Economics 6th Edition

This book looks at the world of the early 21st century. The book will give you an enjoyable introduction to the economist’s world.

John Sloman

853 Pages

130901 Reads



PDF Format

27.3 MB

Economics Books

Download PDF format

  • John Sloman   
  • 853 Pages   
  • 18 Feb 2015
  • Page - 1

    John Sloman sixth editionECONOMICSsixth editionJohn Sloman ECONOMICSwww.pearson-books.comeasy to learn from, flexible to teach from…John Sloman’s Economics has proven to be an extremely popular text, with consistently positive feedback fromstudents. Comprehensive and completely up-to-date, this sixth edition is the ideal introduction to economicsfor those looking to be interested and motivated by the subject. It’s carefully designed to enhance your learningand help you to raise your read more..

  • Page - 2

    ECONOMICSVisit the Economics, sixth edition Companion Website to find valuable student learningmaterial including:• Learning objectives and chapter overview for each chapter• Multiple choice questions to test your learning• Extra case studies with questions per chapter• Maths cases with exercises, related to the Looking at the Mathsboxes in the book• Answers to all in-chapter questions• Topical Economic Issues, with analysis and links to keyconcepts, read more..

  • Page - 3

    We work with leading authors to develop thestrongest educational materials in economics, bringing cutting-edge thinking and bestlearning practice to a global market.Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications which help readers to understand and apply their content, whether studying or at work.To find out more about the complete range of ourpublishing, please visit us on the World Wide Web read more..

  • Page - 4

    John Sloman University of the West of England and the Economics NetworkSixth editionECONOMICSEC6_A01.qxd 10/28/05 16:55 Page iii read more..

  • Page - 5

    Pearson Education LimitedEdinburgh GateHarlowEssex CM20 2JEEnglandand Associated Companies throughout the worldVisit us on the World Wide Web edition published 1991Second edition published 1994Updated second edition published 1995Third edition published 1997Updated third edition published 1998Fourth edition published 2000Fifth edition published 2003Sixth edition published 2006© John Sloman 1991© John Sloman, Alison Bird and Mark Sutcliffe 1994, 1997© John Sloman, read more..

  • Page - 6

    PrefacexiiiPart A: Introduction11Introducing Economics3Part B: Foundations of Microeconomics312Supply and Demand333Government Intervention in the Market69Part C: Microeconomics894Background to Demand915Background to Supply1196Profit Maximising under Perfect Competition and Monopoly1567Profit Maximising under Imperfect Competition1778Alternative Theories of the Firm2049The Theory of Distribution of Income22710Inequality, Poverty and Policies to Redistribute Incomes26311Markets, Efficiency and the read more..

  • Page - 7

    Part F: The World Economy63323International Trade63524The Balance of Payments and Exchange Rates66825Global and Regional Interdependence70226Economic Problems of Developing Countries720Appendix 1: Some Techniques of Economic AnalysisA:1Appendix 2: WebsitesA:14Threshold Concepts and Key IdeasT:1GlossaryG:1IndexI:1viBRIEF CONTENTSEC6_A01.qxd 10/28/05 16:55 Page vi read more..

  • Page - 8

    A HDviiContentsPrefacexiiiGuided TourxxPart A:Introduction11 Introducing Economics31.1 What do economists study?41.2 Different economic systems 161.3 The nature of economic reasoning 27Boxes1.1 What's the latest economic news?51.2 Looking at macroeconomic data71.3 The opportunity costs of studying economics111.4 Scarcity and abundance131.5 Rise and fall of planning in the former Soviet Union181.6 Adam Smith and the invisible hand241.7 Ceteris paribus? An economics joke!28Part B:Foundations of read more..

  • Page - 9

    viiiCONTENTS5.6 Cost curves in practice130*5.7 The Cobb-Douglas production function1365.8 Minimum efficient scale: some evidence144*5.9 Using calculus to find maximum profit output1526 Profit Maximising under PerfectCompetition and Monopoly1566.1 Alternative market structures1576.2 Perfect competition1586.3 Monopoly1666.4 The theory of contestable markets172Boxes6.1 Concentration ratios1596.2 Is perfect best?1606.3 E-commerce and perfect competition1656.4 Windows cleaning!1706.5 X read more..

  • Page - 10

    CONTENTSix15.4 The monetarist–Keynesian debate44315.5 The current position: an emerging consensus?447Boxes15.1 Balance the budget at all costs43715.2 The crowding-out effect43815.3 Will wage cuts cure unemployment?44016 Short-run Macroeconomic Equilibrium45116.1 Background to the theory45216.2 The determination of national income46216.3 The simple Keynesian analysis of unemployment and inflation46816.4 The Keynesian analysis of the business cycle471Boxes*16.1 Using calculus to derive the read more..

  • Page - 11

    xCONTENTS18.2 The stability of the velocity of circulation51018.3 Crowding out in an open economy513*18.4 Environmentally sustainable macro-economic equilibrium52019 Fiscal and Monetary Policy52819.1 Fiscal policy52919.2 Monetary policy542*19.3 ISLM analysis of fiscal and monetary policy55419.4 Fiscal and monetary policy in the UK55719.5 Rules versus discretion565Boxes19.1Managing the US economy53219.2Discretionary fiscal policy in Japan53619.3Riding a switchback53819.4Following the Golden read more..

  • Page - 12

    CONTENTSxi24.5 The effectiveness of monetary and fiscal policies under floating exchange rates68925 Global and Regional Interdependence70225.1 Globalisation and the problem of instability70325.2 Concerted international action to stabiliseexchange rates70625.3 European economic and monetary union (EMU)71025.4 Achieving greater currency stability714Boxes25.1 Globalisation and the US trade imbalance70525.2 Attempts at international policyharmonisation70825.3 Optimal currency areas71325.4 The Tobin read more..

  • Page - 13

    Supporting resourcesVisit to find valuable online resourcesCompanion Website for students• Learning objectives and chapter overview for each chapter• Multiple choice questions to test your learning• Extra case studies with questions per chapter• Maths cases with exercises, related to the Looking at the Maths boxes in the book• Answers to all in-chapter questions• Topical Economic Issues, with analysis and links to key concepts, updated regularly• read more..

  • Page - 14

    • A direct and straightforward written style; short para-graphs to aid rapid comprehension.• Key ideas highlighted and explained where they firstappear. These ideas are key elements in the economist’s‘toolkit’ and whenever they recur later in the book, anicon appears in the margin and you are referred back tothe page where they are defined and explained.• Fifteen ‘threshold concepts’ (a new feature for this edi-tion). Each one is explained in a separate panel. Graspingthese read more..

  • Page - 15

    xivPREFACEmathematically that have just been covered in wordsand/or graphically. Most of them link to Maths Cases onthe book’s website. These cases give worked mathemat-ical examples and also include one or more numericalquestions for you to work through, either at home or inclass.• Website references. Extensive web references are given atthe end of each chapter. These refer you to the websiteslisted at the end of the book in Appendix 2. These can allbe accessed directly from the read more..

  • Page - 16

    PREFACExvSome use calculus; some do not. They are designed to beused on more rigorous courses and go further than othertextbooks at introductory level in meeting the needs ofstudents on such courses. Most refer students to workedexamples in Maths Cases on the book’s website. Some of these use simultaneous equations; some use simpleunconstrained optimisation techniques; others use constrained optimisation, using both substitution andLagrange multipliers. The ‘Looking at the maths’ sec-tions read more..

  • Page - 17

    xviPREFACEAlternative 4: Introduction tomacroeconomicsChapters 1, 2, 13–25. The level of difficulty can be varied byincluding or omitting starred sections and boxes from thesechapters.Alternative 5: Outline coursesChapters 1, 2, 5, 6, 13, 14, 16, 17, 23, 24 (section 24.1).Omit boxes at will.Alternative 6: Courses with a theory biasChapters 1, 2, 4 –9, 11, 13–18, 20, 21, 23, 24. The level ofdifficulty can be varied by including or omitting starredsections and boxes from these read more..

  • Page - 18

    PREFACExvii• Tutor guide to using chapters and discussion of teaching/learning issues.• Answers to end-of-chapter questions (password protected).• Testbank with over 2000 questions to help you preparetests and exams (password protected).• Workshops, with answers (password protected).• Answers to the Case Studies and Maths Cases found on theStudent Companion Website (password protected).This site is regularly updated.CD-ROM (new edition)The CD produced for tutors using the 5th edition read more..

  • Page - 19

    xviiiPREFACEDr Christopher J. Gerry, University College London,SSESS, UKProfessor Mark J. Holmes, Waikato University, New ZealandIan Jackson, Staffordshire University, UKTony McGough, Course Director, Cass Business School,City University, London, UKWilfried Pauwels, University of Antwerp, BelgiumStuart Sayer, University of Edinburgh, UKWalter Vanthielen, Hasselt University, BelgiumA special thanks to Peter Smith from the University ofSouthampton who has revised the Workbook to accompanythis read more..

  • Page - 20

    We are grateful to the following for permission to repro-duce copyright material:Box 5.8 table (b) from Economies of Scale, The SingleMarket Review Subseries V Vol. 4, Office for OfficialPublications of the European Communities (EuropeanCommission/Economists Advisory Group Ltd. 1997);Box 7.3 figure from chart showing crude oil prices,1970 –2004 in Annual Statistical Bulletin 2004,(Organization of the Petroleum Exporting Countries2004); Box 8.5 figure (b) from Mergers & Acquisitions read more..

  • Page - 21

    Guided TourChapter14Macroeconomic Issues and Analysis: an Overview14.1 Unemployment396The meaning of ‘unemployment’396Official measures of unemployment397The duration of unemployment397The composition of unemployment399Unemployment and the labour market400Disequilibrium unemployment401Equilibrium unemployment40314.2 Aggregate demand and supply and the level of prices405The aggregate demand curve405The aggregate supply curve406Equilibrium40714.3 Inflation407The costs of inflation408Causes read more..

  • Page - 22

    GUIDED TOURxxiPRACTISING AND TESTING YOUR LEARNING71825 GLOBAL AND REGIONAL INTERDEPENDENCESecond, the wider bands would leave countries freer tofollow an independent monetary policy: one that couldtherefore respond to domestic needs.The main problem with the system is that it may notallow an independent monetary policy. If the rate ofexchange has to be maintained within the zone, monetarypolicy may sometimes have to be used for that purposerather than controlling inflation.Nevertheless, read more..

  • Page - 23

    xxiiGUIDED TOURTake the Chapter Tests in MyEconLab to generate a personalised Study Plan.You will then be directed to specific resources in MyEconLab to help you focusyour studies and improve your grades. For details on how to access MyEconLab,see the access card that is packaged with every new copy of this book.A printed Workbook is available for purchase (from,ISBN 0 273 70517 2), which contains over 1500 questions of various types, carefullymatched to the content of the read more..

  • Page - 24

    GUIDED TOURxxiiiAIDING YOUR UNDERSTANDING4.2 DEMAND UNDER CONDITIONS OF RISK AND UNCERTAINTY101into the future you look, the less certain you will be of itscosts and benefits to you.Take the case of a washing machine costing you £400. Ifyou pay cash, your immediate outlay involves no uncer-tainty: it is £400. But washing machines can break down.In two years’ time you could find yourself with a repair billof £100. This cannot be predicted and yet it is a price youwill have to pay, just read more..

  • Page - 25

    xxivGUIDED TOURAPPLYING ECONOMICS TO THE REAL WORLD16.1 BACKGROUND TO THE THEORY457Consumer spending follows a regular cyclical patterneach year, reaching its peak in the fourth quarter asChristmas approaches. The graph shows the levels ofUK personal disposable income and total consumerexpenditure (i.e. consumption before indirect taxes andimports have been deducted) from 1995 Q1 to 2005 Q1.The annual cyclical pattern can clearly be seen, withconsumption actually falling in quarter 1 of each read more..

  • Page - 26

    GUIDED TOURxxvTopical Economic Issues on the Student Companion Website provide discussion of some of thekey economic issues over the past six months related to passagesin the book, with links to relevant websites.Economics News Articles on the Student Companion Website are updated monthly, and providehotlinks to recent economics articles from newspapers andmagazines related to passages in the book.EC6_A01.qxd 10/28/05 16:56 Page xxv read more..

  • Page - 27

    xxviGUIDED TOURFLEXIBLE LEARNING2.3 PRICE AND OUTPUT DETERMINATION45?What will happen to the equilibrium price and quantityof butter in each of the following cases? You shouldstate whether demand or supply (or both) have shifted and in which direction. (In each case assumeceteris paribus.)(a) A rise in the price of margarine. (b) A rise in thedemand for yoghurt. (c) A rise in the price of bread. (d) A rise in the demand for bread. (e) An expected rise in the price of butter in the near future. read more..

  • Page - 28

    Part A: IntroductionIn this opening part of the book you will get a glimpse of what the subject of economicsis all about. One thing to be stressed right from the outset: economics is not just a set offacts or theories to be memorised. Studying economics gives you a way of thinkingabout the world. It helps you to make sense of the decisions people are making all thetime: decisions we make about what to buy or what job to do; decisions our governmentmakes about how much to tax us or what to spend read more..

  • Page - 29

    EC6_C01.qxd 10/27/05 16:30 Page 2 read more..

  • Page - 30

    Chapter1Introducing Economics1.1 What do economists study?4The problem of scarcity4Demand and supply5Dividing up the subject5Macroeconomics6Microeconomics6The production possibility curve12The circular flow of goods and incomes151.2 Different economic systems16The classification of economic systems16The command economy17Assessment of the command economy19The free-market economy20Assessment of the free-market economy23The mixed economy251.3 The nature of economic reasoning27Economics as a read more..

  • Page - 31

    Many people think that economics is about money. Well, tosome extent this is true. Economics has a lot to do withmoney: with how much money people are paid; how muchthey spend; what it costs to buy various items; how muchmoney firms earn; how much money there is in total in theeconomy. But despite the large number of areas in whichour lives are concerned with money, economics is morethan just the study of money.It is concerned with the following:• The production of goods and services: how read more..

  • Page - 32

    1.1 WHAT DO ECONOMISTS STUDY?5economists do not claim that we all face an equal problemof scarcity. In fact this is one of the major issues economistsstudy: how resources are distributed, whether between dif-ferent individuals, different regions of a country or differentcountries of the world.But given that people, both rich and poor, want morethan they can have, this makes them behave in certain ways.Economics studies that behaviour. It studies people atwork, producing the goods that people read more..

  • Page - 33

    61 INTRODUCING ECONOMICSMicroeconomics is concerned with the individual partsof the economy. It is concerned with the demand and supply of particular goods and services and resources: cars,butter, clothes and haircuts; electricians, secretaries, blastfurnaces, computers and oil.?Which of the following are macroeconomic issues,which are microeconomic ones and which could beeither depending on the context?(a) Inflation.(b) Low wages in certain service industries.(c) The rate of exchange between read more..

  • Page - 34

    1.1 WHAT DO ECONOMISTS STUDY?7much will pensioners receive? How much of the nation’sincome will go to shareholders or landowners?All societies have to make these choices, whether they be made by individuals, groups or the government. Thesechoices can be seen as microeconomic choices, since theyare concerned not with the total amount of national out-put, but with the individual goods and services that make itup: what they are, how they are made, and who gets theincomes to buy them.Choice and read more..

  • Page - 35

    81 INTRODUCING ECONOMICSthroughout the book. Once you have grasped these con-cepts and seen their significance, they will affect the waythat you understand and analyse economic problems. Theywill help you to ‘think like an economist’.Rational choicesEconomists often refer to rational choices. This simply meansthe weighing-up of the costs and benefits of any activity,whether it be firms choosing what and how much to Scarcity, as we have seen, is at the heart of economics.We face scarcity read more..

  • Page - 36

    1.1 WHAT DO ECONOMISTS STUDY?9alarm for 7.00. That will give you plenty of time to get upand get ready, but it will mean a relatively short night’ssleep. Perhaps you will decide to set it for 7.30 or even 8.00.That will give you a longer night’s sleep, but much more ofa rush in the morning to get ready.So how do you make a rational decision about when thealarm should go off? What you have to do is to weigh upthe costs and benefits of additional sleep. Each extra minutein bed gives you more read more..

  • Page - 37

    101 INTRODUCING ECONOMICS• Efficiency in production ( productive efficiency). This iswhere production of each item is at minimum costs.Producing any other way would cost more.• Efficiency in consumption. This is where consumersallocate their expenditures so as to get maximum satis-faction from their income. Any other pattern of con-sumption would make people feel worse off.• Efficiency in specialisation and exchange. This is wherefirms specialise in producing goods for sale to read more..

  • Page - 38

    1.1 WHAT DO ECONOMISTS STUDY?11You may not have realised it, but you probablyconsider opportunity costs many times a day. Thereason is that we are constantly making choices: whatto buy, what to eat, what to wear, whether to go out,how much to study, and so on. Each time we make achoice to do something, we are in effect rejecting doingsome alternative. This alternative forgone is theopportunity cost of the action we choose.Sometimes the opportunity costs of our actions arethe direct monetary read more..

  • Page - 39

    121 INTRODUCING ECONOMICSThe social implications of choiceIn practice, the consequences of the choices that peoplemake may be neither efficient nor equitable. Firms may useinefficient techniques or be poorly managed; people oftenmake wrong decisions about what to buy or what job totake; governments may be wasteful or inefficient in theiruse of tax revenues; there may be considerable inequalityand injustice.What is more, the effects of people’s choices often spillover to other people. Take read more..

  • Page - 40

    1.1 WHAT DO ECONOMISTS STUDY?13produce 7 million units of clothing with no resources at allbeing used to produce food.The information in the table can be transferred to agraph (Figure 1.1). We measure units of food on one axis(in this case the vertical axis) and units of clothing on theother. The curve shows all the combinations of the twogoods that can be produced with all the nation’s resourcesfully and efficiently employed. For example, productioncould take place at point x, with 6 million read more..

  • Page - 41

    141 INTRODUCING ECONOMICSmaterials differ one from another; and so on. Thus as thenation concentrates more and more on the production ofone good, it has to start using resources that are less andless suitable – resources that would have been better suitedto producing other goods. In our example, then, the pro-duction of more and more clothing will involve a growingmarginal cost: ever increasing amounts of food have to besacrificed for each additional unit of clothing produced.It is because read more..

  • Page - 42

    1.1 WHAT DO ECONOMISTS STUDY?15Illustrating economic issues: the circularflow of goods and incomesThe process of satisfying human wants involves pro-ducers and consumers. The relationship between them is two-sided and can be represented in a flow diagram (see Figure 1.5).The consumers of goods and services are labelled ‘house-holds’. Some members of households, of course, are alsoworkers, and in some cases are the owners of other factorsof production too, such as land. The producers of read more..

  • Page - 43

    161 INTRODUCING ECONOMICSthe goods flow; how the various factors of production arecombined to produce these goods; for whom the wages, dividends, rent and interest are paid out.Macroeconomics is concerned with the total size of theflow and what causes it to expand and contract.This flow diagram, like the production possibility curve,can help us to distinguish between microeconomics andmacroeconomics.Microeconomics is concerned with the composition ofthe circular flow: what combinations of read more..

  • Page - 44

    1.2 DIFFERENT ECONOMIC SYSTEMS17It is nevertheless useful to analyse the extremes, in orderto put the different mixed economies of the real world intoperspective. The mixture of government and the marketcan be shown by the use of a spectrum diagram such asFigure 1.6. It shows where particular economies of the realworld lie along the spectrum between the two extremes.The diagram is useful in that it provides a simple pictureof the mixture of government and the market that exists invarious read more..

  • Page - 45

    181 INTRODUCING ECONOMICSThe amount of resources it chooses to devote toinvestment will depend on its broad macroeconomicstrategy: the importance it attaches to growth as opposedto current consumption.• At a microeconomic level, it plans the output of eachindustry and firm, the techniques that will be used, andthe labour and other resources required by each industryand firm.In order to ensure that the required inputs are avail-able, the state would probably conduct some form ofinput–output read more..

  • Page - 46

    1.2 DIFFERENT ECONOMIC SYSTEMS19It may distribute goods and services directly (forexample, by a system of rationing); or it may decide thedistribution of money incomes and allow individuals todecide how to spend them. If it does the latter, it maystill seek to influence the pattern of expenditure by setting appropriate prices: low prices to encourage con-sumption, and high prices to discourage consumption.Assessment of the command economyWith central planning, the government could take an read more..

  • Page - 47

    201 INTRODUCING ECONOMICSrelative efficiency of two alternative techniques that usedifferent inputs, if there is no way in which the value ofthose inputs can be ascertained. For example, how can a rational decision be made between an oil-fired and acoal-fired furnace if the prices of oil and coal do notreflect their relative scarcity?• It is difficult to devise appropriate incentives to encourage workers and managers to be more productivewithout a reduction in quality. For example, if read more..

  • Page - 48

    1.2 DIFFERENT ECONOMIC SYSTEMS21Likewise the pattern of supply changes. For example,changes in technology may allow the mass production ofmicrochips at lower cost, while the production of hand-built furniture becomes relatively expensive.In all cases of changes in demand and supply, the result-ing changes in price act as both signals and incentives.A change in demand.A rise in demand is signalled by arise in price. This then acts as an incentive for supply to rise.What in effect is happening is read more..

  • Page - 49

    221 INTRODUCING ECONOMICSThe fact that markets adjust so as to equate demand andsupply is our fourth ‘Threshold Concept’ (see panel).?1. Why do the prices of fresh vegetables fall when theyare in season? Could an individual farmer preventthe price falling?2. If you were the owner of a clothes shop, how would you set about deciding what prices to charge for each garment at the end-of-season sale?3. The number of owners of compact disc players hasgrown rapidly and hence the demand for read more..

  • Page - 50

    1.2 DIFFERENT ECONOMIC SYSTEMS23• This causes the price of the good to rise.• This eliminates the shortage by choking off some ofthe demand and encouraging firms to produce more.2. Factor market• The increased supply of the good causes an increase inthe demand for factors of production (i.e. inputs)used in making it.• This causes a shortage of those inputs.• This causes their prices to rise.• This eliminates their shortage by choking off some ofthe demand and encouraging the read more..

  • Page - 51

    241 INTRODUCING ECONOMICSEconomic interaction between people can take a numberof different forms. Sometimes it takes place in markets.For example, when goods are exchanged, there isinteraction between the consumer and the shop. Whensomeone is employed, there is interaction between the employer and the employee. When a firm buys rawmaterials, there is interaction between the purchasingfirm and the selling firm.In each case there is a mutual gain. If there wasn’t, theinteraction would not read more..

  • Page - 52

    1.2 DIFFERENT ECONOMIC SYSTEMS25DefinitionsMixed market economy A market economy wherethere is some government intervention.Relative price The price of one good compared withanother (e.g. good x is twice the price of good y).naturally, or rather necessarily, leads him to preferthat employment which is most advantageous to the society . . . he intends only his own gain, and heis in this, as in many other cases, led by an invisiblehand to promote an end which was no part of hisintention. Nor is read more..

  • Page - 53

    261 INTRODUCING ECONOMICSAlthough market forces can automatically equatedemand and supply, and although the outcomes of theprocess may often be desirable, they are by no meansalways so. Unbridled market forces can result in severeproblems for individuals, society and the environment.Markets tend to reflect the collective actions of indi-vidual consumers and firms. But when consumers and firms make their decisions, they may fail to takeaccount of the broader effects of their actions. Theymay read more..

  • Page - 54

    1.3 THE NATURE OF ECONOMIC REASONING27Economics is one of the social sciences. So in what sense isit a science? Is it like the natural sciences such as physics andastronomy? What is the significance of the word ‘social’ insocial science? What can economists do, and what is theirrole in helping governments devise economic policy?Economics as a scienceThe methodology employed by economists has a lot incommon with that employed by natural scientists. Bothattempt to construct theories or models read more..

  • Page - 55

    281 INTRODUCING ECONOMICSIf the predictions are wrong, the first thing to do is tocheck whether the deductions were correctly made. If theywere, the model must be either adapted or abandoned infavour of an alternative model with better predictive ability.Sometimes an economist will want to retain a modelwith poor predictive powers if it nevertheless helps to give some insight into the workings of the economy. Forexample, a model of some ideal world in which the goals of efficiency, growth and read more..

  • Page - 56

    1.3 THE NATURE OF ECONOMIC REASONING29Section summary1. The methodology used by economists is similar tothat used by natural scientists. Economists constructmodels which they use to explain and predicteconomic phenomena. These models can be testedby appealing to facts and seeing how successfullythey have been predicted or explained by the model.Unsuccessful models can be either abandoned oramended.2. Being a social science, economics is concerned with human actions. Making accurate predictions read more..

  • Page - 57

    301 INTRODUCING ECONOMICS• For news articles relevant to this chapter, see the Economics News Articles link from the book’swebsite.• For a tutorial on finding the best economics websites, see site C8 (The Internet Economist).• For general economics news sources, see websites in section A of the Web Appendix at the end of thebook, and particularly A1–9, 24, 38, 39. See also A38, 39, 43 and 44 for links to newspapers worldwide;and A41 and 42 for links to economics news articles from read more..

  • Page - 58

    Part B: Foundations ofMicroeconomicsIn the first half of the book, we focus on microeconomics. Despite being ‘small eco-nomics’ – in other words, the economics of the individual parts of the economy, ratherthan the economy as a whole – it is still concerned with many of the big issues of today.To understand how the economy works at this micro level, we must understand howmarkets work. This involves an understanding of demand and supply.In Chapter 2, we look at how demand and supply read more..

  • Page - 59

    EC6_C02.qxd 10/27/05 16:32 Page 32 read more..

  • Page - 60

    Chapter2Supply and Demand2.1 Demand34The relationship between demand and price34The demand curve35Other determinants of demand36Movements along and shifts in the D curve372.2 Supply39Supply and price39The supply curve40Other determinants of supply41Movements along and shifts in the S curve412.3 Price and output determination43Equilibrium price and output43Movement to a new equilibrium43*Identifying demand and supply curves452.4 Elasticity48Price elasticity of demand48Measuring price elasticity read more..

  • Page - 61

    342 SUPPLY AND DEMANDThe markets we will be examining are highly competitiveones, with many firms competing against each other. Ineconomics we call this perfect competition. This is whereconsumers and producers are too numerous to have anycontrol over prices: they are price takers.In the case of consumers, this means that they have toaccept the prices as given for the things that they buy. Onmost occasions this is true. For example, when you get tothe supermarket checkout you cannot start read more..

  • Page - 62

    2.1 DEMAND35at a point in time). Thus we would talk about daily demandor weekly demand or annual demand or whatever.?Assume that there are 200 consumers in the market. Of these, 100 have schedules like Tracey’s and 100 haveschedules like Darren’s. What would be the total marketdemand schedule for potatoes now?The demand schedule can be represented graphically asa demand curve. Figure 2.1 shows the market demand curvefor potatoes corresponding to the schedule in Table 2.1.This price of read more..

  • Page - 63

    362 SUPPLY AND DEMAND?1. Draw Tracey’s and Darren’s demand curves forpotatoes on one diagram. Note that you will use the same vertical scale as in Figure 2.1, but you will need a quite different horizontal scale.2. At what price is their demand the same?3. What explanations could there be for the quite different shapes of their two demand curves? (This question is explored in section 2.4 below.)Two points should be noted at this stage:• In textbooks, demand curves (and other curves too) read more..

  • Page - 64

    2.1 DEMAND37?1. Do all these six determinants of demand affect both an individual’s demand and the market demand for a product?2. Relate each of these six determinants to the demandfor butter.Movements along and shifts in thedemand curveA demand curve is constructed on the assumption that‘other things remain equal’ (ceteris paribus). In other words,it is assumed that none of the determinants of demand,other than price, changes. The effect of a change in price is then simply illustrated by read more..

  • Page - 65

    382 SUPPLY AND DEMANDTo distinguish between shifts in and movements alongdemand curves, it is usual to distinguish between a changein demand and a change in the quantity demanded. A shift inthe demand curve is referred to as a change in demand,whereas a movement along the demand curve as a result ofa change in price is referred to as a change in the quantitydemanded.?1. Assume that in Table 2.1 the total market demand for potatoes increases by 20 per cent at each price – due, say, to read more..

  • Page - 66

    2.2 SUPPLY39Supply and priceImagine you are a farmer deciding what to do with your land.Part of your land is in a fertile valley. Part is on a hillside wherethe soil is poor. Perhaps, then, you will consider growingvegetables in the valley and keeping sheep on the hillside.Your decision will depend to a large extent on the pricethat various vegetables will fetch in the market and like-wise the price you can expect to get from sheep and wool.As far as the valley is concerned, you will plant the read more..

  • Page - 67

    402 SUPPLY AND DEMAND• As firms supply more, they are likely to find that beyonda certain level of output, costs rise more and morerapidly. In the case of the farm just considered, if moreand more potatoes are grown, then land progressivelyless suitable to potato cultivation has to be used. Thisraises the cost of producing extra potatoes. It is the samefor manufacturers. Beyond a certain level of output,costs are likely to rise rapidly as workers have to be paidovertime and as machines read more..

  • Page - 68

    2.2 SUPPLY41Not all supply curves will be upward sloping (positivelysloped). Sometimes they will be vertical, or horizontal oreven downward sloping. This will depend largely on thetime period over which firms’ response to price changes isconsidered. This question is examined in the section on theelasticity of supply (see section 2.4 below) and in moredetail in Chapters 5 and 6.Other determinants of supplyLike demand, supply is not simply determined by price.The other determinants of supply read more..

  • Page - 69

    422 SUPPLY AND DEMAND?This question is concerned with the supply of oil forcentral heating. In each case consider whether there is a movement along the supply curve (and in whichdirection) or a shift in it (and whether left or right). (a) New oil fields start up in production. (b) The demand for central heating rises. (c) The price of gas falls. (d) Oil companies anticipate an upsurge in demand for central-heating oil. (e) The demand forpetrol rises. (f) New technology decreases the costs of read more..

  • Page - 70

    2.3 PRICE AND OUTPUT DETERMINATION43Equilibrium price and outputWe can now combine our analysis of demand and supply.This will show how the actual price of a product and theactual quantity bought and sold are determined in a freeand competitive market.Let us return to the example of the market demand andmarket supply of potatoes, and use the data from Tables 2.1and 2.2. These figures are given again in Table 2.3.What will be the price and output that actually prevail?If the price started at 20p read more..

  • Page - 71

    442 SUPPLY AND DEMANDA change in demandIf one of the determinants of demand changes (other thanprice), the whole demand curve will shift. This will lead to amovement along the supply curve to the new intersectionpoint.For example, in Figure 2.6, if a rise in consumer incomesled to the demand curve shifting to D2 , there would be ashortage of h− g at the original price Pe1. This would causeprice to rise to the new equilibrium Pe 2. As it did so, therewould be a movement along the supply curve read more..

  • Page - 72

    2.3 PRICE AND OUTPUT DETERMINATION45?What will happen to the equilibrium price and quantityof butter in each of the following cases? You shouldstate whether demand or supply (or both) have shifted and in which direction. (In each case assumeceteris paribus.)(a) A rise in the price of margarine. (b) A rise in thedemand for yoghurt. (c) A rise in the price of bread. (d) A rise in the demand for bread. (e) An expected rise in the price of butter in the near future. (f) A tax on butter production. read more..

  • Page - 73

    462 SUPPLY AND DEMANDIf you are thinking of buying a house sometime in thefuture, then you may well follow the fortunes of thehousing market with some trepidation. In the late 1980sthere was a housing price explosion in the UK: in fact,between 1984 and 1989 house prices doubled. Afterseveral years of falling or gently rising house prices inthe early and mid-1990s, there was another boom from1996 to 2004, with house prices rising by 26 per centper year at the peak (in the 12 months to January read more..

  • Page - 74

    2.3 PRICE AND OUTPUT DETERMINATION47The determinants of house pricesHouse prices are determined by demand and supply. If demand rises (i.e. shifts to the right) or if supply falls(i.e. shifts to the left), the equilibrium price of houseswill rise. Similarly, if demand falls or supply rises, theequilibrium price will fall.So why did house prices rise so rapidly in the 1980s,only to fall in the early 1990s and then rise rapidly againin the late 1990s and early 2000s? The answer liesprimarily in read more..

  • Page - 75

    482 SUPPLY AND DEMANDDefinitionsIdentification problem The problem of identifying the relationship between two variables (e.g. price andquantity demanded) from the evidence when it is notknown whether or how the variables have been affected by other determinants. For example, it is difficult to identify the shape of a demand curve simply by observingprice and quantity when it is not known whether changesin other determinants have shifted the demand curve.Price elasticity of demand The read more..

  • Page - 76

    2.4 ELASTICITY49Assume that initially the supply curve is S1, and that itintersects with both demand curves at point a, at a price ofP1 and a quantity of Q1. Now supply shifts to S2. What willhappen to price and quantity? In the case of the less elasticdemand curve D, there is a relatively large rise in price (toP2 ) and a relatively small fall in quantity (to Q2 ): equilib-rium is at point b. In the case of the more elastic demandcurve D′, however, there is only a relatively small rise read more..

  • Page - 77

    502 SUPPLY AND DEMANDElastic (> 1).This is where a change in price causes a pro-portionately larger change in the quantity demanded. Inthis case the value of elasticity will be greater than 1, sincewe are dividing a larger figure by a smaller figure.Inelastic (< 1).This is where a change in a price causes aproportionately smaller change in the quantity demanded.In this case elasticity will be less than 1, since we are divid-ing a smaller figure by a larger figure.Unit elastic (= read more..

  • Page - 78

    2.4 ELASTICITY51For example, if consumers buy 3 million units (Q ) at a priceof £2 per unit (P), they will spend a total of £6 million (TE).Total consumer expenditure will be the same as the totalrevenue (TR) received by firms from the sale of the product(before any taxes or other deductions).What will happen to consumer expenditure (and hencefirms’ revenue) if there is a change in price? The answerdepends on the price elasticity of demand.Elastic demandAs price rises so quantity demanded read more..

  • Page - 79

    522 SUPPLY AND DEMANDthe price rises, the bigger will be the level of consumerexpenditure. Thus in Figure 2.13(a), consumer expenditurewill be higher at P2 than at P1.?Can you think of any examples of goods which have atotally inelastic demand (a) at all prices; (b) over aparticular price range?Infinitely elastic demand.This is shown by a horizontalstraight line. At any price above P1in Figure 2.13(b),demand is zero. But at P1 (or any price below) demand is‘infinitely’ large.This seemingly read more..

  • Page - 80

    2.4 ELASTICITY53The first is when the elasticity just so happens to be thesame all the way along a curve, as in the three special casesillustrated in Figure 2.13. The second is where two curvesare drawn on the same diagram, as in Figure 2.10. Here wecan say that demand curve D is less elastic than demandcurve D′ at any given price. Note, however, that each ofthese two curves will still have different elasticities along its length.Although we cannot normally talk about the elasticity ofa whole read more..

  • Page - 81

    542 SUPPLY AND DEMANDThe way we measure a proportionate change in quantity isto divide that change by the level of Q: i.e. ∆Q/Q. Similarly,we measure a proportionate change in price by dividingthat change by the level of P: i.e. ∆P/P. Price elasticity ofdemand can thus now be rewritten as:∆Q ÷∆PQPBut just what value do we give to P and Q? Consider the demand curve in Figure 2.15. What is the elasticity ofdemand between points m and n? Price has fallen by £2(from £8 to £6), but what read more..

  • Page - 82

    2.4 ELASTICITY55*The measurement of elasticity: point elasticityRather than measuring elasticity between two points on ademand curve, we may want to measure it at a single point:for example, point r in Figure 2.16. In order to measurepoint elasticity we must first rearrange the terms in the for-mula ∆Q/Q ÷∆P/P. By doing so we can rewrite the formulafor price elasticity of demand as:∆Q×P∆PQSince we want to measure price elasticity at a point onthe demand curve, rather than between two read more..

  • Page - 83

    562 SUPPLY AND DEMAND(A knowledge of the rules of differentiation isnecessary to understand this box. See Appendix 1.)The following is an example of an equation for ademand curve:Qd= 60 − 15P+ P2(where Qd is measured in 000s of units). From this thefollowing table and the graph can be constructed.P60−15P+P2=Qd (000s)060−0+0=60160−15+1=46260−30+4=34360−45+9=24460−60+16=16560−75+25=10660−90+36=6Point elasticity can be easily calculated from such ademand equation using calculus. read more..

  • Page - 84

    2.4 ELASTICITY57Price elasticity of supply (PS)When price changes, there will be not only a change in the quantity demanded, but also a change in the quantitysupplied. Frequently we will want to know just how respon-sive quantity supplied is to a change in price. The measurewe use is the price elasticity of supply.Figure 2.17 shows two supply curves. Curve S2 is moreelastic between any two prices than curve S1. Thus, whenprice rises from P1 to P2 there is a larger increase in quantitysupplied read more..

  • Page - 85

    582 SUPPLY AND DEMANDOther supply curves’ elasticities will vary along theirlength. In such cases we have to refer to the elasticity eitherbetween two points on the curve, or at a specific point.Calculating elasticity between two points will involve thearc method. Calculating elasticity at a point will involvethe point method. These two methods are just the same forsupply curves as for demand curves: the formulae are thesame, only the term Q now refers to quantity suppliedrather than quantity read more..

  • Page - 86

    2.4 ELASTICITY59As we have seen in the case of price elasticity ofdemand, elasticity measures the responsiveness of one variable (e.g. quantity demanded) to change inanother (e.g. price). This concept is fundamental tounderstanding how markets work. The more elasticvariables are, the more responsive is the market tochanging circumstances.Elasticity is more than just a technical term. It’s notdifficult to learn the formula:PD=%∆QD%∆Pin the case of price elasticity of demand, and then read more..

  • Page - 87

    602 SUPPLY AND DEMANDto butter or better quality margarine. Unlike normal goods,which have a positive income elasticity of demand, inferiorgoods have a negative income elasticity of demand.?Look ahead to Box 3.4 (page 79). It shows the incomeelasticity of demand for various foodstuffs. Explain thedifference in the figures for milk, bread and fresh fish.Income elasticity of demand is an important concept tofirms considering the future size of the market for theirproduct. If the product has a read more..

  • Page - 88

    2.5 THE TIME DIMENSION61Price expectations and speculationIn a world of shifting demand and supply curves, prices donot stay the same. Sometimes they go up; sometimes theycome down.If prices are likely to change in the foreseeable future,this will affect the behaviour of buyers and sellers now. If,for example, it is now December and you are thinking ofbuying a new winter coat, you might decide to wait untilthe January sales, and in the meantime make do with yourold coat. If, on the other hand, read more..

  • Page - 89

    622 SUPPLY AND DEMANDto buy it back later. For example, if you own shares andexpect their price to fall, you may sell them now and buythem back later when their price has fallen. Again, youmake a profit from the difference in price.Sometimes the term speculation is used in this narrowersense of buying (or selling) commodities or financial assetssimply to make money from later selling them (or buyingthem back) again at a higher (or lower) price. The termspeculators usually refers to people read more..

  • Page - 90

    2.5 THE TIME DIMENSION63Speculation can either help to reduce price fluctuationsor aggravate them: it can be stabilising or destabilising.Stabilising speculationSpeculation will tend to have a stabilising effect on pricefluctuations when suppliers and/or demanders believe thata change in price is only temporary.An initial fall in price.In Figure 2.21 demand has shiftedfrom D1 to D2 ; equilibrium has moved from point a topoint b, and price has fallen to P2. How do people react tothis fall in read more..

  • Page - 91

    642 SUPPLY AND DEMANDDestabilising speculationSpeculation will tend to have a destabilising effect on pricefluctuations when suppliers and/or buyers believe that achange in price heralds similar changes to come.An initial fall in price.In Figure 2.23 demand has shiftedfrom D1 to D2 and price has fallen from P1 to P2. This time, believing that the fall in price heralds further falls in price to come, suppliers sell now before the price doesfall. Supply shifts from S1 to S2. And demanders wait: read more..

  • Page - 92

    2.5 THE TIME DIMENSION65One way of reducing or even eliminating uncertainty isby dealing in futures or forward markets. Let us examinefirst the activities of sellers and then of buyers.SellersSuppose you are a farmer and want to store grain to sell at some time in the future, expecting to get abetter price then than now. The trouble is that there is a chance that the price will go down. Given thisuncertainty, you may be unwilling to take a gamble.An answer to your problem is provided by read more..

  • Page - 93

    662 SUPPLY AND DEMANDDefinitionUncertainty When an outcome may or may not occurand its probability of occurring is not known.Section summary1. A complete understanding of markets must take intoaccount the time dimension.2. Given that producers and consumers take a time to respond fully to price changes, we can identifydifferent equilibria after the lapse of different lengthsof time. Generally, short-run supply and demandtend to be less price elastic than long-run supply anddemand. As a result, read more..

  • Page - 94

    2.5 THE TIME DIMENSION67END OF CHAPTER QUESTIONS1. The weekly demand and supplyschedules for T-shirts (in millions) in a free market are as follows:Price (£)87654321Quantity demanded68 10 12 14 16 18 20Quantity supplied18 16 14 12 10864(a) What is the equilibrium price and quantity?(b) Assume that changes in fashion cause thedemand for T-shirts to rise by 4 million at eachprice. What will be the new equilibrium priceand quantity? Has equilibrium quantity risen asmuch as the rise in demand? read more..

  • Page - 95

    682 SUPPLY AND DEMAND• For news articles relevant to this chapter, see the Economics News Articles link from the book’swebsite.• For general news on markets, see websites in section A, and particularly A2, 3, 4, 5, 8, 9, 18, 24, 25, 26,36. See also links to newspapers worldwide in A38, 39, 43 and 44, and the news search feature inGoogle at A41.• For links to sites on markets, see the relevant sections of I4, 7, 11, 17.• For data on the housing market (Box 2.2), see sites B7, 8, 11.• read more..

  • Page - 96

    Chapter3Government Intervention in the Market3.1 The control of prices70Setting a minimum (high) price70Setting a maximum (low) price713.2 Indirect taxes73The effect of imposing taxes on goods73Elasticity and the incidence of taxation743.3 Government rejection of market allocation76Free provision: the case of health care76Prohibiting goods: the case of illegal drugs773.4 Agriculture and agricultural policy78Why intervene?78Government intervention80The Common Agricultural Policy of the read more..

  • Page - 97

    703 GOVERNMENT INTERVENTION IN THE MARKET?Draw a supply and demand diagram with the price of labour (the wage rate) on the vertical axis and the quantity of labour (the number of workers) on the horizontal axis. What will happen toemployment if the government raises wages from the equilibrium to some minimum wage above theequilibrium?The government can use various methods to deal withthe surpluses associated with minimum prices.• The government could buy the surplus and store it,destroy it or read more..

  • Page - 98

    3.1 THE CONTROL OF PRICES71Setting a maximum (low) priceThe government may set maximum prices to prevent themfrom rising above a certain level. This will normally bedone for reasons of fairness. In wartime, or times of famine,the government may set maximum prices for basic goodsso that poor people can afford to buy them.The resulting shortages, however, create further prob-lems. If the government merely sets prices and does notintervene further, the shortages will lead to the following:• read more..

  • Page - 99

    723 GOVERNMENT INTERVENTION IN THE MARKETbe issued with a set number of coupons for each itemrationed.A major problem with maximum prices is likely to be the emergence of black markets, where customers, unableto buy enough in legal markets, may well be prepared to pay very high prices: prices above Pe in Figure 3.2 (seeBox 3.2).Another problem is that the maximum prices reduce thequantity produced of an already scarce commodity. Forexample, artificially low prices in a famine are likely read more..

  • Page - 100

    3.2 INDIRECT TAXES73Section summary1. There are several ways in which the governmentintervenes in the operation of markets. It can fixprices, tax or subsidise products, regulateproduction, or produce goods directly itself.2. The government may fix minimum or maximumprices. If a minimum price is set above theequilibrium, a surplus will result. If a maximum price is set below the equilibrium price, a shortagewill result.3. Minimum prices are set as a means of protecting the incomes of suppliers read more..

  • Page - 101

    743 GOVERNMENT INTERVENTION IN THE MARKETIn each of the diagrams (which are all drawn to the samescale), the size of the tax is the same: the supply curve shiftsupwards by the same amount. Price rises to P2 in each caseand quantity falls to Q2; but as you can see, the size of thisincrease in price and decrease in quantity differs in each case,depending on the price elasticity of demand and supply.The total tax revenue is given by the amount of tax perunit (the vertical difference between the two read more..

  • Page - 102

    3.2 INDIRECT TAXES75The remainder (the green area) is the producers’ share.This is the amount by which the producers’ net price (P2− t)is below the original price (P1) multiplied by Q2.From these diagrams the following conclusions can bedrawn:• Quantity will fall less, and hence tax revenue for thegovernment will be greater, the less elastic are demandand supply (cases (1) and (3) ).• Price will rise more, and hence the consumers’ share ofthe tax will be larger, the less elastic is read more..

  • Page - 103

    763 GOVERNMENT INTERVENTION IN THE MARKETSometimes the government may consider that certainproducts or services are best not allocated through the mar-ket at all. This section examines two extreme cases. The firstis goods or services that are provided free at the point ofdelivery, such as treatment in National Health Service hos-pitals and education in state schools. The second is goodsand services whose sale is banned, such as certain drugs,weapons and pornography.Providing goods and services read more..

  • Page - 104

    3.3 GOVERNMENT REJECTION OF MARKET ALLOCATION77larger amount of medical treatment than younger people.The second has to do with advances in medical science andtechnology. More and more medical conditions are nowtreatable, so there is now a demand for such treatmentwhere none existed before.What is the solution? The answer for most people wouldbe to increase supply, while keeping treatment free. Partlythis can be done by increases in efficiency, and, indeed, vari-ous initiatives have been taken read more..

  • Page - 105

    783 GOVERNMENT INTERVENTION IN THE MARKETSection summary1. Sometimes the government will want to avoidallocation by the market for a particular good orservice. Examples include things provided free at thepoint of use and products that are prohibited by thegovernment.2. If products are provided free to consumers, demandis likely to exceed supply. This is a particularproblem in the case of health care, where demand isgrowing rapidly.3. If products such as drugs are prohibited, an illegalmarket is read more..

  • Page - 106

    3.4 AGRICULTURE AND AGRICULTURAL POLICY79Demand problems.Food, being a basic necessity of life,has no substitute. If the price of food in general goes up,people cannot switch to an alternative: they have either to pay the higher price or to consume less food. They might consume a bit less, but not much! The price elasticity for food in general, therefore, is very low (see Box 3.4).It is not quite so low for individual foodstuffs because if the price of one goes up, people can always switch to read more..

  • Page - 107

    803 GOVERNMENT INTERVENTION IN THE MARKETThis very low income elasticity of demand has a crucialeffect on farm incomes. It means that a rise in nationalincome of 1 per cent leads to a rise in food consumption of considerably less than 1 per cent. As a result, total farmincomes will grow much more slowly than the incomes ofother sectors. Unless people leave the land, farmers’incomes will grow less rapidly than those of the owners ofother businesses, and farm workers’ wages will grow read more..

  • Page - 108

    3.4 AGRICULTURE AND AGRICULTURAL POLICY81releasing the food back on to the market when harvests are bad. They can thus only be used with food that can be stored: i.e. non-perishable foods, such as grain, wine ormilk powder; or food that can be put into frozen storage,such as butter and meat. The idea of buffer stocks is a veryancient one, as Web Case 3.2, Seven years of plenty and sevenyears of famine, demonstrates.What the government does is to fix a price. Assume thatthis is Pg in Figure read more..

  • Page - 109

    823 GOVERNMENT INTERVENTION IN THE MARKETthe market price. An alternative, therefore, would be to letthe size of the subsidy vary with the market price. Thelower the price, the bigger the subsidy.An advantage of subsidies is that they result in lower pricesfor the consumer. On the other hand, they have to be paidfrom tax revenues and therefore result in higher taxes.?The total amount paid in subsidies is greater in Figure 3.11 than in Figure 3.12. Will it always be thecase that, for a given read more..

  • Page - 110

    3.4 AGRICULTURE AND AGRICULTURAL POLICY83In open markets, however, a reduction in domestic supplycould simply lead to an increase in imports, with the resultthat the price would not rise to the desired level. In such a case, a combination of a reduction in domestic supplyand import levies (or other import restrictions) would berequired. This can be illustrated using Figure 3.14. First, bythe use of various restrictions on output, the domestic sup-ply curve could be shifted to the left, so that read more..

  • Page - 111

    843 GOVERNMENT INTERVENTION IN THE MARKETCriticisms of the CAPIf the arguments in favour of the CAP’s system of price sup-port are questionable, the arguments against are substantial.Agricultural surpluses (not sold on world markets)The costs of the surpluses are borne by consumers and taxpayers. They can be illustrated by referring back toFigure 3.14. Assume that the intervention is Pmin.• The cost to the taxpayer is shown by the shaded area.• The cost to the consumer arises from having read more..

  • Page - 112

    3.4 AGRICULTURE AND AGRICULTURAL POLICY85agriculture in developing countries: (a) exporters of food-stuffs find it very difficult to compete with subsidised EU exports; (b) farmers in developing countries who areproducing for their domestic market find that they cannotcompete with cheap imports of food.Agriculture in the developing world thus declines.Farmers’ incomes are too low to invest in the land. Manymigrate to the overcrowded cities and become slum dwellersin shanty towns, with read more..

  • Page - 113

    863 GOVERNMENT INTERVENTION IN THE MARKETcurves of D and S1, the surplus was Qs1 − Qd1. Farmers’ rev-enues were abcd. The effect of the increased set-aside hasbeen to shift the supply curve of cereals to the left, shownby S2. This, plus a reduction in the intervention price to P2,has reduced the surplus to Qs 2 − Qd2. Farmers’ revenueshave been reduced to a′b′c′d, but the CAP pays compen-sation payments for the loss in profits.In the first three years after these reforms, annual read more..

  • Page - 114

    3.4 AGRICULTURE AND AGRICULTURAL POLICY87Section summary1. Despite the fact that a free market in agriculturalproduce would be highly competitive, there is large-scale government intervention in agriculturethroughout the world. The aims of interventioninclude preventing or reducing price fluctuations,encouraging greater national self-sufficiency,increasing farm incomes, encouraging farminvestment, and protecting traditional rural ways of life and the rural environment generally.2. Price read more..

  • Page - 115

    883 GOVERNMENT INTERVENTION IN THE MARKETAdditional case studies on the book’s website ( A case study in the use of rationing as an alternative to the price mechanism. In particular, it looksat the use of rationing in the UK during the Second World War.3.2Seven years of plenty and seven years of famine. This looks at how buffer stocks were used by Joseph inbiblical Egypt.3.3Buffer stocks to stabilise farm incomes. This theoretical case shows how the read more..

  • Page - 116

    Part C: MicroeconomicsWe now examine in more detail how economies function at a micro level. In doing so,we will look at some of the big questions of our time. Why do some firms make suchlarge profits? Why is there such a gap between the rich and the poor? Why, if everyonewants a better environment, are we plagued with problems of pollution and congestion?Chapters 4 and 5 examine demand and supply in more detail. Then in Chapters 6 to 8 welook at how the degree of competition a firm faces read more..

  • Page - 117

    EC6_C04.qxd 10/28/05 17:03 Page 90 read more..

  • Page - 118

    Chapter4Background to Demand4.1 Marginal utility theory92Total and marginal utility92The optimum level of consumption94Marginal utility and the demand for a good96Optimum combination of goods consumed97The demand curve994.2 Demand under risk and uncertainty100The problem of imperfect information100Attitudes towards risk and uncertainty101Diminishing MU of income and risk taking102Insurance: a way of removing risks103*4.3 Indifference analysis105The limitations of marginal utility read more..

  • Page - 119

    924 BACKGROUND TO DEMANDAs we are going to be examining the rational consumer, it is important to understand what we mean by the term. Itmeans a person who attempts to get the best value formoney from his or her purchases. Given that we have limited income, we do not want to waste our money. Thusmost of the time, we try to ensure that the benefits of whatwe are buying are worth the expense to us.Sometimes we may act ‘irrationally’. We may purchasegoods impetuously or out of habit, with read more..

  • Page - 120

    4.1 MARGINAL UTILITY THEORY93eaten 1 packet, he has less craving for a second. A thirdpacket gives him less extra utility still: marginal utility has fallen to 2 utils, giving a total utility of 13 utils (i.e. 11 + 2).By the time he has eaten 5 packets, he would rather not eat any more. A sixth actually reduces his utility (from14 utils to 13): its marginal utility is negative.The information in Table 4.1 is plotted in Figure 4.1.Notice the following points about the two curves:• The MU curve read more..

  • Page - 121

    944 BACKGROUND TO DEMANDThe relationship between total utility and marginalutility can be shown using calculus. If you are notfamiliar with the rules of calculus, ignore this box (or see Appendix 1, pp. A:9 – 12).A consumer’s typical utility function for a goodmight be of the form:TU= 60Q− 4Q2where Q is the quantity of the good consumed.This would give the figures shown in the followingtable.Q60Q− 4Q2=TU160− 4=562120− 16=1043180− 36=1444240− 64=176····?Complete this table to read more..

  • Page - 122

    4.1 MARGINAL UTILITY THEORY95Marginal consumer surplusMarginal consumer surplus (MCS ) is the differencebetween what you are willing to pay for one more unit of agood and what you are actually charged. If Darren werewilling to pay 25p for another packet of crisps which in factonly cost him 20p, he would be getting a marginal con-sumer surplus of 5p.MCS= MU – PTotal consumer surplusTotal consumer surplus (TCS ) is the sum of all themarginal consumer surpluses that you have obtained fromall the read more..

  • Page - 123

    964 BACKGROUND TO DEMANDmarginal utility curve: i.e. areas 1 + 2. Total consumer sur-plus (TU – TE ) is shown by area 2.?If a good were free, why would total consumer surplusequal total utility? What would be the level of marginalutility at the equilibrium level of consumption?Marginal utility and the demand curve for a goodAn individual’s demand curveIndividual people’s demand curve for any good will be thesame as their marginal utility curve for that good, whereutility is measured in read more..

  • Page - 124

    4.1 MARGINAL UTILITY THEORY97consumption will bring less satisfaction than previously. Inother words, it is likely that the marginal utility of moneydiminishes as income rises.Unless a good occupies only a tiny fraction of people’sexpenditure, a fall in its price will mean that their realincome has increased: i.e. they can afford to purchase moregoods in general. As they do so, the marginal utility of theirmoney will fall. We cannot, therefore, legitimately usemoney to measure utility in an read more..

  • Page - 125

    984 BACKGROUND TO DEMANDThe rule for rational consumer behaviour is known asthe equi-marginal principle. This states that a consumerwill get the highest utility from a given level of incomewhen the ratio of the marginal utilities is equal to the ratioof the prices. Algebraically, this is when, for any pair ofgoods, A and B, that are consumed:MUA PAMUB=PB(1)To see the sense of this, say that the last unit of good A you consumed gave three times as much utility as the lastunit of B. Yet good A read more..

  • Page - 126

    4.1 MARGINAL UTILITY THEORY99equation (1). One point on the individual’s demand curvefor good A has been determined.If the price of good A now falls, such that:MUA PAMUB>PB(and similarly for goods C, D, E, etc.)the person would buy more of good A and less of all othergoods (B, C, D, E, etc.), until equation (1) is once moresatisfied. A second point on the individual’s demand curvefor good A has been determined.Further changes in the price of good A would bring further changes in the read more..

  • Page - 127

    1004 BACKGROUND TO DEMANDDo you take a taxi or go by bus? How long do youspend soaking in the bath? Do you go to the bother of cooking a meal or will you get a take-away?We have argued that such decisions, if they are to be rational, should involve weighing up the relativemarginal utilities of these activities against theirrelative marginal costs.One crucial dimension we have ignored up to now isthe time dimension. One of the opportunity costs ofdoing any activity is the sacrifice of time.A read more..

  • Page - 128

    4.2 DEMAND UNDER CONDITIONS OF RISK AND UNCERTAINTY101into the future you look, the less certain you will be of itscosts and benefits to you.Take the case of a washing machine costing you £400. Ifyou pay cash, your immediate outlay involves no uncer-tainty: it is £400. But washing machines can break down.In two years’ time you could find yourself with a repair billof £100. This cannot be predicted and yet it is a price youwill have to pay, just like the original £400. In other words,when read more..

  • Page - 129

    1024 BACKGROUND TO DEMANDon the throw of a dice. There is a one in six chance of thishappening. Would you gamble? It depends on what oddsyou were offered and on your attitude to risk.Odds can be of three types. They can be favourable odds.This is where on average you will gain. If, for example, youwere offered odds of 10 to 1 on the throw of a dice, then fora £1 bet you would get nothing if you lost, but you wouldget £10 (plus your £1 stake) if your number came up. Sinceyour number should read more..

  • Page - 130

    At an income of £10 000, your total utility is U2. If yourgamble pays off and raises your income to £15 000, yourtotal utility will rise to U3. If it does not pay off, you will be left with only £5000 and a utility of U1. Given that you have a 50:50 chance of winning, your average expectedutility will be midway between U1 and U3 (i.e. ) = U4.But this is the utility that would be gained from an incomeof £8000. Given that you would prefer U2 to U4 you willchoose not to take the gamble.Thus read more..

  • Page - 131

    1044 BACKGROUND TO DEMANDpremiums it must charge in order to make a profit. Withindividuals, however, the precise risk is rarely known. Doyou know your chances of living to 70? Almost certainlyyou do not. But a life assurance company has the statisticaldata to work out precisely the chances of a person of yourage, sex and occupation living to 70! It can convert youruncertainty into the company’s risk.The spreading of risks does not just require a large numberof policies. It also requires the read more..

  • Page - 132

    *4.3 INDIFFERENCE ANALYSIS105Section summary1. When people buy consumer durables, they may beuncertain of their benefits and any additional repairand maintenance costs. When they buy financialassets, they may be uncertain of what will happen to their price in the future. Buying under theseconditions of imperfect knowledge is therefore aform of gambling. When we take such gambles, ifwe know the odds we are said to be operating underconditions of risk. If we do not know the odds, we aresaid to read more..

  • Page - 133

    1064 BACKGROUND TO DEMANDof satisfaction. From this we can plot an indifference curve.We measure units of one good on one axis and units of theother good on the other axis. Thus in Figure 4.6, which is based on Table 4.2, pears and oranges are measured onthe two axes. The curve shows that Clive is indifferent as towhether he consumes 30 pears and 6 oranges (point a) or24 pears and 7 oranges (point b) or any other combinationof pears and oranges along the curve.Notice that we are not saying how read more..

  • Page - 134

    *4.3 INDIFFERENCE ANALYSIS107?Although indifference curves will normally be bowed intowards the origin, on odd occasions they might not be.Which of the following diagrams correspond to whichof the following?(a) X and Y are left shoes and right shoes.(b) X and Y are two brands of the same product, andthe consumer cannot tell them apart.(c) X is a good but Y is a ‘bad’ – like household refuse.An indifference mapMore than one indifference curve can be drawn. For example, referring back to read more..

  • Page - 135

    1084 BACKGROUND TO DEMANDWe have said that the amount people can afford to buywill depend on (a) their budget and (b) the prices of the twogoods. We can show how a change in either of these twodeterminants will affect the budget line.A change in incomeIf the consumer’s income (and hence budget) increases, thebudget line will shift outwards, parallel to the old one. Thisis illustrated in the last two columns of Table 4.3 and inFigure 4.9, which show the effect of a rise in the read more..

  • Page - 136

    *4.3 INDIFFERENCE ANALYSIS109This will enable us to show how much of each of the twogoods the ‘rational’ consumer will buy from a given budget.Let us examine Figure 4.11.The consumer would like to consume along the highestpossible indifference curve. This is curve I3 at point t.Higher indifference curves, such as I4 and I5, although representing higher utility than curve I3, are in the infeas-ible region: they represent combinations of X and Y thatcannot be afforded with the current budget. read more..

  • Page - 137

    1104 BACKGROUND TO DEMANDThe line joining these points is known as the income–consumption curve.If your money income goes up and the price of goodsdoes not change, we say that your real income has risen. Inother words, you can buy more than you did before. Butyour real income can also rise even if you do not earn anymore money. This will happen if prices fall. For the sameamount of money, you can buy more goods than previ-ously. We analyse the effect of a rise in real income causedby a fall in read more..

  • Page - 138

    *4.3 INDIFFERENCE ANALYSIS111point. The line that connects these points is known as theprice–consumption curve.Deriving the individual’s demand curveWe can use the analysis of price changes to show how in theory a person’s demand curve for a product can bederived. To do this we need to modify the diagram slightly.Let us assume that we want to derive a person’s demandcurve for good X. What we need to show is the effect on the consumption of X of a change in the price of X assum-ing the read more..

  • Page - 139

    1124 BACKGROUND TO DEMAND• The good is now more expensive relative to other goods.Therefore consumers substitute alternatives for it. This isthe substitution effect.We can extend our arguments of Chapter 2 by demon-strating the income and substitution effects with the use ofindifference analysis. Let us start with the case of a normalgood and show what happens when its price changes.A normal goodIn Figure 4.16 the price of normal good X has risen and thebudget line has pivoted inwards from B1 read more..

  • Page - 140

    KI 9p58*4.3 INDIFFERENCE ANALYSIS113The income effect.In reality, the budget line has shiftedto B2 and the consumer is forced to consume on a lowerindifference curve I2: real income has fallen. Thus themovement from QX2 to QX3 is the income effect.In the case of a normal good, therefore, the income andsubstitution effects of a price change reinforce each other.They are both negative: they both involve a reduction in thequantity demanded as price rises (and vice versa).2The bigger the income and read more..

  • Page - 141

    1144 BACKGROUND TO DEMAND?Illustrate on two separate indifference diagrams theincome and substitution effects of the following:(a) A decrease in the price of good X (and no change inthe price of good Y).(b) An increase in the price of good Y (and no change inthe price of good X).An inferior goodAs we saw above, when people’s incomes rise, they will buyless of inferior goods such as poor-quality margarine andcheap powdered instant coffee, since they will now be ableto afford better-quality read more..

  • Page - 142

    *4.3 INDIFFERENCE ANALYSIS115Characteristics theory was developed in the mid-1960sby Kelvin Lancaster. He argued that people demandgoods not for their own sake, but for the characteristicsthey possess.Take cars, for example. When choosing between thedifferent makes, consumers do not just consider theirrelative prices, they also consider their attributes:comfort, style, performance, durability, reliability, fuelconsumption, etc. It is these characteristics that giverise to utility.Characteristics read more..

  • Page - 143

    1164 BACKGROUND TO DEMAND?Are there any Giffen goods that you consume? If not,could you conceive of any circumstances in which oneor more items of your expenditure would becomeGiffen goods?The usefulness of indifference analysisIndifference analysis has made it possible to demonstratethe logic of ‘rational’ consumer choice, the derivation ofthe individual’s demand curve, and the income and sub-stitution effects of a price change. All this has been donewithout having to measure read more..

  • Page - 144

    *4.3 INDIFFERENCE ANALYSIS117END OF CHAPTER QUESTIONS1. Imagine that you had £10 per month to allocate between two goods a and b.Imagine that good a cost £2 per unit and good b cost £1 per unit. Imagine also that the utilitiesof the two goods are those set out in the table below.(Note that the two goods are not substitutes for eachother, so that the consumption of one does not affectthe utility gained from the other.)(a) What would be the marginal utility ratio(MUa /MUb) for the following read more..

  • Page - 145

    1184 BACKGROUND TO DEMAND• For news articles relevant to this chapter, see the Economics News Articles link from the book’swebsite.• For general news on demand and consumers, see websites in section A, and particularly A2, 3, 4, 8, 9,11, 12, 23, 25, 36. See also site A41 for links to economics news articles on particular search topics (e.g. consumer demand and advertising).• For data, information and sites on products and marketing, see sites B2, 10; I7, 11, 13, 17.• For student read more..

  • Page - 146

    Chapter5Background to Supply5.1 The short-run theory of production120Short- and long-run changes in production120The law of diminishing returns121Total product121Average and marginal product1235.2 Costs in the short run126Measuring costs of production126Costs and inputs127Total cost127Average and marginal costs1285.3 The long-run theory of production131The scale of production131Location133The size of the whole industry133The optimum combination of factors134*Isoquant/isocost approach135Decision read more..

  • Page - 147

    1205 BACKGROUND TO SUPPLYDefinitionsRational producer behaviour When a firm weighs up thecosts and benefits of alternative courses of action and thenseeks to maximise its net benefit.Traditional theory of the firm The analysis of pricing andoutput decisions of the firm under various market conditions,assuming that the firm wishes to maximise profit.Alternative theories of the firm Theories of the firm basedon the assumption that firms have aims other than profitmaximisation.Fixed read more..

  • Page - 148

    5.1 THE SHORT-RUN THEORY OF PRODUCTION121example, if a shipping line wanted to carry more passengersin response to a rise in demand, it could possibly accom-modate more passengers on existing sailings if there wasspace. It could possibly increase the number of sailingswith its existing fleet, by hiring more crew and using morefuel. But in the short run it could not buy more ships: therewould not be time for them to be built.The long run is a time period long enough for all inputsto be varied. read more..

  • Page - 149

    KI 20p1821225 BACKGROUND TO SUPPLYThe law of diminishing returns has potentiallycataclysmic implications for the future populations of the world.If the population of the world grows rapidly, thenfood output may not keep pace with it. There will bediminishing returns to labour as more and more people crowd on to the limited amount of landavailable.This is already a problem in some of the poorestcountries of the world, especially in sub-SaharanAfrica. The land is barely able to support read more..

  • Page - 150

    5.1 THE SHORT-RUN THEORY OF PRODUCTION123is low, since the workers are spread too thinly. With moreworkers, however, they can work together – each, perhaps,doing some specialist job – and thus they can use the landmore efficiently. In Table 5.1, output rises more and morerapidly up to the employment of the third worker (point b).In Figure 5.1 the TPP curve gets steeper up to point b.After point b, however, diminishing marginal returns setin: output rises less and less rapidly, and the TPP read more..

  • Page - 151

    1245 BACKGROUND TO SUPPLYAPP= TPP/QvThus in Table 5.1 the average physical product of labourwhen four workers are employed is 36/4 = 9 tonnes per year.Marginal physical productThis is the extra output (∆TPP) produced by employing onemore unit of the variable factor.Thus in Table 5.1 the marginal physical product of thefourth worker is 12 tonnes. The reason is that by employingthe fourth worker, wheat output has risen from 24 tonnesto 36 tonnes: a rise of 12 tonnes.In symbols, marginal physical read more..

  • Page - 152

    5.1 THE SHORT-RUN THEORY OF PRODUCTION125In this chapter we have just examined the concepts ofaverage and marginal physical product. We shall becoming across several other average and marginalconcepts later on. It is useful at this stage to examinethe general relationship between averages andmarginals. In all cases there are three simple rules that relate them.To illustrate these rules, consider the followingexample.Imagine a room with ten people in it. Assume thatthe average age of those read more..

  • Page - 153

    KI 2p81265 BACKGROUND TO SUPPLYSection summary1. A production function shows the relationshipbetween the amount of inputs used and the amountof output produced from them (per period of time).2. In the short run it is assumed that one or morefactors (inputs) are fixed in supply. The actual lengthof the short run will vary from industry to industry.3. Production in the short run is subject to diminishingreturns. As greater quantities of the variable factor(s)are used, so each additional unit of read more..

  • Page - 154

    5.2 COSTS IN THE SHORT RUN127Likewise the replacement cost is irrelevant. That shouldbe taken into account only when the firm is consideringreplacing the machine.Costs and inputsA firm’s costs of production will depend on the factors of production it uses. The more factors it uses, the greaterwill its costs be. More precisely, this relationship dependson two elements:• The productivity of the factors. The greater their physical productivity, the smaller will be the quantity ofthem required read more..

  • Page - 155

    1285 BACKGROUND TO SUPPLYTotal fixed cost (TFC)In our example, total fixed cost is assumed to be £12. Sincethis does not vary with output, it is shown by a horizontalstraight line.Total variable cost (TVC)With a zero output, no variable factors will be used. ThusTVC= 0. The TVC curve, therefore, starts from the origin.The shape of the TVC curve follows from the law ofdiminishing returns. Initially, before diminishing returnsset in, TVC rises less and less rapidly as more variable fac-tors are read more..

  • Page - 156

    5.2 COSTS IN THE SHORT RUN129For example, assume that a firm is currently producing 1 000 000 boxes of matches a month. It now increases out-put by 1000 boxes (another batch): ∆Q = 1000. As a result,its total costs rise by £30: ∆TC = £30. What is the cost ofproducing one more box of matches? It is:∆TC=£30 = 3p∆Q 1000 (Note that all marginal costs are variable, since, by defini-tion, there can be no extra fixed costs as output rises.)Given the TFC, TVC and TC for each output, it is read more..

  • Page - 157

    1305 BACKGROUND TO SUPPLYAverage (total) cost (AC)This is simply the vertical sum of the AFC and AVC curves.Note that as AFC gets less, the gap between AVC and ACnarrows.The relationship between average cost andmarginal costThis is simply another illustration of the relationship thatapplies between all averages and marginals (see Box 5.3).As long as new units of output cost less than the average,their production must pull the average cost down. That is,if MC is less than AC, AC must be falling. read more..

  • Page - 158

    KI 16p1205.3 THE LONG-RUN THEORY OF PRODUCTION131Section summary1. When measuring costs of production, we should be careful to use the concept of opportunity cost. In the case of factors not owned by the firm, theopportunity cost is simply the explicit cost ofpurchasing or hiring them. It is the price paid for them.In the case of factors already owned by the firm, it isthe implicit cost of what the factor could have earnedfor the firm in its next best alternative use.2. In the short run, some read more..

  • Page - 159

    1325 BACKGROUND TO SUPPLYproduction increases. Clearly, if a firm is getting increasingreturns to scale from its factors of production, then as itproduces more it will be using smaller and smaller amountsof factors per unit of output. Other things being equal, thismeans that it will be producing at a lower unit cost.There are several reasons why firms are likely to experi-ence economies of scale. Some are due to increasing returnsto scale; some are not.Specialisation and division of labour.In read more..

  • Page - 160

    5.3 THE LONG-RUN THEORY OF PRODUCTION133Financial economies.Large firms may be able to obtainfinance at lower interest rates than small firms. They maybe able to obtain certain inputs cheaper by buying in bulk.Economies of scope.Often a firm is large because it produces a range of products. This can result in each individual product being produced more cheaply than if it was produced in a single-product firm. The reason forthese economies of scope is that various overhead costs and read more..

  • Page - 161

    1345 BACKGROUND TO SUPPLY?1. Name some industries where external economies of scale are gained. What are the specific externaleconomies in each case?2. Would you expect external economies to beassociated with the concentration of an industry in a particular region?The member firms of a particular industry might experi-ence external diseconomies of scale. For example, as anindustry grows larger, this may create a growing shortage ofspecific raw materials or skilled labour. This will push read more..

  • Page - 162

    5.3 THE LONG-RUN THEORY OF PRODUCTION135*The optimum combination of factors: the isoquant/isocost approachThis section is optional. You can skip straight to page 139without loss of continuity.A firm’s choice of optimum technique can be showngraphically. This graphical analysis takes the simplest caseof just two variable factors – for example, labour and cap-ital. The amount of labour used is measured on one axisand the amount of capital used is measured on the other.The graph involves the read more..

  • Page - 163

    1365 BACKGROUND TO SUPPLYThe isoquant shows the whole range of alternative waysof producing a given output. Thus Figure 5.5 shows notonly points a to e from the table, but all the intermediatepoints too.Like an indifference curve, an isoquant is rather like acontour on a map. And like contours and indifferencecurves, a whole series of isoquants can be drawn, each onerepresenting a different level of output (TPP). The higherthe output, the further out to the right will the isoquant be.Thus in read more..

  • Page - 164

    5.3 THE LONG-RUN THEORY OF PRODUCTION137(∆K = 2) could be replaced by 1 unit of labour (∆L = 1) theMRS would be 2. Thus:MRS=∆K=2 = 2∆L 1The MRS between two points on the isoquant will equalthe slope of the line joining those two points. Thus inFigure 5.7, the MRS between points g and h is 2 (∆K/∆L =2/1). But this is merely the slope of the line joining points gand h (ignoring the negative sign).When the isoquant is bowed in towards the origin, the slope of the isoquant will diminish read more..

  • Page - 165

    1385 BACKGROUND TO SUPPLY?1. What will happen to an isocost if the prices of bothfactors rise by the same percentage?2. What will happen to the isocost in Figure 5.8 if thewage rate rises to £15 000?The slope of the isocost equals:PLPKThis can be shown in the above example. The slope of the isocost in Figure 5.8 is 15/30 = 1/2. But this is PL/PK (i.e. £10 000/£20 000).Isoquants and isocosts can now be put on the same dia-gram. The diagram can be used to answer either of twoquestions: (a) What read more..

  • Page - 166

    5.3 THE LONG-RUN THEORY OF PRODUCTION139If the prices of factors change, new isocosts will have tobe drawn. Thus in Figure 5.10, if the wage rate goes up, lesslabour can be used for a given sum of money. The isocostwill swing inwards round point x. The isocost will getsteeper. Less labour will now be used relative to capital.Postscript: Decision making in differenttime periodsWe have distinguished between the short run and the longrun. Let us introduce two more time periods to completethe read more..

  • Page - 167

    1405 BACKGROUND TO SUPPLY?1. Could the long run and the very long run ever bethe same length of time?2. What will the long-run and very-long-run marketsupply curves for a product look like? How will theshape of the long-run curve depend on returns toscale?*3. In the very long run, new isoquants will have to bedrawn as factor productivity changes. An increasein productivity will shift the isoquants inwardstowards the origin: less capital and labour will berequired to produce any given level of read more..

  • Page - 168

    5.4 COSTS IN THE LONG RUN141flatten out. Then (possibly after a period of constant LRAC)the firm will get so large that it will start experiencing dis-economies of scale and thus a rising LRAC. At this stage,production and financial economies will begin to be offset bythe managerial problems of running a giant organisation.?Given the LRAC curve in Figure 5.11, what would thefirm’s long-run total cost curve look like?Assumptions behind the long-run average cost curveWe make three key read more..

  • Page - 169

    The relationship between long-run andshort-run average cost curvesTake the case of a firm which has just one factory and faces a short-run average cost curve illustrated by SRAC1 inFigure 5.13.In the long run, it can build more factories. If it therebyexperiences economies of scale (due, say, to savings onadministration), each successive factory will allow it to pro-duce with a new lower SRAC curve. Thus with two factoriesit will face SRAC2; with three factories SRAC3, and so on.Each SRAC curve read more..

  • Page - 170

    *Derivation of long-run costs from anisoquant map4Cost curves are drawn on the assumption that, for any output, the least-cost combination of factors is used: thatis, that production will take place at the tangency point of the isoquant and an isocost, where MPPL /MPPK = PL/PK:i.e. where MPPL/PL= MPPK/PK. By drawing a series of isoquants and isocosts, long-run costs can be derived foreach output.In Figure 5.14, isoquants are drawn for some hypothet-ical firm at 100 unit intervals. Up to 400 read more..

  • Page - 171

    1445 BACKGROUND TO SUPPLYTwo of the most important studies of economies ofscale are those made by C. F. Pratten5 in the late 1980sand by a group advising the European Commission6 in1997. Both studies found strong evidence that manyfirms, especially in manufacturing, experiencedsubstantial economies of scale.In a few cases, long-run average costs fellcontinuously as output increased. For most firms,however, they fell up to a certain level of output andthen remained constant.The extent of read more..

  • Page - 172

    Average revenue (AR)Average revenue is the amount the firm earns per unit sold.Thus:AR= TR/QSo if the firm earns £5000 (TR) from selling 1000 units (Q),it will earn £5 per unit. But this is simply the price! Thus:AR= P(The only exception to this is when the firm is selling itsproducts at different prices to different consumers. In thiscase, AR is simply the (weighted) average price.)Marginal revenue (MR)Marginal revenue is the extra total revenue gained by sell-ing one more unit (per time read more..

  • Page - 173

    1465 BACKGROUND TO SUPPLYWe now need to see how each of these three revenue con-cepts (TR, AR and MR) varies with output. We can show thisgraphically in the same way as we did with costs.The relationships will depend on the market conditionsunder which a firm operates. A firm that is too small to beable to affect market price will have different-shaped revenuecurves from a firm that is able to choose the price it charges.Let us examine each of these two situations in turn.Revenue curves when read more..

  • Page - 174

    5.5 REVENUE147Revenue curves when price varies with outputThe three curves (TR, AR and MR) look quite different whenprice does vary with the firm’s output. If a firm has a relativelylarge share of the market, it will face a downward-slopingdemand curve. This means that if it is to sell more, it mustlower the price. It could also choose to raise its price. If itdoes so, however, it will have to accept a fall in sales.Average revenueRemember that average revenue equals price. If, read more..

  • Page - 175

    1485 BACKGROUND TO SUPPLYwill be inelastic at that quantity, since a rise in quantitysold would lead to a fall in total revenue.Thus the demand (AR) curve in Figure 5.17 is elastic tothe left of point r and inelastic to the right.Total revenueTotal revenue equals price times quantity. This is illustratedin Table 5.8. The TR column from Table 5.8 is plotted inFigure 5.18.Unlike the case of a price-taking firm, the TR curve is nota straight line. It is a curve that rises at first and then read more..

  • Page - 176

    5.6 PROFIT MAXIMISATION149Shifts in revenue curvesWe saw in Chapter 2 that a change in price will cause amovement along a demand curve. It is similar with revenuecurves, except that here the causal connection is in theother direction. Here we ask what happens to revenuewhen there is a change in the firm’s output. Again the effectis shown by a movement along the curves.A change in any other determinant of demand, such astastes, income or the price of other goods, will shift thedemand curve. By read more..

  • Page - 177

    1505 BACKGROUND TO SUPPLYShort-run profit maximisation: usingaverage and marginal curvesTable 5.10 is based on the figures in Table 5.9.?1. Fill in the missing figures (without referring to Table 5.8 or 5.9).2. Why are the figures for MR and MC entered in thespaces between the lines in Table 5.10?Finding the maximum profit that a firm can make is a two-stage process. The first stage is to find the profit-maximising output. To do this we use the MC and MRcurves. The second stage is to read more..

  • Page - 178

    5.6 PROFIT MAXIMISATION151Stage 2: Using average curves to measure the sizeof the profitOnce the profit-maximising output has been discovered,we use the average curves to measure the amount of profit atthe maximum. Both marginal and average curves corres-ponding to the data in Table 5.10 are plotted in Figure 5.21.First, average profit (AΠ ) is found. This is simply AR−AC. At the profit-maximising output of 3, this gives a figurefor AΠ of £6 − £42/3= £11/3. Then total profit is read more..

  • Page - 179

    1525 BACKGROUND TO SUPPLYfood retailing, it is relatively low. Where outcomes are veryuncertain, such as mineral exploration or the manufactureof fashion garments, it is relatively high.Thus if owners of a business earn normal profit, they will(just) be content to remain in that industry. If they earnmore than normal profit, they will also (obviously) preferto stay in this business. If they earn less than normal profit,then after a time they will consider leaving and using theircapital for read more..

  • Page - 180

    Loss minimisingIt may be that there is no output at which the firm canmake a profit. Such a situation is illustrated in Figure 5.22:the AC curve is above the AR curve at all levels of output.In this case, the output where MR= MC will be the loss-minimising output. The amount of loss at the point whereMR= MC is shown by the shaded area in Figure 5.22.Whether or not to produce at allThe short run.Fixed costs have to be paid even if the firmis producing nothing at all. Rent and business rates read more..

  • Page - 181

    1545 BACKGROUND TO SUPPLYSection summary1. Total profit equals total revenue minus total cost. Bydefinition, then, a firm’s profits will be maximised atthe point where there is the greatest gap betweentotal revenue and total cost.2. Another way of finding the maximum profit point isto find the output where marginal revenue equalsmarginal cost. Having found this output, the level ofmaximum profit can be found by finding the averageprofit (AR− AC) and then multiplying it by the read more..

  • Page - 182

    5.6 PROFIT MAXIMISATION155Additional case studies on the book’s website ( returns to nitrogen fertiliser. This case study provides a good illustration of diminishing returnsin practice by showing the effects on grass yields of the application of increasing amounts of nitrogenfertiliser.5.2Deriving cost curves from total physical product information. This shows how total, average and marginalcosts can be derived from total product information and the read more..

  • Page - 183

    Chapter6Profit Maximising under PerfectCompetition and Monopoly6.1 Alternative market structures1576.2 Perfect competition158Assumptions of perfect competition158The short run and the long run158The short-run equilibrium of the firm160The short-run supply curve161The long-run equilibrium of the firm162The long-run industry supply curve162Perfect competition and economies of scale163Perfect competition and the public interest1646.3 Monopoly166What is a monopoly?166Barriers to read more..

  • Page - 184

    KI 9p586.1 ALTERNATIVE MARKET STRUCTURES157Table 6.1Features of the four market structuresType of marketNumber of Freedom of Nature of productExamplesImplication forfirmsentrydemand curve for firmPerfect Very manyUnrestrictedHomogeneous Cabbages, carrotsHorizontal. The firmcompetition(undifferentiated)(these approximate tois a price takerperfect competition)MonopolisticMany/severalUnrestrictedDifferentiatedBuilders, restaurantsDownward sloping,competitionbut relatively elastic. The firm has read more..

  • Page - 185

    1586 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYThe market structure under which a firm operates willdetermine its behaviour. Firms under perfect competitionwill behave quite differently from firms which are mono-polists, which will behave differently again from firmsunder oligopoly or monopolistic competition.This behaviour (or ‘conduct’) will in turn affect the firm’sperformance: its prices, profits, efficiency, etc. In manycases, it will also affect other firms’ read more..

  • Page - 186

    6.2 PERFECT COMPETITION159In the long run, however, the level of profits affectsentry and exit from the industry. If supernormal profits aremade (see page 153), new firms will be attracted into theindustry, whereas if losses are being made, firms will leave.Note that although we shall be talking about the level ofprofit (since that makes our analysis of pricing and outputdecisions simpler to understand), in practice it is usuallythe rate of profit that determines whether a firm stays in read more..

  • Page - 187

    1606 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYfor a small firm. The rate of normal profit, however, willprobably be similar.?1. Why do economists treat normal profit as a cost ofproduction?2. What determines (a) the level and (b) the rate ofnormal profit for a particular firm?Thus whether the industry expands or contracts in thelong run will depend on the rate of profit. Naturally, sincethe time a firm takes to set up in business varies from indus-try to industry, the read more..

  • Page - 188

    6.2 PERFECT COMPETITION161OutputThe firm will maximise profit where marginal cost equalsmarginal revenue (MR= MC), at an output of Qe. Note that,since the price is not affected by the firm’s output, marginalrevenue will equal price (see page 146 and Figure 5.15).ProfitIf the average cost (AC ) curve (which includes normalprofit) dips below the average revenue (AR) ‘curve’, the firmwill earn supernormal profit. Supernormal profit per unit atQe is the vertical difference between AR read more..

  • Page - 189

    1626 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYSo, under perfect competition, the firm’s supply curve isentirely dependent on costs of production. This demon-strates why the firm’s supply curve is upward sloping.Given that marginal costs rise as output rises (due to dimin-ishing marginal returns), a higher price will be necessary toinduce the firm to increase its output.Note that the firm will not produce at a price belowAVC. Thus the supply curve is only that portion of read more..

  • Page - 190

    6.2 PERFECT COMPETITION163the industry. The short-run supply curve shifts to S2 andequilibrium moves to point c. Thus the long-run effect ofthe increase in demand has been to move the equilibriumfrom point a to point c. This means, therefore, that thelong-run supply curve will pass through points a and c. Thisis illustrated in each of the three diagrams.If price falls back to its original level (i.e. points a and care at the same price) the long-run supply curve will be hori-zontal (see diagram read more..

  • Page - 191

    1646 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYPerfect competition could only exist in any industry,therefore, if there were no (or virtually no) economies ofscale.?1. What other reasons can you think of why perfectcompetition is so rare?2. Why does the market for fresh vegetablesapproximate to perfect competition, whereas that foraircraft does not?Perfect competition and the public interestThere are a number of features of perfect competitionwhich, it could be argued, benefit read more..

  • Page - 192

    The relentless drive towards big business in recentdecades has seen many markets become moreconcentrated and increasingly dominated by largeproducers. And yet forces are at work that areundermining this dominance and bringing morecompetition to markets. One of these forces is e-commerce.In this case study, we will consider just how far e-commerce is returning ‘power to the people’.Moving markets back towards perfectcompetition?To see the extent to which e-commerce is makingmarkets more read more..

  • Page - 193

    1666 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYSection summary1. The assumptions of perfect competition are: a verylarge number of firms, complete freedom of entry, ahomogeneous product and perfect knowledge of thegood and its market by both producers andconsumers.2. In the short run, there is not time for new firms toenter the market, and thus supernormal profits canpersist. In the long run, however, any supernormalprofits will be competed away by the entry of newfirms.3. The read more..

  • Page - 194

    6.3 MONOPOLY167companies might find it unprofitable to serve the sameroutes, each running with perhaps only half-full buses,whereas one company with a monopoly of the routes couldmake a profit. Electricity transmission via a national grid isanother example of a natural monopoly.Even if a market could support more than one firm, anew entrant is unlikely to be able to start up on a very largescale. Thus a monopolist already experiencing economiesof scale can charge a price below the cost of read more..

  • Page - 195

    1686 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYEquilibrium price and outputSince there is, by definition, only one firm in the industry,the firm’s demand curve is also the industry demand curve.Compared with other market structures, demand undermonopoly will be relatively inelastic at each price. Themonopolist can raise its price and consumers have no alter-native firm in the industry to turn to. They either pay thehigher price or go without the good altogether.Unlike the read more..

  • Page - 196

    6.3 MONOPOLY169other firm, unable to make supernormal profit, will not beattracted into the industry.PL may well be below the monopolist’s short-run profit-maximising price, but the monopolist may prefer to limitits price to PL to protect its long-run profits from damage bycompetition.Fear of government intervention to curb the mono-polist’s practices (e.g. the Office of Fair Trading referringthe firm to the Competition Commission: see section 12.3)may have a similar restraining effect read more..

  • Page - 197

    TC 3p21KI 19p1571706 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYIn addition to these problems, monopolies may lack theincentive to introduce new product varieties, and largemonopolies may be able to exert political pressure andthereby get favourable treatment from governments.Advantages of monopolyDespite these arguments, monopolies can have someadvantages.Economies of scale.The monopoly may be able to achievesubstantial economies of scale due to larger plant, cen-tralised read more..

  • Page - 198

    TC 3p21KI 10p626.3 MONOPOLY171Competition for corporate control.Although a monopolyfaces no competition in the goods market, it may face analternative form of competition in financial markets. Amonopoly, with potentially low costs, which is currentlyrun inefficiently, is likely to be subject to a takeover bidfrom another company. This competition for corporatecontrol may thus force the monopoly to be efficient inorder to avoid being taken over.Innovation and new products.The promise of read more..

  • Page - 199

    KI 3p101726 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYSection summary1. A monopoly is where there is only one firm in anindustry. In practice, it is difficult to determine that a monopoly exists because it depends on hownarrowly an industry is defined.2. Barriers to the entry of new firms are usuallynecessary to protect a monopoly from competition.Such barriers include economies of scale (makingthe firm a natural monopoly or at least giving it acost advantage over new (small) read more..

  • Page - 200

    6.4 THE THEORY OF CONTESTABLE MARKETS173As an example, consider a catering company engaged bya factory to run its canteen. The catering company has amonopoly over the supply of food to the workers in thatfactory. If, however, it starts charging high prices or provid-ing a poor service, the factory could offer the running ofthe canteen to an alternative catering company. This threatmay force the original catering company to charge ‘reason-able’ prices and offer a good service.Perfectly read more..

  • Page - 201

    1746 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYCostless exit, therefore, encourages firms to enter anindustry, knowing that, if unsuccessful, they can alwaystransfer their capital elsewhere.The lower the exit costs, the more contestable the mar-ket. This implies that firms already established in othersimilar markets may provide more effective competitionagainst monopolists, since they can simply transfer capitalfrom one market to another. For example, studies of air-lines in the read more..

  • Page - 202

    6.4 THE THEORY OF CONTESTABLE MARKETS175established firm. There may be no cost barriers to entry orexit (i.e. a perfectly contestable market), but the establishedfirm may let it be known that any firm that dares to enterwill face all-out war! This may act as a deterrent to entry. Inthe meantime, the established firm may charge high pricesand make supernormal profits.Contestable markets and the public interestIf a monopoly operates in a perfectly contestable market, itmight bring the ‘best read more..

  • Page - 203

    1766 PROFIT MAXIMISING UNDER PERFECT COMPETITION AND MONOPOLYAdditional case studies on the book’s website ( electronic marketplaces. This case study examines the growth of firms trading with each other over theInternet (business to business or ‘B2B’) and considers the effects on competition.6.2Measuring monopoly power. An examination of how the degree of monopoly power possessed by a firm canbe measured.6.3Competition in the pipeline? Monopoly in the read more..

  • Page - 204

    Chapter7Profit Maximising under Imperfect Competition7.1 Monopolistic competition178Assumptions of monopolistic competition178Equilibrium of the firm178Limitations of the model179Non-price competition180The public interest1807.2 Oligopoly181Two key features of oligopoly182Competition and collusion182Industry equilibrium under collusive oligopoly182Tacit collusion: price leadership184Tacit collusion: rules of thumb185Factors favouring collusion188The breakdown of collusion188Non-collusive read more..

  • Page - 205

    KI 9p58TC 2p10KI 8p431787 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONWe will start by looking at monopolistic competition. Thiswas a theory developed in the 1930s by the Americaneconomist Edward Chamberlin. Monopolistic competitionis nearer to the competitive end of the spectrum. It can bestbe understood as a situation where there are a lot of firmscompeting, but where each firm does nevertheless havesome degree of market power (hence the term ‘mono-polistic’ competition): each firm has read more..

  • Page - 206

    7.1 MONOPOLISTIC COMPETITION179firm’s LRACcurve. Output will be QL: where ARL = LRAC.(At any other output, LRAC is greater than AR and thus lessthan normal profit would be made.)?1. Why does the LRMC curve cross the MRL curvedirectly below the tangency point of the LRAC andARL curves?2. Assuming that supernormal profits can be made inthe short run, will there be any difference in the long-run and short-run elasticity of demand? Explain.Limitations of the modelThere are various problems in read more..

  • Page - 207

    TC 2p101807 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONor ‘representative’ firm may earn only normal profit inthe long run, other firms may be able to earn long-runsupernormal profit. They may have some cost advantageor produce a product that is impossible to duplicate perfectly.• One of the biggest problems with the simple modelshown in Figure 7.1 is that it concentrates on price andoutput decisions. In practice, the profit-maximising firmunder monopolistic competition also has to read more..

  • Page - 208

    7.2 OLIGOPOLY181• Less will be sold and at a higher price.• Firms will not be producing at the least-cost point.By producing more, firms would move to a lower pointon their LRAC curve. Thus firms under monopolistic com-petition are said to have excess capacity. In Figure 7.2 thisexcess capacity is shown as Q1 − Q2 . In other words, mono-polistic competition is typified by quite a large number offirms (e.g. petrol stations), all operating at an output less than that necessary to achieve read more..

  • Page - 209

    KI 10p62TC 3p21KI 19p1571827 PROFIT MAXIMISING UNDER IMPERFECT COMPETITION• The interdependence of firms may make them wish tocollude with each other. If they could club together andact as if they were a monopoly, they could jointly max-imise industry profits.• On the other hand, they will be tempted to compete withtheir rivals to gain a bigger share of industry profits forthemselves.These two policies are incompatible. The more fiercelyfirms compete to gain a bigger share of industry read more..

  • Page - 210

    7.2 OLIGOPOLY183At first glance, the UK brewing industry might appearto be highly competitive, with many pubs in closeproximity to one another and with many brands of beer and lager offered for sale. However, in realitymost pubs are owned by the major brewers. These‘tied houses’ sell only a limited range of the beers andlagers that are available. Consumer choice is clearlyconstrained.The oligopolistic nature of the brewing industry canbe seen when we consider the market shares of theleading read more..

  • Page - 211

    1847 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONAlternatively, the cartel members may somehow agree todivide the market between them. Each member would begiven a quota. The sum of all the quotas must add up to Q1.If the quotas exceeded Q1, either there would be outputunsold if price remained fixed at P1, or the price would fall.But if quotas are to be set by the cartel, how will it decidethe level of each individual member’s quota? The mostlikely method is for the cartel to divide the read more..

  • Page - 212

    7.2 OLIGOPOLY185in this case it is the price set by the leader, and thus theirjoint supply curve is simply the sum of their MC curves –the same as under perfect competition.The leader’s demand curve can be seen as that portion ofmarket demand unfilled by the other firms. In other words,it is market demand minus other firms’ supply. At P1 thewhole of market demand is satisfied by the other firms, andso the demand for the leader is zero (point a). At P2 theother firms’ supply is read more..

  • Page - 213

    1867 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONOne example of a rule of thumb is average cost pricing.Here, producers simply add a certain percentage for profiton top of average costs. Thus, if average costs rise by 10 percent, prices will automatically be raised by 10 per cent. Thisis a particularly useful rule of thumb in times of inflation,when all firms will be experiencing similar cost increases.OPEC is probably the best known of all cartels. It wasset up in 1960 by the five major read more..

  • Page - 214

    7.2 OLIGOPOLY187?If a firm has a typically shaped average cost curve andsets prices 10 per cent above average cost, what will itssupply curve look like?Another rule of thumb is to have certain price bench-marks. Thus clothes may sell for £9.95, £14.95 or £19.95(but not £12.31 or £16.42). If costs rise, then firms simplyBOX 7.3being to push oil prices upwards and then stabilisethem at around $25 per barrel. The alliance betweenOPEC and non-OPEC oil producers is the first suchinstance of read more..

  • Page - 215

    1887 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONraise their price to the next benchmark, knowing that otherfirms will do the same.Rules of thumb can also be applied to advertising ( do not criticise other firms’ products, only praise your own); or to the design of the product (e.g. lightingmanufacturers tacitly agreeing not to bring out an everlast-ing light bulb).Factors favouring collusionCollusion between firms, whether formal or tacit, is morelikely when firms can clearly read more..

  • Page - 216

    7.2 OLIGOPOLY189When considering whether to break a collusive agree-ment, even if only a tacit one, a firm will ask: (1) ‘Howmuch can we get away with without inviting retaliation?’and (2) ‘If a price war does result, will we be the winners?Will we succeed in driving some or all of our rivals out ofbusiness and yet survive ourselves, and thereby gain greatermarket power?’The position of rival firms, therefore, is rather like that ofthe generals of opposing armies or the players in a read more..

  • Page - 217

    1907 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONWe can now conduct a similar analysis for firm B, again using a diagram like Figure 7.7(a). If it assumes thatfirm A will produce a particular level of output, it will thendecide its profit-maximising price and output in the lightof this. Firm B’s reaction curve in Figure 7.7(b) shows all the profit-maximising outputs for firm B for each output of firm A.What will the market equilibrium be? This will be atpoint e in Figure 7.7(b). It is read more..

  • Page - 218

    7.2 OLIGOPOLY191On these assumptions, each oligopolist will face ademand curve that is kinked at the current price and output(see Figure 7.8). A rise in price will lead to a large fall in salesas customers switch to the now relatively lower-priced rivals.The firm will thus be reluctant to raise its price. Demand isrelatively elastic above the kink. On the other hand, a fallin price will bring only a modest increase in sales, sincerivals lower their prices too and therefore customers do read more..

  • Page - 219

    1927 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONLet us assume that at present both firms (X and Y) arecharging a price of £2 and that they are each making aprofit of £10 million, giving a total industry profit of £20million. This is shown in cell A in Table 7.1.Now assume they are both (independently) consideringreducing their price to £1.80. First they must take intoaccount what their rival might do, and how this will affectthem. Let us consider X’s position. In our simple example,we read more..

  • Page - 220

    7.2 OLIGOPOLY193campaign, new model) and six possible responses fromrivals (e.g. all rivals cutting price, some cutting price, allincreasing advertising). It is assumed that firm X can calcu-late the effects on its profits of these various reactions.Which strategy will X choose? It may go for the safestrategy – maximin. Here it will choose strategy 2. The worstoutcome from strategy 2 (response c) will still give a profitof £20 million, whereas the worst outcome from strategy 3(response b) read more..

  • Page - 221

    1947 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONstrategy 3 is only £90 million (response a), and for strategy2 only £60 million (response f).Alternatively, it may go for a compromise strategy andchoose strategy 3. The best outcome from strategy 3(response a) is only slightly lower than strategy 1 (responsea) – £90 million compared with £100 million. The worstoutcome (response b) is only slightly lower than strategy 2(response c) – £15 million compared with £20 million.It is also read more..

  • Page - 222

    7.2 OLIGOPOLY195business situations, much more complex trees could beconstructed. The ‘game’ would be more like one of chess,with many moves and several options on each move. Ifthere were more than two companies, the decision treewould be more complex still.?Give an example of decisions that two firms could makein sequence, each one affecting the other’s nextdecision.Assessing the theory of gamesThe advantage of the game theory approach is that the firmdoes not need to know which read more..

  • Page - 223

    1967 PROFIT MAXIMISING UNDER IMPERFECT COMPETITION?Which of the following are examples of effectivecountervailing power?(a) Tour operators purchasing seats on charter flights.(b) A large office hiring a photocopier from RankXerox.(c) Marks & Spencer buying clothes from a garmentmanufacturer.(d) A small village store (but the only one for milesaround) buying food from a wholesaler.The power of oligopolists will also be reduced if the mar-ket in which they operate is contestable (see section read more..

  • Page - 224

    7.3 PRICE DISCRIMINATION197Up to now we have assumed that a firm will sell its outputat a single price. Sometimes, however, firms may practiseprice discrimination. This is where a firm sells the sameproduct to different consumers at different prices eventhough production costs are the same. There are three majorvarieties of price discrimination:• First-degree price discrimination is where the firmcharges each consumer the maximum price he or she isprepared to pay for each unit. For read more..

  • Page - 225

    1987 PROFIT MAXIMISING UNDER IMPERFECT COMPETITION• The firm must be able to set its price. Thus price discrim-ination will be impossible under perfect competition,where firms are price takers.• The markets must be separate. Consumers in the low-priced market must not be able to resell the product inthe high-priced market. For example, children must notbe able to resell a half-priced child’s cinema ticket for useby an adult.• Demand elasticity must differ in each market. The firmwill read more..

  • Page - 226

    market), it may use the high profits in the first market tosubsidise a very low price in the oligopolistic market, thusforcing its competitors out of business.Profit-maximising prices and outputAssuming that the firm wishes to maximise profits, whatdiscriminatory prices should it charge and how much shouldit produce? Let us first consider the case of first-degree pricediscrimination.First-degree price discriminationSince an increase in sales does not involve lowering theprice for any unit read more..

  • Page - 227

    2007 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONOne of the commonest forms of price discrimination is where children are charged a lower price than adults, whether on public transport or for publicentertainment. Take the case of cinema tickets. In most cinemas, children pay less than adults during the day. In the evening, however, many cinemas charge both adults and children the same price.But why do cinemas charge children less during the day? After all, the child is seeing the same film read more..

  • Page - 228

    Diagram (c) shows the MC and MR curves for the firm asa whole. This MR curve is found by adding the amountssold in the two markets at each level of MR (in other words,the horizontal addition of the two MR curves). Thus, forexample, with output of 1000 units in market X and 2000in market Y, making 3000 in total, revenue would increaseby £5 if one extra unit were sold, whether in market X or Y.Total profit is maximised where MC= MR: i.e. at an output of 3000 units in total. This output must read more..

  • Page - 229

    2027 PROFIT MAXIMISING UNDER IMPERFECT COMPETITIONAdditional case studies on the book’s website ( motor vehicle repair and servicing industry. A case study of monopolistic competition.7.2The corner shop and the hypermarket. A case study in non-price competition: how the corner shop cansurvive competition from the big supermarkets.7.3Curry wars. Monopolistic competition in the take-away food market.7.4Bakeries: oligopoly or monopolistic competition. A case study read more..

  • Page - 230

    7.3 PRICE DISCRIMINATION203• For news articles relevant to this and the previous chapter, see the Economics News Articles link fromthe book’s website.•For general news on companies and markets, see websites in section A, and particularly A2, 3, 4, 5, 8,9, 18, 24, 25, 26, 36. See also A38, 39, 40, 43 and 44 for links to newspapers worldwide; and A41 and 42for links to economics news articles from newspapers worldwide.•For sites that look at competition and market power, see B2 (third read more..

  • Page - 231

    Chapter8Alternative Theories of the Firm8.1 Problems with traditional theory205Difficulties in maximising profit205Alternative aims205The principal–agent problem207Survival and attitudes towards risk2088.2 Alternative maximising theories209Long-run profit maximisation209Managerial utility maximisation210Sales revenue maximisation (short run)210Growth maximisation212Growth by internal expansion212Growth by merger213Growth through strategic alliances214Growth through going read more..

  • Page - 232

    TC 9p101KI 15p101KI 9p58KI 20p1828.1 PROBLEMS WITH TRADITIONAL THEORY205The traditional profit-maximising theories of the firm have been criticised for being unrealistic. The criticisms aremainly of two sorts: (a) that firms wish to maximise profitsbut for some reason are unable to do so; or (b) that firmshave aims other than profit maximisation. Let us examineeach in turn.Difficulties in maximising profitOne criticism of traditional theory sometimes put forwardis that firms do not use read more..

  • Page - 233

    2068 ALTERNATIVE THEORIES OF THE FIRMprofits so as to increase their dividends and the value oftheir shares. Shareholders elect directors. Directors in turnemploy professional managers who are often given consid-erable discretion in making decisions. There is therefore aseparation between the ownership and control of a firm. (SeeWeb Case 8.1 for an examination of the legal structure offirms.)But what are the objectives of managers? Will they wantto maximise profits, or will they have some read more..

  • Page - 234

    8.1 PROBLEMS WITH TRADITIONAL THEORY207to go to an estate agent. The point is that these agents have specialist knowledge and can save you, the principal,a great deal of time and effort. It is merely an example ofthe benefits of the specialisation and division of labour.It is the same with firms. They employ people with specialist knowledge and skills to carry out specific tasks.Companies frequently employ consultants to give themadvice or engage the services of specialist firms such as read more..

  • Page - 235

    TC 9p101TC 3p21KI 15p1012088 ALTERNATIVE THEORIES OF THE FIRM• The principals must have some way of monitoring theperformance of their agents. Thus a company mightemploy efficiency experts to examine the operation ofits management.• There must be incentives for agents to behave in the prin-cipals’ interests. Thus managers’ salaries could be closelylinked to the firm’s profitability.Alternative theories of the firm therefore place consider-able emphasis on incentive mechanisms in read more..

  • Page - 236

    8.2 ALTERNATIVE MAXIMISING THEORIES209price cutting, it might invoke a strong response from itsrivals. The resulting war may drive it out of business.Concern with survival, therefore, may make firms cautious.Not all firms, however, make survival the top priority.Some are adventurous and are prepared to take risks.Adventurous firms are most likely to be those dominatedby a powerful and ambitious individual – an individual pre-pared to take gambles.The more dispersed the decision-making power read more..

  • Page - 237

    2108 ALTERNATIVE THEORIES OF THE FIRMconsumer demand, future costs, etc., and try to avoid deci-sions that would appear to conflict with long-run profits.Often this will simply involve avoiding making decisions(e.g. cutting price) that may stimulate an unfavourableresult from rivals (e.g. rivals cutting their price).Managerial utility maximisationOne of the most influential of the alternative theories of thefirm has been that developed by O. E. Williamson1 in the1960s. Williamson argued read more..

  • Page - 238

    8.2 ALTERNATIVE MAXIMISING THEORIES211their sales. Thus sales revenue maximisation may be a moredominant aim in the firm than profit maximisation, particu-larly if it has a dominant sales department.Sales revenue will be maximised at the top of the TRcurve at output Q1 in Figure 8.1. Profits, by contrast, wouldbe maximised at Q2. Thus, for given total revenue and total cost curves, sales revenue maximisation will tend to lead to a higher output and a lower price than profitmaximisation.?Draw read more..

  • Page - 239

    2128 ALTERNATIVE THEORIES OF THE FIRMTR curve upwards and also the TC curve (since advertisingcosts money).Sales revenue maximisation will tend to involve moreadvertising than profit maximisation. Ideally the profit-maximising firm will advertise up to the point where themarginal revenue of advertising equals the marginal cost ofadvertising (assuming diminishing returns to advertising).The firm aiming to maximise sales revenue will go beyondthis, since further advertising, although costing read more..

  • Page - 240

    8.2 ALTERNATIVE MAXIMISING THEORIES213Reduced uncertainty.A business that is not verticallyintegrated may find itself subject to various uncertainties inthe marketplace. Examples include uncertainty over futureprice movements, supply reliability or access to markets.Barriers to entry.Vertical integration may give the firmgreater power in the market by enabling it to erect entrybarriers to potential competitors. For example, a firm thatundertakes backward vertical integration and acquires akey read more..

  • Page - 241

    2148 ALTERNATIVE THEORIES OF THE FIRMMerger for monopoly power.Here the motive is to reducecompetition and thereby gain greater market power andlarger profits. With less competition, the firm will face aless elastic demand and will be able to charge a higher per-centage above marginal cost. This obviously fits well withthe traditional theory of the firm.?Which of the three types of merger (horizontal, vertical and conglomerate) are most likely to lead to (a) reductions in average costs; (b) read more..

  • Page - 242

    8.2 ALTERNATIVE MAXIMISING THEORIES215organisation. The creation of Cellnet by BT and Securicor isan example of such a strategy.Consortia.In recent years, many consortia have been cre-ated. Camelot, the company that runs the UK NationalLottery, and Trans Manche Link, the company that builtthe Channel Tunnel, are two examples. A consortium isusually created for very specific projects, such as a largecivil engineering work. As such they have a very focusedobjective, and once the project is read more..

  • Page - 243

    2168 ALTERNATIVE THEORIES OF THE FIRMWhat have been the trends, patterns and drivingfactors in mergers and acquisitions2 (M&A) around theworld over the past ten years? An overview is given infigure (a). The 1990s saw a rapid growth in M&A as theworld economy boomed. Then with a slowing down ineconomic growth after 2000, M&A activity declined,both in value and in the number of deals.The 1990sThe early 1990s saw relatively low M&A activity as theworld was in recession, but as read more..

  • Page - 244

    8.2 ALTERNATIVE MAXIMISING THEORIES217BOX 8.5looking to other parts of the world to expand theiractivities. This is illustrated in figure (b).The two major target regions have been (a) the restof Europe, especially the ten countries joining the EU in2004 plus Russia, and (b) Asian countries, especiallyIndia and China. These new markets have the twinattractions of rapidly growing demand and low costs,including cheap skilled labour and low tax rates.Companies from the EU-15 countries have read more..

  • Page - 245

    2188 ALTERNATIVE THEORIES OF THE FIRMthe franchisee is responsible for manufacturing and/or sell-ing, and the franchiser retains responsibility for brandingand marketing.Subcontracting.Like franchising, subcontracting is a lessformal source of strategic alliance, where companies main-tain their independence. When a business subcontracts, it employs an independent business to manufacture or supply some service rather conduct the activity itself. Carmanufacturers are major subcontractors. Given read more..

  • Page - 246

    8.3 MULTIPLE AIMS219firms to look to improved products, new products and newtechniques, the consumer may benefit from such a con-cern. To the extent, however, that growth encourages agreater level of industrial concentration through merger,the consumer may lose from the resulting greater level ofmonopoly power.As with the traditional theory of the firm, the degree ofcompetition a firm faces is a crucial factor in determiningjust how responsive it will be to the wishes of the consumer.?How read more..

  • Page - 247

    2208 ALTERNATIVE THEORIES OF THE FIRMIn many firms, targets will be set for production, sales,profit, stockholding, etc. If, in practice, target levels are notachieved, a ‘search’ procedure will be started to find whatwent wrong and how to rectify it. If the problem cannot be rectified, managers will probably adjust the target down-wards. If, on the other hand, targets are easily achieved,managers may adjust them upwards. Thus the targets to which managers aspire depend to a large extent read more..

  • Page - 248

    8.3 MULTIPLE AIMS221and since many managers prefer to avoid conflict, targetstend to be changed fairly infrequently. Business condi-tions, however, often change rapidly. To avoid the need tochange targets, therefore, managers will tend to be fairlyconservative in their aspirations. This leads to the phe-nomenon known as organisational slack.When the firm does better than planned, it will allowslack to develop. This slack can then be taken up if the firm does worse than planned. For example, read more..

  • Page - 249

    TC 9p1012228 ALTERNATIVE THEORIES OF THE FIRMSection summary1. In large firms, decisions are taken by or influencedby a number of different people, including variousmanagers, shareholders, workers, customers,suppliers and creditors. If these different peoplehave different aims, a conflict between them is likelyto arise. A firm cannot maximise more than one ofthese conflicting aims. The alternative is to seek toachieve a satisfactory target level of a number ofaims.2. If targets were easily read more..

  • Page - 250

    KI 21p 207KI 20p1828.4 PRICING IN PRACTICE223In 1995 the Bank of England conducted a survey of price-setting behaviour in 654 UK companies.3Among other things, the survey sought to establishwhat factors influenced companies’ pricing decisions.The results are given table (a).Companies were asked to rank alternative methodsof pricing of their main product . . . The mostpopular response was that prices were set withrespect to market conditions. The top preference4 foralmost 40 per cent of read more..

  • Page - 251

    2248 ALTERNATIVE THEORIES OF THE FIRMderived by adding the mark-up to the AC curve. This isshown by curve S1 in Figure 8.4. If, however, a firm is aiming for a particular level of total profit, and does notadjust this target, its supply curve will be like curve S2. Thegreater the output, the less the profit per unit needs to be(and hence the less the mark-up) to give a particular level of total profit.In either case, price and quantity can be derived fromthe intersection of demand and read more..

  • Page - 252

    8.4 PRICING IN PRACTICE225Section summary1. Many firms set prices by adding a profit mark-up toaverage cost. This cost-plus pricing is most likelywhen firms are profit satisficers or when they do not have the information to find the price that willequate marginal cost and marginal revenue.2. The mark-up could be based on achieving a target level of either total profit or profit per unit.In either case, a supply curve can be derived byadding the corresponding mark-up to the averagecost read more..

  • Page - 253

    2268 ALTERNATIVE THEORIES OF THE FIRM• For news articles relevant to this chapter, see the Economics News Articles link from the book’swebsite.• For general news relevant to alternative strategies, see websites in section A, and particularly A2, 3, 8,9, 23, 24, 25, 26, 35, 36. See also A38, 39, 43 and 44 for links to newspapers worldwide; and A42 and 43for links to economics news articles on particular search topics from newspapers worldwide.• For student resources relevant to this read more..

  • Page - 254

    A HD227Chapter9The Theory of Distribution of Income9.1 Wage determination under perfect competition228Perfect labour markets228The supply of labour229The demand for labour: marginal productivity232Wages and profits under perfect competition235Equality and inequality2359.2 Wage determination in imperfect markets236Firms with market power in employing labour237Labour with market power237Firms and labour with market power238Collective bargaining239The efficiency wage hypothesis241Other labour read more..

  • Page - 255

    TC 4p222289 THE THEORY OF DISTRIBUTION OF INCOMEPerfect labour marketsWhen looking at the market for labour, it is useful to makea similar distinction to that made in the theory of the firm:the distinction between perfect and imperfect markets.Although in practice few labour markets are totally perfect,many do at least approximate to it.The assumptions of perfect labour markets are similar tothose of perfect goods markets. The main one is that every-one is a wage taker. In other words, neither read more..

  • Page - 256

    9.1 WAGE DETERMINATION UNDER PERFECT COMPETITION229Diagram (c) shows how an individual worker also has toaccept this wage. In this case it is the demand curve for thatworker that is infinitely elastic. In other words, there is asmuch work as the worker cares to do at this wage (but noneat all above it).We now turn to look at the supply and demand forlabour in more detail.The supply of labourWe can look at the supply of labour at three levels: the sup-ply of hours by an individual worker, the read more..

  • Page - 257

    2309 THE THEORY OF DISTRIBUTION OF INCOMEa greater sacrifice of income and hence consumption. Theysubstitute income (i.e. work) for leisure. This is called thesubstitution effect of the increase in wage rates.On the other hand, people may feel that with higherwage rates they can afford to work less and have moreleisure. This is called the income effect.The relative magnitude of these two effects determinesthe slope of the individual’s supply curve. It is normallyassumed that the substitution read more..

  • Page - 258

    9.1 WAGE DETERMINATION UNDER PERFECT COMPETITION231the job at each given wage rate. This depends on threethings:• The number of qualified people.• The non-wage benefits or costs of the job, such as thepleasantness or otherwise of the working environment,job satisfaction or dissatisfaction, status, power, the degreeof job security, holidays, perks and other fringe benefits.• The wages and non-wage benefits in alternative jobs.A change in the wage rate will cause a movement alongthe read more..

  • Page - 259

    2329 THE THEORY OF DISTRIBUTION OF INCOME?1. Assume that there is a growing demand forcomputer programmers. As a result more peopletrain to become programmers. Does this represent arightward shift in the supply curve of programmers,or merely the supply curve becoming more elastic inthe long run, or both? Explain.2. Which is likely to be more elastic, the supply of coalminers or the supply of shop assistants? Explain.If the demand for a particular category of workerincreases, the wage rate will read more..

  • Page - 260

    9.1 WAGE DETERMINATION UNDER PERFECT COMPETITION233the costs of employing extra labour against the benefits. Itwill use exactly the same principles as in deciding howmuch output to produce.In the goods market, the firm will maximise profitswhere the marginal cost of an extra unit of goods producedequals the marginal revenue from selling it: MC= MR.In the labour market, the firm will maximise profitswhere the marginal cost of employing an extra workerequals the marginal revenue that the read more..

  • Page - 261

    2349 THE THEORY OF DISTRIBUTION OF INCOMEProfits will be maximised at an employment level of Qe,where MCL (i.e. W ) = MRPL. Why? At levels of employmentbelow Qe, MRPL exceeds MCL. The firm will increase profitsby employing more labour. At levels of employment aboveQe, MCL exceeds MRPL. In this case, the firm will increaseprofits by reducing employment.Derivation of the firm’s demand curve for labourNo matter what the wage rate, the quantity of labourdemanded will be found from the read more..

  • Page - 262

    9.1 WAGE DETERMINATION UNDER PERFECT COMPETITION235factors, then a reduction in W will lead to a largeincrease in labour used to replace these other factors.• The greater the elasticity of supply of complementaryfactors. If the wage rate falls, a lot more labour will bedemanded if plenty of complementary factors can beobtained at little increase in their price.• The greater the elasticity of supply of substitute factors.If the wage rate falls and more labour is used, less sub-stitute factors read more..

  • Page - 263

    2369 THE THEORY OF DISTRIBUTION OF INCOME• Jobs differ enormously in terms of the skills they requireand in terms of their pleasantness or unpleasantness.What is more, since demand and supply conditions areconstantly changing, long-run general equilibrium through-out the economy will never be reached.Conclusions: Who are the poor? Who are the rich?The low paid will be those whose labour is in low demandor high supply. Low demand will be due to low demand forthe good or low labour productivity. read more..

  • Page - 264

    9.2 WAGE DETERMINATION IN IMPERFECT MARKETS237When a monopsonist employer faces a monopolistunion, the situation is called bilateral monopoly.Firms with market power in employinglabour (monopsony, etc.)Monopsonists (and oligopsonists too) are ‘wage setters’ not‘wage takers’. A large employer in a small town, for exam-ple, may have considerable power to resist wage increasesor even to force wage rates down.Such firms face an upward-sloping supply curve oflabour. This is illustrated in read more..

  • Page - 265

    2389 THE THEORY OF DISTRIBUTION OF INCOMEto Q2. There will be a surplus of people (Q3 – Q2 ) wishing towork in this industry for whom no jobs are available.The union is in a doubly weak position. Not only willjobs be lost as a result of forcing up the wage rate, but thereis also a danger that these unemployed people might under-cut the union wage, unless the union can prevent firmsemploying non-unionised labour.Wage rates can be increased without a reduction in thelevel of employment only if, read more..

  • Page - 266

    9.2 WAGE DETERMINATION IN IMPERFECT MARKETS239increase both the wage rate and employment. Figure 9.10shows how this can be so.Assume first that there is no union. The monopsonistwill maximise profits by employing Q1 workers at a wagerate of W1. (Q1 is where MRPL = MCL.)What happens when a union is introduced into this situ-ation? Wage rates will now be set by negotiation betweenunions and management. Once the wage rate has beenagreed, the employer can no longer drive the wage ratedown by read more..

  • Page - 267

    2409 THE THEORY OF DISTRIBUTION OF INCOMEThe wage settlement may be higher if the union repre-sents only core workers. It may be able to secure a higherwage rate at the expense of non-members, who might losetheir jobs or be replaced by part-time or temporary workers.The core workers can be seen as insiders. Their union(s) canprevent the unemployed – the outsiders – from competingwages down.Industrial action imposes costs on both unions andfirms. Unions lose pay. Firms lose revenue. It is read more..

  • Page - 268

    9.2 WAGE DETERMINATION IN IMPERFECT MARKETS241(see Box 10.3), or prevent discrimination against workerson various grounds. Similarly, it could pass laws that curtailthe power of unions. The UK Conservative governmentsbetween 1979 and 1997 put considerable emphasis onreducing the power of trade unions and making labourmarkets more ‘flexible’. Several Acts of Parliament werepassed. These included the following measures:• Employees were given the right to join any union. Thiseffectively read more..

  • Page - 269

    2429 THE THEORY OF DISTRIBUTION OF INCOMELess ‘shirking’.In many jobs it is difficult to monitor theeffort individuals put into their work. Workers may thusget away with shirking or careless behaviour. This is anexample of the principal–agent problem (see page 208).The worker, as an agent of the employer (the principal), isnot necessarily going to act in the principal’s interest.The business could attempt to reduce shirking by impos-ing a series of sanctions, the most serious of which read more..

  • Page - 270

    9.2 WAGE DETERMINATION IN IMPERFECT MARKETS243reduced by paying a wage above the market-clearing rate.By paying such a wage rate the business is seeking a degreeof loyalty from its employees.Morale.A simple reason for offering wage rates above the market-clearing level is to motivate the workforce – tocreate the feeling that the firm is a ‘good’ employer thatcares about its employees. As a consequence, workers mightbe more industrious and more willing to accept the intro-duction of new read more..

  • Page - 271

    2449 THE THEORY OF DISTRIBUTION OF INCOMEus assume that there are no laws to prevent the firm dis-criminating in terms of either wages or employment.Figure 9.11(a) shows the MC and MRP curves for blackworkers. If there were no discrimination, employment ofblack workers would be at QB1, where MRPB = MCB. Thewage rate paid to black workers would be WB1.Figure 9.11(b) shows the position for white workers.Again, if there were no discrimination, QW1 white workerswould be employed at a wage of WW1: read more..

  • Page - 272

    9.2 WAGE DETERMINATION IN IMPERFECT MARKETS245If the firm now discriminates against black workers, it will employ workers along a lower curve, MRPB − x(where x can be seen as the discriminatory factor). Employ-ment of black workers will thus be at the lower level of QB2 and the wage they receive will be at the lower level of WB2.How will discrimination against black workers affectwages and employment of white workers? Let us considertwo cases.In the first case, assume that the employer read more..

  • Page - 273

    2469 THE THEORY OF DISTRIBUTION OF INCOMEworkers on profit-maximising principles. Thus white workers would be employed up to that point where theirMC equals their MRP. But the fact that fewer black workersare now being employed will mean that for any givenquantity of white workers there will be fewer workersemployed in total, and therefore the MRP of white workerswill have increased. In Figure 9.11(b) the white workers’MRP curve has shifted to MRPW2. This has the effect of KI 21p207The past read more..

  • Page - 274

    9.2 WAGE DETERMINATION IN IMPERFECT MARKETS247raising employment of white workers to QW2 and the wagerate to WW2.Firms may, however, also practise economic discrim-ination in favour of certain groups. Figure 9.11(b) also illustrates this second case, where the employer practiseseconomic discrimination in favour of white workers. Herethe firm will employ workers along a higher curve, MRPW2 +y, where y is the discriminatory factor. The effect is furtherto increase the wage rate and level of read more..

  • Page - 275

    2489 THE THEORY OF DISTRIBUTION OF INCOMEequally when applying for jobs. The problem here is thatan employer which wants to continue discrimination can always claim that the black applicants were less wellqualified than the white applicant who got the job. Suchlaws are therefore difficult to enforce.The type of discrimination considered so far can be seenas ‘irrational’ if the firm wants to maximise profits. Afterall, to produce a given amount of output, it would be pay-ing out more in read more..

  • Page - 276

    TC 2p10KI 17p1219.3 CAPITAL AND PROFIT249The non-human factors of productionIn the final two sections of the chapter, we consider themarket for other factors of production. These can be dividedinto two broad groups.Land.This includes all those productive resources suppliedby nature: in other words, not only land itself, but also allnatural resources. (We examine land in section 9.4.)Capital.This includes all manufactured products that areused to produce goods and services. Thus capital read more..

  • Page - 277

    2509 THE THEORY OF DISTRIBUTION OF INCOMEcapital. For example, if a farmer increases the amount ofland farmed while holding other factors constant, diminish-ing returns to land will occur. If the same number of farmworkers and the same amount of agricultural machineryand fertilisers are used but on a larger area, then returns perhectare will fall.In diagram (a) the firm is a price taker. The factor price isgiven at Pf1. Profits are maximised at Qf1 where MRPf = Pf(since Pf = MCf).In diagram read more..

  • Page - 278

    9.3 CAPITAL AND PROFIT251horizontal supply curve at the going rental rate (Re). If,however, it has monopsony power, it will face an upward-sloping supply curve as in Figure 9.12(b).Supply by a single firmThis is illustrated in Figure 9.13(c). On the demand side,the firm is likely to be a price taker. It has to accept thegoing rental rate (Re) established in the market. If it tries to charge more, then customers are likely to turn to rivalsuppliers.But what will the individual supplier’s read more..

  • Page - 279

    2529 THE THEORY OF DISTRIBUTION OF INCOMEsupply as much as it likes in the long run. The supply curvewill be relatively elastic, or if it is a price taker itself (i.e. ifthe scaffolding firm simply buys scaffolding at the marketprice), the supply curve will be horizontal. This long-runsupply curve will be vertically higher than the short-runcurve, since the long-run MC includes the cost of purchas-ing each additional piece of equipment.Maths Case 9.1 on the book’s website shows how read more..

  • Page - 280

    KI 24p 2539.3 CAPITAL AND PROFIT253Thus the present value of the investment (i.e. its MRP) is £3852, not £5000 as might seem at first sight. In otherwords, if the firm had £3852 today and deposited it in abank at a 10 per cent interest rate, the firm would earnexactly the same as it would by investing in the machine.So is the investment worthwhile? It is now simply aquestion of comparing the £3852 benefit with the cost ofbuying the machine. If the machine costs less than £3852,it will read more..

  • Page - 281

    2549 THE THEORY OF DISTRIBUTION OF INCOMESo should the investment go ahead? Yes, if the actualrate of interest (i) is less than 20 per cent. The firm is betteroff investing its money in this project than keeping it inthe bank: i.e. if MEC> i the investment should proceed.This is just one more application of the general rule thatif MRPf > MCf then more of the factor should be used: onlyin this case, MRP is expressed as a rate of return (MEC), andMC is expressed as a rate of interest read more..

  • Page - 282

    9.3 CAPITAL AND PROFIT255*Determination of the rate of interestThe rate of interest is determined by the interaction of sup-ply and demand in the market for loanable funds. This isillustrated in Figure 9.15. As we have seen, supply repre-sents accumulated savings.The demand curve includes the demand by householdsfor credit and the demand by firms for funds to financetheir investment. The curve slopes downwards for two reasons. First, households will borrow more at lower ratesof interest. It read more..

  • Page - 283

    2569 THE THEORY OF DISTRIBUTION OF INCOMEthe amount of profit the company makes and distributes to shareholders. The proportion of business financingfrom this source clearly depends on the state of the stockmarket. In the late 1990s, with a buoyant stock market,the proportion of funds obtained through share issueincreased. Then with a decline in stock market pricesfrom 2000 to 2003, this proportion fell.Alternatively, firms can issue debentures (or companybonds). These securities are read more..

  • Page - 284

    9.3 CAPITAL AND PROFIT257are more concerned with a company’s short-term perfor-mance and its share value. In responding to this, thebusiness might neglect its long-term performance andpotential.Is the stock market efficient?One of the arguments made in favour of the stock market isthat it acts as an arena within which share values can beaccurately or efficiently priced. If new information comeson to the market concerning a business and its perform-ance, this will be quickly and rationally read more..

  • Page - 285

    2589 THE THEORY OF DISTRIBUTION OF INCOMEIf stock markets were fully efficient, the expected returnsfrom every share would be the same. The return is referredto as the yield: this is measured as the dividends paid onthe share as a percentage of the share’s market price. Forexample, if you hold shares whose market price is £1 pershare and you receive an annual dividend of 3p per share,then the yield on the shares is 3 per cent. But why shouldthe expected returns on shares be the same? If any read more..

  • Page - 286

    9.4 LAND AND RENT259Rent: the reward to landlordsWe turn now to land. The income it earns for landowners is the rent charged to the users of the land. This rent, likethe rewards to other factors, is determined by demand andsupply.What makes land different from other factors of produc-tion is that it has an inelastic supply. In one sense, this isobvious. The total supply of land in any area is fixed. It is inthe very nature of land that it cannot be moved from oneplace to another!In another read more..

  • Page - 287

    KI 23p 251TC 3p21TC 6p26KI 4p112609 THE THEORY OF DISTRIBUTION OF INCOMEAs world population inexorably rises, so the demandson our planet’s resources continue to grow. Some ofthese resources are renewable. Water resources arereplenished by rain. The soil, if properly managed, cancontinue to grow crops. Felled forests can be replanted.Of course, if we use these resources more rapidly thanthey are replenished, stocks will run down. We are allaware of the problems of seas that are over fished, read more..

  • Page - 288

    9.4 LAND AND RENT261Let us assume that the market rate of interest is 10 percent (i.e. 0.1). Then according to the formula, a purchaserwould be prepared to pay:£10000.1 = £10 000Why should this be so? If a person deposits £10 000 in thebank, with an interest rate of 10 per cent this will earn thatperson £1000 per year. Assuming our piece of land is guar-anteed to earn a rent of £1000 per year, then provided it costs less than £10 000 to buy, it is a better investmentthan putting money read more..

  • Page - 289

    2629 THE THEORY OF DISTRIBUTION OF INCOMEAdditional case studies on the book’s website ( rent and transfer earnings. This examines a way of classifying the earnings of a factor of productionand shows how these earnings depend on the elasticity of supply of the factor.9.2Other labour market imperfections. This looks at the three imperfections identified on page 243: namely,imperfect information, persistent disequilibria in labour markets and non-maximising read more..

  • Page - 290

    Chapter10Inequality, Poverty and Policies to Redistribute Incomes10.1 Inequality and poverty264Types of inequality264The size distribution of income265Measuring the size distribution of income265The functional distribution of income267Other determinants of income inequality269The distribution of wealth270Causes of inequality271Government attitudes towards inequality27310.2 Taxes, benefits and the redistribution of income274The use of taxation and government expenditure to redistribute read more..

  • Page - 291

    KI 4p11KI 6p29KI 23p 25126410 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESInequality is one of the most contentious issues in the worldof economics and politics. Some people have incomes farin excess of what they need to enjoy a comfortable, if notluxurious, lifestyle, while others struggle to purchase eventhe basic necessities.The need for some redistribution from rich to poor isbroadly accepted across the political spectrum. Thus thegovernment taxes the rich more than the poor and read more..

  • Page - 292

    10.1 INEQUALITY AND POVERTY265• The number or proportion of people or householdsfalling into the category.• The occupational distribution of poverty.• The geographical distribution of poverty.• The distribution of poverty according to age, sex, ethnicorigin, marital status, educational attainment, etc.It is not possible in this chapter to look at all aspects of inequality in the UK. Nevertheless some of the moreimportant facts are considered, along with questions oftheir measurement and read more..

  • Page - 293

    26610 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESThe horizontal axis measures percentages of the popula-tion from the poorest to the richest. Thus the 40 per centpoint represents the poorest 40 per cent of the popula-tion. The vertical axis measures the percentage of nationalincome they receive.The curve starts at the origin: zero people earn zeroincomes. If income were distributed totally equally, theLorenz curve would be a straight 45° line. The ‘poorest’ 20 per cent of the read more..

  • Page - 294

    10.1 INEQUALITY AND POVERTY267Ratios of the shares in national income of twoquantile groupsThis is a very simple method of measuring income distribu-tion. A ratio quite commonly used is that of the share ofnational income of the bottom 40 per cent of the populationto that of the top 20 per cent. Thus if the bottom 40 per centearned 15 per cent of national income and the top 20 percent earned 50 per cent of national income, the ratio wouldbe 15/50 = 0.3. The lower the ratio, therefore, the read more..

  • Page - 295

    26810 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESPensioners are clustered in this group because they tend tobe fairly poor (pensions being less than wages), but not aspoor as the unemployed or families on low incomes.One perhaps surprising feature to note is that the pro-portion of income coming from profits, rent and interest(column (3)) varies little between the income groups. Infact only for those people in the top 1 or 2 per cent is itsignificantly higher. The conclusion from read more..

  • Page - 296

    10.1 INEQUALITY AND POVERTY269Other determinants of income inequalityDifferences in household compositionOther things being equal, the more dependants there are in a household, the lower the income will be per memberof that household. Figure 10.7 gives an extreme example ofthis. It shows the average household income in the UK in2003/4 of four different categories of household.Households with two adults and four or more childrenhad approximately the same income as households withonly one man and read more..

  • Page - 297

    27010 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMES?List the reasons for each of the three factors above. (Re-read section 9.2 and Box 9.7 if you need help.)Differences in the geographical distribution of incomeFigure 10.8 shows the gross weekly household incomes indifferent regions of the UK in 2003/4. Differences in incomesbetween the regions reflect regional differences in industrialstructure, unemployment and the cost of living. As can beseen from Figure 10.8, average incomes are read more..

  • Page - 298

    10.1 INEQUALITY AND POVERTY271The four major causes of inequality in the distribution ofwealth are as follows:• Inheritance. This allows inequality to be perpetuatedfrom one generation to another.• Income inequality. People with higher incomes can savemore.• Different propensities to save. People who save a largerproportion of their income will build up a bigger stock of wealth.• Entrepreneurial and investment talent/luck. Some people are successful in investing their wealth and making read more..

  • Page - 299

    27210 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESTC 6p26KI 4p11In February 1995 the Rowntree Foundation publishedthe results of a comprehensive inquiry into the UK’sgrowing inequality since 1979.2 The findings madegrim reading. Inequalities in income had widenedfurther and faster than in any other period in history.The rich had got substantially richer, while the poorhad become not only relatively poorer, but absolutelypoorer.This growing divide, the report argued, wasthreatening read more..

  • Page - 300

    10.1 INEQUALITY AND POVERTY273• Discrimination, whether by race, sex, age, social back-ground, etc.• Degree of government support. The greater the supportfor the poor, the less will be the level of inequality in theeconomy.• Unemployment. When unemployment levels are high,this is one of the major causes of poverty.?Which of the above causes are reflected in differencesin the marginal revenue product of factors?Government attitudes towards inequalityThe political right sees little problem read more..

  • Page - 301

    27410 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESThe Labour government introduced a statutory UKminimum wage in April 1999. The rate was £3.60 perhour for those aged 22 and over, and £3.00 for thosebetween 18 and 21. The rates have been increasedevery year and in 1995/6 were £5.05 and £4.25.The call for a minimum wage had grown strongerduring the 1990s as the number of low-paid workerswithin the UK increased. There were many peopleworking as cleaners, kitchen hands, garment read more..

  • Page - 302

    10.2 TAXES, BENEFITS AND THE REDISTRIBUTION OF INCOME275attitudes of society that increase or at least perpetuateinequalities. Examples of such policies include attackingprivileges, encouraging widening participation in highereducation, promoting worker share ownership, encourag-ing industries to move to areas of high unemployment andencouraging the provision of crèche facilities at work.Before we turn to look at the use of taxation and govern-ment expenditure to redistribute incomes, we must read more..

  • Page - 303

    27610 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESEquity between recipients of benefits.Under the benefitprinciple, it is argued that those who receive the mostbenefits from government expenditure ought to pay themost in taxes. For example, it can be argued that roadsshould be paid for from fuel tax. That way those who usethe roads the most will pay the most towards their con-struction and maintenance.?1. Does the benefit principle conflict with either verticalor horizontal read more..

  • Page - 304

    10.2 TAXES, BENEFITS AND THE REDISTRIBUTION OF INCOME277taxes, on the other hand, are paid via a middle person. Forexample, value added tax (VAT) is designed to be a tax onconsumption. But you the consumer do not pay it to theauthorities: it is paid by firms, which then pass it on to consumers in higher prices (see section 3.2). You are thustaxed indirectly when you buy goods and services.Direct taxesPersonal income tax.All types of income are included –wages, salaries, interest, dividends read more..

  • Page - 305

    27810 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESof a person’s property. This is a particularly common formof local taxation (the others being local income tax, localbusiness tax and local sales tax).Poll taxes.These are fixed-sum charges per head of thepopulation, irrespective of the person’s income. Very fewcountries use such taxes as they are regarded as grosslyunfair. A poll tax (or ‘community charge’) was introducedin Scotland in 1989 and in England and Wales in 1990 read more..

  • Page - 306

    10.2 TAXES, BENEFITS AND THE REDISTRIBUTION OF INCOME279Details of tax rates in the UK are given in Web Case 10.3 on the book’s website. This case study also examines how pro-gressive or regressive the various types of tax are.The balance of taxationTable 10.5 shows the balance of the different types of tax inselected countries. Some striking differences can be seenbetween the countries. In France, income taxes account foronly 17.8 per cent of tax revenue, whereas in the USA theyaccount for read more..

  • Page - 307

    28010 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMEShowever progressive, can increase the incomes of the poor.This will require subsidies (i.e. benefits).But what about tax cuts? Can bigger tax cuts not begiven to the poor? This is possible only if the poor arealready paying taxes in the first place. Take the two cases ofincome tax and taxes on goods and services.• Income tax. If the government cuts income tax, thenanyone currently paying it will benefit. A cut in tax rateswill read more..

  • Page - 308

    10.2 TAXES, BENEFITS AND THE REDISTRIBUTION OF INCOME281be a relatively slight fall in take-home pay (the workers’share of the tax is relatively small). The tax will, therefore,have only a relatively slight redistributive effect away fromthis group of workers.?1. Do poor people gain more from a cut in income taxwith an elastic or an inelastic supply of labour? Is thesupply of unskilled workers likely to be elastic or inelastic?2. Draw two diagrams like Figure 10.12, one with asteep demand read more..

  • Page - 309

    28210 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMEScigarettes, alcohol, petrol and gambling, at higher ratesthan other goods and services. We will examine these argu-ments in the next chapter.Although there are costs of redistribution, there are alsobenefits extending beyond those to whom income is redis-tributed. If redistribution to the poor reduces crime, van-dalism and urban squalor, then it is not just the poor whogain: it is everyone, both financially in terms of read more..

  • Page - 310

    10.2 TAXES, BENEFITS AND THE REDISTRIBUTION OF INCOME283deter them from undertaking training in order to get a better wage.For those people who are not employed, a rise in taxrates may make them feel that it is no longer worth lookingfor a job.Reducing tax allowances.For all those above the old taxthreshold, there is no substitution effect at all. The rate of taxhas not changed. However, there is an income effect. Theeffect is like a lump-sum tax. Everyone’s take-home pay iscut by a fixed read more..

  • Page - 311

    28410 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESThe benefits could be given as grants or merely as loans.They could be provided as general income support or forthe meeting of specific needs, such as rents, fuel bills andhousehold items.Universal benefits.Universal benefits are those that every-one is entitled to, irrespective of their income, if they fallinto a certain category. Examples include state pensions,and unemployment, sickness and invalidity benefits.Benefits in read more..

  • Page - 312

    10.2 TAXES, BENEFITS AND THE REDISTRIBUTION OF INCOME285distributed very unevenly, however, largely due to the age factor. Old people use a large proportion of health services,but virtually no education services.Benefits in kind tend to be consumed roughly equally bythe different income groups. Nevertheless they still havesome equalising effect, since they represent a much largerproportion of poor people’s income than rich people’s.They still have a far smaller redistributive effect, read more..

  • Page - 313

    28610 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESFigure 10.14Social protection benefits in various European countriesSource: Eurostat, 2005.a Figures have been corrected to take account of differences in the purchasing power of a euro in the different countries.EC6_C10.qxd 10/27/05 16:45 Page 286 read more..

  • Page - 314

    10.2 TAXES, BENEFITS AND THE REDISTRIBUTION OF INCOME287Benefits and the redistribution of incomeIt might seem that means-tested benefits are a much moreefficient system for redistributing income from the rich tothe poor: the money is directed to those most in need.With universal benefits, by contrast, many people mayreceive them who have little need for them. Do familieswith very high incomes need child benefit? Would it not bebetter for the government to redirect the money to thosewho are read more..

  • Page - 315

    28810 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMESpoor and lost by the rich could be quantified so that anynet gain from redistribution could be weighed up againstlost output. But such ‘interpersonal comparisons of utility’are not possible. For example, the benefit that a personreceives from a cooker or an electric fire cannot be meas-ured in ‘utils’ or any other ‘psychic unit’. What people areprepared to pay for the items is no guide either, since apoor person read more..

  • Page - 316

    10.2 TAXES, BENEFITS AND THE REDISTRIBUTION OF INCOME289END OF CHAPTER QUESTIONS1. Using the data shown on the pie chartsin Figure 10.1, construct two Lorenz curves(on the same diagram), corresponding to thebefore- and after-tax income figures. Interpret andcomment on the diagram you have drawn.2. Can taxes be used to relieve poverty?3. In what ways might the views of different politicianson what constitutes a ‘good’ tax system conflict?4. Distinguish between proportional, progressive read more..

  • Page - 317

    29010 INEQUALITY, POVERTY AND POLICIES TO REDISTRIBUTE INCOMES• For news articles relevant to this and the previous chapter, see the Economics News Articles link fromthe book’s website.• For general news on labour markets, see websites in section A, and particularly A1, 2, 4, 5 and 7. See also A41 and 42 for links to economics news articles from newspapers worldwide.• For data on labour markets, see links in B1 or 2, especially to Labour Market Trends on the NationalStatistics site. Also read more..

  • Page - 318

    Chapter11Markets, Efficiency and the Public Interest11.1 Efficiency under perfect competition292Social efficiency: ‘Pareto optimality’292The simple analysis of social efficiency: marginal benefit and marginal cost292Social efficiency through the market293Simple analysis of general equilibrium295*Intermediate analysis of social efficiency: marginal benefit and marginal cost ratios297*Efficiency in the goods market298*Efficiency in the factor market299*Intermediate analysis of read more..

  • Page - 319

    KI 3p10TC 2p10KI 4p11KI 2p829211 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTPerfect competition has been used by many economistsand policy makers as an ideal against which to compare thebenefits and shortcomings of real-world markets.As was shown in Chapter 6, perfect competition has various advantages for society. Under perfect competition,firms’ supernormal profits are competed away in the longrun by the entry of new competitors. As a result, firms areforced to produce at the bottom of read more..

  • Page - 320

    KI 2p9311.1 EFFICIENCY UNDER PERFECT COMPETITION293words, where the marginal benefit from consumption isequal to the marginal cost of consumption. Do you re-member the case of Tina and her purchases of petrol? (Seepage 95.) She goes on making additional journeys andhence buying extra petrol as long as she feels that the journeys are worth the money she has to spend: in otherwords, as long as the marginal benefit she gets from buyingextra petrol (its marginal utility to her) exceeds its read more..

  • Page - 321

    29411 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTProfit is the excess of total revenue over total costs. A related concept is that of total producer surplus (TPS).This is the excess of total revenue over total variable costs:TPS = TR − TVC. In other words, total producer surplus istotal profit plus fixed costs: TPS = TΠ + TFC. But since thereare no marginal fixed costs (by definition), both producersurplus and profit will be maximised at the same output.Total producer surplus for all read more..

  • Page - 322

    11.1 EFFICIENCY UNDER PERFECT COMPETITION295Private efficiency in the market: MU = MCIn Figure 11.1, both consumer surplus and producer sur-plus are maximised at output Qe. This is the equilibriumoutput under perfect competition. Thus, under perfectcompetition, the market will ensure that total surplus(areas A+ B), sometimes called total private surplus, is max-imised. At this output, MU = P = MC.At any output other than Qe total surplus will be less. Ifoutput were below Qe, then MU would be read more..

  • Page - 323

    29611 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTFigure 11.2The interdependence of goods and factor marketsFactor demandThe rise in the price of the good will lead to an increase inthe marginal revenue product of factors that are employedin producing the good. The reason for this is that themarginal revenue product of a factor is its marginal physicalproduct multiplied by the price of the good (see section9.1). But since the price of the good has now gone up, theoutput of factors will be worth read more..

  • Page - 324

    11.1 EFFICIENCY UNDER PERFECT COMPETITION297The following pages examine social efficiency in moredetail. You may omit these and skip straight to section 11.2(page 300) if you want to.*The intermediate analysis of socialefficiency: marginal benefit and marginalcost ratiosIn practice, consumers do not consider just one good in isolation. They make choices between goods. Likewisefirms make choices as to which goods to produce andwhich factors to employ. A more satisfactory analysis ofsocial read more..

  • Page - 325

    29811 MARKETS, EFFICIENCY AND THE PUBLIC INTEREST*Efficiency in the goods market(intermediate analysis)Private efficiency under perfect competitionConsumption.The optimum combination of two goodsX and Y consumed for any consumer is where:MUX (i.e. MRS)=PXMUYPYThe marginal rate of substitution in consumption (MRS) (seepage 106) is the amount of good Y that a consumer wouldbe willing to sacrifice for an increase in consumption ofgood X (i.e. ∆Y/∆X). MRS = MUX/MUY since, if X gave twicethe read more..

  • Page - 326

    11.1 EFFICIENCY UNDER PERFECT COMPETITION299page 12). Its slope is given by ∆Y/∆X and shows how muchY must be given up to produce 1 more of X. Its slope, there-fore, is the marginal rate of transformation (MRT ).Social indifference curves can be drawn showing the vari-ous combinations of X and Y that give particular levels ofsatisfaction to consumers as a whole. Their slope is given by∆Y/∆X and shows how much Y consumers are prepared togive up to obtain 1 more unit of X. Their slope, read more..

  • Page - 327

    TC 6p2630011 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTSection summary1. Social efficiency (Pareto optimality) will beachieved when it is not possible to make anyonebetter off without making someone else worse off.This will be achieved if people behave ‘rationally’under perfect competition providing there are noexternalities.2. Rational behaviour involves doing more of anyactivity whose marginal benefit (MB) exceeds itsmarginal cost (MC ) and less of any activity whosemarginal cost read more..

  • Page - 328

    11.2 THE CASE FOR GOVERNMENT INTERVENTION301Thus the full cost to society (the social cost) of the pro-duction of any good is the private cost faced by firms plusany externalities of production. Likewise the full benefit tosociety (the social benefit) from the consumption of anygood is the private benefit enjoyed by consumers plus anyexternalities of consumption.There are four major types of externality. (In each case,we will assume that the market is in other respects perfect.)External read more..

  • Page - 329

    30211 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTOther examples are noisy radios in public places, thesmoke from cigarettes, and litter.?Is it likely that the MSB curve will be parallel to the MUcurve? Explain your reasoning.External benefits of consumption (MSB > MB)When people travel by train rather than by car, other people benefit by there being less congestion and exhaustand fewer accidents on the roads. Thus the marginal socialbenefit of rail travel is greater than the marginal read more..

  • Page - 330

    KI 29p 30311.2 THE CASE FOR GOVERNMENT INTERVENTION303provided only by the government or by the governmentsubsidising private firms. (Note that not all goods producedby the public sector are public goods.)?1. Give some other examples of public goods. Does theprovider of these goods (the government or localauthority) charge for their use? If so, is the method of charging based on the amount of the good thatpeople use? Is it a good method of charging? Could you suggest a better method?2. Name read more..

  • Page - 331

    30411 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTcommon resource diminishes the amount available for others. This result is an overuse of common resources. Thisis why fish stocks in many parts of the world are severelydepleted, why virgin forests are disappearing (cut down fortimber or firewood), why many roads are so congested andwhy the atmosphere is becoming so polluted (being used asa common ‘dump’ for emissions). In each case, a resourcethat is freely available is overused.How can we read more..

  • Page - 332

    11.2 THE CASE FOR GOVERNMENT INTERVENTION305?Referring back to Figure 9.8 on page 237, and assumingthat the MRPL curve represents the marginal socialbenefit from the employment of a factor, and that the price of the factor represents its marginal social cost (i.e. assuming no externalities), show that amonopsony will employ less than the Pareto optimalamount of factors.Deadweight loss under monopolyAnother way of analysing the welfare loss that occurs undermonopoly is to use the concepts of read more..

  • Page - 333

    30611 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTtheir pricing and output depends on their interpretation ofthe activities of their rivals.?Why will Pareto optimality not be achieved in marketswhere there are substantial economies of scale inproduction?Other market failuresIgnorance and uncertaintyPerfect competition assumes that consumers, firms and factor suppliers have perfect knowledge of costs and bene-fits. In the real world, there is often a great deal of ignor-ance and uncertainty. read more..

  • Page - 334

    11.2 THE CASE FOR GOVERNMENT INTERVENTION307government could either provide them free or subsidisetheir production.? How do merit goods differ from public goods?Other objectivesAs we saw in Chapter 10, one of the major criticisms of the free market is the problem of inequality. The Pareto criterion gives no guidance, however, as to the most desir-able distribution of income. A redistribution of income will benefit some and make others worse off. Thus Paretooptimality can be achieved for any read more..

  • Page - 335

    TC 6p26KI 4p1130811 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTFaced with all the problems of the free market, what is agovernment to do?There are several policy instruments that the govern-ment can use. At one extreme, it can totally replace themarket by providing goods and services itself. At the otherextreme, it can merely seek to persuade producers, con-sumers or workers to act differently. Between the twoextremes, the government has a number of instrumentsthat it can use to change the way read more..

  • Page - 336

    to the point where MSC= MSB. This is known as the first-best solution.Of course, the real world is not like this. It is riddled withimperfections. What this means is that, if one imperfectionis ‘corrected’ (i.e. by making MSB= MSC), it might aggravateproblems elsewhere. For example, if an airport like Gatwickbanned night-time flights so as not to disturb the sleep of local residents, the airlines might simply use Heathrowinstead. This simply passes the buck. It now imposes anadditional read more..

  • Page - 337

    31011 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTfor two main microeconomic purposes: (a) to promotegreater social efficiency by altering the composition of pro-duction and consumption: and (b) to redistribute incomes.We examined their use for the second purpose in Chap-ter 10. Here we examine their use to achieve greater socialefficiency.When there are imperfections in the market (such asexternalities or monopoly power), Pareto optimality willnot be achieved. Taxes and subsidies can be used read more..

  • Page - 338

    11.3 FORMS OF GOVERNMENT INTERVENTION311amount of tax paid to the government. If the lump-sum taxwere large enough to make the AC+ lump-sum tax curvecross the demand curve at point a, all the supernormalprofits would be taken as tax.If the government also wants to increase the mono-polist’s output to the socially efficient level of Q2, andwants it to charge a price of P2, it could do this with a careful combination of a per-unit subsidy (which will shift both the AC and the MC curves read more..

  • Page - 339

    31211 MARKETS, EFFICIENCY AND THE PUBLIC INTEREST?What could we say about the necessary subsidy if the MR curve crossed the horizontal axis to the left of point b?Advantages of taxes and subsidiesMany economists favour the tax/subsidy solution to mar-ket imperfections (especially the problem of externalities)because it still allows the market to operate. It forces firmsto take on board the full social costs and benefits of theiractions. It is also adjustable according to the magnitude ofthe read more..

  • Page - 340

    11.3 FORMS OF GOVERNMENT INTERVENTION313onus would be on me to report them. Or I could agree notto report them if they paid me adequate compensation.But even in cases where only a few people are involved,there may still be the problem of litigation. Justice may notbe free, and thus there is a conflict with equity. The rich canafford ‘better’ justice. They can employ top lawyers. Thuseven if I have a right to sue a large company for dumpingtoxic waste near me, I may not have the legal muscle read more..

  • Page - 341

    31411 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTThe problem is that the firms most likely to exploit theconsumer are often the ones that are most elusive when itcomes to prosecuting them.Regulatory bodiesA more subtle approach than banning or restricting variousactivities involves the use of regulatory bodies.Having identified possible cases where action might berequired (e.g. potential cases of pollution or the abuse ofmonopoly power), the regulatory body would probablyconduct an read more..

  • Page - 342

    KI 22p 208TC 1p8TC 7p26KI 15p101by not being infected. A free health service thus helps tocombat the spread of disease.Dependants.If education were not free, and if the qualityof education depended on the amount spent, and if parentscould choose how much or little to buy, then the quality of children’s education would depend not just on their parents’ income, but also on how much they cared. A government may choose to provide such things free inorder to protect children from ‘bad’ read more..

  • Page - 343

    31611 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTnoise to local residents and destruction of wildlife as well asthe direct costs and benefits to the travellers.The procedureThe procedure at first sight seems fairly straightforward.• All costs and benefits are identified. These include all private monetary and non-monetary costs and benefitsand all externalities.• A monetary value is assigned to each cost and benefit.This is essential if costs and benefits are to be added up: acommon read more..

  • Page - 344

    *11.4 COST–BENEFIT ANALYSIS317case of a new Underground line, for example, such costswould include excavation, construction and capital costs(such as new rolling stock) and the operating costs (such as labour, electricity and maintenance). Revenues would be the fares paid by travellers. There are two problems, nevertheless:• What will these financial costs and revenues be? It is allvery well using current prices, but prices rise over time,and at different and unpredictable rates. Also, it read more..

  • Page - 345

    31811 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTestimates of air traffic (an essential piece of informationwhen deciding whether to build a new airport) have oftenbeen proved wrong as the world economy has grown morerapidly or less rapidly than previously forecast.Another problem is that the consumer surplus gainedfrom the project (e.g. the Channel Tunnel) may replace thealbeit smaller consumer surplus from a competing service(e.g. cross-Channel ferries). In this case, the non-monetaryprivate read more..

  • Page - 346

    *11.4 COST–BENEFIT ANALYSIS319Individual uncertain outcomesA range of possible values can be given to an uncertain item in the CBA: for example, damage from pollution.Table 11.1 illustrates two possible cases.The lowest estimate for pollution damage is £10 million;the highest is £50 million. In case A, given a very high mar-gin of benefits over other costs, the project’s desirability isnot sensitive to different values for pollution damage. Evenwith the highest value (£50 million), the read more..

  • Page - 347

    32011 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTIn signing up to the Kyoto Protocol environmentaltreaty (see Box 12.2), the EU committed itself toreducing carbon dioxide emissions and othergreenhouse gases by up to 8 per cent of 1990 levels by2012. How best might such reductions be achieved?What strategy would achieve the benefits from lowercarbon dioxide emissions at least cost?One investigation conducted for the EU to assesssuch questions2 aimed to evaluate the costs andbenefits of lowering read more..

  • Page - 348

    *11.4 COST–BENEFIT ANALYSIS321*BOX 11.5become a lot more favourable (scenarios 3 and 5). Asdrivers swap to new vehicles using sulphur-free fuel,the gain from fuel efficiency consistently outweighs theincrease in refining costs.The use of cost–benefit analysis thus demonstratedthe best strategy for introducing low-sulphur fuel. A phased-in use of sulphur-free fuel would generate a higher NPV than the compulsory introduction of the fuel for all vehicles at a specified point in time.?Why is read more..

  • Page - 349

    32211 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTThe strict Pareto criterionAccording to the strict Pareto criterion, a project is un-equivocally desirable only if there are some gains and noone is made worse off. According to this, then, a projectwould be accepted only if the gainers fully compensated thelosers, with the gainers still being better off after doing so.In practice, this never happens. Often compensation issimply not paid. Even when it is, the recipients rarely feelas well off as read more..

  • Page - 350

    TC 7p26KI 15p101TC 4p2211.5 GOVERNMENT FAILURE AND THE CASE FOR THE MARKET323Government intervention in the market can itself lead toproblems. The case for non-intervention (laissez-faire) orvery limited intervention is not that the market is the per-fect means of achieving given social goals, but rather thatthe problems created by intervention are greater than theproblems overcome by that intervention.Drawbacks of government interventionShortages and surpluses.If the government intervenesby read more..

  • Page - 351

    32411 MARKETS, EFFICIENCY AND THE PUBLIC INTEREST• A fear that excessively high profits might encouragefirms to attempt to break into the industry (assumingthat the market is contestable).• Competition from closely related industries (e.g. coachservices for rail services, or electricity for gas).• The threat of foreign competition. Additional competi-tion was one of the main purposes behind the SingleEuropean Act which led to the abolition of trade barrierswithin the EU in 1993 (see read more..

  • Page - 352

    11.5 GOVERNMENT FAILURE AND THE CASE FOR THE MARKET325from government regulation are desirable for their ownsake. As a fundamental ethical point of view, this can bedisputed, but not disproved.• In principle, the issue of whether a government ought tointervene in any situation could be settled by weighingup the costs and benefits of that intervention. Such costsand benefits, however, even if they could be identified,are extremely difficult, if not impossible, to measure,especially when the read more..

  • Page - 353

    32611 MARKETS, EFFICIENCY AND THE PUBLIC INTERESTAdditional case studies on the book’s website ( the market provide adequate protection for the environment? This explains why markets generally failto take into account environmental externalities.11.2Catastrophic risk. This examines how a cost–benefit study could put a monetary value on a remote chance ofa catastrophe happening (such as an explosion at a nuclear power station).11.3Evaluating the cost of read more..

  • Page - 354

    Chapter12Applied Microeconomics12.1 Economics of the environment328The environmental problem328An optimum use of the environment330Market failures331Market-based policies331Non-market-based policies333Tradable permits336How much can we rely on governments?33812.2 Traffic congestion and urban transportpolicies339The existing system of allocating road space340Identifying a socially efficient level of road use (short run)341Identifying a socially optimum level of road space (long run)343Solution read more..

  • Page - 355

    TC 1p8TC 2p10TC 1p8KI 13p9332812 APPLIED MICROECONOMICSScarcely a day goes by without some or other environ-mental issue featuring in the news: another warning aboutglobal warming, a company fined for illegally dumpingwaste, a drought or flood blamed on pollution, a healthscare about car exhausts, smog in tropical countries causedby forest fires.Ask virtually anyone if they would like a cleaner andmore attractive environment and the answer would be yes.Ask them, however, what we as taxpayers read more..

  • Page - 356

    12.1 ECONOMICS OF THE ENVIRONMENT329more and more. The answer has been to use increasingamounts of fertiliser and pesticides. Likewise, if the increas-ing world population is to have higher levels of materialconsumption, this will generate increased demands for natural resources, many of which are non-renewable, andgenerate more pollution.The environment is able to absorb most types of wasteup to certain levels of emission. Beyond such levels, how-ever, environmental damage is likely to read more..

  • Page - 357

    33012 APPLIED MICROECONOMICSAn optimum use of the environmentIf the current levels of pollution and environmental degra-dation are too high, then can we identify an optimum useof the environment? To do this, we have to go back to firstprinciples, and look at the ethics of our relationship with thenatural world and at our attitudes towards sustainability.Different approaches to sustainabilityWe can identify four different approaches to the environ-ment and sustainability.The free-market read more..

  • Page - 358

    12.1 ECONOMICS OF THE ENVIRONMENT331The line MCpollution shows the amount of pollution fromeach additional unit of the good. Up to level of activity Q1there is no pollution: the environment can cope with thewaste generated. The curve gets steeper as output increasesbecause the environment is increasingly unable to copewith the waste. The costs of pollution therefore accelerate.The line MB− MC shows the net marginal private benefitfrom the good (i.e. its private profitability). The curve read more..

  • Page - 359

    33212 APPLIED MICROECONOMICSExtending private property rightsIf those suffering from pollution are granted propertyrights, they can charge the polluters for the right to pollute.According to the Coase theorem (see page 312), this would result in the socially efficient level of output beingachieved.We can use Figure 12.2 to illustrate the Coase theorem. Ifoutput is initially less than Q3, the marginal profit to thepolluter will exceed the marginal pollution cost to the sufferer. In this case, read more..

  • Page - 360

    12.1 ECONOMICS OF THE ENVIRONMENT333Environmental (‘green’) taxes and subsidiesRather than charging for environmental use, a tax could be imposed on the output (or consumption) of a good,wherever external environmental costs are generated.These are known as green taxes. In this case, the goodalready has a price: the tax has the effect of increasing the price. To achieve a socially efficient output, the rate of tax should be equal to the marginal external cost. The alternative is to read more..

  • Page - 361

    33412 APPLIED MICROECONOMICSVoluntary agreementsRather than imposing laws and regulations, the govern-ment can seek to enter into voluntary agreements (VAs)with firms for them to cut pollution. Such agreements mayinvolve a formal contract, and hence be legally binding, orthey may be looser commitments by firms. VAs will behelped if (a) companies believe that this will improve theirimage with customers and hence improve sales; (b) there isan underlying threat by the government of read more..

  • Page - 362

    12.1 ECONOMICS OF THE ENVIRONMENT335As far as the effectiveness of VAs is concerned, thatdepends on how tightly specified the agreements are andhow easy they are for government inspectors to monitor. It also depends on the goodwill of firms. Without it, firmsmay well try to draw up agreements in a way that allowsthem to get around having to cut emissions as much as wasintended by the government.EducationPeople’s attitudes are very important in determining theenvironmental consequences of read more..

  • Page - 363

    33612 APPLIED MICROECONOMICSmany people like to do their own little bit, however small,towards protecting the environment.This is where education can come in. If children, andadults for that matter, were made more aware of environ-mental issues and the consequences of their actions, thenpeople’s consumption habits could change and more pressure would be put on firms to improve their ‘green credentials’.Policy alternatives: tradable permitsA policy measure that has grown in popularity in read more..

  • Page - 364

    12.1 ECONOMICS OF THE ENVIRONMENT337each. If firm A managed to reduce the pollutant to 8 units,it would be given a credit for 2 units. It could then sell thisto firm B, enabling B to continue emitting 12 units. Theeffect would still be a total reduction of 4 units between thetwo firms. However, the trade in pollution permits allowspollution reduction to be concentrated where it can beachieved at lowest cost. In our example, if it cost firm Bmore to reduce its pollution than firm A, the read more..

  • Page - 365

    33812 APPLIED MICROECONOMICSmain problem with this approach is that it could be seen asunfair by those firms that are already using cleaner techno-logy. Why should they be required to make the same reduc-tions as firms using dirty technology?The EU carbon trading system.In the EU, a carbonEmissions Trading Scheme (ETS) has been in place sinceJanuary 2005 as part of the EU’s approach to meeting itstargets under the Kyoto Treaty (see Box 12.2). Under thescheme, some 12 000 industrial plants read more..

  • Page - 366

    12.2 TRAFFIC CONGESTION AND URBAN TRANSPORT POLICIES339stick to it: this is the dominant strategy – a lesson thatGeorge W. Bush seemed quick to learn! Cell D is preferableto Cell A; E is preferable to B; F is preferable to C. But whenall countries reason like this, the world ends up in Cell F,with no cut in pollution. Cell F is worse for all countriesthan Cell A!Only if countries believe that the other countries will (a)ratify the agreement and (b) stick to it once it is ratified willthe read more..

  • Page - 367

    34012 APPLIED MICROECONOMICSBetween 1970 and 2004 road traffic in Great Britain roseby 148 per cent, whereas the length of public roads rose byonly 22 per cent (albeit some roads were widened). Mostpassenger and freight transport is by road. In 2004, 93 percent of passenger kilometres and 62 per cent of freight ton-nage kilometres in Great Britain were by road, whereas railaccounted for a mere 6 per cent of passenger traffic and 7per cent of freight tonnage. Of road passenger kilometres,92 per read more..

  • Page - 368

    12.2 TRAFFIC CONGESTION AND URBAN TRANSPORT POLICIES341Price of substitutes.If bus and train fares came down,people might switch from travelling by car. The cross-priceelasticity, however, is likely to be relatively low, given thatmost people regard these alternatives as a poor substitutefor travelling in their own car. Cars are seen as more comfortable and convenient.The ‘price’ of substitutes also includes the time taken totravel by these alternatives. The quicker a train journey is read more..

  • Page - 369

    34212 APPLIED MICROECONOMICSA socially efficient level of consumption occurs wherethe marginal social benefit of consumption equals itsmarginal social cost (MSB= MSC ). So what are the marginalsocial benefits and costs of using a car?Marginal social benefit of road usageMarginal social benefit equals marginal private benefit plus externalities. Marginal private benefit is the directbenefit to the car user and is reflected in the demand for car journeys, the determinants of which we read more..

  • Page - 370

    12.2 TRAFFIC CONGESTION AND URBAN TRANSPORT POLICIES343The socially efficient level of road usageThe point where the marginal social benefit of car use isequal to the marginal social cost can be illustrated on a dia-gram. In Figure 12.6, costs and benefits are shown on thevertical axis and are measured in money terms. Thus anynon-monetary costs or benefits (such as time costs) must begiven a monetary value. The horizontal axis measures roadusage in terms of cars per minute passing a read more..

  • Page - 371

    34412 APPLIED MICROECONOMICSit also underestimated the direct effect it would have onencouraging people to use the motorway rather than somealternative route, or some alternative means of transport,or even not to make the journey at all. It also underestim-ated the effect it would have on encouraging people to livefurther from their place of work and to commute along themotorway. The result is that there is now serious conges-tion on the motorway.Thus new roads may simply generate extra read more..

  • Page - 372

    TC 3p21TC 3p2112.2 TRAFFIC CONGESTION AND URBAN TRANSPORT POLICIES345Restricting car accessOne approach involves reducing car access to areas that aresubject to high levels of congestion. The following mea-sures are widely used: bus and cycle lanes, ‘high occupancyvehicle lanes’ (confined to cars with two or more occu-pants), pedestrian-only areas and no entry to side streetsfrom main roads.There is a serious problem, however, with these mea-sures. They tend not to solve the problem of read more..

  • Page - 373

    34612 APPLIED MICROECONOMICSArea charges.One simple and practical means of charg-ing people to use congested streets is the area charge.People would have to pay (normally by the day) for usingtheir car in a city centre. Earlier versions of this schemeinvolved people having to purchase and display a ticket ontheir car, rather like a ‘pay-and-display’ parking system.More recently, electronic versions have been developed.The London Congestion Charge is an example. Car driversmust pay £8 per read more..

  • Page - 374

    12.2 TRAFFIC CONGESTION AND URBAN TRANSPORT POLICIES347The London congestion charging system has reducedtraffic in the zone by nearly 20 per cent and has sig-nificantly increased the rate of traffic flow. The charge isnot a marginal one, however, in the sense that it does notvary with the degree of congestion or the amount of timespent or distance travelled by a motorist within the zone.This is an intrinsic problem of area charges. Nevertheless,their simplicity makes the system easy to read more..

  • Page - 375

    TC 6p26KI 19p15734812 APPLIED MICROECONOMICSSection summary1. Increased car ownership and car usage have led to agrowing problem of traffic congestion.2. The allocation of road space depends on demandand supply. Demand depends on the price tomotorists of using their cars, incomes, the cost ofalternative means of transport, the price of cars andcomplementary services (such as parking), and thecomfort and convenience of car transport. The priceand cross-price elasticities of demand for car read more..

  • Page - 376

    12.3 COMPETITION POLICY349monopolists or oligopolists are anti-competitive. Some ofthese practices may be made illegal, such as price fixing by oligopolists; others may be assessed on a case-by-caseapproach to determine whether or not they should be per-mitted. Such an approach does not presume that the merepossession of power is against the public interest, but ratherthat certain uses of that power may be.? Try to formulate a definition of ‘the public interest’.The targets of competition read more..

  • Page - 377

    35012 APPLIED MICROECONOMICSnot to ‘poach’ on each other’s territory. For example, twoor more supermarket chains could agree to open only onesupermarket in each district.Banning formal cartels is easy. Preventing tacit collusionis another matter. It may be very difficult to prove that firmsare making informal agreements behind closed doors.Competition policy in the European UnionEU legislation is contained in Articles 81 and 82 of theAmsterdam Treaty and in additional regulations read more..

  • Page - 378

    12.3 COMPETITION POLICY351In a report on world-wide cartels published in 2000, the OECD found that:Actions against price fixing and other such ‘hardcore’ cartels have halted billions of dollars in secretovercharges to individual consumers and businesspurchasers. The lesson of these successful cases isthat such cartels are much more prevalent andharmful to the global economy than previouslybelieved.4The report cited the following cases:• A global citric acid cartel, which raised prices by read more..

  • Page - 379

    35212 APPLIED MICROECONOMICS19 were prohibited. In many cases (too many, claim critics),the Commission accepted the undertakings of firms.There is considerable disagreement in the EU betweenthose who want to encourage competition within the EUand those who want to see European companies beingworld leaders. For them, the ability to compete in worldmarkets normally requires that companies are large, whichmay well imply having monopoly power within the EU.?To what extent is Article 82 consistent read more..

  • Page - 380

    12.3 COMPETITION POLICY353case is investigated by the OFT, which uses a two-stage pro-cess in deciding whether an abuse has taken place.The first stage is to establish whether a firm has a posi-tion of dominance. The firm does not literally have to be amonopoly. Rather ‘dominance’ normally involves the firmhaving at least a 40 per cent share of the market (nationalor local, whichever is appropriate), although this figure willvary from industry to industry. Also, dominance dependson the read more..

  • Page - 381

    35412 APPLIED MICROECONOMICSSecondly, most commentators favour the system of cer-tain practices being prohibited, with fines applicable to thefirst offence. This acts as an important deterrent to anti-competitive behaviour.A problem with any policy to deal with collusion is thedifficulty in rooting it out. When firms do all their deals‘behind closed doors’ and are careful not to keep records orgive clues, then collusion can be very hard to spot. Thecases that have come to light, such as read more..

  • Page - 382

    12.4 PRIVATISATION AND REGULATION355BOX 12.6concluded that there had been an abuse of monopolypower, stating that:Were this market fully competitive such that the top five EW retailers’ returns were no greater than their cost of capital,9 we estimate that EW prices would have been, on average, up to one-third lower....Many of the practices that we have identifiedduring the course of our investigation operate ormay be expected to operate against the publicinterest. They result in lack of read more..

  • Page - 383

    35612 APPLIED MICROECONOMICS• Greater competition in the goods market. If privatisationinvolves splitting an industry into competing parts (forexample, separate power stations competing to sell elec-tricity to different electricity distribution companies), theresulting competition may drive costs and prices down. • Greater competition for finance. After privatisation acompany has to finance investment through the market:it must issue shares or borrow from financial institu-tions. In doing read more..

  • Page - 384

    12.4 PRIVATISATION AND REGULATION357If, however, the industry remained nationalised, or if itwas privatised but regulated, it could be run as a monopolyand thus achieve the full economies of scale. And yet itcould be directed to set a price that just covered costs(including normal profits), and thus make no more profitthan a highly competitive industry. In Figure 12.8, it wouldproduce Qn at a price of Pn. We examine regulation later inthis section.Planning and the co-ordination of read more..

  • Page - 385

    35812 APPLIED MICROECONOMICSabove MC. At least that way it will not cause a diversion ofconsumption away from relatively low-cost industries (atthe margin) to a relatively high-cost one. The second-bestrule is therefore to set P= MC+ Z, where Z in this case is 10 per cent.The privatised industry produces externalitiesIn the first-best situation the privatised industry shouldproduce where price equals marginal social (not private)cost: P = MSC. The second-best solution is to produce whereP= MSC+ read more..

  • Page - 386

    12.4 PRIVATISATION AND REGULATION359Regulation in the UKTo some extent the behaviour of privatised industries maybe governed by general monopoly and restrictive practicelegislation. For example, in the UK, privatised firms can beinvestigated by the Office of Fair Trading and if necessaryreferred to the Competition Commission.In addition to this, there is a separate regulatory office tooversee the structure and behaviour of each of the privatisedutilities. These regulators are as follows: the read more..

  • Page - 387

    36012 APPLIED MICROECONOMICSThe electricity industry in England and WalesCompetition is generally seen as better than regulationas a means of protecting consumers’ interests. Theelectricity industry provides a good case study of waysto introduce competition into a privatised industry.The industry before privatisationUnder nationalisation, the industry in England andWales was organised as a monopoly with the CentralElectricity Generating Board (CEGB) supplying 99 percent of all electricity. It read more..

  • Page - 388

    12.4 PRIVATISATION AND REGULATION361BOX 12.7suppliers competing to sell to customers. Let usexamine each of these markets in turn.Competition in the wholesale market for electricity: NETA and BETTASince 2001 in England and Wales electricity has been traded in the wholesale market under the NewElectricity Trading Arrangements (NETA). In April 2005,this system was extended to Scotland and renamed the British Electricity Trading and TransmissionArrangements (BETTA). Participants in the read more..

  • Page - 389

    36212 APPLIED MICROECONOMICSwill become distorted and time and energy will bewasted in playing this game of cat and mouse.• Alternatively, there is the danger of regulatory capture.As regulators become more and more involved in theirindustry and get to know the senior managers at a personal level, so they are increasingly likely to see the managers’ point of view and will thus become lesstough. This, it is argued, has happened in the USA.Commentators do not believe that it has happened yetin read more..

  • Page - 390

    Section summary1. From around 1983 the Conservative government in theUK embarked on a large programme of privatisation.Many other countries have followed suit.2. The economic arguments for privatisation include:greater competition, not only in the goods marketbut in the market for finance and for corporatecontrol; reduced government interference; andraising revenue to finance tax cuts.3. The economic arguments against privatisation ofutilities include the following: the firms are likely to read more..

  • Page - 391

    36412 APPLIED MICROECONOMICSAdditional case studies on the book’s website ( subsidies. An examination of the use of subsidies around the world that are harmful to theenvironment.12.2Selling the environment. This looks at the proposals made at international climate conferences to usemarket-based solutions to global warming.12.3Environmental auditing. Are businesses becoming greener? A growing number of firms are subjectingthemselves to an ‘environmental read more..

  • Page - 392

    Part D: Foundations ofMacroeconomicsWhy do economies sometimes grow rapidly, while at other times they suffer from reces-sion? Why, if people want to work, do they sometimes find themselves unemployed?Why do economies experience inflation (rising prices), and does it matter if they do?Why do exchange rates change and what will be the impact of such changes on importsand exports? These macroeconomic issues affect all countries, and economists arecalled on to try to find explanations and read more..

  • Page - 393

    EC6_C13.qxd 10/27/05 16:50 Page 366 read more..

  • Page - 394

    Chapter13The National Economy13.1 The scope of macroeconomics368The major macroeconomic issues368Government macroeconomic policy36913.2 The circular flow of income370The inner flow, withdrawals and injections370The relationship between withdrawals andinjections372Circular flow and the four macroeconomicobjectives372Equilibrium in the circular flow37213.3 Measuring national income and output373Three ways of measuring GDP373Taking account of inflation374Taking account of population375Taking read more..

  • Page - 395

    KI 1p4KI 1p436813 THE NATIONAL ECONOMYTable 13.1Economic growth (average % per annum), unemployment (average %) and inflation (average % per annum)FranceGermanyItalyJapanUKUSAEU read more..

  • Page - 396

    13.1 THE SCOPE OF MACROECONOMICS369Today we are used to inflation rates of around 2 or 3 percent, but it was not long ago that inflation in most devel-oped countries was in double figures. In 1975, UK inflationreached 24 per cent.In most developed countries, governments have a par-ticular target for the rate of inflation. In the UK the target is2 per cent. The Bank of England then adjusts interest ratesto try to keep inflation on target (we see how this works inChapter 19).The balance of read more..

  • Page - 397

    KI 23p 25137013 THE NATIONAL ECONOMYOne way in which the four objectives are linked is throughtheir relationship with aggregate demand (AD). This is thetotal spending on goods and services made within thecountry (‘domestically produced goods and services’). Thisspending consists of four elements. The first is consumerspending on domestically produced goods and services(Cd), (i.e. total consumer expenditure on all products (C)minus expenditure on imports (M )). The other three elements are: read more..

  • Page - 398

    13.2 THE CIRCULAR FLOW OF INCOME371Net saving (S).Saving is income that households choosenot to spend but to put aside for the future. Savings are normally deposited in financial institutions such as banksand building societies. This is shown in the bottom centre ofthe diagram. Money flows from households to ‘banks, etc.’.What we are seeking to measure here, however, is the netflow from households to the banking sector. We thereforehave to subtract from saving any borrowing or drawing read more..

  • Page - 399

    37213 THE NATIONAL ECONOMYmay invest in plant and equipment or may simply spendthe money on building up stocks of inputs, semi-finishedor finished goods.Government expenditure (G).When the governmentspends money on goods and services produced by firms,this counts as an injection. Examples of such governmentexpenditure include spending on roads, hospitals andschools. (Note that government expenditure in this modeldoes not include state benefits. These transfer payments, aswe saw above, are read more..

  • Page - 400

    13.3 MEASURING NATIONAL INCOME AND OUTPUT373bring the economy back to a state of equilibrium whereinjections are equal to withdrawals.To illustrate this, let us consider the situation again whereinjections exceed withdrawals. Perhaps there has been arise in business confidence so that investment has risen. Orperhaps there has been a tax cut so that withdrawals havefallen. As we have seen, the excess of injections over with-drawals will lead to a rise in national income. But as nationalincome read more..

  • Page - 401

    TC 12p 37437413 THE NATIONAL ECONOMYtherefore, is to add up all these incomes. This is known asthe income method.The third method focuses on the expenditures necessaryto purchase the nation’s production. In this simple modelof the circular flow of income, with no injections or with-drawals, whatever is produced is sold. The value of what issold must therefore be the value of what is produced. Theexpenditure method measures this sales value.Because of the way the calculations are made, the read more..

  • Page - 402

    13.3 MEASURING NATIONAL INCOME AND OUTPUT375Taking account of population: the use ofper-capita measuresThe figures we have been looking at up to now are totalGDP figures. Although they are useful for showing how bigthe total output or income of one country is comparedwith another, we are often more interested in output orincome per head. Luxembourg obviously has a much lowertotal national income than the UK, but it has a higher GDPper head.Other per-capita measures are sometimes useful. read more..

  • Page - 403

    37613 THE NATIONAL ECONOMYDo GDP statistics give a good indication ofa country’s standard of living?If we take into account both inflation and the size of thepopulation, and use figures for real per-capita PPS GDP, willthis give us a good indication of a country’s standard of liv-ing? The figures do give quite a good indication of the levelof production of goods and the incomes generated from it,provided we are clear about the distinctions between thedifferent measures. But when we come read more..

  • Page - 404

    13.4 SHORT-TERM ECONOMIC GROWTH AND THE BUSINESS CYCLE377casual jobs that again they do not declare, this time for fearof losing benefits.Problems of using GDP statistics to measure welfareGDP is essentially an indicator of a nation’s production. Butproduction may be a poor indicator of society’s well-beingfor the following reasons.Production does not equal consumption.Production isdesirable only to the extent that it enables us to consumemore. If GDP rises as a result of a rise in read more..

  • Page - 405

    KI 1p437813 THE NATIONAL ECONOMYFor many developing countries, economic growth is a necessity if they are to remove mass poverty. Whenthe majority of their population is underfed and poorly housed, with inadequate health care and little access to education, few would quarrel with the need for an increase in productive potential. The main query is whether the benefits of economicgrowth will flow to the mass of the population, orwhether they will be confined to the few who arealready relatively read more..

  • Page - 406

    KI 31p 368There are thus two major policy issues concerned witheconomic growth: the short-run issue of ensuring thatactual growth is such as to keep actual output as close aspossible to potential output; and the long-run issue of whatdetermines the rate of potential economic growth.Economic growth and the business cycleAlthough growth in potential output varies to some extentover the years – depending on the rate of advance of tech-nology, the level of investment and the discovery of newraw read more..

  • Page - 407

    38013 THE NATIONAL ECONOMYThere are four ‘phases’ of the business cycle. They areillustrated in Figure 13.3.1. The upturn. In this phase, a contracting or stagnanteconomy begins to recover, and growth in actual outputresumes.2. The expansion. During this phase, there is rapid economicgrowth: the economy is booming. A fuller use is made of resources, and the gap between actual and potentialoutput narrows.3. The peaking out. During this phase, growth slows downor even ceases.4. The slowdown, read more..

  • Page - 408

    13.4 SHORT-TERM ECONOMIC GROWTH AND THE BUSINESS CYCLE381Countries rarely experience stable economic growth.Instead they experience business cycles. Periods ofrapid economic growth are followed by periods of lowgrowth or even a fall in output (negative growth).Sometimes these cycles can be the result of govern-ment policy: raising taxes in a recession in order tocompensate for falling tax revenues caused by lowerincomes and lower expenditure. The higher taxationdampens consumer demand and causes read more..

  • Page - 409

    38213 THE NATIONAL ECONOMYIf the economy grows, how fast and for how long can it grow before it runs into inflationary problems?What level of growth might be sustainable over thelonger term? To answer this question, economists havedeveloped the concept of ‘output gaps’.4 The outputgap is the difference between actual output andsustainable output. Sustainable output5 is the level of output corresponding to stable inflation. If output is below this level (the gap is negative), there will be read more..

  • Page - 410

    13.4 SHORT-TERM ECONOMIC GROWTH AND THE BUSINESS CYCLE383a rapid rise in aggregate demand: the faster the rise inaggregate demand, the higher the short-run growth rate. A recession, by contrast, is associated with a reduction inaggregate demand.A rapid rise in aggregate demand, however, is notenough to ensure a continuing high level of growth over anumber of years. Without an expansion of potential outputtoo, rises in actual output must eventually come to an end.Once spare capacity has been used read more..

  • Page - 411

    TC 14p 385KI 16p12038413 THE NATIONAL ECONOMYFor growth to be sustained over the long term, there mustbe an increase in potential output. In other words, the coun-try’s capacity to produce must increase. In this section wesee what determines this capacity and why some countriesgrow faster than others over the long term. What we areconcerned with here, therefore, is the supply side of theeconomy, rather than the level of aggregate demand.Causes of long-term growthThere are two main determinants read more..

  • Page - 412

    KI 17p121TC 14p 385Land and raw materials.The scope for generating growthhere is usually very limited. Land is virtually fixed in quant-ity. Land reclamation schemes and the opening up ofmarginal land can add only tiny amounts to national out-put. Even if new raw materials are discovered (e.g. oil), thiswill result only in short-term growth: i.e. while the rate ofextraction is building up. Once the rate of extraction is at amaximum, economic growth will cease. Output will simplyremain at the read more..

  • Page - 413

    KI 28p 30038613 THE NATIONAL ECONOMYThe classical theory of growthThe classical economists of the nineteenth centurywere very pessimistic about the prospects foreconomic growth. They saw the rate of growthpetering out as diminishing returns to both labour and capital led to low wages and a falling rate of profit.The only gainers would be landlords, who, given thefixed supply of land, would receive higher and higherrents as the demand for scarce land rose.New growth theoryEconomists today are read more..

  • Page - 414

    13.5 LONG-TERM ECONOMIC GROWTH387The effects of actual growth on potential growthSome economists argue that potential growth is not influ-enced by actual growth. It depends largely on growth infactor productivity, and that in turn depends on scientificand technical advance. Such advances, they argue, areindependent of the state of the economy.Other economists, however, argue that actual growthstimulates investment and the development of new tech-nology. For these economists, therefore, it is read more..

  • Page - 415

    38813 THE NATIONAL ECONOMYAs explained in section 13.3, there are three ways of estim-ating GDP. In this appendix, we discuss each method inmore detail. We also look at some alternative measures ofnational income.The product method of measuring GDPThis approach simply involves adding up the value ofeverything produced in the country during the year: theoutput of cars, timber, lollipops, shirts, etc.; and all themyriad of services such as football matches, haircuts, busrides and insurance read more..

  • Page - 416

    APPENDIX: CALCULATING GDP389here is that some goods start being produced before the yearbegins. Thus when we come to work out GDP, we mustignore the values that had previously been added to stocksof raw materials and goods. Similarly, other goods are onlysold to the consumer after the end of the year. Neverthelesswe must still count the values that have been added duringthis year to these stocks of partially finished goods.A final problem concerned with stocks is that they mayincrease in value read more..

  • Page - 417

    39013 THE NATIONAL ECONOMYSome qualificationsStock (inventory) appreciation.As in the case of the product approach, any gain in profits from inventoryappreciation must be deducted, since they do not arisefrom a real increase in output.Transfer payments.GDP includes only those incomesthat arise from the production of goods and services. We do not, therefore, include transfer payments such as socialsecurity benefits, pensions and gifts.Direct taxes.We count people’s income before the pay-ment read more..

  • Page - 418

    APPENDIX: CALCULATING GDP391When working out GDP, however, we add in these taxesand subtract these subsidies to arrive at a market pricevaluation.The expenditure method of measuring GDPThe final approach to calculating GDP is to add up allexpenditure on final output (which will be at marketprices). This will include the following:• Consumer expenditure (C). This includes all expenditureon goods and services by households and by non-profitinstitutions serving households (NPISH) (e.g. clubs read more..

  • Page - 419

    39213 THE NATIONAL ECONOMY• Investment expenditure (I ). This includes investment incapital, such as buildings and machinery. It also includesthe value of any increase (+) or decrease (–) in invent-ories, whether of raw materials, semi-finished goods orfinished goods.• Exports of goods and services (X ).We then have to subtract imports of goods and services (M ) from the total in order to leave just the expenditure on domestic product. In other words, we subtract the part of consumer read more..

  • Page - 420

    APPENDIX: CALCULATING GDP393any undistributed profits. This gives us the gross incomethat households receive from firms in the form of wages,salaries, rent, interest and distributed profits.To get from this to what is available for households tospend, we must subtract the money that households pay inincome taxes and national insurance contributions, butadd all benefits to households, such as pensions and childbenefit: in other words, we must include transfer payments.Households’ read more..

  • Page - 421

    39413 THE NATIONAL ECONOMYAdditional case studies on the book’s website ( GDP deflator. An examination of how GDP figures are corrected to take inflation into account.13.2Taking into account the redistributive effects of growth. This case shows how figures for economic growthcan be adjusted to allow for the fact that poor people’s income growth would otherwise count for far lessthan rich people’s.13.3Simon Kuznets and the system of national income read more..

  • Page - 422

    Chapter14Macroeconomic Issues and Analysis: an Overview14.1 Unemployment396The meaning of ‘unemployment’396Official measures of unemployment397The duration of unemployment397The composition of unemployment399Unemployment and the labour market400Disequilibrium unemployment401Equilibrium unemployment40314.2 Aggregate demand and supply and the level of prices405The aggregate demand curve405The aggregate supply curve406Equilibrium40714.3 Inflation407The costs of inflation408Causes of read more..

  • Page - 423

    TC 13p 38139614 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWUnemployment fluctuates with the business cycle. In reces-sions, such as those experienced by most countries in theearly 1980s, early 1990s and early 2000s, unemploymenttends to rise. In boom years, such as the late 1980s and late1990s, it tends to fall. Figure 14.1 shows these cyclicalmovements in unemployment for selected countries.As well as experiencing fluctuations in unemployment,most countries have experienced long-term read more..

  • Page - 424

    14.1 UNEMPLOYMENT397Official measures of unemploymentClaimant unemploymentTwo common measures of unemployment are used in offi-cial statistics. The first is claimant unemployment. This issimply a measure of all those in receipt of unemployment-related benefits. In the UK claimants receive the ‘jobseeker’sallowance’.Claimant statistics have the advantage of being very easyto collect. However, they exclude all those of working agewho are available for work at current wage rates, but read more..

  • Page - 425

    39814 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWThe duration of unemployment will depend on the rateof inflow and outflow. The rate is expressed as the numberof people per period of time. Table 14.3 shows the inflowsand outflows in selected years.Note the magnitude of the flows. In each of the years,the outflows (and inflows) exceed the total number un-employed. The bigger the flows are relative to the totalnumber unemployed, the less will be the average durationof unemployment. This read more..

  • Page - 426

    14.1 UNEMPLOYMENT399The composition of unemploymentUnemployment rates vary enormously between countriesand between different groups within countries.Geographical differences.Table 14.4 illustrates the con-siderable differences in unemployment rates betweencountries. Compare the unemployment rates in Irelandand Spain! Countries have very different labour markets,very different policies on unemployment, training schemes,redundancy, etc., and very different attitudes of firmstowards their workers. read more..

  • Page - 427

    40014 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWthe average. In the UK, the unemployment rate for Afro-Caribbeans is 21/2 times greater than that for whites. Forthose of Pakistani and Bangladeshi origin, it is three timesgreater. Explanations are complex, but include differencesin educational opportunities, a higher proportion of youngerpeople, a greater sense of alienation among the unemployed,and the attitudes and prejudices of employers.Unemployment and the labour marketWe now turn to the read more..

  • Page - 428

    14.1 UNEMPLOYMENT401This curve is relatively inelastic, since the size of the labourforce at any one time cannot change significantly. Never-theless it is not totally inelastic because (a) a higher wagerate will encourage some people to enter the labour market(e.g. parents raising children), and (b) the unemployed willbe more willing to accept job offers rather than continuingto search for a better-paid job.The aggregate demand for labour curve (ADL ) slopesdownwards. The higher the wage rate, read more..

  • Page - 429

    40214 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWthose who are still employed could lead to extra consumerexpenditure. This addition to aggregate demand would in turn lead to firms demanding more labour, as theyattempted to increase output to meet the extra demand. InFigure 14.3, the ADL curve will shift to the right, therebyreducing the gap A – B.?If the higher consumer expenditure and higher wagessubsequently led to higher prices, what would happento: (a) real wages; (b) unemployment read more..

  • Page - 430

    14.1 UNEMPLOYMENT403?If this analysis is correct, namely that a reduction inwages will reduce the aggregate demand for goods,what assumption must we make about the relativeproportions of wages and profits that are spent (giventhat a reduction in real wage rates will lead to acorresponding increase in rates of profit)?Growth in the labour supplyIf labour supply rises with no corresponding increase in thedemand for labour, the equilibrium real wage rate will fall.If the real wage rate is read more..

  • Page - 431

    40414 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWmay expand while in others it contracts. There are twomain reasons for this.A change in the pattern of demand.Some industriesexperience declining demand. This may be due to a changein consumer tastes as certain goods go out of fashion. Or it may be due to competition from other industries. Forexample, consumer demand may shift away from coal andto other fuels. This will lead to structural unemployment inmining areas.A change in the methods of read more..

  • Page - 432

    KI 7p3514.2 AGGREGATE DEMAND AND SUPPLY AND THE LEVEL OF PRICES405the costs to relatives and friends, and the costs tosociety at large in terms of lost tax revenues, lostprofits and lost wages to other workers, and in termsof social disruption.5. Unemployment can be divided into disequilibriumand equilibrium unemployment.6. Disequilibrium unemployment occurs when realwage rates are above the level that will equate theaggregate demand and supply of labour. It can becaused by unions or government read more..

  • Page - 433

    40614 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWfind that they are paying a larger proportion of their incomesin taxes. As a result, they cannot afford to buy so much.Substitution effects.In the microeconomic situation, ifthe price of one good rises, people will switch to alternativegoods. This is the substitution effect of that price rise andhelps to explain why the demand curve for a particulargood will be downward sloping. But how can there be asubstitution effect at a macroeconomic read more..

  • Page - 434

    14.3 INFLATION407labour may be harder to find, and certain raw materialsmay be harder to obtain.Thus rising costs explain the upward-sloping aggregate supply curve. The more steeply costs rise as productionincreases, the less elastic will the aggregate supply curve be.It is likely that, as the level of national output increases andfirms reach full-capacity working, the aggregate supplycurve will tend to get steeper (as shown in Figure 14.8).Shifts in the aggregate supply curveThe aggregate read more..

  • Page - 435

    40814 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWinflation was particularly severe between 1973 and 1983,and relatively low in the mid-1980s and since the mid-1990s. Although most countries have followed a similarpattern over time, the average rates of inflation have dif-fered substantially from one country to another. These dif-ferences, however, have tended to narrow in recent years asbarriers to international trade and capital movements havebeen reduced and as increasing numbers of read more..

  • Page - 436

    14.3 INFLATION409If people could correctly anticipate the rate of inflationand fully adjust prices and incomes to take account of it,then the costs of inflation would indeed be relatively small.For us as consumers, they would simply be the relativelyminor inconvenience of having to adjust our notions ofwhat a ‘fair’ price is for each item when we go shopping.For firms, they would again be the relatively minor costs ofhaving to change price labels, or prices in catalogues or onmenus, or read more..

  • Page - 437

    41014 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWincreasing output (there is a move up along the AS curve).Just how much they raise prices depends on how muchtheir costs rise as a result of increasing output. In otherwords, it will depend on the shape of the AS curve.The aggregate supply curve will tend to become steeperas the economy approaches the peak of the business cycle.In other words, the closer actual output gets to potentialoutput, and the less slack there is in the economy, the read more..

  • Page - 438

    14.3 INFLATION411Cost-push inflationCost-push inflation is associated with continuing rises incosts and hence continuing leftward (upward) shifts in theAS curve. Such shifts occur when costs of production riseindependently of aggregate demand.If firms face a rise in costs, they will respond partly byraising prices and passing the costs on to the consumer,and partly by cutting back on production. This is illustratedin Figure 14.11. There is a leftward shift in the aggregatesupply curve: from read more..

  • Page - 439

    41214 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWThe interaction of the two causes is illustrated in Figure14.12. Assume that powerful groups are constantly pushingup the costs of production. The AS curve is constantly shift-ing to the left. At the same time, assume that the govern-ment, in order to prevent a rise in unemployment, isconstantly boosting the level of aggregate demand (say, bycutting taxes). The AD curve is constantly shifting to theright. The net effect on output and employment read more..

  • Page - 440

    14.3 INFLATION413Thus the higher the expected rate of inflation, the higherwill be the level of pay settlements and price rises, and hencethe higher will be the resulting actual rate of inflation.Just how expectations impact on inflation depends onhow they are formed. We examine some models of expec-tations in Chapter 20.Policies to tackle inflationWe will be examining a number of different anti-inflation-ary policies in later chapters. These policies can be directedtowards the control of read more..

  • Page - 441

    41414 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWsupply, thereby making less money available for spending,or by putting up interest rates and thus making borrowingmore expensive. If people borrow less, they will spend less.Supply-side policiesThe aim here is to reduce the rate of increase in costs. Thiswill help reduce leftward shifts in the aggregate supply curve.This can be done either (1) by restraining monopoly influ-ences on prices and incomes (e.g. by policies to restrict theactivities read more..

  • Page - 442

    14.3 INFLATION415BOX 14.5unemployment could be bought at the cost of higherinflation, and vice versa. Unfortunately, the experiencesince the late 1960s has suggested that no such simplerelationship exists beyond the short run.The breakdown of the Phillips curveFrom about 1966 the Phillips curve relationshipseemed to break down. The UK, and many othercountries in the western world too, began toexperience growing unemployment and higher rates of inflation as well.Figure (b) shows price read more..

  • Page - 443

    41614 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEW4. Cost-push and demand-pull inflation can interact toform spiralling inflation.5. Inflation can also be caused by shifts in the pattern of demand in the economy, with prices rising in sectors of increasing demand but beingreluctant to fall in sectors of declining demand.6. Expectations play a crucial role in determining thelevel of inflation. The higher people expect inflationto be, the higher it will be.7. Policies to tackle inflation read more..

  • Page - 444

    14.4 THE BALANCE OF PAYMENTS AND EXCHANGE RATES417The capital accountThe capital account records the flows of funds, into thecountry (credits) and out of the country (debits), associatedwith the acquisition or disposal of fixed assets (e.g. land),the transfer of funds by migrants, and the payment ofgrants by the government for overseas projects and thereceipt of EU money for capital projects (e.g. from theAgricultural Guidance Fund).The financial account3The financial account of the balance read more..

  • Page - 445

    41814 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEW• Direct investment. If a foreign company invests moneyfrom abroad in one of its branches or associated com-panies in the UK, this represents an inflow of moneywhen the investment is made and is thus a credit item.(Any subsequent profit from this investment that flowsabroad will be recorded as an investment income outflowon the current account.) Investment abroad by UK com-panies represents an outflow of money when the invest-ment is read more..

  • Page - 446

    14.4 THE BALANCE OF PAYMENTS AND EXCHANGE RATES419in the balance of payments, since it represents an outflowfrom it (to the reserves).When all the components of the balance of paymentsaccount are taken together, the balance of paymentsshould exactly balance: credits should equal debits. As weshall see below, if they were not equal, the rate of exchangewould have to adjust until they were, or the governmentwould have to intervene to make them equal.When the statistics are compiled, however, a read more..

  • Page - 447

    42014 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWsince 1995 and are based on trade solely in manufacturedproducts during the period 1989–91. The Bank of Englandplans to change these weights every year to reflect chang-ing patterns of trade, not only in manufactured products,but also in services. It also plans to incorporate a wider setof countries, including China and South Korea.Note that all the exchange rates must be consistentwith each other. For example, if £1 exchanged for $1.50 read more..

  • Page - 448

    14.4 THE BALANCE OF PAYMENTS AND EXCHANGE RATES421The demand curve for pounds, therefore, typically slopesdownwards. The equilibrium exchange rate is where the demand forpounds equals the supply. In Figure 14.14 this is at anexchange rate of £1 = $1.60. But what is the mechanismthat equates demand and supply?If the current exchange rate were above the equilibrium,the supply of pounds being offered to the banks wouldexceed the demand. For example, in Figure 14.14 if theexchange rate were $1.80, read more..

  • Page - 449

    42214 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEW• Longer-term changes in international trading patterns.Over time the pattern of imports and exports is likely tochange as (a) consumer tastes change, (b) the nature andquality of goods change and (c) the costs of productionchange. If, as a result, UK goods become less competitivethan, say, German or Japanese goods, the demand forsterling will fall and the supply will rise. These shifts, ofcourse, are gradual, taking place over many years.?Go read more..

  • Page - 450

    14.4 THE BALANCE OF PAYMENTS AND EXCHANGE RATES423rate. This, in turn, might cause uncertainty for businesses,which might curtail their trade and investment.The government may thus ask the central bank (theBank of England in the case of the UK) to intervene in theforeign exchange market. But what can it do? The answerto this will depend on the government’s objectives. It maysimply want to reduce the day-to-day fluctuations in theexchange rate, or it may want to prevent longer-term, read more..

  • Page - 451

    TC 13p 38142414 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWSection summary1. The balance of payments account records allpayments to and receipts from foreign countries.The current account records payments for importsand exports, plus incomes and transfers of money to and from abroad. The capital account records alltransfers of capital to and from abroad. The financialaccount records inflows and outflows of money for investment and as deposits in banks and otherfinancial institutions; it read more..

  • Page - 452

    14.5 THE RELATIONSHIP BETWEEN THE FOUR MACROECONOMIC OBJECTIVES425prices make UK goods less competitive internationally. As aresult, unless there is a compensating rise in interest rates,the equilibrium exchange rate is likely to fall, which willraise the price of imports, thus further stoking up inflation.This will probably increase inflationary expectations.At the peak of the cycle (phase 3), unemployment isprobably at its lowest and output at its highest (for the timebeing). But growth has read more..

  • Page - 453

    42614 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEWThe long-term relationship between the objectivesIn the long run, the relationship between the objectives ismuch less straightforward. Over the long term, they can allget better or all get worse. Table 14.9 illustrates this. It looksat the four indicators in five-year periods.?1. Was there any five-year period when all fourindicators were better than in the previous fiveyears?2. Which macroeconomic problem(s) has/havegenerally been less read more..

  • Page - 454

    14.5 THE RELATIONSHIP BETWEEN THE FOUR MACROECONOMIC OBJECTIVES427Section summary1. In the short run, the four macroeconomic objectivesare related to aggregate demand and the businesscycle. In the boom phase, growth is high andunemployment is falling, but inflation is rising andthe current account of the balance of payments ismoving into deficit. In the recession, the reverse isthe case.2. In the long run, the relationship between the four objectives is less straightforward.Nevertheless, read more..

  • Page - 455

    42814 MACROECONOMIC ISSUES AND ANALYSIS: AN OVERVIEW• For news articles relevant to this and the previous chapter, see the Economics News Articles link fromthe book’s website.• For general news on macroeconomic issues, both national and international, see websites in sectionA, and particularly A1–5, 7–9, 20 –25, 31. See also links to newspapers worldwide in A38, 39, 43 and 44,and the news search feature in Google at A41. See also A42 for links to economics news articles read more..

  • Page - 456

    Part E: MacroeconomicsWe now build on the foundations of the last three chapters. We will see why economiesgrow over the longer term but why they fluctuate in the short term and what govern-ments can do to prevent these fluctuations.In Chapter 15, to help understand the context of modern macroeconomics, we sketch outhow the subject has developed over the past 100 years. In the following three chapters,we look at what determines the level of national income and the role that money plays inthe read more..

  • Page - 457

    EC6_C15.qxd 10/27/05 16:54 Page 430 read more..

  • Page - 458

    Chapter15The Roots of Modern Macroeconomics15.1 Setting the scene: three key issues432Issue 1: The flexibility of prices and wages432Issue 2: The flexibility of aggregate supply432Issue 3: The role of expectations433Policy implications43415.2 Classical macroeconomics434Classical analysis: output and employment435Classical analysis: prices and inflation436The classical response Great Depression43715.3 The Keynesian revolution439Keynes’ rejection of classical macroeconomics439Keynes’ read more..

  • Page - 459

    43215 THE ROOTS OF MODERN MACROECONOMICSMacroeconomics as a separate branch of economics had itsbirth with the mass unemployment experienced in the1920s and 1930s. The old ‘classical theories’ of the time,which essentially said that free markets would provide ahealthy economy with full employment, could not providesolutions to the problem. Their analysis seemed totally atodds with the facts.A new analysis of the economy – one that did offer solutions to mass unemployment – was put read more..

  • Page - 460

    15.1 SETTING THE SCENE: THREE KEY ISSUES433The arguments centre on the nature of the aggregatesupply curve (AS). Three different AS curves are shown inFigure 15.1. In each of the three cases, it is assumed that the government now raises aggregate demand through theuse of fiscal and/or monetary policy. Aggregate demandshifts from AD1 to AD2. The effect on prices and output willdepend on the shape of the AS curve.Some economists, generally supported by the politicalright, argue that output is not read more..

  • Page - 461

    43415 THE ROOTS OF MODERN MACROECONOMICSThus, they argue, increased aggregate demand merelyfuels inflation and can do no more than give a very temporary boost to output and employment. If anything,the higher inflation could damage business confidence andthus worsen long-term output and employment growth bydiscouraging investment.Those who criticise this view argue that the formation ofexpectations is more complex than this. Whether peopleexpect an increase in demand to be fully matched read more..

  • Page - 462

    15.2 CLASSICAL MACROECONOMICS435The classical analysis of output andemploymentThe classical theory predicted that, in the long run, equilib-rium in the economy would be at virtually full employ-ment. In the long run, any unemployment would be merelyfrictional unemployment: namely, people in the process ofchanging jobs.There were two important elements in the classical theory.The free-market economy works to equate demandand supply in all marketsThis element of classical theory assumes flexible read more..

  • Page - 463

    43615 THE ROOTS OF MODERN MACROECONOMICSSay’s lawJ.-B. Say was a French economist of the early nineteenthcentury (see Person Profile on the book’s website). Say’slaw states that: supply creates its own demand. What thismeans is that the production of goods and services willgenerate expenditures sufficient to ensure that they aresold. There will be no deficiency of demand and no need to lay off workers. There will be full employment. Thejustification for the law is as follows.When read more..

  • Page - 464

    15.2 CLASSICAL MACROECONOMICS437?Assuming that Y rises each year as a result of increasesin productivity, can money supply rise without causinginflation? Would this destroy the validity of the quantitytheory?The classical response Great Depression The classical economists had predicted that there would bevirtual full employment. Any unemployment would simplybe the frictional unemployment of people being ‘betweenjobs’. Before the First World War their predictions were not far from the truth. read more..

  • Page - 465

    43815 THE ROOTS OF MODERN MACROECONOMICSThe deflationary policies of the 1920s seemed to be directlyresponsible for increasing unemployment. Many criticsargued that the government ought deliberately to expandaggregate demand. However, the Treasury and other class-ical economists rejected the analysis that unemploymentwas caused by a lack of demand; they also rejected policiesof reflation (e.g. increased government expenditure).The classical Treasury view on unemploymentWould deflation of read more..

  • Page - 466

    15.3 THE KEYNESIAN REVOLUTION439lead to a rise in the price level from P1 to P2. Nationaloutput (and hence employment) would not increase. It would remain constant at Q1. A re-emergence ofinflation, which had been eliminated in the early 1920s,would further erode the competitiveness of Britishgoods, jeopardising the return to the gold standard atthe pre-war exchange rate.Treasury orthodoxy insisted, therefore, that governmentshould attempt to balance its budget, even if this meantcutting read more..

  • Page - 467

    44015 THE ROOTS OF MODERN MACROECONOMICSFigure 15.5The problem of demand deficiencyin the labour marketFigure 15.6Disequilibrium in the market for loanable fundsIn The General Theory of Employment, Interest andMoney, Keynes rejects the classical argument thatunemployment is due to excessive wages. In Chapter 2he argues:[T]he contention that the unemployment whichcharacterises a depression is due to a refusal bylabour to accept a reduction of money wages is notclearly supported by the facts. It read more..

  • Page - 468

    15.3 THE KEYNESIAN REVOLUTION441an increased spending of money may lead to substantialincreases in real income (Y ) and leave prices (P) littleaffected.?Demonstrate this argument on an aggregate demandand supply diagram.If the government were to cut money supply in anattempt to reduce prices, the major effect might be to reduceoutput and employment instead. In terms of the quantityequation, a reduction in M may lead to a reduction in out-put and hence real income Y rather than a reduction in read more..

  • Page - 469

    44215 THE ROOTS OF MODERN MACROECONOMICS(Yp) at which there would be full employment of resources.This represents a limit to output. If aggregate demand wereinitially at AD1, equilibrium would be at Y1, considerablybelow the full-employment potential.In this case, argued Keynes, governments should inter-vene to boost aggregate demand. There are two policyinstruments that they can use.Fiscal policyRemember how we defined this in Chapter 14 (page 413). It is where the government alters the read more..

  • Page - 470

    15.4 THE MONETARIST–KEYNESIAN DEBATE443into recession. Likewise a reflationary policy may beginto work only when the economy is already booming,thus further fuelling inflation.• The UK’s long-term growth at around 2.8 per cent per annum was appreciably lower than that of otherindustrialised countries. Some of the blame for this was attributed to an over-concentration on short-termpolicies of stabilisation, and a neglect of underlyingstructural problems in the economy.• Persistent read more..

  • Page - 471

    44415 THE ROOTS OF MODERN MACROECONOMICSMonetarists argued that over the long run, in the equa-tion MV= PY, both V and Y are independently determinedand are not, therefore, affected by changes in M. Anychange in money supply (M ), therefore, will only affectprices (P). Whether or not monetarists were correct in argu-ing that V and Y are not affected by changes in M will beexamined in later chapters.Monetarists drew two important conclusions from theiranalysis.• The rising inflation from the read more..

  • Page - 472

    15.4 THE MONETARIST–KEYNESIAN DEBATE445result – and there will be a certain amount of unemploy-ment of labour (and other resources too) that cannot beeliminated simply by expanding aggregate demand.In other respects, Keynesians differed markedly from monetarists.InflationInflation was not just a problem of excess demand (causedby too much money). It was also caused by increased cost-push pressures: the increasing concentration of economicpower in large multinational companies and large read more..

  • Page - 473

    44615 THE ROOTS OF MODERN MACROECONOMICSthe stock market, the money market and the foreignexchange market can respond quite violently to short-termpressures. Such fluctuations can be very damaging toinvestment. For example, violent swings in exchange rates,as experienced between the euro and the dollar in the early2000s (see Box 23.4), can dissuade firms from making long-term investment decisions to develop export markets. Asudden rise in exchange rates may make it impossible tocompete abroad, read more..

  • Page - 474

    15.5 THE CURRENT POSITION: AN EMERGING CONSENSUS?447KI 5p21KI 10p62TC 9p101A range of viewsFrom the monetarist–Keynesian debates of the 1970s and1980s has emerged a degree of consensus among manyeconomists that draws on insights from both schools. Thisis not to suggest, however, that all economists agree. Infact, a whole range of views can be identified.One simple way of classifying these differing views is tosee them falling along a spectrum. At the one end are thosewho see the free market read more..

  • Page - 475

    44815 THE ROOTS OF MODERN MACROECONOMICSclear the labour market and eliminate demand-deficientunemployment. In recent years new Keynesians, as theyare called, have attempted to discover the reasons for the downward stickiness in real wages during a recession.These include the following:• The worry of employers about demotivating their workforce, and thus causing efficiency to suffer. This isknown as the efficiency wage theory.• The power of insiders to resist real wage cuts.• The power read more..

  • Page - 476

    15.5 THE CURRENT POSITION: AN EMERGING CONSENSUS?449• In the long run, changes in aggregate demand will havemuch less effect on output and employment and muchmore effect on prices. In fact, many economists say thatthere will be no effect at all on output and employment,and that the whole effect will be on prices. There is still a substantial body of Keynesians, however, especiallypost-Keynesians, who argue that changes in aggregatedemand will have substantial effects on long-term out-put and read more..

  • Page - 477

    45015 THE ROOTS OF MODERN MACROECONOMICSAdditional case studies on the book’s website ( equation of exchange. This examines two more versions that are commonly used: the Fisher version andthe Cambridge version.15.2Money and inflation in ancient Rome. A very early case study of the quantity theory of money: how theminting of extra coins by the Romans caused prices to rise.15.3The Great Depression and the return to the gold standard. A time of great hardship read more..

  • Page - 478

    Chapter16Short-run Macroeconomic Equilibrium16.1 Background to the theory452Aggregate demand and national income452The Keynesian 45° line452Consumption453Withdrawals455Injections45816.2 The determination of national income462Equilibrium national income462The multiplier: W and J approach463The multiplier: Y and E approach465*The multiplier: some qualifications466The relationship between the 45° linediagram and the AD/AS diagram46716.3 The simple Keynesian analysis ofunemployment and read more..

  • Page - 479

    TC 13p 38145216 SHORT-RUN MACROECONOMIC EQUILIBRIUMThe relationship between aggregatedemand and national incomeThis chapter explains what determines the level of nationalincome (GDP) in the short run. It is based on the modeldeveloped by John Maynard Keynes, back in the 1930s.The basic explanation is quite simple: the level of pro-duction in the economy depends on the level of aggregatedemand. If people buy more, firms will produce more inresponse to this, providing they have spare capacity. If read more..

  • Page - 480

    16.1 BACKGROUND TO THE THEORY453output) on the horizontal axis, and the various componentparts of the circular flow (Cd, W and J ) on the vertical axis.If the two axes are plotted to the same scale (which theyare), then at every point on the 45° line the items on eachaxis are equal.But what items on the vertical axis will always equalnational income (Y ), which is plotted on the horizontalaxis? The answer is Cd+ W, since, by definition, Y= Cd+ W.For example, if Y were £100 billion, then Cd+ read more..

  • Page - 481

    45416 SHORT-RUN MACROECONOMIC EQUILIBRIUMnational income that goes on consumption.1 In Table 16.1for each £10 billion rise in national income there is an £8billion rise in consumption. Thus the marginal propensityto consume is £8 billion/£10 billion = 8/10 or 4/5 or 0.8.The formula is:mpc=∆C/∆YIn Figure 16.3, the consumption function is a straightline: it has a constant slope, and hence the mpc is also constant.?It is possible that as people get richer they will spend a smaller and read more..

  • Page - 482

    16.1 BACKGROUND TO THE THEORY455Consumption of domestically produced goods (Cd )The parts of consumption that go on imports and indirecttaxes constitute withdrawals from the circular flow of incomeand thus do not contribute to aggregate demand. We shallconcentrate on the part of consumption that does: namely, theconsumption of domestic product (Cd). The Cd function liesbelow the C function, as in Figure 16.5. The gap between themconstitutes imports of consumer goods and indirect read more..

  • Page - 483

    45616 SHORT-RUN MACROECONOMIC EQUILIBRIUMThe mpt depends on tax rates. In a simple world where therewas only one type of tax, which was charged at a constantrate – for example, an income tax of 22 per cent – the mptwould be given directly by the tax rate. In this example, foreach extra pound earned, 22p would be paid in income tax.The mpt=∆T/∆Y = 22/100 = 0.22. In practice, of course,there are many types of tax charged at many different rates,and thus working out the mpt is more read more..

  • Page - 484

    16.1 BACKGROUND TO THE THEORY457Consumer spending follows a regular cyclical patterneach year, reaching its peak in the fourth quarter asChristmas approaches. The graph shows the levels ofUK personal disposable income and total consumerexpenditure (i.e. consumption before indirect taxes andimports have been deducted) from 1995 Q1 to 2005 Q1.The annual cyclical pattern can clearly be seen, withconsumption actually falling in quarter 1 of each year.The area between consumer expenditure read more..

  • Page - 485

    KI 10p6245816 SHORT-RUN MACROECONOMIC EQUILIBRIUM• Tastes. If consumer tastes shift towards foreign goodsand services, imports will rise. For example, it mightbecome more popular to go abroad for your holidays.• Relative quality. If the quality of foreign goods and services increases relative to that of domestic goods andservices, imports will rise.• The determinants of consumption. Since imports of goodsand services are part of total consumption (as opposed to Cd), the various read more..

  • Page - 486

    16.1 BACKGROUND TO THE THEORY459The cost and efficiency of capital equipment.If the costof capital equipment goes down or machines become moreefficient, the return on investment will increase. Firms willinvest more. Technological progress is an important deter-minant here.The rate of interest.The higher the rate of interest, themore expensive it will be for firms to finance investment,and hence the less profitable will the investment be. Justhow responsive total investment in the economy is read more..

  • Page - 487

    46016 SHORT-RUN MACROECONOMIC EQUILIBRIUMIn the boom years of the late 1980s, business optimismwas widespread throughout Europe. Investment wascorrespondingly high, and with it there was a high rateof economic growth.Surveys of European business expectations in the early 1990s, however, told a very different story. Pessimism was rife. Europe was in the grip of a recession, and output was falling (see Table (a)). Along with this decline in output and deteriorating levels of business and read more..

  • Page - 488

    16.1 BACKGROUND TO THE THEORY461KI 31p 368BOX 16.3If the economy expands and firms respond byinvesting, there will be a time lag before this can bereflected in increased industrial capacity, since capitaltakes a time to build and/or install. In the meantime, thepercentage utilisation of capacity could expand veryrapidly, as existing slack is taken up. Then, as newcapacity comes on line, the percentage capacityutilisation figure could rapidly cease rising, or even fall, depending on the rate of read more..

  • Page - 489

    46216 SHORT-RUN MACROECONOMIC EQUILIBRIUMexcept in the case of a cut in income taxes, they willcause saving to fall and vice versa. Net tax revenues,apart from being dependent on incomes, depend onthe rates of tax and benefits that the governmentsets and how progressive or regressive they are.Imports depend on the relative prices and quality ofdomestic and foreign goods, total consumption andtastes.5. In the simple Keynesian model, injections areassumed to be exogenous variables. They read more..

  • Page - 490

    16.2 THE DETERMINATION OF NATIONAL INCOME463respond by producing less and employing fewer factors ofproduction. National income would thus fall and go onfalling until Ye was reached.? Why do a − b = e − f, and c − d = g − h?The multiplier: the withdrawals andinjections approachWhen injections rise (and continue at the higher level),this will cause national income to rise. But by how much?In fact, national income will rise by more than injec-tions: Y rises by a multiple of the rise in read more..

  • Page - 491

    46416 SHORT-RUN MACROECONOMIC EQUILIBRIUMNote that in this simple Keynesian theory we are assum-ing that prices are constant (i.e. that there is no inflation)and hence that any increase in income is a real increase inincome matched by extra production. So when we talk aboutextra injections into the economy causing extra spending,it is the extra output that this spending generates that weare concerned with. If the multiplier were 3, for example,this would mean that an injection of £1 of read more..

  • Page - 492

    16.2 THE DETERMINATION OF NATIONAL INCOME465A shift in withdrawalsA multiplied rise in income can also be caused by a fall inwithdrawals. This is illustrated in Figure 16.9.The withdrawals function shifts from W1 to W2. Thismeans that, at the old equilibrium of Ye1, injections nowexceed withdrawals by an amount a− b. This will causenational income to rise until a new equilibrium is reachedat Ye2 where J= W2. Thus a downward shift of the with-drawals function of a− b (∆W) causes a rise in read more..

  • Page - 493

    46616 SHORT-RUN MACROECONOMIC EQUILIBRIUMnational income. Aggregate expenditure (column 4) equalsCd + J. Equilibrium national income is £700 billion. This iswhere Y= E.Now assume that injections rise by £20 billion to £120 billion. Aggregate expenditure is now shown in thefinal column and is £20 billion higher than before at each level of national income (Y ). At the original equilibriumnational income (£700 billion), aggregate expenditure isnow £720 billion. This excess of Eover Y of read more..

  • Page - 494

    16.2 THE DETERMINATION OF NATIONAL INCOME467£13 million leaks abroad (mpm= 13/100). This leaves £50 million that goes on the consumption of domesticproduct (mpcd = 50/100 = 1/2). Substituting these figures inthe above formula gives:mpcd = mpc (1 − tE)(1 − tY) − mpm= 7/8(1 − 1/10)(1 − 2/10) − 13/100= 7/8 . 9/10 . 8/10 − 13/100= 63/100 − 13/100 = 50/100 = 1/2Note that the mpcd, mps, mpm and mpt are all based on the rise in gross income, not disposable income. They are50/100, read more..

  • Page - 495

    TC 15p 46346816 SHORT-RUN MACROECONOMIC EQUILIBRIUMaggregate demand dependent on the price level. The sec-ond shows aggregate demand (i.e. aggregate expenditure(E)) dependent on the level of national income. Figure 16.11shows the multiplier effect simultaneously on the two diagrams. Initially, equilibrium is at Ye1 where aggregatedemand equals aggregate supply and where the aggregateexpenditure line crosses the 45° line.Now assume that there is an autonomous increase inexpenditure. For example, read more..

  • Page - 496

    16.3 THE SIMPLE KEYNESIAN ANALYSIS OF UNEMPLOYMENT AND INFLATION469administration in the USA in 2001, when attempts weremade to stimulate aggregate demand through the use offiscal and monetary policy in order to pull the US economyout of recession.The deflationary gapIf the equilibrium level of national income (Ye) is below thefull-employment level (Yf), there will be excess capacity inthe economy and hence demand-deficient unemployment.There will be what is known as a deflationary gap. read more..

  • Page - 497

    47016 SHORT-RUN MACROECONOMIC EQUILIBRIUMEven if the government does not actively pursue adeflationary policy, the inflationary gap may still closeautomatically. If the rich are better able than the poor todefend themselves against inflation, there will be a redis-tribution from the poor to the rich. But the rich tend tohave a higher marginal propensity to save than the poor.Thus saving will rise and consumption will fall. This willswing the W line up and the E line down, thus narrowingthe read more..

  • Page - 498

    16.4 THE KEYNESIAN ANALYSIS OF THE BUSINESS CYCLE471is at Ye1 in both parts of the diagram, where AD1 = AS andwhere E1 crosses the 45° line.Now let us assume that there is a rise in aggregatedemand. The E line shifts initially to E2 in diagram (b). Ifthis rise in demand were to lead to a full multiplied rise inreal income, equilibrium income would rise to Ye2. But weare now assuming that inflation can occur before the full-employment level of income is reached. In other words, we are assuming read more..

  • Page - 499

    47216 SHORT-RUN MACROECONOMIC EQUILIBRIUMKeynesians seek to explain why aggregate demandfluctuates, and then to devise appropriate stabilisation policies to iron out these fluctuations. A more stable eco-nomy, they argue, provides a better climate for invest-ment. With more investment, potential output grows morerapidly. This, given appropriate demand management policy, then allows a faster growth in actual output to bemaintained.Instability of investment: the acceleratorOne of the major read more..

  • Page - 500

    16.4 THE KEYNESIAN ANALYSIS OF THE BUSINESS CYCLE473• Machines produce exactly 100 units of output per year.This figure cannot be varied.• The firm always adjusts its output and its stock ofmachinery to match consumer demand.The example shows what happens to the firm’s invest-ment over a six-year period when there is first a substantialrise in consumer demand, then a levelling off and then aslight fall. In year 2, consumer demand shoots up from1000 units to 2000 units. In year 3, it read more..

  • Page - 501

    47416 SHORT-RUN MACROECONOMIC EQUILIBRIUMTable 16.6The multiplier/accelerator interactionPeriod tJ ↑→ Y ↑(Multiplier)Period t+ 1Y↑→ I ↑(Accelerator)I↑→ Y ↑(Multiplier)Period t+ 2If ↑ Yt+1 >↑ Yt then I↑5If ↑ Yt+1 =↑ Yt then I stays the same6(Accelerator)If ↑ Yt+1 <↑ Yt then I↓7This in turn will have a multiplied upward effect,no effect, or a multiplied downward effectrespectively on national income.Period t+ 3This will then lead to a further accelerator read more..

  • Page - 502

    16.4 THE KEYNESIAN ANALYSIS OF THE BUSINESS CYCLE475Fluctuations in stocksFirms hold stocks (inventories) of finished goods. Thesestocks tend to fluctuate with the course of the businesscycle, and these fluctuations in stocks themselves con-tribute to fluctuations in output.Imagine an economy that is recovering from a recession.At first, firms may be cautious about increasing production.Doing so may involve taking on more labour or makingadditional investment. Firms may not want to make read more..

  • Page - 503

    47616 SHORT-RUN MACROECONOMIC EQUILIBRIUMSection summary1. Keynesians explain cyclical fluctuations in theeconomy by examining the causes of fluctuations inthe level of aggregate demand.2. A major part of the Keynesian explanation of thebusiness cycle is the instability of investment. The accelerator theory explains this instability. Itrelates the level of investment to changes in nationalincome and consumer demand. An initial increase in consumer demand can result in a very largepercentage read more..

  • Page - 504

    16.4 THE KEYNESIAN ANALYSIS OF THE BUSINESS CYCLE477Additional case studies on the book’s website (’ views on the consumption function. An analysis of how the assumptions made by Keynes affect theshape of the consumption function.16.2The relationship between income and consumption. This examines three different theories of theconsumption function – the absolute income hypothesis, the relative income hypothesis and the permanentincome hypothesis. Each read more..

  • Page - 505

    Chapter17Money and Interest Rates17.1 The meaning and functions of money479The functions of money479What should count as money?48017.2 The financial system480The role of the financial sector480The banking system481Deposit taking and lending482Liquidity and profitability484The central bank486The role of the London money market48817.3 The supply of money490Definitions of the money supply490The creation of credit: the simplest case490The creation of credit: the real world493What causes money read more..

  • Page - 506

    KI 23p 25117.1 THE MEANING AND FUNCTIONS OF MONEY479Before going any further we must define precisely what we mean by ‘money’ – not as easy a task as it sounds.Money is more than just notes and coin. In fact the maincomponent of a country’s money supply is not cash, butdeposits in banks and other financial institutions. Only a very small proportion of these deposits are kept by thebanks in their safes or tills in the form of cash. The bulk ofthe deposits appear merely as bookkeeping read more..

  • Page - 507

    48017 MONEY AND INTEREST RATESFor example, money in the form of bookkeeping entries inbank accounts can be transferred by the use of cheques,debit cards, standing orders and direct debits.A means of storing wealthPeople need a means whereby the fruits of today’s labourcan be used to purchase goods and services in the future.People need to be able to store their wealth: they want ameans of saving. Money is one such medium in which tohold wealth. It can be saved.A means of evaluationMoney allows read more..

  • Page - 508

    17.2 THE FINANCIAL SYSTEM481and on alternative ways of obtaining finance. This shouldhelp to encourage the flow of savings and the efficient useof them.Expertise in channelling fundsFinancial intermediaries have the specialist knowledge tobe able to channel funds to those areas that yield the highestreturn. This too encourages the flow of savings as it givessavers the confidence that their savings will earn a goodrate of interest. Financial intermediaries also help to ensurethat projects read more..

  • Page - 509

    48217 MONEY AND INTEREST RATESinternational trade and capital movements, and they dealextensively in the foreign exchange market. Most of theirdeposits are in foreign currencies.They also include finance houses, which specialise inlending to businesses and in providing hire-purchasefinance for the purchase of consumer durables, such as cars,furniture and electrical goods.They are called wholesale banks because they specialisein receiving large deposits from and making large loans to industry read more..

  • Page - 510

    17.2 THE FINANCIAL SYSTEM483some allow customers to use cash cards. The most familiarform of time deposits are the deposit and savings accountsin banks and the various savings accounts in building soci-eties. No overdraft facilities exist with time deposits.A substantial proportion of time deposits are from thebanking sector: i.e. other banks and other financial institu-tions. Inter-bank lending has grown over the years asmoney markets have become deregulated and as depositsare moved from one read more..

  • Page - 511

    48417 MONEY AND INTEREST RATESThese are like the banks’ own current accounts and are usedfor clearing purposes (i.e. for settling the day-to-day pay-ments between banks). They can be withdrawn in cash ondemand. In the UK, banks are also required to deposit asmall fraction of their assets as ‘cash ratio deposits’ with theBank of England. These cannot be drawn on demand.Both cash and operational balances, however, earn nointerest for banks. The vast majority of banks’ assets aretherefore read more..

  • Page - 512

    17.2 THE FINANCIAL SYSTEM485Liquidity.The liquidity of an asset is the ease with whichit can be converted into cash without loss. Cash itself, bydefinition, is perfectly liquid.Some assets, such as money lent at call to other financialinstitutions, are highly liquid. Although not actually cash,these assets can be converted into cash on demand with nofinancial penalty.Other assets, such as gilts, can be converted into cashstraight away by selling them on the Stock Exchange, butwith the read more..

  • Page - 513

    48617 MONEY AND INTEREST RATESand liquidity tend to conflict. In general, the more liquidan asset, the less profitable it is, and vice versa. Personaland business loans to customers are profitable to banks, buthighly illiquid. Cash is totally liquid, but earns no profit.Thus financial institutions like to hold a range of assetswith varying degrees of liquidity and profitability.The ratio of an institution’s liquid assets to total assets isknown as its liquidity ratio. For example, if a read more..

  • Page - 514

    17.2 THE FINANCIAL SYSTEM487public. If people draw more cash from their bank accounts,the banks will have to draw more cash from their balancesin the Bank of England. These balances are held in theBanking Department. The Banking Department will thushave to acquire more notes from the Issue Department,which will simply print more in exchange for extra govern-ment or other securities supplied by the Banking Depart-ment. Thus the amount of notes in circulation is alwaysmore at Christmas time.It read more..

  • Page - 515

    48817 MONEY AND INTEREST RATESthe Bank of England can affect the exchange rate. For ex-ample, if there were a sudden selling of sterling (due, say, tobad trade figures and a resulting fear that the pound woulddepreciate), the Bank of England could help to prevent thepound from falling by using reserves to buy up pounds onthe foreign exchange market. Intervention in the foreignexchange market is examined in detail in Chapter 24.?1. Would it be possible for an economy to functionwithout a central read more..

  • Page - 516

    17.2 THE FINANCIAL SYSTEM489the face value, thus effectively charging interest to thebanks. The price is set so that the ‘rediscount rate’ reflectsthe interest rate set by the Monetary Policy Committee.In being prepared to rediscount bills or provide moneythrough gilt repos, the Bank of England is thus the ultimateguarantor of sufficient liquidity in the monetary systemand is known as lender of last resort.The need for banks to acquire liquidity in this way is notuncommon. It is generally read more..

  • Page - 517

    KI 23p 25149017 MONEY AND INTEREST RATESDefinitions of the money supplyIf money supply is to be monitored and possibly controlled,it is obviously necessary to measure it. But what should be included in the measure? Here we need to distinguishbetween the monetary base and broad money.The monetary base (or ‘high-powered money’) consistsof cash (notes and coin) in circulation outside the centralbank. Thus, in the eurozone, the monetary base is given bycash (euros) in circulation outside the read more..

  • Page - 518

    17.3 THE SUPPLY OF MONEY491TC 15p 463UK measuresThere are two main measures of the money supply in the UK: M0 and M4. M0 is referred to as the ‘widemonetary base’ and M4 is referred to as ‘broad money’or simply as ‘the money supply’. In addition, there is a measure called ‘Retail deposits and cash in M4’(previously known as M2). This measure excludeswholesale deposits.The definitions are as follows:M0.Cash in circulation with the public and cash held by banks and building read more..

  • Page - 519

    TC 15p 463TC 12p 37449217 MONEY AND INTEREST RATESbalances correspondingly increase by £10 billion. The com-bined banks’ balance sheet now is shown in Table 17.4.But this is not the end of the story. Banks now have surplus liquidity. With their balances in the central bankhaving increased to £20 billion, they now have a liquidityratio of 20/110, or 18.2 per cent. If they are to return to a 10 per cent liquidity ratio, they need only retain £11 billionas balances at the central bank (£11 read more..

  • Page - 520

    17.3 THE SUPPLY OF MONEY493The creation of credit: the real worldIn practice, the creation of credit is not as simple as this.There are three major complications.Banks’ liquidity ratio may varyBanks may choose a different liquidity ratio.At certaintimes, banks may decide that it is prudent to hold a biggerproportion of liquid assets. If Christmas or the summer holidays are approaching and people are likely to make bigger cash withdrawals, banks may decide to hold moreliquid assets.On the other read more..

  • Page - 521

    49417 MONEY AND INTEREST RATESa whole. By using them for credit creation, the banking sys-tem is operating with a lower overall liquidity ratio.?What effects do debit cards and cash machines (ATMs)have on (a) banks’ prudent liquidity ratios; (b) the size ofthe bank multiplier?The non-bank private sector chooses to hold less cashHouseholds and firms may choose to hold less cash. Again,the reason may be a greater use of cards, direct debits, etc.(see Box 17.6). This means that a greater read more..

  • Page - 522

    17.3 THE SUPPLY OF MONEY495cheques drawn on its account with the Bank of England.When the recipients of these cheques pay them into theirbank accounts, the banks will present the cheques to theBank of England and their balances there will be duly cred-ited. These additional balances will then become the basisfor credit creation. There will be a multiplied expansion ofthe money supply.Similarly, if the government borrows through additionalTreasury bills, and if these are purchased by the read more..

  • Page - 523

    49617 MONEY AND INTEREST RATESThe relationship between money supplyand the rate of interestSimple monetary theory often assumes that the supply ofmoney is totally independent of interest rates. This is illustrated in Figure 17.1. The money supply is exogenous.It is assumed to be determined by government: what the government chooses it to be, or what it allows it to be by its choice of the level and method of financing the PSNCR.More complex models, and especially Keynesian models,assume that read more..

  • Page - 524

    TC 9p10117.4 THE DEMAND FOR MONEY497Section summary1. Money supply can be defined in a number ofdifferent ways, depending on what items areincluded. A useful distinction is between narrowmoney and broad money. Narrow money includesjust cash, and possibly banks’ balances at the central bank. Broad money also includes deposits in banks and possibly various other short-termdeposits in the money market. In the UK, M4 is the preferred measure of broad money. In theeurozone it is M3.2. Bank read more..

  • Page - 525

    49817 MONEY AND INTEREST RATESdesire to hold assets in liquid form. Money balances heldfor these two purposes are called active balances: money tobe used as a medium of exchange. What determines thesize of L1?The major determinant of L1 is nominal national income(i.e. national income at current prices). The bigger people’smoney income, the greater their expenditure and the bigger their demand for active balances. The frequency withwhich people are paid also affects L1. The less frequently read more..

  • Page - 526

    17.4 THE DEMAND FOR MONEY499Moreover, the possession of a credit card reduces or eveneliminates the need to hold precautionary balances formany people. On the other hand, the increased availabil-ity of cash machines, the convenience of debit cards andthe ability to earn interest on current accounts have allencouraged people to hold more money in bank accounts.The net effect has been an increase in the demand formoney.The speculative (or assets) demand for money: L2The speculative demand for read more..

  • Page - 527

    50017 MONEY AND INTEREST RATES(as money). If, however, people believe that it will be a slowrise over time, they will want to buy sterling assets (such asUK government bonds) rather than money, since suchassets will also earn the holder a rate of interest.Conversely, if people believe that the exchange rate islikely to fall in the near future, they will economise ontheir holdings of sterling, preferring to hold their liquidassets in some other currency – the one most likely toappreciate read more..

  • Page - 528

    17.5 EQUILIBRIUM501will seem lower relative to the ‘normal’ rate than it used to be. People will be more inclined to hold speculative balances of money in anticipation of a rise in interest rates.This will tend to shift L upwards.In an era of uncertainty about inflation, interest rates and exchange rates, people’s expectations will be hard topredict. They will be volatile and susceptible to rumours and political events. In such circumstances, the L curveitself will be hard to predict and read more..

  • Page - 529

    TC 9p10150217 MONEY AND INTEREST RATESequilibrium will be achieved by changes in the exchangerate. Assume that the money supply increases. This hasthree direct effects:• Part of the excess money balances will be used to purchaseforeign assets. This will therefore lead to an increase inthe supply of domestic currency coming on to the foreignexchange markets.• The excess supply of money in the domestic money mar-ket will push down the rate of interest. This will reducethe return on domestic read more..

  • Page - 530

    17.5 EQUILIBRIUM503END OF CHAPTER QUESTIONS1. Imagine that the banking systemreceives additional deposits of £100million and that all the individual banks wishto retain their current liquidity ratio of 20 per cent.(a) How much will banks choose to lend outinitially?(b) What will happen to banks’ liabilities when the money that is lent out is spent and therecipients of it deposit it in their bank accounts?(c) How much of these latest deposits will be lentout by the banks?(d) By how much will read more..

  • Page - 531

    Chapter18The Relationship between the Money and Goods Markets18.1 The effects of monetary changes on national income505The quantity theory of money505The interest rate transmission mechanism505The exchange rate transmission mechanism508Portfolio balance509How stable is the velocity of circulation?51118.2 The monetary effects of changes in the goods market512The monetary effects of an increase in injections512Crowding out513Is money supply exogenous or endogenous?515*18.3 ISLM analysis515The read more..

  • Page - 532

    TC 12p 374KI 5p2118.1 THE EFFECTS OF MONETARY CHANGES ON NATIONAL INCOME505In this section we examine the impact on the economy of changes in money supply and interest rates: how theyaffect aggregate demand and how this, in turn, affectsnational income. A simple way of understanding the issuesis in terms of the quantity theory of money.The quantity theory of moneyIn section 15.2 (page 434), we looked at the following ver-sion of the quantity equation:MV= PYIn case you did not study Chapter 15, read more..

  • Page - 533

    50618 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETS• The less elastic the liquidity preference curve (L): thiswill cause a bigger change in the rate of interest.• The more interest elastic the investment curve (I ): thiswill cause a bigger change in investment.• The lower the marginal propensity to withdraw (mpw),and hence the flatter the withdrawals function: this willcause a bigger multiplied change in national income andaggregate demand.The problem is that stages 1 and 2 may be read more..

  • Page - 534

    18.1 THE EFFECTS OF MONETARY CHANGES ON NATIONAL INCOME507• Changes in foreign interest rates. Domestic interest rateswould have to follow suit if the authorities wished tomaintain a stable exchange rate.• Changes in exchange rates. With a falling exchange rate,the authorities may raise interest rates to prevent itdepreciating further.• Statements of government intentions on economic policy.• Good or bad industrial news. With good news, peopletend to buy shares.• Newly published read more..

  • Page - 535

    50818 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETSMonetary policy is likely to be effective, therefore, onlyif people have confidence in its effectiveness. This psycho-logical effect can be quite powerful. It demands consider-able political skill, however, to manipulate it.The exchange rate transmissionmechanismThere is another mechanism that backs up the interest ratemechanism. This includes the exchange rate as an inter-mediate variable between changes in the money supply andchanges read more..

  • Page - 536

    18.1 THE EFFECTS OF MONETARY CHANGES ON NATIONAL INCOME509Stage 1 will tend to be more powerful than in a closedeconomy. The liquidity preference curve will tend to be lesselastic because, as interest rates fall, people may fear adepreciation of sterling and switch to holding other curren-cies. Just how strong stage 1 will be depends on how muchpeople think the exchange rate will depreciate.Stage 2 is likely to be very strong indeed. Given theopenness of international financial markets, read more..

  • Page - 537

    KI 30p 30651018 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETSHow stable is the velocity of circulation (V ) in practice?Does the evidence support the monetarist case that it isrelatively stable or the Keynesian case that it fluctuatesunpredictably, at least in the short run? Unfortunately,the facts do not unequivocally support either side. The evidenceHow has V behaved over time? To answer this we needto measure V. A simple way of doing this is to use theformula V= PY/M (rearranging the read more..

  • Page - 538

    18.1 THE EFFECTS OF MONETARY CHANGES ON NATIONAL INCOME511and services. As more assets are purchased, this will drive up their price. This will effectively reduce their ‘yield’. Forbonds and other financial assets, this means a reduction in their rate of interest. For goods and services, this means a reduction in their marginal utility/price ratio: a higher level of consumption will reduce their marginal utility anddrive up their price. The process will stop when a balancehas been restored read more..

  • Page - 539

    51218 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETSthen controlling aggregate demand by choosing an appro-priate rate of interest. In these circumstances, the moneysupply must be passively adjusted to ensure that the chosenrate of interest is the equilibrium rate. This means expand-ing the money supply in line with the increase in realnational income (Y) and the targeted increase in the pricelevel (P).We explore inflation targeting and its effects in section18.4. We explore the operation read more..

  • Page - 540

    18.2 THE MONETARY EFFECTS OF CHANGES IN THE GOODS MARKET513Crowding outAnother example of the monetary constraints on expan-sion in the goods market is the phenomenon known asfinancial crowding out. This is where an increase in public-sector spending reduces private-sector spending.To illustrate the effects, assume that previously the government has had a balanced budget, but that now itchooses to expand the level of government expenditurewithout raising additional taxes. As a result, it runs a read more..

  • Page - 541

    51418 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETSThe extent of crowding outJust how much crowding out will occur when there is anexpansionary fiscal policy, but when money supply is notallowed to expand, depends on two things.The responsiveness (elasticity) of the demand for moneyto a change in interest rates.If the demand is relativelyelastic (as in Figure 18.8(a)), the increase in demand, represented by a horizontal shift in the liquidity preferencecurve from L to L′, will lead to read more..

  • Page - 542

    *18.3 ISLM ANALYSIS: THE INTEGRATION OF THE GOODS AND MONEY MARKET MODELS515Is money supply exogenous orendogenous?Money supply is exogenous (independently determined) if it can be fixed by the authorities and if it does not vary with aggregate demand and interest rates. In Figure 18.7(b)the M ‘curve’ would be vertical. It would shift only if thegovernment or central bank chose to alter the money supply.Money supply is endogenous (determined within themodel) if it is determined by aggregate read more..

  • Page - 543

    51618 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETSmoney and a resulting rise in interest rates to r2. This inturn had an effect back in the goods market, with a higherinterest rate dampening investment and consumption some-what and reducing the final rise in income.The effect of a rise in money supply in the two marketswas shown in Figures 18.1 and 18.6 (on pages 506 and 508).The rise in money supply reduces interest rates. This then, via an increase in investment (or a reduction in read more..

  • Page - 544

    *18.3 ISLM ANALYSIS: THE INTEGRATION OF THE GOODS AND MONEY MARKET MODELS517The size of the multiplier.This is given by 1/mps (i.e.1/mpw in the full model). The mps is given by the slope ofthe S curve. The flatter the curve, the bigger the multiplier.The larger the value of the multiplier, the bigger will be theeffect on national income of any rise in investment and fall in saving, and the more elastic therefore will be the IS curve. Thus the flatter the S curve in the top part of the diagram, read more..

  • Page - 545

    51818 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETSNow what will happen if the level of national incomechanges? Let us assume that national income rises to Y2.The effect is to increase the transactions-plus-precautionarydemand for money. The L curve shifts to the right: to, say, L″. This will cause the rate of interest to rise to the new equilibrium level of r2. This therefore gives us a secondpoint on the LM curve (point d ).Thus higher national income leads to a greater demandfor read more..

  • Page - 546

    *18.3 ISLM ANALYSIS: THE INTEGRATION OF THE GOODS AND MONEY MARKET MODELS519curve from point a, since the higher income will generate a higher demand for money and hence push up interestrates. And as interest rates rise, so the desired level ofinvestment will fall and the desired level of saving will riseso as to reduce the equilibrium level of national incomebelow Y2. There will be a movement back up along the IS curve from point b. Once the interest rate has risen to re, the actual level of read more..

  • Page - 547

    52018 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETSChanges in the goods marketAssume that business confidence rises and firms decide to increase their investment. The rise in injections leads to a rightward shift in the IS curve. This is illustrated in Figure 18.13(a). It is assumed that there is no exogenousincrease in the money supply and that, therefore, the LMcurve does not shift. Income rises to Y2, but interest ratesalso rise (to r2 ).The rise in the rate of interest to r2 read more..

  • Page - 548

    *18.3 ISLM ANALYSIS: THE INTEGRATION OF THE GOODS AND MONEY MARKET MODELS521bigger. If the downward shift in the LM curve is matched bya rightward shift in the IS curve, then the effect is oncemore illustrated in Figure 18.13(c).To summarise: the effect on national income of a change in either market depends on the slope of the IS and LMcurves.*BOX 18.4sloped? This shows that a lower rate of interest, by encouraging the use of more capital-intensive (i.e. cleaner) technology, would allow a read more..

  • Page - 549

    52218 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETS• The effect of a shift in the IS curve will be bigger whenthe LM curve is shallow and the IS curve is steep. WhenLM is shallow, a rightward shift in IS will lead to only a small rise in the rate of interest (r ). If IS is steep, this rise in r will lead to only a small curtailing of investment.In these two circumstances, the dampening effect oninvestment and consumption is limited. There will be alarge increase in national income (Y read more..

  • Page - 550

    18.4 TAKING INFLATION INTO ACCOUNT5233. A change in interest rates will cause a movementalong the IS curve. A change in anything else thataffects national income (i.e. a change in injections or withdrawals other than as a result of a change ininterest rates) will cause a shift in the IS curve.4. Equilibrium in the money market is shown by the LMcurve. This shows all the combinations of nationalincome and the rate of interest where the demandfor money (L) equals the supply (M ). As nationalincome read more..

  • Page - 551

    52418 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETSBefore we look at the properties of the model, let usexamine each of the three lines in turn. The first two areillustrated in Figure 18.15.The inflation target lineThis is simply a horizontal line at the target rate ofinflation. If inflation is above target, real interest rates willbe raised by the central bank. If it is below target, real inter-est rates will be cut.If the government or central bank changes the target,the line will read more..

  • Page - 552

    18.4 TAKING INFLATION INTO ACCOUNT525run it will be relatively steep, if not vertical at the sustain-able level of national income. The curve illustrated inFigure 18.16 is the short-run ASI curve. But why is it shapedthis way? Why will a higher rate of inflation lead to higherreal national income?Assume that the economy is currently generating a realnational income of Y1 and that inflation is on target (πtarget).Equilibrium is at point a. Assume also that Y1 represents thelong-run sustainable read more..

  • Page - 553

    52618 THE RELATIONSHIP BETWEEN THE MONEY AND GOODS MARKETScentral bank will not change its monetary policy. The ADIcurve, therefore, will not shift.As the supply shock subsides, aggregate supply will fallagain. The ASI curve will shift back from ASI2 to ASI1, caus-ing inflation to rise again. The result is a move back up theADI1 curve from point d to point a.?1. Trace through the effect of an adverse supply shock,such as a rise in oil prices.2. What determines the amount that national read more..

  • Page - 554

    18.4 TAKING INFLATION INTO ACCOUNT527END OF CHAPTER QUESTIONS1. Using one or more diagrams likeFigures 18.1, 18.6, 18.7, 18.8 and 18.9,illustrate the following:(a) The effect of a contraction in the money supplyon national income. Refer to both the interest-rate and the exchange-rate transmissionmechanisms and show how the shapes of thecurves affect the outcome.(b) The effect of a fall in investment on nationalincome. Again show how the shapes of thecurves affect the outcome. Specify read more..

  • Page - 555

    52819 FISCAL AND MONETARY POLICYChapter19Fiscal and Monetary Policy19.1 Fiscal policy529Government finances: some terminology529The government’s ‘fiscal stance’530Automatic fiscal stabilisers531The effectiveness of automatic stabilisers532Discretionary fiscal policy533The effectiveness of discretionary fiscal policy534Problems of magnitude534Problems of timing535Relative merits of changing governmentexpenditure and changing taxes53819.2 Monetary policy542The policy setting542Control read more..

  • Page - 556

    TC 15p 46319.1 FISCAL POLICY529Fiscal policy has two possible roles. The first is to removeany severe deflationary or inflationary gaps. In other words,expansionary fiscal policy could be used to prevent aneconomy experiencing a severe or prolonged recession,such as that experienced in the Great Depression of the1930s or in east and south-east Asia, Russia and Brazil inthe late 1990s. It has also been used for this purpose inJapan in recent years, and to a lesser extent in the USA in 2001/2. read more..

  • Page - 557

    53019 FISCAL AND MONETARY POLICYthe PSNCR for selected years from 1982 to 2004. As you cansee, in most years it has been positive (i.e. the public sectorwas running a deficit and had to borrow).General governmentA final category is ‘general government’. This includes central and local government, but excludes public cor-porations. Thus we can refer to general government deficitsand surpluses and general government debt. Table 19.2shows government deficits/surpluses and debt for read more..

  • Page - 558

    19.1 FISCAL POLICY531the state of the economy. If the economy is booming withpeople earning high incomes, the amount paid in taxes willbe high. In a booming economy the level of unemploymentwill be low. Thus the amount paid out in unemploymentbenefits will also be low. The combined effect of increasedtax revenues and reduced benefits is to give a public-sectorsurplus (or a reduced deficit). By contrast, if the economywere depressed, tax revenues would be low and governmentexpenditure on read more..

  • Page - 559

    53219 FISCAL AND MONETARY POLICYThe effectiveness of automatic stabilisersAutomatic stabilisers have the obvious advantage that theyact instantly as soon as aggregate demand fluctuates. Bycontrast, it may take some time before the government caninstitute discretionary changes in taxes or governmentexpenditure, especially if forecasting is unreliable.Nevertheless automatic stabilisers can never be the com-plete answer to the problem of fluctuations. Their effect ismerely to reduce the read more..

  • Page - 560

    19.1 FISCAL POLICY533In these circumstances, if the economy began to recover,the automatic stabilisers would act as a drag on the expan-sion. This is known as fiscal drag. By reducing the size ofthe multiplier, the automatic stabilisers reduce the magni-tude of the recovery. Similarly, they act as a drag on discre-tionary policy: the more powerful the automatic stabilisersare, the bigger the change in G or T that would be necessaryto achieve a given change in national income.Discretionary read more..

  • Page - 561

    53419 FISCAL AND MONETARY POLICYThe effectiveness of discretionary fiscal policyHow successful will discretionary fiscal policy be? Can it‘fine tune’ demand? Can it achieve the level of nationalincome that the government would like it to achieve?There are two main problem areas with discretionaryfiscal policy. The first concerns the magnitude of the effects.If G or T is changed, how much will total injections andwithdrawals change? What will be the size of the multi-plier? How much will read more..

  • Page - 562

    19.1 FISCAL POLICY535• The responsiveness of investment (and consumption) toa change in interest rates. The more responsive investmentis to a rise in interest rates, the more will the J curve shiftdownwards and the bigger will be the crowding-out effect.If the fiscal policy is not pure fiscal policy, if the extra government borrowing is financed by borrowing from thebanking sector, then the supply of money curve will shiftto the right. If it were to shift as far as M′s, the rate of read more..

  • Page - 563

    53619 FISCAL AND MONETARY POLICYdampened in stage 2 and stimulated in stage 4. This wouldmake the resulting course of the business cycle more likepath (b), or even, if the policy were perfectly stabilising, a straight line. With time lags, however, contractionarypolicies taken in stage 2 may not come into effect untilstage 4, and expansionary policies taken in stage 4 may notcome into effect until stage 2. In this case, the resultingcourse of the business cycle will be more like path (c). read more..

  • Page - 564

    19.1 FISCAL POLICY537will not be instituted until the new financial year or atsome other point in the future. As Budgets normally occurannually, there could be a considerable time lag if the prob-lems are recognised a long time before the Budget.Time lag between action and changes taking effect.Achange in tax rates may not immediately affect tax pay-ments as some taxes are paid in arrears and new rates maytake a time to apply.Time lag between changes in government expenditureand taxation and read more..

  • Page - 565

    53819 FISCAL AND MONETARY POLICYdelayed effects can be taken into account. Fiscal policycould go some way to reducing fluctuations, especially ifforecasting techniques are improved and measures are usedwhich involve the minimum of time lags.Steady as you goGiven the problems of pursuing active fiscal policy, manygovernments today take a much more passive approach.Instead of changing the policy as the economy changes, a rule is set for the level of public finances. This rule is then applied read more..

  • Page - 566

    designer jeans, junk food and home security continues togrow rapidly, the public sector is deprived of resources.State education is squeezed; the streets are dirty; the envir-onment is threatened; crime increases; the lot of the poorand homeless deteriorates. Private affluence goes side byside with public poverty.The political right argues that the solution to social andeconomic problems does not lie in a growth of the ‘nannystate’, which stifles individual initiative. It is better, so the read more..

  • Page - 567

    54019 FISCAL AND MONETARY POLICYIf the government persistently runs a budget deficit, thenational debt will rise. If it rises faster than GDP, it willaccount for a growing proportion of GDP. There is thenlikely to be an increasing problem of ‘servicing’ thisdebt: i.e. paying the interest on it. The governmentcould find itself having to borrow more and more tomeet the interest payments, and so the national debtcould rise faster still. As the government borrows moreand more, so it has to pay read more..

  • Page - 568

    19.1 FISCAL POLICY541BOX 19.4ceiling. In other words, meeting the zero deficit targetwould mean further deflationary fiscal policies:something that most political leaders in Europe felt to be inappropriate at a time when there were fears of a world recession.Later the criticisms turned on whether the Pact was flexible enough. From 2002, both Germany andFrance breached the 3 per cent ceiling (see Figure (a)).This was partly the result of slow growth and risingunemployment, and hence falling read more..

  • Page - 569

    54219 FISCAL AND MONETARY POLICYDefinitionMinimum reserve ratio A minimum ratio of cash (or other specified liquid assets) to deposits (either totalor selected) that the central bank requires banks to hold.Each month the Bank of England’s Monetary PolicyCommittee (MPC) meets to set interest rates. The event getsconsiderable media coverage. Pundits, for two or three days before the meeting, try to predict what the MPC willdo and economists give their ‘considered’ opinions aboutwhat the read more..

  • Page - 570

    19.2 MONETARY POLICY543a 10 per cent cash ratio, and if the central bank imposes a20 per cent cash ratio, the bank multiplier is reduced from10 (= 1/1/10) to 5 (= 1/1/5).A major problem with imposing restrictions of this kindis that banks may find ways of getting round them. Afterall, banks would like to lend and customers would like to borrow. It is very difficult to regulate and police everysingle part of countries’ complex financial systems.Public-sector deficitsAs we saw in section read more..

  • Page - 571

    54419 FISCAL AND MONETARY POLICYThus to operate a tighter monetary policy, the authorit-ies can do the following:• Reduce money supply and accept whatever equilibriuminterest rate results. Thus if money supply is reduced to Q2 in Figure 19.4, a new higher rate of interest, r2 , willresult.• First raise interest rates to r2 and then manipulate themoney supply to reduce it to Q2.There are two other possibilities. The first is to keep inter-est rates low (at r1), but also reduce money supply read more..

  • Page - 572

    19.2 MONETARY POLICY545Open-market operations involve the sale or purchase bythe central bank of government securities (bonds or bills)in the open market. These sales or purchases are not inresponse to changes in the PSNCR, and are best understoodin the context of an unchanged PSNCR.If the central bank wishes to reduce the money supply, it sells more securities. When people buy these securities,they pay for them with cheques drawn on banks. Thusbanks’ balances with the central bank are read more..

  • Page - 573

    54619 FISCAL AND MONETARY POLICYWhether or not banks choose to obtain extra moneyfrom the central bank depends on (a) the rate of interestcharged by the central bank (i.e. its discount rate, repo rate or lending rate); and (b) its willingness to lend (orrepurchase securities).In some countries, it is the policy of the central bank tokeep its interest rate to banks below market rates, therebyencouraging banks to borrow (or sell back securities) when-ever such facilities are available. By read more..

  • Page - 574

    19.2 MONETARY POLICY547the Bank of England. These special deposits were frozen,and could not be drawn on until the authorities chose torelease them. They provided a simple means of reducingbanks’ liquidity and hence their ability to create credit.Difficulties in controlling money supplyThe authorities may experience considerable difficulties incontrolling the money supply. Difficulties occur whetherthey focus on the monetary base or on a wider range of liquid assets.Problems with monetary read more..

  • Page - 575

    54819 FISCAL AND MONETARY POLICYwould merely shift business to other uncontrolled insti-tutions, including overseas ones. Banks operate in aglobal market. Thus UK banks can do business with UKborrowers using money markets abroad, thereby divert-ing potentially profitable business away from London.This is an example of Goodhart’s law (see Box 19.8).• Alternatively, if those banks subject to statutory cashrequirements were short of cash, they could attract cashaway from the uncontrolled read more..

  • Page - 576

    19.2 MONETARY POLICY549∆M4/∆M0 in the UK). In the mid-2000s, the money multi-plier in the UK was around 28 and highly variable. In otherwords, controlling the monetary base (M0) would have ahighly unpredictable effect on the money supply (M4).For these reasons, the support for monetary base controlhas waned in recent years.?1. Trace through the effects of a squeeze on the monetarybase from an initial reduction in cash to banks’liquidity being restored through gilt repos. Will read more..

  • Page - 577

    TC 9p10155019 FISCAL AND MONETARY POLICYobliged to restore the amount of cash it had withdrawnfrom the system, there has been a decrease in bills andshort-term bonds held by the banks. Banks’ overall liquidityhas thus been reduced. Such measures could be backed upby funding.But, as with monetary base control, there are problemswith attempting to control broad money supply. Banksmay be prepared to reduce their liquidity ratio. This islikely if they already have surplus liquidity, or if their read more..

  • Page - 578

    19.2 MONETARY POLICY551In the event of banks having a surplus of liquidity,Figure 19.6(b) applies. Here banks are seeking to use theirsurplus liquidity to buy bills from the central bank. Theirdemand curve is upward sloping: the higher the rate of dis-count (i.e. the lower the price that banks have to pay forbills), the more the banks will demand. In this case, thecentral bank can raise the rate of discount by offering morebills for sale. By increasing the supply of bills from S1 to S2,it can read more..

  • Page - 579

    55219 FISCAL AND MONETARY POLICYindustries competing with imports. Many firms in the UKhave suffered badly in recent years from a high exchangerate (see Table 14.7 on page 420) induced partly by higherinterest rates than those in the eurozone.Evidence suggests that the demand for loans may indeedbe quite inelastic, especially in the short run. Althoughinvestment plans may be curtailed by high interest rates,current borrowing by many firms cannot easily be curtailed.Similarly, while read more..

  • Page - 580

    19.2 MONETARY POLICY553• If people think interest rates will rise and bond pricesfall, in the meantime they will demand to hold theirassets in liquid form. The demand for money will rise.• If people think exchange rates will rise, they will demandsterling while it is still relatively cheap. The demand formoney will rise.• If people think inflation will rise, the transactionsdemand for money may rise. People spend now whileprices are still relatively low.• If people think the economy is read more..

  • Page - 581

    55419 FISCAL AND MONETARY POLICYSection summary1. Control of the growth in the money supply over thelonger term will normally involve governmentsattempting to restrict the size of the PSNCR. Whilstthis is relatively easy once inflation has been broughtunder control, it can lead to serious problems ifinflation is initially high. Increases in taxes and cutsin government expenditure are not only politicallyunpopular, but could also result in a recession.2. In the short term, the government can read more..

  • Page - 582

    *19.3 ISLM ANALYSIS OF FISCAL AND MONETARY POLICY555Figure 19.8(b) shows the effect of an increase in moneysupply. The LM curve shifts downwards. Interest rates fallto r3 and this encourages an increase in investment. As aresult of this, income rises to Y3.Figure 19.8(c) shows what happens when the govern-ment finances higher government expenditure or lowertaxes by increasing the money supply. There is no rise ininterest rates, and thus no crowding out. National incomerises by a greater amount read more..

  • Page - 583

    55619 FISCAL AND MONETARY POLICY?According to Keynesians, which will have a bigger effect on national income and employment:(unforeseen) fluctuations in investment or (unforeseen) fluctuations in the money supply?If money supply is endogenous, fiscal policy will be moreeffective still. A relatively elastic supply of money curve inthe left-hand diagram of Figure 18.11 (on page 517) willgive an even shallower LM curve.Keynesians also stress that the IS curve tends to be unstable (for example, read more..

  • Page - 584

    TC 7p26TC 13p 381KI 32p 36919.4 FISCAL AND MONETARY POLICY IN THE UK557This historical section is optional and may be omittedwithout loss of continuity, or you may prefer to look just atthe final part of this section dealing with the most recentperiod.Attitudes towards demand managementThe history of demand management in the UK since the1950s has mirrored debates between different schools ofthought. Economists and politicians calling themselves‘Keynesian’ advocated active fiscal policy as read more..

  • Page - 585

    55819 FISCAL AND MONETARY POLICYThis was the rate of interest set by the Bank of England, towhich all the banks had to gear their rates. Bank rate rosequite steeply on several occasions.During the 1960s, however, the maintenance of balanceof payments equilibrium and of growth at full employmentbecame increasingly incompatible objectives. Stop–go policywas thus perceived as swinging from one objective (correc-tion of balance of payments deficits with ‘stop’ policy) tothe other (stimulating read more..

  • Page - 586

    19.4 FISCAL AND MONETARY POLICY IN THE UK559Provided demand was prevented from expanding toorapidly, any tendency for inflation to increase would bemore due to cost-push or structural factors. These would be much better dealt with by using interventionist supply-side policies, such as prices and incomes policy to preventcost-push inflation, and selective investment grants andinfrastructure projects to relieve bottlenecks.Finally, improvements in forecasting techniques and theswifter read more..

  • Page - 587

    56019 FISCAL AND MONETARY POLICYThe adoption of floating exchange rates.In June 1972 afixed exchange rate with the dollar was abandoned. A float-ing pound reduced the need to pursue deflationary policiesin response to a balance of payments deficit. Instead theexchange rate could be allowed to depreciate. This removeda major constraint on the growth in money supply. Thisapplied not just in the UK but throughout the world ascountries moved over to floating exchange rates.Oil prices.Between read more..

  • Page - 588

    19.4 FISCAL AND MONETARY POLICY IN THE UK561In the medium term, the achieving of money supply targets would require a progressive reduction in the PSNCRas a proportion of GDP (if crowding out was to be avoided).Indeed, targeted reductions in the PSNCR were part of themedium-term financial strategy. Thus tight monetary pol-icy was backed up by tight fiscal policy. In the public mind,the government’s monetarist policy became synonymouswith ‘cuts’.Demand-side policies in the early read more..

  • Page - 589

    56219 FISCAL AND MONETARY POLICYimported). House prices soared as mortgages were easy to obtain. Car sales boomed, as did the sales of electricalgoods, furniture and foreign holidays.Monetary policy was relatively expansionary through-out the world, and part of the extra money went into stocksand shares. The resulting increase in share prices was fasterthan the increase in profits and dividends. Eventually, inOctober 1987, ‘the bubble burst’ and share prices crashed.To avoid a collapse of read more..

  • Page - 590

    19.4 FISCAL AND MONETARY POLICY IN THE UK563rates would have to fall and that sterling, as a result, wouldhave to be devalued. Eventually, on ‘Black Wednesday’, 16 September 1992, after a 5 percentage point rise in inter-est rates was insufficient to stop the speculation, the UK leftthe ERM and the pound was allowed to float.A return to domestic-orientated policies:targeting inflationWith the need to defend the value of the pound removed,the government could focus once more on the read more..

  • Page - 591

    56419 FISCAL AND MONETARY POLICYgolden rule, of financing additional investment by borrow-ing, thereby providing a stimulus to a sluggish economy.The golden rule also permitted increased governmentexpenditure (or tax cuts) if there was a budget surplus. Thusin the 2001 Budget, the government announced spendingincreases of 3.7 per cent per year for three years and alsomodest tax cuts. The effect was to turn a forecast surplus of£16 billion in 2000/1 into a forecast deficit of £10 billion read more..

  • Page - 592

    KI 30p 306KI 15p10119.5 RULES VERSUS DISCRETION565Section summary1. In the 1950s and 1960s, both Labour andConservative governments pursued active demandmanagement policies. The dominating constraintson these policies were the balance of payments andelectoral considerations. Demand management waslittle more than stop–go policy dictated by the stateof the balance of payments and the need to winelections.2. The 1950s and 1960s was a period of relativeeconomic success. But whether this was due to read more..

  • Page - 593

    56619 FISCAL AND MONETARY POLICYAdvocates of this point of view in the 1970s and 1980swere the monetarists, but in recent years support for thesetting of targets has become widespread. As we have seen,in both the UK and the eurozone countries, targets are setfor both inflation and public-sector deficits.?Would it be desirable for all countries to stick to thesame targets?The case for discretionKeynesians reject the argument that rules provide the environment for high and stable growth. Demand, read more..

  • Page - 594

    19.5 RULES VERSUS DISCRETION567government may find it difficult to keep to its targets. Thistoo may cause uncertainty and instability.Difficulties with the choice of targetIf the government is to adopt a target, which one should itchoose? If a money supply measure is to be chosen, whichone? They frequently do not grow at the same rate. What ismore, the adoption of one measure as the target may leadto distortions as people switch the form of their holdings ofliquidity and wealth (Goodhart’s read more..

  • Page - 595

    56819 FISCAL AND MONETARY POLICYon page 524). Assume that the economy is currently atpoint a, with inflation on target and real national incomeat Y0, which happens to be the sustainable level. Nowassume that inflation rises to π1. As this is above the targetlevel, the central bank raises the rate of interest. This causesreal national income to fall and is represented by a move-ment up along the ADI curve.If the central bank puts a high weight on controllinginflation rather than on read more..

  • Page - 596

    19.5 RULES VERSUS DISCRETION569The Taylor rule is explored in more detail in Box 19.11and is compared with the rule followed by the Bank ofEngland of having an inflation target based on forecastinflation (rather than current inflation).Difficulties with the target levelWhen a target is first set, the short-term costs of achievingit may be too high. If expectations are slow to adjust down-ward and inflation remains high, then adherence to a tightmonetary or inflation rule may lead to a read more..

  • Page - 597

    57019 FISCAL AND MONETARY POLICYoccasionally. But if rules should not be stuck to religiously,does this mean that the government can engage in finetuning? Keynesians today recognise that fine tuning maynot be possible; nevertheless, significant and persistentexcess or deficient demand can be corrected by demandmanagement policy. For example, the actions taken in theUSA by the Federal Reserve Bank in 2001 to cut interestrates substantially, and by the US government to increase itsexpenditure read more..

  • Page - 598

    19.5 RULES VERSUS DISCRETION5713. Does it matter if a country has a large national debtas a proportion of its national income?4. If the government is running a budget deficit, doesthis mean that national income will increase?5. What factors determine the effectiveness ofdiscretionary fiscal policy?6. Why is it difficult to use fiscal policy to ‘fine tune’ the economy?7. Assume that a bank has the following simplifiedbalance sheet, and is operating at its desiredliquidity read more..

  • Page - 599

    57219 FISCAL AND MONETARY POLICY• For news articles relevant to this chapter, see the Economics News Articles link from the book’swebsite.• For general news on fiscal and monetary policies, see websites in section A, and particularly A1–5. Seealso links to newspapers worldwide in A38, 39 and 43, and the news search feature in Google at A41.See also links to economics news in A42.• For information on UK fiscal policy and government borrowing, see sites E30, 36; F2. See also read more..

  • Page - 600

    Chapter20Aggregate Supply, Unemployment and Inflation20.1 Aggregate supply574Short-run aggregate supply574Long-run aggregate supply575The classical model of labour markets576Keynesian models of labour markets577Aggregate demand and supply, and inflation57820.2 The expectations-augmented Phillips curve581Adaptive expectations582The accelerationist theory582The long-run Phillips curve and the naturalrate of unemployment583The effects of deflation583Explanations of read more..

  • Page - 601

    KI 9p5857420 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONThe effect of an increase in aggregate demand on output,employment and prices is a crucial issue in macroeco-nomic policy and is at the heart of macroeconomic debate.The debate hinges on the shape of the aggregate supplycurve and how it varies with time.The extreme Keynesian and new classical positions areshown in Figure 20.1. Extreme Keynesians argue that up to full employment (Yf), the aggregate supply (AS) curve is horizontal, at least read more..

  • Page - 602

    20.1 AGGREGATE SUPPLY575When there is a general rise in demand in the economy,the aggregate supply response in the short run can be seenas simply the sum of the responses of all the individualfirms. The short-run AS curve will look something like thatin Figure 20.3. If there is generally plenty of spare capacity,a rise in aggregate demand (e.g. from AD1 to AD2) will havea big effect on output and only a small effect on prices.However, as more and more firms find their costs rising asthey get read more..

  • Page - 603

    57620 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONmachinery or labour. This is more likely when the eco-nomy is already operating near its full potential.?1. Will the shape of the long-run AS curve here dependon just how the ‘long’ run is defined?2. If a shift in the aggregate demand curve from AD toAD1 in Figure 20.5 causes a movement from point ato point d in the long run, would a shift in aggregatedemand from AD1 to AD cause a movement frompoint d back to point a in the long read more..

  • Page - 604

    20.1 AGGREGATE SUPPLY577more labour only if there is a fall in the real wage rate tocompensate them for the lower output produced by theadditional workers.A higher real wage rate encourages more people to enterthe labour market. For example, more married women mayseek employment. The total number in the labour force (N)rises. The curve gets steeper as the limit of the potentiallabour force is reached.There will, however, be some frictional and structuralunemployment. Some workers will be read more..

  • Page - 605

    57820 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONsmall fall in prices. The flatter are firms’ marginal costcurves, the smaller will be the fall in prices.But what about the long run? Clearly it depends on howlong the long run is. Many Keynesians argue that pricesand especially wages exhibit a degree of inflexibility overquite a long period of time, and over this period of time,therefore, the aggregate supply curve would not be vertical.What is more, Keynesians argue that the long-run AS read more..

  • Page - 606

    20.1 AGGREGATE SUPPLY579long-run aggregate supply curve is vertical. The only effectof the shift in AD to AD3 has been inflation.Note that, although costs in Figure 20.9(b) haveincreased and hence the AS curves have shifted upwards, this is not cost-push inflation because the rise in costs is theresult of the rise in demand.?If point g is vertically above point a, does this mean that the long-run AS curve is vertical? Are there anycircumstances where point g might be to the left ofpoint read more..

  • Page - 607

    58020 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONWe can use the ADI/ASI model to analyse theimplications of demand-pull and cost-push pressuresunder a policy of inflation targeting. The diagrambelow is similar to Figure 18.17 (on page 526). Assumethat the central bank operates with an inflation target ofπtarget and that the economy is currently in equilibriumat point a with aggregate demand and supply given byADI1 and ASI1 respectively. Real national income is atthe sustainable (or read more..

  • Page - 608

    20.2 THE EXPECTATIONS-AUGMENTED PHILLIPS CURVE581Bank of England) tend to concentrate on various factorsaffecting aggregate demand, such as the size of the PSNCRand business and consumer confidence. In most cases,changes in inflation are indeed caused by changes in therate of growth of aggregate demand.There are, however, occasions when there are exogenouschanges in costs. In the short run, these can be shocks suchas a rise in oil prices or a period of industrial unrest. In thelonger term, read more..

  • Page - 609

    58220 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATION• Third, if there are any exogenous cost pressures on infla-tion (κ) (such as increases in international commodityprices), this must be added too.Thus if people expected a 3 per cent inflation (πe = 3%) andif excess demand were causing demand-pull inflation of 2 per cent (f (1/U ) = 2%) and exogenous increases in costswere adding another 1 per cent to inflation (κ = 1%), actualinflation would be 3 + 2 + 1 = 6 per cent.The model is read more..

  • Page - 610

    20.2 THE EXPECTATIONS-AUGMENTED PHILLIPS CURVE583Year 5.Expected inflation is now 8 per cent (the level ofactual inflation in year 4). The Phillips curve shifts up toposition III. If at the same time the government now triesto keep unemployment at 6 per cent, it must expand nom-inal aggregate demand 4 per cent faster in order to validatethe 8 per cent expected inflation. The economy moves topoint e along curve III. Inflation is now 12 per cent.Year 6 onwards.To keep unemployment at 6 per read more..

  • Page - 611

    58420 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATION2 per cent downward pressure on inflation: f (1/U ) = –2.Inflation thus falls to 18 per cent. But unemployment rises,let us assume, from 8 per cent to 13 per cent. The economymoves along curve X to point k.Next year the expected rate of inflation will fall to 18 percent to match, and if real demand is still being deflated bythe same amount ( f (1/U ) = –2), actual inflation will fall to16 per cent. The economy moves to point l on curve read more..

  • Page - 612

    20.2 THE EXPECTATIONS-AUGMENTED PHILLIPS CURVE585below Un, there is still demand-pull inflation. The economymoves to point e. The government now allows unemploy-ment to rise to Un, but the Phillips curve still shifts up asexpectations catch up with last year’s inflation. The eco-nomy moves from point e to point f.Thereafter the government allows unemployment to risefurther, and the economy eventually returns to point a, viapoints g, h, i and j. The economy has thus moved through aclockwise read more..

  • Page - 613

    58620 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONbegan (see sections 18.4 and 19.5). At the same time, Unwould seem to have increased from about 4.5 per cent inthe mid-1970s to around 11 per cent in the mid-1980s, andto have fallen to about 8 per cent in the late 1980s/early1990s and to about 5 per cent in the mid-2000s.Policy implicationsThe implications of the expectations-augmented Phillipscurve are that monetary or fiscal policy can have no long-run effect on unemployment. They can only be read more..

  • Page - 614

    20.3 INFLATION AND UNEMPLOYMENT: THE NEW CLASSICAL POSITION587There are two crucial assumptions in new classicalmacroeconomics:• Prices and wages are flexible, and thus markets clear veryrapidly.• Expectations are ‘rational’, but are based on imperfectinformation.Flexible wages and pricesNew classical economists assume that markets clear virtu-ally instantaneously. This is likely, they argue, in moderneconomies with flexible labour markets (see Box 9.8 onpage 246) and facing global read more..

  • Page - 615

    58820 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONshort-run aggregate supply curve shifts upwards, eventuallyreaching SRAS2. Long-run equilibrium is thus at point c,where AD2 = LRAS. In the short run, therefore, if the gov-ernment expands aggregate demand, there will be a rise inoutput and employment. It is only in the long run that theeffect is confined to higher prices. The actual length of timeit takes to reach point c will depend on how quickly expec-tations adjust upwards.In Figure read more..

  • Page - 616

    20.3 INFLATION AND UNEMPLOYMENT: THE NEW CLASSICAL POSITION589short-run aggregate supply curve based on a particular price(e.g. SRAS1 based on a price level P1) cannot be movedalong. The moment aggregate demand shifts to the right,people will correctly anticipate a rise in the price level.Thus the moment the economy begins to move up alongSRAS1from point a, the whole SRAS curve will shiftupwards. As a result, the economy moves directly to point c.Thus the actual short-run supply curve is read more..

  • Page - 617

    59020 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONIf, however, firms underpredict the rate of inflation too,the effect on employment will be more complicated. Onthe one level, as explained above, firms will want to pro-duce more, and thus the demand for labour will tend toincrease. For example, it might shift to ADL2 in Figure 20.17,and thus employment would rise to Q3. On the other hand, given that they are underpredicting the rate ofinflation, they will believe that any given level of read more..

  • Page - 618

    20.3 INFLATION AND UNEMPLOYMENT: THE NEW CLASSICAL POSITION591recessions? How can they explain the business cycle? Theiranswer, unlike Keynesians, lies not in fluctuations in aggreg-ate demand. Rather it lies in shifts in aggregate supply. In arecession, the vertical short- and long-run aggregate supplycurves will shift to the left (output falls) and the verticalshort- and long-run Phillips curves will shift to the right(unemployment rises). The reverse happens in a boom. Sincethe new classical read more..

  • Page - 619

    59220 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONSo far we have seen how the theory of real businesscycles explains persistent rises or falls in aggregate supply.But how does it explain turning points? Why do recessionsand booms come to an end? The most likely explanation isthat once a shock has worked its way through, aggregatesupply will stop shifting. If there is then any shock in theother direction, aggregate supply will start moving backagain. For example, after a period of recession, an read more..

  • Page - 620

    20.4 INFLATION AND UNEMPLOYMENT: THE MODERN KEYNESIAN POSITION593trade unions, a growing concentration of monopoly powerin industry, and rising oil and other commodity prices. Theeffect was to push the short-run Phillips curve outwards.Later, with a decline in industrial unrest in the 1990sand a growth of international competition keeping pricesdown, the Phillips curve apparently shifted inwards again.Keynesians attributed this partly to a decline in cost-pushinflation. (These cost-push read more..

  • Page - 621

    59420 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONoutsiders) are not, or if the insiders have special skills orknowledge that give them bargaining power with employ-ers while the outsiders have no influence, then there is nomechanism whereby the surplus labour – the outsiders– can drive down the real wage rate and eliminate thedemand-deficient unemployment.These two features help to explain why real wage rates didnot fall during the recessions of the early 1980s and early1990s.The read more..

  • Page - 622

    20.4 INFLATION AND UNEMPLOYMENT: THE MODERN KEYNESIAN POSITION595Contraction of aggregate demandMany Keynesians argue that the short-run Phillips curve iskinked at the current level of real aggregate demand. Areduction in real aggregate demand will have only a slighteffect on inflation, since real wages are sticky downwards.Unions may well prefer to negotiate a reduction in employ-ment levels, preferably by natural wastage (i.e. not replacingpeople when they leave), rather than accept a read more..

  • Page - 623

    TC 13p 381KI 5p21KI 9p58TC 9p101KI 10p6259620 AGGREGATE SUPPLY, UNEMPLOYMENT AND INFLATIONWhilst there is some disagreement among economists overthe nature of the aggregate supply and Phillips curves, andhence over the effects of changes in aggregate demand, it is important not to get the impression that economists disagree over everything. There is, in fact, quite a lot ofcommon ground among the majority of economists overthe issues that we have examined in this chapter.If you look back to read more..

  • Page - 624

    20.5 POSTSCRIPT: COMMON GROUND AMONG ECONOMISTS?597Additional case studies on the book’s website ( the shape of the short-run Phillips curve. This shows how money illusion on the part of workerscan explain why the Phillips curve is downward sloping.20.2The quantity theory of money restated. An examination of how the vertical long-run AS curve in the adaptiveexpectations model can be used to justify the quantity theory of money.20.3Getting predictions read more..

  • Page - 625

    Chapter21Long-term Economic Growth 21.1 Long-run economic growth in industrialised countries599Growth over the decades599Comparing the growth performance of different countries600The causes of economic growth60021.2 Economic growth without technological progress601Capital accumulation601A simple model of economic growth601An optimum rate of saving?603An increase in the workforce60321.3 Economic growth with technological progress604The effect of technological progress in output604Endogenous read more..

  • Page - 626

    KI 2p821.1 LONG-RUN ECONOMIC GROWTH IN INDUSTRIALISED COUNTRIES599Quite naturally, governments and individuals are con-cerned with the ups and downs of the business cycle. Howdoes this year’s economic performance compare with lastyear’s? Are the various macroeconomic indicators such as growth, unemployment and inflation getting better orworse?When we step back, however, and look at the longerspan of history, these short-term fluctuations take on lesssignificance. What we see is that read more..

  • Page - 627

    60021 LONG-TERM ECONOMIC GROWTHComparing the growth performance ofdifferent countriesAs you can see from these two tables, there has been a con-siderable difference in the rates of growth experienced by thedifferent countries. Japan, Italy, France and West Germanyhad much higher rates of growth than the UK and USA inthe earlier part of the period, but then they experienced aslowdown in growth rates in the later periods. Ireland hashad generally high rates of growth throughout. The UK andUSA, read more..

  • Page - 628

    21.2 ECONOMIC GROWTH WITHOUT TECHNOLOGICAL PROGRESS601• An increase in the productivity of factors. Here we wouldinclude an increase in the skills of workers, a more efficientorganisation of inputs by management and more pro-ductive capital equipment. Most significant here is techno-logical progress. Developments of computer technology,of new techniques in engineering, of lighter, stronger andcheaper materials, of digital technology in communica-tions and of more efficient motors have all read more..

  • Page - 629

    60221 LONG-TERM ECONOMIC GROWTHThe model is illustrated in Figure 21.2. The size of thecapital stock (K ) is measured on the horizontal axis; thelevel of national output (Y ) is measured on the vertical axis.We start by looking at the effects of a growth in the cap-ital stock on national output (i.e. on real national income(Y )). This is shown by the green output curve. As the cap-ital stock increases, so output increases, but at a diminishingrate (the curve gets less and less steep). The reason read more..

  • Page - 630

    21.2 ECONOMIC GROWTH WITHOUT TECHNOLOGICAL PROGRESS603Human capital and educationThe analysis of Figures 21.2 and 21.3 need not be confinedto the stock of physical capital: machines, buildings, tools,etc. It can also apply to human capital. Human capital, aswe saw in Chapter 9, refers to the skills and expertise ofworkers that have been acquired through education andtraining. If part of saving is used for investment in educa-tion and training, then the productivity of workers willrise, and so read more..

  • Page - 631

    60421 LONG-TERM ECONOMIC GROWTHpopulation wishing to work) or of people working longerhours, then GDP per capita will be higher, even thoughoutput per hour worked will be lower. If, however, theincreased hours worked were the result of an increased population, with no increase in the participation rate ornumber of hours worked per worker, then, because ofdiminishing returns to labour, output per head of the popu-lation will have gone down: GDP per capita will be lower.?1. If there were a higher read more..

  • Page - 632

    21.3 ECONOMIC GROWTH WITH TECHNOLOGICAL PROGRESS605The effect of an increase in the saving rate with agiven rate of technological progressFigure 21.7 shows the combined effects of an increased sav-ing rate and continuing technological progress. The rate oftechnological progress gives the slope of the steady-stategrowth path. This is the growth path for any given savingrate. The saving rate determines the position (as opposed toslope) of the curve. Assume that the economy is on steady-state read more..

  • Page - 633

    KI 21p 20760621 LONG-TERM ECONOMIC GROWTHto R&D and training will increase the long-run rate of eco-nomic growth.The second factor is the responsiveness of Y to In. Thegreater the value of ∆Y/In, the greater will be the rate of eco-nomic growth: the steeper will be the steady-state growthpath.The values of In and ∆Y/In depend on a range of factors,such as attitudes of business and financial institutions, taxincentives, government grants, a research infrastructure(laboratories, the read more..

  • Page - 634

    21.3 ECONOMIC GROWTH WITH TECHNOLOGICAL PROGRESS607BOX 21.1the USA. It shows that, in the period 1996 –2002, theUSA’s long-term growth was higher than the EU’s forall three reasons: faster growth in the employment oflabour, faster growth in the capital stock and fastergrowth in total factor productivity.The importance of productivityThe higher the productivity of its factors of production,the higher will be a country‘s potential output; and thefaster the rate of growth in productivity, read more..

  • Page - 635

    60821 LONG-TERM ECONOMIC GROWTHEND OF CHAPTER QUESTIONS1. For what reasons do countriesexperience very different long-run rates ofeconomic growth from each other?2. Why do developed countries experience a degree ofconvergence over time? Would you expect there tobe total convergence of GDP per head?3. If increased investment (using current technology)does not lead to increased long-run economicgrowth, does it bring any benefits?4. What determines the rate of depreciation? Whatwould happen if the read more..

  • Page - 636

    Chapter22Supply-side Policies22.1 Approaches to supply-side policy610Supply-side policies and the different macroobjectives610The new classical approach610The Keynesian approach611‘Third Way’ supply-side policies611The link between demand-side and supply-side policies61122.2 Market-orientated supply-side policies612Supply-side policies in the 1980s612Reducing government expenditure612Tax cuts: effects on labour supply613Tax cuts for business and other incentives614Reducing the power of read more..

  • Page - 637

    TC 14p 385KI 21p 207TC 3p2161022 SUPPLY-SIDE POLICIESSupply-side policies and the differentmacro objectivesEconomic growthAs we saw in Chapter 21, economic growth over the long run depends primarily on technological progress. Buta lot of technological progress is embodied in new capitalequipment. In other words, you cannot have the new tech-nology without having the equipment that uses it. To takeadvantage of new technology, therefore, firms often haveto invest in new capital. Also, workers and read more..

  • Page - 638

    22.1 APPROACHES TO SUPPLY-SIDE POLICY611will be willing to take risks and develop new products andnew techniques.Unlike neoclassical economists, who concentrate on thedesirability of achieving economic efficiency in competi-tive markets, the neo-Austrians take a longer-term perspec-tive. They argue that the prospect of monopoly profits isoften what provides a major motivation for firms to takerisks. The search to achieve market advantages throughnew products and new techniques is just as read more..

  • Page - 639

    61222 SUPPLY-SIDE POLICIESSimilarly, supply-side policies of tax cuts designed toincrease incentives will increase aggregate demand (unlessaccompanied by a cut in government expenditure). It isthus important to consider the consequences for demandwhen planning various supply-side policies.Likewise, demand management policies often have supply-side effects. If a cut in interest rates boosts investment,there will be a multiplied rise in national income: ademand-side effect. But that rise in read more..

  • Page - 640

    22.2 MARKET-ORIENTATED SUPPLY-SIDE POLICIES613Tax cuts: the effects on labour supply and employmentCutting the marginal rate of income tax was a major objec-tive of the Thatcher and Major governments (1979–97), asit was of the Reagan administration. In 1979, the standardrate of income tax was 33 per cent, with higher rates risingto 83 per cent. By 1997 the standard rate was only 23 percent and the top rate was only 40 per cent. The Blair government continued with this policy, so that by read more..

  • Page - 641

    61422 SUPPLY-SIDE POLICIESeffects will roughly cancel each other out. Anyway, formany people there is no such choice in the short run. Thereis no chance of doing overtime or working a shorter week. In the long run, there may be some flexibility in that people can change jobs.More people wish to workThis applies largely to second income earners in a family,mainly women. A rise in after-tax wages may encouragemore women to look for jobs. It may now be worth the costin terms of transport, child read more..

  • Page - 642

    22.2 MARKET-ORIENTATED SUPPLY-SIDE POLICIES615An alternative policy would be to increase investmentallowances. Investment allowances are the system wherebythe cost of investment can be offset against pre-tax profit,thereby reducing a firm’s tax liability.Reducing the power of labourIn Figure 22.5, if the power of unions to push wage rates upto W1 were removed, then (assuming no change in thedemand curve for labour) wage rates would fall to We.Disequilibrium unemployment (Q2 – Q1) would read more..

  • Page - 643

    61622 SUPPLY-SIDE POLICIES?Would a cut in benefits affect the Wo curve? If so, withwhat effect?In the early 1980s, the gap between take-home pay andwelfare benefits to the unemployed did indeed widen.However, over the same period unemployment rose dra-matically. Nevertheless, the claim that there was too little incentive for people to work was still a major part of the Thatcher government’s explanation of growingunemployment.A major problem is that with changing requirements forlabour read more..

  • Page - 644

    22.2 MARKET-ORIENTATED SUPPLY-SIDE POLICIES617reducing inflation. Five major types of policy have beenpursued under this heading.PrivatisationIf privatisation simply involves the transfer of a naturalmonopoly to private hands (e.g. the water companies), thescope for increased competition is limited. However, wherethere is genuine scope for competition (e.g. in the supplyof gas and electricity), privatisation can lead to increasedefficiency, more consumer choice and lower prices.Alternatively, read more..

  • Page - 645

    61822 SUPPLY-SIDE POLICIESrates that they charge, and on-line share dealing hasbecome commonplace.Introducing market relationships into the public sectorThis is where the government tries to get different depart-ments or elements within a particular part of the public sector to ‘trade’ with each other, so as to encourage com-petition and efficiency.The process often involves ‘devolved budgeting’. Forexample, under the locally managed schools scheme (LMS),schools have become read more..

  • Page - 646

    TC 7p26TC 6p26KI 28p 300KI 11p6622.3 INTERVENTIONIST SUPPLY-SIDE POLICY619Section summary1. Market-orientated supply-side policies aim toincrease the rate of growth of aggregate supply byencouraging private enterprise and the freer play ofmarket forces.2. Reducing government expenditure as a proportion of GDP is a major element of suchpolicies.3. Tax cuts can be used to encourage more people to take up jobs, and people to work longer hours and more enthusiastically. They can be used toreduce read more..

  • Page - 647

    62022 SUPPLY-SIDE POLICIEScompanies on the Stock Exchange provides a large windfallgain to the original owners. This encourages entrepreneursto set up companies, but discourages them from makinglong-term commitments to them. This all leads to the UKdisease of ‘short-termism’: the obsession with short-termprofits and the neglect of investment that yields profitsonly after a number of years.Finally, in the case of ailing firms, if the government doesnot help finance a rescue investment read more..

  • Page - 648

    22.3 INTERVENTIONIST SUPPLY-SIDE POLICY621The forms of interventionNationalisation.This is the most extreme form of inter-vention, and one that most countries have now rejected,given the worldwide trend of privatisation. Nevertheless,many countries have stopped short of privatising certainkey transport and power industries, such as the railwaysand electricity generation. Having these industries underpublic ownership may result in higher investment than if they were under private ownership. Thus read more..

  • Page - 649

    62222 SUPPLY-SIDE POLICIESservices, with obvious benefits to rail users and the economygenerally.Grants.The government may sponsor research and devel-opment in certain industries (e.g. aerospace) or in specificfields (e.g. microprocessors). It may back investment pro-grammes considered to benefit the economy as a whole.Rationalisation.The government may encourage mergersor other forms of industrial reorganisation that will lead togreater efficiency and/or higher levels of investment. read more..

  • Page - 650

    22.3 INTERVENTIONIST SUPPLY-SIDE POLICY623various forms of advisory services, grants and tax conces-sions. For example, small firms pay a 19 per cent rate of corporation tax compared with 30 per cent for larger com-panies. In addition, small firms are subject to fewer planningand other bureaucratic controls than large companies.Support to small firms in the UK is examined in WebCase 22.7.TrainingThe government may set up training schemes, or encour-age educational institutions to make their read more..

  • Page - 651

    62422 SUPPLY-SIDE POLICIESopportunities were good, firms would invest without theneed of government support.• UK investment has remained low in the past despiteinterventionist industrial policy.• If the government is to help industry, it is best to reducethe tax burden generally, so as to increase the return oninvestment. The microeconomic allocation of invest-ment resources will then still be provided by the market.? Provide a critique of these arguments.An example of a ‘Third Way’ read more..

  • Page - 652

    22.4 REGIONAL AND URBAN POLICY625than in the past to be located in a specific region, and cantherefore move to parts of the country where labour andother costs are lower. The problem today, therefore, is seento be more one of specific areas, especially inner cities andurban localities subject to industrial decline.Let us first, however, examine the causes of regionalimbalance.Causes of regional imbalanceIf the market functioned perfectly, there would be noregional problem. If wages were lower read more..

  • Page - 653

    62622 SUPPLY-SIDE POLICIESaway as well as a disincentive for new firms to move intothe area.Approaches to regional and urban policyMarket-orientated solutionsSupporters of market-based solutions argue that firms arethe best judges of where they should locate. Governmentintervention would impede efficient decision taking byfirms. It is better, they argue, to remove impediments to themarket achieving regional and local balance. For example,they favour either or both of the following.Locally read more..

  • Page - 654

    22.4 REGIONAL AND URBAN POLICY627Regional policy in the UKCertain areas are identified as requiring government fin-ancial assistance to boost their local economies. These areknown as assisted areas (AAs) and cover around 29 percent of the UK population. They are divided into two categories. Tier 1 areas are those suffering the most acuteeconomic problems. There are four of these areas: Cornwall,South Yorkshire, Merseyside and much of Wales. Tier 2areas include large parts of Scotland and the read more..

  • Page - 655

    62822 SUPPLY-SIDE POLICIESWith the signing of the Maastricht Treaty, whichestablished the European Union in November 1993,member states agreed to work together to ensure that:• The distribution of benefits from Europeanunification were spread fairly.• Economic and social development was speeded up in the less prosperous countries, so that theymight play a fuller part in the EU’s futuredevelopment.• Economic imbalances between countries did notdistort the operation of the internal read more..

  • Page - 656

    22.4 REGIONAL AND URBAN POLICY629BOX 22.5of the EU level for the last three years. This objectiveis funded by the ERDF, ESF and EAGGF.• Objective 2: to support regions adversely affected by industrial and rural decline. In order to qualify forassistance under this objective, a region must havean unemployment rate above the EU average overthe last three years. This objective is funded by theERDF and ESF.• Objective 3: to combat long-term unemployment,and help other groups excluded from the read more..

  • Page - 657

    63022 SUPPLY-SIDE POLICIESCurrently there are five major elements of regenerationpolicy:Communities Plan.This scheme for sustainable commun-ities was launched in 2003 and involves investment inaffordable housing, refurbishing council housing, regen-erating deprived areas and improving parks and publicspaces. The plan has a budget of £22 billion from 2002/3 to2005/6: see Table 22.3 (note that this also includes some ofthe following items).Neighbourhood Renewal Unit.This was set up in 2002and read more..

  • Page - 658

    22.4 REGIONAL AND URBAN POLICY631Section summary1. Regional and local disparities arise from a changingpattern of industrial production. With many of theolder industries concentrated in certain parts of the country and especially in the inner cities, andwith an acceleration in the rate of industrial change, so the gap between rich and poor areas has widened.2. Regional disparities can in theory be corrected bythe market, with capital being attracted to areas oflow wages and workers being read more..

  • Page - 659

    63222 SUPPLY-SIDE POLICIES• For news articles relevant to these three chapters, see the Economics News Articles link from thebook’s website.• For general news on unemployment, inflation, economic growth and supply-side policy, see websitesin section A, and particularly A1–5. See also links to newspapers worldwide in A38 and 39, and thenews search feature in Google at A41. See also links to economics news in A42.• For data on unemployment, inflation and growth, see links in B1 or 2; read more..

  • Page - 660

    Part F: The World Economy‘Globalisation’ is a word frequently used nowadays. But it neatly captures one of the keyfeatures of economics today: that it is global in nature. International trade has grown at amuch faster rate than the levels of national output in any country. International financialflows have grown faster still. The result is that economies around the globe are inter-meshed, and what happens in one country can have profound effects on others.In Chapters 23 and 24 we look at read more..

  • Page - 661

    EC6_C23.qxd 10/27/05 17:08 Page 634 read more..

  • Page - 662

    Chapter23International Trade23.1 The advantages of trade636The growth of world trade636Specialisation as the basis for trade636The law of comparative advantage636The gains from trade based on comparativeadvantage637International trade and factor prices640The limits to specialisation and trade640The terms of trade641*Intermediate analysis of gains from trade643Other reasons for gains from trade64423.2 Arguments for restricting trade645Methods of restricting trade645Arguments in favour of read more..

  • Page - 663

    TC 1p863623 INTERNATIONAL TRADEThe growth of world tradeWorld trade has grown rapidly over the past 60 years and atconsistently higher rates than world GDP. Table 23.1 showsexports as a proportion of various countries’ GDP. As youcan see, in all cases the proportion was higher in 2005 thanin 1965, and in some cases considerably higher.The major industrial economies dominate world trade(see Figure 23.1). They account for 64 per cent of worldexports and 67 per cent of world imports. The top ten read more..

  • Page - 664

    23.1 THE ADVANTAGES OF TRADE637country may be able to produce 1 fridge for the same cost as 6 tonnes of wheat or 3 compact disc players, whereasanother country may be able to produce 1 fridge for thesame cost as only 3 tonnes of wheat but 4 CD players. It isthese differences in relative costs that form the basis oftrade.At this stage, we need to distinguish between absoluteadvantage and comparative advantage.Absolute advantageWhen one country can produce a good with less resourcesthan another read more..

  • Page - 665

    63823 INTERNATIONAL TRADEAssume, then, that the pre-trade exchange ratios ofwheat for cloth are as follows:LDC: 2 wheat for 1 clothDeveloped country : 1 wheat for 2 cloth (i.e. 4 for 8)Both countries will now gain from trade, provided theexchange ratio is somewhere between 2:1 and 1:2. Assume,for the sake of argument, that it is 1:1, that 1 wheat tradesinternationally for 1 cloth. How will each country gain?The LDC gains by exporting wheat and importing cloth.At an exchange ratio of 1:1, it now read more..

  • Page - 666

    23.1 THE ADVANTAGES OF TRADE639200 kilos of wheat that the developed country produces, ithas to sacrifice 400 metres of cloth. Straight-line pre-tradeproduction possibility ‘curves’ can thus be drawn for thetwo countries with slopes of (minus) 2/1 and (minus) 1/2respectively. These lines illustrate the various total combin-ations of the two goods that can be produced and henceconsumed. They are shown as the blue lines in Figure 23.2.Assume that before trade the LDC produces (and con-sumes) read more..

  • Page - 667

    64023 INTERNATIONAL TRADEInternational trade and its effect onfactor pricesCountries tend to have a comparative advantage in goodsthat are intensive in their abundant factor. Canada has abund-ant land and hence it is cheap. Therefore Canada special-ises in grain production since grains are land intensive.South Asian countries have abundant supplies of labourwith low wage rates, and hence specialise in clothing andother labour-intensive goods. Europe, Japan and the USAhave relatively abundant and read more..

  • Page - 668

    23.1 THE ADVANTAGES OF TRADE641food or its forests to produce timber. The opportunity costsof diverting all agricultural labour to industry would bevery high.Thus increasing opportunity costs limit the amount of acountry’s specialisation and hence the amount of its trade.There are also other limits to trade:• Transport costs may outweigh any comparative advant-age. A country may be able to produce bricks morecheaply than other countries, but their weight maymake them too expensive to read more..

  • Page - 669

    64223 INTERNATIONAL TRADEIf the terms of trade rise (export prices rising relative toimport prices), they are said to have ‘improved’, since fewerexports now have to be sold to purchase any given quantityof imports. Changes in the terms of trade are caused bychanges in the demand for and supply of imports andexports, and by changes in the exchange rate.The terms of trade and comparative advantageAssuming there are two goods x and m, trade can be advantageous to a country as long as the terms read more..

  • Page - 670

    23.1 THE ADVANTAGES OF TRADE643under perfect competition. The country is too small toinfluence world prices, and thus faces a horizontal demandcurve for its exports and a horizontal supply curve for itsimports. In foreign currency terms, therefore, the terms oftrade are outside its control. Nevertheless, these terms oftrade will probably be to its benefit, in the sense that thegains from trade will be virtually entirely received by thissmall country rather than the rest of the world. It is read more..

  • Page - 671

    64423 INTERNATIONAL TRADEMCxPxMUxMCm=Pm=MUmHow much will be imported and how much will beexported? With production at P2 and consumption at C2,country A will import C2 − D of good m in exchange forexports of P2 − D of good x.Similar diagrams to Figure 23.6 can be drawn for othercountries. Since they show equilibrium for both importsand exports on the one diagram, economists refer to themas general equilibrium diagrams (see page 299 for anotherexample).?1. Draw a similar diagram to Figure read more..

  • Page - 672

    KI 2p823.2 ARGUMENTS FOR RESTRICTING TRADE645Section summary1. Countries can gain from trade if they specialise in producing those goods in which they have acomparative advantage: i.e. those goods that can be produced at relatively low opportunity costs. This is merely an extension of the argument thatgains can be made from the specialisation anddivision of labour.2. If two countries trade, then, provided that the tradeprice ratio of exports and imports is between thepre-trade price ratios of read more..

  • Page - 673

    64623 INTERNATIONAL TRADEExport taxes.These can be used to increase the price ofexports when the country has monopoly power in theirsupply.Subsidies.These can be given to domestic producers toprevent competition from otherwise lower-priced imports.They can also be applied to exports in a process known asdumping. The goods are ‘dumped’ at artificially low pricesin the foreign market. (This, of course, is a means ofartificially increasing exports, rather than reducing imports.)Administrative read more..

  • Page - 674

    23.2 ARGUMENTS FOR RESTRICTING TRADE647To reduce reliance on goods with little dynamic potential.Many developing countries have traditionally exported prim-aries: foodstuffs and raw materials. The world demand forthese, however, is fairly income inelastic, and thus growsrelatively slowly. In such cases, free trade is not an engineof growth. Instead, if it encourages countries’ economies tobecome locked into a pattern of primary production, it mayprevent them from expanding in sectors like read more..

  • Page - 675

    64823 INTERNATIONAL TRADETo prevent the establishment of a foreign-based mono-poly.Competition from abroad, especially when it involvesdumping, could drive domestic producers out of business.The foreign company, now having a monopoly of the mar-ket, could charge high prices with a resulting misallocationof resources.All of the above arguments suggest that governmentsshould adopt a ‘strategic’ approach to trade. Strategic tradetheory (see Box 23.4) argues that protecting certain indus-tries read more..

  • Page - 676

    23.2 ARGUMENTS FOR RESTRICTING TRADE649But the marginal cost of imports curve will be above thesupply curve because, given the country’s size, the pur-chase of additional imports would drive up their price. Thismeans that the cost of additional imports would be thenew higher price (given by the supply curve) plus the rise inexpenditure on the imports that would previously havebeen purchased at a lower price. The country will maximiseits gain from trade at point f by importing Q2, where read more..

  • Page - 677

    65023 INTERNATIONAL TRADETo improve the balance of payments.Under certain special circumstances, when other methods of balance ofpayments correction are unsuitable, there may be a case forresorting to tariffs (see Chapter 24).‘Non-economic’ argumentsA country may be prepared to forgo the direct economicadvantages of free trade – consumption at a lower oppor-tunity cost – in order to achieve objectives that are oftendescribed as ‘non-economic’:• It may wish to maintain a degree of read more..

  • Page - 678

    23.2 ARGUMENTS FOR RESTRICTING TRADE651society. Firms face a higher price, and thus gain extra profits(area 1): where profit is given by the area between the priceand the MC curve. The government receives extra revenuefrom the tariff payments (area 3): i.e. Q4 − Q3 × tariff. Theserevenues can be used, for example, to reduce taxes.But part of this cost is not recouped elsewhere. It is a netcost to society (areas 2 and 4).Area 2 represents the extra costs of producing Q3 − Q1at home, rather read more..

  • Page - 679

    65223 INTERNATIONAL TRADEWorld multiplier effects.If the UK imposes tariffs or otherrestrictions, imports will be reduced. But these imports areother countries’ exports. A reduction in their exports willreduce the level of injections into the ‘rest-of-the-world’economy, and thus lead to a multiplied fall in rest-of-the-world income. This in turn will lead to a reduction indemand for UK exports. This, therefore, tends to undo thebenefits of the tariffs.?What determines the size of this read more..

  • Page - 680

    23.2 ARGUMENTS FOR RESTRICTING TRADE653continued at meetings around the world and culminated in a deal being signed in April 1994. By that time, the aver-age tariff on manufactured products was 4 per cent andfalling. In 1947 the figure was nearly 40 per cent. TheUruguay round agreement also involved a programme ofphasing in substantial reductions in tariffs and other restric-tions up to the year 2002 (see Web Case 23.2).Despite the reduction in tariffs, many countries havestill tried to read more..

  • Page - 681

    65423 INTERNATIONAL TRADESection summary1. Countries use various methods to restrict trade,including tariffs, quotas, exchange controls, importlicensing, export taxes, and legal and administrativebarriers. Countries may also promote their ownindustries by subsidies.2. Reasons for restricting trade that have some validityin a world context include the infant industryargument, the inflexibility of markets in respondingto changing comparative advantage, dumping andother unfair trade practices, the read more..

  • Page - 682

    23.3 PREFERENTIAL TRADING655Types of preferential trading arrangementThere are three possible forms of such trading arrangements.Free trade areasA free trade area is where member countries remove tariffs and quotas between themselves, but retain whateverrestrictions each member chooses with non-member countries.Some provision will have to be made to prevent importsfrom outside coming into the area via the country with thelowest external tariff.Customs unionsA customs union is like a free trade read more..

  • Page - 683

    65623 INTERNATIONAL TRADEconsumers. This gain is illustrated in Figure 23.10. The diagram assumes for simplicity that the UK is a price takeras an importer of good x from France: the EU price is given.The diagram shows that, before joining the EU, the UKhad to pay the EU price plus the tariff (i.e. P1). At P1 the UKproduced Q2, consumed Q1 and thus imported Q1− Q2 .With the removal of tariffs, the price falls to P2. Consump-tion increases to Q3 and production falls to Q4. Importshave thus read more..

  • Page - 684

    23.3 PREFERENTIAL TRADING657A customs union is more likely to lead to trade diversionrather than trade creation:• When the union’s external tariff is very high. Underthese circumstances, the abolition of the tariff within theunion is likely to lead to a large reduction in the price ofgoods imported from other members of the union.• When there is a relatively small cost difference betweengoods produced within and outside the union. Here theabolition of even relatively low tariffs within the read more..

  • Page - 685

    65823 INTERNATIONAL TRADEIn Africa, the Economic Community of West AfricanStates (ECOWAS) has been attempting to create a commonmarket between its members and to achieve the adoptionof a single currency for most of its members by July 2005.North American Free Trade Association (NAFTA)Along with the EU, NAFTA is one of the two most powerfultrading blocs in the world. It came into force in 1994 andconsists of the USA, Canada and Mexico. These three coun-tries have agreed to abolish tariffs between read more..

  • Page - 686

    23.4 THE EUROPEAN UNION659Historical backgroundThe European Economic Community was formed by thesigning of the Treaty of Rome in 1957 and came into oper-ation on 1 January 1958.The original six member countries of the EEC (Belgium,France, Italy, Luxembourg, Netherlands and West Ger-many) had already made a move towards integration withthe formation of the European Coal and Steel Communityin 1952. This had removed all restrictions on trade in coal,steel and iron ore between the six countries. The read more..

  • Page - 687

    66023 INTERNATIONAL TRADEgrouped under 12 headings covering areas such as the guarantee of decent levels of income for both the employedand the non-employed, freedom of movement of labourbetween member countries, freedom to belong to a tradeunion and equal treatment of men and women in thelabour market. However, the charter was only a recom-mendation and each element had to be approved separatelyby the Council.Then in December 1991 the Maastricht Treaty was signed.This set out a timetable for read more..

  • Page - 688

    23.4 THE EUROPEAN UNION661countries can now specialise further in those goods and ser-vices that they can produce at a comparatively low oppor-tunity cost.Reduction in the direct costs of barriers.This categoryincludes administrative costs, border delays and technicalregulations. Their abolition or harmonisation has led inmany cases to substantial cost savings.Economies of scale.With industries based on a Europe-wide scale, many firms can now be large enough, and theirplants large enough, to read more..

  • Page - 689

    66223 INTERNATIONAL TRADEfactor immobility, the removal of internal barriers to tradehas merely exaggerated the problems of inequality and eco-nomic power. More specifically, the following criticisms aremade.Radical economic change is costly.Substantial economicchange is necessary to achieve the full economies of scaleand efficiency gains from a single European market. Thesechanges necessarily involve redundancies – from bank-ruptcies, takeovers, rationalisation and the introduction of new read more..

  • Page - 690

    23.4 THE EUROPEAN UNION663Since 1 January 1993 trade within the EU has operatedvery much like trade within a country. In theory, thereshould be no more difficulty for a firm in Birminghamto sell its goods in Paris than in London. At the sametime, the single market allows free movement of labour and involves the use of common technicalstandards.The features of the single market are summed up intwo European Commission publications:3• Elimination of border controls on goods within theEU: no read more..

  • Page - 691

    66423 INTERNATIONAL TRADEThis success or otherwise of implementing EU internalmarket directives is measured by the Internal MarketScoreboard, which tracks the transposition (or‘implementation’) deficit for each country. This is thepercentage of directives that have failed to beimplemented by their agreed deadline.The Scoreboard has been published every sixmonths since 1997 and, in addition to tracking thedeficit for each country, also shows the average deficitacross all 25 EU countries. read more..

  • Page - 692

    23.4 THE EUROPEAN UNION665the deficit for the original 15 EU members had risen to 2.9 per cent.?If there have been clear benefits from the single marketprogramme, why do individual member governmentsstill try to erect barriers, such as new technicalstandards?The effect of the new member statesGiven the very different nature of the economies of manyof the new entrants to the EU, and their lower levels of GDP per head, their potential gain from membership hasbeen substantial. The gains come read more..

  • Page - 693

    66623 INTERNATIONAL TRADEEND OF CHAPTER QUESTIONS1. Imagine that two countries, Richlandand Poorland, can produce just two goods,computers and coal. Assume that for a givenamount of land and capital, the output of these twoproducts requires the following constant amounts of labour:RichlandPoorland1 computer24100 tonnes of coal45Assume that each country has 20 million workers.(a) Draw the production possibility curves for thetwo countries (on two separate diagrams).(b) If there is no trade, and read more..

  • Page - 694

    23.4 THE EUROPEAN UNION667• For news articles relevant to this chapter, see the Economics News Articles link from the book’swebsite.• For general news on international trade, see websites in section A, and particularly A1–5, 7–9, 24, 25,31. See also links to newspapers worldwide in A38, 39 43 and 44, and the news search feature inGoogle at A41. See also links to economics news in A42.• For international data on imports and exports, see site H16 >Resources >Trade statistics. See read more..

  • Page - 695

    Chapter24The Balance of Payments and Exchange Rates24.1 Alternative exchange rate regimes669Policy objectives: internal and external669Nominal and real exchange rates670Alternative exchange rate regimes671Correction under fixed exchange rates672Correction under free-floating exchange rates674Intermediate exchange rate regimes67624.2 Fixed exchange rates678*Effects of short-term shocks678Causes of longer-term balance of paymentproblems under fixed exchange rates679Advantages of fixed exchange read more..

  • Page - 696

    KI 32p 36924.1 ALTERNATIVE EXCHANGE RATE REGIMES669Policy objectives: internal and externalA country is likely to have various internal and externalpolicy objectives. Internal objectives include such things aseconomic growth, low unemployment and low inflation.External objectives include such things as avoiding currentaccount balance of payments deficits, encouraging inter-national trade and preventing excessive exchange rate fluc-tuations. Internal and external objectives may come read more..

  • Page - 697

    67024 THE BALANCE OF PAYMENTS AND EXCHANGE RATESAssume in diagram (b) that the exchange rate is er1.Currency demand and supply curves are given by D and S1and there is no central bank intervention. Thus er1 is theequilibrium exchange rate and there is external balance inthe loose sense. Assume also that there is external balancein the narrow sense: i.e. a current account balance.Let us also assume, however, that there is a recession.This is illustrated in diagram (a). Equilibrium nationalincome read more..

  • Page - 698

    24.1 ALTERNATIVE EXCHANGE RATE REGIMES671prices): in other words, adjusted for the terms of trade.Thus if a country has a higher rate of inflation for itsexports than the weighted average inflation of the importsit buys from other countries, its real exchange rate index(RERI) will rise relative to its nominal exchange rate index(NERI).The real exchange rate index can be defined as:RERI = NERI × PX/PMwhere PX is the domestic currency price index of exportsand PM is the foreign currencies read more..

  • Page - 699

    67224 THE BALANCE OF PAYMENTS AND EXCHANGE RATESIn the case of a freely floating rate, there is no governmentintervention in the foreign exchange market. Exchange ratesfluctuate according to market forces – according to changesin the demand for and supply of currencies on the foreignexchange market. Changes in the exchange rate may wellaffect internal policy objectives, however, and thus causethe government to take various internal policy measures.?What adverse internal effects may follow read more..

  • Page - 700

    24.1 ALTERNATIVE EXCHANGE RATE REGIMES673In the late 1980s, the UK current account balance ofpayments moved sharply into deficit, as the diagramshows. In 1989 the current account deficit was 5 percent of GDP – the highest percentage ever recorded.Opinions differed dramatically, however, as to howseriously we should have taken these figures. Notsurprisingly, the government claimed that the problemwas merely temporary and was not something to causeserious concern. The opposition parties (also read more..

  • Page - 701

    67424 THE BALANCE OF PAYMENTS AND EXCHANGE RATESThis process of countering the effects on money supplyof a balance of payments deficit or surplus is known as sterilisation.?Describe the open-market operations necessary tosterilise the monetary effects of a balance of paymentssurplus. Would this in turn have any effect on thecurrent or financial accounts of the balance ofpayments?There is a problem with sterilisation, however. If themoney supply is not allowed to change, the currency read more..

  • Page - 702

    24.1 ALTERNATIVE EXCHANGE RATE REGIMES675The supply of pounds curve will shift to the right (to S2in Figure 24.5). UK exports will now be relatively moreexpensive for foreigners. Less will be sold. The demand forpounds curve will shift to the left (to D2).Foreign exchange dealers will now find themselves with a glut of unsold pounds. They will therefore lower theexchange rate (to r2 in Figure 24.5). The amount that theexchange rate has to change depends on:• The amount that the curves shift. read more..

  • Page - 703

    67624 THE BALANCE OF PAYMENTS AND EXCHANGE RATESalso lead to higher inflation. There will thus be an adversesubstitution effect too. This will partially offset the bene-ficial substitution effect of the depreciation. The higherinflation will have the effect of shifting the X− M line backdown again somewhat.In the extreme case, where money supply expands to accommodate the rise in aggregate demand, X− M maysimply return to its original position. The depreciation willfail to correct the read more..

  • Page - 704

    24.1 ALTERNATIVE EXCHANGE RATE REGIMES677Exchange rate bands could be narrow (say ±1 per cent) orwide (say ±15 per cent).Exchange rate bands can be incorporated in other sys-tems – the band could be adjustable, crawling or fixed. Forexample, Figure 24.7 illustrates a crawling peg system withan exchange rate band.The exchange rate mechanism (ERM) of the EuropeanMonetary System (EMS) was an example of a joint floatagainst non-member currencies and an adjustably peggedexchange rate band with read more..

  • Page - 705

    TC 12p 374KI 7p3567824 THE BALANCE OF PAYMENTS AND EXCHANGE RATESIn this section we examine the causes of balance of pay-ments problems under fixed nominal exchange rates, inboth the short run and the long run. First, in an optionalsection, we look at short-run causes and whether balancewill be restored. We then look at longer-run, more funda-mental causes of balance of payments problems. Finally,we assess the desirability of fixed exchange rates.*Effects of shocks under fixed exchange read more..

  • Page - 706

    24.2 FIXED EXCHANGE RATES679exchange rate, wage and price flexibility in the long runwill eventually restore internal balance. The question is,how long will the long run be? How long will the recessionpersist? If it is too long, and if interest rates cannot be cut,then can expansionary fiscal policy be used? We examinethis in Box 24.2.Response to an external shockAssume now that there is a fall in demand for exports.Short-run effect.The fall in exports causes the currentaccount to go into read more..

  • Page - 707

    68024 THE BALANCE OF PAYMENTS AND EXCHANGE RATES2001, when the old currencies of the eurozone countrieswere still used, but were totally fixed to the euro, there wasno speculation that the German mark, say, would changein value against the French franc or the Dutch guilder.?When the UK joined the ERM in 1990, it was hoped thatthis would make speculation pointless. As it turned out,speculation forced the UK to leave the ERM in 1992. Canyou reconcile this with the argument that fixed read more..

  • Page - 708

    24.2 FIXED EXCHANGE RATES681Disadvantages of fixed exchange ratesThe new classical viewNew classicists make two crucial criticisms of fixed rates.Fixed exchange rates make monetary policy ineffective.Interest rates must be used to ensure that the overall bal-ance of payments balances. As a result, money supply mustbe allowed to vary with the demand for money in order tokeep interest rates at the necessary level. Thus monetarypolicy cannot be used for domestic purposes (see Box 24.2).Inflation read more..

  • Page - 709

    68224 THE BALANCE OF PAYMENTS AND EXCHANGE RATESwin (devaluation); tails they stay the same (no devalu-ation). This speculative selling will worsen the deficit, andmay itself force the devaluation. Speculation of this sorthad disastrous effects on some south-east Asian currenciesin 1997 (see Web Case 24.4) and on the Argentinian peso in2002 (see Web Case 24.6).?To what extent do Keynesians and new classicistsagree about the role of fixed exchange rates?PostscriptAn argument used in favour of read more..

  • Page - 710

    24.3 FREE-FLOATING EXCHANGE RATES683at international levels. For simplicity, let us assume thatthere is no inflation abroad. How will a floating exchangerate system cope with this internal shock of a rise in aggreg-ate demand? The exchange rate will simply depreciate to maintain the competitiveness of exports and importsubstitutes.For example, assume an initial exchange rate of £1 = $2.A UK product costing $2 in the USA will earn £1 for the UK exporter. If UK inflation now causes prices to read more..

  • Page - 711

    68424 THE BALANCE OF PAYMENTS AND EXCHANGE RATESthat, therefore, the long-term equilibrium exchange rate is constant over time. This is shown by the horizontal lineat erL.Now assume, as before, that there is a rise in aggregatedemand and a resulting rise in interest rates. This occurs attime t1. As the demand for imports rises, the current accountgoes into deficit. Higher interest rates, however, lead to afinancial inflow and an immediate appreciation of theexchange rate to er1. But then, the read more..

  • Page - 712

    24.3 FREE-FLOATING EXCHANGE RATES685BOX 24.3The table shows the degree of overvaluation or undervaluation in Big Mac PPP terms of a range of currencies. You can see that the pound is overvalued against the dollar by 12 per cent. In other words, for a Big Mac to cost the same in the UK as in the USA, the exchange rate would have to be 12 per cent lower, at £1 = $1.63, rather than themarket rate of £1 = $1.83.Our index shows that burger prices can certainly fall out of line with each other. If read more..

  • Page - 713

    68624 THE BALANCE OF PAYMENTS AND EXCHANGE RATESrate depreciates from r1 to r2. Speculators seeing the ex-change rate falling can react in one of two ways. The first iscalled stabilising speculation; the second is called destabilis-ing speculation (see section 2.5).Stabilising speculationThis occurs when speculators believe that any exchangerate change will soon be reversed.In our example, speculators may anticipate that the cen-tral bank will raise interest rates or take some other measureto read more..

  • Page - 714

    24.3 FREE-FLOATING EXCHANGE RATES687?Draw a similar diagram to Figure 24.9, showing how aninitial appreciation of the exchange rate would similarlybe reduced by stabilising speculation.Destabilising speculationThis occurs when speculators believe that exchange ratemovements will continue in the same direction.In our example, speculators may believe that inflationwill not be brought under control. They anticipate a con-tinuing fall in the exchange rate and thus sell now beforethe exchange rate read more..

  • Page - 715

    68824 THE BALANCE OF PAYMENTS AND EXCHANGE RATESbelow the purchasing-power parity rate. At this point specu-lators, believing that the rate will rise again, will start buying pounds again. This causes the exchange rate to rise.Obviously, governments prefer stabilising to destabilis-ing speculation. Destabilising speculation can cause severeexchange rate fluctuations. The resulting uncertainty isvery damaging to trade. It is very important, therefore, thatgovernments create a climate of read more..

  • Page - 716

    24.3 FREE-FLOATING EXCHANGE RATES689from this inflation will itself fuel the inflation by raisingthe price of imports.ConclusionNeither fixed nor free-floating exchange rates are free from problems. For this reason, governments have sought acompromise between the two, the hope being that someintermediate system will gain the benefits of both, whileavoiding most of their disadvantages.One compromise was tried after the Second World War. This was the adjustable peg. Another is the system that read more..

  • Page - 717

    69024 THE BALANCE OF PAYMENTS AND EXCHANGE RATESDefinitionBretton Woods system An adjustable peg systemwhereby currencies were pegged to the US dollar. TheUSA maintained convertibility of the dollar into gold atthe rate of $35 to an ounce.the financial account balance. This will influenceexchange rates and destroy the purchasing-powerparity theory. The current account will go out ofbalance (in an equal and opposite way to thefinancial account).3. External shocks will be reflected in changes read more..

  • Page - 718

    24.4 EXCHANGE RATE SYSTEMS IN PRACTICE691Problems of adjustment to balance of payments disequilibriaTo avoid internal policy being governed by the balance ofpayments, and to avoid being forced into a depression,countries with a fundamental deficit were supposed todevalue. There were several difficulties here, however.• Identifying whether a deficit was fundamental. Govern-ments were frequently overoptimistic about the futurebalance of payments position.• If devaluation did take place, it read more..

  • Page - 719

    69224 THE BALANCE OF PAYMENTS AND EXCHANGE RATESUS balance of payments deficits in the 1960s got steadilyworse. The financing of the Vietnam War, in particular,deepened the deficit. Dollars flooded out of the USA. Worldliquidity thus expanded rapidly, fuelling world inflation.Furthermore, the rapid growth in overseas dollar holdingsmeant that US gold reserves were increasingly inadequateto guarantee convertibility. Some countries, fearful that theUSA might eventually be forced to suspend read more..

  • Page - 720

    24.4 EXCHANGE RATE SYSTEMS IN PRACTICE693The UK experience of managed floatingFigure 24.12 shows the fluctuations in UK exchange ratessince 1976, with respect to both the dollar and the moreimportant trade-weighted average exchange rate with allother countries. As can be seen, the fluctuations have beenlarge and often violent. Other countries have experiencedsimilar fluctuations. Also, there have been clear long-termtrends, as Table 24.1 shows.But why have exchange rates changed so much? read more..

  • Page - 721

    69424 THE BALANCE OF PAYMENTS AND EXCHANGE RATESto prevent the exchange rate from rising too much. Vastamounts of sterling were sold, and the foreign exchangeacquired was used to build up the reserves and to pay offsome of the foreign loans of previous years.Then, from autumn 1977 to autumn 1981, the poundwas allowed to float relatively freely. The result was a mas-sive 30 per cent appreciation of the exchange rate (a 53 percent appreciation in the PPP rate!) from its low point in1976. There read more..

  • Page - 722

    24.4 EXCHANGE RATE SYSTEMS IN PRACTICE695However, in 1987 the pound began to rise. Oil priceswere firmer; inflation had fallen to just over 3 per cent andinterest rates were still very high relative to those of othercountries. The Chancellor, Nigel Lawson, anxious to avoidrepeating the damage to UK industry that was done by thehigh exchange rate of the early 1980s, was keen to preventthe pound rising. He was also keen to keep the exchange ratepegged as closely as possible to the German mark, read more..

  • Page - 723

    69624 THE BALANCE OF PAYMENTS AND EXCHANGE RATESbetween profit and loss for trading companies. There are anumber of reasons for this volatility:• Money supply or inflation targets. Central banks mayhave to make considerable changes to interest rates inorder to keep to their targets. These in turn causeexchange rate fluctuations.• A huge growth in international financial markets. Thishas encouraged the international transfer of money andcapital.• The abolition of exchange controls in read more..

  • Page - 724

    KI 9p58KI 8p43*APPENDIX: THE OPEN ECONOMY AND ISLM ANALYSIS697In this appendix, we show how the ISLM analysis that weexamined in section 19.3 can be extended to incorporatethe open economy. We will first assume a fixed rate ofexchange and then later a free-floating rate.Analysis under a fixed exchange rateThe BP curveWe start by introducing a third curve, the BP (balance ofpayments) curve. This curve, like the IS and LM curves,plots a relationship between the rate of interest (r ) and read more..

  • Page - 725

    69824 THE BALANCE OF PAYMENTS AND EXCHANGE RATESThe reason is that for any given rate of interest there will bea higher equilibrium level of national income than before.This will increase national income, but the extrademand for money that results will drive up interest rates.In a closed economy, equilibrium would now be at point b(r2, Y2), where IS2 = LM1. But in our open economy model,this equilibrium is above the BP curve. There is a balance ofpayments surplus. The reason for this is that the read more..

  • Page - 726

    *APPENDIX: THE OPEN ECONOMY AND ISLM ANALYSIS699savings) will an expansion of money supply lead to highernational income.?1. Why does this conclusion remain the same if the BP curve is steeper than the LM curve?2. Trace through the effects of a fall in exports (thereby shifting the BP curve).3. Show what will happen if there is (a) a rise inbusiness confidence and a resulting increase ininvestment; (b) a rise in the demand for moneybalance (say, for precautionary purposes).Analysis under read more..

  • Page - 727

    70024 THE BALANCE OF PAYMENTS AND EXCHANGE RATESIn an open economy under a floating exchange rate, thefall in the rate of interest will cause the exchange rate todepreciate and the BP curve to shift downwards. The depre-ciation will cause exports to rise and imports to fall. Thisincrease in aggregate demand will shift the IS curve to theright. The new equilibrium will thus be at point c, whereLM2 = IS2 = BP2. This represents a large change from the ini-tial point a.Thus monetary policy can have read more..

  • Page - 728

    *APPENDIX: THE OPEN ECONOMY AND ISLM ANALYSIS701Additional case studies on the book’s website ( Marshall–Lerner condition. An analysis of the determinants of the elasticities of demand and supply of a currency.24.2The gold standard. A historical example of fixed exchange rates.24.3The sterling crisis of early 1985. When the pound fell almost to $ turmoil in the 1990s. Two examples of speculative attacks on currencies: first on the Mexican read more..

  • Page - 729

    Chapter25Global and Regional Interdependence25.1 Globalisation and the problem of instability703Interdependence through trade703Financial interdependence704The need for international policy co-ordination70425.2 Concerted international action to stabilise exchange rates706International harmonisation706The European Monetary System 70725.3 European economic and monetary union (EMU)710The advent of EMU710Advantages of the single currency711Opposition to EMU71225.4 Achieving greater currency read more..

  • Page - 730

    TC 15p 46325.1 GLOBALISATION AND THE PROBLEM OF INSTABILITY703We live in an interdependent world. Countries are affectedby the economic health of other countries and by theirgovernments’ policies. Problems in one part of the worldcan spread like a contagion to other parts, with perhaps nocountry immune.There are two major ways in which this process of ‘glob-alisation’ affects individual economies. The first is throughtrade. The second is through financial markets.Interdependence through read more..

  • Page - 731

    70425 GLOBAL AND REGIONAL INTERDEPENDENCEinterdependence and their vulnerability to world tradefluctuations.?Are exports likely to continue growing faster than GDP indefinitely? What will determine the outcome?Financial interdependenceInternational trade has grown rapidly over the last 30 years,but international financial flows have grown much morerapidly. The value of banks’ holdings of liabilities to foreignresidents (individuals and institutions) has been increasingby an average of some read more..

  • Page - 732

    The USA has a huge current account deficit. In 2004, it was $666 billion (5.7 per cent of GDP), up from $531billion (4.8 per cent of GDP) in 2003. The chart showsthis deepening deficit since 1991.The current account deficit is offset by an equal andopposite capital-plus-financial account surplus, muchof which consists of the purchase of US governmentbonds and Treasury bills. These massive inflows to theUSA represent some 80 per cent of the savings whichthe rest of the world invests abroad. read more..

  • Page - 733

    70625 GLOBAL AND REGIONAL INTERDEPENDENCEpursuing incompatible policy goals? Would the cumulativeactions of individual nations cause the global economy to grow too fast? With such knowledge, fluctuations ininternational economic activity might be more effectivelyregulated, if not totally removed.Although co-operation is the ideal, in practice discordoften tends to dominate international economic relations.The reason is that governments are normally concernedwith the economic interests of other read more..

  • Page - 734

    25.2 CONCERTED INTERNATIONAL ACTION TO STABILISE EXCHANGE RATES707demand for money, interest rate fluctuations could besevere.• Harmonising interest rates would involve abandoningmonetary, inflation and exchange rate targets (unlessinterest rate ‘harmonisation’ meant adjusting interestrates so as to maintain monetary or inflation targets or afixed exchange rate).• Countries have different internal structural relation-ships. A lack of convergence here means that countrieswith higher read more..

  • Page - 735

    70825 GLOBAL AND REGIONAL INTERDEPENDENCEIn recent years, governments of the major industrialnations have tried to come to terms with the ever-growing interdependence of their economies.Economic disruptions in one country (e.g. a worseningUS budget or current account deficit or a unilateraldecision by, say, the ECB or Japan to raise interestrates) can have profound effects on the worldeconomy.G7 meetingsAs a result of the potentially highly unstable nature ofeconomic relationships, finance read more..

  • Page - 736

    25.2 CONCERTED INTERNATIONAL ACTION TO STABILISE EXCHANGE RATES709ERM an ‘adjustable peg’ system. All the currencies floatedjointly with currencies outside the ERM.If a currency reached the upper or lower limit against anyother ERM currency, intervention would take place tomaintain the currencies within the band. This would takethe form of central banks in the ERM selling the strong cur-rency and buying the weak one. It could also involve theweak currency countries raising interest rates read more..

  • Page - 737

    71025 GLOBAL AND REGIONAL INTERDEPENDENCEThe old ERM appeared to be at an end. The new ±15 percent bands hardly seemed like a ‘pegged’ system at all.However, the ERM did not die. Within months, the mem-bers were again managing to keep fluctuations within avery narrow range (for most of the time, within ±21/4 percent!).The road to EMUThe EU countries were right to stress the importance ofconvergence of their economies. Certainly, if they were toprogress from the ERM to eventual monetary read more..

  • Page - 738

    25.3 EUROPEAN ECONOMIC AND MONETARY UNION (EMU)711Stage 2 began on 1 January 1994 with the establishmentof the EMI. It attempted to co-ordinate monetary policyand encourage greater co-operation between EU centralbanks. During stage 2, the member states sought to meetfive convergence criteria:• Inflation: should be no more than 11/2 per cent above theaverage inflation rate of the three countries in the EUwith the lowest inflation.• Interest rates: the rate on long-term government read more..

  • Page - 739

    71225 GLOBAL AND REGIONAL INTERDEPENDENCEIncreased inward investment.Investment from the restof the world is attracted to a eurozone of some 310 millioninhabitants, where there is no fear of internal currencymovements. By contrast, the UK, by not joining, has foundthat inward investment has been diverted away to coun-tries within the eurozone.From 1990 to 1998, the UK’s share of inward investmentto EU countries (including from other EU countries) wasnearly 22.2 per cent. From 1999 to 2003, it read more..

  • Page - 740

    25.3 EUROPEAN ECONOMIC AND MONETARY UNION (EMU)713to be attracted to such countries. This could help to narrowthe gap between the richer and poorer member states.The critics of EMU counter this by arguing that labour isrelatively immobile, given cultural and language barriers.Thus an unemployed worker in Wales could not easilymove to a job in Turin or Helsinki. What the critics arearguing here is that the EU is not an optimal currency area(see Box 25.3).Perhaps the most serious criticism is that read more..

  • Page - 741

    71425 GLOBAL AND REGIONAL INTERDEPENDENCEaffect an oil-exporting country like the UK differently fromoil importing countries. This problem is more serious, the less the factor mobility between member countries andthe less the price flexibility within member countries.This problem, however, should not be overstated. Thedivergences between economies are often the result of a lack of harmony between countries in their demand-management policies: something that is impossible in thecase of monetary read more..

  • Page - 742

    25.4 ACHIEVING GREATER CURRENCY STABILITY715floating exchange rate, with no attempt by the central bankto support the exchange rate. With no intervention, thereis no problem of a shortage of reserves!The second is to share a common currency with othercountries: to join a common currency area, such as theeurozone, and let the common currency float freely. Thecountry would give up independence in its monetary pol-icy, but at least there would be no problem of exchange rateinstability within the read more..

  • Page - 743

    71625 GLOBAL AND REGIONAL INTERDEPENDENCEwould be to impose the tax only at times of exchange marketturbulence, or to impose a higher tax at such times. At leasta tax is far less distortionary than quantitative controls.Non-interest-bearing deposits.Here a certain percentageof inflows of finance would have to be deposited with thecentral bank in a non-interest-bearing account for a setperiod of time. Chile in the late 1990s used such a system.It required that 30 per cent of all inflows be read more..

  • Page - 744

    25.4 ACHIEVING GREATER CURRENCY STABILITY717of Washington’s Institute for International Economics.2Williamson advocates a form of crawling peg within broadexchange rate bands (see Figure 24.7 on page 677). Thiswould have four major features:• Wide bands. Currencies would be allowed to fluctuate by±10 per cent of their central parity.• Central parity set in real terms, at the ‘fundamental equilibrium exchange rate’ (FEER): i.e. a rate that is con-sistent with long-run balance of read more..

  • Page - 745

    71825 GLOBAL AND REGIONAL INTERDEPENDENCESecond, the wider bands would leave countries freer tofollow an independent monetary policy: one that couldtherefore respond to domestic needs.The main problem with the system is that it may notallow an independent monetary policy. If the rate ofexchange has to be maintained within the zone, monetarypolicy may sometimes have to be used for that purposerather than controlling inflation.Nevertheless, crawling bands have been used relativelysuccessfully by read more..

  • Page - 746

    25.4 ACHIEVING GREATER CURRENCY STABILITY719Additional case studies on the book’s website ( new economy. Does globalisation bring economic success?25.2High oil prices. What is their effect on the world economy?25.3Crisis in south-east Asia. Causes of the severe recession in many south-east Asian countries in 1997/8.25.4The 1997/8 crisis in Asia: the role played by the IMF.25.5Converging on the euro. Did the 11 countries that adopted the euro in 1999 genuinely read more..

  • Page - 747

    Chapter26Economic Problems of Developing Countries26.1 The problem of underdevelopment721The gulf between rich and poor countries721The meaning of ‘development’72126.2 International trade and development725The importance of international trade725Trade strategies725Approach 1: Exporting primaries726Approach 2: Import-substituting industrialisation (ISI)728Approach 3: Exporting manufactures73126.3 Structural problems within developing countries735The neglect of agriculture735Inappropriate read more..

  • Page - 748

    KI 1p4KI 17p12126.1 THE PROBLEM OF UNDERDEVELOPMENT721The gulf between rich and poor countriesThe typical family in North America, western Europe,Japan and Australasia has many material comforts: plenti-ful food to eat; a house or apartment with electricity andrunning hot and cold water; an inside toilet connected toan underground sewerage system; access to free or afford-able health care and education; numerous consumer dur-ables; holidays away from home; visits to the cinema, concerts, sports read more..

  • Page - 749

    72226 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESmaterial standard of living. But should development includesocial and political factors such as ‘self-esteem’, freedomfrom servitude and freedom of religion?The second problem is in measuring each of the items. It is possible to measure such things as income per head, literacy rates and mortality rates. It is much more difficult,however, to measure the achievement of social and pol-itical objectives such as self-esteem.The third problem is in read more..

  • Page - 750

    26.1 THE PROBLEM OF UNDERDEVELOPMENT723• The rules for the measurement of GNY are universallyagreed.• Virtually all countries compile GNY statistics.• Although not every item that affects human welfare isincluded in GNY, a sustained rise in GNY is generallyagreed to be a necessary condition for a sustained rise inwelfare.• There is a fairly close correlation between the level ofper-capita GNY and other indicators such as mortalityrates, literacy rates, and calorific and protein read more..

  • Page - 751

    72426 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESSince 1990, the United Nations Development Program(UNDP) has published an annual Human DevelopmentIndex (HDI). This is an attempt to provide a morebroadly based measure of development than GDP orGNY. HDI is the average of three indices based on threesets of variables: life expectancy at birth, education (a weighted average of adult literacy (two-thirds) andaverage years of schooling (one-third)), and real GDPper capita, measured in US dollars at read more..

  • Page - 752

    26.2 INTERNATIONAL TRADE AND DEVELOPMENT725Generally, the price of non-traded goods and services indeveloping countries will be lower than the price of similargoods and services in advanced countries. The level of GNYis therefore likely to understate the level of production inpoor countries. If, on the other hand, the proportion oftraded goods increases over time, the growth of GNY willagain overstate the growth in production. It is much better,therefore, to estimate GNY using purchasing-power read more..

  • Page - 753

    72626 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIEScountries. The main conclusion was that industrialisationwas the key to economic success.But industrialisation required foreign exchange to pur-chase capital equipment. This led to a policy of import-substituting industrialisation, which involved cutting backon non-essential imports and thereby releasing foreignexchange. Tariffs and other restrictions were imposed onthose imports for which a domestic substitute existed, orwhich were regarded as read more..

  • Page - 754

    26.2 INTERNATIONAL TRADE AND DEVELOPMENT727good. There is far too little demand within Zambia to con-sume its potential output of copper. The same applies toNamibian uranium or Peruvian tin.Exporting primaries provides an ‘engine for economicgrowth’.According to this argument, developing coun-tries benefit from the growth of the economies of the devel-oped world. As industrial expansion takes place in the richNorth, this will create additional demand for primariesfrom the poor read more..

  • Page - 755

    72826 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESmobile phones and iPods. In fact, the whole process hasbeen dubbed ‘Coca-Colanisation’.Deterioration in the terms of trade.The slow growth in de-mand for primary exports and the rapid growth in demandfor manufactured imports has led to chronic current accountbalance of payments problems for primary exporters. Thishas caused their exchange rates to depreciate and hencebrought a decline in their terms of trade, where a country’sterms of trade read more..

  • Page - 756

    26.2 INTERNATIONAL TRADE AND DEVELOPMENT729as one moves from the raw materials to the intermedi-ate product to the finished product stage. Thus finishedgoods have higher tariffs than intermediate products. Thisencourages assembly plants, which are protected by hightariffs from imported finished products, and are able toobtain components at a lower tariff rate.One of the problems with ISI is that countries are desper-ately short of resources to invest in industry. As a result, apolicy of ISI read more..

  • Page - 757

    73026 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESIt has involved artificially low real interest rates.Toencourage capital investment in the import-substitutingindustries, governments have often intervened to keepinterest rates low. This has encouraged the use of capital-intensive technology with a consequent lack of jobs. It hasalso starved other sectors (such as agriculture) of much-needed finance, and it has discouraged saving.It has led to urban wages above the market-clearing level.Wage read more..

  • Page - 758

    26.2 INTERNATIONAL TRADE AND DEVELOPMENT731deepens the divide between rich and poor. Finally, the relat-ively high wages of the modern sector encourage workersto migrate to the towns, where many, failing to get a job,live in dire poverty.Social, cultural and environmental costs.A policy of ISIoften involves imposing an alien set of values. Urban lifecan be harsh, competitive and materialistic. Moreover, thedrive for industrialisation may involve major costs to the environment, as a result of read more..

  • Page - 759

    73226 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESsaving a unit of foreign exchange by replacing imports withhome-produced goods. In other words, resources will beused more efficiently.Economies of scale.If the home market is too small to allow a firm to gain all the potential economies of scale, these can be gained by expanding into the exportmarket.Increased competition.By having to compete with for-eign companies, exporters will be under a greater competi-tive pressure than industries shielded read more..

  • Page - 760

    26.2 INTERNATIONAL TRADE AND DEVELOPMENT733barriers. This will encourage (a) resource saving in the short run, both through their better allocation and through reductions in X inefficiency (see Box 6.5), and (b) innovation and investment, as firms attempt to adoptthe latest technology, often obtained from developedcountries.Increased investment.To the extent that outward-lookingpolicies lead to a greater potential for economic growth,they may attract more foreign capital. To the extent read more..

  • Page - 761

    73426 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESthat the marginal propensity to save may be quite high. Theextra savings can be used to finance extra investment.It can lead to more employment and a more equal dis-tribution of income.According to the Heckscher–Ohlintheory, the manufactured goods in which a country willhave a comparative advantage are those produced bylabour-intensive techniques. Export expansion will thusincrease the demand for labour relative to capital, and cre-ate more read more..

  • Page - 762

    TC 3p21TC 7p2626.3 STRUCTURAL PROBLEMS WITHIN DEVELOPING COUNTRIES735capital goods stage. ISI, it was hoped, would allowcountries to benefit from the various dynamicadvantages associated with manufacturing.5. For many countries, however, ISI brought as many,if not more, problems than it solved. It often led tothe establishment of inefficient industries, protectedfrom foreign competition and facing little or nocompetition at home either. It led to considerablemarket distortions, with tariffs read more..

  • Page - 763

    73626 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESalso help by providing finance for the adoption of the newmethods.Education and advice.Many farmers are simply unawareof new more efficient farming methods. Training schemesor rural advisers can help here.Land reform.As population grows, land holdings aredivided and subdivided as they are passed from generationto generation. Thus many farmers operate on tiny plots ofland that can never yield an adequate income. Increasingly,they get into debt and read more..

  • Page - 764

    26.3 STRUCTURAL PROBLEMS WITHIN DEVELOPING COUNTRIES737In recent years, with the criticism of ISI has come thecriticism of capital-intensive technologies.• Capital-intensive equipment may require more main-tenance.• It may have to be imported, and may use a high propor-tion of imported inputs. This will put a strain on thecountry’s balance of trade. By using less domestic inputs,there will be less spread effect to other sectors of theeconomy: there will be a smaller multiplier effect.• read more..

  • Page - 765

    73826 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESsimply not been fast enough to create enough jobs for theseextra workers.Capital-intensity biasAs we have seen, import-substituting industrialisation hasinvolved a bias in favour of capital-intensive technology.This has led to the production of goods and to the use ofprocesses that provide only limited employment opportu-nities. As long as the relative price of capital to labour iskept low, or as long as there is a lack of modern read more..

  • Page - 766

    26.3 STRUCTURAL PROBLEMS WITHIN DEVELOPING COUNTRIES739• The ‘risk attitude’ of the person: in other words, howwilling potential migrants are to take the gamble ofwhether or not they will get a job.• The degree of misinformation. People may migrate tothe towns, attracted by the ‘bright lights’ of the city and the belief (albeit probably misplaced) that theirprospects are much better there.?What would be the effect on the levels of migration and urban unemployment of the creation of read more..

  • Page - 767

    74026 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESof women so that they have a freer choice over familysize, and policies directed at tackling extreme poverty sothat the very poor do not feel the need to have a largefamily as an insurance that they will be supported intheir old age.?1. Is there any potential conflict between the goals ofmaximising economic growth and maximisingeither (a) the level of employment or (b) the rate ofgrowth of employment?2. What is the relationship between read more..

  • Page - 768

    26.4 THE PROBLEM OF DEBT741The oil shocks of the 1970sIn 1973– 4, oil prices quadrupled and the world went intorecession. Oil imports cost much more and export demandwas sluggish. The current account deficit of oil-importingdeveloping countries rose from 1.1 per cent of GNY in 1973to 4.3 per cent in 1975.It was not difficult to finance these deficits, however. Theoil surpluses deposited in commercial banks in the indus-trialised world provided an important additional source offinance. The read more..

  • Page - 769

    In December 2001, the IMF refused a fresh loan of $1.3 billion to Argentina. This triggered a crisis in thecountry with mass rioting and looting. As the crisisdeepened, Argentina announced that it was defaultingon its $166 billion of foreign debt. This hardly came as a surprise, however. For many commentators, it wassimply a question of when.The severity of Argentina’s predicament wassummed up by a 2001 report from Jubilee Plus, whichstated:Argentina has to pay $75.3bn in foreign debtpayments read more..

  • Page - 770

    26.4 THE PROBLEM OF DEBT743But despite the apparent advances made by the ParisClub in making its terms more generous, the majority oflow-income countries failed to meet the required IMF con-ditions, and thus failed to have their debts reduced. What ismore, individual Paris Club members were often reluctantto reduce debts unless they were first convinced that othermembers were ‘paying their share’. Nevertheless, somecreditor countries have unilaterally introduced more gener-ous terms and read more..

  • Page - 771

    74426 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESEven with substantial debt rescheduling and some debtcancellation, highly indebted countries were being forcedto make savage cuts in government expenditure, much of iton health, education and transport. The consequence was agrowth in poverty, hunger, disease and illiteracy. Africancountries on average were paying four times more to richcountries in debt servicing than they were spending onhealth and education: it was like a patient giving a read more..

  • Page - 772

    26.4 THE PROBLEM OF DEBT745country reaches the ‘completion point’ and debts are can-celled by the various creditors, on a pro rata basis, to bringthe debt to the sustainable threshold.Despite the welcome given to the HIPC initiative back in1996, it has been heavily criticised:• The qualifying period is too long. By 2005, only 18 coun-tries had reached the completion point, with another 9having reached the decision point. The total amount of relief committed by the end of 2004 was £32 read more..

  • Page - 773

    74626 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESAccording to many charities, such as Oxfam, a muchbetter approach would be to target debt relief directly atpoverty reduction, with the resources released being usedfor investment in fields such as health, education, ruraldevelopment and basic infrastructure. The focus, they argue,should be on what countries can afford to pay after essen-tial spending on poverty relief and human development.?Imagine that you are an ambassador of a developingcountry read more..

  • Page - 774

    26.4 THE PROBLEM OF DEBT747Should all debt be cancelled and aid increased?In recent years there have been growing calls for the cancel-lation of debts and a significant increase in aid, especiallyfor the poorest developing countries, many ravaged by war,drought or AIDS. The United Nations has for many yearscalled on wealthy countries to give 0.7 per cent of theirGDP in aid. In practice they give only a little over 0.2 percent.As we have seen, the G8 meeting in Gleneagles in 2005agreed to cancel read more..

  • Page - 775

    74826 ECONOMIC PROBLEMS OF DEVELOPING COUNTRIESEND OF CHAPTER QUESTIONS1. Compare the relative merits of usingGNY statistics with those of various basicneeds indicators when assessing both thelevel and the rate of a country’s economicdevelopment.2. If a developing country has a comparativeadvantage in primary products, should thegovernment allow market forces to dictate thepattern of trade?3. What are the advantages and disadvantages for adeveloping country of pursuing a policy of ISI?4. read more..

  • Page - 776

    The Pacific Ocean –A blue demi-globe.Islands like punctuation marks.A cruising airliner,Passengers unwrapping pats of butter.A hurricane arises,Tosses the plane into the sea.Five of them flung onto an island beach,Survived.Tom the reporter.Susan the botanist.Jim the high-jump champion.Bill the carpenter.Mary the eccentric widow.Tom the reporter sniffed out a stream of drinkable water.Susan the botanist identified a banana tree.Jim the high-jump champion jumped up and down and gave them each read more..

  • Page - 777

    750POSTSCRIPT: THE CASTAWAYS OR VOTE FOR CALIBANBill the carpenter constructed a wooden water wheelAnd converted the water’s energy into electricity.Using iron ore from the hills, he constructed lampposts.They all worried about Mary, the eccentric widow,Her lack of confidence and her –But there wasn’t time to coddle her.The volcano erupted, but they dug a trenchAnd diverted the lava into the seaWhere it formed a spectacular pier.They were attacked by pirates but defeated themWith bamboo read more..

  • Page - 778

    As you will see if you flick back through the pages, there aremany diagrams and tables and several equations. But thisdoes not mean that there are many mathematical tech-niques that you will have to master in order to study thisbook. In fact there are relatively few techniques, but theyare ones which we use many times in many different con-texts. You will find that if you are new to the subject, youwill very quickly become familiar with these techniques. Ifyou are not new to the subject, read more..

  • Page - 779

    A:2APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISa certain level of income the expenditure on entertainmentbecomes greater than that on food.? What else is the diagram telling us?Representing real-life statisticsIn many cases, we will want to depict real-world data. Wemay want to show, for example, how unemployment haschanged over the years in a particular country, or howincome is distributed between different groups in the popu-lation. In the first we will need to look at time-series data. read more..

  • Page - 780

    APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISA:3are then joined up to form a single line. Thus if you wantedto find the level of unemployment at any time between2001 Q1 and 2005 Q1, you would simply find the appropri-ate date on the horizontal axis, read vertically upward tothe line you have drawn, then read across to find the levelof unemployment.Although a graph like this cannot give you quite such anaccurate measurement of each point as a table does, it givesa much more obvious picture read more..

  • Page - 781

    A:4APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISCross-section dataCross-section data show different observations made atthe same point in time. For example, they could show thequantities of food and clothing purchased at various levelsof household income, or the costs to a firm or industry ofproducing various quantities of a product.Table A1.3 gives an example of cross-section data. Itshows the distribution of household income in the UKbefore the deduction of taxes and the addition of read more..

  • Page - 782

    APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISA:5assume that unemployment has risen but inflation hasfallen. The government highlights the inflation statistics toshow how successful its policies have been. The oppositionparties do the opposite: they concentrate on the unemploy-ment statistics to demonstrate the failure of governmentpolicy.Graphical presentation of dataTwo graphs may present exactly the same data and yet con-vey a quite different impression about them. Figure A1.6shows how read more..

  • Page - 783

    A:6APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISAgain both were correct, but they had chosen either toinclude or to ignore the periods from 1979 to 1982 andfrom 1990 to 1993 when the real growth rate was negative.Index numbersTime-series data are often expressed in terms of index numbers. Consider the data in Table A1.5. It shows indexnumbers of manufacturing output in the UK from 1979 to2004.One year is selected as the base year and this is given thevalue of 100. In our example this is 2001. read more..

  • Page - 784

    APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISA:7the previous year. To work this out we use the followingformula:(It − It−1)×100It−1where It is the index in the year in question and It−1 is theindex in the previous year.Thus to find the growth rate in manufacturing outputfrom 1987 to 1988 we first see how much the index hasrisen (It − It−1). The answer is 89.5 − 83.4 = 6.1. But this doesnot mean that the growth rate is 6.1 per cent. According toour formula, the growth rate is read more..

  • Page - 785

    A:8APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISaffected by taxes, or by incomes; how the cost of producingwashing machines is affected by the price of steel; how therate of unemployment is affected by the level of govern-ment expenditure. These relationships are called functionalrelationships. We will need to express these relationshipsin a precise way, preferably in the form of a table or a graphor an equation.Simple linear functionsThese are relationships which produce a straight line read more..

  • Page - 786

    APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISA:9Notice two things about the relationship between theequation and the graph:• The point where the line crosses the vertical axis (at avalue of 4) is given by the constant (a) term. If the a termis negative, the line will cross the vertical axis below thehorizontal axis.• The slope of the line is given by the b term. The slope is 2/1: for every 1 unit increase in x there is a 2 unitincrease in y.?On a diagram like Figure A1.8 draw the graphs read more..

  • Page - 787

    A:10APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISincrease. At point a the slope of the curve is 11. This isfound by drawing the tangent to the curve and measuringthe slope of the tangent. At this point on the curve, whatwe are saying is that for each one unit increase in outputthere is an £11 increase in costs. (Obviously as the graph iscurved, this rate of increase will vary at different outputs.)This rate of increase in costs is known as the marginalcost. It is the same with other read more..

  • Page - 788

    APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISA:11From the second quarter of 1990 unemployment rosecontinuously for many quarters. By the third quarter of1991 unemployment had increased by some 0.75million. What good news could the governmentpossibly draw from this?Governments, always in search of any glimmer ofgood economic news, proclaimed that unemploymentwas rising more slowly (in other words, that the rate ofincrease in unemployment was falling). This wasperfectly correct.To show this let read more..

  • Page - 789

    A:12APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISIt can be seen at a glance that profits are maximised at an output of 6 units. But we could have worked this outdirectly from the profit equation without having to drawup a table or graph. How is this done?Remember that when we differentiate a curve, the equa-tion we get (known as ‘the first derivative’) gives us theslope of the curve. You can see that at the point of max-imum profit (the top of the curve) its slope is zero: the tangent read more..

  • Page - 790

    APPENDIX 1: SOME TECHNIQUES OF ECONOMIC ANALYSISA:13partial differentiation. This involves the same techniqueas simple differentiation but applied to just the one vari-able that is not held constant.Thus to find the rate of change of costs with respect toquantity in equation (8), we differentiate the equation withrespect to Q and ignore the W term. We ignore it as it isheld constant and is thus treated like the constant (20)term in the equation. Using the rules of differentiation, thepartial read more..

  • Page - 791

    A:14APPENDIX 2: WEBSITESAll the following websites can be accessed from this book’s own website ( When youenter the site, click on Hot Links. You will find all the followingsites listed. Click on the one you want and the ‘hot link’ will takeyou straight to it.The sections and numbers below refer to the ones used in theWeb icons throughout the text. Thus if the icon contained thenumber A21, this would refer to the Money World site.(A) General news read more..

  • Page - 792

    APPENDIX 2: WEBSITESA:1525. Japanese Economic Foundation26. Ministry of International Trade and Industry ( Japan)27. Nomura Research Institute ( Japan)28. Nanyang Technological University, Singapore: Statistical DataLocators29. Richard Tucker’s Data Resources site30. Oanda Currency Converter31. World Economic Outlook Database ( IMF)32. Economist Country Briefings33. OFFSTATS links to data sets34. Treasury Pocket Data Bank (source of UK and world economicdata)35. Economic and Social Data read more..

  • Page - 793

    A:16APPENDIX 2: WEBSITES7. Eurostat8. US Federal Reserve Bank9. Netherlands Central Bank10. Bank of Japan11. Reserve Bank of Australia12. Bank Negara Malaysia ( English)13. Monetary Authority of Singapore14. National Bank of Canada15. National Bank of Denmark ( English)16. Reserve Bank of India17. Links to central banks from the Bank for InternationalSettlements18. The London Stock Exchange(G) European Union and related sourcesFor information on European issues, the following is a wide range read more..

  • Page - 794

    THRESHOLD CONCEPTSPage1. Choice and opportunity cost.82. Rational decision making involves choices at the margin.103. People respond to incentives. It is important, therefore, that these have the desired effect.214. Markets equate demand and supply.225. People gain from voluntary economic interaction.246. Markets may fail to meet social objectives.267. Governments can sometimes improve market outcomes.268. Elasticity: of a variable to a change in a determinant.599. People’s actions depend on read more..

  • Page - 795

    T:2THRESHOLD CONCEPTS AND KEY IDEAS8. Equilibrium is the point where conflicting interests are balanced. Only at this point is the amount that demanders are willing to purchase the same as the amount that suppliers are willing to supply. It is a point that will be reached automatically in a free market through the operation of the price mechanism.439. Elasticity. The responsiveness of one variable (e.g. demand) to a change in another (e.g. price). This concept isfundamental to understanding how read more..

  • Page - 796

    THRESHOLD CONCEPTS AND KEY IDEAST:328. Externalities are spillover costs or benefits. Where these exist, even an otherwise perfect market will fail to achieve social efficiency.30029. The free-rider problem. People are often unwilling to pay for things if they can make use of things that other people have bought. This problem can lead to people not purchasing things that would be to the benefit of them and other members of society to have.30330. The problem of time lags. Many economic actions read more..

  • Page - 797

    EC6_Z04.qxd 10/27/05 17:17 Page 4 read more..

  • Page - 798

    Absolute advantageA country has an absolute advant-age over another in the production of a good if it can produce it with less resources than the other country can.Accelerationist theoryThe theory that unemploymentcan only be reduced below the natural rate at the cost ofaccelerating inflation.Accelerator coefficientThe level of induced investmentas a proportion of a rise in national income: α = Ii /∆Y.Accelerator theoryThe level of investment depends onthe rate of change of national income, read more..

  • Page - 799

    G:2GLOSSARYcountry’s payments to or deposits in other countries(debits) and its receipts or deposits from other countries(credits). It also shows the balance between these debitsand credits under various headings.Balance of payments on current accountThe balanceon trade in goods and services plus net investmentincome and current transfers.Balance on trade in goodsExports of goods minusimports of goods.Balance on trade in goods and services (or balance oftrade)Exports of goods and services read more..

  • Page - 800

    GLOSSARYG:3Collusive oligopolyWhere oligopolists agree (formallyor informally) to limit competition between themselves.They may set output quotas, fix prices, limit product pro-motion or development, or agree not to ‘poach’ eachother’s markets.Collusive tenderingWhere two or more firms secretlyagree on the prices they will tender for a contract. Theseprices will be above those which would be put in under agenuinely competitive tendering process.Command-and-control (CAC) systemsThe use of read more..

  • Page - 801

    G:4GLOSSARYDebit cardA card that has the same use as a cheque. Itsuse directly debits the person’s current account.Debt servicingPaying the interest and capital repay-ments on debt.DecilesDivisions of the population into ten equal-sizedgroups (an example of a quantile).Decision tree (or game tree)A diagram showing thesequence of possible decisions by competitor firms andthe outcome of each combination of decisions.Debentures (company bonds)Fixed-interest loans tofirms. These assets can be read more..

  • Page - 802

    GLOSSARYG:5DumpingWhen exports are sold at prices below mar-ginal cost – often as a result of government subsidy.DuopolyAn oligopoly where there are just two firms inthe market.EconometricsThe science of applying statistical tech-niques to economic data in order to identify and test eco-nomic relationships.Economic discriminationWhen workers of identicalability are paid different wages or are otherwise discrimin-ated against because of race, age, sex, etc.Economic efficiencyA situation where read more..

  • Page - 803

    G:6GLOSSARYeventually moving back to the new long-run equilibriumlevel.Exchange rate: realA country’s exchange rate adjustedfor changes in the domestic currency prices of its exportsrelative to the foreign currency prices of its imports. If acountry’s prices rise (fall) relative to those of its tradingpartners, its real exchange rate will rise (fall) relative tothe nominal exchange rate.Exchange rate regimeThe system under which the gov-ernment allows the exchange rate to be read more..

  • Page - 804

    GLOSSARYG:7FlowAn amount of something occurring over a period oftime: e.g. production per week, income per year, demandper week. (Contrasts with stock.)Flow-of-funds equationThe various items making up anincrease (or decrease) in money supply.Forward exchange marketWhere contracts are madetoday for the price at which currency will be exchangedat some specified future date.FranchisingWhere a firm is given the licence to operate a given part of an industry for a specified length of time.Free read more..

  • Page - 805

    G:8GLOSSARYH-form organisation (holding company)Where theparent company holds interests in a number of sub-sidiary companies.Historic costsThe original amount the firm paid for factors it now owns.Hit-and-run competitionWhen a firm enters an indus-try to take advantage of temporarily high profits andthen leaves again as soon as the high profits have beenexhausted.Horizontal equityThe equal treatment of people in thesame situation.Horizontal mergerWhen two firms in the same industryat the read more..

  • Page - 806

    GLOSSARYG:9Injections ( J )Expenditure on the production of domes-tic firms coming from outside the inner flow of the cir-cular flow of income. Injections equal investment (I )plus government expenditure (G) plus expenditure onexports ( X ).Input–output analysisThis involves dividing the eco-nomy into sectors where each sector is a user of inputsfrom and a supplier of outputs to other sectors. The tech-nique examines how these inputs and outputs can bematched to the total resources read more..

  • Page - 807

    G:10GLOSSARYvariable. (It is assumed that the least-cost method of production will be chosen for this extra output.)Long-run profit maximisationAn alternative theory ofthe firm which assumes that managers aim to shift costand revenue curves so as to maximise profits over somelonger time period.Long-run shut-down pointThis is where the AR curve istangential to the LRAC curve. The firm can just makenormal profits. Any fall in revenue below this level willcause a profit-maximising firm to read more..

  • Page - 808

    GLOSSARYG:11M-form (multi-divisional form) of corporate organisa-tionWhere the firm is split into a number of separatedivisions (e.g. different products or countries), with eachdivision then split into a number of departments.MicroeconomicsThe branch of economics that studiesindividual units: e.g. households, firms and industries. It studies the interrelationships between these units indetermining the pattern of production and distributionof goods and services.Minimum priceA price floor set read more..

  • Page - 809

    G:12GLOSSARYof unemployment at which the vertical long-run Phillipscurve cuts the horizontal axis.)Non-bank private sectorHouseholds and non-bankfirms: in other words, everyone in the country other thanbanks and the government (central and local).Non-collusive oligopoly Where oligopolists have no agree-ment between themselves either formal, informal or tacit.Non-excludabilityWhere it is not possible to provide agood or service to one person without it thereby beingavailable for others to read more..

  • Page - 810

    GLOSSARYG:13Poverty trap (for developing countries)When countriesare too poor to save and invest enough to achieve real percapita growth.Poverty trap (for individuals)Where poor people arediscouraged from working or getting a better job becauseany extra income they earn will be largely taken away intaxes and lost benefits.Predatory pricingWhere a firm sets its prices below aver-age cost in order to drive competitors out of business.Preferential trading arrangementsA trade agreementwhereby read more..

  • Page - 811

    G:14GLOSSARYdeficit of the public sector (central government, localgovernment and public corporations), and thus theamount that the public sector must borrow.Public-sector debt repayment (PSDR) or Public-sectorsurplusThe (annual) surplus of the public sector, andthus the amount of debt that can be repaid.Purchasing-power parity theoryThe theory that theexchange rate will adjust so as to offset differences incountries’ inflation rates, with the result that the samequantity of internationally read more..

  • Page - 812

    GLOSSARYG:15Regulatory captureWhere the regulator is persuaded tooperate in the industry’s interests rather than those ofthe consumer.Relative priceThe price of one good compared withanother (e.g. good X is twice the price of good Y ).Replacement costsWhat the firm would have to pay toreplace factors it currently owns.Resale (or retail) price maintenanceWhere the manu-facturer of a product (legally) insists that the productshould be sold at a specified retail price.Restrictive practiceWhere read more..

  • Page - 813

    G:16GLOSSARYmake at least one person better off without making any-one worse off.Social rate of discountA rate of discount that reflectssociety’s preferences for present benefits over future ones.Social-impact standardsPollution control that focuseson the effects on people (e.g. on health or happiness).Sole proprietorshipA firm owned by one person. Thatperson has unlimited liability.Special depositsDeposits that the banks can be requiredto make in the Bank of England. They remain read more..

  • Page - 814

    GLOSSARYG:17Sustainability (environmental)The ability of the envir-onment to survive its use for economic activity.Sustainable outputThe level of national output corres-ponding to no excess or deficiency of aggregate demand.Tacit collusionWhere oligopolists take care not toengage in price cutting, excessive advertising or otherforms of competition. There may be unwritten ‘rules’ ofcollusive behaviour such as price leadership.Takeover bidWhere one firm attempts to purchaseanother by read more..

  • Page - 815

    G:18GLOSSARYUniversal benefitsBenefits paid to everyone in a certaincategory irrespective of their income or assets.UtilAn imaginary unit of satisfaction from the consump-tion of a good.Value added tax (VAT)A tax on goods and services,charged at each stage of production as a percentage ofthe value added at that stage.Variable costsTotal costs that vary with the amount ofoutput produced.Variable factorAn input that can be increased in supplywithin a given time period.Velocity of circulationThe read more..

  • Page - 816

    ability, inequality and 271absolute advantage 637absolute poverty 264, 271, 272absolute values A:5abundance 640, 726scarcity and 13accelerationist theory 582–3, 583accelerator 475, 535, 596, 728coefficient 472effect 472, 474, 537interaction with multiplier 473–4,535, 537theory 458, 472, 484–6, 472accountability (to shareholders) 356acid rain 334, 342, 357acquisitions 213, 216–17, 349acreage controls (under CAP) 85Action Plan (EU) 662active balances 498actual economic growth 377–9, read more..

  • Page - 817

    I:2INDEXaggregate supply (continued )Keynesian approach 440, 575 – 8of labour 400 –2, 576 – 8of labour curve 400 –2, 400long-run 575 – 8monetarist approach 447Phillips curve and 586, 587–90, 591,592, 596price levels and 405 –7shocks 579short-run 574 –5unemployment and 400 –1, 403,445, 581aggression (barrier to entry) 167agricultural policybuffer stocks 80 –1, 80CAP 83 – 6, 659demand problems 79EU 78, 80, 82, 83 – 6, 659government intervention 78 – 87price fluctuations read more..

  • Page - 818

    INDEXI:3bank (or deposit) multiplier 492,542–3, 544, 546, 547, 492Bank Advisory Committee (BAC) 743bank bills 484bank deposits 481, 490 –2Bank of England 223, 490, 491, 566balance sheet 486 –7bank assets with 483 – 4, 549bank rate 557– 8, 560control of interest rate 369, 413,423, 425, 550 –1exchange rate and 420, 421, 423,494, 672, 687, 693government and 418, 423, 486, 487,494–5, 544, 563independence 550, 564, 695lender of last resort 489Monetary Policy Committee 487,488–9, 542, read more..

  • Page - 819

    I:4INDEXbusiness cycles (continued)demand management policies 442economic growth and 377– 84, 599fiscal policy and 529, 535 – 6, 540 –1,564fluctuation 381, 382–3, 475inflation and 410international 381–3, 704 – 6investment and 472–3irregular 536Keynesian analysis 442, 471– 6multiplier/accelerator interaction473 – 4, 535, 537output gap and 382phases 380, 398, 424 –5, 471political 425, 585in practice 380 –2real 381, 447, 590–2, 447, 591recession 380, 381, 471– 6stocks read more..

  • Page - 820

    INDEXI:5choice (continued)rational 8, 10, 292, 324, 8social implications 12within households 98 –9Churchill, Winston 437circular flow of income 15 –16, 370 –3,452, 474equilibrium in 372–3interdependence 295, 296Keynesian analysis 441–2macroeconomic objectives and 372circulation, velocity of 370, 436, 510,511–12, 548, 566, 436claimant unemployment 397, 624,397class of recipient (income) 264classical analysisoutput and employment 435 – 6prices and inflation 436classical read more..

  • Page - 821

    I:6INDEXconstant returns to scale 131, 142, 604construction costs (roads) 349consumer demand 295, 296, 458, 728consumer durables 100 –1, 116, 454,482, 100consumer expenditureGDP measurement 391, 392inflation and 407, 413price elasticity of demand and 50 –2savings and 457total 50 –1, 51unemployment and 402consumer information 314consumer price index (CPI) 359, 360,407, 564, A:7consumer protection 313–14consumer sovereignty 164consumer surplus 94, 281, 293, 305,650, 94marginal read more..

  • Page - 822

    INDEXI:7costs (in cost-benefit analysis)discounting future 319distribution of 319, 322identifying 316measurement 316 –18council tax 278, 625, 630countervailing power 195 – 6, 324, 195Cournot equilibrium 190Cournot model 189 –90, 189crawling peg exchange system 676,677, 717, 676credible threat/promise 194credit 736bank liquidity and 493cards 479–80, 498, 499, 510–11, 552control 544, 551–2, 560creation of 490 –3, 510money supply and 490 –3rationing 544, 551–2, 560crop yields read more..

  • Page - 823

    I:8INDEXdemand (continued)price elasticity of see price elasticityof demandproblems (agriculture) 79 – 80under risk/uncertainty 100 –5for road space 340 –1Say’s law 436, 441, 436schedules 35, 38, 35time dimension 61– 4unstable (for money) 507– 8, 552–3demand-deficient unemployment seeunemploymentdemand-pull inflation see inflationdemand-shift inflation 412demand-side policy 6, 413, 471, 596,690, 6, 413under Conservative government561rules-based approach 564supply-side policies read more..

  • Page - 824

    INDEXI:9discretionary fiscal policy 532, 533 – 8,560 –2, 565 –70, 713, 533discretionary investment 210discretionary monetary policy 561–2,565 –70discretionary system (regulation) 359discriminationeconomic 243 – 8, 243inequality and 273legislation 244 –5price 197–201, 350, 197wage determination 243 – 8diseconomies of scale 133, 142, 143in customs union 657external 134, 163, 134technical 144disequilibrium 21, 300, 372, 529balance of payments 674, 678, 681,688, 691exchange rate read more..

  • Page - 825

    I:10INDEXeconomies of scale (continued)in developing countries 729, 732efficiency and 132in EU 659, 661, 662external 133, 163, 167, 644, 657,133financial 133, 488growth maximisation 212internal 644, 657international trade 636, 644, 647manufacturing exports 732merger for 213under monopoly 166 –7, 170 –1perfect competition and 163 – 4privatisation and 356, 357economies of scope 133, 167, 133in banking 488economists 4 –16, 596economyexpectations and 596overall performance 557state of read more..

  • Page - 826

    INDEXI:11equilibrium (continued)exchange rate 421, 501–2, 670, 676,683 – 4, 692of firm 160 –1, 162–3, 178 – 9, 218foreign exchange markets 501–2gains from trade 643, 644general see general equilibriumof industry 182–3interest rates 255, 501, 502, 545,550, 672ISLM analysis 518 –19, 520 –1long-run 162–3, 164, 178 –9, 683 – 4in money market 501, 517national income 462–3, 601–2new (movement to) 43 –5output 168 –9price 20, 43 –5, 168 –9, 222, 224,407, 20short-run read more..

  • Page - 827

    I:12INDEXexchange rates (continued)floating see floating exchange ratefree-floating see free-floatingexchange rategovernment intervention and422–3, 672– 4index 419inflation and 421, 669, 678, 679,681, 682, 695, 717–18interest rate and 421, 423, 553, 674,678intermediate regimes 672, 676 –7,672ISLM analysis 697–700Keynesian policy 445, 446, 669, 678,681–2, 694management of 422–3meaning of 419 –20monetary policy and 674, 680, 681,694, 718money supply and 507, 509, read more..

  • Page - 828

    INDEXI:13factors of production 4, 636, 641, 4capital as 134 –9, 249 –50, 601–3circular flow 15 –16, 370 –1income distribution 264labour as 134 –9, 229, 242land as 249, 259markets 15 –16, 22 –3, 299mobility 273non-human 249 –50optimum combination 134 – 9ownership 126 –7productivity of 386, 601quantity of 600factory work 238fair competition 652fairness 357, 358fallacy of composition 80, 193, 467family 98 –9, 112–13, 400, 737fan charts 569farm income 79 – 80federal read more..

  • Page - 829

    I:14INDEXflexibility (continued)labour market 220, 246 –7, 275, 615managed 676, 692numerical 246, 247, 246prices/wages 432regulation system 359flexible exchange rate 677flexible firm 246–7, 620, 246flexible prices 432, 587flexible wages 432, 587floating exchange rate 420, 509, 513,560, 420fiscal policy under 689, 699ISLM analysis 699 –700monetary policy under 689,699 –700open economy 420, 421, 699 –700floors, ceiling and 475flow-of-funds equation 495 – 6, 495flow diagrams read more..

  • Page - 830

    INDEXI:15goodscircular flow 15 –16, 296, 370 –3complementary 36, 60, 341, 36deadweight loss from taxes 311direct provision 314 –15domestically produced 370 –1, 455,370free movement 655free at point of delivery 76 –7harmful (imports) 648illegal see illegal productsindirect tax on see indirect taxationinferior see inferior goodsjoint supply 41, 42, 41necessity 58normal 36, 59– 60, 112–14, 36, 60,112optimum combination 97– 9production see productionprohibiting sale of 77substitute read more..

  • Page - 831

    I:16INDEXharmonised consumer price index 407Hayek, F.von 324 –5health care/servicesas benefit in kind 274, 284hospital treatment 76 –7, 618market system 308 – 9health and safety (EU policy) 660heavily indebted poor countries(HIPC)initiative 744 – 6, 747Heckscher-Ohlin theory 726, 734, 736,726Hewitt, Patricia 355Hicks, John R. 322Hicks-Kaldor criterion 322high occupancy vehicle lanes 345hire purchase credit 544hiring 250, 251historic costs 126 –7, 126Hitch, C.J. 190Hoffman La-Roche read more..

  • Page - 832

    INDEXI:17income effect (continued)normal goods 113 –14of price change 111–16, 111tax cut 613, 626tax rise 282–3, 282wage rise 230income elasticity of demand 58 – 60,681, 58agriculture 79 – 80formula 58imports/exports 679income-consumption curve 110for primary products 727income and expenditure approach464–6income method (GDP measurement)373 – 4, 389 – 91income redistribution 264, 533benefits and 287economic costs of 281–2economic growth and 378government expenditure and 274 read more..

  • Page - 833

    I:18INDEXinflation (continued)aggregate supply and 407, 409,410 –11, 523 – 6, 578 – 81causes 409 –13, 579, 581in circular flow 372classical analysis 436control of 523cost-push 411–12, 414, 559,579 – 80, 581, 592–3, 615, 681,411costs 408–9, 707demand-pull 409 –10, 411–12, 424,470, 578 –9, 580, 582, 584, 409demand-shift 412demand-side policies 409 –10,411–12, 413–14, 424, 561, 413elimination 584EMU and 711, 712exchange rate and 421, 669, 678,679, 681, 682, 695, read more..

  • Page - 834

    INDEXI:19international business cycles 381–3,704–6international harmonisation 706 – 8,706International Labour Organisation(ILO) 397, 398international liquidity 681, 688,691–2, 705, 681International Monetary Fund (IMF)423, 560, 690 –1, 693, 708, 715,741–3HIPC initiative 744 – 6, 747quotas 691international policy coordination704–6international trade 481–2absolute advantage 637advantages 636 – 45comparative advantage 636 – 41,650 –1and development 725 –35effect on factor read more..

  • Page - 835

    I:20INDEXKeynesianism/Keynesians (continued)aggregate supply 440, 575 – 8background to theory 452– 63business cycle 442, 471– 6circular flows in 441–2classical macroeconomics and439–41criticism on non-intervention 595demand management policies seedemand management policiesdemand for money 514employment/inflation 441–2exchange rates 445, 446, 669, 678,681–2, 694extreme 447– 8, 515, 574fiscal policy 432, 442, 529, 555 – 6fixed exchange rates 678, 681–245° line diagram read more..

  • Page - 836

    INDEXI:21legislation (continued)monopolies 313, 350, 352, 353oligopolies 313prohibiting/regulating undesirablebehaviour 313 –14transport 344 –5leisure 100, 231, 282, 284 –5lender of last resort 489, 546, 548, 489lending, deposit taking and 482–4Lenin, V.I. 18less developed countries 637– 41liabilities 482of banks 482–3eligible 542libertarian movement 25libertarianism see neo-Austrian/libertarian schoollicences (car use) 345, 346lifelong learning 621limit pricing 168–9, 168linear read more..

  • Page - 837

    I:22INDEXMacSharry reforms 85 – 6mainstream consensus 448 – 9maintenance costs 251Major government 355, 401, 613majority voting (EU) 660Malthus, Thomas Robert 122managed flexibility 676, 692managed floating 676, 688, 689, 676forms of managed flexibility 692problems (since 1972) 692UK experience 693 –5managed trade 647managerial utility maximisation 206,210managers 206, 208, 210manufactured exports 679, 731– 4manufactured imports 728manufactured products 679, 727,731– 4manufactured read more..

  • Page - 838

    INDEXI:23markets (continued)size 657social efficiency through 293 –5supply curve 40 –1Marx, Karl 97, 229Marxism 229, 448mass rail transit (MRT) system 346materials, free movement of 655mathematical techniques A:1–A:12maturity date 484, 485maturity gap 485maturity transformation 481maximax (in game theory) 192, 193,205, 338, 192maximin (in game theory) 192, 193,205, 192maximising by managers 206, 208,210maximising theories, alternative209 –19maximum point of a curve A:10 –A:12maximum read more..

  • Page - 839

    I:24INDEXmoney (continued)current transfers 416definition 479, 480establishing value 480evaluation role 480functions 479 – 80interest rates and 478 –503, 506–7M0 490, 491, 494, 510, 543 – 4, 547,549, 558, 563M1 491M2 491M3 490, 491, 495, 548, 549, 561M3 (eurozone) 490, 491M4 490, 491, 493 – 6, 510, 544, 549,563marginal utility 96 –7medium of exchange 479 – 80, 479motives for holding 497multiplier 493, 494, 548 –9, 493narrow definitions 480near 493printing extra 438 –9quantity read more..

  • Page - 840

    INDEXI:25multiplier (continued)marginal propensity to consume464–5, 466 –7money 493, 494, 548 – 9, 493numerical illustration 465size of 517, 533, 535withdrawals/injections 463 –5multiplier effect 441–2, 493, 533–4, 441on 45° line diagram 467– 8regional 625, 657, 625world 652mutual recognition 659, 660, 661, 660narrow definitions of money 480narrow monetary base 490Nash equilibrium 190, 192, 193, 194,190National Bus Corporation 617national debt 487, 529, 546, 706, 711,529national read more..

  • Page - 841

    I:26INDEXnon-marketed items 376non-monetary benefits 315, 316,317–18non-monetary costs 315, 316non-monetary externalities 318non-price competition 180, 182, 196,180non-profit institutions servinghouseholds (NPISH) 391non-renewable resources 260, 329,379non-rivalry 302non-tariff barriers 660non-traded goods (in developingcountries) 723, 725non-union labour 239normal goods 36, 59 – 60, 112–14, 36,60, 112normal profit 151, 152, 153, 159 – 60,235, 151normal rate of return 255normative read more..

  • Page - 842

    INDEXI:27Paris Club 741, 743, 744park-and-ride schemes 344parking charges 341, 346 –7parking restrictions 345parking spaces (tax) 345, 347part-time work 243, 247, 274, 397,614, 620partial derivative A:12partial differentiation A:12partial equilibrium 22participation rate 603 – 4, 603passenger transport 339 – 48patents 255, 623, 653, 737PAYE system 277, 280peak-load pricing 198peaking out phase (business cycle) 380pedestrian-only areas 345pensions 272, 274, 284, 285, 371, 393per-capita read more..

  • Page - 843

    I:28INDEXpre-trade production possibilites638 –9precautionary demand for money497–9precautionary motive (holdingmoney) 497predatory pricing 175, 201, 353, 201prediction 27, 28see also speculationpreferential tradingarrangements 654 –5, 654common market 655, 657, 655customs union 655 –7, 655EU 659 – 65most-favoured nations 652in practice 657– 8trade creation 655 – 6, 657trade diversion 656 –7types of arrangements 655see also international tradepresent value approach 252–3, read more..

  • Page - 844

    INDEXI:29privatisation (continued)potential problems 356 –7regulation and 355 – 63supply-side policies 617, 621privatised industriesbehaviour 358competition in 356, 360 –2externalities 357, 358as monopoly 357– 8privatised utilities 314, 356electricity industry 360 –1, 362merger 216regulation 359UK 360 –2problem of the second best 308procurement hubs 165procurement policies 646, 655producer sovereignty 648producer supply 295, 296producer surplus 295, 305producersaims of 41in circular read more..

  • Page - 845

    I:30INDEXpublic interest 24alernative maximising theories218 –19competition policy and 348 –9, 353contestable markets and 175monopolistic competition and180 –1monopoly and 169 –71oligopoly and 195 – 6ownership and 355perfect competition and 164price discrimination and 201satisficing and 221public limited company 205 – 6, 256,205public opinion, environment and 329public ownership 315arguments against 355 – 6arguments for 355of nationalised industries 315, 355,356, 357of natural read more..

  • Page - 846

    INDEXI:31Regional Development Agencies(RDAs) 622, 627, 630, 627regional electricity companies 360,362Regional Greenhouse Gas Initiative337regional interdependence 706 –18regional multiplier effects 625, 657,662, 625regional policy 404approaches 626disparities 624 –5effectiveness 627EU 622, 628 – 9, 659, 712government attitudes 630imbalance (causes) 625interventionist policies 626UK 627, 628 –9Regional Selective Assistance (RSA)627regional unemployment 404, 624 – 6,627, 404regression read more..

  • Page - 847

    I:32INDEXsatisficing 219 –20, 221savingsin circular flow 371consumption and 457determinants 455effect of increase 602–3, 605golden-rule savings rate 603interest rate and 516investment and 372marginal propensity to save 455,466–7, 470, 734, 455net 371, 455, 457optimum rate 603paradox of thrift 467as withdrawals 371, 455, 457Say, Jean-Baptiste 436Say’s law 436, 441, 436scarcity 4, 8, 20, 23, 297, 4abundance and 13problem of 4 –5, 13rationing 19, 71–2, 323, 71search procedure read more..

  • Page - 848

    INDEXI:33social-impact standards 333social benefit 301marginal 292–3, 301–2, 342road usage 342social chapter (Maastricht Treaty) 660social charter 659 – 60social cost 301, 620, 731, 301marginal 293 – 4, 301–2, 304,309 –11, 330, 342of pollution 312road usage 342social effects (economic growth) 379social efficiency 292, 297, 292approach (environment) 330, 331,334in exchange 298 –9externalities and 293, 295, 300 –2,308general equilibrium and 294, 295 –7in goods market 298 read more..

  • Page - 849

    I:34INDEXsubsidies 623advantage of 312in agriculture 81–2, 84, 86in depressed areas 626disadvantage of 312environment 333GDP measurement 389, 390 –1government intervention 309 –12income method (GDPmeasurement) 389, 391income redistribution 274privatisation and 358protection and 646, 647taxation and 309 –12trade restriction by 646 –7, 648, 651transport 347, 357subsistence production 17substitute goods 34, 36, 41, 51, 60,341, 36substitutes in supply 41substitution effect 34, 35, 532, read more..

  • Page - 850

    INDEXI:35taxation 77, 400, 438ad valorem 73, 278, 73, 278advantage of 312allowances 277, 283, 614, 277average rate 277, 280avoidance 276, 280, 717, 276balance of 279basic rate 277, 282–3, 284 –5, 277benefit principle of 276capital gains 277changes 535, 537, 538 –9collection costs 276in common markets 655concessions 623, 626, 737consumption and 454convenience requirements 276corporation 277, 371, 393, 614, 623,663correcting for monopoly 310 –11council 278, 625, 630credits 272, 287– 8, read more..

  • Page - 851

    I:36INDEXtrade (continued)deficit 416and development 653diversion 656 –7, 662, 656as engine of growth 644equality and 727as exploitation 640in goods account 416interdependence through 703 – 4international see international tradelimits to 640 –1restrictions see restricting traderounds (WTO) 652 – 4in services account 416strategies 725 – 6terms of see terms of tradetraditional theory 727unfair practices 647, 648trade-offs 8, 307trade cycle 379see also business cyclestrade unions 236, read more..

  • Page - 852

    INDEXI:37United Nations 747Conference on Environment andDevelopment (UNCED) 745Development Program (UNDP) 724United Statesairline deregulation 174 –5budget deficit 694cartels 351exchange rates 686 –7, 691–2, 694 –5globalisation and 703, 704, 705Justice Department (Microsoft case)170 –1managing the economy 532merger activity 216 –17monetary policy 547Reaganomics 613, 694steel industry 652trade imbalance 705training approach 620universal benefits 284, 287, 284unpredictable events read more..

  • Page - 853

    I:38INDEXwithdrawals (continued)tax as 371, 455 – 6total (function) 458womenequal pay 244 –5income inequality 269unemployment 399workmarginal disutility 229 –30, 229see also employment; labourWork-based Learning for Adults 621workersoutput per 606supply of hours by 229surplus 243see also labourworkforce increase (economic growth)603–4working age, output and 606working conditions (in EU) 660working hours 228, 229 –30, 271, 606,613–14, 660working population 384, 386working to rule read more..

Write Your Review