ECONO

MICS Theme 1
Introduction to Markets and Market
Failure
Theme 2
The UK Economy – Performance and
Policies
Theme 3
Business Behaviour and the Labour
Market
Theme 4
International Economics

Doina Brad
 Theme 1
Introduction to Markets and Market Failure
1.1 Nature of Economics
- Economics as a Social Science
- Positive and Normative Economics
- The Economic Problem
- Productive Possibility Frontiers
- Specialisation and the Division of Labour
- Free Market Economies, Mixed Economy and Command
Economy
1.2 How markets work
- Rational Decision Making
- Demand
- Price, Income and Cross Elasticities of Demand
- Supply
- Elasticity of Supply
- Price Determination
- Price Mechanism
- Producer and Consumer Surplus
- Indirect Taxes and Subsidies
- Alternative Views on Consumer Behaviour
1.3 Market failure
- Types of Market Failure
- Externalities
- Public Goods
- Information Gaps
1.4 Government Intervention
- Government Intervention in markets
 Economics as a social science
Social sciences study human beings as individuals and groups and how
they interact with each other. Human interactions are complex and are
influenced by many variables. Economics, psychology and politics are
social sciences.
Economics as a social science is concerned with the production, distribution
and consumption of goods and services.
Due to the complexities within societies, economists build models so as to
better understand certain interactions. A model is a simplified version of
reality. All models make a range of assumptions. These are often
generalisations about behaviour, choices and likely outcomes.
Models use both qualitative information and statistical data to underpin the
theoretical thought process. They also use empirical information to help
evidence outcomes.
Economic models are developed by economists once a hypothesis has
been repeatedly proven or rejected in different circumstances.

These assumptions are necessary so as to account for complex human

behaviour and constantly changing variables.
When evaluating different models, the underlying assumptions should
always be considered.
Due to the large number of variables that can influence any particular
economic interaction in society, economists create models using the
principle of ceteris paribus -'all other variables remain constant’. It allows
economists to simplify and explain causes and effects, even if the
explanation is somewhat limited by the assumptions

Basic Concepts Of Microeconomics

Incentives and behaviours – how people as individuals or in firms, react
to the situations with which they are confronted.
Utility theory – consumers will choose to purchase and consume a
combination of goods to maximise their happiness or “utility” , subject to
constraint of how much income they have available to spend.
Production theory – this is the study of production / process of converting
 Positive and Normative Economic Statements
Decisions are made by individuals, firms and governments. Based on
normative statements, moral views and value judgemnets, political
judgements, short-term positive consequences.
There are two types of economic statements :
Positive Statements are objective, factually based and can be tested and
proven right or wrong. They are unbiased.
Normative Statements are subjective, questionable comments that are
difficult to test. They contain value judgements and are biased and partial.
Positive economics is concerned with objective statements of how a market
or an economy works.
Positive economic statements are based on empirical evidence and tend to
be statements of fact. They can be proven to be true or false.
Normative economics focuses on value judgements. These judgements are
built around opinions and beliefs as to what the best economic policies or
solutions may be. These judgements are called normative economic
statements.
Normative economic statements are what separate political parties and the
different economic agendas they put forward.

The role of value judgements :

Value judgements influence individuals choices in the economic
decisions they make. These decisions can be related to any part of their
lives, from what they eat, to where they work, to how they maintain their
health.
For example, deciding not to eat meat is often a value judgement based
around unethical methods of food production. By providing statistics on the
harmful impact that meat production has on the environment,
environmental campaigners are attempting to demonstrate that this is no
longer a normative issue.
Another example is the way that many individuals choose to smoke
nicotine based products. The value judgement they make is that the benefits
they get from smoking outweighs any risk of cancer.
.
 The Economic Problem
Economics is the study of scarcity and its implications for resource
allocation in society
The Basic Economic Problem : How can the available scarce resources be
used to satisfy people’s infinite needs and wants as effectively as possible.
There are finite resources available in relation to the infinite wants and
needs that humans have.
In economics, these resources are called the factors of production – land,
labour, capital and enterprise.
Due to the problem of scarcity, choices have to be made by producers,
consumers and governments about the best (most efficient) use of these
resources.
Resources that are scarce are called economic goods. Resources that are not
scarce are called free goods.
In a free market, scarcity has a direct influence on prices :
- The scarcer a resource, the higher the price for it will be
- The less scarce a resource, the lower the price for it will be
Resources can either be renewable or non-renewable :
- Renewable resources can be used repeatedly and naturally
replenished, for example wind generated electricity
- Non-renewable resources cannot be naturally replenished at a
pace that keeps up with consumption. For example, oil and coal
Opportunity cost is the loss of the next best alternative when making a
decision
Resources are scarce but wants are unlimited. This leads to the basic
economic problem of scarcity and forces economic agents to make choices
of what to produce, how to produce it and who to produce it for. These
choices have a range of alternatives. These choices can be granted in terms
of benefits to be gained from each alternative. The benefit lost from the best
next alternative is called opportunity cost of the choice.
The range of alternatives that have been given up when making a decision
is referred to as ‘trade-offs’ .
Free goods have no opportunity cost.
 Production Possibility Frontiers
Production possibility frontiers (PPFs) show the maximum possible production (output) of
two goods or services an economy can produce at any given time.
Any two goods/services can be used to demonstrate this model.
Many PPF diagrams show capital goods and consumer goods on the axes
- Capital goods are assets that help a firm or nation to produce output (manufacturing). For
example, a robotic arm in a car manufacturing company is a capital good
This is a PPF for an economy demonstrating
- Consumer goods are end products and have no future productive use. For example, a
the use of its resources to produce capital or
watch The use of PPF to depict the maximum productive
consumer goods
potential of an economy.
The curve demonstrates the possible combinations of the
maximum output this economy can produce using all of
its resources (factors of production).
• At A, its resources are used to produce only consumer
goods (300)
• At B, its resources are used to produce only capital
The use of PPF to depict efficiency,
goods (200)
• Points Cinefficiency,
and D both attainable
represent fulland (efficient)
unattainableuse of an
economy's production
resources as these points fall on the curve.
• Producing
At C, 150 capital goods at and
any 120
pointconsumer
on the curve
goods are
produced represents productive efficiency
The use of PPF to depict opportunity cost usingAny marginal analysis.
point inside the curve
To produce one more unit of capital goods, thisrepresents
economy inefficiency
must give up(pointproduction
E) of some
units of consumer goods (limited resources) • Using the current level of resources
• If this economy moves from point C (120, 150)available, to D (225, 100), theproduction
attainable opportunity is cost of
any point
producing an additional 105 units of consumeron goods is 50 the
or inside capital
curvegoods
and any point outside
As opposed to a movement in the PPF described
• A movement in the PPF occurs when there is any above, the entire PPF of an
economy can shift inwards or outwards thechange
curve isinunattainable
the allocation of existing
(point F)
resources within an economy such Economic
as the movementgrowthfrom occurs
pointwhenC tothere
D is an increase in
the productive potential of an economy.
- This is demonstrated by an outward shift of the entire
curve. More consumer goods and more capital
goods can now be produced using all of the available
resources.
- This shift is caused by an increase in the quality or
quantity of the available factors of production
One example of how the quality of a factor of production
can be improved is through the impact of training and
education on labour. An educated workforce is a more
productive workforce and the production possibilities
Economic decline occurs when thereincrease.
is any impact on an economy that reduces the
quantity or quality of the available factors of production.
One example of how the quantity of a factor of
One example of how this may happenproduction
is to consider
can behow the Japanese
increased tsunami
is through of 2011in
a change
devastated the production possibilities of Japanpolicies.
migration for manyIfyears. It shifted
an economy theirmore
allows PPF foreign
 Specialisation and the Division of Labour
Scotsman Adam Smith is often referred to as the 'father of Economics’
published 'The Wealth of Nations' in March 1776 and explained many
fundamental economic principles that we still use today.
The premise of the book was to discuss how to increase productivity and
wealth.
Based on observations made during a visit to a pin factory, he developed
the ideas of specialisation and the division of labour. He noted that a single
worker could not make more than 20 pins a day as it involved around 18
different processes, such as cutting the wire, sharpening the end, stamping
the head etc.
However, if the labour was divided up into different tasks and
workers specialised in just that one task, Adam Smith estimated that just 10
workers could produce 48,000 pins per day,
Specialisation occurs when economic units such as individuals, firms,
regions or countries concentrate on producing specific goods or services.
Globalisation is currently increasing this process of Specialisation between
nations. Specialisation can also occur within economies.
The division of labour is when a task is broken up into several component
tasks. This allows workers to specialise by focusing on one (or a few) of the
components that make up the production process and thereby gain
significant skill in doing it. This results in higher output per worker and so
increases productivity.
Specialisation can occur on an individual, business, regional or global level.
Advantages:
- Higher labour productivity lowers cost/unit for firms
- Lower costs can be passed on to consumers in the form of lower prices
- Lower costs can mean higher profits for the firms. This may lead
to higher wages for workers
- Increased productivity allows some firms to sell beyond their local
market into international markets
- It creates many low skilled jobs
- Enables workers to gain skills in a narrow range of tasks which enables
them to be more productive.
 Specialisation and the Division of Labour
Advantages of Division of Labour and Specialisation in trade:
- Higher labour productivity lowers cost / unit for firms, which makes
their goods more competitive internationally (exports)
- Increased exports can result in economic growth for the nation
- Economic growth usually leads to higher income and a better standard
of living
- Income gained from exports can be used to purchase other goods from
around the world (imports). This increases the variety of goods available
in a country
Disadvantages of Division of Labour and Specialisation in trade:
- International trade is beneficial for the firms that can compete globally.
However, some industries will be unable to compete and will go out of
business
- Many firms in an entire industry may close leading to structural
unemployment
- Specialisation may create over-dependency on other countries'
resources. This may cause problems if conflict arises (For example,
Europe's reliance on Russian natural gas during the Ukraine crisis)
- Specialisation using a country's own resources will lead to resource
depletion over time. Specialisation will increase the rate of resource
depletion
As individuals and firms trade with each other in order to acquire goods or
raw materials, they require a means of exchange that is acceptable and easy
to use. Modern currency fulfils this purpose and money functions as a
medium of exchange, a measure of value, a store of value, and a method of
deferred payment.
Functions of money :
- A medium of exchange : Without money, it becomes necessary for
buyers and sellers to barter (exchange goods). Bartering is problematic
as it requires two people to want each other's good (double co-incidence
of wants). Money easily facilitates the exchange of goods as no double
co-incidence of wants is necessary
- A measure of value : Money provides a means of ascribing value to
 Economies
An economy is the large set of inter-related production and consumption
activities that aid in determining how scarce resources are allocated.
An economic system is a complex network of individuals, organisations and
institutions that allocates resources.
The market mechanism allocates resources through bringing together buyers and
sellers who agree on a price for the product or resource being sold.
Market failure happens when free markets result in undesirable outcomes. Eg
traffic congestion.
Governments interfere when there’s a market failure through changes in law or
taxation or create other types of incentive or they can also provide or buy goods
and services.
In order to solve the basic economic problem of scarcity, economic systems
emerge or are created by different economic agents within the economy. These
agents include consumers, producers, the government, and special interest
groups (e.g. environmental or trade unions)
The economic system aims to allocate the scarce factors of production. Any
economic system needs to decide how to answer the three fundamental economic
questions : What to produce? Who to produce for? How to produce it?
Adam Smith, Karl Marx and Friedrich Hayek had very different ideas about how
these questions should be answered :
- A free-market economy is an economy that has no government
intervention in the allocation of resources and distribution of goods/services
- Friedrich Hayek believed that free markets with no government intervention
provided the most efficient allocation of resources and that command
economies were flawed. He identified information gaps between what the
economies actually required and what the central planners in command
economies were saying it required. These gaps led to shortages or surpluses of
goods/services in command economies. He felt that the threat to efficiency
and economic growth is government intervention
- A command economy is an economy in which all of the resources are owned
by the state and the government controls the distribution of goods/service
- Karl Marx believed that free markets lead to capitalism in which the owners
of the factors of production (Capitalists) exploited the workers. This
 Economies

Pros of Free Market Economies : Cons of Free Market Economies :

- Profit incentive motivates - Wealth gets concentrated in the hands of
people to work or develop the few as they are able to keep buying
entrepreneurial ideas up the scarce factors of production
- Greater variety of - This increases inequality such that the
goods/services gap between the rich and the poor
- Competition leads to better continues to grow
quality of goods/services - Sometimes product quality falls as firms
- Competition leads to lower lower quality standards in order
prices of goods/services to increase profits
- Competition - Workers get exploited
encourages innovation and - Resource depletion and environmental
product development degradation are often ignored
-Pros of Command
Profits, Economies
income and :
wealth are - Cons of Command
Monopolies developEconomies :
as firms increase
- unlimited
Social equality is the
resulting in goal
betterof -market
Receiving
powerthe same mergers and
through
the systemofasliving
standards opposed to profit wage disincentives people from
acquisitions
- More
maximisation, so there
efficient use is
of scarce - Thisgaining difficult
leads to skills (e.g.
exploitation doctor) as
of consumers
less inequality
resources and8 supply
years ofchains
study results in the same
- All workers receive the same wage as no study
wage irrespective of role or - A lack of competition means that there
career. This helps create social is less innovation and product
equality development
- Less unemployment - There is a continual lack of
- Resources of the nation can be efficiency as central planning always
directed towards urgent results in surpluses or shortages of
There are three
priorities main sectors in the economy:
quickly goods/services
•- The
Primary sector – raw materials are -extracted,
government and food
Black markets is grown.
multiply Eg of
as the
industries
owns are agriculture,
monopoly businessesforest
so management, fishing,
population seeksextracting
to address oilshortages
and
mining. exploitation through
consumer - Access to higher standards of living is
• high
Secondary sector
prices can – raw material are transformed
be avoided limited for into
mostgoods.
of the Eg of industries
population
are motor manufacturing, food processing, furniture
- Personal making
freedoms areand steel
restricted
production.
• Tertiary sector – produces services such as transport, sport and leisure,
distribution, financial services, education and health.

Economies are split in two sectors.

Public sector – state or government sector of the economy. Production of goods
 Rational Decision Making
The margin is the change in a variable caused by an increase of one unit of the
other variable. The marginal cost of a good is the additional cost of making one
additional good.
Marginal cost is the difference between total cost at the new output level and the
total cost at one unit less than that.
The economic theory is based on the assumption that people make decisions
based on marginal changes. The concept of the margin is important is
understanding how consumers act rationally.
Traditional/Classical economic theory assumes that economic agents want to
maximise their utility. Different economic agents will have different ways of
maximizing their utility. In order to maximise utility, economic agents will act
rationally. This means that they will make decision solely based on trying to
maximise utility and nothing else.
Marginal utility is the benefit gained from consuming one additional unit of a
good.
Total utility is the overall benefit gained from consuming a good.
The law of diminishing marginal utility states that for each additional unit of a
good that’s consumed, the marginal utility gained decreases.
A rational consumer will choose a good at the point where marginal utility = price
If marginal utility decreases, then the price a consumer is willing to pay for each
extra good will decrease.
The law of diminishing marginal utility explains why the demand curve slopes
downwards.
Maximisation occurs when an economic agent tries to obtain the most that they
can from the economic activity that they undertake.
Economic agents have different objectives to maximise their utility.
- Consumers are assumed to act rationally. They Wish to maximise their utility
while not spending more of their income. Utility will involve different things
such as assets or luxury goods. It is assumed that when consumers spend their
money they’ll act rationally to increase their utility. Workers are assumed to
want to maximise their income while having as much as free time as possible
as they want. They do this by balancing welfare at work with consideration of
both pay and benefits
 Behavioral Economics
The key assumptions used in traditional economic/neo-classical theory
are :
- Economic agents are utility maximisers
- Economic agents are rational
Behavioral economics challenge these assumptions, because they are not
realistic. Individuals have limits on their self-control / ‘bounded self-
control’
Economic agents will not be rational.
- Traditional economic theories assume that everyone has perfect or
symmetric information and the ability to use this information to make
rational decisions. In real life it is likely for them to have
asymmetric/imperfect information.
- Another reason might be that the time available to make a decision is
limited.
- Not all the information is available or the information available is
incorrect/biased.
- People might not be able to process vast amount of data involved in
making a decision and might not be good at calculating the costs of
alternatives. (computation weakness)
- Social norms - individuals could be following trends and be influenced
by other people’s behaviour and society’s norms.
- Habitual behaviour where the consumer will do the same thing over
and over again.
- Rules of the thumb are useful tools for when making a decision such
as choosing the middle prices option.
The limits on decision making are known as ‘bounded rationality’.
People tend to satisfice rather than spend ages trying to make a rational
decision.
Governments can use behavioural economic theory for their policies
because traditional economic theories are based on unrealistic assumptions
and are not very useful.
Choice architecture is where an individual’s choice is influenced by
 Demand
Demand is the amount of a good/service that a consumer is willing and
able to purchase at a given price in a given time period. If a consumer is
willing
A demandto purchase
curve isaagood, but cannot afford to, it is not effective
graphical
demand.
representation of
the price and quantity demanded
(QD) by consumers. If data were
plotted, it would be an actual curve,
however economists simplify curves
in their sketches into straight
lines so as to make analysis easier.
A change in price is always shown
-byAadecrease
movement in the the the
along price, which leads to a movement down the curve
curve,
(from point aAshift
meanwhile to point
of theC)curve
and an
is increase in quantity demanded is called
an extension
caused in Quantity
by a change demanded.
in the amount
-demanded
A increaseatina the theprice.
given price, which leads to a movement up the curve
(from point A to point B) and a decrease in quantity demanded is called a
contraction in Quantity demanded.
The law of demand captures this fundamental relationship between price
and quantity demanded. It states that there is an inverse relationship
between price and quantity demanded.
- When price rises the QD falls
- When prices fall the QD rises
This relationship partly explains why the demand curve is downward
sloping.
The law of diminishing marginal utility : The utility gained from
consuming the first unit is usually higher than the utility gained
from consuming the next unit
Marginal utility is the additional utility (satisfaction) gained from the
consumption of an additional product
To calculate total utility, the marginal utility of each unit consumed
is added together. This means that total utility keeps increasing even
while marginal utility is decreasing.
 Demand
Factors that will cause a shift in the Demand curve
- Change in Real Income : Real Income (income adjusted to inflation)
determines how many goods/services can be enjoyed by consumers.
There is a direct relationship between income and demand for normal
goods. If income increases then the demand curve shifts from D to
D1. If income decreases then the demand curve shifts from D to D2.
- Changes in tastes / fashion : If goods/services become
- more
Changes fashionable then demand
in advertising for them
/ branding increases.
: If more money There is a direct
is spent
relationship
on advertising between changes
or branding, in taste/fashion
then and demand. Ifwill
demand for goods/services the good
becomes
increase as more
more fashionable
consumersthen are the demand
aware of thecurve shifts
product. fromisD to
There
D1. If the
a direct good becomes
relationship betweenless branding/advertising
fashionable then the demand curveIf
and demand.
- shifts from
advertising
Changes in D
thetoprices
D2. then
increases, of demand curve shifts from D to D1. If
advertising
substitute goodsdecreases then the demand curve shifts from D to D2.
: Changes
in the price of substitute
goods will influence the
demand for a
product/service. There is
a direct relationship between
- the price in
Changes of the
good A of
prices
and demand for good
complementary goods: B. If
the price in
Changes of the
substitutes
price
(good A) increases,goods
of complementary then will
demand
A and demand
influence for
thegoodforBgood
demand forB.a If the price of complimentary goods A
increases,
increases then and vice
product/service. demandversa.
There for good B decreases and vice verse.
is
- an inversein population size/distribution : If the population size of a
Changes
relationship
country changes between
overthetime,price
then the demand for goods/services will
of good
also change. There is a direct relationship between the changes in
population size and demand. Demand will also change if there is a
change to the age distribution in a country as different ages demand
different goods/services e.g an ageing population will buy more
hearing aids. If the population increases then demand increases and
the demand curve shifts from D to D1. If the population decreases
then the demand curve shifts from D to D2.
 Price, Income and Cross Elasticities of Demand
The law of demand states that when there is an increase in price (P), there will be a
fall in the quantity demanded (QD).
Price elasticity of demand (PED) reveals how responsive the change in QD is to a
change in P.
Formula for PED :

TO calculate % change :

The PED value is always negative, so economists ignore the sign.

- If PED = 0 , then PED is perfectly Inelastic : QD is completely unresponsive
to a change in P
- If PED = 0 ~ 1 , then PED is Relatively Inelastic : the in QD is less than
proportional to the in P (eg. addictive products)
- If PED = 1 , then PED is Unitary Elastic : the in QD is equal to the in P
- If PED = 1 ~ , then PED is Relatively Elastic : the in QD is more than
proportional to the in P (eg. luxury products)
- If PED = , then PED is Perfectly Elastic : the in QD will fall to 0 with any in
P
Factors that affect PED :
- Availability of substitutes : good availability of substitutes result in a higher
PED (relatively elastic)
- Addictiveness of the products : addictiveness turns products into necessities
resulting in a low value of PED (relatively inelastic)
- Price of product as a proportion of income : the lower the PED value will be.
Consumers are less responsive to price changes on cheap products (relatively
inelastic)
- Time period : In the short term, products are less responsive to price increases
resulting in a low value of PED ( relatively inelastic). Over a longer time period
consumers may feel the price increase more and will then look for substitutes
resulting in a higher value of PED (relatively elastic)
Changes in income result in changes in demand for goods/services.
Income elasticity of demand (YED) reveals how responsive the change in quantity
demanded (QD) is to a change in income (Y).

Formula for YED :

 Price, Income and Cross Elasticities of Demand
Changes in the prices of complementary goods and substitutes affect the demand
for related products.
Cross price elasticity of demand (XED) reveals how responsive the change in
quantity demanded for good A is to a change in price for good B.
Formula for XED :

- XED is < 0 , then the goods are complementary. the higher the value then the
stronger complements they are
- XED is > 0 , then the goods are substitutes, the higher the value the stronger the
relationship.
- XED is = 0 , then the goods are unrelated

Knowledge of PED is important to firms seeking to maximise their revenue. If

the product is price inelastic in demand, the company should raise their prices to
maximise revenue. If the product is price elastic, then they should lower their
prices.

Knowledge of PED is important to governments with regard to taxation and

subsidies. If they tax price inelastic in demand goods, they can raise tax revenue
without harming firms too much. Consumers are less responsive to price changes so
firms will pass on the tax to the consumer. If they subsidies price elastic in demand
products, there can be a greater than proportional increase in demand.

Knowledge of XED is important to firms as they seek to maximise their revenue.

It can help them to adjust pricing strategies for substitute and complementary
goods. It can help them understand the likely impact of competitors pricing
strategies. Price elasticity varies along the length of
a straight demand curve, moving from
Knowledge of YED is important to firms
infinity, asA,
point they
to seek to maintain
1 at point B, to 0 sales
at and
maximise profits through periods of recession
point C or economic growth. Firms should
consider providing more inferiorBetween
goods inAaand
recessionary
B the PEDenvironment.
is elastic Firms
should consider providing moreBetween
luxury products
B and Cduring
the PEDperiods of economic
is inelastic
growth.

The revenue rule of PED : in order to maximise revenue, firms should increase the
price of products that are inelastic in demand and decrease prices on products that
are elastic in demand.
 Supply
Supply is the amount of a good/service that a producer is willing and able to supply
at a given price in a given time period.
A supply curve is a graphical representation of the price and quantity supplied by
producers, If data were plotted, it would be an actual curve, however economists
simplify it by drawing it as a straight line.
The supply curve is slopping upwards as there is a positive relationship
between price and quantity demanded. Rational profit maximising
Producers would want to supply more as price increase in order to
maximise their profits.

If price is the only factor (ceteris paribus), there will be a change in Quantity
Supplied (QS). This change is shown through a movement along the supply
curve.
A price increase from £7 to £9 will cause a movement up the curve from A to
B, leading to an increase in QS. A price decrease from £7 to £4 will lead to a
movement down the curve from A to C, leading to a decrease in the QS.

Factors affecting supply that will cause a shift in the entire supply curve :
- Costs of Production : If the price of raw materials or other costs of production
Change, firms respond by changing supply. If costs increase then S will shift to S1.
If costs decrease then S shifts to S2.
- Indirect taxes : Any change to specific taxes or ad valorem taxes change the cost
of
Production for a firm and impact supply. If taxes increase, then S shifts to S1, and
If taxes decrease then S shifts to S2.
- Subsidies : Changes to producer subsides directly impact the cost of production
for the
Firm. If the subsidy increase, then S shifts to S2. If the subsidy decreases then S
shifts to S1.
- New Technology : New technology increases productivity and lowers costs of
production. Ageing technology can have the opposite effect. IF technology
increases then S shifts to S2. If technology decreases then S shifts to S1.
- Changes in the number of firms in the industry : The entry and exit of firms
into the market has a direct impact on the supply, If ten new firms start selling and
building materials, then the supply of the materials will increase. If the number of
firms increases then S shifts to S2. If the number of firms decreases then S shifts to
S1.
 Elasticity of Supply
The law of supply states that when there is an increase in price (ceteris paribus),
producers will increase the quantity supplied and vice versa,
Price elasticity of supply (PES) reveals how responsive the change in quantity
supplied is to a change in price.
The values of PES vary from 0 to .
- If PES = 0, then it is price inelastic. This means that QD is completely
unresponsive to a change in P (eg. Fixed number of seats in theater)
- If PES = 0 ~ 1, then it is relatively inelastic. This means that the in QS is less
than proportional to the in P (eg. Agricultural products)
- If PES = 1 ~ , then is it relatively elastic. This means that the is QS is more than
proportional to the in P (eg. T-shirts)
- If PES =, then it is perfectly elastic. This means that The in QS will fall to
zero with any in P. However, supply is unlimited at a particular price. This is a
very theoretical scenario but is evident when examining international trade
diagrams
Factors that influence PES:
- Mobility of the factors of production : if producers can quickly switch their
resources between products, then the PES will be more elastic. For example, if
prices of hiking boots increase and shoe manufacturers can switch resources
from producing trainers to boots, then boots will be price elastic in supply.
- Availability of raw materials : if raw materials are scarce then PES will be
low (inelastic). If they are abundant, PES will be higher(elastic).
- Ability to store goods : if products can be easily stored then PES will be
higher (elastic) as producers can quickly increase supply (for example, tinned
food products). An inability to store products results in lower PES (inelastic).
- Spare capacity : if prices increase for a product and there is capacity to produce
more in the factories that make those products, then supply will be elastic. If
there is no spare capacity to increase production, then supply will be inelastic.
- Time period : In the short run, producers may find it harder to respond to an
increase in prices as it takes time to produce the product (e.g., avocados).
However, in the long run they can change any of their factors of production so as
to produce more.
Distinctions between short run and long run :
The resources used in production are called factors of production. All four factors
of production are required to produce any good/service.
- Short run is any period of time in which at least one factor of production is fixed
 Price Determination
In a free market economy, prices are determined by the interaction of demand and
supply in a market.
A market is any place that brings buyers and sellers together, they can be both
physical and virtual.
Buyers and sellers trade at an agreed price. Buyers agree the price by purchasing
the good/service. If they don’t agree on the price then they do not purchase the
good/service and are exercising their consumer sovereignty (the economic power
exerted by consumers in a market).
Based on this interaction with buyers, sellers will gradually adjust their prices until
there is an equilibrium price and quantity that works for both parties.
At the equilibrium price, sellers will be satisfied with the rate/quantity of
sales. At the equilibrium price, the utility/price combination is maximised for the
buyers
Equilibrium in a market occurs when demand = supply. At this point the price is
called market
clearing price. This is the price at which sellers are clearing their stock at an
acceptable rate.
At any price above or below P creates disequilibrium in the market.
Disequilibrium occurs whenever
there is excess demand or supply in a market.
Disequilibrium can create excess demand or excess supply.
Excess demand occurs when the demand is greater than the supply. It can occur
when prices are too low or when demand is so high that supply cannot keep up with
it.
- At a price of P1, the quantity demanded of electric scooters (Qd) is greater than
the
quantity supplied (Qs). There is a shortage in the market equivalent to QsQd.
- The market is in disequilibrium, Sellers realise they can increase prices and
generate more
revenue and profits. Sellers will gradually rise prices from P! to Pe.
- This causes a contraction in QD as some buyers no longer desire the
good/service at
a higher price.
- This causes an extension in QS as sellers are more incentivised to supply at
higher prices.
- In time, the market will have cleared the excess demand and arrive at a position
 Price Determination
Real world markets are constantly changing and are referred to as dynamic
markets
Market equilibrium can change every few minutes in some markets (e.g.
stocks and shares), or every few weeks or months in others (e.g clothing)
Any change to a condition of demand or supply will temporarily
create disequilibrium and market forces will then seek to clear the excess
demand or supply
Shifts in the demand or supply curves will change market equilibrium.
- A shift in the demand curve to the right will cause the price to increase
and supply will extend.
- A shift in the demand curve to the left will cause the price to decrease
and supply will contract.
- A shift in the supply curve to the right will cause the price to decrease
and demand to extend.
- A shift in the supply curve to the left will cause the price to increase and
demand to contract.
Elasticity will affect the point of the new equilibrium. This is because PES
and PED influence the size of changes in the equilibrium price and
quantity caused by supply and demand curve shifts.
- A shift of a price inelastic of supply or demand curve will have a greater
impact on the price.
- A shift of a price elastic of supply or demand curve will have a greater
impact on the quantity.
When using the demand and supply model we assume that:
- Demand and supply are independent of each other
- All markets are perfectly competitive
- Ceteris Paribus applies

However in real life, the market price could be at any level and there could
be excess demand or supply at any given time. The market prices will not
necessarily have to change to their equilibrium price.
Competitive market – large number of buyers and sellers.
 Price Mechanism
The price mechanism is the interaction of demand and supply in a free market.
This interaction determines prices which are the means by which scarce resources
are allocated between competing wants/needs.
Economic incentives provide the reasons for economic agents to provide goods
- Rationing
and services. These are based -on
Signalling -
the price mechanism, the method by which prices
for goods Incentive
and services are achieved. Economic incentives are the reasons for
economic agents providing goods and services.
They include:

The rationing function

- Excess demand for a good or service will lead to a rise in the price of a good or
service.
- Due to the scarcity of the product, there will be a price rise which will lead to a
reduction in demand.
- The scarcer a product the higher the price. This leads to a rationing of the product
as its use is restricted . There will be a movement along the demand curve showing
a decrease in quantity demanded and an increase in price
The incentive function
- Higher prices act as a motivator for producers to increase the supply of a good or
service
- This is due to greater contribution per unit i.e. the difference between selling
price and variable cost. As prices rise so do revenue and profit. There will be a
movement along the supply curve showing a increase in quantity supplied and a
decrease in price
Contribution per unit of a product is the difference between the selling price of a
product and the variable cost
The signalling function
Occurs because changing prices give a signal to consumers and producers as to
whether to leave or enter a market.
(All of these signals will lead to shifts in the supply or demand curves)
- An increase in price will give an indication to producers that they should increase
supply
- An increase in price will give an indication to consumers that they should reduce
demand
- A decrease in price will give an indication to producers that they should decrease
supply
- A decrease in price will give an indication to consumers that they should increase
 Producer and Consumer Surplus
Consumer and producer surplus relate to the size of the benefit to
consumers and producers from a given price level.
Consumer Surplus Area below the demand curve and
above equilibrium price line
Consumers have different tastes, incomes and views on how much they
are
prepared to pay. When a consumer pays less for a good than the amount,
they’re prepared to pay for it, this amount of money is known as
consumer
surplus.
Consumer surplus is the difference between the price that a consumer is
willing
to pay for a good and service and the price that they actually pay.
Producer Surplus
Producers have different costs when making goods/ services. If a
producer receives Area below the demand curve and
above equilibrium price line
more for a product or service than the price they’re willing to accept, the
extra
earnings are known as the producer surplus.
Producer surplus is the difference between the price that a producer is
willing to A shift in the A shift in the
supply a good or servicedemand
at and the price they receive for it. supply curve
curve from from S1 to
When the market is at equilibrium
D1 to D2 the producer and consumer surplus
are maximised S2 will cause
will cause an
Consumer surplus + producer an increase in
increase insurplus = social/community surplus
Any disequilibrium reduces theofsocial surplus
the area the area of
both both
A shift in
consumer consumer
A shift in the
andthe demand
producer and producer
supply curve
curve from
surplus surplus
from S1 to
D1 to D2
S2 will
will cause a
cause a
decrease in
decrease in
the area of
the area of
both
both
 Indirect Taxes and Subsidies
Governments intervene to a regulatory action taken by the government that
seek to change the decisions made by individuals, groups and organisations
about social and economic matters.
Governments sometimes provide subsidies to encourage demand for a
good.
A subsidy is a financial incentive to produce or consume a given product.
Government use taxation to finance their spending and control the
economy. They place indirect tax on a good or service to reduce the
demand for it.
A direct taxes is a tax on an individual or an organisation.
The incidence of a tax or the burden of tax is the amount that the consumer
or producer will pay for the tax.

Indirect taxes
- Tax on expenditure. There are 2 main types : value added tax (VAT) and
excise duties.
- VAT is is a example of ad valorem tax. The tax charged increases in
proportion to the value of the tax base.
- Excise duties are an example of a specific or unit tax. The amount of tax
charged does not change with the value of the goods but with the amount
or volume of the goods purchased. It is only paid if consumers make
a purchase
- It is usually levied by the government on demerit goods to reduce the
quantity demanded (QD) and/or to raise government revenue.
Government revenue is used to fund government provision of
goods/services e.g education

- Producers and consumers each pay a share (incidence) of the tax

The government places a specific tax on a demerit good
The supply curve shifts left from S1→S2 by the amount of the tax
The price the consumer pays has increased from P1 before the tax,
to P2 after the tax
The price the producer receives has decreased from P1 before the tax
 Indirect Taxes and Subsidies
A Side by Side Comparison of The Impact of PED on Tax Incidence
Aiming to maximise their profits, producers pass on as much of the indirect tax as
they can to consumers and pay the balance themselves
The amount passed on to consumers depends on the price elasticity of demand
In both diagrams, the specific
(PED) of the product
tax shifts the supply
curve from S1→S2There is
a higher market price at
P2 and lower QD at Q2
Tax revenue for the
government is the sum of A+B
Consumer incidence is
represented by A and producer
incidence by B
The difference in PED results in a different steepnessTotal
to therevenue
demand for the seller is
curve
calculated
For an inelastic product (e.g., cigarettes), producers pass usinghigher
on a much P3 X Q2
proportion of the tax to consumers (A) and pay the rest themselves (B)
The QD decreases (Q1→Q2) but by a much smaller proportion than the increase
in price (P1→P2)
For an elastic product (e.g., pizza), producers pass on a much smaller proportion of
the tax to consumers (A) and pay the rest themselves (B)
The QD decreases (Q1→Q2) but by a much larger proportion than the increase
in price (P1→P2)

Subsidies
A producer subsidy is a per unit amount of money given to a firm by the
government.
To increase production.
To increase provision of a merit good.
The incidence (share) of the subsidy is determined by the PED of the product
If governments subsidise goods/services with high PED, the increase in QD will
be more than proportional to the decrease in price
Producers keep some of the subsidy and pass the rest on to the consumers
The original equilibrium is at P1Q1. The subsidy shifts the supply curve from S →
S + subsidy:
- This increases the QD in the market from Q1→Q2
- The new market equilibrium is P2Q2
 Alternative Views on Consumer Behaviour
Alternative Views on Customer Behaviour
Free markets are built on the assumptions of rational decision making
In classical economic theory, the word 'rational' means that economic agents are able
to consider the outcome of their choices and recognise the net benefits of each one
- Rational agents will select the choice which presents the highest benefits
In many ways, the assumption of rational decision making is flawed. Consumers are
often more influenced by the following than a rational computation of net benefits
• The influence of other people's behaviour
• The importance of habitual behaviour
• Consumer weakness in computation

Influences on other people’s behaviour

Peer pressure often prompts consumers to make purchasing decisions that may go
against a computation of net benefits
Producers influence consumers choices through various forms of advertising,
including lifestyle, celebrity endorsement and influencer culture
- This results in emotional decisions and not necessarily rational decisions e.g.
consumers purchasing the branded Nurofen when they could purchase the much
cheaper (and essentially identical) Ibuprofen
Producers use advanced behavioural psychology techniques to influence consumer
choices e.g. Neuro branding

The importance of habitual behaviour

Consumers make so many purchasing decisions that they often rely on habits to
speed up the process
- Using rule of thumb refers to a short cut that makes a quick estimation of benefits
without gathering too much information
- Consumers use information from the past, which may be outdated, as they
habitually purchase the same products e.g. visiting the same sections in a
supermarket for several years
Consumer inertia often develops as convenience is prioritised
Consumers make purchasing decisions that directly harm them and are usually
addictive, for e.g. alcohol
Sellers recognise habitual patterns and exploit them. for example, products placed at
the checkout till to benefit from impulse purchasing (chewing gum)

Consumer Weakness at computation

 Types of Market Failure
Market failure occurs when the allocation of goods and services are
inefficient.
The role of the market is to allocate scarce resources efficiently. However
sometimes they fail because of allocative inefficiency.
In a free market, the price mechanism determines the most efficient
allocation of scarce resources in response to the competing wants and
needs in the market place
- Scarce resources are the factors of production (land, labour, capital,
enterprise)
- Free markets often work very well
However, the free market sometimes leads to Market Failure, where there
is a less than optimum allocation of resources from the point of view of
society. For example, when the free market causes a lack of
equity (inequality) or environmental degradation
- There is either over-provision or under-provision of the goods/services
and therefore an over-allocation or under-allocation of the resources
(factors of production) used to make these goods/services
- From society’s point of view there is a lack of allocative efficiency
- Markets may not exist (missing markets), leading to no production of a
good or service. This is known as complete market failure.
- Markets may lead to production of too many or too few goods; this is
known as partial market failure.
Sources of market failure include the existence of externalities, an under-
provision of public goods, and the existence of information gaps in markets
.

Externalities occur when there is an external impact (cost or benefit) on a

third party not involved in the economic transaction. These impacts can
be positive or negative
A positive externality of consumption occurs when the external impact
on society/third party is positive such as when electric vehicles are
consumed CO2 emissions fall
A positive externality of production occurs when the external impact on
society/third party is positive such as when managed pine forests produce
timber but also increase CO2 absorption
 Externalities
Externalities occur when there is an external impact on a third party not involved
in the economic transaction
- These impacts can be positive or negative and are often referred to as spill over
effects
- These impacts can be on the production side of the market (producer supply) or on
the consumption side of the market (consumer demand)

External costs occur when the social costs of an economic transaction are greater
than the private costs
- A private cost for the producer is what they actually pay to produce a good/service
- An external cost (negative externality) is the damage not factored in to the
economic activity (for example, generating air pollution when producing
electricity)
- Private cost + external cost = social costs

External benefits occur when the social benefits of an economic transaction are
greater than the private benefits
- A private benefit for the consumer is what they actually gain from consuming a
good/service
- An external benefit (positive externality) is the benefit not factored in to the
economic activity (for example, someone who studies law enjoys private benefits
but society benefits from having strong legal institutions)
- Private benefit + external benefit = social benefits

The Impact of Externalities and Government Intervention in Different Markets

The Impact of Negative Externalities and Government Intervention
- Extraction of Iron Core (mining)
- External Costs are : Soil erosion, Loss of habitat for species, Decrease in air
quality, Chemical leakage into the water table
- Possible Stakeholders : producers (miners), manufacturers who purchase the
iron, environment, community who live nearby, government, special intrest
groups such as environmental pressure groups such as Greenpeace
- Government intervention : indirect taxation, legislation and regulation
enforcement through fines

The Impact of Positive Externalities and Government Intervention

- Leisure Centres
- External Benefits : Healthy people require less state medical care, Relieves
 Externalities
External Costs of Production
Negative externalities of production are often created during the production of a
good/service.
The market is failing due to over-provision of these goods/services as only
the private costs are considered by the producers and not the external costs. If
the external costs were considered, the quantity of the goods/services
provided would decrease and they would be sold at a higher price.
Marginal analysis in economics considers the cost or benefit of the next unit
produced or consumed
The marginal private cost (MPC) is the cost of the next unit produced
or consumed
The marginal private benefit (MPB) is the benefit derived from the
production or consumption of the next unit
The marginal social benefit (MSB) is assumed to be equal to the marginal private
benefit (MPB) as the focus is on the producer side of the market.
The free-market equilibrium can be seen at PeQe. This is where the MPC = MSB
The larger the external costs in production, the larger the gap between the MPC
and the marginal social cost (MSC)
The optimal allocation of resources from society’s point of view, would generate
an equilibrium where MSB = MSC. This can be found at PoptQopt.
There is no market failure at this equilibrium
The free market is failing due to over-provision of this good/service at Qe
The factors of production used to manufacture this over-provision represent
a welfare loss to society (pink triangle)
To be socially efficient, fewer factors of production should be allocated to
producing this good/service
There is an opportunity for government intervention (indirect taxes, legislation,
regulation etc.), to force this market to be more socially efficient
Any intervention that reduces the welfare loss will be beneficial
External Benefits of Consumption
Positive externalities of consumption are created during the consumption of a
good/service (merit goods)
The market is failing due to under-consumption of these goods/services as only
the private benefits are considered by the consumers and not the external benefits
If the external benefits were considered, the quantity of the goods/services
consumed would increase and they would be sold at a higher price
MSC is assumed to be equal to the MPC as the focus is on the consumer side
 Private and Public Goods
Private goods are goods which firms are able to provide to generate profits. They
can generate profits as these goods are excludable and rivalrous.
- The firm is able to exclude certain customers from purchasing their
goods through use of the price mechanism. If customers cannot afford to buy
them, then they are excluded.
- Customers can also compete for these goods which are limited in supply
and this rivalry helps to generate profits for firms.
Public goods are goods that are beneficial to society but which will not be provided
by private firms due to the principles of non-excludability and non-rivalry.
- Non-excludability refers to the inability of private firms to exclude
certain customers from using their products. In effect, the price mechanism
cannot be used to exclude customers e.g. street lighting
- Non-rivalry refers to the inability of the product to be used up, so there
is no competitive rivalry in consumption to drive up prices and generate
profits for firms
- Therefore, governments will often provide these beneficial goods
themselves, and so they are called public goods
If firms decided to provide these goods anyway, it would give rise to what is called
the ‘free rider’ problem. Information Gaps
This is a situation where customers realise that they can still access the
goods, even without paying for them
If they are paying, they stop and continue to enjoy the benefits. They
are ‘free-riding’ on the backs of other paying customers
Over time, any customers who are paying for the goods will stop
At some point firms will cease to provide these goods and they will
become under-provided in society

Information gaps exist in nearly all free markets and distort market outcomes
resulting in market failure. One of the underlying assumptions of a free market is
that there is perfect information in the market.
This means that buyers and sellers have exactly the same level of information about
the good/service. This is called symmetric information
In many markets buyers and sellers have different levels of information. This is
called asymmetric information. For example, there is asymmetric information in
the used car market - sellers know more about the vehicle than the buyers
 Government Intervention in Markets
Governments intervention is necessary for several reasons
- Support firms : in a global economy, governments choose to support key
industries so as to help them remain competitive
- Promote equity : to reduce the opportunity gap between the rich and poor
- Collect government revenue : governments need money to provide essential
services, public and merit goods, Revenue is raised through intervention such as
taxation, privatisation, sale of licenses (e.g. 5G licenses), and sale of
goods/services.
- Support poorer households : poverty has multiple impacts on both the
individual and the economy, Intervention seeks to redistribute income (tax the
rich and give to the poor) so as to reduce the impact of poverty
- Correct market failure : in many markets there is a less than optimal
allocation of resources from society's point of view. In maximising their self-
interest, firms and individuals will not self-correct this allocation of resources
and there is a role for the government. They often achieve this
by influencing the level of production or consumption
Four of the most common methods used to intervene in markets are indirect
taxation, use of subsidies, maximum prices, and minimum prices
Indirect Taxation
An indirect tax (a tax on consumption, only paid when a good is purchased) can be
either ad valorem or specific
Ad valorem is a tax that is a percentage of the purchase price, eg. VAT
The more goods/services consumed, the larger the tax bill. This causes the second
supply curve to diverge from the original supply curve.
VAT raises significant government revenue.
Initial equilibrium is at P1Q1
Supply shifts left due to the tax from S → S + tax
- The two supply curves diverge as percentage tax means more tax is paid
at higher prices
Consumer incidence of tax is (P2 - P1) x Q2 - Area A
Producer incidence of tax is (P1 - P3) x Q2 - Area B
New equilibrium is at P2Q2
- Final price is higher (P2) and QD is lower (Q2)
 Government Intervention in Markets
A Specific tax is a fixed tax per unit of output (specific amount)
Specific Tax on Negative Externality of Production
Governments frequently tax firms that pollute or create harmful external costs in
production
The free-market equilibrium is at PeQe - where MSB = MPC
- Market failure exists as MSC > MSB at equilibrium
- Optimum level of output is at Qopt
- There is over-provision of this product
A specific tax shifts the supply curve left from S → S1
- The tax does not completely eradicate the welfare loss but moves the market
closer to the optimum level of output (Qopt)
- The welfare loss has been reduced as shown in the diagram
A diagram that shows the impact of a tax
The new market equilibrium is at P1Q1 on a product that is over-provided in
- This is a higher price and less output society. The tax reduces the welfare loss
- There is less over-provision and so less market failure
and moves production closer to the
- The external costs have been reduced optimum level of production
Specific Tax on Negative Externality of Consumption
Governments frequently tax demerit goods such as cigarettes, alcohol, fatty foods,
and polluting vehicles
The free-market equilibrium is at PeQe - where MPB = MSC
- Market failure exists as MSC > MSB at equilibrium
- Optimum level of consumption is at Qopt
- There is over-consumption of this product
A specific tax shifts the supply curve left from S → S1
- The tax does not completely eradicate the welfare loss but moves the
market closer to the optimum level of output (Qopt)
- The welfare loss has been reduced as shown A diagram that shows the impact of a tax
in the diagram
The new market equilibrium is at P1Q1 on a product that is over-consumed in
- This is a higher price and lower output society. The tax reduces the welfare loss
- There is less over-consumption and so lessand moves
market consumption closer to the
failure
- The external costs have been reduced optimum level of production
 Government Intervention in Markets
Subsidies
Governments frequently use subsidies to encourage production/consumption
of merit goods such as energy efficient products, electric vehicles, healthcare, and
education
The free-market equilibrium is at PeQe - where MPB = MSC
- Market failure exists as MSB > MSC at equilibrium
- Optimum level of output is at Qopt
- There is under-consumption of this product
A subsidy shifts the supply curve right from S → S1
- It does not completely eradicate the potential welfare gain
but moves the market closer to the optimum level of output (Qopt)
- The potential welfare gain has been reducedAasdiagram
shown in theshows
that diagram
the impact of
The new market equilibrium is at P1Q1 a subsidy on a product that is
- This is a lower price and higher output under-consumed in society. The
- There is less under-consumption and so lesssubsidy
market failure
reduces the potential
- Some of the external benefits available havewelfare
been realised
gain and moves
consumption closer to the optimum
level
Other Methods of Government Intervention
Trade Pollution Permits
Governments create a pollution permit market and issue permits to polluting firms
This helps to reduce negative externalities of production
Each permit is typically valid for the emission of one ton of pollutant
More polluting firms have to buy additional permits from less polluting
firms
The price of the permit represents an additional cost of production
If the price of additional permits is more than the cost of investing in new pollution
technology, firms will be incentivised to switch to cleaner technology:
Firms can then sell their spare permits and gain additional revenue
State Provision of Public Goods
Public goods are beneficial for society and are not provided by private firms due to
the free rider problem
They are usually provided free at the point of consumption, but are paid for
through general taxation
Examples include roads, parks, lighthouses, national defence
Regulation
 Government Intervention in Markets
MAXIMUM PRICES
Governments will often use maximum prices in order to
help consumers. Sometimes they are used for long periods of time e.g. housing
rental markets.
Other times they are short-term solutions to unusual price increases e.g. petrol
A maximum price is set by the government below the existing free market
equilibrium price and sellers cannot legally sell the good/service at a higher price
Initial market equilibrium is at PeQe
A maximum price is imposed at Pmax
- The lower price reduces the incentive to supply and there is contraction in QS
from Qe → Qs
- The lower price increases the incentive to consume and there is an extension in
QD from Qe → Qd
- This creates a condition of excess demand QsQd
Some consumers benefit as they purchase at lower prices
- Others are unable to purchase due to the shortage
- This unmet demand usually encourages the creation of illegal markets
(black/grey markets)

MINIMUM PRICES
Governments will often use minimum prices in order to help producers or
to decrease consumption of a demerit good e.g. alcohol
A minimum price is set by the government above the existing free market
equilibrium priceand sellers cannot legally sell the good/service at a lower price.
Minimum prices are also used in the labour market to protect workers from wage
exploitation. These are called minimum wages.
.

Initial market equilibrium is at PeQe

A minimum price is imposed at Pmin
- The higher price increases the incentive to supply and there is an extension in
QS from Qe → Qs
- The higher price decreases the incentive to consume and there is a contraction in
QD from Qe → Qd
- This creates a condition of excess supply QdQs

Differences in Government Responses to the Excess Supply

 Government Failure
Government failure occurs when the government intervenes in a market to correct
market failure, but the intervention results in a more inefficient allocation of
resources from society's point of view.
- This results in even greater welfare loss
- Usually represents poor value for money
- May have long term consequences

Causes of Government Failure

- Distortion of Price Signals :
The signaling function of the price mechanism is artificially altered.
Price intervention may help solve one problem but creates others
- Unintended Consequences :
Producers and consumers aim to maximise their self interest. This often leads them
to look for legal or illegal loop holes to bypass government intervention. This result
creates unintended consequences such as the creation of illegal markets and/or
illegal production/consumption
- Excessive Administrative Costs :
Regulation or administration costs can be expensive. The costs can sometimes
be greater than the savings in social welfare.
- Information Gaps :
Government decision making is subject to the same information gaps and cognitive
biases (e.g. anchoring) that consumers face. Decision makers do not have perfect
information. Decision makers are subject to political pressure

Government Failure in Various Markets :

- Environment Agency - Regulatory Failure
The Environment Agency is responsible for regulating major industry, waste, and
treatment of contaminated land. water quality and resources
According to the BBC, in 2021 there were more than 375,000 instances of raw
sewage pumped into England's rivers
- UK Energy Market - Regulatory Failure
The UK energy market was privatised between 1986 and 1990. Ofgem, the energy
market regulator in the UK sets a maximum price on energy costs
In 2021, British Gas (owned by Centrica) profits were £948m. In 2022, Ofgem
raised the maximum price by 53%
Unable to afford the increased payments, some pensioners ride buses in the winter
to stay warm
 Theme 2
The UK Economy – Performance and Policies
2.1 Measures of Economic Performance
- Economic Growth
- Inflation
- Employment and Unemployment
- Balance of Payments
2.2 Aggregate Demand
- The Characteristics of AD
- Consumption (c)
- Investment (I)
- Government Expenditure (G)
- Net Trade (X-M)
2.3 Aggregate Supply
- The Characteristics of AS
- Short-run AS
- Long-run AS
2.4 National Income
- National Income
- Injections and Withdrawals
- Equilibrium Levels of Real National Output
- The Multiplier
2.5 Economic Growth 2.6 Macroeconomic Objective
- Causes of Growth and Policies
- Output Gaps - Possible macroeconomic
- Trade (Business) Cycle Objectives
- Demand-side Policies
- The Impact of Economic Growth
- Supply-side Policies
-
 Economic Growth
Economic Growth describes an increase in the quantity and quality of the economic
goods and services that a society produces and consumes.
It is the rate of change of output. It is an increase in the long term productive
potential of the country which means there is an increase in the amount of goods and
services that a country produces.
It is typically measured by the percentage change in real GDP per annum. It can also be
shown through a shift of PPF.
It can be measured through the expenditure approach : adds up the value of all
expenditure in the economy, including consumption, investment by firms, net exports
and government spending,
It can also be measured through the income approach : adds up the rewards of the
factors of production used, wages from labour, rent from land, intrest from capital and
profit from entrepreneurship.
Both should give off the same figure as one party’s expenditure is another’s income.
The value of GDP is different to the volume of GDP.
The value in the monetary worth
The volume is the physical number
Gross Domestic Product: ​The standard measure of output, which allows us to compare
countries. It is the total value of goods and services produced in a country within a year.
- It is an indicator of the standard of living in a country
- Total GDP represents the overall GDP for the country whilst GDP per capita is the
total GDP divided by the number of people in a country
- GDP per capita grows if national output grows faster than population over a given
period, so there are more goods and services to enjoy per person
- Nominal GDP is the actual value of all goods/service produced in an economy in a
one-year period
- Real GDP is the value of all goods/services produced in an economy in a one-year
period and is adjusted for inflation whilst Nominal GDP does not
Gross National Income (GNI) : The value of goods and services produced by a country
over a period of time plus net overseas interest payments and dividends. This means that
it adds what a country earns from overseas investments and subtracts what foreigners
earn in a country and send back home from the GDP. It is affected by profits from
businesses owned overseas and remittances sent home by migrant workers. This is
increasingly used rather than GDP because of the growing size of remittances and aid.
Gross National Product (GNP) : The value of goods and services over a period of time
through labour or property supplied by citizens of a country both domestically (GDP)
and overseas. This means it is the value of all the goods produced by citizens of a
country, whether they live in the country or not, whilst GDP is the value of all goods
 Economic Growth
Purchasing power parity (PPP) is a conversion factor that can be applied to GDP,
GNI and GNP.
It calculates the relative purchasing power of different currencies.
The aim of PPP is to help make a more accurate standard of living
comparison between countries where goods/services cost different amounts.
An exchange rate of one currency for another which compares how much a ​typical
basket of goods ​in the country costs compared to one in another country.
National happiness and societal well-being are measured in the UK by the Office
for National Statistics (ONS).
While GDP focusses on production, happiness focuses on health, relationships, the
environment, education, satisfaction at work and living conditions
The UN happiness report found ​six key factors​: real GDP per capita, health and
life expectancy, having someone to count on, perceived freedom to make life
choices, freedom from corruption, and generosity.

Problems of using GDP to compare standard of living:

- Inaccuracy of data: In Some countries are ​inefficient at collecting or
calculating data and therefore comparisons can become less effective.
There is a ‘​hidden’ or ‘black’ market in which people work without declaring
their income to avoid tax or to continue claiming benefits, and so GDP is
underestimated because these incomes aren’t taken into account. This varies
hugely between countries and may change overtime. Errors in calculating the ​
inflation rate means real GDP will be slightly inaccurate. Over time, ​methods
used to calculate GDP will change and so therefore it can be difficult to compare
countries overtime. Similarly, different countries may use different methods to
calculate their GDP.
- Inequalities: An increase in GDP may be due to a growth in income of just one
group of people and so therefore a growth in the national income may not
increase living standards everywhere. Income distribution changes overtime and
varies between countries so makes comparisons difficult.
- Quality of goods and services​: The quality of goods and services is much
higher than those fifty years ago, but this is not necessarily reflected in the real
price of these goods and services. Therefore, living standards may have
increased more than GDP would suggest since the quality of goods and services
has improved greatly. Improved technology may allow prices to fall, suggesting
falling living standards, when this is not the case.
- Comparing different currencies: ​There are issues over which unit should be
 Inflation

Inflation is the sustained increase in the average price level of goods/services in an

economy (which erodes the purchasing power of money).
Low inflation is generally considered to be better than high inflation.
Deflation ​is the fall of prices and indicates a slowdown in the rate of growth of
output in the economy. Deflation only occurs when the percentage change in prices
falls below zero %
Disinflation ​is a reduction in the rate of inflation i.e. prices are still rising but they
are not rising by as much.
Indices: ​Nominal figures must be changed into real figures to make comparisons.
This is done by choosing one year for the base year and adjusting all other figures
into equivalent figures.
In Britain, the most well-known indices are the retail price index (RPI) and the
consumer price index (CPI). The base figure is given an index figure of 100 and
all the figures before or after that time are then compared to that figure.
(new figure/base figure)
x 100
The inflation rate is the change in average price levels in a given time period.
The inflation rate is calculated using an index with 100 as the base year
Consumer Price Index
A 'household basket' of 700 goods/services that an average family would purchase
is compiled on an annual basis. A household expenditure survey is conducted to
determine what goes into the basket
Each year, some goods/services exit the basket and new ones are added.

Each month, prices for these goods/services are gathered from 150 locations across
the UK. These prices are averaged out
The price x the weighting determines the final value of the good/service in the
basket. These final values are added together to determine the price of the 'basket’

The percentage difference in CPI between the two years is the inflation rate for the
period.
.
Limitations of CPI
The CPI provides a level of inflation for the average basket and the basket of many
households is not the average basket. Depending on what households buy the level
 Inflation

Retail Price Index

The retail price index (RPI) is calculated in exactly the same way as the CPI.
Certain goods/services that are excluded from the CPI are included with the RPI.
These include council tax, mortgage interest payments, house depreciation,
and other house purchasing costs such as estate agents fees.
Due to the extra inclusions, inflation measured using the RPI is usually higher
than the CPI.
This is mainly due to its sensitivity to interest rate changes which affect mortgage
interest.
It's argued that the RPI is a more accurate indication of a households inflation.
Causes of Inflation
An increase in the average prices in an economy can be caused by demand pull
inflation, cost push inflation, an increase in the money supply, and an increase
in wages

Demand Pull Inflation

Demand pull inflation is caused by excess demand in the economy
Aggregate demand (AD) is the sum of all expenditure in the economy
AD = Consumption (C) + Investment (I) + Government spending (G) + Net
Exports (X-M)
Short run aggregate supply (SRAS) is the total supply provided in the economy at
a given average price level.
If any of the four components of AD increase, there will be a shift to the right
of the AD curve from AD1 → AD2.
At the original price (AP1), there is now a condition of excess demand in
the economy.
As prices rise, there is a contraction of AD and an extension of SRAS
Prices for goods/services are bid up from AP1 → AP2
Demand pull inflation has occurred.

Cost Push Inflation

Cost push inflation is caused by increases in the costs of production in an economy
If any of the costs of production increase (labour, raw materials etc.),
or if there is a fall in productivity, there will be a shift to the left of
the SRAS curve from SRAS1→SRAS2
 Inflation

Changes to the Money Supply

If the Central Bank lowers the base rate, there is likely to be increased
borrowing by firms and consumers.
This will result in an increase in consumption and investment
It is likely to lead to a form of demand-pull inflation
The Central Bank can also increase the money supply through quantitative easing
- This will result in increased liquidity and lower interest rates
- It is likely to lead to a form of demand-pull inflation

Quantitative Easing is when the Central Bank purchases securities such as bonds
on the open market so as to increase the money supply.

Changes to Wages
Increased aggregate demand in an economy causes demand-pull inflation.
Workers now feel less well off as their wages no longer have the
same purchasing power.
Workers may demand wage increases to compensate for the higher prices
Those wage increases are now a form of cost push inflation (increased
costs of production) and drive prices even higher
This economic phenomenon is called a wage-price spiral

Effects of Inflation on Different Stakeholders.

Firms :
- Uncertainty. Rapid price changes create uncertainty and delay investment
- Price changes force firms to change their menu prices too and this can be
expensive
Consumers :
- Decrease in purchasing power
- Decrease in the real value of savings (as money will be worth less in real terms)
- Fall in real income for those on fixed incomes/pension

Government :
- Inflation erodes international competitiveness of export industries
- Trade-offs involved in tackling inflation e.g reducing inflation may increase
unemployment and/or reduce economic growth
Workers :
- Demand higher wages to compensate for reduced purchasing power
 Employment and Unemployment
The unemployed are those people able, available and willing to work at the going wage
but cannot find a job despite an active search for work.
Unemployment is a waste of scarce resources, This is because output would be higher if
employment rises.
The rate of unemployment is the number of people who are looking for a job but
cannot find one, the number of people out of work as a percentage of the labour force.
A country's population is divided into the labour force - and non labour force
- The labour force is made up of those in employment and those who are unemployed.
The labour force is also known as the economically active population.
- The non labour force includes all those not seeking work e.g. stay at home parents,
pensioners, school children
Economically inactive are those people who are between 16-65 and not working or not
seeking work
Unemployment in the UK is measured using two different approaches :
- The International Labour Organisation (ILO) Survey
The International Labour Organisation has set an international standard for
measuring unemployment which is used by the OECD, the statistical office of the EU
and many other countries.
An extensive survey is sent to a random sample of ≈ 60,000 UK households every
quarter
Respondents self-determine if they are unemployed based on the ILO criteria
- Ready to work within the next two weeks
- Have actively looked for work in the past one month
The same survey is used globally so it’s useful for making international
comparisons
- The Claimant Count
Counts the number of people claiming job seekers allowance (JSA) in the UK
More stringent requirement to be considered unemployed than with the ILO survey
Requires claimants to meet regularly with a 'work coach’
Unlike the unemployed, people who are underemployed are working.
Someone is underemployed when they want to work more hours than they currently
work or they are working in a job that requires lower skills than they have e.g. an
architect working as a gym instructor.
Underemployment is often a response to cyclical unemployment – unemployment
caused by a fall in AD in an economy which causes firms to lay off workers.
Underemployment is also a consequence of structural unemployment –
Unemployment caused by a mismatch between jobs and skills as the structure of an
economy changes
 Employment and Unemployment
The Significance of Changes to Employment, Unemployment and Inactivity
Rates
Four Metrics Are Commonly Used When Analysing the Labour Market in an
Economy:
Unemployment rate :

Labour force participation rate :

Employment rate :

Inactivity rate :

The Significance of Changes to Employment, Unemployment and Inactivity

Rates
The employment rate could be increasing even as the unemployment rate is
increasing:
- May be caused by increased immigration which causes working age population to
increase
- May be caused by a decrease in the inactivity rate as people move from inactive to
employed
Unemployment rates do not capture the hidden unemployment that occurs in
the long term
- Workers look for a job but may eventually give up and become economically
inactive
- This actually improves the unemployment rate as fewer people are actively
seeking work

The Significance of Migration On Employment/Unemployment

Labour is a key factor of production and one way to expand output in an economy
is to increase the amount of labour available.
Net migration is the difference between inward migration and outward migration
(emigration)
Less developed economies generally have net outward migration
More developed economies generally have net inward migration
More developed economies usually have skilled workers emigrating
Employment and Unemployment
 Balance of Payments
The Balance of Payments (BoP) for a country is a record of all the financial
transactions that occur between it and the rest of the world.
The BoP has two main sections:
The current account: all transactions related to goods/services along
with payments related to the transfer of income
The financial and capital account: all transactions related to savings,
investment and currency stabilisation
It is called the BoP as the current account should balance with the
capital/financial account and be equal to zero. If the current account balance
is positive, then the capital/financial account balance is negative (and vice versa)
Money flowing into the country is recorded in the relevant account as a credit
(+) and money flowing out as a debit (-)
Current Account
The Current Account is often considered to be the most important account in the
BoP.
It records the net income that an economy gains from international
transactions
- Goods are also referred to as visible exports/imports
- Services are also referred to as invisible exports/imports
- Net income consists of income transfers by citizens and corporations
Credits are received from UK citizens who are abroad and
send remittances home
Debits are sent by foreigners working in the UK back to their countries
- Current transfers are typically payments at government level between countries
e.g. contributions to the World Bank
- The Current Account balance is often expressed as a % of GDP
This allows for easy international comparisons
Current Account Deficits and Surpluses
A Current Account deficit occurs when the value of the outflows is greater than
the value of the inflows
Usually occurs when the imports > exports
A Current Account surplus occurs when the value of the inflows is greater than
the value of the outflows
Usually occurs when imports < exports
The UK government has a macroeconomic aim to get their Current Account
 The Characteristics of AD
Aggregate demand (AD) is the total demand for all goods/services in an economy
at any given average price level.
Its value is often calculated using the expenditure approach
AD = Consumption (C) + Investment (I) + Government spending (G) +
(Exports-Imports) (X-M)
AD = C + I + G + (X-M)
If AD increases then economic growth has occurred and vice versa
Consumption is the total spending on goods/services by consumers (households) in
an economy
Investment is the total spending on capital goods by firms
Government spending is the total spending by the government in the economy:
Includes public sector salaries, payments for provision of merit and
public goods etc.
It does not include transfer payments
Net exports are the difference between the revenue gained from selling
goods/services abroad and the expenditure on goods/services from abroad

Depending on the country, the value of each component and its contribution to
AD can vary significantly:
Government spending in Sweden is 53% of AD and in the UK, it is 25% of AD
The % that each component contributes to AD in the UK is approximately :
Consumption: 60%
Investment: 14%
Government spending: 25%
Net Exports: 1%
A 1 % increase in consumption or government spending will have a much larger
impact on economic growth than a 1% increase on net exports
The AD curve is downward sloping due to three reasons:
1. The interest rate effect: At higher average price (AP) levels, there are
likely
to be higher interest rates. Higher interest rates increase investment and are an
incentive for households to save - and vice versa
2. The wealth effect: As AP increases, the purchasing power of households
decreases and AD falls - and vice versa
3. The exchange rate effect: As AP falls, interest rates are likely to fall too.
 The Characteristics of AD
Whenever there is a change in the average price level (AP) in an economy,
there is a movement along the aggregate demand (AD) curve
An increase in the AP (ceteris paribus) from AP1 → AP2 leads
to a movement along the AD curve from A → B
There is a contraction of real GDP from Y1 → Y2
.

A decrease in the AP (ceteris paribus) from AP1 → AP3 leads

to a movement along the AD curve from A → C
There is an expansion of real GDP (output) from Y1 → Y3

Whenever there is a change in any of the determinants of aggregate

demand (AD) in an economy, there is a shift of the entire AD curve
An increase in any one of the determinants of aggregate demand (AD)
results in a shift right of the entire curve from AD1 → AD2
At every price level, real GDP has increased from Y1 → Y2
.

A decrease in any one of the determinants of AD results in a shift left

of the entire curve from AD1 → AD3
At every price level, real GDP has decreased from Y1 → Y3
 Consumption
The Influence of Disposable Income On Consumption
Disposable income is the money that households have left from
their salary/wages after they have paid their taxes and have received any transfer
payments/benefits.
If taxes increase, then disposable income decreases - and vice versa
If wages fall, then disposable income decreases - and vice versa
If transfer payments to a household increase (e.g. Unemployment benefits),
then disposable income increases - and vice versa
- Consumption increases as disposable income increases
- Consumption decreases as disposable income decreases
The Relationship Between Savings and Consumption
Disposable income can either be saved or spent on goods/services (consumption)
- When savings decrease, consumption usually increases
- When savings increase, consumption usually decreases
.

The household savings ratio calculates household savings as a proportion of

household income
This percentage is often low when an economy is booming and full of confidence -
and vice versa
During lockdown in 2020 this ratio reached a record high in the UK of around 25%
Other Influences on Consumer Spending
Changes to Interest Rates
Interest rates are set by the government's Central Bank. Changes to the base
rate cause commercial banks to change the lending and saving rates they offer
customers
A change in interest rates will change the level of consumer spending and
savings
- If interest rates increase there is a greater incentive to save
More saving = less consumption
- If interest rates increase, the monthly repayment on any loan
or mortgage increases
Higher loan repayments = less consumption
.

Changes to Consumer Confidence

The stronger the economy, the higher consumer confidence
Consumers feel secure in their jobs and are confident of receiving regular salary
payments. Consumption increases and saving decreases
.
 Investment
Gross and Net Investment
Investment is the total spending on capital goods by firms.
- Investment helps to increase the capacity (production possibilities) of an
economy. Increased capacity = increased potential economic growth
Depreciation is the decrease in monetary value of a capital good (asset) over time.
Replacing old capital goods does not necessarily increase capacity
It can, if the replacement technology means an increase in capacity is possible.
A distinction can be drawn between gross and net investment
- Gross investment is the total amount of spending on capital goods
This spending includes replacing old capital goods and purchasing new capital
goods
- Net investment is the gross investment - depreciation
This metric provides information on the addition of new capital goods to an
economy
It gives a better indication of the extra production possibilities that have been
created through investment by firms
Firms will choose to invest if they feel confident that they will make a good return
on their investment.
The decision to invest is linked to the business objective of profit maximisation
The influences on Investment are :
- Rate of Economic Growth
Increasing growth sends a signal that higher output will generate higher profits
The faster the economic growth, the greater the urgency to invest
- Interest Rates
Most investment by firms is financed through business loans
Decreasing interest rates encourage investment
There is a mostly inverse relationship between investment and interest rates
- Demand for exports
If demand for exports increases, firms will likely invest to meet the global demand
Demand for exports can increase if the exchange rate depreciates
Goods/services now seem cheaper to foreigners
- Influence of governments and regulations
Government intervention can increase investment e.g. subsidies
Government regulation can decrease investment (it raises costs of production for firms and can
lower profits)
- Business expectations and confidence
The longer a period of economic growth, the higher the business confidence will be. If growth
 Government Expenditure
Government expenditure refers to the purchase of goods and services, which
include public consumption and public investment, and transfer payments
consisting of income transfers (pensions, social benefits) and capital transfer.
Government expenditure is influenced by the trade/business cycle and spending
linked to achieving policy aims
Government expenditure can happen on a local level (e.g., Kent County Council) or
a national level (central government)
Influence of The Trade/Business Cycle on government expenditure
- Unemployment decreases with a booming economy leading to a lower
level of means tested benefit payments - and vice versa
- Tax revenue increases with a booming economy and can be used to pay
back government debt or increase expenditure on public/merit goods - and
vice versa
Influence of Policy Aims on government expenditure
- Fiscal Policy is set once a year and announced during the presentation
of the Government's budget
- Expenditure is directly related to the Government's objectives
and policy aims. E.g., A policy aimed at upgrading Britain's Navy
requires increased expenditure
The trade/business cycle is the stages of economic growth that an economy moves
through including boom, slowdown, recession and recovery.
- Real output increases when there are periods of economic growth. This is the
recovery stage.
- The boom is when economic growth is fast, and it could be inflationary or
unsustainable.
- During recessions, there real output in the economy falls, and there is negative
economic growth.
governments might increase spending to try and stimulate the economy. This could
involve spending
on welfare payments to help people who have lost their jobs, or cutting taxes.
This will increase the government deficit, and they may have to finance this.
- During periods of economic growth, governments may receive more tax revenue
since consumers
will be spending more and earning more. They may decide to spend less, since the
economy does not
 Net Trade
The net trade balance is the difference between the value of the exports and
imports (X-M)
The net trade balance is influenced by changes to real income, exchange rates, state
of the world economy, and the degree of protectionism.
Exports are goods and services that are produced in one country and sold in
another.
Imports are goods and services brought into a country after being produced in
another.
Exports are an inflow of money to a country, and imports are an outflow.
Exports are an injection into the circular flow and imports are a withdrawal.

How net trade is affected by a change in its factors.

- An increase in UK real income will have little effect on the amount of
exports, but will cause an increase in the value of imports as consumers
purchase more. Therefore the trade balance weakens.
- An increase in real income abroad will cause an increase in the value of
exports as foreigners will purchase more UK products, but it will have little
effect on the amount of imports. Therefore the trade balance strengthens.
- The UK £ appreciates, this will lead to UK goods being too expensive for
foreigners and hence the amount of exports decreases, and the foreign goods
will be cheaper for UK and hence imports increase. Therefore the trade
balance weakens.
- The UK £ depreciates, this will lead to UK goods being less expensive for
foreigners and hence the amount of exports increases, and the foreign goods
will be more expensive for UK and hence imports decrease. Therefore the
trade balance strengthens.
- The world economy booms, this will lead to an increase in demand for UK
goods and hence increasing exports and will have little effect on the amount
of imports. Therefore the trade balance strengthens.
- The world economy slows, this will lead to an decrease in demand for UK
goods and hence decreasing exports and will have little effect on the amount
of imports. Therefore the trade balance weakens.
- Protectionism increases, the amount of exports depends on the retaliation
measures from other countries, there will be a decrease in demand for
imported goods as they will be more expensive. Therefore the trade balance
 Characteristics of AS
Aggregate supply is the total supply of goods/services produced within an
economy at a specific price level at a given time
The AS curve is upward sloping due to two reasons:
1. The aggregate supply is the combined supply of all individual supply curves
in an economy which are also upward sloping
2. As real output increases, firms have to spend more to increase production
e.g. wage bills will increase. Increased costs result in higher average prices

Whenever there is a change in the average price level (AP) in an economy, there is
a movement along the short run aggregate supply (SRAS) curve
An increase in the AP (ceteris paribus) from AP1 → AP2 leads to a movement
along the SRAS curve from A → B
There is an expansion of real GDP from Y1 → Y2
A decrease in the AP (ceteris paribus) from AP1 → AP3 leads to a movement
along the SRAS curve from A → C
There is a contraction of real GDP (output) from Y1→Y3

Whenever there is a change in the conditions of supply in an economy (e.g. costs of

production or productivity changes), there is a shift of the entire SRAS curve
A decrease in costs or increase in productivity results in a shift right of
the entire curve from SRAS1 → SRAS2
At every price level, output and real GDP has increased from Y1 → Y2
An increase in costs or decrease in productivity results in a shift left of
the entire curve from SRAS1 → SRAS3
At every price level, output and real GDP has decreased from Y1 → Y3

The Relationship Between Short-run and Long-run AS

Short run aggregate supply (SRAS) is influenced by changes in the costs of
production or productivity.
Short run refers to the time period where at least one factor of production is fixed
Long run aggregate supply (LRAS) is influenced by a change in the productive
capacity of the economy
Productive capacity is changed by changes to the quantity or quality of the factors
of production
When production capacity changes, it is equivalent to a shift inwards/outwards of
the production possibilities frontier (PPF)
 Short Run AS
There are multiple factors that can influence the short-run aggregate supply
(SRAS).
These include: Changes in costs of raw materials and energy
Changes in exchange rates (E/R)
Changes in tax rates

Changes that Influence SRAS

- If there is an increase in the cost of raw materials, SRAS decreases and shifts
to the left. As the price of input costs rise, fewer goods/services can
be produced with the same amount of money
- If there is an decrease in the cost of raw materials, SRAS increases and shifts
to the right. As the price of input costs decrease, more goods/services can
be produced with the same amount of money
- If there is an appreciations in exchange rates, SRAS increases and shifts to the
right. Producers often import raw materials. Stronger currency means cheaper
imports and Cheaper imports means decrease in input costs. Therefore Lower
costs will lead to more output
- If there is a depreciation in exchange rates, SRAS decreases and shifts to the
left. Producers often import raw materials. Weaker currency means more
expensive imports, and more expensive imports mean increase in input costs.
Therefore higher costs will lead to less output
- If there is a decrease in tax rates, SRAS increases and shifts to the right. Taxes
represent an additional cost for firms. Decreasing taxes means a decrease in
costs and lower costs will lead to more output
- If there is an increase in tax rates, SRAS decreases and shifts to the left. Taxes
represent an additional cost for firms. Increasing taxes meand an increase in
costs and Higher costs will lead to less output

Short Run Aggregate Supply (SRAS) curve.

SRAS slope up from left to right. They show
that with an increase in the price level, there’s
an increase in the amount of output firms are
willing to supply.
If SRAS is price inelastic, the SRAS curve slopes
Steeply upwards.
If SRAS is price elastic, the SRAS curve would be less steep.
 Long Run AS
In the short run, supply can be increased by offering overtime but in the long run ​
there will be a limit on how much supply can be increased. There is a limit on the
number of people and machines that are available and once labour productivity is
maximised, supply cannot be increased any further. On the LRAS curve, unlike the
SRAS curve, wage rates are variable and can change.
It’s assumed that an economy will move towards an equilibrium when all resources
are being used to full capacity – full productive potential.
Long run aggregate supply (LRAS) is influenced by a change in the productive
capacity of the economy
Productive capacity is changed by changes to the quantity or quality of the factors
of production
Economists have two opposing views on how LRAS works in an economy.
The original view is called the classical view.
The insights developed by John Meynard Keynes in 1936 are called the Keynesian
view.
The Classical LRAS
The classical view believes that the LRAS is perfectly inelastic (vertical) at a point
of full employment of all available resources.
This point corresponds to the maximum possible output on a production
possibilities frontier (PPF).
The classical view believes that in the long-run an economy will always return to
this full employment level of output
In the long run, AS is ​independent of the price level and is ​determined by the level
of all factors of production and the quality of technology​. The LRAS is a
measure of a country’s potential output and the concept is linked to the idea of
PPF; it shows the productive potential of the economy.
It shows the ​full capacity output i.e. where all resources are
being fully utilised, and this can be linked to output gaps
between the GDP trend line and the actual GDP.
In the short run it is possible for an economy to ​exceed
the maximum potential LRAS by allowing factors of production
to ​work overtime or not allow time for maintenance of machinery etc.
However, this is ​not possible in the long run as machines will eventually
stop and workers will want a break.
The vertical AS curve is based on the classical view that ​markets tend to correct
themselves fairly quickly. This means although an economy can be in
 Long Run AS

The Keynesian LRAS

Keynes believed that the long-run aggregate supply curve (LRAS) was more L
shaped. Supply is elastic at lower levels of output as there is a lot of spare
production capacity in the economy. Struggling firms will increase output without
raising prices.
Supply is perfectly inelastic (vertical) at a point of full employment
(YFE) of all available resources
The closer the economy gets to this point the more price inflation will occur as
firms compete for scarce resources
The Keynesian view believes that an economy will not always self-correct and
return to the full employment level of output (YFE). It can get stuck at an
equilibrium
well below the full employment level of output

The Keynesian view believes that there is role for the government to increase its
expenditure so as to shift aggregate demand and change the negative 'animal
spirits' in the economy
Factors Influencing LRAS
1. Technological advances: these often improve the quality of the factors of
production e.g. development of metal alloys
2. Changes in relative productivity: process innovation often results
in productivity improvement e.g. moving from labour intensive car production
to automated car production
3. Changes in education and skills: over time this increases the quality of labour
in an economy
4. Changes in government regulations: these can improve the quantity of the
factors of production. e.g. deregulation of fracking (extracting oil from shale
deposits) increased oil reserves
5. Demographic changes and migration: a positive net birth rate or positive net
migration rate will increase the quantity of labour available
6. Competition policy: regulating industries so as to prevent monopoly
power results in more firms supplying goods/services in an economy and
this increases the potential output of an economy
 National Income
The circular flow of income is an economic model that illustrates money flows in
an economy
The circular flow of income is a way of representing the flows of money between
the two main groups in society - producers (firms) and consumers (households).
These flows are part of the fundamental process of satisfying human wants.
National Output = National Expenditure = National Income

As we have already seen, a free market economy consists of two components,

or sectors, as they are called. These are firms and households. People in households
work for firms (selling their factor services) and receive wages in exchange. On the
scale of the whole economy, this is known as national income - the total amount of
income earned over a given time period. This money is spent on food, clothing,
transport, entertainment etc, and so it returns to the firms. This is the circular flow

Households own the wealth in the economy. These are the factors of production
Households supply their factors of production to firms and receive income as a
reward
They receive rent for land, wages for labour, interest for capital, and profit for
enterprise
With this income, they purchase goods/services from firms
Firms purchase factors of production from households
They use these resources to produce goods/services
They sell the goods/services to households and receive sales revenue
National income is the value of the output of an economy over a period of time. It
can be calculated using the income approach or expenditure approach
expenditure = income
Income is a flow in the economy, whereas wealth is a stock of assets that can be
used to generate income
 Injections and Withdrawals
Money can enter or leave the circular flow of income in an economy
Injections add money into the circular flow of income and increase its size
- Increased government spending (G)
- Increased investment (I)
- Increased exports (X)

Withdrawals or leakages remove money from the circular flow of

income and reduce its size
- Increased savings by households (S)
- Increased taxation by the government (T)
- Increased import purchases (M)

Injections represent new income in the economy

A leakage is any income not passed on in the circular flow.
The multiplier effect can cause the economy to grow by a greater amount than
the size of the injection
E.g. If government spending increases, the money becomes income for households
who then spend it purchasing goods/services from firms, who then spend some of it
on purchasing raw materials
Changes to any of the factors that influence government spending, investment,
consumption and net exports will increase/decrease the relative size of the circular
flow of income.
The size of the multiplier is dependent on the marginal propensity to consume
(MPC), the marginal propensity to save (MPS), the marginal propensity to import
(MPM) and the marginal propensity to be taxed (MPT).
The leakages from the circular flow are:
Savings (S)
Taxation (T)
Purchase of imported goods and services (M) (goods and services in but money out
- UK firms pay overseas ones)
The injections from the circular flow are :
Investment (I) - expenditure on capital goods
Sale of exports (X) (goods and services out, but money now flows in)
Government Expenditure (G)
An economy is in equilibrium when injections match the leakages.
 Equilibrium Levels of Real National Output
Real National Output equilibrium occurs where aggregate demand
intersects with aggregate supply
The diagram shows the Classical Short Run equilibrium in an
economy resulting in an equilibrium price at Ap1 and Real
Output of Y1.
According to classical theory, this economy is in short run
equilibrium at AP1Y1.
Any changes to the component of AD will cause the AD curve
to shift left or right Creating a new short-run equilibrium.
Any changes to the determinants of SRAS will shift the SRAS
curve left or right creating a new short-run equilibrium.

Classical and Keynesian economists have different views on the long-run

equilibrium of the real national output.
Classical Economists believe that the economy will always return to its
full potential level of output and all that will change in the long-run is the
average price level.
Keynesians economists believe that the economy can be in long run
equilibrium at any level of output.

The diagram shoes the Classical view of Long-run equilibrium which

occurs at the intersection of LRAS and SRAS and AD.
The LRAS curve demonstrates the maximum possible output of an
economy
using all of its scarce resources.
The SRAS intersects with AD at the LRAS curve.
This economy is producing at the full employment level of output (Y FE)
The average price level at YFE is AP1

The diagram that shows the Keynesian view of long-run equilibrium

which occurs at the intersection of long-run LRAS and AD.
The vertical portion of the LRAS curve corresponds to the classical view
of LRAS.
The Keynesian view believes there is a maximum level of possible output.
 The Multiplier
The multiplier ratio is the ratio of change in real income to the injection that
created the change.
The multiplier process is based on the idea that one individual’s spending is
another’s income.
An increase in consumption immediately increases AD. Store
owners who have benefited from the extra consumption now gave extra
income.
They spend some of that income on goods/services. Their
expenditure on goods/services is now income for the next tier of
individuals.
Due to the successive rounds if spending, the final increase in
national income is much larger than the initial injection.
The size of the multiplier is entirely dependent on the size of
leakages that occur in the process. The higher the leakage the
smaller the multiplier.
The initial injection shifts AD to the right. The result of the multiplier process
is that there is then a secondary movement of AD to the right which (if the
multiplier were 2) may be double the initial movement.
The multiplier can also work in reverse when injections are reduced
(downward multiplier effect) .
The 'marginal propensities' refer to the proportion of the next £ earned that
a consumer saves, consumes, is taxed, or purchases imports with.
Marginal propensities are calculated for economies and provide insights into
how each additional £ of income is allocated.
Sweden has a higher tendency to save than the USA. Their marginal
propensity to save is higher, The USA, therefore, has a greater multiplier on
any injections into the Circular Flow.
Marginal Propensity to consume (MPC) – proportion of additional income
that is spent = consumption / income
Marginal Propensity to save (MPS) – proportion of additional income that
is saved = savings / income
Marginal Propensity to Tax (MPT) – proportion of additional income that
is paid in tax = tax / income
 Causes of Growth
Economic growth can occur in the short-run or long-run and each is explained
differently.
Changes to any of the components of aggregate demand (AD) will cause short-run
economic growth to occur.
This is illustrated on an AD/AS diagram by a rightward shift in AD.
It can also be illustrated by using the production possibilities frontier model by
moving from a point inside the curve to a point closer to the curve.
An increase in consumption, investment, government spending or net exports
has caused a shift in AD from AD→AD1
The current real output has increased from Y1→Y2 which represents an
increase in real GDP
An increase in real GDP = economic growth
This short-run growth has led to an increase in average prices from AP1→AP2

An
increase in production has caused a shift in production combinations
from
X→Y
The
current real output has increased moving closer to the maximum possible
output
of the economy
This
represents an increase in real GDP
An
increase in real GDP = economic growth

Long-run economic growth is caused by any improvements to the quality or

quantity of the factors of production.
These factors include all of the determinants of long-run aggregate supply.
A change to the quantity/quality of the factors of production has increased
potential output of the economy from YFE→YFE1
E.g. More rigorous competition policy creates a higher number of firms in
each industry leading to greater aggregate supply in the economy
This shifts the long-run aggregate supply curve to the right LRAS1→LRAS2 resulting
 Output Gaps
Actual growth is the percentage increase in a country’s real GDP and it is usually
measured annually. It is caused by increases in AD.
The long-term trend in growth rates is the long run expansion of the productive
potential of an economy. It is caused by increases in AS.
The potential output of an economy is what the economy could produce if resources
were fully employed.
An output gap is the difference between the actual level of output (real GDP) and the
maximum potential level of output.
 A positive output gap occurs when real GDP is greater than the potential real GDP
 A negative output gap occurs when the real GDP is less than the potential real GDP
There is spare capacity in the economy to produce more goods/services
than are being produced
It is difficult to measure output gaps accurately
- This is because it is hard to know exactly what the maximum productive
potential of an economy is
- Rapidly rising prices can indicate a positive gap is developing
- Rising unemployment and slowdown in economic growth can indicate that a
negative gap is increasing
Negative Output Gap

The potential output of this economy is at YFE. The economy is in a short-run

equilibrium at AP1Y1. A negative output gap exists at Y1 - YFE
This effectively gives the economy sparer capacity in the short-term
One cause of this may be that the AD has recently decreased due to a fall in
consumption
The Classical view is that the output will return to YFE in the long-run, but at a lower
average price level
The Keynesian view is that an economy may be stuck in a negative output gap for a
long period of time
 Trade Business Cycle
A trade (business) cycle refers to the changes in real GDP that occur in an
economy over time.
The real GDP will fluctuate above and below the long-term trend rate of growth
There are four recognisable points in the cycle
Peak/boom; slowdown/downturn; recession(two or more consecutive quarters of
negative economic growth), recovery

A positive output gap is identified as growth of real

GDP that is above the trend
A negative output gap is identified as growth of GDP
that is below the trend
There is often a natural flow through the different
stages from boom to slowdown to recession to recovery
This flow of real GDP can be moderated by government
intervention
E.g. increasing taxes in a boom period or increasing spending
in a recession
Characteristics of a recession
- Two consecutive quarters (6 months) or more of negative economic growth
- Increasing/high unemployment
- Increasing negative output gap and spare production capacity
- Low confidence for firms/households
- Low inflation
- Increase in government expenditure perhaps leading to a great budget deficit

Characteristics of a Boom
- Increasing/high rates of economic growth
- Decreasing unemployment and increasing job vacancies
- Reduction of negative output gap or creation of a positive gap. Spare capacity is
reduced or eliminated
- High confidence and more risky decisions taken
- Increasing rate of inflation - usually demand pull
- An improvement in the government budget as tax revenues rise and expenditure
falls
 The Impact of Economic Growth
Economic growth is considered to be the main contributor to an improvement in
the standards of living
Due to the negative aspects of economic growth, there is much controversy about
maintaining it as a central macroeconomic aim.
Benefits of Economic Growth:
- Increased incomes lead to better standards of living
- Decreased levels of absolute poverty
- Improvement in the quality/quantity of environmentally friendly technologies
- Higher sales revenue for firms and greater profits
- Increased investment by firms increases the potential output of the economy
- Reduced expenditure by governments on benefits
- Higher government tax revenue due to rising incomes and surging corporate
profits
- Increased employment resolves some of the negative social impacts of
unemployment

Costs of Economic Growth

- Rising aggregate demand causes demand pull inflation; purchasing power of
people on fixed incomes may fall
- Lack of equity in the distribution of income - the rich may get richer and the
poor poorer
- Environmental damage caused by negative externalities of production
- Increased inflation can harm export sales
- Decreased export sales may lead to a delay in investment by firms
- Increased income usually leads to greater consumption of demerit goods
- Greater output often requires more time from workers and can decrease leisure
time and well-being
 Possible Macroeconomic Objectives
ECONOMIC GROWTH
Economic growth is a central macroeconomic aim of most governments
Many developed nations (UK included) have an annual target rate of 2-3%. This
is considered to be sustainable growth.
Growth at this rate is less likely to cause excessive demand pull inflation.
Politicians often use it as a metric of the effectiveness of their policies and
leadership
Economic growth has positive impacts on confidence, consumption, investment,
employment, incomes, living standards and government budgets
1998-2007
Steady growth fluctuating between 2-4%
2008-2015
Global financial crisis followed by rapid bounce back due to government
intervention - and then steady growth
2016-2019
Gradual disinflation possibly due to future expectations regarding the impact of the
Brexit vote
2020-Present
Supply chain issues due to Brexit. Decreased consumption due to the impact of
Covid 19. These created a deep recession (short-lived due to government
intervention)

LOW UNEMPLOYMENT
The target unemployment rate for the UK is 4-5%.
This is close to the full employment level of labour (YFE)
There will always be a level of frictional unemployment. This makes it impossible
to achieve 100% employment
Different economies have different rates that are considered to be close to the full
employment level of labour e.g. Japan's level is about 2.5%
Within the broader unemployment rate, there is an increased emphasis on the
unemployment rate within different sections of the population
In 2021, black unemployment in the UK was 11% and white unemployment was
4%
Unemployment tends to be inversely proportional to real GDP growth
 When real GDP increases, unemployment falls
 When real GDP decreases, unemployment rises
Unemployment in the UK remained relatively high for the six years following the
 Possible Macroeconomic Objectives
BALANCE OF PAYMENTS EQUILIBRIUM ON THE CURRENT ACCOUNT
The Balance of Payments (BoP) for a country is a record of all the financial
transactions that occur between it and the rest of the world
The current account focuses mainly on the financial transactions related to exports
and imports of goods/services
Governments aim for Balance of Payments equilibrium on the Current Account
 If exports > imports it will create a current account surplus
 If imports > exports, it will create a current account deficit
Each one of these conditions has advantages/disadvantages associated with it.
However, a current account deficit is more problematic in the long-run
The UK has traditionally run a small deficit
As a % of GDP the UK current account deficit is insignificant so has not been
problematic.
The trade deficit has been falling steadily since 2016. During this time period the
value of exports was increasing slightly faster than the value of imports
BALANCED GOVERNEMNT BUDGET
The Government Budget is presented annually and includes the forecasted revenue
and expenditure.
Revenue comes from the sale of assets, taxes, sales revenue from goods/services e.g.
train tickets
Expenditure includes all government spending such as public sector salaries;
unemployment benefits; spending on public and merit goods
The UK Government aims to run a balanced budget
 If expenditure > revenue, there is a budget deficit
 Any deficit has to be financed through public sector borrowing
 Any borrowing is added to the public sector debt (Government debt)
If the UK Government debt becomes too high (expressed as a % of GDP), then
lenders begin to lose confidence in the Government's ability to repay the debt. The
Government then has to raise the interest rate it offers to lenders, which makes
borrowing more expensive
The UK Government has worked extremely hard recently to reduce the budget deficit
and run a balanced budget
Covid 19 expenditure has eroded the progress they made
Reducing the deficit can mean tough choices for the economy
E.g. cutting public sector pay; raising taxes; reducing unemployment benefits;
reducing spending on merit goods
 Demand Side Policies
Demand-side policies aim to shift aggregate demand (AD) in an economy.
There are two categories of demand-side policies : Fiscal policy and monetary
policy
Fiscal policy involves the use of government spending and taxation to influence
AD
The government is responsible for setting fiscal policy. The UK Government
presents their fiscal policies to the country each year when it delivers the
Government budget.
Monetary policy involves adjusting interest rates and the money supply so as to
influence AD
The Bank of England (UK central bank) is responsible for setting monetary policy.
The Bank's Monetary Policy Committee meets 8 times a year to set policy.
Monetary Policy has two main instruments
- Incremental adjustment to the intrest rates (usually not more than 0.25%)
- Quantitative easing which increases the supply of money in the economy. It is
a process in which the Central bank buys back UK Government securities
(gilts/bonds) from the open market by creating new money.
When a policy decision is made, it creates a ripple effect through the economy and
this effect is known as a transmission mechanism
Incremental Changes to Intrest Rates
The transmission mechanism of changes to the intrest rates
The official Rate is the base
rate of intrest set by the bank
of England’s MPC.
Market Rates is the intrest rate
set by commercial banks to
consumers (savings and loans)
Asset Prices : an asset is any
resource/good that can provide future economics.
Exchange Rates are the price of one currency
in terms of another.
Net External Demand is the demand for a country’s exports.
Inflation is a sustained increase in the average price level of goods/services in an
economy.
 Demand Side Policies
Fiscal Policy Instruments involves the use of government spending and taxation
to influence AD in the economy.
Government spending includes direct expenditure, but not transfer payments.
Transfer payments are part of fiscal policy, but are not counted as government
spending in the AD formula.
For example the Government increases VAT from 20% to 22% . Because of this
consumers pay more tax, this will lead to discretionary income reducing, leading to
a decrease in consumption which will reduce AD. Hence inflation eases.

Government Budget (Fiscal) Deficit and Surplus

The Government Budget (Fiscal policy) is presented each year as a balanced
budget, a budget deficit, or a budget surplus
 A balanced budget means that government revenue = government expenditure
 A budget deficit means that government revenue < government expenditure
 A budget surplus means that government revenue > government expenditure
A budget deficit has to be financed through public sector borrowing. This
borrowing gets added to the public debt.

Direct and Indirect Taxation

The main source of government revenue is taxation.
Direct taxes are taxes imposed on income and profits. They are paid directly to the
government by the individual or firm .
E.g. Income tax, corporation tax, capital gains tax, national insurance contributions,
inheritance tax
Indirect taxes are imposed on spending. The supplier is responsible for sending
payment to the government
Depending on the PED and PES producers are able to pass on a proportion of the
indirect tax to the consumer.
The lower a consumer spends the less indirect tax they pay
E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on demerit goods,
excise duties on fuel etc.

Expansionary Demand side Policy

Contractionary Demand-side Policies
Demand-side policies that aim to increase
Demand-side policies that aim to decrease aggregate demand
aggregate demand are called expansionary policies
 Demand Side Policies
The Role of the Bank of England
The Bank of England's Monetary Policy Committee (MPC) consists of nine
members.
They meet 8 times a year to set the monetary policy. At this meeting they set the Bank
Rate and discuss if quantitative easing is required (or should continue). Policy is
decided by majority vote. It can take up to two years for the full effects of decisions to
be seen in the economy - Unemployment
The single most important consideration in their deliberations is the inflation target of
figures
2% CPI - Business and
Factors that influence decisions made by the MPC : Consumer
confidence
- Without further intervention, the likely state of the economy a few months ahead
- Rate of real GDP growth (output gaps?) - Global outlook
- Current level of CPI Inflation - The exchange rates
- Interest rate elasticity (low confidence = inelastic response)
- State of the property market

Strengths of Monetary Policy

- The Bank of England operates independently from the Government (political
process)
- Is able to consider the long-term outlook
- Targets inflation and maintains stable prices
- Depreciating the currency can increase exports

Weaknesses of Monetary Policies

- Conflicting goals e.g economic growth puts upward pressure on inflation
- Time lags between policy and the desired impact (up to 2 years)
- Expansionary policy is less effective in negative output gaps than when used with
positive output gaps. Consumers may not respond to lower interest rates when
confidence is low
- Cheaper credit can inflate asset prices in the long term
- The interest rate has limitations on downward adjustment

Strengths of Fiscal Policy

- Spending can be targeted on specific industries
- Short time lag as compared with monetary policy
- Redistributes income through taxation
- Reduces negative externalities through taxation
- Increased consumption of merit/public goods
 Demand Side Policies
Demand-side Policies during the great depression and 2008 global financial crisis.
The Great Depression started in the USA in October 1929 and continued until the late 1930’s.
By 1932 the USA unemployment rate was around 25%
More than 9,000 banks closed during this decade. The flow of money in the economy was weak
(poor liquidity)
The Great Depression created a global slump. In the UK, unemployment doubled and exports
halved leading to a major recession
Fiscal Policies used USA
- Roosevelt's New Deal (1933-1939) provided large government spending on infrastructure and
conservation projects (Keynesian approach which increases AD). The government employed
many people. Construction projects included The Edgar Hoover Dam and The Golden Gate
Bridge
- Protectionism increased to increase domestic production and consumption (the Smoot–
Hawley Tariff Act in 1930). Entry into the 2nd World War further boosted government
spending and recovery
Monetary Policy used USA
- There is disagreement over the effectiveness of monetary policy. In February 1930 the
Federal Reserve Bank cut the Bank Rate from 6% to 4%. In late 1930 they raised the rate
again to help strengthen the exchange rate as investors were selling dollars to buy gold.
Raising the rate was a contractionary policy that further weakened the flow of money
Fiscal Policies used UK
- The Government prioritised a balanced budget with contractionary policies as they wanted to
avoid crowding out. In 1931, they cut public sector wages and unemployment benefits by
10% - which further reduced consumption and confidence in the economy. In 1931 they
raised income tax from 22.5% to 25% which decreased disposable income and consumption.
In 1932, they introduced a 10% tariff on all imports (except from British Colonies) so as to
increase production and consumption within the UK
Monetary Policy used UK
- In 1931 the, the UK stopped using the gold standard which had appreciated the currency
significantly since 1919. The Pound (£) depreciated by nearly 25%; exports immediately
increased and so did AD. The Bank Rate was lowered from 6% to 2% in late 1931 and this
helped AD increase

The 2008 Global Financial Crisis started in the USA in September 2008 with the collapse of the
investment bank, Lehman Brothers.
The crisis was inextricably linked to interest rates and risky lending in the property market. In
total, about 10 million households lost their homes (roughly 1 in every 20 homes).
Unemployment doubled from around 5% to 10%. 489 Banks failed in the five-year period
following the crisis - most were bailed out by central governments. The 2008 Global Financial
Crisis created a global slump. UK unemployment rose from 5.2% to 7.8%
Fiscal Policies used USA
 Supply Side Policies
Supply-side policies aim to shift the long-run aggregate supply (LRAS).
There are two categories of supply-side policies : Interventionist and market-
based
Interventionist supply-side policies require government intervention in order to
increase the full employment level of output
These are mainly used to correct market failure
Market-based supply-side policies aim to remove obstructions in the free market
that are holding back improvements to the long-run potential
E.g. Setting up a regulator to prevent monopolies forming

Market Based and Interventionist Strategies to Meet the Aims of Supply-side

Policies
1. To Increase Incentives
Market based approach : Reducing income/corporation tax rates. Restructuring the
unemployment benefits system to incentivise the unemployed to seek work
2. To Promote Competition
Market based approach : Privatisation and deregulation. Trade liberalization
(removing barriers of international trade such as tariffs and quotas)
Interventionist approach : Increased government spending on innovation. Direct
support to firms (subsidies) promotes international competitiveness.
3. To Reform the Labour Market
Market based approach : Decreasing trade union power so wages can be decreased.
Decreasing minimum wages to lower costs of production
Interventionist approach : Increased government spending on improving
occupational mobility.
4. To Improve the Skill and Quality of the Labour Force
Interventionist approach : Increasing government spending on education and
retraining. Increasing government spending on healthcare so that productivity
improves
5. To Improve Infrastructure
Increased government spending on infrastructure.
Diagrams to Illustrate Supply Side Policies :
Successful supply-side policies will increase the long-run aggregate supply
(LRAS). This equates to an increase in the production possibilities of an economy.
 Supply Side Policies
Strenghts of Supply Side Policies :
- They increase the rate of growth of an economy
- They reduce average price levels
- They reduce unemployment
- They often increase the value of net exports
- Improvements in Infrastructure can raise the quality of life for all citizens

Weaknesses of Supply Side Policies :

- The distribution of income worsens as labour market reforms and wage policies
lower worker's wages
- They are expensive to implement
- There are significant time lags between expenditure and seeing the benefits
- Due to the long-term nature, changes in government often result in changes to
budgets and scope of projects. The end result may be less effective than it could
have been
- Vested interests can result in less effective outcomes e.g. There are many
examples of privatisation occurring in such a way that the government's
preferred bidders obtained an asset at a knock down price. Often the preferred
bidders were not necessarily the most efficient firms
 Conflicts and Trade Offs between Objectives and Policies
Policy decisions by governments often create a trade-off in the macroeconomic
objectives.
Achieving one objective may come at the cost of worsening progress in another
objective.
Economic Growth and Inflation : Increasing economic growth causes the
economy to move closer to full employment. Prices for remaining resources are bid
up leading to inflation which may outpace the target inflation rate of 2%
Economic Growth and Environmental Sustainability : Economic growth often
increases pollution, negative externalities and the depletion of non-renewable
resources. The higher the growth, the faster the depletion.
Economic Growth and Inequality : During periods of high economic growth, the
profits the owners of the factors of production receive are disproportionate to any
increase in workers' wages leading to greater inequality
Economic Growth and Balanced Budget : Economic growth driven by
expansionary fiscal policy often requires a budget deficit
Economic Growth and Balancing the Current Account : Economic growth
usually leads to higher incomes which leads to an increase in imports by
households thereby worsening the current account balance
Low Unemployment and Low Inflation : The closer an economy moves to full
employment the less workers will be available for hire and wage inflation will help
increase overall inflation.

The Short-run Phillips Curve (SRPC) observes that there may be a trade-off
between unemployment and inflation
Rising inflation is accompanied by falling unemployment. Rising unemployment is
accompanied by falling inflation
This trade-off makes it difficult for the government to achieve both low
unemployment and low inflation
The economy is initially
in equilibrium at AP1YFE
At this point, unemployment
is at 4% and inflation is at
3% and this is considered to
be full employment (YFE)
There is always some
unemployment due to the
 Theme 3
Business Behaviour and the Labour Market
3.1 Business Growth
- Sizes and Types of Markets
- Business Growth
- Demergers
3.2 Business Objectives
- Business Objectives
3.3 Revenue, Costs and Profits
- Revenue
- Costs
- Economies and Diseconomies of Scale
- Normal Profits, Supernormal Profits and Losses
3.4 Market Structures
- Efficiency
- Perfect Competition
- Monopolistic Competition
- Oligopoly
- Monopoly
- Monopsony
- Contestability
3.5 Labour Markets
- Demand for Labour
- Supply of Labour
- Wage Determination in Competitive and Non-Competitive
Markets
3.6 Government Intervention
- Government Intervention
 Size and Types of Firms
A firm is an organisation that brings together different factors of production, to
produce a good or service, in order to make a profit.
Many firms start small and will grow into large companies or even multi-national
corporations.
DIFFERENT TYPES OF FIMRS/OWNERSHIPS
→ Sole trader (one person)
→ Private limited company (LTD) – has limited liability
→ Public limited company (PLC/TNC/MNC) – has limited liability
→ Cooperatives (worker owned)
→ Partnership (two or more people)

Main objective of a firm in the public sector is to deliver goods and services rather
than to generate profits.
They are owned and runed by the government and are financed through
government spending.
Main objective of a firm in the private sector is to maximise profits.
They are run and owned by private individuals, on a commercial basis.
The main objectives of a non-profit organisation/firm in the voluntary sector are
to provide a public service or help people, such as through promoting education,
raise funds for a cause and raising awareness. They might cover their costs out of
the profits/money raised.
Non-profit organizations are part of the private sector, however the government
exempts them from paying direct taxes. They are regulated by the UK Charity
Commission
Reasons why firms grow :
→ Owners/Shareholders/Managers desire to run a large business and continually
seek to grow it.
→ Owners/shareholders desire for higher levels of profit
→ Desire for stronger market power (monopoly) so as to increase profits
→ Desire to reduce costs by benefitting from economies of scale
→ Growth provides opportunities for product diversification
→ Larger firms often have easier access to finance

Why do some firms remain small?

→ They operate in a niche market where demand is specialized and limited (more
personalized service)
 Size and Types of Firms
As firms grow, the owners (or shareholders) often appoint managers to run the
business for them.
There is a separation (divorce) between the owners and the managers who control
the day-to-day running of the business.
This divorce gives rise to the Principal-Agent problem. (E.g. Shareholders want
to maximise their profits, but workers want to maximise their salaries.)
→ Managers, elected board of
principal - agent problem directors, CEOs, CFOs
Principal → Day to day decision making
Agent about operations
→ Share owners are owners of a PLC
→ They exercise control through voting rights
→ May have different objectives to the agents
Aim – maximise profits in order to get higher dividend yields
Aim – satisficing behaviour like producing satisfactory profits,
and want rising share prices.
power, bonuses, large expense accounts, prestige and status.

The problem is caused by information gaps where the agents have a lot more
information than the owners and are often able to control the flow of that
information.
One way that Principals attempt to diminish the problem is by granting share
options to managers. If managers are shareholders, then they will be likely to align
their interests more with those of the owners
 The Growth of Firms
Business growth depends on :
- owner objectives
- size of market, affects demand
- the competitiveness of the market
- access to finance, smaller business are likely seen as riskier, interest rates tend to
be high
- amount of regulation from the government, could affect amount of profit the
business makes.
The growth of a firm can be either internal or external
Organic/internal
Organic growth (internal) growth
is usuallyis when a firm expands by re-investing profits
or using loan
generated by finance.
: There is no other firm ainvolvement
- opening new store in this. An example
would be expanding
- gaining production
greater market share or-buying new branches.
international expansion
- product diversification
- Investing in new technology/production
ADVANTAGES
machinery - have Disadvantages - slow
more control over the process
direction - expensive
of the business for the firm
- less - must have
risky as they don’t depend on demand for their products

other firms
- maintain
distinctiveExternal
capacity growth is when firms merge, integrate or may be taken over by
other firms.
Integration – bringing together two or more firms
Merger – bringing together two or more firms to form one under joined ownership.
Takeover – when one firm gains control over another and becomes the owner such
as through buying shares and having a majority (>50%) .
Takeovers can also be hostile.
Inorganic growth (external) usually takes place in one of three ways:
→ Vertical (backwards) - a firm takes over another firm behind it in the process,
such as suppliers
→ Vertical (forwards) - a firm takes over another firm ahead of it in the process,
such as sellers
→ Horizontal - two firms at the same stages within a process integrate
→ Conglomerate - when two unrelated firms integrate
 The Growth of Firms

Vertical Integration :
Advantages: Disadvantages :
- secure suppliers - finance required
- secure outlet - clash of culture
- gain foothold in a market - can impact on focus of business
- benefit from expertise - can impact on economies of scale as
- brand recognition different processes
- diseconomies of scale can occur due
Horizontal Integration to communication and coordination
Advantages : problems
- gain monopoly power
- benefit from expertise Disadvantages :
- remove competition from market - finance required
- achieve economies of scale - clash of culture
- synergy 1 + 1 = 3 - decentralised leading to less tight
- Achieve corporate objectives control of businesses taken over
- diseconomies of scale with
Conglomerate Integration communication and coordination
Advantages : problems between the business and
- spreads risk between different markets as firms
that diversifies
taken over
- allows for growth when current markets are saturated
- allows for cross selling of products in different markets due to brand
recognition and access to customers
- allows market research to be shared acrossDisadvantages
different markets;
- finance required
- lack of understanding and expertise
Constraints on Business Growth when taking over firms in other
markets
There are several factors that constrain (hold back) firms from growing
- might reduce the focus of the firm
1.The size of the market: the more niche the market the smaller the number of
potential customers. Even large firms face this on its core as
constraint business and market
they move closer to
- diseconomies of scale with
capturing the domestic market - to increase market size they will have to expand
internationally communication and coordination
-
2.Access to finance: small firms find it harder problems
to access between the business
loans as they are and
considered to be more risky than larger firms. that
Duetaken
to theover
perceived risk, interest
rates for any loans acquired tend to be higher
3.Owner objectives: Many owners desire to grow a business to a point that
provides a certain lifestyle or standard of living - and not beyond.
 Demergers
A demerger occurs when a firm sells off at least one of the businesses it owns,
or splits itself into separate parts to create two or more firms
Demergers may occur because of :
• Reducing diseconomies of scale - decreasing the size of the firm can reduce the
diseconomies and lower the cost/unit which increases the profitability
• Increased business focus - if efforts and resources are scattered across a large
number of firms/ industries it can be hard to maintain focus and profitability.
Narrowing the focus can improve profitability
• Cultural differences - the most common reason for failures of mergers is cultural
differences. Sometimes these differences are irreconcilable and not worth the
expense to change
• Remove loss making divisions - it can be more profitable to remove loss-making
divisions and replace them with outsourcing
• Increase liquidity and dividend payments - demergers generate extra revenue for
the firm in the year they occur. This may increase the profit and dividend
payments
• Comply with the demands of the Competition Commission - Sometimes firms
are forced to demerge by the competition regulator due to concerns about the
high level of market share they may have, which is considered to be anti-
competitive and bad for consumers
A spin off occurs when a business creates a separate company from part of its
existing one, but retains some form of ownership
Impacts of demergers
The impacts on the firm conducting the demerger should be mostly positive and
include
→ Opportunity for a narrower focus on the core business
→ Removing loss-making portions of the business
→ Increased efficiency and lower costs/unit
→ Increasing the annual profits for the year that the demerger occurred
→ Removing some difficult cultural differences

The impacts on employees include

→ Some workers may lose their jobs
→ Reduced friction from cultural differences can help build better team dynamics
→ Smaller workforce provides more opportunity for promotion
→ Less complication in daily tasks due to more narrow focus
 Business Objectives
Firms seek to attain the highest level of profit, their rational business objective is
profit maximisation.
Profits benefit shareholders as they receive dividends and also increase the
underlying share price which increases the wealth of the shareholder.
Marginal Cost (MC) is the cost of producing one more unit
Marginal Revenue (MR) is is the revenue received from selling one more unit
Total Cost = Fixed Cost + Variable Cost TC = FC + VC
Fixed costs are costs that do not vary with output eg. Cost of rent
Variable costs are costs that do vary with output eg. Cost of materials

Profit maximisation occurs when Marginal Cost = Marginal Revenue

• no additional profit can be extracted by producing another unit of output
• level of output where the difference between total revenue (TR) and total cost
(TC) is at its highest
When MC < MR additional profit can still be extracted by producing an additional
unit of output
When MC > MR the firm has gone beyond the profit maximisation level of output
This firm has market power as the MR and average revenue (AR)
curve are downward sloping
At the profit maximisation level of output (MC = MR)
• The selling price is P1
• The average cost is C1
• The supernormal profit = ( P1 - C1 ) x Q1

Profit Satisficing
Profit satisficing occurs where the firm is not operating at its profit maximising
level of output.
Some firms have the business objective of satisficing. This often occurs as a result
of the principal agent problem.
Rationally, managers know shareholders want to profit maximise
Rationally, managers want to maximise sales or revenue so as to increase their
wages
Managers (who control the business) settle for a level of output
somewhere between profit and sales maximisation.
 Business Objectives
Sales maximisation
• occurs at AC = AR (normal profit)
• In the short-term firms may use this strategy to clear stock during a sale. They
sell remaining stock without making a loss per unit.

This firm has market power as the MR and average revenue (AR) curve
are downward sloping
At the sales maximisation level of output (AR = AC)
• The selling price is P1
• The average cost is also at P1
• The firm is breaking even (normal profit)

Revenue maximisation
• occurs due to principal agent problem.
• Sales managers often receive commission on sales as part of their wages and
this incentivises them to maximise sales
• Profit maximisation for shareholders becomes a secondary objective for the
sales managers
Firms will also maximise revenue in order to increase output and benefit
from economies of scale
In the short-term firms may use this strategy to eliminate the competition as the
price is lower than when focussing on profit maximisation.
To achieve revenue maximisation firms produce up to the level of output where MR
= 0.
When MR > 0, producing another unit of output will increase total revenue.
This firm has market power as the MR and average revenue (AR) curve are
downward sloping
At the revenue maximisation level of output (MR = 0)
• The selling price is P1
• The average cost is C1
• The supernormal profit = ( P1 - C1 ) x Q1

The supernormal profit is less than when the firm follows the profit maximisation
rule.
The firm always achieves revenue maximisation when the Price Elasticity of
 Revenue
→ Total Revenue is the total value of all sales a firm incurs
Total Revenue (TR) = Selling Price (P) X Quantity sold (Q)
→ Average Revenue is the overall revenue per unit
Average Revenue (AR) = Total Revenue (TR) / Quantity Sold (Q)
→ Marginal Revenue is the extra revenue received from the sale of an additional unit of
output
Marginal Revenue (MR) = in Total Revenue / in Quantity sold
The relationship between TR, AR and MR is different in perfect competition and imperfect
competition
When MR = 0, then the price elasticity of demand (PED) = 1. This is unitary elasticity
The total revenue rule states that in order to maximise revenue, firms should increase the
price of products that are inelastic in demand and decrease prices on products that
are elastic in demand
- When a good/service is price elastic in demand, there is a greater proportional increase in the
quantity demanded to a decrease in price
- When a good/service is price inelastic in demand, there is a smaller than proportional
decrease in the quantity demanded to an increase in price
Perfect Competition
In perfect competition firms face a perfectly elastic demand curve. Each firm can sell all of its
output at the current market price, P. Therefore, it would not lower its price. If it were to raise
price it would sell nothing as buyers would go to another seller. Thus, the D curve is
horizontal.
The D curve is also the AR curve as total output divided by price is always
the same. The D curve is also the MR curve. As prices do not change, an
additional unit sold will bring in the same revenue every time.
Observations
- Every unit of output is sold at the same price
- A higher price would decrease sales to zero
- A lower price would result in all sellers lowering their price
- TR increases at a constant rate
- MR = AR = Demand
Imperfect Competition
In imperfect competition firms face a downward sloping demand curve. The D curve is also
the AR curve.
The MR curve will fall twice as steeply as the AR curve. To sell an extra unit the firm has to
lower price. However, this means it must lower price for all units.
The TR curve peaks when MR = 0. At this point TR is maximised.
When MR is above 0 each additional unit sold adds to TR.
After this point we have negative marginal revenue. TR will fall.
 Costs
Fixed costs are costs that do not change as the level of output changes.
Variable costs are costs that vary directly with output
Marginal cost is the cost of producing an additional unit of output
Total Cost ( TC ) = Total Fixed Cost ( TFC) + Total Variable Cost (TVC)
Total Variable Cost ( TVC ) = Variable Cost (VC) x Quantity ( Q )
Average Total Cost ( AC ) = Total Cost ( TC ) Quantity ( Q )
Average Fixed Cost ( AFC ) = Total Fixed Cost ( TFC ) Quantity ( Q )
Average Variable Cost ( AVC ) = Total Variable Cost ( TVC ) Quantity ( Q )
Marginal Cost (MC) = Total Cost (TC) Quantity (Q)
Short Run Curve : That period of time in which at least one factor of production is
fixed. E.g. it is difficult to change machinery or the number of factories in the short run,
but that can be achieved in the long run. The variable factor that is usually added to
production is labour as it is easy to hire new workers
Long Run Curve : That period of time in which all of the factors of productions are
variable. This is also called the planning stage as firms can plan for increased capacity
and production
Marginal product of labour (MP) : The change in output that results from adding
an additional unit of labour
Law of diminishing marginal productivity : In the short run, as more of a variable factor
(e.g. labour) is added to fixed factors (e.g. capital), there will initially be an increase in
productivity. However, a point will be reached where adding additional units begins to
decrease productivity due to the relationship between labour and capital
The law of diminishing marginal productivity
The Law of Diminishing Marginal Productivity states that if one factor of production
e.g. labour is increased whilst another factor e.g. capital is fixed the productivity of the
variable factor will eventually decrease.
We use the terms marginal product (MP), average product (AP) and total product
(TP)
We could use marginal returns (MR), average returns (AR) and total returns (TR)
instead
Total (physical) product is the total output produced by a firm given the factor inputs
e.g. the amount of capital and labour over a period of time
Average (physical) product x Units of Variable Input
Marginal (physical) product is the difference between total output when an extra unit
of the variable factor, here labour, is added
total output variable input
 Economies and Diseconomies of Scale
Economies of scale occur when there is a fall in average total cost as the scale of
production increases.
As a firm increases its scale of output in the long-run, its long-run average total
costs (LRATC) will initially decrease due to the benefits it receives.
During this period the firm is enjoying increasing returns to scale
Diseconomies of scale occur when there is an increase in average total cost as the
scale of production increases. As a firm continues increasing its scale of output in
the long-run, its LRATC will start to increase at some point because of
diseconomies of scale.
During this period the firm is facing decreasing returns to scale
Minimum efficient scale (MES) is the lowest cost point on a long-run average
total cost (LRATC) curve. It represents the lowest possible cost per unit that a firm
in the industry can achieve in the long run.
Increasing returns of scale – occurs when an increase
in the quantity of inputs leads to a larger than proportional
increase in output.
Decreasing returns of scale – occurs when an increase
in the quantity of inputs leads to a less than proportional
increase in the quantity of outputs.

Internal economies of scale occur due to an increase in the scale of production of a

firm
Internal Economies of Scale
• Financial Economies : large firms often receive lower interest rates on loans than
smaller firms as they are perceived as less risky
• Managerial Economies : occurs when large firms can employ specialist managers
who are more efficient at certain tasks and this efficiency lowers the AC. Managers in
small firms often have to fulfill multiple roles and are less specialised.
• Purchasing Economies : occurs when large firms buy raw materials in greater
volumes and receive a bulk purchase discount which lowers the AC.
• Technical Economies : Occurs when a firm is able to use its machinery at a higher
level of capacity due to the increased output thereby spreading the cost of the
machinery over more units and lowering the AC.
• Marketing Economies : large firms spread the cost of advertising over a large
number of sales and this reduces the AC. They can also reuse marketing materials in
different geographic regions which further lowers the AC.
 Economies and Diseconomies of Scale
External economies of scale occur due to an increase in the scale of production
within the industry in which the firm operates
Sources of External Economies of Scale
- Geographic Cluster : As an industry grows, ancillary firms move closer to
major manufacturers to cut costs and generate more business. This lowers
the LRATC.
- Transport Links : Improved transport links develop around growing industries
in order to help get people to work and to improve the transport logistics. This
lowers the LRATC.
- Skilled Labour : An increase in skilled labour can lower the cost of skilled
labour, thereby decreasing the LRATC. The larger the geographic cluster, the
larger the pool of skilled labour.
- Favorable Legislation : This often generates significant reductions in LRATC
Costs MC Costs
as governments support certain industries in order to achieve their wider
LRAC
objectives LRAC

Perfect Competition
D = AR Graph
= MR
Monopolistic Competition Graph
Outp Outp
ut MES
In perfect competition the ut this type of
The MES is often low in
occurs at very low levels of output industry as fixed costs are low.
as there are no barriers to entry for Therefore, it is easy to enter the
the firm. industry as there are no major costs
acting as a barrier to entry.
Costs Costs

LRAC

LRAC
Oligopoly/Monopoly Graph
Natural Monopoly Graph
Outp Outp
ut ut
In conditions of oligopoly and In conditions of natural monopoly we
monopoly diseconomies of scale see continual returns to scale. This
will set in at higher levels of output leads to an L-shaped LRAC curve
than that of monopolistic where average costs are always
competition. falling.
 Normal Profits, Supernormal Profits and Losses
Profit Maximisation occurs when Marginal Cost (MC) = Marginal Revenue (MR)
PRICE M Marginal Cost
is the cost of C
producing one more additional unit.
PROFIT
AC Marginal
MAXIM
Revenue is the revenue received from selling one more additional unit.
ASATIO
N Profit = Total
revenue (TR) - Total Cost (TC)
AR
Normal
M COS
Profit occurs when
R TR = TC
TS
Supernormal
profit occurs when TR > TC.
A loss occurs
when TR < TC

Explicit costs are the costs which have to be paid e.g raw materials, wages etc.
Implicit costs are the opportunity costs of production (This is the cost of the next
best alternative to employing the firm's resources)

Short Run Shut Down Point

In the short-run, if the selling price (average revenue) is higher than the average
variable cost (AVC), the firm should keep producing (AR > AVC)
A firm should shut down in the short-run if the selling price (AR) is unable to
cover the AVC
The firm produces at the profit maximisation level of output (Q) where MC=MR
At this level, the P = AVC
This means that there is no contribution towards the firm's fixed costs
The selling price literally only covers the cost of the raw materials used in
production
There is no point in continuing production and the firm should shut down

Long Run Shut Down Point

In the long-run, if the selling price (AR) is higher than the average cost (AC) the
firm should remain open (AR > AC) if the selling price (AR) is equal to or lower
than the average cost (AC), the firm should shut down (AR = AC)
A firm should shut down in the long-run if the selling price (AR) is unable to
 Efficiency
Economic Efficiency occurs when the maximum amount of products are produced
at their minimum cost whilst maximising their benefit to society. It occurs when
there is both allocative and productive efficiency at the same time.
Allocative Efficiency occurs where consumer satisfaction is maximised in the
production of goods and services.
Occurs at level of output where AR = MC. There is no excess demand or supply.
Productive Efficiency occurs where there is no additional or maximum output that
can be produced from the factor inputs available at the lowest possible average or
unit cost. Productive efficiency would occur s where MC=AC
Dynamic Efficiency occurs where firms improve technology and production
methods over a period of time. Long-term efficiency is a result of innovation as a
firm reinvests its profits. It results in improvements to manufacturing methods. This
lowers both the short-run and long-run average total costs
X-inefficiency occurs when a firm lacks the incentive to control production costs.
The ATC is higher than it should be. It often occurs due to a lack of competition in
industry or in a firm that has no consequences for making a loss (e.g. some
government owned companies)
Static efficiency occurs when all resources are being used in the most efficient
manner at a point in time.

Market structures can be separated into perfect competition and imperfect

competition
Market structures are the characteristics of the market in which a firm or industry
operates
These characteristics typically include - The firm produces at the profit maximisation
Inefficiency in the imperfectlevel of output where MC = MR (A)
market
- The firm is not productively efficient as AC
- The number of buyers
> MC at this level of output (B - A) .
Productive efficiency would occur at point E
- The number and size of firms where MC=AC
- Theorfirm
- The type of product in the market (homogenous differentiated)
is not allocatively efficient as AR
(P) > MC at this level of output (D - A).
Allocative efficiency would occur where AR =
- The types of barriers to entry and exit - profit maximisation level MC of output
- The degree of competition where
- The MCfirm
= MR (Y) to experience dynamic
is likely
- productively efficient
efficiency as be
as it will MC = AC
able to reinvest its
Imperfect competition includes the following market
- allocatively structures
efficient as increase
AR (P) =innovation
MC
profits so as to
Monopolistic - unlikely to experience dynamic
efficiency as it is unlikely to
 Perfect Competition
Perfect Competition - large number of producers in a market, each firm is
relatively small and sell to a large number of small buyers. No barriers of entry or
exit. Entry costs are either low or nonexistent.
Characteristics of Perfect Competition :
There are many buyers and sellers: due to the number of market participants
sellers are price takers (meaning they are not large enough to influence the price.)
There are no barriers to entry and exit from the industry: firms can start-up or
leave the industry with relative ease which increases the level of competition
Buyers and sellers possess perfect knowledge of prices: this assumption
presupposes perfect information e.g if one seller lowers their price then all buyers
will know about it
The products are identical and homogenous: this means firms are unable to build
brand loyalty as perfect substitutes exist and any price changes will result in losing
customers.

The demand curve is perfectly price elastic (D = AR = MR).

AR is always the same, MR is always the same.
In order to maximise profit, firms in perfect competition produce
up to the level of output where MC=MR
In the short-run, firms can make supernormal profit or losses
in perfect competition
However, they will always return to the long-run equilibrium where they
make normal profit

Short-run Profit Maximisation

Firms in perfect competition are able to make supernormal profit in the short-run
The MC curve is the supply curve of the firm
The firms is producing at the profit maximisation level
of output where MC=MR (Q1)
At this point the AR (P1) > AC (C1)
The firm is making supernormal profit = (P1 - C1) x Q1

Short Run Losses

Firms in perfect competition are able to make losses in the short-run
The firms are producing at the profit maximisation level of output
where MC=MR (Q1)At this level of output, the AR (P1) < AC (C1)
 Monopolistic Competition
Monopolistic Competition - large number of firms in a market sell differentiated
products. Small degree of monopoly power as each firm offers something different
to the others. Barriers of entry are low and therefore it easy for firms to enter the
market. This creates high competition.
Characteristics of monopolistic competition:
1. There are a large number of small firms : each one is relatively small and can
act independently of the market
2. There is low barriers of entry and exit from the industry : firms can start-up
or leave the industry with relative ease which increases the level of competition
3. The products are slightly differentiated : this structure exists as consumers
have different desires e.g. two nail bars differentiate their product through
express or pampered service. Some consumers want an express service and
others want to linger. A relatively homogenous product has now been
differentiated
4. There is a low degree of market power and some price setting ability
Profit maximising in the short run vs long run
In order to maximise profit, firms in monopolistic competition produce up to the
level of output where marginal cost = marginal revenue (MC=MR).
The firm does have some market power and is able to influence the price and
quantity - The firm is a price maker
This is due to the fact that they have a differentiated product that is desirable by
certain consumers
The firm can make supernormal profit in the short-run.
In the long-run, the firm will return to a long-run equilibrium position in which
they make normal profit.
This is due to inability to defend against new competitors who enter the
market and copy the products of existing sellers
Firms will attempt to find new ways to differentiate their product to
prolong the period of supernormal profit
Monopolistic Competition Graph
Short Run Profit Maximisation
The AR curve is the demand curve of the firm and it is downward sloping
The firm has some market power due to the level of product
differentiation that exists
To sell an additional unit of output, the firm will have to decrease its price
InThe
themarginal
long run revenue
firms in (MR)
monopolistic
curve will fall twice as quickly as the AR
 Oligopoly
An oligopoly is an industry dominated by a few large firms. An oligopoly occurs
when a market is dominated by few companies who exert significant control over
the given market.
Characteristics of an oligopoly :
1. Product branding: Each firm in the market is selling a branded product.
2. High Entry barriers: Entry barriers maintain supernormal profits for the
dominant firms. It is possible for many smaller firms to operate on the
periphery of an oligopolistic market, but none of them is large enough to have
any significant effect on prices and output. Entering the industry is difficult due
to the existing dominance of relatively few firms. Start-up costs tend to be
high. Leaving the industry is difficult due to the high level of sunk costs
3. Inter-dependent decision-making: Inter-dependence means that firms must
take into account the likely reactions of their rivals to any change in price,
output or forms of non-price competition. This interdependence generates the
use of game theory
4. Non-price competition: Non-price competition is a consistent feature of the
competitive strategies of oligopolistic firms.
Examples of Oligopolies :
- Petrol retail -Newspapers
- Pharmaceutical industry - Book Retail
- Coffee shop retail

Firm ratio’s
A concentration ratio reveals what percentage of the total market share a specific
number of firms have
A 10-firm concentration ratio reveals the total market share (concentration) of the
top 10 firms in the industry
A 5-firm concentration reveals the total market share (concentration) of the top 5
firms in the industry
The higher the value - and the lower the number of firms - the more concentrated
the market power in the industry e.g. the UK supermarket's 5-firm concentration
ratio is constantly around 67%
A five-firm concentration ratio of around 60% is considered to be an oligopoly
A one-firm concentration ratio of 100% would be a pure monopoly
The UK Competition Commission defines a monopoly as a firm with more than
25% market share. It prevents mergers or acquisitions from taking place which
 Oligopoly
Collusive behaviour in oligopolies occurs when firms cooperate to fix prices and
restrict output. They cease to compete as vigorously as they can.
Non collusive behaviour in oligopolies occurs when firms actively compete to
maintain/increase market share.
Reasons for collusion :
- Few firms / competitors : This makes it relatively easy for each firm to
understand other competitors' actions and responses, or to collaborate on
prices/output
- Similar costs : Firms face almost identical costs as any remaining competitors
have all experienced economies of scale
- Similar revenue : Competitors' goods/services sell for similar prices as there is
little incentive to lower them as other firms would respond by keeping their
market share the same but decreasing the profits
- High barriers of entry : The barriers to entry make it unlikely that new
entrants will emerge to disrupt the status quo
- Ineffective regulation : A lack of regulation empowers firms to collude as there
is little consequence for their actions
- Brand Loyalty : There is usually a high degree of brand loyalty in oligopoly
markets and firms have an established market share. This decreases the benefits
of competition as consumers are unlikely to change brands

Types of Collusion :
Collusions Can be overt or tacit
The net effect of collusion is that a group of firms end up acting more like
a monopoly in the market
1. Overt Collusion occurs when firms explicitly agree to limit competition or raise
prices (price fixing)
A cartel is the most restrictive form of collusion and is illegal in most countries
The consequences of overt collusion include:
- Higher prices for consumers - Less output in the market
- Poor quality products and/or customer service - Less investment in innovation
Overt collusion often happens in the following ways
- Price fixing : occurs when competitors agree on a fixed price for all of their
competing products, which is usually above market equilibrium.
- Setting output quotas which limit supply and naturally results in price increases
- Agreements to block new firms from entering the industry
- Agreements to pay suppliers the same price thereby driving down prices in the
 Oligopoly
Game theory is a mathematical framework which is used by firms to
ensure optimal decisions are made in a strategic setting where there is a high level
of interdependence (such as in oligopoly markets).
Firms typically use game theory in the following situations:
- When making decisions to raise or lower prices
- When making decisions about new advertising and branding initiatives
- When making decisions about investment in product innovation
- When making decisions on product bundling e.g. combined phone and broadband
packages

Any game has three elements

- The players (firms)
- The strategies available to the players
- The payoffs (outcomes) that each player receives for
each combination of strategies

Firms in an oligopoly market engage in three types of price competition

Price wars: occur when competitors repeatedly lower prices to undercut each other
in an attempt to gain or increase market share. This often occurs when there is a
lower level of non-price competition and where firms find it difficult to collude
(either formal or tacit)
Predatory pricing: this is the practice of lowering prices when a new competitor
joins the industry in order to drive them out. Prices are often lowered to a point
below the cost of production. Once they have left the market, prices are raised
again. This pricing strategy is usually illegal as it is anticompetitive
Limit pricing: occurs when firms set a limit on how high the price will go in the
industry. A lower price reduces profit and disincentivizes other firms from joining
the industry. The greater the barriers to entry the higher the limit price is likely to
be as firms are already disincentivized

Firms engage in a wide range of non-price competition strategies.

The aim is to increase product differentiation, develop or increase brand loyalty,
and to increase market share
Types of non-price competition strategies are :
- Loyalty cards and rewards - Branding - Packaging
- Celebrity or Influencer Endorsement
- After Sale Service - Delivery Policies - Product Warranties
 Monopoly
A monopoly is a market structure in which there is a single seller
The firm has complete market power and is able to set prices and control output
This allows the firm to maximise supernormal profit in the short-run
High barriers to entry exist. One of the main barriers is the ability of the monopoly
to prevent any competition from entering the market, such as through purchasing
companies who are a potential threat
The UK Competition Commission defines a monopoly as a firm with more than 25%
market share. It prevents mergers or acquisitions from taking place which would give one
firm more than 25% market share.
Profit Maximising Equilibrium
As a single seller of goods/services, the firm in a monopoly market is also the entire
market. There is no differentiation between the firm and the industry.
In order to maximise profits, it produces at the point where marginal cost (MC) =
marginal revenue (MR)
This is a diagram illustrating a monopoly making supernormal profit
in the short-run and long-run as the AR > AC at the profit maximisation
level of output (Q1)
The firm produces at the profit maximisation level of output where
MC = MR (Q1)At this level the AR (P1) > AC (C1)
The firm is making supernormal profit = (P1 - C1) x Q1

Costs a Monopoly :
To the firm : Due to a lack of competition, there is a reduced incentive to be efficient;
Cross subsidisation can create inefficiencies ; Monopolies lead to a misallocation of
resources as P > MC. The price is above the opportunity cost of providing the goods ; Due
to a lack of competition, innovation sometimes lacks effectiveness
To the employees : Having only one supplier in the industry limits the opportunity
to change employers
To the consumers : A lack of competition is likely to result in higher prices as no
substitute goods are available ; A lack of competition may result in no product
innovation and worse product quality over time ; May experience worse customer
service as the incentive to improve it is limited ; Cross subsidisation is likely to increase
prices on some products offered by the firm e.g. Champagne prices ; Consumer surplus
decreases
To the Suppliers : There is less competition for their products and a monopoly often has
the power to dictate what price they will pay to suppliers (monopsony power) ; There is a
chance not to be profitable
 Monopoly
A natural monopoly occurs when the most efficient number of firms in the industry
is one.
This is often due to associated infrastructure issues, It can also be due to
the significant cost that is generated when entering the industry e.g. the sunk costs. It
can also be due to the ability of economies of scale to lower prices for consumers.
Third Degree Price Discrimination
Price discrimination occurs when a firm charges a different price for the same
good/service in order to maximise its revenue.
There are different types (degrees) of price discrimination
Third degree price discrimination occurs when a firm charges different prices
to different consumers for the same good/service e.g. rail fares are priced differently
depending on the time of travel.
Markets are often sub-divided based on time, age, income and geographic location.
Some airline ticket portals charge higher prices to customers using an Apple
computer as they are likely to have higher income

The Following Conditions Must Be Met for Third Degree Price Discrimination to
Occur :
1. Market Power : The firm must have the ability to change prices and it works
best when there are no/few substitutes
2. Varying Consumer Price Elasticity of Demand (PED) : Some consumers must
be willing to pay more and the firm must be able to identify these different
consumer groups i.e. split the market into sub-markets
3. Ability To Prevent Resale of Tickets : It must be able to prevent
consumers buying in the low-price sub-market and reselling in the higher ones

In order to illustrate third degree price discrimination diagrammatically, the different

sub-market diagrams are placed side by side
The total market diagram is a combination of the
sub-market diagrams
The total profit is a combination of profits from
the sub-markets
The diagram below illustrates the market for rail
travel in the UK where inelastic demand is 'peak' hour
demand and elastic demand is any other time of the
day i.e. 'off-peak’
 Monopsony
Monopsony occurs when there is only one buyer in the market, but many sellers.
A pure monopsony is actually very rare, however there are many cases where there
is a dominant buyer in an oligopoly or monopoly market structure.
Oligopsony is the term used to describe a few buyers in the market. This can be seen
in the supermarket industry.
A monopolist can set the prices for their buyers. A monopsonist can set the price it
pays to its suppliers; this is because it is set by how much the monopsonist is willing
to pay as it is the only consumer.
Monopsony power indicates that firms in the market face an upward sloping supply
curve, unlike in perfectly competitive markets
A monopsonist has three main characteristics
1. They are wage makers: this is especially prevalent in industries where
the government is the majority purchaser of labour e.g. doctors, nurses, teachers,
emergency services staff, military personnel
2. They are profit maximisers: They aim to minimise their costs and maximise
their profits by paying suppliers as little as possible
3. They purchase a large portion of the market supply provided by sellers
In a perfectly competitive market, equilibrium is where price = quantity. In a
monopsony, the monopsonist can bargain for a lower price.

Costs and benefits of monopsonist power:

Firms Benefits : Reduced costs of productionlead to higher profits
Costs : May experience some reputational damage for the way
they treat their suppliers
The continual price pressure on suppliers often results
in conflictwith them which can be difficult to manage
In the long-run, they may drive their suppliers out of business
causing supply chain issues
Employees Benefits : The higher profits often result in higher wages for the
monopsonists employees
Costs : Employees may find it difficult to reconcile
their ethics/values with the way suppliers are treated
Consumers Benefits : Lower average costs for the firm may result in lower
pricesfor consumers
Costs : The quality of the product may decrease as suppliers
 Contestability
A contestable market occurs when there is freedom of entry into a market and
where costs of exit are low.
A contestable market and competition are different. Competition is based upon the
number of firms competing in a market
A contestable market is based upon the threat of new entrants

Characteristics of a contestable market :

• No barriers to entry or exit: barriers to entry are low or non-existent and there
are no sunk costs. This allows firms to easily join or leave the market
• No competitive disadvantages on entry: new firms are able to setup and
immediately compete with existing firms and have access to the same
technology
• Perfect information: There is no proprietary knowledge that would limit
competition (e.g. patents)
• Hit and run competition: Short-run supernormal profit acts as a profit
signaling mechanism and new firms easily enter the market, extract profit, then
leave
The more contestable a market, the more the behaviour of firms resembles that of
firms imperfect competition

Barriers to entry are conditions that make it difficult or expensive for a firm to
enter a market in order to compete with the existing suppliers.
Types of Barriers of Entry
Economies of Scale : Occurs when an increase in the scale of output results in
a lower cost per unit e.g purchasing economies
Legal barriers : Patents, copyright and government licenses prevent competitors
from entering the market e.g. 5G licenses in the mobile industry
Ownership of essential resources : If existing competitors' own resources that
are essential to the production of a product, entry into the industry will be limited
e.g cobalt is essential when manufacturing electric batteries and in 2021,
Glencore controlled 22% of the world's supply
Anti-Competitive practices by competitors : These include predatory
pricing, limit pricing and aggressive takeover activity in order to limit the amount
of competition
 Demand for Labour
The labour market is composed of sellers of labour (households) and buyers of
labour (firms). Workers supply their labour and firms demand labour.
The demand for labour is a derived demand. This means that it depends on the
demand for goods/services.
If demand for goods/services increases then the demand for labour will increase -
and vice versa.
Demand is derived
-> Contributes towards productivity and therefore the profit of the firm
The cost of labour is wages
-> At high wage rates demand will be low. At low wage rates demand will be high.
Derived demand for a factor of production occurs as a result of demand for a
product.
Elasticity
Price of demand for labour S is directly linked to the elasticity of demand
Wages
S
for
the product being made
All finished
P1
products create derived demand for factorsP1
such as labour and capital.
The demand
P for labour will be influenced by its productivity.
P

Demand For Good

D D D D
Demand for Labour
1 to make Good 1

Q Q1 Q Q1
Quantity Number of
workers

Factors That Influence The Demand for Labour

The price of the product being produced -
• If the selling price of the product increases, it increases the marginal revenue
product of labour and the firm will demand more labour
• Higher priced products incentivise firms to supply more (law of supply) and
demand for labour will continually increase with increasing prices
The demand for the final product -
• As demand for labour is a derived demand, when an economy is booming
 Demand for Labour
An increase in demand for one good will see an increase in the derived demand for
labour.
Total (physical) product is the total output produced by a firm given the factor
inputs e.g. the amount of capital and labour over a period of time.
It is calculated as: Average (physical) product x units of variable input
Marginal product is the difference between total output when an extra unit of the
variable factor e.g. labour is added.
It is calculated as: Change in total output / Change in variable input.
Production is measured in physical rather than in monetary terms so we can also
use the term Marginal Physical Product (MPP)
Marginal revenue is the addition to revenue of selling an additional unit of output:
Δ TR/Δ Q( where Δ stands for change in)

Marginal revenue product (MRP) is the change in total revenue from the
employment of an extra unit of labourWage
rate/MRP
MPP looks at production in terms of physical units whilst MRP looks at production
in terms of monetary units
If we multiply the additional to total output (MPP) by the revenue received from
that extra output (MR) we find
D = MRP
the addition to total revenue (MRP) or: MRP = MPP x MR
Quantity of Labour
MRP can be shown diagrammatically.
Due to the law of diminishing marginal returns total
Wage
product will rise at first and then start to decline.
rate/MRP
The MRP shows how many workers are demanded by
a firm at each wage rate. WR1
Therefore, it is the demand curve for labour.
WR2
D = MRP

Q1 Q2 Quantity of
Demand and supply theory for labour is similar to Labour
demand and supply theory for a product.
The wage rate is the price of labour rather than
the price of a product.
At a wage rate of WR1
the quantity demanded of labour will be Q1. If the wage
rate falls to WR2 the quantity demanded for labour will increase to Q2.
 Supply of Labour
There are numerous factors that influence the amount of labour supplied to
a particular industry.
• Different factors are present in different markets e.g. in the labour market for
doctors, the length of time it takes to study to become a doctor limits the supply
of doctors. However, in the nursing labour market, the low wages paid to nurses
limit the amount of workers who offer their labour as nurses

Factors That Influence The Supply for Labour

• Training Period : Long training periods act as a barrier to entry and exclude
many households from offering labour in certain markets
• Wages in other occupations : Comparative wage rates in substitute labour
markets strongly influence the supply of labour e.g. it is getting harder to recruit
economics teachers as the private sector offers higher wages for their skills
• Changes in migration policy : Policies that increase the net migration rate
increase the supply of labour to certain industries e.g. Brexit revealed the extent
of foreign labour in the hotel industry in the UK and the withdrawal created a
shortage of workers
• Income tax levels : At a certain level, income taxes become a disincentive to
households offering their labour. The assumption is that as income tax increases,
labour supply decreases - and vice versa
• Working conditions : The working conditions and non-pay benefits can act as
strong incentive in certain industries e.g. tech companies are well known for
their laid-back work environment and wide range of benefits e.g. on-site
childcare and restaurants
• Trade Union Power : Trade unions can increase the supply of labour to certain
industries as workers consider the benefits of belonging to the union e.g higher
wages and a safer working environment
• Level of Welfare benefits : The higher the level of welfare benefits, the lower
the incentive for low-skilled labour to offer their labour - and vice versa
• Social Trends : Social trends include any major changes within society and can
influence the supply of labour to certain industries. Work from home during
Covid resulted in significant changes to the labour market once economies
opened up again e.g many restaurant workers did not feel safe returning to the
jobs they previously had

Market failure occurs in the labour market when workers are unable to easily
move between jobs. This is caused by:
 Wage Determination in Competitive and Non-competitive Markets
Labour market equilibrium occurs where the demand for labour (DL) is
equal to the supply of labour (SL)
- The DL is the demand by firms for workers
- The SL is the supply of labour by workers
.

Wage differentials are the differences in wages that workers obtain for
their services:
- High demand and low supply will lead to a higher wage rate
- Low demand and high supply will lead to a lower wage rate
.

Individual firms are price takers in the labour market as they have to accept
the wage rate that workers
are being paid in the industry.
- If they offer a lower wage, they will likely struggle to recruit workers
- If they offer a higher wage there will be a large number of workers
applying to work there
The theory of perfectly competitive labour markets is used to compare
pure labour markets with those that exist in the real world.
They are similar to perfectly competitive product markets.
Perfectly competitive labour markets have the following characteristics:
- Many buyers of labour i.e. firms
- Perfect knowledge regarding wage rates, jobs available and conditions in
the market
- Homogenous jobs
- Homogenous workers with the same experience and skills
- Many suppliers of labour i.e. workers
- Individual firms and workers have no impact on the wage level
Profit maximisation occurs where:
MRPL = MCL
Non Competitive Labour Markets :
A non-competitive or imperfect labour market is one where firms and
labour have the power to influence wage rates.
Labour market imperfection is influenced by monopsony power, trade
 Wage Determination in Competitive and Non-competitive Markets
The Elasticity of Demand for Labour
This refers to how responsive a firms demand for labour is to a change in the price of
labour (wage rate)
- If the demand for labour is elastic, then an increase in the wage rate will result in
a more than proportional decrease in the quantity of labour demanded by firms
- If the demand for labour is inelastic, then an increase in the wage rate will result in
a less than proportional decrease in the quantity demanded of labour demanded by
firms
If demand is elastic firms will be very responsive to changes in wage rates,
rapidly hiring workers when wages fall and firing workers when wages rise.
If demand is inelastic firms will have a much smaller response to rising or falling
wages
Factors that Influence PED :
- The proportion of labour costs to total costs : The higher these are then the
more elastic the demand for labour will be; the lower these are then the
more inelastic the demand for labour will be
- Ease and cost of factor substitution : If substituting capital for labour is easy and
the cost is comparable to the increase in wages, the demand for labour will be more
elastic - and vice versa
- PED of the final product : If the product being produced is price inelastic in
demand, then the demand for labour is likely to be more inelastic i.e if wages rise,
firms will pass on the increased costs of production to the final consumers
- Time Period : In the short-run, demand for labour is likely to be more price
inelastic i.e an increase in wages will have a less than proportional decrease in the
quantity demanded. However, in the medium to long-term firms can
research alternative methods of production and the demand for labour becomes more
price elastic.
The Elasticity of Supply of Labour
- If the supply of labour is elastic, then an increase in the wage rate will result in
a more than proportional increase in the quantity of labour supplied
- If the supply of labour is inelastic, then an increase in the wage rate will result in
a less than proportional increase in the quantity of labour supplied
InMarginal
low skilled occupations
revenue the quantity
is the addition of of
to revenue labour supplied
selling is very
an additional unitresponsive
of output: to a
change in wageΔ TR/rates
Δ Q i.e. supplywhere
of labour is elastic
Δ stands for change in
Occupations whichproduct
Marginal revenue require (MRP)
a longer andchange
is the higherinlevel
total of training
revenue fromtend to have an of
the employment
inelastic
an extra supply of labour
unit of labour MRP i.e= even
MPP if wage rates increased significantly, there would
x MR
beMPP looks
a less thanatproportional
production in terms of physical
increase units whilst
in the supply MRP looks
of labour in theatshort
production
run in
 Wage Determination in Competitive and Non-competitive Markets
Current Labour Market Issues in the UK
Skills shortages:
• In December 2021 more than 50% of firms surveyed reported difficulties in finding skilled
workers
• A shortage of skilled labour means that firms are having to increase wage rates to attract
labour
• Firms are effectively poaching skilled labour from each other and there is a shortage of
new skilled labour entering the market
• Some of the many labour markets experiencing shortages include nursing, engineering,
pharmacies, secondary teaching, and graphic design
Youth Unemployment:
• Unemployment for 16-24 year olds in April 2022 was at 10.8% compared to the general
unemployment rate of 3.8%
• This means that it is nearly three times as likely for a young person to be unemployed
• Where possible employers prefer to hire workers with more experience as it can lead to
higher productivity
• The education or skills gap is another reason for youth unemployment. Young people leave
school without the skills that employers require
Changes to Retirement Ages:
• In 1995 the state retirement age was 60 for women and 65 for men
• In recent years, State Pension reform has been ongoing and the retirement age is gradually
being increased to 68 for both men and women
• This means that workers are expected to remain in the workforce for longer
• One reason for the change is that with too many pensioners in the system, it is difficult for
the government to fund monthly pension payments
• An improvement to life expectancy has meant there are more pensioners in the system
School Leaving Age:
• The earlier a student leaves school the lower their skill level
• Different policies are in place in England as compared with Scotland, Northern Ireland and
Wales
• In the latter three the school leaving age is 16 and there are no further conditions in place
• In England, students can leave school at 16 but have to do one of the following until they
are 18
Stay in full-time education, e.g. at a college
Start an apprenticeship or traineeship
Spend 20 hours or more a week working or volunteering, while in part-time
education or training
• This aims to increase the skill level but also puts increased pressure on training providers
• There are not enough apprenticeships to match the demand
Zero Hour Contract:
• In 2022, nearly 1 million workers were on zero-hour contracts which is more than five
 Wage Determination in Competitive and Non-competitive Markets
Government Intervention in the Labour Market:
The UK Government usually intervenes in the labour market in order to improve
equity and avoid the exploitation of workers.
A maximum wage is a government imposed price ceiling below the market price and is
rarely used
There has been some discussion recently to set maximum wages for CEOs as
their wages in early 2022 were 86x the average wage of full-time employees. If
CEOs were paid less then the average pay per worker may increase
A minimum wage is a legally imposed wage level that employers must pay their
workers
It is set above the market rate
The minimum wage/hour varies based on age
The market equilibrium wage and quantity for truck drivers in the UK is seen at WeQe
The UK government imposes a national minimum wage (NMW) at W1
Incentivised by higher wages, the supply of labour increases from Qe to Qs
Facing higher production costs, the demand for labour by firms decreases from Qe to Qd
This means that at a wage rate of W1 there is excess supply of labour and the potential
for real wage unemployment equal to QdQs
Public Sector Wage Setting
- The UK government is the largest employer in the nation. In April 2022 there
were 5.74 million public sector workers out of a total of 29.6 million employed workers
(19.39%)
- In many industries, the UK Government is the dominant employer and so is able to
exercise monopsony power in setting the wage rates
There are several implications of this public sector wage setting.
If the government increases the National Minimum Wage (NMW), they are
significantly increasing their own wage bill.
The private sector often uses public sector wages as a benchmark for their own wage
calculations.
If public sector wages increase and private sector ones do not, it can create tension
between workers in the different sectors.
Increases to public sector pay often have to be paid for by increases in tax rates for the
entire working population.
In June 2022, public sector workers were striking due to issues with the pay increases
offered by the Government
Worker's wages were frozen from 2010 to 2015 after the 2008 global financial crisis
This was followed by rampant inflation and wage increases well below the level of
inflation
 Government Intervention
Competition policy seeks to improve the competitive nature of markets.
It seeks to alleviate market failure in order to protect the interests of consumers
(consumer welfare) and society as a whole.
This can be achieved by:
• Curtailing monopoly power and protecting competitive markets
• Restricting mergers and prohibiting cartels. If a merger creates a firm that is
deemed to have too much monopoly power it won’t be allowed
• Improving the way in which markets work e.g. providing greater information
• Creating fairness in markets for both firms and consumers so that firms don’t
abuse their dominant market position but are able to make acceptable profits that
will drive innovation and increases in productivity
• Increasing productive, allocative, static and dynamic efficiency

The Competition and Markets Authority (CMA) is the UK Government

regulator tasked with ensuring that the creation of monopoly power is avoided and
that consumers are not exploited in markets. The main forms of consumer
exploitation include higher prices, less choice and/or poor quality products. A
key function of the CMA is to monitor merger activity with the aim of preventing
any single firm gaining more than 25% market share
There are similar regulators in Europe (European Competition Commission) and
in the USA (Antitrust Commission)
Arguments for Intervention :
1. Protect jobs – potential restructuring; moving abroad; closing UK plants
2. Protect the consumer – exploitation (monopoly power); greater choice
3. Economic environment – protect jobs; support UK owned industries; GDP
4. British ownership – International pride; loss of identity; protect IP

Arguments against Intervention :

5. Competitiveness – Survival of fittest
6. Foreign direct investment (FDI) – creates jobs
7. Strategic interests – eg. Defense
8. Can other countries do a better job?

Intervention to Promote Competition and Contestability

- Promotion of small business: providing tax incentives or subsidies to small
firms can help increase the number of new entrants into industries and thus
promote competition
- Deregulation: Government regulations can increase industry costs or act as a
barrier to entry. Removing regulations can promote competition which will also
 Government Intervention
Types of Intervention in Monopoly Markets :
- Price Regulation : Monopolies aim to produce at the profit maximisation level of
output (MC=MR)
This results in higher prices and limited output in the
market
The CMA uses maximum prices to lower prices and
increase output
One way in which they determine where the maximum
price should be is to identify the point of allocative efficiency and set
the maximum price there
This strategy is often used on natural monopolies
Firms will make less supernormal profit than before
- Profit Regulation :The CMA may choose to limit the supernormal profit a
monopoly can earn
They do this by calculating the firms total costs and
then adding a percentage of profit to it
However, it is a very contentious policy as : Costs are
difficult for the CMA to calculate;
Firms often try to inflate their perceived costs so as
to make more profit than allowed;
Monopolies have no incentive to lower costs, so if costs
are higher than they would be in perfect competition consumers still
end up paying higher prices;
Even with this policy in place, natural monopolies seem
to post record profits year on year.
- Quality Standards : One way to maximise profit is to reduce the quality
of the raw materials which reduces the quality of the end
good/service
If there are no substitutes then this is a likely
outcome
Regulators can step in to insist that certain
quality standards are met
It can be difficult for them to know what the
potential quality of a product is or what standards to impose
Firms push back on these quality standards as
they reduce their supernormal profit
- Performance Targets : Regulators can also set performance targets so as to
 The Impact of Government Intervention
The desired outcomes of government intervention :
1. Prices : Affordable and stable
2. Profit : Permitting enough to keep firms in the industry (normal profit) but
limiting how much they make so that household income is protected
3. Efficiency : Reducing wastage of valuable resources and one of the best ways to
achieve this is by developing rigorous competition
4. Quality : Ensuring products are fit for purpose and contribute to a better
standard of living.
5. Choice : Wider choice improves standard of living and also helps to improve
product quality. More choice also generates more economic activity in an
economy and increases the GDP.
Limits to Government Intervention :
Government intervention is not always effective. Two of the main reasons for this
are the existence of regulatory capture and asymmetric information.
Regulatory Capture : Regulatory capture occurs when firms influence the
regulators to change their decisions/policies to align more with
the interests of the firm.
Firms spend millions lobbying regulators directly – or
in many cases lobbying politicians who can issue instructions to the
regulators e.g in 2021 the former UK Prime Minister, David Cameron,
was caught in an embarrassing case of lobbying for a
failed financial venture by a firm called Greensill Capital.
Some lobbying activity is corrupt and there is a fine
line between influencing activity and bribing. The UK Government has an
agenda to improve the transparency of any lobbying activity.
Naturally, regulatory capture can completely prevent
fair outcomes in the markets concerned.

Asymmetric Information : Often governments believe they are making the best
decision in order to meet their aims
Many times it is not the best decision due to
the fact that the government or regulators either do not have the full
and relevant information - or they do not understand the
market they are trying to regulate e.g. many financial
markets are fast moving and incredibly complex
This existence of asymmetric
information has been responsible for some spectacular government failures
 Theme 4
International Economics
4.1 International Economics
- Globalisation
- Specialisation and Trade
- Patterns of Trade
- Terms of Trade
- Trading Blocs and the World Trade Organisation (WTO)
- Restrictions of Free Trade
- Balance of Payments
- Exchange Rates
- International Competitiveness
4.2 Poverty and Inequality
- Absolute and Relative Poverty
- Inequality
4.3 Emerging and Developing Economies
- Measures of Development
- Factors Influencing Growth and Development
- Strategies Influencing Growth and Development
4.4 The Financial Sector
- Role of Financial Markets
- Market Failure in the Financial Sector
- Role of Central Banks
4.5 The Role of the state in the Macroeconomy
- Public Expenditure
- Taxation
- Public Sector Finances
- Macroeconomic Policies in a Global Context
 Globalisation
Globalisation is the process of greater integration and inter-connectedness
between countries.
It is the economic integration of different countries through increasing
freedoms in the cross-border movement of people, goods/services,
technology and finance.
This integration of global economies has impacted national cultures, spread
ideas, speeded up industrialisation in developing nation and led to de-
industrialisation in developed nations.
Improvements in technology and the speed of global connections have
exponentially increased the level of interdependence between nations in the
past 50 years
IMF (International Monetary Fund) is an international organization that
provides financial assistance and advice to member countries. 190/195
countries are part of this of IMF.
The IMF came into existence in 1944. Along with the World Bank, it was
created to bring financial stability to the world following World War II.
The Four Main Characteristics of Globalisation
→ Increased Foreign Ownership of Companies
→ Increasing movement of Increased
→labour internationalacross
and technology capitalism
borders
→ Increased outsourcing
→ Free trade in goods/services
→ Falling
→ Easy flows of capital (finance) transport
across costs / the “death of
borders
distance”
Globalisation usually includes the following
→ Growth of size andfeatures and
influence of
characteristics: multinational corporations (MNCs)
→ Trade liberalization
→ Growth of international trade
→ Enhanced mobility of labour
→ Enhanced mobility of capital
→ Increased cultural exchange

Factors Contributing to Globalisation in the Last 50 Years :

→ Trade agreements - The World Trade Organisation (WTO) has assisted
in the reduction or removal of trade barriers and there has been a greater
proliferation of trade agreements across the world
 Globalisation
In the 1990's there was deregulation of many financial markets which
resulted in the expansion of global financial services and provided more
access to capital
→ More globalised financial systems - There has been a significant
relaxation on the rules and regulations surrounding the movement of
capital, which can move either freely, or at very low cost, quickly across
the globe
→ Greater labour mobility - Workers are more willing to move across
national borders in search of employment
→ Improvements in transportation - This has made the movement of
people, goods and services across the globe faster and cheaper
→ Growth of multinational corporations - Many large organisations have
taken advantage of lower trade barriers, labour mobility and cheaper
transportation to grow rapidly and enter previously
Negatives :untapped markets
• Structural
→ Greater ‘openness’ of former ‘closed’ economies Unemployment
- Large and rapidlyfrom
developing countries such as India and China shifting
whichsectors
were previously
• Monopoly
largely closed to trade have become increasingly power into
integrated of the
multinationals
global economy and play a vital role in the creation of new markets and
• Rapid depletion of natural
the provision of low cost labour resources
• Increase in global warming
Impacts of Globalisation • Deforestation
Positives : • Increase in organised crime
• Increased capital and labour mobility • rising inequality
• Greater competition – lower prices • Tax avoidance easier
• Reduction in absolute poverty
• Rising incomes
• Rising levels of education
• Increased trade – greater choice of goods
• Economies of scale – more efficient production
 Specialisation and Trade
Absolute advantage occurs when a country is able to produce a product using
fewer factors of production than another country. A country may well have absolute
advantage but still not have comparative advantage
It should produce goods/services in which it has comparative advantage

Comparative advantage is the theory developed by David Ricardo in 1817 which

states that a country should specialise in the goods/services that it can produce at
the lowest opportunity cost
By specialising, the volume of production increases, excess production can
be exported and goods/services which are not produced in the country can
be imported.

The Assumptions of Comparative Advantage

→ Transport costs are zero: it does not account for moving the goods/services
between countries. Depending on a nation's location this is more or less of a
problem
→ There is perfect knowledge: each country knows what it has a comparative
advantage in and also the comparative advantages of other countries
→ Factor substitution is easily achieved: economies can quickly adjust to changing
Computers
global market conditions by switching from capital to labour - and vice versa
200,000
→ Constant costs of production: the theory does not take into account
the economies of scale that can be achieved with an increase in output
80,000

Production possibility frontiers can be used to illustrate these comparative and

absolute advantage.
Country B Country A

Country A has an absolute advantage

80,000 Laptops as it can produce more of both products
100,000
Country A can produce either 200,000 computers or 100,000 laptops

To produce 100,000 laptops, it gives up production of 200,000 computers.

The opportunity cost of producing 1 laptop is 2 computers

The opportunity cost of producing 1 computer is 0.5 laptops

Country B can produce either 80,000 computers or 80,000 laptops

 Specialisation and Trade
Limitations of comparative advantage
- Over dependance, Specialisation creates a dependence on other countries which
generates vulnerability
- Environmental damage, the impact of negative externalities of production is not
considered by the theory and these can significantly worsen the quality of life in
towns, cities and countries
- Distribution of income, The GDP/capita is likely to increase, however
the distribution of the extra income is likely to be uneven with the wealthier
sections of the population gaining more
- Structural Unemployment, although there should be a net increase in employment,
as countries specialise certain industries are likely to shut down resulting in
unemployment for some workers. These workers may not be able to move into
other occupations and if so the number of long-term unemployed will rise

Advantages of International Specialisation and trade

- Lower prices
- Greater variety in goods and services
- More competition leads to better quality products
- Economies of scale create efficiencies
- Higher economic growth
- Improved living standards

Disadvantages of International Specialisation and trade

- Global monopolies emerge, as transnational firms grow in size and increase
market power, they can dictate prices and output in many regions. They are also
able to wield their influence to influence governments and gain access to raw
materials through bribery and corruption
- Exposure to external shocks, Shocks to other economies have a knock-on
effect due to the interdependence that develops with trade
- Deficit on the Current Account of the Balance of Payments, Some countries
will import more than they export resulting in a deficit on the current account.
When this happens in developed countries, it is usually because the income of
the citizens is high and they are importing to improve their standard of living.
In developing countries, this situation is usually as a result of a lack of global
competitiveness and it is importing necessity products
- Unemployment, many firms that were successful in the local market may
well fail in a global market. Employment in successful industries will increase
and employment in unsuccessful industries will decrease. Structural
 Patterns of Trade
Factors that influence the pattern of trade between countries
- Comparative advantage: this is less a grand plan and more
a natural market outcome as firms seek to profit maximise. Where it
makes sense to increase production due to natural advantages, firms do.
When it makes financial sense to outsource production because another
country does it better/cheaper, firms do. Over time, this changes what
countries produce and trade.
- Impact of emerging economies: Emerging world economies like China,
Brazil, India and Thailand have obtained a much higher share of the
global business which means that other countries are losing out
as trading relationships change.
- Growth of trading blocs and bilateral trading agreements: By December
of 2016, the World Trade organisation. (WTO) had helped to facilitate
more than 420 regional trading blocs and bilateral agreements (between
2 countries). This results in trade creation and causes trade diversion.
- Changes in relative exchange rates: If a country's exchange rate
appreciates, then its exports are relatively more expensive and its
imports become cheaper. This means that changes to the exchange rates
influence the patterns of trade over time as goods/services
either become cheaper or more expensive in relation to the price of
goods/services in other countries.
 Terms of Trade
The terms of trade is the ratio of (average) price of exports to (average) price of
imports.
- An increase in the export prices leads to an improvement in the terms of trade.
This occurs if the value of the currency rises.
- An increase in the import prices leads to the deterioration in the terms of trade.
This occurs if the value of the currency falls.

The index for exports and imports is created in much the same way that a consumer
price index is created
(using a weighted basket of imports and exports).
Factors influencing a country’s terms of trade.
Inflation rates : inflation increases the price of goods/services within a country. This
means UK prices will be higher than everywhere else. If the exports are price
inelastic in demand this will improve the terms of trade, if elastic then it is likely to
worsen the terms of trade.
Exchange rates : if the £ appreciates in value then relatively, export prices will
increase by more than import prices, leading -toChanges
the improvement in terms
to disposable of trade.
income
This will also lead to a fall in exports. - Changes to standards of living
Productivity rates : continuous improvements- inChanges
productivity can lower costs
to unemployment and
levels
these can be passed on in the form of lower prices. Lower prices for export
products will mean that the terms of trade will deteriorate.
Impact of changes in the terms of trade.
Depending on the contribution that net exports make to GDP, changes to the terms
of trade can have far reaching impacts on an economy. These include :
- Changes to the current account balance in the Balance of Payments
- Changes to the level of international competitiveness
- Changes to national output (GDP)

PED and Changes To the Terms of Trade

Improvement, caused by a rise in export prices. If PED of exports is inelastic then
the reduction in quantity demanded will be less than the increase in price and the
economy will benefit. Likely outcomes : output increases, Unemployment
decreases, Standard of living improves
Improvement, caused by a fall in export prices. If PED of imports is elastic
(necessity) then the increase in quantity demanded will be more than the decrease
in price and the economy will spend more on imports. Likely outcomes : more
 Trading Blocks and the World Trade Organisation WTO
A trading bloc is a group of countries who come together and agree to reduce or
eliminate any barriers to trade that exist between them.
There are different levels of economic integration ranging from relatively low
integration in a bilateral agreement to high integration in a monetary union such as
Eurozone.
Globally, there were more than 420 regional trade agreements in effect in 2022.
The trading blocs below have an increased level of economic integration:
Free Trade Area
A free trade area is a bloc in which countries agree to abolish trade restrictions
between themselves but maintain their own restriction with other countries. EG.
Canada – United States – Mexico Agreement (CUSMA).
In the diagram, Mexico, Canada and the USA have reduced/eliminated many
trade restrictions between themselves.
The USA refuses to trade with Cuba and has placed a complete embargo ban on
all exports/imports to Cuba.
Canada trades with Cuba but imposes tariffs on all imports.
Mexico trades freely with Cuba.

Customs Unions
A custom union is an agreement between countries in which all goods/services
produced
by members are traded tariff free.
Additionally countries agree on common tariff rates on imports from all external
third
party countries.
In the diagram, countries in the European Union have eliminated all tariff
barriers between
themselves but impose common tariff barriers on third party countries such as the
UK or China.

Common Markets
Similarly, to a customs union, goods/services are traded tariff free in common
markets. Additionally, the four factors of production flow freely between member
countries. The goal is to improve the allocation of resources between the common
market members and lower costs of production
 Trading Blocks and the World Trade Organisation WTO
Essential condition for a successful monetary union such as the Eurozone :
1. Movement of Labour : Labour should be able to move freely without any
major barriers e.g. language. The main languages of the Eurozone are English,
French and German but language is still a limiting factor.
2. Similar Trace Cycles : The trade cycles of member countries should be similar
so as to avoid tensions with the union e.g. after the 2008 Financial Crisis,
Southern European countries were in a depression compared to the temporary
recession in Northern European countries. This created extreme pressure on the
survival of the Eurozone
3. Mobility of Finance : There should be complete mobility of finance with
prices and wages free to adjust based on market conditions. This is a strength of
the Eurozone and labour markets fluctuate based on members market
conditions.
4. Fiscal Transfers : To maintain stability, there should be automatic fiscal
transfers to countries that are performing poorly. This is especially important as
members have lost the use of monetary policy to deal with a crisis in their
nation e.g. fiscal transfers to Spain, Portugal and Greece post 2008 Financial
Crisis were very weak. Political tensions emerged in which citizens of wealthier
countries (Germany) did not want their tax revenue used to bail out countries
with perceived poor fiscal history (Greece).

Benefits of Regional Trade Agreements.

- Trade creation improves efficiency and generates higher income
- Tariffs between member states are eliminated. Common tariffs to third party
countries simplify trading conditions
- A monetary union simplifies trading costs and provides pricing transparency.
Some member countries gain from improved monetary policy conditions
e.g. European interest rates may well be lower than an individual country's rates
would have been. There is less uncertainty surrounding exchange rates as
members all use the same currency

Costs of Regional Trade Agreements

- Trade diversion occurs as countries reallocate trade to partners in their
agreement. This may worsen global efficiency
- Some domestic industries experience structural unemployment. Increased
negative externalities of production, resource depletion and environmental
damage
- Transitioning to a monetary union can be expensive and firms may find it hard
 Restrictions of Free Trade
Protectionism, sometimes referred to as trade protectionism, is the
economic policy of restricting imports from other countries through
methods such as tariffs on imported goods, import quotas, and a variety of
other government regulations.
Reasons for Protectionism :
- Infant Industries : To protect new firms that would be unlikely to
succeed at start-up due to the level of global competition. Once
established support is removed
- Sunset Industries : Similar to above, but at the other end of the life
cycle, these firms are on their way out and the government chooses to
support them to help limit the economic damage that would occur if
they closed abruptly
- Strategic Industries : Industries such as energy, defence and agriculture
are essential to self-sufficiency and security. Being reliant on other
countries for these creates vulnerabilities for a nation
- Dumping : Dumping occurs when foreign firms sell products at unfairly
low prices in foreign markets and usually below their normal cost of
production. It is anti-competitive and can harm a country's industries
- Employment : When firms outsource production to other countries or
certain industries are experiencing structural
unemployment governments will step in to protect jobs
- Current Account Deficit : When imports > exports the amount of
money leaving the country to support foreign firms is greater than that
entering to support domestic firms. Protectionism aims to correct
this imbalance
- Labour/Environmental Regulations : Many countries offer cheap
labour and low-cost production due to poor environmental regulations.
Protectionism can help apply pressure to bring about change in these
countries
Although free trade ensures that global output is maximised as countries
produce the goods and services where they enjoy comparative advantage,
all countries operate some kinds of protectionism, aimed at either
reducing imports or increasing exports. The main protectionist measures
 Restrictions of Free Trade
Tariffs
A tariff is a tax on an imported good. It can be an ad
valorem or specific tax. Manufactured goods, such as cars are usually
subject to ad valorem tariffs, whilst commodities, such as agricultural
products and minerals are subject to specific tariffs.
Domestic producers/retailers have to pay the tariff when the good/service
crosses the border into the country
This raises the cost of production for domestic firms. Firms often pass on
the increased costs to consumers in the form of higher prices.
These higher prices allow some domestic firms to increase
their output (law of supply)
More inefficient domestic firms are now producing at the expense of more
efficient firms globally who reduce their output due to the tariff.
With increased domestic output, employment may increase.
Administrative and Product Regulation Barriers
A country can restrict imports through regulations that are difficult for
foreign producers to satisfy or which may increase their costs. Imports may
be subject to stringent product safety standards, for instance, which can be
changed at short notice, or imports may be subject to delays at customs
posts. Some countries have restricted certain imports on the grounds of
protecting the environment, or to protect endangered species. For instance
the USA imposed a rule that imported tuna has to be caught using ‘dolphin
friendly’ nets.
Exchange rate manipulation
A government may deliberately try to push down the exchange rate of its
currency.
in order to gain a competitive advantage for its exports and to make
domestically produced goods more competitive against imports. It can
achieve this through a combination of low interest rates, increasing the
domestic money supply and selling its own currency in exchange for
foreign currency. It is not always easy to prove that a currency is being
deliberately held below its market value, but a country can make a
complaint to the WTO that it is a victim of exchange rate manipulation and
 Restrictions of Free Trade
Impacts of tariffs on stakeholders
Domestic Producers : Before the tariff domestic producers produced
output equal to 0Q1 and their revenue was equal to Pw X Q1
After the tariff was imposed domestic producers produced 0Q3 and
their revenue was equal to Pw X Q3
Domestic producer surplus has increased by area 2
Domestic consumers : Before the tariff domestic consumers consumed
Q2 products at a price of Pw
After the tariff domestic consumers consumed fewer products (Q4) at a
higher price of Pw+tariff
Domestic consumer surplus has decreased by areas 1, 2, 3 and 4
Government : After the tariff is imposed the government receives tax revenue equal to
((Pw+tariff) - Pw) x (Q4-Q3) - area 3
Standards of Living : the standards of living for consumers worsen as the value of their
income is eroded as they are paying higher prices.
Domestic firms who benefit from increased production may increase employees' wages.
This would increase the standard of living for employees
Equality : Workers in industries that have been experiencing structural
unemployment due to foreign competition will feel that the tariff results in them being
treated more fairly
Impacts of Quotas on Stakeholders
Domestic Producers : Increases their output; Raises the selling price; Increases
their revenue
Foreign Producers : Decreases their output; Compared to a tariff, those firms who
manage to export in the quota receive a higher price for their sales
Consumers : Results in higher prices and less choice
Government : They do not receive any tariff revenue (as there is no tariff); They may
receive higher tax revenue at the end of the financial year when domestic firms pay
their corporation tax
Standards of Living : Reduces for consumers as higher prices erode the purchasing
power of their income
Equality : Improves for domestic firms but worsens for foreign firms
Impacts of Subsidies on Stakeholders
Domestic Producers :Decreases costs of production; Increases output;
Increases international competitiveness
Foreign Producers : Makes it harder for them to compete with domestic firms
Consumers : Lowers Prices
Government : This costs the government the amount of the subsidy; There is
an opportunity cost associated with every subsidy provided
 Balance of Payments
The Balance of Payments (BoP) for a country is a record of all the financial
transactions that occur between it and the rest of the world.
The BoP has two main sections:
The current account: all transactions related to goods/services along with
payments related to the transfer of income
The financial and capital account: all transactions related to savings, investment
and currency stabilization.
Money flowing into the country is recorded in the relevant account as a credit
(+) and money flowing out as a debit (-)
The Current Account is often considered to be the most important account in the
BoP. It records the net income that an economy gains from international
transactions.
Goods are also referred to as visible exports/imports.
Services are also referred to as invisible exports/imports.
Net income consists of income transfers by citizens and corporations
- Credits are received from UK citizens who are abroad and
send remittances home
- Debits are sent by foreigners working in the UK back to their countries
Current transfers are typically payments at government level between countries
e.g. contributions to the World Bank
The Capital Account records small capital flows between countries and is
relatively inconsequential.
E.g. debt forgiveness by the government towards developing countries
E.g. capital transfers by migrants as they emigrate and immigrate
The Financial Account records the flow of all transactions associated with changes
of ownership of the UK’s foreign financial assets and liabilities
It includes the following sub-sections
1. Foreign Direct Investment (FDI): flows of money to purchase a controlling
interest (10% or more) in a foreign firm. Money flowing in is recorded as a
credit (+) and money flowing out is a debit (-)
2. Portfolio Investment: flows of money to purchase foreign company shares and
debt securities (government and corporate bonds). Money flowing in is
recorded as a credit (+) and money flowing out is a debit (-)
3. Financial derivatives: are sophisticated financial instruments which investors
use to speculate and return a profit. Money flowing in is recorded as a credit (+)
 Balance of Payments
Causes of Deficits and Surpluses on the Current Account
It is called the BoP as the current account should balance with the capital and
financial account and be equal to zero.
If the current account balance is positive, then the capital/financial account
balance is negative (and vice versa). The excess spending on imports (current
account deficit) has to be financed from money flowing into the country from the
sale of assets (financial account surplus).
If there is a current account surplus, there must be a deficit in the capital and
financial account. The excess income from exports (current account surplus) is
financing the purchase of assets (financial account deficit) in other countries.
1. Relatively Low Productivity : Low productivity raises costs. Exporting firms
with low productivity may find themselves at a price and cost disadvantage in
overseas markets which will decrease competitiveness and the level of exports.
With higher domestic prices, consumers may also buy abroad thus increasing
the imports. Falling exports and rising imports creates a deficit.
2. Relatively high value of the country’s currency : Currency appreciation
makes a country's exports more expensive relative to other nations. Foreign
buyers look for substitute products which are priced lower. Exports fall and the
balance on the current account worsens. Similarly, currency appreciation makes
imports cheaper. Domestic consumers may switch demand to foreign goods and
as imports rise, the balance on the current account worsens.
3. Relatively high rate of inflation : A relatively high rate of inflation makes a
country's exports more expensive than other nations. Foreign buyers look for
substitute products which are priced lower. Exports fall and the balance on the
current account worsens. Similarly, high inflation may mean that goods/services
are cheaper in other countries. Domestic consumers may switch demand to
foreign goods and as imports rise, the balance on the current account worsens.
4. Rapid economic growth resulting in increased imports : Rapid economic
growth raises household income. Households respond by purchasing
goods/services with a high-income elasticity of demand (income elastic). Many
of these goods are imported and as imports rise, the balance on the current
account worsens.
5. Non-price factors such as poor quality and design : When a country develops
a reputation for poor quality and design, its exports fall as foreign buyers look
for better substitutes elsewhere. Domestic buyers who are able to shop abroad
also choose to buy better quality products elsewhere and the level of imports
rise. A fall in exports and a rise in imports worsens the balance on the current
 Balance of Payments
Measures to Reduce Imbalances on the Current Account
- Do nothing Pros : Floating exchange rates act as a self-correcting
mechanism. Over time a higher level of imports will end up
depreciating the currency causing imports to decrease (they are
now more expensive) and exports to increase (they are
now cheaper). This improves the deficit
Cons : There may be other external factors that prevent the
currency from depreciating. It may take a long time for self-
correction to happen and many domestic industries may go out of
business in the interim. The longer it takes to self- correct, the more
firms will delay investment in the economy

- Expenditure Switching Pros : This is often successful in changing

the buying habits of consumers, switching consumption on
imports to consumption on domestically produced
goods/services. This helps improve a deficit
Cons : Any protectionist policy often leads
to retaliation by trading partners. This may consist of reverse
tariffs/quotas which will decrease the level of
exports. This may offset any improvement to the deficit
caused by the policy

- Expenditure Reducing Pros : Deflationary fiscal policy invariably

reduces discretionary (disposable) income which leads to a fall
in the demand for imported goods and improves
a deficit
Cons : Deflationary fiscal policy also
dampens domestic demand which can cause output to fall. When
output falls, GDP growth slows and
unemployment may increase

- Supply-Side Pros: Improves the quality of products and lowers the

costs of production. Both of these factors help the level of exports
to increase thus reducing the deficit
 Exchange Rates
An exchange rate is the price of one currency in terms of another.
International currencies are essentially products that can be bought and sold on the
foreign exchange market (forex).
The Central Bank of a country controls the exchange rate system that is used in
determining the value of a nation's currency.
There are three exchange rate systems:
- A floating exchange rate
- A fixed exchange rate
- A managed exchange rate

FLOATING EXCHANGE RATE

It is a system in which demand and supply determines the rate at which one
currency exchanges for another.
As with any market, if there is excess demand for the currency on the forex market,
then prices rise (the currency is worth more).
In a floating exchange rate system this is called an appreciation.
If there is an excess supply of the currency on the forex market, then prices fall (the
currency is worth less)
In a floating exchange rate system this is called a depreciation.
FIXED EXCHANGE RATE
It is a system in which the country’s Central Bank intervenes in the currency
market to fix the exchange rate in relations to another currency.
The Central Bank negotiates with the international Monetary Fund (IMF) to fix
(peg) their currency to another one
Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar
Often the peg is not at parity e.g. Hong Kong has pegged its currency to
the US$ at a rate of HK$ 7.75 = US$ 1
A revaluation occurs if the Central Bank decides to change the peg and increase the
strength of its currency
A devaluation occurs if the Central Bank decides to change the peg and decrease the
strength of its currency
MANAGED EXCHANGE RATE
It is a system in which the free market determines the value of the currency but also
where central banks will intervene from time to time so as to keep the currency value
withing the desired range. This is a combination of the fixed and floating
mechanism.
The Central Bank determines the preferred currency value - and then the
 Exchange Rates
Factors Influencing Floating Exchange Rates
- Speculation : the vast majority of currency trades are speculative. Speculation
occurs when traders buy a currency in the expectation that it will be worth more in
the short to medium term, at which point they will sell it to realise a profit.
- Quantitative Easing : involves increasing the money supply and much of the new
supply is used to buy back gilts. Many of these gilts are owned by foreigners who
then exchange the £s received for their own currency. The increase in the supply of
£'s depreciates the £
- Relative Intrest Rates : influence the flow of hot money between countries. If the
UK increases its interest rate, then demand for £'s by foreign investors increases
and the £ appreciates. If the UK decreases its interest rate, then the supply of £'s
increases as investors sell their £'s in favour of other currencies and the £
depreciates
- The Current Account : UK exports have to be paid for in £'s. UK imports have to
be paid for in local currencies, which requires £'s to be supplied to the forex
market. Due to this, an increasing trade surplus will result in an appreciation of the
£ and an increasing deficit will result in a depreciation of the £.
- Net Investment : foreign direct investment (FDI) into the UK creates a demand for
the £ which leads to the £ appreciating. FDI by UK firms abroad creates a supply of
£'s which leads to the £ depreciating.
- Relative Inflation Rates : as inflation in the UK rises relative to other countries,
its exports become more expensive so there is less demand for UK products by
foreigners, which means there is less demand for £’s and so the £ depreciates.
Intervention in Markets Using Forex Transactions and Interest Rates
When using a managed exchange rate system, Government intervention in currency
markets takes place in two ways and is managed by the Central Bank.
1. Changing interest rates: if the Central Bank wants to appreciate the country’s
currency, it would raise interest rates thereby making it more attractive for
foreigners to move money into the country's banks (hot money). Decreasing
interest rates has the opposite effect and causes a depreciation
2. Buying a selling currency in the forex market: The Central Bank can change the
demand or supply for their currency using their reserves. If they want to appreciate
the currency then they buy it on the forex market using foreign currencies e.g. to
bolster the value of the £, the Central Bank could take US$'s from their reserves
and buy £'s. If they want to depreciate the currency then they sell their own
currency and buy foreign currencies.
 Exchange Rates
Impacts of Changes in Exchange Rates
1. Current Account Balance
Depreciation of the £ causes exports to be cheaper for foreigners to buy and imports to
the UK are more expensive
The extent to which this improves the current account balance depends on the
Marshall-Lerner condition
This follows the revenue rule which states that in order to increase revenue, firms
should lower prices for products that are price elastic in demand
If the combined elasticity of exports/imports is less than 1 (inelastic), a depreciation
(fall in price) will actually worsen the current account balance
It is also important to recognise that there is a time lag between the depreciation of the
£ and any subsequent improvement in the current account balance
This is explained by the J-Curve effect
It takes time for firms and consumers to respond to changes in price
Once it becomes evident that price changes will last for a longer period of time, firms
and consumers switch
E.g. a firm in the USA has been importing electric scooters from the UK. If the Euro
depreciates, the price of scooters in France becomes relatively cheaper. In the short-
term, the USA firm will not switch immediately to purchasing scooters from France as
the exchange rate may soon bounce back. They also have a good relationship with
their UK suppliers. In the long term they are likely to switch
2. Unemployment
If depreciation leads to an increase in exports, unemployment is likely to fall as more
workers are required to produce the additional products demanded
An appreciation of the currency will have the opposite effect
3. Price Stability (Inflation)
Cost push inflation is likely to occur as the price of imported raw materials increases
with currency depreciation
Net exports are a component of aggregate demand (AD)
A depreciation that results in an increase in net exports will lead to an
increase in aggregate demand
This may lead to an increase in demand pull inflation
An appreciation of the currency will have the opposite effect
4. Economic Growth
Net exports are a component of aggregate demand (AD)
A depreciation that results in an increase in net exports will lead to economic growth
 International Competitiveness
International competitiveness refers to how well a country's products compete in
international markets. Competitiveness can change over time
In order to make a comparison between the competitiveness of two countries, two
metrics are commonly used:
1. Relative unit labour costs: the total wages in an economy divided by output.
This provides a number that indicates the labour costs for each unit of output
produced. It is then possible to look at the relative unit labour cost for the UK
compared to France. If it is lower than the UK is more competitive in the
international market
2. Relative export prices: monitoring export prices provides insight into whether
they are rising or falling over time. If they are rising in the UK relative to other
countries, then the UK is becoming less competitive. If they are falling in the
UK, it is becoming more competitive
Factors Influencing International Competitiveness
- Relative Unit Labour Costs : A rise in productivity levels of UK
workers, relative to their competitors, will lower the production cost per unit and
increase competitiveness
A decrease or stagnation in productivity, relative to their
competitors, will worsen competitiveness
- Relative Wages and : Increases in labour costs, relative to
other countries, are likely to make exports more expensive as the costs of
non-wage costs production have increased resulting in
a worse level of competitiveness
Increases in non-wage costs such as
pensions or social security taxes paid by the employer are likely to reduce output
or raise costs of production, thus making
exports less competitive
Decreasing wage and non-wage costs have
the opposite effect
- Relative rate of Inflation : Inflation raises the price of goods/service in an
economy
If inflation increases in the UK, relative to
other countries, then foreign buyers pay more for the exports they
purchase and this worsens competitiveness
Decreasing inflation has the opposite effect
- Relative level of regulation : Government regulation tends to raise costs of
 Absolute and Relative Poverty
Absolute poverty is a situation where individuals cannot afford to acquire the basic
necessities for a healthy and safe existence.
These necessities include shelter, water, nutrition, clothing and healthcare
In 2022, the World Bank defined absolute poverty as anyone who was
living on less than $1.90 a day
Absolute poverty is more prevalent in developing countries than developed
ones
Relative poverty is a situation where household income is a certain percentage less
than the median household income in the economy. Poverty in a household is
considered relative to income levels in other households.
The UK defines relative poverty as households that are living with less
than 60% of the median household income
In May 2022, the median UK monthly household income was
£2072/month
This meant that the relative poverty line was any household earning less
than £1243,20/month
In early 2022, 22% of the UK population was in relative poverty.
Relative poverty is the main form of poverty that occurs
in developed countries
The ​poverty line is the minimum level of income deemed necessary to achieve an
adequate standard of living in a given country. The ​poverty trap affects people on
low incomes, when the tax and benefits system creates a disincentive to look for
work or work for longer hours. By working longer hours, individuals may find they
lose income due to income tax and national insurance contributions as well as losing
some income-related state benefits.
There has been a significant decrease in absolute poverty since 1990. There were
1.9 billion people in absolute poverty in 1990. By 2022 it had fallen to 750 million.
Absolute poverty can decrease even while income inequality increases. This
means that the income of wealthier households is rising faster than the income of the
poorer households.
A reduction in absolute and relative poverty requires the benefits of both the
workings of the free market and government intervention.
There is a strong correlation between economic growth and a decrease in absolute
poverty. Economic growth increases household incomes.
Government tax and benefit policies can support the most vulnerable groups in
society e.g. children, pensioners, people stuck in long-term unemployment
 Inequality
Income is a ​flow ​of earnings, whilst wealth is a ​stock of asset.
Income inequality refers to the unequal distribution (flow) of income to households
i.e rent, wages, interest and profit.
Wealth inequality refers to differences in the amount of assets that households own.
The two main measures of income inequality are the Lorenz Curve and the Gini
coefficient.
The Lorenz Curve is a visual representation of the inequality that exists between
households in an economy.
Data is commonly presented in quintiles (population divided into 5 groups i.e 20%)
or deciles (population divided into 10 groups i.e 10%)
E.g. in 2021 42% of the income flow in the UK went to the top 20% of households
while only 7% went to the bottom 20%
Perfect income distribution is not the goal (20 % of the population get 20% of the
income; 40% get 40% percent of the income etc.)
That would equate to socialism and completely remove incentives for work as
everyone would be paid equally.
More equal income distribution is desired as it reduces poverty and social unrest.
What constitutes acceptable income equality is a normative economic issue.
An illustration of Income Inequality for the UK (green line) and Sweden (red
line)
using a Lorenz Curve Model. The income distribution in the UK is more unequal
than that of Sweden.
The line of equality represents perfect income distribution (not desirable)
In the UK the bottom 20% of households receive 5% of the income flow while in
Sweden
they receive 9% of the income flow
In the UK the top 10% of households receive 45% of the income flow while in
Sweden
they receive 25%
Sweden has a more equal distribution of income than the UK
The Lorenz curve can be used to calculate the Gini Coefficient
Gini Coefficient =
A represents the area between the line of equality and the UK Lorenz curve
B represents the area under the Lorenz curve
 Inequality
Causes of Wealth and Income Inequality
1. Education, Training and Skills : The higher the skill level the higher the level of
income. A country with a poor education system will see greater inequality than
one with a good education system.
2. Trade Unions : Countries with strong trade union membership tend to have higher
levels of income. With low trade union membership, the exploitation of workers
through low wages is easier.
3. Benefit System : Countries that provide a range of benefits (such as
unemployment, disability, child support, housing support etc) raise the income of
the lowest 20% of the population resulting in more equal distribution.
4. Pension Payments : State pension payments ensure a minimum standard of living
for retirees resulting in a more equal distribution of income. Countries without it
have a much higher percentage of pensioners living in poverty.
5. Wage Rates : The purpose of a national minimum wage is to improve the equity
in the distribution of income. Without it, more households would be earning less
and inequality would increase.
6. Employment Legislations : Generally, the more workers are protected by law, the
better the income distribution in an economy e.g. maternity benefits ensure that
new mothers have a higher level of income during the first months of leave after a
birth.
7. Tax Structure : Progressive tax systems allow all income earners to contribute to
public revenue according to their ability. Decreasing taxes on the lower end and
increasing it on the upper end would mean that the system is more progressive and
there would be a more equal distribution of income.
8. Asset Ownership : Assets generate income. The more equal the asset ownership
in an economy the less the inequality in income distribution. This was one reason
why the UK government changed the law in 1980 allowing council house tenants
the right to buy their property at a discounted rate. It is also a reason for the
current shared ownership scheme.

Impact of Economic Change and Development on Inequality

In the 1950's Simon Kuznets developed a hypothesis that described how income
inequality changed as an economy went through stages of industrialisation and
development
This hypothesis was explained using the Kuznets Curve.
Industrialisation results in increased inequality as some workers move from the
lower
 Measures of Development
Whilst economic growth is measured purely by real GDP and the productive
potential of the country, economic development is about ​improvements in living
standards​.
A developed country is one with a high GDP per head and tends to be thought as
Western. There are high levels of healthcare and education, reliable and safe transport
infrastructure and operations and high productivity and investment. They are likely to
have entered a stage of de-industrialisation and may have developed their service
sector. Governments are democratically elected and not corrupt.
On the other hand, a developing country is one with a lower GDP per head, low
levels of physical and human capital and high levels of unemployment and
underemployment. Health tends to be low with high mortality rates and high levels of
population growth, due to high birth rates. Institutional structures are weak and
corrupt.
The Human Development Index (HDI)
Developed by the United Nations, it is a combination of 3 indicators :
 Healthcare (life expectancy), Japan has a life
expectancy of 83.6 and UK has a life expectancy of 80.3
 Education (mean years of schooling) Australia has a mean of
19.6 years, UK’s 16.4 years and Somalia’s is 2.4 years
 Income (real GNI per capita and PPP) Qatar has an average
income of £55,177 whilst UK has a average yearly income of £25,971
Each indicator is given equal weighting in the index
The index ranks countries on a score between 0 and 1
The closer to 1, the higher the level of economic development and the better the
standard of living
• A value of < 0.550 is considered low development e.g. Chad 0.394
• A value of 0.550-0.699 is considered medium development e.g. El Salvador 0.673
• A value of 0.700-0.799 is considered high development e.g Thailand 0.777
• A value ≥ 0.800 is considered very high development e.g. Norway 0.957

Advantages of HDI to compare countries :

• It is a composite indicator which provides a more useful comparison metric than
single indicators do
• It incorporates three of the most important metrics for households i.e. health,
education and income
• It is widely used all over the world which provides an opportunity for meaningful
comparisons
 Measures of Development
There are many more single indicators of economic development. These can be used
to compare the relative standing of countries at any point in time. They also serve to
provide targets for improving the lives of citizens.
Other Indicators of Development:
• The proportion of the male population engaged in agriculture
• Energy consumption per person
• The proportion of the population with access to clean water
• The proportion of the population with internet access
• Mobile phones per thousand people
• Number of girls completing primary education

Two other useful composite indicators include:

 The inequality adjusted HDI (IHDI)
Created in 2010 to deal with the lack of information that the HDI provides on
inequality
It adjusts HDI for inequality in the distribution of each dimension across the
population.
The difference between the HDI and IHDI can be expressed as a percentage and
represents the loss in potential human development due to inequality
It provides greater insight into the differences in human development that exist in a
country as opposed to the average human development
 The Multi-dimensional Poverty Index (MPI)
Launched in 2010 by the Oxford Poverty and Human Development Initiative at the
University of Oxford
A poverty measure that reflects the multiple deprivations that poor people face in
education, health and living standards
It tracks deprivation across three dimensions and 10 indicators: health (child
mortality, nutrition), education (years of schooling, enrolment), and living standards
(water, sanitation, electricity, cooking fuel, housing, assets)
It first identifies which of these 10 deprivations each household experiences
Then identifies households as poor if they suffer deprivations across 1/3 or more of
the weighted indicators
It can focus in on regions, ethnicities and also any of the three dimensions making it a
useful tool for policymakers and non-government organisation (NGOs) working to
reduce poverty
 Factors influencing Growth and Development
Data shows that economic growth has a very positive impact on economic
development.
In most cases growth precedes development, but his is not always true e.g.
Bangladesh used a range of strategies (including micro-finance) to transform the
quality of life for many households.
In some cases (usually in developing countries) economic growth is tied to one
industry and generates so many negative externalities of production that the
standard of living decreases for many even as growth increases.
Economic factors That Influence Growth and Development
1. Primary Product Dependency : Primary products include agriculture, mining
etc. A large amount of most developing country’s economic activity is based on
a primary product. These cause issues for a number of reasons. Natural
disasters can wipe out production of the primary product and so means that
farmers are left with no income. They are often ​non-renewable​, which means
the country will suffer when they run out of the product. In 2022 copper exports
from Zambia accounted for 70% of their total exports and primary products in
excess of 90%. They are suffering from over-specialisation. Primary products
tend to have a very low-income elasticity of demand (YED). As world income
rises, there is a less than proportional increase in demand. This means that there
is limited scope to continue increasing demand. Primary products have very
little added value. Exporting manufactured products raises the added value,
incomes and profits. Not all primary products have a low income elasticity of
demand, for example diamonds.
Increased savings → increased investment → higher capital stock
2. Volatility of Commodity Prices : Due to the inelastic nature of both the
→ higher
Based onand economic
this, growth → increased
any intervention orsavings
(foreignsmall governmental) to increase the can
demand supply of commodities, changes in demand or supply
capital
lead stock changes
to large in an economy
in price.will leadlarge
These to growth.
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There are many
producers’ income criticisms
and the of the model
​country’s including
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 It does
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ifficult for and
to plan many other
carry outfactors suchinvestment
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as well as
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meaning technological
that producers can seeinnovation
their income fall very rapidly, causing ​poverty.
 It was
When created
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of commodities risefrom
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the focused
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In 2020,investment
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Bolivia's GDPother
wastypes such as
generated by
investment
exports. in human
Commodities capital (labour)
accounted for 60% of its exports. When commodity
prices rise, GDP rises - and vice versa. A more diversified range of exports
prevents this.
3. The Savings gap ( Harrod-Domar model) - In the 1950's two economists
 Factors influencing Growth and Development
5. Capital flight : Occurs when money or assets rapidly leave a country. This may
happen due to political upheaval, economic sanctions, war, or changes to
government policy (e.g. interest rates). Sanctions applied to Russia in 2022
resulted in $75 billions of capital outflows. Capital flight reduces the money
available for investment, reducing growth and development. If money was
placed in banks within the country, then credit could be created by banks for
consumers and businesses to spend.
6. Demographic factors : Developing countries tend to have ​higher population
growth​, which limits development. If population grows by 5%, the economy
needs to grow by 5% to even maintain living standards. This means developing
countries need to have higher rates of growth to develop than more developed
countries would do. If the dependency ratio is high it means there is less money
available for savings and investment. Many developing countries have high
dependency ratios. It places strains on the ​education system and leads to ​youth
unemployment​. The ​population of Africa is expected to more than double by
2050, complicating efforts to reduce hunger.
7. Access to credit and banking : Financial institutions enable individuals and
firms to borrow money which can be used for investment or to generate growth.
A lack of financial institutions prevents this from happening. Developing
countries have ​limited access to credit and banking compared to developed
countries, who have complex systems. This means those in developing
countries cannot access ​funds for investment and they struggle to ​save for the
future​. Some families may use ​loan sharks​, who give high interest rates and
leave individuals permanently in debt.
8. Infrastructure : In a developed country, there is a complex network of
buildings, roads, ports, railways, airports, utilities and electricity cables. Good
infrastructure reduces business costs and attracts foreign direct investment.
Some developing countries have such poor infrastructure that it makes it
difficult to generate economic activity. This is one reason why China has
invested so heavily in infrastructure projects in Asia and Africa as it unlocks
economic potential. However, the development of infrastructure can be ​
expensive and tends to conflict with ​environmental goals. India is a good
example of country suffering from poor infrastructure. For example, they saw
power blackouts in 2012 and this damages their potential tourism industry.
About half their roads are not paved and they need to invest around $400bn in
the power sector.
 Strategies Influencing Growth and Development
Market-orientated strategies are strategies that create the conditions for private
individuals and firms to pursue economic activity with the aim of maximising
profit.
A market-orientated strategy involves the use of private sector organisations that
use market forces to supply goods and services.
Market Oriented Strategies :
- Trade Liberalisation : More trade increases output, employment and incomes.
If an economy becomes more open to trade then it is likely to see greater export
opportunities. This could be achieved through lowering tariffs and quotas. It might
also occur if government remove rules and regulations that act as a barrier to trade.
If foreign firms feel that it is easy to trade with that country e.g. removal of
bureaucracy economic growth is likely to occur. As these countries see increased
trade more investment will be undertaken, increasing the productive capacity of the
economy and leading to further growth.
- Foreign Direct Investment : More FDI increases output, employment and
income.
Promoting foreign direct investment will lead to an increase in productive capacity
as more firms look to locate in the developing country. This can be achieved
through relaxing the rules and regulations surrounding the movement of capital,
which can move either freely or at very low cost quickly across the globe. This has
led to an increase in foreign direct investment. The greater freedom of movement of
capital enables businesses to invest outside their country of origin. This may lower
their own costs of production and improve economic prospects and job
opportunities in the invested country
- Subsidy Removal : Subsidy removal can increase competition, efficiency,
employment, profits and income.
Removing government subsidies means that an industry will have to survive in the
free market without financial assistance. This means that it may be forced to
become more productively and allocatively efficient if it is to survive. This will
increase international competitiveness and those firms that survive will be able to
invest in productive capacity. Only those firms that have a market and can make a
profit will survive with profit maximisation becoming the main corporate objective.
This will free up government finances that can be used for elsewhere e.g.
infrastructure.
- Floating Exchange Rate Systems : Appreciation can generate higher incomes
as the cost of imported raw materials reduces possibly leading to higher income.
A floating exchange rate is one that is set purely by the forces of demand and
 Strategies Influencing Growth and Development
Interventionist strategies occurs when the government intervene in domestic
markets. They are put in place by governments to correct the failings of the free
market and promote the welfare/development of its citizens.
- Human Capital : Policies aimed at developing human capital raise the potential
output of the economy which leads to an increase in income
There is a close correlation between increased productive capacity and the
development of human capital as the workforce improves. Educational achievement
and the development of cognitive skills will allow individuals to operate the capital
goods within a country. A highly skilled labour force will lead to increased capacity
utilisation within the economy as the workforce are better able to use the current
capital equipment. It will also lead to physical capital development as human capital
utilise their skills to increase productive capacity
- Protectionism : This can intervene in natural market forces which lower wage
rates. Protecting employees can lead to higher levels of income
An inward looking strategy is one where there is significant government intervention
in the economy and protectionist policies are undertaken . Import substitution occurs
where government promotes domestic industries, helped by the imposition of tariffs
and quotas on imports. At the same time there is heavy subsidisation of industries,
particularly those where imports had been significant. This helps to protect infant
industries and creates employment in the economy. However, these strategies can lead
to retaliation and reduced market access in terms of exports.
- Managed Exchange Rates : In a floating exchange rate mechanism, rising
exports will lead to currency appreciation which, in time, will lead to a slowdown
or fall in exports. Managing currency prevents appreciation and a slowdown in
exports leading to long periods of growing income
A managed exchange rate aims to gain the advantages of both floating and fixed
systems, whilst minimising the disadvantages. The government might manage the
exchange rate in order to achieve international competitiveness e.g. a weaker currency
will make exports cheaper. The government and central bank will look to control the
exchange rate in order to make the currency more competitive e.g. by increasing
interest rates to attract hot money. By helping to maintain a low exchange rate exports
become more attractive, allowing the economy to grow through increased demand
- Infrastructure : Developing infrastructure reduces the cost of business and makes
economic activity easier. This increases FDI, output, employment and income
Developing countries might invest in infrastructure such as roads, railways and
 Strategies Influencing Growth and Development
Buffer Stocks : Price stability ensures income stability. It also results in excess
production which increases levels of employment. It was used extensively in Europe
post second world war (Common Agricultural Policy) and is still used extensively in
different markets in India, Thailand (rice), Vietnam, Indonesia (rice and coal)
Buffer stocks are created when the government buys up supplies of agricultural
products when harvests are plentiful, stores them - and then sells them when supplies
are low.
It aims to support agricultural producers, consumers and stabilise the market price of
agricultural products.
While doing good, they create several problems, including
• Storage is expensive
• Transport to and from storage is expensive
• It is difficult to analyse and control market forces
• It requires all producers to participate honestly in the scheme e.g. producers in
Vietnam have been caught importing cheap rice from Thailand and then selling i to
the government at a profit in the buffer stock scheme
The Vietnamese government has set a price ceiling (maximum price) and
price floor (minimum price) in the market for rice.
The equilibrium is initially at P1Q1.
If the price of rice drops below P2, the government will purchase large quantities
and store it (FG).
A buffer stock scheme for rice in Vietnam
This will reduce market supply, preventing the price fromwith falling below
P2 as the floor and P3 the
as the minimum
ceiling
price (P2).
If the price of rice rises above P3, the government releases it from storage (AB)
and sells the rice.
This increases market supply and ensures that the price does not rise above the ceiling
price.
The World Bank, International Monetary Fund (IMF) and many non
governmental organisations (NGOs) play an active role in economic development.
World bank
Founded in 1944 as the International Bank for Reconstruction and Development to fund
postwar redevelopment. They provide reconstruction loans to countries devastated by war.
They provide loans to developing countries to aid in their development. They provide loans
to countries to assist with the development of infrastructure. They work with governments
and institutions so as to encourage economic reform and trade liberalization.
International Monetary Fund (IMF)
 Strategies Influencing Growth and Development
Other Strategies :
Industrialisation: the Lewis model
Developed in 1955, the Lewis Model described economies as having two sectors - the
rural agricultural sector and the urban industrial sector. Productivity and incomes are
higher in the industrial sector so Lewis argued countries should transform their
structure. Critics argue that many developing countries have high unemployment in
urban areas; the theory also assumes that manufacturing will be a labour intensive
task when in reality it is often capital intensive.
Development of Tourism
For many developing countries this is an excellent source of employment, revenue
and income. Rising global incomes have increased demand for tourism. Ecotourism is
developing as a response to negative externalities of consumption that tourism creates.
e.g. increased waste, noise, use of scarce resources (drinking water)
Development of Primary Industries
Some countries have successfully developed as a result of GDP growth that has been
driven by relatively few primary industries e.g Zambia has benefitted from the copper
industry; most Middle East countries developed entirely due to oil; Ethiopia depends
on coffee and cut flowers. Developing these primary product industries is lucrative
due to their comparative advantage
Fairtrade Schemes
Many developed countries use protectionism to shift profits from developing nations
to developed nations
E.g. the USA has no tariff on cocoa beans imported into the USA from Ghana, but
does place a tariff of 12% on cocoa powder. It want manufacturers in the USA to
benefit from processing cocoa beans
The price of many commodities is set far away from where the farmers are - the
Chicago Board of Exchange. Here, prices are set months in advance and determine
the price buyers will pay sellers on a particular day in the future. Fair trade schemes
aim to bypass these restrictions by connecting ethical buyers directly with the farmers
in developing countries. They pay them higher prices. They often help them to
develop and market value added products.
Aid
Three of the most common forms are humanitarian aid, grants and soft loans. Aid has
proven beneficial in times of distress
Critics argue that aid breeds dependency, corruption and disincentivises individual
 Role of Financial Markets
Financial markets are any place or system that provides buyers and sellers the
means to exchange goods/services and trade financial instruments
These include bonds, equities, international currencies, and derivatives.
1. They facilitate saving: storing money for future use is essential for households
and firms. It also provides a pool of money that financial institutions can lend
i.e. one person's savings is another person's borrowing
2. They lend to businesses and individuals: access to credit is a key requirement
for economic growth and development. Being able to borrow money speeds up
consumption by households and investment by firms. It also allows households
or firms to purchase assets and pay them off over an extended period of time
e.g. mortgages on home purchases
3. They facilitate the exchange of goods and services: each purchase of
goods/services requires the movement of money between at least two parties.
Financial markets provide multiple ways for this exchange to happen including
phone apps (Google Pay), debit cards, credit cards and bank transfers
4. They provide forward markets in currencies and commodities: forward
markets are also called futures markets. They provide some price stability in
commodity markets and enable investors to make a profit by speculating on
future prices
5. They provide a market for equities: equities are shares in public companies
that are listed on stock exchanges around the world. Financial markets facilitate
both long term investment and speculation by providing platforms which
connect buyers and sellers e.g. E-Trade
 Market Failure in the Financial Sector
Market failure in financial markets has far reaching consequences. The Global
Financial Crisis of 2008 highlighted the interdependence and fragility of the global
financial system.
Types of market Failure in Financial Markets:
1. Asymmetric Information : Many financial products are complex and difficult
for consumers to understand. The sellers often have a significant information
advantage over the buyers. E.g. During the financial crisis, financial institutions
bundled thousands of mortgages together and sold them on to investors. The
sellers had more information on the risk profile of each bundle than the buyers.
E.g. Mortgage sellers often understand the implications of interest rate changes
to repayments much better than the average consumer. The Global Financial
Crisis demonstrated that asymmetric information even exists between financial
markets and the regulators set up to monitor them
2. Externalities : Negative externalities of production and consumption exist in
financial market. When investors speculate on property prices, a negative
consumption externality occurs as young buyers end up paying more (or being
forced out of the market) due to the higher prices caused by speculation
(AirBnB effect). E.g. When banks in many developed nations relaxed mortgage
lending requirements this helped cause the Global Financial Crisis. The impact
of the crash reverberated around the world causing a global depression which
reduced or eliminated imports from many developing countries (third parties to
the global mortgage market)
3. Moral Hazards : Moral Hazard has increased in the financial sector since 2008
as Governments have stepped in to save individual banks from failure (e.g.
RBS). Banks seem to be considered 'too big to fail' and governments bear the
consequences of their risky behaviour. The financial sector returned to
questionable practices within two years: The China Hustle documents how
investment funds and stockbrokers played up obscure Chinese companies who
presented fake financial data. This stimulated investor demand, temporarily
pushing up prices. Many investors lost a lot of money
4. Speculation and market bubbles : The higher the money supply in an
economy, the greater the speculation and potential for market bubbles.
Significant amounts of quantitative easing since 2008 have increased the money
supply and created potential bubbles in different markets (e.g. property,
cryptocurrency, shares)
 Role of Central Banks
The central bank ​controls monetary policy through interest rates and controlling
money supply in order to keep inflation low and stable.
Central Banks play a vital role in maintaining stability in the financial system.
Additionally, the policy tools at their disposal help to meet Government economic
objectives and create economic growth.
Roles of Central Banks :
1. Lender of last resort : Commercial banks are able to borrow from the Central
Bank if they run into short-term liquidity issues. Without this help, they might
go bankrupt leading to instability in the financial system - and a potential loss
of savings for many households
2. The Government’s bank : the Government sets the annual budget but it is the
Central Bank that manages the tax receipts and payments. In 2022 there were
5.7 million public sector workers in the UK who had to be paid each month
3. Regulate the banking industry : the high level of asymmetric information in
financial markets requires that commercial banks are regulated in order to
protect consumers. One of the key regulatory actions to manage the money
supply and promote stability in the financial system is the implementation of
required reserve ratios. Raising the ratio decreases the money supply in the
economy - and vice versa
4. Monetary Policy : Monetary policy involves adjusting interest rates and the
money supply (quantitative easing) so as to influence AD

Financial Regulation : Regulation can include banning market rigging; preventing

the sale of unsuitable products; maximum interest rates to prevent consumer
exploitation and prevent excessively risky lending; deposit insurance to protect
consumer deposits and increase stability; and liquidity ratios, when banks are
forced to hold a certain percentage of liquid assets.
There are three key bodies for financial regulation:
5. The FPC identifies and reduces system risk and supports government economic
policy (macroprudential)
6. The PRA ensures competition, ensures consumers have access to services,
minimises risk should a bank fail and ensures banks take responsible action.
(microprudential)
7. The FCA protects consumers, promotes competition and enhances the integrity
of the system by preventing market rigging.
 Public Expenditure
Public expenditure entails government spending to pay for the needs of society such
as health, education and infrastructure.
Public expenditure (government spending) represents a significant portion of the
aggregate demand (AD) in many economies. The expenditure can be broken down
into three categories :
1. Current expenditure – short-term spending on day to day running of the country.
These include the daily payments required to run the government and public
sector. E.g. The wages and salaries of public employees such as teachers, police,
members of parliament, military personnel, judges, dentists etc. It also includes
payments for goods/services such as medicines for the NHS.
2. Capital expenditure – long-term spending on assets e.g. hospitals, schools, and
infrastructure. These are investments in infrastructure and capital equipment.
3. Transfer payments – Payments made by the government for which no
goods/services are exchanged. E.g. Unemployment benefits, disability payments,
subsidies to producers and consumers etc. This type of government spending does
not contribute to GDP as income is only transferred from one group of people to
another.
Reasons for public expenditure:
- To tackle market failure : Governments will spend money to encourage the
consumption of merit goods or discourage goods and services that create negative
externalities in either production or consumption
- To redistribute income : Governments can redistribute income via public
expenditure to achieve more equality
- To supply public and merit goods : The government has a vital role in the
provision of schools, healthcare and support infrastructure projects that would be
underprovided if left to the free market
- To support UK industry : The government can support UK exporters via
subsidies, or help to assist new business start-ups with various financial incentives
Factors Affecting The Size and Composition of Public Expenditure :
- Changing incomes
Countries with low incomes have low tax revenue leading to low government
expenditure. As incomes in an economy increase, government tax revenues increase
which allows them to increase their expenditure
As incomes increase, citizens demand a higher quantity and quality of government
services (which are very income elastic) - e.g. library services, cleaner coastal waters,
better recycling facilities
 Public Expenditure
Changes in the size of public expenditure
- Productivity and Growth
Public expenditure injects money into the circular flow of income. The government
will spend money to stimulate aggregate demand and help economic activity to ensure
economic growth is sustained. Government spending also boosts the supply side of
the economy.
Public expenditure on capital projects and infrastructure makes firms more efficient
e.g. easier to distribute goods or faster and better communications through improved
broadband. Improving labour market flexibility via education spending will enhance
long run productive potential and improve UK competitiveness. These will lead to
improved productivity for all firms in the economy.
- Living Standards
Increased public expenditure can be targeted at improving the living standards of all
in society. Increases in productivity and growth are indicators of improved living
standards. Through increased spending on public and merit goods the government
plays a vital role in the provision of schools, healthcare and support infrastructure
projects that would be underprovided if left to the free market. Investment in
education and training leads to improvements in human capital. Over time, these
benefit both the individual and the economy, leading to improvements in living
standards.
- Crowding Out
If the UK government increase public expenditure through increased demand for
borrowed funds, then this may bid-up the rate of interest.
This makes borrowing by firms for investment projects more costly and therefore less
attractive. As a consequence, increased public expenditure due to higher levels of
borrowing causes financial crowding out, reducing supply from the private sector. If it
increases spending through increased taxation then people have less disposable
income to spend on goods and services with consumption falling. Once again, the
private sector will suffer as demand for goods and services will fall. The impact of
public expenditure will differ dependent on where the economy is on the economic
cycle. In a recession, private sector investment is less likely to be crowded out and
increased public expenditure through borrowing can kick-start the economy, attracting
the private sector as economic growth starts to pick up
- Level of Taxation
Public expenditure has to be financed from a variety of sources.. This could be from
the selling off of state assets or by raising revenue from state owned organisations e.g.
the NHS charge for prescriptions.. However, most increases in public expenditure are
 Taxation
Tax systems can be classified as progressive, proportional or regressive
Most countries have a mix of progressive (direct taxation) and regressive (indirect
taxation) taxes in place.
A proportional tax is also known as a flat tax. The percentage of income paid in
tax is constant, no matter what the level of income e.g 10% tax is paid irrespective
of whether income is £10,000 or £100,000. Bolivia uses this system and the tax rate
is 13%
Advantages
Disadvantages
- simple to understand -
burden falls on poorer members of society
- easy to calculate -
therefore, creates greater inequality
- greater transparency so might lead to less tax evasion
A progressive tax means that a higher rate of tax is paid as incomes increase. This
can be seen with our current income tax system. As income rises, a larger.
percentage of income is paid in tax (e.g. UK Income Tax; UK Corporation Tax).
This system is built around the idea of marginal tax rates
Advantages
- Reduces tax burden on low-income earners
- Fairly distribute tax amounts to individuals depending on their wealth
- Can help the government earn more taxes
Disadvantages
- Discriminates against people making more money,
- Can lead to class warfare
- Penalizes those that work harder
- Can lead to individuals hiding income or assets
A regressive tax is one where a lower rate of tax is paid as incomes increase. As
income rises, a smaller
More percentage
equal of income is paidLess
in taxequal
(e.g. excise duties on
alcohol and petrol in the UK; VAT; Air passenger duty). Regressive taxes can have
• on
a big impact Progressive
low-income households. In•2020
taxes Regressive taxes 30% of income
they represented
• Increasing inheritance tax • Reducing inheritance tax
for the poorest 20% of households - but only 10% of income for the top 20% of
• Extending universal • Restricting universal
households benefits benefits
Advantages • Increasing the National • Reducing or maintaining
Disadvantages Minimum Wage National Minimum Wage
- It encourages people tospending
• Increased earn more
on • Reduced spending on -
 Taxation
The Economic Effects of Changes in Tax Rates
Incentive to Work
The higher the tax rate, the lower the incentive for the unemployed to seek work - or
for existing workers to work overtime
In 2022, the Adam Smith Institute calculated that average earners in the UK work
from the 1st January to the 8th June (Freedom Day) to pay their taxes - all income
after that point belongs to them.
Tax Revenues
The Laffer curve illustrates the relationship between increasing tax rates and the
level of government revenues received
The broad idea is that as tax rates increase, a point will be reached where
disincentivized workers work less resulting in less income and less government
tax revenue. More people will actively seek to avoid paying tax (tax avoidance)
or try to move their income elsewhere
Tax rate increases up to point A, will result in an increase of tax revenue.
Further tax rate increases from A to B result in a loss of tax revenue from C to D
Income Distributions
A progressive tax system redistributes from those with higher income to those with
lower income and reduces income inequality.
Sometimes the benefits of a good progressive tax system are eradicated by the
penalties imposed through multiple regressive (indirect) taxes.
Real Output and Employment
If the tax rate increases, more money is withdrawn from the circular flow of income
(leakage)
This will likely cause a reduction of aggregate demand (AD) as firms and households
have less disposable income
As AD slows down, fewer workers may be required for production a d unemployment
may increase
Average price Level
An increase in indirect taxes reduces disposable income and so workers may petition
their employer for a salary increase
If they receive the increase the economy may face a wage-price spiral
Indirect taxes also increase costs of production for firms possibly leading to cost-push
inflation
The Trade Balance
An increase in taxes can reduce disposable income which is likely to reduce the level
 Public Sector Finances
Automatic stabilisers are automatic fiscal changes as the economy moves through
stages of the business/trade cycle.
They do not require active intervention from the government but happen
automatically in the background.
Discretionary fiscal policy is a demand-side policy that uses government spending
and taxation policy to influence aggregate demand (AD)
This will include the use of interest rates, government expenditure and taxation.
Can be used to expand or contract the economy.
A fiscal deficit occurs when the level of government spending is greater than the
government tax revenue in any given year. This will lead to increased government
debt that will have to be paid off in future years.
A fiscal surplus occurs when a government receives more income through tax
receipts and other government revenues than it has to pay out in its spending plans.
This will allow the government to reduce its debt burden and therefore reduce
interest payments.
The national debt is the accumulation of all previous deficits/government debt.
The deficit in one year adds to the national debt from previous years.
Cyclical deficits occur due to downturns in the business/trade cycle, usually as a
result of a recession.
 When aggregate demand falls during a recessionary period, government
spending will rise i.e. welfare benefits, and tax revenue will fall i.e. lower levels
of government income e.g. income tax receipts.
 Governments receive less tax revenue as profits and income fall - and
government spending increases.
 These deficits tend to self-correct as the economy starts to grow again, as tax
revenues recover and outgoings on welfare are reduced.
 Given the nature of economic cycles, it is generally accepted that the cyclical
deficit is a less serious economic issue.
Structural deficits are present even when an economy may be operating at the full
employment level of output.
 Therefore is regarded as a more serious issue. These deficits are difficult to
correct.
 Even if the economy is operating at full employment, the structural deficit
remains
 The size of the structural deficit is a key indicator of the governments overall
financial management
 Public Sector Finances
Factors Influencing the Size of National Debts
- Size of fiscal deficits : As national debt is the accumulation of annual fiscal
deficits, the size of the fiscal deficit each year will grow by the size of the
deficit. If the UK were to run a budget surplus in any year, this additional
revenue could be used to pay back some of the debt - or it may be used to fund
government spending or investment in the following year.
- Government Policies : These directly impact tax revenue and government
spending which can change the level of the fiscal deficit leading to a change in
the national debt level. E.g. Reducing corporation tax during a boom in the
economy will reduce government revenue and possibly increase the deficit and
national debt at a time when the deficit would naturally be decreasing due to the
automatic stabilisers

The Significance of the Size of Deficits and National Debts

1. Interest rates: The higher the level of UK Government debt as a proportion of
GDP, the more concerned global lenders will be to continue lending to fund
future deficits. This may require the UK to raise interest rates to entice lenders
to make their money available to the UK government
2. Debt servicing: there is an opportunity cost to paying back debt and debt
interest. The higher the debt, the greater the opportunity cost e.g. every £ spent
on paying back interest could have been spent on education improvements
instead
3. Inter-generational equity: today's borrowing has to be paid back from tax
revenue received from future generations. The greater the debt, the greater the
burden on the next generation of tax payers
4. Rate of inflation: Inflation reduces purchasing power (which is bad) but at the
same time it allows the UK Government to pay back lenders with money worth
less than when it was originally borrowed
5. Nation's credit rating: Standard and Poor's is a credit rating agency based in
the USA who provides credit ratings for different Nations. Investors use this to
guide their lending. Countries with a good credit rating will be able to borrow
funds at a lower interest rate
6. Foreign direct investment (FDI): the higher the level of external debt, the
more foreign currency is required by the Government to pay it (e.g. UK
borrowing from the USA in US$ needs to be repaid in US$). Countries may run
short of foreign currency and one way to obtain more is to make foreign direct
 Macroeconomic Policies in a Global Context
Due to globalisation, economies do not operate in isolation but are highly
interdependent.
This means that the effectiveness of any of the macroeconomic policies and direct
controls used by a government is dependent on the global environment
The extent to which it is dependent is influenced by the size and development of
the economy
Different approaches are used by different governments to attempt to solve the
same problem
E.g. After the Global Financial Crisis of 2008, the UK Conservative led
government initially used a Keynesian approach to bailing out the banks and then
quickly followed this with a contractionary demand-side policy of austerity. The
Democratic led USA Government also used a Keynesian approach to rescuing
financial institutions and then followed it up with further expansionary fiscal and
monetary policy.

The use of Policy measures to Reduce Fiscal Deficits and National Debts
Debt is not necessarily bad as it can be used to leverage growth - but unsustainable
debt is bad
One study found that once debt exceeds 90% of the annual GDP, it becomes
unsustainable very quickly
With the recent willingness of Central Banks to print new money to facilitate
quantitative easing, questions have been raised about the need to borrow to finance
capital expenditure - why not print it?
The use of austerity to reduce deficits and debts has long term effects and creates
hardship for many households. It also increases inequality as many government
services are cut e.g. 800 libraries have closed in the UK since austerity was
implemented in 2010.

The use of Policy measures to Reduce Poverty and Inequality

Countries have different approaches. Some have a progressive tax system which
helps to redistribute income based on financial need (means tested)
Others have a progressive tax system plus free education and healthcare for all
The measures taken to reduce poverty and inequality are very much influenced by
political ideology and normative economics e.g. there is a strong bias against free
healthcare in the USA as many people believe that equates to socialism
Meanwhile data shows that the healthcare system in the USA is one of the most
inefficient in the top 50 wealthiest countries in the world
 Macroeconomic Policies in a Global Context
The use of Policy measures to increase international competition
These typically include protectionism, currency depreciation and the use of supply
side policies
The effectiveness of these policies depends on the response of trading partners
Policies to improve international competitiveness can result in creating internal
domestic conflicts which are difficult to resolve e.g. by protecting the steel
manufacturing industry in the UK, the cost of steel as an input for broader industry
increases
Employment gained in steel manufacturing is very likely surpassed by employment
lost in steel related industries as a result of the increased costs of production
The following recent external shocks to the global economy have forced
governments to respond with a range of policies in order to steer their economies
through the crisis
1. The Global Financial Crisis of 2008
2. The Arab Spring which started in 2011: This was a further development of the Iraq
War and the long running war on terror. It continued to develop into a major
conflict centered in Syria, raising geopolitical tensions. Many Western economies
benefitted through an increase in gross domestic product as governments
increased spending on military hardware
3. The Asian Tsunami of 2011 had major impacts on the supply chains of many
automotive and electronic industries
4. The Global Trade War that developed under President Trump and continued from
2016 to 2020
5. The Global Pandemic, Covid19, which started in January of 2020
6. The Russian War on the Ukraine which started in February 2022. The Ukraine is
one of the world's largest producers of grain and Russia is one of the world's
largest exporters of natural gas
The ability of governments to control global companies is dependent on a range
of factors including
 The power of the government in relation to the power of Transnational
Corporations
 The absence of corruption e.g. Singapore is ruthless in stamping out corruption but
Romania and Democratic Republic of Congo are well known for their high levels
of corruption. The latter allow Transnational Corporations to influence legislation
and to decide how the factors of productions are used/exploited
 The state of development of the legal, financial, media and political institutions
e.g. many of these institutions remain undeveloped in Cambodia and Transnational
 Macroeconomic Policies in a Global Context
Other Measures to Reduce Transnational Abuse of Power
Setting more rigorous labour protection laws as well as ensuring that transnationals
are using local labour and not labour from their own country
Establishing more rigorous laws around technology transfer between local and
transnational firms
Establishing limitations or targets on the level of exports by the transnational firms

Problems Facing Policymakers When Applying Policies :

 Inaccurate Information
Data often lags reality as underlying economic conditions can change quickly.
Data on unemployment, inflation, GDP growth etc. is useful for identifying trends, but
the reason for the trend may not always be clear and policy decisions may be based on
incorrect assumptions.
 Risks and Uncertainties
Identifying risks and establishing the uncertainties contained within any policy
decision can be a very difficult task indeed
The risks may be greater than expected.
The uncertainties may not even be identifiable when the policy is instituted e.g. the
impact of the Brexit vote contained many foreseen outcomes (e.g. loss of free
movement), but there were also many uncertainties which were not recognised e.g.
the need for many small UK firms to relocate operations to Europe in order to avoid
excessive export costs
 Inability to control external shocks
As mentioned above, external shocks have a ripple effect on economies around the
world and globalisation makes it very difficult to protect against them.
Governments can respond to external shocks but are unlikely to have full control of
them
In a global economy the government can more fully control events in its own country
It has little legal jurisdiction in other countries
Therefore, it will undertake diplomacy and alliances in order to further its
macroeconomic objectives
As external shocks are unexpected the government will be reactive rather than
proactive in responding to them
a