of the organization  Jobsmay be brokendownintospecialistpartsandthe workersmayfindtheirjobs toorepetitive and boring. Advantages of small firms  Flexibility. Small firms can adapt readily to consumer needs, designing products to meet individual requirements,whilstsome productscannotbe massproduced.  Industrial relations. The boss of the small firms tends to have a wide general knowledge of the performance of their employees, and may have a friendly relationship. This could increase morale and motivation. There is alsolesschance of poorproductivityasthere are lesspeople insmall firms.  Customer relations. Likewise, small firms are more likely to know their customers and to be able to offer personalized services to their customers. Personal attention is more feasible in small businesses, such as private music/sportstuition.  Local monopoly. Some firms supply only to a small market, and specialist businesses are not interested in these markets.
  • 13. 13 Public and Merit Goods In a mixedeconomythe governmentexistsalongside the freemarkettoprovide certaingoodsandservices.These tendto be publicgoodsand meritgoodsbecause afree market wouldeitherfail toprovidethemornotprovide theminsufficientquantities. PublicGoods These are thingslike streetlighting,coastguard,police,firebrigade,andthe army. Itis clearthat people want streetstobe litandto be keptsafe fromattack so whydoesn’tthe marketreactand satisfythese wants?Whydoyou believethatprivate firmswouldbe reluctanttoprovide these?Theyhave twodistinctive features:Theyare non- rivalry, meaningthatanyone can use it,and theyare non-excludable,meaningthattheycan’tstoppeople fromusing it andit isdifficulttoprevent“free riders”. MeritGoods Merit goodsare not providedenoughby the private sectors because it is not profitable. Theyare thingslike healthcare,education,libraries,sportscenters,countryparks,publichousing,andpublichospitals.Publichousing and hospitalsare publicbecause the people whouse thesefacilitieshave noorlow income toaffordit. Again, people wanttobe keptwell andwantto be educated.The marketcan provide these goods;ESFisa private educationproviderwhilstinthe USA healthcare isalmostexclusivelycarriedoutbythe private sector.Whythenin manycountriesdogovernmentsstepinandprovide healthcare? Trade Unions Definitions Trade Unions: Anorganizationof workersthathave bandedtogethertoachieve common goals,promote andprotectthe interestsof theirmember. Collective bargaining:a processof negotiationsbetweenemployersandagroup of employees aimedat reachingagreementsthatregulate workingconditions andpay. Openshop :A firmthat can employunionizedandnon-unionizedlabour Closedshop :All workersinaplace of workhave to be unionmembers.The closedshopis outlawedinsome countriesbecauseitgave unionstoomuchpowertodictate whoa firmcouldemploy Shop Steward: One of the firm’semployeeswhoisgrantedtime off,duringworkinghours, to deal withtrade unionmatters. Insome largercompanies,ashopsteward may be employed full-time on industrialrelations. Hisor her Wage Councils:These organisationssetminimumwages(notNational)fortheirrelevant industries.Wage councilshave declineddramaticallyinnumberssince 1979. EmploymentLaws: Lawspassedby the governmentorthe EuropeanUnionthat setoutrulesof behaviourforworkers,employersandtrade unionswithregardtoemployment Single unionagreement:Anagreementbetweenanemployeranda unionsuchthat the unionwill
  • 14. 14 representall the workersat a particularworkplace.Thismeansthatone unioncan representall the workers,whatevertheiroccupation,inthe same workplace. Industrial relations: The relationshipsbetweenemployeesand employers Trade UnionsPast and Present– The change of trade unions Since their establishment, the membership and influence of trade unions continued to grow until the early 1980s. The Conservative government at that time responded to public anger over strikes by introducing laws that restricted the unions’ activities. In addition, rising unemployment and the decline in the manufacturing industries (that formed the traditional base of the unions) have reducedunionmembership. The increase in part-time jobs and the increased number of women working have also had an impact on union membership. In the past, neither of these groups have been strong supporters of trade unions. In addition, the 1980s and 1990s have seen a dramatic increase in the number of self-employed people - who are not usually unionized. In response, unions have tried to improve their image by making their services more appealing and relevant to today’s world - e.g. the ATL union (Association of Teachers and Lecturers) has a “no strike” policy. Many unions now offertheirmembersloans,mortgages,insurance,creditcards,discountholidayvouchersanddiscountcarhire. Today, some trade unions also provide grants for college courses, or arrange retraining programmes (the process of developing new skills), for their members who have been made redundant. In addition, they also provide representatives for members in cases of redundancy, grievance, disciplinary hearings and legal action (e.g. on equal pay). Trade UnionMembershipAround the World According to the International LabourOrganisation, only 25% of the world’s 1.3bn workers were members of trade unions in November 1997. However, since the ILO also concluded that trade unions are adjusting to the realities of today,it islikelythattrade unionmembershipwill increase overthe nexttenyears. In a recent ILO survey of 92 countries, only 14 had a unionised workforce of over 50% (and 48 countries had less than 20%). Resultsof selectedcountriesare shownbelow Trade Union Densityin selected countries(ILO): Country 1995 density % change since 1985 Sweden 91.1 +8.7 Italy 44.4 -7.4 SouthAfrica 40.9 +130.8 Australia 35.2 -29.6 UK 32.9 -27.7 Germany 28.9 -17.6 NewZealand 24.3 -55.1 Japan 24.0 -16.7 USA 14.2 -21.1 SouthKorea 12.7 +2.4
  • 15. 15 France 9.1 -37.2 Source:adapted fromILOLabourReport1997 Types ofTrade Unions Although the number of trade unions and the number of members in unions have declined steadily since 1979, we can still distinguishbetweenfourdifferenttypesof trade unions: 1. Craft Unions These are the oldest type of unions, which were formed originally to organize workers according to their particular skill. For example, engineers and printers formed their own respective unions. Today, the GPMU (Graphical, Paper and Media Union) has members working in the printing, paper, publishing and media industries. The decline in the demandforsome particularcrafts hasledto many of the olderunionstorecruitsemi-skilledandunskilledworkers. 2. Industrial Unions These unions attempt to organise all workers in their industry, irrespective of their skills or the type of work done. The National Union of Mineworkers (NUM) is an example. National Union of Teachers (NUT), Trade Union Congress (TUC) 3. General Unions These unions are usually prepared to accept anyone into membership - regardless of the place they work, the nature of work, or industrial qualifications. These unions have a very large membership of unskilled workers. The TGWU (Transport and General Workers Union) is a very large General Union in the UK. Their members include drivers, warehouse workers,hotel employeesandshopworkers. 4. ‘White Collar’Unions Also called non-manual unions and professional associations, these recruit professional, administrative and clerical staff (salaried workers) and othernon-manual workers. They are very strong in teaching, banking, the civil service and local government. The Role/Functions/AimsofTrade Unions The primaryrole of Trade Unionsis to protectthe workers’ interests. Examplesinclude:  Collective pay bargaining – trade unions are able to operate openly and are recognized by employers, they may negotiate withemployersoverwagesandworkingconditions.  Subscription – Early trade unions, like Friendly Societies, often provided a range of benefits to insure members against unemployment, ill health, old age and funeral expenses. In many developed countries, these functions have been assumed by the state; however, the provision of professional training, legal advice, support for members that are mad redundant and representation for members is still an important benefit of trade unionmembership.  Political activity – Trade unions may promote legislation favorable to the interests of their members or workers as a whole. To this end they may pursue campaigns, undertake lobbying, or financially support individualcandidatesorparties(suchasthe Labour Party inBritain) forpublicoffice.
  • 16. 16  Industrial action– Trade unions may enforce strikes or resistance to lockouts in furtherance of particular goals. Aims ofthe Trade Union  Defendingtheiremployee rightsandjobs  Securingimprovementsintheirworkingcondictions,includinghoursof workandhealthandsafetyof work  Improvingtheirpayandother benefits,includingholidayentitlements  Improvingsickpaypensionsandindustrialinjurybenefits  Encouragingfirmsto increase workerparticipationinbusinessdecisionmaking  Developingandprotectingthe skillsof Unionmembers. Aims ofthe workers: Workerswill aimtomaximize:  HigherWages – matchinginflation(index-linksalariestoCPI)  Jobsecurity – no sackingwithoutnotice orreasons  Workingconditions - Health&Safety;workinghours  Careerprogressionopportunities:Trainingandup-to-date information  Healthand Safetyatwork  Perks,Healthinsurance,pensions,car,educationallowance Aims ofthe employers For the employer,targetstomaximisemayinclude:  Profits  Sales  Lowercosts Industrial disputes Definition: Disputeswiththe workforce and/ortheirrepresentatives - andanyresultingindustrial action - are costly and damagingtoboth the businessandworkers. Causes 1. Economic Cause  Demand for increase in wages on account of increase in all-India Consumer Price Index for Industrial Workers.  Demandforhighergratuityand otherretirementbenefits.
  • 17. 17  Demand for certain allowances such as: House rent allowance, medical allowance, demand for paid holidays and reductionof workinghours,Betterworkingconditions,etc. 2. Personnel Causes. Sometimes, industrial disputes arise because of personnel problems like dismissal, retrenchment,layoff,transfer,promotion,andmore vacationsetc. 3. Indiscipline. Industrial disputes also take place because of indiscipline and violence on the part of the workforce. The managementstocurb indisciplineandviolence resorttolock-outs 4. Misc. causes. Some of the other causes of industrial disputes can be workers' resistance to rationalization, introduction of new machinery and change of place, non-recognition of trade union, rumors spread out by undesirable elements, working conditions and working methods, lack of proper communication behaviour of supervisorstointer-tradeunionrivalry. How collective bargainingis organized Definition:the processwherebyrepresentativesof the workers(inaparticularindustry) negotiate say paysettlements - withrepresentativesof the employers(inthatindustry). Generally, an individual worker is in a weak bargaining position - the main purpose of a trade union is to remove this weaknessby“forcing”the employertonegotiate withthe representativesof his/herworkforce. Trade unions are autonomous bodies - they have complete freedom to act in their own interests. Most unions, however, are affiliated to the Trade Union Congress (TUC), which is the largest trade union. It has an important role in bringing trade unions’ points of views on a national scale, possibly affecting government decisions - e.g. the TUC have beenat the forefrontof the National MinimumWage negotiations. If the more powerful unions make full use of their bargaining strength, they could succeed in getting larger and/or more frequent wage increases than the weaker unions. This highlights the importance of “unionisation” within trade unions - the largerand more unitedthe union,the betterthe bargainingposition,ceterisparibus. How is it organized Collectivebargainingisorganizeddependingonthe relationshipbetweenaunion andfirmsthat employunionized labor.  In a openshop,a firmcan employunionizedandnon-unionizedlabor  In a closedshopall workersina place of work have to be unionmembers.The closedshopisoutlawedin some countriesbecause itgave unionstoomuchpowertodictate whoa firmcouldemploy.A unioncould alsocall the entire workforce inafirm/industryoutonstrike.Inthese ways,aunionmayact like amonopoly and restrictthe supplyof labourso as to force upthe marketwage fora job/occupation.  A single unionagreementallowsauniontorepresentall the workers,whatevertheiroccupation,inthe same workplace.Thisisusuallyinreturnforcertaincommitmentsfromthe uniononpayor productionlevels,and for agreeingnottotake strike action.Negotiatingwithasingle unionratherthanseveral ata time ismuch easierfora firm. The ChallengesfacingTrade Unions
  • 18. 18  Decline of manufacturingindustries  Growth inpart-time employment  Switchfrommale to female employment(intermsof percentage increases.  Co-operationwithmanagement  Governmentlegislation(whichseekstoreduce unioninfluence) The Basis for Wage Claims Trade uniondemandsforhigherwagesare normallybasedonone ormore of the following: 1. A rise inthe cost ofliving(e.g.due to inflation) hasreducedthe real income of theirmembers. 2. Workersincomparable occupationshave receivedawage increase. 3. The increasedprofitsinthe industry justify ahigherreturnto labour. 4. The productivityof labourhasincrease How can Trade Unionsraise wages? 1. Restrictingthe Supplyof Labour Unions can restrict the supply of labour in an industry, for instance, by pushing for longer apprenticeships or tough examination(entry)requirements. Thisincreasesthe wage rate inthe industryfrom W1 toW2 inthe diagrambelow. S2 S1 W2 W1 D Q2 Q1 Employment However,aproblemhasarisen - the quantityof labourable to enterthe industryisrestrictedby Q1 to Q2.
  • 19. 19 2. Increasingthe Demand for Labour Unions can influence the demand for labour by use of productivity deals. They try to persuade workers to increase productivity (which in turn helps to increase the Marginal Revenue Product of Labour - recall that the MRPL is the demand for labour). In return, trade unions negotiate wage increases for their members, justified by their increased productivity. SL W2 W1 D2 = MRPL2 D1 = MRPL1 Q1 Q2 Employment Externalities Calculations Social Costs= Private + External Costs Social Benefits = Private + External Benefits Definition  Social costs and benefits are therefore the costs and benefitsincurred by the entirety of society (producer, consumerand third party) as a resultof the production and/or consumptionof a good or service.  Privatecosts and benefits are the costs and benefits incurred by individuals directly involved in the production and/or consumption ofa good or service.  Where no marketfailure existssocial costswouldbe equal toprivate costs.  If external benefits exist more of the said good should be produced and consumed (it is being under- consumedorunder-produced)thusthe marketsystemisnotsupplyingthe optimumresource allocation.  If external costs exist than less of the said good should be produced and consumed (it is being consumed or producedinexcessivequantities) thusthe marketsystemisnotsupplyingthe optimumresource allocation.  Firms and individuals will not consume/produce any good or service unless the private benefit of their activityexceeds the privatecostincurredintheiractivity. The governmentwill make sure that:  Merit goods (goods with external benefits) are encouraged (to prevent under-consumption or under- productionfromoccurring.)  Demerit goods (goods with external costs) are discouraged (to prevent over-consumption or over- productionfromoccurring.)  Demeritgoods do not have priceswhich account for theirexternal costs. Productivity deals have the effect of raising the MRPL curve from D1 to D2, thereby raising wages from W1 to W2. The advantages of this method are that productivity deals help to increase the supply of and demand for labour.
  • 20. 20  Smokingandalcohol are examplesof demeritgoods. The governmentwill:  Subsidize merit good producers to reduce the costs of production and thereby encourage production of such goods whilst causing prices to be lowered as a result of the increase in supply and the decrease in prices of productioncausedbysubsidization.  Tax demerit good producers to increase the costs of production and thereby discourage production of such goods whilst causing prices to increase as a result of the decrease in supply caused by taxations as well as by the increase inthe price of production.  Sometimes the government may choose to nationalize certain industries that are producing externalities to regulate andcontrol themand soforce themtoproduce at the sociallyoptimumlevel.  Laws and regulations –Limits on the level of emissions of certain chemicals through use of the law and a finingsystemtopunishfirmsforinfringement.  Ban on the use of certain chemicals which may result in significant external costs through use of the law and a finingsystemtopunishanyinfringement.  Forcing firms to internalize all costs: Pollution permits (these can be traded to firms who can then pollute more at a reasonable price). Pollution permits are given out to firms by the government before any trading is done. (Equivalent and derived from the Carbon Credits used internationally to restrict national pollution). But this scheme is costly (administration costs are high) to implement, it is difficult to measure pollution levels accurately, rich firms may simply buy their permits off poorer firms and so pollution may not have been decreasedatall,itis hard to calculate how manypollutionpermitstogive out.  If external benefits exist then the public would be willing to pay more for a certain good to assure that it is producedat the sociallyoptimumlevel.(Increase indemand,extensionalong the supplycurve).  If external costs exist that the public would be willing to pay more to assure that it is produced at the socially optimumlevel.(Decrease insupply,contractionalongthe demandcurve.) Government Regulation These are used to:  Promote competition.  Resolve externalitieswhere marketfailure exists:  Provisionof publicgoods.  Taxingdemeritgoods.  Enforce law andorder. Influence the location offirms:  Preventovercrowdingincities.  Preventregionsfrombeingneglected. Governments do not desire oligopolistic or monopolistic markets as such markets areuncompetitive when compared with competitionbasedmarkets. Often,a governmentwill restrictthe formation of such markets by:  Breakinguplarger firmsintosmallerones  Providingincentive forotherfirmstosetupinthe market  Preventingmergesthatmayprove detrimentaltocompetition How does the governmentregulate private enterprises?  Investigate existing monopolies and suggesting ways in which competition may be introduced into these monopolist-dominatedmarkets.  Investigate proposed mergers and prevent such merges from taking place if they are believed to be detrimental tocompetition.
  • 21. 21 Influencingthe Location of Firms: Whyis this done?  o Some regions may be economically depressed, usually due to the decline of a traditional industry (this may leadto regional unemployment).  o Some regions may be overcrowded with too much pollution, traffic congestion, insufficient housing and publicservicesasa resultof toomany firmschoosingtosetup inthe said regions. How is this done? Give firmsincentivesto set up indepressedregions:  Lowloan interestrates.  Grants forthe constructionof infrastructure.  Grants forthe trainingof workers.  Tax holiday/allowance.  Lowrent/free premises.  By buildingandimprovingthe infrastructure presentinthe saiddepressedregion.  Persuade firms in congested regions to move to depressed regions (stop granting licenses to operate in a congestedregion). Monopoly Definition:A monopolyisasituationwhere the marketisdominatedessentiallybyone firm.The legal definitionof “monopoly”isa firmthathas 25% or more marketshare inthe market. Advantages and Disadvantages of Monopolies Advantages  Firmsusuallymakeshigherprofits  The firmcan use profitstoinvestinnew or improve uponexistingproducts  Price Maker because doesnotface any competitors  Economies of Scale: Increased output will allow average unit prices of production to drop. This can be passed onto consumers in the form of lower prices, so customers may be more inclined to buy the firms products in the future.  A firmmay become amonopolythroughefficiency;A monopolyisthusasignof successand not inefficiency. Disadvantages  Consumersmayhave to payhigherpricesdue tolack of competition  Consumershave lesschoice because marketisdominatedbythe monopolisticfirm.  Lessinnovationof products  Firms may not be efficient with allocation and utilization of resources because they do not have any pressure to reduce costs. Oglipoly What is it?  An oligopolyexistswhenthereare several dominate firmsinone market.  If there are only two sellers in one market than that the market structure of the said market is a duopoly whichis a special case of an oligopolisticmarket.  Examples include the petroleum industry, TV broadcasting industry (duopoly in HK), supermarket industry and the bankingindustry.
  • 22. 22  Please note that, as a general rule of thumb, even if a market has hundreds of providers, if the top 3 –7 providers together possess 50% or more of the market’s total market share then that market is said to be oligopolistic. Main Features  A few sellers dominate market supply/or a few sellers supply a major part of the total market supply irrespectiveof the total numberof smallersuppliersinthe market  The same goodsbutwhichare heavilydifferentiatedbyuse of advertising,brandingandothersuchmethods.  These firms produce similar but heavily differentiated products; this differentiation makes the goods look differenttothe consumer.(Heterogeneousgoods)  These firms engage in many forms of non-price competition but rarely deign to involve themselves in price based competition as such competition can lead to price wars which only benefit the consumers and no one else.  Brand image isoftenveryimportantforsuchfirms.(Coke andPepsi test). 1. Oligopolistic firms will advertise a lot more than monopolists in the attempt to build a strong brand image and to differentiatetheirgoodsfromthe productsof theircompetitors. 2. If one firm has a better brand image, even with an inferior product, the said firm may be able to sell more of its productthan anotherfirmwitha worse brandimage.  Entry into such markets is restricted either because of governmental decrees or because of the huge startup capital or technology requirements needed in order to open shop in the said market. Furthermore, because of the furious level of competition between existing oligopolistic firms, these firms generally produce at a very low price, a feat which would be very difficult for smaller firms which do not wield the same level of economiesof scale asthe largeroligopolisticfirms.  Market information is restricted and often incomplete as no firm knows what another competitor will do. To combat this, such firms often collude to form cartels (trade agreements) and conduct themselves with all the advantages,anddisadvantages,of monopolists.These agreementsare generallyillegal.  The actions of one firm will affect what the other competing oligopolistic firms will do as such firms will react veryquicklytothe actionsof a competitor.(Sellersare highlyinterdependent). Barriers to Entry  Existingfirmsare well establishedandhave strongbrandimages.  Existingfirmsenjoyeconomiesof scale andare much more efficient.  Existingfirmsenjoycustomerconfidence.  The government may have issued rules that govern entry, sometimes for a certain number of years, into a certain market. These rules would have been put in place to encourage entrepreneurs to enter into a market where one wouldrequire large startupcapitals.(Mobilephone industryinChina). Pricing Strategies:  Price wars.  Price Leadership:  When the dominate firm in a market determines the price of a good other firms have no choice but to follow their example or lose market share unless they choose to lower their prices even further and risk a price war.  Sometimestheywill evencollude topreventprice warsfromhappening. Price collusion:  Forminga cartel.  Predatorypricingotherwiseknownasdestructionpricing.
  • 23. 23 Advantages  Economiesof scale (lowaverage costachievedonaccountof a highlevel of output).  Excess(abnormal orsupernatural) profits.  Promotes research and development because these firms can spread the potential costs involved in R&D overa much largerrange of income sourcesthusloweringthe riskof R&D. Disadvantages  Loweroutputlevelsandhigherpricesasthese firmscontrol suchthings  Lesschoice for consumers.  The needforgovernmentregulationtopreventoligopolyfirmsfromoverusingtheirpowers. Economic growth Definition Recovery: The periodwhere the economymovesbetweenarecessionanda boom. Boom: This periodisfasteconomicgrowth.Outputisvery highdue toincrease indemand,and unemploymentisverylow.Additionally,consumersmay be confidentaboutthe economy so thismay leadtoextraspending Recession:EconomicGrowthslowsdownandlevel of outputmayhave a negative impact. Unemploymentincreasesandconsumersare likelytosave insteadof spend,sothere is lessmoneycirculatinginthe economy. Slump: A periodwhere outputstartsto decrease.Consumerconfidence mayalsobegintodeplete. GDP: The total or national outputof a country overa periodof time. GDP  It measuresthe total amountof income earnedina macro economy – national income.  Changesusedtomeasure economicgrowth – Real change in GDP over time.  National Output = National Income = National Expenditure  Total value of outputproducedbyall domesticfirmswithineconomy.  GDP = Consumption+ GovernmentExpenditure +Investment+ Net imports  Some of the output income will flow overseas, as people from other countries may achieve output in your economy  GDP ismeasuredintermsof money.  However, money is subject to change in its value and inflation. To solve this problem, the real value of output or GDP is adjusted for inflation so we know how much is really generated from economic growth and howmuch issimplydue to risingprices. Inflation Definition Inflation:A general andsustainedrise inthe level of pricesof goodsandservices –prices of vast majorityof goodsand servicesonsale toconsumerskeepsrisingovertime. Stagflation: Persistenthighinflation combinedwithhighunemploymentandstagnantdemandin a country's economy.
  • 24. 24 Hyperinflation:Pricesrise atphenomenal ratesinshortperiodsof time,renderingmoney worthless. Usually,the inflationrate isindouble digits Deflation:The pricesof goodsand servicesfall. Thisisusually negative inflation. Disinflation:Fall inthe rate of inflation. Ideas  Price change overtime (inflation) isalwaysgivenperperiodof time.  Deflation can be a cause for concern – deflation will usually occur when demand for goods and services are falling,causingfirmstolose profits,profitsandreduce workforce.  This will reduce household incomes, causing further reduction in goods and services. The value of debts heldbypeople andfirmswill rise inreal terms aspricesfall andburdenof makingloanrepaymentsrises.  Eventuallythe economygoesintorecession. How to measure inflation Measuredby • CPI (ConsumerPrice Index) • RPI (Retail Price Index) 1. A base yearor startingpointis chosen.Thisbecomesthe standardagainstwhichprice changesare measured. 2. A listof itemsboughtbyan average familyisdrawnup.Thisis facilitatedbythe LivingCostsandFoodSurvey. 3. A setof weightsare calculated,showingthe relative importance of the itemsinthe average familybudget- the greaterthe share of the average householdbill,the greaterthe weight. 4. The price of each itemismultipliedbythe weight,adjustingthe item'ssizeinproportiontoitsimportance. 5. The price of each itemmustbe foundinboththe base yearand the year of comparison(ormonth). Thisenablesthe percentage change tobe calculatedoverthe desiredtime period. Calculating the CPI/RPI:  Indicesexpresschange inpricesof anumberof differentproductsasa movementinasingle number.  Average of ‘basket’of productsinfirstyearcalculationor base year isgiventhe number100.  If on average the basketrisesoverall by25% nextyear,thenindex becomes125.  If in second year it rises another 10%, then 125 x 1.1 = 137.5 – 37.5 becomes average price rise in two year period.  To construct a CPI, a sample of households are taken and surveyed – their spending patterns observed for 12 monthswhichisthe base year. The proportion of income spenton each category is recorded.  Average prices of differentgoodsandservices(minusfuel andfood) are recordedfromasample of shops.  The proportion of income spent on each category is used to weight average prices of each type of good/service tofindtheirweightedaverage prices.  This shows how big an impact a change in price of a particular type of good or service will have on cost of livingforthe average household.  The proportional of household income spent on a certain type of good/service is multiplied by the average price of the good/service purchasedin the category, to generate its weighted average price – these weighted pricesare thenall addedtogether,whichisthe overall average price forgoodsandservicesinthe basket.
  • 25. 25  The weighted total price of the basket can be compared each year to work out percentage changes in average consumerprices. Uses of CPI/RPI Data: 1. As economic indicator – CPI is widely used measure of price inflation, and therefore is measure of changesin cost of living. Governments try to control inflation using macro-economic policies. The CPI will be used by workers to seek wage increases, and used by entrepreneurs in business making concerning purchases and settingwage andprices. 2. As a price deflator – Rising prices reduce purchasing power, value, of money. Rising prices can therefore affect real value of wages, profits, pensions, savings, interest payments, tax revenues and other economic variables important to people and decision making. CPI therefore used to deflate other economic series to calculate real inflation-free values. i.e. wages go up 10% but inflation is 15%, therefore real wages fallen by almost5% less. 3. Indexation – involves tying certain payments to rate of increase in CPI. E.g. pensions may be indexed. Similarly, savings may be index-linked, meaning interest rate is set equal to CPI, protecting real value of people’s savings. Many workers may also be covered by collective bargaining agreements that tie wage increases to CPI changes. Government may alsoindex threshold at which people start to pay tax or higher tax ratesto stop people payingmore orlesstax. Problems with Price Indices:  Overtime typical householdbasketof goodsandserviceswill change.  CPIneedstotake account of this,butdecidinghow andwhento make themcan be difficult.  Changesdue to: o Fashionandtaste o Introductionof newgoodsandservices o Change in population and household size due to migration, birth/death rates, marriage timing and numbersetc. o Similarly CPI needs to take into account changes in quality of goods and services over time, how and where householdsbuygoodsandservicessuchasinternetandnew shops. o International comparisons of CPIs are hard to make due to different household compositions and spendingpatterns. o Argued that exclusion of food, energy, house prices and income taxes means CPI cannot accurately measure change of livingcost. Inflation  Economiststodaytendto agree maincause of inflationis ‘toomuchmoneychasing too fewgoods.’  This means people are able to increase spending on goods and services faster than producers can supply goodsand services,boostingaggregate demandandforcingpricesup.  A government can allow supply of money to increase in an economy by issuing more money or allowing bankingsystemtocreate more credit – lendingmore topeople andfirms.  A governmentmaydosoto : o Increase total demandineconomytoreduce unemployment. o In response toincrease indemandforgoodsandservicesforgoods. o In response toworkersdemandforhigherwages,orrise inotherproduction costs. o As moneysupplyrises,people’spurchasingpowersrise andinflationcanoccur. o To stop excessive inflation, a monetary rule government’s should follow is to only allow supply of moneytoexpandat same rate as increase inreal outputorreal GDP overtime. o If moneysupplyincreasesfasterthanoutput,theninflationwill occur. o Stagflation – when inflation and unemployment are both high and increasing – often due to rising livingcostscausingincreaseddemandforhigherwagesandlesslabourdemand. Causesof inflation  Increase in MoneySupply – an increase inmoneysupplywouldincrease the spending
  • 26. 26 power of the average consumer, thus increasing demand and hence pushing up prices. This then causes inflation.  Demand Pull Inflation– Whenaggregate demandisincreased,firmsare nolongerable to meet demand in production and thus prices inflate. To finance this, firms may borrow more or money supply increased.  Cost Pull Inflation – When the cost of producing goods is increased, firms may want tooffset these increased costs to consumers to keep a certain level of profit, thus the extra cost is added to price of the good or service,causing inflation. Wage Price Spiral is when workers demand higher and higher wages, causing cost pushinflationandpromptingthemtoaskfor higherwagesagain.  Imported Inflation – rising prices in one country may be exported to another country through international trade in many different goods and services. Many countries have been able to enjoy stable inflation as China’slarge supplyof goodsandservicesisproducedthroughcheaplabour. Consequences and Costs of Inflation:  Personal Costs: o Reduce purchasingpower o Real income falls o People likepensionersandstudentsonfixedincomeswillsufferfrominflation. o Low paidand non-unionizedworkersoftenfailtogetsufficientrisestostopreal income falling. o Professionalworkersmayaskforwage increasesthatprotector cause increasesinreal wage levels. o Saversand lendersmaybe hurtby inflationrate if interestisless. o People whoborrowedmaybenefit. o Demand-pull inflation increased spending can boost company profits, while cost-push may reduce profits. Rising profits could yield more tax, however government may have to pay more for goods and services. o Economical Costs:  Possible unemployment –purchasingpowerdrops,lessdemand  Some people save more,reducingeconomicactivityandoverall output  Causesgoodsand servicestobecome uncompetitive internationally  Benefits:  Economicgrowth  Reduce debtvalues –fallingvalue of moneyreducesreal debtvalues  Higherstockvalue  Valuesof fixedassetscouldrise –financial security  Possible increasedemployment  Stimulate technological advancement Economic Growth and Inflation Most governments hope that they can achieve steady economic growth without it causing acceleration in demand- pull and / or cost-push inflationary pressures. The dangers of a booming economy is that inflationary pressures build and that the economymustslowdownorfall intorecessionforthese inflationriskstobe controlled.
  • 27. 27  During the early part of the last decade, the British economyenjoyed a period of steady growth and relatively lowand stable inflation  In 2007-08 the trade-off betweengrowthandinflationworsened  Inflationsurgedhigher–mainlybecause of external factorssuchashighfoodand oil prices  The economysufferedasteepdescentintorecessionfollowingthe global financial crisis  In early 2009 the economy experienced recession and higher inflation – some economists warned of a lengthyphase of “stagflation”conditions  Inflation fell back largely because of the recession. But in 2010 and into 2011, inflation has been rising again whilstGDPgrowthhas beenweakwiththe riskof a seconddownturn(a“double-dip”) Stagflation Stagflation is a period of economic stagnation accompanied by rising inflation. In other words, both of these key macro objectives are worsening. It can happen when an economy goes into a downturn or a recession but when other external forces are bringing out higher inflation. The obvious example of this is when recession is afflicting a country but the prices of imported products are surging causing prices to rise and real incomes and profits to fall. The rise in the cost of imports can be shown by an inward shift in the short run aggregate supply curve leading to a contractionin real national outputandan increase inprices. One of the dangers of stagflation is that the fall in real incomes causes consumer and investment spending to fall and thus the rate of economic growth suffers too (a deterioration in a third objective of policy). Wage demand may also pick up as people experience rising prices. The central bank needs to consider appropriate policy responses to this. Too severe a tightening of monetary policy for example will help to curb inflation but risk causing a deep recession. The combinationof deflationandasustaineddropineconomicoutputistermedaneconomicdepression An improvement in aggregate supply can help to resolve the growth – inflation trade off. We see in the diagram how aggregate supply has moved outwards and this allows aggregate demand (C+I+G+X-M) to operate at a higher level withoutthreateningapersistentincrease inthe general price level (inflation).
  • 28. 28 Overcominga conflictbetweeneconomicgrowth and inflation – increasesin AD and AS Conflictsbetweenobjectives –the economicsofdeflation Deflation is a sustained fall in the prices of goods and services, and thus the opposite of inflation. Increased attention has focused on the impact of price deflation in several countries in recent years – notably in Japan (inflation -0.3% in 2010) and in some Euro Area countries such as Ireland Greece where prices have been falling, national output has droppedand unemploymenthasbeenrising.
  • 29. 29 It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can be caused by rising productive potential, which leads to an excess of aggregate supply over demand. Greece has suffered from a severe rise in unemployment (right hand scale) and is now seeing her relative living standardsfall.A deflationary depression isa risk for Greece Possible damagingconsequencesofpersistentprice deflation  Holding back on spending: Consumers may postpone demand if they expect prices to fall further in the future.  Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people’s willingness to spend. This isespecially the case withmortgage debtsandotherbig loans.  The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. If inflation is negative, the real cost of borrowing increases and this can have a negative effect on investmentspendingbybusinesses  Lower profit margins: Lower prices hit revenues and profits for businesses - this can lead to higher unemploymentasfirmsseektoreduce theircostsbysheddinglabour.  Confidence and saving: Falling asset prices including a drop in property values hits wealth and confidence – leadingtodeclinesinADandthe threatof a deeperrecession. Resolvingthe threat ofprice deflation  UsingexpansionaryMonetary Policy o Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and therebyboostconsumption o Quantitative Easing – printing money in the hope that, by injecting it into the economy, people and companieswill be more likelytospend.  UsingexpansionaryFiscal policy o Keynesian economists believe that fiscal policy is a more effective instrument of policy when an economyisstuckin a deflationaryrecessionandaliquiditytrap o The key Keynesian insight is that a market system does not have powerful self-adjustments back to full-employment after there has been a negative economic shock. Keynes talked of persistent under- employment equilibrium – an economy operating in semi-permanent recession leading a persistent gap betweenactual demandandthe potentiallevel of GDP.
  • 30. 30 Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to get aneconomy onthe path back to full(er) employmentandtopreventdeflation. Unemployment Definition Frictional Unemployment:Occursas workerschange jobsand spendtime withoutjobsduringthis period. Seasonal Unemployment: Occurs when consumer demand for certain goods and services are seasonal, and as a resultpeople are onlyemployedduringperiodsof time. Cyclical Unemployment:Occurswhenthere istoolittle demandforgoodsandservicesinthe economyduringa recession,andfirmsare producinglessasaresult, employinglesslabourasa result. Structural Unemployment:Occurswhenthe labourmarketisunavailabletoprovide jobsforall workersbecause of a mismatchbetweenthe worker’sskillsandthe skill requirementof the jobs.Itarisesfromlong-termchangesinthe structure of the economy,asentire industriesclose downdue tolackof demandforgoodsand servicestheyproduce.Workerswhobecome unemployedandhave skillsnolongerneededare occupationally immobile. Voluntary Unemployment:Voluntaryunemploymentincludesworkerswhorejectlow wage jobs whereasinvoluntary unemploymentincludesworkersfireddue toan economiccrisis,industrial decline,companybankruptcy,or organizational restructuring. International labour organization The International Labour Organization (ILO) measure of unemployment assesses the number of jobless people who want to work, are available to work and are actively seeking employment. It is used internationally so comparisons can be made between countries. It also enables consistent comparisons over time. The ILO measure is calculated using data from surveys of a country’s labour force; it can therefore be subject to sampling differences betweenone country and another. It differs from the claimant count unemployment tmeasure, which only includes people claiming unemployment-related welfare benefits. The ILO measure gives a higher figure than the claimant count measure as it includes those who are classified as available for work but who are not claiming jobless benefits. The ILO measure may include students who are actively seeking work but may not qualify for jobless benefits. Similarly, second earners within a household may be reluctant to claim jobless benefits but would be classified as unemployed underthe ILO measure astheyare available forwork. Government Policy Definition Monetary policy:The processbywhichthe government,central bank,ormonetaryauthorityof a countrycontrolsthe supplyof money,availabilityof money,andcostof money or rate of interest,inordertoattain growthand stabilityof the economy. Fiscal policy: Governmentpolicythatattemptstoinfluence the directionof the economythrough changesingovernmenttaxesorthroughsome spending.
  • 31. 31 Expansionary policy: Contractionary policy: Government macroeconomic objectives and policies Most of the governmentsroundthe worldhave fourmainobjectives.These are  Keepinflationundercontrol  Maintaina lowlevel of unemployment  Achieve ahighlevel of growthrate  Maintaina healthybalance of payments. GovernmentEconomicPolicies Governmentinfluencesthe economythroughitseconomicpolicies.These are Fiscal Policy It is related with taxes and government spending. This policy is there to control inflation and demandin the economy. Usually government collects money in the form of taxes and spends money through its development expenditure such as building roads, bridge, defense, transports etc. Government constantly monitors the aggregate demand in the economy.Inflationrate givesthe correctmeasure of the aggregate demandinthe economy. When the aggregate demand in the economy is high, prices rise, this shows that the economy is spending too much. In this case, the government will lower is expenditure budget and cut back on investment spending, such as on road construction and hospital equipment. On the other hand the government might also increase the taxes, which would take spending power out of the economy by leaving consumers and businesses with less income to spend. In the opposite scenario, when the economy is heading for a recession and unemployment is rising, the government might increase its expenditure plans. There might be a reduction in taxes so as to leave consumers and businesses withhigherdisposable incomes. Monetary Policy Monetary Policy is related with a change in interest rates by the government or the Central bank. When the forecast for inflation is that it will rise above the targets set by government, then the Central Bank will raise its base rate and all other banks and lending institutions will follow. It is usually done when the economy is at the boom stage of the businesscycle. A higher interest rate will resultin…businesswillnotbe able toexpandastheyhave to pay more interesttothe bankfor theirloansandtheyhave lessprofitleft.Businessesthatare planningtotake loanfor expandingmay postpone theirdecisionsandwaitfora cut ininterestrates.Consumersdemandwillalsofall astheywill notbe gettingcheaploanstopay for the buyingnewhousesandluxuryitems. If inflationislowandisforecastedtoremainbelow governmentstargets,thenthe Central Bankmaydecide to reduce interestrates. Supplyside policies It includesall those policieswhichaimatimprovingthe efficientsupplyof goodsandservices.These mightinclude:  Privatization  Impartingtrainingandimprovingthe educationlevel of the workforce resultinginhigherskills.  Increase competitioninall industriesbyremovingentrybarriers,thusleadingtomore efficiency.
  • 32. 32 Factors causing a change incomponents ofAD Change in consumption A change inconsumptioniscausedbyany of the followingfactors  Changesin income:Income increasesconsumptionincreasesandvice versa.  Changes in interest rates: Fall in interest rates will make borrowing money cheaper. Consumers will now be tempted to take loans and purchase goods and services. Consumption will rise. On the other hand if the interest rates increase, borrowing becomes expensive. Consumers will be more tempted to save rather than spend.Consumptionwillfall.  Changes in wealth: A rise in house prices or the value of stock and shares makes a person feel wealthy. Consumersfeel more confidentandtendtospendmore .  Changesin consumer confidence:Higherconsumerconfidence islikelyleadtoincreasedconsumption. Change in Investment  Interest Rates: If interest rates are low firms will find it easy to borrow funds for investment. Investment increase wheninterestratesfall.  Changes in National Income: If the national income increases, firms will have to invest further to increase output(inducedinvestment).  Technological change: Regular changes in technological front demand firms to invest in order to keep up withthe changesand remaincompetitive.  Business Confidence: The economic environment in an economy is a major factor in determining the investment level. When an economy is showing signs of healthy growth, firms will have positive expectation and will invest in expanding their facilities and to meet higher demands in the future. During troughs firms will be more conservativeintheirinvestmentsandthusADwill be affected. Change in GovernmentExpenditure GovernmentExpendituredependson  Macroeconomics objectives: If the government is considering increasing employment then it might increase itsspendingonpublicprojects.  Condition of the economy: During phases of slow economic growth, government is more likely to increase its spendinginordertostimulate the economy. Changesin net exports Exports are domesticgoodsboughtbyforeigners.Exportswillrise when  Foreignersincome rise  Exchange rate of the exportingcountryisfalling.  The economyfollowsamore liberal trade policyi.e.free trade increase  Inflationrate inthe economyiscomparativelylowerthanitstradingpartners. Imports are the goodsboughtfrom foreigncountry.Importswillrise when  Domesticincome rises.Thisisbecause peoplewillincreasetheirconsumptionandthusimportswillincrease.  Exchange rate of the importing country increase. Now it becomes cheaper for the country to purchase from outside astheircurrencyisstrongerthan theirtradingpartners.  If the economyisfollowingaliberal trade policyi.e.free trade increases.  Inflationrate ishigh Possible conflictbetweenmacroeconomicobjectives  It israre for a country to achieve all of itsmainobjectivesatthe same time  Frequently conflicts appear between the different aims and as a result, choices might have to be made about whichobjectivesare tobe givengreatestpriority.
  • 33. 33  This will vary from one country to another since the needs of different nations will differ according to their stage of economicdevelopment. Here are some possible policyconflicts:  Inflation and unemployment: Falling unemployment might create demand-pull and cost-push inflationary pressuresleadingtoa fall inthe value of money  Economic growth and environmental sustainability: Rapid economic growth and development frequently puts extra pressure on scarce environmental resources threatening the sustainability of living standards in the future  Economic growth and inflation – an overheating economy may suffer accelerating inflation which then has negative effectsontrade performance,businessprofitsandjobs  Economic growth and the balance of payments: Strong GDP growth fuelled by high levels of consumer demand for goods and services might lead to a worsening of the trade balance. This is particularly true when an economyhasa highmarginal propensitytoimport. Unemploymentandinflation – the PhillipsCurve concept  Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemploymenttorise  If a Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the productmarkets. The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product marketsfroman increase innational income,outputandemployment.
  • 34. 34  The labour market: As unemployment falls, labour shortages may occur where skilled labour is in short supply. This puts pressure on wages to increase and prices may rise as businesses pass on these costs to their customers.  Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so doesthe deriveddemandforcomponentsandraw materials. Product markets: Rising demand can lead to suppliers raising prices to increase their profit margins. The risk of rising pricesisgreatestwhendemandisout-strippingsupply-capacityleadingtoexcessdemand(i.e.apositive outputgap.) Fiscal policy The two maininstrumentsof fiscal policyare governmentspendingandtaxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:  Aggregate demandandthe level of economicactivity.  The patternof resource allocation.  The distributionof income. How fiscal policywork High rate of inflation High rate of inflation is caused by too much aggregate demand in the economy. Government will use deflationary fiscal policy. Government will try to influence aggregate demand by reducing its public spending. The government will spend less on construction of roads, bridges and other public spending and thus aggregate demand will fall. On the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable income outpeople’spocketresultinginalowerdemand.
  • 35. 35 Low rate ofinflation In an economic recession, aggregate demand, output and employment all tend to fall.Now the Government wants to increase employment in the economy, it can attempt to do so by increasing aggregate demand. The Government will increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so that people have more disposableincome tospendandinstigate demandinthe economy. Role of fiscal policies The two maininstrumentsof fiscal policyare governmentspendingandtaxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:  Aggregate demandandthe level of economicactivity.  The patternof resource allocation.  The distributionof income. AD=C+G+I+(X-M)
  • 36. 36 As we can see in the above equation that G (Government Expenditure) is a component of AD, it can be used by Government to influence AD in the economy. The government can use expansionary or deflationary fiscal policy to getthe desiredresults.Let’sdiscusseachpolicyindetail. Expansionary fiscal policy Expansionary fiscal policy is used to increase the Aggregate demand in the economy. If the economy is having a deflationarygap,the governmentcanuse expansionaryfiscal policytoreduce the gapor totallyeliminate it. Deflationarygap Deflationary gap is the difference between full level of employment and the actual level of output of the economy. We can see inthe diagrambelow,thatthe economyisoperatingalevel ‘a’below the Yf (full levelof employment). The consequence is that due to deflationary gap all the resources of the economy are not being usedin the optimum level and they are idle. This results in unemployment and low level of output. This is not desirable for any government.Inordertoreduce/eliminatethe deflationarygap,the governmentuses expansionaryfiscal policy. Government will either increase its spending or reduce taxes (or both) in order to stimulate the aggregate demand. Increase Government spending will result me more projects being funded by the government and thus employment and output will increase. Even a lower tax rate will result in more disposable income for households and encourage consumption. Increased G and C will leadtohigherAD.However,thismightalsoleadtohigherprices/inflationinthe economy. Contractionary fiscal policy Contractionary fiscal policy involves the reduction of government spending and increase taxes as a measure to control inflation/AD in the economy. With reduced government spending, the AD will fall and thus reduce pressure on the economic resources and the average price level in the economy will come down. Similarly, increased taxes will take away the excess disposable income from the households and result in a fall in AD. Contractionary fiscal policy is thususedto reduce the inflationarygap. Inflationarygap Inflationary gap is when the Aggregate demand exceeds the productive potential of the economy. As we can see through the diagram, the economy is operating at a level above the full employment level of the output. Due the
  • 37. 37 limitation of the economy to fulfil this increased demand the average price level in the economy increases resulting ininflation. Problemsof fiscal policy Reduce incentive to work Raising taxes on income and profits reduce work incentives, employment and economic growth. An effort to reduce aggregate demand may cause disincentives to work, if this occurs there will be a fall in productivity and Aggregate supplycouldfall. Adverse effectofloweringPublicSpending Reduced government spending to Increase Aggregate demand could adversely affect public services such as public transportand educationcausing marketfailure andsocial inefficiency. ‘Crowdingout’ effect With an increase in government expenditure, there will be greater competition for limited resources. This will offset private investmentsresultinginshrinkingof the private sector. Inaccurate forecasting If the Government’s estimate or forecasting is wrong or inaccurate the fiscal policy will suffer. For example, if a recession isexpected and the government practices deficit budget, and yet the recession turns out to be a boom,this will cause inflation. Implementationofthe Policy Planning for the spending is done once by most of the governments. If there is a delay in the implementation of the fiscal policy,itmightreduce the effectivenessof the policy. Thusthe time lagisimportant. Poor Information Fiscal policy will suffer if the government has poor information. e.g. If the government believes there is going to be a recession, they will increase AD, however if this forecast was wrong and the economy grew too fast, the government actionwouldcause inflation.
  • 38. 38 Time Lags If the government plans to increase spending this can take a long time to filter into the economy and it may be too late.Spendingplansare onlysetonce ayear. There isalsoa delayinimplementinganychangestospendingpatterns. Budget Deficit Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget deficit which has many adverse effects.Higherbudgetdeficitwill require highertaxesinthe future andmaycause crowdingout(see below Other ComponentsofAD If the government uses fiscal policy its effectiveness will also depend upon the other components of AD, for example if consumerconfidence isverylow,reducingtaxesmaynotleadtoan increase inconsumerspending. Dependson Multiplier Change ininjectionsmaybe increasedbythe multipliereffect;thereforethe size of the multiplierwill be significant. Monetary Policy Monetarypolicyisgenerallyreferredtoaseitherbeingan expansionarypolicy,or a contractionary policy. An expansionary policy increases the total supply of money in the economy and is traditionally used to combat unemployment in a recession by lowering interest rates. Lowered interest rates encourage the household and the firms to increase their consumption and investment respectively. This will shift the AD to the right and result in higherreal outputandmore employment. Contractionary policy decreases the total money supply and involves raising interest rates in order to combat inflation. The result will be that investment will fall, and consumption will fall. All of these changes will shift the AD to the left.
  • 39. 39 It is argued that an increase in the money supply causes an increase in the rate of inflation. Maintaining a low and stable inflation is one of the main macroeconomic objectives of the Government. Government does so by controlling the supplyof moneytothe economy.Thispolicyisknownas monetarypolicy. Monetary policy in any country is usually controlled by the Central Bank of that country. The Central bank alters the interestratesinthe economyafterassessingthe inflationarypressuresinthe market. Monetary Policytools Central Bankhas three toolsof monetarypolicy: Openmarket operations  Openmarket purchases:The central bankbuysgovernmentsecuritiestoincrease the monetarybase.  Openmarket sales:The central bank sellsgovernmentsecuritiestodecrease the monetarybase. Openmarketoperationshave anumberof advantages:  Theyare underthe directand complete control of the central bank  Theycan be large or small.  Theycan be easilyreversed.  Theycan be implementedquickly Discount loans When a bank receives a discount loan from the central bank, it is said to have received a loan at the “discount window.”The Central Bankcan affectthe volume of discountloansbysettingthe discountrate:  A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discountloans.  A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discountloans. Discountlendingismostimportantduring?nancial panics:  Whendepositorslose con?dence inthe ?nancial system, theywill rushtowithdraw theirmoney.  Thislarge depositout?owputsthe bankingsystemingreatneedof reserves.  The central bank stands ready to supply these reserves by making discount loans. In such situations, the central bankacts as a lenderof lastresort. Changesin reserve requirements The portion (expressed as a percent) of depositors' balances banks must have on hand as cash. This is a requirement determined by the country's central bank. It affects the money multiplier; changes in the required reserve ratio can leadto changesin the moneysupply.Thisisalsoreferredtoasthe "cashreserve ratio" (CRR).
  • 40. 40 How money supplyworks Money supply includes all the notes and coins in circulation with the public plus the money with banks. It also includes the deposits in banks and building societies. The later is more significant supply of money and is usually the target of Governmentsmonetarypolicy.The waysthroughwhichGovernmentcontrolsthe moneysupplyare: Openmarket operations Government usually sells treasury bills and bonds to raise money. Private individuals invest in these bonds and bills in orderto get a healthyrate of interest.Thisreducesthe depositswithbanksandthe moneysupply. Variation of legal reserve requirements Usually, the commercial banks have to maintain a certain percentage of their assets as depositwith the Central Bank. When the Central Bank wants to reduce money supply it will increase the limit of the deposit kept by the banks. The commercial banksare leftwithlessmoneytolendtotheircustomers. Central banks Central Banks are charged with regulating the size of a nation’s money supply, the availability and cost of credit, and the foreign-exchange value of its currency. Regulation of the availability and cost of credit may be designed to influence the distribution of credit among competing uses. The principal objectives of a modern central bank in carrying out these functions are to maintain monetary and credit conditions conducive to a high level of employment and production,areasonablystable levelof domesticprices,andanadequate levelof international reserves. Functionof a Central Bank A central bankusuallycarriesoutthe followingresponsibilities:  Implementationofmonetary policy.  Controlsthe nation'sentire moneysupply.  The Government'sbankerandthe bankers'bank("Lenderof Last Resort").  Manages the country'sforeignexchange andgoldreservesandthe Government'sstockregister;  Regulationandsupervisionof the bankingindustry  Setting the official interest rates- used to manage both inflation and the country's exchange rate - and ensuringthatthisrate takeseffectviaa varietyof policymechanisms Role of taxation in promoting equity Tax isa fee charged("levied") byagovernmentonaproduct, income,oractivity. Whytaxes are imposed? There are differentreasonsforimposingtaxes.  To finance government expenditure. One of the most important uses of taxes is to finance public goods and services,suchasstreetlightingandstreetcleaning.  To reduce consumptionof goodsthatcreatesnegative externalities.  To control the amountof importedgoodsi.e.tariffs  Usedas a part of fiscal policytocontrol aggregate demandinthe economy.  To control income inequality. Classificationoftaxes Progressive taxes A progressive tax isatax imposedsothatthe tax rate increasesasthe amountsubjecttotaxationincreases.Insimple terms,itimposesagreaterburden(relative toresources)onthe richthan on the poor.It can be appliedtoindividual taxesor to a tax systemas a whole.Progressive taxesattempttoreduce the tax incidence of peoplewithalower ability-to-pay,astheyshiftthe incidencedisproportionatelytothose withahigherability-to-pay.The resultispeople withmore disposable income payahigherpercentage of thatincome intax than do those withlessincome.
  • 41. 41 Regressive Tax The opposite of a progressive tax isa regressive tax,where the tax rate decreasesasthe amountsubjectto taxation increases.Itimposesagreaterburden(relative toresources) onthe poorthanon the rich.Regressive taxesattempt to reduce the tax incidence of people withhigherability-to-pay,astheyshiftthe incidence disproportionatelyto those withlowerability-to-pay. Proportional Tax A proportional tax isone thatimposesthe same relative burdenonall taxpayers—i.e.,where tax liabilityandincome grow inequal proportion.Insimple terms,itimposesanequal burden(relativetoresources) onthe richand poor. Proportional taxesmaintainequal tax incidence regardlessof the ability-to-payanddonotshiftthe incidence disproportionatelytothose withahigheror lowereconomicwell-being. Types oftaxes Direct Taxes It isa tax paiddirectlytothe governmentbythe personsonwhomitisimposed. Examples  Tax imposedonpeoples’income-Incometax  Tax on wealth –wealthTax  Tax on firm’sprofits.- corporate tax IndirectTaxes Indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the consumer). The intermediary later files a tax return and forwards the tax proceedstogovernmentwiththe return. Indirect taxes are generally included in the price of goods and services, so are less obvious to those paying the taxes than directlevies. Thusindirecttaxesare alsoknownasexpendituretax orconsumptionbasedtax. Examples  GST (Goodsand service tax)  VAT(Value addedtax)  Consumers are charged a percentage of tax while purchasing a good/service and then the seller pays the tax collectedtothe Government. Other measuresto promote equity The governmentsalsoundertake expenditurestopromote income equity.Theseinclude Subsidies Provide directly, or to subsidize, a variety of socially desirable goods and services. These include health care services, education,andinfrastructure thatinclude sanitationandcleanwatersupplies. Transfer payments Government provides various kind of assistance to low income groupsin the society. The objective is to support them in maintaining a reasonable standard of living and to lower inequality. These payments are given directly to these groups in the form of monetary help. Examples include Social Security, unemployment compensation, welfare, and disabilitypayments. Government policy to control inflation Governmentusesanumberof policiestodeal withthe differenttypesof inflation.These are:
  • 42. 42 Demand Side policies-tocontrol demandpull inflation Deflationary fiscal policy: This involves an increase in taxes and lowering of government spending. Increasing taxes will result inlower disposable income for household and thus less consumption. Moreover, increased taxeswill result inlowerprofitsforfirmsandthus lessinvestmentbyfirms.Allthese factorswill lowerthe ADin the economy. Deflationary monetary policy: It involves rising of interest rates and reducing money supply. Higher interest rates mean higher loan and mortgage repayments. This will deter households and firms to borrow, leading to fall in consumptionand investmentrespectively. Supplyside policies-tocontrol cost pushinflation It includesall those policieswhichaimatimprovingthe efficientsupplyof goodsandservices.These mightinclude:  Privatization  Impartingtrainingandimprovingthe education level of the workforce resultinginhigherskills.  Increase competitioninall industriesbyremovingentrybarriers,thusleadingtomore efficiency. Exchange rate policiesto control importedinflation This involves increasing the value of currency to reduce importedinflation. Increase currency rate will alsolead to fall indemandfor exports(componentof AD). International aspects Definition Exchange rate: The price of one’scurrencyintermsof anothercurrency Foreignexchange market: The marketwhere currenciesare boughtandsold. Exchange control: Limitsonthe amountof foreigncurrencyavailabletoimporters,which consequentlylimitimports Appreciation:The rise in value of a currencyagainstothers.Exportswill become more expensive abroad andimportscheaperat home. Depreciation:The fall invalue of a currencyagainstothers.Exportswill become cheaperabroad and importsexpensiveathome. Devaluation:Depreciationbroughtaboutthe government,normallybyagovernmentwhich fixes the value of itscurrency. Exports: The movementof goodsorcommoditiesoutof the country. Imports: The movementof goodsorcommoditiesintothe country. Protectionism:Policyof protectingdomesticindustriesagainstforeigncompetitionbymeansof tariffs,subsidies,importquotas,orotherhandicapsplacedonimports. Free trade: A systemof trade policythat allowstraderstotrade across national boundaries withoutinterference fromthe respective governments.
  • 43. 43 Globalisation What is it?  It is the increasingintegrationof countries’individual economies.  It is the global movement towards trade, financial and communications integration through the development of free trade, free flow of capital, and the freedom to tap into cheaper foreign factor markets. (Official definition) Benefits  Most efficientformof production:  Because firmswill choose toproduce where costsare lowest.  Stimulatesthe economy,particularlythatof LEDCs, bydrawinginmore foreigndirectinvestment.  Employmentopportunities  Openingjobs. Training • Introducesskillsandtechnologytonationsthroughacompany’simplementationsof such:  Thisincreasesthe productivityof anation’sworkforce,etc. • OpeningnewindustriesinLEDCssuchas the white phosphorusminingindustryinYemen. • Increasescompetition:  Lowers prices  Lessinflation.  Betterqualitygoods.  Betterefficiency. Costs • Environmental damage.  Because the companyis sopowerful thatitcan affordto operate inefficientlyforconveniencessake. • Creates uncertainty:  Foreignfirmsownmostof the marketshare ina country,notdomesticfirms. • May choose to source theirresourcesfromabroadandnot fromlocally:  Thus local resource producerswill gooutof business. • Human rightsabuses.  Infringementsonindigenousrights. • Terrorism. • Investmentsinnationsfacingpolitical sanctionsasaresultof theirwrong-doings. • Leaching from governmentfunds:  Large MNCs may be too important for a government to allow to go bankrupt thus whenever said MNC is facingtroublestheywill be givenaidbytheirgovernment. • Price manipulation. • Labour abuse:  Childlabour.  Bad workingconditions.  Poor healthcare.  Sweatshops.  Bad wages.  Restrictionstorestinghours.  Anti-Labour-Unionpolicies. • Usingtactics detrimental to competition:  Predatorypricing.  Monopolypower.
  • 44. 44 • Tax evasion:  Through transferpricing. • Using illegal methodsandmaterialstoproduce goodsandservices.  Or to force people tobuytheir goodsor services:  Great AmericanStreetcarscandal. • Blockingof technologies:  Bribery.  Blockingbatterytechnologyforhybridcarssoone can sell more oil.  Concealmentof imports.  Causingtrade deficit:  Wal-Mart is accusedof beingone of the largestsourcesof the trade deficitinthe USA. Objections Third world debt.  Debt in the developing, less developed or least developed third world countries in Africa, Asia, Latin America and the Middle East.  Globalizationis leaching resourcesfrom these countries and the revenue generated from this leaching is not fed back into these countries. Furthermore, with population growth causing the needs and wants of these countriestoalsogrow, these countriesare fallingintodebtinordertopay forthese needsandwants. • Animal rights. • Childlabour. • Anarchism. • Anti-capitalist Exchange rates Demand for and Supply of a currency Thisis whatdeterminesexchange rate inafree-floatingexchangerate system:  Whena currencyhas strong demanditwill appreciate invalue.  In contrast,whenthere isa large scale sellingof acurrency itwill depreciate. Demand for a currency:  Exportsand importsof goods/services o If a country has a decline in export industries and earnings, yet its people continue buying imports, the exchange rate islikelytofall.  This is possibly not true for countries such as Hong Kong which are dependent on imports of oil and food. o Fewer exports will mean less demand for the currency to pay for them, so the demand for the currency will decrease. o Thiswill leadtodepreciation o Whena currency has depreciated,thismakesthe countries’exportscheaperabroad. o Thus,exportsshouldbecome more competitive overseas.  Price elasticityof demandforimports o Whena currency depreciates,importsbecomemore expensive. o If the demandforimportsisprice elastic,thisshouldleadtoafall inexpenditure onimports o Thissituationisfoundwhere importscompetewithhome-producedalternatives. o When countries import necessities, such as food and oil, demand tends to be price inelastic so expenditure riseswhenthe currencyfalls. • Pure speculative demand. o Speculatorsoftenpurchase currenciesthattheythinkwill appreciate invalueagainsttheirowncurrency. • Official buyingof the currencybythe central bank. o Thismightbe done forinvestmentorspeculationorsecurityorotherreasons.
  • 45. 45 • Comparativelyhigherdomesticinterestrate. o Thus savers will be likely to convert their own money into your currency to save in your nation and enjoy the comparativelyhigherdomesticinterestratesyouoffer. Supplyof a currency  Importsof goodsand services.  Outflowsof directinvestment.  Outflowsof portfolio investment.  Speculative sellingof the currency.  Official sellingofthe currency by the central bank.  Rate ofinterestabroad. Appreciationand Depreciation • Foreignerswilltendtosave moneyinone’snation.  Thus the demandforone’scurrency riseswhichcan cause one’scurrencyto appreciate ingeneral. • Depreciationmeansthatthe value of the currencyintermsof othercurrenciesgoesdown: • If the USD depreciatesagainstthe RMB thenitwill take fewerRMBto buyeach USD. • If 1 Euro was worthHKD 10.2 at the start of the year. • It may depreciate if the Greek government declared that it would withdraw from the Eurozone and go back to usingthe Drachma in orderto depreciate theircurrency. • Thiswill cause otherstolose confidence inthe Euroandspeculationwillcause people tosell the Euro. • Thismay endupcausingthe Euro to depreciate toHKD7 perEuro. • In this case the Euro has depreciated against the HKD because it now takes more Euros to purchase each HKD. • But the HKD has appreciatedagainstthe Eurobecause itnow takesfewerHKDto buy1 euro Advantages of a Strong Currency  Lowerimportprices – This boostslivingstandardsof consumers.  An increase in the real purchasing power of HK residents traveling overseas for business and leisure purposes.  Cheaper to import raw materials, components and capital inputs – causes an outward shift in short-run aggregate supply.  Improvementinthe termsof trade (lowerimportprices).  Helps to control RPI inflation – Domestic producers face stiff international competition and must keep their prices down. Lower inflation allows the MPC/HKMA to keep nominal interest rates at a lower level than if the exchange rate wasweak.  An increase in a country’s relative position in international league tables showing real GDP per capita when expressedinacommoncurrency:  Even if one’s GDP, as measured in one’s own currency, is no more than previously, because one’s currency has appreciated in value, the GDP of one’s nation will also increase when it is translated into another currency. Disadvantages of a Strong Currency • Cheaperimportsleadtorisingimportpenetrationandlarge trade deficit: • Import penetration means that a larger portion of the goods and services provided by a nation’s firms is now providedbyforeignfirms. • Exportersalsolose price competitivenessandmarketshare thuscausinga trade deficit. • Damagedprofitandemploymentinsome sectorstowhichexportingisthe keymeansof generatingrevenue. • Negative impact on economic growth (exports – injections of aggregate demand, imports - leakages of wealth formthe circularflowof income).
  • 46. 46 • Some regions which have a higher than average dependency on exporting industries are more affected than others. Balance of Payments on Current Accounts What is it?  It is a set of accounts that record a country’s international transactions and which (because double entry bookkeepingisused) isalwaysinbalance withnosurplusordeficitshownonthe overall basis.  It serves to highlight a country’s competitive strengths and weaknesses and helps in achieving balanced economicgrowth.  Because the international market isso large it is unlikelytoadhere to the businesscycle.  Therefore, a country which has a healthy BoP account will likely have balanced growth because the levels of investment, consumption and capital of the international market is unlikely to fluctuate much and will grow steadily.  The demand from the international market is unlikely to fluctuate much and will grow steadily therefore investment and capital will also grow steadily (this growth happens because people are getting richer, world populationisgrowing,etc.).  Capital inthiscase shouldindicate the moneyinvestedinbusinessesto generate income:  If investments grow so too will capital because capital is the money already invested and investments are the source of capital. The Balance of PaymentsAccount  The currentaccount, capital accountand financial account.  The capital and financial accountsusedtoknown collectivelyasthe capital account. The BoP is always balanced  When the news talks about a BoP surplus or deficit they are usually referring to the net transactions of the CurrentAccountor just the Balance of Trade.  Calculatedbysubtractingthe total value of importsfromthe total value of exports BoT isBalance ofTrade  Positive figure (surplus)–Value of imports< Value of exports.  Negative figure(deficit) –Value of imports>Value of exports.  A negative BoP indicates that a country’s exports are not competitive enough to compete with those producedbyothercountries:  Thus there isa net leakage of wealthfromthe country. Correctingtrade imbalances Large trade imbalances,whetherabigdeficitora bigsurplus,can cause problemsfora national economy. Problemswith a trade surplus  There may be political and economic pressure on the government from other countries to reduce its trade surplussotheycan reduce theirtrade deficits  Exporting firms will enjoy significant overseas revenues – profits and wages may rise – but the increase in demandmaycause demand-pushinflation  A surplus causes the value of the currency to appreciate or stay high, and may eventually reduce demand for exportsandcause a lossof jobs.
  • 47. 47 Problemswith a trade deficit  If more money is paid out for imports than is earned from exports then this loss of money from an economy may mean less can be spent on domestic goods and services. Domestic firms facing a fall in demand for their productsmay cut back productionandtheirdemandforlabourresultinginhigherunemployment.  The value of the exchange rate will fall, causing imports to become more expensive and resulting in imported inflation. If demand for price-inelastic goods or services falls, more money will be paid out for imports and the demandfordomestically-producedgoods/serviceswill decrease.  The trade deficit might be a symptom of a declining industrial base, with fewer firms in the economy over time producinggoodsandservicesforexport. Economic growth and trade balance A period of fast growth may come into conflict with the balance of payments. Much depends on the income elasticity of demand for traded goods and services. In the case the UK, the evidence is that consumers have a high propensity to consume imports; the income elasticity of demand is strongly positive. Say for example, real disposable incomes grow by 3% and that the income elasticity for imports = +2.5. That would lead to a 7% rise in the volume of imports. Unless there is a corresponding rise in exports, we expect to see a worsening of the balance of trade (i.e. a widening trade deficit). In a recession, this effect works in reverse as demand for imported products including raw materials, components and ready to consume goods and services declines. The trade balance will improve although the root cause is a drop ineconomicactivity. Correctingtrade balances 1. Do nothing,asa floatingexchangerate will correctit. Trade deficitsandsurplusescanbe self-correctingif allowedtoadjustfreely. 2. Fiscal policy A contractionary fiscal policy is when the government may cut public expenditure and raise taxes to reduce the total demand in their economy so people have less to spend on imports. This will help reduce the trade deficit. However, a fall in demand may also affect domestic firms, who may cut output and employment in response tothe fall indemand An expansionary fiscal policy is when the government lowers tax rates and raise public expenditure. This boosts spending on imports and help to correct a trade surplus. However, it may also help domestic firms if demandfortheirgoodsand servicesalsorises,andmayhelptohaltany decline inthe industrial base. 3. Monetarypolicy An expansionary monetary policy is when the government attempt to attract more inwards investments to their economy to help offset a trade deficit by raising interest rates. Higher interest rates will also make borrowing more expensive and reduce the demand for loans by consumers and firms that may be used to pay forgoodsand servicessuppliedoverseas. A contractionary monetary policy is when the government lowers interest rates to help correct for a trade surplus by lowering the cost of borrowing from firms and consumers, and will lower the return overseas investorscanexpect ontheirinwardinvestmentsinthe economysothattheyinvestelsewhere instead. 4. Protectionism This is when a country uses trade barriers such as tariffs to make imports more expensive or limit the amount of importsinorderto correct a trade deficit.
  • 48. 48 Visible and Invisible Visible Trade Visibletrade involvestradingof goodswhichcanbe touchedandweighed.Examplesincludetrade ingoodssuchas Oil,machinery,food,clothesetc. VisibleTrade consistsof  Visible exports:Sellingof tangible goodswhichcanbe touchedandweighedtoothercountries.  Visible imports:Buyingof tangible goodswhichcanbe touchedandweighedfromothercountries. Balance of trade It isthe difference betweenthe value of visible exportsand value of visibleimportsof acountry. If the value of visibleexportsismore thanvisible importsthe countrywill have asurplusbalance of trade. If the value of visibleimportsismore thanvisibleexportsthe countrywill have anUnfavourablebalance of trade. Invisible trade Invisibletrade involvesthe importandexportof servicesratherthangoods. Example include servicessuchas insurance,banking,tourism,education. If a UK studentcomesto Singapore tostudy,itwouldbe invisibleexportforSingapore asitisearningforeign exchange byprovidingeducationalservices. If a Singapore citizentravelstoUKfor a holiday.Itwill be invisible importforSingapore andinvisibleexportforUK. Balance of invisible trade It isthe difference betweenthe value of invisible exportsandvalue of invisible importsof acountry. Comparative advantage The theory of comparative advantage states that a country should specialise in the production of good or service in which it has lower opportunity cost and it should import commodities which have a higher opportunity cost of production. Example Suppose for example we have two countries of equal size, Northland and Southland. Both produce and consume two goods, Food and Clothes. The productive capacities and efficiencies of the countries are such that if both countries devotedall theirresourcestoFoodproduction,outputwouldbe asfollows:  Northland:100 tonnes  Southland:200 tonnes If all the resourcesof the countrieswere allocatedtothe productionof clothes,outputwouldbe:  Northland:100 tonnes  Southland:100 tonnes Assuming each has constant opportunity costs of production between the two products and both economies have full employment at all times. All factors of production are mobile within the countries between clothing and food industries, but are immobile between the countries. The price mechanism must be working to provide perfect competition. Southlandhasan absolute advantage overNorthlandinthe productionof Food.Bothcountriesare equallyefficient inthe productionof clothes.There seemstobe nomutual benefitintrade betweenthe economies.The opportunity costs showsotherwise.Northland'sopportunitycostof producingone tonne of Foodisone tonne of Clothesandvice versa.Southland'sopportunitycostof one tonne of Foodis 0.5 tonne of Clothes.The opportunitycostof one tonne of Clothesis2 tonnesof Food.Southlandhasa comparative advantage infoodproduction,because of itslower opportunitycostof productionwithrespecttoNorthland.Northlandhasa comparative advantage overSouthlandin the productionof clothes,the opportunitycostof whichishigherinSouthlandwithrespecttoFoodthan in
  • 49. 49 Northland. To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, considerthe countriesproduce andconsume onlydomestically.The volumesare: Food Clothes Northland 50 50 Southland 100 50 Worldtotal 150 100 Production and consumptionbefore trade Thisexample includesnoformulationof the preferencesof consumersinthe twoeconomieswhichwouldallow the determinationof the international exchangerate of ClothesandFood.Giventhe productioncapabilitiesof each country,inorder fortrade to be worthwhile Northlandrequiresaprice of at leastone tonne of Food inexchange for one tonne of Clothes;andSouthlandrequiresatleastone tonne of Clothesfortwotonnesof Food.The exchange price will be somewhere betweenthe two.The remainderof the exampleworkswithaninternational tradingprice of one tonne of Foodfor 2/3 tonne of Clothes. If both specializeinthe goodsinwhichtheyhave comparative advantage,theiroutputswill be: Food Clothes Northland 0 100 Southland 200 0 Worldtotal 200 100 Production aftertrade World production of food increased. Clothing production remained the same. Using the exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level of consumption: Food Clothes Northland 75 50 Southland 125 50 Worldtotal 200 100 Consumptionafter trade Northlandtraded50 tonnesof Clothingfor75 tonnesof Food.Both benefited,andnow consume atpointsoutside theirproduction possibilityfrontiers. Assumptionsin Example 2  Two countries,two goods o The theory is no different for larger numbers of countries and goods, but the principles are clearer and the argumenteasiertofollow inthissimplercase.  Equal size economies o Again,thisisa simplificationtoproduce aclearerexample.  Full employment
  • 50. 50 o If one or other of the economies has less than full employment of factors of production, then this excesscapacitymustusuallybe usedupbefore the comparative advantagereasoning canbe applied.  Constant opportunity costs o A more realistic treatment of opportunity costs the reasoning is broadly the same, but specialization of production can only be taken to the point at which the opportunity costs in the two countries become equal. This does not invalidate the principles of comparative advantage, but it does limit the magnitude of the benefit.  Perfectmobilityof factors of production withincountries o This is necessary to allow production to be switched without cost. In real economies this cost will be incurred: capital will be tied up in plant (sewing machines are not sowing machines) and labour will need to be retrained and relocated. This is why it is sometimes argued that 'nascent industries' should be protected from fully liberalised international trade during the period in which a high cost of entryintothe market(capital equipment,training) isbeingpaidfor.  Immobilityof factors of productionbetweencountries o Why are there different rates of productivity? The modern version of comparative advantage (developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes these differences to differences in nations' factor endowments. A nation will have comparative advantage in producing the good that uses intensively the factor it produces abundantly. For example: suppose the US has a relative abundance of capital and India has a relative abundance of labor. Suppose further that cars are capital intensive to produce, while cloth is labor intensive. Then the US will have a comparative advantage in making cars, and India will have a comparative advantage in making cloth. If there is international factor mobility this can change nations' relative factor abundance. The principle of comparative advantage still applies, but who has the advantage in whatcan change.  Negligible TransportCost o Cost isnot a cause of concernwhencountriesdecidedtotrade.Itis ignoredandnotfactoredin.  Assume that halfthe resourcesare used to produce each goodin each country. o Thistakesplace before specialization  Perfectcompetition o This is a standard assumption that allows perfectly efficient allocation of productive resources in an idealizedfree market. Absolute advantage A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resourcesthananothercountry. For example if one unit of labor inAustralia can produce 80 units of wool or 20 units of wine; while in France one unit of labor makes 50 units of wool or 75 units of wine, then Australia has an absolute advantage in producing wool and France has an absolute advantage inproducingwine. Australia can get more wine with its labor by specializing in wool and trading the wool for French wine, while France can benefitbytradingwine forwool. Example 1  CountryA can produce one widgetusingone unitof labour.  CountryB can produce one widgetusingtwounitsof labour.  CountryA has an absolute advantage overCountryBinproducingwidgets. Example 2  CountryA has 100 unitsof labour.It uses20 to produce 80 unitsof Parachutes,and80 to produce 20 unitsof Barbie dolls.
  • 51. 51  CountryB has 100 unitsof labour.It uses40 to produce 100 unitsof Barbie dolls,and60 to produce 20 units of Parachutes.  If the countriesmaximizedtheirpotential,CountryA couldproduce 400 unitsof Parachutes,andcountryB couldproduce 250 unitsof Barbie dolls.Throughtrade,the twocountrieswouldachieve amore efficient allocationof resourcesandincrease theirprosperity. Free trade Definition:International trade lefttothe mechanismsof demandandsupplywithoutinfluence of protectionist methods. Reasons for Free Trade  DomesticNon-availability o A nation trades because it lacks the raw materials, climate, specialist labour, capital or technology neededtomanufacture aparticulargood.Trade allowsagreatervarietyof goodsand services.  Cost effectiveness o It ischeaperto buyfrom othercountriesratherthanproducingthemselves. BenefitsofTrade  Lower pricesfor consumers o When there is free trade, consumers can free to buy goods from the producer who is willing to sell at the lowestprices.Hence consumersgainfromlowerprices.  Greaterchoice for consumers o With free trade, consumers have access to variety of goods and services from different producers across the globe.Thismeansmore choice.  Abilityof producersto benefitfromeconomiesofscale o Producers have access to a larger market thus they can produce more at lower cost and benefit from economiesof scale.  Abilitytoacquire neededresources o Through free trade producers can not only sell in a large market but also gain from purchasing from suppliersacrossthe world.  More efficientallocationofresources o When there is free trade, the most efficient producers get the opportunity to produce due to their cost efficiency.Thisleadstoproductiveefficiency.  Increasedcompetition o In free trade producers from different regions can compete with each other in terms of price, quality and variety.Increasedcompetitionleadstoefficientallocationof resources.  Source of foreignexchange o Free trade involves the transaction of goods and services between nations. In order to purchase goods from abroad (imports), we need foreign currency. This is possible through exporting of goods to othercountries.
  • 52. 52 Free Trade diagrams Protectionism methods The chief protectionist measures, government-levied tariffs, raise the price of imported articles, making them less attractive to consumers than cheaper domestic products. Import quotas, which limit the quantities of goods that can be imported,are anotherprotectionistdevice. Tariffs A tariff is a tax on foreign goods upon importation. Tariff rates vary according to the type of goods imported. Import tariffs will increase the cost to importers, and increase the price of imported goods in the local markets, thus loweringthe quantityof goodsimported.
  • 53. 53 Quotas An import quota is a type of protectionist that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time. This leads to a reduction in the quantity imported and therefore increases the market price of imported goods. Quotas, like other trade restrictions, are used to benefit the producers of a good ina domesticeconomyatthe expenseof all consumersof the goodinthat economy. Administrative Barriers Countries are sometimes accused of using their various administrative rules (eg. regarding food safety, environmental standards,electrical safety,etc.) asa way to introduce barrierstoimports. Embargo An embargo is the prohibition of commerce and trade with a certain country, in order to isolate it and to put its government into a difficult internal situation, given that the effects of the embargo are often able to make its economysufferfromthe initiative. Subsidies Government subsidies (in the form of lump-sum payments or cheap loans) are sometimes given to local firms that cannot compete well against foreign imports. These subsidies are purported to "protect" local jobs, and to help local firmsadjustto the worldmarkets. Anti-dumpinglegislation Supporters of anti-dumpinglaws argue that they prevent "dumping" of cheaper foreign goods that would cause local firms to close down. However, in practice, anti-dumping laws are usually used to impose trade tariffs on foreign exporters. Externalities,MarketFailure and Import Controls Protectionism can also be used to take account of externalities and dealing with de-merit goods. Goods such as alcohol, tobacco and narcotic drugs have adverse social effects and are termed de-merit goods. Protectionism can safeguard society from the importation of these goods, by imposing high tariff barriers or by banning the importation of the goodaltogether.
  • 54. 54 Non-EconomicReasons Countries may wish not to over-specialise in the goods in which they possess a comparative advantage. One danger of over-specialisation is that unemployment may rise quickly if an industry moves into structural decline as new international competitionemergesatlowercosts. The government may also wish to protect employment in strategic industries, although clearly value judgments are involved in determining what constitutes a strategic sector. The recent trade dispute arising from the decision bythe United States to introduce a tariff on steel imports is linked to this objective. The US steel tariff was declared unlawful by the WTO in July 2003 and eventually the United States was pressurized into withdrawing these tariffs in the late autumnof 2003. Tariffs are not usually a major source of tax revenue for the Government that imposes them. In the UK for example, tariffs are estimated to be worth only £2 billion to the Treasury, equivalent to only around 0.5% of the total tax take. Developingcountriestendtobe more reliantontariffsforrevenue. Economic Argumentsagainst Import Controls Protectionism– hurting customers Tariffs,non-tariff barriersandotherformsof protectionserve asa tax on domesticconsumers.Moreover,theyare veryoftena regressive formof taxation,hurtingthe poorestconsumersfarmore thanthe betteroff.Inthe EU for instance,the nature of existingprotectionmeansthatthe heaviesttaxestendtofall onthe necessitiesof life suchas food,clothingandfootwear. According to Professor JagdishBhagwati, “the fact that trade protection hurts the economy of the country that imposesitisone of the oldestbutstill moststartlinginsightseconomicshastooffer.” The folly of protection has been confirmed by a range of studies from around the world. These indicate that that it has brought few benefits but imposed substantial costs. Among the main criticisms of protectionist policies are the following:  Market distortion:Protectionhasprovedan ineffective andcostlymeansof sustainingemployment. a. Higher prices for consumers: Trade barriers in the form of tariffs push up the prices faced by consumers and insulate inefficient sectors from competition. They penalise foreign producers and encourage the inefficient allocation of resources both domestically and globally. In general terms, import controls impose costs on society that would not exist if there was completely free trade in goods and services. It has beenestimated for example that the recent tariff and other barriers placed on importsof steel intothe US increasedthe price of everycarproducedthere byan average of $100 b. Reduction in market access for producers: Export subsidies, depressing world prices and making them more volatile while depriving efficient farmers of access to the world market. This is a major criticism of the EU common agricultural policy. In 2002 the EU sugar regime lowered the value of Brazil, Thailand and South Africa’s sugar exports by over $700 million – countries where nearly 70 millionpeoplesurviveonlessthan$2 a day.  Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus arising from a lossof allocative efficiency.Welfare isreducedthroughhigherpricesandrestrictedconsumerchoice.  Regressive effect on the distribution of income: It is often the case that the higher prices that result from tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on those products that lower income families spend a higher share of their income. Thus import protection may worsen the inequalities in the distribution of income making the allocation of scarce resources less equitable  Production inefficiencies: Firms that are protected from competition have little incentive to reduce productioncosts.Governmentsmustconsiderthese disadvantagescarefully  Little protection for employment: One of the justifications for protectionist tariffs and other barriers to trade is that they help to protect the loss of relatively low skilled and low paid jobs in industries that are coming under sever international competition. The evidence suggests that, in the long term, tariffs are a costly and
  • 55. 55 ineffective way of protecting such jobs. According to the DTI study on trade published in 2004, since 1997 UK employment in textiles manufacturing has fallen by 45%, in clothing manufacture by nearly 60%, and in footwear manufacturing by around 50% - and this despite the protection afforded to European Union textile manufacturers. The cost of protecting each job runs into hundreds of thousands of Euros for the EU as a whole. Might that money have been spent more productively in other ways? Often there is a huge opportunitycostinvolvedinimposingimporttariffs.  Trade wars: There is the danger that one country imposing import controls will lead to “retaliatory action” by another leading to a decrease in the volume of world trade. Retaliatory actions increase the costs of importingnewtechnologies  Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in total trade will have a negative multiplier effect affecting many more countries because exports are an injection of demand into the global circular flow of income. The negative multiplier effects are more pronouncedwhentrade disputesboil overandleadtoretaliation. The diagram below shows the welfare consequences of imposing an import tariff In a newstudyof the benefitsof global trade andinvestmentpublishedinMay2004, the UK Departmentof Trade of Industry outlinedtheiroppositiontoimportcontrols(protectionism) Higher taxesand higherprices Protectionismimposesadouble burdenon tax payers and consumers.Inthe case of Europeanagriculture,the cost to tax payersisabout€50 billionayear,plusaround€50 billionayearto consumersviaartificiallyhighfoodprices – togetherthe equivalentof over£800 a yearon the annual foodbudgetof an average familyof four. Furthermore huge distortionsininternational agriculture marketspreventthe world’spoorestcountriesfromtrading inthe productstheyare bestable to produce.Continuingbarrierstotrade are costingthe global economyaround $500 billionayearinlostincome. Protectionistpoliciesrarelyachieve theiraims.Theycanbe costly to administerandtheynearlyalwaysprovide domesticsupplierswithaprotectionistshieldthatencouragesinefficienciesleadingtohighercosts. Protectionismisa‘secondbest’approachtocorrectingfor a country’sbalance of paymentsproblemorthe fearof risingstructural unemployment.Andimportcontrolsgoagainstthe principlesof free trade enshrinedinthe theories of comparative advantage.Inthissense,importcontrolscanbe seenasexamplesof governmentfailure arisingfrom intervention inmarkets.
  • 56. 56 Economic nationalism Economicnationalismisatermthat has become usedmore frequentlyinrecentyears.Itisusedtodescribe policies whichare guidedbythe ideaof protectingacountry's home economy,i.e.protectingdomesticconsumption,jobs and investment,evenif thisrequiresthe impositionof tariffsandotherrestrictionsonthe movementof labour, goodsand capital.Economicnationalismmayincludesuchdoctrinesasprotectionismandimportsubstitution. Examplesof economicnationalismincludeChina'scontrolledexchangeof the yuan,andthe UnitedStates'use of tariffstoprotect domesticsteel production.The termgainedamore specificmeaningin2005 and 2006 afterseveral EuropeanUniongovernmentsintervenedtopreventtakeoversof domesticfirmsbyforeigncompanies.Insome cases,the national governmentsalsoendorsedcounter-bidsfromcompatriotcompaniestocreate 'national champions'.Suchcasesincludedthe proposedtakeoverof Arcelor(Luxembourg) byMittal Steel (India).Andthe Frenchgovernmentlistingof the foodanddrinksbusinessDanone(France) asa'strategicindustry'to pre -empta potential takeoverbidbyPepsiCo(USA). Sample IGCSE Questions 1. When the exchange rate of a currency depreciates, the balance of trade improves. Do you agree with this statement?Give reasonsfor your answer.(6) Depreciation is referred to as the decrease in the value of currency relative to another country. It is often linked with the balance of trade, the amount of exports subtracted by the amount of imports. When the balance of the trade improves, this means the value of exports is greater than the value of imports; a trade surplus. This means that the value of exports is cheaper overseas so people are able to buy more of the country’s exports so demand for the good increases and thus they would have higher purchasing power to buy your good. This causes the country to export more. Another reason is that because of depreciation, importsbecome more expensive sodemandforimports decreasesaspricesforimportsrise. However, exports may not rise if another country has depreciated its currency even further or produced that good at a lower cost. Exports may not even increase if there are a lot of substitutes for the good, such as coffee beans. If the exports are inelastic, there is little change in quantity demanded. Countries like Hong Kong are dependent on food and oil, they are forced to pay a higher price and quantity demanded will not fall toomuch. In general,currency depreciationshouldimprove the balance of trade. 2. Apart from depreciation of the currency, identify and briefly explain twomeasures that a government may use to increase exports.(4) a. Demand-side policy  promotion of products made in the country, for example, The British Council has an annual trade fair on British goods to attract more buyers. Similarly, for Hong Kong, it is the Hong KongTrade andDevelopmentCouncil (HKTDC). b. Supply-side policy  Subsidies to export companies to lower production cost and increase supply. For example,China’ssubsidiestosolarpanel producers. 3. To what extent is international borrowing by a developing country likely to lead to an increase in the standard ofliving?Give reasonsfor your answer.(6) International borrowing is when countries or government borrowing money from banks overseas. Standard of living is the welfare of individuals. One example of international borrowing is when the Chinese government borrowed from the International Monetary Fund (IMF) to build the Three Gorges Dam. By building this dam, it allows people in China to have access to clean water which reduces cholera and other water-borne diseases outbreaks and increases their health. Another added benefit of building this dam is
  • 57. 57 that it is a hydroelectric plant and produces a large supply of electricity to power businesses and therefore increase productivity. Irrigation can also be provided by the dam to improve the marginal agricultural areas. Thus, farmers in these areas can produce more agricultural products and increase their standard of living. Another important benefit is that by building this dam, it creates jobs for construction workers as well as engineers,architectsandmanyothers. However, international borrowing results in high interest rates and in the long-term, debt. The disadvantage of building a dam is that the surrounding wildlife and habitat will be destroyed and some people will be relocatedandthus,thiswill decrease theirstandardof living. In conclusion, for the majority of the people, the standard of living will increases due to international borrowing. 4. How does combatting inflationaffectthe exchange rates?(6) Raising benchmark interest rates is the preferred plan of action when it comes to the central bank's fight against inflation. It's the easiest and simplest strategy, and the results can sometimes be quicker compared to other methods. All a monetary body does, in this instance, is increase the benchmark that most commercial and retail banks refer to when creating client loans. These products include mortgage, student and car loans, along with commercial loans for businesses. Once these rates rise, the cost of money increases. This isn't a good thing for customers or companies. (For more on the relationship between interest rates and inflation. Global investors constantly search for high interest rate returns combined with relatively low risk. The same goes for foreign exchange investors. So, when a central bank elects to raise rates, you can be sure that demand for that currency will rise. For example, the Australian dollar benefited from this phenomenon beginning in June 2010. The central bank of Australia raised rates several times between late 2009 and early 2011. By January 2011, the Australian dollar had risen by 26% compared to the U.S. dollar in response As the Australian economy rebounded quickly amid a slumping global economy, the country's central bank was forced to raise rates more than once – by 25 basis points each time – in order to fight inflation. The decisions led to higher demand for the Aussie, especially against the U.S. dollar, during that time. An equally effective strategy for central banks is to raise the reserve requirements of banking institutions. When a central bank elects to raise the reserve requirements, is limiting the amount of money or cash in the system - referred to as the monetary base. An increase in the reserve requirement increases the minimum cash reserve that a commercial bank is governed to hold, so this adjustment prevents the bank from lending out that cash. This restriction of money will slow the rise in prices as there will be less money chasing the same expensively priced goods (hopefully suppressing demand). The Chinese government favors this policy due toits own semi-fixed currency policy. Since the beginning of 2011, the People's Bank of China haselected to raise the reserve requirementthree times –increasingthe rate by50 basispointseachtime. The decision to raise reserve requirements should eventually slow down the inflation of a nation's currency. More often than not, such a decision also helps to fuel the foreign exchange rate's upward trend in value due to speculators.So,the central bank'sdecisionholdssignificanceforthe foreignexchange investor. By increasing the reserve requirement, the central bank is acknowledging that inflation is a problem and is aggressively dealing with it. However, this could increase a currency's attractiveness to forex investors, as they anticipate another round of reserve requirement increases. As the supply of money thins - a result of higher reserves held by banks - speculation helps to support and even propagate a higher currency valuation (thuslowering inflation). Referring back to the Chinese yuan, the effects of speculative demand are apparent: The currency gained by almost 4% following a series of reserve rate increases from June 2010 to January 2011, as speculatorsanticipatedfurtherreserve quotaincreasesforChinese domesticbanks.
  • 58. 58 5. Changes in rate of exchange meant that exports of good from Egypt decreased a they became more expensive inothercountries a. Explainwhat is meantby a rate of exchange.(3) A rate of exchange is the rate at which one currency can be exchanged for another on the global foreign exchange market. It is therefore the market price of one currency in terms of another currency,for example,the price of eurosintermsof US dollars b. If exports from Egypt become more expensive, how might that affect production and employment both in Egypt and in countries importingEgyptian goods? (7) If exports from Egypt become more expensive, global demand for them is likely to fall. Unless global demandisprice inelasticthiswill lose revenue and their profits will fall. In response, exporters may cut back their production and reduce their employment of labour. If exports are a major source of revenue forEgypt,thiscouldresult inasignificantlossof income andhighunemployment. In the country importing Egyptian goods there could be inflation, especially if the Egyptian goods make up a significant proportion of total imports and are used by firms in the production of other goods and services. However, consumers in this country may be able to buy similar products from domestic producers instead. Domestic firms are likely to respond by increasing their output and demand for labour rise. However, if consumers also switch some of their demand to other imported goods from other countries then the potential for growth and employment in their country will be reduced. c. Describe the structure of balance of payments on current account of a country (4) The balance of payments of a country records international transactions with other countries. The current account within the balance of payments records payments made to other countries for visible and invisible imports and payments received from overseas from the sale of visible and invisible exports. The balance of trade is therefore the difference between the value of goods exported and the value of goods imported by a country. The balance of invisibles is the difference between the value of services purchased by overseas firms and residents and the value of services purchasedfromby domesticfirmsandresidents. The current account also records income flows into and out of a country including wages earned by residents working overseas or paid out to migrant workers from overseas, and any international payments of interest, profits and dividends. It also records current transfers including payments of taxesandexcise dutiesbyvisitingresidentsof othercountries,orsimilarpaymentsmadoverseas. d. Discuss what might leadto an improvementinthe current account of a country (6)