Mayo 2015

ECONOMICS IB
Summary

Valentina Premoli
6A
Most important Command Terms:

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 MICROECONOMICS

UNIT 1 – The foundations of economics

Economics: social science that studies the way in which societies allocate (distributers) scarce resources (factors of
production) among competing uses

- Economics is a social science because it studies how society react to certain things. Every person is different and
reacts differently and has different opinions. But you study it through the scientific method.
- Economists are model builders because they build theoretical models to see or explain their theory. In order to
do this, they use “ceteris paribus”, making everything but what there trying to explain at a constant. So that
their point stands out and shows its effect without external factors. This is only to explain the theory, it isn’t
used in the real world.

Need: things (goods) that are essential to survive (food, shelter, clothes). Needs are infinite.

Want: things that make our lives more comfortable, things that we would like to have, but which are not necessary for
our immediate physical survival (computer, car, and phone). Wants are infinite.

Good: Are physical objects, (physical things) that can be touched, smelled, eaten. (Food, gasoline, movie)

Service: Intangible things that cannot be touched. A service is an activity or result from one, provision of a good
(restaurant, gas station, and cinema)

Scarce Resource: when there is limited availability of a product. There aren’t abundant and therefore are valued more
since there isn’t a lot of supply. All goods and services that have a price are relatively scarce. Even though a great number
of them exist, not everyone that would like a good can have one, usually because they cannot afford it.

Economic Good: every good or service that has a price, and therefore are being rationed, because they are limited (petrol,
food, jewelry) - thus they are said to have an opportunity cost.

Free Good: goods that don’t have a price because they are unlimited (air, salt water) - thus, do not have opportunity cost.

Allocation: the distribution of resources among competing uses.

Choice: As people do not have infinite incomes, they have to make choices on which product or service to purchase
(choose between alternatives). To make a choice is to use/allocate a resource in the most efficient way possible to take
the best outcome out of it

Opportunity Cost: the next best alternative forgone when an economic decision is made (what you give up doing because
you choose another option). Key concept linked with scarcity. It is what you give up in order to have something else.

Basic economic problem

There are scarce resources to satisfy unlimited needs and wants (scarcity)
What to produce? It can’t produce everything it needs/wants with scarce resources
How to produce? In order to get the maximum use of scarce resources to obtain the best outcome
For whom to produce? It can’t satisfy the whole population
Society answers these questions by means of rationing systems

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Rationing Systems
Planned/command economies: decisions as to what, how and for whom to produce, are made by a central
body, the government. All resources are collectively owned. Government bodies arrange all production, set
wages and set prices through central planning. Decisions are made by the government on behalf of the people
and, in theory, in their best interests. (private sector)
Free market economies: (private enterprise economy or capitalism), prices are used to ration goods and
services. All production is in private hands and demand and supply are left free to set wages and prices in the
economy. The economy should work relatively efficiently and there should be few cases of surpluses and
shortages. (public sector)

Satisfaction/Utility: the benefit gained after the consumption of a product. It is a measure of usefulness and pleasure. It
gives an idea of how much usefulness or pleasure a consumer receives when they consume a product. Two basic means
of measuring utility: total utility and marginal utility.
Total Utility: whole satisfaction obtained from the consumption of a given amount of a product.
Marginal Utility: the extra utility gained from consuming one more unit of a product.

Positive Economics: works with facts that are either right or wrong, they are generally figures, statements.
Normative Economics: deals with opinion and belief, changing according to every person and open for discussion.

Ceteris Paribus: “All other thing being equal. The method known as holding all but one of the variables constant. Is used
when economists want to test the effect of one variable on another and they need to be able to isolate the effect of one
variable by assuming that there is no change in any of the other variables.

Economic Growth: the increase in real output in an economy over a period of time measured by the GDP. The
measurement of economic growth, which is simply the change in GDP, is not in any way a sufficient measurement of
economic development since economic development is a much broader concept. Even within wealthier, high income
countries, we must not assume that all citizens enjoy the same benefits from high levels of income. Some citizens may
experience lower levels of economic development. Economic growth does not ensure that increased equity is achieved
within a country.

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Economic Development: a measure of the life quality of the people in the country. Not only does it measure GDP
(economic growth) but also measures education, health, social indicators and so on. LUCIANO DEFINICION END OF
BOOKLET!

Potential growth: the improvement of the quality or quantity of the factors of production. This can lead to an economic
growth.

GDP (also referred as Gross national Income (GNI): It is the sum of the values of all final goods and services produced in
a local economy, in a given time period (usually one year) without extracting the effects of inflation through a price index.
RGDP: It is the sum of the values of all final goods and services produced during a period of one year, extracting the effects
of inflation through a price index.

Sustainable development refers to economic development that meets the needs of present generations but does not
compromise the ability of future generations to meet their needs.

Factors of Production
Land: land itself, what grows in it, what is under it (natural resources) (woods, oil, crops, cattle) Paid through rent
Labor: human factor available for work. Paid through wages
Capital: includes capital goods (physical capital: machinery, tools, trucks), human capital (the value of the
workforce) and financial capital. Paid through interest.
Entrepreneurship: this includes the risk-taking and creative activities of people when they are bringing together
the other factors of production. The payment to management is profit.

Production Possibility Curve

Shows the maximum combinations of output (goods and services) that can be produced by an economy in a
given time period, if all the resources in the economy are being used fully and efficiently and the state of
technology is fixed.

- It shows the concepts of scarcity, choice and opportunity cost.

- The PPC is a curve because not all the factors of production used to build product A and B are equally good at
both occupations. The closer we move to point X, more workers for product A will turn to produce product B
but will not be as efficient as the original producers of product B.
- Any point inside the PPC is possible to achieve, but it means that not all of the factors of production in the
economy are being used and/or some of the factors are being used inefficiently.
- In reality, economies are always producing within their PPCs, since there are always some unemployed factors
of production in a country.

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 - Any point on the PPC shows potential output (Z) Possible output a better possibility if all resources are
efficiently used
- At point Z, the skilled workers in each industry will be specialized in the production at which they are best and
so both sets of workers will be at their most productive.
- A movement from Z to Z1 would be potential growth
- The opportunity cost of more consumer goods is the number of producer goods that are not produced.
- An outward shift of the PPC (from YX to Y1X1) can only be achieved if there is an improvement in the quantity
and/or quality of factors of production. If the shift is achieved, there is an increase in potential output but
this does not necessarily mean that there is an increase in actual output. That would require a movement of
the current point of actual output towards the new PPC.
- A fall in quantity of factors of production would cause the PPC to shift inwards. This might be due to war or
natural disasters.

UNIT 2 – Demand and Supply

Market: A market is a virtual or physical place where potential buyers and sellers interact exchanging goods or services
for money, carrying out economic transactions.

Demand
The willingness and ability of a consumer to purchase a quantity of a good or service at a certain price in a
given time period.
- Law of demand: As the price of a good falls, the quantity demanded will
normally increase
- Demand Curve Shows the relationship between each price and quantity
Downwards sloping
Movement along the curve means a change in the price of a
product. It occurs when there is a shift in the OTHER side of
the market (supply)
Shift means a change in any other determinant of demand
(smoking is banded-shift to the left)

Non price determinants of demand

Income:
- Normal Goods: as income increases, the demand for the good or service increases (clothes, MEJOR
food etc.)
DEFINICION
- Inferior Goods: when income increases, the demand for good or service decreases (car
LUCIANO END
instead of bus)
OF BOOKLET!!!
Price of other products:
- Substitutes: has the uses and properties as the one demanded. If the price of the substitute
decreases, more people will demand that one so demand for the other product decreases since they have the
“same” product cheaper (chicken and meat)
- Complement: if demand of one of the components increases, demand of the other will increase to. (A DVD player
and a DVD)
- Unrelated: goods not linked in any way, demand remains the same.
Tastes: Outcome depends on whether the change is in favor of or against the product

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Other factors that alter demand
Size of population: the more people there are in the country, the more demand
Changes in population: if there are more kids, the demand for toys will increase
Seasonal change: in winter demand for sweaters increases
Income Distribution: if income is distributed properly along the population, there will be more demand for
basic needs (of better quality) since more people can afford it.
Government Policy: increase in taxes causes less money available for spending so a decrease in demand. Also if
regulations change like making something illegal or compulsory (helmets or cigarettes)
Culture

Supply
- The willingness and ability of a producer to produce a quantity of a good or service at a certain price in a given
time period.
- Law of Supply: As the price of a good rises, the quantity supplied will increase, ceteris paribus.
- Supply Curve: Shows the relation between quantity supplied at a given price
Upwards sloping
Movement along the curve is caused by a change in price of
the product. Occurs when there is a shift in the OTHER side
of the market (demand)
Shift of the curve is a change in any determinant of supply (if
it used to cost $5 to make a pen, but now, because of a new
machine it costs $2, the supply curve will move to the right
because they can make more quantity than before at an x
price)

Non price determinants of supply

Cost of production: if cost decreases, supply increases (shift of the curve to the right)
Price of other products that suppliers produce: if they choose to produce something else, supply for the
product will decrease. This is usually because the other product has a higher benefit
State of Technology: if it improves, it increases supply and makes the curve shift to the right
Government intervention: indirect taxes increase price so supply decreases. Subsidies decrease the cost so
supply increases
Expectations: if they expect
there will be more demand or
higher prices, they will produce
more or store products

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 UNIT 3 – Market equilibrium, the price mechanism, and market efficiency

Equilibrium
A state of rest, self-perpetuating in the absence of any outside disturbance.
- When demand and supply come together, we get the creation of the equilibrium market price and quantity.
- The market is in equilibrium at the price P*, since the amount of the product that people wish to buy at that
price, Q*, is equal to the amount of the product that suppliers wish to sell at that price.
- Price P* is sometimes known as the market clearing price, since everything produced in the market will be sold.

Excess Supply: when suppliers produce more than what is demanded.

If price increases from p* to P2, this will cause demand to decrease from
Q* to Qd. Since less people buy, there will be more availability of a product.
In order for the market to be in equilibrium again, supply has to shift to the
left, decreasing supply.

Excess Demand: when a product is more demanded than the quantity supplied.
A decrease in price causes more people to be willing and able to purchase
a product hence an increase in demand. But a decrease in price doesn’t
cause an increase in supply. More people want the product than the
amount supplied. Supply won´t meet demand. In order for the market to
be in equilibrium gain, demand would have to shift to the left.

- If an outside factor changes the supply or demand, the line will shift and there will be a new equilibrium point,
it is “self-righting”.

To eliminate excess demand, producers increase prices, less quantity demanded and more quantity supplied;
reaching the same equilibrium price.
To eliminate excess supply, producers lower prices, more quantity demanded, and more quantity supplied;
reaching the same equilibrium price.

Price Mechanism:
Supply and demand forces acting on their own interact to generate prices, attracting or expelling resources towards
their best final use.

PRICES ACT AS SIGNALS ALLOCATING RESOURCES TOWARDS THEIR BEST FINAL USE!!!!

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 - The forces of supply and demand are known as price mechanism
- It helps to allocate scarce resources, these are allocated and re allocated in response to changes in price
- Higher price will give producers an incentive to produce more of a good
- No central agency is needed, free market

Market Efficiency
Producer Surplus: the additional benefit that the producer receives
for selling the good in the market (higher than the price they were
willing to receive). Producers' surplus exists when actual price
exceeds the minimum price sellers will accept. For example,
chocolate is sold at $10 but producers were willing to sell it at $1.

- Here, total revenue is given by the rectangle OBDE, and total costs
are given by the area OADE. The difference, shown by the triangle
ABD is producer surplus.

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 Consumer Surplus: a measure of the welfare that people gain from
the consumption of goods or services. The extra satisfaction gained
by consumers from paying a price that is lower than the one they
were prepared to pay. For example, the price for chocolate is $10
but, some people were willing and able to buy it up to $19.

- Here, total benefits are given by the shaded area OCDE; total
expenditures are given by the rectangle OBDE. The difference,
shown by the triangle BCD, is consumer surplus.

Community Surplus: is the welfare of society and it is made up of a

consumer surplus plus a producer surplus. It exists when it is
impossible to make someone better off without making someone
else worse off. Producer surplus + Consumer surplus. It is the welfare
of the society of selling and buying the product in the market.

- When the consumer surplus is equal to producer surplus

- It exists when the market is in equilibrium, with no external
influences and no external effects.
- Market is said to be socially efficient when community surplus is at
its maximum.

Allocative efficiency: A condition achieved when resources are allocated in a way that allows the maximum
possible net benefit from their use. When an efficient allocation of the resources has been attained, it is
impossible to increase the well-being of anyone person without harming another person.

UNIT 4 - Elasticity

Elasticity: A measure of the responsiveness of how much something changes when there is a change in one of the
factors that determines it.

Elasticity of demand: A measure of how much the demand for a product changes when there is a change in
one of the determinants of demand.

Price Elasticity of Demand: measure of how much the demand of a product changes when there is a change
in the price of the product

The result will always be negative- LAW OF DEMAND

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Range of Values:
PED=0 inelastic If price increases, the quantity demanded will not change and so the total revenue will increase.
(Bread increases people will still buy it, cigarettes)

- PED smaller than 1 relatively inelastic

- Harsher taxes are usually put on products with inelastic demands as if the price of the product increases, the
quantity demanded will decrease less than proportionately.

PED=infinity elastic If price increases, the quantity demanded will decrease more than proportionately, and
total revenue will decrease

- PED larger than 1 relatively elastic

- If PED is elastic, then total revenue can be increased by lowering the price of the product

PED=1 unitary elastic If price increases by 5% quantity demanded will decrease by 5%, the total revenue will not
change

- If PED is equal to 1, then total revenue is being maximized.

The determinants of PED:

- The number and closeness of substitutes – the more substitutes it has and the closer they are, the more elastic
will be the demand for a product
- The necessity of the product and how widely it is defined – the less necessary it is, the more elastic will be the
demand for a product. (demand for food is inelastic but demand for one particular brand of butter is)
- The time period being considered – the longer the time period being considered, the more elastic will be the
demand for a product

Cross Elasticity of Demand (XED): measures how much the demand of a product changes when
there is a change in the price of another product. It shows the relationship between two products.

Range of Values
If the value of XED is positive, then goods are substitutes for each other, e.g. Coke and Pepsi. The larger the
value, the closer the relationship
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 If the value of XED is negative, then goods are complements for each other, e.g. DVD players and DVDs. The
larger the value, the closer the relationship.
If the value of XED is zero, then the goods are unrelated, e.g. strawberries and mobile phones.

Income Elasticity of Demand (YED): measure of how much the demand of a product changes when
there is a change in the consumers income.

Range of Values
- If YED is positive: normal goods (necessity goods (bread) are inelastic (0-1), luxury
goods (Ferrari) are elastic (larger than 1)
- If YED is negative: inferior good (demand decreases as income increases (cheap wine)

Elasticity of Supply
Price Elasticity of Supply (PES): measure of how much the supply of a product changed when there is a
change in the price of the product

- The answer will be always positive LAW OF SUPPLY

Range of Values
PES is inelastic when the value is between zero and 1.
PES is unitary when the value is 1.
PES is elastic when the value is between 1 and infinity.

The determinants of PES

- How much costs rise as output increases – if total costs rise significantly as a producer attempts to increase
supply, then supply will not be raised and so supply will be relatively inelastic
- The time period being considered – the longer the time period being considered, the more elastic will be the
supply of a product. In the immediate time period, PES will be perfectly inelastic. In the short run, as firms can
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 change variable factors, PES will become more elastic. In the long run, when firms can change all factors, PES
will be even more elastic.
- Capacity to store stock: (the existence of unused capacity, the mobility of factors of production)

Primary Commodities
- PED for commodities: they have an inelastic demand as they are necessities to the consumers who buy them
and they have few or no substitutes. Usually manufacturing industries buy these products, even if price rises,
production cannot cease so they have little choice but to continue consuming. As well as if price for commodities
decreases, they will still demand the same amount
- PES for commodities: they have an inelastic supply as a change in price cannot lead to a proportionately large
increase in quantity supplied. Producers would be unable to respond with a proportionate increase in the
quantity as it takes time to grow and to re allocate resources. If there is a fall in price supply might not change
as the crop might already have been harvested.

Manufactured Goods
- PED for manufactured goods: Demand for manufactured goods tends to be more elastic as there are many
more substitutes available to consumers.
- PES for manufactured goods: Supply for manufactured goods tends to be more elastic as it is easier to increase
or decrease quantity supplied in response to a change in price.

UNIT 5 – Indirect taxes, subsidy, and price controls

Why do governments tax?

1. To reduce the quantity of products the production or consumption of which causes negative externalities (i.e. to
correct market failure).
2. To raise money for government spending.
3. To manage the level of AD in the economy. (Keynesian demand management.) DEFINICION TAX
4. To redistribute income. LUCIANO END
5. Taxes on imported goods may be imposed to reduce the consumption of imported goods. OF BOOKLET!!!

Indirect tax-
- An indirect tax is a tax imposed upon expenditure. ALL INDIRECT TAXES ARE
REGRESSIVE.
- It is a tax that is placed upon the selling price of a product, so it raises the firm’s
costs and thus shifts the supply curve for the product vertically upwards by the
amount of the tax.
- Less will be supplied at every price because of this. Producers and consumers
will, between them, bear the burden of any tax that is put on.
- The amount that each pays will depend upon the elasticity of demand.

Specific tax: fixed amount of tax that is imposed upon a product

Percentage tax: the tax is a percentage of the selling price. The gap between S1
and S+tax will get bigger as the tax rises. (VAT%)

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 1. If PED (elastic) is greater than PES (inelastic),
then the producer will pay more of the tax
(greater tax burden).
2. If PED (inelastic) is less than PES (elastic),
then the consumer will pay most of the tax.
3. If PED equal to PES then the burden of the
tax is equally shared between consumers and
producers.

TAXES:

The market is in equilibrium in Qe being supplied and demand at a price Pe. After the tax of XY per unit is imposed, the
supply curve shifts vertically upwards from S1 to S1 + tax. The producers would like to raise the price to P2 and so pass on
all the cost of the tax to the consumers. However, at that price, there is an excess supply and so price has to fall until a
new equilibrium is reached, which is at price P1, where Q1 is both demanded and supplied. As we can see, the price of
the product for the consumers rises from Pe to P1. Producers now receive C per unit, after paying the tax of XY to the
government. The market falls in size from one producing Qe units to one producing Q1 units. This may have implications
on employment.

This is why governments tend to place indirect taxes on products that have relatively inelastic demand, such as alcohol
and cigarettes. By doing this, the government will gain high revenue and yet not cause a large fall in employment, because
demand changes by a proportionately smaller amount than the change in price.

Subsidy
- A subsidy is an amount of money paid by the government to a firm, per
DEFINICION
unit of output.
SUBSIDY
- If a subsidy is granted to a firm, then the supply curve for the product will
LUCIANO
shift vertically downwards by the amount of the subsidy, because it reduces
END OF
the costs of production for the firm, and more will be supplied at every price.
BOOKLET!!!
The main reasons for subsidy are:

To lower the price of essential goods to consumers so consumption of the product increases
To guarantee the supply of products that the government think are necessary for the economy, such as a basic
food supply or a power source. It may also be that the industry crates a lot of employment that would be lost,
thus causing economic and social problems.
To enable producers to compete with overseas trade, thus protecting the home industry.

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The market is in equilibrium with Qe being supplied and demanded at price Pe. After the subsidy of WZ per unit is granted,
the supply curve shifts vertically downwards from S1 to S1 – subsidy. The producers lower their prices and increase output
until a new equilibrium is reached, which is at a price of P1, where Q1 is both demanded and supplied. The price to
consumers falls from Pe to P1, not the whole amount of the subsidy, which would need to fall to P2. The income of the
producers rises. The consumers pay OP1ZQ1 for their purchases and P1DWZ is paid to producers by the government as
the subsidy on the Q1 units. The consumers get to but the original Qe units at a lower price, P1, thus saving the expenditure
P1PeXY. However, they do purchase more units QeQ1, because the price is lower, spending QeYZQ. Total expenditure
may increase or fall depending upon the relative savings and extra expenditure.

Things that need to be evaluated when a government is considering the granting of a subsidy:

- The opportunity cost of government spending on the subsidy in terms of other alternative government spending
projects
- Whether the subsidy will allow firms to be efficient, if they do not have to compete with foreign producers in a
“free market”.
- Although a subsidy allows consumers to buy products at a lower price, they may also be the taxpayers who are
funding the subsidy. Who is paying the taxes?
- What damage will it do to the sales of foreign producers who are not receiving subsidies from their governments?
High income country farmers are accused of dumping their products in developing countries. The produce far too
much (overproduction), damaging small scale farmers in developing countries.

Maximum price
The government may set a maximum price, below the equilibrium price, which then prevents producers from raising the
price above it. This is sometimes known as the ceiling price.

Maximum prices are usually set to protect consumers and they are normally imposed in markets where the product in
question is a necessity and/or a merit good. For example, governments may set maximum prices in agricultural and food
markets during times of food shortages to ensure low-cost food for the poor or they may set maximum prices on rented
accommodation to attempt to get affordable accommodation for those on low incomes.

At price Pmax, Q2 will be demanded because the price has fallen, but only Q1 will
be supplied. Thus we have a situation of excess demand. If the government does
not intervene further, they will find that consumption of bread actually falls from
Qe to Q1, even though it is a lower price.

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The excess demand creates problems. The shortages may lead to the emergence of a black market, (an illegal market) and
queues developing in the shops. Thus, governments have to act. Essentially, they have two options.

Attempt to shift the demand curve to the left, until equilibrium is reached at the maximum price, but this would
limit the consumption of the product, which goes against the point of imposing the maximum price.
Attempt to shift the supply curve to the right, until equilibrium is
reached at the maximum price, with more being supplied and
demanded. There are a number of ways of doing this.
- The government could offer subsidies to the firms in the industry to
encourage them to produce more.
- The government could start to produce the product itself, thus
increasing the supply.
- If the government had previously stored some of the product, then they
could release some of the stored goods into the market.

NOTE: IN MAX PRICES, PRODUCERS REVENUE= CONSUMER’S EXPENDITURE. MATHS!!!

Minimum price
The government may set a minimum price, above the equilibrium price, which then prevents producers from reducing the
price below it. This is sometimes known as the floor price. Minimum prices are mostly set for one of two reasons:

- To attempt to raise incomes for producers of goods and services that the government thinks are important, such
as agricultural products
- To protect workers by setting a minimum wage, to ensure that workers earn enough to lead a reasonable
existence.

At the price of Pmin, only Q1 will be demanded because the price has risen, but Q2
will now be supplied. Thus we have a problem of excess supply. If the government
does not intervene further, they will find that consumption of wheat actually falls from
Qe to Q1, at a higher price.

The excess supply creates problems. Producers will find that they have surpluses and will be tempted to try to get around
the price controls and sell their excess supply for a lower price.

Thus, the government has to intervene. The government would normally

eliminate the excess supply by buying up the surplus products, at the
minimum price, thus shifting the demand curve to the right and creating a
new equilibrium a Pmin with Q2 being demanded and supplied. The
government could then store the surplus, destroy it or attempt to sell it
abroad.

However storage is rather expensive, destroying products is considered wasteful and the government could be accused
of dumping when selling abroad. In the European Union agricultural policy, farmers are guaranteed a minimum price and
are paid to set aside land that they would have used to produce the product in question. They are then paid the price for
an estimated harvest and nothing is actually grown. This costs the same for the government, but avoids storage costs or
destroying produce.

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There are two other ways that the minimum price can be maintained.

- Producers could be limited by quotas, restricting supply. This would keep price at
PMin, but would mean that only a limited number of producers would receive it.
- The government could attempt to increase demand for the product by advertising
- By restricting supplies of the product that are being imported, through protectionist
policies, thus increasing demand for domestic products.

If governments do protect firms by guaranteeing minimum prices, there are problems that are
likely to occur.

- Firms may think that they do not have to be as cost-conscious as they should be and this may lead to inefficiency
and a waste of resources.
- It may also lead to firms producing more of the protected product than they should and less of other products
that they could produce more efficiently.

Unit 6 – Costs, revenues, and profit

Cost theory

Short run: The period of time in which at least one factor of production is fixed. All production takes place in the
short run. The length of the short run for a firm will be determined by the time it takes to increase the quantity of
a fixed factor.
Long run: The period of time in which all factors of production are variable, but the state of technology is fixed.
All planning takes place in the long run.

Fixed factor: some element of capital or land, technology, a type of highly skilled labour. The firm cannot quickly
increase the quantity of them that it has. If a firm plans ahead to change its fixed factors then all factors of
production are variable as the plans are being made. However, as soon as the fixed factors are changed, the firm
is once again in the short run, it simply has a different number of fixed factors.
Variable factor: workers, raw material, spare parts, components. Can be easily increased in quantity.
Firm: unit of decision making which as particular objectives such as profit maximization, the avoidance of risk taking,
achieving its long term growth etc. economic organisations that transforms factors of production (inputs) into goods and
services (outputs) to satisfy the market.

Product and the law of diminishing returns

The law of diminishing returns causes
production eventually to become inefficient
as more of a variable factor is applied to
fixed factors and so the rate of growth of
total product begins to decrease and the
output per unit of the variable factor, and
from each extra unit of the variable factor,
begins to fall.

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 The hypothesis of eventually diminishing marginal returns: As extra units of a variable factor are added to a
given quantity of a fixed factor, the output from each additional unit of the variable factor will eventually diminish.
The hypothesis of eventually diminishing average returns: As extra units of a variable factor are added to a
given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish.

Total product (TP) is the total output that a firm produces, using its fixed and variable factors in a given time period.
Output in the short run can only be increased by applying more units of the variable factors to the fixed factors, while it
plans ahead to change the number of fixed factors that it has.
𝑇𝑃
Average product (AP) is the output that is produced, on average, by each unit of the variable factor. 𝐴𝑃 = 𝑉

Marginal product (MP) is the extra output that is produced by using an extra unit of the variable factor.
∆ 𝑇𝑃
𝑀𝑃 =
∆𝑉
Change in total output divided by the change in the number of units of the variable factor employed.
Costs:
Economic cost: the economic cost of producing a god is the opportunity cost (resources that have been used in
producing the good or service) of the firm’s production. In order to work out the economic cost of production we separate
the factors used by a firm into two categories

Factors that are purchased from others and not already owned by the firm: the opportunity cost for these products
is the price that is paid for them and the alternative things that could have been bought. Explicit cost: any costs to a firm
that involve the direct payment of money

Factors that are already owned by the firm: implicit costs: earnings that a firm could have had if it had employed its
factors in another use or if it had hired out or sol them to another firm. The very existence of the firm depends upon
covering this cost. If not the next best alternative would be chosen.

Short run costs

Total fixed cost (TFC) is the total cost of the fixed assets that a firm uses in a
given time period. Since the number of fixed assets is fixed, TFC is a constant
amount. It is the same whether the firm produces one unit or one hundred
units. (Building, insurance, administrative salaries). DO NOT DEPEND IN THE
LEVEL OF OUTPUT.
𝑇𝐹𝐶 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 × 𝑡ℎ𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑎𝑐ℎ 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡

Total variable cost (TVC) is the total cost of the variable assets that a firm
uses in a given time period. TVC increases as the firm uses more of the variable
factor. If there is no output then there is no variable cost. (Raw materials,
labour, spare parts) . DEPEND ON THE LEVEL OF OUTPUT.
𝑇𝑉𝐶 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑓𝑎𝑐𝑡𝑜𝑟𝑠 × 𝑡ℎ𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑎𝑐ℎ 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑓𝑎𝑐𝑡𝑜𝑟
Semi variable: part fixed and part variable (salesman: fixed + commission)

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Total cost (TC) is the total cost of all the fixed and variable factors used to produce a certain output. 𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶
Average fixed cost (AFC) AFC is the fixed cost per unit of output. As TFC is
𝑇𝐹𝐶
a constant, AFC always falls as output increases. 𝐴𝐹𝐶 = 𝑞

Average variable cost (AVC) AVC is the variable cost per unit of output. AVC
tends to fall as output increases and then to start to rise again as the output
continues to increase. This is explained by the hypothesis of eventually
𝑇𝑉𝐶
diminishing average returns. 𝐴𝑉𝐶 =
𝑞

Average total cost (ATC) ATC is the total cost per unit of output. It is equal
to AFC plus AVC. As with AVC, ATC tends to fall as output increases and then to
𝑇𝐶
start to rise again as the output continues to increase. 𝐴𝑇𝐶 = 𝑞

Marginal cost (MC) is the increase in total cost of producing an extra unit of output. MC tends to fall as output increases
and then to start to rise again as the output continues to increase. This is explained by the hypothesis of eventually
diminishing marginal returns. As more of the variable factors are applied to the fixed factors, the extra output from each
∆ TC
additional unit of the variable factor added eventually falls, and so the extra cost per unit of output rises. 𝑀𝐶 = ∆q

Tips to draw a graph

1- Draw ATC (V shape)
2- Draw AVC below ATC making sure that its minimum point is to the left of
ATC minimum. Also note that they get closer but never touch as you move
to the right
3- MC always cuts ATC and AVC at their minimum points
4- MC initially goes down and the up like a Nike swoosh shape.

Long run costs

An entrepreneur is free to adjust the quantity of all the factors
of production that are used and is only restrained by the
current level of technology. In the long run, we look at what
happens to costs when all of the factors of production are
increased in order to increase output. In theory, the long-run
average cost curve (LRAC) is an ‘envelope’ curve, i.e. it
envelops an infinite number of short-run average cost (SRAC)
curves.

C3 is the lowest possible cost of producing the output, since it is a point on the SRAC curve that is tangent to the LRAC
curve

If demand increases and the firm now wishes to produce q2, it can do so in the short run by employing more variable
factors and moving along SRAC1 until q2 is being produced at a cost per unit of C*. This is a lower cost per unit than before,
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but the firm will know that they could produce this output even more cheaply if they were able to alter all the factors of
production if they were in the long run. Thus they will plan ahead to change all the factors of production and will eventually
move to SRAC2: producing q2 at a cost per unit of C2.

The LRAC curve is the boundary between the unit cost levels that are attainable by the firm and unit cost levels that are
unattainable.

When long-run unit costs are falling (rising) (constant) as output increases, we say that
the firm is experiencing increasing (decreasing) (constant) returns to scale. This means
that a given percentage increase in all factors of production will lead to a greater
(smaller) (same) percentage increase in output, thus reducing (increasing) (leaving the
long run average costs the same) long-run average costs.

Why do long-run costs increase or decrease as output increases?

1. Economies of scale – these are any falls in long-run average costs that come about when a firm alters all of its
factors of production in order to increase its scale of output. Economies of scale lead to the firm experiencing
increasing returns to scale. The main economies of scale that may benefit a firm as it increases the scale of its
output are:
Specialization
Division of labour: breaking a production process down into small activities that workers can perform
repeatedly and efficiently
Bulk buying: negotiate discounts with their supplies
Financial economies: banks tend to charge lower interest rates to larger firms since they are considered
less of a risk and more likely to repay their loans
Transport economies: large firm making bulk order may be charged less for delivery cots and they may
own their own transport fleet.
Promotional economies: advertising, sales promotion, publicity. The cost of promotion tends not to
increase by the same proportion as output. Insurance costs or the costs of providing security for the
production unit also falls.
2. Diseconomies of scale – these are any increases in long-run average costs that come about when a firm alters all
of its factors of production in order to increase its scale of output. Diseconomies of scale lead to the firm
experiencing decreasing returns to scale. The main diseconomies of scale are:
Control and communication problems: as firms grow in scale, the management will find it harder to
control and coordinate the activities, leading to inefficiency.
Alienation and loss of identity: workers begin to think that what they do does not matter, they work less
hard and become less productive.

All of the above economies and diseconomies of scale relate to the unit cost decreases or increases that might be
encountered by a single firm. They are known as internal economies and diseconomies of scale. There are other economies
and diseconomies that come about when the size of the whole industry increases and this has an effect on the unit costs
of individual firms. They are known as external economies (when a university starts courses that relate to the skills
required in the industry) and diseconomies (competition among individual firms) of scale.

Long run cost curves are U shaped in theory because of the existence of economies
and diseconomies of scale

In reality, economists have not yet found evidence of a firm becoming so large that
the diseconomies of scale start to outweigh the economies of scale in the long run.

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 Revenue theory
Revenue is the income that a firm receives from selling its products goods and services over a certain period of time

Total revenue (TR): the total amount of money that a firm receives from selling a certain amount of a good or service in
a given time period. 𝑇𝑅 = 𝑝 × 𝑞
𝑇𝑅
Average revenue (AR): revenue that a firm receives per unit of its sales. 𝐴𝑅 = 𝑞
= 𝑃𝑟𝑖𝑐𝑒

Marginal revenue (MR): the extra revenue that a firm gains when it sells one more unit of a product in a given time
∆ TR
period. 𝑀𝑅 = ∆q

Revenue curves and output

Revenue when price does not change with output

We can assume that the firm is very small in terms of the size of the whole industry, and
that they can increase their output without affecting total industry supply, and thus the
price, in any significant way. Therefore the firm can sell all that it produces at the same
price. Total revenue increases at a constant rate as output increases

Revenue when price falls as output increases

When PED is elastic to increase revenue lower the price, losing revenue on the
goods that could have been sold at a higher price in order to get the revenue from
the extra sales. (TR was $160 ($40 x 4), price drops TR is now $210 ($35 x6)

When PED = 1, MR = 0 and TR is maximized. No change should be done.

When PED is inelastic to increase revenue increase the price. After a certain time,
demand becomes inelastic, TR is no longer maximized and as price decreases,
demand does not increase at a rate that should be needed for average revenue
to continue increasing, marginal revenue decreases. (TR was $160 ($10 x 16), price
drops TR is now $90 ($5 x18)

In a normal downwards sloping curve, TR rises at first but eventually starts to fall
as output increases because the extra revenue gained from lowering the price and
selling more units, is outweighed by the laws in revenue from the units that could
have been sold at a higher price.

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 Profit theory
𝑡𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑐𝑜𝑠𝑡 (𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡 + 𝑖𝑚𝑝𝑙𝑖𝑐𝑖𝑡)

1. Normal profit or economic profit: Total revenue = total cost (fixed cost, variable cost and opportunity cost).
The opportunity cost is the amount of profit that the owner of the firm expects to make. If the owner does, then
he/she is happy. Breakeven point.
2. Abnormal profit or economic profit: Total revenue > total cost (fixed cost, variable cost and opportunity
cost). The owner is making more than his/her expected profit and so is very happy.
3. Losses or negative economic profit: Total revenue < total cost (fixed cost, variable cost, and opportunity
cost). The owner is making less than his/her expected profit and so, if the losses continue in the long run, the
owner will shut down the firm and move to his/her next best occupation.

The firm should shut down when its revenue

gained has failed to cover all of the variable
factors. By doing so, it will only lose its total
fixed cost, this is better than producing and
not getting enough revenue to cover
variable costs. (ex: boliches de pinamar)

Breakeven price is the price at which a firm

is able to make normal profit in the long run.
Covering all of its costs, including the
opportunity cost in the long run.

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If a firm finds that at its present level of
output the cost of producing another unit
(MC) is less than the revenue that the
unit would bring in (MR), the firm could
increase its profits increasing production.

If a firm wishes to maximize its profits, it

should produce at the level of output
where MC cuts MR from below.

Allocative/ Economic Efficiency: When the price that consumers pay for the last unit purchased is
equal to the marginal cost of the last unit produced (MC=AR). Suppliers producing optimal mix of goods and
services required by consumers.

Productive Efficiency: A firm is said to be productively efficient if it produces is product at the lowest
possible per unit cost. Firms combining resources as efficiently as possible.

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Interdependence and the Kinked demand curve:

Relates to the non-collusive oligopolies behaviour around price setting strategies.

Collusion: Illegal arrangements between firms belonging to an oligopoly with the objective off setting prices and/or
quantities as to maximize profits.

Cartel: Legal arrangement between firms belonging to an oligopoly with the objective of stabilizing market prices of
sensitive goods.

Because of rational behaviour and interdependence, prices tend to be stable in an oligopoly. (Unilaterally changing a
price is not rational for any of the firms). Firms in an oligopoly are afraid to raise prices because other firms may not
follow and they will lose sales. Firms may be afraid to lower prices because other firms will follow, creating a price war
that harms all firms involved.

UNIT 11 – Price discrimination

Price discriminations exists when a producer sells the exact same product to different consumers at different prices.

To be able to price discriminate, three conditions are necessary:

1. The producer must have some price-setting ability, the market must be imperfect. The more price-setting ability
the producer has, the easier to price discriminate
2. Consumers must have different price elasticities of demand for the product. A consumer with a relative inelastic
demand for a product will be prepared pay a higher price than a consumer with relative elastic demand.
3. Producer must be able to separate the consumers, so they are not able to buy the product and then sell it to
another consumer. If not, this would destroy the ability of the producer to practice price discrimination.

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Producers are able to separate markets in different ways:

Time: Consumers are often prepared to pay higher prices at certain times than at others,
Age: Firms may change the prices to consumers based on their ages. E.g. Children are charged lower prices than
adults for visiting the cinema.
Income: Firms may charge higher prices to people with higher incomes. E.g. Lawyers job.
Geographical distance: Firms sell products in different regions at different prices. This is possible as long as the
cost of transferring the product is greater than the difference in prices.
Types of consumer: Firms sell products at different prices to different users. Electricity companies may charge
different rates to industrial users than domestic users

Three levels of price discrimination:

1. First degree price discrimination: Occurs when each consumer pays exactly the price
that he/she is prepared to pay.
2. Second degree price discrimination: Occurs when a firm charges different prices to
consumers depending upon how much they purchase. This is how utilities companies
work. They may charge a high price for the first number of units, and then a lower
price for any extra units consumed.
3. Third degree price discrimination: Occurs when consumers are identified in different
market segments, and a separate price is charged in each market that recognizes the
different price elasticities in each segment. (Cinema/zoo)

Advantages of price discrimination to the firm:

Enables the producer to gain a higher level of revenue from a given amount of sales. Consumer surplus is eroded
Enable the producer to produce more of the product and thus gain from economies of scale. Lowers average
costs, and lowers prices in all market segments
Enables firms to drive competitors out of the more elastic market. If the firm price discriminates, it may use
profits gained in the inelastic market segment to lower prices in the more elastic segment and thus, undercut its
competitors in that segment.

Advantages to the consumer:

Enable some consumers to purchase a product that they would not have been able to if other
consumers were not paying a higher price and thus “subsidizing” the poorer consumers.
Allows some people to purchase a product at a lower price than they would have had to pay if the
producer had not been able to secure high prices from others.

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 Increases total output in a market and so the product is more available to more consumers.
Lead to economies of scale, lower unit costs, and lower prices for consumers in all market segments.

Disadvantages to the consumer:

Any consumer surplus that existed before the price discrimination will be lost.
Some consumers will pay more than the price that would have been charged in a single, non-
discriminated market.
Damping

Unit 12 - Market Failure

Market Failure - occurs when there is an inefficient allocation of resources in a free market. Community surplus is not
maximized and there is no allocative efficiency.

Paretto Optimality - When it is impossible to make someone better off without making someone else worse off

- Marginal Social Benefit – Demand (MSB) The value that consumers put on the product (price received for a unit)
- Marginal Social Cost – Supply (MSC) The cost of the product to society (cost of producing one more unit)
- Marginal Private Cost – private supply curve based on the firm’s cost of production
- Marginal Private Benefit – utility or benefit to consumer

When:
MSC=MSB Allocative efficiency
MSC=MPC + - external cost or benefits of production (producers) (supply curve)
MSB=MPB + - external cost or benefits of consumption (consumers) (demand curve)
MSC ≠ MSB externality

Types of market failure:

Externality the effect that the production or consumption of a product has on a third party, someone who isn’t
involved in the transaction. LUCIANO: Costs or benefits passed upon third parties not involved in an economic
transaction, that may arise from the consumption or the production of a good or service, and may be positive (benefit)
or negative (cost)

Positive Externality of Consumption

These happen when the consumption of a good or service creates external benefits that are good for third parties, e.g.
having vaccinations or using deodorant. The benefits to society are greater than the benefits to the consumer, because
there is positive utility gained by the third parties. The good or service will be under consumed and so there is a
potential welfare gain, if consumption is increased to the point where MSC = MSB. The government could:

subsidize the supply of the good or service (opportunity cost)

use positive advertising to increase demand for the good or service (opportunity cost)
Pass laws making consumption of the good or service obligatory.
- In a free market. consumption will be at Q1 because Demand = Supply (private benefit = private cost)
- However this is socially inefficient because Social Cost < Social Benefit. Therefore there is under consumption of
the positive externality
- Social Efficiency would occur at Q* where Social Cost = Social Benefit

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For example in the real world without government intervention there would be too little education and public transport.

Subsidy on Positive externalities

- Subsidy = P* - P2
- The supply curve shifts to MSC + subsidy and Price falls from P1 to P2
- People will now consume more at Q*
- Q* = Social Efficiency: because MSC = MSB

Advantages of Subsidies
- Enables greater social efficiency. Consumers end up paying the socially
efficient price, which includes the external benefit.
- If you subsidize public transport, it will encourage people to drive less,
and reduce their negative externalities.

Disadvantages of Subsidies
- Is expensive and will requires higher taxes.
- Difficult to estimate the extent of the positive externality and how much subsidy is needed
- Giving subsidies to firms may encourage inefficiency, because the firms can rely on government aid.
- Gov Failure: The gov. may have poor information about the service and how much to subsidise.

Positive Externality of Production

These happen when the production of a good or service creates external
benefits that are good for third parties, e.g. when a factory provides training for
employees (could shift PPC outwards). The costs to the firm are production
costs plus the external costs of training, which society does not have to pay for.
The good or service will be under-produced and so there is a potential welfare
gain, if output is increased to the point where MSC = MSB. The government
could:
subsidize the firm to reduce the firm’s costs
provide the training itself

Negative externality of Production

These happen when the production of a good or service creates external costs that are harmful to third parties, on top
of the private costs e.g. when a factory pollutes a river with waste. The costs to society are the costs of the firm plus the
external costs that the firm creates, but does not pay for. The good or service is over-produced and so there is a welfare
loss. The government could:

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 tax the firm to recover the external costs
legislate to ban the firm or to set environmental standards (loss of jobs and non-consumption of the good
(which could be important or necessary or valuable))
Issue tradable emission permits (difficult to know how many permits to give out, difficult to measure pollution
levels, pollution still occurs. Countries who pollute more than their quotas can simply buy permits off others.
Therefore rich developed countries have been buying permits of less developed countries) example: the Kyoto
Protocol signed by 187 countries globally (not USA), to reduce greenhouse gases. (cap and trade system).
Tradable pollution permits is a scheme designed to reduce the level of pollution of a particular industry, where
those firms that pollute above the industry’s average, should but pollution permits to those firms that pollute
below the average.

- In a free market, the firm will only be concerned with its private costs
and will produce at Q1, their profit maximizing level of output.
- This is socially inefficient because at Q1 Social Cost > Social Benefit.
Market Failure
- Social Efficiency occurs at Q2 where Social Cost = Social Benefit
- The blue triangle is the area of dead weight welfare loss. It indicates the
area of overconsumption (where MSC is greater than MPC)

Negative Externality of Consumption

This happens when the consumption of a good or service creates external
costs that are harmful to third parties, e.g. through secondary smoking or
cars and air pollution. The benefits to society are less than the benefits to
the consumer, because there is negative utility suffered by the third parties.
The good or service is over consumed and so there is a welfare loss. The
government could:

ban consumption of the good or service (loss of jobs, loss of revenue in

taxes, loss of votes)
impose indirect taxes on the good or service (if the tax is too high, black
markets will arise)
Provide education and negative advertising to reduce demand for the
good or service. (high cost)

Tax on Negative Externalities-

If tax=external cost then externality is internalized if it is different, the dead weight burden is reduced.

Advantages of Taxes

- Provides incentives to reduce the negative externality such as pollution.

E.g. cars have become more fuel efficient
- Social efficiency, 1st best solution.(where MSC = MSB)
- Taxes raise revenue for the govt. This can be spent on alternatives

Disadvantages of taxes

- Difficult to measure the level of negative externality e.g. what is the cost
of pollution from a car?
- If Demand is inelastic then higher taxes will not reduce demand much
- Taxes will cause inequality
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 - Cost of administration
- Possibility of evasion. E.g. with tax on disposing of rubbish there has been an increase in fly tipping (illegal Dumping
of rubbish)
- May be difficult to decide who is causing pollution
- Difficult to know which company is polluting and how much
- Pollution goes on although the activity is taxed

Merit goods (under supply)

Merit goods are goods that would be underprovided by the free market, and so would be under-consumed. Since they
are goods that are considered to be of benefit to society, this under provision is considered to be a market failure.
Examples would be education, health care, sports facilities. All public goods are merit goods

Governments may try to reduce this market failure by:

- direct provision of more-important merit goods, such as education or health care

- Subsidization of less-important merit goods, such as sports facilities and the opera.

Demerit goods (over supply)

De-merit goods are goods that would be over-provided by the free market, and so over consumed. Since they are goods
that are considered to be harmful to society, this over-provision is considered to be a market failure. Examples would be
child pornography, hard drugs, cigarettes and alcohol.

A demerit goods has two characteristics:

1. A good, which harms the consumer. For example, people don’t realize or ignore the costs of doing something
2. Usually these goods also have negative externalities. (Costs imposed on third parties) Example: Alcohol
consumption can cause personal health problems and also cost for society because of increase in crime etc.

Governments may try to reduce this market failure by:

- completely banning the worst of these goods, for example child pornography and hard drugs
- Taxing relatively less-damaging goods, such as cigarettes and alcohol. The level of the tax reflects the level of the
damage

Under provision of Public Goods

Public goods are goods that would not be provided at all in a free market. Since they are goods that are considered to be
of benefit to society, this lack of provision is considered to be a market failure.

1. Non-rival– one person consuming them does not prevent another person consuming them as well... E.g. benefiting
from a streetlight doesn’t reduce light for others, but eating an apple would.
2. Non-excludable – it is impossible to stop other people consuming them once they have been provided. E.g.
erecting a dam to stop flooding, or providing law and order. (Free Rider Problem) Therefore there is no incentive
for people to pay for the good because they can consume it without paying for it. However this will lead to there
being no good being provided. Therefore there will be social inefficiency.

Governments may try to reduce this market failure as follows.

- They may provide the goods themselves, for example national defence or flood barriers. The use of taxes to fund
the provision spreads the cost over a large number of people, who would not be prepared to pay individually.
- They may subsidize private firms, covering all of the costs, to provide the goods.

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 The immobility of factors of production
In a perfect market, in theory, resources move easily between uses, attracted by higher factor payments. In reality, this
does not happen so easily and there are shortages of factors and time lags, e.g. coal miners may not quickly become
software engineers or workers in eastern Austria may not move to jobs in western Austria. To correct this type of market
failure, governments adopt policies that either take work to the workers or take the workers to the work. They will also
have to encourage retraining schemes.

Problems of information- Asymmetric information

Theory tells us that in a perfect market, both consumers and producers have perfect knowledge of the market. In reality,
of course, this is not the case and so decisions are often being made based upon incomplete information. This makes it
very hard for marginal costs and marginal benefits to be equated and this leads to market failure. Consumers make
decisions to purchase goods that they do not buy often, and so have little knowledge of, such as cars and houses.
Producers have to estimate demand over a period of time and so often set an average price to cover a range of possibilities.
Governments may try to improve the flow of information to correct this market failure, but this is expensive and may not
be possible for all markets.

The creation of inequality

The free market often leads to the existence of large differences in income and wealth between different groups of people
in the economy. It may be that society sees the creation of inequality as a failure of the market and may then attempt to
use progressive taxation to redistribute income from one group of the population in order to benefit a less fortunate
group.

Short-termism
Sometimes, short-term decisions are made that may have severe long-term implications. Let us consider two examples.

- Firstly the private sector is often blamed for pursuing short-term profit-based objectives at the cost of long-term
problems. Firms may use up resources in the short-term at a rate that means that development in the future will
not be able to be sustained at the present rate. This reduces the potential for sustainable development.
- The second example concerns the public sector – the government. Governments may intervene in the workings
of markets in the short-term in order to gain results that will lead to re-election, even though this intervention
may go against the long-term best interests of society. They are, in effect, causing a market failure in these markets
by their intervention.

Imperfect competition
Monopolists, and other imperfect markets, restrict output in order to push up prices and maximize profits. The result
is that they do not produce at the socially optimum level of output, Q1, where MSC = MSB, as we see below on the
left. Instead, they produce at Q2, as shown on the right. There is a loss of community surplus of a + b.

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 Governments may try to reduce this market failure by intervening to reduce the power of the monopoly by:

using legal measures to make the market more competitive, by making mergers and takeovers more difficult
to achieve
setting up regulatory bodies, monopolies watchdogs, to take action if they feel that the public interest is being
harmed

Sustainability
Sustainability exists where the consumption needs of the present generation are met without reducing the ability to meet
the needs of future generations.

- Common access resources are typically natural resources. The nature of the resource and the inability to
charge for them may encourage overuse or over consumption, and eventually lead to the depletion of the
resource. The benefit to the individual outweigh the external cost and give the individual the incentive to keep
using the resource.
- Where the common property and the pursuit of economic growth result in environmental problems such as the
over exploitation of land, soil erosion, land degradation, and deforestation.
- Heavy global demand for fossil fuels causes increased greenhouse gases. Producers and consumers of such fossil
fuels are not able to account for the external costs to future generations means that fossil fuels are both over
produced and over consumed.

Solutions

Renewable sources of energy and energy efficient designs are seen as a solution. Governments can assist by subsidizing
the development of clean technologies or by offering tax credits to firms that invest in clean technologies (corporate social
responsibility code (seem nice being involved in sustainable development for marketing reasons).

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 MACROECONOMICS

Unit 13 - The level of overall economic activity

Five economic main aims for government.

1. A steady rate of increase of national output (economic growth)

2. A low level of unemployment
3. A low and stable rate of inflation
4. A favourable balance of payments position
5. An equitable distribution of income.

The circular flow of income

- Households: consumers of goods and services. Owners and providers of the factors of production
- Firms: productive units that make use of the factors of production (private sector)
- It is a flow because income moves through it as payment for different things
- Households supply factors of production (land, labor, capital, management) and in return receive goods and
services which they pay for with the money they receive from rent, wages, interest and profit.
- Leakages causes the amount of income circulating in the economy to fall, it is not used to finance expenditure on
goods and services
- Injections a source of income not coming directly from the household, causes the amount of income circulating
in the economy to rise (transfer payments1 are not an injection; the income of one household is transferred to
that of another).
The economy is in equilibrium when leakages are equal to injections
If leakages rise, without a corresponding increase in injections, national output will fall to a new equilibrium as
there will be less income circulating. And the converse if injections are higher than leakages.

Measurement of national income

Gross domestic product (GDP) is the total of all economic activity in a country, regardless of who owns the
productive assets. The total value of all final goods and services produced in an economy in a year. It is the most

1
Payments to individuals that are not the result of an increase in output. For example pensions, unemployment benefits.
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 commonly used measure of a country’s national income2. There are three different methods that are all used to
calculate this figure:
1. The output method measures the actual value of the goods and services produced. This is calculated by summing
all of the value added by all the firms in an economy. When we say value added, it means that at each stage of a
production process, we deduct the costs of inputs, so as not to ‘double count’ the inputs.
2. The income method measures the value of all the incomes earned in the economy.
3. The expenditure method measures the value of all spending on goods and services in the economy (AD)
GDP = C + I + G + (X – M)
Gross national product (GNP or GNI) is the total income that is earned by a country’s factors of production,
regardless of where the assets are located. Income earned from assets abroad minus income paid to foreign assets
operating domestically
GNP = GDP + net property income from abroad
Net national product (NNP or NNI) is simply gross national product minus depreciation (capital consumption).
May be due to wear and tear as machinery is used, there may be damage to capital equipment, or technology
might make machinery obsolete.
NNP = GNP – depreciation MEJOR
Real GDP: If there is inflation, then this will overstate the value of GDP. GDP will rise even if DEFINICION
there hasn’t actually been an increase in economic activity. It makes it possible to compare LUCIANO END
data over time. OF BOOKLET!!!
Real GDP = nominal GDP adjusted for inflation
GDP per capita makes judgement about the progress of a country in comparison with other
countries in terms of raising living standards
GDP per capita = GDP / the size of the population.
Green GDP = GDP – environmental costs of production

Why gather national income statistics?

People use the statistics to judge whether or not a government has been successful in achieving its
macroeconomic objective of increased growth
Governments use the statistics to develop policies
Economists use the statistics to develop models of the economy and make forecasts about the future
Businesses use statistics to make forecasts about future demand
The performance of an economy over time can be analysed (as long as real data is used)
People often use national income accounts as a basis for evaluating the standard of living or quality of life of a
country’s population.
National income statistics are often used as a basis for comparing different countries

Limitations of national income data

Inaccuracies – data that is used to calculate the various measures of national income come from a vastly wide
range of sources, including tax claims by households and firms, output data and sales data. Figures tend to become
more accurate after a lag time as they are revised when additional data is included.
Unrecorded or under-recorded economic activity –national income accounts can only record economic activity
that has been officially recorded. They don’t include any do-it-yourself work (This is perhaps most significant for
developing countries, where much of the output does not make it to any recorded market (for example
subsistence farmers)), illegal jobs such as drug trafficking, unrecorded activity that is legal but the people are doing

2
National output = national income = national expenditure

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 it illegally such as illegal immigrants, work that is not recorded because people want to evade taxes (the countries
with higher tax burdens have a higher amount of hidden economic activity).
External costs – GDP figures do not take into account the costs of resource depletion.
Other quality of life concerns – GDP may grow because people are working longer hours or taking fewer holidays.
While people may earn higher incomes as a result, they might not actually enjoy higher standards of living. GDP
accounting does not include free activities such as volunteer work or people caring for the elderly and children at
home.
Composition of output – it is possible that a large part of a country’s output is in goods that do not benefit
consumers, such as defence goods or capital goods.

The business cycle

The business cycle is the periodic fluctuations in economic activity measured by changes in real GDP over time. A country’s
business cycle may be linked to its electoral cycle.

• Recovery: Economic Expansion, GDP increasing at a rising rate.

Usually driven by an increase in the aggregate demand in the
economy, as household and businesses are encouraged to spend
more. Higher demand means more output produced, takes more
workers, so employment increases. The newly employed workers
spend their income on new goods and services and so household
spending increases even more. An increase in AD can cause an
increase in average prices (inflation).
• Thus as an economy booms, it is likely that inflationary pressure will
build up and the rate of growth of GDP will fall, as the economy nears
its employment output. Economic policy makers will react trying to
slow down the growth of the economy which causes a fall in the
aggregate demand. This is the beginning of the recession part of the
cycle.
• A recession is defined as two consecutive quarters of negative GDP growth, that is, falling GDP. During recession
falling AD, will lead to firms to lay off workers, so unemployment rises. Thus there will be less spending. Low levels
of demand result in lower rates of inflation or even deflation.
• Trough. Output cannot continue to fall for ever as there will always be some people with jobs to maintain a given
level of consumption, foreigners will demand exports, governments will continue to spend by running budget
deficits, and people will be able to use savings to finance their consumption. The low demand for money for
investment will result in lower interest rates. Thus AD will pick up, the economy will enter the recovery phase, and
the cycle will repeat itself.

The second recovery is at a higher level of real GDP than the first and each boom
is higher than the last. Economies tend to go through periodic fluctuations in
real GDP around their long term growth trend, or long term potential output.

At a point A there is a negative output gap. The economy is producing below its
trend and unemployment is likely to be a problem. At point B there is a positive
output gap. The economy is producing above its trend, beyond capacity, and
inflation is likely to be a problem.

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 Goal Expansion Contraction
Economic growth Achieved – GDP rises Not achieved – GDP falls
Low unemployment Achieved – more workers are needed Not achieved – as workers are laid off
to produce the growing output when less output is demanded
Low and stable rate of inflation Not achieved – inflationary pressure Achieved – inflation falls
builds
Favourable balance of payments Not achieved – as the current account Achieved – the current account
position worsens improves

Unit 14 – Aggregate Demand

Aggregate demand (AD): The total planned expenditure by all economic agents, on locally goods and services in a period
of time at a given price level.

𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑁)

Components of AD (they set the position of the AD curve):

Consumer spending (C) Consumption: The total spending by consumers on domestic goods and services.
- Durable goods such as cars, computers, used by consumers over a period of time
- Non-durable goods such as rice, toilet paper, used up immediately or over a short period of time.
Investment expenditure by firms (I) Investment: is defined as the addition of capital stock to the economy. There
are two kind of investment carried out by firms:
- Replacement investment occurs when firms spend on capital in order to maintain the productivity of their
existing capital
- Induced investment occurs when firms spend on capital to increase their output to respond to higher
demand in the economy
Government spending (G) the amount of government spending on goods and services depends on its policies and
objectives.
Net exports: The value of export revenues minus import expenditure over a period of time. Revenue from
expenditure by foreign residents on the country’s exports (X) minus domestic expenditure on imports (M). If
positive export revenues exceed import revenues, it will add to AD.

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Changes in components of aggregate demand

Changes in consumption
Changes in interest rates: some of the money that is used to buy durable goods comes from money which people
borrow from banks. If there is an increase in interest rate, it is likely for there to be less borrowing and more
savings so consumption will fall. People who are paying interest (for example mortgages) will have less disposable
income.
Changes in wealth: wealth is made up of the assets that people own, physical assets (houses, art) and monetary
assets (shares in companies, government bonds or bank savings). Two main factors that can change the level of
wealth
- A change in house prices: if house prices increase, consumers feel more wealthy, confidence hence consumption
increases (they save less or borrow more)
- A change in the value of stocks and shares: if the value of the shares increases then people feel wealthier. This
might encourage them to spend more. Alternatively, they might sell those shares and then use the earnings to
increase consumption.
Changes in expectations/ consumer confidence: if people are optimistic about their economic future, then they
are likely to spend more.
Household indebtedness: the extent to which households are willing and able to borrow money affects
consumption. If it is easy to borrow money and interest rates are low then it is likely that households will take on
more debt by getting loans or using their credit cards and spending on goods and services will rise.

Changes in investment
Interest rates: in order to invest firms need money, the can either use their “retained profits” or they can borrow
money. An increase in interest rates may lead to a fall in investment and the firms may prefer to put their retained
profits in the bank and earn higher returns as savings, rather than use them to invest.
Changes in the level of national income: as national income rises, this leads to an increase in consumption. This
will put pressure on the existing capacity of firms. This is likely to encourage firms to invest in new plant and
equipment to meet the increase in demand.
Technological change: in order to keep up with advances in technology and to remain competitive, firms will need
to invest.
Expectations/business confidence: if they are confident about the future and expect consumer demand to rise,
then they will want to be ready to meet the increase in consumer demand by investing to increase potential
output and productivity.

Changes in government spending

Changes in interest rates
Changes in the goals of the government: if the government has made a commitment to financially support a given
industry or are obliged to spend to correct market failure, a new education or health policy may cause government
spending to rise.

Public spending Government income

Capital expenditure – spending that Income taxes
adds to the capital stock of the Corporate taxes
economy (building schools) Indirect taxes paid on expenditure
Current expenditure – expenditure Social security payments
that is ongoing (wages to public sector Tariff paid on the purchase of
employees) imported goods

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 Renting out government owned
buildings or land
Transfer payments - Payments to Profits of government owned
individuals where no good or service businesses
were produced in return (pensions) Selling nationalized industries

NOTE: Tranfer payments: transfer of funds from the government to “selected groups of individuals for which no
counterpart is expected in return (grants) which especially goes to: the poor, veterans, war, handicapped.

The government can run either a budget deficit or surplus. If there is a deficit, the government could borrow money either
from the households and firms thin the country or by borrowing from abroad.

Changes in net exports

The net export depends on domestic national income (affecting the demand for imports (greater investment so
more capital goods and components will be purchased from abroad)), foreign national incomes (affecting the
demand for exports), changes in exchange rates, changes in trade policies and relative inflation rates.

Demand-side polices government policies that affect the level of aggregate demand in the economy.

Fiscal demand side policy

Set of government policies where gov. alter their own expenditure and taxation to affect the
MEJOR
economy.
DEFINICION
To expand the economy, the government could reduce direct taxes (lower income and LUCIANO END
corporate taxes) and increase its spending. Governments have major investment projects OF BOOKLET!!!
themselves and may increase their spending in order to improve or increase public
services). AD would shift to the right.
To contract the economy, the government could increase direct taxes (increase income and corporate taxes) and
lower its spending. Governments should limit themselves to reduce their spending. AD would shift to the left.

Monetary demand side policy

Central bank alter the interest rate and/or the supply of money to affect the economy.

To expand the economy, the government could reduce interest rates (reduces the cost of borrowing and can lead
to increases in both consumption and investment) and increase the money supply. AD would shift to the right.
To contract the economy, the government could raise interest rates (increasing the cost of borrowing and can
lead to a reduction in both consumption and investment) and reduce the money supply of the market. AD would
shift to the left.

What are the problems?

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 - Demand side policies involve a trade-off.
- Usually, if demand pull inflation is improved, demand-deficient unemployment gets worse and vice versa.

Unit 15 – Aggregate Supply

Aggregate supply (AS): The total amount of goods and services that all industries in the economy will produce at
every given price level. The sum of all the supply curves of all the industries in the economy.

Short-run aggregate supply (SRAS)

Short run is defined as the period of time when the prices of factors of production do not change. Most importantly price
of labour – the wage rate – is fixed.

The law of diminishing returns means that marginal and average costs will rise as output increases in the short run. An
increase in output will be accompanied by an increase in average costs, they will need to receive higher prices to encourage
them to produce more.

Factors that cause the SRAS curve to shift are known as supply shocks. The SRAS curve can only be shifted by factors that
change costs of production.

Shift in SRAS
Change in wage rates: increase in wages increase the costs of production so there is a fall in aggregate supply
Change in the costs of raw materials: increase in the price of significantly widely
used raw materials (oil)
Change in the price of imports: if the capital or raw materials used by a country’s
industries are imported, then a rise in import prices will increase the cost of
production. This can occur in changes in exchange rate.
Change in government indirect taxes and subsidies: an increase in indirect taxes
increases the cost of production. An increase in subsidies reduces costs of
production.

Long-run aggregate supply (LRAS)

There are two major views relating to the shape of the LRAS. The different beliefs about the shape of the LRAS curve lie
at the basis of controversies about appropriate policies to be followed by governments.

The new-classical view (monetarist or free market view)

The efficient of market forces and their view that there should be the very minimum of government intervention in the
allocation of resources in the economy.

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 These economists argue that the LRAS curve does not respond to changes in AD in the long
run and is determined completely independently of demand.
LRAS is perfectly inelastic, “full employment level of output”, and represents the potential
output that could be produced if the economy were operating at full capacity. Potential
output is based on the quantity and quality of factors of production and not the price level.
An expansion of AD will always lead to demand-pull inflation and will not, in the long run,
lead to growth in output and thus employment. So new-classical economists argue that
national output may only be increased by adopting supply-side policies to shift the LRAS
to the right.

Long run new classical equilibrium output

The impact of any changes in aggregate demand will be on price level only, not on real output

There may be a short run increase in output if there is an increase in aggregate demand, but the economy, without
any government intervention, will always return to its long run equilibrium at the full employment level of output.

Aggregate demand rises Aggregate demand falls

Long run equilibrium at Yf P1 Long run equilibrium at Yf P1
Increase in AD from AD1 to AD2 Decrease in AD from AD1 to AD2
There is an increase in output on the short run, from Yf to There is an decrease in output on the short run, from Yf to
Y1 and an increase in price level (P1 to P2) Y1 and a decrease in price level (P1 to P2)
Inflationary gap (Yf to Y1), where the economy is in Deflationary gap (Yf to Y1), where the economy is in
equilibrium at a level of output that is greater than the full equilibrium at a level of output that is less than the full
employment level of output employment level of output

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 This is possible in the short run by paying existing workers This deflationary gap will not persist in the long run.
overtime wages as a short term solution but not in the long
run.
As the economy is originally at the full employment level The fall in price level means that the prices of the
of output, there are no unemployed resources. In the economy’s factors of production (cost) have fallen.
effort to increase their output, firms are competing for
increasingly scarce labour and capital. This increases price
from P1 to P2. The rise in the price means an increase in
costs to firms
The result is a shift to the left in the short run aggregate The result is a shift to the right in the short run aggregate
supply from SRAS1 to SRAS2 supply from SRAS1 to SRAS2
Although firms were willing to supply a higher level of
output due to the higher prices they were receiving in the
short run, their higher costs of production result in no real
gain, so they reduce output back to Yf
Output returns to its full employment level of output (Yf) Output returns to its full employment level of output (Yf)
but at a higher price (P3) but at a lower price (P3)

The Keynesian view (interventionist view)

In region 1, the LRAS is perfectly elastic at low levels of economic activity.
Producers in the economy can raise their level of output without higher average
costs, because of spare capacity (unused factors) in the economy.

In region 2, as the economy approaches its potential output (Yf), and the spare
capacity is used up, the available factors in the economy become scarcer. As
producers increase output, they bid for the increasingly scarce factors and prices
begin to rise (higher costs of production).

In region 3, when the economy is at full capacity, all factors are being used and so
output cannot increase. Thus, LRAS is perfectly inelastic. Output cannot be
increased without an increase in the quantity or improvement in the quality of the
factors of production.

Long run Keynesian equilibrium output

1. The economy may be in long run equilibrium at a level of output below the full employment level of output (Yf)
Operating at a level where there is spare capacity, the equilibrium level of output depends mainly on the level of
aggregate demand.
Deflationary gap: whereby the level of aggregate demand in the economy is not sufficient to buy up the potential
output that could be produced by the economy at the full employment level of output. (output gap)

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 Aggregate demand can increase such that there is an increase in the level of real output, without any consequent
increase in the price level
Increase in real output from Y1 to Y2, but no change in price level due to spare capacity. Producers can employ
the unused factors of production to increase output with no increase in cost thus there is no inflationary pressure.

2. If aggregate demand increases further to AD3 then the economy starts to

experience inflationary pressure as available factors of production become scarcer
and their prices are bid up. Price level rises from P1 to P2 to compensate producers
for their higher costs.

3. If the economy is operating at full employment and there is an increase in

aggregate demand, there is no increase in output and the only change is an
increase in the price level. It is impossible for the economy to produce any
further increase in output in the long run, given the existing factors of
production.
Inflationary gap from P1 to P2 whereby the level of aggregate demand cannot
be satisfied given the existing resources. As a result, price level rises to allocate
the scarce resources among competing components of aggregate demand.

Shift in LRAS
The LRAS curve will shift to the right if there is an improvement in the quantity and/or quality of the factors of
production in the economy.
A shift of the LRAS curve to the right is equivalent to an outward shift of the PPC curve, its productive potential
output has increased (may be economic growth)

For Keynesian economists, the impact of an increase in the LRAS depends on the initial equilibrium position of
the economy. If it is operating below the full employment level of output, an increase in the LRAS increases the
potential output in the economy but the AD is not sufficient to buy up this potential so actual output does not
increase, the equilibrium remains at Y. hence the government must implement demand side policies if it is
operating below the full employment level of output
For new classical economists, an increase in the LRAS has a favourable impact. There will be an increase in the
full employment level of income from Yf1 to Yf2 and a fall in the price level from P1 to P2. Supply side policies are
the most effective way of achieving a country´s macroeconomic goals according to new classical economists.
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 Factor of production Increase in quantity Improvement in quality
Land (all natural resources) - Land reclamation - Technological advancements
- Increased access to supply of that allow for increased
resources access to resources or the
- Discovery of new resources discovery of new resources
- Fertilisers
- Irrigation
Labour + entrepreneurship - Increase in birth rate - Education
- Immigration - Training
- Decrease in the natural rate - Re training
of unemployment - Apprenticeship programmes
Capital - Investment - Technological advancements
that contribute to more
efficient capital
- Research and development

Supply side policies are designed to increase LRAS, also known as the full employment level of output.
Advantages of supply-side policies
Lower inflation – shifting aggregate supply (AS) to the right will cause a lower price level. By making the economy
more efficient supply-side policies will help reduce cost-push inflation.
Lower unemployment – supply-side policies can help reduce structural, frictional and real-wage unemployment
and therefore help reduce the natural rate of unemployment.
Improved economic growth – supply-side policies will increase economic growth by increasing AS.
Improved trade and balance of payments – firms will become more competitive so they will be able to export
more.

There are two kinds:

1. Interventionist policies: government has a fundamental role to play in actively encouraging growth
2. Market based policies: increase the incentives for labour to work harder and more productively and to increase
the incentives to firms to invest and to increase productivity.

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 Unit 16 – Macroeconomic equilibrium

Short run equilibrium output

The economy is in short run equilibrium where aggregate demand equals short run
aggregate supply. There is no inflationary or deflationary pressure. Unless nothing
changes to influence AD or AS, the economy rests at this equilibrium.

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The multiplier effect (KEYNESIAN)
- If a government is planning to intervene to try to fill a deflationary gap, it must
Try to estimate the gap between equilibrium output and full employment output
Have some estimate of the value of the multiplier so as to be able to inject into the economy in order to
fill the gap
- If a government decides to fill a deflationary gap by increasing its own spending, the final increase in aggregate
demand will be greater than the amount of spending.
- Any increase in AD will result in a proportionately larger increase in national income.
- Government spending and business investment are injections into the circular flow of income and any injections
are multiplied through the economy as people receive a share of the income and then spend a part of what they
receive.
- During each “round”, some income is withdrawn from the circular flow (marginal propensity to withdraw (mpw)
= marginal propensity to save (mps) + marginal rate of taxation (mrt) + marginal propensity to import (mpm))and
some stays to be re spent (marginal propensity to consume (mpc))
- Any change in any of the withdrawals from the circular flow will result in a change in the economy’s multiplier. If
the taxation rate increases, for example, then the value of the multiplier will fall. If the marginal propensity to
import falls, then there will be an increase in the multiplier.

For example, a government spends $100 million on a school building project, so $100m ends up as income in the pockets
of people who provide the factors of production for the building project. Some of the income goes back to the government
as taxes (mrt = 20% for example), some of it is saved (mps = 10%), some of it is spent on foreign goods and services (mpm
= 10%) and the rest is spent on domestically produced goods and services (mpc = 60%, for example). This last expenditure
goes to another group of people, who pay taxes, save and buy imports and then spend the rest on domestic goods and
services.

Unit 17 - Low unemployment

Unemployment: The situation that exists when the number of people who are actively looking for work exceeds
the number of jobs available.
The number unemployed people: Those working age individuals who are without work, but who are available for
work at the current wage rates an actively seeking for one.
The labour force: Those in employment plus those unemployed, the economically active population.
The labour market represents the demand and supply for all labour in the economy.
The unemployment rate: The number unemployed expressed as a percentage of the total labour force (not the
whole population).
Flow concept: Unemployment is a flow. The number of people unemployed may stay the same, but the actual
people involved will always be changing as some people gain jobs and others lose them.
The pool of unemployment (number of people that are unemployed) is in constant change, at any given time
people are becoming unemployed while others are gaining employment.

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 Y axis: price of labour

ADL: total demand for labour at every given average wage rate. At a lower wage level,
producers are more willing to take on more labour. ADL is dependent on AD in the
economy, if AD falls, fewer workers are needed to produce.

ASL: total number of an economy’s workers that are willing and able to work in the
economy at every given wage rate. As the average wage rate increases, more people
are willing and able to work.

Inaccuracies
When calculating unemployment, there may be inaccuracies in such data and there may be inconsistency in the definitions
across different countries

It can be calculated based on:

The people who are registered as unemployed (as in Austria, Switzerland)

The number of people who are claiming unemployment benefits (Britain, Belgium) - A person who is not entitled
to any benefits is not likely to register as unemployed.

Hidden unemployment
People who have been unemployed for a long period of time and have given up the search for work. Since they
are no longer looking for a job, presumably they lost hope and are no longer unemployed.
People who have part time work but would really prefer to be working full times.
People who are working in jobs for which they are greatly over qualified. Such people would like to find work that
utilizes their skills and pays higher income, but must stay in the lower skilled job as it is better than no job at all.

Distribution of unemployment
Unemployment rate establishes an average for a whole country, and this is very likely to mask inequalities among different
groups in an economy:

Geographical disparities: inner city unemployment might be a bit higher than suburban or rural unemployment
Age disparities: unemployment rates in the under 25 age group are higher than the national averages
Ethnic differences: ethnic minorities offer suffer from higher unemployment rates than the national averages in
many countries. This may be the result of differences in educational opportunities or possibly due to attitudes
and/or prejudices of employers
Gender disparities: unemployment rates among women have tended to be much higher than rates for men in
many industrialized countries. This may be because of differences in education, discrimination by employers.

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 Costs of unemployment
The costs of unemployment increase the longer that people are unemployed.

Costs to the economy

The actual output of the economy is below the potential output, within its production possibility curve, and the
output lost can never be regained. Loss of output due to underuse of scarce resources
The longer people remain unemployed, the more deskilled they become. This reduces potential output.
The government loses tax revenues, since lower incomes pay less direct tax and spend less money (indirect tax)
The government incurs extra costs of supporting the unemployed, even if it is only in terms of administrative costs.
Spending more money to solve the social problems created by unemployment or paying unemployment benefits
(Opportunity cost)
Greater disparity in distribution of income (a lower proportion of the population receives the larger proportion
of the income
Costs to society
Poverty
Homelessness
Increased gang activities
Possible higher levels of crime, violence and vandalism
Increase indebtedness
Costs to individuals
There is a direct financial cost to the unemployed themselves, measured as the difference between their previous
wage and any unemployment benefit received. (loss in standard of living)
There are personal costs for the unemployed in terms of stress related illness and family problems caused by the
strain of being unemployed.
Higher levels of suicide
Possible loss of updated skills
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 Causes of unemployment

Disequilibrium unemployment
Disequilibrium unemployment: occurs when there are any conditions that prevent the labour market from clearing that
is, reaching the labour market equilibrium.

1. Real-wage (classical) unemployment trade unions and government

minimum wages interfering with the labour market, pushing wages above the
market-clearing level (from We to W1). This is ab in the diagram above, ASL is
greater than ADL. It prevents the wage from falling to equilibrium, and so there
is excess supply of labour.
Solutions:
If trade unions are preventing the labour market from clearing, then
the government should pass laws to reduce the power of the trade
unions (market based supply side policy).
If the government is preventing the labour market from clearing, then
the minimum wage should be reduced or removed (market-based supply side policy).
This may also be cured by an expansionary demand-side policy, but this does not really cure the actual
cause of the ‘problem’.
Problems:
It is difficult to reduce union power
A reduction in minimum wage will reduce the income and living standards of those workers who are
already earning low wages (lower standard of living)
Greater inequity
2. Demand-deficient (cyclical/Keynesian) unemployment is where unemployment occurs because of a
cyclical downturn in the economy(recession), and so the demand for labour has also fallen
The economy is initially operating at a high level of economic activity, Y1. There is ADL at ADL so the
equilibrium wage will be We for Qe workers.
If AD falls from Y1 to Y2, to reduce their output (cut back on production), firms will reduce their demand
for labour from ADL to ADL1.
If labour markets functioned perfectly, then the average wage would fall to W1 (c)
Wages are “sticky downwards”: while workers’ wages can easily increase, it is less likely that real wages
will fall because:
- Firms realize that paying lower real wages is likely to lead to discontent and reduce motivation
among workers
- Firms may not be able to reduce wages due to labour contracts and trade union power
Since wages are likely to remain “stuck” at We, the ASL will be greater than the ADL and unemployment
a –b will be created

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 Solutions: The government can intervene to bring about an increase in AD through the use of an expansionary
fiscal or monetary demand side policy to close the negative output gap
The government could use fiscal policy by increasing AD itself through increased government spending
Lower indirect and direct taxes to indirectly increase consumption by households and investment by
firms
The central bank could use monetary policy by decreasing interest rates or increasing money supply
Problems: Risk of inflation

Equilibrium (natural) unemployment

Equilibrium unemployment: Unemployment that exists when there is no general
disequilibrium in the economy.

It can only be cured by supply side policies, which shift the LRAS curve to the right.
Designed to make people more able to take vacant jobs, or encourage them to
be more willing to take the available jobs.
When the labour market is in equilibrium, the number of job vacancies in the
economy is the same as the number of people looking for work
But at any given wage rate, there will be more people looking for jobs than those
who are actually willing and/or able to take the jobs.
There are jobs available but a – b people are not willing or able to take the job (job vacancies in the domestic
services industry but the unemployed mechanical engineers are unwilling to take them and so on)
Notice the gap between the ASL and the LF becomes smaller at higher wages
An economy is at full employment when the unemployment that exits in the economy is only the natural
employment

1. Frictional unemployment occurs when people leave their jobs and are unemployed while they are looking for
a new job, or just having a break from working, or they have left education and are waiting to take up their first
job. It is not generally perceived to be a negative outcome in any dynamic economy
Solutions:
Lower unemployment benefits (market-based policy) to encourage unemployed workers to take the jobs
that are available rather than allow them the chance to wait for a better one to come along
Improving the flow of information from potential employers to people looking for jobs: internet job sites,
newspapers, job centres, employment counsellors (interventionist policy)
2. Seasonal unemployment occurs when the demand for labour fluctuates with the seasons of the year.
Solutions:
Improve information flows so that people can find jobs in the off-season,
Give grants to encourage growth of industries that work in different seasons (interventionist policies)
Lower unemployment benefits (market-based policy).
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 3. Structural unemployment: occurs when there is a permanent fall in demand for a particular type of labour,
as a result of the changing structure of an economy.
- Long term unemployment as people who lose their jobs in one area lack the necessary skills to take on the
newly created jobs, they lack the occupational mobility to change jobs.
- If the changes cause unemployment in a specific geographical region, then this is known as regional
structural unemployment. People lack the geographical mobility.
- Demand deficient unemployment is caused by an overall fall in the demand for all labour in the economy,
structural unemployment is caused by a permanent fall in the demand for one type of labour
- Demand deficient unemployment caused by a lengthy period of economic activity could result in structural
unemployment.
Causes of structural unemployment (This may be a change in the pattern of demand, or a change in the methods
of production)
- New technologies can make certain types of labour unnecessary: technological unemployment
- Demand for a particular type of labour may fall due to lower cost labour in foreign countries.
- Changes in consumer taste (more green energy less demand for coal, coal miners unemployed)
Solutions:
Interventionist and market based supply side policies

Problems:
Interventionist policies have high opportunity costs
Only effective in the long term
Lower living standards in market based policies
Inequity
Worse working conditions for labour in market based

Problems with the solutions for unemployment

In order to use expansionary fiscal policy, a government may have to run a budget deficit and spend more than it
takes in revenues
If government reduces taxes, there is no guarantee that people will spend their extra disposable income
If governments reduce interest rates to encourage spending there is no guarantee that it will have the desired
effect on increasing consumption and /or investment
If consumer or business confidence is low then there is unlikely to be an increase in borrowing to finance
consumption and investment
Even when successful, there is likely to be a lag before they come into effect. It is possible that AD will increase,
but by the time that it does, the economy may have been already recovered, and the extra impetus can then be
inflationary
At full employment, the economy is producing near full capacity. Increases in aggregate demand at this point
would result in inflationary pressure
As it’s difficult to distinguish which unemployment is occurring (or more than one), the government apply a mix
of demand and supply side policies. Example: manipulate interest rate to narrow possible business cycle
fluctuations and output gaps, and to make labour more suitable and skilled and flexible to changes in jobs.

Crowding out
Occurs when governments run budget deficits in order to stimulate an economy and reduce unemployment. To run a
budget deficit the government has to borrow money.

New classical economics say that if government borrows money in order to inject extra fund in the economy
(expansionary fiscal demand side policy) then interest rate will increase provoking a decrease in the private sector
spending or investment and that will offset the expansionary effect
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 To run a budget deficit, the government has to borrow money. They do this by selling government bonds to financial
institutions who then sell them on to people who want to save their money. They are increasing demand for the savings
or loanable funds that are in the economy.

The increase in demand from D1 to D2 for savings in order to finance a deficit results in an increase in the interest rate
from I1 to I2.
The government wished to increase AD by increasing government spending, but the higher interest rate causes interest
sensitive private investment to fall, thus reducing AD.
Keynesian economists say that it will not occur if the economy is producing at less than the full employment. New
classical economists, who are opposed to the use of demand management policies, argue that crowding out is a
significant problem of increased government spending: Monetary criticism of Keynesian expansionary fiscal policy
(multiplier effect)
Crowding out depends on the type of government spending. If its capital spending (infrastructure) then it has a positive
effect in private businesses (better transport, communications, etc.). It lowers costs so they are more productive,
economic growth is accelerated.
If there is a budget deficit financed with foreign debt, domestic interest rate won’t increase in the short term but, these
can bring problems in the long run.

Unit 18 - A low and stable rate of inflation

Inflation: a persistent increase in the average price level in the economy making the value of money fall.
Inflation rate: It is usually measured by governments using a retail price index (RPI). The rate of inflation is the
percentage increase in that index over the previous 12 months.
Inflation measures: Inflation is sometimes measured using other prices, such as commodity prices, food prices,
house prices, import prices, and so on.

Disinflation: inflation grows at a lower rate than before; average price level still rises but at a smaller amount

How is inflation measured?

Through the consumer price index CPI
- They choose a representative “basket” (A list of the typical consumer goods and services consumed by the average
household and measure how the price of this basket changes over time. When the price of the basket increases
this means that the average price level has risen.

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 - Some of the goods and services consumed are far more important than others, because they take up a larger
share of consumer’s income. Categories are given a weight in the index to reflect their importance in the average
consumer’s income.
- The components and the weighting of the basket are determined by surveys of household spending habits and
will change according to changes in consumer habits.
Commodity price index: tracks changes in raw material prices. Upwards movement in commodity prices are
signals of cost – push pressures and may lead inflation.
Producer price index: tracks the price of goods as they leave the factories and before distributors, wholesalers, or
retailers add their profit margins.

Issues involving the measurement of inflation

The purchasing habits of different people will clearly vary greatly, the basket only represents a “typical” household
There may be variations in regional rates of inflation within a country.
There may be errors in the collection of data that limit the accuracy of the final result. The larger the sample, the
more accurate the result will be, but this is time consuming and very costly.
If the items in the basket are changes, then this limits the ability of analysts to make comparisons from one time
period to another. The quality of goods change over time; the price of a computer may rise but it reflects
improvement not inflation
Countries measure their rate of inflation in different ways and include different components. This can make it
problematic to make international comparisons
Prices may change for a variety of reasons that are not sustained

Causes of inflation

Demand-pull inflation
When inflation originates from aggregate demand rising, associated with a booming economy. If AD shifts to the right
from AD1 to AD2, due to changes in any components of AD, firms will respond by raising prices from P1 to P2 and output
from Q1 to Q2.

How much prices rise will depend upon the slope of the SRAS curve. The steeper the
SRAS curve, the more prices will rise and the less output will increase. The SRAS
curve will tend to be steeper as actual output gets closer to potential output.

It is a counterpart of demand-deficient unemployment. When the economy is in

boom, demand deficient unemployment will be low, but demand-pull inflation will
be high. In a recession the opposite occurs.

Solution
Deflationary fiscal policy (increase direct taxes and reduce government spending)
Deflationary monetary policy (raise interest rates and reduce the money supply)
Supply side policies to increase production and avoid inflation

Cost-push inflation
This is when inflation originates from an increase in the costs of production. It is also known as supply-side inflation.

The rises in costs may have different origins. The origins enable us to differentiate different types of cost-push inflation.

Wage-push inflation is where trade unions push wages up, independently of the demand for labour.

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 Import-price-push inflation is where import prices rise independently of the level of AD, e.g. the oil price rises of
2007.
Tax-push inflation is where increased taxation adds to the cost of living, e.g. when VAT was raised from 15% to
17.5%.
The exhaustion of natural resources is where major natural resources become depleted and so their prices rise
and the AS curve shifts to the left, e.g. with the gradual running down of North Sea oil production for the UK or
with sea pollution and thus falls in fishing stocks.

SRAS shifts to the left from SRAS1 to SRAS2. If firms face a rise in costs, they will respond
by raising prices from P1 to P2 and passing the costs on to consumers, and by cutting
back on production from Q1 to Q2.

The less elastic (steeper) the AD curve, the more prices will rise and the less output will
decrease. Producers are able to pass on more of the cost increases. With cost push
inflation, output and hence employment tend to fall.

Solution
Deflationary demand-side policies may be used, but they will result in lower national output and are likely to cause
unemployment to rise.
Thus, demand-side policies are ineffective and supply-side policies are appropriate. However, when inflation does
occur, it is difficult to distinguish between the demand-pull and cost-push factors, and so policy makers are likely
to use a mixture of solutions.

Inflationary spiral (demand pull and cost push inflation together): the problem of inflation is that it tends to perpetuate
itself

1. If we assume that the economy is near full employment then the increase
in AD results in an increase in demand pull inflation as the price rises from
P1 to P2.
2. The higher price level means that costs of production rises. Also because
the price level increases, workers will negotiate for higher wages and this
further increases the cost of production.
There will be a shift in the short run AS from SRAS1 to SRAS2 as a result of
cost push pressures
3. Higher wages may give households the illusion that they have more
spending power and this might encourage further increases in
consumption

Stagnation: period of time of high inflation rate and high unemployment rate

Inflation due to excess in monetarist (new classical)/ due to monetary growth:

Excessive increase in money supply in a government
Increase in money supply = increase in aggregate demand = inflation

There is too much money chasing too few goods. Monetarists say that increases in the money supply result in higher AD
from AD1 to AD2. Because the economy rests at the full employment level of output in the long run, such increases in AD
due to increases in the money supply are purely inflationary.

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Solutions
The money supply should only increase by the same amount as the real increase in national output.
Supply side policies (market orientated/free)
As it’s difficult to know which type of inflation is happening, a mix of solutions should be applied

Solutions of inflation
A reduction in government spending will inevitably impact upon a variety of groups in the economy and this may result in
less support for the government. It takes a long time for a government to bring about a change in its fiscal policy.

Higher interest rates mean higher loan and mortgage repayments and will therefore be unpopular.

Greater independence for central banks and inflation targeting, many countries have successfully prevented high inflation
from occurring.

As long as people have faith in the central banks’ ability to contain inflation, then they will not expect higher rates of
inflation. If they do not expect higher inflation then they will not make demands for increases in wages any higher than
the expected rate of inflation and this will keep the costs of labour from rising excessively. This suppresses cost push
inflationary pressure.

Nowadays, monetary policy is considered to be the most effective way of managing AD in the economy and changes in
interest rates are considered the best weapon in the fight against inflation. Fiscal policy is not seen to be as effective. It
would be very difficult for governments to reduce their spending because of their commitments to the public.

Deflationary demand side are likely to cause unemployment to rise. Demand side policies are ineffective and supply side
policies are the appropriate policies to deal with cost push inflation. A mix of solutions is needed.

The responsibility for managing AD might be the best left with the automatic stabilizers of fiscal policy and the careful
changes in monetary policy carried out by an independent central bank.

Consequences of inflation
Loss of purchasing power: if your income remains constant then you will not be able to buy as many goods and
services as you could before the increase in average price level, there is a fall in real income which reduces living
standards. Expectations about inflation are important; incomes can be negatively affected if the actual rate of
inflation turns out to be higher than the expected rate.
Effect on savings: it discourages savings, people choose to buy fixed assets and benefits those who borrow. If you
save with 4% annual interest and the inflation rate is 6%, then the real rate of interest will be negative and your
savings will not be able to buy as much as they could have the previous year.
Effect on interest rates: if there is a high rate of inflation then banks raise their nominal interest rates in order to
keep the real rate that they earn positive.
Effect on international competitiveness: if a country has a higher rate of inflation than that of its trading partners
then this will make its exports less competitive and will make imports from lower inflation trading partners more
attractive. There will be fewer export revenues and greater expenditure on imports, thus worsening trade balance.
The outcome depends upon the price elasticity of demand (PED) for exports and imports.
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 Uncertainty: firms may be discourages from investing due to the uncertainty associated with inflation, this has
negative implications for economic growth since there is a tendency not to invest.
Labour unrest: this may occur if workers do not feel that their wages and salaries are keeping up with inflation. It
may lead to disputes between unions and management.
It redistributes wealth to those with assets, e.g. property, that rise in value particularly rapidly during periods of
inflation.
Resources are wasted in coping with the effects of inflation, e.g. constant re-pricing, accountants and other
financial experts having to be employed by companies in order to cope with the uncertainties.

Deflation: a persistent fall in the average level of prices in an economy this will make the value of money rise.
Causes of deflation
Good deflation is productivity-driven and comes about as costs and prices are pushed lower by improvements in
productivity. An increase in the LRAS can result in an increase in real output and a fall in price level. There be a
lower level of unemployment.

Bad deflation reflects a sharp slump in demand, excess capacity and a shrinking money supply (as in the USA in
the 1930s). A fall in AD will result in a decrease in the price level, real output and employment.

Solution
This only really applies if the deflation is ‘bad’ deflation, and then there is a need for demand-side policies, as described
above, to shift the AD curve to the right, thus reducing the downward pressure on prices. Although this will expand the
economy and improve employment, it may also lead to inflation, if the process goes too far.

Consequences of deflation
Unemployment: firms hire less employees because consumers (decrease in aggregate demand) defer
consumption, there is less production. This can lead to a deflationary spiral. If prices are falling, consumers will
put off the purchase of durable goods as they will want to wait until the prices drop even further. This will further
reduce AD.
Effect on investment: businesses make less profit, or make losses. This may lead to unemployment and business
confidence to decrease so less investment. His has negative implications for future economic growth.

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 Costs to debtors: anyone who has taken a loan suffers as a result of deflation because the value of their debt
rises. If profits are low, this may make it too difficult for businesses to pay back their loans and there may be
many bankruptcies. This will further worsen business confidence. However, it benefits lenders.
It may improve the balance of payments, depending upon the price elasticity of demand for exports and imports.
Interest rates tend to be very low.
It redistributes wealth from those with assets to those who are earning high incomes or who have high cash
balances.

The inflation-unemployment trade off debate

Philips curve
Shows the inverse relationship between the inflation rate and the unemployment rate of an economy. As one variable
increases, the other decreases.

The economy is initially in equilibrium at Y1, at a price level of P1. If the government feels there is too much
unemployment at this point, then it might use Keynesian demand management techniques to bring about an increase
in AD, from AD1 to AD2. This will result in an increase in output, which h is produced by hiring more workers, so
unemployment is assumed to fall. However, there is also a higher price level, inflation. A decrease in unemployment
occurs at a cost of higher inflation. This would be like the movement from A to B.

High inflation and high levels of unemployment is known as stagflation. According to the Philips curve, the two problems
should not worsen simultaneously and so the model became under attack.

Long run Philips curve

There is no trade-off between inflation and unemployment. This is consistent with the explanation of the new classical
LRAS.

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 1. The economy is in long run equilibrium at point A on the SRPC. The government decides they want to reduce
unemployment and so adopt an expansionary demand side policy.
2. AD would increase and this would lead to an increase in the demand for labour and so an increase in wage levels.
However, at the same time, there would be an increase in the inflation rate, in this case to 6%.
3. In the short run there would be a fall in unemployment as workers who had not been prepared to take jobs at
existing wage levels before are now attracted by what they think are higher wages and the economy moves from
A to B. however these are higher nominal wages and real wages have not risen (money illusion).
4. When the workers realize that their real wages have not risen, then they leave the jobs and unemployment goes
back to the natural rate but now at an inflation rate of 6%.
5. Now that inflation is running at 6%, people will expect prices to continue to rise at 6% and negotiate an equivalent
increase in wages, so the economy will be at point C, on SRPC2.
6. Unemployment has returned to its natural rate at a higher rate of inflation. The natural rate of unemployment is
the unemployment rate that is consistent with a stable rate of inflation. Any attempt to use expansionary policies
again to reduce the unemployment below this natural rate will only result in higher inflation (C to D to E) and a
move to another short run Philips curve, SRPC3.

The long run Philips curve (LRPC) is vertical at the natural rate of unemployment (NRU). At any given point in time, there
may be a short run trade-off between inflation and unemployment, but the economy will always return to unemployment
at the natural rate. Governments cannot reduce this rate by using demand management policies. The natural rate of
unemployment is the unemployment that occurs when the economy is at full employment and the labour market is in
equilibrium.

Supply side policies, not demand management policies, are the solution for reducing the natural rate of unemployment.
Supply side policies will reduce the natural rate of unemployment and shift the LRPC to the left from LRPC1 to LRPC2.

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Demand side policies may be appropriate for reducing cyclical demand deficient unemployment, but not for reducing the
frictional, seasonal and structural unemployment that make up natural unemployment.

Differences of NRU between countries are due to a number of things including the availability of unemployment benefits,
trade union power, the extent of labour regulations, and wage setting practices by firms. Make labour market reforms to
reduce unemployment, they are usually referring to measures that will reduce the natural rate.

Unit 19 - Economic Growth

Economic growth: an increase in real GDP over time.

Economies face periodic fluctuations in economic
activity and growth rates, known as the business cycle.

Consider an economy which is operating with a

deflationary gap (less consumption than what can be
supplied, a fall in economic growth or negative economic
growth), this would be equivalent to the economy
operating at a point a.

The economy’s resources are not being used to the

fullest possible extent.

If AD increases from AD1 to AD2, then the deflationary gap would be removed and there would be an increase in real
output (more employment of resources/factors of production) from Y1 to Y2, equivalent to a movement from a to b. The
economy will not be on its PPC (potential output) since an economy will never employ all resources to the fullest extent
possible, there is natural unemployment. This is solved through expansionary demand management policies which will
narrow the fluctuation in the business cycle.

The increase in real output is an increase in real GDP, so there has been economic growth. This economic growth was
achieved by making better use of its existing resources and increasing GDP by moving towards the full employment level
of output.

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Economic growth can also occur in the long term as a result of increasing the full employment level of output or potential
output.

There is an increase in GDP as a result of the shift of the LRAS, equivalent to and outwards shift of the PPC.

This comes as a result from an increase in quantity or an increase in quality of an economy’s factors of production and
advances in technology, and may come about through market forces or government supply side policies (either
interventionist or market based.

The trend growth line shown on a business cycle diagram is influenced by the supply side policies that generate long term
economic growth.

Positive consequences of economic growth:

When the economy grows, pushing out the AS curve, economies can experience non-inflationary growth from a
to b. more labour will be needed to produce the higher level of output, so unemployment should also fall.

Increase in standards of living

- Since economic growth is an increase in national output, this is equivalent to an increase in national income. If
GDP per capita increases it depends on population growth, then the income of the average person would increase.
- Contributes to great leaps in technology, leading to advances in several areas such as medicine, transportation,
making life easier and more pleasurable.
- Higher incomes lead to greater tax revenues, and this may make it possible for the government to spend more on
merit and public goods.
Tax systems could reduce income inequalities

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 Economic growth that comes as a result of higher productivity may also bring about an improvement in the
competitiveness of a country’s exports, leading to further increases in AD.
As national income rises, so do levels of education and human capital and, with it, greater demands for freedoms
and democracy.

Negative consequences of economic growth:

AD tends to increase steadily as population size and income grow. Without supply side improvements to shift out
the LRAS, AD would increase more than the AS and there would be inflation
The drive for economic growth and higher incomes may result in poorer standards of living
- Sacrificing leisure time and neglecting personal relationships
- The more people earn the more goods and services they want and are therefore never satisfied
There may be structural unemployment as the economy may move from the primary to the secondary to the
tertiary sector with economic growth, and even within the sectors there may be changes.
Inequalities may widen
Rapid economic growth results in higher emissions of greenhouse gases, higher national income may result in
higher levels of households waste.
Depletion of non-renewable resources
Economic growth may come at the expense of sustainable development. (The extent to which this occurs may be
diminished if the more educated and wealthier citizens demand policies and develop technologies that promote
sustainability.

Unit 20– Equity

Reasons why incomes may be low and so people live in poverty:

- They may have been born into a household where incomes are low
- Poor or no education
- May have suffered in terms of poor health care and malnutrition
- They may have found it necessary to find work before completing an education

Consequences of poverty
- Low living standards
- Lack of access to sufficient health care
- Low levels of education
This leads to low levels of human capital and that in turn makes it likely that people will continue to be poor, it is cyclical.

Equity means fairness. Governments attempt to redistribute income to make the distribution fairer. They are not
aiming for equality, where everyone would receive the same income since, this would destroy the incentive to work harder
for many people.

Market systems result in some degree of inequality – demand and supply in labour markets mean different levels of
income. The degree of inequality may be measured using the Gini index and Lorenz curve.

Lorenz curve
It takes data about household income gathered in national surveys and represented them graphically.

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Households are ranked in ascending order of income levels and the share of total income going to groups of households
is calculated.

For example, if we look at Brazil, we see that the poorest 20% of households receive only 3% of total household income
while the richest 20% of the households receive 58.7%. This contrasts with Croatia, where the data suggests more equality
in distribution, with the poorest 20% receiving 8.8% of total household income and the richest 20% receiving 27.9%

The line of absolute equality indicates a perfectly equal distribution of income.

Each country has its own Lorenz curve based on income data. The further away a country’s curve is from the line of
absolute equality, the more unequal is the distribution of income.

While low income countries tend to have higher levels of inequality than high income countries, there is no hard and fast
correlation between the level of development of a country measured by its HDI and Gini index. Moreover, it would not be
correct to assume that it is necessary to have more equality in order to raise living standards. If the national income rises
and the income distribution pattern remains the same, then the poorest will receive a larger amount, even if their share
remains the same. They get the same proportion of a larger amount.

Taxation

Direct tax: Tax paid on income. Households pay income tax, businesses pay corporate tax. (Macroeconomics) these
taxes are unavoidable, because households and firms are obliged to declare their full income to governments and pay
taxes on it accordingly.

Indirect tax: Expenditure tax on goods and services, e.g. IVA in Argentina. It is shown as a decrease in supply.
(Microeconomics) Consumers who buy the goods pay the tax to the seller, or producer, who then pays the tax to the
government, this tax can be avoided. Governments vary the rate of indirect tax.

Progressive tax: A system of direct taxation where tax is levied at an increasing rate for successive bands of income.
The marginal tax rate is higher than the average tax rate.

Usually there’s a certain amount of income that is not taxed, so a person earning low income might pay no taxes at all.
Tax deductions allow people to reduce their “taxable income” as a result of spending on certain things. For example, if
a worker must travel a long distance to work, and this costs $1000 a month, the government might allow the person to
deduct the amount of tax that she pays. The government might do this because it feels that this will encourage people
to find work and lower unemployment.

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In progressive taxes, marginal rates are greater than average tax rates

Regressive tax: The higher the income, the lower the average rate of tax paid. All indirect taxes are regressive. A higher
proportion of income is paid at lower levels of income. Regressive taxation refers to a system of taxation in which tax is
levied at a decreasing average rate as income rises.
For example, a 1 euro tax on a package of cigarettes will make up a lower proportion of income for a high-income person
than for a lower-income person.
Direct taxes are never regressive. (Macroeconomics)
Regressive taxes may be a good source of government revenue and they might discourage the consumption of demerit
goods, but they can worsen income inequality.

Proportionate tax: A system of direct taxation where people at all income levels pay the same average tax, e.g. all
people pay 15% of income. (Macroeconomics) (Flat tax)

Arguments against higher taxes.

A key feature of the market system is incentives. Higher taxes may create a disincentive effect because if people
know that higher income means that they have to pay higher marginal rates of taxes, then they may not be
motivated to work harder and get better-paying jobs.
There is likely to be less entrepreneurial activity without the incentive of higher incomes. Since entrepreneurship
is one of the factors of production, then this will have negative supply side effects on the economy.
If businesses earn higher profits and this puts them into a higher tax bracket, then they have less incentive to
invest to increase capacity.
There might be a brain drain as high-skilled people leave the economy to go to work in places where they don’t
pay such high taxes. It may be difficult for the country to attract foreign direct investment, since multinationals
will prefer to work in countries where taxes are lower.

This may be referred to as the ‘efficiency versus equity’ argument. Higher taxes may result in greater equity, but the
negative consequence might be a less efficient allocation of resources.

Taxes used for:

Transfer payments
Governments can use tax revenues to redistribute income and provide different types of assistance to groups
in the economy to improve standards of livings. Payments made to increase the income of particular groups
within the economy: child support assistance, unemployment benefits, and pensions.
Government expenditure to provide essential goods and services
They use their tax revenue to provide directly, or to subsidize, a number of goods and services that are socially
desirable, merit and public goods, with positive externalities. The provision is carried out to ensure that the
poorer members of the economy have access to essential goods and services and so leads to economic
development.

Evaluation of redistribution of income policies

Economists who support new classical (capitalism USA) point of view argue against the active role of government in
redistributing income since it interferes with market forces and results in inefficiencies. Optimal allocation of resources
occurs in free market and so government taxation must be kept to a minimum. They might argue that:
- If firms have to pay insurance and social security costs for workers, then this will encourage firms to hire fewer
workers, thus contributing to unemployment
- High taxes in a country might discourage entrepreneurial activity and even encourage entrepreneurs to leave a
country in search of more favourable tax climates

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 - High taxes have negative effects on overall growth in the economy since lower taxes will encourage economic
activity leading to an overall increase in output that will be to the benefit of all people.
A free market view might argue that taxes should be used to finance the obligations of the government to ensure poverty
rights, reduce the effects of market failure, provide an effective security and judicial system, and promote competition,
but taxation should not be used to redistribute income.

Distribution of income
Short run
- The government uses a mixture of progressive taxes coupled with a system of transfer payments
- Social health insurance aims at increasing the income of low income strata, this will lead to economic
development
Long run
- The most effective way of satisfying equity is by improving quality and access to education and health care for
the most deprived income groups by job creation, lower corruption, and a fair judicial system.

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 INTERNATIONAL ECONOMICS

Unit 21 – Why do countries trade?

International Trade is the exchange of goods and services between countries.

Gains from International Trade (Disadvantages of Protectionism)

- Lower prices than the domestic ones
- Consumers have a greater choice, the quality and variety of goods available to consumers increases
- Imports may be resources that a country needs in order to produce other products but does not have
- The market will increase, it will turn worldwide (more demand) so the level and size of production will increase
hence economies of scale may arise (more efficiency) or specialization increases
- Increased competition should lead to greater efficiency
- Countries which are best at the production of certain products will be able to produce these gods and services at
the lowest cost and take advantage of their efficiency
- It is a source of foreign exchange since exported products are paid in foreign currencies, this then enables them
to use that foreign exchange in order to buy imports
- Can lead to economic growth

Absolute Advantage
An individual, firm or country uses less resources to produce a unit of output than others. So the country is most efficient
at producing something.

Country Lamb (kg) Cloth (m)

Australia 6 1
China 4 3
Total without trade 10 4

Australia has an absolute advantage producing lamb and China has an absolute advantage producing Cloth. The output of
both products will be maximized when the countries specialize and, after trading, both countries will gain. Total output of
both goods will rise following specialization.

Comparative Advantage
A country is said to have comparative advantage in the production of a good if it can produce the good at a lower
opportunity cost than another country.

Country Wine (L) Opp.Cost of 1 L of wine Cheese (kg) Opp.Cost of 1 kg of cheese

France 3 4/3 Kg of Cheese 4 3/4 L of Wine
Poland 1 3 Kg of Cheese 3 1/3 l of Wine

France has an absolute advantage in the production of both goods. However, France has a comparative advantage in the
production of wine and Poland has a comparative advantage in the production of cheese. This is because Poland´s
opportunity cost to produce 3 kg of cheese is 1/3 of wine whereas of France, it is 3/4 (in order to produce 4 kg of cheese,
I have to give up 3 L of wine) France has a higher opportunity cost in the production of cheese. The lower the opportunity

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cots, the higher the comparative advantage. France should specialize in the production of wine and Poland in the
production of cheese.

Comparative Advantage for the better producer (France) given in the distance
between the PPC which is greater (a)

France´s line is above Poland´s, it has absolute

advantage in both productions

Comparative advantage for the worse producer,

the less efficient one (Poland) given in the distance
between the PPC which is smaller (b).

The slopes of the lines show the opportunity cost.

The diagram 21.2 shows two equal opportunity
cost, in this case there are no gains made by trading, it makes no sense to trade.

What gives a country comparative advantage?

It is based on a country´s factor endowment. For example, a country with beautiful beaches and a favorable climate may
develop comparative advantage in the output of tourist services.

The abundance of a particular factor will make the price of this factor relatively lower than the price of other factors,
thereby allowing the opportunity cost of the goods or services using that factor to be lower than it would be in other
countries.

Limitations to the theory of Comparative Advantage:

- The producers and consumers have perfect knowledge and are aware where the least expensive goods may be
produced
- There are no transport costs
- There are two economies that produce only two products
- The goods being traded are identical
- Constant costs
- Factors of production remain in the country
- There is free trade (no barriers to enter or exit the market)

The World Trade Organization (WTO)

The WTO is an international organization that sets the rules for global trading and resolves disputes between its member
countries. The WTO was established in 1995 and now has 149 members. (Average world tariffs for manufactured goods
have declined from approximately 40% to 4%.)

The aims of the WTO are to administer WTO trade agreements, to be a forum for trade negotiations, to handle trade
disputes among member countries, to monitor national trade policies, to provide technical assistance and training for
developing countries and to cooperate with other international organizations.

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 Unit 22 – Free trade and protectionism

Free Trade
Trade that takes place between countries when there are no barriers to trade set by governments or international
organizations.

0Q1 will be supplied by domestic market in local producers.

Q1 Q2 will be supplied by foreigners.

Demand will be 0Q2.

Price will be Pw.

Protectionism
Setting trade barriers by the government to restrict or reduce trade, protecting local industries and stimulating import
substitution. They can be market based or non-market based.

Arguments for protectionism

To protect domestic employment (local industries cannot compete with foreign competition, this may lead to
structural unemployment) – this argument is not very strong, since it is likely that the industry will continue to
decline and that protection will simply prolong the process.
To protect the economy from low-cost labor (manufacturing workers in developed countries fear they will lose
their job to workers in emerging countries such as China and India because of cheap labor which creates cheaper
products)
To protect an infant (sunrise) industry (DEFINICION LUCIANO END OF BOOKLET) – developing countries, without
access to sophisticated capital markets (no economies of scale yet which increase efficiency), can use the infant
industry argument to justify protectionist policies.
To avoid the risks of over-specialization (the country could become over dependent on the export sales of one
or two products, ant change in the world´s market for these products might have serious consequences on the
economy.)
Strategic reasons, e.g. in times of war – in many cases, it is unlikely that countries will go to war or, if they do, that
they will be completely cut off from all supplies. Then, it is likely that the argument is being used as an excuse for
protectionism.
To prevent dumping (Dumping: The selling by a country of large volumes of a commodity, at a price lower than
its production cost, in another country.) – It is very difficult to prove whether or not a foreign industry has actually
been guilty of dumping, or whether there is just a comparative advantage.
To protect product standards – a valid argument, as long as the concerns are valid.
To raise government revenue – not an argument for protectionism, but a means of raising government revenue.
To correct a balance of payments deficit – this will only work in the short run.

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Types of Protectionism
1. Tariff
A tax that is charged on imported goods. In the case of a tariff, it will shift the world supply curve upwards (Sworld to
Sworld + tariff), since it is placed on the foreign producers of the good and not the domestic producers.

Domestic producers are able to sell more (0Q1 to OQ3) at a higher price (Pw
to Pw+T) and domestic employment will increase, their revenue also
increases (g to g,h,a,b,c). Domestic consumers will pay higher prices and
consume less. The government will receive revenue from the tariffs paid by
the foreign producers (d,e). The foreign producers end up selling less (from
Q1 Q2 to Q3 Q4) at the same price because the increase in price is due to the
government, revenue decreases (from h,I,j,k to i,j) . This will affect
employment in the foreign countries.

There is a dead-weight loss of consumer surplus for domestic consumers (f)

and there is a dead-weight loss of welfare, because inefficient domestic
producers take the place of efficient foreign producers (c).

2. Subsidy
An amount of money paid by the government to a firm, per unit of output. In this case, the government is giving a subsidy
to domestic producers to make them more competitive and so the effect will be to shift the domestic supply curve
downwards (from S domestic to S domestic + subsidy) by the amount of the subsidy.

Domestic producers are able to sell more (from 0Q1 to 0Q3) at a higher
price (they receive Pw + subsidy) and domestic employment will
increase, revenue increases. Domestic consumers will consume the
same amount (0Q2) at the same price (Pw). The government will have to
find the money to pay the subsidies. The foreign producers end up selling
less (from Q1 Q2 to Q3 Q2) at the same price. This will affect employment
in the foreign countries.

There is a dead-weight loss of welfare, because inefficient domestic

producers take the place of efficient foreign producers (g). However,
there is no loss in consumer surplus, demand is met, but there is an
opportunity cost.

3. Quota
A physical limit on the numbers or value of goods that can be imported into
a country. For example, the EU imposes import quotas on Chinese garlic and
mushrooms.

Domestic producers are able to sell more (from 0Q1 to 0Q1, 0Q3 0Q2) at a
higher price and domestic employment will increase. Domestic consumers
will pay higher prices (from Pw to Pquota) and consume less (from 0Q2 to
0Q4). The foreign producers end up selling less (from Q1 Q2 to Q1 Q3) at a
higher price. This will affect employment in the foreign countries.

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There is a dead-weight loss of consumer surplus for domestic consumers (k) and there is a dead-weight loss of welfare,
because inefficient domestic producers (h) take the place of efficient foreign producers.

Non Market Based

4. Administrative barriers
a- When goods are being imported, there are usually administrative processes that have to be undertaken. This may
be known as dealing with ‘red tape’. If these processes are lengthy and complicated, then they can act as a
restriction to imports.
b- Health and safety standards and environmental standards – this is where various restrictions are placed upon
the types of goods that can be sold in the domestic market, or on the methods used in the manufacture of certain
goods. These regulations will apply to imports and may restrict their entry.
c- Embargoes – in effect, an embargo is an extreme quota. It is a complete ban on imports and is usually put in place
as a form of political punishment. For example, the USA has a trade embargo on products from Cuba. Complete
embargoes are rare.
5. Nationalistic campaigns
Governments will sometimes run marketing campaigns to encourage people to buy domestic goods instead of foreign
ones in order to generate more demand for domestic goods and preserve domestic jobs.

Unit 23 - Exchange Rates

Exchange rate: The value of one currency expressed in terms of another, e.g. €1 = US$1.42.
Exchange rate regime: the way that a county manages its exchange rate

Types of exchange rate systems

1. Fixed exchange rate

An exchange rate regime where the value of a currency is fixed, or pegged, to the value of another currency, to the average
value of a selection or to the value of some other commodity (for example gold). e.g. the Yuan has been pegged against
the US$ so that US$1 = 6.8275 CNY (China Yuan Renminbi).

Revaluation An increase in the value of a country’s currency

Devaluation A decrease in the value of a country’s currency

Ways of maintaining a fixed exchange rate system:

If supply increased, increase demand

Supply increased (shift of the curve from S1 to S2) and there is excess supply, without
government intervention, the exchange rate will fall. To maintain its fixed exchange
rate, the Barbadian government buys excess supply of its own currency thus shifting
the demand curve from D1 to D2. It does this by using previously amassed reserves
of foreign currencies.

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 If demand increased, increase supply

Demand increases from D1 to D2, this will make the exchange rate rise. To maintain
its fixed exchange rate, the Barbarian government needs to sell its own currency to
satisfy its excess demand thus shifting the supply curve from S1 to S2. This will increase
the Barbarian reserves in foreign currencies.

Another way that the fixed exchange system can be maintained is by making it
illegal to trade currency at any other rate however, black markets may arise from this
imposition.

Advantages of a fixed exchange rate

A fixed exchange should reduce uncertainty for all economic agents in the country. Businesses will be able to plan
ahead in the knowledge that their predicted costs and prices for international trading agreements will not change.
Ensure sensible government policies on inflation.
Reduce speculation in the foreign exchange markets.

Disadvantages of a fixed exchange rate

The government is compelled to keep the exchange rate fixed. The main way of doing this is through the
manipulation of interest rates. However, if the exchange rate is in danger of falling, then the government will have
to raise the interest rate in order to increase demand for the currency, but this will have a deflationary effect on
the economy, lowering demand and increasing unemployment. This means that domestic macroeconomic goals
(low unemployment) may have to be sacrificed.
In order to keep the exchange rate fixed and to instill confidence on the foreign exchange markets, a country with
a fixed exchange rate has to maintain high levels of foreign reserves in order to make it clear that it is able to
defend its currency by the buying and selling of foreign currencies.
Setting the level of the fixed exchange rate is difficult.
May create international disagreement.

2. Floating exchange rate

An exchange rate system where the value of a currency is allowed to be determined solely by the demand for, and supply
of, the currency on the foreign exchange market. It is the equilibrium exchange rate.

Appreciation An increase in the value of a country’s currency

If the dollar appreciated against the euro, the purchasing power for the dollar has risen, a given amount of US$ will buy
more European goods than before.

1US$ could buy 0.80 euros. If a bottle of French wine costs 10 euros, the under the first exchange rate this would be equal
to US$ 12.50. But, if the US$ appreciates to 1US$ = o.85 euros, the bottle of wine falls to US$ 11.77.

Depreciation A decrease in the value of a country’s currency

When the dollar appreciates, the euro depreciates. Before, 1 euro = US$ 1.25 but now, 1 euro = US$ 1.18. This means that
a given amount of euros will buy fewer American goods, purchasing power has been lost.

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 1US$=0.80euros

The demand curve represents the demand for dollars by people who hold
euros.

The supple curve shows the supply of dollars by the US.

The equilibrium price is the exchange rate.

Advantages of a floating exchange rate

As the exchange rate does not have to be kept at a certain level, interest rates are free to be employed as domestic
monetary tools and can be used for demand management policies, such a controlling inflation.
Adjust itself, in order to keep the current account balanced. For example, if there is a current account deficit, then
the demand for the currency is low, since export sales are relatively low, and the supply of the currency is high,
since the demand for imports is relatively high. This should mean that the market will adjust and that the exchange
rate should fall.
As reserves are not used to control the value of the currency, it is not necessary to keep high levels of reserves of
foreign currencies and gold.

Disadvantages of a floating exchange rate

Uncertainty on international markets
In reality, floating exchange rates are affected by more factors than simply demand and supply, such as
government intervention, world events like 9/11 and speculation. This means that they do not necessarily self-
adjust in order to eliminate current account deficits.
A floating exchange rate regime may worsen existing levels of inflation. If a country has relatively high inflation to
other countries, then this will make its exports less competitive and make imports more expensive. The exchange
rate will then fall, in order to rectify the situation. However, this could lead to even higher import prices of finished
goods, components and raw materials, and cost-push inflation, which may further fuel the overall inflation rate.

3. Managed exchange rate

An exchange rate system where the value of the currency is allowed to float, but with some element of interference from
the government. Usually, the central bank sets an upper and lower exchange rate value and then allows the currency to
float within those limits, intervening when the exchange rate moves beyond the limits to bring it back within them.

People will demand, or want to buy, the euro currency in the foreign exchange market in order to:
European goods and services are demanded more. This could be because European inflation is lower than that of
other economies, making European goods more competitive; or foreign incomes have risen; or tastes have
changed in favor of European goods.
European investment prospects improve.
European interest rates increase, making it more attractive to save in European financial institutions.
People think the value of the euro will rise in the future, so they buy it now.

The euro currency will be supplied on the foreign exchange market in order for:
Europeans increase their demand for foreign goods and services. This could be due to the fact that European
inflation is relatively higher than that of other economies, making foreign goods more competitive; or European
incomes have risen; or tastes have changed in favor of foreign goods.
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 Foreign investment prospects look good.
Foreign interest rates increase, making it more attractive to save in foreign financial institutions.
People think the value of the euro will fall in the future, so they sell it now.

Advantages and disadvantages of high and low exchange rates

Reasons for government intervention in the foreign exchange market

lower the exchange rate in order to increase employment
raise the exchange rate in order to fight inflation
maintain a fixed exchange rate
avoid large fluctuations in a floating exchange rate
achieve relative exchange rate stability in order to improve business confidence
Improve a current account deficit, which is where spending on imported goods and services is greater than the
revenue received from exported goods and services.

Methods of intervening in the foreign exchange market:

1- By using their reserves of foreign currencies to buy, or sell, foreign currencies
- Increase the value of the currency needs to decrease demand of its own currency
- Lower the value of its currency needs to increase supply of its own currency
2- By changing interest rates
- Increase the value of the currency, then it may raise the level of interest rates in the country. This will make the
domestic interest rates relatively higher than those abroad and should attract financial investment from abroad.
In order to put money into the country, the investors will have to buy the country’s currency, thus increasing the
demand for it and so its exchange rate
- Lower the value of the currency, then it may lower the level of interest rates in the country. This will make the
domestic interest rates relatively lower than those abroad and should make financial investment abroad more
attractive. In order to invest abroad, the investors will have to buy foreign currencies, thus exchanging their own
currency and increasing the supply of it on the financial exchange market.

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 Unit 24 - Balance of Payments

Balance of payments is a record of the value of all the transactions between the residents of one country and the residents
of all other countries in the world over a given period of time. (Money entering the country is called credit and leads to a
positive balance of payments, money leaving the country is called debit and is given a negative value)

The current account

1- Balance of trade in goods: A measure of the revenue received from the export of tangible (physical) goods minus
the expenditure on the imports of tangible goods over a given period of time. (surplus= export > import , deficit =
export < import)
2- Balance of trade in services: A measure of the revenue received from the export of tangible services minus the
expenditure on the imports of services over a given period of time.
3- Income: A measure of the net monetary movement of profit, interest and dividends moving in and out of a country
over a given period of time as a result of financial investment abroad.
4- Current transfers: A measurement of the net transfers of money, these are payments made between countries
when no goods or services change hands. (foreign aid and grants, remittances, private gifts)
- Current account balance = balance in trade of goods + balance of trade in services + net income flow + net transfers

The capital account (not a significant effect on the balance)

1) Capital transfers: A measure of the net monetary movements gained or lost through actions such as the transfers
of goods and financial assets by migrants entering or leaving the country, debt forgiveness, and transfers relating
to the sale of fixed assets, gift taxes, inheritance taxes, and death duties.
2) The net international sales and purchases of non-produced, non-financial, intangible assets. For example land or
the right to natural resources, patents, copyrights, brand names, etc.

The financial account is a measure of the buying and selling of assets between countries. It measures the net change
in foreign ownership of domestic assets.

1) Direct investment: a measure of the purchase of long-term asses, where the purchase is aiming to gain a lasting
interest in a company in another economy. For example the buying of a property, purchasing a business or stocks
or share all expecting to have a positive return in the future but there is no guarantee of this.
2) Portfolio investment: a measure of stock and bond purchases, which are not direct investment since they do not
lead to a lasting interest in a company. (treasury bills and government bonds)
3) Reserve assets: the reserves of gold and foreign currencies which all countries hold and which are itemized in the
official reserve account.

Current account = capital account + financial account + net errors and omissions

Current account and the exchange rate

Import > export – more people buy foreign currency and sell the national one – more supply of national currency –
depreciation

Fixed exchange rate system

In the short run the deficit may be covered by the government using reserve assets, but in the long run these will run out
so exchange rate will have to be depreciated.

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If there is a surplus in the balance of payments, in the short run, this may be offset by increasing reserve assets (buying
excess demand). But in the long run, other countries will be unhappy with the artificially low exchange rate and demand
higher rates or implement protectionist measures against the country´s exports.

Floating exchange rate system

The deficit implies there is an excess supply of the currency in the foreign exchange rate markets. Because of less demand
for exports and for the national currency and an increase in demand for imports and the foreign currency. When the
exchange rate falls, it improves competitiveness of the country´s exports and increasing the domestic price for imports.
With a surplus, the opposite occurs.

Consequences of a current account deficit

Capital account in surplus to balance the current account deficit

1- Foreign exchange reserves may be used to increase the capital account but eventually these will run out
2- A high level of foreigners buying domestic assets may be financing the current account deficit. This is based on
foreign confidence in the domestic economy but if it is lost, this will devaluate the money, it is also a threat to
economic sovereignty.
3- A high level of borrowing, with high interest repayments, may be financing the current account deficit.

Consequences of current and capital account surpluses

1- The country can have a deficit on capital account by building up reserves or purchasing assets abroad.
2- The surplus usually leads to an appreciation of the currency, which makes imports cheaper, reducing inflation, but
exports more expensive, leading to unemployment.
3- There may be increased protectionism from other countries.

A current account deficit or surplus is placed in context of the country´s GDP. The burden of a deficit depends on the ability
to pay.

Methods of correcting a persistent current account deficit

1) Expenditure-switching policies: any policies designed to attempt to switch the expenditure of domestic consumers
away from imports towards domestically produced goods. For example, the government could introduce policies
to depreciate or devalue the value of the currency, and thus make imports more expensive, reducing demand for
them, (Success depends on the PED for import) or apply protectionist measures, such as tariffs, quotas, embargoes
and legal restraints, but these measures may lead to retaliation, may be against WTO agreements, and they also
encourage domestic producers to be inefficient hence not a good long term solution.

2) Expenditure-reducing policies: policies designed to attempt to reduce overall expenditure in the economy, thus
shifting aggregate demand to the left, and reducing the demand for all goods and services, including imports
(Success depends on the marginal propensity to import). Deflationary demand-side policies are used (fiscal
(increase in direct taxes and/or reducing government expenditure) and/or monetary (higher interest rates and/or
reducing the monetary supply). However, although import expenditure may be reduced, the policy is also likely
to lead to a fall in domestic employment and a fall in domestic employment. This is probably too big a cost to pay
for external balance.

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Marshall Lerner condition
The effect of a price change on expenditure or revenue depends on elasticity of demand.

The Marshall Lerner condition tells us how successful a depreciation or devaluation of a currency´s exchange rate will be
as means to improve a current account deficit in the balance of payments.

PED exports + PED imports > 1 (elastic)

If there is a devaluation, this means cheaper exports and more expensive imports. If PED for exports is elastic, an increase
in price will lead to a less than proportional increase in demand so expenditure increases. If PED for imports is elastic, a
decrease in price will lead to will lead to a more than proportionate increase in demand so expenditure decreases.

J- Curve
If the Marshall Lerner condition is satisfied, in the short run, the current account gets worse before it gets better since
PED is inelastic in the short run, since it would take time for other countries to realize that the prices have fallen or they
have entered into contracts. Purchasers of imports will also take time to find new suppliers or may also be tied to contracts.
From point y onwards, the Marshall Lerner condition is satisfied.

Unit 25 - Economic Integration

Economic Integration describes a process whereby countries coordinate and link their economic policies. It can be either
between two countries (bilateral) or several (multilateral).

Trading bloc is groups of countries that join together in some form of agreement in order to increase trade between
themselves and/or to gain economic benefits from co-operation on some level.

1. Preferential trading area (PTA) is a trading bloc that gives preferential access to certain products from certain
countries.

2. Free trade area is an agreement made between countries, where the

countries agree to trade freely amongst themselves, but are able to trade
with countries outside of the free trade area in whatever way they wish, e.g.
NAFTA.

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 3. Customs union is an agreement made between countries, where the countries agree to trade freely amongst
themselves, and they also agree to adopt common external barriers against any country attempting to import into
the customs union e.g. Mercosur.

4. Common market is a customs union with common policies on product regulation, and free movement of goods,
services, capital and labour, e.g. EU.

5. Economic and monetary union is a common market with a common currency and a common central bank,
e.g. the Eurozone. It is advisable when there are high fluctuations between the exchange rates of the countries
involved.
Advantages of monetary unions
Exchange rate fluctuation disappear
The currency is more stable against speculations
Business confidence improves which may lead to internal growth and trade growth
Transaction cost when changing currencies are eliminated
Prices may equalize across borders since price differences are more obvious
Disadvantages of monetary unions
Countries are no longer fee to set their own interest rates and so the tool of monetary policy I no longer
an option to influence the inflation rate, unemployment rate, and the rate of economic growth.
Some countries will be more fiscally irresponsible than others and this may threaten the stability of the
union
Individual countries are not able to alter their own exchange rates in order to affect international
competitiveness of exports
The initial costs of converting the individual currencies into one currency is very large

6. Complete economic integration: individual countries involved would have no control of economic policy, full
monetary union, and complete harmonisation of fiscal policy.

Advantages of trading blocs

Greater size of market with the potential for larger export markets
Increase competition leading to greater efficiency
More choice
Lower prices for consumers
Stimulus for investment due to large market sizes
Foreign investment attracted from outside the bloc
Greater political stability and cooperation.

Disadvantages of trading blocs:

Enact discriminatory policies against non-members
Damaging negotiations in the WTO
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Trade creation
Occurs when the entry of a country into a customs union leads to the production of a good or service transferring from a
high-cost producer to a low-cost producer. It is an advantage of greater economic integration. Welfare gain, because fewer
resources are being used to produce the product.

Trade diversion
Occurs when the entry of a country into a customs union leads to the production of a good or service transferring from a
low-cost producer to a high-cost producer. This represents a misallocation of the world’s resources and represents a
disadvantage of economic integration. World welfare loss because more resources are being used to produce the product.

Unit 26 - Terms of Trade

The TOT is an index that shows the value of a country’s average export prices relative to their average import prices.
𝑤𝑒𝑖𝑔ℎ𝑒𝑑 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑥𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒𝑠
𝑇𝑂𝑇 = 𝑤𝑒𝑖𝑔ℎ𝑒𝑑 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑚𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒𝑠
× 100

If the value of TOT increases, there has been an improvement. If it decreases, there has been a deterioration. If the TOT
improves, then a given quantity of exports will buy a larger quantity of imports than before.

Short-run causes of changes in the TOT

Changes in conditions of demand and supply. This will affect the price
Changes in relative inflation rates. If inflation rate is one country is higher than in another, their export prices will
begin to rise.
Changes in exchange rates. Change in the price of exports relative to imports
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Long-run causes of changes in TOT
income changes (more demand for luxury goods, the same for necessity goods)
long-run improvements in productivity within a country
Deterioration of the TOT since real prices will not rise significantly
long- run improvements in technology within a country
This will cause lower costs of production hence lower prices so a deterioration in the TOT.

Price elasticity of demand for exports

If the demand for exports is elastic, then a change in the average price of exports will lead to a greater proportional change
in the demand for them so revenue increases. Commodities have inelastic demand.

Price elasticity of demand for imports

If the demand for imports is inelastic, then a change in the price of imports will lead to a smaller proportional change in
the demand for them.

How good is an improvement in TOT?

It depends where it comes from.

1- If it is from an increase in the demand for a country’s exports, then it is always a good thing and more will be
demanded at a higher price. This leads to an improvement in the current account balance.

2- If it is from higher export prices caused by domestic inflation, then it will depend upon the elasticity of demand
for exports. For most products, demand is elastic on the foreign trade markets, because they are very competitive.
Thus, if export prices rise through inflation, there would be a relatively large fall in demand and thus a fall in total
export revenue. This leads to an improvement in the current account balance when the demand for exports is
inelastic.

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Many developing countries, but certainly not all, are heavily dependent upon the exports of one or two commodities for
their export revenue. There has been a long-term downward trend in commodity prices for many years. There are a
number of reasons for this

improvements in the technology of their production (supply)

discovery of synthetic replacements for natural commodities (demand)
income inelastic demand for commodities from developed countries (demand)
protectionist policies in developed countries (supply)
miniaturization of products, so less requirement for commodities to make and package the goods (demand)

Both demand and supply increase but price falls

The deterioration in the TOT for developing countries that depend on commodities has several harmful
consequences.

o Developing countries have to sell more and more exports in order to buy the same amount of imports. This is bad
enough, but in order to do this, the developing countries then increase supply and this tends to push commodity
prices down even more. We have a vicious circle.

o Many developing countries have high levels of indebtedness. Falling export prices and thus export revenue makes
it harder to service their debt. Indeed, in extreme cases, this leads to countries having to increase their borrowing,
thus increasing their levels of indebtedness. Another vicious circle. This vicious circle links to the previous one. In
order to pay back their debts, many countries have had to increase their output of the commodities in which they
have a comparative advantage. This increases the supply and drives the prices down.

o In order to increase the supply of commodities and gain more export revenue, some developing countries have
overused their resources, resulting in negative externalities such as land degradation, desertification, soil erosion
and massive deforestation. This is clearly not sustainable in the long run.

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 DEVELOPMENT

Unit 27 – Economic development

Economic Development: Can be seen as a process of expanding the real freedoms that people enjoy. Development
requires the removal of mayor sources of unfreedom: poverty as well as tyranny, poor economic opportunities as well as
systematic social deprivation, neglect of public facilities as well as intolerance or over activity of oppressive states.

Luciano DEF= Broad concept associated with the standards of living of a community (country) usually measured through
a series of indicators such as life expectancy, infant mortality, literacy rates…

Sources of Economic Growth:

Quantity Quality
PAGE 44!!!
Natural new factors of production better methods of production
encouraging immigration and better health and education, more
Human Capital
higher birth rates training programs
Savings, domestic investment,
government involvement, foreign higher education, research and
Physical
investment (capital widening). development, access to foreign
Capital and
More extraction if natural technology and enterprise (capital
technological
resources, more factors of deepening)
production.
infrastructure, good international relationships
Institutional banking system, structured legal system, good education system,
political stability

Capital widening: Exists when extra capital is used with an increased amount of labour, but the ratio of capital per worker
does not change. Total production rises, but productivity is likely to remain unchanged.

Capital deepening: This exists when there is an increase in the amount of capital for each worker. This means that there
have been improvements in technology, and will usually lead to improvements in labour productivity as well as increases
in total production.

Economic growth occurs when there is an increase in the real output of an economy over
time. Stated above are the sources of economic growth either due to an increase in quantity
or quality of factors of production. If this occurs, the PPC (fig 1.1) will shift outwards, from X
to X1 and Y to Y1. Point Z1 will now be possible, potential output Z now increased to a new
potential output, point Z1. An actual output increase requires a movement of the current
point of actual output towards the new PPC, for example from V to W. So if V moves to W
and then to Z over time, economic growth has been achieved.

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 Does economic growth lead to economic development?
Economic development: the increased standard of living. Increasing their freedoms, reducing poverty and hunger, public
provision of education, health care, the maintenance of law and order, guaranteeing civil liberties, the opportunity of civic
participation, more provision of water or sanitary facilities, social care, more environmental sustainability.

Higher incomes: higher levels of economic growth lead to a higher GDP which may lead to a higher standard of
living but economic development is only achieved if income is equally distributed. (yes)
Improved economic indicators of welfare: economic growth in several cases leads to a higher life expectancy,
more years of schooling, higher literacy rates however, this is not necessarily the case for all sections of the
population. (yes and no)
Higher government revenues: an increase in the GDP leads to an increase in government revenue from taxation
which should lead to an increase in the provision of services like health care and infrastructure. (yes)
Creation of inequality: an increase in the level of economic growth, leads to an increase in GDP which in several
cases increases inequality. The gap between the rich and the poor is said to grow, since the rich get the majority
of the gains. (no)
Negative externality and lack of sustainability: economic growth usually leads to more pollution, soul
degradation, deforestation, reduction in bio diversity, global warming because of the increasing needs for energy;
all these are negative externalities of consumption and production. Market prices of goods and services do not
reflect the full cost to society and the environment. If consumption and production rates continue there will be
several consequences brought by an ecological unbalance such as: less access to safe water, tropical diseases
spreading further north, more droughts and flooding, less food production in the tropics and subtropics, a rise in
sea level. (no)

However, nowadays economic growth is commonly unsustainable; creating negative externalities therefore in
several cases doesn’t lead to economic development.

- Uneconomic growth: when increases in production come at an expense in resources and well-being that is
worth more than items made.

Common characteristics of developing countries

Low standards of living, characterized by low incomes, inequality, poor health, and inadequate education
Low levels of productivity. The main cause are the low education and health standards and the lack of investment
in physical capital and access to technology
High rates of population growth and child dependency burdens (high birth rate and low life expectancy). However,
developed countries have high old age dependency ratios (low birth rate but high life expectancy). People who
work (between 15 and 64) have to maintain these people.
High and rising levels of unemployment (10% - 20%) and underemployment.
- Unemployed for so long that they have given up searching for a job and no longer appear as unemployed.
- Hidden unemployed, those who work for a few hours in the day on a family farm or in a family business or trade
of some sort, and so do not appear as unemployed.
- Underemployed, those who would like full time work, but are only able to get part time employment, often on
an informal basis.
If all these are considered, an employment of about 50% is estimated.
Substantial dependence on agricultural production and primary product exports.
Prevalence of imperfect markets and limited information. Developing countries lack many of the necessary
factors that enable markets to work efficiently, lack a functioning baking system, which enables and encourages
saving and the investment. They lack a developed legal system, which ensures that business takes place in a fair
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 and structures manner. They lake adequate infrastructure. They lack information systems for both producers and
consumers, which often leads to imperfect information, the misallocation of resources and misinformed
purchasing decisions.
Developed countries generally tend to dominate these countries (economic and political power), creating
dependency (one trade, access to technology, aid, investment) and vulnerability from part of the developing
countries since they are so dependent and dominated by them.

Diversity among developing countries:

Developing countries display notable diversity in a number of areas:

Resource endowment: it is assumed that they must be poorly endowed with resources, both physical and human.
However, it is common for the human resources to be undernourished and poorly educated and thus low skills,
endowment in terms of physical resources can vary immensely between developing countries, a lack of physical
resources does not necessarily mean that a country cannot be successful. (Ex: Angola has oil and diamonds.
Bangladesh, poor physical resources)
Historical Background: a large proportion of developing countries were once colonies of developed countries.
However, this varies greatly. Much depends upon the length of time that these countries were colonized and
whether the eventual independence was given freely or had to be fought for. Some countries gained some positive
outcomes from colonization such as Singapore but others not so much such as Angola. Whatever developing
country we consider, there will be marked historical differences that will set the countries apart from each other
socially, politically, and economically.
Geographic and demographic factors: developing countries differ hugely in terms of geographical size and in
terms of population size. China is big while Jamaica is small. China approx. 1,330 million while Fiji less than one
million.
Ethnic and religious breakdown: developing countries have a wide range of ethnic and religious diversity. High
levels of ethnic and religious diversity within a country increases the chances of political unrest and internal
conflict. Ex, Angola with several religions while Jamaica which is more homogenous.
The structure of industry: it is widely assumed that all developing countries depend upon the production and
exportation of primary products. Whilst this may be true for many, developing countries such as Angola, may be
typical of many, in terms of primary product export dependence, but other countries such as Bangladesh are
exporters of manufactured products and other such as Maldives are mainly exporters of services, in the form of
tourism.
Per capita income levels: it is often thought that all developing countries have very low levels of income per capita,
we should be aware that there are marked differences in per capita income from developing country to developing
country. Malaysia has a GDP per capita (PPP US$) of $13,518 while Sierra Leone $679.
Political structures of developing countries:
- Democracies such as Brazil, Indonesia
- Monarchies such as Brunei, Tonga
- Military rule, such as Myanmar and Pakistan
- Single party states, such as China, Cuba, Syria
- Theocracies, such as Iran
- Transitional political systems, here a country is in transition, often caused by conflict an civil war, an so cannot
be classified such as Haiti or Somalia
Within each of these structures there are sub structures.

The problem is that, since developing countries are so diverse, it is very difficult to establish one size fits all
solutions to developmental problems. In conclusion we can say that, while there are some common
characteristics that are held by developing countries to a certain degree, there are also several significant
differences. One must be very cautious in making generalizations that imply that all developing countries are
the same.
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 International development goals:
Millennium development goals were adopted in 2000 with the aim of being achieved by 2015. Each country has tailored
the MDG’s to suit specific development needs.

Each goal is supported by a number of quantifiable targets that in turn are measured by specific indicators.

Unit 28 – Measuring development:

Poverty can be measured in two ways:

Relative poverty: comparative level of poverty. A person is said to be in relative poverty if they do not reach some
specified level of income. It depends on where the specified level of income is set hence on who sets it, it is a
relative concept. Relative poverty defined in terms of society in which an individual lives, differs between countries
and over time.
Absolute poverty: the amount that a person needs to have in order to live, basic necessities satisfied. Purchasing
power parity is used to make comparisons of this around the world. Below US$1.25 per day. The same in all
countries and does not change over time.

Poverty trap is any linked combination of barriers to growth and development that forms a poverty cycle, thus self-
perpetuating unless the cycle can be broken.

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 Single Indicators:
Single indicators are solitary measures that may be used to assess development.

Financial measures
1- GDP (economic activity in a country) and GNI (economic activity of national firms only) per capita measure
growth and/or development:
Developing countries usually have GDP>GNI (firms move abroad for cheaper labour). Developed countries
on the other hand GNI>GDP (because of FDI and remittances). In India in 2008 FDI was of 4 billion dollars.
If a country has a large amount of FDI then its GDP figures will be significantly higher than its GNI figures,
since they will include profits that may well have been repatriated.
2- GDP per capita figures and GDP per capita figures at PPP:
Purchasing power of a person´s income will be different in different countries since goods and services
don’t cost the same worldwide.
Purchasing power parity exchange rate attempts to equate the purchasing power of currencies in different
countries. It is calculated by comparing the prices of identical goods and services in different countries.
(Big Mac index)
Health measures
1- Life expectancy at birth: average number of years that a person may expect to live from the time that they
are born.
High life expectancy may mean:
Good level of health care and health services
Provision of clean water supply
Adequate sanitation
Provision of nationwide education
Reasonable supplies of food
Healthy diets and lifestyles
Low levels of poverty
Lack of conflict (civil war)
2- Infant mortality rate: average number of deaths of babies under the age of one year per thousand live
births in a given year. It will be affected by factors that affect life expectancy.
Education measures
1- Adult literacy rate: proportion of the adult population, aged 15 or over, which is literate (can read and
write), expressed as a percentage of the whole adult population for a country at a specific point in time.
2- Net enrolment ratio in primary education: number of children of primary school age who are enrolled in
primary school, to the total number of children who are of primary school age in the country.

Composite Indicators –
Composite indicators combine a number of single indicators with weighting, to give a single, combined figure:

HDI was developed to measure levels of development, HDI looks at three variables:
1. Standard of living (income adjusted to local costs of living i.e. purchasing power)
2. Life expectancy at birth
3. Adult literacy rate and primary, secondary, and tertiary school enrolment rate
The HDI calculations score all countries between 0 and 1. Higher values represent more development. Norway
had an HDI of 0.971 while Sierra Leone of 0.365.
If we compare a country´s GDP and HDI we see the country´s success in translating the benefits of national income
into achieving economic development.

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 Gender-related development index (GDI) it is the HDI adjusted for gender inequality. Inequality between men and
women will result in a GDI figure that is lower than its HDI
Gender empowerment (GEM): it reveals whether women can take active part in the economic and political life. It
exposes gender inequalities. It tracks the percentage of women in parliament, among legislators and professional
and technical workers, and gender disparity in earned income reflecting economic independence. The closer to 1
the value, the higher the level of empowerment for women. Norway has a GEM of 0.837 while Yemen of 0.127.
If a country has a low GEM value in relation to GDI, this would imply that the access to basic needs, education,
and health is not necessarily being translated into greater opportunities and participation for women.
Human poverty index (HPI): proportion of people who are deprived of the opportunity to reach a basic level in
each area. It is useful for observing how evenly the benefits of development are spread within a country. It is
expressed as a percentage, with a higher percentage indicating a greater level of deprivation, this a higher level
of poverty.
Genuine progress indicator (GPI) attempts to measure whether a country´s growth, which is simply an increase in
the output of goods and services, has actually led to an improvement in the welfare of the people.
To the GDP figures it
- Adds a measure of non-monetary benefits. Household work, parenting, volunteer work.
- Deducts costs of economic growth. Environmental (global warming, acid rain, ozone depletion), social
(crime, loss of leisure time, family breakdown), commuting costs, costs of automobile accidents.

The GPI It is all difficult to measure. Economists are constantly looking for ways to measure the consequences of growth
so that developed and developing countries can aim for growth that is equitable and sustainable since an increase in GDP
does not mean an increase in welfare.

Unit 29 –Domestic factors and economic development

Domestic factors and economic development

There are many domestic factors that can act as sources of economic development or as barriers to development if they
are not present. They are part of the institutional framework of a country. Institutions in a country are the structure that
humans impose on human interaction, and therefore define the incentives that determine the choices that individuals
make that shape the performance of societies and economies over time.

Institutional factors affecting development

1- Education: Improvements in education improve the well-being of the ones who study and the society as a whole,
generating external benefits. Besides leading to a more efficient work force, it also makes people better at reading and
communicating with each other, creating space for debates. This can lead to social change, including the following
benefits.

2-Improve the role of women in society: women gain power through education, and the child survival and fertility rates
are higher when women are educated. Also, it is said that the participation of women in politics and economy leads to
development.

3-Improve levels of health: as people are more educated, they can communicate better and have knowledge of diseases
or health conditions that might affect them.

One of the development goals is to make all the children, boys and girls, finish their primary schooling in the entire world.
Although there have been improvements, still a lot of children are not able to be educated, especially in Africa and Asia.

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The provision of education costs a lot of money that might not be available in all the countries. Also, the money that is
directed to education is often unequally distributed, as the urban areas have more funds than the rural areas. Also, many
children do not go to school because they come from poor families where the mothers and fathers are not educated, and
also the children are needed for work to help support the family. Moreover, enrolment in secondary school is even lower,
as teenagers have to work to get money to live,

4-Health Care: High levels of health care, ideally combined with high levels of education, will lead to an improvement in
the levels of economic development. Life expectancy, for example, will have a positive correlation with GDP, as countries
that spend a higher proportion of their GDP on healthcare will have people who are better taken care of and live longer.

There has been a lot of progress in healthcare, especially in the provision of clean water, the training of doctors and nurses
and the building of new public hospitals and clinics. There has been a fall in infant and maternal mortality, and life
expectancy has increased. Still, in the poorest countries, very few people have access to a proper water supply, decent
doctors and nurses, and preventive measures, such as vaccines.

5-Infrastructure: Infrastructure is the essential facilities and services such as roads, airports, sewage treatment, water
systems, railways, telephone, and other utilities that are necessary for economic activity. For example, better roads
allow children to go to school and adults to get to their jobs and to the market, where they buy goods and insert money
into the system. A good radio and television allow people to communicate and get in touch with other communities. Gas
and electricity are important in houses for cooking and food preservation. Also, sewage treatment and a good water supply
help preserve people’s health. Some examples of infrastructure are:

Transport: roads, seaports, airports, sidewalks

Public utilities: electricity, water supply, gas supply
Public services: police, firemen, education, hospitals
Communication services: radio, television, post office

6-Political stability and lack of corruption: Countries with political stability are those more likely to get Foreign Direct
Investment (FDI) that leads to economic growth, and aid that lead to development. Political stability means that people
trust the government because it is structures, long-term, and the laws are reliable and apply to everyone.

Political instability causes uncertainty, and in extreme cases, economic breakdown. It leads to a poor economic
performance, high levels of poverty and low standards of living, besides the fact that FDI and aid are not likely to get.

Corruption is the dishonest exploitation of power for personal gain. It challenges both growth and development, and it
is when:

Governments are not accountable to the people

Governments spend large amounts of money in large scale projects
Official accounting practices are not well formulated or controlled
Government officials are not well paid
Political elections are not well controlled of non-existent
Legal structure is weak
There is no freedom of speech

These thing appear most likely in developing countries. There are many types of corruption, like bribery, extortion, fraud,
patronage, influence peddling and nepotism. This will affect growth and development for different causes

If the elections are not properly done, the government will not rule for the majority because they were not voted by them.
This will result in the needs of the people not being met.

Corruption reduces the power of the legal system, because if money can save people from punishments, they will go on
breaking the law.
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Corruption leads to market failure and a misallocating of resources. If they go to the one who pays higher bribes but not
to the most efficient producer, they are being misallocated and there is a sustain of inefficient producers.

Bribes increase the costs of businesses, in cash and in time management, increasing the prices of what is produced.

It reduces trust in the economy, so there will be less FDI

The government takes money from public investment and puts it in capital projects that are not important like education,
so the services of the government are less efficient.

Officials are not strict on regulations, so, for example, the environment can be damaged.

Money obtained from corruption often leaves the country, leaving less for internal investment

Paying small bribes is not good for the citizens as it reduces their economic well-being

7-Legal system: An honest and effective legal system is essential for development. If not, there is no way to produce and
maintain contracts and property rights that are essential to legal rights. They are:

The right to own assets like land and buildings

The right to do whatever we want with our assets, like add sanitation
The right to benefit from our asset, like renting them
The right to sell our assets
The right to choose who can use our assets

This allows people to benefit from private property, but only if there is a guarantee that it will not be taken away. If not,
people will not invest because they would be at risk of losing all the investment, and growth together with development
would be reduced.

8-Financial system, credit, and micro-finance: Financial institutions are essential for economic development, but they are
not often present in developing countries. These countries have dual financial markets. Financial markets are the
institutions where lending and borrowing is carried out. In developing countries, the official institutions are controlled
by foreign banks and only lend money to big established businesses, often abroad. The unofficial markets are illegal, and
they are not controlled. These markets lend money at very high interest rates to poor desperate people who need the
money.

Saving is important to be used, later, in investment that is essential for growth and development. Still, in countries where
the financial institutions are not trustworthy, saving is very difficult, since there is no guarantee that the money will be
regained. This is why people that want to save buy assets, causing the money to be frozen and not circulating in the
system, or invest outside the country, leading to capital flight.

In developing countries, it is very difficult for poor people to get access to financial institutions and banks, as they do not
have job, savings, or an asset to act as collateral. This is why, even if they are willing to start a business, they cannot do it
because they don’t have money. To solve this problem, it exists micro-finance that gives the poor financial services, like
small loans, saving accounts, insurance and cheque books.

The provision of small loans is known as micro-credits. They originated in developing countries as a way of giving poor
people an opportunity to start a small business called micro-enterprises, such as roadside kiosks, bicycle repair services,
or knitting. The loans give protection from seasonal problems, and may help families to get a stable income and escape
poverty. Usually, loans are given to women as they are more likely to pay back. Also, women are the ones who take care
of their children, so if a mother escapes poverty, her children will do so as well, allowing them, for example, to go to
school.

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9-Taxation: Taxes give the government the money to finance the public services, like education and healthcare, and to
improve the infrastructure of the country. Still, these things are difficult to finance if people do not pay the taxes. In
developing countries, only 3% of the population pays the taxes they must. This can be related to the fact that there is a
very poor administration and control of taxes. Also, corporate tax revenues tend to be low because there is little corporate
activity in developing countries. Lastly, the main source of tax revenue is from exports and imports, but they are only
effective and enough for the government if the country is heavily involved in foreign trade. So, as said before, problems
administrating the taxes, the lack of information and the pure corruption leads to people evading paying them.

Another important aspect to consider are black markets that are not controlled by the government, so they are not taxed.
For example, the income of someone working in the black market will not be recorded, so no tax will be paid for that
income. This will lead to less revenue for the government that should be invested in the population. Another negative
effect of black markets is that people are not protected from, for example, poorly paid jobs.

10-The use of appropriate technology: Appropriate technology is technology that is appropriate for use with existing
factor endowments. This applies to both production and consumption.

In terms of production, developing countries wanted to modernize and industrialize their output. Still, this was said not to
be appropriate as it did not use what the countries had. In most developing countries, there is an excess of labour supply.
Therefore, the technology appropriate for these countries would be one that makes use of the abundant labour supply.
An example is the nut Sheller. This is a machine that breaks nuts, and it is operated by one worker. Industrially, it gives a
lot of output, and it also generates many jobs, adding to development.

In consumption, an example is the solar oven. It is made from aluminium foil and plastic film, which are very cheap, and
it operates with sunlight, available in most developing countries. This is very positive as it eliminates the need of firewood
to cook and the loss of time finding that wood, and it gives women who cook a better position.

11-The empowerment of women: Giving power to women through education and healthcare is very important to achieve
development. Still, these things do not only help the women themselves, but also the society as a whole. This is seen
below:

The welfare of the families is improved, especially regarding children, as women have more knowledge about
healthcare and diet and the families are better
The education of children improves, as women pass on their knowledge to their kids and they see education as
something important
Because of the two things listed above, the work force in the future of the country will be better
With more power women gain more money that will improve the situations of their families
With better education, women are more concern of contraception, they marry later, and have less kids, reducing
population growth.

12-Income distribution: In developing countries the gap between the rich and the poor is very big. This inequality in the
distribution of income has negative effects, like little saving, because the poor only save a small amount of their money
and low savings means low investment that means low growth. Moreover, the rich control politics and the economy, so
the policies used tend to benefit them and there is no pro-poor growth. Lastly, this inequity relates to the rich moving
large amounts of money out of the economy, like buying goods from abroad and not helping the domestic economy. This
is why it can be said that the inequality in income distribution acts as a barrier to both, growth and development.

Unit 30 –International trade and economic development

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 International barriers to development
1-Over-specialization on a narrow range of products

There are some developing countries that are generating markets for manufactured goods, but most depend on the trade
of primary commodities. If the prices of these commodities increase, the country will be benefitted and have economic
growth, and if the revenues are used to finance health, education and infrastructure, it may even lead to development.
Still, if the prices of these commodities fall, the country will experience deterioration in the economy and they will have
current account deficits. So, unless they can change their pattern of trade, the countries that depend on the export of
primary products will find it difficult to achieve development through international trade.

No matter what the exports are either primary, secondary or services such as tourism, if a country depends on only the
export of one type of products, it will suffer uncertainty in development.

2-Price volatility of primary products (AGROSECTOR)

The price elasticity of demand and supply for commodities is inelastic in the world. Therefore, if there is a minimum change
in the demand or supply for a commodity, there will be large price fluctuations. So, for example, a small increase in supply
would lower a lot the price, and a small decrease in supply would increase a lot the price. This price volatility makes it
difficult for governments and producers in developing countries to plan ahead. As a consequence, less people invest in
companies, affecting growth and the government spending in health, education and infrastructure, affecting negatively
development.

Low PED: they are a necessity, life sustaining

Low PES: limited capability of stock, the time it takes to produce the good.

Government solution to price volatility and price decline.

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Short run problem of the agro sector (P volatility):

1. The Buffer Stock Scheme: It is a government run programme that aims

a stabilizing agro products at appropriate times. It is very expensive
programme that leads to food wastage. In good weather year
conditions, the government would present itself in the market and buy
the quantity ea, at the target price selected as to prevent market forces
from lowering the price to plow. The gov would have to stock these
purchases in gov run storage units (silos). In bad weather years, the
gov. would take from those stock the quantity needed be and bring it
to the market as to prevent market prices to increase to phigh.

Advantages:

This policy achieves the objective of stabilizing prices.

Stable prices imply stable incomes for farmers which might stimulate investment and improve the standard
of living.

Disadvantages:

Very expensive
Everybody pays taxes but only farmers are benefited
Agro products are perishable so faced consecutive good weather years, food might start to rot in the silos.

2. The Guaranteed Price System: It is a Gov. run programme designed to stabilize farmer’s income (not necessarily
he price of agro products) by allowing the market prices to fluctuate and then sending a deficiency payment check
to the farmer to cover the difference between low market price and the target price guaranteed to the farmer.

Advantages:

Stabilizes farmers income

No stocks needed to be accumulated

Disadvantages:

Expensive programme, everybody pays taxes but farmers only get benefited.

Solutions to price decline:

Industrialization: Set of policies designed to stimulate local production of Industrial Products by protecting local
producers from more efficient foreign producers, through any combination of protectionist policies.
Tariffs
Quotas
Subsidies

3-Inability to access international markets

If developed countries imposed protectionist measures against developing countries that do not let them use their
comparative advantages, these will result heavily harmed and they will be limited to gain revenue from foreign exchange.

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If, for example, a government in a developed country gives subsidies to the producers of a primary good, these producers
will be encouraged to produce more and the price of that product in the world will decrease. This is negative for the
producers in developing countries who do not have the access to subsidies, so the products will be dumped in developing
countries, harming their economies. So, small scale producers in developing countries find it difficult to earn a living,
provide for their families, and send their children to school, which is a clear barrier to development.

Another important issue is tariff escalation, where tariffs increase as the products are more processed. A developed
country imports raw materials with low tariffs and then works the goods to produce manufactured ones. Therefore, it sets
high tariffs for manufactured goods, so they do not enter so easily to the country and do not compete with the local
products. Also, these countries import cheap raw materials, process the goods and then exports the finished
manufactured goods to other countries. This is harmful for developing countries as the producers of raw materials will
have little incentive to produce manufactured goods, that will enter other countries with high tariffs and so, non-
competitive. Therefore, it can trap them in producing raw materials.

A final factor that prevents countries to enter foreign markets is that they have non-convertible currencies. These are
currencies that can only be used domestically and that are not accepted for exchange in the foreign exchange markets.
Mostly, developing countries have their currencies pegged to a more acceptable currency, like the US dollar.

The fact that countries have non-convertible currencies mean that trade is less likely to occur, because traders would take
risks if they got involved in trade with a non-convertible currency, as well as in foreign investment. Moreover, non-
convertible currencies can lead to a black market to get other currencies, so the local currency might become unaccepted
and damage local as well as international trade.

4-Trade strategies for economic growth and economic development

Growth strategies are economic policies and measures designed to gain growth, and development strategies are economic
policies and measures to achieve human development, like improve the well-being of people. Economic growth is not the
same as economic development, but it can generate an extra income that, depending on how it is used, may lead to
development. Next, there are strategies to achieve growth and development.

Trade strategies for economic growth and economic development

1-Import substitution

Import substitution is known as Import Substitution Industrialization (ISI), and also as inward-oriented strategy. It says
that a developing country should produce all the good it needs, and the ones it can, domestically instead of importing
them, to be more competitive in the world markets in the future. In order to work properly, there are several conditions
needed

The government needs to adopt a policy that establishes the goods that will be domestically produced. They
usually are goods that need a lot of workers that do not need to be very skilled.

The government should provide subsidies in order to promote the domestic production of goods and encourage
the production

The government should implement protectionist policies so as to keep foreign products outside of the country
and have less competition for domestic products

There are several advantages and disadvantages with ISI

Advantages

ISI protects jobs, as foreign products are less able to compete and local products are needed more

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 It protects local culture and social habits, as the economy is not influenced by foreign countries

It protects the economy and bad habits of multinational corporations

Disadvantages

ISI can only protect jobs in the short-run, as in the long-run there might be a decrease in economic growth and
there might be a decrease in job creation

It might result in locally produced inefficient products, since producers do not have any competition and they do
not worry about competition. Therefore, consumers would be forced to buy inefficient products instead of
choosing from products produced abroad

ISI can lead to high rates of inflation due to domestic aggregate supply restrictions

ISI may cause other countries to gain a bad feeling towards the country that imposes it and the countries might
apply protectionist measures to harm that country with ISI. INTERNATIONAL DISAGREEMENTS

The main countries that imposed these policies were in Latin America and Africa, and although they worked in the 1960s
and 1970s; they began to fail in the 1980s. This was because the governments spent too much money and they couldn’t
repay loans, forcing themselves to ask the IMF for help.

2-Export promotion

Export promotion, also known as export-led growth, is an outward-oriented growth strategy, based on openness and
increased international trade. It is achieved by increasing exports and export revenue to increase GDP and get higher
incomes, leading to growth in domestic and exporting markets. The country focuses on producing and exporting the
products that it can due to its comparative advantage.

In order to achieve this export promotion, the country will need to adopt certain policies

Liberalized trade: open up domestic markets to foreign competition to gain access to foreign markets

Liberalized capital flows: reduce restrictions in FDI

A floating exchange rates

Investment in the provision of infrastructure to enable trade to take place

Deregulation and minimal government intervention

This list is the theoretical package of policies that should appear in a country with export-led growth, but countries do not
apply all of them.

Developing countries might export primary or manufactured products that generate a change in the growth they produce.

Many developing countries depend on the export of primary products. Still, the trend of prices for primary
products has gone down. This combined with protectionist measures imposed by developing countries result in
growth due to the export of primary products very difficult to achieve.

Mostly, this strategy is used by exporting manufactured goods in which the countries have comparative
advantage. These products are based on low-cost labour, with low-skill workers, but as time goes by, the products
change to be more sophisticated, with more skilled workers, achieved with better education.

Still, there are disadvantages that appear from export-led growth

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 As a consequence of the rise of developing countries due to the export of manufactured goods, developed
countries imposed protectionist measures against these goods. This is because the trade unions from developed
countries argued that they could not compete with the low prices of the products from abroad due to their cheap
labour, so the government imposed tariffs, reducing the comparative advantage of the developing countries. Tariff
escalation also reduced the possibility of developing countries to export manufactured goods, so they have to
export primary products or low-skilled manufactured goods instead.

There is a great debate amongst economists in the world because some say that the government must intervene
in order to make a successful country, while some say that the government should not intervene. Still, in countries
that have achieved growth through this strategy have had a lot of government intervention, like providing
infrastructure, subsidizing output, and promoting savings and improvements in technology. Moreover, this
strategy was more effective in countries where the government protected the national industries that were not
able to compete with foreign firms and promoted the industries that were ready for foreign markets. So, there is
a great debate amongst economist, as some say that the intervention on behalf of the government slows down
growth.

If the countries try to achieve their export-led growth by attracting MNCs (Multinational Organizations), taking
the risk of the MNCs getting too much power and lead to problems

It is argued that free-trade export-led growth may increase the inequity in the income distribution, so growth
would be achieved at the expense of development.

3-Trade liberalization

Trade liberalization is the removal, or at least reduction, of trade barriers that block the free trade of goods and services
between countries. It involves the elimination of such things as tariff barriers, quotas, export subsidies, and administrative
legislation.

It is believed that trade liberalization will increase world trade and so developing countries will be able to export the goods
better for its comparative advantage. The WTO is an organization that promoted trade liberalization.

The economist John Williamson said that there were several things that a developing country should implement to achieve
economic growth. One was trade liberalization. The others were

Fiscal discipline, that is, balanced budget

Redirect spending priorities from things like indiscriminate subsidies to basic health and education

Lower marginal tax rates and broaden the tax base

Interest rate liberalization

A competitive exchange rate

Trade liberalization

Liberalization of FDI inflows

Privatization

Deregulation

Secure property rights

These policies are similar to the supply-side policies, and they became known as the Washington Consensus. Still, some
economists criticize these ideas in the movement known as the anti-globalization movement. The people from this
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movement claims that it is a way of MNCs to get into the developing countries and produce goods at very low cost, paying
low wages to the workers, and then sell them at high prices in developed countries. So, trade liberalization is not a way of
achieving growth, but the contrary as it can cause economic crises and increase debt, apart from creating a higher inequity
in the distribution of income and exploitative work, acting as a barrier to development.

4-Bilateral and regional preferential trade agreements

Preferential trade agreements are related to preferential trading areas, as countries give benefits to the neighbour
countries, by diminishing or abolishing barriers such as tariffs. These agreements can be between two countries, that is
bilateral, or between two regional groups, in which case they are regional. It is believed that the more trading agreements
made, the more countries will be able to trade and have economic growth, leading to development.

5-Diversification

A problem that most developing countries have is that they export only one, or maybe two, primary commodities. Now,
many countries are trying to get out of this and diversify their exports from primary commodities to manufactured or
semi-manufactured goods, in order to protect themselves from the fluctuating prices of primary commodities, to stabilize
or increase export revenue, and to increase employment. Also, this will generate more use of technology and a demand
for more skilled workers.

Still, diversification has barriers, such as tariff escalation and a need for more skilled workers in order to produce the
sophisticated products.

6-Development strategies

In developing countries, many workers cannot make a living income and find life very difficult. Fair trade schemes are an
attempt to ensure that producers of food, and some non-food, products in developing countries receive a fair deal when
they are selling their products. If consumers are aware of the conditions of the farmers, they might be willing to buy goods
from the producers that pay a higher price to the farmers.

The Fairtrade Labelling Organization International (FLO) is the one in charge of fair trade in many countries, aiming to help
small farmers and workers. The schemes were used for many years, but they began to be useful when the FLO started
giving a sticker to the products that were produced under the proper conditions established by the organization. By this,
the consumers can know if the product they are buying was produced with Fairtrade and see if what they are paying for
did not involve the exploit of any worker of farmer. The criteria that a trading company must follow to get the International
Fairtrade Certification Mark are

The product must reach the trader with as few intermediates as possible

The product must cost at least the minimum price required by the FLO, that covers the costs of sustainable
production

The producer receives a premium if the product is certified as organic

The trader must be committed to a long-term contract, that will guarantee security to the producer

The producer can request up to 60% of the purchase price put by the trader

If there are small farmers involved, the products must come from producers that are managed democratically.
That is, for example, that it the products come from plantations, the workers must receive a benefit from, for
example, trade unions and there must be no child labour.

The producer must use sustainable farming methods to produce the good

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 The trader must pay a Fairtrade premium to the producer, that will then be controlled to use that money to help
the society in things such as health and education

Some examples of food certified are bananas and coffee and some non-food are cotton and cut flowers. Although the
prices of Fairtrade products are higher than those of non-Fairtrade, consumers will be more able to pay for that higher
price if they know that it will help people. Therefore, Fairtrade is a way of achieving growth and also development.

Unit 31 –Foreign direct investment and economic development

Foreign direct investment (FDI)

FDI is long-term investment by private multinational corporations (MNCs) in countries overseas. This can occur in two
ways. MNCs can either: expand and set new facilities in foreign countries known as Greenfield investment- or buy firms
in foreign countries.

MNCs are attracted to developing countries for several reasons

These countries may be rich in natural resources, and MNCs have the technology to explode them.

There are some developing countries that have great markets, so if MNCs are located in the market, they have
more access to consumers as incomes grow.

Labour is cheaper in developing countries, so the MNCs can produce at lower prices and sell at lower prices to
make more profits

In developing countries, the government regulations are much less severe than in developed countries, so the
MNCs can establish easier and reduce the cost of production. Also, in developing countries the governments give
tax rewards to the foreign companies that invest in order to attract them. In many developing and developed
countries governments have encouraged FDI by, for example, lowering the taxes.

Possible advantages associated with FDI

As we know, a necessary condition for growth is savings, and developing countries suffer form a big savings gap.
FDI may help reduce this gap, thus leading to economic growth

MNCs generate jobs in the country and may even train and educate the workers. This improves the work force,
leading to development

MNCs allow developing countries to gain access to technology and a market expertise, enhancing their
industrialization

Increased employment and earning might influence the local economy that might start generating jobs, improving
the economy and stimulating growth

The governments might gain tax revenue from MNCs to the use in things such as infrastructure, health and
education, leading to development

If MNCs buy companies in other countries, they are injecting money into that country’s flow of income

MNCs can improve infrastructure or make governments do so in order to attract them

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 The MNCs in a country might provide different and better goods and at lower prices for consumers

MNCs can lead to a better allocation of resources worldwide

Possible disadvantages associated with FDI

Although MNCs do provide employment, they often bring their own teams to work and only use the local workers
for basic production jobs and don’t provide any kind of special training

As MNCs are large, they gain power and have benefits like subsidies or lower taxes, so the government has less
budget to spend on the host country. Also, they are accused of having too much power, influencing the decisions
and policies of international organizations like the WTO.

MNCs practice transfer pricing, that is that they sell goods and services from one division of the company in one
country to another division in another country. In this way, they take advantage as they produce in countries with
low taxes and sell in developed countries, damaging the governments in both types of countries. Although
governments have ways of controlling and monitoring this, they are difficult to implement.

MNCs might situate in countries where the control of pollution is not very strict, so they reduce their private costs
but increase the external costs. They might apply the same strategy in countries where labour is not controlled,
so they can exploit the workers and get more profit for themselves.

MNCs might go to a country that has special resources, use them, and then leave. This will result in the country
having its resources taken away to foreigners

It is argued that MNCs use capital-intensive methods (that need a lot of capital) to use abundantly the natural
resources of a country. Still, MNCs should use appropriate technology to allocate efficiently the natural resources,
so if there are many workers, they should use labor-intensive production methods

Mostly, when MNCs buy an industry in a country, they don’t give the owner money to invest in the national
economy, but they give him shares in that MNC, so the money will not get in the flow of income of the country

MNCs can send their profits back to their country of origin, so none of them is seen in the local market

So, FDI can be said to be positive, but only if the government of the country where MNCs try to appear can control them
and use the benefits to achieve the development goals.

There are many problems related to MNCs investing in countries, like labour exploitation, child labour, and pollution
caused by the MNCs, that are easily spread thanks to the social media. As a consequence, MNCs want to have a clean
image to the world, so they try to show that they work properly and for sustainable development. This is known as
Corporate Social Responsibility (CSR), and companies publish their CSR in their websites and in advertisements, showing
that they support human rights, environmental protection, sustainable development, etc. This is not well controlled, but
it is a step in the right direction.

Unit 32 –Aid, debt, and economic development

Aid: any assistance that is given to a country that would not have been provided through normal market forces.

Reasons for needing aid:

Natural disaster
War
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 Help achieve economic development
Create or strengthen political or strategic alliances
To fill savings gap hence encourage investment
To improve the quality of the human resources
To improve levels of technology
To fund specific development projects

Different types of aids

Official development assistance (ODA), which is aid that is organized by a government or an official organized agency of a
donor country

Unofficial aid which is organized by non-governmental organizations (NGO) Greenpeace. They are usually charitable
organisations who aim to benefit local communities and support the development of countries.

Humanitarian Aid
Humanitarian Aid is aid given to alleviate short-term suffering, which may be caused by such events as droughts, wars or
natural disasters. It is short term and is usually a gift and does not have to be repaid.

The three main forms of grant aid are:

Food aid: the provision of food from donor countries or money to pay for food, which also includes money given
for transport, storage and distribution of food.
Medical aid: The provision of medical services and provisions from donor countries, as well as money to facilitate
medical services.
Emergency aid: the provision of emergency supplies, including temporary shelters, tents, clothing, fuel, heating
and lighting.

Emergency aid: Help that is given to a country that is suffering from a natural disaster or conflict. Emergency aid may
include food, water, tents, and clothing or even rescue teams to look for victims of natural disasters.

Development aid
Aid that is given to benefit the country, in order to alleviate poverty in the long run and improve welfare of individuals.
This might be money given to build a new road or port to improve infrastructure or money given to build a new hospital
or school to benefit the people of a country. Also defied as: flows to developing countries and multilateral institutions
provided by their executive agencies.

Types of development aid:

1. Tied aid: Aid that is given to a country with proviso that they spend it in a particularly way or follow a particular
policy.US Ties North Korea Food Aid to Nuclear Progress - BBC article
2. Long term loans: Loans that are usually repayable by the developing country over a period of 10 to 20 years. They
are known as concessional loans, which are sometimes repayable in foreign currency, sometimes in the local
currency, and sometimes in a mixture of both. They may come via official aid or non-official aid.
3. Untied aid: Aid that is given to a country with no policy or spending requirements attached.
4. Multilateral (official) aid: Aid that is given by multiple donors to a specific country. Multilateral aid may be
collected by an NGO or a UN organisation e.g. UNHCR or WFP.
5. Bilateral (official) aid: Aid that is given by one country directly to another country.
6. World Bank: Formed at Bretton Woods in 1944 the World Bank is charged with helping developing nations.
7. IMF: Also formed at Bretton Woods in 1944, the International Monetary Fund aims to stabilise currencies and
support weak economies.
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 8. SAPs: Structural Adjustment Programmes were implemented by the IMF. Aid or loans was usually dependent on
countries following SAPs. SAPs aimed to cut social expenditure, liberalise trade, privatise assets and reduce
corruption. Unfortunately many of the policies were criticised because they ended up favouring MEDCs and TNCs
who were able to obtain favourable trading terms and purchase undervalued government assets.

Advantages of aid

After a natural disaster, food and medical aid can be vital in saving lives and cannot always be provided by the
affected government.
Aid can help build expensive infrastructure products that wouldn't normally be built e.g. new roads, ports,
irrigation projects or HEP stations.
Can help build schools and hospitals that improve the health and education of local populations.
Many aid agencies employ local workers to carry out projects. This not only creates employment but teaches local
new skills. This is especially true of bottom-up aid where locals are fully involved and make all key decisions.
Many charities provide education about hygiene, diet and health. These schemes are not creating dependency,
because they are not necessarily giving money, but do improve the well-being of societies.

Disadvantages of aid

Countries can become dependent on money given by foreign donors instead of developing their own economy to
become independent.
Aid money does not always reach the ones who need most, and instead is taken by corrupt officials. Some aid like
medicine can also get help up by bureaucracy and actually be out of date by the time it reaches the intended
recipients. Kleptocratic (corrupt) governments may also take money for themselves and not give it to the people
that need it.
Tied aid can force countries to carry out policies that are not necessarily beneficial to the country. Also many of
the contracts might go to companies from donor countries, so the receiving country is not receiving the full benefit
in terms of jobs, training and income. The IMF had structural adjustment programmes which forced countries to
make harmful economic changes in order to get loans.
Food aid or worse food dumping, can force local food production to collapse. Often food is dumped when it is not
needed. This undercuts the local food market and takes local farmers out of business. (US urged to stop Haiti rice
subsidies - BBC article)
Aid may stop because of political changes in donor country or receiving country or because of economic
downturns. However, the UK has protected its development budget in the current economic downturn
Aid might fund inappropriate and/or harmful technologies that cannot be sustained after aid has been removed
e.g. nuclear power. Other projects like roads and dams can cause large scale environmental problems.
Aid sometimes takes the forms of loans which can lead to high levels of debt. Many African countries borrowed
large amounts of money off the IMF and World Bank and now have huge debt problems.

Concerns about aid

Research suggests that there appears to be no significant correlation between the level of aid given to a developing
country and the growth of GDP. There are a number of concerns associated with aid as a means of reducing poverty.

In many developing countries, the government in power not necessarily have the welfare of the majority of the population
at heart. This means that when aid is received it often goes to a small sector of the population when in many cases these
are relatively wealthy city dwellers.

Also, sometimes aid is given for political reasons rather than being given to countries where the need is greatest. It is
argued that the developed countries tend to give aid to those countries that are of political or economic interest to them.

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Tied aid is not as effective as untied aid. Buying goods and services from the donor country might result more expensive.
It creates no employment or extra output in the developing country, since no expenditure takes place there. Imports may
replace domestic products, which may further harm domestic industries.

Short term provision of food may be essential, but long term provision of large quantities of food may force down domestic
prices and make matters worse for domestic farmers. It could be considered better for farmers to have a reduction in the
subsidies given to farmers in the developed countries.

Aid is often only available if the country agrees to adopt certain economic policies. Donors may argue that aid will only be
effective if it is given to countries that adopt what it considers to be “sound” economic policies and these often reflect the
Washington Consensus policies that emphasize the free market principles of liberalization, deregulation, and privatization
to promote economic growth. It is argued that these policies might be more in the interest of the developed countries
and multinational companies and not necessarily in the best interest of developed countries.

People in developed countries are beginning to suffer from aid weariness. This may start to reduce the flows of aid.

Non-government organizations
The priority of NGOs is to promote economic development, humanitarian ideals, and sustainable development. Their work
might be to provide emergency relief in cases of disasters or to provide long term development assistance. They plan and
implement specifically targeted projects in developing countries and they act as lobbyists to try to influence public policy
in areas such as poverty reduction, workers’ rights, human rights and the environment. It may also influence the buying
working conditions and the promotion of sustainable development.

Debt Relief- Indebtedness

Even though the current news stories are all about EU and US debt, in reality many of these countries are able to pay their
debt and borrow more money as long as they make public sector savings. Even though these countries owe much greater
amounts of money than many poor countries, it is the poorest countries who are having to spend a greater percentage of
their GDP on debt repayments (debt service). Many poor countries incurred large debt burdens after decolonisation. They
received loans for governments and banks flush with money from the Middle East oil boom. The borrowing of money did
not lead to the expected growth and soon many countries had mountains of debt. Enforced IMF structural adjustment
programmes often forced countries to sell of government assets cheaply, opened the economy to outside competition
(often exploitation) and slashed spending on vital infrastructure projects and services (schools and hospitals). As interest
rate payments rose many countries were unable to pay and defaulted.

The IMF lent fund to developing countries with the condition that they follow the Structural Adjustment Policies which
include:

Encouraging trade liberalization, lifting restrictions on imports and exports

Encourage the exports of primary agricultural commodities
Reduce gov. expenditure, to be sure gov. budgets are balanced
Encouraging FDI
Devaluing currency
Austerity measures reducing social expenditures
Improving governance, the process by which decisions are taken and policies are implemented, and reducing
levels of corruption

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Even though they were much criticized, they contribute to:

Controlling inflation
Improving the workings of the internal markets in the economy
Lowering government budget deficits
Reducing public ownership
Reforming exchange rate policies

They have serious costs, felt mainly on the very poor, which included:

A reduction in government-provided services, such as education and healthcare

Increasing unemployment
A fall in real wage levels
Increased prices of essential products, as government subsidies were taken away.

One reason to be cancelled is because most countries with debts ended in a concept known as de-development, indicated
by increasing rates of malnutrition, declining school attendance rates, and increasing infant mortality figures. Short term
costs to the very poor are simply so great. Many believe that the debts of developing countries should be reduced or
cancelled.

One reason in favour of debt relief relates to debt servicing, the repayment of the original debt plus interest repayments.
Another reason is that the need to service debt means that governments are unable to spend money on other areas of
the economy. This is the case of opportunity cost that has a detrimental effect on two fronts. First, it slows down economic
growth since governments are not allowed to invest in improving infrastructure. Also it slows down development, as gov.
cannot afford to provide essential services.

Odious debt is a legal term and refers to debt that is incurred by a regime and is then used for purposes that do not serve
the interests of the people. Much of the debt incurred by developing countries should be classified as odious debt.
Dictators may have used much of the borrowed money for individual purposes and yet the people of the countries, having
received no real benefits from the money, are now the ones that have to pay it back.

Susan George suggests that debt creates problems for the developed countries in areas such as environmental damage,
increased drug usage, higher taxes, higher unemployment, increased immigration and increased levels of conflict. She
argues that the developing country would benefit if the debt was to be eliminated. It is also exposed that the developing
country experiences better rates of economic growth. Rising incomes crate more demand and this would benefit exporters
in more developed countries.

Unit 33 –The balance between markets and intervention

Market led strategies (free-market policies/new classical policies/neo-liberal policies) are policies designed to minimize
the role of the government and to maximize the free operation of supply and demand in markets. (e.g.: export-led growth,
growth through FDI,, privatization of national industries, deregulation, and the Structural Adjustment Policies and Poverty
Reduction Strategy Papers of the International Monetary Fund and the World Bank.

Interventionist strategies are policies involving an active role by the government and manipulation of the workings of the
markets in the economy. (e.g.: import substitution, protectionist trade policies exchange rate intervention, regulations,
nationalization of industries, and government involvement in export markets to promote certain industries and their
products.)

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Since the end of the WWII, there were various trends in terms of how to achieve economic growth and development over
that time, emphasizing government planning. But no examples of sustained growth and development in countries was
involved, and diverse problems arose:

Public sector in these countries grew too much

Political instability
Corrupt practices
Nationalized industries were inefficient and thus, loss making.
Excessive government spending
Increases in the money supply tended to inflation
Expenditure was on large infrastructure projects with no or little success.

Developing countries were encouraged to reduce the role of the government in their economies and to adopt a more
outward looking approach to achieving growth. In general terms, this included:

Freeing domestic markets by eliminating price controls and subsidies

Liberalizing international trade, eliminating trade restrictions and encouraging FDI
Privatizing national industries
Reducing Gov. Expenditure in order to eliminate Budget deficits.

However, a number of concerns raised about the value of adopting a pure market-led approach:

Infrastructure is unlikely to be created through market based approach

Protectionism in developed countries makes it very difficult for developing countries to compete on a fair basis.
In the short run, unemployment rises as do the prices of essential products and the provision of public services
also falls. This will hit the poorest sector of the population more than anyone else, increasing income inequality.
The adoption of free market strategies concentrates attention on the urban sectors of an economy and this
increases the divide between rural and urban areas, leading to migration. This creates large areas of slums on the
edge of many mayor cities in developing countries.
Even though governments may adopt the concept of liberalized flows of capital, a lack of political stability means
that countries are not in a position to attract the FDI necessary to achieve growth.

There are several conditions that are necessary for both economic growth and economic development:

Trade justice so that developing countries are trading on a fair basis with the developed countries, not hampered
by protectionist policies.
Debt relief to release funds that may be invested in physical and human capital
Free working domestic markets
The encouragement of political stability and good governance, and elimination of corruption
Effective, targeted aid that leads to pro-poor growth.

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 GLOSSARY LUCIANO DEFINITIONS
Demand: is the quantity of a good/service that consumers are willing and able to purchase at a particular Price
and at a determined moment in time, ceteris-paribus.
Supply: is the quantity of a good/service that producers are willing and able to produce at a determined price
and at a determined moment in time, ceteris paribus.
Market: is a physical or virtual institution where potential buyers and sellers interact, exchanging
goods/services, determining the equilibrium price and quantity and ultimately, indirectly defining the final
resource allocation.
Normal goods: are those whose demand is known to increase if income were to rise. For example, air travel is
shown in the diagram bellow. In this case as income rises the demand curve for air travel moves to the right.
Inferior goods: a good is considered to be inferior when the demand for the product will fall as income rises and
the consumers start to buy higher priced substitutes in place of the inferior good. E.G: supermarket detergent
Substitute goods: Two goods are substitutes if they can satisfy a particular desire with a minimum degree of
loss of satisfaction or utility. E.g.: coke-Pepsi
Complementary goods: two goods are complementary if they need to be used jointly in order to satisfy a
particular desire. For example DVDs-DVD Players
Taxes: compulsory transfer of funds from firms or individuals to the government. There are different types of
taxes, such as direct, indirect, progressive, etc.
Subsidies: are payments (transfer of funds) made by the government to firms that will in effect reduce their
costs and stimulate output, may be used as a protectionist measure against imports.
Law of Demand: as the price of the product falls, the quantity demanded of the product will usually increase,
ceteris paribus.
Law of Supply: as the price of a product rises, the quantity supplied increases, ceteris paribus.
Ceteris Paribus: means that all other things (variables) remain constant, it is a necessary assumption for theory
analysis.
Excess Demand: also known as shortage. Occurs when more is being demanded than supplied at a certain price,
occurs at prices below the equilibrium price.
Excess supply: also known as surplus. Occurs when more is being supplied than demanded at a certain price,
occurs at prices above the equilibrium price.
Giffen Goods: are a unique type of inferior goods, very poor people tend to buy more of the basic foodstuff on
which they depend when the price rises and less when the price falls
Veblen Goods: some products become more popular as their price rises because they have a “snob value”, it is
a good of ostentation

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XED: it is the percentage change in quantity demanded of good A over the percent change in price of good B. It
allows us to analyse the relation between the two goods, either as substitutes, complementary or unrelated
goods.
PED: it is the percentage change in quantity demanded over the percentage change in the price of a product, it
allows us to identify the demand as a price-elastic, price-inelastic or perfectly inelastic
PES: it is the percentage change in the quantity supplied of the product over the percentage change in the price
of the product. It allows us to identify the demand a price-elastic, price inelastic and perfectly inelastic
YED: is the percentage change in the quantity demanded over the percentage change in income. It allows us to
identify if a product is a normal good or an inferior good and whether it is a luxury or a basic necessity.
Elasticity: is a measure of responsiveness of one variable to a percentage change in another, key elasticities in
economics are PED, PES, YED, XED.
Price inelastic Demand: Occurs when a given percentage change in price leads to a less than proportional
change in quantity demanded. PED is less than one, in absolute terms.
Price elastic Demand: Occurs when a given percentage change in price leads to a more than proportional change
in quantity demanded. PED is greater than one, in absolute terms.
Maximum price policy: it is a type of price control policy where the government sets a price below what the
market would have generated, effectively acting as a ceiling price. It is designed to protect consumers but it also
leads to shortages and a black market incentive.
Minimum price policy: it is a price control policy designed to protect producers by setting a price above of what
the market would have generated. It leads to surplus.
Rationing System: are implemented by the government to alleviate the impact of a shortage, usually through
“purchasing cards” (max number of units per customer)
Basic necessity: when income increases, the demand increases but less than proportionately (i.e. Milk, butter)
Luxury Good: as income increases the demand increases more than proportionately. (Air travel)
Buffer Stock Scheme: a government run program whose objective is to stabilize agricultural prices and farmers’
income, by buying excess supply in good weather years, storing the product and re-selling them in times of bad
weather. It is a very expensive measure and may lead to waste as agro products are perishable
Guaranteed Price System: is a government program designed to stabilize farmers’ income (not necessarily the
price of agro products) the government guarantees a particular price to the farmer, and in good weather years,
when prices fall to Plow, the government sends a “deficiency payment”; by the amount of the difference between
the guaranteed price and the market price brought to the market: (P target–Plow)x tons. In years of good weather
when prices rise to PHigh, Farmers whose income is higher than the guaranteed price are forced to pay a
supplementary tax.
Industrialization: Set of policies designed to develop a local industry, as to substitute goods with local
production. Done through any combination of protectionist policies (tariffs, quotas, subsidies, etc.)
Tariff: Is a tax on imports, it makes imported products relatively more expensive as seen by the local market

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Quota: is a physical limit on the number or value of units that may enter the country as imports, once the quota
is fulfilled local producers carry on production to satisfy local demand
Market Failure: occurs when demand and supply forces, acting on their own (without government intervention)
fail to allocate resources to its social optimum level, the main areas of market failure are: externalities, provision
of public goods, income distribution and business cycles
Social Optimum: also known as Paretto-efficient, is a resource allocation that maximizes society’s welfare or
utility, where no one can be better off without making someone worse off.
Price Mechanism: supply and demand forces acting on their own, interact to generate prices, attracting or
expelling resources towards certain economic activities. PRICES ACT AS SIGNALS.
Externalities: costs or benefits (measured in monetary value) passed to third parties not involved in an economic
transaction, may result from the production or consumption of a good or service, can be positive (benefit) or
negative (cost)
Marginal Private Benefit: utility or satisfaction extracted by an individual out of the next unit consumed, it is
the market demand curve
Marginal Private Cost: it is the cost faced by the firm out of the next unit produced; it reflects wage, rents,
interests, profits, etc. It is the payment to the factors of production; it is the market supply curve
Marginal Social Benefit: are the benefits enjoyed by society as a whole out of the consumption of a good or
service, if no externalities exist on consumption then MSB=MPB.
Marginal Social Cost: are the costs faced by society as a whole out of the production of a good or service, if no
externalities exist, then MPC=MSC
Merit Goods: are those goods or services that generate positive externalities on third parties when consumed
or produced. Example: vaccines
Demerit Goods: goods or services that generate negative externalities on third parties when consumed or
produced. Example: alcohol
Public Goods: economic good that cannot be sold through market mechanisms and have the characteristics of
being non-excludable and non-rival; e.g.: National Defence
Non-excludable: it is physically impossible to prevent the use of the good once it has been provided, there is no
exclusion mechanism and thus prices cannot act as a gate of entry
Non-rival: additional simultaneous users do not reduce the level of satisfaction of pre-existing users
Private Good: a good that can be sold, is excludable and rival
Government provided goods: relates to a wide range of goods/services that aim at improving the standards of
living of the poor (hospitals/schools/food/shelter, etc.)
Transfer payments: transfer of funds from the government to “selected groups” individuals for which no
counterpart is expected in return (grants), this specially go to: extreme poverty families, handicapped, war
veterans

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Business Cycle: periodic upturns and downturns (fluctuations) in the levels of economic activity, accompanied
by changing levels of inflation and/or unemployment. This series of recessions and growth seem to be
characteristic of market economies and may be generated by local/foreign factors
Macroeconomics: The study of economic aggregates at an economy wide level, unemployment, inflation and
economic growth become the focus of the study
Aggregate demand: total planned expenditure by all agents of the economy on locally produced goods
(AD=C+I+G+X-M) its main determinant is the level of economic activity
Consumption: expenditure of households on goods/services. E.g. food
Durable consumption: expenditure by households on goods that are designed to last over a year, usually bought
through credits
Interest Rate: opportunity cost of money, it represents the money lost by not depositing savings in the banks
or the extra cost of asking for a loan
Investment: fixed capital formation such as machinery or new factory plants (may be understood as human
capital formation (H&E) depending on the context)- The addition of capital stock to an economy
Government expenditure: spending by all levels of government on goods/services (from chalk to missiles)
Budget: plan spending and tax revenues decided through a political process
Exports: purchases/expenditure made by foreign agents on locally produced goods and services. For example,
tourism
Imports: purchases/expenditure made by local agents on foreign goods and services. It is susceptible to
protectionist measures like tariffs or quotas.
Aggregate Demand Curve: shows the correlation between total expenditure on all locally produced goods and
services at different price levels
Price level: is an indicator of nominal prices on all goods and services produced in the local economy, an increase
will denote inflation and a decrease would denote deflation
Real Gross Domestic Product: it is the sum of the value of final goods or services produced in the local economy
during a period of one year, excluding the effects of inflation, through a price index. It is the main indicator of
the level of economic activity.
Aggregate Supply: shows all planned production by local firms utilizing the existing installed capacity, it reflects
the productive capabilities of a country
Aggregate Supply curve: shows the correlation between planned production out of the existing installed
capacity, and the price level
Inflation: sustained increase in the average price level of an economic activity over a period of time, formally
measured through a price index
Deflation: sustained decrease in the average price level of an economic activity over a period of time, formally
measured through a price index

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Dis-Inflation: is a decrease in the rate of increase of the price level, while still rising, prices are doing so at a
slower rate
Fiscal Policy: set of government policies dealing with taxation and/or government spending with the objective
of affecting the Aggregate Demand and ultimately the levels of inflation and/or unemployment
Contractionary fiscal policy: faced with full employment or approaching full employment, the government may
want to implement a CFP, where by rising taxes consumption expenditure by families will fall and by reducing
government expenditure, the government expenditure of the AD would fall
Expansionary fiscal policy: faced with unemployment the government may want to implement EFP, whereby
reducing taxes, consumption by families will increase and by increasing government expenditure the
government expenditure component of AD rises
Monetary policy: it is the control by the central bank of the legal-reserve ratio and of money supply with the
objective of modifying the interest rate and ultimately the AD, through its investment and durable consumption
components, the objective is to affect the levels of inflation and/or unemployment
Central Bank: a government institution in charge of controlling the local commercial banks, setting the legal
reserve ratio. It has the capability of affecting the interest rate and ultimately investment
Legal Reserve Ratio: it is the fraction of every deposit that commercial banks must keep and not loan out. It is
determined by the central bank and serves as a security measure against sudden withdrawals
Money Supply: it represents all means of payment where the transaction is cancelled the moment it is made
(cash or debit accounts) money supply= monetary base/LRR
Unemployment: able bodied individuals, within the legal working age that are actively searching for a job (within
the last two weeks) and cannot find one
Seasonal unemployment: unemployment related with the season of the year, where individuals might be
periodically out of work. E.g. Ski instructor
Real Wage unemployment: unemployment that results from setting a minimum wage above the equilibrium
level, usually the result of labour union renegotiations
Demand Deficient/Cyclical unemployment: unemployment associated with the downturn of the business cycle
(recessions), where the AD contracts away of full employment
Structural Unemployment: result of the changing structure of an economy, this occurs when there is a
permanent fall in demand for a particular type of job. Usually long term
Frictional unemployment: is the short-term unemployment that occurs when people are between jobs, or in
search of a better one. Also known as natural unemployment
Demand-pull inflation: is an inflationary process caused by an overstimulated AD that puts pressure on existing
productive capabilities, this usually occurs as the AD reaches full employment
Cost push inflation: an inflationary process caused by the increase in price of a key factor of production or raw
material, most commonly crude oil

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Stagflation: denotes the joint occurrence of rising unemployment and inflation at the same time, usually the
result of cost push inflation
Supply side policies: set of policies designed to stimulate the productive capabilities of a nation, through the
improvement in the “quality” and/or “quantity” of its factors of production
Interventionist Supply side policies: this policies are based on the idea that the government has a fundamental
role to play in actively encouraging growth
Market Oriented Supply side policies: focus on allowing markets to operate freely, with minimal government
intervention
Tax incidence: a concept that relates to the impact a government indirect tax will have on producer’s revenues
(and profits) and on consumers (utility and satisfaction).
Consumer’s surplus: show the difference between what consumers are willing and able to pay for a particular
product and the lower price they pay through a market equilibrium price.
Producer’s surplus: show the difference between what producers are willing and able to pay for a particular
product and particular price and the higher price they receive through a market equilibrium price.
TYPES OF TAXES
Direct: is set (levied) directly on an individuals or firms specific level of income / wealth or profits (e.g.: income
tax, property tax).
Indirect: are placed on the porches of a good or service. It is indirect because the seller acts as an intermediary
between the tax payer and Gov. All indirect taxes are regressive (e.g.: VAT).
Ad-valorem tax: is a type of indirect tax (on the sale of products) that is set as a PERSENTAGE of the sale prime.
(e.g.: VAT)
TAX SHEMES
Progressive: a tax scheme were, as the income of the individual rises the percentage of income pay as taxes
rises more than proportionally. The marginal tax rate is above the average tax rate. (e.g.: income tax).
Regressive: a tax scheme were, as the income of the individual rises the percentage of income pay as taxes rises
less than proportionally. The marginal tax rate is below the average tax rate. (e.g.: income tax).
Gini-coefficient: income dist. Indicator build upon the Lorenz curve, it ranges from 0 to 1, being a lower values
an indicator of a more EQUALITARIAN dist. Of income.
Lorenz-curve: curve that represents the commutative distribution of income between different qualities of
society.
Income ratio: income ratio compares the income of the top decile (IR of 10) or quintile (IR of 20) with that of
the bottom decile (IR of 10) or quintile (IR of 20). It represents the number of times the income of the wealthiest
exceeds that of the poorest.
National income = RGDP = the sum of the values of all final goods and services produced in an economy in a
period of one year extracting the effects of inflation through a price index.

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Capital depreciation: is an indicator of the wear of machinery and infrastructure that resolves from its use. In
order to keep capital working at current conditions firms and gov. must spend funds ($) for the up keep or the
equipment. (Parks, repairs).
Multinational companies: firms that have production unit’s more than one country. Usually with headquarters
in more developed countries. They are the ones that carry out foreign direct investment.
Keynesian multiplier: phenomenon by which any infection into the circle of flow income that comes as a shock
will generate a more than proportionally impact on the level of economic act. Given by the formula =∆𝑅𝐺𝐷𝑃 =
1
× ∆𝐺.
1−𝑐

Marginal propensity consumes: indicate how much out of every extra new unit of income will be spent and
what proportion will be saved.
Gross domestic product: RGDP without extracting the effects of inflation.
RNDP: RGDP – capital deprecation
RGNP: RGDP + Net property income from aboard
Green GDP: GDP – a valuation of the ecological footprint of economic act.
Economics of scale: a production in per-unit cost (av. Cost) as the size of the firm increases.
Comparative adv. Model: a country is said to have a comparative adv. over other if it in the production of a
particular good. All countries have a comparative advantage on something.
Protectionism: Gov. Policies design to restrict trade and protect local industries, it may be market-based or non-
market based.
Tariffs: is a tax of imports, is a protectionism measurement design to protect local industry. It is regulated by
W.T.O accords.
Quota: it is a limit set by the gov. in terms of quantities or values of the amount of imports that may enter a
country. After that limit is full field, local industries may continue with local production.
Subsidies: is a transfer of payments from the gov. to industries or individuals.
Infant industry agreement: agreement in favour of protectionism where newly created firms/individuals have
not achieved international-competitive levels, are protected while they undergo a process of learning-by-doing,
and become more efficient. Also known as sun rise industries.
Senile industry argument: protections agreement where eldest firms that have lost international competitive
levels, are protect while they undergo a process of learning-by-doing, and become more efficient.
Exchange rate: is the value of one currency expressed in terms of other currency. There are 3 mayors of ER
systems, free-floating, fixed and managed.
Free-floating ER: is an exchange rate system where the value of cone currency expressed in terms of another,
is determined exclusively by demand and supply forces of currencies. Government plays no role.
Fixed: the value of the currency is set and defended by the CB at the given ratio. It reduces uncertainty about
the future value of the currency but requires extensive use of the CB’s R.
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Managed: is an ER system where the value of the currency is allowed to float freely but with an upper and lower
boundary set by the CB. The CB will use it resources to keep the value of the currency between the boundaries.
Appreciation: the increase of the value of one currency expressed in terms of another in the context of a free-
floating ER system.
Depreciation: the decrease of the value of one currency expressed in terms of another in the context of a free-
floating ER system.
Trading blocs: is the coming together of countries with the intention of facilitating trade among them and
setting common policies.
Preferential trading area: is an agreement between countries that give preferential access to certain products
from the member’s countries. It reduces tariffs on certain goods and services.
Free-trading area: that while keeping their external policies agrees to trade freely goods and services. Labour is
not allowed to move freely.
Custom union: (free trade area) + common external tariffs. Labour is not allow to move freely.
Common market: maintain the characteristics of customs union with free movement of forces of labour and
capital. This free movement will required the coordination’s of some other Gov. policies.
Trade creation: transfer of production from a higher-cost block member to a lower-cost member.
Trade diversion: transfer of production from a more efficient “extra block” producers to a less efficient “intra-
block” producers.
Balance of payments (BoP): is a register of the value of all transactions between the resident of one country
and the residence of all others countries in the universe, over a period of time.
Current account: is the measure of the flow of funds from trade of G/S and income transfers from residents and
non-residents.
Balance of trade (BoT): (current account) export rev-imports expenditure in goods (v) and services (I).
Net income from aboard: is a measure of the net monetary movements or profits, interest moving in and out
of the country. Including transfers of MNC or family members of one country to another.
Capital account: is a register of the transfer of founds retreated to ownership of assests such as direct
investment (firms, property-long term) and portfolio investment (shares, bonds- short term).
M-L conditions: when PEDx + PEDm>1, then the devaluation or deprecation of a countries currency will lead to
an improvement in the balance of trade.
The J-curve: relates to the M-LC and reflects the evaluation over time of the balance-of trade deficit depending
on whether the M-LC is met or not.
Terms of trade: it is a weighted average of exports prices over a weighted average of imports prices. Intuitively
it indicates how many baskets of imports can a representative basket of exports buy.

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Development: it is a broad concept, associated with the standards of leaving of a community (country). Usually
measure through a series of indicators such as life expectancy, infant mortality, literacy rate. (Single indicators
of HDI (composite indicators)) must not be confused with economic growth.
Sustainable development: the improvements of the standards of leaving (development) of a community’s
current generation does not limit the ability of future generations to improve their standards of leaving.
Dependency ratio: percentage of population outside the legal working age in comparison to the percentage of
population in the legal working age. LCD´S tend to have a higher child dependency ratio and MED´S are tending
towards a high old age depending ratio.
Vicious-cycle of poverty: self-perpetuating phenomenon through which low levels of income derive into low
level of investment (in physical and human capital) which yield low level of productivity growth and generate
low levels of income again. It can be stated in a human or fixed capital version.
Capital flight: process through which money and other assets flow out of a country in search of a “safe country”,
particular short term assets. This process is particularly harmful for LED´S as it generates grate volatility in the
Balance of Payments / Exchange Rates / Central bank Reserves.
AID: is any source of assistance that would not have been generated through normal market mechanism. May
vary in nature.
Tied AID: are loads given under the condition that the funds may be spent on G/S produce by the donor country.
May be officials or not.
Bilateral AID: aid directly from a government to another.
Multilateral AID: this is an AID given by member countries to international AID agencies which then change
funds to particular member countries. Is it then up to the agency to decide if the AID is more needed and will
be more “effectively” used (EVALUATION)
Washington consensus: set of structural-reform-Policies commonly believed to help LDC to break-out of the
poverty trap, and set by the IMF-WB-TD as conditionality’s as to receive a loom.
NGO´s: wide-range of institutions with varying objectives whose main common characteristics in its lack of
dependence from government financing / control or profit motive. Their aims may be set at environmental,
human rights and community development levels.
Micro-credits: small scale loads would not have been granted by the traditional banking system because of the
lack of collateral of the individuals. Financial collateral is replaced by GROUP-membership commitment.
Collateral: any form of physical or financial ASSET that may be used as a guarantee against a loan.
Fair trade: marketing strategy trough which an NGO ensures that producers receive a fair deal when selling a
product. Usually by guaranteeing a minimum price and by passing intermediaries the scheme is heavily dep. on
the consumers understanding on the benefits on the scheme for producers. (As prices are usually higher than
those from traditional companies.)
Market: place either real or virtual where potential consumers and producers interact exchanging income for
G/S. a market equilibrium price is determined where the willing/ability of consumers/producers exchange
coincide. Characteristics: N° of firms in market, the type of product and the existence of barriers to entry.

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Collusion: illegal arrangement between firms in an oligopoly with the objective of setting prices and/or
quantities as to maximize profit.
Cartel: legal arrangement between firms in an oligopoly with the objective of stabilizing market prices of
sensitive goods.
Fixed costs: costs that do not depend on the level of output. Are faced even if cero units are produced. (Rent
expenses, property taxes...)
Variable costs: costs that depend on the level of output. Are directly connected to the level of output. (hs of
labour, raw material…)
Accounting costs: registry of expenses as accredited in books ($cost).
Economic costs: accounting cost + opportunity cost.
Total revenue: $ x q = total amount of funds ($) perceived through the sale of G/S.
Profits: total cost – the payment of factors of production other than entrepreneurship.
Extraordinary profits: is a level of profit above the normal profit. If barriers to entry are sufficiently low other
firms will be tend to enter the industry.
Normal profit: it is levels of profit were all economic costs are conversed including the opportunity cost of
remaining in the industry.
Short-run: time – frame in which at least 1 factor of production maintain fixed (in general will be capital).
Long-run: all factors of production are variable.
Marginal revenue: the revenue (perceive funds) generated by the next unit sold, in general (expect under
perfect competition) the MR curve will lay below the demand curve.
Total cost: fixed cost + variable cost.
Economics of scale (EOS): it is a phenomenon where under certain circumstances PER UNIT AVERAGE costs fall
as the size (SCALE) of the firm increases. Sources of EOS: bulk buying of imports, administrative cost –
servings/secretary/accountant/managers, financials savings (cheaper-bank-loans) and division of labour
(specializations of workers).
Price discrimination: is a pricing strategy that occurs when a producers sales the exact same product (with some
production costs) to different consumers at different prices. The idea is to maximize profits by extracting us
much consumer’s surplus as possible from different consumers groups.
Contestable markets: is one where due to the lack or low barriers to entry a firm that could earn extraordinary
profits chooses to earn normal profits as to not tempt other firms to enter the market. Occurs at P=ATC.
Shut down point: is a level of output and price below which a firm would rather shut down/close because it is
not covering any part of the variable cost. Above that price and up to the normal profit price the firm will be
making losses but at least it would be covering part of its variable cost (and the fix cost). This situation can only
hold in the short-run as no firm was endless funds to finance losses in the long-run.

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Allocate efficiency: occurs when the price (signal) that consumers pay for the last unit purchase is equal to the
MR of that lost unit produced. P=MC. These only occur for perfect competition under normal profits.
Productive efficiency: a firm is set to be productivity efficiency if it produces it products at its lowest possible
per unit cost (qe = ATCmin). Only occurs at the perfect competition in the long-run (normal profits).

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Glossary
absolute advantage Where a country is able to barrier to trade Anything which prevents
produce more output than other countries free trade between two countries, e.g.
using the same input of factors of production. tariffs, quotas.
ad valorem taxes An indirect tax where a given barriers to entry Obstacles that prevent a new
percentage is added to the price of a good or firm from entering a market, such as
service. economies of scale, product differentiation
administrative barriers (in the context of trade) and legal protection.
Any administrative requirement that might break-even price The price where average
prevent or reduce the amount of imports. revenue is equal to average total cost. Below
aggregate demand Total spending in the this price, the firm will shut down in the long
economy, made up of consumption, run.
investment, government spending and net budget deficit A situation that exists when
export spending. planned government spending exceeds
aggregate supply the total amount of domestic planned government revenue. A government
goods and services supplied by businesses and may ‘run a budget deficit’ in order to increase
the government, including both consumer aggregate demand (AD) in the economy.
goods and capital goods. budget surplus A situation that exists when
allocative efficiency Occurs where the marginal planned government revenue exceeds
social cost of producing a good is equal to the planned government spending .
marginal social benefit of the good to society. business cycle A diagram showing the periodic
In different words, it occurs where the or cyclical fluctuations in economic activity.
marginal cost of producing a good (including The business cycle shows that economies
any external costs) is equal to the price that is typically move through a pattern of economic
charged to consumers. (P = MC) growth with the phases: recovery, boom,
anti-dumping Legislation to protect an economy slowdown, recession.
against the importing of a good at a price capital The factor of production that is made by
below its unit cost of production. humans and is used to produce goods and
appreciation An increase in the value of a services. It occurs as a result of investment.
country’s currency in a floating exchange cartel A formal agreement among firms in a
rate system. collusive oligopoly.
appropriate technology Where technology caters central bank The government’s bank. The
to the particular economic, social and institution that is responsible for an economy’s
environmental characteristics of its users. monetary policy.
automatic stabilizers Features of government ceteris paribus A latin expression meaning ‘let
fiscal policy, e.g. unemployment benefits and all other things remain equal’ used by
direct tax revenues, that automatically economists to develop economic theories or
counter-balance fluctuations in economic models.
activity. For example, government spending circular flow of income model A simplified
on unemployment benefits automatically rise model of the economy that shows the flow of
and direct tax revenues automatically fall money through the economy.
when economy activity is slow.
classical AS model A model showing that the
balance of payments The accounting record of long-run aggregate supply curve is vertical at
all transactions (debits and credits) between the full employment level of output.
the households, firms and government of one
collusive oligopoly Where a few firms in an
country, and the rest of the world.
oligopoly act together to avoid competition
balanced budget A situation that exists when by resorting to agreements to fix prices or
planned government spending is equal to output.
planned government expenditure.

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 Glossary

common access resources Also known as cross price elasticity of demand A measure of
common pool resources or common property the responsiveness of the quantity of one good
resources, these are resources which have demanded in response to a change in the price
properties similar to public goods in that it is of a related good. XED = %D in Qd of Good
very difficult or impossible to prevent people A/%D in price of Good B
from using or consuming the resource. crowding out A situation where the government
Therefore, they are vulnerable to overuse and/ spends more (government expenditure) than
or degradation. it receives in revenue and needs to borrow
common market A customs union with money, forcing up interest rates and ‘crowding
common policies on product regulation, and out’ private investment and private
free movement of goods, services, capital consumption,
and labour. current account (of the balance of
comparative advantage* Where a country is able payments) A measure of the international
to produce a good at a lower opportunity cost flow of funds from trade in goods and services,
of resources than another country. plus net investment income flows (profit,
complementary good Goods used in combination interest and dividends) and net transfers of
with each other, e.g. digital cameras and money (foreign aid, grants and remittances).
memory cards. Complementary goods have current account deficit Where revenue from the
negative cross-price elasticity. exports of goods and services and income
constant returns to scale A given percentage flows is less than the expenditure on the
increase in the quantity of all factors of import of goods and services and income flows
production results in an equal percentage in a given year.
change in output and thus no change in long- current account surplus Where the revenue from
run average costs. the export of goods and services and income
consumer price index A measure of the average flows is greater than the expenditure on the
rate of inflation which calculates the change import of goods and services and income flows
in the price of a representative basket of in a given year.
goods and services purchased by the customs union An agreement made between
‘average’ consumer. countries, where the countries agree to work
consumer surplus The additional benefit or utility towards free trade among themselves and
received by consumers by paying a price that is they also agree to adopt common external
lower than they are willing to pay. barriers against any country attempting to
import into the customs union.
consumption Spending by households on
consumer goods and services. cyclical (demand-deficient)
unemployment Unemployment that exists
core inflation A measure of inflation that factors
when there is insufficient aggregate demand
out the changes in the prices of products that
in the economy and wages do not fall to
tend to experience volatile price swings, e.g.
compensate for this. This is usually associated
food and energy prices. This gives policy
with a slowdown in economic growth or
makers a better indication of long-term
negative growth.
changes in the price level.
de-merit goods Products that are considered to
corporate social responsibility An approach
be harmful for people that would be over-
taken by firms where they attempt to produce
provided or over-consumed in a purely free
responsibly or ethically towards the
market economy. De-merit goods are
community and environment, demonstrating
generally considered to be products whose
a positive impact on society.
consumption creates negative externalities.
cost-push inflation A persistent increase in the
debt cancellation The act of eliminating the debt
average price level that comes about as a
owed by a developing country government in
result of increases in the costs of production
order to allow it to achieve development
and a decrease in aggregate supply (AS).
objectives.
credit Borrowed money.

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 Glossary

decreasing returns to scale A given percentage disinflation A fall in the rate of inflation.
increase in the quantity of all factors of diversification A strategy to reduce reliance on
production results in a smaller percentage the export of a narrow range of exports by
increase in output and thus an increase in re-allocating resources to a wider range
long-run average costs (diseconomies of scale). of industries.
deflation A persistent fall in the average level of dumping The selling of a good in another
prices. country at a price below its unit cost
deflationary (recessionary) gap The gap that of production.
occurs when macroeconomic equilibrium economic costs The total opportunity costs of
occurs at a level that is less than the full production to a firm, including the
emplyoment level of output. opportunity cost of entrepreneurship.
demand The quantity of a product that economic development A multidimensional
consumers are willing and able to buy at a concept involving improvement in standards
given price in a given time period. of living, reduction in poverty, improved
demand curve A curve, or line showing the health and education along with increased
relationship between the price of a product freedom and economic choice.
and quantity demanded over a range of prices. economic growth An increase in the actual level
demand-pull inflation A persistent increase in of output of goods and services produced by
the average price level that comes about as a an economy, i.e. an increase in real GDP
result of increases in aggregate demand (AD). over time.
demand schedule A chart or table showing the economic profit (abnormal or supernormal
quantity of a product demanded at each price. profit) Economic profit (abnormal or
A demand schedule, or a demand function, is supernormal profit) is earned when a firm’s
used to draw a demand curve. revenues are greater than its total opportunity
demand-side policies Also known as demand- costs (its economic costs).
management policies, these are policies to economies of scale A fall in average costs in the
change the level of aggregate demand (AD) in long run.
the economy deliberately in order to achieve excess demand Occurs where the price of a good
macroeconomic objectives. is lower than the equilibrium price, such that
depreciation A decrease in the value of a the quantity demanded is greater than the
country’s currency in a floating exchange rate quantity supplied.
system. excess supply Occurs where the price of a good
deregulation A type of supply-side policy where is higher than the equilibrium price, such that
the government reduces the number or type the quantity supplied is greater than the
of regulations governing the behaviour quantity demanded.
of firms. exchange rate The value of one currency
deterioration (worsening) in the terms of expressed in terms of another currency.
trade Where the index of the average price of expenditure-reducing policies Policies
exports falls relative to the index of the implemented by the government that attempt
average price of imports. to reduce overall expenditure in the economy,
devaluation A decrease in the value of a in order to reduce expenditure on imports.
country’s currency in a fixed exchange expenditure-switching policies Policies
rate system. implemented by the government that attempt
development indicators Statistics that may be to switch the expenditure of domestic
used to assess the level of development of an consumers away from imports towards
economy. These may be single indicators, e.g. domestically produced goods and services.
infant mortality rate, or composite indicators, export promotion Strategies to encourage
e.g. Human Development Index) economic growth through increased
direct taxation Taxation imposed on people’s international trade and the promotion of
income or wealth, and on firms’ profits. export industries.
diseconomies of scale An increase in average
costs in the long run.

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 Glossary

factor endowment The factors of production that GDP per capita The total money value of all final
a country has available to produce goods and goods and services produced in an economy in
services. one year per head of the population.
factors of production The land, labour, capital GDP The total money value of all final goods and
and management (entrepreneurship) that are services produced in an economy in a given
used in production. time period, usually a year.
financial account (of the balance of payments) Gini coefficient A coefficient (or index) that is
A measure of the net change in foreign derived from the Lorenz curve and is a
ownership of domestic financial assets, numerical indicator of income equality. It is
including foreign direct investment, portfolio calculated by dividing the distance between
investment and changes in foreign reserves, the Lorenz curve and the line of absolute
formerly called the capital account. equality by the total area under the line of
fiscal policy The set of government polices absolute equality (multiplied by 100 for the
concerning its taxation and expenditure. Fiscal index). The higher the figure, the more
policy may be used to manage the level of unequal the income distribution.
aggregate demand (AD) and may be GNP/GNI The total money value of all final
expansionary (to raise AD) or contractionary goods and services produced in an economy in
(to lower AD). one year, plus net property income from
fixed costs Costs that do not vary with the level abroad (interest, rent, dividends and profit).
of output. government spending Spending by governments
fixed exchange rate An exchange rate regime on goods and services.
where the value of a currency is fixed, or green GDP A measure of the total output of an
pegged, to the value of another currency, (or economy having taken into account the
to the average value of a selection of environmental consequences (externalities)
currencies, or to the value of some other involved in the production of that output.
commodity, e.g. gold). homogeneous products Completely identical
floating exchange rate An exchange rate regime products, as produced in perfect competition.
where the value of a currency is allowed to be import substitution Strategies to encourage the
determined solely by the demand for, and domestic production of goods in order to
supply of, the currency on the foreign reduce imports and stimulate local producers.
exchange market. Such policies rely on the use of protectionism.
foreign debt The total debt owed by the improvement in the terms of trade Where the
government of one country to foreign lenders. index of the average price of exports rises
foreign direct investment Long-term relative to the index of the average price
investment by a multinational company in of imports.
a foreign country. incentive function of price Prices give producers
free trade area An agreement made between the incentive either to increase or decrease the
countries, where the countries agree to work quantity they supply. A rising price gives
towards free trade among themselves, but are producers the incentive to increase the
able to trade with countries outside the free quantity supplied, as the higher price may
trade area in whatever way they wish. allow them to earn higher revenues.
frictional unemployment Unemployment that incidence of tax The amount of an indirect tax
occurs when people are entering the workforce paid by consumers of a good or producers of
after leaving education, or people who have a good.
left one job and are searching for a new job. income elasticity of demand A measure of the
full employment level of output The level of responsiveness of demand for a good to a
output that is produced by the economy when change in consumers’ income. YED = %D in
there is only natural unemployment. D/%D in Y
game theory A method of analysing the way that indirect taxes Taxes placed upon the expenditure
the ‘players’ in an interdependent relationship on a good or service, e.g. value added tax, or
(such as oligopoly) make strategic decisions. goods and services tax.

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 Glossary

infant industry argument The argument that new may remain at this level of output in the
industries should be protected from foreign absence of active intervention on the demand
competition until they are large enough to side by the government.
achieve economies of scale that will allow labour The work done by humans that is used in
them to be competitive. the production of goods and services.
inferior good A good whose demand falls as labour union or trade union An organization of
income rises. An inferior good has negative workers whose goals include the improvement
income elasticity. of working conditions and payments to
inflation A persistent increase in the average workers. Unions work on behalf of workers
level of prices. through negotiations with management.
inflationary gap The gap that occurs when land All raw materials that are used in the
macroeconomic equilibrium occurs at a prodcuction of goods and services
level that is above the full employment law of demand As the price of a product
level of output. increases, the quantity demanded decreases,
infrastructure The large-scale capital usually ceteris paribus.
provided by government that is necessary for law of diminishing marginal returns In the short
economic activity to take place. run, as increasing units of a variable factor are
injections The investment, government spending added to a fixed factor, the addition to total
and export revenues that add spending to the output (MP) will eventually fall.
circular flow of income. law of supply As the price of a product increases,
inreasing returns to scale A given percentage the quantity supplied increases, ceteris paribus.
increase in the quantity of all factors of leakages The savings, taxes and import spending
production results in a greater percentage that remove spending from the circular flow
increase in output and thus a fall in long-run of income.
average costs (economies of scale). linear demand function An equation in the form
interest rate The price of credit or borrowed Qd = a – bP which shows the relationship
money. between the price and the quantity of a
International Monetary Fund (IMF) An product demanded.
organization working to foster global monetary linear supply function An equation in the form
cooperation, secure financial stability, facilitate Qs 5 c 1 dP which shows the relationship
international trade and reduce poverty. between the price and the quantity of a
international reserves Foreign currencies held by product supplied.
governments (central banks) as a result of long run In terms of the theory of the firm, the
international trade. Reserves may be held so period of time in which all factors are variable.
that the government may maintain a desired long-run average cost curve (LRAC) A graphical
exchange rate for the country’s currencies. representation of long -run average costs. The
investment Spending by firms on capital goods; LRAC is u-shaped due to economies and
the addition of capital stock to an economy. diseconomies of scale.
J-curve Suggests that in the short term, a fall in Lorenz curve A curve showing what percentage
the value of the currency will lead to a of the population earns what percentage of
worsening of the current account deficit, the total income in the economy. It is
before things improve in the long term. calculated in cumulative terms. The further
joint supply Goods which are produced together, the curve is from the line of absolute equality
or where the production of one good involves (45 degree line), the more unequal is the
the production of another product, e.g. meat distribution of income.
and leather (a by-product). macroeconomics The study of how the economy
Keynesian AS model A model showing the as a whole works.
interpretation of the Keynesian view of management or entrepreneurship The factor of
aggregate suppy in the economy. In this production that brings together the other
model, with three distinct phases of aggregate three factors of production with the aim of
supply, macroeconomic equilibrium may making profit. Entrepreneurship tends to
occur at a level of output that is less than full involve risk taking.
employment, and suggests that the economy

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 Glossary

manufactured goods Goods that have been Millenium Development Goals Eight goals
processed by workers. adopted by international leaders in 2000,
marginal private benefit The extra benefit or to be achieved by 2015, including goals and
utility to the consumer of consuming an targets on income poverty, hunger, maternal
additional unit of output. and child mortality, disease, inadequate
shelter, gender inequality, environmental
marginal private cost The extra (private) cost to
degradation and the Global Partnership for
the producer of producing an additional unit
Development.
of output.
monetary policy The set of official policies
marginal social benefit The extra benefit or
concerning an economy’s official interest rate
utility to society of consuming an additional
and money supply. Monetary policy may be
unit of output, including both the private
used to manage the level of aggregate demand
benefit and the external benefits.
(AD) and may be expansionary (to raise AD)
marginal social cost The extra cost to society of or contractionary (to lower AD).
producing an additional unit of output,
monetary union Where two or more countries
including both the private cost and the
share the same currency and have a common
external costs.
central bank.
market A place where buyers and sellers of a
monopolistic competition A market structure
product come together to make an exchange,
charaterized by a large number of small firms,
or a trade. A market does not need to be a
producing differentiated products, with no
physical place, e.g. a stock market or foreign
barriers to entry or exit.
exchange market, where the product is traded
via computers. monopoly A market structure where there is
only one firm, or a dominant firm, in the
market equilibrium The point where the
industry. There are high barriers to entry.
quantity of a product demanded is equal
to the quantity of a product supplied. This multinational corporations Companies based in
creates the market clearing price and quantity one country that set up production units,
where there is no excess demand or excess e.g. factories, farms, mines or retail outlets,
supply. in other countries.
market failure Occurs when the production of a multiplier The amount by which an injection is
good does not take place at the socially multiplied in order to calculate the final
efficient level of output (allocative efficiency addition to national income as a result of
where MSC = MSB). the injection.
Marshall-Lerner condition States that a natural monopoly A situation where there are
depreciation, or devaluation, of a currency only enough economies of scale available in a
will only lead to an improvement in the market to support one firm, such that it is
current account balance if the elasticity of natural that the industry be dominated by one
demand for exports plus the elasticity of firm only.
demand for imports is greater than one. natural rate of unemployment* The rate of
merit good Products that are considered to be unemployment that is consistent with a stable
beneficial for people that would be under- rate of inflation. It is the rate of unemployment
provided or under-consumed in a purely free that exists when the economy is at the full
market economy. Merit goods are generally employment level of output. It is the rate
considered to be products whose consumption where the long run Phillips curve touches
create positive externalities of consumption. the x-axis.
micro-credit Loans of small amounts that given negative externality of consumption The
to people who use the loans to start up small- external costs to a third party that occur when
scale businesses. People who obtain micro- a product is consumed.
credit would have difficulty getting loans from negative externality of production The external
the formal banking sector due to a lack of costs to third party that occur when a product
income and collateral. is produced.
microeconomics The study of the behaviour net exports Export revenues minus import
(supply and demand) of individual markets. expenditure.

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 Glossary

non-collusive oligopoly Where firms in an Preferential trade agreement Where a country

oligopoly do not resort to agreements to fix agrees to give preferential access, e.g. reduced
prices or output. Competition tends to be tariffs, to certain products from one or more
non-price. Prices tend to be stable. trading partners.
non-government organizations price ceiling (maximum price) A maximum price
(NGOs) Organizations that are not associated set by the government or other authority
with a government that exist to promote above which the product may not be sold
economic development and/or humanitarian in order to support the consumers of the
ideals and/or sustainable development product. Examples of maximum prices
normal good A good whose demand rises as include those set on essential food
income rises. A normal good has positive products or rent.
income elasticity. price discrimination The act of charging different
official development assistance (ODA) Aid that is consumers of an identical product different
provided to a country by another government prices, e.g. based on time of purchase, age of
or an official government agency. It may be consumer, quantity of purchase or time of
multilateral or bilateral in nature. consumption.
oligopoly A market structure characterized by a price elasticity of demand A measure of the
small number of large firms dominating the responsiveness of the quantity of a good
industry due to high barriers to entry. There demanded to a change in its price. PED =
are many different theories of oligopoly. %Din Qd/%Din price. PED = P1DQ/Q1DP
overvalued currency When the value of a price elasticity of supply A measure of the
currency is believed to be higher than what is responsiveness of the quantity of a good
perceived to be its market equilibrium value, supplied to a change in its price. PES = %Din
based on its balance of payments position or Qs/%Din price. PES = P1DQ/Q1DP
its international purchasing power. price floor (minimum prices) A minimum price
perfect competition A market structure set by the government or other authority
characterized by a large number of firms, below which the product may not be sold in
producing homogeneous products, each of order to support the producers of a product.
which is too small to influence the market. The Examples of minimum prices include those set
firms are price takers because of this. There are on agricultutral products and wages in a
no barriers to entry or exit and all the firms labour market.
have perfect knowledge of the market. price taker In perfect competition, each firm is a
Phillips curve in the short run* A curve that price taker, taking the equilibrium price set in
illustrates the view that there is a short-run the market.
inverse relationship between the inflation rate primary commodities Raw materials.
and the unemployment rate. privatization A type of supply-side policy where
Phillips curve* in the long run* A vertical line at the government sells public assets to the
the natural rate of unemployment that private sector.
illustrates the view that there is no trade-off producer surplus The additional benefit received
between the inflation rate and the by producers by receiving a price that is higher
unemployment rate. than the price they were willing to receive.
portfolio investment The purchase of financial product differentiation A strategy employed by
investments such as shares and bonds in order producers where they attempt to make their
to gain a financial return in the form of products different from those of their
interest or dividends. competitors, e.g. differences in quality,
positive externality of consumption The external performance, design, styling or packaging. It is
benefits to a third party that occur when a a form of non-price competition.
product is consumed. profit maximization Often assumed to be the
positive externality of production The external primary goal of firms. This is where the
benefits to a third party that occur when a difference between total revenue and total
product is produced. revenue is at the maximum or where
poverty trap or poverty cycle Any circular chain marginal cost is equal to marginal revenue
starting and ending in poverty, meaning that (MC = MR).
poverty perpetuates itself.

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 Glossary

progressive taxation A system of direct taxation short-run average cost curve (SRAC) A graphical
where tax is levied at an increasing rate for representation of short-run average costs. The
successive bands of income. The marginal tax SRAC is u-shaped due to the law of
rate is higher than the average tax rate. diminishing marginal returns.
proportional taxation A system of taxation in shut-down price The price where average
which tax is levied at a constant rate as revenue is equal to average variable cost.
income rises, for example 10% of each Below this price, the firm will shut down in
increment of income as income rises. the short run.
public good A product which is non-rivalrous signalling function of price Prices give signal to
and non-excludable and so would not be both producers and consumers. A rising price
provided at all in a purely free market gives a signal to producers that they should
economy. increase their quantity supplied and signals to
quota Import barriers that set limits on the consumers that they should decrease the
quantity or value of imports that may be quantity demanded, and vice versa.
imported into a country. specific taxes An indirect tax where a fixed
regressive taxation A system of taxation in amount is added to the price of a good or
which tax is levied at a decreasing average service.
rate as income rises. This form of taxation speculation (in the context of exchange
takes a greater proportion of tax from the low- rates) Where foreign currency traders make a
income taxpayer than from the high-income decision to buy or sell a currency based on
taxpayer. their expectations of future exchange
resource allocation A primary focus of the study rate movements.
of economics is to examine the way that stagflation The situation where an economy is
scarce factors of production (land, labour and facing stagnant growth, with high rates of
capital) are used (allocated) to meet unemployment and high rates of inflation.
unlimited demand. structural unemployment Unemployment that
retaliatory tariff Where a country responds to exists when in the long term the pattern of
the imposition of a tariff by a trading partner demand and production methods change and
by imposing a tariff on that country’s there is a permanent fall in the demand for a
products. particular type of labour. There is a mismatch
revaluation An increase in the value of a between skills and the jobs available.
country’s currency in a fixed exchange subsidy (in the context of international trade) An
rate system. amount of money paid by the government to
revenue maximization An alternative goal of a firm, per unit of output, to encourage output
firms (as opposed to profit maximization). This and to give the firm an advantage over foreign
occurs when marginal revenue is equal to zero competition.
(MR = 0). subsidy The amount of money given to
revenue The income received by a firm from producers of a product by the government.
selling its product. A subsidy increases the supply of the good
by effectively lowering the firms’ costs of
satisficing An alternative goal of firms (as
production.
opposed to profit maximization) . This occurs
when enterpreneurs endeavour to cover their substitute good Goods which can be used in
opportunity costs, but do not push themselves place of each other, e.g. Adidas running shoes
significantly further, even though they might and Nike running shoes. Substitute goods
be able to earn higher profits. It is essentially a have positive cross-price elasticity.
mix of the words ‘satisfy’ and ‘suffice’. supply curve A curve or line showing the
seasonal unemployment Unemployment that relationship between the price of a product
exists when people are out of work because and the quantity supplied over a range of
their usual job is out of season, e.g. a ski prices.
instructor in the summer. supply The amount of a good or service that
short run In terms of the theory of the firm, the producers are willing and able to supply at a
period of time in which at least one factor of given price in a given time period.
production (usually capital) is fixed.

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 Glossary

supply-side policies Policies designed to shift the trade diversion Occurs when the entry of a
long-run aggregate supply (LRAS) curve to country into a customs union leads to the
the right, thus increasing potential output in production of a good moving from a low-cost
the economy. producer out-side the union to a high-cost
sustainability In economic terms, sustainability is producer inside the union.
linked to the concept of sustainable trade International trade involves the exchange
development, which is development that of goods or services between two countries.
meets the needs of present generations transfer payments A payment from the
without compromising the ability of future government that is received when there is
generations to meet their needs. Sustainability no good or service exchanged, e.g. a student
implies an ability to sustain the world’s grant or a pension. Transfer payments are
resources over time. a means of redistributing income in
tariff A duty (tax) that is placed upon imports to an economy.
protect domestic industries from foreign underemployment Exists when workers are
competition. carrying out jobs for which they are over-
tax allowances or tax credits A type of supply- qualified or when workers are employed part-
side policy where the government allows time, even though they are available for full-
households or firms to reduce the amount of time employment.
direct tax paid to the government. undervalued currency When the value of a
terms of trade An index that shows the value currency is believed to be lower than what is
of a country’s average export prices relative to perceived to be its market equilibrium value,
their average import prices. based on its balance of payments position or
tied aid Grants or loans that are given to a its international purchasing power.
country, but only on the condition that the unemployment rate The number of unemployed
funds are used to buy goods and services from workers expressed as a percentage of the
the donor country. total workforce.
total, average and marginal cost Total costs unemployment The state of being without work,
include the complete cost of producing a level but willing and able to work, and actively
of output. Average costs are costs per unit of looking for a job.
output (AC = TP/Q). Marginal cost is the variable costs Costs that vary directly with the
addition to total cost of producing one extra level of output.
unit of output (MC = DTC/DQ)
weighted price index An approach to calculating
total, average and marginal product Total product the change in the price level by giving a
is the total output of a firm at a given level of weight to each item according to its
input. Average product is the output that is importance in consumers’ budgets.
produced, on average, by each unit of the
World Bank An organization whose main aims
variable factor. (AP = TP/V). Marginal product is
are to provide aid and advice to developing
the extra output that is produced by using an
countries, as well as reducing poverty levels
extra unit of a variable factor. (MP = DTP/DV)
and encouraging and safeguarding
total, average and marginal revenue Total international investment.
revenue is the price of a product multiplied by
World Trade Organization (WTO) An
the quantity sold (TR = PxQ). Average revenue
international body that sets the rules for
is the revenue that a firm receives per unit sold
global trading and resolves disputes between
(AR = TR/Q). Marginal revenue is the extra
its member countries. It also hosts
revenue that a firm gains when it sells one
negotiations concerning the reduction of trade
more unit of a product (MR = DTR/DQ).
barriers between its member nations.
trade bloc Any association of one or more
zero economic profit (normal profit) Normal
countries where an agreement is made to
profit is earned when revenue is equal to the
reduce trade barriers.
total opportunity costs to the firm. A firm
trade creation Occurs when the entry of a earning normal profit (or zero economic
country into a customs union leads to the profit) has no incentive to leave the industry.
production of a good moving from a high-cost
producer to a low-cost producer.

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