Economics

Definitions: Section 1

Demand: Quantity purchased at a given price over a period of time

Supply: Quantity produced at a given price over a period of time

Z elasticity of Y: %change Z/%change Y

Part 1: Demand and Supply

Demand

Demand: Quantity purchased at a given price over a period of time Change in disposable income Taste Price of substitutes and complements Advertising

Supply

Supply: Quantity producers sell at a given price over a period of time Costs of factors of production Changes in technology Changes in taxes and subsidies

PED

Responsiveness of demand to a change in price

% change in demand / % change in price

Horizontal line = perfectly elastic. Gentle slope = elastic. Steep slope = inelastic. Vertical line = perfectly inelastic.

SPLAT: S: Substitutes P: Proportion of income L: Luxury or not A: Addictive or not T: Time to respond

PES

Responsiveness of supply to a change in price

% change in supply / % change in price

PES 1 = unitary. Change in price = change in supply

Affected by stock levels, production speed, spare capacity, ease of entry into the market

YED

Responsiveness of demand to changes in income

% change in income/ % change in price

Main factor: necessity or luxury

Normal goods: relationship between income and demand positive

Inferior goods: relationship between income and demand negative

Elasticity and Firms

PED and firms PED inelastic = price and revenue relationship

positive Always try to make products inelastic

YED and firms Long run benefits for firms, income increases =

demand increases Product switching: Firms switch to YED elastic

products Product planning: planning ahead in order to

change your product to take advantage of elasticity

The Market System

Resolving scarcity

Economic problem: there are infinite wants but finite resources What to produce? How to produce? For whom to

produce?

Opportunity cost: the cost of the next best alternative foregone

Choice: solution to the economic problem

Resolving scarcity cont.

Production Possibility Curves: Show the maximum combinations of goods and services that can be produced by an economy in a given time period.

PPC shift to the right = economic growth

An economy can produce consumer goods (goods purchased by households) or capital goods (goods used to produce other goods)

Mixed Economy

Efficiency Measure of output per unit of input Efficiency conserves scarce resources

Market Failure When producers operate inefficiently Can be caused by

Lack of competition Missing market: some goods not provided by private

sector (public/merit) Lack of information Factor immobility (factors move from one use to another)

Part 2: Labor Market

Division of Labor

When production process is broken down into a number of components

Worker Firm

Advantages Become highly skilled. Can demand higher pay.

Much more efficient.

Disadvantages

Become unmotivated and bored. If unemployed will take time to learn new trade

Quality and productivity go down as a result of demotivation

Demand for Labor

Derived demand

Cost and availability of machinery/cheaper labor (substitutes)

Productivity

Costs other than wage rate (housing, insurance, uniform)

Supply for Labor

Working age

Participation of women

Age distribution

Net migration

Quality of labor Education and training

Wage differences between occupations

Training/qualifications required

Physical risk/hours (terms and conditions)

Expanding industries

Public v private sector

Interference in the Labor Market

Minimum Wage

Minimum Wage – the least amount of money that can be legally paid Benefits disadvantaged workers Reduces poverty May cause unemployment

Trade Unions

Negotiate for better pay and conditions

Provide legal protection

Pass laws benefiting workers

Restricting of trade unions Secret ballots Closed shops banned Businesses seek compensation

Strong trade unions force up wages in some markets

Production

Factors of Production

Factors of Production: The resources used to create goods and services

Production: Total output.

Land

Labor

Capital: Fixed Working

Enterprise: Risk takers

Productivity: output per unit input (e.g. per worker, per worker per hour, per machine, etc)

Sectors of the Economy

Primary Sector – Extraction of raw materials

Secondary Sector – Manufacturing

Tertiary Sector – Services and retail

Deindustrialization

Developed economies shift from primary to tertiary production

Demand changes from goods to services

Competition from LEDCs forces MEDCs to shift to services

Machines reduce employment in manufacturing

Production Costs and Revenue

Production Costs and Revenue

Fixed costs – do not change as output increases

Variable costs – vary as output increases

TC = FC + VC

AC = TC/Q produced

Revenue = PQ

Economies of Scale

Technical: Large firms can afford and use technology and machinery efficiently

Purchasing: bulk = cheaper rates

Marketing: in house delivery is cheaper than hiring

Financial: Larger loans = cheaper interest

Managerial: Specialist managers

Risk – bearing: Wider range of products, less risk

External and Diseconomies of Scale

External Economies – benefits from growth of industry Skilled labor pool, infrastructure, ancillary services

Diseconomies of Scale Bureaucracy – too many resources used in

administration Labor relations Co – ordination and control

Productivity

Increases in productivity = PPC shift outward

Land: Fertilizer, GM crops, drainage, irrigation, infrastructure

Labor: Quantity: Immigrant workers, increased birth rate Quality: Education, motivation, improved working

practices (job rotation)

Capital: Technology and machinery

Externalities

An impact on a 3rd party

Social cost = private cost + negative externalities

Social Optimum: Social Cost = Social Benefit

Dealing with externalities Taxation Legislation and regulation Education and advertising on dangers of externalities Subsidies encouraging positive externalities (job

creation, training and education)

Competition

Competitive Markets

Rivalry for sales

Usually occurs when products are homogenous

Competition varies between industry

Perfect competition Many buyers and sellers Firms have little to no control over price Many close substitutes High levels of information Low barriers to entry

Competition

Firms Customer Economy

Advantages • Produce efficiently. • Innovation. • Product

differentiation

• Low prices• High quality• Variety and

choice

• Efficient resource allocation

• More innovation

• Products internationally attractive

Disadvantages • Limited profit due to low prices.

• Little control over market

• Market uncertainty

• Some wasted resources – immobile factors of production

Small vs. Big Firms

Small Firms Big Firms

Advantages • Flexibility – can adapt quickly

• Personal service – customer relationships

• Innovation to face competition

• Economies of scale

• Access to finance• Market

domination and brand loyalty

Disadvantages

• High costs – no economies of scale

• Vulnerable to changes in the economy

• Difficulty in hiring • Lack of finance

• Bureaucracy• Poor motivation

Growth of Firms

Organic Growth – increasing market share and output

Mergers and Acquisitions Horizontal – Same industry and stage of production Vertical – Same industry, different stage of

production Lateral – Same products/services, do not compete Conglomerate – Different industries

Motives and Limitations to Growth

Motives Economies of scale Increased market share Diversifying

Limitations Limited market Lack of finance Aims of entrepreneur Diseconomies of scale

Monopoly

When the market is supplied by 1 firm

Monopolies set price or determine quantity

Demand is highly inelastic

Natural Monopoly – Market is more efficiently served by one supplier High sunk costs – high initial investment. Usually caused by

high infrastructure costs e.g. water and railways

Features High barriers to entry One dominant supplier Unique products – no close substitutes

Consumer Firm Economy

Advantages • Natural monopoly – more efficient if 1 firm supplies all

• Economies of scale may be passed on

• Research and development

• Can charge high prices due to little competition

• Reduced costs due to economies of scale

• International competitiveness and increase in national employment

Disadvantages • High prices• Lack of

innovation• Low choice• Low quality• Inefficiency

• Potential diseconomies

• Poor motivation• Low efficiency

• Inefficient allocation of resources

Oligopoly

A market dominated by a few large producers

Firms are interdependent

Price rigidity

Non – price competition

Consumer Firm

Advantages • Lower prices if they compete

• Benefits (promotions)• Choice and variety• Economies of scale

passed on

• Can charge relatively high

• Economies of scale

Disadvantages • Collusion (cartels) leads to high prices, low choice, low efficiency, etc.

• Too much moneys spend on advertising

• Must spend on non price competition

• Price wars• Interdependence

Public and private sectors

Public and Private Sector

Public sector – ministries, local services and government business organizations

Private sector – sole traders (single person), partnerships and companies (shareholders elect a board of directors)

Aims

Public sector Community welfare Provide services not provided by the private sector Minimizing costs Allowing for social costs and benefits

Private sector Profit maximizing/satisficing Survival Growth

Government Regulation

Regulation is needed to restrict excessive market power

Regional Policy Designed to solve regional problems.

Setup incentive (take jobs to workers) Reduce income inequity Reduce congestion

Competition Policy - UK

Methods of promoting competition Encouraging the growth of small firms (free business advice, loan guarantees,

profit tax breaks etc.) Legislation – passing laws Removing legal barriers to entry Introducing anti-competitive legislation (UK Fair Trading act, Competition Act)

Organizations OFT – determines competition policy, enforces consumer protection

legislation, investigates suspected unfair trading Competition Commission – investigates mergers/markets where

consumers may be exploited, enforces policy and prosecutes

Example of enforcing legislation UK government forced the corporation to sell 2/3 airports in London,

had ruled they had been operating as a monopoly

Privatization

Transfer of assets from public to private

Methods Issuing shares Contracting out Sale of land and property

Reasons Create efficiency Create income Reduce political interference

Effect on Stakeholders

Consumers: Lower prices, better choice and quality. Loss in services

Workers: Extreme unemployment in the short run

Firms: Objectives shift from welfare to profit

Government: Loses control, gains income

Economy: Improved resource allocation due to efficiency

Macroeconomic Objectives

Macroeconomic Objectives

Economic Growth – GDP. Limitations include inflation, population and standard of living. Progresses as a cycle

Control of Inflation – Measured in RPI or CPI. Demand pull, cost push, or money supply.

Unemployment – cyclical, frictional, seasonal, voluntary

Balance of payments on the current account – trade of goods and services, deficit and surplus

Protection of the environment – regulation and taxation

Economic Growth

Economic Growth

The increase in the productive capacity of an economy (shift in PPC curve National income measured by real GDP Economic growth measured in changes in real GDP GDP: value of total output produced in a country over a period of

time

Limitations of GDP as a measure of growth Population changes Statistical errors Hidden economies

Economic Cycle Boom – high employment, rising inflation, strong economic growth,

high interest rates Recession – initially slow growth, rising unemployment, slowing

inflation Recovery – rising employment and inflation, economic growth

returns

Economic Cycle

Benefits of growth

Advantages Better living standards (higher income, more leisure

time) Greater life expectancy Better public services

Disadvantages Exhausting of finite resources (unsustainable

growth) Environmental damage (negative externalities) Inequitable distribution of income Regional differences

Inflation

Inflation

Persistent and general rise in average prices over time

Deflation: prices falling

Decreasing inflation: rising prices at a slower rate

Measured using RPI or CPI Consumer Price Index: based on a select amount of

goods purchased by consumers (weighted)

Causes of Inflation

Demand Pull Caused by shift in AD AD = C + I + G + (X-M)

Cost Push Caused by changes in cost of production to firms Cost of Factors of Production + Government Tax + Imported

Inflation (oil)

Money Supply Caused when households, firms and the government borrow

more money from the banks Increases circulation of money, creating more demand and

causing prices to rise

Consequences of Inflation

Savers lose out (value of savings goes down), borrowers gain (value of debt goes down), people on fixed incomes miss out

International trade effect – If a country’s inflation rate is higher than others, exports become less competitive

Reduces purchasing power – Same amount of money buys less

Increased business costs – More expensive factors of production and higher wages are demanded

Balance of payment deficit – exports become relatively more expensive, imports become relatively cheaper. (comparative inflation rate)

Increases government costs – Some government expenditure is index linked

Functions of money become warped

Unemployment

Unemployment

ILO measurement of unemployment: the proportion of the labor force without a job, of working age, willing, able and actively seeking a job.

Unemployment (Cont.)Type of Unemployment

Description Causes Possible Solution

Cyclical / Demand Deficient

Peaks during recession, low during booms.

Fall in demand for goods/services, decreases in C, I or (X-M) or falling national output

Implementation of fiscal/monetary policy aimed at increasing AD and raising national output

Structural Those who re unable to find work because their skills are not demanded

Permanent decline in demand in a particular industry/sector, new technology, outsourcing/globalization

Improve training, education and mobility of labor to encourage relocation.

Voluntary Those not prepared to work at that wage rate / do not like the idea of work

None None

Frictional Time spent in-between jobs

New workers entering the labor force / those who quit to seek better jobs

Improved information symmetry between employers and job seekers

Seasonal Varies according to the season

Workers who work in hospitality industry (resorts, hotels, etc)

See above

Effects of Unemployment

Individual Business Economy Local community

Decreased income

Redundancy / severance pay.

Less tax income + increased claims for welfare payment

Downward pressure on wages for those employed (supply of labor increase)

Loss of skill to be employed (fixed by supply side policies)

Loss in aggregate demand (less spending)

Lost output (opportunity cost) and wasted resource

Lower morale

Unused spare capacity

Social costs (petty crime)

Petty crime

Balance of Payments on the Current Account

Balance of Payments on the Current Account

Balance of (visible) trade = visible exports – visible imports Physical merchandise Visible exports/imports: sale/purchase - deficit + surplus

Balance of invisible trade = invisible exports – invisible imports Sale and purchase of services Most services provided domestically

Balance of payments – a record of all transactions relating to international trade (current and capital account)

Current account – part of the BoP where exports and imports are recorded Balance of visible trade + balance of invisible trade

Effect of Persistent Current Account Deficit and Surplus

Deficit Surplus

Increase in external debt More credit, less debt

Supply of currency increases. Currency depreciates

Currency appreciates

Economy becomes uncompetitive, causing unemployment

Employment in export industry. Higher national income, (possibly higher inflation)

May reflect structural weakness

May lead to domestic shortage.

International tension

Environmental Protection

Protection of the Environment

Regulation – legislation, guidelines

Environmental agencies – take action against polluters.

Taxation – discourages things that cause pollution

Subsidies – incentive to reduce pollution

Road charges (London Congestion Charge)

Compensation – making those that cause damage to pay compensation

Recycling

International targets – Kyoto protocol

Pollution permits

Economic Policies and Policy Instruments

Fiscal Policy

Demand side policy

Decides amount of government spending, taxation and borrowing

Budget – a plan of expenditure

Reasons for taxation Government revenue Discourage certain activities Control AD Fairer distribution of wealth

Fiscal Policy cont.

Budget deficit – govt. spending > govt. income. Increased AD and economic activity, more govt. debt

Budget surplus – govt. income > govt. spending Decreased AD, increased savings

Contractionary Fiscal Policy (less govt. spending, more taxation) Decreased inflation – AD falls, less disposable income Evens out current account deficit – preference switches to domestic

goods, which are cheaper

Expansionary Fiscal Policy Increases economic growth – More jobs, higher demand, more

investment. Decreases unemployment – stimulating demand Increased government spending is more direct: taxation may not

affect the behavior of the public as much as the government wants

Taxation

Direct tax – taxes on income or wealth Profit, income, inheritance and capital gains tax

Indirect tax – taxes on expenditure VAT (HK has very few) ‘Sin’ taxes: tobacco, alcohol, fuel.

Progressive tax – one where proportion taken in tax will rise as income rises Income tax – different rates for different income brackets

Proportional tax – one where the same proportion is applied to all levels of income Profit tax

Regressive tax – proportion taken decreases as income increases Flat rates of tax (e.g. tax on tobacco) Mostly expenditure tax Burden is greater on low income earners.

Monetary Policy

Demand side policy dealing with interest rates and supply of money Interest rates – cost of borrowing, reward for saving Money supply – total amount of money circulating in

an economy

Increased interest rates (very reactive) causes Decreased consumption Less investment Fall in demand for labor Decreased inflation Reduced demand for imports Reduced economic growth

Monetary Policy (cont.)

Decreased interest rates are much less reactive This is because confidence levels during a recession

are low

Monetary policy is strong during a boom, but weak during a recession

Advantages over fiscal policy, does not acquire debt

Supply Side Policies

• Policies used to expand AS (outward shift in PPC)

• Affects labor, capital and product markets

• 2 types: interventionist, non interventionist• Interventionist policies cost much more money. E.g.

education• Interventionist policies can also increase AD: e.g.

education employs teachers, increasing disposable income and thus AD

• Non – interventionist policies: abolishing minimum wage

• Work almost exclusively in the long term

Supply Side Policies Improving the Labor Market

Improving Flexibility

Restoring Incentive

Increasing quality + quantity of labor

• Trade union reforms

• More part time contracts - cuts costs for businesses

• Fixed term contracts – gets rid of unproductive workers

• Reducing tax – high taxes reduces incentive to work

• Cutting minimum wage – more are employed

• Increasing working age

• Migration• Training and

education

Supply Side PoliciesProduct and Capital Markets

Product Market - Increases in efficiency lead to an increase in AS and PPC Privatization Deregulation – improves speed of communication Helping small firms (loans, grants, business advice)

Capital Market – Increases in investment increases PPC Reduced profit tax rates – allows more investment Allowing firms to offset cost of investment against

tax

Relationship between Objectives and Policies

Positive Effects Negative Effects

Expansionary Fiscal Policy

• GDP rises – more spending/investment

• Unemployment falls – firms employ more

• Tax revenue rises• Govt. spending improves public

services

• Demand pull inflation

• Tax cuts causes imports to rise

• Government debt increases

Contractionary Fiscal Policy

• Inflation falls• Government debt decreases• Imports fall – less disposable income

+ income tax

• GDP growth slows• Unemployment rises

Tight Monetary Policy

• Reduces inflation – borrowing, spending and AD decrease

• Savers benefit• Exchange rate strengthens, imports

become cheaper

• Falling GDP and rising unemployment – caused by falling AD

• Hampers long term development of firms

Loose Monetary Policy

• GDP and employment rise• Current account surplus – demand

for exports increases as a result of depreciating exchange rate

• Firms raise prices instead of increasing supply to cope with rising AD

• Increasing inflation

Globalization

Globalization - The growing integration of the world’s economies

Features Free trade of goods, services and flow of capital High levels of interdependency between nations

Reasons for increasing globalization Improvements in transport and communication Deregulation, reduced barriers to trade and international

agreements (GATT/WTO) Multinational companies’ need for larger markets

Multinationals (MNCs): >1 country. Competitive prices due to economies of scale Powerful branding and marketing Financial/technical superiority

Winners and Losers

Advantages Disadvantages

MEDC • Repatriated profits from multinationals

• Quality and choice• Reduced international

conflict

• Manufacturing jobs lost• Interdependence

between all countries

LEDC • Increased disposable income

• Increased tax revenue• Increased employment• Increased exports

• Environmental degradation

• Exploitation by MNCs (avoiding taxes, repatriating profits, low wages)

• Worldwide increase in commodity prices

• Loss of culture

Foreign Direct Investment

Long – term Investment in another country by a company of a foreign company E.g. building factories overseas, purchase of shares

of a foreign company)

Methods of attracting FDI Tax breaks/subsidies/grants Deregulation – easier for firms to invest Infrastructure development Educating the workforce

Host Country Firm

Advantages

• Increased employment• Profit taxes• Technology transfer• Training and education

provided by the MNC• Infrastructure

development

• Low wages = low operating costs

• Bypassing of import tariffs

• Tax breaks from host country

• Lax regulations• Long term access

to market in the long run.

Disadvantages

• Exploitation of labor (low pay, poor working conditions)

• Ring-fenced operations: guarding technology

• Company protects operations to prevent benefits (repatriated profits)

• Exploitation of resources by MNC

• Possible harm to workers in unstable conditions

Developmental Aid

Humanitarian Aid: help provided in times of crisis, e.g. drought, earthquakes, etc.

Bilateral / multilateral Bilateral – country to country Multilateral – govt. gives money to agencies, who distribute it

according to their aims

Grants Cash for free, without a need for repayment E.g. govt. gives grants for clean water / education

Loans Not given at commercial rates, interest free / lower rates

Tied Aid Conditional aid E.g. country has to award contracts to firms of donor country

International Trade

International Trade

Motives Buying goods that cannot be produced domestically / are cheaper

overseas Increased consumer choice Benefits of Economies of Scale Selling off unwanted commodities

Advantages Economic growth – their firms have larger markets Choice and competition – increases efficiency, drives price down,

increases innovation

Disadvantages Overspecialization – becoming to dependent on a narrow range of goods Change in demand patterns causes structural unemployment High competition Environmental damage

Effects of Protectionism

Customers Producers Importers Government

Tariffs and Quotas

Less choice, higher prices for imported goods

Sales and profit increase

Sales and profit decrease

Increased revenue from tariffs (only tariffs)

Subsidies Lower prices Lower operating costs, profits, sales and market share increase

Sales and profits decrease

Extremely expensive

Protectionism

Tariffs – tax on imported goods, giving domestic producers a cost advantage Shifts supply for imports to the left, changing preference

from imports to domestic goods Revenue for governments

Quotas – limit on amount of products that can be imported Hard to avoid

Subsidies - payments to domestic producers Reduces cost of production, increasing supply Extremely expensive for governments in recession

Administrative barriers – insisting imports meet health/safety regulations

Protectionism

Any measure, financial or non – financial, taken by a government to give an advantage to domestic producers

Reasons for protectionism are always in the short term, in the long term protectionism is not advantageous

Infant industry argument: industry must gain economies of scale to become competitive. Arguments against: natural competition would be more effective in

stimulating innovation and creating competitive international industries

Protection of jobs Short term: helps protect workers in declining industries (e.g. American

car industry. Short term mass unemployment would have created a large shock to the US economy)

Long term: the protected industries will still be unable to compete internationally, which will not help their competitiveness in the long run

Reasons and Impact of Protectionism

Dumping Short term: allows international firms to eliminate

competition, then raise prices Long term: dumping is highly favorable for

consumers, but there is no guarantee it will last.

Problems Reductions in efficiency: sending resources to

inefficient sectors/industries Retaliation from other countries Benefits of free trade foregone

Trading Blocs

Groups of countries, usually in the same area, that agree to abolish or reduce barriers to trade E.g. EU, ASEAN Allow free movement of goods and labor

Advantages Better choice, lower price Consumer benefits Invites FDI, giving access to the entire bloc through 1 country Improves political relationships (Brazil and Argentina)

Disadvantages Blocks outside trade Administrative fees high Overdependence on the bloc

World Trade Organization

Started as GATT (General Agreement on Trade and Tariffs)

Became WTO in 1995

Aims – reduce barriers to trade through negotiation, act as an international court for solving disputes

Administer rules and monitor member’s trade policies

Each case takes 2 years to prosecute

Strengths Many members All rules agreed on by consensus

Weaknesses Favors richer nations (better representation, more resources) Favors multinationals over labor (ruled that governments cannot ban

goods based on how they are produced) Environmental damage

Developed and Developing Countries

Developing countries – low: GDP per capita, life expectancy, literacy rates and FDI. Poor infrastructure and low labor productivity. High rates of population growth

Trends in trade in developing countries Increase in net migration (trying to find work in richer areas) Increased FDI in Africa – particularly due to China Reduced reliance on commodities

Trade in developed countries Deindustrialization – causing current account deficit and

structural unemployment Increased trade in services Widening developmental gap More air travel

Exchange Rates

Exchange Rates

The price of one currency in terms of another

Traded on Foreign Exchange markets Floating exchange rate – determined only by supply and demand Fixed exchange rate – pegged to another. Guarantees certainty,

but requires large foreign currency reserves

Factors affecting demand for a currency Currency speculation Demand for that country’s exports and services Amount of FDI moving into the country (foreign investors buy land,

labor, etc) High interest rates (high rates = more people changing money into

the country’s banks)

Factors affecting supply for a currency – currency speculation, demand for imports, outwards FDI and low interest rates

Government Policy and Exchange Rates

Manipulating ForEx markets using foreign currency

To solve a current account deficit, a government may devalue its currency by lowering exchange rates

Exchange rates and PED Appreciation – Increase in the value of a currency under a floating

exchange rate if PED for exports and imports is inelastic, export profits increase and import

bill increases slightly

Depreciation If PED for x and i is elastic, export profits will increase while the import bill

decreases slightly

Evaluation /Devaluation for a fixed

Exchange Rate

P of Exports

D for Exports

P of Imports

D for Imports

Rises Rises Falls Falls Rises

Falls Falls Rises Rises Falls