AS – ECONOMICS (9708)

MICRO

CHAPTER 1
Basic economic ideas

Topics Lectures
Topic 1: Basic Economic Ideas 1

Topic 2: Production Possibility Curve (PPC) 2,3

Topic 3: Economic Systems 4

AS / MICRO — [NOTES] — CHAPTER 1

TOPIC 1: BASIC ECONOMIC IDEAS

Lecture 1

Economics
Definition: It is a social science that studies human behavior between unlimited wants and limited resources
with their alternative uses. In other words, it just simply tells us how we can make the best use of what we
have in order to satisfy our needs and wants. There are TWO broad divisions:
Microeconomics Macroeconomics

This deals with individual decisions taken They examine individual variables at the level
by household or firms in a particular of aggregate economy
market.

1. BASIC ECONOMICS PROBLEM/PROBLEM OF SCARCITY

Definition | Basic Economic Problem: The resources are limited in this world whereas wants are unlimited
which leads to the problem of scarcity or the basic economic problem. This problem is faced by every
economy as to how to allocate the scare resources.

Limited Resources + Unlimited Wants = Scarcity

1. Limited Nature of Resources

Definition: Resources are all those materials and efforts which can be used to produce goods and services.
E.g. agriculture, farmers, machines etc. Resources are of TWO types:
1. Unlimited or free resources / Free Goods: These are unlimited in supply e.g. sunlight, sea water, air rain
etc. These resources are not much of a concern for economists.

2. Scarce resources / Economic Good: These are limited in supply. E.g. machines, building, agricultural
area, oil, wheat etc.

2. Opportunity Cost
Definition: People are forced to make choices due to the presence of the basic economic problem mentioned
above. Opportunity costs is defined as the next best alternative forgone. In simpler terms, the sacrifice by an
individual or organization while giving preference to one product to the other is known as the opportunity
cost of a particular decision. Remember that this is made by all economic decision makers: Consumers,
businesses and government.
Example:
(1) Consumer – An individual has $1000 and he/she can either buy a laptop or a smart phone. If the
individual chooses the laptop the smart phone becomes the opportunity cost.

(2) Businesses – A business has $1million. It can either spend it on expansion to a new country or invest
in research and development. If the businesses choose to invest it in expansion, the research and
development becomes the opportunity cost.

(3) Government – A government has two options either to build roads or building schools in the country. If
the government chooses to build roads, developing schools would become the opportunity cost.

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AS / MICRO — [NOTES] — CHAPTER 1

3. The THREE basic economic questions

All the three economic agents (Individuals, Firms and Government) try to answer the following three
basic economic questions:
Question Description

1. What to Produce? What goods and services should be produced and how should the
resources be allocated?

2. How to Produce? How should the economic resources be used to produce the goods
and services

3. For whom to produce? How should the goods be allocated among the population?
Understanding the target population.
4. Choosing at the margin
Definition | Margin: This implies that economic decision makers will take a decision to compare the benefits
of an extra activity to the cost of the extra activity. If the marginal benefit exceeds the marginal cost you go
ahead with the decision
Marginal Benefit > Marginal Cost Go ahead with the decision
Marginal Benefit < Marginal Cost Do not take the decision

5. The time dimensions

Time Dimension Description

1. Short Run This is a time period where firm is able to change some usually one and not all
factor inputs. Example: Labor might be variable but capital and land might be
fixed.

2. Long Run This is a time period a from can change all factors of production. This makes
them more flexible. Example: Hire more labor, more capital etc.

3. Very Long Run This is when the entire industry/market may be able to adjust. This is because
not only that all factors of production are variable but also key inputs like
technology, government regulation and social norms are variable.

2. FACTORS OF PRODUCTION
Definition: These elements are required to carry out a business activity are collectively known as the factors
of production. These include:
Factor Description

1. Land It represents all the natural resources which are consumed during the business activity,
e.g. plains, seas, mines etc. (Rent)

2. Labor The term refers to any kind of physical or mental human effort. E.g. carpenters, doctors,
etc. (Wages and Salaries)

3. Capital The term refers to the manufactured resources required in the production process.
E.g. machinery, tools, equipment, vehicles etc. (Interest)

4. Enterprise Also known as entrepreneurship. This is the skill and risk-taking ability of the person
who brings the other three resources or factors of production together to produce a
good or service. They are innovate to promote efficiency For example, the owner of a
business. (Profits and Dividends)

Note: These factors of production tend to vary from economy to economy. Agricultural economies tend to
reply more on the primary output whereas industrialized economies tend to reply on the secondary output.
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3. POSITIVE AND NORMATIVE STATEMENTS

AS / MICRO — [NOTES] — CHAPTER 1

Definition | Positive Statements: This is a statement the is based on empirical evidence or

facts/actual evidence. This can be true or false. These statements can be tested. This tells us what it is.
Example: 1. A fall in supply of petrol will lead to an increase in its price...
2. An increase in tourist numbers in the Maldives will create more employment...
3. An increase in taxation on cars will result in fewer cars being sold...

Definition | Normative Statements: This is a statement that have an opinion or value judgement. This
tells what should happen. These statements cannot be tested. The above statements can become normative
statements, for example, by adding:
1. ... and this should be beneficial for the environment.
2. ... and therefore the government of the Republic of Maldives should do everything it can to help promote
this industry.
3. ... and this should reduce traffic congestion.

4. SPECIALIZATION AND DIVISION OF LABOR

Definition | Specialization: The process by which individuals, firms and economies concentrate on producing
those goods and services where they have an advantage over others. The aim is to concentrate on what they are
best at as a result the production of the products go up. Specialization refers to performing a specific task of
the whole production by an individual worker, or producing one of few products rather than a number of
goods and services by a firm, region, or country.

Definition | Division of Labor: This is known as specialization at individual level. When the whole
production process is divided into several individual tasks and each task is carried out by a single worker.

Advantages and Disadvantages of Specialization/Division of Labor [Economy]

Advantages Disadvantages
 1. Efficiency: Specialization results in efficient use 1. Overspecialization: This is a situation where
of factors of production. This results in higher the country specializes in a particular product and
GDP. this makes its economy vulnerable. Example:
Economy’s like Iran that are highly dependent on
2. Labor Productivity: Labor becomes more oil export, a trade embargo by the west on oil
productive since due to repetition of jobs their skills results in a major economic collapse.
are enhances. This leads to greater output in lesser
time. 2. High labor turnover: Since the workers are
specialist they will continuously be searching
3. Increase productive capacity: Specialization helps for better paid jobs. This result in companies
to shift the PPC outwards. However, the shift is have to rehire which increase the cost.
usually pivotal because the product the county is
specializing in will have a greater increase in output. 3. Low Labor mobility: Since the worker is only
skilled in a particular field it would be hard for
4. Economies of Scale: Since production increases him to understand other function of the
therefore firms enjoy larger economies of scale. business. This makes the labor force inflexible.
These cost cuts can be passed on to consumers in
the form of lower prices. Hence reducing inflation. 4. Lack of variety of consumers: Consumers
have less choice since the company
5. Improved Competitiveness: This gives the firm specializes in only one type of product. This
a competitive advantage in the international reduces international competitiveness.
market. A competitive advantage results in
higher exports, appreciation in currency, higher 5. Cost: The cost to employ specialist workers
AD, and improved standard of living. is high. This can lead to expensive products
being developed by the firm, ultimately leading
reducing profits.

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AS / MICRO — [NOTES] — CHAPTER 1

TOPIC 2: PRODUCTION POSSIBILITY CURVES (PPC)

Lecture 2 and Lecture 3

Definition | PPC: It is a curve that shows all the maximum possible combinations of two goods and
services which a country can produce using all of available resources with efficient technique of production
at given state of technology. This shows mainly two main economic concepts. (1) Opportunity Cost (2)
Economic Growth.

1. Assumptions of PPC: Let’s assume that the PPC is of Country A.

(1) There are only two goods being produced in the country, Agricultural goods and Manufactured
goods. (2) Economy is operating at full employment: All available resources are utilized to produce
goods and services.
(3) The country is using the best available technique of production.
(4) Country A has limited number of factors of production. (Land, Labor, Capital).
(5) State of technology will not change in the given time constraint.
A – All resources dedicated to the production of Agricultural Goods
B – All resources dedicated to the production of Manufactured Goods
C – A1 agricultural goods produced alongside M1 manufactured goods
D – A2 agricultural goods produced alongside M2 manufactured goods cars
E – This point is beyond the PPC and is unattainable since it lies outside of the productive capacity of
the economy.
F – This point is within the PPC. The production of both agricultural and manufactured goods can be
increased without any opportunity cost as there are idle resources in the economy. Therefore it shows
unemployment.

Note: Movement from point F to any point on the PPC shows short-term economic growth and the shift of
the PPC represents long term economic growth.

Note: The gradient of the PPC is called the MRT (The marginal rate of transformation). This shows the
number of one good that would need to be scarified to produce an extra unit of another good. The PPC can
be used to show Economic Growth and Opportunity Cost.

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AS / MICRO — [NOTES] — CHAPTER 1

2. SHIFTS IN PCC
A PPC curve can shift
i) Inward or Outward: Inward shows a decrease and outward shows an increase
ii) Parallel or Pivotal: Depends
Outward Shift Inward Shift
 An outward shift shows an increase in An inward shift shows a decrease in productivity
productivity and output. and output.

Parallel Shift Pivotal Shift

Parallel shift of PPC occurs when increase in Pivotal shift occurs in PPC when change in
quantity and quality of resources in equally quantity and quality of resources affects only one
suitable/disastrous for both goods. good or affects one good more than the other.
Example: A genetic breakthrough in productive of
wheat, rice or cotton will increase only the
agricultural capacity of a country.

3. SOURCES OF SHIFT IN PPC

There are THREE major sources of shift in PPC of a country:
1. The quantity of factors of production in an economy change
2. The quality/productivity of factors of production change
3. Reallocation of Resources
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AS / MICRO — [NOTES] — CHAPTER 1

1. The quantity of factors of production in an economy change

1. Land

Land may increase because of: Land may decrease because of:
1. Discovery of oil, metal, minerals, reserves 1. Depletion of non-renewable natural resources
etc. 2. Barren land irrigated and made e.g. oil, gas etc.
productive 2. Natural disasters like earthquakes, floods
etc. Inward shift of PPC
Outward shift of PPC

2. Labor

Labor may increase because of: Land may decrease because of:
1. Increase in working population 1. Decrease in working population
2. More immigration than emigration 2. More emigration than Immigration
3. More women in jobs 3. Less women in jobs
4. High retirement age 4. Poor health facilities

Outward shift of PPC Inward shift of PPC

3. Capital

Labor may increase because of: Land may decrease because of:
1. Gross Investment* > Depreciation* 1. Gross Investment < Depreciation

Outward shift of PPC Inward shift of PPC

*Gross Investment: Total spending on capital goods and services in a given time
*Depreciation: Loss in the value of an asset due to wear and tear, obsolesce or just passing time.

2. The quality/productivity of factors of production change

Definition | Productivity: It is defined as output per unit of input. It measures how efficiently factors of
production are used. Several factors influence productivity:
Factor Description

1. Technology Makes capital more productive and increases productive capacity.

Technology 🡩 Productivity 🡩 PPC outward shift

Technology 🡫 Productivity 🡫 PPC inward shift

2. Education and Training It helps to improve labor and hence they can use capital more efficiently
of Labor force and come up with better ideas and products.

Education 🡩 Productivity 🡩 PPC outward shift

Education 🡫 Productivity 🡫 PPC inward shift

3. Research and Technology This involves better techniques of extractions, improved methods of
farming etc.

R&D🡩 Productivity 🡩 PPC outward shift

R&D 🡫 Productivity 🡫 PPC inward shift

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3. Reallocation of Resources
AS / MICRO — [NOTES] — CHAPTER 1

Definition: Reallocation means switching factors of production from production of one product to another
type of product. There are TWO types of reallocation:
Primary to manufacturing/service sector Consumer Goods* to Capital Goods*

Since manufacturing and service sector is more Since capital goods have higher added value and
productive than the primary sector, more services can contribute to a larger success of a country in
and manufacturing the economy produces higher the long run hence more the capital goods higher
the productivity. the productivity.

PPC outward shift PPC outward shift

Manufacturing/Service > Primary Capital Goods > Consumer Goods

PPC inward shift PPC inward shift

Manufacturing/Service < Primary Capital Goods < Consumer Goods

*Capital Goods: Goods that increase the future capacity of an economy. Example: Machinery, factory
buildings. The expenditure on these goods in known as investment.

*Consumer Goods: These goods are for present use. Examples: Apple, car, TVs etc. The expenditure on
these goods in knowns as consumption.
Note: If an economy chooses to produce more capital goods and less consumer goods in the present it will
enhances the productive capacity of the economy and this will lead to production of both goods in the future.
The decision to produce more capital goods today mean fewer consumer goods today. The choice is of having
a higher standard of living today vs. economic prosperity in the future.

4. INCREASING AND CONSTANT OPPORTUNITY COSTS PPC

Increasing Opportunity Cost Constant Opportunity Cost

Increasing opportunity costs arise as for each Constant opportunity costs arise when the factors
additional unit of computers that is produced, the of production are equally well suited to the
opportunity cost, consisting of microwave ovens production of both goods, such as in the case of
sacrificed, gets larger and larger as computer basketballs and volleyballs, which are very similar
production increases. This happens when resources to each other, therefore needing similarly
are non-homogenous. specialized factors of production to produce them.
This happens when resources are homogenous.

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TOPIC 3: ECONOMIC SYSTEMS Lecture 4

AS / MICRO — [NOTES] — CHAPTER 1

Definition | Economic Systems: This is the way in which production is organized and choices are made in
an economy.
1. MARKET ECONOMY
Definition: A market economy is a system where ownership of resources in the hand of private individuals and
private producers who allocate them as they see fit and government intervention is minimized. The forces of
demand supply are used to allocate resources and the private sector decision the answer to the three
fundamental economic questions.

Features include:
(1) No government interference
(2) Resources are allocated on the basis of price. Higher the price more the supply, lower the price more
the demand. Resources are sold to individuals who have the willingness and ability to pay.
(3) Production of profitable products is maximized whereas production of unprofitable products is
stopped. (4) There is competition in the market which leads to greater choice for the consumers.
Advantages Disadvantages

1. Market economies are efficient and pay attention 1. Market economies create negative externalities
to what consumers want. Due to presence of like noise, air and water pollution etc. in an
competition companies try to create unique selling attempt to reduce their private costs under their
points and tend to develop better technology and profit maximization motive.
try to create
innovative products to attract and satisfy 2. Market economy lacks any redistributive
their consumers. mechanism of income. The rich tend to get richer
and the poor tend to get poorer.
2. They also have freedom of choice since the
government intervention is minimized. Individuals 3. Private firms under profit maximization will
can choose to buy whatever they like. This produce demerit goods. Demerit goods are bad
produces variety of goods and services. of society like Alcohol, cigarettes etc.

3. Market economies are driven by the profit 4. Due to absence of government control, public
motive which motivates business and individuals goods such as street lighting and roads might not
to work hard. These incentives help boost the be provided.
economic growth and raise the standard of
living. 5. Due to competition firms tend to waste
valuable resources on activities like excessive
4. Least interference of govt. eliminates advertising to gain competitive advantage. This
bureaucratic hurdles in economic activities. This also leads to consumer exploitation.
improves the ability of a business to response to
changes in consumer preferences.

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AS / MICRO — [NOTES] — CHAPTER 1

2. PLANNED ECONOMY
Definition: A planned economy is where all the resources are allocated by the government. They use a
rationing mechanism of central planning and quotas. The aim in planned economy is collective social welfare.

Features include:
(1) Basic economic questions answered by the government.
(2) Wage differentials are minimal due to the aim of quality and eliminating social gap. (3) There is
minimal engagement in international trade as the government prefers to be self-sufficient.
Advantages Disadvantages
 1. There is a large potential for economies of scale 1. Due to absence of price mechanism the
by operating large state monopolies like water government is unable to guess exact quantities
supply, public transport, electricity. demands which can lead to surplus and shortages
in the economy.
2. Due to absence of competition wastage can be
reduced. Since costs of advertisement will be 2. There is a lack of variety of goods which
nonexistent and state will only provide goods that reduces the standard of living. Since the market
are necessary which will lead to less wastage of lacks competition and the government is more
scarce resource. focused on being self-sufficient which leads to
production of necessities not variety of goods.
3. The gap between rich and poor is minimized.
Since the government provides basic needs to be 3. The economy is less responsive to consumer
met for everyone in the society. Example: needs. Since bureaucrats take the decision, they
education and health care for all. don’t take entrepreneurial risks and lack
innovation.
4. The government keep on externalities like
pollution and reduce the production of demerit
goods like alcohol, cigarettes etc.

5. Customer exploitation is prevented since there

are no private monopolies that can over charge
customers.

3. MIXED ECONOMY
Definition: A mixed economy is a combination of both market and planned economy. It has the benefits of
the free market but through government interventions the negative aspects are reduced.

Features include:
(1) Both government and private businesses work together.
(2) Private sector uses price mechanism and public sector uses rationing mechanism
(3) Private sector provides most of the goods but government provides public and merit goods. (4)
Merit Goods: Underprovided by the private sector and government provides the remaining (5) Demerit
Goods: These goods will be provided by the private sector but the government will control it through
taxes and regulations
(6) Public Goods: Governments will provide all the public goods
(7) Income inequality will be low due to progressive taxes and welfare payments.
(8) Governments will reduce negative externalities by imposing taxes, fines, regulations and pollution permits.

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AS – ECONOMICS (9708)
 MICRO

CHAPTER 2
Demand, Supply and Equilibrium

Topics Lectures

Topic 1: Demand 1

Topic 2: Supply 2

Topic 3: Market Equilibrium 3

Topic 4: Consumer and Producer Surplus 3

TOPIC 1: DEMAND
Lecture 1
AS / MICRO — [NOTES] — CHAPTER 2

Definition | Demand: It is regarded as the willingness and ability of consumers to buy goods and services at
given prices over a certain period of time. The willingness and ability highlight effective demand and separate
it from a want or desire.

1. Law of Demand
Definition: If other things do not change i.e. ceteris paribus, quantity demanded falls as prices rises and
vice versa. This marks that demand has an inverse (i.e. negative) relationship with price.
P🡩 Qd🡫
P🡫 Qd🡩

2. Demand Schedule
Definition: It is a table that shows negative relationship between price and quantity demanded for a product.

3. Demand Curve
Definition: It is a curve that shows relationship between price and quantity demanded of a product. It helps to
highlight the inverse relationship between price and quantity demanded. Taking the price on y-axis and
quantity demanded on x-axis, a downward sloping (-ve sloped) curve is known as a demand curve.

Demand
Schedule Demand Curve

4. Market Demand
Definition: It is the sum of all individual demand at a given price of a product. It can be obtained from
horizontal sum of individual demand curves. It is usually flatter than induvial demand curves.

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5. Determinants of Demand
AS / MICRO — [NOTES] — CHAPTER 2

Factor Description

1. Income of Consumers Higher the income, higher the demand. This is only valid for normal
goods like cars, quality clothing, housing etc. However, it should be noted
that when income increases demand for inferior goods fall. These are
goods whose demand decrease as the income increase. Example: Poor
quality clothing, second hand phones etc.

2. Price of substitutes Substitutes are alternatively demanded goods. Example Pepsi and
(Alternative Demand) Coke. If price of Pepsi goes up, Qd for coke will go up.
3. Price of complements Complements are jointly demanded goods like car and petrol. If price of
(Joint Demand) petrol goes up, Qd for cars would fall.

4. Level of advertising If level of advertisement goes up, Qd in likely to increase since more
consumers would be informed about the product and would be persuaded
to buy the product.

5. Government policies If sales tax increases on a product it would make it expensive, hence
reducing the demand, on the other hand if govt. offers subsidy on a
product like electric cars that would make them cheaper hence demand
would increase.

6. State of the Economy If the economy is booming it is likely to increase the demand for goods
since consumers would have money to spend on goods and services.
However, if the economy is in a recession consumer’s incomes are falling
and they lack confidence in the economy hence reducing demand.

7. Fashions and Taste If the product is in fashion the quantity demanded would go up. Examples
include smart watches and smart phones are in fashion hence the demand
goes up. However, if the product is out of fashion the demand would fall.
Example: Old clothing designs.

8. Derived Demand This is where something is required because it is needed for the
production of other goods and services. Example: Hotel workers and
hotel services. If the demand for hotel services rise, the demand for hotel
workers will increase.

Changes in Demand

Change in Quantity Demanded Change in Demand

🡫 🡫
Movement along the Demand Curve Shift in the Demand Curve
🡫 🡫
Due to the Price Factor Due to the Non-Price Factor

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TOPIC 2: SUPPLY
Lecture 2
AS / MICRO — [NOTES] — CHAPTER 2

Definition | Supply: It is regarded as the willingness and the ability of sellers to sell goods and services at various
prices over a period of time.

1. Law of Supply
Definition: If others things do not change i.e. ceteris paribus, higher would be the quantity supplied at higher
prices and vice versa. This marks that supply has a positive relationship with price.
P🡩 Qs🡩
P🡫 Qs🡫

2. Supply Schedule
Definition: It is a table that shows positive relationship between price and quantity supplied of a product.

2. Supply Curve
Definition: It is a curve that shows relationship between price and quantity supplied of a product. Taking the price
on the y-axis and quantity supplied on the x-axis, an upward sloping (+ve sloped) curve is known as supply curve.

3. Market Supply
Definition: It is regarded as the sum of all producer’s supply at a given price of a product. It can be derived from
adding all the sellers supply curve.
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AS / MICRO — [NOTES] — CHAPTER 2

4. Determinants of Supply

Factor Description

1. Cost of If a factor price rises, production costs increase, production becomes less profitable and the firm
Production produces less; the supply curve shifts to the left. If a factor price falls, costs of production fall,
production becomes more profitable and the firm produces more; the supply curve shifts to the
right.

2. Technology A new improved technology lowers costs of production, thus making production more profitable.
Supply increases and the supply curve shifts to the right. In the (less likely) event that a firm uses a
less productive technology, costs of production increase and the supply curve shifts leftward.

3. Competitive Competitive supply of two or more products refers to production of one or the other by a firm;
supply the goods compete for the use of the same resources, and producing more of one means
producing less of the other. For example, a farmer, who can grow wheat or corn, chooses to grow
wheat. If the price of corn increases, the farmer may switch to corn production as this is now
more profitable, resulting in a fall in wheat supply and a leftward shift of the supply curve. A fall
in the price of corn results in.

4. Joint supply Joint supply of two or more products refers to production of goods that are derived from a single
product, so that it is not possible to produce more of one without producing more of the other. For
example, butter and skimmed milk are both produced from whole milk; petrol (gasoline), diesel oil
and heating oil are all produced from crude oil. This means that an increase in the price of one
leads to an increase in its quantity supplied and also to an increase in supply of the other joint
product(s).

5. Indirect Taxes Firms treat taxes as if they were costs of production. Therefore, the imposition of a new tax or the
increase of an existing tax represents an increase in production costs, so supply will fall and the
supply curve shifts to the left. The elimination of a tax or a decrease in an existing tax represents a
fall in production costs; supply increases and the supply curve shifts to the right.

6. Subsidies A subsidy is a payment made to the firm by the government, and so has the opposite effect of a tax.
The introduction of a subsidy or an increase in an existing subsidy is equivalent to a fall in
production costs, and gives rise to a rightward shift in the supply curve, while the elimination of a
subsidy or a decrease in a subsidy leads to a leftward shift in the supply curve

7. The number An increase in the number of firms producing the good increases supply and gives rise to a
of firms rightward shift in the supply curve; a decrease in the number of firms decreases supply and
produces a leftward shift. This follows from the fact that market supply is the sum of all
 individual supplies.

8. Supply Shocks Sudden, unpredictable events, called ‘shocks’, can affect supply, such as weather conditions in the
case of agricultural products, war, or natural/man-made catastrophes.

Changes in Supply

Change in Quantity Supplied Change in Supply

🡫 🡫
Movement along the Supply Curve Shift in the Supply Curve
🡫 🡫
Due to the Price Factor Due to the Non-Price Factor

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TOPIC 3: MARKET EQUILIBRIUM Lecture 3

AS / MICRO — [NOTES] — CHAPTER 2

Definition | Market: It is a set of arrangement that allows transactions to take place. In other words, it is
an arrangement where commodities are traded, or the buyers and sellers meet.

Definition | Equilibrium: It is defined as a state of balance between different forces, such that there is
no tendency to change.

Definition | Disequilibrium: A situation where demand and supply are not equal.

Definition | Market Equilibrium: When quantity demanded is equal to quantity supplied, there is market
equilibrium; the forces of supply and demand are in balance, and there is no tendency for the price to
change. Qd = Qs
Graphically it is a position where demand curve intersects supply curve.
1. CHANGES IN EQUILIBRIUM
The equilibrium can change due to only THREE changes.
1. Demand shifts
2. Supply Shifts
3. Simultaneously demand and supply shifts

1. Demand Shifts
Rises (Demand Shifts Outwards) Falls (Demand Shifts Inwards)

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AS / MICRO — [NOTES] — CHAPTER 2

2. Supply Shifts
Rises (Supply Shifts Outwards) Falls (Supply Shifts Inwards)
3. Simultaneously demand and supply shifts

Sometimes in an economy both the demand and supply shift simultaneously. Example: The government gave a
subsidy on the production of electric cars, which resulted in the supply to shift from So to S2. Furthermore, the
advertisement of electric cars and the consumer awareness increased about environmental friendly cars
resulted in the demand to shift from Do to D1. This resulted in the equilibrium quantity to shift from Qo to
Q*.
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2. THE WORKING OF THE PRICE MECHANISM

AS / MICRO — [NOTES] — CHAPTER 2

Definition | Price Mechanism: Price mechanism refers to the system where the forces of demand and supply
determine the prices of commodities and the changes therein. It is the buyers and sellers who actually
determine the price of a commodity. A concept of invisible hand which operates in a competitive market
through the pursuit of self-interest to allocate scare resources in society’s best interest. There are FOUR main
functions of price mechanism:
Functions Description

1. Signaling Price acts as a signal to both consumers and producers. A rise in demand causes prices
and of to rise which signals produces to produce more. Whereas if demand falls it signals to
Transmission the producers to produce less.
of
Preferences It also tells producers about the customers. If consumers do not buy a product then
because they don’t like it or it is too expensive. Hence businesses have to react by
reducing price or changing the product.

2. Incentives An incentive is something that motivates a producer or consumer to follow a course of

action or to change behavior. Higher prices provide an incentive to existing producers to
supply more because they provide the possibility or more revenue and increased profits.
Whereas high price makes consumers buy less.

3. Rationing Due to scarce resources firms increase prices to eliminate excess of demand. The
increase in price discourages demand and consequently rations resources. For example,
plane ticket prices might rise as seats are sold, because spaces are running out. This is a
disincentive to some consumers to purchase the tickets, which rations the tickets.

4. Allocation After the three function are done. We achieve a new equilibrium at new price and a
of new quantity.
Resources
 Demand Shifts to the Right Supply Shifts to the Right

AATIK TASNEEM | AS / LEVEL: ECONOMICS (9708) | 03041122845 7

AS / MICRO — [NOTES] — CHAPTER 2

TOPIC 4: CONSUMER AND PRODUCER SURPLUS

Consumer Surplus Producer Surplus

Consumer surplus is defined as the highest price Producer surplus is defined as the price received by
consumers are willing to pay for a good minus the firms for selling their good minus the lowest price
price actually paid. Consumer surplus is shown in that they are willing to accept to produce the good.
the diagram below as the shaded area between the Producer surplus is shown as the area above the
demand (or marginal benefit) curve, and the firms’ supply curve and below the price received
equilibrium price P1. by firms, P2, which is determined in the market.

When we combine the above two diagrams we get:

How consumer and Producer surplus changes with the market price
Change in Consumer Surplus Chance in Producer Surplus

From the diagram above we see that when the

market price shifts from P1 to P2 the consumer From the diagram above we see that when the
surplus shrinks. market price shifts from P2 to P3 the producer
surplus increase. The increase is shown by the
Market Price 🡩 Consumer Surplus 🡫 grey region. Market Price 🡩 Producer Surplus 🡩
Market Price 🡫 Consumer Surplus 🡩 Market Price 🡫 Consumer Surplus 🡫

AATIK TASNEEM | AS / LEVEL: ECONOMICS (9708) | 03041122845 8

AS – ECONOMICS (9708)
MICRO

CHAPTER 3
Elasticities

Topics Lectures
 Topic 1: Price Elasticity of Demand (PED) 1,2

Topic 2: Income Elasticity of Demand (YED) 3

Topic 3: Cross Elasticity of Demand (XED) 4

Topic 4: Price Elasticity of Supply (PES) 5

Topic 5: Elasticities: Business 6

Topic 6: Elasticities: Government 7

AS / MICRO — [NOTES] — CHAPTER 3

TOPIC 1: PRICE ELASTICITY OF DEMAND (PED)

Lecture 1

Definition | Elasticity: Elasticity refers to degree of responsiveness of one variable to the change in
another variable.

Definition | Price Elasticity of Demand: PED is defined as the degree of responsiveness of Quantity
Demanded due to the change in price of a product.
������ �� ����� =
PED = ����������
���4��� ���
������ �� �������� ��4��
��

��������
����������

Example: Suppose consumers buy 5000 DVD players when the price is $300 per unit, and they buy 6000
DVD players when the price is $255.

Answer:
P1 = $300 P2 = $255
Q1 = 5000 Q2= 6000
GHI4GHJ

PED = 67897:;<=7 >?<:=7 @: AB<:;@;C D7E<:F7F

GHJ

67897:;<=7 ><?:=7 @: 68@97 =

KI4KJ
KJ

Note: We ignore the negative sign because the demand curve is downward slopping hence the answer will always
be –ve.

Interpreting PED calculation

1. Price Inelastic
2. Price Elastic
3. Perfectly Inelastic
4. Perfectly Elastic
5. Unitary Elastic

1. Price Inelastic Demand | PED < 1

Definition: If the price change causes a smaller proportionate change in quantity demand the demand is said to be
price inelastic. Example: Price went up by 10% however demand decreased by only 5%. In order worlds if PED <
1 = Inelastic

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 1

AS / MICRO — [NOTES] — CHAPTER 3

2. Elastic Demand | PED > 1

Definition: If the price change causes a greater proportionate change in quantity demanded the demand is said to
be price elastic. Example: Price went up by 10% however the demand decreased by 15%. In order words, PED > 1
= Elastic

3. Perfectly Inelastic | PED = 0

Definition: This is a theoretical possibility where a change in price has no impact on the quantity demanded.
Example: Price went up by 20% however the demand stayed the same. In other words, PED = 0 = Perfectly
Inelastic. These are usually for products that have no substitutes, a real-life example can be a specific
lifesaving drug.

4. Perfectly Elastic | PED = infinity (∞)

Definition: This is a theoretical possibility where the demand is only on a certain price. If the price increase from
that point it will lead to zero quantity demanded. Example: Price went up by 10%, the quantity demanded dropped
to zero. In order words, PED = infinity (∞). These are usually for products that have perfect substitutes. Example:
Petrol. If shell increases its price even by $1, all the customers will start buying from Total or PSO.

5. Unitary Elastic | PED = 1

Definition: This is a theoretical possibility where the percentage change in price leads to the same
proportionate change in quantity demanded. Example: Price increased by 10% and quantity demanded fell by
10%. In other worlds, PED = 1.

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 2

Determinants of Price Elasticity of Demand
AS / MICRO — [NOTES] — CHAPTER 3

Lecture 2

Factors Description

1. Number of 1. More the substitutes of a product, it would be easier for consumers to shift from
Substitutes one product to another, hence making the demand more elastic. Example: Mobile
phones have several competing brands with similar features. If price of one goes
up consumers can easily substitute. However, on the other hand electricity is only
available from LESCO making its demand more inelastic.

2. Proportion of Goods like matchboxes are goods in which consumers spend a small amount of their
consumer Income income. Therefore, consumers remain indifferent to any change in price. But goods
like car, TV, house etc. are those on which consumer’s major income is spend
making them elastic.

3. Nature of the good Goods and services that are necessities like food, water, clothing have inelastic
demand while goods that are luxuries like Nike shoes, Apple watch have elastic
demand.

4. Habits, Good and services that are addictive in nature e.g. Alcohol, cigarettes, will have
additions, inelastic demand since once consumers start they would be unable to stop the use.
fashion and tastes Similarly, brands that advertise extensively and build a loyal customer base like
Beats, Starbucks coffee etc. will have an inelastic demand.

5. Time (Short-run In the short run the demand would be inelastic since customer won’t be able to
vs Long-run) adjust their demand, however over the long run they can by searching for
substitutes hence making the demand elastic.
 6. Definition of a If goods and services are broadly defined such as car, house, education, food etc. the
good demand would be more elastic, however if a specific type is picked e.g. soft drinks
they would be more inelastic.

Methods to make PED more INELASTIC [Business]

Method Description

1. Advertising Companies can use persuasive advertising to influence consumers to buy a product.
This highlights the benefits of the products compared to its substitutes. This leads the
consumers have more value for the one product over the other making it more inelastic.

2. Branding Branding allows one product to look more superior to its rivals. This allows the
company to project itself different from rivals and therefore making the PED more
inelastic.

3. Mergers If firms start to take over rival brands this allows them to eliminate competition and increase
market share. One company controlling more shares leads to less competition which leaves
less options for the consumers making the PED more inelastic.

4. Monopoly Some firms tend to become private monopolies. This is usually done through owning
patents. This makes the company the only producer of the product and give the company
the power to overcharge customers.

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 3

AS / MICRO — [NOTES] — CHAPTER 3

1. VARIABLE PED AND THE STRAIGHT-LINE DEMAND CURVE

Along any downward-sloping, straight-line demand curve, the PED varies (changes) as we move along the

curve.
Important points of a straight-line demand curve:
1. The terms ‘elastic’ and ‘inelastic’ should not be used to refer to an entire demand curve (with the exception of
the three special cases (Perfectly elastic, Perfectly inelastic and unitary elastic where PED is constant throughout
the entire demand curve). Instead, they should be used to refer to a portion of the demand curve that corresponds
to a particular price or price range.

2. PED should not be confused with the slope of a demand curve. Whereas the slope is constant for a linear
(straight line) demand curve, PED varies throughout its range. It is not only the steepness of the demand curve that
determines elasticity but also the point on the curve where the elasticity is measured.
 AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 4
AS / MICRO — [NOTES] — CHAPTER 3

TOPIC 2: INCOME ELASTICITY OF DEMAND (YED)

Lecture 3
Definition | YED: It is the degree of responsiveness of quantity demanded to the change in income of
consumers. YED can be categorized into THREE types on the bases of sign:
1. Positive YED (Normal Goods)
2. Negative YED (Inferior Goods)
3. Zero YED (Very Basic Necessities)
=
Y.E.D. = % ������ ��
���4��� ���
�������� �������� ��4��
��

% ������ �� ������
 Example: Suppose the income of a consumer increases from $800 per month to $1000 per month, and the
purchases of clothes increase from $100 to $140 per month. What is the income elasticity of demand for
clothes?

Answer:
Y1 = $800 Y2 = $1000
Q1 = $100 Q2= $140

Note: In PED we ignored the sign but in case of YED the sign has great concern.

1. Positive YED (Normal Goods)

Definition: When an increase in income leads to an increase in Qd and a decrease in income leads to a decrease in
Qd the YED is said to be positive because income and demand are moving in the same direction. Goods that have
a positive YED are called normal goods, Example: Cars, TVs, mobiles etc. Positive YED can be either elastic of
inelastic

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 5

AS / MICRO — [NOTES] — CHAPTER 3
Positive Income Elastic | YED > 1 Positive Income Inelastic | YED < 1
 Definition: When a smaller percentage change Definition: When a large percentage change increase
increase in income leads to a greater percentage in income leads to a smaller percentage increase in
increase in Qd and vice versa in called income elastic Qd and vice versa in called income inelastic
demand. Superior goods like luxuries on which a demand. These include necessities on which
large proportion of consumer income is spent fall in consumers spend a small proportion of their income.
this category. Example: Luxury cars, foreign Example: Regular clothing, biscuits, stationary etc.
holidays, etc.

2. Negative YED (Inferior Goods)

Definition: When an increase in income leads to a decrease in demand of the product YED would be negative since
income and demand are moving in the opposite direction. Goods that have a negative YED are called inferior
goods, Example: second hand clothing, used cars. Negative YED can be either elastic of inelastic

Negative Income Elastic | YED > 1 Negative Income Inelastic | YED < 1

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 6

AS / MICRO — [NOTES] — CHAPTER 3

3. Zero YED (Very Basic Necessities)

Definition: When any percentage change in income leads to no change in demand. It is known as zero
income elasticity of demand. Basic necessities like salt and sugar are examples. YED = 0.

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 7

AS / MICRO — [NOTES] — CHAPTER 3

TOPIC 3: CROSS ELASTICITY OF DEMAND (XED)

 Lecture 4
Definition | XED: It is defined as the responsiveness of quantity demanded of one good to the change in price
of another good. XED can be categorized into THREE types:
1. Positive XED (Substitutes)
2. Negative XED (Complements)
3. Zero XED (Unrelated Goods)
X.E.D. = % ������ �� ��������
�������� ��� ���� � 1. Positive XED (Substitutes)
���4��� ���
��4��
��
% ������ �� ����� �� ���� � =

Definition: Any proportionate change in price of a produce will cause an increase in the demand for its substitute
and vice versa. Substitutes are those goods which are alternatively demanded. Example: Pepsi and Coke, Nestle
Juice and Shezan Juice, Tea and Coffee etc. Substitutes have a +ve XED. As when price of Pepsi will go up
people will start consuming more coke since it provides almost the same utility.
Example: Suppose the price of coffee increases from $10 per kilogram (kg) to $12 per kg and the amount of
tea purchased increases from 1500kg to 1650kg. What is the XED?

Answer:
P1 = $10 P2 = $12
Q1 = $1500 Q2= $1650

Note: A +ve XED shows that it is a substitute. Since when price of coffee went up people starting consuming
more tea.

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 8

 AS / MICRO — [NOTES] — CHAPTER 3

2. Negative XED (Complements)

Definition: Any proportionate increase in the price of a product will lead to a proportionate decrease in demand for
its complement and vice versa. Compliments are those goods or services which are jointly demanded. Example:
Car and Petrol, Bread and Butter etc. Complements have a -ve XED. As when price of petrol will go up people
will start buying less cars since now affording a car is more expensive.
Example: Suppose the price of pencils increases from $1.00 per pencil to $1.30 and the quantity of
erasers purchased falls from 1000 erasers to 800. What is the XED?

Answer:
P1 = $1 P2 = $1.3
Q1 = 1000 Q2= 800

Note: A -ve XED shows that it is a compliment. Since when price of pencils went up the demand for
erasers dropped as without a pencil an eraser is not much of any use.

3. Zero XED (Unrelated Goods)

Definition: Any proportionate increase or decrease in price of one product generates no response in the quantity
demanded of another product, these types of goods are unrelated. Unrelated goods are those goods which have no
link with each other. Example: shirts and burgers, potatoes and telephones etc. Unrelated goods have a 0 XED.
As these goods will neither be substitutes nor complements.
 AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 9
AS / MICRO — [NOTES] — CHAPTER 3

TOPIC 4: PRICE ELASTICITY OF SUPPLY (PES)

Lecture 5
Definition | PES: PES is defined as the degree of responsiveness of Quantity Supplied due to the change in price
of a product. A high PES would show that the suppliers can quickly increase the supply if there is an increase in
price. This helps the firm gain a competitive edge and be more flexible to the price changes.
������ �� ����� =

PES = ���������� ���4��� ���

��4��
������ �� �������� ��

��������
����������

Example: Suppose the price of strawberries increases from $3 per kg to $3.50 per kg, and the
quantity of strawberries supplied increases from 1000 to 1100 tonnes per season. Calculate PES for
strawberries.

Answer:
P1 = $3 P2 = $3.5
Q1 = 1000 Q2= 1100

Note: Since the answer is less than 1, the PES is inelastic

Interpreting PES calculations

1. Inelastic Supply
2. Elastic Supply
3. Perfectly Inelastic Supply
4. Perfectly Elastic Supply
5. Unitary Elastic Supply
1. Inelastic Supply | PES < 1 = Inelastic
Definition: If the price change causes a smaller proportionate change in quantity supplied the supply is said to be
price inelastic. Example: Price went up by 10% however supply increased by only 5%. In order worlds if PES < 1
= Inelastic

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 10

AS / MICRO — [NOTES] — CHAPTER 3

2. Elastic Supply | PES > 1 = Elastic

Definition: If the price change causes a greater proportionate change in quantity supplied the supply is said to
be price elastic. Example: Price went up by 10% however the supply decreased by 15%. In order words, PES >
1 = Elastic

3. Perfectly Inelastic Supply | PES = 0

Definition: This is a theoretical possibility where a change in price has no impact on the quantity supplied.
Example: Price went up by 20% however the supply stayed the same. In other words, PED = 0 = Perfectly
Inelastic. This shows that there is not spare capacity in the economy due to which suppliers are unable to increase
the supply even when the price increases.
4. Perfectly Elastic | PED = infinity (∞)
Definition: This is a theoretical possibility where the supply can change without any corresponding change in
price. If the price increase from that point it will lead to zero quantity supplied. Example: Price stayed the same,
the quantity supplied increased by 10%. In order words, PED = infinity (∞). This shows that there is space
capacity in the economy and the suppliers can increase the supply without increasing the price.

5. Unitary Elastic | PED = 1

Definition: This is a theoretical possibility where the percentage change in price leads to the same proportionate
change in quantity supply. Example: Price increased by 10% and quantity supply increased by 10%. In other
worlds, PED = 1.

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 11

AS / MICRO — [NOTES] — CHAPTER 3

Determinants of Price Elasticity of Supply

Factors Description

1. Level of Spare When the industry is operating below full capacity, this shows that it has
Capacity unemployed resources. Industry can expand easily by using the previously unused
resources and that would make the supply elastic. However, at full capacity no spare
resources in the industry which makes expansion difficult making the supply
inelastic.

2. Number of More the suppliers in the industry the elastic would be the supply since as soon as the
producers in the price goes up more producers would start supplying. However, if there are more
industry barriers to entry, supply would be inelastic.

3. Time Period In the short run firms, cannot change their factors of production making the supply
inelastic. In the long run supply, would be elastic since level of production can
change their factors of production.
 4. Ease and Cost of This shows to what extend can labor and capital be switched. If switching is easy and
Factor Substitution quick this will make the supply elastic. However, if switching is difficult supply would
be inelastic.

5. Availability to If a country can import raw-material, machines etc. from abroad easily and cheaply
Import supply would be elastic. However, if the country is a closed economy or the
international barriers to import are high supply would be inelastic.

6. Ability to Store If products can be stored easily and cheaply supply would be elastic since when prices
the Product are low the supply can be reduced and as soon as the prices increase supply can be
increased.

Methods to make PES more ELASTIC [Business]

Method Description

1. Increase Stocks If the company increases storage it would allow the firm to keep extra raw materials
and finished goods. In case demand goes up the firm can quickly match the demand.

2. Train Labor If the labor is trained and multi skilled it is easy to adapt to market changes quickly
because they can quickly shift to developing new products or are able to increase the
supply at will.

3. Improve With diverse machinery the supply becomes more elastic. In case the demand increases
machinery the machinery can quickly adapt to meet the high demand by running for more hours.

4. Keep If a company keeps both local and foreign suppliers it can quickly order stocks and
multiple raw materials in case the demand increases.
suppliers

5. Keep extra If the company is operating below full capacity and has extra resources at their
resources disposable it would be easy to increase supply when required.

Methods to make PES more ELASTIC [Government]

Method Description

1. Subsidy More businesses enter this market and increase the supply for the product making PES
elastic.

2. Better Training Better training of workers leads to an improvement in the quality of labor
resources, increasing the productivity of labor, which is one of the key causes of
higher output.

3. Research and New technologies, resulting in new or improved capital goods which is another important
Development cause of increases in potential agricultural output. This allows for more flexible
machinery to produce goods.

4. Invest in Good road, railway and warehousing facilities save time and effort spent in
Infrastructure transporting perishable items, allowing more output to be transported.

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 12

 PED

TOPIC 5: ELASTICITIES: Use 1: Price Variations

AS / MICRO — [NOTES] — CHAPTER 3
BUSINESS

Lecture 6

PED can help a business to adjust its prices according to the elasticities. When the demand is elastic the
prices would be kept lower whereas when the demand is inelastic the prices would increase. Examples: (1)
Charge higher during peak hours and lower during off peak hours
(2) Cheaper to purchase airline tickets months before vs buying them a few days before.

Use 2: PED and Total Revenue

Definition | Total Revenue: It is the price multiplied by quantity. As we see from the diagram the change in total
revenue. At price P1 the revenue was (OP1 x OQ1) at price P2 the revenue became (OP2 x OQ2).

Price changes would leave different effects on price elastic, inelastic and unitary elastic demands
Factor Description

1. Price Elastic Any reduction in price would leave to increase in Total Revenue. Here the increase
in quantity demanded insufficient to compensate for the decrease in price.

2. Unitary Elastic On the midpoint the total revenue stops rising and is it at its maximum. There is no
change in total revenue with a rise or fall in price of the product.

3. Price Inelastic A decrease in price would lead to a decrease in total revenue. Here the increase in
quantity demanded in insufficient to compensate for the decrease in price.
 AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 13
AS / MICRO — [NOTES] — CHAPTER 3

YED
Use Description

1. Economy – When the economy is growing people have more incomes and hence they will demand
Boom more normal and luxury goods and less of inferior goods. This also happens at year ends
when salaries are paid and crops are sold. In this time companies should focus on
producing luxuries and promote them by attractive displays and other promotional
activities.

2. Economy – When the economy is experiencing slow economy growth or is experiencing a recession
Recession income are falling and hence at this point people are more interested in buying cheaper
products. The firms should start producing cheaper version of products and advertise low
prices and USPs.

XED
Use Description

1. Price change If the price of coffee rises, tea sellers should realize that consumers will buy more tea and
in substitutes they should launch more advertisement campaigns to increase sales. Furthermore, if coffee
prices increase tea seller might also increase their prices to gain extra profits. The higher
the number the more non-price competition should be used.

Similarly, if the price of coffee falls, tea sellers might have to give discounts or coupons to
stop the individuals form shifting to coffee. Furthermore, they might even have to decrease
their prices which will reduce profitability.

2. Price change If the price of butter falls, a bread seller might increase his sales. The bread seller will
in advertise more and offer variety and promotional campaigns.
complements
If the price of butter increases, a bread seller sale might decrease. Hence, he might need to
give discounts and offer special offers like buy one get one free to prevent a drop in sales.
PES
Use Description

1. Tell how PES Elastic: It shows that the business can easily respond to the changes in the market. If
quickly can the the demand increases the business knows that it can easily increase the supply and meet
business the excess demand and earn profits. Whereas if the demand decreases the company can
adapt to the change quickly cut back on production to save costs.

PES Inelastic: It shows that the business cannot respond to market changes. If the
demand increases the business knows it is difficult to increase supply due to lack of
resources or flexibility of machinery. This restricts the ability to earn profits.

2. Impact on price PES Inelastic: With inelastic supply if the demand changes the impact on prices is
much higher. If the demand increases the prices rise by a large percentage.

PES Elastic: With elastic supply if the demand changes the impact on prices is much
smaller. If the demand increases the prices rise by a small percentage.

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 14

AS / MICRO — [NOTES] — CHAPTER 3

TOPIC 6: ELASTICITIES: GOVERNMENT

Lecture 7

PED

Use 1: Tax Revenue

The government can check how much tax revenue are they going to earn.

Inelastic PED - If the government charges a tax on inelastic products the tax revenue would be high because
people won’t be shifting their demand too much.

Elastic PED - If the government charges a tax on elastic products the tax revenue low be low because people
will quickly shift their demand.

Use 2: Tax incidence

PED can tell who shares the burden of the tax in the economy.

Inelastic PED – Burden is more on the consumer

Elastic PED – Burden is more on the producer

 Inelastic Elastic

Use 3: Indirect tax and Demerit Goods

By looking at the elasticity the government can predict how much will the demand fall when an indirect tax
is imposed. The more inelastic the good the small the fall in the consumption for demerit goods.

AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 15

AS / MICRO — [NOTES] — CHAPTER 3

Use 3: Subsidy
Price elasticity of demand helps the government to assess the extent to which a subsidy causes a fall in price
and increase in consumption.

PED Elastic – A subsidy is more effective where demand for a good is elastic, this is because a subsidy will
reduce the price significantly and therefore will result in proportionately larger increase in consumption.

PED Inelastic A subsidy is less effective where demand for a good is inelastic, this is because a subsidy will
reduce the price significantly but will result in proportionately small increase in consumption.

YED
Use Description

1. Impact of Normal Goods – The demand for normal goods will decline when an income tax is
Income Tax imposed. If the good is elastic the impact would be much higher.

Inferior Goods – The demand for inferior goods will increase when the government imposes
an income tax. The impact would be higher if the goods is elastic.

2. Impact of Growth – The government knows that the demand for normal goods increase during
economic growth hence it is better to tax these items to earn more revenue and subsidies the
changes companies making inferior goods.

Recession - The government knows that the demand for inferior goods increase during
growth hence it is better to tax these items to earn more revenue and subsidies the
companies making normal goods.
 AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 16

AS – ECONOMICS (9708)
MICRO

CHAPTER 4
Government Intervention Microeconomic

Topics Lectures

Topic 1: Classification of Goods and Services 1

Topic 2: Market Failure: Corrections 2,3

Topic 3: Income and Wealth Inequality 4

AS / MICRO — [NOTES] — CHAPTER 4

TOPIC 1: CLASSIFICATION OF GOODS AND SERVICES

Lecture 1
Goods and services in an economy can be divided into FIVE main classifications:
Good Type Description

1. Free Goods Free goods are goods that are not scarce, and therefore are available without limit. A
free good is available in as great a quantity as desired with zero opportunity cost to
society. A good that is made available at zero price is not necessarily a free good.
Example: Air, water in local river, sunlight etc.

2. Private Goods Private goods (also known as economic goods). These goods have a cost and are
scare. These goods are excludable* and rivalrous*. Example:
*1. Excludability: Individuals can be stopped or excluded from consuming them by
charging a high price. Furthermore, once it is purchased by one individual it cannot
be consumed by another.
*2. Rivalry: This means that consumption of the good by one person reduces
the availability for others.
 3. Public Goods These goods are non-excludable, non-rivalrous and non-rejectable and non
marketable. Which means that consumers cannot be excluded from consuming the
goods and consumption by one person does not affect the amount of the good
available for others to consume. Example: Street lighting, lighthouse, defense, police
protection etc. Note: There is one issue with public goods. These goods have a
free-rider problem. This means that individuals can consume the good and avoid
having to pay for the good at the same time if it is provided. Hence, they are not
provided by the private sector and the government has to provide them.

4. Merit Goods These are goods that have positive effect on the society. Individuals do not perceive
the full benefit from consumption due to information failure (not having complete
information on the benefits) and hence they are under-consumed. Example: Health
care, education, housing etc.

5. Demerit Goods These are goods that have a negative effect on the society. Individuals do not perceive
the full harm from consumption due to information failure (not having complete
information on the drawbacks) and hence they are over-consumed. Example: Drugs,
tobacco, junk food etc.

Note: When deciding merit and demerit goods we are accepting paternalism. This is a situation where society
knows the best and has the right to make value judgement.

Definition | Market Failure: When the free market does not make the best use of scare resources. It is an
inefficient allocation of goods and services. The price mechanism fails to take into account all of the costs and
benefits that are necessary to produce or consumer a product.
(1) Lack of Public Goods
(2) Under-production of Merit Goods
(3) Overconsumption of Demerit Goods
(4) Externalities.

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AS / MICRO — [NOTES] — CHAPTER 4

TOPIC 2: MARKET FAILURE: CORRECTIONS

METHOD 1: INDIRECT TAXES
Definition | Tax: A tax is a compulsory levy on private individuals and organizations by the government to raise
revenue to finance expenditure on public goods and services like defense, healthcare, transport etc. There are
TWO main types of taxes:

1. Indirect Taxes
Definition: Those taxes which are levied on expenditure of goods and services and whose burden can be passed to
someone else are known as indirect taxes. Example: GST, VAT, tariff, custom duties etc. Cause a shift in the supply
curve since they are the part of cost of production.
Indirect, excise taxes can be:
 Specific taxes Ad valorem taxes

A fixed amount of tax per unit of the good or A fixed percentage of the price of the good or service;
service sold; for example, €5 per packet of in this case, the amount of tax increases as the price
cigarettes. of the good or service increases.
Ad valorem Tax🡩 Cost of Production 🡩 Qs
Specific Tax🡩 Cost of Production 🡩 Qs 🡫
🡫

Tax Incidence
Definition: A tax incidence is an economic term for the division of a tax burden between buyers and sellers.
The key concept is that the tax incidence or tax burden does not depend on where the revenue is collected, but
on the price elasticity of demand and price elasticity of supply.

In order to understand the incidence in taxation we need to understand how a tax effects the consumer and
producer surplus. The loss in the consumer surplus will be regarded as the burden shared by the consumer and the
loss in the producer surplus will be regarded as the burden shared by the producer.

As we
see from the diagram(a) above, the market is in equilibrium at P* and Q* with the relevant area of consumer and
producer surplus. However when then government places a tax a certain portion of both areas is lost and both the
consumer and producer surplus shrinks. As after the tax the price is Pc with quantity Qt. the area (a+b) is the
welfare loss which is the fall in total surplus that results from a market distortion, such as a tax and the area
between Pc and Pp is taken as government tax revenue.

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AS / MICRO — [NOTES] — CHAPTER 4

Tax Incidence
Incidence of an indirect tax with PED
 Inelastic Demand Elastic Demand

From the above diagram we can conclude the following:

1. Inelastic Demand More burden on consumers

2. Elastic Demand More burden on producers

1. Inelastic Supply More burden on producer

2. Elastic Supply More burden on consumers

Advantages and Disadvantages of Indirect Taxes

Advantages Disadvantages

1. Decreases consumption: The tax increases the 1. Not effective if demand is inelastic: It won’t be
price of the product which results in a decrease in highly effective in reducing the demand for products
quantity. This can be used to reduce consumption of that have an inelastic demand.
harmful products.
2. Regressive in nature: These taxes are regressive
2. Revenue for merit goods: It generates revenue for in nature as the burden of the tax will fall more
the government which can be used to provide merit on poor people rather than rich individuals which
goods for the masses like education and health care. generates inequality.

3. Check Harmful Consumption: By being imposed 3. Harmful to Industries: They discourage

on harmful products, they can check consumption industries if raw materials are taxed. This will raise
of harmful commodities. That is why tobacco, the cost of production and impair their competitive
wine and other intoxicants are taxed. capacity.

4. Non-evadable: They cannot be evaded, as they 4. No Civic Consciousness: These taxes do not
are a part of the price. They can be evaded only develop civic consciousness, because many times
when the taxed article is not consumed, and this the tax-payer does not even know that he is paying
may not always be possible. tax. The tax is concealed in the price. This might
not deter the consumption.
 AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 3
AS / MICRO — [NOTES] — CHAPTER 4

Lecture 2

METHOD 2: SUBSIDIES
Definition | Subsidies: It is the grant given by the govt. to firms to increase their production and reduce the
market prices so that consumers become able to buy necessities at cheaper prices. When paid to a producer, a
subsidy has the opposite effect of an indirect tax. It is the equivalent of a fall in costs for the producer and results
in a rightward shift in the market supply curve.

As we see from the diagram above, before the subsidy was given the market price was P* and Quantity produced
was Q*. However the government wanted to increase the production and at the same time reduce the price.
Hence the government provided a subsidy to the producers to increase the production. A subsidy reduces the
cost of production hence supply shifts outwards.
Advantages Disadvantages

1. Increase in production and consumption of 1. The cost will have to be met through taxation.
merit goods. Some taxation, e.g. income tax, may reduce
incentives to work.
2. Reduces prices for the customers. Lower inflation
increases the standard of living and tend to increase 2. Difficult to estimate the extent of the positive
the access of these goods to all classes of the externality. Therefore the government may have
masses. poor information about the service and how much
to subsidize.
3. In the long term, subsidies for a good will help
change preferences. It will encourage firms to 3. There is a danger that government subsidies may
develop more products with positive externalities. encourage firms to be inefficient and they come to
rely on subsidy rather than improve efficiency.
4. If the subsidy is given on a exported good this
can help a country increase its exports. 4. Opportunity cost for the govt.

Note: Giving a subsidy leads to interfering with the price mechanism and has an opportunity cost. Another
problem is that subsidies are so-called ‘blanket’ or lump sum payments and, unlike taxes on consumers, cannot
easily be linked to incomes and the ability to pay. It is therefore necessary to assess who benefit from a particular
subsidy.

Incidence of Subsidy
PED Inelastic = More benefit to the consumer
PED Elastic = More benefit the producer.

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AS / MICRO — [NOTES] — CHAPTER 4

METHOD 3: DIRECT PROVISION

Definition: To reduce inequality in society the government provides certain important services free of charge to the user. Such
services are financed through the tax system. If such services are used equally by all citizens, then those on lowest incomes
gain most as a percentage of their income thereby lowering inequality. This is usually in the case of merit and public goods.
Example: Healthcare, education, street lighting etc.

[However] the market overprovides especially where no direct charge is made leading to inefficient resource allocation. If a
charge is made or introduced, demand is likely to fall. It can also be argued that many consumers could afford to pay a charge,
so reducing the tax burden or allowing the funding saved in this way to be put to alternative uses.

METHOD 4: PROVISION OF INFORMATION

(1) Education and Advertisement / Merit Good: The government can also informative advertisement and education to
explain to the masses the benefits of consuming consumption products that are good for them. Example: The government
might launch campaigns in schools and on several media platforms encouraging masses to consume fresh fruits and
vegetables. This would increase the demand and create healthier economy where fewer individuals would use healthier
services, producing an external benefit to the society.
Advantages Disadvantages

1. Since the individuals know the benefits of vegetables 1. The money spend on educating and advertisements
they are more likely to consume the product. could have been spent on other merit goods.

2. Successful advertisements might lead a cultural change 2. Not all advertisements are equally effective.
in the long term. Individuals might train their next
generation to consume more fruits and vegetables. 3. It takes time for people to change habits.

(2) Education and Advertisement / Demerit Goods: Governments can also use schools and advertisements to motivate
people not to smoke. Governments can launch campaigns against smoking in schools and on television to discourage the
habits. When children would be educated they are less likely to carry on the habit in the future. The impact can be shown with
the help of a diagram:
Advantages Disadvantages

1. Since the individuals know the dangers of smoking they 1. The money spend on educating and advertisements
are less likely to consume the product. could have been spent on other merit goods.

2. Successful advertisements might lead a cultural change 2. Not all advertisements are equally effective.
in the long term. Individuals might train their next
generation to avoid demerit goods. 3. It takes time for people to change habits and in the
meantime the consumption of demerit goods is
 continued.

METHOD 5: LAWS AND REGULATION

Definition: These are laws which place restrictions on activities of firms:
(1) Regulations: Governments can also impose rules and regulations in an attempt to solve market failure. These laws can
include imposing age restriction like smoking is only allowed for individuals above the age of 18 to passing laws that
restrict consumption like banning smoking in public, airports etc. This will reduce the consumption by decreasing the
demand.
Advantages Disadvantages

1. This reduces the consumption of demerit goods. 1. Restriction causes formation of black markets where
goods are sold illegally and at a high price.
2. The behavior of the individuals might be modified in
the long run, as it will become a habit. 2. Individuals might by pass the law by making
false identification cards.

3. If the fine or punishment is not high enough the laws

won’t be effective.

(2) Complete Ban: For some items the government imposes a complete restriction of the consumption of the product. This is
usually done for products that have highly inelastic demand and are extremely harmful for products like drugs. This allows the
government to deal with even the most harmful products in which taxes would not have resulted in any change. [However]
This can potentially cause black markets to form and the government can lose out on tax revenue that it could have earned.

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AS / MICRO — [NOTES] — CHAPTER 4

Lecture 3

METHOD 6: Maximum Price

Definition: A government may in some situations set a legal maximum price for a particular good; this is called a
price ceiling. It means that the seller cannot charge a price higher than the maximum price. This usually happens
for necessities where the government wants necessities or certain commodities to be more affordable for to the low
income earners. Examples: Rent controls and Food price controls.

By imposing a price that is below the equilibrium price, a maximum price results in a lower quantity supplied and
sold than at the equilibrium price. In this situation Quantity demanded is Q3 whereas quantity supplied is only
Q1. This creates a shortage in the market. A price ceiling does not allow the market to clear. It creates a situation
of disequilibrium where there is a shortage (excess demand).
Advantages Disadvantages

1. Some consumers who bought the good can enjoy 1. Firms receive lower prices and some may leave
it at a low price are better off. the industry.

2. Reduce inflation by keeping the prices low. 2. Consumers who were not able to get the good
are worse off.
3. Can reduce burden on the poor as now the rich and
the poor can both afford it on the same price. 3. Shortages would lead to long ques and selling
would be on first come first serve basis limiting the
rationing function of the price mechanism and lead
to
misallocation. This is due to non-price rationing.

4. Some firms might keep goods under the counter

and sell in the black market or on the basis of
favoritism.

Evaluation: This method would only work if the government adopts a system of rationing in which they limit the
amount the people can buy this would ensure a more fair distribution of goods because an unregulated shortage
lead to unfair distribution. However it should be noted that shortages would still exist.

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AS / MICRO — [NOTES] — CHAPTER 4

METHOD 7: Minimum Price

Definition: A legally set minimum price is called a price floor. It means that the seller cannot charge a price lower
than the minimum price. This usually happens to provide income support for farmers by offering them prices for
their products that are above market- determined prices and to protect low-skilled, low- wage workers by offering
them a wage (the minimum wage) that is above the level determined in the market. Examples: Minimum wage
law, increasing prices of agricultural products and reduce demand for demerit goods like tobacco products and
 alcohol.
By imposing a price that is above the equilibrium price, a minimum price results in a lower quantity demanded
than at the equilibrium price. In this situation Quantity demanded is only Q1 whereas quantity supplied is Q2.
This creates a surplus in the market. A price ceiling does not allow the market to clear. It creates a situation of
disequilibrium where there is a surplus (excess supply).
Advantages Disadvantages

1. Can reduce wealth gap if a minimum wage 1. Higher prices for consumers and firms for
law is passed. that product. Leading to loss of welfare.

2. Consumption of demerit goods might go down due 2. Minimum prices encourage oversupply and are
to high prices. inefficient. The same resources could have been
used in other areas of the economy.
3. Govt. can earn high tax revenues both through
direct and indirect taxes which can be spent on 3. The government has to dispose the surplus this can
welfare. be done by buying surplus which would incur extra
cost.

4. Firms do not bother to cut down costs and deploy

efficient production methods because they believe
they can cover the cost using the higher price and
beat any low cost competitor.

Evaluation: This method is only going to work if the govt. buys the excess supply of Q1-Q2 and may be export it
to gain more foreign exchange.

METHOD 8: BUFFER STOCK SCHEME

Definition | Buffer Stock Scheme: It is a technique to limit the fluctuations of prices of goods. The government
smooths out price rises and falls by buying and selling stocks of products depending on market conditions. The
scheme sets a minimum and a maximum price. Basically the government sets a range and makes sure that the
price stay between in.

(1) A minimum price is set for the product. If the market price is going below the minimum the government will
buy up stocks and store them in the warehouse. This reduces supply and causes price to rise.

(2) A maximum price is set for the product. If the price is going above this price the government will try to boost
the supply if the price goes above this which increases supply and brings the prices down.

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AS / MICRO — [NOTES] — CHAPTER 4
TOPIC 3: INCOME AND WEALTH INEQUALITY
Lecture 4
1. Income and Wealth
Definition | Income: Income is the reward for the factors of production. It includes wages and salaries, rent,
interest and profits. It is a flow concept because the returns are variable over time.

Definition | Wealth: Stock of assets the someone has built over time. Example: Property, gold, shares etc. These
assets provide security and income steam in some cases.

2. Measuring Income and Wealth

Income and wealth inequality are measured through the Gini Coefficient. The value ranges from 0 to 1. The
higher the Gini Coefficient the higher the income inequality.

3. Reasons for Inequality for income and wealth

1. Lack of formal employment
2. Poor training
3. Lack of investment in education and health care
4. Low savings which reduces investment in the economy
5. Poor financial institutions which reduces lending.

4. Methods to reduce income and wealth inequality

(1) Minimum wage
(2) Transfer payments
(3) Progressive income taxes, inheritance and capital taxes
(4) State provision of essential goods and services

METHOD 1: Minimum Wage

Definition: It is the least amount an employer can legally pay one of its workers. It is usually expressed in wage
rate per hour.

Advantages Disadvantages

1. This can help stop exploitation of workers when firms 1. Increase in the minimum wage may cause price
are paying too low. This has helped reduce the poverty inflation of goods as the firms pay higher wages to the
as the workers receive significantly increased weekly employees.
income.
2. Increase in NMW may cause unemployment. As the
2. More people would be willing to work due to the high wage budget is increased companies tend employ less
wage rate. This reduces the burden on the government for employees and more machinery directly resulting in
relying on welfare payment. unemployment. Unemployment can emerge in two ways
when there is less demand of work or when there is more
3. The implementation of NMW helped reduce supply of labor.
discrimination against age, gender, race religion, sexuality
or disability. It also acts as a tool for reducing male female 3. Foreign investors might be discouraged to invest
age differentials. in an economy that has high labor costs.

4. The national minimum wage helps poor people improve

their standard of living. In addition, when people are
 employed they get a feeling of being wealthier, likely to
have more disposable income.

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AS / MICRO — [NOTES] — CHAPTER 4

METHOD 2: Transfer Payment

Definition: Transfer payments are payments from tax revenue that are received by certain members of the
community. They are not made through the market, as no production takes place. Like a progressive taxation
system, their function is to provide a more equitable distribution of income. Their main recipients are vulnerable
groups such as the elderly, the disabled, the unemployed and the very poor. Payments tend to transfer income
from those able to work and pay taxes to those unable to work or in need of assistance. Examples include, old age
pensions, unemployment benefits, housing allowances, food coupons, child benefits etc.
- Means tested benefits: Which means these benefits will be given to people whose income fall below a
certain level.
- Universal benefits: A benefit without reference to the income of the receiving person.
Advantage Disadvantages

1. It is clear that in most cases they are necessary 1. Unemployment benefits and benefits to the poor
to protect the most vulnerable groups in the can act as a disincentive to accepting work, so
community. They result in less poverty and increasing the unemployment rate. As a
provide for a more equitable distribution of consequence, output in the economy is less than it
income might be and there is a form of inefficiency.

2. Some individuals might go into the poverty trap

which means there is no incentive to take up a job
since any additional income will be taken away in
taxes due to progressive taxation along with benefits.

METHOD 3: Progressive income tax, inheritance and capital taxes

Tax Description

1. Progressive Tax It is a form of taxation where the rate of taxation rises more than proportionately to the
rise in income. The percentage of tax gets higher when the income rises. [however]
This can act as an incentive to work and investors might move to countries with low
taxes.

2. Inheritance tax This is a tax that is imposed when an individual acquires an amount of wealth.

3. Capital Tax This is a tax imposed on financial gains a person may have made overtime on an
asset. Example: Property.

METHOD 4: State Provision of goods and services

Some governments provide certain goods and services often free of charge to the uses. This facility is
maintained though a system of taxes. These services help the poor segment to get benefits of health care and
education. [however] this can increase taxes on the general population.
 AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 9

AS – ECONOMICS (9708)
MACRO

CHAPTER 1
Basic macroeconomic ideas

Topics Lectures

Topic 1: National Income Statistics 1

Topic 2: Circular Flow of Income 1

Topic 3: Aggregate Demand and Aggregate Supply 2

Topic 4: Types of Policies 3,4,5

AS / MACRO — [NOTES] — CHAPTER 1

TOPIC 1: NATIONAL INCOME STATISTICS

Lecture 1
Definition | National Income: The total amount of money earned within a country. There are several key
concepts in National Income.
Concept Description

1. Gross This shows the value of final goods and services produced by factors of production
Domestic within a country.
Product (GDP)

2. Gross This shows the value of final goods and services produced by factors of production owned
National by a country ‘citizen, regardless of where in the world this is earned.
Product (GNI) GNP = GDP + Property Income from Abroad – Property Payments to
Abroad OR
GNP = GDP + Net Property Income from Abroad

3. Net National Out of the income earned in the economy some will be spent replacing the equipment that
Product (NNI) has depreciated. To measure additional (or new or net) income earned we deduct the
amount spend simply on replacement of items. This is also called net income.

NNI = GNP - Depreciation

1. CALCULATING NATIONAL INCOME

There are THREE methods of calculating national income:
1. Expenditure Method
2. Income Method
3. Output method
Output = Income = Expenditure

Example: If $100 worth of goods are produced (Output) this has generated $100 of income for various
factors of production (Income) and will lead to $100 of spending (Expenditure)

1. Expenditure Method
This method adds up spending in the economy.

GDP at Market Price = C + I + G + (X-M)

Note: Imports are deducted because this is the spending on goods and services from abroad. This amount leaves
the economy.
C – Consumers Expenditure
I – Investment spending by firms, this includes planned investment in capital and unplanned increase in
stock G – Government Spending
X – Exports
M – Imports

The expenditure method: Market Price to Factor Cost

If spending of different groups in the economy is added up this will show the spending at current market prices.
This does not reflect the income earned by the factors of product because:
1. Market Price is too high because of indirect taxes
2. The Market price is too low because of subsidies

GDP at market Price – indirect taxes + subsidies = GDP at factor cost

 AATIK TASNEEM | AS / LEVEL: ECONOMICS (9708) | 03041122845 1
AS / MACRO — [NOTES] — CHAPTER 1

2. Income Method
This approach looks at the flow of economic activities from the income point of view. It can be calculated
by: 1. Wages and salaries
2. Interest and Dividends
3. Rent
4. Profits
5. Income of self employed
GDP = Total Domestic Income

Note: Transfer Payments are not added in the national income because these are payments for which no
corresponding good or service is produced. Example: Pensions, scholarships, unemployment benefits
etc.

3. Output Method
1. This method adds up the value of every firm’s output (i.e. the value of the output minus the value of the input).
This avoids double counting example counting the value of steel and the value of car which also includes the
value of steel.

2. Adds up the output of final goods and services.

GDP Deflator

Real national income is calculated by adjusting national income figures for inflation. The retail price index is
not used as it only considers consumer prices, a more complex measure of inflation is used called the GDP
Deflator. This convers money GDP to real GDP.
Real GDP = Money GDP x ���� ���� �����
������� ����� �����

Example:

AATIK TASNEEM | AS / LEVEL: ECONOMICS (9708) | 03041122845 2

INCOME 1. Simple Circular flow of Income
Model
TOPIC 2: CIRCULAR FLOW OF
AS / MACRO — [NOTES] — CHAPTER 1
Definition: The circular flow of income shows that in any given time period (say a year), the value of output
produced in an economy is equal to the total income generated in producing that output, which is equal to
the expenditures made to purchase that output.

Example: The income in an economy is $100. This means that $100 of output is produced and in a simple
circular flow model this all bought by households who earn $100 and spend $100.

2. Injections and Withdrawals

Injections (J) | Increases AD Withdrawals (W) | Reduces AD

Definition: These represent spending on final goods Definition: These represent a leakage from the
and services in addition to consumers spending. economy. They represent income which is earned by
Injection increase AD. Planned injections represent households but which is not spent on final goods and
spending in addition to that of the households in the services. Withdrawals reduce the AD. Planned
economy. Example: Government firms, overseas withdrawals represent the income which households
buyers. Hence injection would equal to investments have earned which they do not want to spend within
+ government spending + exports. the economy. This could be because they want to
save it (S), they have to pay taxes (T) or they want to
spend it on imports (M).

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

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flow
AS / MACRO — [NOTES] — CHAPTER 1

3. Adding Injection and Withdrawals to the circular

In reality, households may not want to spend all of the $100 in the economy, they may withdraw $40 and only want
to spend $60. In this case the level of demand in the economy is too low, $100 is produced but only $60 is
demanded. Equilibrium will be restored provided the other groups (Firms, Government and overseas buyers) want
to buy up to $40 of output that the households do not want. i.e. provided the planned injections = withdrawals there
will be an equilibrium
Equilibrium | J = W & Y=AD

— If other groups only want to buy $30 of goods, there will still be $10 leftover. AD is too low. Because the
planned injection did not compensate for the planned withdrawals demand is too low. i.e. if planned injections are
less than planned withdrawals, then the AD is too low.
J < W Y > AD

— If the other groups wanted to buy $50, demand would have been too high because there was only $40 goods left
over, i.e. if planned injections are greater than planned withdrawals, then AD is too high.
J > W Y < AD

4. National Income Equilibrium

Definition: This is a situation where there is no further tendency to change National Income. It is a state of an
economy where withdrawals are equal to injections into the circular flow of income. In a 2-Sector economy there
are only households and firms and no govt. and international trade.

AATIK
TASNEEM | AS / LEVEL: ECONOMICS (9708) | 03041122845 4
AS / MACRO — [NOTES] — CHAPTER 1

TOPIC 3: AGGREGATE DEMAND & AGGREGATE SUPPLY

Lecture 2

1. AGGREGATE DEMAND
Definition: It is the total demand of all sectors in an economy. All economies consist of basic FOUR sectors
i.e. households, firms/businesses, government, and foreign sector.
AD = C + I + G + (X-M)
 ECONOMY

SECTORS

HOUSEHOLDS FIRMS GOVERNMENT FOREIGN

Those who spend on Those who produce The part of the The part of the
consumer goods and goods and services economy which economy involved in
services for their in the economy controls and international trade
personal satisfaction manages all i.e. exports and
economic activities imports
🡫
🡫 Firms demand 🡫 🡫
Households demand Government’s demand Foreign demand
🡫
🡫 Investment 🡫 🡫
Consumption Govt. Spending Net Exports

C I G (X-M)

1. Aggregate Demand Curve

Definition: It is a curve that shows negative relationship between the general price level and aggregate demand
or GDP. Due to a change in price level there will be a movement on the AD curve.

1. The wealth effect: A rise in the price level will reduce the amount of goods and services that people’s wealth
can buy. The purchasing power of savings held in the form of bank accounts and other financial assets will fall.
Hence the money supply is held constant.

2. The international effect: A rise in the price level will reduce demand for net exports as exports will become
less price competitive while imports will become more price competitive.

3. The interest rate effect: A rise in the price level will increase demand for money to pay the higher prices.
This, in turn, will increase the interest rate. A higher interest rate usually results in a reduction in consumption
and investment.

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 AS / MACRO — [NOTES] — CHAPTER 1

2. Changes in the Aggregate Demand Curve

1. Consumption and Savings (C)

Definition: It is the part of the household income which they spend on consumer goods and services to satisfy
their needs and wants.

Determinants of consumption and savings

Income, Wealth, Income Tax, Indirect Tax, Age, Family Size/Population, Taste and Attitude, Range of Goods
and Services, Interest Rate, Availability of Credit, Expectation of Increase in Income, Price Level

2. Investments (I)
Definition: It is the total spending by firms on capital goods (e.g. machinery, raw materials, building etc.) in
a country in one year.
Determinants of Investments
Technology, Cost of Capital, Corporation (Profit) Tax, Subsidies, Profits, Infrastructure, Political Stability, Law
and Order, Business Expectations, Foreign Relations, Interest Rate, Demand for Consumer Goods

3. Government Spending (G)

Definition: Expenditures made by state authorities on healthcare, education, roads, railway lines, airports, sea
ports, bridges, dams, police services, national defense etc. is known as Government Spending.
Determinants of Government Spending
Need for merit goods, Need for infrastructure, Poverty, Economic Conditions, Political Reasons, Population

4. Net Exports = Exports – Imports (X-M)

Definition: Exports (X) are spending by foreigners on domestically made goods and services is known as
exports. Definition: Imports (M) are spending by local residents on foreign made goods and services is known
as imports. Definition: Net Imports (X-M) is the difference between exports and imports of a country. Net
exports are also known as balance of current account.
Foreign Income, Domestic Income, Taste/Fashion, Relative Quality, Tariffs/ Duties (Tax on Imports),
Exchange Rate

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 AS / MACRO — [NOTES] — CHAPTER 1

2. AGGREGATE SUPPLY (AS)

Definition: It is the total supply of all the producers of an economy at given price level. Aggregate supply can
be distinguishing between short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).

1. Short-run aggregate supply

Definition: Is the output that will be supplied in a period of time when the prices of factors of production (inputs,
resources) have not had time to adjust to changes in aggregate demand and the price level. The movement along
the SRAS curve will be because of a change in price level.

There are THREE main reasons for a positive relationship:

1. The profit effect: As the price level (that is, the price of goods and services) increases, the price of factors of
production such as wages do not change. So the price level rises, the gap between output and input prices
widens and the amount of profit increases.

2. The cost effect: Although the wage rates and raw material costs remain unchanged in the short run, average
costs may rise as output increases. This is because, for example, overtime payments may have to be paid and costs
will be involved in recruiting more members. To cover any extra costs that may be involved in producing a higher
output, producers will require higher prices.

3. The misinterpretation effect: Producers may confuse changes in the price level with changes in relative
prices. They may think that a rise in the price they receive for their products indicates that their own product is
becoming more popular. As a result they may be encouraged to produce more.

Causes of shift in SRAS

The causes of shift of the SRAS curve are factors other than price level.
 AATIK TASNEEM | AS / LEVEL: ECONOMICS (9708) | 03041122845 7
AS / MACRO — [NOTES] — CHAPTER 1
Factor Description

1. Price of factors If the cost of Land, Labor or Capital increases without an increase in productivity it
of production will result in a fall in supply.
Cost of FOP ↑ AS↓
Cost of FOP ↓ AS↑

2. Taxes on firms When the tax increases it will be more expensive for a firm to produce hence they
reduce the supply.
Cost of corporation taxes ↑ AS↓
Cost of corporation taxes ↓ AS↑

3. A rise in labor productivity and/or capital productivity will cause an increase in

Productivity/quality aggregate supply both in the short and long run
of resources Productivity ↑ AS↑
Productivity ↓ AS↓

4. Quantity of If an economy can import the supply will increase. However in case of a supply shock
resources like natural disasters, wars the supply will fall.
Quantity ↑ AS↑
Quantity ↓ AS↓

2. Long- run aggregate supply

Definition: Is the output that will be supplied in the time period when the prices of factors of production have fully
adjusted to changes in aggregate demand and the price level. There are TWO schools of thought which represent
the LRAS differently:
1. Keynesian
2. New classical
Keynesian New classical
 Keynesians represents that LRAS curve as: Illustrate the LRAS curve as a vertical line. This is
1. Perfectly elastic at low rates of output – As because they think that in the long run the economy
there is space capacity in the economy. will operate at full capacity.

2. Upward sloping over a range of output – The

reason is that as output increases, so does
employment of resources, hence only way to increase
output is to charge higher prices.

3. Perfectly inelastic after that – This is because the

real GDP reaches a level beyond which it cannot
increase anymore; at this point, the price level rises
very rapidly.

Determinants of LRAS
Cost of raw materials, Cost of fuel/oil, Cost of wages, Cost of corporation taxes, Subsidies, Technology,
Climate, Natural Resources, Labor force, Education Skills

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AS / MACRO — [NOTES] — CHAPTER 1

3. NATIONAL INCOME EQUILIBRIUM

Definition: The output and price level achieved where AD equals AS. It is a situation where AD =

AS

Changes in the national income equilibrium

 Changes in AD Changes in AS

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AS / MACRO — [NOTES] — CHAPTER 1

TOPIC 4: TYPES OF POLICIES

Lecture 3

1. GOVERNMENT MACROECONOMIC OBJECTIVES

Definition: These are objectives that the government wants to achieve through its policies. There are FIVE
key macroeconomic objectives:
Objective Description

1. Economic Growth Economic growth is regarded as the increase in county’s GPD (Gross
Domestic Product). Economic growth increase standard of living and can
achieved by increasing factors of production or by increasing their
efficiency.

2. Full employment The government wants that all the factors of productions are fully employed in
an economy and there is wastage. This is necessary for the economy to operate
on the PPC. This also helps to counter the problem of unemployment is who
are able and willing to work but do not have work.

3. Control Inflation Inflation is referred to as the general persistent rise in general price level.
(Price Stability) The plans to keep prices stable by keeping a check on inflation. Since high
rates of inflation reduce international competitiveness and can cause a loss
of trust in investors. Inflation can be either demand-pull or cost-push.

4. Balance of Payment The BOP is the record of financial transactions with other nations. If the
Stability outflows are greater than the inflows the BOP is in a deficit. If the inflows are
greater than the outflows BOP is in a surplus. Deficit drains the money from a
country where
as surplus can cause inflation in the long run hence the governments try to keep
an equilibrium.

2. GOVERNMENT POLICIES
Government uses THREE types of policies to achieve its objectives:
1. Fiscal Policy
2. Monetary Policy
3. Supply Side Policies

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AS / MACRO — [NOTES] — CHAPTER 1

1. FISCAL POLICY
Definition: Fiscal Policy is a government policy concerned about taxes and government spending to
influence economic activity and macroeconomic objectives such as employment, economic growth, inflation
etc.

1. Budget
Definition: An annual statement in which the government outlines plans for its spending and tax
revenue. Govt. Budget = Expected Tax Revenue – Expected Govt. Spending
Balanced Budget: Revenue = Spending
Budget Deficit: Revenue < Spending
Budget Surplus: Revenue > Spending

There are two types of budget deficit

Cyclical Deficit Structural Deficit

A budget deficit caused by a decline in the A structural deficit arises when a government spends
economic activity. Less dangerous because when too much compared to its tax revenue.
the economy recovers it will correct itself.

2. National Debt
Definition: This is the total amount of government debt often expressed as a percentage of the GDP. It increases
during recession and wars due to high government spending and less tax earnings. It contains both local and
external debt.

- If the government has a budget deficit in one year it will increase the debt
- If the government has budget surplus in one year it will decrease the debt.
Drawbacks of having HIGH national debt
(1) Government has to pay interest payments which could have been used to build roads and hospitals (2)
Reduces foreign investments as individuals, firms and governments might have doubts about the government’s
ability to pay interest on the debt.
(3) More debt can cause the government to pay high interest due to high risk.

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AS / MACRO — [NOTES] — CHAPTER 1

3. Taxation
Definition | Tax: A tax is a compulsory levy on private individuals and organizations by the government to raise
revenue to finance expenditure on public goods and services like defense, healthcare, transport etc. There are
several purpose of taxation:
Purpose Description

1. Collect Revenue for Govt. The revenue collected from taxes helps the government to pay its expenses
and provide public goods and services.

2. Redistribute Income Government can reduce income inequality by having a progressive tax
system, removing taxes for poor and high indirect taxation on luxuries.

3. Reduce Inflation The government can impose high direct taxes which reduces household
incomes, leading to lower demand and hence low inflation.

4. Correct Adverse By imposing tariffs demand for imports will fall hence a positive current account.
current account

5. Reduce consumption High indirect taxes on demerit goods like liquor and cigarettes can help
of Demerit goods reduce their demand.

6. Protect Domestic Industry High traffics can protect the domestic industry against dumping and
overseas rivals.
 Marginal Rate of Tax Average Rate of Tax

The proportion of EXTRA income taken in tax. The proportion of total income that is paid in taxes.

Example: Example:
Current Income = $100 Current Income = $100
New Income = $110 Total Tax paid = $10
Tax paid on extra = $3

Marginal Rate of Tax = (3/10) x 100 = 30% Average Tax = (10 / 100) x 100 = 10%

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There TWO main types of taxes:
1. Direct Taxes
2. Indirect Taxes
Lecture 4
1. Direct Taxes
3. Types of Taxes AS / MACRO — [NOTES] — CHAPTER 1

Definition: This type of tax is levied on individuals and firm’s incomes and wealth whose burden can’t be
shared are knows as direct taxes. Example: Income tax, wealth tax, corporation tax etc. There are several
advantages and disadvantages of imposing direct taxes:
Advantages Disadvantages

1. Government collects revenue from direct taxes for 1. Direct taxes discourage savings. As when
its spending e.g. building roads, hospitals, airports disposable income falls consumption and savings
etc. both decrease.

2. Direct tax revenue is certain and the state 2. High direct taxes e.g. income tax act as
authorities can plan their expenditures of coming disincentive to work i.e. they reduce the willingness
years on the revenue they expect from direct taxes. and incentive of workers to work overtime because
major part of extra income would be taken as tax.
3. They help to redistribute the income from rich to
poor as direct taxes are usually progressive in nature. 3. Direct taxes also provide a disincentive to
The rate of tax rises with the increase in income. business men their efforts and initiatives. Example:
Therefore, more tax is collected from rich and poor High rate of corporation tax might discourage
are exempted from multinationals not to locate in a particular country.
payment.
4. Cannot discourage imports directly hence less
4. They help reduce inflation as direct taxes reduce effective in correcting negative balance of
the disposable income and therefore reduce payments.
spending in the economy. Lower aggregate demand
will bring price level down, hence reducing
inflationary pressure.
2. Indirect Taxes
Definition: Those taxes which are levied on expenditure of goods and services and whose burden can be passed
to someone else are known as indirect taxes. Example: GST, VAT, tariff, custom duties etc.
Advantages Disadvantages

1. Indirect taxes do not discourage savings, rather 1. Indirect taxes are usually regressive in nature i.e.
only reduce consumption of goods. the rate of tax falls with the rise in income.
Therefore, more burden of tax falls on poor than
2. These taxes are levied on goods and services rich. This increases the disparity between rich and
therefore all individuals with such taxes irrespective poor.
of their age, sex, and income. They have a wider bas
than direct taxes. 2. Indirect taxes are usually part of the price of a
product therefore increase in indirect tax leads to an
3. These taxes are goods and services therefore have increase in the price of the good, causing inflation.
no disincentive to work for workers.
3. Tax burden can be passed to consumers in the form
4. Can be used to discourage demerit goods e.g. high of high prices.
tax on cigarettes will discourage their consumption.
4. Tax is avoidable, anyone who will not buy will
5. Import tariffs and duties will make imports not pay. This creates uncertainty of revenue for
expensive forcing people to switch their demand to the government.
local substitutes that would correct a deficit in the
BOP.

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AS / MACRO — [NOTES] — CHAPTER 1

4. Tax Systems
Definition: A tax system is a legal system for assessing and collecting taxes. There are THREE types of
tax systems:
1. Progressive Tax 2. Regressive Tax 3. Proportional Tax

Definition: A tax system in Definition: A tax system in Definition: A tax system in

which rate of tax increases which rate of tax falls with the which rate of tax remains the
with the increase in income and vice same
increase in income and vice versa. Example: Import Duties throughout. The percentage of tax
versa. Example: Income Tax. is not affected by the rise of fall
of income. Example:
Corporation Tax

4. Government Spending
Definition: Government spending refers to money spent by the government (public sector) on the acquisition
of goods and provision of services such as education, healthcare, social protection, and defense.
 Types Description

1. Transfer Payments Includes welfare payments to certain groups of people. Includes spending
on unemployment benefits, state pensions and interest payment on
national debt.

2. Current Spending Spending on providing goods and services used to provide state owned
services. Example: wages of government school teachers and medicines in
state hospitals.

3. Capital Spending Spending on capital goods. Example: Spending on building state hospitals and
state own schools

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AS / MACRO — [NOTES] — CHAPTER 1

Expansionary and Contractionary Fiscal Policy

Use Description

1. Expansionary In this the government increases government spending or decreases taxes to

Fiscal Policy increase the aggregate demand in the economy and reducing unemployment. This
is applied in a recession.
Government Spending🡩 OR Taxes 🡫

(Shifts AD towards the right)

2. Contractionary In this the government decreases government spending or increase taxes to

Fiscal Policy decrease the aggregate demand in the economy and reducing inflation. This is
applied in a boom.
Government Spending🡫 OR Taxes 🡩

(Shifts AD towards the left)

Discretionary Fiscal Policy vs Automatic stabilizers

Discretionary Fiscal Policy Automatic stabilizers

These are forms of government spending and These are forms of government spending and
taxation that change with deliberate government taxation that change without any deliberate
action. government action.

Issues with using Fiscal Policy

(1) A government needs to be able to estimate reasonably accurately the likely effect of any change in
the taxation or government expenditure, otherwise the desired objectives may not be achieved.

(2) There may be a conflict of objectives and side-effects on the economy. In the aim to increase employment
the government may cause high rates of inflation.

(3) There may be a significant time lag before a particular revenue or expenditure decision beings to take effects.

(4) Some decision that are justified by economic reasoning may not be taken by a government for political
reasons, especially if an election is due in future.

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AS / MACRO — [NOTES] — CHAPTER 1

Lecture 5

2. MONETARY POLICY
Definition: Monetary Policy is a government policy concerned about (1) interest rate, (2) exchange rates, (3)
credit regulation and the (4) money supply to control the amount of spending and investment in the economy.
Controlling and money supply and the exchange rates are difficult hence the government relies on interest rates to
achieve its objectives.

Uses of Monetary Policy

Use Description

1. Expansionary This is when the government increases the money supply and decrease interest rates.
Monetary Policy This is done at the time of recession to boost demand. Low interest rates increase
borrowing and hence more consumption.

Money Supply 🡩 Interest Rates 🡫

(Shifts AD towards the Right)

2. Contractionary This is when the government decrease the money supply and increases interest rate.
Monetary Policy This is done at the time of boom to lower demand and inflation. High interest rates
discourage borrowing and hence lowers consumption. However lower demand causes
unemployment.

Money Supply 🡫 Interest Rates 🡩

(Shifts AD towards the Left)

Note: Monetary policy can be counterproductive as a contractionary policy discourages foreign investment,
stops economic growth and causes unemployment.

Issues with using Monetary Policy

(1) There is a time-lag between a change in an interest rate and the impact of that change on an economy. It
is difficult to be precise about how long that time lag might be.

(2) The interest elasticity of demand varies from people to people. Rich people in an economy are relatively
inelastic to interest rates where as poor people are more elastic. This makes it difficult to estimate the likely
effects of a change in interest rates on the economy.

(3) If the government goes ahead and increases money supply this can have inflationary effects on the economy.

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AS / MACRO — [NOTES] — CHAPTER 1

3. SUPPLY-SIDE POLICIES
Definition: These are long-term strategies that aim to increase or improve the efficiency of factors of production
to ensure long term growth in the economy. There policies can include:

1. Privatization
Definition: It is a government policy in which state-owned businesses are sold to the private sector. The objective
is that the firms will be more efficient and can generate more profits since they will profit driven.

2. Deregulation
Definition: This policy aims to remove barriers to entry to encourage competition. These can include
minimum wage rates, max price etc. This makes the market more competitive and more productive.

3. Capital investment
Definition: This policy aims to spend funds on research and development and new technologies. This helps in
both product and process innovation which can give the country a competitive advantage in the international
market.

4. Training and Education programs

Definition: This policy aims to increase the quantity and quality of labor in the economy by launching training and
education programs. In order to encourage more workers, the government also lowers taxes to encourage
individuals to join the labor force.

5. Enterprise Zones
Definition: These are areas where there is high unemployment and the government gives incentives like tax
holidays, interest free loans etc. to businesses to locate there. The objective is to boost economic activity in that
area and increase the standard of living of individuals.

Issues with using supply side policies:

(1) There is no guarantee that a firm in the private sector will be more efficient than the one in the public
sector. Privatization may also involve the need to get rid of some workers, leading to an increase in the rate of
unemployment in the country.
(2) A privatized firm may be in a monopoly position in an economy, so all that has been achieved is a move
from state owned to privately owned monopoly.
(3) Lowering unemployment benefits might persuade more people to look for work, but this will have no effect
if there are no jobs available for them.
(4) The effects of supply-side policies can take a longer time to show, as in the case of improvements to
the education system.
(5) Might put pressure on the tax payers to fund these policies.

Evaluation of Policies: There may be problems arising with different policy objectives that a government has.
Example: The aim to reduce inflation might cause unemployment and cause economic recession whereas the
opposite is true if the government wants to boost economic growth it has to face inflation. Therefore, it is
recommended that all three types of polices should be used collectively. In the short-run demand side will
produce results and in the long-run supply side.

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AS – ECONOMICS (9708)
MACRO

CHAPTER 2
Economic Growth

Topics Lectures
 Topic 1: Causes Economic Growth 1

Topic 2: Consequences of Economic Growth 1

AS / MACRO — [NOTES] — CHAPTER 2

TOPIC 1: CAUSES OF ECONOMIC GROWTH

Lecture 1

Definition | Economic Growth: It is an increase in the real GDP (national output) of a country over a period
of time.

1. TYPES OF ECONOMIC GROWTH

There TWO types of economic growth:
(1) Short Run Economic Growth, which in the increase in the actual GDP in a year.
(2) Long Run Economic Growth This is the potential GDP over many years. Economic growth can be
calculated with the following formulae:
Rate of Economic Growth = ��� � & ��� �
��� �x 100

2. TYPES OF ECONOMIC GROWTH

There are TWO types of Economic Growth:
1. Actual (Short-Run)
2. Potential (Long-Run)

1. ACTUAL / SHORT-RUN ECONOMIC GROWTH

Definition: This is called the increase in actual real GDP in a year. This can be shown by the following diagrams:
1. PPC 2. AD/AS Model
[Keynesian Diagram]

1. Short-Run Causes
1. Expansionary Fiscal Policy
This involves reducing taxes and increasing govt. spending. These can include:
(1) If direct taxes are lowered it would result in more profits for companies which would increase investments
(I) along with more salaries for workers which would increase consumption (C).
(2) Furthermore indirect taxes can also result in cheaper goods leading to greater demand. (3) Along with that
tariffs could be imposed on foreign goods to protect domestic producers and reduce imports. Lower the
imports higher would be the local demand and greater would be the economic growth.
2. Expansionary Monetary Policy
This involves reducing interest rates, increasing money supply and depreciating exchange rate. These can
include: (1) Interest is regarded as price of money. Lower the interest rate greater the demand. As it customers
can easily borrow from the banks which would increase consumption (C), firms can also borrow cheaply. (2)
More the money supply customers and companies can spend more e.g. firms can buy expensive machinery,
customers can buy luxuries more easily.
(3) Lowering the exchange rate would cause exports (X) to be cheaper and imports (M) to be expensive. The
next effect would cause the AD to increase and result in economic growth.

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AS / MACRO — [NOTES] — CHAPTER 2

2. POTENTIAL / LONG RUN ECONOMIC GROWTH

Definition: In the long run when the potential of a country to produce goods increases either by an increase in
the quality or the quality of its factors of production which increases is productive capacity. This can be shown
by the following diagrams:
1. PPC 2. AD/AS Model [Keynesian Diagram]

1. Increase in the quantity of resources

This happens when all the factors of production, namely Land, Labor, Capital increase, the productive capacity
of the country will increase which will be a source of economic growth.
(1) When capital increases it results in reduction is average costs due to technical economies. This lower
cost increases the production and hence higher AD.
(2) When the working population increase it increase the labor force and hence increase in national output.
(3) When land and raw material increases more goods can be produced, hence increasing the overall
output.

2. Increase in the productivity of resources

Technological improvements can increase the productivity of capital. Superior machines produce large quantities,
bring the overall cost down. Furthermore, with labor training programs, education, better health the productivity
of labor will also go up. Increased productivity in return increases the potential GDP.

3. Reallocation of resources
A country can raise its GDP by reallocation of resources from less productive to more productive sectors.
Example: Shift from producing consumers to capital goods, because capital goods have a higher added value.
Furthermore, they can move from low productive sectors like primary to high productive sectors like secondary
and tertiary.
4. Supply-Side policies
These are the policies that increase the overall supply in the economy. Methods can
include: 1. Improvement in education
2. Reforming trade unions to make labor markets more competitive
3. Privatization
4. Cut welfare payments to increase the incentive to work
5. Subsidies

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AS / MACRO — [NOTES] — CHAPTER 2

TOPIC 2: CONSEQUENCES OF ECONOMIC GROWTH

Advantages Disadvantages
1. Increased Standard of living: This leads to a 1. Environmental Damage: This results from more
reducing in absolute poverty and more production of pollution from factories, cars etc. Damage to the
consumer goods which would encourage more natural landscape by extracting minerals resources
consume choice. and in terms of depletion of non-renewable
resources might harm the future growth potential
2. Improved Health Care and Education: Since the and also put pressure on the government to solve this
economy is growing the literacy rates increase, issue.
while infant mortality and death rates should fall.
This increases the quality of labor force and also 2. Opportunity Cost: If a country is on its PPC then
reduces the burden on the economy for health care reallocation to capital goods will lead to loss of
in the long-run. consumer goods today. This would reduce the
standard of living today since current consumption
3. Increased Tax Revenue: Since the output would be will fall.
more the government will gain higher tax revenue
from direct taxes and indirect taxes. Direct taxes will 3. Unequal Distribution of Rewards: Growth will
increase since firms and consumer’s profits and likely to result in changes in economic structure and
incomes increase respectively. Furthermore, since ways of production, leading to some people
more goods would be consumed more revenue becoming unemployed while others gain from work.
would be gained from indirect taxes which can fund Some workers might be in stress to learn new skills
hospitals, schools and and longer working hours. This can result in rich
infrastructure in the economy and leads a more might start getting richer and poor might start getting
even distribution of income in the economy. poor if reduction in taxes was used to achieve this
growth.
4. Increased Business Confidence: This growth
encourages business to take a positive view of the 4. Lower Quality of Life: Due to rapid urbanization
economy and to want to invest, innovate, and use cities might get over crowded and with greater stress
more technology this would increase investment in breakdown of family networks and might result in
the economy. Furthermore, consumers would spend more income but poor quality of life. Furthermore,
more increasing the AD. an excess of AD might lead to high level of inflation
future adding to the problem.
5. Avoid Macroeconomic Problems: When people
want higher standard of living they demand higher 5. Imports Increases: Since people are earning more
wages which can lead to BOP deficits, inflation and they might shift their demand from local products to
industrial disputes. However, if long-term policies imported ones resulting in a deficit in the BOP.
are
implemented then the AS shifts outwards and helps 6. Low Foreign investment: Since employment is
the economy to avoid such problems by increasing increasing wages tend to go up. This might result
employment and output while reducing prices and foreign firms from investing the home country
the same time. fearing high cost of production.

Evaluation of Economic Growth

So should countries pursue economic growth? The answer depends on the following
variables: 1. What Costs and Benefits are involved
2. Can opposing views be reconciled
3. Depends on which method is used to achieve economic growth
4. Availability of resources
To conclude the government can view this dilemma as constrained optimization. It can set constraints, level
of environmental protection, minimum wages, maximum rates of depletion of non-renewable resources etc.
It then seeks policies that will maximize growth while keeping within the constraints.

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 AS – ECONOMICS (9708)
MACRO

CHAPTER 3
Unemployment

Topics Lectures

Topic 1: Unemployment 1,2

Topic 2: Measuring Unemployment 1,2

Topic 3: Types of Unemployment 1,2

Topic 4: Effects of Unemployment 1,2

AS / MACRO — [NOTES] — CHAPTER 3

TOPIC 1: UNEMPLOYMENT

Lecture 1 and Lecture 2

1. Unemployment
Definition: This means that people who are willing and able to work can’t find employment. People who do not
want to work or are unable to work are not part of this i.e. they are not part of the labor force (e.g. children,
retired individuals, students enrolled in full time education, disabled etc.). Those are in work or are unemployed
but actively seeking work, form the labor force.

Rate of Unemployment = ������ �� ����������

����� �����x 100

Example: If 100m people are unemployed from a labor force of 1000m the unemployment rate would be 10%
(100/1000) x100 = 10%

Note: Even at full employment it is not like that all the people are employed. There would be people who would be
changing jobs or are unemployed for a short period of time (this is called friction unemployment.
2. Labor Force
Definition: Total number of workers who are available for work. All the people who can contribute to the
production of goods and services

3. Labor Force Participation Rate

Definition: This is the proportion of working age population who are in the labor force. These individuals
are economically active. The participation rate depends on several factors:
(1) Wages
(2) Social attitudes towards women
(3) Care for children and elderly
(4) People going into higher education

4. Level of Unemployment vs Rate of Unemployment

Level of Unemployment Rate of Unemployment

Definition: This means the total number of people Definition: It is the percentage of unemployed
who are willing and able to work but have no jobs workers to the labor force.

Note: This means that a country with a low rate of unemployment might still have more number of
workers unemployed. As the level is the actual number where as the rate depends on the size of the
labor force.

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AS / MACRO — [NOTES] — CHAPTER 3

TOPIC 2: MEASURING UNEMPLOYMENT

There are TWO main method to measure unemployment:

1. Claimant Count
Definition: This is where the government measures the number of people in receipt of
unemployment-related benefits.
Advantages Disadvantages

(1) It is relatively cheap and quick to calculate as it (1) Inaccurate because it may include some people
is based on information which the government who are not really unemployed and may omit people
collects as it pays out benefits. who are genuinely unemployed.

(2) Some of those receiving unemployment benefits

may not be actively seeking work and some may be
working and claiming benefits illegally.

2. Labor Force Survey

Definition: This involves a labor force survey using the International Labor Organization (ILO). This includes as
unemployed all people of working age who in a specified period are without work but who are available for work
in the next two weeks and who are seeking paid employment. This measure picks up some of the groups not
included in the first measure.
Advantages Disadvantages
 (1) It also has the advantage that as it is based (1) The data are more expensive and time-consuming
on internally agreed concepts and definitions it to collect that the unemployment benefit measure.
makes international comparisons easier.
(2) Also as the data are based on a sample survey
that are subject to sampling error and to multitude
of practical problems of data collection.

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AS / MACRO — [NOTES] — CHAPTER 3

TOPIC 3: TYPES OF UNEMPLOYMENT

1. CAUSES/TYPES OF UNEMPLOYMENT
There are several causes of unemployment:
1. Frictional unemployment
2. Seasonal unemployment
3. Youth unemployment
4. Structural unemployment
5. Voluntary unemployment
6. Classical unemployment / Real Wage unemployment
7. Cyclical

1. Frictional unemployment
Definition: This happens when individuals leave a job, are made redundant or fired. This unemployment occurs
when people change jobs due to the time delay between leaving a job and finding a new job. It is a form of
voluntary unemployment. It always exists in an economy but is not considered to be a problem. Example: Some
people take an extended break between jobs. Others might wait before the new job starts.

2. Seasonal unemployment
Definition: This happens when the demand for a particular type of labor is seasonal. These industries can include
tourism, fishing, fruit picking etc. Workers employed in these industries get unemployed in the offseason and are
rehired when the season is in. There is little that can be done to reduce seasonal unemployment because it is
usually linked to the climate. How harmful it is depending on how long does the off season last. If it is small, then
it is less dangerous.

3. Youth unemployment
Definition: This occurs when young graduates find it difficult to get a job. This usually occurs because they
lack experience and skills and the economy is in a recession.

4. Structural unemployment
Definition: This happens when a particular industry in a country declines and the labor is unemployed because
of that. Example: As the country develops the manufacturing sector declines and the service sector grows. There
are THREE main types:
Type Description

1. Sectoral This occurs when people are laid off because the industry they work in is in decline. This
Unemployment may be due to change in consumer tastes. Certain goods may go out of fashion. Or it may
be due to competition from other countries.

2. Technological This arises because new techniques of production often allow the same level of output to
Unemployment be produced with fewer workers. Example: Banks can replace workers with ATMs and
online transactions.

3. Regional This type of structural unemployment occurs in particular areas of a country. As

 Unemployment particular type of industries is concentrated in different parts of the country.

5. Voluntary unemployment
Definition: This means the people are reluctant to accept jobs which are low-paid or have low job satisfaction.
Voluntary stands for that they could have the job if they are prepared to accept the worse conditions but they
have voluntarily kept themselves unemployed and waiting for the that they require which pays them according
to their standards both in terms of financial and non-financial benefits.

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unemployment
AS / MACRO — [NOTES] — CHAPTER 3

6. Classical unemployment / Real Wage

Definition: This exists when the real wage rate is above that needed to clear the labor market even when the
economy is booming. These wages might be driven up above the market clearing level due to TWO main
reasons: 1. Trade Unions: These unions use their monopoly power to drive wages above the market clearing
level. As they serve the interests of their members, pushing up their wages, negotiating for better working
conditions etc.

2. Government: This happens when the government intervenes in the labor market and sets a minimum wage
above the market wage.

This causes the demand for labor to fall because it is expensive to deploy labor, where the supply for labor
increases due to high wages. This creates a surplus in the market, which leads to unemployment. This can be
explained with the diagram below:

As we see from the above diagram when the minimum wage is set at W2, the demand for labor is N3 and the
supply for labor is N2, which creates unemployment between N3 and N2.

7. Cyclical / Demand Deficient Unemployment

Definition: This is linked to the economic cycle. When an economy moves from a boom into a downturn business
activity slows down and people are laid off. This will continue, and worsen if the economy goes into a recession
or depression. People lose their jobs because demand for goods and services starts to fall. Firms often react to
falling demand by laying off staff.

Cyclical unemployment may be even more serious than structural unemployment as potentially, it can affect more
workers and it is spread though the country. It arises from a lack of aggregate demand. The figure below shows the
economy operating below full employment (Y1). In such a situation the government will try to increase
government spending or decrease taxes (Expansionary fiscal policy) to increase AD.

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AS / MACRO — [NOTES] — CHAPTER 3

TOPIC 4: EFFECTS OF UNEMPLOYMENT

1. Costs to individuals
Their incomes fall because state benefits are generally lower than wages. In extreme cases unemployed people
lose their homes because they can pay mortgage payments. This leads to a lower standard of living for the
individuals and can lead to an increase in wealth gap in the economy.

2. Costs to the Business

(1) When firms lay off workers they have to give redundancy payments which reduces the firm’s
profits. Furthermore, the remaining workers are demotivated as they know that they might be the next to
go.

(2) Secondly for firms laying off workers results in operating at a lower capacity. There will be unused machinery,
tools, equipment which might result in high fixed costs of machinery. This might even result in machinery
becoming obsolete over time which will add to further cost of replacement in the future.

(3) This also leads to a fall in demand for goods since the purchasing power is low. Sales are likely to fall
for most businesses when unemployment starts to rise in the economy. This is because people have less to
spend. However, firs producing non-essential items (Elastic items) would be hit harder.

3. Cost to the Economy

(1) People who are not working may no contribution to the economy. This is a waste of resources and results
in lower levels of national income. If there is full employment in an economy, output will be higher and income
per head will be higher. This is lead a reduction on GDP in the economy

(2) Tax revenue will also fall because most taxes are linked to income and spending. This means government has
less to spend may have to cut public sector services. The government will also be under pressure because it will
have to pay out more in benefits to those who lose their jobs. Although taxes may not go up immediately they have
to go up eventually this will lead to an increased burden on those people who are earning. In the long-run
government might be forced to increases borrowing added to interest payments burden on the economy.

4. Cost to local communities

In times of unemployment some areas struggle to survive. Small business start to shut down creating more
unemployment. Households do not have enough money to maintain their houses and gardens and the residential
environment starts to have lower standard of living which can even result in increases crime rate added to
additional cost to the government of maintaining it.

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AS – ECONMICS (9708)
MACRO

CHAPTER 4
Inflation

Topics Lectures

Topic 1: Types of Inflation 1

Topic 2: Measurement of Inflation 1

Topic 3: Causes and Effects of Inflation 2

Topic 4: Policies to Correct Inflation 2

Topic 5: Deflation 3,4

 Topic 6: Policies to Correct Deflation 3,4

TOPIC 1: TYPES OF INFLATION Lecture 1

1. INFLATION
AS / MACRO — [NOTES] — CHAPTER 4

Definition: It is a persistent increase in general price level in an economy over time. High inflation rates tend
to reduce the value of money hence government wants to keep it low.

Types of Inflation
Types Description

1. Mild inflation When price level rise by a relatively high rate it is known as mild inflation.
(5%- 10%)

2. Galloping inflation When price level rise by a high rate is known as galloping inflation. (10-20%)

3. Hyper inflation It is an extreme form of inflation in which price level rises by 100’s and 1000’s.
The money starts losing its value and the economy may collapse.

4. Deflation It is a persistent fall in general price level. This leads to a rise in value for money.

5. Disinflation It is a situation where general price level rises which a decreasing rate. Price
level rises, but rate of inflation slows down.

Example
 Key Points:
1. As long as the Rate of inflation is positive. Even if the graph is sloping downward prices are
increasing. 2. When the Rate of inflation is negative. Only then will prices go down. Which is called
deflation. 3. From Year 0 to Year 1 we see disinflation. As the % of inflation is going down but it is still
in the positive zone.
4. Between year 1 and year 2 these is deflation
5. After year 2 to 3.5 there is inflation where prices are increasing
6. After year 3.5 again we experience disinflation.

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AS / MACRO — [NOTES] — CHAPTER 4

TOPIC 2: MEASUREMENT OF INFLATION

Definition: Inflation is measured by changes in the retail price index (RPI) or Consumer Price Index (CPI)
which records changes in the genera price level. The RPI is a statistical device that indicates changes in the
general price level from the base year to the current year, measuring the changes in the value of money.
There are EIGHT steps in the calculation of RPI:

STEP 1: To show the changes in general price level, it is simple impossible to record and calculate the price
changes of all the goods and services produced in a country. Therefore, by using the statistical techniques of
sampling almost a basket of goods is selected for indication of changes in general price level. This basket of
goods contains goods and services that an average family uses, food, clothing, fuel etc. Goods and services
that
are used by a very limited group of people will not be taken in the selected basket e.g. luxury cars,
designer clothing etc.

STEP 2: A normal economic year in which there are no political or economic imbalances should be taken as
the “Base Year”. Base year is a standard year with which rest of years prices are compared. Price level in base
year is represented by 100.

STEP 3: Statistical department of govt. collects information about the prices in base year as well as current
year. This information about prices of selected basket of goods is collected from retail outlets, newspapers,
price lists etc.

STEP 4: Calculate the weights. This refers to the relative importance of the various items. In other words,
some items are more important than others. Weightage is reflected by consumer expenditure. Example: If a
consumer expenditure on food, clothing, transport and housing are $100, $200, $300 and $400 respectively.
Hence the weightage 1:2:3:4 ratio.

STEP 5: Index are calculated using the following formulae

 Index = ������� ���� �����
���� ���� ������ ���

STEP 6: Weights are multiplied by indexes to calculate the weighted index.

Weighted Index = Index X Weight

STEP 7: RPI is obtained by taking sum of all weighted indexes and dividing it by the total
weights. RPI = ����� �������� �����
����� �������

STEP 8: Rate of inflation is calculated by taking percentage change in the current year average price (i.e.
RPI of current year) to the base year (i.e. RPI of base year)

Rate of Inflation = ����<����

����� ���

Note: Money Values are values at the prices operating at the time. Real values are values adjusted for inflation.

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AS / MACRO — [NOTES] — CHAPTER 4

There are TWO Types of Questions on calculation of inflation.

Type 1: Example [M/J 2009/Q24]
 STEP 1: Always convert % of income spent in decimals and take % change in price as it
is. STEP 2: Multiply Weight and Index to calculate the weighted index
STEP 3: Total the Weighted Index
Weight / % of income spent Index / % Change in Price Weighted Index 0.10 8 0.80
0.15 6 0.9
0.25 4 1
0.50 -9 -4.5
-1.8% [ANSWER] ROI
–

Type 2: Example [O/N 2015/Q26]

In some quesitons the CPI is already given. In this case we just have to apply the formulea of % change in
CPI to calculate the rate of inflation.
Rate of Inflation = ����<����
����� ���
Year Rate of Inflation
2008 -
2009 4%
2010 -1.92%
2011 2.95%
2012 2.86%
2013 2.77%
—

Problems with measuring Inflation accurately

(1) Choosing the base year needs a year with normal condition. This can be difficult to find a year.
(2) The selection of basket of goods needs to reflect average consumption patterns and allow for
the introduction of new products.
(3) Weighting the individual contents has to reflect up to date spending patterns.
(4) Sampling sales outlets must cover a wide range of types and locations. This can be time consuming
and difficult.
(5) Even if these are achieved the average picture may not accurately reflect the position of groups
e.g. pensioners.
(6) It may not reflect changes in quality of goods.
(7) It may lag behind events and it may be based of inaccurate statistics and invalid sampling. This can
cause actual inflation to have changed.

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AS / MACRO — [NOTES] — CHAPTER 4

TOPIC 3: CAUSES AND EFFECTS OF INFLATION

Lecture 2

There are THREE main causes of inflation:

1. Demand-pull Inflation
2. Cost-push Inflation
3. Money Supply Inflation

1. Demand-pull Inflation
Definition: If there is too much demand in the economy relative to the supply of goods and services prices
will rise and this type of inflation is known as demand-pull inflation. Demand-pull inflation can occur when:
1. Economy is below full employment
2. Economy is already at full employment.
Economy is below full employment Economy is already at full employment

When the economy is initially operating below full When we say that there is full employment in the
employment, increase in AD will lead to an increase economy, we mean that all the economy’s resources
in price as well as real GDP. It can be shown with are employed and that the economy is operating at
the following diagram. As AD increase from AD to full-capacity. Any further increase in AD at full
AD1, according to the figure below price level employment will lead to inflation without further
rises from P to P1 causes demand-pull inflation. increase in real output. It can be shown in the
However, there is an increase in total output from diagram below. When AD rises from AD2 to AD3,
Y to Y1 because the economy was operating below price level rises from P2 to P3 however there is no
the full employment. increase in level of output.

Note: Demand-pull inflation is associated with low unemployment because excess demand in the economy
lead to increased production and employment. This is a tradeoff between demand-pull inflation and
unemployment.
Reasons for increase in AD
AD = C + I + G + (X-M)
1. Consumer spending increased due to excessive income, lower interest more wealth etc. 2. Capital
investment increased due to lower interest rates, business optimism, better technology 3. Government Spending
increased due to expansionary fiscal policy, too much spending on health care, schools etc.
4. Exports increased and imports decreased. This can be due to fall in the value of domestic currency etc.

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AS / MACRO — [NOTES] — CHAPTER 4

2. Cost-push Inflation
Definition: Cost-push inflation is caused by higher costs of production, which makes firms raise their price in
order to maintain their profit margins. This may be due to increase in (1)raw material prices, (2) wages, (3)
indirect taxes, (4) import prices etc. Since the businesses are faced with rising costs they put up their prices
to protect their profit margins.

Costs can increase due to several reasons:

(1) Raw material prices: If the raw materials get expensive the cost of production goes up and in order
to generate same levels of profits the firms increases its prices.
(2) Wages: This can be when trade unions get strong and were able to put pressure on employers to
increase wages. This extra money paid is recovered by employers by raising prices.
(3) Indirect taxes: This is added directly in to the price of the product. Also if entrepreneurs want to
make profits or maintain profits they would increase prices hence this will lead to cost push inflation. (4)
Import prices: If import price raw material rises due to falling exchange rate this can cause cost push
inflation.

3. Money Supply Inflation

Definition: This inflation is caused by the growth of money supply according to the monetarist school of
thought. This can be due to easier credit, e.g. loans and credit cards by households, firms and the
government. More money supply increases total spending, hence raising the AD causing inflation.
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