OSC

Economics
Higher Level
4 Edition
 CONTENTS

ABOUT THIS BOOK - Please read!........cccveeererrersarsnrsensns 3

SECTION 1: MICROECONOMICS.........cccvrmrrnrrrnninnssnnens 4
Scarcity ...
Markets....
Demand
SUPPIY et
Equilibrium: the Interaction of Demand and Supply ..
Market Efficiency .......ccccoocevvveniinniieiiinsieninnenns
Elasticities of Demand and Supply..
Price Elasticity of Demand ...........
Cross Price Elasticity of Demand............... ... 18
Income Elasticity of Demand..................... svi 18
Price Elasticity of Supply .... 19
Government Intervention........ .21
Maximum and Minimum Prices. s
Indirect Taxation...........ccc.... ...23
Subsidies............ .25
Market Structures ”
Aims and Objectives of Firms ... 26
Production and Costs......... w28
Revenue................ 29
Profit......cccc.... w1
Perfect Competition.. 32
Monopoly .......ccccvenneee. 34
Monopolistic Competition
OlIGOPOIY .ot 40
Price DisCHMMatioN .. vivamsmsmamimsirmissisamsissmsms 42
Market Failure and Government Response. .. 43
Externalities.........cccoeeiieiiiiiiiiiciicncn ... 43
Negative Externalitios . .u.iwmsissmmmamsmsmmsissemiosis 43
Positive Externalities ..........cccccooevviiiiiiiinnieniesece e, 47
Public Goods................ ... 48
Merit and Demerit Goods
Monopoly Power
Common Access Resources and Sustainability.................... 50
Asymmetric Information............ccccecevieriennne
Microeconomics Sample Questions

SECTION 2: MACROECONOMICS.........cocvvmrimenennsnnnnne 53
Measuring National InCome........ccccceeiiicirrmrcirreree
e 53
Circular Flow of Income...
Business Cycle Model......
Macroeconomic Models..........coovrrrmrcrsernnenenns 56
Aggregate Demand and Supply Analysis......... 56
The Keynesian/Monetarist Debate......... 64
The Multiplieswsssssmusssrmsmess 65
Demand-side Policies................ 65
Supply-side Policies .................. 69
Unemployment and Inflation..........cccecerecmncmncnnccnncenssenscennnes 70

1B HL Economics Page 1 3rd Edition

 Unemployment ..uwwsmammssmsamsmi -t
Inflation .......ccceee... e 74
ECONOMIC GROWTH ....... e 82
DISTRIBUTION OF INCOME .......... ....85
Macroeconomics Sample Questions.......ccccuerreeremeesinnnnanns 88

SECTION 3: INTERNATIONAL ECONOMICS..........cueen. 89

Reasons for Trade
Terms of Trade ....
Free Trade/ProtectioniSm .......cccccsiemnsmnsssnnssnensnsssnssnnessnnnsans
Economic Integration....
Exchange Rates..........
Balance of Payments .
Correcting a Current Account Deficit..
International Trade and Exchange Rate Sample Questions
............................................................................................... 104

SECTION 4: DEVELOPMENT ECONOMICS............ccoeees 105

Introduction to Development .........cccoviuneees ..105
Measuring Development...... ..108
Domestic Factors ....... ..110
International Trade......... 111
Foreign Direct Investment....... . 113
Aid and Multilateral Assistence . 114
International Debt............cccoviiunennns 117
Markets vs. Intervention ...........cccccvnininiianns ..118
Development Economics Sample Questions ..........ccccevee 119

REVISION ADVICE.........cccoiiirrsmcrenreessssssssmssssssnssssssesssnnns 120

Assessment Objectives (AOS) ......ccoeeissmmsssensssmsmsssnnssanes 121
Higher Level Assessment..........cccoermnmmnsnnsssenmssssmnsnenns
Essay Technique ........ccounmmmimisemnseminmssnseemssssssens
Model Markschemes .......cccccvvmmmmsmmrismsennssecnsns
s nssnssan
Data Response Technique
Model Markschemes ........cocvvmmiemmmssmsess
s e

IB HL Economics Page 2 3rd Edition

 ABOUT THIS BOOK - PLEASE READ!
This is not a textbook. By the time you read this, you should
already have covered the whole syllabus and have attempted
some examination-style questions. This guide will give you a solid
outline of all the material in the Higher Economics Syllabus, but it
should be used in conjunction with your experiences in class, your
own notes, your textbooks, and past papers.

In this guide the emphasis is on subject knowledge, the structure

of that knowledge, and how to answer examination questions. The
final exam is not only a test of knowledge, but also a test of how
you use economic theories and concepts to solve economic
questions and problems. A good candidate will therefore see the
contents of this book more as a toolkit with which they can
successfully tackle the questions with which they are faced and
maximise their exam mark. At the end of each section there are
sample IB-style questions for you to put this approach into
practice. The model markschemes for these questions are in the
final section of the guide so that you can attempt the questions as
you progress through each section and then check your efforts by
turning to the back of the guide. All successful candidates will have
attempted as many past papers and examination-style questions
as possible. It is the most efficient and effective way to test the
knowledge you are consolidating in your revision programme.

Key terms are printed in bold type and definitions are signalled by
italicised type.

This guide contains a considerable number of diagrams, and |

make no apologies for this! ~ Whilst | might have had to be
economical with the explanation of some ideas, diagrams could
not be sacrificed. They are central to all aspects of the
examination. You will be asked questions about diagrams, and
any good candidate will be expected to use diagrams to illustrate
their work.

Each page is printed with a wide margin. As | go through each

area of the syllabus | have highlighted key exam skills and hints
relevant to that particular area in this margin. Although the
numerical questions in the Higher Level Paper 3 are covered in a
separate OSC Guide by George Graves, | will indicate the
numerical skills needed for each section of the syllabus.

Please feel free to email me at [email protected] with any

feedback, so later editions of this guide may be revised to improve
the help given to candidates.

Best of luck for your revision!

Stephen Holroyd

IB HL Economics Page 3 3rd Edition

 SECTION 1: MICROECONOMICS

SCARCITY

The basic economic problem is scarcity. But, to be more

accurate, the problem is finite resources (land, labour, capital and
enterprise) in relation to infinite wants. Because these resources
are finite, individual consumers, firms and governments constantly
have to make choices between having one thing, and not having
another. These choices can be focused down into three
questions.

What to produce?
How to produce?
For whom to produce?

All economies, whether tending to command or to free market,

exist as an attempted solution to these three questions. All
economies, including developed and less economically developed,
face the same problem, and therefore the same questions. For
example, developed economies might face the choice between
more nuclear weapons or more healthcare, whereas a less
economically developed country (ELDC) might face a choice
between clean water and basic vaccination programmes.

Factors of Production are the scarce resources that an economy

has at its disposal to produce goods and services.

Land represents natural resources

It is important that you understand Labour is the human resource
that the act of investment involves
Capital is goods that are used to produce other goods, and
the buying of capital goods and
requires an economy to forgo current consumption
has nothing to do with money.
Enterprise, also a human resource, organises the three
other factors to produce goods and services. The reward
for this risky activity is profit

Allocation of these resources can be organised through several

different Economic Systems. In the end, all economies are
mixed, although some will tend towards free market (eg. UK,
USA), and others will tend towards centrally-planned or
command (North Korea, Cuba). Traditional systems still exist in
many of the poorest LDCs, and involve actions such as barter, gift
and communal activities.

Opportunity Cost is the cost of the next best thing forgone. As

long as economic resources are used in the production of a good
or service, a cost is involved, even if a price is not.

A Production Possibility Curve (also referred to as boundary, or

frontier) shows the combinations of two goods/services that can be
produced efficiently with a given set of resources:

IB HL Economics Page 4 3rd Edition

 Consumer goods

PPC1

Capital goods

You will normally see a curved PPC, because as more consumer

goods are produced, more capital goods have to be given up in
order to produce each marginal unit of consumer goods. As we
shall see later on, this is due to the law of diminishing returns.

Any combination of goods produced within the PPC (A) means that
there are unemployed resources. Points on the PPC (B) represent
different bundles of goods, but with fully employed resources.
Points beyond the PPC (C) are currently unattainable. In order to
attain these points, an economy would have to increase the
number of resources, increase the productivity (efficiency) of its
current resources, or improve technology. For example, Brazil
discovers offshore oil, a developed economy invests in its human
capital, and car factories become robotised.

IB HL Economics Page 5 3rd Edition

 Good X
You should use arrows or actual
numbers to show clearly that you
understand the concept of
Opportunity Cost in an exam.

Good Y

As this economy moves from a combination of goods X and Y

represented by A to a combination represented by B, the increase
in the production of Y results in a reduction in the production of X.
The opportunity cost of increasing Y is the forgone production of X.

A shift in the PPC represents an improvement in productivity and

efficiency, or an increase in the quality and/or quantity of
resources. It also represents economic growth:
Consumer goods

PPC2

Merit goods

IB HL Economics Page 6 3rd Edition

The PPC above shows an economy that is both growing and
developing. The PPC has moved outwards and the production of
merit goods has increased.

Some other important fundamental concepts that you need to

know are:

Positive and normative statements. Positive economic

statements are objective, and therefore can be tested by available
evidence. Normative statements are subjective and express an
opinion. These statements often contain the words ‘should’,
‘could’ or ‘would’. For example, ‘governments should ban smoking
in public places’ is a normative statement, whereas ‘unemployment
is higher this year than last year' is a positive statement.

Whether goods are economic goods or free goods. This

depends upon whether they are scarce or not. Free goods are not
scarce (they have no opportunity cost), and therefore have no
market price. Economic goods are scarce.

Utility, which is the satisfaction or pleasure gained from an

economic action. For a consumer, this is the satisfaction gained
from consuming a product, and it is usually assumed that as more
goods and services are consumed, the extra utility gained from
consuming one more unit (marginal utility) will diminish.

MARKETS

A market is a place where buyers (demand) and sellers (supply) You cannot avoid knowing about
meet to exchange goods or services at the market-clearing price. this most important area of
Prices are determined in a free market solely by the interaction of syllabus areas. You MUST expect
demand and supply. As we shall see later on, governments can it to be tested in all three papers
and do intervene to influence both price and output, and therefore on markets, how they work, how
the allocation of resources. governments intervene in them
and how they fail.

Effective demand is a want (quantity of goods/services) backed

by the willingness and ability to buy at a given price. Other things Other things being equal, or
ceteris paribus, is an important
being equal, more will be demanded at lower prices than at higher
assumption made by economists
prices, and so there will be an inverse relationship between price so that they can isolate the effect
and quantity. of a single variable on something
else.

1B HL Economics Page 7 3rd Edition

 ® Movement along the demand curve (extension/
It is absolutely crucial to be able to contraction)
distinguish clearly between a
movement along a demand curve
(caused by a change in price) and

Price
a movement of the demand curve
(caused by a change in one or
more of the determinants of
demand). This also applies to the
distinction between a change in
the quantity supplied and a
change in supply. Your exam will
test you on this knowledge in a
variety of different ways, ranging
from part (a) of essays, and early
data response questions and
numerical questions.

Q2 Ql
Quantity

A change in the price of the good itself will cause a movement

along the demand curve, and therefore change the quantity
demanded. In the diagram above, a fall in price from P, to P¢ will
cause an increase in the quantity demanded from Q; to Q;, and an
increase in price from P4 to P, will cause a fall in the quantity
demanded from Qq to Q.. The relationship between the price
change and the resultant quantity change will be explored later on
when we look at price elasticity of demand.

A demand curve is downward sloping for two reasons:

The income effect. As prices fall, so real income

increases. Consumers can therefore afford to consume a
greater quantity.
The substitution effect. As a good falls in price it
becomes cheaper in relation to other goods (substitutes).

IB HL Economics Page 8 3rd Edition

 ® Movement of the demand curve
Price

P2

P1

Q2 Q1

Quantity

The following factors will cause a movement in the demand curve

itself:

Income. For normal goods, an increase in income will T -

cause an increase in demand (a shift of the demand curve N°rlm,5‘| g”_d (ljnfer_xlor r?°°d5 will be
to the right). 5 For inferior goods, an increase in income will | SXPlained in detail when looking at
; income elasticity of demand.
cause a fall in demand (a shift of the demand curve to the
left).
A change in the distribution of income will also change the
pattern of demand.
Population. As population increases, the demand for most
goods will increase. A change in the distribution of
population will also have an effect. Thus, an ageing
population has increased the demand for healthcare.
Price of complements. Goods and services are often
consumed together, and are thus said to be in joint
demand, for example, cars and petrol. An increase in the
price of cars (leading to a fall in the quantity demanded of
cars) will lead to a fall in the demand for petrol.
Price of substitutes. Many goods and services can be
consumed as alternatives to other goods and services, and
are thus said to be in competitive demand. An increase in
the price of foreign holidays will lead to an increase in the
demand for domestic holidays.
Tastes and preferences. These change frequently.
There has been a great increase in the demand for organic
food products in recent years. Of course, individuals’
tastes and preferences are affected by advertising and
marketing.

IB HL Economics Page 9 3rd Edition

Supply is the quantity of a good or service producers are able and
willing to supply to a market at a given price. An increase in price
will usually lead to an increase in the quantity supplied, and thus
there is a positive relationship between price and supply.

® Movement along the supply curve (extension/ contraction)

Price

w
P2

Pl

Q1 Q2
Quantity
In the diagram above, a fall in price from P, to P4 will cause a fall in
the quantity supplied from Q to Q4 (contraction), and an increase in
price from P to P, will cause a rise in the quantity supplied from Q
to Q. (expansion). Here, the changes in price will have been
caused by a movement of the demand curve.

® Movement of the supply curve

The following factors will cause a movement of the supply curve
itself:

Costs of production. This is the key factor that shifts the

supply curve. An increase in the price of factors of
production will decrease supply, and a decrease in the price
of factors of production will increase supply. An increase in
the productivity of factors will increase supply.
Technology. Technological advances reduce costs of
production and so shift the supply curve to the right.

IB HL Economics Page 10 3rd Edition

 New firms entering a market. Any new firm that enters a
market will increase market supply. This will be explored
more when looking at perfect competition.
Indirect taxes and subsidies. Taxes will decrease supply,
and subsides will increase supply.
Price of substitutes. A rise in the price of apples will
encourage fruit growers to move from growing pears etc. to
producing apples, and thus the supply of pears will
decrease.
Price

S2

Questions quite often ask

candidates to comment upon the
determinants of demand and
supply. If you know your
determinants, these are very
simple questions on which to
score high marks.

Q1 Q Q2
Quantity

Here S to S; represents a decrease in supply, and S to S,

represents an increase in supply.

| Equilibrium: the interaction of demand and supply—|

Equilibrium exists when demand equals supply (P,Q). Examination questions in all three
Disequilibrium exists if there is a situation of excess demand (at papers frequently ask candidates
Pa) or excess supply (at Pb) as shown below: to illustrate, explain and analyse
price changes, and a flexible
knowledge of the determinants of
demand and supply and the
forces that lead to equilibrium is
something that any successful
candidate must have. You
should see the determinants of
demand and supply as flexible
tools that you can apply to any
market (house prices, oil prices
and commodity prices) to explain
price movements.

IB HL Economics Page 11 3rd Edition

Price
Surplus
—_

Qsb Qda Qe Qsa Qdb

Quantity

The equilibrium price is also known as the market-clearing price,

as all the surpluses and excesses are cleared from the market and
the forces of demand and supply are not acting to change this
equilibrium. If disequilibrium exists, then the forces of demand and
supply will automatically adjust the market to equilibrium. With
excess demand, prices will be forced upwards due to the shortage
that exists, and with excess supply, prices will be forced
downwards due to the surplus that exists:
Price

Quantity

IB HL Economics Page 12 3rd Edition

 Price

P1

Q1 Q
Quantity

In a free market, a change in price can only be caused by changes

in demand and/or supply, and nothing else. An increase in price
can be caused either by an increase in demand or a decrease in
supply. A fall in price can be caused either by a fall in demand or
an increase in supply, as shown in the two diagrams above.

Numerical application:
Linear demand function (Qd = a - bP)
Linear supply function (Qs = c + dP)
Calculate equilibrium and excess demand/ supply
Plot, identify slope and horizontal intercept, and shift curves

® The Role of the Price Mechanism

Prices act as a signal, an incentive and a rationing device and
the price mechanism helps to allocate resources. For example, if
the demand for a product rises, then its price will rise, signalling to
producers that consumers want to buy more of this good. The
rising profits (from rising prices and rising consumption) will
incentivise firms to produce more. As goods become scarce, their
rising prices will ration their consumption.

Market Efficiency

Concepts of allocative efficiency, productive efficiency and Pareto

optimality will be covered in detail under the heading of Market
Structures.

1B HL Economics Page 13 3rd Edition

 ® Consumer and Producer Surplus

Price
Consumer surplus

Producer surplus

Quantity

Consumer surplus is the extra utility, over and above the price
paid, gained by consumers. Producer surplus is the extra
revenue gained by producers, over and above the price that the
producer would need to be paid to produce that unit of output. The
sum of these two surpluses is known as community surplus (the
total benefit to society). The increase or decrease of either of
these two ‘surpluses’ and the movement of a ‘surplus’ from one
stakeholder to another or even the disappearance of a ‘surplus’
are important ways of illustrating benefits or losses from economic
events, and will be used widely later on in this Guide (see Market
Failure, Trade Barriers).

Many students have major

problems with the topic of | ELASTICITIES OF DEMAND AND SUPPLY
elasticity. They frequently see it
as an isolated topic and an Elasticity measures the responsiveness of one variable to a
excuse for examiners to ask change in another.
questions that involve numbers.
The concept of elasticity is
immensely important for
economists, as it enables us Price Elasticity of Demand
more accurately to picture,
analyse and evaluate what goes Price Elasticity of Demand (PED) measures the responsiveness
on in the real world. Without of the quantity demanded to a change in price.
PED and PES our demand and
supply analysis would not be
half as effective.

IB HL Economics Page 14 3rd Edition

 PED = % change in quantity demanded Students should always look to
% change in price comment on elasticity wherever
they can. They should carefully
An alternative formula which is very useful is consider whether they can use
their knowledge of PED and
PED = AQ/Q PES to draw demand and
AP/P supply curves which accurately
reflect the market situation. For
where AQ is the change in quantity demanded, Q is the original example, diagrams to illustrate
agricultural and commodity
quantity, AP is the change in price, and P is the original price.
markets should always have
price inelastic demand and
The calculation of PED results in a coefficient, or real number, and supply curves.
this tells us two major things about the responsiveness of the
quantity demanded to a change in price.

Sign (positive or negative) gives information about the direction of

the relationship. For all Normal goods, PED will be negative, as
there is a negative relationship between price and quantity on a
downward-sloping demand curve. We always ignore this negative
sign. If PED is positive, then we have a perverse demand curve.
Magnitude. The size of the number resulting from the elasticity
calculation tells us about the degree of response. The bigger the
number, the bigger the response, and vice versa.

PED >1 means the good is price elastic

PED < 1 means the good is price inelastic
PED = 1 means the good has unit elasticity
PED = 0 means the good is perfectly price inelastic
PED = « means the good is perfectly price elastic

Price elastic means that the quantity demanded is highly

responsive to a change in price. In the diagram below a change in
price from P4 to P; results in a proportionately large response in
the quantity demanded from Q; to Qa:

IB HL Economics Page 15 3rd Edition

Price

Qi @
Quantity

Price inelastic means that the quantity demanded is highly

unresponsive to a change in price. In the diagram below a change
in price from P4 to P, results in a proportionately small response in
the quantity demanded from Q; to Qz:
Price

Q1L Q2
Quantity

PED varies at every point along a straight-line demand curve.

PED is not the same as the gradient.
At high prices, PED tends towards infinity.

1B HL Economics Page 16 3rd Edition

At low prices, PED tends towards zero.
At the mid-point PED = 1:
Price

3 4 7 8
Quantity

As price increases from 10 to 12:

-1/4 =(-)1.25
+2/10

As price increases from 2 to 4:

-1/8 =(-)0.125
+2/2

® Determinants of PED
Closeness of substitutes. PED will be more price elastic
if there are close substitutes available.
Luxury or necessity. Luxury goods tend to be price
elastic, and necessities tend to be price inelastic.
Percentage of income spent on the good. The smaller
the percentage of income spent on a good, the more price
inelastic demand will be.
Time period. In the long run, demand tends to be more
price elastic, as it takes time for consumers to react to price
changes.

® PED of Commodities and Manufactured Goods

Demand for commodities tends to be price inelastic as they are PED will appear again when we
necessities and have few substitutes. Therefore, any change in look at price discrimination, and
the supply of commodities will cause wide fluctuation in prices. On the effects of a depreciation in
the exchange rate on the
the other hand, manufactured goods with more substitutes tend to
balance of payments.
have price inelastic demand curves, and thus supply-side
fluctuations will cause less substantial changes in prices.

1B HL Economics Page 17 3rd Edition

 ® PED and Total Revenue (TR)
TR=PxQ

Total revenue is a useful way to check the PED of a demand

curve. If arise in price causes total revenue to increase, then PED
is inelastic. If an increase in price causes total revenue to
decrease, then the demand curve is price elastic. If an increase in
price causes total revenue to increase then the demand curve is
price inelastic. If a change in price does not change total revenue,
the PED is unitary (= 1).

In the diagrams on page 16, TR at P> = P, x Q2. After an increase

in price, TR at P4 = P4 x Q4 (shaded area).

Cross Price Elasticity of Demand |

Cross Price Elasticity of Demand (XED) measures the
You should see the link
between XED and the price of responsiveness of the quantity demanded of one good to a
other goods, which was change in price of another.
compliments and substitutes as
determinants of demand. A fall XED = % change in quantity demanded good A
in the price of a complement will % change in price good B
cause an increase in demand (a
shift of the demand curve to the An alternative formula which is very useful is
right) for the good that is in joint
demand. A fall in the price of a XED = AQA/QA
substitute will cause a decrease
APB/PB
in demand (a shit of the
demand curve to the left) for the
good that is in competitive where AQA is the change in quantity demanded of good A, QA is
demand. the original quantity of good A, APB is the change in price of good
B, and PB is the original price of good B.

Sign (positive or negative). Substitutes (goods in

competitive demand) will have a positive XED.
Complements (goods in joint demand) will have a negative
XED.
Magnitude. The higher the value of XED the closer the
relationship (either complement or substitute) will be
between the two goods in question.

Income Elasticity of Demand

Income Elasticity of Demand (YED) measures the

responsiveness of the quantity demanded to a change in the real
income of consumers.

YED = % change in guantity demanded

% change in real income

IB HL Economics Page 18 3rd Edition

An alternative formula which is very useful is

YED = AQ/Q
AYIY

where AQ is the change in quantity demanded, Q is the original

quantity, AY is the change in income, and Y is the original income.

Sign (positive or negative). Positive means that the good

is a normal good (as income increases, so will the quantity
demanded). Here an increase in income will result in the
demand curve shifting to the right. Negative means that
the good is an inferior good (as income increases, so the
quantity demanded will fall). Here an increase in income
will result in the demand curve shifting to the left.
Magnitude. The higher the value of YED the closer the
relationship will be between a change in income and the
change in the quantity demanded (0-1 being necessities
and 1-« being luxuries).

Price Elasticity of Supply

Price Elasticity of Supply (PES) measures the responsiveness of

the quantity supplied to a change in price. Questions quite often ask
candidates to comment upon the
determinants of PED and PES. If
PES = % change in quantity supplied
you know your determinants,
% change in price these are very simple questions
on which to score high marks.
An alternative formula which is very useful is

PES = AQs/Qs
AP/P

where AQs is the change in quantity supplied, Qs is the original

quantity supplied, AP is the change in price, and P is the original
price.

Sign (positive or negative). Supply curves have a positive

PES.
Magnitude. The size of the number resulting from the elasticity
calculation tells us about the degree of response. The bigger
the number, the bigger the response, and vice versa.

PES >1 means the good is price elastic.

PES < 1 means the good is price inelastic.
PES = 1 means the good has unit elasticity (any
curve from the origin).
PES = 0 means the good is perfectly price inelastic.
PES = « means the good is perfectly price elastic.

1B HL Economics Page 19 3rd Edition

 S (PES<1)

Price
S (PES=1)

S (PES>1)

Quantity

® Dpeterminants of PES

Time period. In the very short run all factors are fixed, and
therefore PES = 0. In the short run at least one factor is
fixed and at least one factor is variable, and therefore PES =
<1. In the long run all factors are variable (except
technology), and PES >1.
Level of spare capacity. If firms are at full capacity the
supply curve will be price inelastic. The more spare capacity
the more price elastic the supply curve will be.
Type of Good. For some goods there are time lags in
production. This is particularly true in agricultural markets.
Supply may be perfectly price inelastic in the very short run
Level of stocks. If firms are in the habit of keeping high
stock levels, they will easily be able to respond to changes in
demand, and therefore supply will be price elastic.

® PES of Commodities and Manufactured Goods

Supply of commodities tends to be price inelastic as it takes time
for producers to respond to increases in demand given that not all
factors are variable (many commodities have growing seasons).
Manufactured goods tend to have a price elastic supply, as there
are not the same time-lags in production.

Price inelastic supply combined with price inelastic demand for

commodities means that any changes in demand or supply lead to
considerable fluctuations in prices. The volatility of commodity
prices makes commodity producers vulnerable to fluctuations in
income (the major source of investment).

1B HL Economics Page 20 3rd Edition

Numerical application:
Calculate PED, XED, YED and PES
Sign and magnitude
Application and implication for stakeholders

GOVERNMENT INTERVENTION |

Governments intervene in markets because they believe that the It is important that you see the
equilibrium reached by the free market is not desirable. In other links between government
words, they believe that price and/or quantity are in the wrong intervention in the market, price
place. Thus they employ a variety of methods to move both price elasticity of demand and supply,
and quantity. For example, most governments believe that the and market failure.
free market equilibrium price of cigarettes would be too low and
therefore they tax them. Of course, there are issues of market
failure involved here.

| Maximum and Minimum Prices |

A maximum price is also known as a price ceiling, and to be

effective it must be set below the market-clearing price.

8 s
& Surplus
PATHITR fesesererssnssmsamseNigsree
oo et smoanssssss s nemtsptnssisssing Floor (min)

Pe

Ceiling (max)
P8 [ ce mns rsrsrarm inionsanasocs snmsemsnemsins msns aes B s aimmemsmisntt essinensissts .

Shortage D

Q1 Q3 Qe Q4 Q2

Quantity

A maximum price will result in a shortage or excess demand (Q1

to Q2), with consumers benefitting from lower prices. However,
often a parallel market will evolve. To cure this problem, a
government might have to introduce rationing, or, as in the graph

IB HL Economics Page 21 3rd Edition

below, the government could attempt to shift the supply curve by
using subsidies, producing themselves, or releasing stocks of
previously produced goods into the market.

Price
Sg

Excessf demand Max price

P max

Quantity

A minimum price, also known as a price floor, must be set

above the equilibrium price to be effective. A classic example of a
minimum price is minimum wage legislation, resulting in a surplus
Q3 to Q4 (this would be unemployment in a labour market). A
minimum price will raise or protect incomes for producers and a
minimum wage will protect incomes for workers. However, both
create excess supply, and here the government can intervene to
increase demand, as in the graph below. This it can do by buying
the surplus at the minimum price, which then must be stored, sold
in alternative markets, or simply destroyed.

1B HL Economics Page 22 3rd Edition

 o
=
o
S5

Excess supply
P min Min Price

Pe Lo X

D govt

0 Qd Qe Qs

Quantity

Indirect taxation

Indirect taxes are taxes on expenditure. As these increase a

It is important to be able both to
firm’s costs of production, they will move the supply curve upwards analyse and evaluate the effects
to the left. If the tax is a specific tax (a fixed monetary amount on of the various methods of
each unit of output, for example four pence on a litre of petrol), the government intervention. An
supply curve shift will be a parallel shift. If the tax is an ad average candidate will simply
valorem tax (a percentage tax, for example 20% VAT in the UK), state the effects. A good
the new supply curve will gradually diverge from the original. candidate will comment on how
effective the measures are, and
As the text increases costs of production, it will reduce supply. the wider implications. For
Although the tax is imposed on producers, some of the burden of example, in the diagram on the
next page, a good candidate
the tax can be passed on to consumers. The final balance of the
would comment that the tax
burden (between consumers and producers) will depend upon the does not reduce equilibrium
price elasticity of demand and the price elasticity of supply for the quantity very much, and that the
good or service. consumer pays most of the
burden of taxation.
In the next graph, with a price inelastic demand curve, the
producer finds it relatively easy to pass the tax onto the consumer.
The tax per unit is represented by the vertical distance between
the two supply curves. The total tax revenue is equal to the tax
per unit multiplied by the equilibrium quantity (0 to QT). Here the
tax has a relatively small effect on the equilibrium quantity.

IB HL Economics Page 23 3rd Edition

Price
St

Consumer

Pe

Producer

Q Qe
Quantity
Price

St

Consumer

Producer

Qt Qe
Quantity
Here, in the graph above, the producer finds it relatively difficult to
pass the tax onto the consumer.
The consumer will carry the greater tax burden if price elasticity of
demand is inelastic, or price elasticity of supply is elastic. The
producer will carry the greater tax burden if price elasticity of
demand is elastic, or price elasticity of supply is inelastic.

1B HL Economics Page 24 3rd Edition

Subsidies are payments by a government to producers. They
reduce the costs of production and increase output. As they
reduce the costs of production they will shift the supply curve
downwards to the right. They will have the effect of increasing the
price the producer receives for each unit of output (Pe to Pp in the
diagram below), and reducing the price the consumer pays for
each unit consumed (Pe to Pc). The total cost of the subsidy, to
the government, is Pp to Pc multiplied by 0 to Qs (area
atb+c+d+etf).

Before the subsidy consumer spending was f+e+g. After the

subsidy consumer spending is g+i+j for an increased quantity.
Price

PO T ccssnsmssmssssssssiomsionmissny

Qe Q sub
Quantity

The increase in producer revenue is a+b+c+d+i+j (from f+e+g).

It is important that you can discuss the consequences of all these

forms of government intervention for the stakeholders in the
market (consumers, producers and the government). In order to do
this you should look to comment on consumers and producer
surplus, producer revenue, government revenue and expenditure
as well as the actual impacts on the equilibrium price and quantity.

Numerical application:
Plot demand and supply curves
New supply curves for taxes and subsidies
New equilibria
Calculate changes in consumer expenditure, producer revenue,
tax revenue, government expenditure, tax incidence (burden), total
subsidy per unit, excess demand, excess supply

IB HL Economics Page 25 3rd Edition

 MARKET STRUCTURES

There is a wide range of possible aims and objectives for firms to

Profit maximisation dominates
target, including sales revenue maximisation, output maximisation,
this section. You need, however,
managerial goals, behavioural goals, market share and satisfising,
to understand where a firm might
maximise sales revenue/total but underpinning much of the theory in this section is the aim of
revenue. profit maximisation.

Profits = total revenue — total cost

Total revenue = price x quantity

Total cost = average cost x quantity

(Or fixed costs + variable costs)

To understand effectively how a firm works, you need to

understand costs and revenue in some detail.

Production and Costs

® Costs in the Short Run

TC=FC+VC A firm is a combination of the four factors of production. These
ATC=TC/Q four factors are transformed into output. As these factors must be
ATC = AFC + AVC paid for, production incurs costs.
AFC=FC/Q
AVC=VC/Q In the short run, at least one factor is variable, and at least one
MC = ATC / AQ factor is fixed. Even though the firm's size is fixed, increasing
MC = the slope of TC amounts of a variable factor (eg. labour) can be added to the firm.

Here the law of diminishing returns applies. This law states that
as successive units of the variable factor are added, the extra
(marginal) output produced will at first increase and then decrease.
This results in the marginal product (MP) and average product
(AP) curves below:

Questions asking you to

distinguish between short and
long run costs do appear in the
essay paper (part a), but
clsewhere all you will be
required to do is to draw your
cost curves accurately, and in
combination with revenue
curves, analyse the behaviour of
firms.

IB HL Economics Page 26 3rd Edition

 Total product

MP

Q of variable factor
Of course, each time a unit of the variable factor is added, a new
cost is incurred. If this new cost allows output first to increase and
then decrease, the marginal costs and average variable costs
must first decrease and then increase. This results in the
marginal cost (MC) and average variable cost (AVC) curves
below. Marginal cost is the cost of producing one extra unit of
output:
Costs

MC
MC intersects min AC

ATC

AVC

MC intersects min AVC

\ ATC=AFC+AVC

Dim returns sets in as MC increases AFC

Quantity

IB HL Economics Page 27 3rd Edition

Fixed costs are the cost of producing nothing, and so average
fixed costs (AFC) fall as output increases. Total costs are the
sum of fixed and variable costs, and so average total costs are
the sum of average fixed costs and average variable costs. In the
diagram above, ATC is created by adding the AVC and AFC lines
together.

Economic costs of production are divided into two types of costs.

Explicit costs are the monetary payments (wages etc) to factors of
production not already owned by a firm. Implicit costs (normal
profit) are those faced by a firm forgoing what it could have earned
by employing its factors in another activity (opportunity cost).

® Costs in the Long Run

In the long run, all factors are variable, and therefore a firm can
change its size (scale).

If a firm increases its size, then one of three things can happen to
output:
1) Output can increase more than proportionately
(increasing returns to scale).
2) Output can increase proportionately (constant returns
to scale).
3) Output can increase less than proportionately
(decreasing returns to scale).

1) will cause average costs to fall, 2) will cause average costs to

remain constant, and 3) will cause average costs to rise, resulting
in the long run average cost curve below.

Decreasing returns to scale

Increasing returns to scale LRAC

Costs

~ Constant returns to scale

Quantity produced

LRAC is the ‘envelope’ curve of all SRACs that make up the short
run.

IB HL Economics Page 28 3rd Edition

 It is economies of scale that cause average costs to fall in the
long run, and diseconomies of scale that cause average costs to
rise in the long run.

Economies of scale can be divided into the following categories:

* Financial economies
* Marketing economies
* Technical economies
* Purchasing economies
* Managerial economies

Diseconomies of scale tend to be very firm specific, but can be

divided into the following categories:

* Communication issues
* Alienation and firm politics
* Increased regulation from government

Revenue

The shape of a firm’s revenue curves (AR, MR, TR) depends upon
whether the firm is in perfect or imperfect competition. TR=PxQ
AR=TR/Q
AR therefore =P
In perfect competition the firm is a price taker. Price is constant,
MR = ATR / AQ
and therefore the following revenue curves are generated:
MR = the slope of TR
Revenue

TR

P AR=MR=D

Quantity

TR is a straight line because MR is constant.

In imperfect competition the firm is a price maker, and so it can
influence the price at which its goods sell, or the number of goods

1B HL Economics Page 29 3rd Edition

which it sells. It thus faces a normal downward-sloping demand
curve. As the demand curve shows us price/quantity demanded
combinations, it also shows us AR.

Revenue
PED=%0

AR=D

PED=0

MR Quantity
As AR is downward sloping, MR must be falling below it. When MR
=0,PED =1.

As MR is the slope of TR, TR will rise at a declining rate. When

MR cuts the quantity axis, total revenue will cease to rise, as MR =
0. As MR becomes negative, TR will fall. When MR = 0, TR is
maximised.

__— MR=0
Revenue

TR

Q TR max
Quantity

IB HL Economics Page 30 3rd Edition

As shown above, PED varies all the way along a straight-line
demand curve. At the mid-point, PED = 1, and this coincides with
MR = 0. When MR = 0, total revenue (sales revenue) is also
maximised.

Economic profit is different from accounting profit.

Profit = TR — TC (implicit and explicit costs)

Profit = (AR x Q) — (AC x Q)
Profit = Q (AR — AC)

TR = TC results in normal profit.

TR > TC results in supernormal/abnormal profit.
TR < TC results in losses.

Profit maximisation involves maximising the degree to which TR

> TC. Firms will want to produce every single good that
contributes more to total revenue (MR) than it contributes to total
costs (MC). A profit maximising firm will therefore produce every
single good with an MR greater than its MC.

The diagram below uses the revenue curves from a perfectly

competitive firm, however, the profit maximising condition is the
same for imperfectly competitive firms with downward sloping
revenue curves.
Price

MC

N
MC=MR

P / AR=MR=D

Q
Quantity
A firm should keep increasing its output as long as MR is greater
than MC, and so profit maximising equilibrium is where MC =
MR.

IB HL Economics Page 31 3rd Edition

 Numerical application:
Calculate TP, AP, MP
Calculate TC, FC, VC, MC, ATC, AFC and AVC
Calculate TR, AR, MR
Calculate profit maximisation level of output and profit levels

All these need to be calculated from both tables and/or diagrams

Perfect Competition

Although unlikely to exist, perfect competition provides an

essential theoretical benchmark with which to compare other, less
perfect, forms of competition. It illustrates the perfect working of
the price mechanism. It is based on the following assumptions:

¢ Perfect knowledge
s A large number of small firms
e Freedom of entry and exit
¢ Homogeneous product
e Profit maximisation

Because of these assumptions, firms are price takers from the

market equilibrium. Firms cannot sell at a higher price and would
be irrational to sell at a lower price, as they would not sell a greater
quantity:
Price

Although the diagrams might look MC

daunting, it is important to be able Abnormal profits AC

to use perfect competition as a

way of illustrating how a free
market can lead to economic
efficiency. It is also an important
tool with which to evaluate
monopoly, and IB questions often
link perfect competition and
monopoly together, with good
answers requiring strong
diagrammatical analysis.

Market Fieit Quantity

Profit maximisation is where MC = MR. The firm starts in

equilibrium at P, Q. An increase in demand in the market
increases the market price to P4, and so the firm now takes a new
price at P4 with the equilibrium output level at Q;. Because AR >
AC at output level Qq this firm is making supernormal profits. New
firms are attracted by these profits and enter the market, thus
increasing the market supply curve. As supply increases, price,
and therefore profits, fall. New firms will continue to enter as long
as supernormal profits are being made. But when price falls back
to P normal profits are made, and the firm reaches long run
equilibrium (P, Q).

1B HL Economics Page 32 3rd Edition

If losses are being made in the short run firms/resources will leave
the market, resulting in the market supply curve shifting to the left
and prices rising. With the rising market prices firms will also
increase prices, and so losses will decrease until long run
equilibrium is reached at normal profit:
Price

MC
AC

Losses
p D=AR=MR

Quantity

At long run equilibrium, P = Q = AR = MR = D = AC = MC, and

here both allocative and productive efficiency are achieved.

Allocative efficiency is achieved when price = marginal cost.

Productive (technical) efficiency is achieved where AC is at a

minimum (MC = AC).

Perfect competition is said to lead to a Pareto optimal situation

where the allocation of resources cannot be changed to make
someone better off without making someone worse off.
Here we have made the important assumption that there are no
externalities in this market.

In perfect competition, the MC curve is the firm’s supply curve.

In the short run, this extends down towards the AVC curve. The
shut-down condition is that firms will stay in business as long as
they are covering their variable costs. But in the long run firms will
only stay in business if they cover their average costs.

IB HL Economics Page 33 3rd Edition

Price
mc ATC
AVC

Pa ARa=MRa

Pb ARb=MRb

Quantity
In the diagram above, the firm will stay in business at price Pa but
shut down at price Pb.

A pure monopoly is a single seller (a firm that produces 100% of

market output), although it is assumed that any firm with a market
share in excess of 25% will have market power.

A monopoly market is characterised by a firm which is

A single seller
Produces branded goods
Creates barriers to entry
Maximises profits

As the firm is the market, the firm’s revenue curves will be

downward sloping. It is barriers to entry (economies of scale,
legal barriers, sunk costs, capital costs, brand loyalty, control of
inputs, predatory pricing and other aggressive tactics) that give a
monopoly its market power (the power to change price).

The monopoly will maximise profits where MC = MR. P, Q is both

the short-run and the long-run equilibrium, because barriers to
entry stop new firms entering, and supernormal profits persist in
the long run, as shown below. In the long run a monopoly
produces at a point which is both allocatively and productively
inefficient.

1B HL Economics Page 34 3rd Edition

 Price

MC
Abnormal profits

AC

AR=D

MR
Quantity
P > MC. Consumers are willing to pay a price higher than it costs
to produce the product. In perfect competition, output would
increase, so P = MC.

Q is not at minimum average cost. The monopoly is not using

the most efficient combination of factors.

A monopoly is assumed to be “bad” because it is both allocatively

and productively inefficient, and because it increases prices and
reduces output.
A monopoly aiming to maximise total revenue will produce where
MR = 0.
A monopoly aiming to maximise output will produce where AR =
AC.
The diagram below illustrates different potential output levels for a
monopolist, depending upon its goals.
MC
Price

AC

AR=D

a1 Q3
Q2'mr
Quantity

IB HL Economics Page 35 3rd Edition

 Q1: Profit maximisation (MC=MR)
Q2: Revenue maximisation (MR=0)
Q3: Output maximisation (AR=AC)

A natural monopoly exists when the costs of production are at

their lowest, through economies of scale, when only one firm is in
the market. Good examples are utility markets (electricity, gas and
water).

With the minimum efficient scale of production at Q1 a single firm,

operating efficiently, can supply all the market demand. If this
market were to be split between two or more firms (Q2 and Q3)
then the costs of production would rise:
Price

LRAC

Quantity

| Perfect Competition and Monopoly Compared I

We have already seen that a monopoly is not allocatively and

Candidates are frequently productively efficient, whereas perfect competition is. The
asked to compare perfect diagrams below show that a monopoly will increase price (PMm)
competition and imperfectly compared to that of perfect competition (PPC), and reduce output
competitive structures in essay
(QM) compared to perfect competition (QPC). The shaded area
questions. If you can master a
represents welfare loss. Here we have generated a perfectly
few diagrams and a clear
structure it is an easy way of competitive equilibrium from the AR curve, because in perfect
gaining good marks. competition P = MC.

IB HL Economics Page 36 3rd Edition

 w The diagram on the left provides
o
& a smooth transition from a very
basic comparison between
Pm
perfect competition and
monopoly to the more
Ppc sophisticated analysis and
evaluation of market structures
Econs
that examiners like to see.

Pm*

AR=D

Qm Qpc Qm:
MR
Quantity

8
&

MC
Loss of consumer surplus

Pm |-

PR [seesssarenasd
Loss of producer surplus

AR=D

Qm Qpc 10

Quantity

But this initial comparison using MC is flawed. We have assumed

the same cost conditions for both firms, and a monopoly is likely to
be able to benefit from economies of scale, thus reducing
marginal costs to MCegcons. If the monopoly can reduce marginal
costs far enough, it might be able to produce a level of output Qm*
that is greater than QPC and reduce price PM* below PPC.

IB HL Economics Page 37 3rd Edition

It is important that you are able
There are other reasons why a monopoly may be beneficial:
to discuss firms in terms of their
market power and their impact s Supernormal profits may be used for Research and
on efficiency. Development
A good candidate will be able to « Monopolies may be beneficial for both employment and export,
analyse and evaluate these and tax revenues
concepts in a way which takes e “Creative destruction”
into account the impact a firm
might have on different
stakeholders.
Monopolistic Competition

Here the assumptions are now differentiated products, relatively

free entry and exit for firms and a relatively large number of firms
(in comparison to monopoly). Although the market is still very
competitive, firms now have the ability to set prices. New firms are
attracted by abnormal profits (as a shown in the diagram below)
and so long-run equilibrium exists when only normal profits exist.
Price

Abnormal profits

AC

AR=D

Quantity

New firms enter (or leave), attracted by supernormal profits (or

forced out by losses) and this causes the demand (AR) curve, of
current firms, to fall (or rise) until long run equilibrium (normal
profits when AR=AC) is reached.

1B HL Economics Page 38 3rd Edition

Short-run losses:
Price

AC

Losses

AR=D

Quantity

Long-run equilibrium:
Price

Quantity

Good examples of monopolistically competitive markets are take-

away food, hairdressing and book publishing.

IB HL Economics Page 39 3rd Edition

 Whilst firms in monopolistic competition are not allocatively and
productively efficient, consumers can benefit from choice and non-
price competition and firms can benefit from brand loyalty. Firms
still only make abnormal profits in the short run and will not benefit
from economies of scale, and the costs of non-price competition
can be high.

Oligopoly

Oligopoly is the predominant existing market structure. The market

Whilst Kinked Demand Curve
theory is the mainstay of is dominated by a few large firms. Significant barriers to entry
oligopoly theory in the IB exist. Economic theory seeks to explain why prices are ‘sticky’ but
syllabus, you should not not why they exist in the first place, as in perfect competition or
automatically respond to any monopoly. Other oligopolistic characteristics are non-price
oligopoly question with this competition, collusive behaviour and interdependence.
theory. This important market
structure deserves a more A concentration ratio (CR) quantifies the proportion of total
complete analysis, involving market output that is held by a number of firms. A five-firm
game theory and price
concentration ratio (CR5) is calculated by dividing the total output
leadership as an explanation of
of the five largest firms in a given market by the aggregate output
the interdependent behaviour of
firms.
of that market. The larger the ratio the more concentrated the
market and so the closer to monopoly. A CR of 50-80% (medium
CR) would indicate an oligopolistic market and anything of 80%
and above (high CR) would indicate a monopoly market.

Oligopoly models are divided into collusive and non-collusive

models. If you are required to analyse/evaluate a collusive
oligopoly then use the monopoly model as this is when firms have
a formal or informal (‘tacit) agreement to limit competition and raise
prices. In non-collusive markets firms do not ‘cooperate’ and so
they have to develop strategies to cope with their
interdependence. Here the Kinked Demand Curve model, game
theory and price leadership can be used to explain their behaviour.

The Kinked Demand Curve explains why, once a price is

achieved, a firm will tend not to move from this price. This is
because if a firm increases price, other firms will not follow, so the
firm will lose total revenue (an increase in price leading to a fall in
total revenue means the demand curve is price elastic). On the
other hand, if the firm decides to reduce price, other firms will
follow, and the firm will lose total revenue again (a decrease in
price leading to a fall in total revenue means the demand curve is
price inelastic). As the demand curve (AR) is kinked, two different
MR curves are needed, and a discontinuous zone is formed. If the
marginal cost curve varies within this zone, prices will still not
change. If the MC curve moves out of this zone (MC) then P and
Q will change:

IB HL Economics Page 40 3rd Edition

 Price

Q2 Q

MR Quantity

Game Theory explains interdependence. What is often called ‘the

prisoner's dilemma’ illustrates the choices a firm faces when
deciding whether to make a competitive change to price or to
cooperate with rival firms.

Firm X
$3.00 $2.70
Firm $3.00 $15 milleach | $7.5 mill
Y $18 mill
$2.70 $18 mill $12 mill each
$7.5 mill

The box shows the outcomes of each firm’s decision to change

price. If Firm Y cuts its price from $3.00 to $2.70 and X does not
follow, then Y’s profits will rise to $18 mill and X’s profits will fall to
$7.5 mill. If firm X follows the cut in price both firms will experience
a fall in their profits to $12 mill. If Y kept its price at $3.00 and firm
X cut its price to $2.70, Y’s profits would fall to $7.5 mill. This is
the dominant strategy in this game. The safe option (maximin) is
to cut price knowing that the other firm might follow and so the loss
of profits is minimised. The more optimistic approach (maximax) is
to cut price and hope that the other firm does not follow. Therefore
the same strategy, cutting price, is followed in both approaches.

Price Leadership Models illustrate situations in which a single

firm leads other firms in price-making decisions (‘tacit’ collusion).
The leading firm changes price, and other firms follow. Dominant
firm price leadership is where the dominant firm in a market sets
the price and other follow. Barometric firm price leadership is
where the firm that others believe reflects market conditions most
accurately sets the price and others follow.

1B HL Economics Page 41 3rd Edition

 Price Discrimination

Price discrimination occurs when different consumers are

Throughout Market Structures
charged different prices for the same good or service. Firms price
you should be able to apply the
discriminate to turn consumer surplus into profit. There are three
concepts of productive and
allocative efficiency, and illustrate conditions which must exist for this to take place:
them in diagrams when
assessing different market e A firm must have monopoly power
structures. ¢ There is no possibility of resale
¢ Different groups must be identified clearly

For example, students and pensioners often pay reduced rates for
goods such as train tickets.

1%t degree price discrimination is when firms charge

consumers the maximum price they are willing to pay.
2" degree price discrimination is when firms charge
different prices according to how much is consumed.
3™ degree price discrimination is when a market is divided
into two or more discrete markets each with its own price.
This is the most common form of price discrimination.
Price

MC

AR (b) MR (a+b)

13 15 28
Quantity

Here, the two discrete markets (‘a’ and ‘b’) are aggregated into
(a+b) and the firm will profit maximise where the aggregate MR
curve is equal to MC. This level of MC intersects MR in both
discrete markets setting the profit maximising level in each market
(13 in market ‘a’ and 15 in market ‘b’). The price in market ‘b’ is
higher than in market ‘a’ as it reflects the more price inelastic
demand of these consumers.

For price discrimination to be effective, a firm must be a price

maker, markets must be easily separated in terms of factors such

IB HL Economics Page 42 3rd Edition

as time and place, there must be no possibility of resale, and price
elasticity of demand must differ in each individual market.

Firms able to price discriminate will benefit from an increase in

total revenue. They may also be able to force competitive firms
out of business, by cross-subsidising on markets (predatory
pricing). Some consumers will benefit from the lower prices, and if
profits are reinvested they will benefit from reinvestment and
possible lower future costs.

Numerical application:
Calculate short-run shut-down price and break-even price
Calculate revenue max level of output

MARKET FAILURE AND GOVERNMENT RESPONSE|

Market Failure is any situation when the market mechanism fails

to allocate scarce resources efficiently. This is often seen as a This is a very important part of
rationale for government intervention. The four main types of the syllabus, and there are plenty
market failure are: of current real-world examples of
market failure. Your exam will
* Negative and positive externalities of production and contain questions on market
failure, particularly on the short
consumption
answer and essay paper. When
* Lack of public goods writing about market failure it is
* Merit and demerit goods important that you are able to
* Abuse of monopoly power explain exactly why the market
* Common access resources and sustainability fails, and analyse the causes of
* Asymmetric information these failures. Once failure has
been explained, cures or
You should also be aware of income and wealth inequality. responses should not only be
listed and described, but
evaluated. For each type of
market failure, can you complete
Externalities the sentence ‘the market fails
because...”? If you use this
Here the market fails because it fails to measure the true costs or sentence and successfully
benefits of production or consumption. Externalities are the costs complete it in your answer, you
or benefits of production or consumption that are experienced by will have shown your examiner
third parties, but not by the producers and consumers who cause that you can analyse the causes
of market failure.
them.

Negative externalities

Classic examples of negative externalities are any form of pollution

and traffic congestion. They are best illustrated as negative
externalities from production (this will focus on the supply curve).
Here, the market fails to measure the true costs of production to
society. In a free market the supply curve measures the marginal

1B HL Economics Page 43 3rd Edition

private cost (MPC), but it fails to measure the marginal external
cost (MEC). The true cost to society, the marginal social cost
(MSC), is equal to MPC + MEC. The shaded area is welfare loss:

Price
MSC=MPC+MEC

MPC

PSE Fermmarsnmmssrnmas
i X

Ppc {-- Deadweight welfare loss

MSB=MPB

Qsc Qpc

Quantity
The free market equilibrium (where demand = supply, or marginal
social benefit MSB = MPC), results in both over-production and
over-consumption of the good or service. In the diagram above,
this is output level QrcC. If the market were to take into account the
true costs of production, as shown by the MSC curve, then output
would be at Qsc (socially optimal level). So here the free market
has failed to allocate resources efficiently, and has
overproduced/consumed goods with negative spillover effects.

The shaded area represents the welfare loss to society created by

this overproduction. In the diagram below, each good has a MSC
that is greater than its MSB. In this example, we have assumed
that there is no positive externality in consumption, and therefore
marginal private benefits are equal to marginal social benefits.

IB HL Economics Page 44 3rd Edition

 Price

MSC=MPC

PP foeeeererserrees
oo eereeneeee :

Psb

MPB

MSB=MPB+MEB

Qsb Qpb

Quantity

There are several policy options open to governments looking to

cure the problems of negative externalities.

® Taxation (see diagrams on pages 23-4)

The benefit of a tax is that it simply shifts the supply curve Good candidates will be able to
upwards, increasing MPC to MSC. Good examples of this analyse and evaluate the
approach are environmental taxes: taxes on fuel, for example, various policy options available
landfill taxes, and, more recently, carbon taxes. Here, the polluter to cure market failures. They
pays. will realise that curing market
failures is often not a clear-cut
There are several problems with taxing negative externalities. issue, and nearly all cures have
both benefits and costs.
* Setting a tax to represent MEC. It is very difficult to calculate
accurately a monetary value of the spillover effects of a
negative externality.
e Goods with a price inelastic demand curve. Here,
producers can pass most of the tax burden onto consumers,
and so output/consumption will not radically be reduced.
* The regressive nature of some taxation. Income inequality
may be widened.
° International competitiveness. If a country takes a unilateral
action to tax negative externalities, it may make its exports less
competitive as prices rise.
* Optimal tax rates. High taxes might not reduce consumption
at all, but create black markets and other illegal activities.

® Tradable Permits
Tradable permits are used to limit the negative activities of firms.
These can vary from the emission of polluting gases to the
overfishing of the North Sea. The optimal level of pollution or

IB HL Economics Page 45 3rd Edition

production is set by a government or regulatory body, and this total
is then divided into individual firm permits to pollute or produce.
Firms are able both to buy and sell these permits. In the case of
pollution, firms have an obvious incentive to be environmentally
efficient so they can sell their permits to other firms (a very
profitable activity). In the case of production permits, firms are
allowed to maintain their income while they are not producing (for
example a North Sea trawler might be out of action through
repairs, but could still rent out their permits to other firms). Also,
efficient producers can buy quotas from less efficient firms to
increase their output.

These tradable permits are presently one of the front-line

responses to market failure.

® Regulation
Governments can intervene directly with measures such as quotas
to set the optimal level of production/consumption. Most firms
today have to comply with minimum environmental requirements.
For example, building regulations in the UK stipulate minimum
insulation requirements for all new buildings.

There are several problems with regulation:

» Setting a limit. It is very easy to over- or underestimate a limit

that coincides with a socially efficient outcome.
e Costs of regulation. All forms of regulations are costly to
administer and enforce.
* Benefits greater than costs. Some firms will still not reduce
pollution if the benefits from pollution are greater than the costs
of doing so (fines).

® Extending property rights

Property rights are the legal right to own or to do something. If
individuals have the legal right to clean air, for example, and this
right is easily and effectively enforced through the courts, then
polluting activities can be stopped, and/or financial recompense is
available.

This approach is only effective in societies where property rights

are easily enforced. This is often not the case in many
economically less developed economies and also many of the
previously centrally-planned economies.

® |nternational co-operation
The 1997 United Nations pact signed at Kyoto required the major
industrialised nations to make meaningful reductions in
greenhouse gas emissions. The EU’s target was to cut 1990
emission levels by 8% before 2010. In 2004 a report stated that
only two countries (UK and Sweden) out of the then 15 would be
able to meet these targets. Of course, the USA still refuses to sign
up to the treaty and this is a major blow to any international
agreement to cut emissions. International agreements are beset by

IB HL Economics Page 46 3rd Edition

 political problems with the process of negotiation often taking
some time. Policing of agreements is very difficult and there are
great incentives to ‘cheat’. In October 2004 Russia agreed to ratify
the Kyoto agreement. Now 30 countries are committed to legally
binding reductions in greenhouse gasses (5% on 1990 levels).

Positive externalities

A good example of a positive externality is the environmentally

beneficial effects of bee-keeping. Bees pollinate plants and
increase crop yields. They are best illustrated as positive
externalities from consumption. Here, the market fails to measure
the true benefits of consumption to society. In a free market the
demand curve measures the marginal private benefit (MPB), but
it fails to measure the marginal external benefit (MEB). The true
benefit to society, the marginal social benefit (MSB) is equal to
MPB + MEB. The shaded area below is welfare loss:
Price

Potential welfare gain

MSC=MPC

B e e - i X

[ 1)

MSB=MPB--MEB

MPB

Qpb Qsb

Quantity
The free market equilibrium (where demand = supply, or marginal
social cost MSC = MPB) results in both underproduction and
underconsumption of the good or service. In the diagram above,
this is output level Qpb. If the market were to take into account the
true benefits of consumption, as shown by the MSB curve, then
output/consumption would be at Qsb (socially optimal level). Here
the free market has failed to allocate resources efficiently, and has
underproduced/ consumed goods with positive spillover effects.

The shaded area below represents the welfare loss to society

created by this underconsumption. Here, each good has a MSB
that is greater than its MSC. In this example, we have assumed

IB HL Economics Page 47 3rd Edition

that there is no negative externality in production, and therefore
marginal private costs are equal to marginal social costs.

Price
MPC

MSC=MPC+MEC

Potential welfare gain

MSB=MPB

Qpc Qsc
Quantity

There are several policy options open to governments looking to

increase the consumption of goods with positive externalities.

® Subsidies
Subsidies aim to reduce the marginal private costs (MPC) of
production until the equilibrium level of output is reached (QsB).
As with taxes in the case of negative externalities, the problem
here is one of information. It is very hard to gain accurate
estimates of costs, benefits and the external effects associated
with positive externalities. If demand is price inelastic, then a
subsidy will only result in a small increase in consumption.

® Free Provision
In many countries both education and most healthcare services
are provided free of charge at the point of consumption.

® |nformation
One of the best ways of increasing the consumption of goods with
positive externalities is to educate and inform people of the
benefits, and so encourage people to make informed consumption
choices.

Public Goods

Here the market fails because the key features of public goods
are non-excludability and non-rivalry in consumption.

Non-excludability means that even if you have paid for a

good you cannot confine its use to yourself.
Non-rivalry means that the consumption of a good does
not reduce its availability to others.

1B HL Economics Page 48 3rd Edition

 Good examples of public goods are national defence and street-
lighting.

In a free market, public goods would not be provided because of

the two above features, and because individuals could free-ride
on others’ consumption.

Merit and Demerit Goods

Here the market fails because consumers make choices which It is important that you do not
society defines as wrong. In the case of merit goods, consumers
automatically assume that merit
consume too few goods and services that are seen as being good goods are goods with positive
for them (like education, art galleries). In the case of demerit externalities and vice versa, and
goods, consumers consume too many goods and services that that demerit goods are goods
are seen as being bad for them (alcohol and cigarettes, for with negative externalities and
example). Merit goods can also (but not always) have positive vice versa. This is an area in
externalities. Demerit goods can also (but not always) have which candidates often muddle
negative externalities. their definitions.

If merit and demerit goods do have externalities, then the cures

mentioned above can be used. But education and information are
very valid approaches, as consumer choices are at the heart of the
failure of the market mechanism.

Monopoly Power

A detailed diagrammatic analysis of market power is undertaken in

the Market Structures section of this Revision Guide. Along with externalities, this is
the key area of market failure on
which exams focus. You should
Here the market fails because monopolies (single sellers, or firms
be prepared to answer both
with 100% market share) erect barriers to entry, preventing short answer and essay
competition. These barriers enable them to develop market questions on monopolies and
power (the ability to increase prices). Monopolies will tend to the comparison of monopoly
result in both higher prices and lower output, and a decrease in with other market forms,
economic efficiency (with prices greater than market cost and especially perfect competition.
output not produced at minimum average cost), although, as we Whilst the diagrammatic analysis
shall see later on, this might not necessarily always be the case. is both detailed and complex, it
is a very well-structured part of
There are a wide the syllabus. With some careful
variety of cures for market power open to planning, therefore, you should
government:
be able to produce well-directed
written answers to examination
® Banning questions.
The formation of monopolies can be banned and existing
monopolies split up. This is the approach taken by the Sherman
Act in America.

® Investigation and Regulation

Most countries have organisations that investigate concentrating
markets (in the UK this is the Competition Commission in
combination with the Office of Fair Trading). These organisations

IB HL Economics Page 49 3rd Edition

make decisions about whether or not mergers/takeovers/
monopolies are in the public interest. They also investigate trading
practices. Recent examples include the concentration of UK
supermarkets, concern over the actions of Microsoft in America,
and the EU competition ruling on the production of vitamin
supplements. The powers that individual regulatory organisations
have vary widely from country to country (from fines to prison
sentences).

® Regulation of Privatised Industries

Most economies have privatised some or many of their previous
nationalised industries in recent decades. Because these risk
becoming private monopolies, they tend to be regulated in terms of
price and quality of service provision, alongside measures to
reduce barriers to entry and therefore encourage competition.
This has been especially true in the UK.

® | aissez-faire
Some economists suggest that the problems created by
monopolies are best cured by the actions of a free market.

Common Access Resources and Sustainability J

Common Access Resources are resources that are available to

everyone without payment, do not have a price, and are not owned
by anyone. Good examples are clean air, fish in the sea, and
biodiversity. It is not possible to exclude anyone from using these
resources (they are non-excludable), however, their use reduces
their availability to others (they are rivalrous). As these resources
have no price, they are overused, resulting in serious
environmental degradation and depletion.

Sustainability happens when resources are used today in such a

way that does not compromise their use by future generations.
Here we have a conflict between the economic goal of growth and
the environmental goal of sustainability. The concept of negative
externalities can be used here to illustrate how economic activity
threatens sustainability. Government responses to sustainability
can be linked into government responses to negative externalities
(legislation, carbon taxes, cap and trade schemes).

The major problem is the global nature of sustainability. ‘Common

access’ means ‘world-wide access’, so effective response requires
international co-operation. A good example of this is the European
Union Emissions Trading System (a carbon dioxide permit scheme
with trading in a carbon market).

IB HL Economics Page 50 3rd Edition

 Asymmetric Information

Sometimes, buyers and sellers do not have equal information

about the market in which the economic transaction is taking
place. Used car sellers and homeowners have more information
than potential buyers. If consumers are concerned about possible
dangers from consumption, then they will underconsume. If
consumers are unaware of possible dangers, then they will
overconsume. Both of these scenarios result in a misallocation of
resources.

Governments can respond through legislation, regulation and the

provision of information. A major problem occurs when a risk-
taking party does not face the full costs of their risks. This type of
asymmetric information and lack of moral hazard has been seen
as one of the major causes of the financial crisis that begun in
2008.

IB HL Economics Page 51 3rd Edition

[ MICROECONOMICS SAMPLE QUESTIONS |

Microeconomics is examined in Paper 1 (extended response/

essay) Section A.

1. (a) Explain the importance of cross elasticity of demand

and price elasticity of demand for firms when making
decisions. (10 marks)

(b) Studies have shown that the demand for petrol tends to be
highly price inelastic. Evaluate a policy of substantially
raising taxes on petrol as a method of reducing its
consumption. (15 marks)

2. (a) Using diagrams, explain the difference between a perfectly

competitive firm, in terms of profits, in the short-run and the
long-run. (10 marks)

(b) Evaluate the view that perfect competition is a more

desirable market structure than monopoly. (15 marks)

Model markschemes to these questions are on pages 126-40.

IB HL Economics Page 52 3rd Edition

 SECTION 2: MACROECONOMICS

[ MEASURING NATIONAL INCOME | You need to know how to

calculate various measures of
national income for the data
National income = national output = national expenditure response paper, but apart from
that you should not concern
Income method = payments to factors of production yourself too much with them.

Output method = the value of final output produced by

various industrial sectors

Expenditure method = GDP = C + | + G + (X-M)

* C = consumption
| = investment
G = government spending
X = exports
M = imports.

GDP is the total value of output produced in an economy in a

given time period.

GNI = GDP + net property income from abroad

NNI = GNI - depreciation (capital consumption)

Factor cost = market prices — indirect taxes + subsidies

Real GDP/GNI = nominal GDP/GNI — inflation

GDP/GNI per capita = GDP/GNI / population

Green GDP = GDP - environmental costs of production

There are problems with GDP as a measure of national income.

GDP itself does not take into account the negative spillover effects
of economic activity or the degradation of natural resources.
However, it also underestimates national income by failing to
measure black market activity, unpaid work carried out by
volunteers or housework and care for family members, and does
not take into account of improvements in the quality of output.

Numerical application:
Calculate GDP, GNP/ GNI
Real GDP and base year prices

IB HL Economics Page 53 3rd Edition

 Circular Flow of Income

——| Households
i

A
Firms

Income flowing into the flow is known as injections (J), and

income flowing out of the flow is known as withdrawals (W).

J=G+1+X
W=T+S+M

Equilibrium level of national income exists when planned J =

planned W. This equilibrium level of income might not necessarily
coincide with the full employment level of national income. The
total level of income in the circular flow at any given time period is
equal to national income.

Business Cycle Model

The business/trade cycle shows a pattern of growth (around a

trend rate of growth) of boom, recession, trough and recovery
measured by changes in real GDP, as shown in the diagram
below.

IB HL Economics Page 54 3rd Edition

 Peak/boom

Recession Long term trend

GDP

Time

Recession (Two consecutive quarters of GDP growth)

* Rising unemployment
* Falling consumption
* Falling investment
° Increasing government spending and falling tax revenue
* Business failures

Recovery (a period of economic growth post-recession)

* Falling unemployment
* Increasing consumption
* Increasing investment
* Rising inflation

Boom (an extended period of above-trend growth)

* Accelerating inflation
* Shortages of scarce factors (skilled labour)
* Rapidly rising property and equity values

Trough (lowest level of GDP in the cycle)

* Widespread long-term unemployment

Fluctuations in growth are shown in fluctuations in actual output.

The long-term trend rate of growth shows the rate of growth that
an economy can sustain over time (potential growth). The
difference between actual and potential growth is the output gap.
At A there is a negative output gap and at B there is a positive
output gap.

A decrease in GDP (where the economy actually shrinks) is

different from a decrease in GDP growth (where the economy
continues to grow, but at a slower rate).

1B HL Economics Page 55 3rd Edition

 MACROECONOMIC MODELS

figgregate Demand and Supply Analysis |

Equilibrium level of national income is where aggregate

AD and AS analysis is the main
demand (AD) is equal to aggregate supply (AS).
system for analysing macro-
economic problems and
policies. Once mastered, it is a ® Aggregate Demand
very flexible tool which is easily AD = Consumption (C) + Investment (I) + Government Expenditure
brought into any macro-
(G) + (Exports (X) — Imports (M)).
economic situation. You should
be able to manipulate AD/AS
diagrams accurately to explain AD is the total demand for an economy’s goods and services.
any macroeconomic situation.
Average price level (P)

AD1

AD

Y1 Y2

Real output (Y)

AD is downward-sloping because as prices rise, the demand for an

economy’s goods and services will be less. Goods will be less
competitive in international markets and real income is less.

AD will shift if any of C + | + G + (X — M) change.

Factors that influence consumption:

e Consumer confidence
¢ Interest rates
¢ Wealth
* Income taxes
* Debt

Factors that influence investment:

* Interest rates
¢ Taxes on profits and investment

IB HL Economics Page 56 3rd Edition

 * Business confidence
* Corporate debt

Factors that influence government spending:

e Political and economic priorities

Factors that influence net exports:

* Exchange rates
* Protectionism
* Income levels of trading partners

Important Factors that shift the AD curve are:

Fiscal policy. An increase in government spending will | Diagrams to illustrate these

increase AD, and a decrease in government spending will | demand-side policies can be
decrease AD. A decrease in taxation will increase AD, as it | found where this guide
will increase disposable income and thus C. An increase in | discusses Macro Equilibrium
taxation will decrease AD as it will decrease disposable | @nd the different approaches
income and thus C. Thus, a budget deficit (G > T) will f\'jl‘ke” by § Keyneclan. and
increase AD and a budget surplus (G < T) will decrease Eonetar[st/Neo—C!asswal
. ) . \ . conomists. You should be
AD. Expa}nswn‘ary flscal_pollcy (increasing AD)'can thus be | Jpie to draw AD/AS diagrams
used to ‘close’ a deflationary gap and deflationary fiscal | that ilustrate the impacts of
policy (decreasing AD) can be used to ‘close’ an expansionary fiscal and
inflationary gap. monetary policies as well,
enabling you to discuss the
Monetary policy. An increase in the rate of interest will | importance of the shape of the
decrease AD by increasing saving and so reducing | AS curves when analysing and
consumption, by decreasing investment, and by | evaluating policy.
strengthening the exchange rate and so reducing exports.
A decrease in the rate of interest would have the opposite
effect. An increase in the money supply may be used to
increase AD.

Exchange Rates. An increase in the value of an

economy’s currency will, other things being equal, make an
economy’s exports less competitive and imports more
competitive and so reduce AD. The opposite is also the
case. There is a lot of controversy
over the shape of the AS curve.
Of course, ceteris paribus applies to all these factors. The shape affects the final
outcome of any shift in the AD
curve. The implication of macro
policies and the potential
® Aggregate Supply solutions to macro problems all
AS represents the total value of goods and services that an depend upon one’s view of the
economy can produce in a given time period. shape of the AS curve. There
is, however, agreement over the
AS curve being vertical when an
economy. reaches full
employment. The disagreement
lies in whether an economy is
always at full employment or
not. Keynesians believe that an
economy may not necessarily
be in equilibrium at full
employment.

IB HL Economics Page 57 3rd Edition

Average price level (P)
SRAS1

SRAS

¥2 Y1

Real output (Y)

In the short run AS slopes upwards because, as prices rise, firms
find it profitable to increase their output, and new firms will start
producing.

Factors that shift SRAS:

¢ Changes to raw material and component costs
e Business taxes and subsidies
e Changes to labour costs
e Supply-side shocks

In the long run, AS is vertical as the economy is at full capacity.

Output cannot therefore be increased in responses to increases in
aggregate demand.

Factors that shift LRAS:

¢ Changes to the stock of productive resources
¢ Changes to productivity/efficiency
e Changes to technology
e Institutional changes

These factors lead to changes in the quantity and/or quality of

factors of production.

® Alternative views of LRAS

Keynsian
Different levels of spare capacity in an economy give the
aggregate supply curve three distinct sections:

IB HL Economics Page 58 3rd Edition

 Average price level (P)

Y fe

Real output (Y)

In section ‘A’ above, there is plenty of spare capacity in the

economy and so output can be increased without increasing costs.
In section ‘B’ shortages of some factors exist and so increases in
output will cause prices to rise as the cost of hiring these scarce
factors increases. In section ‘C’ the economy is at full employment
(in the long run and at full capacity) and so any attempt to increase
output will be purely inflationary.

An improvement in the quantity and/or quality of factors of

production will shift the long run aggregate supply section of the
Keynesian AS curve to the right (AS1 to AS2).

Monetarist/ New Classical

In the following graph, LRAS is vertical at the full employment level
of output (full capacity and potential output). As potential output is
based on factors (their quantity and quality), the price level does
not affect LRAS. Employment is determined in factor markets and
this determines the total level of output in an economy.

IB HL Economics Page 59 3rd Edition

 LRAS 1 LRAS 2

Average price level (P)

PL Lo |

Y fc

Real output (Y)

® Equilibrium
Macroeconomic equilibrium is where AD = AS:
Average price level (P)

Real output (Y)

Here, short run equilibrium is where AD=SRAS.

In the Keynesian model, the economy is at equilibrium where

AD=AS (actual output) at any level of output. If equilibrium is
below full employment (actual < potential output) then there is a

1B HL Economics Page 60 3rd Edition

deflationary (recessionary) gap (Y1 and Y2 < Yfc in the diagram You should be careful not to get
below). This ‘gap 'is also known as a negative output gap. Here too hung up on the differences
growth need not be inflationary, as there is spare capacity in the between Keynesians and
economy. Monetarists unless the questions
ask you clearly to distinguish
between these two schools of
thought. You need to be able to
use AD and AS analysis
effectively to analyse and
evaluate economic issues, and so
you should use an AS curve that
allows for both analysis of the
£ short and the long run. | would
° use the diagrams on the left and
>
o right to do this.
g
s
d)
o
&
<
g

AD 2

Y1 Y2 Y fc
Real output (Y)

£
©
>
2
g
s
@
o
]
g
3

AD 2

XL Y2 Yfc

Real output (Y)

At equilibrium levels of output below full capacity (Yfc), Keynesian

economists would suggest that demand side policies should be
used to increase output, as shown above.

IB HL Economics Page 61 3rd Edition

Any increase in AD at full capacity (Yfc) will be purely inflationary
(inflationary gap where actual > potential), as there is no spare
capacity in the economy:

Average price level (P)

AD 2

AD 1

Y fc

Real output (Y)

Monetarists and New Classical economists believe that an
economy is always at full employment, and therefore the AS curve
is vertical.

LRAS

—
£
T PP et gt
&
@
e=
s
@ P e
o
o
<
< >
AD 2

AD 1

Y fc
Real output (Y)

As you can see in the diagram above, any increase in AD will be

purely inflationary in the long run.

IB HL Economics Page 62 3rd Edition

At full employment, the only way to increase national income and
reduce unemployment without causing inflation is to use supply-
side policies to move the LRAS curve outwards to the right (LRAS
1to LRAS2):
Average price level (P)

LRAS 1 LRAS 2

PRLicsuosssmsnsssanusnmssass sammscsstonsinintasssssiniad)

P [roesrermannimsnsnreresenmmtrastmms sty

AD

Y1 Y2

Real output (Y)

Increasing AD at full employment reduces unemployment in the
short run, but creates an inflationary gap. Output can only be
increased by paying existing factors of production more (overtime),
so rising costs of production will shift SRAS to SRAS*, returning
output to the full employment level, but at a higher price level (P*):
Average price level (P)

LRAS SRAS *

SRAS

AD 2

AD 1

/ Inflationary gap

Yi vz

Real output (Y)

IB HL Economics Page 63 3rd Edition

 With falling AD the opposite happens via a deflationary gap (actual
output is less than potential output):

£
@
>
2
g LRAS
a SRAS
o
o
g
z2 S RAS*

PR
AD 1

AD 2

Deflationary gap

Real output (Y)

In order to increase output in the long run, policy should aim to

increase LRAS (LRAS1 to LRAS2) using supply-side policies.

Macroeconomic policy is in effect a balance between demand-side

and supply-side policies. AD can be allowed or encouraged to
increase as long as there is room on the supply side for it to do so.
Most developed economies can only sustain a 2-3% growth rate of
national income without causing inflation to accelerate.

Governments need to use demand-side policies (fiscal and

monetary policies) to make sure that AD does not grow out of
control (unsustainably), whilst using supply-side policies to
encourage the growth of productive potential to make sure that
economic growth is sustainable at low levels of inflation. Of course
many developing economies can sustain much higher growth
rates. Currently China is ‘targeting’ a 7% growth rate with a 4%
inflation target.

Students frequently find this a The Keynesian/Monetarist Debate |

very confusing area. Both
schools of thought seem to have Keynesians believe that:
persuasive arguments to account
e Markets are slow to adjust
for the way in which the
¢ An economy can be in equilibrium below full employment
economic world works. Good
economics is about differing ¢ Governments should and can effectively intervene to stabilise
opinions! The extremist an economy
proponents of these two schools ¢ Fiscal is more effective than monetary policy
of thought will carry on arguing
well into the future.

1B HL Economics Page 64 3rd Edition

Monetarists believe that:
° Markets work You should focus on their
e Economies tend towards full employment different views on the workings of
» Inflation is caused by excessive money supply growth the market, the rationale and
* Governments should intervene really only to control inflation by effects of government
controlling money supply growth intervention and the shape of the
AS curve, and be prepared to
illustrate, analyse and evaluate
each side of the debate.
The Multiplier

The multiplier effect is the proportion by which an initial increase

in injections, or reduction in withdrawals, causes a greater final
increase in the level of national income.

The size of the multiplier depends upon the marginal propensities

to consume (MPC) and withdrawal (MPW = MPS + MPT + MPM).
The greater the MPC (the less the MPW), the greater the multiplier
will be, as all income is either consumed or withdrawn (Y = C + W).
This is because a greater proportion of an increase in income will
be spent with domestic firms. Household saving and consumption
plans are difficult to predict, and so the value of the multiplier is
hard to predict and it may change over time.

Numerical application:
Calculate MPC and MPW (MPS + MPT + MPM) from the data
Calculate the value of the multiplier:
1
(1-MPC)

1
(MPW)

Calculate effect on GDP ofa change in an injection

Determine the level of G or | needed to generate a given change in
GDP

I DEMAND-SIDE AND SUPPLY-SIDE POLICIES

Demand-side Policies

® Fiscal Policy
Fiscal policy is the use of government spending (current, capital
and transfer payments) and taxation (direct and indirect) to
influence AD, raise revenue, redistribute income and influence
consumption patterns. A government's fiscal stance is how
expansionary or contractionary their budget is. The way in which
government spending and taxation influences AD has already

IB HL Economics Page 65 3rd Edition

been mentioned above, but there can be problems with fiscal
policy.

The government budget:

Budget deficit is when total expenditure > total tax revenue (in a
particular year).
Budget surplus is when total expenditure < total tax revenue (in a
particular year).

National debt is the accumulation of all the past years’ deficits. A

budget deficit will increase the size of the national debt. A budget
surplus will reduce the size of the national debt.

Government expenditure:
e Current: spending on factor payments and goods
e Capital: investment spending and spending on assets
e Transfer payments: a payment from the government to an
individual (eg. unemployed or pensioner) where no output is
generated. It is a means of redistribution of income

Government revenue:
e Direct taxes: taxes on income (wages/salaries, interest,
dividends, rent and profit)
* Indirect taxes: taxes on expenditure (paid indirectly by firms
supplying goods and services)
* Sale of goods, services and the privatisation of nationalised
industries

Automatic (built-in) stabilizers:

In most economies there is an element of automatic fiscal policy
creating some stability in GDP. As GDP grows, government
spending decreases (falling benefit payments) and taxation
increases (progressive taxes). As output and GDP fall government
spending increases and taxation falls. This ‘built-in’ process seeks
to help stabilize short-term fluctuations in GDP.

Fiscal Policy strengths/weaknesses:

Strengths:
° Targetable
¢ Direct impact on AD
* Role in recession

Weaknesses:
* Time lags
* Political influence
e Inflexible
e Budget deficits can lead to increases in interest rates (to
encourage bond sales) and taxation in the future
¢ Crowding-out is when government bond sales result in the
public sector needing to compete with the private sector for
funds. They will have to offer higher rates of interest in order to
sell bonds, and the availability of funds in the loanable fund
market will decrease. Thus the private sector will be forced to
offer high interest rates as well, discouraging investment and

IB HL Economics Page 66 3rd Edition

 spending. Some economists argue that this will only happen
when an economy is at full capacity

Because of the limitations of fiscal policy, most governments focus

their demand-side policies around monetary policy and the rate of
interest in particular. Fiscal policy is now often used to improve the
supply-side of an economy, for example by cutting direct taxes and
benefits.

Fiscal policy and potential output (LRAS):

Fiscal policy can be, and is increasingly, used to increase potential
output and thus long-run economic growth. Creating incentives via
the tax system for firms to invest and individuals to work, creating
an environment that is favourable for business and employment
and actual government spending on infrastructure are all examples
of fiscal policies that target potential output.

® Monetary Policy
Monetary policy is the use of the rate of interest predominantly to
influence AD (the money supply control and targeting the
exchange rate can also be used).

Equilibrium interest rates are determined in the money market and

central banks can influence interest rates by either
increasing/decreasing the money supply or changing interest rates
and then changing the money supply to support this decision.

In the graph below, the interest rate is determined by the demand

(D m) for and supply (S m1 and S m2) of money. Here an increase
in the money supply (S m1 to S m2) results in a fall in the rate of
interest:

Sml
Interest rate (r)

rl

r2

Q1 Q2
Quantity of money

IB HL Economics Page 67 3rd Edition

The role of the central bank:
° Banker to the government
¢ Regulates the commercial banking system
* Manages government’s borrowing by issuing bonds to finance
budget deficit
e Sets interest rates to achieve macro targets (eg. inflation
targeting in the Eurozone and the UK)
¢ Manages the supply of money through nominal interest rates,
the issue of notes and, more recently, quantitative easing
* Manages gold and foreign currency reserves (the exchange
rate)

Inflation targeting:
As a response to the failure of discretionary macroeconomic
policies, many countries have turned to inflation targeting as their
‘core’ macroeconomic policy. Here, monetary policy focuses on the
rate of inflation rather than a broad set of frequently-conflicting
macro goals. Interest rates (and sometimes the money supply) are
used to achieve a target that is either symmetrical (Canada 2% +/-
1%) or asymmetrical (Eurozone <2%). Once the target has been
achieved, it is then ‘simply’ a matter of using interest rates to
maintain the target level.

Until recently, economic growth does not seem to have generated

inflation as it had in the past, and so targets were achieved with
relative ease. However, recently, inflation has come from rising
commodity prices resulting from rapid growth in countries such as
India and China. Many of these prices rises have been cost-driven
and seen as ‘temporal’ so a simple interest rate response
(increasing rates) would have reduced AD, causing a recession
rather than hitting the ‘cost-push’ causes of the inflation.

Monetary Policy strengths/weaknesses:

Strengths
e Independence of central banks removes political influence
¢ Incremental changes are possible
¢ Relative speed of change

Weaknesses
e Investment can be interest-inelastic
* Time lags
e One policy fits all (blunt instrument)
e Ineffective against cost-push inflation
Low consumer/investor confidence in deep recession mean
that consumers and firms fail to respond to low borrowing rates
and may pay back debts instead of borrowing

Most developed economies now actively use the rate of interest to

influence AD. Independent central banks dominate rate of interest
decision-making. They are able to respond instantly to changing
economic circumstances, whereas fiscal policy often has to wait
for the democratic wheels to turn.

IB HL Economics Page 68 3rd Edition

 Supply-side Policies

Supply-side policies aim to increase an economy’s productive

potential by changing the quantity and/or quality of resources in
the economy, as shown in the following two diagrams:

&
5g
2

g
s
o
o
&
g
<

Yl Yfe2
Real output (Y)

g LRAS1 LRAS2
3
>
3
o
&
a —_—
o
o
£
g
<

|
|

|
, ; | ;
Y fcl Y fc2

Real output (Y)

Policies can either be market-based or interventionist.

IB HL Economics Page 69 3rd Edition

 Interventionist-based:
¢ Investment in human capital
¢ Investment in new technology
¢ Investment in infrastructure
e Industrial policy

Here the individual needs of countries may differ significantly and

the needs of ELDCs differ considerably from developed
economies. There may well be negative effects on a government’s
budget, and time lags can be substantial.

Market-based:
» Deregulation, privatisation and encouraging competition
* Labour market reforms
* Incentives to work and invest (firms)

These policies can result in increased monopoly power for firms

and reduced incomes/job protection and health and safety
measures for workers. They will also redistribute income and the
impact of incentives is not clear as individuals respond in different
ways to the same policies.

[ UNEMPLOYMENT AND INFLATION |

Essays ask easy factual Unemployment

questions about the types,
causes and cures of both The Unemployed are the people who are registered as willing,
unemployment and inflation. able and available for work at the market-clearing wage, but who
are unable to find work.

The Unemployment Rate is the number of people unemployed as

a percentage of the labour force.

Underemployment is when workers who want full-time jobs are

only able to find part-time employment. Low wages and output per
worker are reflections of work with low rates of productivity.

Hidden Unemployment is the part of the working population

excluded from any measure of unemployment because of the
definition of unemployment used.

One of the major problems with any measure of unemployment is

that it is an aggregated and average measure that takes no
account of regional, gender, age and ethnic variations and
disparities.

The costs of unemployment are:

¢ Loss of output

IB HL Economics Page 70 3rd Edition

 * Waste of productive potential
* Loss of skills
* Government finances (loss of tax revenue, increased benefit
spending)
* Social problems
* Loss of consumer spending
* Increased income disparity

The types (causes) of unemployment are:

* Cyclical (Demand Deficient)
* Frictional
* Seasonal
e Structural

Equilibrium unemployment
Average wage

Qe
Quantity of labour

Here, A to B is the equilibrium level of unemployment (natural level

of unemployment). The main causes of this type of unemployment
are frictional, seasonal and structural. ASL is the aggregate supply
of labour and LF is the labour force. At We the quantity of labour
willing and able to work at We is less than the labour force. Jobs
are available, however, A to B workers are not willing or able to
work at the market-clearing wage.

Solutions to frictional (search) unemployment include

incentivising unemployed workers to take job opportunities (eg.
reducing benefit levels) or providing information about available
vacancies. Similar solutions can also be applied to seasonal
unemployment.

IB HL Economics Page 71 3rd Edition

Solutions to structural unemployment (a mismatch between skills
and opportunities caused by technological change, a fall in
demand for a particular job/skill and changes in consumers tastes)
focus on supply-side policies to increase the mobility (in terms of
skill, occupation and geography) of labour. Education, training
(apprenticeships) and relocation incentives all target structural
causes of unemployment.

® Disequilibrium unemployment

Average wage

w1

Qe
Quantity of labour

Here, with W1 above We, A to B represents unemployment as

‘sticky’ wages stop the wage rate falling to We (equilibrium wage
rate). A good example of this is unemployment caused by trade
unions and minimum wages (real wage/classical unemployment).

Demand deficient unemployment is caused by recessions. As

shown in the following graph, as aggregate demand falls (AD1 to
AD2), firms reduce employment as the demand for their output
falls:

IB HL Economics Page 72 3rd Edition

 Average price level (P)

AD1

AD 2

Y2 Y1 Yfc

Real output (Y)

Cyclical or Keynesian unemployment sees the economy in

equilibrium below the full employment level of income (Yfc), and so
policy here would aim to increase AD by the use of fiscal and/or
monetary policies.
Average wage

ADL 1

ADL 2

Qa Qb
Quantity of labour

Here the demand for labour falls from ADL 1 to ADL 2, and with
wages reluctant to fall, disequilibrium unemployment exists from A
to B.

IB HL Economics Page 73 3rd Edition

Average wage

Quantity of labour

Of course, several causes of unemployment may ‘coexist’ in an

economy at any given time period. In the diagram above, A to B is
disequilibrium unemployment and B to C is equilibrium
unemployment, and so different strategies are needed to cure the
overall problem.

® The Natural Rate of Unemployment

The natural rate, also known as the equilibrium rate, is any
unemployment that exists when the aggregate demand for labour
equals the aggregate supply of labour. Supply-side policies
should be used as a cure. The natural rate exists at the full
employment level of income (where there is no demand deficient
unemployment), and this is where the AS curve is vertical. This
again emphasises the need for supply-side policies.

Numerical application:
Calculate unemployment rate from data

Inflation

Inflation is a constant rise in prices over a given time period.

There are problems with the measurement of inflation. Should
mortgage payments and indirect taxes be included? Is a weighted
basket system (Consumer Price Index) fully representative of all
people’s costs of living, and does it take into account the change in
quality of goods and services produced?

IB HL Economics Page 74 3rd Edition

 Disinflation is a fall in the rate of inflation.

Corel/underlying inflation excludes the impacts of volatile prices

(oil and food are good current examples).

Producer price index (PPIl) measures inflation using a ‘basket’

factors that are used in the production process (eg. capital, raw
materials and energy prices). This measure gives us an indication
of the extent to which SRAS might be affected by price changes.

® The consequences of inflation:

* Redistribution of income (savers versus borrowers, weak
versus strong bargainers in the labour market, fixed incomes)
Devaluation of money/loss of purchasing power
Reduction of investment
Reduction of international competitiveness
A potential for a wage-price spiral if inflation runs out of control
Shoe-leather and menu costs
Potential for wage/price spirals

Many of the costs of inflation depend upon whether inflation is

anticipated or unanticipated. Volatile inflation makes it difficult for
businesses and individuals to plan and predict inflation in the short
to medium term. Volatility results in businesses and individuals
taking steps to protect their interests. The overall impact of inflation
is therefore a reduction in economic growth combined with an
increase in unemployment.

® The types (causes) of inflation:

Cost-push inflation can be caused by:
* Rising raw material costs
* Rising labour costs
* Increased indirect taxation

Cost-push inflation is shown in the diagram below by a decrease in

SRAS resulting in an increase in the average price level from P4 to
P>.

Macro policies are rather ineffective at attempting to cure cost-

push inflation in the short run, as a demand-side focus is not
appropriate and supply-side policies are only really effective in the
long run.

IB HL Economics Page 75 3rd Edition

 SRAS 2

Average price level (P)

Y2 Y1

Real output (Y)

Demand-pull inflation can be caused by:

* Reduced taxation
¢ Increased government spending
* Reduced interest rates
* Rising consumer confidence stimulated by rising asset prices
¢ Economic growth in other countries
¢ Depreciation of a country’s exchange rate

Demand-pull inflation is shown in the diagram below by an

increase in AD when near or at full employment, resulting in an
increase in price level from P4 P2 and Pa.

Any increase in a component of AD can cause demand—pull

inflation.

1B HL Economics Page 76 3rd Edition

 Average price level (P)

AD 3

Yi Y2 ¥Yic

Real output (Y)

As output nears full employment (Yfc), factors of production

become scarcer and competition for limited output drives up
prices.

Here, cures for inflation should focus on reducing the rate of

growth of aggregate demand or, in extreme circumstances,
actually reducing aggregate demand and national income.

® The cures for inflation:

It is important that fiscal and
Demand side: monetary policies work in
tandem. There is no point in
* Monetary policy (an increase in interest rates)
tightening monetary policy if it is
» Fiscal policy (reducing government spending and/or increasing
contradicted by a slackening of
direct taxation) fiscal policy.

Supply side:
* Policies to increase the total supply of goods and services by
an economy

The control of inflation is a balancing act between AD and AS.

Governments or independent central banks need to keep control of
the rate of growth of AD whilst policies are needed to continually
expand an economy’s productive capacity. Increased output
produced at lower cost gives an economy room to grow without
causing rising inflation.

Deflation is a constant fall in prices over a given time period.

Demand-side deflation is a dangerous type of deflation and is

caused by a fall in AD linked to a time of recession (AD1 to AD2, in

1B HL Economics Page 77 3rd Edition

the diagram below). As a recession extends in time employment
falls and there is downward pressure on prices.

price level (P)

Average

Y2 Y1
Real output (Y)

With rising unemployment, falling investment, rising saving and

falling consumption, unchecked deflation can result in delayed
consumption and further deflation. It is crucial that this type of
deflation is checked by demand-side policies to increase AD.

Supply-side deflation from lower commodity and oil prices,

productivity gains, more competitive wages and lower indirect
taxes can result in increased output and lower unemployment in
parallel to the deflation. This type of deflation is very much
desirable.

In the graph below, this is illustrated by movement from SRAS 1 to

SRAS 2 as costs of production fall.

1B HL Economics Page 78 3rd Edition

 Average price level (P)

Y1 vy2

Real output (Y)

Numerical application:
Construct a weighted price index from data
Calculate inflation using price index and base year

® Inflation/ Unemployment trade-off

With a standard set of AD and AS curves there is an inverse
relationship between inflation and unemployment (as output rises,
it is assumed that unemployment falls). Keynesian economists,
based on their view of the AS curve, theorise that increases in AD
would reduce unemployment because at low levels of output spare
capacity means that prices are stable. It would be as the economy
neared full employment inflation would start to increase.

In 1958 A. W. Phillips’ study of 95 years of unemployment and

inflation data suggested an inverse relationship and led to the
development of the Phillips Curve.

In the following diagram, AD is increased from AD1 to AD2

(equilibrium from A to B), with output increasing from Y1 to Y2
(unemployment falling) and the price level rising from P1 to P2:

IB HL Economics Page 79 3rd Edition

 Average price level (P)

AD2

The astute of you will have

noticed the difference between Y1 Y2 Yfc
to two vertical axis labels on the
‘paired’ diagrams on the right. Real output (Y)
‘Inflation”, on the Phillips
curves, and “Average price
level” on the AD/AS diagrams The Phillips curve below then illustrates this ‘inverse’ relationship
measure different things. These with a choice of inflation/unemployment combinations at A and B.
diagrams are used to illustrate a
relationship and a link to the
AD/AS model. Here it Iis
assumed that an increase in the
Inflation rate (%)

average price level is the same

as an increase in the rate of
inflation at this time.

P1 deeremneenenneen

SRPC2

SRPC1

2L
Unemployment rate (%)

This ‘relationship’ broke down in the late 1960s and early 1970s
when stagflation (stagnation, hence rising unemployment with
rising inflation) appeared in most developed/ industrial economies.
This is illustrated by the movement from A to C in the diagram
above. Rising factor costs and oil prices fuelled rising inflation,

IB HL Economics Page 80 3rd Edition

and the situation was made worse by government policies aimed
at increasing AD, to cure rising levels of unemployment.

It was soon suggested that the ‘inverse’ relationship between

inflation and unemployment was in reality more complex, and
Milton Friedman argued that the trade-off between inflation and
unemployment only existed in the short run. Government policy to
increase AD in order to reduce unemployment would only be
successful in the short run, but higher inflation would eventually
result with a return to higher unemployment in the long run.
Increasing rates of both inflation and unemployment are
represented by an outward shift in the short-run Phillips curve
(SRPC1 to SRPC2 to SRPC3). In the long run, unemployment
would remain stuck at the natural rate of unemployment. This is
the level of unemployment that exists at full employment, i.e. at the
long-run vertical AS curve. The solution here is the use of supply-
side policies to reduce the natural rate of unemployment.
Inflation rate (%)

The area of inflation/

unemployment trade-off is a
difficult one. It is best to base
your ideas around the short-run
and the long-run AS curves.
Increases in AD to reduce
unemployment will not cause
accelerating inflation while on a
SRAS. But at full employment
and the LRAS any increase in
AD will be purely inflationary
and therefore supply-side
policies should be used.

SRPC3

SRPC2

2 ul
Y SRPC1
-1

Unemployment rate (%)

In the diagram above, a government decides to move from A to B

(reducing unemployment by increasing AD from AD1 to AD2 in the
diagram below). The trade-off here is a higher rate of inflation (P2).
Wages rise to compensate for the higher prices, and this causes
an increase in the costs of production. This decreases SRAS1 to
SRAS?2, resulting in a higher average price level. Output falls back
to Y1, and unemployment returns to the natural rate at U1.

1B HL Economics Page 81 3rd Edition

Average price level (P)
LRAS SRAS 2

SRAS1

P3

AD2

AD1

| Inflationary gap
—

Y1 Y2

Real output (Y)

ECONOMIC GROWTH

Economic Growth is an increase in real GDP over a given time

period.

It is important that you can distinguish between actual and

potential growth.

Actual growth happens when an economy is below full

employment and moves towards full employment by improving the
use of existing resources (AD1 to AD2 in the diagram below).

1B HL Economics Page 82 3rd Edition

 Average price level (P)

AD 2

Y1 Y2 Yfc

Real output (Y)

In the diagram above, with AD1 to AD2, the economy grows from
Y1 to Y2. This is the same as the move from A to B in the PPC
diagram below, with fewer resources unemployed at B than at A.
Consumer goods

PPC1

Capital goods

Potential growth is the long-term trend rate of growth (LRAS1 to

LRAS2 in the diagram below). An increase in the quantity and/or
quality of factors will result in potential growth. This type of
growth occurs in the long run with an increase in the full

IB HL Economics Page 83 3rd Edition

employment level of income (Y1 to Y2 and PPC1 to PPC2 in the
diagrams below) or potential level of output.

g
@
LRAS 1 LRAS 2
>

2
gg
o

s
L

-
i
5g
<

P2 b

AD

Y1 Y2
Real output (Y)

2vo
o
=5
o

£5
32
o
Q

PPC2

Capital goods

Key causes of this long run growth are investment in both physical
and human capital resulting in productivity growth (output per unit
of factor input).

IB HL Economics Page 84 3rd Edition

 ® Consequences of economic growth
Benefits of growth:
* Per capita income growth and increased consumption
e Higher living standards
* Fiscal dividend (reduced government spending and increased
tax revenue)
* Reduced unemployment/increased employment
* Easier to redistribute income/care for the environment

Costs of growth:
e Inflation
Externalities and resource depletion
Increased importing and current account deficit
Unbalanced growth from a focus on consumption
Unequal distribution of income

Numerical application:
Calculate change in GDP
Calculate % change in real GDP (using a price index)

DISTRIBUTION OF INCOME

Income is unequally distributed within economies, and whilst

inequality does provide some useful functions, such as providing
incentives and rewards, there is a broad acceptance of the need
for redistribution from rich to poor. Where the disagreement lies is
in the amount of redistribution that should take place, and by what
means. Any analysis of income distribution needs to consider
whether taxes have been removed and benefits been added.

® Measuring the distribution of income

A Lorenz curve shows the proportion of a nation’s income that is
earned by any given percentage of the population.

100
Complete
equality

% of income \A

<4—— Lorenz curve

0 % of population 100

IB HL Economics Page 85 3rd Edition

 The curve is below the line of complete equality because, for
example, the poorest 20% of the population will own less than
20% of national income. The more ‘bowed’ the line, the greater
the degree of inequality.

The Gini coefficient gives a numerical measure to the degree

of inequality (the higher the number the greater the inequality).

Gini coefficient = A
A+B

Incomes differ for a wide variety of reasons including: labour

market conditions, bargaining power, tax and benefit
structures, wealth, discrimination, household composition,
qualifications and hours worked.

Government tax and benefit measures to redistribute

income
By using the tax and benefit system, governments can
redistribute income from rich to poor. For example, progressive
income taxes will take income from the rich that can then be
redistributed using transfer payments (income transferred
from one person to another without any production taking
place) such as unemployment benefit or pensions.

Taxes can be progressive (the average rate of tax rises as

income rises) regressive (the average rate of tax falls as
income rises) or proportionate (the average rate of tax is
constant).

Direct taxes are taxes on income and wealth that are paid
directly to tax authorities. Indirect taxes are taxes on spending
that are paid by suppliers and therefore not directly by
consumers.

Direct taxes tend to be progressive and indirect taxes tend to

be regressive. Any movement away from direct to indirect
taxation will therefore tend to make the distribution of income
less equal.

Other methods of promoting equity are based on government

intervention to promote health care and education services
(often through direct provision or subsidies), clean water and
sanitation, as well as other basic infrastructures.

Poverty
Most countries have a level of income that is defined as a
‘poverty line’ (set at a level that is the minimum needed for
basic needs), and if a family has an income that is below this
then they are in absolute poverty. The World Bank defines
‘extreme poverty’ as living on less than $1.25 a day. Relative
poverty compares incomes in a country with median incomes
(a measure of income needed for a lifestyle typical for a certain
society and above absolute poverty).

1B HL Economics Page 86 3rd Edition

 Causes of poverty:
Low incomes
Unemployment
Unequal distribution of ownership of land and resources
Age, gender and other forms of discrimination
Lack of human capital
Poverty cycles

Consequences of poverty:
Social problems
Lack of access to health care and education
Low living standards
Higher levels of preventable disease and iliness, infant
mortality, child and maternal mortality

Numerical application:
Calculate marginal and average tax rates
Calculate tax payable at a given level of income

IB HL Economics Page 87 3rd Edition

 MACROECONOMICS SAMPLE QUESTIONSJ

Macroeconomics is examined in Paper 1 (extended

response/essay) Section B.

1. (a) Explain why a country may wish to reduce its inflation rate.
(10 marks)

(b) Evaluate the likely effects on an economy of relying

on demand-side policies to reduce the rate
inflation. (15 marks)

2. (a) Explain how fiscal policy can be used to make supply-

side improvements to an economy. (10 marks)

(b) Evaluate the use of supply-side policies to increase

Gross Domestic Product (GDP). (15 marks)

Model markschemes to these questions are on pages 126-40.

IB HL Economics Page 88 3rd Edition

 SECTION 3: INTERNATIONAL ECONOMICS

REASONS FOR TRADE

Countries trade because there are gains from doing so:

Specialisation and comparative advantage
Increased choice
Lower costs
Lower prices
Gains from competition
Economies of scale
Increased efficiency in the allocation of resources
Source of foreign exchange
Price

S dom

Sw

D dom

Ql Qe Q2

Quantity

In the diagram above, the shaded area represents the increase in

consumer surplus from trade. The world price (Pw) is below the
domestic equilibrium price (Pe) and imports are Q1 (domestic
quantity supplied) to Q2 (domestic quantity demanded).

Absolute Advantage

Absolute advantage exists if a country can produce a good using

fewer resources than another country.

IB HL Economics Page 89 3rd Edition

 Comparative Advantage

Comparative advantage exists if a country can produce a good at

a lower opportunity cost than another country. Countries have
Here the cost is an opportunity differing factor endowments, and if countries specialise in goods in
cost, NOT a monetary cost. which they have a comparative advantage, then world output will
The distinction becomes clear increase and countries will be able to consume beyond their
when you realise that Production Possibilities Frontier (given certain assumptions). Even
comparative advantage graphs if a country has an absolute advantage, this will still be true.
and numerical examples are
just examples of Production 100
Possibilities Frontiers.
Computers

40 S
%,
2
%, &
&y

20 25
Cars

Computers Cars
X 100 25
Y 40 20

Both the diagram and the table above show the production
possibilities of countries X and Y with a given set of resources.
Here country X has an absolute advantage in both goods (it can
produce more of both goods with the same resources as Y). From
the graph we can see that the opportunity costs of production of
each good differ in each country because the PPFs are not
parallel. X has a comparative advantage in computers and Y has
a comparative advantage in cars.

In X:
the opportunity cost of producing 1 computer is 'I40f a car
(100/100 -> 25/100)
the opportunity cost of producing 1 car is 4 computers
(25/25 ->100/25)
InY:
the opportunity cost of producing 1 computer is "I, 0f a car
(40/40 -> 20/40)

IB HL Economics Page 90 3rd Edition

 the opportunity cost of producing 1 car is 2 computers
(20720 -> 40/20)

So if country X can buy cars from Y for less than 4 computers and
Y can sell cars to X for more than 2 computers then both countries
will gain. If country Y can buy computers for less than % car and
country X can sell computers for more than % car then both
countries will gain.

Here the terms of trade will be 1 car : 3 computers.

The above model is based on the following assumptions:

Two countries and two products
Each country has a given set of resources
Perfect factor mobility
No transport costs
Constant returns to scale
No externalities from production

Comparative advantage is limited by the existence of barriers to

trade in the real world, it ignores transport costs, it assumes
perfect factor mobility and the fact that specialisation could cause
either economies or diseconomies of scale.

Numerical application:
Calculate opportunity cost from data or graph to determine
comparative advantage

TERMS OF TRADE

Terms of Trade measure the rate at which one good is exchanged

for another.

Index of Terms of Trade = Index of Export Prices x 100

Index of Import Prices

An improvement in the terms of trade means that export prices

have risen relative to import prices.

Changes in the terms of trade have impacts both on an economy’s

domestic economy and on the balance of payments. Non-oil
exporting developing countries have faced falling terms of trade
and so ELDCs have had to sell greater quantities of exports in
order to pay for imports. ELDCs tend to produce and export
primary products which have a low income elasticity of demand.
On the other hand, they tend to import manufactured goods that
have a higher positive income elasticity of demand, so as world
income increases, demand-side factors increase the price of

IB HL Economics Page 91 3rd Edition

manufactured goods faster than primary products. On the supply
side, developed economies have overproduced agricultural goods
(especially through the CAP in the EU) and this oversupply has
further depressed primary product prices. With the demand for
primary products being price inelastic, any increase in supply will
have a stronger depressing effect on prices.

The effect on the balance of payments will depend upon the price
elasticities of demand for exports and imports (see Marshall-Lerner
condition, page 102).

Numerical applications:
Calculate terms of trade index from an export price index and an
import price index
Calculate (percentage) the extent of an improvement or
deterioration in the terms of trade

® The World Trade organization (WTO)

The WTO deals with global ‘rules’ governing trade between
different economies/countries. It has an overall aim to increase
trade between countries by lowering trade barriers and easing the
general flow of trade.

WTO functions:
* Execute and administer WTO agreements between members
Provide a forum for trade negotiation
Rule on trade disputes between member countries
Monitor member trade policies
Provide assistance for ELDCs on trade issues

Much of this work is carried out in cooperation with other

international organizations such as the IMF and the World Bank.

[FREE TRADE/PROTECTIONISM |
Free trade is the international exchange of goods and services
without any artificial barriers to trade (actions taken by
governments to either restrict imports or promote domestic
production and exports).

Arguments for protectionism:

Infant industry argument
Anti-dumping
Protecting employment
Balance of Payments
Externalities and demerit goods
Strategic/security reasons
Unrealistic assumptions of comparative advantage

IB HL Economics Page 92 3rd Edition

 Arguments against protectionism:
Loss of comparative advantage
Costs to consumers/producers
Increased prices/costs of importing
Loss of competitiveness and efficiency
Governments choose the wrong areas to protect
Retaliation and trade wars
Misallocation of resources

® Tariffs
A tax on imports both restricts imports and raises revenue for the
government.

Y
&
o

Pw+t Sw+t

Pw 1 Sw

D dom

Q1 Q3 Qe Q4 Q2

Quantity
In the graph above, D and S represent domestic demand for and
domestic supply of a particular good, and the pre-trade equilibrium
is at (Pe,Qe). The world price of this good (Pw) is lower that the
price of domestically-produced goods (Pe), and so quantity
demanded increases from Qe to Q. and the quantity supplied by
domestic firms falls to Q. This shortfall (Qs to Q) is covered by
imports. Then this country decides to put a tariff on imports and
this increases the price of imports (Pw.t), thus reducing the
quantity demanded to Q4 and increasing the quantity supplied by
domestic firms to Qs. This reduced shortfall is covered by a
reduced number of imports (Qzto Qg).

The shaded (light and dark) trapezium represents the loss of

consumer surplus from the tariff (caused by the increase in price).
This area can be divided into the following ‘sub areas’ that explain
what has happened to that ‘lost’ consumer surplus: ‘a’ is the
addition to domestic producer surplus, ‘c’ (dark shaded area) is the

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 tariff revenue gained by the government, and both ‘b’ and ‘d’
represent the deadweight welfare loss from the tariff.

The final effects of a tariff will depend upon the price elasticities of
demand and supply and the size of the tariff itself.

It is important that you are able to ® Quotas

analyse and evaluate the effects A quota is a physical limit on imports in terms of volume or value.
of protectionist measures. Whilst
there might be short-term gains,

Price
S dom
such as a reduction in imports
and tax revenue for the
government, there will always be
an increase in prices and a loss
of economic welfare due to a
reduction in consumption, an
S dom+quota
increase in consumer prices, and
increased output from inefficient
domestic firms. Of course, there P Lt s se e X
is always the threat of retaliation
as well.

D dom

Quantity

The graph above shows how the restriction on imports (quota)

increases the price of imports. This essentially has the same
impact as a tariff by increasing the quality supplied by domestic
suppliers (Q1 to Q3) and reducing the quantity demanded by
domestic suppliers (Q2 to Q4), thus reducing imports to Q3 to Q4.
This time, area ‘c’ is the revenue gained by the importing firms
from overseas, who are able to import under the quota system at
higher prices.

® Subsidies
A subsidy lowers the production costs for domestic producers but
does not alter the market price. In the graph below, with lower
production costs (vertical distance between S dom and S
dom+sub), domestic producers increase supply (S dom+sub).
Imports fall to Q3 to Q2 (from Q1 to Q2) and domestic firms’
revenue rises from box ‘a’ (pre-subsidy) to ‘a’+'b’+'e’. Importers
now have a revenue of just ‘c’'+'d’. The shaded area ‘e’ represents
the monetary cost of the subsidy to the government. Triangle ‘f’
represents the inefficiency caused by the misallocation of
resources away from a low cost producer (importers) to a high cost
producer (domestic producers).

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 Price

S dom+sub

D dom

Q1 Q3 Qe Q2

Quantity

® Administrative Barriers
Countries can make it difficult to import goods by using
bureaucratic delays and tight safety restrictions

Numerical application:
Calculate from diagrams the effects of a tariff, quota and subsidy
on all stakeholders (domestic consumers and producers, foreign
producers and the government)
Calculate the change in net welfare

ECONOMIC INTEGRATION

Globalization, as defined by the OECD, is ‘the geographical

dispersion of industrial and service activities and the cross-border
networking of companies’. The rate of growth of international trade
far exceeds the rate of growth of world output. This process has
been happening for many centuries, but today’s communications
systems and the growth of MNCs/TNCs have accelerated the pace
of globalisation.

® Preferential trade agreements

These are where two or more countries agree to remove or reduce
artificial trade barriers such as tariffs between themselves. The
‘preferential’ element of this agreement involves countries buying

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imports from a country in the agreement rather than from a lower
cost producer outside the agreement. These agreements can be
bilateral or multilateral. Currently Chile and India have a bilateral
agreement on goods. An example of a multilateral agreement is
the Melanesian Spearhead Group (Fiji, Papua New Guinea,
Solomon Island and Vanatu).

® Trading Blocs
A Free Trade Area is created when countries form a trading area
within which they move goods and services freely but each
individual country retains its own barriers to outside countries.
In a Customs Union individual country trade barriers no longer
exist and there is a unified trade policy.
A Common Market is a customs union with the free movement of
factors of production as well.

Customs Unions may cause either Trade Creation (a shift of

production from high-cost to low-cost countries) or Trade
Diversion (a shift in production from low-cost countries outside the
union to high-cost, although tariff-free, countries inside the union).

The reluctance to surrender both political and economic

sovereignty may act as a barrier to further integration.

® NMonetary union
This is a common market with a common currency and a common
central bank (eg. the Eurozone)

Advantages:
¢ Resource allocation more efficient
e Increased real incomes/quality of life
¢ Increased export markets/ease of trade
* Price transparency
e Coordinated macro policy with lower inflation and interest rates
¢ Increased inward investment
¢ Reduced ER uncertainty between members

Disadvantages:
¢ Increased competition costs
* With lower levels of integration, firms may exploit differences in
employment and environmental legislation
e Loss of economic sovereignty (especially monetary policy)
e ‘One size fits all’ nature of monetary policy
s Problems dealing with asymmetric shocks

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 EXCHANGE RATES

An exchange rate is the price of one currency in terms of another.

® Floating Exchange Rates

Here the value of a currency is solely determined by the forces of
demand and supply. There is no target exchange rate set by the Your work on exchange rates
government and there is no government intervention in foreign should be structured around a
currency markets. clear understanding of the factors
that determine the demand for,
The demand for a currency is based upon: and supply of, a currency. As
with a normal market, a clear
° The demand for exports of goods and services
understanding of the
* Inflows of direct and portfolio investment determinants of market forces will
* Speculative buying enable you to apply your
* Central Bank officially buying the currency knowledge to a variety of
situations.
The supply of a currency is based upon:
¢ The demand for imported goods and services
* Outflows of direct and portfolio investment
* Speculative selling
* Central Bank officially selling the currency
Exchange rate ($:£)

ER2

ER1

Q1 Q2
Quantity of §

As the above graph shows, currency will appreciate as the

demand for it increases (D4 to D,).

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Exchange rate ($:£)
ER1

ER2

Q1 Q2
Quantity of §

A currency will depreciate as the supply of it increases (Ss to Sy),

as indicated in the graph above.

Factors that change a floating exchange rate:

Monetary Policy. Investors move funds around the world in
search of the highest rates of return. Relatively high rates of
interest attract funds and so increase the demand for a
currency
Fiscal Policy. Countries with sound public finances will tend
to see their currencies appreciate
Growth. Increase in national income may increase the
demand for imports and therefore depreciate a currency. But
slow growth is a sign of economic weakness, and this will also
depreciate a currency
Inflation. Countries with relatively high rates of inflation will
see a loss in export competitiveness and imports becoming
relatively cheaper. A downward pressure will be brought to
bear on their exchange rate. Purchasing Power Parity Theory
suggests that exchange rates will adjust to reflect the
differences in inflation rates between countries. This will
equalise the real purchasing power in each country
Trade Balance. A trade surplus will tend to cause an
exchange rate to rise, and a deficit will tend to cause an
exchange rate to fall
Speculation. This can have a huge impact on the value of a
currency

Managed Floating Exchange Rates (managed float)

Here the exchange rate is determined by the forces of demand
and supply, but governments (central banks) aim to limit

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fluctuations and might ‘manage’ the value of the currency to
achieve a macroeconomic goal such as low inflation or to stimulate
export growth.

® Fixed Exchange Rate

Here the exchange rate cannot fluctuate from the central rate — it is
‘pegged’ to another currency. The exchange rate will then have a
specific target and will be a dominant part of economic policy. The
government will intervene to maintain the value of the currency
using the rate of interest and/or currency reserves.
Exchange rate (ER)

Decrease in demand

BRI frorrrrrsmmrmsososoneo) x

Cefntral bank buysyraises interets rates

D1

Q1 Q
Quantity of currency
In the graph above, the central bank responds to a fall in demand
by buying the currency and/or raising interest rates.

In China the government has used a variety of methods to sustain

a low fixed exchange rate in order to maintain export
competitiveness.

In Argentina the government has used a variety of methods to

sustain a high fixed exchange rate in order to reduce the rate of
inflation.

® Common Currencies and Monetary Integration

Here, countries replace their national currencies with a common
currency. The best example of this is the Euro, where monetary
policy, controlled by a single central bank, covers all countries (the
ECB).

Advantages of a floating exchange rate:

* No need for currency reserves
* Monetary policy free to target domestic goals

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 ¢ Automatic balance of payments adjustment
¢ Reduced risk of speculation

Advantages of fixed exchange rates:

* Inflation discipline
e Certainty through currency stability increases trade
¢ Reduces costs of currency hedging for firms

Advantages of a strong currency:

The disadvantages of each ¢ Reduced import costs
system are the opposite of the
¢ Inflationary discipline
advantages of the alternative
e |mprovement in the terms of trade
system. For example, a floating
exchange rate does not provide ¢ Increased real purchasing power abroad
inflation discipline, and a fixed
exchange rate requires currency Disadvantages of a strong currency:
reserves. * Increased import penetration
¢ Exports struggle to maintain competitiveness
¢ Reduces economic growth
+ Asymmetrical effects on regions and sectors

Depreciation vs. devaluation

A depreciation is the fall in value of a currency in a floating

exchange rate system caused by movements in the demand for
and supply of the currency. A devaluation is the fall in the value
of a currency in a fixed exchange rate system after a conscious
decision by a government to reduce the value of its currency.

Appreciation vs. revaluation

An appreciation is the rise in value of a currency in a floating

exchange rate system caused by movements in the demand for
and supply of the currency. A revaluation is the rise in the value
of a currency in a fixed exchange rate system after a conscious
decision by a government to increase the value of its currency.

Numerical application:
Calculate changes in the value of a currency from a set of data
Calculate and exchange rate from data and using linear demand
and supply functions plotted from data
Calculate, using exchange rates, the price of a good in different
currencies

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 BALANCE OF PAYMENTS

The Balance of Payments is an account of a country’s financial

transactions with the rest of the world. The current account
measures the value of trade in goods and services and net
investment income and transfers. The capital and financial
accounts measure capital flows (shares, government debt and
foreign investment).

The Balance of Payments must balance. If a country runs a

current account deficit then this must be funded by a
financial/capital account surplus. This surplus can either come
from foreign direct investment, attracting short-term inflows of
funds through attractive rates of interest, or from the selling of
government foreign currency reserves.

Current account:
e Balance of trade in goods
* Balance of trade in services
* Income
* Current transfers

Capital account:
* Capital transfers
* Transactions in non-produced, non-financial assets

Financial account:
* Direct investment
* Portfolio investment
* Reserve assets

Current account = capital account + financial account + errors

and omissions

® Current account deficit

When the total value of an economy’s exports of goods and
services is less than the total value of imports of goods and
services from the rest of the world (including income and
transfers).

A deficit will, other things being equal, exert a downward pressure

on an economy'’s exchange rate.

Implications of a persistent current account deficit:

* Ownership of financial and capital assets transfers overseas
* Downward pressure on ER. This is inflationary, and the central
bank may need to respond by raising interest rates
e Opportunity costs of debt funding
* Effects on credit rating

® Current account surplus

When the total value of an economy’s exports of goods and
services is greater than the total value of imports of goods and

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services from the rest of the world (including income and
transfers).

A surplus will (other things being equal) exert an upward pressure

on an economy’s exchange rate.

Implications of a persistent current account surplus:

¢ Risk of protectionist measures for deficit countries
* Upward pressure on the currency

Numerical Application:
Calculate the balance of payments from data

CORRECTING A CURRENT ACCOUNT DEFICIT

® Changes in the Exchange Rate

A devaluation of an exchange rate will make exports more
competitive and imports more expensive and vice versa.

The final impact of a devaluation on the balance of payments will

depend upon the Marshall-Lerner condition (a devaluation in the
exchange rate will improve the balance of payments if the sum of
the price elasticities and demand for exports and imports is greater
than 1). A devaluation might take time to have a positive effect on
the balance of payments, and it might even make thing worse
initially, because of the ‘J’ curve effect. It takes time for traders to
adjust to new prices and so the Marshall-Lerner condition is not
immediately satisfied.

® Changes in Aggregate Demand

There is obviously a strong link between international trade and
AD=C+[+G+(X-M).
An increase in export revenues will increase AD, and an increase
in expenditure on imports will decrease AD.

For a country with a high marginal propensity to import, an

increase in AD will increase import expenditure and so move the
balance of payments towards a deficit.

® Protectionism
A country with a fixed exchange rate will not be able to rely upon a
devaluation in order to improve the competitiveness of its exports
and so it might well have to consider protectionist measures to
attempt to improve its balance of payments.

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 ® Supply-side policies
These aim to increase the productive potential of an economy,
enabling it competitively to produce goods for which there is an
international market. These are policies that encourage resources
to be mobile towards goods and services that are in demand, and
the development of areas where comparative advantage exists.
Other policies that encourage investment, innovation, competition
and flexible factor payments (especially wages) are key areas for
policy focus.

® Expenditure Switching and Expenditure Changing

Under a managed exchange rate system there are some long-term
options for making balance of payments adjustments:

Expenditure switching aims to encourage domestic consumers

to switch expenditure from imports to domestic goods using
policies such as protectionism, devaluation (see Marshall-Lerner
condition and the ‘J’ curve) and increasing competitiveness.

Expenditure changing aims to reduce aggregate demand

(especially for countries with a high marginal propensity to import)
and so reduce expenditure on imports by using fiscal and
monetary policies to influence AD.

® Persistent Current Account Deficits

A deficit is caused by cyclical and structural factors and a
persistent deficit will tend to be caused by structural factors. An
economy might have a problem with its competitiveness or it simply
may not produce the type of goods that are needed by its domestic
consumers or in export markets. In a floating exchange rate
system the currency will depreciate, but in a fixed exchange rate
system this is not an option. Here the government will have to
encourage inflows on the capital account and buy up excess
foreign currency. This can only happen in the short term, as it
requires foreign currency reserves to be used.

A country might improve its international competitiveness by

increasing productivity, reducing the costs of production, devaluing
the currency, improving the quality of output, encouraging
investment and innovation, and stimulating competition by reducing
protectionist measures.

® Ppersistent Current Account Surplus

If a country imports far less than it exports (China) then this
essentially means that a country is not using the total value of its
national income to consume. The surplus national income is then
‘saved’ by buying overseas financial and physical capital (a
financial account inflow for countries with a current account deficit),
thus funding current accounts deficits in other countries. There will,
of course, be upward pressure on the surplus country’s exchange
rate. However, China maintains a ‘weak’ RMB in the forex markets.

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 INTERNATIONAL TRADE AND EXCHANGE RATE
SAMPLE QUESTIONS

International Economics is examined in Paper 2 (data

response) Section A.

1. (a) Define the following terms:

(i) Exchange rate (2 marks)

(i) Appreciation (2 marks)

(b) Using an appropriate diagram, explain how increased

spending on food imports could affect an exchange rate.
(4 marks)

(c) Using an appropriate diagram, explain how the continuing

increase in prices for imported raw materials could affect
the general price level and output. (4 marks)

(d) Using information from the text/data and your knowledge of

economics, evaluate the impact on an economy of the
decision to introduce tariffs. (8 marks)

Data responses are questions that are based upon text and data,
which are not included here. There is more information on this
with the model markschemes at the end of the book.

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 SECTION 4: DEVELOPMENT ECONOMICS

Many economic models that appear in the section on

Development Economics have already appeared in earlier
sections of this guide (as they do in the syllabus). You should
seek to apply these concepts to development issues, thus
giving a topic that is often seen as not having a theory
structure behind it a clear structure for economic analysis and
evaluation.

Theory already highlighted in the micro part of the course: Development Economics is a
Prices: volatile commodity prices, PED/PES dangerous area for most
students, because they forget all
* Externalities: education (+ve) and environmental damage (-ve)
the pure theories and concepts
* Merit goods
around which good economics is
¢ Public good and common resource issues structured. Instead, Development
* PPC —investment Economics tends to slide into an
* Opportunity cost unstructured mass of anecdotal
stories that do little to explain,
analyse and evaluate the
Theory already highlighted in the macro part of the course: problems experienced by
* Sources of growth developing economies. Good
» Factor endowments and global inequality Development Economics will
make use of as many economic
* Gains from trade
concepts as any other area of the
* Problems with trade and trade barriers syllabus. To help you with this,
* Measuring GDP etc economic concepts are high-
* Income inequality and Lorenz curves/Gini coefficients lighted in bold type.
* Government policies to targets growth (demand and supply-
side)

| INTRODUCTION TO DEVELOPMENT

| Distinction between Growth and Development—l

Growth is not the same as development. Growth, measured in

terms of an increase in GDP, is a quantitative measure.
Real GDP per capita figures are an inadequate means of making
comparisons both within countries and between countries.

Limitations of GDP as a measure to compare welfare between

countries:
* The ‘shadow’ economy often means that GDP calculations are
an underestimation of actual GDP
* Regional variations exist within countries
e Externalities are unaccounted for
* New products and improvements in quality are unaccounted for

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e Some countries have more leisure time for similar levels of
GDP
e Currencies in one country may not have the same purchasing
power as in another country and so a common currency ($)
may be used to make comparisons
* Even with a common currency not all goods are traded,
products are regionally differentiated, there are local taxes, and
currencies fluctuate

Development is a qualitative measure of an improvement in the

quality of life. An economy can grow without developing and an
economy can develop without growth, however in the long run,
economic growth is usually a necessary condition for development.

Economic development is a broad concept involving:

e Improvement in the standard of living
* Reduction in poverty
¢ Improved health care and education
¢ Reduction in underemployment
¢ Greater income distribution equality
¢ Increased freedom and choice
e Environmental protection

[ Characteristics of Economic Growth |

® variations in long-run growth rates

Given compound growth rates, small differences in annual growth
rates can open up wide gaps in growth and income between
countries. Poor countries find it easier to achieve high growth
rates than rich countries, as they are growing from comparatively
low levels of income. Growth also needs to take into account
changes in population (GDP per capita).

® Changes associated with economic growth

* Primary = Secondary = Tertiary (changes driven by income
elasticity of demand)
e Urbanisation
e Growth of GDP per capita
¢ Increased productivity
e Increased international trade

® pollution and environmental degradation

All economies damage the environment as they grow. Developed
economies, with high levels of consumption demand, cause
environmental damage, as do countries developing from modest
foundations. Deforestation caused by clearing for farmland,
timber use for fuel and exportation causes soil erosion and
contributes to global warming and a loss of biodiversity. Over-
farming leads to soil degradation. Hazardous waste products
are generated by unregulated industries and slums. Polluted
water generates disease. Air pollution is caused by lack of
government controls on pollution, overpopulation and the burning

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 for fuel of polluting materials. Carbon dioxide emissions deplete
the ozone layer, causing global warming.

® Income inequality
If growth rather than development is prioritised, investment has a
central part to play. In order for investment to occur there needs to
be saving by a high-income sector, and this requires an unequal
distribution of income. In most ELDCs the richest 10% of the
population own 40-50% of the total national income.

® Sustainable development
Sustainable development means that economic growth in the
short run must not compromise the ability of an economy in the
long run to meet the needs of future generations.

At the moment many of our actions, particularly those that are

permanent and irreversible, are limiting the actions of future
generations. The problem is that whilst a majority of pollution is
caused by highly industrialised economies, serious and
unsustainable environmental consequences will be experienced if
ELDCs use the same industrial techniques. But if ELDCs have to
develop in a more sustainable way, their growth and development
will be hampered and slowed.

Solutions:
Government provision of basic sanitation and clean water
Extension of property rights
Prohibition of polluting activities
Pollution taxes
Tradable pollution permits
Finding environmental actions that actually promote growth
Education of farmers and communities
Family planning
Removal of subsidies that encourage the use of fossil fuels

Whilst it is dangerous to generalise, there are Common

characteristics of ELDCs:
Low levels of GDP per capita
High levels of poverty
Relatively large agricultural/primary sectors
Large informal/imperfect markets
High birth rates
Low levels of productivity
High levels of unemployment/underemployment
Dominated/dependent upon developed economies

There are also key areas that represent causes of diversity

between ELDCs:
* Historical background (colonisation is a big issue here)
Resource endowment and geographical factors
Political structures
Industrial structure (primary/secondary/tertiary)
Ethnic/religious factors

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® poverty cycle/trap
Low income => low savings (in order to save a surplus is required
and this is difficult to generate with low incomes and subsistence
living) = low investment (the forgoing of current consumption in
order to increase future consumption; this forgoing of consumption
is not possible in subsistence economies) = low income = etc.

Growth Development
Low level:
Low health/education
econ growth \ / \

. Low level
Low Low income human
investment

NS
capital

N Low savings Low productivity

® International development goals

There are eight UN Millennium Development Goals (adopted in
2000 by 189 countries and aimed to be achieved by 2015). They
are to:
Eradicate extreme poverty and hunger
Achieve universal primary education
Promote gender equality and empower women
Reduce child mortality rate
Improve maternal health
Combat HIV/AIDS, malaria, and other diseases
Ensure environmental sustainability
Develop a global partnership for development

[ MEASURING DEVELOPMENT |

Indicators of Development

® Indicators
As development is so hard to define, a variety of indicators can be
used:

Monetary/financial:
* GNP/GDP

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 ° GNP/GDP per capita (low-, middle- and high-income
countries). These figures are limited in their use, eg. income
distribution
* Use of PPP to make comparisons for GNP/GDP per capita

Health:
* Birth rates in ELDCs tend to be double those in developed
countries
* Life expectancy at birth is the number of years that a
newborn baby can expect to live given constant health
standards, and is much lower in ELDCs
° Infant mortality rates measure the number of deaths per 1000
under the age of one year (not including babies born dead)
* Population growth tends to be high in ELDCs, because of
poverty, and the age structure is weighted towards the young

Education:
* Literacy rates are a problem for ELDCs
* Net primary education enrolment
* Primary teacher/pupil ratio

These are not an exhaustive list of possible indicators and you

should feel free to develop an understanding of ELDCs through a
variety of different measures.

The key thing that you must be able to do is to compare and

contrast figures, for all the above underlined headings (including
HDI data) for economically more developed and economically less
developed countries.

® Composite Indicators
The Human Development Index (HDI) is seen as a method of
overcoming issues that surround the use of single indicators. It
combines GNP per capita, life expectancy and literacy rates,
and shows that growth does not necessarily equate with
development. There are countries with low GNP per capita and
yet a high HDI, and vice versa.

You must be able to compare and contrast HDI figures for

economically more developed and economically less developed
countries.

Often countries have different global rankings for GDP/GNI per

capital in comparison to their global ranking for HDI. Kuwait is a
good country to illustrate such differences in ranking (5 for GDP
per capital and 45" for HDI). These differences can be explained
by political factors and the choices that policymakers make in
terms of prioritising growth and development. Some countries
clearly underperform in HDI terms in relation to their income levels.

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 DOMESTIC FACTORS

® Education and health

People create wealth. An expanding population might mean a
plentiful labour supply but it will also tend to reduce GNP per
capita. The quality of labour is important and so investment in
education, training and health care needs to take place — but it
involves an opportunity cost. Entrepreneurs are also needed.
Social and cultural barriers often exist and inhibit change, new
methods of working, and a more scientific approach to production.
There is very strong statistical evidence of the link between
education/health and income growth. Health is a clear
improvement of the quality of life and enables individuals to have a
more consistent working life. Both factors enable workers to be
more productive.

In the provision of both education and health care there is often a

high degree of opportunity cost for governments, and also for
families ‘releasing’ children from work to education.

® Appropriate technology
Investment is the forgoing of current consumption for increased
future consumption. Technological change and capital investment
often go hand-in-hand. Development depends upon appropriate
technology, enabling ELDCs to focus on reducing poverty instead
of simply enabling income to increase.

® Credit and micro-credit

Investment cannot take place unless there is saving, but saving
requires there to be surplus income. Financial institutions such as
stock exchanges, savings and investment banks play an important
role in channelling savings towards investment opportunities.
These often do not effectively exist for small firms and farms, and
this is where a large part of economic activity happens in ELDCs
and where inroads can be made into poverty.

Micro-credit schemes are systems of small loans for income-

generating activities (eg. fish farming, mat-weaving, small-scale
retailing and brick-making) which enable poor communities in
ELDCs to gain some economic stability. Schemes are planned to
provide people with the resources they need without encouraging
debt. Micro-credit represents a significant way in which people
can make a difference to their own lives without the dependence
associated with hand-outs. Credit is often only given after a period
of financial and skill training has been completed, and the
schemes are designed to meet the particular needs and
circumstances of those individuals taking part. Schemes aim to
enable communities to diversify their skills so that communities do
not suffer the problems associated with an over-concentration on
one particular skill. Most micro-credit institutions also encourage
saving.

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 ® Empowerment of women
Women are in a position to play an important role in development.
The more educated women become, the lower birth rates tend to
be. This reduces dependency rates and enables existing
education/health/food resources to be divided among fewer
people. Of course population growth rates also affect GDP per
capita. Women workers are an important resource, but one which
is ‘underused’ (in terms of the production of output) in many
ELDCs.

® Income distribution
A highly unequal distribution of income tends to constrain growth
and development because those on low incomes have a high
propensity to consume (low savings results in low levels of
investment) and the wealthy, gaining political power, tend to
generate policies that favour the status quo. Wealthy individuals in
ELDCs also tend to have a high marginal propensity to import and
generate large amounts of ‘capital flight'.

® Institutional Factors
Taxes, legal frameworks, over-regulation, a lack of effective
property rights and traditional thoughts and practices can all
provide the wrong incentives and act as barriers to development.
Also a lack of basic infrastructure inhibits development.

Political instability, a lack of national cohesion and the cultural and

economic attitudes needed for economic growth as well as the
desire by developed countries to maintain the present status quo
all act as barriers to growth.

In the formal economy activities are recorded officially but in

many ELDCs economic activity is often unrecorded and even
illegal and this is the informal economy.

INTERNATIONAL TRADE

International trade problems:

® Over-specialisation
Adverse movements in the terms of trade and protectionist
measures by developed economies are both strong barriers to
development. The cause of adverse movements in the terms of
trade has already been covered. Many ELDCs also focus on a
narrow range of exports.

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® Primary product price volatility
The volatility of commodity prices has already been covered earlier
in this guide. The volatility of prices will affect revenues/incomes,
making investment and planning difficult for both firms and
governments.

® |nability to access international markets

Many ELDCs are concerned that countries such as the USA and
those in the European Union support free trade on the one hand
and yet use subsidies and other methods as trade barriers.
These are used to unfairly support their domestic industries with
the result that world markets are flooded with surplus goods,
driving prices down. Many protectionist measures that exist do so
in the form of standards and regulations that are technically hard or
costly for ELDCs to comply with.

Trade strategies:
® Open, outward-oriented (export promotion) vs. closed,
inward-oriented (import substitution)
An open, outward-oriented strategy aims to encourage export
production to fund imports, and a closed, inward-oriented strategy
aims to discourage imports and provide domestically-produced
substitutes.

An open, outward-oriented strategy embraces free trade (although

facing problems caused by developed world protectionism),
MNCs and the free movement of productive resources. Because
of the problems mentioned above with primary products, exports
will tend to centre on manufactured goods. This approach has
been key to rapid growth rates in China and India.
In theory, countries should specialise in producing goods and
services in which they have a comparative advantage.
Practically, for most ELDCs, this means primary goods.
Developed economies dominate world trade, with ELDCs
representing around 20% of world exports (although this figure is
inflated by ELDCs that export oil). A dependence on primary
products has resulted in a slow growth of exports (low YED and
protectionism by developed countries), fast growth of imports
(high YED), and worsening terms of trade.

A closed, inward-oriented strategy erects tariffs and other

protectionist measures. It does not embrace the activities of
MNCs, and restricts the movement of resources. Many countries
taking this approach have experienced low growth (Ghana, and
many South American countries).

® Trade liberalisation
Moves towards ‘freer’ trade, it is believed, will help ELDCs focus
on exporting goods and services in which they have a comparative
advantage (covered earlier on in this guide).

IB HL Economics Page 112 3rd Edition

 ® The role of the WTO
This is covered earlier on in this guide.

® Diversification
As already mentioned, a narrow focus on primary product exports
is problematic for ELDCs. Diversification aims to move production
into the secondary sector exporting manufactured/semi-
manufactured goods and thus avoiding the problems of primary
products. With this strategy should come higher and more stable
revenues as well as gains in skill, capital investment, productivity
and incomes.

® Bilateral and regional preferential trade agreements

These are covered earlier on in this guide.

® Fair Trade organizations

The 48 least-developed countries are home to 10 per cent of the
world’s citizens and their share of world exports has declined to
0.4 per cent over the past two decades. The USA and EU contain
roughly the same number of people and account for nearly 50 per
cent of world exports. Small traders find it hard to compete in a
world in which trade has been ‘liberalised’ by the WTO. If small
traders and ELDCs can be helped to overcome the significant
barriers to fair trade, then trade can be a solution to slow growth
and underdevelopment.

Fair Trade guarantees a price for producers that covers their costs
of production and provides a sustainable living. It also provides
long-term contracts and business training vital for long-term
stability. Fair trade allows consumers to purchase goods that
actually start to favour commaodity producers in ELDCs.

| FOREIGN DIRECT INVESTMENT |

® Foreign Investment (MNCs)

FDI is often centred on the activities of MNCs (multi national
corporations) who invest, in the long run, in expanding existing
productive capacity or buying out existing firms overseas. These
corporations do not just bring investment funds into ELDCs, but
they also bring new technology, training, entrepreneurial skills
(helping fill resource gaps), open new markets and have a
multiplier effect on the wider economy. These new enterprises
create jobs, generate export and tax revenue. On the other hand,
monopolistic MNCs can be criticised for being inefficient,
exploiting cheap labour and avoiding paying tax wherever possible
as well as exploiting relaxed environmental regulations.

IB HL Economics Page 113 3rd Edition

 MNCs are attracted by new markets, natural resources, low labour,
costs and regulatory frameworks that are often more ‘relaxed’ than
in more developed countries.

Potential advantages of FDI:

* Investment in physical and financial resources overcoming the
saving ‘gap’
Employment
Training and education, expertise and R&D
Improvements to local infrastructure
Tax revenue
Local multiplier effects
Competition benefits
Wider choice and lower prices for ELDC consumers

Potential disadvantages of FDI:

e Little impact on employment as own management teams are
‘parachuted’ in with impact of training thus limited
¢ Profits repatriated and taxes avoided
¢ Borrowing from ELDC financial sectors ‘crowds out’ local
domestic investment spending
¢ Political power/influence over ELDC governments
e Transfer pricing to take advantage of different tax rates
between countries
¢ Usel/extract resources then leave
* Take advantage of ‘relaxed’ labour market and environmental
regulations

| AID AND MULTILATERAL ASSISTENCE

® Aid
Aid to ELDCs comes from two sources:
¢ Donor governments, called official development assistance
(ODA)
¢ Non-governmental organisations (NGOs)

Humanitarian aid (alleviation of short-term issues and NGO

priority):
¢ Food aid
¢ Medical aid
e Emergency relief aid

Development aid (long-term aid and often ODA focus):

¢ Grants
Concessional long-term loans
You need to be able to compare
Project aid
and contrast the nature and
sources of ODA in two ELDCs. Tied aid
Technical assistance

IB HL Economics Page 114 3rd Edition

Bilateral aid is given by individual governments and multilateral
aid is given by multilateral agencies such as the World Bank.

Aid can help to fill resource gaps, which probably most often
appear as a lack of capital goods. Aid can also involve developing
much needed skills with which the aid itself can effectively be
used. Tied aid is very common, and donor countries often have
one eye on how they will benefit from giving aid. Aid can also
delay much needed reforms, do little to reduce income
inequalities, and support/fund dictatorships.

Grants may be used to fund specific projects or education and

soft loans have lower rates of interest and more relaxed
conditions. Food aid might be given using surpluses.

There are often less than ideal motives for countries giving aid,
with politics and self-interest in ELDCs with abundant natural
resources playing a part.

Benefits of aid:
* Fills savings and foreign exchange gaps
¢ Funds health/education/infrastructure
e Aids recovery from disaster

Disadvantages of aid:
Does not reach those most in need
ELDCs lack skills to carry out projects effectively
Food aid causes dependency
Tied aid
Dependency culture develops
Aid strengthens government control
Industrialisation might happen too quickly
Resources diverted away from productive sectors
Corruption

Whilst aid might help fill in ‘gaps’, and certainly NGOs do provide a
lot of important funds which often bypass governments and so
reach the people most in need, aid is no substitute for sound
economic policies and good economic management in general.
Whilst the amount ($) of aid is growing in absolute terms when
measured as a percentage of donor country national incomes, it is
in relative decline. Few countries (Denmark, Luxembourg,
Netherlands, Norway and Sweden) have reached the OECD
guideline of 0.7% of GNI. The USA donates around 0.2% of GNI.

® Trade vs. aid

The theoretical benefits of trade to ELDCs have already been
outlined. Trade could expand export markets and enable a growth
in incomes/revenues that can then be used to fund capital and
human capital investment, and primary sectors may be able to
access the benefits from economies of scale. Diversification may
also be possible and enable ELDCs to access further export
markets. Increases in income may then play a key role in reversing

1B HL Economics Page 115 3rd Edition

existing poverty cycles/traps. With increased incomes comes the
possibility of a reduced reliance on aid.

However there are a number of significant barriers to such a

process. Currently the USA and EU subsidise/protect their
agricultural markets to a significant extent and this acts as a very
effective barrier to ‘free’ trade in exactly the markets in which many
ELDCs have a comparative advantage. ELDCs have had to also
contend with falling commodity prices due to over-production by
the subsidised US and EU economies. Freer trade would also
result in many exceptions to WTO rules, which would have to be
abandoned by ELDCs, and this would result in a competitive
environment in which they would be at a distinct disadvantage.

® The IMF
The IMF aims to foster global monetary cooperation, secure
financial stability, facilitate international trade, promote high levels
of employment and sustainable economic growth, and reduce
world poverty. IMF loans usually come with a package of policies,
known as stablisation policies. These policies have meant that
ELDC governments have been restricted in their use of fiscal
policy. Government spending is restricted, and tax systems are
reformed to collect revenue more effectively, be more progressive
and counter tax avoidance/evasion by the wealthy. Most policies,
focusing on reforming the structure of ELDC economies, are
supply-side policies. Given the structure of these economies, an
active demand management policy is hard to organise.
Stabilisation programmes often impart a sharp shock to ELDC
economies with which they are not able to cope. The tightening of
domestic monetary and fiscal policies reduces aggregate demand
leading to recession. The IMF ‘blueprint’ often fails to recognise
the differences between individual countries and there are cases
where countries that have followed a different path from that
suggested by the IMF, have been able to develop just as well, if
not better, than those following IMF advice. IMF decision-making is
also dominated by rich countries.

® The World Bank

The World Bank attempted to encourage growth and development
through loans for investment with accompanying advice and tight
conditions for repayment. During the 1970s and 1980s Structural
adjustment programmes (SAPs) caused many problems for the
ELDCs associated with these two international institutions. Whilst
targeting growth, programmes were criticised for causing de-
development and so the bank now has much more of a focus on
sustainable development as well as poverty alleviation and debt
relief for poor countries.

More recently the World Bank has focused on sustainable

development, the breaking of poverty cycles and the institutional
reforms needed for the effective working of markets, for example:
* Health care and education provision
e Effective taxation systems
¢ Access to credit

IB HL Economics Page 116 3rd Edition

 Property rights
Empowerment of women
Reduced corruption
Infrastructure
Innovation
Political rights

As with the IMF, World Bank decision-making is dominated by rich

countries and the scope of the changes advised can result in a
‘loss of sovereignty’ for many ELDCs. Tight conditions for ELDCs
(tight fiscal and monetary policies and well as free trade) can seem
very harsh for poor countries and often result in a widening income
distribution.

INTERNATIONAL DEBT |

International finance
The debt problem has its roots back in the 1973/4 petrol price
inflation and ‘petrodollars’ flooding banks in rich countries. Many of
these banks loaned this inflow of funds to ELDCs who were
importing oil and thus needed foreign exchange to help with their
current account deficits. Debts involve huge servicing costs (both
the principle loan and the interest payments) which have to be paid
before anything else. Debt therefore severely hampers a country’s
attempts to develop, as income has to be used for debt repayment
rather than investment in capital, human capital or social and
economic infrastructure. A rescheduling of debts has often been
accompanied by forced structural reforms. These reforms have
been based upon market forces, supply-side policies,
deflationary fiscal and monetary policies to target inflation, the
reduction of government debt and the encouragement of exports
by devaluing the currency. These reforms have often been a
painful experience for many ELDCs, resulting in reduced welfare
provision and widening income distribution.

The HIPC (Heavily Indebted Poor Country) Initiative along with the
MDRI (Multilateral Debt Relief Initiative) both seek to provide debt
relief to the most indebted ELDCs. Countries qualify if their GNI
per capita is below a certain level and then they have to follow
World Bank/IMF policies and use any ‘savings’ for poverty
reduction.

ELDCs can also suffer problems by not being able to convert their
domestic currency (non-convertible currency) for foreign
currencies causing obvious problems for international trade.

Capital flight is a capital outflow from any country, but for ELDCs
this can be a particular problem as valuable funds for investment
resources move to another country.

IB HL Economics Page 117 3rd Edition

|MARKETS VS. INTERVENTION |

® Market-oriented policies
Policies:
* Free trade
* Floating exchange rates
¢ Labour market reforms
¢ Deregulation and privatisation
e Liberalised flows of capital, goods and services

Strengths:
* Reduced incidence of government failure
» Efficient working of the price mechanism
* Competition and efficiency
¢ Allocative and productive efficiency from reduced barriers to
entry and the movement of resources

Weaknesses:
* Market failure (externalities and merit goods especially)
* Asymmetric information in markets
* Weak/missing institutions needed for effective markets
* Income/access to resource and credit inequality
* Development of dual economy

® Interventionist policies
Policies:
e Provision of infrastructure
e State provided/subsidised education and health care
* Welfare safety nets
* Demand-side policies to maintain macro stability

Strengths:
* Correction of market failure
e Stable macro objectives
¢ Reduced income inequality and safety nets provided
e Infrastructure provision

Weaknesses:
* Government failure
* Red tape, bureaucracy and corruption
* Planning problems through lack of information and time-lags

® Market with government intervention

Good governance is key to balancing markets and intervention
effectively, focusing on how rather than what policies are pursued.
There are many examples of how intervention can work (health
care, education and infrastructure) and there are many examples
where markets work (export promotion, reduced trade barriers,
privatisation). Whilst the poorest ELDCs can certainly benefit from
initially more interventionist policies, a gradual withdrawal of
government ‘control’ is seen as ideal. There is no ‘blueprint’ set of
policies: all countries are unique, with different histories, resources
endowments, different cultures and different circumstances.

IB HL Economics Page 118 3rd Edition

| DEVELOPMENT ECONOMICS SAMPLE QUESTIONS |

Development Economics is examined in Paper 2 (data

response) Section B.

1. (a) Define the following terms:

(i) Economic development (2 marks)

(i) Bilateral aid (2 marks)

(b) Explain how foreign aid can help a country to break out of
a poverty cycle. (4 marks)

(c) With reference to [...], explain why there is a difference

between the Human Development Index (HDI) figures for
country A and country B. (4 marks)

(d) Using information from the text/data and your knowledge of

economics, evaluate the effectiveness of aid in promoting
economic development. (8 marks)

Data responses are questions that are based upon text and data,
which are not included here. There is more information on this
with the model markschemes at the end of the book.

IB HL Economics Page 119 3rd Edition

 REVISION ADVICE

Whatever subject you are revising for, your aims, and to a certain
extent, your methods, are the same. You are aiming to learn your
subject material, and to develop exam skills.

Each person has to find the revision technique which works best
for them. If you are in the final stages of your IB revision in the
run-up to your exams you will probably have been able to try out
some techniques already in your trial exams and will know whether
they have worked for you or not. If they have not worked, then
don’t use them again. Try something different.

One of the dangers of just reading through your notes (apart from
the fact that this tends to send even the most enthusiastic student
to sleep) is that you will confuse understanding with memory.
Understanding and memory are different brain functions. You
understand your notes, but you can never be sure that you have
actually acquired and internalised the information they contain.
You must test your knowledge to be sure of this.

The good news is that this doesn’t have to mean sitting through
three-hour trial exam papers! To learn your material, you will have
to go over it again and again (there is no substitute for this
repetition: it's the way that your brain creates the neurological
connections which constitute memory). Practise the techniques
that you will be using in the exam: defining terms, drawing and
explaining diagrams, brainstorming, essay plans (you will be doing
essay plans in the exam!), graph drawing etc., all of which will
enable you to test your knowledge, and develop and practise
exam skills in an efficient timeframe. The most effective time
period to revisit a chunk of material is between 20-30 minutes; any
more and your brain’s efficiency starts to decline (the law of
diminishing marginal returns), and any less it doesn’t have time to
get into gear. In 20 minutes you can do two essay plans.

Always start with what you know. Say, for example, you are
revising monopoly. Your first revision of this topic might start with
a blank sheet of paper on which you write everything you can think
of about monopoly. After you have spent 10 minutes on this, go
back to your notes and see what you didn't know. Add this
information to your brainstorm. The next time you revise this topic
do, for example, three monopoly-based questions. Don’t waste
time actually writing them... just jot down a plan for them (don't
forget the graphs), then go back to your notes once again and see
what you forgot. You should remember more than the first time.
Not only will you be testing your monopoly knowledge and
increasing it as you go over the material for a second time, but you
will be forcing yourself to plan, and almost best of all, you will be
forced to write three different plans which answer the questions in
a structured way, rather than writing your catch-all standard
answer on monopoly. While it is difficult to predict what is going to
come up on a paper, it's a certainty that you won’t see a question

IB HL Economics Page 120 3rd Edition

inviting you to ‘Write down everything you know about monopoly’.
Your third revision of monopoly might see you writing out those
short answers in full, or doing a couple of essay plans.

The key to making your revision work is to organise your time.

Make a revision plan. This plan should divide the topics you
need to revise into the total amount of time you have left before the
exam. Don't wait: do it today! There’s always less time than you
think. Don't leave out this important stage in the revision process:
you might be working away happily thinking you are accomplishing
a great deal, without a sense of how much you are effectively
getting covered. Plan to cover each topic at least three times, and
include in your plan the method you are going to use to cover the
material, whether a brainstorm, getting a really full set of notes,
doing two essay plans and two data-response plans.

This method helps to calm exam fears. As you progress through

your revision plan, you will have positive proof your knowledge is
improving as you revisit each topic. You will know your revision is
working. You will be in control of the process, and will be focusing
on small, manageable tasks rather than a gigantic formless mass
of syllabus material. Almost everyone will be worried about their
upcoming exams, no matter what grade they will get. Just
because you are worried does not mean that you are not going to
do well.

With a structured set of notes, a realistic revision plan and some

good old-fashioned graft, you can do well. Probably better than
you think! | wish you all the very best of luck with your revision,
and with your exam.

ASSESSMENT OBJECTIVES (AOS)

These assessment objectives give candidates a clear indication of
the type and level of skill required for each section of the syllabus
and in each type of assessment. You should use them as a guide
to the depth of understanding and the types of skills you need to
develop for each idea and concept.

AO1: Demonstrate knowledge and understanding.

For example:
¢ Definitions in part (a) of essays
e Definitions in (a) parts (i) and (ii) of data responses

AO2: Demonstrate application and analysis of knowledge

and understanding.
For example:
* Explaining appropriate diagrams in parts (b) and (c) of data
responses.

1B HL Economics Page 121 3rd Edition

 * Developing explanations of theory in part (a) of essays.

AO3: Demonstrate synthesis and evaluation.

For example:
* Part (b) of essays.
¢ Part (d) of data responses.

AO4: Select, use and apply a variety of appropriate skills and

techniques.
For example:
* Selecting the appropriate diagrams in parts (b) and (c) of data
responses.
* Selection of mathematical techniques in HL paper 3.

HIGHER LEVEL ASSESSMENT

| External assessment (4 hours) 80% T

Paper 1 (1 hour 30 minutes) 30%

Essay paper

AOs 1,2, 3and 4

50 marks

Divided into two sections. Candidates have to answer one

question from each section.

There is a choice of two questions in each section. Each essay is

marked out of 25 marks, with 10 marks for part (a) and 15 marks
for part (b).

Section A
Microeconomics (Syllabus section 1)

Section B
Macroeconomics (Syllabus section 2)

Paper 2 (1 hour 30 minutes) 30%

Data response paper

AOs 1,2,3and 4
40 marks

Divided into two sections and candidates have to answer one

question from each section.

IB HL Economics Page 122 3rd Edition

 There is a choice of two questions in each section. Each data
response is marked out of 20 marks (2, 2, 4, 4, 8 for each
subsection in turn).

Section A
International economics (Syllabus section 3)

Section B
Development economics (Syllabus section 4)

Paper 3 (1 hour) 20%

HL extension paper (quantitative techniques)

AOs 1,2 and 4

50 marks

Candidates answer two questions from a choice of three (25 marks

per question).

This paper is based on all the HL extension material throughout all

four sections of the syllabus, and focuses on the mathematical
elements of the course.

finternal assessment (4 hours) 20%

AOs 1,2,3and 4
45 marks

A portfolio of three commentaries (20 teaching hours)

internally assessed by teachers and externally moderated by
the IB at the end of the course.

Each commentary (max 750 words) is marked out of 14 with 3

marks, overall, for the rubric requirements.

IB HL Economics Page 123 3rd Edition

 ESSAY TECHNIQUE
The problem with giving model answers for essays in this kind of
revision guide is that one has to be provided for each area of the
syllabus, and space constraints prevent this here. If you are
getting together to revise with friends, you might want to compare
essays you have done in the past, looking carefully at where your
teacher has indicated good and bad practice, and where marks
have been indicated in the margin, as well as comments for your
future improvement. One surprisingly effective thing to do is to
mark each others’ essays, using the readily available
markschemes. This will give you a real insight into what points
actually constitute marks.

There is a danger of pre-learning answers to essays in one'’s

revision, resulting in generalised, unfocused and unstructured
answers in an exam. The suggestions offered on the use of essay
planning in one’s revision in the revision advice section above will
help you to avoid this pitfall.

Examiners often comment on candidates who do not separate the

two parts of essays. The markscheme the examiner is working
with instructs him or her to award marks specifically in each part of
the question. If your answer to a two-part question consists of one
undifferentiated answer, your examiner will struggle to apply the
markscheme. It is also something which is calculated to annoy
your examiner! Another frequent cause of lost marks is to provide
information in part (a) which should really be in part (b). Careful
planning (practised in your revision) will solve this problem entirely.

Well-planned and written essays will address the command

words of the question (eg. “Explain...”, “Discuss...”). If you are
not sure about the precise meanings of the various command
words, then your revision period is your chance to find out. Good
sources of this information are to be found in the IBO Economics
Guide.

| have placed much emphasis on the use of diagrams in all your

work. Marks are available in your examiner's markscheme for
your graphs. In essays they must be clearly drawn and accurately
labelled and fully integrated into the text (‘in the diagram below...’
‘this is shown in the diagram below...’). Weak candidates do not
use diagrams, and if they do, they are messy, incorrectly labelled,
hard to read, contain wrongly-positioned curves and are
sometimes irrelevant to the question.

IB HL Economics Page 124 3rd Edition

 MODEL MARKSCHEMES

Section A (Microeconomics)

1. (a) Explain the importance of cross elasticity of

demand and price elasticity of demand for firms
when making decisions.

Answers should include:

* A definition of XED
e A definition of PED
* The link between the demand for a good and
changes in the prices of complements and
substitutes
¢ The link between price changes, total revenue and
PED
* Real-life examples to illustrate the above

Answers may include:

* Use of diagrams to illustrate PED and total revenue
e Use of diagrams to illustrate complement/substitute
relationships
e Explanation that both XED and PED are both hard
to measure accurately

(a) 10 marks

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

Level Marks
0 Completely inappropriate answer 0
1 Little understanding of the specific demands of the question 1-3
Very little recognition of relevant economic theory
Relevant terms not defined
Significant errors
2 Some understanding of the specific demands of the 4-6
question
Some recognition of relevant economic theory
Some relevant terms defined
Some errors
3 Understanding of the specific demands of the question 7-8
Relevant economic theory explained and developed
Relevant economic terms defined
Few errors
Where appropriate, diagrams included
4 Clear understanding of the specific demands of the 9-10
question
Relevant economic theory clearly explained and developed
Relevant economic terms clearly defined
No major errors
Where appropriate, diagrams included and explained
Where appropriate, examples used

IB HL Economics Page 125 3rd Edition

 (b) Studies have shown that the demand for petrol
tends to be highly price inelastic. Evaluate a policy
of substantially raising taxes on petrol as a method
of reducing its consumption.

Answers may include:

e Petrol as an example of market failure
* Use of MSC/MSB diagram to illustrate market
failure
* Inelastic demand and the implications for a tax on
petrol (PED<1 may result in a proportionately small
decrease in quantity demanded of petrol)
* Size of tax increase that may be needed to have a
substantial impact
¢ Incidence of tax
* Problem of Tax=MSC
* Impact of government tax revenue
* Assessment of alternative policies

(b) 15 marks

Effective evaluation may be to:

consider short-term versus long-term consequences
examine the impact on different stakeholders
discuss advantages and disadvantages
prioritize the arguments.

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

Level Marks
0 Completely inappropriate answer 0
1 Little understanding of the specific demands of the question 1-5
Very little recognition of relevant economic theory
Relevant terms not defined
Significant errors
2 Some understanding of the specific demands of the 6-9
question
Some recognition of relevant economic theory
Some relevant terms defined
Some errors
3 Understanding of the specific demands of the question 10-12
Relevant economic theory explained and developed
Relevant economic terms defined
Few errors
Where appropriate, diagrams included
An attempt at evaluation
4 Clear understanding of the specific demands of the 13-15
question
Relevant economic theory clearly explained and developed
Relevant economic terms clearly defined
No major errors
Where appropriate, diagrams included and explained
Where appropriate, examples used
Evidence of appropriate evaluation

1B HL Economics Page 126 3rd Edition

2. (a) Using diagrams, explain the difference between a
perfectly competitive firm, in terms of profits, in the
short-run and the long-run.

Answers should include:

¢ Definitions of abnormal and normal profits
* An outline of perfect competition
e Short-run perfect competition diagram showing
abnormal profit at the profit maximising output level
* Explanation of new firms/resources entering
(attracted by abnormal profits), market supply
increasing resulting in price falling and normal
profits in the long-run

Answers may include:

* Microeconomics distinction between short and long
run
* Further explanation of why abnormal profits are
made
e Further diagrams to explain the movement of the
firm from short to long-run equilibrium

(a) 10 marks

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

Level Marks
0 Completely inappropriate answer 0
1 Little understanding of the specific demands of the question 1-3
Very little recognition of relevant economic theory
Relevant terms not defined
Significant errors
2 Some understanding of the specific demands of the 4-6
question
Some recognition of relevant economic theory
Some relevant terms defined
Some errors
3 Understanding of the specific demands of the question 7-8
Relevant economic theory explained and developed
Relevant economic terms defined
Few errors
Where appropriate, diagrams included
4 Clear understanding of the specific demands of the 9-10
question
Relevant economic theory clearly explained and developed
Relevant economic terms clearly defined
No major errors
Where appropriate, diagrams included and explained
Where appropriate, examples used

IB HL Economics Page 127 3rd Edition

 (b) Evaluate the view that perfect competition is a more
desirable market structure than monopoly.

Answers may include:

* An explanation of the difference between perfect
competition and monopoly
e Diagrams to illustrate the two market structure
e Explanation of “desirable” in terms of different
stakeholders
e Comparison in terms of: allocative/productive
efficiency, dynamic efficiency in the long run,
price/output/profits, choice for consumers, barriers
to entry, non-price competition, research and
development, benefits from economies of scale etc
¢ An assessment of which market structure is most
desirable

(b) 15 marks

Effective evaluation may be to:

consider short-term versus long-term consequences
examine the impact on different stakeholders
discuss advantages and disadvantages
prioritize the arguments.

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

Level Marks
0 Completely inappropriate answer 0
1 Little understanding of the specific demands of the question 1-5
Very little recognition of relevant economic theory
Relevant terms not defined
Significant errors
2 Some understanding of the specific demands of the 6-9
question
Some recognition of relevant economic theory
Some relevant terms defined
Some errors
3 Understanding of the specific demands of the question 10-12
Relevant economic theory explained and developed
Relevant economic terms defined
Few errors
Where appropriate, diagrams included
An attempt at evaluation
4 Clear understanding of the specific demands of the 13-15
question
Relevant economic theory clearly explained and developed
Relevant economic terms clearly defined
No major errors
Where appropriate, diagrams included and explained
Where appropriate, examples used
Evidence of appropriate evaluation

IB HL Economics Page 128 3rd Edition

Section B (Macroeconomics)

1. (a) Explain why a country may wish to reduce its

inflation rate.

Answers should include:

* An explanation of the rate of inflation
¢ An explanation of the causes of inflation
¢ An explanation of the reason to reduce inflation in
terms of the various costs of inflation. This may
include the impact of competitiveness, the price
mechanism, redistribution of incomes, devaluing
incomes, confidence etc

(a) 10 marks

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

Level Marks
0 Completely inappropriate answer 0
1 Little understanding of the specific demands of the question 1-3
Very little recognition of relevant economic theory
Relevant terms not defined
Significant errors
2 Some understanding of the specific demands of the 4-6
question
Some recognition of relevant economic theory
Some relevant terms defined
Some errors
3 Understanding of the specific demands of the question 7-8
Relevant economic theory explained and developed
Relevant economic terms defined
Few errors
Where appropriate, diagrams included
4 Clear understanding of the specific demands of the 9-10
question
Relevant economic theory clearly explained and developed
Relevant economic terms clearly defined
No major errors
Where appropriate, diagrams included and explained
Where appropriate, examples used

IB HL Economics Page 129 3rd Edition

(b) Evaluate the likely effects on an economy of
relying on demand-side policies to reduce the
rate of inflation.

Answers may include:

¢ An explanation of fiscal and monetary policies to
reduce inflation
e Linkages to AD
* Use of AD and AS diagrams to illustrate
* An explanation of the suitability of demand side
policies for demand-pull inflation
» Strengths and weaknesses of fiscal policies
» Strengths and weaknesses of monetary policies
* The impact of output, growth, employment and
balance of payments and possible policy
conflicts/trade-offs
¢ Cost-push inflation and the effectiveness of
demand-side policies
¢ Alternative supply-side policies
¢ Inflation targeting

(b) 15 marks

Effective evaluation may be to:

consider shori-term versus long-term consequences
examine the impact on different stakeholders
discuss advantages and disadvantages
prioritize the arguments.

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

Level Marks
0 Completely inappropriate answer 0
1 Little understanding of the specific demands of the question 1-5
Very little recognition of relevant economic theory
Relevant terms not defined
Significant errors
2 Some understanding of the specific demands of the 6-9
question
Some recognition of relevant economic theory
Some relevant terms defined
Some errors
3 Understanding of the specific demands of the question 10-12
Relevant economic theory explained and developed
Relevant economic terms defined
Few errors
Where appropriate, diagrams included
An attempt at evaluation
4 Clear understanding of the specific demands of the 13-15
question
Relevant economic theory clearly explained and developed
Relevant economic terms clearly defined
No major errors
Where appropriate, diagrams included and explained
Where appropriate, examples used
Evidence of appropriate evaluation

IB HL Economics Page 130 3rd Edition

2. (a) Explain how fiscal policy can be used to make
supply-side improvements to an economy.

Answers should include:

* Definition of fiscal policy
* Explanation of “supply-side” improvements
¢ Use of AD/AS concepts and diagrams
¢ Explanation of how government spending may be
used to affect LRAS (eg. reduced spending on
benefits, increased spending on health care and
education)
* Explanation of how taxes may be used to affect
LRAS (eg. reduced direct taxation to improve
incentives to work, lower corporation tax to
incentivise investment, reduced costs of production
through lower indirect taxes)

(a) 10 marks

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

Level Marks
0 Completely inappropriate answer 0
1 Little understanding of the specific demands of the question 1-3
Very little recognition of relevant economic theory
Relevant terms not defined
Significant errors
2 Some understanding of the specific demands of the 4-6
question
Some recognition of relevant economic theory
Some relevant terms defined
Some errors
3 Understanding of the specific demands of the question 7-8
Relevant economic theory explained and developed
Relevant economic terms defined
Few errors
Where appropriate, diagrams included
4 Clear understanding of the specific demands of the 9-10
question
Relevant economic theory clearly explained and developed
Relevant economic terms clearly defined
No major errors
Where appropriate, diagrams included and explained
Where appropriate, examples used

IB HL Economics Page 131 3rd Edition

(b) Evaluate the use of supply-side policies to increase
real Gross Domestic Product (GDP).

Answers may include:

* Adefinition of real GDP
* A definition of supply-side policies
* Examples of supply-side policies to be used
* Adistinction between interventionist and market
oriented policies
* AD/AS diagrams to illustrate and increase in real
GDP
¢ Distinction between growth of actual and potential
output
* Benefits of using supply-side policies (eg. reduced
inflation pressure, long-term approach)
* Problems of applying supply-side policies to
increase real GDP (eg. time lag, impact on equity,
interventionist policies and government budget)

(b) 15 marks

Effective evaluation may be to:

consider short-term versus long-term consequences
examine the impact on different stakeholders
discuss advantages and disadvantages
prioritize the arguments.

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

Level Marks
0 Completely inappropriate answer 0
1 Little understanding of the specific demands of the question 1-5
Very little recognition of relevant economic theory
Relevant terms not defined
Significant errors
2 Some understanding of the specific demands of the 6-9
question
Some recognition of relevant economic theory
Some relevant terms defined
Some errors
3 Understanding of the specific demands of the question 10-12
Relevant economic theory explained and developed
Relevant economic terms defined
Few errors
Where appropriate, diagrams included
An attempt at evaluation
4 Clear understanding of the specific demands of the 13-15
question
Relevant economic theory clearly explained and developed
Relevant economic terms clearly defined
No major errors
Where appropriate, diagrams included and explained
Where appropriate, examples used
Evidence of appropriate evaluation

IB HL Economics Page 132 3rd Edition

 DATA RESPONSE TECHNIQUE

Choose the question by reading all of the individual question parts,

especially those with the most marks. Allocate the time you
spend on the different parts of the question according to the
distribution of the marks. You should spend double the amount
of time on an 8-mark question than you spend on a 4-mark
question. This sounds obvious, but a number of students will
misallocate their resources each year with catastrophic results.
Make sure that you are not one of them!

Data response answers must be planned like any good essay.

Use both the text and the data available to you to illustrate your
answers.

The opening questions will require you to be able to provide

definitions of key terms in the text. The next questions will often
ask you to use a diagram to explain either an event described in
the text or to explain a specific piece of theory that is applicable to
the text. The final question will require you to analyse and evaluate
an issue based upon the text, and as these are most difficult skills
needed in the exam this question is awarded 8/20 marks. If you
are to perform well in this paper, then you must seek to maximise
your marks on this question. If you can maximise the number of
marks you gain from the define/describe/explain questions
(questions (a), (b) and (c) give you potentially 12/20 marks) then
4/8 in part (d) will give you 16/20 marks (80%).

Part (a)
2-4 lines will be sufficient to gain full marks on this question. You
will need to make at least two points to gain full marks.

Parts (b) and (c)

There are 2 marks for the diagram, and 2 marks for your writing
about the diagram. Diagrams must be fully labelled. Watch out for
details that matter (eg. an ad valorem tax should be illustrated by a
divergent shift of the supply curve). Your written explanation of the
diagram should describe what has happened in the diagram, and
explain why it has happened.

Part (d)
Making clear use of the text (actually quote and state which
paragraph is being quoted) is necessary to gain more than 5 out of
8 marks. Your answer must be based upon economic concepts
and the development of concepts, rather than simply quoting from
the text.

Evaluation should look at different stakeholders (consumers,

producers, employees, government, community, the environment
and other countries), short- versus long-run, prioritise arguments
and must always be set in the context of the text/data.

IB HL Economics Page 133 3rd Edition

 MODEL MARKSCHEMES

Section A (International Economics)

(a) Define the following terms indicated in bold in the text:

() Exchange rate (2 marks)

Level Marks
0 Wrong definition 0

1 Vague definition 1

How much a currency is worth.

2 Precise definition 2

It is the price (or value) of one currency expressed or

converted in terms of another. An example is not required

(ii) Appreciation (2 marks)

Level Marks
0 Wrong definition 0

1 Vague definition 1

A currency becomes more expensive.

2 Precise definition 2

It is an increase in the value (or price) of one currency in

terms of another currency in a floating exchange rate
system.

(b) Using an appropriate diagram, explain how increased

spending on food imports could affect an exchange rate.
(4 marks)

Level Marks
0 Inappropriate answer 0

1 Identification of appropriate theory 1-2

For drawing a correctly-labelled exchange rate diagram

showing how an increase in spending on food imports
results in an increase in the supply of the currency on the
foreign exchange market and a fall in the value of the
currency, ceteris paribus or an explanation that the
increased purchase of food imports would lead to an
increase in the supply of the currency on the foreign
exchange market and a fall in the value of a currency,
ceteris paribus.

2 Correct application of appropriate theory 3-4

For drawing a correctly labelled exchange rate diagram

IB HL Economics Page 134 3rd Edition

 showing how an increase in spending on food imports
results in an increase in the supply of the currency on the
foreign exchange market and a fall in the value of the
currency, ceteris paribus and an explanation that the
increased purchase of food imports would lead to an
increase in the supply of the currency on the foreign
exchange market and a fall in the value of the currency,
ceteris paribus.

A diagram showing and explaining a fall in demand for a currency

and so a depreciation may receive a maximum of (1 mark) for the
diagram, and (0 marks) for the explanation.

Candidates who incorrectly label diagrams can be rewarded with a

maximum of (3 marks).

The vertical axis may be price (or value) of the currency in US$ (or
in other currencies), US$/currency or exchange rate. The
horizontal axis should be quantity of currency or just quantity (or
Q). A title is not necessary.

(c) Using an appropriate diagram, explain how the

continuing increase in prices for imported raw materials
could affect the general price level and output. (4 marks)

Level Marks
0 Inappropriate answer 0

1 Identification of appropriate theory 1-2

For drawing a correctly labelled AD/AS diagram showing a

decrease in AS or an explanation of how increased raw
material prices increase production costs, shifting AS and
contributing to a higher price level and lower output.

2 Correct application of appropriate theory 3-4

For drawing a correctly labelled AD/AS diagram showing a

decrease in AS and an explanation of how increased raw
material prices increase production costs, shifting AS and
contributing to a higher price level and lower output.

Candidates who incorrectly label diagrams can receive a maximum

of (3 marks).

For AD/AS, the vertical axis may be price level, average price
level, or inflation. The horizontal axis may be output, real output,
national output, real national output, national income (Y), or GDP.
Any appropriate abbreviations, such as APL, CPl, RNO or RNY
are allowable. A title is not necessary.

IB HL Economics Page 135 3rd Edition

(d) Using information from the text/data and your
knowledge of economics, evaluate the impact on an
economy of the decision to introduce tariffs. (8 marks)

Responses may include:

* A definition of tariffs
e A tariff diagram
* Revenue from tariffs could help reduce the budget deficit
e Tariffs on imported goods will discourage their purchase and
so less imports will reduce the current account deficit
e Tariffs will encourage production in domestic import-
competing industries
e Tariffs can protect and encourage employment in domestic
industries
e Tariffs contribute to a dead-weight loss of welfare, because
of the loss of consumer surplus
* Tariffs lead to an inefficient allocation of resources, because
goods are produced by relatively inefficient domestic
producers as opposed to more efficient foreign producers
* Tariffs can have an inflationary impact in a country tariffs
could encourage producers to diversify and avoid the risk of
over-specialization
e Introduction of tariffs may result in retaliation which may
affect export industries making it difficult to achieve export-
led growth
* Tariffs may go against WTO rules

Examiners should be aware that candidates may take a different

approach which if appropriate, should be rewarded.

If there is no direct reference to the text/data, then candidates may

not be rewarded beyond level 2.

Effective evaluation may be to:

e consider short-term versus long-term consequences
* examine the impact on different stakeholders
* discuss advantages and disadvantages
* prioritize the arguments.

Level Marks
0 No valid discussion 0
1 Few relevant concepts recognized. 1-2
Little discussion or only basic understanding.
2 Relevant concepts recognized and developed in 3-5
reasonable depth
Some attempt at application and analysis.
3 Relevant concepts developed in reasonable depth, 6-8
demonstrating effective evaluation, supported by
appropriate evidence or theory.

IB HL Economics Page 136 3rd Edition

Section B (Development economics)

(a) Define the following terms indicated in bold in the text:

() Economic development (2 marks)

Level Marks
0 Wrong definition 0

1 Vague definition 1

The idea that living standards improve.

2 Precise definition 2

It is a broad concept involving any two of the following:

improvement in living standards
reduction in poverty
improved education and health
reduction in unemployment
greater equality in income distribution
environmental protection
increased freedom

(ii) Bilateral aid (2 marks)

Level Marks
0 Wrong definition 0

1 Vague definition 1

Two countries are involved in aid.

2 Precise definition 2

Aid that is given directly from one country to another.

(b) Explain how foreign aid can help a country to break out
of a poverty cycle. (4 marks)

Level Marks
0 Inappropriate answer 0

1 Identification of appropriate theory 1-2

An explanation of a poverty cycle (eg. low incomes = low

savings = low investment = leading to low incomes etc.)
or that foreign aid can increase resources available in the
economy, leading to higher incomes etc.

2 Correct application of appropriate theory 3-4

An explanation of a poverty cycle (eg. low incomes = to

low savings = low investment = leading to low incomes
etc.) and that foreign aid can increase resources available
in the economy, leading to higher incomes etc.

IB HL Economics Page 137 3rd Edition

N.B. An alternative poverty cycle may be used, and if appropriately
explained, may be fully rewarded. Candidates may also explain a
break in a poverty cycle in a different way and if appropriately
explained, this approach may be fully rewarded.

(c) With reference to the text, explain why there is a

difference between the Human Development Index (HDI)
figures for country A and country B. (4 marks)

Level Marks
0 Inappropriate answer 0

1 Identification of appropriate theory 1-2

For noting that one country has a higher HDI than the other
and that HDI includes other factors than just GDP per
capita.

2 Correct application of appropriate theory 3-4

For noting that one country has a higher HDI than the other
and that HDI includes other factors than just GDP. For full
marks comments on health care and education. In
comparison to GDP per capita figures would be needed.

(d) Using information from the text/data and your

knowledge of economics, evaluate the effectiveness of aid in
promoting economic development. (8 marks)

Responses may include:

* Discussion of types of aid, eg. multi-lateral/bilateral, tied etc.
* A comparison of official aid and unofficial aid.
* Benefits of aid which is targeted to meeting development
objective
* Aid can contribute to economic growth which might then be
used to achieve development objectives
* Benefits of cooperation between aid agencies and other
agencies and groups (eg. governments and local
communities)
* Benefits of aid driven by the needs of the people
» Benefits of aid linked to appropriate domestic policies and
good governance
* Problems associated with aid (eg. corruption and
dependency)

N.B. To reach level 3, candidates must direct their responses to

the issue of promoting economic development, rather than write in
general terms about aid.

Examiners should be aware that candidates may take a different

IB HL Economics Page 138 3rd Edition

approach which if appropriate, should be rewarded.

If there is no direct reference to the text/data, then candidates may

not be rewarded beyond level 2.

Effective evaluation may be to:

consider short-term versus long-term consequences
* examine the impact on different stakeholders
» discuss advantages and disadvantages
* prioritize the arguments.

Level Marks
0 No valid discussion 0
1 Few relevant concepts recognized. 1-2
Little discussion or only basic understanding.
2 Relevant concepts recognized and developed in 3-5
reasonable depth
Some attempt at application and analysis.
3 Relevant concepts developed in reasonable depth, 6-8
demonstrating effective evaluation, supported by
appropriate evidence or theory.

These ‘outline’ answers are structured in exactly the same

format as the markschemes used by the IB. The ‘generic’
markschemes (showing the levels and marks in italics are
taken from past paper markschemes and the Economics
Guide).

IB HL Economics Page 139 3rd Edition

IB HL Economics Page 140 3rd Edition