mbabeuk_sb_15_2015 economics

FACULTY OF MANAGEMENT AND LAW SCHOOL OF MANAGEMENT

D I S T A N C E L E A R N I N G M B A

2015/16

MAN4100M

Business Economics

MODULE STUDY BOOK

Study Book: Business Economics

2 Bradford MBA

Copyright © University of Bradford 1999, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015

First published 1999 Ninth UK edition 2009 Second edition 2002 Tenth revised UK edition 2010 Third edition 2003 Eleventh UK edition 2011 Fourth edition 2004 Twelfth UK edition 2012 Combined edition 2005 Thirteenth UK edition 2013 Combined edition 2006 Fourteenth UK edition 2014 Seventh UK edition 2007 Fifteenth UK edition 2015 Eighth UK edition 2008

MBABEUK–SB–15–2015 MAN4100M

Bradford University School of Management

Director of Studies Jonathan Muir

Global Campus Postgraduate Programme Administrator Matt Hayes [email protected] Anne Carter [email protected] (Dubai only) Clare Haynes [email protected] (Bradford Executive MBA)

Distance Learning Programmes Administrator Gavin Turner [email protected]

Module Leader Dr Simon Rudkin

Module Development Team Bryan Lowes, Damian Ward, Chris Pass, Christine Swales, Simon Rudkin

Bradford University School of Management Emm Lane Bradford BD9 4JL Tel: 01274 234936 Website: www.bradford.ac.uk/management

This Study Book may not be sold, hired out or reproduced in part or in whole in any form or by any means whatsoever without the publisher’s prior consent in writing.

mailto:[email protected]




http://www.bradford.ac.uk/management

Bradford MBA 3

Contents

Introduction to Business Economics 7

Your Module Leader 7

Overview of Module and Module Descriptor 7

Assessment criteria 9

Support for your learning 12

Developing good academic practice 15

Module feedback from previous students 16

PART I: MICROECONOMICS 17

Unit 1: Introduction to Economics 19

Introduction 19

Objectives 20

Diminishing marginal returns 20

Scarcity and choice 21

Opportunity cost 22

Production possibility frontier 22

Summary 26

Unit 2: Issues Relating to Demand 27

Introduction 27

Objectives 28

The demand curve 28

Price elasticity of demand 32

Consumer surplus 40

Summary 42

Unit 3: Production and Output Decisions 47

Introduction 47

Objectives 48

Production and output in the short run 48

Law of diminishing marginal returns 49

Definitions of costs 51

Shutdown point 57

Deriving the firm’s supply curve 58

The supply curve 58


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Elasticity of supply 61

Costs of production in the long run 63

Returns to scale 63

Economies of scale 63

Economies of scale at work 65

Motives for growth 66

Summary 67

References 69

Unit 4: Markets in Action 71

Introduction 71

Objectives 71

Equilibrium 72

Disequilibrium 75

Labour markets 77

Market failure 78

Summary 81

References 82

Unit 5: Market Structures 83

Introduction 83

Objectives 83

Profit maximisation 84

Perfect competition 84

Consumer sovereignty 91

Efficiency 91

Monopoly 92

Comparison of perfect competition and monopoly 95

Monopoly and the public interest 95

Oligopoly 97

Price rigidity 99

Summary 102

References 104

PART II: MACROECONOMICS 105

Unit 6: Introduction to Macroeconomics 107

Introduction 107

Objectives 108

Economic targets 108

Main macroeconomic policy tools 108

Contents

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Inflation 109

What causes inflation? 109

Tackling inflation 110

Unemployment 111

What causes unemployment? 112

Healthy balance of payments 115

Exchange rates 115

Healthy economic growth 116

What causes economic growth? 117

Circular flow of income 118

Summary 122

References 124

Unit 7: Evaluating Government Economic Policy 125

Introduction 125

Objectives 126

Keynesian theory of national income 126

Keynesian solution to unemployment revisited 129

The multiplier 130

Problems with Keynesian theory 130

Keynesian view of inflation revisited 132

Economic policy tools 133

Monetary policy 134

Money, banks and money supply 134

Demand for money 136

Money market equilibrium 136

Updating the Keynesian model 142

Supply side policies 144

Summary 148

References 150

Unit 8: Economics of the Global Economy 151

Introduction 151

Objectives 151

Benefits of international trade 152

Theory of comparative advantage 152

Balance of payments 154

Terms of trade 155

Exchange rates revisited 155

Floating or fixed exchange rate? 160


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Economic and monetary union (EMU) 161

Need for fiscal harmonisation 163

Europe – the future 164

Trends in world trade 165

Multinational corporations 165

Summary 167

References 168

Unit 9: Revision and Assessment 169

Appendix A: Module descriptor 171

Appendix B: Model Answers to Activities 175

Unit 1 175

Unit 2 178

Unit 3 183

Unit 4 188

Unit 5 191

Unit 6 194

Unit 7 196

Unit 8 200

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Introduction to

Business Economics

Your Module Leader

Dr Simon Rudkin

An active researcher in the fields of supermarket impact, oligopolistic competition and regional linkages, Dr Rudkin graduated from the University of Manchester with his PhD in 2008. With work experience at the University of Manchester and at Xi’an Jiaotong-Liverpool University in Suzhou, China prior to coming to the University of Bradford he has a wide range of international academic teaching experience.

Recent publications include a novel model of local shopping as an alternative to a monopolist supermarket in Economics Letters, and a review of the distributional impacts of a new supermarket on fruit and vegetable consumption in a poor neighbourhood of Leeds, West Yorkshire in Environment and Planning A. These are being extended to consider other industries, such as Chinese online shopping, and full dietary diversity.

Keen to consider how applied economics can help answer questions in various fields, Dr Rudkin has also this year completed working papers on fiscal competition, the role of China in South-East Asia and the ethics of large corporations dealing with the crises self-regulation may create.

A fellow of the Higher Education Academy with an active interest in new teaching technologies, he has undertaken research into breaking down silence culture with tablet computers, considered how collaborative wikis can aid learning and sought new ways to bring live elements into established teaching materials.

Overview of Module and Module Descriptor

The aim of the Business Economics module is to provide you with an understanding of the market environment within which organisations operate and to acquaint you with the broader macroeconomic forces which influence organisations.


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We emphasise the application of economics to business, and its role as a foundation subject for other business disciplines: strategy, marketing, finance, etc. This module has two parts.

Part I: Microeconomics

This part develops the central theme of economics. We examine the functioning of markets by analysing how firms and consumers make decisions to buy and supply goods. We then place the organisation within its market environment to understand the determinants of its performance, and in turn explore the application of economics to decision making and strategy.

Part II: Macroeconomics

This part aims to give you an appreciation and understanding of the macroeconomy, both in a domestic and in an international setting. The units aim to develop a more detailed review of the major areas of macroeconomic interest and controversy including macroeconomic policy, aspects of open economy macroeconomics and world trade, and the challenges currently facing the unified Europe. The module will develop frameworks that enable you to evaluate these topics and more generally give you a basis for assessing the choices that are made by governments on a daily basis; choices which affect us both as individuals and organisations.

Module aims and objectives

This module is designed to:

provide an awareness of economic theory

enable you to think ‘economically’

enable you to apply economic ideas to issues in the news and applications in business

enable you to develop problem-solving skills

enable you to interpret diagrams and become familiar in their use

enable you to construct and develop lines of argument

enable you to analyse and critically assess both theory and the application of theory.

Please see Appendix A for the module descriptor.

Introduction to Business Economics

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Assessment criteria

A written assignment of 2,000 words, based on both microeconomics and macroeconomics. Assignments must be submitted by 12 January 2016.

To view the assignment questions, go to the Business Economics Blackboard site and click on ‘Assessment’ in the left hand menu. You should see a folder named ‘Distance Learning Assessment’. Click on this and you will see the assignments.

Assignment

The assignment contributes 100 per cent of the assessment for this module. For guidance on completing assignments see the Effective Learning Service (www.bradford.ac.uk/management/els/)

Assignment aim

The aim of the assignment is for you to show your understanding of the economic concepts covered in the module and your ability to apply the economic concepts in a meaningful, insightful and balanced way. The assignment emphasises the durability and the wider application of the range of economic techniques you have studied and shows how economics can be used to aid decision-making and problem-solving in a business context.

The best practice for the assignment is doing the activities and review activities that have been set in this Study Book. Wherever possible, it would be helpful to think how you could develop your answers to the questions and seek out supporting arguments.

Answering economic questions

Here are some pointers for report writing and answering economics questions.

The starting point lies in careful preparation: reading widely, drawing on knowledge from the textbook and the Study Book, becoming familiar with the major debates or viewpoints, gathering evidence, and organising these

building blocks in the form of a report plan. Finding the best way to fit together all the elements of your answer is intellectually demanding but a good outline plan makes the actual writing much easier. How should you go about this task?

The introduction is one of the most important parts of your reports and should be written carefully. Use this opportunity at the beginning of your report to address the question. This is the place where you can set out

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what you are going to look at in the reports, you can identify and define any terms and significant issues, and say how you propose to examine them. This has two effects: it compels you to discipline yourself and address the question in a relevant fashion; it also shows the reader that you are in control of the subject, and that your report is not just going to meander aimlessly until it has filled a respectable number of pages. The report should not be a magical mystery tour.

In the main body of the report, you should unfold the main arguments in a coherent sequence, bringing relevant evidence to bear on the points you are making. In economics, this section of the report normally requires you to show your understanding of the relevant theory relating to the topic under discussion and the ability to apply the economic concepts in a meaningful, insightful and balanced way. Rarely will this section produce

any clear-cut outcome. Rather this section will highlight your understanding of the economic toolkit and, more importantly, your ability to use it to analyse a wide range of complex and strategic issues, and devise appropriate strategies to deal with the situation in the question. Your ability to use economic theory to think around a problem, reveal the different options/choices that can be made and evaluate the relative effectiveness and appropriateness of these strategies under different circumstances is a strength of economics and a skill you need to show.

You should also consider what you yourself may be able to add to the set of issues under discussion. Often this is not easy but it may be possible to point to problems in the theory, the discussion or debate, for example, ambiguity in the use of economic concepts or the limitations of the existing evidence.

Finally, there is the conclusion. Here you draw together the main elements of the reports in a summary fashion, stating the conclusion (if any) you have reached. These points may help:

do not include any new information or ideas at this stage

summarise briefly the main content of the report

give your own opinion.

While there is no single blueprint for the ideal report, the following guidelines should be helpful.

The report should answer the question set, in your own words (that is, without plagiarising anybody else), and employ accurate grammar, spelling and syntax.

The answer should be well structured, informed and reveal a clear understanding of the topic.


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The literature on which the report is based should be acknowledged, references cited, and a bibliography provided, which is adequate in range and accurate in detail.

The report should make good use of a range of economic concepts and apply them broadly in a logical and balanced manner.

Do not make unsubstantiated statements; back them up with theoretical or practical evidence.

Credit will be given for answers that adopt a critical or original approach to the questions and that are written with clarity and fluency.

Submitting the assignment

Hand-in date for the assignment is 12 January 2016.

All assignments will be submitted electronically via Turnitin on the module Blackboard site: go to Blackboard > Module Site > Assessment > Distance Learning Assessment > Turnitin.

Click on ‘View/Complete’.

You will then be taken to a submission page.

The First and Last name boxes are automatically filled in. Check that your details are correct.

In the submission title box, you should label your work using your UB number and the module code e.g. 0123456789 MAN1234M (you can find the MAN code on the title verso of this Study Book). It is imperative that you upload your assignment in the above format – failure to do so may result in examiners being unable to mark your work.

Click the Browse button to upload your file. Navigate to your file and click Open.

Click Upload. Wait while your file is uploaded to the server.

The next page gives you the opportunity to review your submission. At this point you have not yet submitted, and can return to the submission page to start again if you so wish. If you are happy that this is the correct

paper and you want to continue to submit, scroll to the bottom of the page and click Submit.

You will then be emailed a receipt to your university email address, which will include your assignment identification reference.


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For further information on how to submit your assignments using Turnitin, go to the ‘How To’ section of Blackboard (Under ‘My Organisations’) and see ‘How to Submit an Assignment Electronically’.

Support for your learning

General guidance on the support available for students can be found in the Student Handbook, available online at: http://www.bradford.ac.uk/information-services/.

Approach to studying business economics

As a distance learning student, you will be studying this module at a time and place that fits around your work, social and family commitments. To be successful in your studies, you will need to juggle these commitments and make every effort to maintain a steady flow of activity as you work your way through the module materials. You will need to find windows of time for your studies on a regular, weekly basis. It is strongly advised that you progress through the module studying one unit per week. If you do this, you will find that the issues addressed in the discussion forums and the live online tutorials will correspond closely to your own studies.

With this in mind you should aim to start your studies from the first week of the term on 12 October 2015. This is when the Blackboard materials for this module will be made available. If you follow the study pattern suggested (completing a unit per week) you will finish the final unit of this module at the end of the term around 13 December 2015.

Textbook

Throughout the module, you will need to refer to the module textbook:

Begg, D. and Ward, D. (2013) Economics for Business 4th edition. Maidenhead: McGraw Hill.

The textbook forms an essential part of your study. It is vital that you read the chapters specified at the beginning of each unit to familiarise yourself with the concepts and issues to be covered. A word of warning at this stage: don’t spend too long studying the material in the textbook; a quick

reading should be sufficient.

Module Study Book

This Study Book will provide pointers to what is most essential and allow you to focus on the most important ideas in more depth. When working

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through each unit, you will be directed to read specific pages or analyse particular cases, tables and diagrams.

Activities and review exercises have been provided to help you test your understanding, and guidance has been provided in Appendix B at the end of the module so that you can assess your responses. Completion of the exercises is absolutely essential if you are to develop a good understanding of economics. Reading the textbook and the Study Book will not be sufficient to establish a clear grasp of the concepts and issues covered. You should try wherever possible to consider your own personal experience and provide examples from your own business environment to amplify your answers. You will need to interact with the material and become involved. This requires a commitment to active study.

A word of warning: the units in the Study Book are of unequal length. Some units such as those on scarcity and choice are quite brief. You are advised to break up the study of longer units and allow a little time for concepts to sink in before moving on to the next stage.

Model answers to the activities, where applicable, are provided in Appendix B.

Lecture audio recordings and slides

In each unit, you will be advised to listen to audio recordings and consult the corresponding slides highlighting key theories and ideas.

The discussion board

The discussion board in Blackboard enables you to engage in discussion with other students and the tutor. You will be able to participate in two discussion forums for the following purposes.

General module issues – This is a forum for general questions about the module and its content and direction as well as questions about all the material you will work through on the module.

Assessment issues – You are urged to put any general queries about the assessment here, since the reply provided by the tutor may also answer queries from other students.

Live tutorials on Blackboard Collaborate virtual classroom platform

During the module, you will be required to attend four live, online tutorials conducted by a module tutor. These online tutorials will provide you with an opportunity to engage in detailed, real-time discussions on key issues and concepts with other students and academics. The subject and


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materials for each live online tutorial are outlined in the Study Book. You will be given details of the times and dates of these tutorial sessions once the module has commenced.

If you have never used the Blackboard Collaborate virtual classroom platform before, it is essential that you familiarise yourself with the platform and test your computer setup before you attend the first tutorial. To test your sound settings, please go to the Blackboard Collaborate Support site at http://bit.ly/1etRu2Y. For further support materials and information about Blackboard Collaborate, please see the Blackboard Collaborate Support site at http://bit.ly/1jBpgUc.

Formative assessment

You will be provided with an opportunity to submit two pieces of work that your module tutor will assess and give you detailed feedback on. The two opportunities for formative feedback relate to issues discussed in Units 2 and 7 (see relevant units in the Study Book for further details).

Please note: none of your answers to these formative tasks will count toward the final grade – they are optional exercises that allow you to test (and receive feedback on) your understanding of key concepts/theories and ideas.

Multiple-choice questions

After completing each unit in the Study Book you can test your basic knowledge and understanding of the main economic ideas by tackling the 15 multiple-choice questions. These are available online in Blackboard.

Internet resources

The World Wide Web provides a very useful resource. You will find it particularly useful when you want to analyse business organisations or when you wish to read informed opinion regarding macroeconomic issues.

Sites well worth checking out include:

http://econlinks.com/

www.economist.com

www.ft.com

www.euromoney.com

The Bradford University School of Management library and your local library hold publications and databases relating to industries, organisations

http://bit.ly/1etRu2Y

http://bit.ly/1jBpgUc

http://econlinks.com/

http://www.economist.com/

http://www.ft.com/

http://www.euromoney.com/


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and economic trends. The internet also gives you the possibility to access libraries elsewhere.

Additional textbooks

Sloman, J., Hinde, K. and Garratt, D. (2010) Economics for Business 5th edition. Harlow: FT/Prentice Hall.

Sloman, J. and Jones, E. (2011) Economics and the Business Environment 3rd edition. Harlow: FT/Prentice Hall.

Griffiths, A. and Wall, S. (2011) Economics for Business and Management 3rd edition. Harlow: FT/Prentice Hall.

Developing good academic practice

Harvard referencing style

Students will be required to provide references to the sources used to produce work. This shows what students have read, supports the arguments and acknowledges the work of others.

The referencing system used in this programme is called Harvard. The reference consists of two parts:

1. A citation in the text. This appears next to the information you have used. It consists of the family name of the author followed by the year of

publication. Each citation is matched to a reference.

2. The reference goes in a reference list at the end of your work. The list is in alphabetical order. It contains the full details of all of the sources

referred to in the text.

For details on how to create your reference list, go to: http://www.bradford.ac.uk/library/help/referencing/.

A note about referencing in the Study Book

This Study Book provides you with a model for citing literature and presenting reference lists. Citations in the body of the units and in the references section at the end of each unit follow the University of Bradford version of the Harvard referencing system. However, please note that the references provided in the grey boxes at the start of each unit and at intervals throughout use a different convention, with hyperlinks embedded behind the title of the item (rather than given separately at the end of the

http://www.bradford.ac.uk/library/help/referencing/


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reference) and no access date included. This is simply to increase the flow of text in the grey boxes.

Module feedback from previous students

At the end of the module you will receive an email (and required link) inviting you to comment on the module. Please ensure that you provide feedback regarding your learning experience for the module.

Previous student feedback on the module include:

“The module was presented in simple language that made it easy to be understood”

“The strengths of the Business Economics module were the areas covered during the course and the fact that it provided non-experts with a basis in order to improve further their understanding of economics”

“Course handbook used in conjunction with the textbook made a difficult area of study fairly understandable”

“Subject was stimulating and relevant to life”

“I liked the simplicity of the study materials. Easy to understand”

PART I:

MICROECONOMICS

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Unit 1:

Introduction to Economics

Key reading: 1. Begg, D. and Ward, J. (2013), Chapter 1

Key audio/video: 1. An Introduction to MBA Business Economics (Blackboard > Module Site

> Module Materials > Unit 1) – Activity 1.1

Other: 1. Unit 1 lecture slides and audio (Blackboard > Module Site > Module

Materials > Unit 1 > Lecture slides and audio)

2. Unit 1 multiple-choice questions (Blackboard > Module Site > Formative Exercises > Multiple-Choice Questions > Unit 1) – Activity 1.6

Introduction

Think of something you like; a good example is chocolate. Imagine now you are in a shop and they will allow you eat as much as you like and there will be no charge. How much would you take? What considerations would you give in deciding? As a business trying to meet these needs, how does your company decide how much to provide to the market? What other goods are sold? How do you decide how many resources to allocate to each product?

In economics we recognise that there is a lot more to the market than simply price and the availability of goods. Consumers want a range of products, and in greater quantities than the market can provide. The basic economic problem is thus that consumers have essentially infinite wants but resources are limited; someone, or something, must decide how to allocate resources. No matter how much money you have, or how developed a nation is, these issues persist. Our discussion is phrased in

terms of happiness rather than money, because it is the utility we get as individuals that matters. A great example of this is the child who plays with the box rather than the present on their birthday; they value the box more than the toy despite what the market says the prices should be.

This unit develops a theoretical framework that will enable you to understand the problem of scarcity over choice, and answer the questions posed above.

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Objectives

By the end of this unit, you should be able to:

understand the concept of diminishing marginal returns and its role in economics

understand the importance of utility as a measure of benefit rather than the pure financial value assigned to a good

define the economic problem

define the concept of opportunity cost and understand its importance in a variety of economic situations but with particular reference to business

recognise production possibility frontiers and how they may be applied

distinguish between different economic systems and identify key features of each

develop an initial appreciation of how economists use diagrams as a means of explaining information.

Activity 1.1 – watch and reflect

Watch: An Introduction to MBA Business Economics (Blackboard > Module Site > Module Materials > Unit 1)

Diminishing marginal returns

One of the most important concepts in economics is the law of diminishing marginal returns, the idea that benefits get smaller as quantity rises. This can apply to the amount of a good consumed, the benefits a firm gets from an employee, the output from a machine, even the benefits of having leisure time. This law is quite intuitive but does not make financial sense, as the price (or cost) stays unchanged.

Consider the case of free chocolate. You are offered as much as you would like, and the price will always be zero. This is a great offer and of course you will be really happy about it; the first piece will be really good. Indeed as you eat the 2nd, 3rd, 4th, 5th, 6th piece you will still be really enjoying the great taste. However, after a while you will start feeling like you have eaten too much, maybe feeling guilty for the calories, or sick from the sweetness. As this happens that next piece will not bring you the happiness that the previous one did. Slowly, but surely, there will come a point at which you have had enough and the next piece does not give you any extra happiness at all. Figure 1.1 shows how the extra happiness might look when plotted over the quantity of chocolate consumed.

http://www.brad.ac.uk/acad/management/dlmba/modintro-businessecon/

Unit 1: Introduction to Business Economics

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Figure 1.1: Diminishing marginal returns

In the figure the second unit brings almost as much happiness to the eater as the first, u2 – u1 ≈ u1. As the quantity goes up this is no longer true, the 22nd piece only increases the utility by u4 – u3.

What about the workers? They arrive fresh and ready to work and can produce the first unit quickly, soon getting into a rhythm and producing more. However, over time they will inevitably tire, or become bored, and be able to produce less and less. In the extreme they will need sleep and be unable to produce any more. From your own work you will know there are times when you are more productive than others, but you receive the same wage for each unit of time so there is no financial reason not to assume the same output per unit wage.

Economics begins from the idea that returns, whether happiness from consumption, the output of labour or otherwise, diminish.

Scarcity and choice

The second essential thought on economics comes from the fact that it is not possible to satisfy everyone all of the time with the limited resources of

the planet. We can get more money and buy more inputs, we can use existing resources more productively by improving technology, but we cannot create infinite resources. The factors of production, land, labour, capital and enterprise, simply cannot deliver the goods and services we all desire. Somehow a decision must be made as to how resources are used and who will get their wants. At the national level many of these decisions are solved by governments, the state providing the services the market may not otherwise offer to everyone. In extreme cases all allocation may


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be done by the market, or by central government planners. Neither a complete free market economy, nor a totally planned economy exists in modern times. Economies today are mixed economies, both the private (business) and public (government) sectors exist side by side.

Figure 1.2: The basic economic problem

Opportunity cost

Read: Begg and Ward (2013), pp.5–28

Resources can only be allocated once, and some wants will not get the inputs they need. The alternative uses for the resources are termed the opportunity costs as the economy loses the chance to enjoy the gains that those uses of the resources would have brought. A government spending on education cannot then use that same money to spend more on transport. The opportunity cost in this case might be a new high-speed railway. When you choose to spend time watching television then the alternatives, such as reading a book, are the opportunity cost. Recognising that resources have alternative uses and decisions impact on what we can, and cannot, do is a key part of economics. It is essential to addressing the basic economic problem.

Production possibility frontier

The production possibility frontier (PPF) allows the economist to demonstrate the consequences of some decisions on how resources should be allocated. It gives an indication as to how much production can take place if all the economy’s resources are used efficiently. In addition, it allows for a comparison of production over time and an assessment of how efficiently society is using the resources at its disposal.

Consider Figure 1.3, in which the output of the economy is either capital or consumer goods. These indices could include anything; guns and butter have often been used as examples in the past. We have used capital and consumer goods since they represent massive categories of production as well as representing the different general consumption choices of


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households and businesses. The curve represents the PPF and the PPF demonstrates the various combinations of capital and consumer goods that could be produced. Any point along the PPF represents a full utilisation of resources and a very efficient economy.

Figure 1.3: Production possibility frontier

Points a, b, c, d and e all represent a full utilisation of scarce resources within an economy. With existing productive capacity the economy is unable to reach point x. The only way point x can be reached in future is through developing productive capacity, that is, through economic growth. Now consider point y. Production is below the PPF and as such represents an underutilisation of resources. A society in such a situation faces a major challenge if it is to allocate its resources more effectively.

Activity 1.2 – stop and think

Question 1: In theory all points along the PPF signify a well-functioning economy. Can you identify, however, future problems that may occur with the extreme combinations of goods produced at points a and b in Figure 1.3?

Question 2: Which represents the best combination: c or e?

Consumer

goods

Capital

goods

b

c

d

e

a

x

y


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Activity 1.2 – stop and think answers:

The PPF can be used to examine the concept of opportunity cost. Take an individual firm that has diversified its production and produces good A and good B.

Figure 1.4: Production of good A and good B

Currently the firm is producing at point x which represents a1 production of good A and b1 production of good B. The firm, after extensive market research, decides that product B represents the more profitable long-term

future and decides to reallocate resources from the production of good A to good B. This decision would involve a reduction in the output of good A from a1 to a2 (the opportunity cost) in order to increase the production of B from b1 to b2, point y.

Good A

Good B

x

y

a1

a2

b1

b2


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Figure 1.5: Production possibility frontier graph

Activity 1.3 – read and reflect

Consider Figure 1.5, a PPF for an agricultural economy.

Question 1: Why does the frontier curve?

Question 2: What will happen if technology allows the country’s resources produce twice as much meat?

Activity 1.3 – read and reflect answers:


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Summary

Read: Begg and Ward (2013), Summary, p.25

In this unit we have introduced three of the most important concepts in economics; diminishing marginal returns, the basic economic problem and opportunity cost. Each of these will appear prominently in all of the study units that follow. As economists we recognise that decisions must be driven by happiness; there will necessarily be winners and losers. Production possibility frontiers help us to visualise all of these problems in a clear and simple way. Frontiers also show the importance of getting allocation decisions right.

Review activity 1.4

The United Kingdom government is keen to build a high-speed rail link from Leeds/Manchester to London at a cost of £50bn. It is assumed that there will be huge growth benefits as capacity for trade along traditional routes is freed up by fast trains going onto the new line.

Question 1: What are the opportunity costs for the UK government when deciding to invest taxpayers’ money in this scheme?

Question 2: What effect will the high speed rail link have on the UK production possibility frontier?

Question 3: Why might the government choose a 300km/h line when it is possible to build even faster lines that can operate safely?

Question 4: When your business faces investment decisions like this what are the opportunity costs? How are your production possibilities affected?

Activity 1.5 – lecture slides and audio

Listen to: the audio for this unit and view the accompanying slides at the same time. (Blackboard > Module Site > Module Materials > Unit 1 ).

Activity 1.6 – multiple-choice questions

The multiple-choice questions for this unit will enable you to test your knowledge and understanding of the key concepts covered. (Blackboard > Module Site > Formative Exercises > Multiple-Choice Questions > Unit 1)

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Unit 2:

Issues Relating to Demand





3. Unit 2 live online tutorial (Blackboard > Module Site > Collaborate) – Activity 2.8

4. Unit 2 marked formative assessment (Blackboard > Module Site > Formative Exercises > Marked Formative Assessment > Unit 2) – Activity 2.9

Introduction

In most economies, markets are the principal ways in which scarce resources are allocated to the production of goods and services. A market is anywhere there is a buyer and seller. In essence, markets operate through the price mechanism which co-ordinates the buyers and sellers. For example, as prices rise relative to costs of production, firms offer more for sale. In this way, the price acts as a signal to firms that scarce resources should be reallocated from markets where profits are low to markets where profits are high. The price mechanism is often referred to as the ‘invisible hand’ since it is the result of free market forces.

Have you ever considered why baked beans only cost 25p when they enjoy so much popularity? Why do firms not cash in on this demand by

charging 99p? Why does a pint of beer cost £2.95 in your local pub compared to £5.00 in a nightclub? Why does the government tax cigarettes and beer but not apples? Why does the accountant working at your firm earn more than the cleaner? The answers to all these questions can be found by analysing how demand and supply interact in the market place.


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In this unit you will begin to develop your understanding of how markets behave. First, you will concentrate on the demand side of the market. What affects the level of demand, how do consumers react to price changes, how can firms set prices that will maximise their revenues; and why do firms set different prices for different market segments? Once you feel comfortable with this knowledge, Unit 3 will then introduce concepts related to the supply side of the market. Unit 4 will then combine the ideas from Units 2 and 3 into an integrated understanding of markets. Hopefully, you can see that economics is a subject which builds upon itself and it is, therefore, important to gain confidence in the ideas and issues of each unit before moving onto the next.

Objectives


explain the theory of demand

understand the determinants of demand

explain the concept of consumer and producer surplus

explain the concept of elasticity and appreciate its importance when managers are developing pricing strategies

explain the relationship between elasticity and revenue.

The demand curve

Read: Begg and Ward (2013), Chapter 2, pp.32–40

The demand curve demonstrates the relationship between the quantity demanded and price. Demand is considered as effective demand, which means demand backed up by the ability to pay. Much of the demand curve is hypothetical in that it states what consumers would demand at relative prices. The demand curve is sometimes drawn as a straight line or as a curve. It doesn’t really matter since both are examples of how the economist attempts to develop theory through making assumptions to simplify the process.

Unit 2: Issues Relating to Demand

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Figure 2.1: The demand curve

If we examine the demand curve in Figure 2.1, consider how demand is higher at low prices and how this demand changes as prices increase. Look at how the demand changes as price drops from p1 to p2. There is an extension of demand from q1 to q2. What would cause a contraction of demand? The only factor that causes either an extension or contraction of demand is a change in the price of the product itself. Anything other than a change in price causes a shift in the demand curve itself. These other factors are referred to as the determinants of demand and include:

price of substitute and complementary goods

changes in consumer incomes

consumers’ tastes and preferences and how these may be affected by advertising, fashion, etc

expectations of future price changes

time period.

A change in any of these determinants of demand causes a shift in the demand curve. In Figure 2.2, a shift from D1 to D2 means more of the product is demanded at every price. A shift from D1 to D3 is a reduction in demand at every price.

Price

Quantity

p1

p2

q1

q2

D


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Figure 2.2: Demand curves

If the original price is p0, a successful advertising campaign may increase the demand from D1 to D2. We have shifted from point a to point b on Figure 2.3 below. The quantity demanded at this price has increased from q1 to q2.

Figure 2.3: Change in the demand curve

Price

Quantity

p

q1

q3

q2

D2

D1D

3

Price

Quantity

p0

q1 q

2

D2

D1

a b


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For each of the following scenarios, draw a diagram to show the effect on your firm’s demand.

Scenario 1: An increase in the price of a complementary good.

Scenario 2: A decrease in the price of a substitute good.

Scenario 3: An increase in consumer incomes.

Scenario 4: A brilliant advertising campaign by your main competitor.

Scenario 5: A decrease in the price of your product.



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Of course, at this stage we are only focusing upon demand. You should go back to our definition of a market. We now need to examine the role of the sellers who supply the products if we are to establish how the market determines price and output.

Price elasticity of demand


Price elasticity of demand is a crucial concept for businesses to grasp if they are to be successful in the marketplace. It is worthwhile reflecting on the material at each stage that follows and taking stock of the ideas covered before tackling the activities to be covered later in the unit.

The price elasticity of demand measures the responsiveness of the change in demand for a change in price. If a firm has control over its own pricing policies, the concept allows the firm to establish the effects of a change in price on its revenue and, hence, its profits. It allows firms to answer the questions such as what will happen to revenue if we increase our prices by 2% or reduce price by 75p.

Elasticity of demand can be calculated using the formula:

price in change %

demandedquantity in change %=Ed

Different demand elasticities

If the Ed is > 0 but less than 1 the demand is price inelastic.

If the Ed is >1 the demand is price elastic

Exceptional cases are:

If the Ed is = 1 the demand has unit elasticity.

If the Ed is infinity the demand is perfectly elastic.

If the Ed is = 0 the demand is perfectly inelastic.

Elastic and inelastic demand

Elastic demand means that a relatively small change in price leads to a relatively large change in the quantity demanded. This is shown in Figure 2.4.


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Figure 2.4: Elastic demand

Inelastic demand means that a relatively large change in price leads to a relatively small change in the quantity demanded. This is shown in Figure 2.5.

Figure 2.5: Inelastic demand

If we examine Figures 2.4 and 2.5, we can show the relationships between the relative changes in price and quantity demanded. Strictly speaking this approach should be used to simplify the idea only, since the validity of the diagrams is dependent upon the scale of the axes.

Price

Quantity

D

p2

p1

q2

q1

Price

Quantity

D

p2

p1

q2

q1


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Special cases

The perfectly elastic demand curve suggests even a tiny increase in price will lead to none of the product being sold (see Figure 2.6).

The perfectly inelastic demand curve suggests no matter what happens to price the quantity demanded will not change (see Figure 2.7).

The unit elasticity suggests a 5% change in price will lead to a 5% change in quantity demanded (see Figure 2.8).

Figure 2.6: Perfectly elastic demand curve

Figure 2.7: Perfectly inelastic demand curve

Price

Quantity

Dp

q1

q2

Price

Quantity

D

p2

q

p1


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Figure 2.8: Unit elasticity

Determinants of elasticity

The number and closeness of substitute goods.

The proportion of income spent on the good.

The time factor (short run or long run).

Relationship between elasticity and revenue

If demand is elastic and if there are many close substitutes available then:

an increase in price will lead to a large reduction in the quantity sold and revenue will fall

a decrease in price will lead to a large increase in the quantity sold and revenue will increase.

If demand is inelastic and if there are no close substitutes available then:

an increase in price will only lead to a small reduction in demand and revenue will increase

a decrease in price will only lead to a small increase in demand and revenue will decrease.

Now at this point you might ask: well, if demand is inelastic and consumers will continue to purchase the product even if the price increases, why don’t firms just keep on raising prices indefinitely? This is a good question and it is worthwhile spending some time analysing the response to this question. At this point, we could take the soft option and state it would be easier to answer this question at the end of Unit 3. In Unit 3, we identify how firms choose the level of output which will maximise profits. Having selected this output, the market demand will

Price

Quantity

This is a rectangular hyperbola


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determine the price that the firm charges. You need to remember that profit is equal to revenue minus costs. Raising prices might increase revenue but the traditional theory of a firm assumes the firm will aim to maximise profits and not revenue. This will be clearer at the end of Unit 3.

So how can we answer the question without taking the easy option? This requires a more complex response. The elasticity of demand varies along the course of the demand curve. If we examine Figure 2.9, we note that the demand is inelastic, at lower prices and elastic at higher prices. This would suggest a firm could increase its prices when the price is low and, since demand is inelastic, there will be a smaller proportionate reduction in demand: hence, there is an increase in revenue. But as price is increased and demand becomes more elastic there will come a point where an increase in price will lead to a larger proportionate reduction in demand.

Think of consumers who stick with a product when prices are low and remain loyal as prices increase, but when prices get much higher a larger number of consumers start to look at alternative products.

Figure 2.9: The demand curve and the elasticity of demand

In summary, we can assume the firm will set price at the point where demand is just about to become elastic: that is, the firm has kept on increasing price until the point where it can’t raise it any more without reducing revenue. Note: here we are referring to revenue and not profit.


Consider Figure 2.10 and explain what is happening.

Price

Quantity

Elastic

Inelastic

D


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Figure 2.10: Elasticity, the demand curve and total revenue


Total

revenue

Quantity

Elastic Inelastic

Total revenue

Price

Quantity

Elastic

Inelastic

D

Unit elasticity


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How the time period affects the elasticity of demand

If we consider Figure 2.11, the original demand curve D1 exists within a market that gives an equilibrium price of p1 with a quantity exchanged of q1. If the market price increased to p2, then in the initial period consumers have very little time to seek alternatives and quantity bought might only fall a little to q2. After a little more time has passed, consumers have the ability to adapt their purchasing habits and will have made initial checks on alternatives that exist for the original product. The new demand curve becomes D2 and this gives a reduction in demand to q3 for the market price p2. In the longer period, we can see that the demand curve becomes D3 as this process continues, and we can clearly see that the elasticity of demand has varied over the different time periods given.

Figure 2.11: Time and elasticity of demand

Other kinds of elasticity of demand

Other elasticities of demand exist in addition to the price elasticity of demand we have covered so far.

Income elasticity

Income elasticity measures the responsiveness of a change in demand for a change in income. Income elasticity of demand can be calculated using the formula:

income in change ateProportion

demand in change ateProportiondYE

Price

Quantity

p2

p1

q4

q3

q2

q1

D1

D2

D3

D1

D2

D3

E


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Cross elasticity

Cross elasticity measures the responsiveness of a change in demand for good A for a change in the price of good B. How will a change in the price of a competitor’s product affect the demand for our product?

Cross elasticity can be calculated using the following formula:

B good for price in change ateProportion

Agood for demand in change ateProportionAEd

Importance of income elasticity

As incomes increase, consumers adapt and change their spending patterns and this will have an obvious influence on business. This influence will vary depending upon the income elasticity of demand. Take two firm’s products in separate markets, one with an YEd of 1.5 and one with a value of 0.02. The first business can be optimistic since the market for its product is likely to grow and it will face an expanding market as consumer incomes increase. Its target will be maximising the potential that this opportunity provides and grasping as much of this market growth as is profitable. The firm in the second situation with an income elasticity of 0.02 has a much bleaker outlook. The product is very income inelastic in demand and the market shows little opportunity for growth. Indeed, it is more likely that this firm will consider itself within a static market and its aim will be to devise marketing strategies to take market share from its competitors in this market.


Question 1: Can you identify how income elasticity of demand affects your business? Is your product(s) income elastic or income inelastic in demand? Who is your product aimed at? How would rising prosperity of the well off or less well off affect the demand for your product? Can you identify products with a high income elasticity of demand (elastic) and give examples of products with a low income elasticity of demand (inelastic).

Question 2: Can you remember which of these numerical elasticity values corresponds with elastic, inelastic and unitary?

Ed > 0 and < 1

Ed = 1

Ed > 1

Question 3: Can you find examples of firms that have products with high cross elasticity of demand for your firm’s product?


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Consumer surplus


Consumer surplus is measured for each consumer and is calculated as the difference between the price of the product and the maximum price the consumer would be willing to pay. So if a latte coffee costs £2.00 and I am willing to pay up to £2.50 for a latte coffee, then my consumer surplus is £0.50. If a caffeine junky is willing to pay up to £4.00 for a latte coffee, then his or her consumer surplus would be £2.00.

The consumer surplus for all consumers demanding a given product is illustrated in Figure 2.12.

Figure 2.12: Consumer surplus

Price

Quantity

pe

qe

D

Consumersurplus


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Consumer surplus is important because it represents enhanced consumer welfare, but also lost profits for firms. Governments like to see markets that grow the overall size of the consumer surplus. Firms develop sales tactics that seek to convert consumer surplus into profits. These tactics are generally referred to as price discrimination.

First degree price discrimination charges each consumer the maximum price that they are willing to pay.

Second degree price discrimination charges consumers according to usage. Higher users are charged differently from low rate users.

Third degree price discrimination seeks to charge a different price to each consumer group.

An auction is an example of first degree price discrimination. Various mobile telephone tariffs for low and high users are examples of second degree price discrimination. Business and economy class airline tickets are examples of third degree price discrimination.


Question 1: Can you think of additional examples of price discrimination?

Question 2: Will first, second, or third degree price discrimination extract the most consumer surplus?

Question 3: Why do we not observe more first degree price discrimination?



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Summary

Read: Begg and Ward (2013), Summary, p.54

You should now be able to understand the theory of demand and explain the difference between a movement along and a shift in the demand curves. You should also have a grasp of the important factors behind pricing decisions and how the market reacts to changing conditions. You have examined the ideas of consumer surplus and considered ways in which businesses might maximise revenue in their pricing policies. Importantly, you should have a good knowledge of the concept of elasticity, and its importance to decision making and market strategy.

Review activity 2.5 – demand for flights

Objectives

1. To reinforce the economic theory of demand and the related concept of elasticity by the use of a real life example.

2. To explore the links between elasticity and the total revenue.

3. To understand the concept and importance of consumer surplus.

4. To explore the strategic insights of demand theory.

Emirates Airlines, hubbed in Dubai, this summer announced it was increasing services to London, Birmingham, Copenhagen, Manchester and Madrid by using bigger Airbus A380 double-decker planes. On these planes it has three classes of accommodation: first, business and economy. In advertising it plays on the spa facilities for first class customers on the A380, the bar for business class passengers and the sheer size of the economy cabin. For all classes it points to vast inflight entertainment options and on board wifi. In each case Emirates seeks to differentiate its product from its competitors, and indeed its older smaller planes.

Undoubtedly the airline sector is highly competitive with global hubs offering connectivity to anywhere on the planet for business and tourist travellers alike. Business customers want space to work and to ensure they arrive at their destination relaxed and prepared; they will look for the airline that offers this best. By contrast tourists are looking for new experiences and a comparatively comfortable way to get to their destination. Price sensitivity will be stronger in the tourism sector.

As part of the market research into upgrading its third daily flight to Manchester the airline gathers the following information about customers’


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willingness to pay for flights to Dubai. It surveys 400 potential business passengers and 1200 potential economy class fliers.

Table 2.1: Willingness to pay for return flights to Dubai split by traveller type and class of travel

Percentage of Sample

Maximum willingness to pay (£/return trip)

Business Travellers Tourists

Business Economy Business Economy

0 2500 1000 700 450

5 2413 976 680 440

10 2324 951 669 429

15 2228 927 650 422

20 2144 898 646 408

25 2047 875 619 401

30 1957 849 611 392

35 1874 826 591 382

40 1784 799 581 368

45 1693 776 570 361

50 1598 748 556 348

55 1510 726 529 339

60 1422 702 521 327

65 1334 677 502 317

70 1240 649 493 312

75 1150 627 469 297

80 1057 601 462 289

85 974 575 445 278

90 881 550 433 270

95 791 523 418 259

Task 1: Sketch the following demand curves on separate axes:

a) Business passengers demand for business class.

b) Business passengers demand for economy class.

c) Tourists demand for business class.

d) Tourists demand for economy class.

Task 2: Look at your answers to Task 1 and comment on the elasticities of the demand functions. Is there any reason why the curves might have the elasticities that they do?

Task 3: Emirates can only choose one price for its business class ticket to allow it to be advertised. What price ticket will maximise the revenue from business class seats on the plane? (Note: The airline has no way to know whether the passenger buying the ticket is a business passenger or a tourist.)


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Task 4: If business class tickets sell for £1000 and economy class tickets sell for £350, illustrate the consumer surplus gained by passengers when customers only fly in the class that is best suited to their needs: that is, business passengers fly business class and tourists buy economy class tickets.

Task 5: Table 2.2 provides details of Emirates prices for a return ticket between Manchester and Dubai. Why might we see pricing like this? What type(s) of price discrimination are being applied here?

Table 2.2: Return flight prices using Emirates Airlines from Manchester to Dubai

Leaving Returning Business Economy

Saturday 10 October Saturday 17 October £2,411 £448

Sunday 11 October Sunday 18 October £2,391 £395

Monday 12 October Monday 19 October £2,391 £363

Tuesday 13 October Tuesday 20 October £2,391 £363

Data sourced from www.emirates.com, 10 August 2015.

Task 6: Emirates big rival Etihad has also launched its own A380 with individual suite first class tickets between Abu Dhabi and London Heathrow. With reference to the study on this unit, what is likely to happen to demand for Emirates tickets:

(a) in first class on the Manchester to Dubai route

(b) in first class on the London Heathrow to Dubai route

(c) in economy class on the Manchester to Dubai route.


Listen to: the audio for this unit and view the accompanying slides at the same time. (Blackboard > Module Site > Module Materials > Unit 2 > Lecture slides and audio)



http://www.emirates.com/


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Activity 2.8 – live online tutorial

Live online tutorial: To access the tutorial, please go to Blackboard > Module Site > Collaborate. To test your sound settings for the Blackboard Collaborate virtual classroom, please go to the Blackboard Collaborate Support site at http://bit.ly/1etRu2Y. For further support materials and information about Blackboard Collaborate, please see the Blackboard Collaborate Support site at http://bit.ly/1jBpgUc.

Before the tutorial a short article will be posted onto the module Blackboard site which raises issues from the first two units (Blackboard > Module Site > Module Materials > Collaborate, to gain access to the article). A set of questions will accompany the article. Please read the article and prepare answers to the questions posed.

Question 1: What are the main determinants of demand in the industry being studied?

Question 2: What issues are raised for future demand in the companies mentioned in the article?

Question 3: How do these issues relate to the demand for the product of your business?

Question 4: How should your business deal with a similar competition threat as that discussed in the article?

Activity 2.9 – marked formative assessment

Explain why reducing price might not generate extra revenue for your company.

Use no more than 500 words and be sure to both demonstrate your knowledge and understanding of economics and your ability to apply economics to real business issues.

Email your answer to your tutor, who will advise you via Blackboard on the deadline for submissions in order to receive feedback on your work.



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Unit 3:

Production and Output

Decisions

Key reading: 1. Begg, D. and Ward, J. (2013), Chapters 3 and 4




Introduction

As already identified in the introduction to Unit 1, the factors of production are subject to a law of diminishing marginal returns. This unit provides some of the important background understanding required for our examination of markets in Unit 4 and competition in Unit 5. While consumers can simply turn up at a market and demand goods, firms are not as fortunate. In supplying goods, firms face a number of issues concerning the actual production of goods and services. Having decided what and where to produce, they must make important decisions regarding how much labour and capital should be used. Should it buy components from suppliers, and if so which firms, or should it produce the whole of the product in house? How much will it cost to make different quantities of output? When might the firm expand or when should it shut down?

An important distinction made by economists is that costs behave differently depending on the time scale. The short run is the period of time in which the firm is unable to vary all its factors of production. In other

words, at least one factor of production is fixed. This could be particularly skilled workers in very short supply or it could be a machine that takes a long time to arrive often an order is made. The long run is defined as the period of time in which it is possible to vary all the factors of production. Production may be defined as anything which satisfies a want or a need and, as such, covers the output of services as much as the output of goods.


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Objectives


explain the law of diminishing marginal returns

provide a categorisation for costs and understand the relationship between them

discover when the firm has reached its shut-down point

recognise the importance of decisions taken on the margin

understand the reasons why a firm may expand and how economies of scale affect the firm’s costs.

Production and output in the short run


We look first at how output varies in the short run. We will hold all factors of production fixed apart from the number of workers, which can vary. We can represent how production changes in Table 3.1.

Table 3.1: Changes in product with labour changes

Labour Total product Average product Marginal product

1 43 43 43

2 160 80 117

3 351 117 191

4 600 150 249

5 875 175 275

6 1,152 192 277

7 1,372 196 220

8 1,536 192 164

9 1,656 184 120

10 1,750 175 94

11 1,815 165 65

12 1,860 155 45

Total product = Total amount produced

Average product = Total product

Number of workers

Unit 3: Production and Output Decisions

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Marginal product = (Total product produced by n) – (total product produced by n – 1)

We can express marginal product another way: the additional output achieved by employing one more unit of labour.

The total product can be shown by means of a graph (Figure 3.1).

Figure 3.1: Total product

Note how the total product increases at first, and how it begins to tail off as more units of labour are employed. For the purpose of this theory we need to assume that each worker is just as good and hard working as the next and that the production methods do not change, so that we can isolate the relationship between the number of workers employed and output.

Law of diminishing marginal returns

This law states that as we add successive units of a variable factor to a number of fixed factors of production, after a certain point, total output will continue to grow but at a diminishing rate. This can be shown by means of a different kind of diagram which explores the relationship between average product and marginal product (Figure 3.2).

Note that the marginal product intersects the average product at the highest point on the average product curve. Diminishing marginal returns set in when the marginal product begins to fall. The last worker employed allows production to increase but at a slower rate. This can be identified in Table 3.1. The sixth worker to be employed caused the total production to increase from 875 units to 1,152 units, a difference of 277 units. However, the seventh worker causes output to increase by only 220 units. The law of diminishing returns has set in after the employment of the seventh worker.

Total

product

Total

product

Labour units


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This theory would suggest that in the short run a firm faces strong limitations on its output; less flexibility gives the firm much less room for manoeuvre than is the case in the long run which we will examine later.

Figure 3.2: Average product and marginal product


Question 1: Complete the following table.

Labour Total product Average product

Marginal product

1 10

2 24

3 42

4 56

5 70

6 72

Using graph paper can you plot the total product curve, the average product curve and the marginal product curve?

Question 2: At what point does diminishing marginal returns set in?

Question 3: Why do you think that diminishing returns set in?

Product

Labour units

Marginal

product

Average

product


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Definitions of costs

Fixed costs = Costs which do not vary with output

Variable costs = Costs which vary with output

Total costs = Fixed + variable costs

Average total cost = Total cost

Output

Average variable cost = Total variable cost

Output

Marginal cost = Total cost of producing n units minus total cost of producing (n – 1) units; or, in other words, the total cost of producing one extra unit of production

Average fixed cost = Fixed cost

Output

Let’s take a look at Table 3.2, note how the fixed cost remains the same regardless of the number of workers are employed. If we plotted this information in a graph, we would have the situation shown in Figure 3.3.

Table 3.2: Changes in costs with changes in labour

Labour Fixed cost Variable cost Total cost

1 100 20 120

2 100 40 140

3 100 60 160

4 100 80 180


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Figure 3.3: Labour and costs


Complete the following table calculating the missing figures.

Output Fixed cost Variable cost Total cost

0 200 0 200

1 200

2 300

3 800

4 1,200

5 2,200

Average costs

Average total costs = Total cost

Output

Another way of calculating average total cost is:

Average total cost (ATC) = Average variable cost (AVC) + average fixed cost (AFC)

Cost

Labour units

Total

cost

Fixed cost

Variable

cost


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Consider Table 3.3. We can deduce that the total fixed cost must be 200. Can you see how this has been done? In Figure 3.4 we can show how the AFC is shaped as total fixed cost is spread over a greater quantity of output.

Table 3.3: Output and costs

Output AVC AFC ATC

1 200 200 400

2 150 100 250

3 200 67 267

4 300 50 350

5 400 40 440

Figure 3.4: Average fixed cost

Marginal cost of production

Table 3.4: Output and marginal costs

Output Total cost Marginal cost

1 400 –

2 500 100

3 800 300

4 1,400 600

5 2,200 800

The first marginal cost value is a dash since we are not given the fixed cost when output is zero. If we plot the average cost and marginal cost


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curves on the same diagram, we have Figure 3.5. Notice how the marginal cost curve intersects the average cost curve at its lowest point. This is not just coincidence! This is an important part of the relationship and it is essential for you to remember this when we examine the theoretical framework behind a firm’s output decisions in Unit 4.

Figure 3.5: Average cost and marginal cost



Total output

Fixed cost Variable cost

Total cost Marginal cost

Average cost

0 10 0 10 – –

1 10 2 12 2 12

2 12

3 20

4 26

5 30

6 32

7 39

8 54

9 71

10 100

Cost

Units of output

Marginal cost

Average cost


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Using graph paper can you now plot the average cost and marginal cost curves on the same diagram? Remember, plot costs on the vertical axis and output along the horizontal axis.


Output TFC TVC TC AFC AVC ATC MC

0 40

1 06

2 11

3 15

4 60

5 66

On graph paper can you plot TFC, TVC and TC against output; and AFC, AVC, ATC and MC against output?

Question 3: Complete the following table which includes both revenue and cost information and calculate the missing figures.

Output Price TR MR FC VC TC MC Profit

0 10 – 2

1 10 7 +1

2 10 8

3 10 +4

4 10 36

5 10 –5


Read the following scenario and then answers the questions that follow.

Hitachi to open £82m train plant in Durham this year Adapted from the Financial Times (www.ft.com)

The Newton Aycliffe site, the Japanese company’s first European train factory, was given the go-ahead after the government awarded Hitachi Rail Europe the contract to supply the intercity express programme, the next generation of trains for the East Coast and Great Western main lines. Under this £5.7bn contract, which includes maintenance and runs for


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27.5 years, Hitachi will build 122 trains comprising 866 carriages. Twelve trains are being manufactured at its Kasado works in Japan and the rest at Newton Aycliffe. Hitachi has also been named by Abellio, an arm of the Dutch state rail operator, as preferred bidder for 70 trains for ScotRail.

“We aren’t going to rely on the Japanese supplier base for components. We are going to Europeanise as much of this plant as we can,” Mr Foster [Jamie Foster, Procurement Director for Hitachi] said. The company said it was working with 56 suppliers in Europe, 32 of them based in the UK.

In contrast to Nissan’s high-volume, just-in-time Sunderland operation, which requires some suppliers to be located next to, or even in, the plant, Hitachi, with its longer manufacturing timescales, does not need them on the doorstep.

(Source: Tighe and Powley 2015)

Answer the following questions.

Question 1: What fixed costs are incurred by switching production from Kosado to Durham?

Question 2: What are the likely effects on variable costs from using this new plant?

Question 3: How do the variable costs of Nissan and Hitachi differ according to this article?

Question 4: Train orders are known for being cyclical. Explain why it might be better to have a larger variable cost base in an industry like this.



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Shutdown point


In the short run, the firm has already committed to the fixed costs. They have been paid and can be left out of the short-term decision-making about output. In the short run, the firm will continue to produce provided that the revenue generated exceeds the variable cost. At each output level, the surplus of revenue over variable cost makes a contribution towards paying for the fixed costs. If the revenue is less than the variable cost, it will be more sensible for the firm to cease production. Stopping production will reduce the size of the loss and limit it to the value of the fixed costs already paid. Therefore, the short-run shutdown point occurs when the revenue cannot cover the variable costs.

Of course, in the long run the firm is operating under different decision-making criteria and can vary all its factors of production. In such cases, the firm is more concerned about covering total costs rather than just variable costs. In the long run, the firm will shut down if it cannot cover the total costs.

Figure 3.6: Costs and revenues and output

If we consider Figure 3.6, we can see this clearly. Imagine that the vertical axis includes both costs and revenue. If the average revenue AR1 is below point y, then the AVC exceeds the AR. The firm is not covering its variable costs and should cease production. At point y, the average revenue AR2 is equal to the AVC and the firm is therefore just covering its variable costs. This firm will continue to produce in the short run. At point z, the firm’s average revenue AR3 is equal to the ATC and as such the firm's revenue is covering all its costs and the firm will continue to produce in the long run. Clearly the short- and long-run shutdown points differ. In the short run, the firm will shut down to the left of point y, where it cannot cover its


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variable costs. In the long run, it will shut down to the left of point z, since the revenue does not cover total costs.

Deriving the firm’s supply curve

Figure 3.6 can also be used in order to derive the firm’s supply curve for the product. At points to the left of y, the firm would not be willing to supply the product since AVC exceeds revenue. At point y, the firm is happy to supply in the short run since it is covering AVC. At point z, the firm is happy to produce in the long run since it is covering ATC. At all points to the right of point z, the firm is willing to supply since the revenue exceeds the ATC and the firm will be earning profit. Therefore taking all this information together, the firm is willing to produce in the short run at all

points on the MC curve provided it is at or above point y. The MC curve above point y becomes the firm’s supply curve.

Another way of explaining this idea, which will be useful when we compare the pricing and output decisions of monopolies with those of firms in competitive markets in Unit 4, is as follows:

a firm’s supply schedule shows the quantities that the firm is willing to offer at each market price

since a firm is assumed to operate for profits, then it will only offer output when the market price is greater than the cost of producing the last unit offered

therefore, the firm’s supply schedule is also the firm’s marginal cost curve (where MC exceeds AVC in the short run or ATC in the long run).

The industry or market supply schedule is simply a summation of all firms’ supply schedules.

Analysing firms in the short run shows how constrained they are by having some factors of production fixed. They have far less flexibility in their decision-making and little room for manoeuvre.

The supply curve


The supply curve demonstrates the relationship between the quantity a firm would wish to supply at every price. In Figure 3.7, the firm wishes to supply q1 at price p1. If the price of the product was higher, the firm would wish to supply more goods (an extension of supply). If the price was lower, there would be a contraction of supply. A change in the price of the good or service is the only factor that causes a movement along the supply curve.


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Figure 3.7: The supply curve

Any other factors other than a change in price will cause a shift in the supply curve itself. These factors are referred to as the determinants of supply and include:

changes in the costs of production

changes in the profitability of substitute goods or goods in joint supply

nature, unexpected random shocks, for example, weather in agriculture, the credit crunch and the loss of banking companies

changes in the aims of the firm

expectations of future price changes

state of technology.

Figure 3.8: Supply curves

Price

Quantity

p1

q1

S

Price

Quantity

p1

q1

q2

q3

S3

S1 S

2


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A change in any of the determinants of supply will cause a shift in the supply curve. In Figure 3.8, the initial quantity q1 is supplied at the price p1. A shift from S1 to S2 represents an increase in supply at every price. A shift from S1 to S3 represents a reduction in supply at every price.


For each of the following situations, construct a diagram to demonstrate the effect on supply.

Situation 1: An increase in the cost of raw materials.

Situation 2: An increase in the price of your product.

Situation 3: An increase in productivity on the shop floor.

Situation 4: An increase in wages at all levels in the firm not matched by increased productivity.


Although it may seem somewhat mechanical undertaking these activities, it is to develop a good grasp of demand and supply. This is fundamental to an understanding of the market. To understand how market price is established, we need to understand the behaviour of firms that supply goods and services and the private individuals who demand these products. Economists make an assumption that firms attempt to maximise


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profit and consumers aim to maximise utility (satisfaction). You need to remember that in reality the market can be very complex and not always easy to predict. The economist needs to use the idea of ceteris paribus (everything else remains the same) to continue building an understanding of how the market works.

Elasticity of supply

Elasticity of supply measures the responsiveness of quantity supplied for a given change in price.

Factors affecting elasticity of supply include

time period

level of spare capacity.

The time period effect on the elasticity of supply works in much the same way as for the elasticity of demand.

Figure 3.9: Time and elasticity of supply


Using the explanation of the time period effect for elasticity of demand as a guide, can you explain Figure 3.9?

Price

Quantity

p2

p1

q1

q3

q2

S1

S2

S3

S1 S

2 S3


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Spare capacity

Spare capacity describes the ability of a firm to expand its output given its existing factors of production. A firm may have the flexibility to respond rapidly to increased demand if it carries a large stock of finished products or has the ability to quickly expand output. It might have a large amount of work in progress or workers without a full workload, or the capacity for overtime, or machines that are currently underutilised. When a firm has no spare capacity, it has little room for manoeuvre and the supply curve is relatively inelastic. The concept of spare capacity will be looked at again when we examine how government policy affects the supply of products in the macroeconomics part of the course.


Using your firm as an example, consider how you would be able to respond to an increased demand for your product or service. How flexible is your firm when faced with the opposite scenario: that is, when demand is falling?



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Costs of production in the long run

Let’s start by reminding ourselves of the definition of long run: this is the period of time in which all the factors of production become variable. When all factors of production are variable an economist can analyse how firms perform as they change their scale of production. The word ‘scale’ implies that the same combination of factors of production are used and in the same ratios: that is, the firm may expand but retains the same proportions of factors of production. Of course, in reality the firm has the flexibility to change the proportions by replacing labour with capital etc, but for the purpose of theory this assumption allows economists to establish how scale influences a firm’s costs of production.

Returns to scale

Returns to scale looks at the relationship between changes in the scale of operation and the amount of output generated.

Increasing returns to scale mean that bigger firms are able to generate greater returns than smaller ones. A large number of these will come from the firms’ market power, discussed in Units 4 and 5.

Constant returns to scale occur when size does not matter.

Decreasing returns to scale occur when firms become too large. A classic example being the costs that bureaucracy can impose on large firms’ decision-making.

Economies of scale

Economies of scale explores the relationship between changes in the scale of operation and the average costs of production. We can define it as those aspects of increasing a firm’s size that lead to falling average costs. These economies of scale can be either internal or external. Internal economies of scale are those that arise from the growth of the firm itself. External economies of scale are those that arise from factors outside the individual firm, such as developments in the local infrastructure and improved road communication links, etc.

Firms do not always find that growth leads to falling average costs. Sometimes they can become too big and the diseconomies of scale outweigh the economies of scale. It is important to remember that when looking at how scale affects costs, we are looking at the overall effect of changing scale. When a firm begins to grow it starts to experience economies of scale but also suffers some of the disadvantages of growth. It is why we refer to the ‘outweighing’ nature of the concept.


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Considering the diseconomies of scale arising from the growth of the firm, can you identify how these factors work within your business organisation? If you work for a small firm, identify what problems might emerge from the growth of your firm.

Can you summarise what is happening in Figure 3.10?

Figure 3.10: Economies of scale


Cost

OutputEconomies of scale Constant Diseconomies

LRATC


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Economies of scale at work

If we take Figure 3.11 as our starting point, we can establish the basis for understanding the ‘envelope curve’ in the textbook.

Figure 3.11: Economies and diseconomies of scale

We start on the short-run average cost curve 1 (SRAC1). The current level of production in the short run is q1. The firm in the short run is able to produce this level of output for an average cost of c1. If there is an increase in demand for the product so that the firm considers the level of production should be q2, the firm can only meet this output target in the short run if there is an increase in the average cost to c2. (The firm may need to pay overtime to meet the target.) However, in the long run, the firm can increase the scale of production and moves to short-run average cost curve 2 (SRAC2). The new target output of q2 can now be produced for the reduced average cost c3. The firm is experiencing economies of scale, which outweigh the diseconomies of scale.

If the firm continues to grow, it would move to another short-run average cost curve. At some point it will theoretically reach the optimum scale of production where the product is produced as cheaply as possible. After this level of output the diseconomies of scale outweigh the economies of scale. In Figure 3.12 we draw a long-run average cost curve (LRACC) which envelops the SRACCs. This represents the theoretical view of how average costs vary with the scale of the firm.

In practice, however, many large firms do not experience the envelope curve as described in Figure 3.12. The firm experiences the first part of the curve, where increasing size leads to falling average costs. However, when the optimum scale is reached the firm finds that continued growth leads to constant returns to scale. That is, the economies and

Cost

Output

c2

c1

c3

0 q1

q2

SRAC1

SRAC2


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diseconomies of further growth tend to cancel each other out. This is demonstrated in Figure 3.13 and is referred to as an L-shaped average cost curve.

Figure 3.12: Long-run average cost curve

Figure 3.13: L-shaped average cost curve

Motives for growth

This is an extension of ideas. If you are interested, read Chapter 7 for

more details. Why would firms wish to grow? There are several reasons:

to benefit from economies of scale

to secure a greater market share

to enjoy greater market security.

Cost

Output0

SRACC1 SRACC

2

LRACC

Cost

Output

LRACC


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Summary

This unit has demonstrated some of the constraints placed upon the firm in the short run. The firm is significantly hampered by having at least one factor of production fixed. The theory of diminishing returns shows how the marginal product falls as the units of the variable factor are increased beyond a certain level. In the long run, the firm has far more flexibility and can respond to changing market conditions by expanding the scale of operations. Appreciating the interrelationship between the various costs and revenue will allow us to focus in Unit 4 on how firms arrive at their pricing and output decisions in different market structures.

Review activity 3.9

Question 1: Do you consider that your firm is at its optimum scale of production? How would the diseconomies of scale apply to your organisation if it were to expand? If your firm were to expand how should it best go about this?

Question 2: A knitwear manufacturer produces sweaters in a production facility which incurs unavoidable (fixed) costs of £50 per day. The going rate of pay for workers is £25 per day and each sweater uses materials costing £2. The following table gives output data and some cost information for the knitwear manufacturer.

Labour

(No of

workers)

Output:

Sweaters

(per day)

TFC

(£/day)

Total

labour

cost

(£/day)

Total

material

cost

(£/day)

TVC

(£/day)

TC

(£/day)

0 0 50 0 0 0 50

1 4 50 25 8 33 83

2 10

3 13

4 15

5 16


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Complete the following table.

Labour

(£/sweater)

Output

(£/sweater)

AFC

(£/sweater)

AVC

(£/sweater)

ATC MC

0 0

1 4

2 10

3 13

4 15

5 16

Question 3: Using the clues below, complete the following table.

Output TC MC ATC AFC AVC TVC

2

3

4

5

6

Clues

1. AFC for 6 units of output is £9.

2. AVC for 2 units of output is £30.

3. Total cost is increased by £28 when the third unit of output is added.

4. ATC of 4 units of output is the same as the ATC of 3 units of output.

5. Total cost for 5 units of output is £258.

6. Total variable cost is increased by £100 when the sixth unit of output is added.

7. Total cost increases by £8 when the second unit of output is added.


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Listen to: the audio for this unit and view the accompanying slides at the same time. (Blackboard > Module Site > Module Materials > Unit 3 > Lecture slide and audio)



References

Tighe, C. and Powley, T. (2015) Hitachi to open £82m train plant in Durham this year. Financial Times, 11 January. http://www.ft.com/cms/s/0/972f7360-89fa-11e4-9b5f-00144feabdc0.html#ixzz3iERW8fGQ. Accessed 8 August 2015.

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Unit 4:

Markets in Action

Key reading: 1. Begg, D. and Ward, J. (2013), Chapter 4 and part of Chapter 8

2. D’Aveni, R. (2015) The 3-D Printing Revolution. Harvard Business Review, May (Blackboard > Module Site > Module Materials > Unit 4)




Introduction

In this unit we will combine the demand and supply analysis developed in Units 2 and 3. The purpose of which is to understand the forces that determine the price and quantity of a product traded in a market.

Our analysis will use demand and supply curves within a single diagram and will highlight the concept of market equilibrium. We also consider market disequilibrium and address the forces that push a market back towards equilibrium

While markets are often viewed by economists as an optimal resource allocation mechanism, there are instances where markets can fail. We consider all these factors with a specific focus on the applications to business.

Objectives

By the end of this unit you will be able to:

understand the concept of market equilibrium

understand how changes in demand and supply lead to changes in the market equilibrium

understand how market failure relates to sub-optimal outcomes.

http://search.ebscohost.com.ezproxy.brad.ac.uk/login.aspx?direct=true&db=bth&AN=102262142&site=ehost-live


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understand some of the solutions to market failure.

Equilibrium


Consider Figure 4.1 showing the interaction of demand and supply in the market. The point where demand and supply intersect is called the equilibrium. This is the point at which the buyers and sellers are in agreement about both the price and the quantity to be exchanged at this price.

Figure 4.1: Market equilibrium

Characteristics of equilibrium

The equilibrium condition (p1, q1) is unique.

All other combinations of price and quantity represent points of disequilibrium.

The equilibrium is efficient (demonstrated in Unit 5 when we examine perfect competition).

Free market forces will push the market towards equilibrium.

Effects of changes in demand

In Figure 4.2, there is an increase in demand due to an increase in the fashionability of our product. The demand shifts from D1 to D2, which leads to an extension of supply. The new equilibrium gives a market price of p2 and a quantity exchanged of q2.

Price

Quantity

p1

q1

S

D

Unit 4: Markets in Action

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Figure 4.2: Increase in demand

In Figure 4.3, there is a decrease in demand and this leads to a shift in the demand curve to the left (if you are struggling to see how this shift is to the left think of how the demand curve has moved for every level of price). The new demand D2 gives a new price of p2 and causes a contraction of supply. The quantity of the product exchanged is q2.

Figure 4.3: Decrease in demand

Effects of changes in supply

In Figure 4.4, there is an increase in supply at every price. The new supply curve S2 moves to the right causing a decrease in market price to p2 and this causes an extension of demand to q2 of the product exchanged.

Price

Quantity

p1

p2

q2q

1

S

D2

D1

1

Price

Quantity

p1

p2

q2 q

1

S

D2

D1

1


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Figure 4.4: Increase in supply

In Figure 4.5, there is a reduction of supply. The new supply curve S2 gives a new price of p2, which causes a contraction of demand and a new output exchanged of q2.

Figure 4.5: Decrease in supply

Price

Quantity

p1

p2

q2

q1

S1

S2

D1

Price

Quantity

p2

p1

q1

q2

S2

S1

D1


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Disequilibrium


In Figure 4.6, the market has supplied a level of output q2, which at the market price p2 charged for the product exceeds the quantity demanded q1 at this price. This is described as an example of excess supply. If free market forces operate, what is likely to happen next?

Although firms have produced q2 units of output they only receive revenue from the sale of q1. They are left with q2 – q1 units unsold. In order to clear this excess supply, the price will need to fall. As price falls firms will produce less and there will be an extension of demand until the equilibrium situation is reached. The key point here is that this will happen automatically if the market is left to its own free market devices.

Figure 4.6: Market disequilibrium

In Figure 4.7 the price p3 lies below the equilibrium. This time the quantity demanded is q2 and the quantity supplied is q1. This leads to a shortage. The market price will be bid up by consumers until and equilibrium position is found.

Price

Quantity

p2

q1

q2

S

D


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Figure 4.7: Market disequilibrium – shortage


How do companies launching new products use market disequilibrium to promote their products?



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Labour markets

Wages in the labour market are established through the interaction of demand and supply for labour. The demand for labour is partly derived from the demand for the good or service. The firm also has other factors affecting its elasticity of demand for labour, for example, proportion of total costs accounted for by labour, the ease with which labour can be replaced by machinery or other workers, etc. The elasticity of supply of labour is affected mainly by the length of training required to perform a particular task.

Compare the position of the managing director and the cleaner in your company. Compare, for example, their wages. The managing director requires skill and expertise that makes him or her far more inelastic in supply than the cleaner. The cleaner performs a necessary role for the firm but does not require much training and can be more easily replaced with other cleaners. This gives the cleaner a weak position when wage bargaining.

Figure 4.8: Comparing wages of different personnel


Using Figure 4.8 to help you, explain why doctors get paid more than nurses. Imagine a scenario in which there is an increase in demand for both doctors and nurses due to extra government investment. Draw a new demand curve on your diagram for the doctors and nurses and comment on what you see.

Wage

Number

of workers

W2

W1

S

D

L2

L1

S

D


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Market failure


In some cases, the market does not (or would not) give society the optimal output allocation and, in these cases, the government may intervene to influence the market. Examples might include the provision of public and merit goods, policies to influence the inequitable distribution of income, minimum wage legislation, policies to tackle the uses and abuses of monopoly power, including privatisation.

Public goods

Public goods are goods for which a supply might not be forthcoming if the government did not intervene. It is hard to establish who would pay for these goods at the point of use. Clearly there is a demand for street lighting, but would a firm be willing to supply this service when it is difficult to work out which consumers are using the service and how often? Would the free market be able to provide a police force if left to its own devices?


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Merit goods

Merit goods are goods that can be provided by the private sector but which are considered so important that the government intervenes to enable a greater benefit to society. Examples include the provision of education and health services.

Inequitable distribution of income

The market mechanism cannot differentiate between the spending of a rich or a poor person. The market responds to demand, and scarce resources of society may be allocated to luxuries for the rich rather than necessities for the poor. The demand for products in a free market has

been likened to votes in an economic ballot box. However, some people clearly have more votes than others. The government may intervene to enable the system to make more provision for consumers on lower incomes. The taxation system and government welfare spending programmes are used to tackle the problem of inequality.

Monopoly power

Inevitably, in a competitive situation there will be some winners and some losers. In business, the winners may get increasingly powerful and may grow in size by expanding or through company takeovers. As these firms get bigger and more powerful, they can influence the market significantly. As we shall see in Unit 5 monopolies are able to make more profits and charge higher prices than firms in markets in which substantial competition exists. The UK government has set up agencies such as the Competition and Markets Authority and Financial Conduct Authority, and various watchdogs to regulate monopoly power.

Government intervention in the labour market

Some governments have established a national minimum wage to protect workers in low-paid jobs. A great deal of debate surrounded the introduction of this policy. There were fears of widespread job losses as firms cut back on their growing wage bills by reducing the size of the workforce. Having accepted the principle of minimum wage the government now faces the dilemma of deciding on the going rate.

Taxing demerit goods

The government taxes some goods both in order to generate revenue but also to reduce demand for goods it considers to be harmful. Think of cigarettes and petrol.


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For example, if the government increases the tax on production of a good by 10p, this will cause a shift in the supply curve to the left. A firm producing the goods will be receiving 10p less than before, so it will supply less at every price. In Figure 4.9, the new supply curve S2 is 10p higher than S1 if you look at the vertical difference between any two points on the S1 and S2. The market price has increased from £1 to £1.06. This means the consumer is paying an extra 6p. The firm must be paying 4p of the 10p tax. The more inelastic the demand, the more of a tax increase is paid by the consumer.

Figure 4.9: Market price increase and tax


Around the world governments provide subsidies (negative taxes) for households to make their homes more energy efficient. This helps companies supplying solar panels, installing double glazing or insulating walls.

Question 1: How does the subsidy influence the market for solar panels?

Question 2: How will the market for double glazing be affected by the elasticity of demand?

Question 3: If consumer demand for wall insulation reduced by 3 per cent and price increased by 5 per cent what would be the elasticity of demand?

Question 4: Which of the three products would you expect to have the most elastic demand?

Price

Quantity

£1.06

S2

S1

10p

£1

D


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Summary

This chapter has focused on key economic ideas associated with markets. Demand and supply, developed in previous units, have now been integrated into one framework. The importance is now in understanding the equilibrium price and quantity, as well as the factors that cause demand and supply to change, thus altering the equilibrium. Development of these important concepts include the analysis of disequilibrium, which covers output shortages or surpluses, changes in the elasticity of demand and supply, and a consideration of informational asymmetries. The market framework will now be mixed with cost and revenue concepts to enable a consideration of competition in Unit 5.

Review activity 4.4

Read: D’Aveni, R. (2015) The 3-D Printing Revolution. Harvard Business Review, May (Blackboard > Module Site > Module Materials > Unit 4)

Question 1: Using supply and demand analysis explain the impact on the United States hearing aid market from firms switching to 100% 3D printing production of hearing aids.

Hint: In your answer think about what happens to marginal costs, fixed costs and variable costs. Consider how this affects supply.



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Question 2: 3D printing is heralded for its ability to create a product that can be easily customised to individual needs. Using supply and demand analysis explain what this will do to the market equilibrium.

Question 3: How are your answers to question 1 and question 2 changed by the elasticity of supply?

Question 4: How might technology impact on the equilibrium in the market your business serves?


Listen to the audio for this unit and view the accompanying slides at the same time. (Blackboard > Module Site > Module Materials > Unit 4 > Lecture slides and audio)



References

D’Aveni, R. (2015) The 3-D Printing Revolution. Harvard Business Review, May. http://search.ebscohost.com.ezproxy.brad.ac.uk/login.aspx?direct=true&db=bth&AN=102262142&site=ehost-live. Accessed 28 August 2015.



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Unit 5:

Market Structures






Introduction

In this unit we examine the firm and how it responds to competition in the marketplace. We will analyse the pricing and output decisions of firms within three different market structures. The analysis will also allow us to make an assessment regarding profitability and efficiency in the allocation of resources. We shall build models for the three market structures:

perfect competition, where there are many competitors

monopoly, where a firm faces little or no competition

oligopoly, where large firms face strong competition from a small number of other firms.

We focus first on how perfect competition and then monopoly works; then we compare the two market structures focusing upon price, output, profit and efficiency. Finally, we examine oligopoly and examine the ways in which this market structure forces firms to compete.

Objectives


understand profit maximisation

understand the theory of perfect competition


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evaluate the price and output decisions of firms within perfect competition and how these decisions affect profitability in the long run

identify the market structure faced by a monopolist and compare this with perfect competition

understand oligopolists and the competitive environment within which they operate.

Profit maximisation


Economists assume that firms are in business to make profits for their owners (shareholders). A stronger assumption is that firms seek to maximise profits. In this unit and throughout this module we will also assume profit maximisation. But if you are interested in alternative assumptions for a firm’s behaviour then take some time to read pages 189–199 of Begg and Ward (2013).

If firms are profit maximisers, then they will produce an output where marginal revenue equals marginal cost. The textbook provides a long but accessible explanation for why marginal cost must equal marginal revenue. However, a concise approach is to acknowledge that the firm must maximise profits when the profit from the last unit is zero, i.e. all profits have been extracted and equally where marginal cost equals marginal revenue.

Market structure

Figure 5.1: Continuum of market structure

Figure 5.1 shows a continuum of market structure. Note that the perfect competition (PC) is at the opposite end of the continuum to monopoly. In between lies monopolistic competition and oligopoly, both market structures where the firm faces imperfect competition. In this unit, we will not analyse monopolistic competition.

Perfect competition


Perfect

competition

Monopolistic

competition

Oligopoly Monopoly

Unit 5: Market Structures

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Perfect competition is a theoretical market idea which is extremely useful as a yardstick. It acts as a means of comparison with other market structures. A firm within perfect competition operates in a market in which it has virtually no market power. The firm is powerless to exert any influence on market price. The firm can produce an unlimited amount of its product and sell it all, since it represents such a small part of overall supply.

Assumptions of perfect competition

With perfect competition:

firms are price takers

products are homogeneous

there is perfect knowledge and information

there are no barriers to entry or exit

there is freedom of movement of buyers and sellers in the market.

In essence, the individual firm is so small that it cannot influence market supply and it takes the price established by the market. The firm cannot charge a higher price since consumers have perfect knowledge and know they can get an identical product cheaper elsewhere. There is no incentive to produce and supply at a lower price since firms can sell all that they wish at the market price. This is shown in Figure 5.2.

Figure 5.2: Perfect competition

Figure 5.2 shows the interaction of market demand and supply that gives a market price of p. The individual firm will charge this price for its product since it is a price taker. The firm faces a perfectly elastic demand curve. You should remember what this means from Unit 2. If the price is 50p for example, then the firm will receive 50p for each product sold. This means the firm will have an average revenue (AR) equal to 50p. Selling one more unit will provide the firm with an extra 50p so the marginal revenue (MR)

Price Price

Output Output

p

S

D

Market

MR=AR=D

Firm


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will be 50p also. The firm faces a perfectly elastic demand curve and, at this market price, price is equal to average revenue and marginal revenue.

The obvious question to ask at this stage is why doesn’t the firm just keep on producing more and more of the product if it can sell an infinite amount at the market price? The answer to this question allows the economist to draw together some of the work covered in Units 2 and 3. So far the perfectly elastic demand curve is just focusing on the demand and revenue situation faced by the firm. Profit is the difference between revenue and costs and so we need to introduce the cost curves we identified in Unit 3. We do this, as in Figure 5.3, by introducing the average cost (AC) and marginal cost (MC) curves.

Figure 5.3: Output, price and cost

Figure 5.3 throws up some important information and a couple of conceptual points that we need to explain. Note carefully that there are four levels of output that have been marked on the diagram: q1, q2, q3 and q4. Each of these refers to a point of interest.

Before examining them, however, we must firstly define profit. Normal profit is that which is just about sufficient to keep the firm in that particular industry. It occurs when AR = AC. We include normal profit within AC to denote the opportunity cost of remaining in the industry. Therefore, when AR = AC we are left with normal profit. Any profit in excess of normal profit is referred to as abnormal profit (AR > AC).

If we refer to Figure 5.3 again then points q1 and q4 both show output levels where AR = AC. The firm is making normal profits in each case. At q2 the firm is making maximum profit per unit since the greatest difference exists between AR and AC. However, the profit maximising level of output occurs at q3. Since the theory of the firm assumes that firms aim to maximise the level of profit, q3 is the level of output that the firm chooses

Price

Output

p

q3

MR=AR=P

ACMC

q4

q1

q2


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to produce. The shaded area in Figure 5.4 shows the level of abnormal profit earned by the firm in the short run.

Figure 5.4: Output and profit

The abnormal profit is q3 units of output multiplied by the difference between AR and AC at this point. So why is the profit maximising level of output at q3 rather than q2? Well, it’s true that the firm does maximise profit per unit at q2 but if the firm produced at the bottom of the AC curve, see how much of the shaded profit it would lose out on. The extra profit the firm earns for each level of output beyond q2 (since AR > AC) exceeds the tiny amount of extra AC the firm needs to pay.

The firm maximises profit and produces where MR = MC. It produces right up to the point where MR = MC (q3) in order to squeeze every last bit of profit possible. Producing beyond q3 would not be sensible since the MC would be greater than the MR for the last unit produced and so the level of abnormal profit would fall.

If you still need convincing that q3 is better for the firm than q2, then consider the following argument. Imagine q2 represents output of 10 million units. The p = AR = MR is £4 per unit. The AC is £2 per unit. Abnormal profit in this example is: £4 – £2 = £2 per unit. The firm is producing 10 million units, so this gives abnormal profit of £20 million.

Now consider q3. The firm is producing 12 million units at this point but AC has increased to £2.20. Abnormal profit is £4 – £2.20 = £1.80 per unit. The firm is producing 12 million units, so abnormal profit is £21.6 million. The average cost has increased, there is less profit per unit, but total profit has increased.

Price

Quantity

p

q3

MR=AR=D

ACMC


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The key point to remember is that the firm maximises profit by producing at the level of output where MR = MC.

Of course, not all firms will be able to make a profit. Some firms will find that nobody wants to purchase their goods, they may be unfashionable. In these cases, a firm will minimise its losses in the short run by producing where MR = MC.

If we now go back to the theoretical model of perfect competition we are developing, in the short run the firm is making abnormal profit. Other firms will see this abnormal profit since they have perfect information and so resources are reallocated in the market to increase the output levels of this profitable good. The individual firm is powerless to prevent this happing since there are no effective barriers to entry. Other firms enter the industry

and this causes the market supply curve to move to the right. This will force down the market price and will continue to do so until normal profits are earned again by the now expanded number of suppliers. Note that this is the free market at work. The price acts as a signal to firms and the resources are reallocated accordingly.

Consider Figure 5.5. Note that the supply curve moves to the right. This new supply S2 gives a new equilibrium price of p2 and in diagram b this gives a new perfectly elastic demand curve at this price. In diagram c, MR = MC at the same point as AR = AC and so the firm is earning normal profit. The firm will continue to produce at this point until the next change takes place within the market.


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Figure 5.5: Maximising profit

Price

Quantity(a)

S1

S2

D

Price

Quantity(b)

D1

D2

MR=AR

MR=AR

Price

Quantity(c)

AR=MR

MC AC

P1

P2

Price

Quantity(a)

S1

S2

D

Price

Quantity(b)

D1

D2

MR=AR

MR=AR

Price

Quantity(c)

AR=MR

MC AC

P1

P2


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Using Figure 5.6 to help, can you explain what is happening to the firm that is making short-term losses and how the change in market supply restores normal profit?


Figure 5.6: Making a loss

Price

Quantity

p

q

D=MR=AR

ACMC


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Consumer sovereignty

The perfectly competitive market structure, operating in the way we have described suggests that the market responds to the wishes of the consumer. The consumer dictates how a society’s scarce resources should be allocated and the market responds positively and efficiently to the consumer’s wishes. Consumer sovereignty has been likened to casting votes in the economic ballot box. The more that a product is demanded, the more votes it receives.

Efficiency

An economist might refer to efficiency as productive efficiency or allocative efficiency. A firm is efficient when it is producing at the bottom of its AC curve. This is known as productive efficiency. By referring to our perfect competition diagrams, we can see that perfect competition is productively efficient in the long run. Allocative efficiency refers to the resources being allocated efficiently, and occurs when the firm is charging a price equal to its marginal costs. This concept also requires the firm to be earning normal profits. If a firm is earning abnormal profits, then by deduction, more of the product needs to be supplied to the market to force down prices to the level where normal profits are earned. Therefore, we can state that the firm in perfect competition is allocatively efficient in the long run.

It is important to remember that we must not confuse efficiency and profit. They are related and in general everyday life we know that efficiency can lead to profit. But, a firm that isn’t efficient can also be profitable and so the distinction is important.


Question 1: How realistic is perfect competition?

Question 2: Examine the assumptions and consider their validity. Why do we bother to study a market structure that is unrealistic?


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Monopoly


Definitions of a monopoly can vary from a market where the consumer has no discernible choice of supplier to the UK government’s definition that a monopoly is a firm with over 25 per cent of the market. For the purpose of our analysis, we shall take a monopoly to be a firm that faces no direct competition. We shall assume that there is one seller and many buyers, no close substitutes exist and the monopolist has highly effective barriers to entry.

A monopolist can control either the price of the product or the amount sold. It cannot do both since it cannot control the market demand. The demand curve facing the firm is the market demand curve. If the monopoly firm wishes to sell an extra unit of the product it can do so, provided it lowers the price. If price is lowered, the marginal revenue falls more steeply for the firm since all the products sold to date need to be sold for less. In numerical terms, if the firm lowers price by 1p it sells one more unit per


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month but the marginal revenue falls by more than 1p since the eight products sold by the firm originally have reduced revenue by 8 times 1p. This is shown in Figure 5.7.

Figure 5.7: Monopolies and the demand curve

The profit-maximising monopolist

The profit-maximising monopolist produces at the point where MR = MC (Figure 5.8).

Figure 5.8: Profit and the monopolist

In Figure 5.8, the monopolist produces at the point where MR = MC. We draw this point down to the horizontal axis to denote the level of output. The market demand suggests that p1 is the price consumers are happy to pay for this level of output. The AC of producing this level of output is c1.

Price

Quantity

AR=D

MR

Price

Quantity

AR=D

MR

q1

MCAC

p1

c1


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The shaded area denotes the abnormal profit. In the short run, the monopolist can earn abnormal profit. If this is perfect competition, then other firms would enter the market. This can’t happen in monopoly since the firm has effective barriers to entry. Therefore, the monopolist can earn abnormal profit in both the short run and the long run.


Outline the monopolist’s barriers to entry.

Question 1: Is the monopolist productively efficient?

Question 2: Is the monopolist allocatively efficient?

Question 3: Who provides the monopolist with the abnormal profit?



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Comparison of perfect competition and monopoly

In Unit 4, we identified that an individual firm’s supply curve was that part of the MC which was above the AVC curve. The market supply was the sum of these MC curves added together. This allows us to show the supply curve and MC curve as the same (Figure 5.9).

Figure 5.9: Perfect competition and a monopoly

The price in perfect competition is p1 and this is below the price in monopoly of p2. The output in perfect competition is q1 and this is greater than the output in monopoly of q2. The monopolist is restricting output to increase price to create abnormal profit in both the short and long run.

Monopoly and the public interest

Is a monopoly always against the public interest? In exceptional cases, it may be possible that a monopolist benefiting from substantial economies of scale could provide the product at a lower price than a market where competition exists. It might mean an inefficient market allocation according to the definitions of efficiency that we have given, but the consumer would not complain if the price of the product is lower.

If a firm faces little domestic competition and, therefore, appears to be a strong monopolist, then it would be important to examine its competition from abroad. It might be competing against a strong and all-powerful monopolist in Germany or France. A large domestic monopoly would have a better chance of survival when faced with international competition and this would make jobs safer, etc.


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In some markets, the amount of investment required to keep up with innovations both to the production process and the finished product may require the security offered by a firm with massive assets when seeking financial input. Small firms may be unable or unwilling to take on the massive amounts of investment required.


Read the following scenario and then answer the questions that follow.

Eurostar, operator of high speed rail services between the UK and continental Europe began life as a co-operation between the British, French and Belgian governments. For years a competition restriction prevented any other rail operator from using the Channel Tunnel. Recently that limit has been lifted and rivals will begin services into London soon. For example Deutsche Bahn, the German state operator, is looking at introducing services between Frankfurt and London.

Using the discussion of this unit briefly explain the benefits of allowing Eurostar to operate as a monopoly for its formative years.



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Oligopoly

Many markets in the real world cannot be characterised as either perfectly competitive or monopolistic. Instead, many markets are characterised by a small number of large suppliers. For example, food retailing is usually dominated by a small number of supermarket chains, and retail financial services is controlled predominantly by a small number of banks. Since many of these markets are very important to us as consumers, and also as potential sources of employment, it is clearly important that we have an understanding of these markets. The theory of oligopoly helps us here.

The theories of perfect competition and monopoly assume away the existence of competitive rivalry between firms (why?). In contrast, the theory of oligopoly focuses in on competitive rivalry between firms and, as a consequence, is a major source of economic ideas on strategic decision-making.

Consider a market with only four major suppliers. If one firm decides to change the product that it offers, the price it asks for its product, or the amount it is willing to supply, then this will have a major impact on its competitors’ businesses. As a consequence, economic theory aims to model the behaviour of a firm as a reaction to the expected behaviour of its rival. If you play chess you will know precisely what is being referred to!

Read: Begg and Ward (2013), Chapter 6, pages 136–156

Features of an oligopoly market

The key features of an oligopoly market are:

there are few suppliers

firms select their prices

there is non-price competition

products are differentiated

barriers to entry exist.

An oligopolist at work

Oligopoly means competition between the few. Although price competition can occur, a feature of the oligopoly market is non-price competition. The oligopolist always needs to take the likely reaction of competitors into account when making decisions. In many ways, the oligopolists might be considered as incredibly powerful: they are often household names; they advertise frequently; they have impressive business premises and locations; they tend to attract graduates with good salaries and pension plans; they have executive boxes at important sporting occasions, etc.


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But, and it is a big but, they face incredible competition and live in a ruthless business environment.

The oligopolist has a strange looking demand curve. It is referred to as a ‘kinked’ demand curve. It is really made up of two demand curves. A relatively elastic demand curve to represent the demand faced when prices are increased and a relatively inelastic demand curve to demonstrate the demand faced when price falls (Figure 5.10). The demand curve dd denotes the effect of a price increase by the firm. Note it is relatively elastic. The demand curve DD, represents the demand faced by the firm if it were to decrease price. Note the relatively inelastic nature of this demand curve. Where the two demand curves intersect is the starting price for the firm. This point z can be represented on a slightly different diagram to highlight the workings of an oligopoly market

(Figure 5.11).

Figure 5.10: Oligopolist’s demand curves

Figure 5.11: Oligopoly market


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If the firm in oligopoly starts off at point z, the price charged is p1 and the output is q1. If the firm increases its price then a relatively large reduction in demand will occur. The competitors of the firm will leave their prices unchanged and so only the customers with strong brand loyalty will remain. If the firm lowers its price then its competitors would follow suit and so a relatively large reduction in price would lead to a relatively small increase in demand. Quite clearly, faced with this scenario, the firm would not wish to engage in price competition.


List the many ways in which firms compete in non-price ways. Consider petrol, breweries, banks, supermarkets and hi-fi companies. Consider all the ways in which your firm competes and establish how well this fits with the theory.


Price rigidity

Another means of explaining why oligopolists tend not to compete on price can be found by adapting our earlier diagrams. When we covered monopoly earlier in the unit we identified that the marginal revenue curve slopes more steeply than the demand curve. In Figure 5.12, there is a marginal revenue curve which corresponds to the relatively elastic demand curve and one which complies with the relatively inelastic demand curve. There is also a vertical discontinuity which exists on this marginal revenue curve, denoted by points a and b. We could mathematically explain this but we will invoke the principle of opportunity cost and the notion of what we could more usefully do with our time!


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Figure 5.12: Oligopoly and price

When we consider the price rigidity diagram, Figure 5.12, MC1, MC2 and MC3 denote one firm with three different levels of efficiency. To begin with, the firm with MC1, charges a price p1. When the firm increases efficiency, the MC falls to MC2and then MC3, but the firm will still charge the same price since the MC crosses the MR in the vertical discontinuity area. The firm becomes more profitable by increasing efficiency. In the oligopolist’s marketplace, characterised by cut-throat competition, increasing efficiency becomes one of the most reliable forms of competing. Research and development becomes integral to the success of the firm.

The more the firms in oligopoly can co-operate, the more the firms should have a chance of being profitable. With less the co-operation, then there is more chance that all firms will suffer. In a risky market situation, is it surprising that firms diversify to spread the risk? Consider the amount of diversification in the electrical and white goods markets. Consider the incredible number of new products being launched. Is the consumer still sovereign amidst this vast amount of product choice?


Read the following article and answer the questions that follow.

Africa’s supermarket shopping revolution Adapted from the Financial Times, 24 July 2015

Malls are replacing traditional outdoor markets and street vendors. The new consumerism is all about status, choice — and Swiss chocolate.

At the entrance to the Shoprite supermarket in downtown Lusaka, women are wrestling with shopping trolleys. It is the end of the month and salaries


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have been paid: the women have bought nappies, rice, sugar and sacks of maize meal half the weight of a bag of cement. In front of the main doors, young men stand in the hot sun selling tomatoes and onions; five kwacha a kilo (approximately 40 pence). On the street outside, makeshift stalls tout plastic-weave shopping bags, cellophane-wrapped Bibles, pens and herbals potions. In the car park, women sit on the tarmac selling avocados and dried kapenta fish, a type of sardine. It is, in miniature, a scene typical of the street-side bustle that has long been the African shopping experience.

The supermarket, however, is a newer phenomenon — both to Lusaka, the capital of Zambia, and to Africa. Serene, air-conditioned and well stocked, it is an experience urban Africans are becoming increasingly accustomed to as South African retailers advance north across the

Limpopo river. The trend is being felt from Lagos to Luanda, Maputo to Kampala, and it is radically altering the shopping habits of the burgeoning middle class. Where the supermarkets have led, other international brands have followed: from Barclays to KFC and Nando’s. According to forecasts by McKinsey, Africa’s consumer-facing industries will grow by more than $400bn by 2020. All want the same thing — to tap into the aspirations of a new generation.

Before supermarkets arrived in Lusaka, Anga Kasanda, a 37-year-old account assistant, used to do her shopping at the sprawling open-air Soweto market. Packed with people and ripe vegetables, the place is full of sweat, noise and dust. Now she rarely goes. In the Shoprite on Cairo Road, one of Lusaka’s main highways, Kasanda browses shelves of Italian (rather than Egyptian) pasta. “Every location you go, there’s malls ... I can say that’s development,” she tells me. “It’s changed the perspective of people.” For her, it’s the basics that have made a difference: being able to get hold of electrical appliances such as a steam iron, and being able to do an entire shop under one roof. For millions of Africans, following a decade of strong economic growth, it is these seemingly mundane things that have helped to raise living standards. “It’s revolutionised the way people are shopping,” she adds. “We don’t want to go backwards.”

(Source: England 2015)

Question 1: Why might oligopoly supermarkets be welcomed by consumers when theory tells us that perfect competition amongst small stall holders is better?

Question 2: What are the likely effects of allowing the growth of supermarkets in Africa?


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Summary

There are such a large number of different firms operating in the marketplace that we place them into a market structure. Economists examine the price, output, efficiency and profitability of firms in each of the different market structures. Understanding the context of a firm’s strategic decision-making allows us to make much more sense of an ever-changing market situation that all firms face. Firms do not always behave in the way our theoretical models would suggest; take, for instance, the assumption concerning profit maximisation.

As a general rule of thumb, it would appear that the more competition in the marketplace the better. This is hardly a surprising revelation. Most people in the street would be able to make this same assertion! We do, however, now have as economists a theoretical underpinning to this general rule of thumb.


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Now is the time to broaden the picture by examining the macroeconomy within which the firm operates.

Review activity 5.7

Question 1: If marginal revenue is £10 and marginal cost is £8 will the firm increase or decrease its level of output?

Question 2: Why do you not observe managers trying to measure marginal revenue and marginal cost?

Review activity 5.8

Examine your own industry. Pick one model of competition which best describes your industry. Explain the model and justify why you think the model best describes your industry.




The multiple-choice questions for this unit will enable you to test your knowledge and understanding of the key concepts covered. (Blackboard > Module Site > Formative Exercises > Multiple-Choice Questions > Unit 5).



Before the tutorial a short article will be posted onto the module Blackboard site which raises issues from Units 3, 4 and 5 (Blackboard > Module Site > Module Materials > Collaborate, to gain access to the article). A set of questions will accompany the article. Please read the article and prepare answers to the questions posed.




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Question 1: How is the merger likely to affect competition within the industry?

Question 2: Is it always the case that fewer firms in an industry is bad for competition?

Question 3: If there is a similar merger involving two large players in your industry how would your firm react?

(Hint: You should think about the type of competition you face and how that affects your demand.)

Question 4: Apart from lowering price what else might you consider to help with competition?

References

England, A (2015) Africa’s supermarket shopping revolution. Financial Times, 24 July. http://www.ft.com/cms/s/0/6c0f2576-30b3-11e5-8873-775ba7c2ea3d.html#slide0. Accessed 26 August 2015.

PART II:

MACROECONOMICS

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Unit 6:

Introduction to

Macroeconomics





Introduction

The macroeconomic environment is ever changing. New policies or agreements are continually being made (for example, the current negotiations over the Trans-Pacific Trade Partnership), adjustments to key economic variables (for example, interest rates) are announced, and almost daily some evidence is reported about the present state of the economy. But what does all this indicate? For firms, it is the recognition that not only must they respond to internal change and to changes in trading relationships, but also to the changing macroeconomic environment in which they operate. For example, what are the implications of high or unstable exchange rates? What are the implications of increasing world trade flows and international competition? How does monetary/interest rate policy affect the well-being of firms? Similarly, as individuals, we must recognise the importance of the macroeconomic environment to our everyday well-being. Our ability to gain employment or our potential for a sustained increase in our standard of living are both factors influenced to some extent by macroeconomics.

In this unit, we introduce some of the key macroeconomic concepts and introduce a conceptual framework which we will develop in Unit 7.


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Objectives


highlight the importance of macroeconomics to businesses and individuals

identify the key economic issues and problems in macroeconomics

develop a framework in which to understand the workings of the macroeconomy

be familiar with concepts such as GDP, economic growth, balance of payments, inflation, unemployment, fiscal and monetary policy, the circular flow of income, aggregate demand and supply.

Economic targets


Every government, regardless of its political persuasion, aims to achieve:

low inflation

low unemployment

healthy balance of payments

healthy economic growth.

Each government may differ in the priority attached to the objectives and indeed in the methods and policies used to achieve them. The main difficulty for the government is that it is hard to achieve all these objectives at the same time. Reducing inflation may very well lead to increased unemployment and slower economic growth. Reducing unemployment may be at the expense of rising inflation and increased difficulties with the balance of payments.

Main macroeconomic policy tools

The government can use either fiscal or monetary policy.

Fiscal policy involves the use of taxation and government expenditure.

Monetary policy uses the manipulation of interest rates and policies to influence the money supply.

Unit 6: Introduction to Macroeconomics

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Inflation

Inflation means the general rise in prices. It is expressed as an annual percentage increased and is calculated using the consumer price index or the retail price index (RPI). The products that are priced every month are weighted in order to represent the importance in terms of spending. Quite clearly, an increase in the mortgage rates or cost of electricity is far more important to a household’s outlay each month than a doubling in the price of a box of matches. Inflation means that the pound in your pocket is worth less than it was a year ago in terms of what that pound will buy.

Why is inflation important?

We all feel aggrieved that we pay much more for a product than we did when we were younger; however, there are a number of other important problems associated with inflation. Inflation brings uncertainty to the business environment and business does not like uncertainty. Uncertainty will, ceteris paribus, reduce the amount of investment in the economy and, as such, affect the level of economic growth.

Inflation may bring unemployment. If the UK domestic inflation rate is higher than that of its international competitors, then its goods will face a general reduction in demand. This will cut firms’ profit margins and they will cut back production. This will inevitably lead to a reduction in employment. This reduction in the demand for products will result from UK exports being relatively more expensive and imports into the UK being relatively cheap.

Inflation affects our standard of living. We all feel worse off and so the wage bargaining process is affected. People on fixed incomes such as pensioners and welfare recipients find themselves becoming worse off. Savings become worth less, although the size of borrowers’ debts becomes worth less in real terms. Generally, these factors add up to a more turbulent and riskier economic environment.

What causes inflation?

Inflation can be caused by three main factors.

Cost-push: this type of inflation may result from an increase in the price of a raw material or component. Or it might arise from an increase in the price of a factor of production such as higher labour costs or an increased cost of machinery or higher council tax. An increase a the firm’s costs that is not matched by increased productivity leads to increased costs of production. Firms respond by pushing up prices to maintain profit margins.


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Keynesian demand-pull: this kind of inflation is caused by the aggregate demand in the economy being too great and, subsequently, pulling up prices. Aggregate demand consists of all the spending in the economy: government, consumer, investment and export expenditure; we examine this in more depth later. If the aggregate demand exceeds the ability to supply output, then the demand pulls up prices.

Monetarist demand-pull: this inflation originates in the excess growth of the money supply. If the amount of money in the economy exceeds the supply of products, prices are pulled up. For example, assume the economy only produces red socks, the amount of money in the economy is £200 and there is an output of 100 pairs of socks. Each pair costs £2. If the money supply is doubled and the production of red socks remains unchanged, then £400 will be chasing the red socks.

The likely outcome will be an increase in the price of red socks to £4 per pair. The money supply is doubled and the price level is doubled.

The difference between the Keynesian demand-pull and the monetarist demand-pull lies in the starting point. Roughly speaking, monetarists believe that inflation stems from an increased money supply; Keynesians believe that the money supply changes to accommodate the level of demand and spending in the economy. We examine both these issues in more depth later.

In reality, inflation is probably a feature of all three causes. They may differ in emphasis and detail, and they may change according to different economic times and circumstances, but essentially they may all be factors causing inflation.

Tackling inflation

Inflation can be tackled in a number of ways depending on the economist’s view about what caused the inflation in the first place.

Tackling cost-push inflation

The aim is to keep firms’ costs down. If wages are too high, then wage restraint is urged. The message is that wages should only increase as fast as productivity allows. The success of this policy depends upon the willingness of firms and unions to accept it, and the government would not

wish to resort to an incomes policy. If raw materials are increasing in price and this is fuelling the inflation, then the government could increase interest rates. As we see later, increasing interest rates has the effect of making the pound stronger on the foreign exchange market. Since firms in Britain import a lot of raw materials, the higher exchange rate will reduce import prices and subsequently dampen cost-push inflation.


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Tackling Keynesian demand-pull inflation

Keynesians believe inflation is caused by too much demand. So the solution is to reduce demand. This can be done using contractionary fiscal and monetary policies. We explore these ideas further in Unit 7. Basically, contractionary fiscal policy means increasing taxation or reducing the growth of government spending. If tax is increased, consumers have less disposable income and so there will be a general reduction in demand which will slow down the rate of price increases. Additionally, higher interest rates will make credit spending more expensive and so cut expenditure on credit-related goods. Another feature of higher interest rates is that consumers may save more as the opportunity cost of spending becomes higher and, after paying the higher mortgage rate, etc, we have less money to spend.

Tackling monetarist demand-pull

Monetarists believe inflation is caused by the excess growth of the money supply, so the solution is to cut the growth of the money supply. This can be done by restricting the banking sector’s ability to increase credit in the economy.

Which solution is the best?

The best solution is one that uses elements of all three approaches. If inflation can be caused by different factors that vary in importance according to time and circumstance, then the best solution is one that recognises this fact and incorporates the best elements of each method to make an integrated anti-inflation strategy.

Unemployment

Unemployment may be defined as the difference between the number of people willing and able to work at the prevailing market wage and the number that have jobs. To classify as unemployed for the purpose of government statistics, an individual must be entitled to benefits.

Why is unemployment important?

The cost to the unemployed individual may be harmful. Unemployment can lead to a greater strain on social services due to the social problems that may arise from depression, etc. If there is a greater amount of crime and vandalism in times of high unemployment, then a greater strain is placed upon the police and the legal system. Although as economists we might feel sympathy for the problems that unemployment brings, we are more concerned with financial cost to the government and the opportunity


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cost of the money allocated to tackling the social problems that arise from greater unemployment. Not only does the government have to allocate vast resources to the problems that unemployment brings, it also loses out on the extra tax revenues it would have received had the unemployed been working instead.

In addition to these financial implications, society has lost out on a vast amount of goods and services that would have been produced if everyone had been working. These extra goods and services would have enhanced the standard of living and contributed to government popularity. Think about the production possibility frontiers at this point.

Unemployment affects everyone, not just the unemployed. Think of the opportunity cost and the effects on income tax if there was less

unemployment. Or, consider how tax revenues could be switched to reducing the length of hospital waiting lists and teacher-pupil ratios.

What causes unemployment?

The classical view and monetarist view

Classical economists, whom we can refer to as the pre-Keynesians for the purpose of this unit, believed unemployment was caused by excess wages in the labour market. If we consider Figure 6.1, the equilibrium market wage would be w1 and the number of people employed would be n1. However, if the wage level was w2 then the firms would cut back their demand for labour to point n2. The higher wage would attract a labour supply of n3. According to the theory of how a free market operates, wages would fall to the equilibrium at w1 and this would sort out the surplus labour. The falling wage will allow firms to increase the number of workers until an equilibrium is reached.

Figure 6.1: Workers and wages


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If wages don’t fall, the pre-Keynesians would say that unemployment is caused by labour market imperfections. Whatever is causing the disequilibrium would then be looked at as a cause of unemployment.

Monetarists would also stress that unemployment results from inflation and, therefore, inflation needs to be tackled as the number one priority. Consider how that argument works from our discussions on inflation.

Monetarists would argue furthermore that some unemployment is caused by a combination of benefits and income tax being too high. They argue that if this situation occurs, there is little incentive to work since the gap between disposable income (income after tax) and the income on benefits is too narrow.

Keynesian view of unemployment

Keynesians believe that unemployment is caused by a lack of demand in the economy. Keynesians base their ideas on the work of John Maynard Keynes who wrote a very influential book, the title shortened to The

General Theory, which was published in 1936. Keynes was writing during a period of high unemployment and when the government’s approach was based on classical views that wages were too high. Keynes turned economic theory on its head and came up with an approach to unemployment very different to the orthodoxy of the day.

The Keynesian solution to unemployment

If unemployment was caused by a lack of demand, the solution was to increase demand. Left to its own devices, the economy would not return to an equilibrium that involved full employment and so the government has a responsibility to intervene. The government would need to inject money into the economy and Keynes referred to getting the unemployed to dig holes and fill them in again. Keynes was highlighting that it did not matter what the unemployed did provided there was an increase in spending ability in the economy. If people had more income, they would spend more, which means that firms would sell more, which means they would need more workers, etc. Keynes realised that the solution to unemployment was a lot more complicated than this in the real world, and we shall study this in more depth in Unit 7.


Considering the Keynesian summary, can you highlight all the potential problems with this approach to tackling unemployment?


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Classical and monetarist solution to unemployment

As we have already seen, the classical economists believed wages should fall to restore a full employment labour market equilibrium. Monetarists would agree with this prescription and believe that the union power should be reduced to allow the labour market to work more effectively. In addition, monetarists are extremely sceptical about the Keynesian solution believing that spending more money would just lead to further inflation. Monetarists would stress that the most effective way to reduce unemployment would be to reduce inflation first. If we have lower inflation, then our goods and services will sell more easily and so we will require more workers. In addition, if benefits are lowered and tax is lowered there will be a greater incentive to work and voluntary unemployment would fall.

Which is the best solution to unemployment?

Well, both of the different schools of thought have their merits. A government need not be dogmatically monetarist or Keynesian. It can pragmatically take the best parts of both approaches. Maybe some unemployment is caused by excessive wage growth (if wages are growing faster than productivity) in some markets, some unemployment might

result from a generous level of benefits or excessive taxation reducing incentives to work. Unemployment might result from a lack of international competitiveness due to high inflation. Unemployment might also stem from a period of recession, in which case lack of demand may be the most significant problem to put right.


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In summary, unemployment may be caused by a number of factors and the best solution may vary over time and circumstance. The best solution may be a combination that varies in emphasis and detail and may need to be part of an international approach in today’s global economy.

Healthy balance of payments

The balance of payments measures the flow of money into and out of an economy and reports the overall position as a net inflow. A negative balance of payments means more money is leaving the country to pay for imports than is being received as payments for exports. The balance of payments is influenced enormously by the exchange rate, and the exchange rate is influenced enormously by the demand and supply of

imports and exports.

Is healthy better than a surplus?

At first it might seem strange to suggest that healthy is more important, since a surplus means more money coming into the economy and, hence, a more prosperous situation for successful firms and consumers. But, it depends on what has caused the surplus. If the economy relies on importing raw materials from abroad, then a balance of payments surplus might have been caused by a lack of production in the economy, and this might adversely affect the balance of payments in future. A resurgent economy may be one which has a massive demand for imported raw materials and hi-tech machinery, which may cause an initial deficit but provide a healthier outlook for the future.

Exchange rates

A high exchange rate means imports are relatively cheaper and exports are relatively more expensive. If imports are cheaper, then firms face lower costs of production (for example, cheaper raw materials) and this may be good for reducing cost push inflation. But, cheaper imports and more expensive exports may be bad for businesses that are competing in the world marketplace and reduced demand for domestically produced goods could lead to unemployment. A low exchange rate means imports become relatively more expensive and exports become relatively cheaper.


Explain the consequences of a low exchange rate, using the above explanation to help you.


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Can the government influence the exchange rate?

The chief method of government influence used to be through interest rates. If domestic interest rates were increased above rates in other countries, ‘hot money’ would flow into the economy. Hot money is globally mobile capital that can flow around the world to wherever its investment will yield the best return. This would increase the demand for the currency and so the exchange rate would increase. Hot money is growing as economic development brings opportunities and finance becomes ever more globally minded. Interest rates are generally set by an economy’s central bank, in order to provide a more stable and predictable environment within which firms can make their investment decisions.

Healthy economic growth

Economic growth means an increase in the value of output of goods and services over the last 12 months. It can be measured in a number of ways, such as:

GDP: gross domestic product is the value of all the goods produced within a country’s borders by domestic firms.


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GNP: gross national product is the value of output produced by an economy’s firms, whether at home or abroad.

As we shall see shortly, economic growth can be measured through calculating national income in one of three ways:

income method

expenditure method

output method.

Why is economic growth good?

A society experiencing economic growth will enjoy a general increase in its standard of living. The society has a production possibility frontier (PPF) moving outwards and there is a greater availability of goods and services, which improves material wealth. The electorate feels wealthier and this allows the government to bask in the glow of public opinion. Not everyone is better off, society has inequalities that continue or may even be exacerbated by economic growth.

Economic growth brings more general prosperity. Firms are doing well, consumers are doing well, the government also does well. If firms are selling more products or services to wealthier consumers, then revenues and profits will be healthy. If consumers are earning more, they can spend more money on holidays and other luxuries. If workers are earning and spending more, the government gets more income through taxation. This gives the government a greater amount of scarce resources to allocate in the economy to develop its popularity, etc.

What causes economic growth?

Investment, investment, investment !!!

There are a number of factors that help economic growth:

a good well-researched product

a well-developed production process

an innovative approach

a stable economy within which decisions can be made with confidence

helpful government policies

successful government management of the macroeconomy.

Put these factors together for your country and compare the result with the combination of factors enjoyed by the Germans, French and Japanese.


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Question 1: Why does a country enjoying economic growth find it easier to generate economic growth in the future? Why do underdeveloped economies feel that they are falling further behind?

Question 2: For essay practice, briefly outline the importance of the government’s main economic objectives. Assess why it is difficult to achieve them all at the same time.


Circular flow of income


The basis of macroeconomics is that ‘one person’s expenditure becomes another person’s income’. Looking at the circular flow of income provides us with the opportunity to assess how income and expenditure flows around the economy. In addition, it allows us a simple overview of how government injections and leakages influence national income.

Following the traditional economist approach of keeping things as simple as possible to begin with, let’s imagine an economy with no government, no trade and no financial institutions. In addition, households spend all that they earn. This can be represented in Figure 6.2.


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Figure 6.2: Circular flow of income

Firms produce goods and services, which they sell to households. The households supply labour and other factor inputs like land and capital to firms in return for income, which they then spend on the output produced by firms. In this example, quite clearly we can identify that:

Income = Output = Expenditure

There is no pressure for national income to change. The money just continues to flow around the economy. This simple diagram also suggests that there are three different methods of calculating national income: income method, output method and expenditure method. All should give the same answer, since they are just alternative ways of looking at the same thing.

If we begin to make the model more realistic by accepting that consumers save, buy imports and pay tax, we can include the role of financial institutions, the government and international trade. This can be demonstrated in Figure 6.3, which has a number of important points to examine before we begin to tie up the loose ends of the circular flow.

Households

Firms

WagesSpending Labour Goods and

services


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Figure 6.3: Circular flow of income in the real world

Injections into the circular flow

Injections are autonomous expenditures that enter the circular flow. They increase the income flowing around the circular flow and include:

investment expenditure

government expenditure

export expenditure.

Leakages from the circular flow

Leakages are those parts of income not passed on in the form of expenditure on domestic output. The money withdraws from the circular flow through:

savings

taxation

import expenditure.

If injections are greater than withdrawals, then national income will increase. As national income increases, the ability to save, pay tax and

buy imports increases. The national income will increase until the planned leakages are equal to planned injections. If there is a sudden increase in a leakage then national income will fall, reducing the ability to save, pay tax and buy imports. The income will fall until the economy is back in equilibrium. We consider these arguments in depth in the Keynesian theory of national income in Unit 7.

Households

Firms

Income Spending

Imports

Savings

Tax

Government spending

Investment

Exports


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Read the following scenario and answer the questions that follow.

China seeks to allay renminbi slide fears

The People’s Bank of China on Wednesday sought to dispel fears of a prolonged fall in the renminbi, intervening to prop up the currency after a shock devaluation spread alarm through global markets.

The Chinese currency had fallen by as much as 2 per cent earlier on Wednesday to a low of 6.45 per dollar, before the authorities stepped in to buttress the renminbi, which rallied 1 per cent in the final 15 minutes of the trading day to 6.38 versus the dollar.

China’s decision to tolerate a weaker currency has fanned concerns that its economy, long an engine of global growth, is slowing much faster than previously thought. Investors also worry that a sustained decline in the renminbi and competitive currency devaluations across Asia could have a deflationary effect, which would further weigh on global economic prospects.

However, some have also pointed to China’s recent disappointing trade figures and other worsening economic indicators as reasons for the currency devaluation. Chinese exports tumbled 8.3 per cent in July year-on-year, worse than economists had expected.

While the renminbi had been roughly flat against the dollar this year until this week, it had risen sharply against other currencies of key trading partners, notably the euro and the yen. That appreciation has come in spite of the slowdown in growth, record capital outflows and four cuts to benchmark interest rates in the past year.

(Source: Noble and Wigglesworth 2015)

Question 1: Why might the devaluation of the renminbi increase the amount of money circumnavigating the Chinese circular flow?

Question 2: How else might China have had the same effect on the circular flow without changing the exchange rate?


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Summary

In this unit, we have introduced the macroeconomy and the clear idea that much of what happens in the economy is interconnected, and that there will always be a number of important consequences for any given change in government policy. You should have a reasonable grasp of the interdependence of the government’s economic objectives. The next unit will build upon this introductory work and extend our understanding of how different economists believe that the government’s objectives should best be achieved.


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Review activity 6.5

This exercise is based on the national income of an imaginary country. It is important to remember not to double count. Double counting occurs when the same part of national income is counted twice. For example, suppose a firm takes component products for £2 and adds these to a finished product which sells for £5. The firm has added £3 of value to the product. The total value added in the economy is £5, £3 from the second firm and £2 by the first firm. Double counting would have given an answer of £7. Before tackling the activity, think carefully about what you expect to find. Check back to the circular flow diagram in Figure 5.2 if you are unsure.

Imagine a closed economy that consists of just six firms: Farm, Mine, Flour Mill, Iron Works, Bakery and Oven Factory. Each firm’s basic accounts are as follows:

Farm (produces wheat) Sales £20,000 Wages £10,000

Profit £10,000

Mine (produces iron ore) Sales £16,000 Wages £8,000

Profit £8,000

Flour Mill (produces flour) Sales £50,000 Wages £15,000

Profit £15,000

Wheat £20,000

Iron Works (produces iron) Sales £36,000 Wages £10,000

Profit £10,000

Iron ore £16,000

Bakery Sales £170,000 Wages £40,000

Profit £80,000

Flour £50,000

Oven Factory Sales £70,000 Wages £24,000

Profit £10,000

Iron £36,000

Now work out the national income using the:

output method

income method

expenditure method.


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Activity 6.6– lecture slides and audio




References

Noble, J. and Wigglesworth, R. (2015) China seeks to allay renminbi slide fears. Financial Times, 12 August. http://www.ft.com/cms/s/0/8405dc04-40a0-11e5-9abe-5b335da3a90e.html. Accessed 8 August 2015.

http://www.ft.com/cms/s/0/8405dc04-40a0-11e5-9abe-5b335da3a90e.html

http://www.ft.com/cms/s/0/8405dc04-40a0-11e5-9abe-5b335da3a90e.html

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Unit 7:

Evaluating Government

Economic Policy

Key reading: 1. Begg, D. and Ward, J. (2013), Chapters 11, 12 and 13





4. Unit 7 marked formative assessment (Blackboard > Module Site > Formative Exercises > Marked Formative Assessment > Unit 7) – Activity 7.12

Introduction

Regulating the macroeconomy is based on a firm belief that governments are best placed to intervene in the running of the economy. Obviously, this is a controversial view in its own right, and some economists argue that the economy is best left alone to be regulated by the market. Whatever your view, governments do play an important role in regulating the economy in order to achieve their stated objectives.

In this unit, we examine the government policies that are used to regulate the economy. We assess how realistic the theoretical arguments are likely to be in practice. We start by developing the Keynesian model of how the

economy works and discuss some of its limitations. We move on to examine how the government can use a combination of demand and supply side policies to best manage the economy. This will require the introduction of an aggregate demand and supply framework so that we can assess the impact of government policy.


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Objectives


understand the Keynesian theory of unemployment and inflation

outline the limitations of the Keynesian demand management approach to unemployment

evaluate the use of fiscal and monetary policy

investigate the Phillips curve and how its apparent breakdown with stagflation gave support to the monetarist criticism of the Keynesian approach to managing the economy

debate the use of demand and supply side policies.

Keynesian theory of national income

Read: Begg and Ward (2013), Chapter 11

Keynes believed very strongly that the government had a responsibility to intervene in the economy if it was to achieve its economic objectives. Keynes set out to demonstrate exactly why the economy, left to its own devices, would not bring full employment. In order to do this, he developed the model that we now examine.

Pre-Keynesians believed that spending and savings decisions were primarily influenced by interest rates. When interest rates were high, savings would be high and spending would fall. Keynes recognised a relationship but felt that income was a far stronger determinant of consumption and saving. For Keynes, this idea was crucial and it had important repercussions for how he viewed the workings of the economy. We can build upon the work concerning injections and leakages in Unit 6. Keynes made an assumption that the injections were autonomous and not related to income. The leakages were income related. Consider Figure 7.1 showing planned injections and planned leakages.

Unit 7: Evaluating Government Economic Policy

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Figure 7.1: Planned injections and leakages in the macroeconomy

At point yx, the planned injections and planned leakages are in equilibrium. There will be no pressure for national income to change. At yz, planned leakages exceed planned injections and at yy, planned leakages are less than planned injections.

Consider point yz in more detail. Planned leakages are greater than planned injections. Remember planned injections are drawn as a horizontal line since the injections are assumed autonomous. If planned leakages exceed planned injections, there will be less total expenditure in the economy on goods produced by domestic firms. Firms find that they sell less and their stocks of unsold goods start to accumulate, with firms investing in effect in their own stock. Firms react to this situation by laying off workers and so national income starts to fall. As national income falls so does the ability to save, pay tax and buy imports. Income will fall until the planned injections are equal to planned leakages again at point yx. Keynesians point out that the economy has returned to equilibrium but that this equilibrium has a level of unemployment attached.

Pre-Keynesians believed that unemployment would only occur if there was a situation of disequilibrium. For Keynesians, equilibrium occurs when

Total planned expenditure = Total income/output

And when Planned injections = Planned leakages

So, what is the main idea here? This demonstrates that Keynesians believe that national income changes to restore equilibrium in the economy but that this equilibrium can have a level of unemployment attached. Therefore, if left to its own devices the economy does not give full employment, and it becomes the government’s responsibility to intervene.


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Question 1: Using Figure 7.1 and the associated analysis to help, can you explain what happens when the economy is at point yy?

Question 2: If unemployment needs to fall what should happen to injections?

Question 3: Can you redraw Figure 7.1 but this time with a new planned injection line called planned injections 2 that gives a new equilibrium at point yy?


If you can answer these three questions then you are already some way towards understanding the next part of the Keynesian model. At yy the planned injections exceed the planned leakages in the economy. Spending increases, firms find their stocks become depleted so they take on more workers to increase production. National income increases and so does the ability to save, pay tax and buy imports. National income will increase until the planned leakages are equal to planned injections and the economy is back in equilibrium at yx.

If unemployment exists at yx and we want it to fall then the government should increase autonomous injections until we have full employment equilibrium at yfe. This is demonstrated in Figure 7.2.


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Figure 7.2: Keynesian model

Keynesian solution to unemployment revisited

Keynes believed there should be an injection of government spending into the economy to increase aggregate demand. The greater spending that would result in the economy would increase national income up to the point when planned injections equal planned leakages again.

Aggregate demand = Consumer + Investment + Government expenditure + (Exports – Imports)

AMD = C + I + G + (X – M)

Consider Figure 7.3. The current level of expenditure AMD1 gives an equilibrium output/income of yx. Unfortunately this equilibrium carries with it a level of unemployment. We wish to be in equilibrium at yfe. If there is an increase in government expenditure, the AMD increases from AMD1 to AMD2. This new level of expenditure raises the national income to give a full employment level of national income at yfe. The increased government spending has closed the deflationary gap. The deflationary gap is the amount by which expenditure is short to give full employment equilibrium.


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Figure 7.3: The deflationary gap

The multiplier

The increase in government expenditure will increase national income by an amount greater than the value of the injection. The multiplier stems from the idea that if the government injected £40 million, say, by giving the unemployed lots of money, then they would spend it which creates income for someone else which is spent etc. If the government’s injection raised national income by £200 million, then the multiplier would be 5.

Injection times multiplier = Change in national income

£40 million × 5 = £200 million

If the government knew the size of the multiplier and the increase in national income required, then it would know how much to inject. However, this is easier said than done! The multiplier raises national income by an amount that will generate additional leakages so that planned injections equal planned leakages again at equilibrium.

Problems with Keynesian theory

Many of the problems identified with the Keynesian solution to unemployment were identified by Keynes himself. You will have identified some of the problems in Unit 6. We discuss each problem in turn.

1. Where does the money come from? The government could raise tax to finance the expenditure, but the outcome would be public sector spending replacing private sector spending (crowding out). The government could borrow by selling treasury bills at good rates of


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interest, but this might reduce private sector investment if interest rates increase too much (financial crowding out).

2. What would happen if a lot of the extra spending in the economy goes on imported luxuries from abroad? The extra jobs made available by the injection may be created in foreign countries as a result. In the UK, for example, there is a high marginal propensity to import; consumers spend a lot of the country’s increasing income on imported goods.

3. What would happen if in the face of higher domestic demand, firms cannot increase output quickly enough? The result would be inflation. Firms might not have sufficient spare capacity to increase output and may not be willing to undertake the extensive investment required to meet the new demand unless they have the expectation that the new

level of demand will be long term and sustained.

4. There are crude elements in the Keynesian tools themselves. Working out the amount to inject, understanding the extent of time lags and the general difficulties of gathering up-to-date and accurate statistics mean that the ‘goalposts keep changing’.

5. In a dynamic world economy, the success of domestic government policy relies on the co-operation and complementary policies of international competitors and trading partners.


Using these five points to help you, can you draw up the dream Keynesian scenario if the policy for reducing unemployment is to be effective? This will be helpful for the analysis we shall undertake later in the unit.



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Monetarist criticism of the Keynesian approach

The monetarists focus upon two main arguments. Firstly, the financing of the extra government expenditure just leads to ‘crowding out’ in the marketplace. The increased taxation or higher interest rates used to obtain funds reduces private sector spending. Secondly, the injection of government expenditure just leads to inflation.

The basis of the monetarist argument lies in their view of money supply. Monetarists argue that the only way the government can finance its extra injections into the economy is through increasing the money supply. This inevitably leads to inflation, since money is used as a means of exchange. This pulls up prices, since firms’ output decisions are influenced by interest rates and not the artificial demand created by expansionary government

policy. The monetarist way to reduce unemployment is to reduce inflation first. Remind yourself of the other monetarist arguments about unemployment covered in Unit 6.

Keynesian response to this criticism

Keynesians believe that the monetarists have oversimplified the argument. They argue that rather than the money supply determining price, the direction of causation is the other way around. Namely, the money supply changes to accommodate the level of spending taking place in the economy. In addition, any influence that increasing the money supply has on the economy is unlikely to fuel inflation if spare capacity exists. In addition, money can be used for purposes other than as a medium of exchange. Keynesians believe that inflation can be caused by excessive growth of the money supply, but that it is far more complicated than the simple causal relationship identified by the monetarists. In reality they argue, inflation can be caused by a combination of factors that include the excess growth of the money supply, but can also include cost-push factors and excess aggregate demand.

Further Keynesian views on unemployment will be covered shortly in this unit. But first we look at the Keynesian view of inflation and the Phillips curve.

Keynesian view of inflation revisited

Keynesians believe that inflation can be caused by cost-push factors in addition to demand-pull. When explaining demand-pull, we can adapt Figure 7.3 which we used to explain how unemployment is tackled. Inflation here is caused by the notion that demand in the economy is too great for the available supply of output. Or to put it another way:

AMD or C + I + G + (X – M) exceeds supply


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Consider Figure 7.4. The current level of expenditure in the economy is AMD1. This would give an equilibrium level of income/output at yx. Unfortunately, the economy does not have the ability to produce this level of output. When everyone is working the maximum output is yfe. The current expenditure exceeds the full employment expenditure by the amount ab. This is called the inflationary gap. Spending needs to decrease to reduce AMD1 to AMD2, to close the inflationary gap and give a full employment level of income/output.

Figure 7.4: Inflationary gap

Economic policy tools

The government can use fiscal policy, monetary policy and direct controls. These controls include:

expansionary policy

– reduce taxation or increase government expenditure

– decrease interest rates in the economy

contractionary policy

– increase taxation or reduce government expenditure

– increase interest rates in the economy.


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Why do you consider expansionary policy is preferable for a government?


Monetary policy

Monetary policy generally involves:

increasing or decreasing the money supply

reducing or increasing the rate of interest

removing or imposing controls on the flow of credit.


Money, banks and money supply

To understand the monetarist position it is necessary to define money. Money is a good, it is traded for other goods and services, but it is unique in that everyone understands its value. When you sell your old textbooks you might use the proceeds to enjoy a nice meal. However, if you tried paying for the food using the books you would quickly be turned away. Without money these transactions could not take place. It is this importance of money that means that everyone has an interest in its value.


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The amount of money in the economy is always changing, particularly because of banking. When a bank accepts a deposit it will then seek to lend a percentage of that money to someone else. For example if a depositor places £1000 into their account and a borrower takes £800 on loan both will think they have money. The depositor still considers themselves to have the full £1000, and the borrower will be able to spend £800. This leads to the measures of money in the economy moving beyond the number of notes and coins in circulation.

Table 7.1: United Kingdom money supply in June 2015

Narrow measure of money Notes and coins £65bn

+ Retail deposits £1472bn

+ Wholesale deposits £574bn

= M4 £2106bn

(Source: Bank of England)

Since the financial crisis the requirements on the amount of deposits that banks must hold as reserves has increased, meaning the amount which may be lent out has fallen. This has resulted in a reduction in available credit and is held by some as responsible for slowing economic recovery.

Banks themselves do not need to achieve balanced books as they are able to trade excess deposits, or fund excess loan demand, by going to the interbank market. Here the central bank acts like a bank for all of the other banks, providing them with loans, or accepting their deposits. The interest rate in operation here is set by the central bank and is heavily linked to the policy rate. For the UK, the rate is the London Interbank Offered Rate (LIBOR). Because of this reliance on trade with each other, it is possible for the central bank to have a great deal of influence on the commercial banking sector.

Money being created by the banks can be seen as a concern, since it is outside the government’s control. However, it will have a positive impact on the economy, provided borrowers invest well. The extent to which bank lending generates new money is known as the bank multiplier, and follows the same idea as the other multipliers. When a borrower invests in a business and then pays wages to workers, those workers will save some of their wages, opening up funds to lend to someone else, but still essentially using the money from the initial deposit. In our example the initial borrower put in £1000, the borrower took £800 and this might then be paid to a builder to build a factory, or a worker to increase production. If that worker puts £400 back into the bank, then there will be £320 for lending to another borrower.


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Banks role within the economy can thus be summarised as:

liquidity – helping economy flow smoother by linking those with spare funds with those who need money to invest

risk pooling – depositors funds are pooled before lending, leaving each saver less exposure to risky projects

risk selection – deciding who to lend money to, and monitoring the risks taken through regular screening

risk pricing – rates offered on loans reflect project risk.

Many regulatory issues are raised, especially given banks are able to ‘create money’ and that lending to failed projects can exposed depositors to risks of losing their money. The financial crisis, and bank funding of

subprime loans, meant many savers suffered exactly the loss of funds that they should be protected against.

Demand for money

People want money for many reasons, not least paying for goods and services. Money can also be held in case we need it, or because it is safe compared to investments that might lose value. These motivations are known as transactional, precautionary and asset motives, respectively.

Money market equilibrium

Figure 7.5: Money market equilibrium


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Continuing the money supply discussion, with money demand we reach the money market equilibrium in much the same way that we did for the product market equilibrium in Unit 4. The interest rate serves as the price of money. Higher prices mean that you want to borrow less. Money supply is treated as inelastic because it is the central bank that has ultimate control, recognising the money multiplier effect.

Monetary policy can intervene by:

changing the money supply

raising the interest rate, so that the market then determines supply.

More recently a large amount of focus has been placed on quantitative easing, the central bank buying government bonds to inject money into the

economy. The bank then owns the high-quality bonds and it can theoretically sell them later.

Setting interest rates also allows the bank to influence the wider economy, but this takes time. The process of feeding through is known as the transmission mechanism. As well as the direct effects the bank rate indicates what they expect to happen to inflation, consumers and firms will monitor this when making economic decisions. Should consumers believe conditions are better for saving then they will do so, but should rate falls be likely a credit culture will begin to build up. The consequential changes in consumption, the opportunity cost of saving, will then impact on the GDP of the economy. Firms will have a longer term outlook but the idea is the same, lower interest rates promote investment whilst high interest rates see measures being necessary to deal with reduced demand and reduce the amount of money owing to avoid interest.


In the United Kingdom interest rates are set by the Bank of England’s Monetary Policy Committee (MPC) independently of the government. Minutes from MPC meetings are published allowing readers to form an impression of likely future changes.

Question 1: Why might independence from government help the bank set more economically suitable interest rates?

Question 2: UK inflation is low, but the economy is recovering (growing) after the financial crisis. Why would MPC members feel a rate rise is likely soon?


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Activity 7.5 – research

Research these terms and comment briefly on how they have been made relevant in the recent austerity (balanced budget) approach to economics.

Balanced budget

Budget surplus

Budget deficit

National debt

Public sector net cash requirements (PSNCR) or public sector borrowing requirement (PSBR)

Activity 7.5 – research answers:


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Fiscal or monetary policy, which is best?

The best response to this question is: ‘it depends’. It depends on whether you are a monetarist or a Keynesian; it depends on the situation the economy is in at any particular point in time; and, in any case, it may be that both policies could best be used in conjunction with each other.

The Keynesian view

Keynesians have a preference for fiscal policy, although they also find monetary policy to be supportive. Keynesians prefer fiscal policy because they believe it to be more direct and the outcomes a little more straightforward to predict.

When expanding the economy, Keynesians would increase government expenditure or reduce tax. Increasing expenditure allows the money to be targeted more effectively, since the government does not know what consumers will do with their extra disposable income if taxation is reduced. Reducing interest rates would also be helpful but cannot be relied upon. Keynesians believe that expectations about future demand and profit are more important than lower interest rates when firms are choosing to invest. However, lower interest rates might just persuade the firms on the margin of doubt about whether to invest or not. In addition if interest rates fall, think of the likely consequence for interest payments on the national debt. Also consider the opportunity cost of the lower interest on the national debt.


Using this explanation, outline how the Keynesians would use contractionary policy. Why would higher interest rates not necessarily deter a firm’s investment expenditure?



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The monetarist view

Monetarists have a preference for monetary policy although they are not averse to using fiscal policy in a contractionary sense. When expanding the economy, monetarists would use neither expansionary monetary or fiscal policy. They believe the economy should be left to free market forces and that the government’s role is to create the right conditions for the free market to flourish. Expansionary policy just leads to inflation.

When contracting the economy, monetarists would wish to control the growth of the money supply. One of the methods of doing this is to increase interest rates. Put in simple terms, if interest rates increase consumers might save more, or spend less on credit or may shift resources out of their bank is and into high interest government bonds. If

we take our money out of the bank, this reduces the bank’s ability to create credit and as such the money supply growth will slow down. Contractionary fiscal policy also helps, although increasing taxation is frowned on since it goes against the incentive to work arguments. But reducing government expenditure is helpful since this will reduce the size of the budget deficit. Reducing the budget deficit will reduce the size of the PSNCR or PSBR. Reducing the size of the PSNCR or PSBR will cut the growth of the money supply. Cutting the growth of the money supply will reduce inflation.


Read the following article which has been adapted from the Financial

Times and answer the questions that follow.

US economy: the case (in charts) for optimism

The big question hanging over the US economy is just how strongly it can bounce back from a grim first quarter which saw the weather, a strong dollar and a ports strike all conspire to drag the economy down.

Those, most economists agree, were all temporary factors and the 0.7 per cent contraction therefore a blip. Get ready for a bounce back and a return to growth in the current quarter and through the rest of the year, most economists say. It may even be robust enough growth to justify the Federal Reserve delivering before the end of the year on its much-flagged “lift-off” and the first increase in its policy rate in nine years.

“Today, I come before you as the proverbial two-armed economist,” Bill Dudley, president of the New York Fed told the Economic Club of Minnesota on Friday.


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“On one hand, the economy’s forward momentum has slowed sharply during the first half of the year and inflation remains below the level the [rate-setting] Federal Open Market Committee (FOMC) views as consistent with price stability,” Mr Dudley said.

“On the other hand, I think it is also fair to say that we are still making progress towards our dual mandate objectives [full employment and price stability],” he went on, though he added that even recent solid job gains and a fall in the unemployment rate had occurred “only because productivity growth has slowed markedly”.

(Source: Donnan 2015)

Question 1: Why might the Federal Reserve have a dual mandate of full employment and price stability?

Question 2: How would a rise in interest rates affect the recovery of the United States economy?

Question 3: Why is productivity an important factor in how well unemployment reductions indicate economic growth?



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Updating the Keynesian model

In updating the Keynesian model, we first examine a slightly different way of approaching aggregate demand and supply before adapting the Keynesian argument to take into account the theoretical difficulties we have already examined in this unit.

Aggregate demand curve

Figure 7.6: The aggregate demand curve

Consider Figure 7.6. The aggregate demand curve, AD, gives the total of all goods and services demanded at various price levels. Put another way, the AD curve shows the relationship between the total amount of income/output that will be purchased and the price level. The AD curve slopes in the way that it does for three main reasons.

1. The interest rate effect. This suggests that as prices increase the interest rates in the economy will increase since all lenders will have add an inflation premium to the loan to compensate for the loss in real value of the loan. As interest rates increase, the demand for interest-sensitive goods will fall. Hence, there is a reduction in income/output.

2. The wealth effect. Inflation reduces our purchasing power and we feel less wealthy. We respond by spending less, which reduces income/output.

3. Substitution of foreign goods. The more inflation in an economy, the less competitive the economy’s goods become vis-à-vis foreign competition. Consumers switch from domestic to international producers. This reduces domestic production, and GDP falls.


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The aggregate supply curve

The simple version of this concept shows the aggregate supply curve, AS, as the relationship between real national income per year and the price level. The higher the price level the greater the incentive for the firms to produce. This is shown on Figure 7.7.

Figure 7.7: The aggregate supply curve

If we now put the AD and AS together we find an equilibrium level of prices and national income/output.

Figure 7.8: Equilibrium of aggregate supply and demand

If the government decides to expand demand, you can see the effect on the economy in Figure 7.9.


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Figure 7.9: Changes in the demand curve with increase in demand

The increase in AD shifts the demand curve to the right. This has the effect of increasing national income/output and hence employment but at the expense of higher prices. Whether the reduced unemployment is worth the higher prices is difficult to establish.

If the government decides to go for supply side policies then this picture is changed somewhat.

Supply side policies


These are policies aimed at making the supply of goods and services in the economy more efficient. The policies should increase income/output at each price level. Broadly, supply side policies three types of measure.

1. Introducing more competition into the marketplace by, for example, reducing monopoly power and encouraging competition through privatisation.

2. Making the labour market more flexible. This involves controlling the power of trade unions, improving education and training, and increasing labour mobility.

3. Increasing the incentives for individuals to work and for entrepreneurs to take risks. This could take the form of reductions in income tax and corporation tax.

Supply side policies are essentially microeconomic policies aimed at making the supply of goods more efficient. If they are used to tackle


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unemployment, then a micro-solution is used to tackle a macro-problem. The monetarists embraced supply side policies with a passion. The effect of a supply side policy is shown in Figure 7.10.

Figure 7.10: Supply side policies

Note that the national income/output has shifted to the right; hence, there is greater employment which has resulted from a more efficient supply of goods and services. There is reduced unemployment without inflation. Is this too good to be true? Possibly, say the Keynesians. What if the problem in the economy is mainly lack of demand, as in a recession; who will buy the output? Keynesians suggest an integrated approach that uses both supply side and demand side together. Consider such an approach by expanding demand as much as supply will allow. This is shown in Figure 7.11.

Figure 7.11: Supply and demand side


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Note that the new AD2 and AS2 gives a greater income/output but without inflation. The new income/output is y2. But let’s now deepen the analysis still further. Consider the three scenarios described in Figure 7.12.

1. A situation where there is substantial spare capacity in the economy.

2. The intermediate zone, where some spare capacity exists.

3. A situation where no spare capacity exists.

Figure 7.12: Aggregate supply curve and spare capacity in the economy

In the section of the diagram where substantial spare capacity exists, firms would find it easy to increase supply to meet increasing demand resulting from expansionary government policy. This increase in income/output would reduce unemployment without creating inflationary pressure. This can be seen clearly in Figure 7.13. If there is little or no spare capacity in the economy, then supply is very inelastic. An increase in aggregate demand would lead directly to inflation since firms increase prices rather than output. If this situation existed in the economy, the Keynesian approach to unemployment would be unsuccessful.

The intermediate zone is perhaps the most realistic situation for the economy to be in. Here spare capacity exists for some firms and industries, while other firms and industries are at full capacity. Expanding demand would lead to an increase in income/output and employment. It would also lead to some inflation.

Figure 7.13 suggests that the government’s demand side success is very dependent on firms’ abilities to increase output. If supply side policies are used in the economy, then the supply of output at every price will move to the right. This is shown in Figure 7.14. Note that the new AS2 joins the previous AS1 in the area where no spare capacity exists.


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Figure 7.13: Demand, supply and spare capacity

Figure 7.14: Supply side policies

The final diagram in this model (Figure 7.15) brings the demand and supply side policies together. Pay particular attention to the intermediate area. If you ignore for a moment the other parts of the diagram, do you find something familiar about what is left? You should notice that the intermediate zone is the same as the basic AD and AS diagram in Figure 7.8.

If demand side policy is to be used, it should be in conjunction with supply side policy. Perhaps the government could target expenditure at areas of the economy in which substantial spare capacity exists. In addition, since imports will inevitably increase as incomes go up, government expenditure could be targeted at export firms to avoid balance of payment difficulties.


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Figure 7.15: Demand and supply side policies

Summary

In this unit, we have only touched on a number of issues that need considering when examining how the government can influence economic activity in the economy. You should now be developing an understanding of how the Keynesian model of income allows an explanation of both unemployment and inflation. The role of changing national income is fundamental to an understanding of why Keynesians identify a role for positive government intervention in the economy. We have also examined the use of fiscal and monetary policy and some of the issues surrounding each of these policies. Understanding demand side and supply side policies becomes crucial to an understanding of how modern economists approach the task of achieving economic objectives.

In Unit 8, we focus upon the UK and its role in the international marketplace.

Review activity 7.8

Question 1: Outline the monetarist theory of inflation and discuss the implications of the Keynesian criticism.

Question 2: Outline the Keynesian theory of unemployment and assess the likely success of the Keynesian policies to tackle the problem.


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Listen to the audio for this unit and view the accompanying slides at the same time. (Blackboard > Module Site > Module Materials > Unit 7 > Lecture slides and audio)





In this tutorial we will review a current economic announcement from the Bank of England’s Monetary Policy Committee (MPC). Specific questions for this tutorial will be posted onto the Blackboard site at the same time as the MPC decision information (Blackboard > Module Site > Module Materials > Collaborate). Please review the information and note down answers to the questions posed prior to the tutorial.

Question 1: Why is the decision taken sensible given the prevailing economic conditions?

Question 2: What policies could the UK government follow to achieve the same effect without raising interest rates?

Question 3: Many economists believe that the interest rate will rise through 2016. Does the evidence point to this?

Question 4: Over the coming years what is likely to happen to the UK economy in terms of GDP, inflation and unemployment?

Should the decision be a maintaining of the prevailing rate then question 2 will be altered accordingly. Specific questions will be posted onto the Blackboard site at the same time as the MPC decision information.




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Activity 7.12 – marked formative assessment – macroeconomics

Using appropriate data for your own economy identify the important policy concerns facing your economy. What economic policies might your government use to manage your economy?

Use no more than 750 words and be sure to both demonstrate your knowledge and understanding of economics.

Email your answer to your module tutor, who will advise you via Blackboard (Blackboard > Module Site > Formative Exercises) on the deadline for submissions in order to receive feedback on your work.

References

Donnan, S. (2015) US economy: The case (in charts) for optimism. Financial Times, 5 June. http://www.ft.com/cms/s/0/6985393a-0b92-11e5-8937-00144feabdc0.html#axzz3iu16FL1r. Accessed 8 August 2015.

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Unit 8:

Economics of the

Global Economy





Introduction

It is impossible to talk about a country’s economic well-being and future prosperity without setting it into the context of the global economy. International competition, multinational enterprises, trade agreements and the drive for integration have immeasurably changed the economic landscape. Our aim is to put many of these issues into focus, and to develop an understanding of many of the key concepts in the international economy – the balance of payments, exchange rates and comparative advantage. We move on to show the benefits to be gained from international trade and the cost of protectionist policies. Further, we go on to question the extent of international trade and globalisation. Is it really as far reaching as we think? Finally, we assess the importance of these issues for the future competitiveness of the economy and firms in general.

Objectives

By the end of this unit, you should be able to understand:

the key concepts of international economics

the theory of comparative advantage

terms of trade

how exchange rates are determined and the influence they exert on the economy


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the factors affecting the balance of payments

the debate surrounding protectionism

recent trends in international trade.

Benefits of international trade


International trade has the potential to benefit all participating countries. As the textbook points out, in many ways this is just an extension to the international sphere of why we, as individuals, choose not to be self-sufficient. Most of us specialise in something for which we receive

payment. This allows us to purchase what other people have produced. We do this because we enjoy a better standard of living in this way. You might be a poor hunter, farmer, builder, cook, plumber, electrician and carpet fitter. This does not matter if you can buy the things that these trades supply from someone else. The UK might not have the right climate to grow some foodstuffs or have the natural resources to extract some raw materials. This doesn’t matter since UK firms and consumers can buy these products from abroad. They can pay for these by selling goods and services to other countries. International trade allows us to enjoy a wider range of commodities than would otherwise be the case, and at cheaper prices.

Theory of comparative advantage

It is not difficult to understand the benefits of trade if we have two countries producing two different products, with each country better than the other at producing its product. But what about a situation in which country A is better at producing good X and good Y. Surely in this situation, trade cannot be beneficial? Well, it can! Students often find this a difficult concept to grasp. If you start to struggle with this idea, keep thinking, I might be both a better doctor and cleaner than my cleaner. It still makes sense for me to concentrate on being a doctor and to employ my cleaner to do the housework since I am comparatively a much better doctor than my cleaner but I am only a slightly better cleaner.

If country A produces the product which it is comparatively better at, then, provided the two countries have different opportunity costs, trade will benefit both countries. In the example given in the textbook, USA is better at producing both cars and shirts. The USA is comparatively better at producing cars. The UK is comparatively better at producing shirts.

Unit 8: Economics of the Global Economy

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Make up an example of comparative advantage at work and, using the textbook to help you, see if you can show the different opportunity costs needed for your example to work. Can you show the gains from trade that occur when you select your own rate of exchange between the two opportunity costs?


Other advantages of international trade

International trade creates larger markets, helping firms to benefit from economies of scale.

It opens up domestic markets to more competition and so reduces monopoly power.

It increases consumer choice.

It increases interdependence between trading nations and encourages co-operation rather than conflict.


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Protectionism is the practice of implementing policies that make imports more difficult. It seeks to help domestic firms compete nationally and internationally.

Question 1: In what ways do the European Union promote free trade within the union?

Question 2: How does the interaction between the EU and non-EU nations fit the idea of free trade?


Balance of payments


The balance of payments is the difference between a country’s imports and exports. It is helpful to consider where the money goes in establishing whether a payment is for an import or an export.

The visible trade balance is the difference between the value of imported goods we can see and exported goods we can see.


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The invisible balance takes into account the difference between imports and exports of goods that are not visible or tangible. For example, a Japanese tourist visiting a London theatre show would be an invisible export. (Money is coming into the UK.)

The investment earnings and transfers takes into account the net earnings arising from overseas assets owned plus the transfer of funds to and from the UK.

If we take visibles, invisibles and investment earnings together, we have the balance of payments on current account. To get from the balance of payments on current account to the balance of payments we need to include capital account and financial account transactions. Financial account transactions are made up of investment activity by British

people or institutions abroad; and investment activity by foreign institutions in Britain.

Terms of trade

The terms of trade are defined as the average price of exports divided by the average price of imports expressed as an index. If the terms of trade rise (export prices rising relative to import prices), they are said to have improved, since fewer exports now have to be sold to pay for imports.

Exchange rates revisited


Exchange rates are determined by the interaction of demand and supply on the foreign exchange market. Every time a UK business buys a good from the US it supplies pounds to the foreign exchange market in order to get dollars so that it can pay for the good. The foreign exchange market is anywhere where pounds are exchanged for other currencies. This could be a bank, a travel agent, etc. Every time an American imports a good from Britain the demand for pounds increases. There is a two-way relationship that exists between the exchange rate and the demand for imports and exports. They are both influenced by each other.

If we assume that Americans want to purchase British goods, then they demand pounds. The higher the price of pounds the less will be demanded. As the price of pounds falls, more will be demanded. The demand for pounds is a derived demand and is shown in Figure 8.1.


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Figure 8.1: Demand for pounds

If we want to purchase goods from the USA to import to Britain, we need to supply pounds. The higher the exchange rate the more pounds we supply, since each pound buys more dollars and so the US goods are good value. If the exchange rate was low, then we could buy less dollars, US products would be expensive and, therefore, the supply of pounds would be low. This can be represented in Figure 8.2.

Figure 8.2: Supply of pounds

If we now put the demand and supply of pounds together we are able to determine the exchange rate. This is shown in Figure 8.3.


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Figure 8.3: The exchange rate of the pound

If British goods become very fashionable in the US, then there would be an increase in demand for pounds. The demand curve would shift to the right. This would cause the exchange rate of the pound to increase. The exchange rate increases from p1 to p2. This is shown in Figure 8.4.

Figure 8.4: Increase in demand


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Using Figure 8.4 as a guide, explain what happens when US consumers decide UK products are not worth buying any more. Construct a new diagram to help you explain.


The Americans demand less pounds. The demand curve for pounds shifts to the left. This reduces the exchange rate of the pound and the price of pounds decreases from p1 to p2 as shown in Figure 8.5.

Figure 8.5: Decrease in demand


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If UK customers decide to buy more of a very fashionable US good, then this will increase the supply of pounds on the foreign exchange market. This has the effect of decreasing the exchange rate of the pound and is shown in Figure 8.6.

Figure 8.6: Increase in supply


Using Figure 8.6 to help you, can you explain what happens to the exchange rate if people in the UK don’t want to buy US goods?



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Floating or fixed exchange rate?

So far we have been assuming a floating exchange rate. In such a system, the balance of payments must always balance. Take our earlier example where the UK is increasing its consumption of US goods. Let’s assume the good is a luxury and has a relatively high price elasticity of demand. The large demand for the product increases the supply of pounds on the foreign exchange market. The supply curve shifts to the right and the exchange rate falls. As the exchange rate falls then all US products imported into the UK become more expensive. UK customers are likely to respond by decreasing the demand for US goods. The supply of pounds will shift to the left and the exchange rate will increase. The floating exchange rate should be self-equilibrating.


Using a freely floating exchange rate system can you explain what happens when the US customers increase their demand for British luxuries?


Fixed exchange rate system

A fixed exchange rate would cause a different market reaction. Under a fixed exchange rate, if UK customers demanded more US goods they


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would just keep on demanding them because the exchange rate won’t change – it is fixed. In this situation, the UK would run into balance of payments difficulties. The exchange rate would not fall as it would with a floating exchange rate system, so the government would need to intervene to maintain the value of the pound. The government would do this by buying up any excess pounds on the foreign exchange market, so reducing UK reserves of foreign currency. This could not carry on indefinitely since eventually the UK would have no foreign currency reserves left. If the situation persisted, the government would have to bring in expenditure reducing or expenditure switching policies.

Expenditure reducing policies could include contractionary policy, leading to less income in the economy with which to buy imported goods. Obviously this reduces the demand for domestic goods as well.

Expenditure switching policies would involve devaluation. This would lower the exchange rate and make imports more expensive. UK customers would react by switching from US goods to British goods instead.

In reality, there is no freely floating exchange rate since governments are able to influence the exchange rate in a number of ways. The government will try to act in such a way as to iron out large short-term fluctuations in the exchange rate. This is to provide a more stable economic environment which, as we have seen in earlier units, is essential for business confidence and investment decisions.

Economic and monetary union (EMU)


EMU timetable

1 January 1999 – establish fixed exchange rates between currencies and a single monetary policy to be framed and implemented by European System of Central Banks (ESCB).

1 January 2002 – ESCB put euro notes and coins into circulation and withdrew national banknotes.

1 April 2002 – The changeover to the euro was completed. The independent European Central Bank and the ESCB took over responsibility for monetary policy and interest rates.

Monetary co-ordination advantages

Increased certainty and more effective planning.

Common counter inflationary strategy.


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Reduced EU-wide price disparities.

Increased inward investment.

Reduction in costs and time of currency exchange.

Monetary control disadvantages

Difficulty of maintaining exchange rate values.

Loss of sovereignty in economic policy making.

Freedom would still exist in fiscal policy and member states could pursue independent budgetary policies.

‘One fit’ monetary policy limited given a continuing business cycle and structural disparities between EU members.


The recent Greek bailout has raised more questions about the ability of the European Union to function effectively in its current state. Read this adapted version of an article in the Financial Times.

Mario Draghi casts himself as guardian of monetary union

If anyone ever doubted how much politics and the monopoly power to print currency are irredeemably linked, look no further than the position in which the European Central Bank has found itself over the past few weeks.

Since the region’s crisis began, the unelected technocrats that head the ECB have found themselves accused of overstepping their mandate to guard the value of the single currency.

The ECB chief [Mario Draghi] acknowledged the single currency over which he presides was “fragile, vulnerable and doesn’t deliver all of the benefits that it could”, but maintained the central bank would do its utmost to keep it together. His institution would, he said, continue to act as though Greece “is and will remain a member of the euro area”.

Mr Draghi backed this verbal intervention with action, surprising markets by extending the Emergency Liquidity Assistance lifeline by €900m and indicating that Athens could soon benefit from inclusion in the ECB’s €1.1trn quantitative easing.

(Source: Jones 2015)


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Question 1: How might Greece benefit from being included in the European Union’s quantitative easing programme?

Question 2: What is meant by emergency liquidity assistance?

Question 3: Thinking about the topics covered so far, what benefits should a single currency deliver?

Question 4: Why might Greece not be feeling those benefits?


Need for fiscal harmonisation In theory, at least, fiscal harmonisation, like monetary union, is required

to ensure a single market.

The removal of tariffs alone may give an impression of a free market but various tax differences may provide equivalent distortions.

The movement towards fiscal harmonisation is far less progressed and just as problematical. The Stability and Growth Pact rules which limit Eurozone member countries to budget fiscal deficits which do not exceed 3 per cent of member country’s GDP has been breached by Italy, Germany and France in recent years.


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Question 1: If the UK keeps reducing income tax, how would this affect its trading partners?

Question 2: If the UK increased taxation, how would this affect its partners?

Question 3: How would increasing UK interest rates affect its partners?


Europe – the future Will the UK become a member of the Eurozone?

Are there any alternatives to EMU that allow further economic co-operation by following a different path?

Can the UK afford not to be a member of the full EMU since it has gone ahead anyway?

Will Britons be reminiscing in 25 years about the days we could go to the football match, have a couple of beers and a bag of chips on the way home and still have change from 20 euros?


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Trends in world trade



Summarise the points made about both the geography of international trade and the composition of international trade, particularly with reference to the European Union.


Multinational corporations



Using the knowledge gained from this unit, answer the following questions.

Question 1: What are the advantages and disadvantages to an economy, like that of the UK, of having a large multinational sector?


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Question 2: How might the structure of a multinational differ depending upon whether its objective of being multinational is to reduce costs or to grow?

Question 3: If reducing costs is so important for many multinationals, why is it that they tend to locate production not in low-cost developing economies, but in economies within the developed world?

Question 4: Explain the link between the life cycle of a product and a multinational business.

Question 5: Assess the advantages and disadvantages facing a host state when receiving MNC investment.

Question 6: Debate the following: multinational investment can be nothing but good for developing economies seeking to grow and prosper.



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Summary

In this unit, we have outlined how all economies benefit from international trade. It is easier to see the advantages when countries have an absolute advantage. It is more difficult, but still true, when we use the principle of comparative advantage. You should have demonstrated how comparative advantage works and discovered a real sense of achievement since it is a difficult concept to explain. Firms and industries that rely on international trade are affected significantly by the exchange rate and we have examined what determines the exchange rate and how the exchange rate influences the demand and supply for imports and exports.

In addition, we can identify trends in world trade and understand the growing reliance on trade within the EU.

Review activity 8.10

Read the following article which has been adapted from the Financial Times column feature ‘Free Lunch‘ and then consider the questions that follow:

Free Lunch: Trans-Pacific opacity

Capitol Hill has been agonising over whether to give Barack Obama fast-track authority to submit trade deals, specifically the Trans-Pacific Partnership with 11 other Asia-Pacific nations, to a vote in Congress.

What is clear, though, is that some venerable economic arguments for the benefits of open international commerce are being advanced to support a pact that in the main has nothing to do with free trade as defined therein.

Back when trade deals mainly addressed import tariffs, the thrust of economic analysis, going back to David Ricardo and Adam Smith, was clear. Free trade allowed specialisation and comparative advantage and thus on balance increased efficiency and prosperity.

Translating this into modern trade deals, there was usually an alliance of convenience between mercantilists who wanted to open foreign markets to their exports and economists who held their noses at the fetishisation of exports but recognised that pacts led to lower tariffs all round.

(Source: Beattie 2015)

Question 1: Expand upon the ‘alliance of convenience’ between mercantilists and economists hinted at in the article.


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Question 2: In what ways does the Trans-Pacific Partnership violate the ideas of free trade?

Question 3: Briefly outline the advantages and disadvantages for smaller economies signing up to the Trans-Pacific Partnership.





References

Jones, C. (2015) Mario Draghi casts himself as guardian of monetary union, Financial Times, 16 July. http://www.ft.com/cms/s/0/6ed110be-2bd9-11e5-8613-e7aedbb7bdb7.html - axzz3j5r6YvEd. Accessed 8 August 2015.

Beattie, A. (2015) Free Lunch: Trans-Pacific opacity. Financial Times, 27 May. http://www.ft.com/cms/s/3/afd460bc-fe38-11e4-be9f-00144feabdc0.html#axzz3iu16FL1r. Accessed 8 August 2015.

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Unit 9:

Revision and Assessment

Key audio/video: 1. Concluding MBA Business Economics (Blackboard > Module Site >

Module Materials > Unit 9) – Activity 9.1

Other:


This module has introduced you to key economic ideas and then related them to business. Economics is split into two areas: microeconomics and macroeconomics. Microeconomics covers markets and competition; macroeconomics covers the economy level topics such as inflation, GDP, interest rate policy and fiscal policy.

In terms of assessment, microeconomics and macroeconomics are covered by written assignments. You will find the assignment questions on Blackboard during December. Guidance on answering economic questions is also provided. Further information relating to a summary of the module and approaches to answering economics questions can be found in the talking head video.

Activity 9.1 – watch and reflect

Watch: Concluding MBA Business Economics (Blackboard > Module Site > Module Materials > Unit 9)



During this session you will review an article covering exchange rates and the impact on a particular industry taken from the Financial Times. The article will be posted on Blackboard with a set of specific questions ahead

http://www.brad.ac.uk/acad/management/dlmba/modconc-businessecon/

http://www.brad.ac.uk/acad/management/dlmba/modconc-businessecon/




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of the tutorial (Blackboard > Module Site > Module Materials > Collaborate). Your tutor will also go through some of the basic issues that you need to address in the assignments. In order to get the most out of the session please ensure that you come prepared with any questions or queries that you may have.

Question 1: How does the change in exchange rates impact upon the industry in question?

Question 2: How might this change in the exchange rate affect the growth of the country being studied?

Question 3: How do changing exchange rates impact on your business and what steps can you take to minimise risks?

Your tutor will also go through some of the basic issues that you need to address in the assignments. In order to get the most out of the session please ensure that you come prepared with any questions or queries that you may have.

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Appendix A:

Module descriptor

Module Title: Business Economics

Module Credit: 10

Module Code: MAN4100M

Academic Year: 2015/6

Teaching Period: September intake programmes

Module Occurrence: A

Module Level: FHEQ Level 7

Module Type: Standard module

Provider: School of Management

Related Department/Subject Area: School of Management

Principal Co-ordinator: Dr Simon Rudkin

Additional Tutor(s):

Prerequisite(s): None

Corequisite(s): None

Aims

To educate students in the workings of the market environment within which organisations operate. To provide students with the opportunity to use and apply economic concepts, constructs and frameworks in support of business problem appraisal and decision-making. To enable students to critically evaluate business problems and collect data in the construction and presentation of appropriate business solutions.


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Learning, teaching and assessment strategy

To gain a firm understanding of the subject area and the key issues (as outlined in the syllabus) students will be required to access and engage with a variety of online resources (selected readings, video and audio resources) a designated set text and a module study book that sets out guided reading, self-assessment exercises, case studies and links to additional resources. This relates to module learning outcomes: 1a, 2b, 2c, 3b. Students attend four online tutorials. These sessions allow students to reflect on their learning further applying key academic and practitioner based models and frameworks thereby gaining a detailed understanding of the subject area. This relates to module learning outcomes: 2a, 2b, 2c, 3a, 3b. Students have the opportunity to complete a series of online MCQ exercises for each module unit studied. After completing the questions

students receive instant feedback on their performance. In addition to this there is the option of completing two formative tasks. These tasks involve answering a question(s) on a key issue/theory relating to the module. Written feedback is provided by the module tutor. This relates to module learning outcomes: 2a, 3b. Assessment will be by one assignment.

Study hours

Lectures: 0.00 Directed Study: 95.00

Seminars/Tutorials: 0.00 Other: 5.00

Laboratory/Practical: 0.00 Formal Exams: 0.00 Total: 100.00

Learning outcomes

1. Knowledge and understanding:

On successful completion of this module you will be able to...

a) Analyse how markets work and how market forces affect organisations, including an understanding of micro level market forces and competition and macro level effects stemming from national and international economic policies and changing business environments.

2. Subject-specific skills:


a) Apply economic concepts to economic sectors or industries in order to enhance your understanding of opportunities and threats in those sectors or industries;

b) Analyse economic business problems, collect data and construct business assessments;

Appendix A: Module Descriptor

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c) Make business decisions while taking account of complex sustainability agendas.

3. Personal transferable skills:


a) Deal with business problems in an adaptable and original manner;

b) Effect solutions to complex business problems using economic insight and incomplete data.

Mode of assessment

Assessment type: Coursework

Percentage: 100%

Description: Individual assignment (2,000 words)

Supplementary assessment

As Original.

Outline syllabus

Scarcity and choice. Resource allocation and markets: demand and supply/cost analysis; intervention in markets. Market structure and competition: structure, conduct and performance of companies and markets; market concentration and public competition policy. The determinants of national output/income and fluctuations in growth rates. Key economic variables: output, employment and inflation. Government fiscal, monetary and supply-side policies. Exchange rates and the balance of payments. Globalisation, international trade and international investment.

Version No: 8

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Appendix B:

Model Answers to

Activities

Unit 1

Activity 1.2

At point a, where all resources are used to produce capital goods there will be an extremely unhappy electorate with little choice of home-produced consumer goods to purchase. Consumer goods would have to be imported; in short, a very unbalanced economy would occur. At point b, there are consumer goods galore. A materialist’s paradise! But if all the resources are used to produce consumer goods, then what will be used to produce capital goods when current machinery becomes worn out? Can the country import all the capital goods it needs? Would that provide a balanced economy?

The answer to question 2 is inconclusive. It is not really possible to say which is the better combination; they are both theoretically as good as each other. No information is given regarding the quality of the capital and consumer goods vis-à-vis the foreign competition. More resources may be allocated to a sector either because it is extremely efficient or to make up for its relative weakness.

Activity 1.3

Question 1: Diminishing marginal returns mean that as more of a particular good is produced the process is less efficient and more units of the other product must be given up to allow a unit increase in output. For example, land can be used to graze cattle, but who will produce fertiliser for crops. With only cattle the land never gets chance to recover in the same way and so is less use for cattle as well. Similarly if the land is only used for crops, the crops slowly suck nutrients from the soil and production becomes harder. By combining the two outputs the economy can produce more of each item and rotate fields to keep them productive.


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Figure 1: Production possibility frontier movement

Question 2: If meat can be produced in greater quantities for any given resource allocation then the PPF shifts outwards. For example if at 10 units of crops it was possible to produce 20 units of meat, then it is now possible to produce 40. The crops intercept does not change, but the meat intercept doubles. Figure 1 illustrates the change.

Review activity 1.4

Question 1: This is a government investment and so the opportunity costs are any other possible use for those funds. Examples include health, education, welfare, policing, etc. However it may be that funding comes from borrowing instead, in such cases the opportunity cost would be the austerity policy that has kept borrowing low.

Question 2: The argument is that there will be greater productivity and more opportunities for trade. This will allow the economy to produce more of everything with its resources.

Figure 2 (see next page) illustrates this discussion. Imagine an economy at point A, with 20 units of goods and 15 units of services. Following the improvements to productivity the country can produce 10 more units of service, 20 more units of goods, or some combination thereof. The PDF will undoubtedly expand but the question for government is whether to focus on one good or move to a point like H. Because of diminishing returns there will be an optimal point.

Appendix B: Model Answers to Activities

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Figure 2: Government PPF with expansion

Question 3: Speed costs, the technology to cut through air at higher speeds requires more energy input and is therefore more expensive. Physics ensures that the return to power in terms of speed is diminishing. But, we can also think that a 20 minute saving on a 1 hour journey might be helpful, but a further 5 minutes is unlikely to make particular difference or deliver the value to justify a much higher cost.

Question 4: This exercise is left open to you, but you should make sure that you mention the opportunity cost of investment and the fact that this investment should lead to more possibilities to do business – the PPF should extend outwards.


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Unit 2

Activity 2.1

Scenario 1: If there is an increase in the price of a complementary good, then the demand curve will shift to the left. In Figure 2.3 this is a movement from D2 to D1. This is because the complementary good will be demanded less at the higher price and, since the products are jointly demanded, your product will face a reduction in demand as a result.

Scenario 2: If there is a decrease in the price of a substitute good, then

the demand curve for your product will shift to the left since consumers will purchase the cheaper substitute product instead. This is a movement from D2 to D1 in Figure 2.3.

Scenario 3: If there is an increase in consumer incomes, then we would expect the demand curve to shift to the right since consumers can afford to purchase more of your product at every price. For a normal good, this is a movement from D1 to D2. However for an inferior good, the demand curve for your product would switch to the left as consumers use their higher incomes to purchase alternative products. This is a movement from D2 to D1 in Figure 2.3.

Scenario 4: If there is a brilliant advertising campaign by your main competitor, then your demand will shift to the left. This is a movement from D2 to D1 in Figure 2.3.

Scenario 5: If your product is decreased in price, then you will experience an extension of demand. This means there will be a movement along the original demand curve itself. See Figure 2.1. Price is a movement along the line, all other factors, such as substitutes, income, etc, are movements of the line.

Activity 2.2

When the demand curve is in the elastic region, a decrease in price will increase total revenue. Note how in this region the total revenue is increasing. When the demand curve is in the inelastic region, a decrease in price leads to a decrease in total revenue. When we have unitary elasticity, the total revenue will remain constant.


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Activity 2.3

Question 1: Relate income elasticity to a product/market of your choice.

Question 2: Price inelastic; unitary price elasticity; price elastic demand.

Question 3: Examples of products with close substitutes.

Activity 2.4

Question 1: Razors and blades, games consoles and games, train travel, electricity.

Question 2: First degree.

Question 3: First degree extracts the greatest consumer surplus, but is unlikely to be profitable. It would be very difficult to organise and consumers may not wish to participate in such a market.

Review activity 2.5

Task 1: For this task we have constructed the demand functions in Excel. However, it is unlikely that you will have obtained such accurate lines, indeed all of the demand models have underlying equations that are based on straight lines. The example in Figure 3 shows business travellers demand for business class tickets and it can be seen that the line is downward sloping exactly like the ones we have studied in this unit.

Figure 4 plots the remaining three on the same axis to help with the answer to later questions. Unsurprisingly the lowest line is the demand from tourists (T) for economy class tickets (E), this line is denoted as TE.

The equations for the lines in Figure 4 are as follows:

Business demand for economy (BE): 2500 – 18x

Tourist demand for business (TB): 1100 – 5x

Tourist demand for tourist (TE): 450 – 2x.


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Figure 3: Business class demand

Figure 4: Demand functions

Task 2: Business class for business is the least elastic, while the economy class demand from tourists is the most elastic. This is because quite often business class travellers must actually make the journey as a means to an end. Tourists, by contrast, might like extra comforts of business class but their willingness to pay is constrained. Low prices in economy can tempt passengers to fly, and this is the lowest priced set of tickets offered.

0

500

1000

1500

2000

2500

3000

0 20 40 60 80 100

Business Travellers Demand For Business Class

0

200

400

600

800

1000

1200

0 20 40 60 80 100

Demand Functions

BE

TB

TE


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Task 3: Based on the data, the revenue is maximised at 280 business class passengers paying £1240 for each ticket. This gives a total revenue of £347,200. It should, of course, be noted that this would be too many passengers for one plane, even the A380 only has 76 business class seats (source: emirates.com)

It is possible to derive this result from the demand function, but do not worry if you are not able to do this mathematics. We know that p = 2500 – 18x, where p is the price people are willing to pay and x is the percentage of people. Hence the revenue will be equal to the price multiplied by the quantity sold (x per cent of the 400 total, this equals 4x). Now we have R = pq = 4x (2500 – 18x). It can be readily checked that this is a quadratic function, which is strictly concave (the second order derivative is –144). Hence there is a unique maximum which is found by

setting the first order derivative, 10000 – 144x, equal to zero and solving for x. This tells us that the maximum percentage is 69.4%, which would give a price of £1250 by substitution back into the demand function.

However, because a random element has been added into the function this is not quite the same as the answer given by the graph.

Task 4: Using the graph from task 1 we can easily add the consumer surplus when the price is £1300.

Figure 5: Consumer surplus

A similar imposing of the consumer surplus triangle onto the TE graph will give the second part of the answer. Although the total surplus is much smaller it still means there will be a large number of consumers who feel they have got a good deal.

0

500

1000

1500

2000

2500

3000

0 20 40 60 80 100

Business Travellers Demand For Business Class


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Task 5: This question features two parts and relates to the demand data from Table 2.

(a) Weekends are always more popular as children are not at school and it is easier to book a solid week off work. With a greater potential demand prices will be higher. It is also possible that other events cause weekend demand, and any well-reasoned argument is welcomed here.

(b) This is an example of third degree price discrimination because passengers are being differentiated by the day that they want to travel. There is no difference in quantity, which is always one ticket, and as such there is no opportunity for first, or second, degree price discrimination here.

In reality airlines use frequent flyer rewards as a means to obtain second-degree discrimination and get someway towards first-degree. There are also revenue management models in place, which mean that if you were to check the prices today you could find they are lower (not enough people on the plane) or higher (the plane has limited-to-no seats left).

Task 6: Again this task has been split into subparts for consideration.

(a) Manchester to Dubai in first class may suffer a little bit if passengers choose to travel to Heathrow to board the rival flight. However, if the appeal of the regional airport is that there is no need to travel to London, then there will be very limited effect. Manchester to Dubai and London Heathrow to Abu Dhabi are not strong substitutes.

(b) London Heathrow to Abu Dhabi is a much closer substitute for the London Heathrow to Dubai route and so there will be a lot more competition faced. Emirates would look to dampen this by talking about the other facilities offered, such as the on-board spa. It may also talk of the convenience of having more flights.

(c) Economy class tickets are a more competitive market as passengers are often looking for the lowest price. Here again Emirates will seek to create differentiation. However, it should also be noted that for those who are closer to Manchester, the extra cost of getting to London might make the new Abu Dhabi flight less of a substitute. Etihad, as sponsors of Manchester City football club, also has flights into

Manchester, which would be more of a substitute.


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Unit 3

Activity 3.1

Question 1:

Labour Total product Average product

Marginal product

1 10 10 10

2 24 12 14

3 42 14 18

4 56 14 14

5 70 14 14

6 72 12 2

Question 2: Diminishing marginal returns set in with the addition of the fourth worker.

Question 3: The number of workers becomes too great for the capital available and so each worker slacks off a little since they know they will have to wait for new machinery to become available.

Activity 3.2

Output Fixed cost Variable cost Total cost

0 200 0 200

1 200 200 400

2 200 300 500

3 200 600 800

4 200 1,200 1,400

5 200 2,200 2,400


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Activity 3.3

Question 1:

Total output

Fixed cost

Variable cost

Total cost

Marginal cost

Average cost

0 10 0 10 – –

1 10 2 12 2 12

2 10 12 22 10 11

3 10 20 30 8 10

4 10 26 36 6 9

5 10 30 40 4 8

6 10 32 42 2 7

7 10 39 49 7 7

8 10 54 64 15 8

9 10 71 81 17 9

10 10 90 100 19 10

Question 2:

Output TFC TVC TC AFC AVC AC MC

0 40 0 40 – – – –

1 40 6 46 40 6 46 6

2 40 11 51 20 5.5 25.5 5

3 40 15 55 13.3 5 18.3 4

4 40 20 60 10 5 15 5

5 40 26 66 8 5.2 13.2 6

Question 3:

Output Price TR MR FC VC TC MC Total profit

0 10 0 – 2 0 2 – –2

1 10 10 10 2 7 9 7 +1

2 10 20 10 2 15 17 8 +3

3 10 30 10 2 24 26 9 +4

4 10 40 10 2 34 36 10 +4

5 10 50 10 2 53 55 19 –5


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Activity 3.4

Question 1: New plant construction and associated planning permissions, the creation of necessary networks and the set-up of new suppliers will all be fixed costs that will be sunk before any production can take place. Land and machinery might have resale value and so these two are merely fixed costs.

Question 2: Variable costs will fall as a result of the move because there is no shipping of finished trains from Japan. Components may be cheaper or more expensive depending on the relative cost of buying in Japan and shipping to Europe against the cost of sourcing in Europe.

Question 3: Nissan runs its car plant with high variable costs, importing all of the items needed to assemble the finished car. Hitachi does not have these shipment costs and so can enjoy lower variable costs.

Question 4: In this case the demand for trains picks up as the economy picks up and the ridership increases. In the UK there was a long period of not ordering new units in the period surrounding rail privatisation, but that was a unique time. For Hitachi its investment indicates a confidence that the initial order for the IEP and the ScotRail order are only the first of many. Should there be a downturn then the company will be left with a plant that is underutilised and not generating any payback on the large fixed costs. Whether Hitachi goes past the shutdown point is questionable, but it is usually considered that keeping the fixed cost base small in cyclical industries is wise.

This case actually opens up a discussion about government funding and

the role that the state plays in making sure people can travel during times of economic downturn. Such questions are avoided here.

Activity 3.5

Situation 1: If there is an increase in the cost of raw materials, the supply curve will shift to the left since it now costs more to supply each unit of output at each price.

Situation 2: If there is an increase in the price of the product, then there will be an extension of supply on the original supply curve.

Situation 3: An increase in productivity will cause a shift in the supply curve to the right since more can be supplied at every price than before.

Situation 4: An increase in wages causes the supply curve to shift to the left since it now costs more to produce each unit of output than it did before.


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Activity 3.6

An example that could be given to outline this situation at work is a scenario in which house prices are increasing rapidly. In the initial period the market supply has great difficulty in adapting much and the price of rented accommodation will remain high. In the short term, there is a little more flexibility since extra rooms may be made available for rent by letting parts of large houses or taking in lodgers. In the longer term, landlords will enter the market and adapt houses for renting and new housing may be made available, which gives the consumer more choice. The supply curve will become steadily more elastic as the time period becomes longer.

Activity 3.7

Consider fixed and variable inputs in the short run; ability to expand all inputs in the long run.

Activity 3.8

Figure 3.10 summarises how economies of scale should work in theory. At first, the expanding firm will experience economies of scale. After it reaches a certain size, the firm will experience constant returns and after it has grown larger it will find that the diseconomies of scale become far more significant. Figure 3.10 is a simplified diagram and should only be used as a starting off point. Figure 3.11 is a more detailed and informative diagram.


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Review activity 3.9

Question 2:

Lab Output TFC TLC TMC TVC TC AFC AVC ATC MC

0 0 50 0 0 0 50 – – – –

1 4 50 25 8 33 83 12.5 8.25 20.75 8.25

2 10 50 50 20 70 120 5 7 12 6.2

3 13 50 75 26 101 151 3.8 7.8 11.6 10.3

4 15 50 100 30 130 180 3.3 8.7 12 14.5

5 16 50 125 32 157 207 3.1 9.8 12.9 27

Working out the above table is not easy, particularly the last column where we work out the MC. You do this by dividing the change in total cost by the change in output.

Question 3: This is a fairly searching question. You have done well if you completed the table in less than ten minutes.

Output TC MC ATC AFC AVC TVC

2 114 8 57 27 30 60

3 142 28 47.3 18 29.3 88

4 189 47.2 47.3 13.5 33.8 135

5 258 68.8 51.6 10.8 40.8 204

6 358 100 59.7 9 50.7 304


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Unit 4

Activity 4.1

See Begg and Ward (2013), section 4.6.

Activity 4.2

An increase in demand for doctors requires a substantial increase in wages in order to attract a small increase in the number of doctors. This is

because doctors are relatively inelastic in supply and many years of training are required before an individual can qualify as a doctor. A nurse is also a skilled worker, but the wage increase is smaller since nurses can be trained on the job and, therefore, more people can quickly enter the market for nursing. Nurses are relatively elastic in supply vis-à-vis doctors.

Activity 4.3

This activity hinges entirely on the fact that a subsidy is a negative tax. So where the taxes in the notes cause the supply curve to shift left, a subsidy will cause it to shift right. By introducing the subsidy the government is enabling suppliers to bring their goods to market at a lower price than they otherwise would have done.

Question 1: In this case a subsidy is applied to the price. This causes supply to shift right with the difference at every quantity being equal to the per unit subsidy.

To illustrate this we assume that the subsidy is £100 and that the original price was £2000. The quantity of solar panels installed at this price is 5000. When the subsidy is implemented the quantity rises and the price falls, we shift right along the existing demand curve. The new price is £1980 and the new quantity 5400. This means that there will be more solar panels in operation, good news for the environment, and that consumers will be paying a lower price. Consumer surplus increases, which is good news for the economy. We do not know whether profit increases, but certainly £80 from the subsidy is not being passed on to the consumer.


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Figure 6: Subsidy in the solar panel market

Question 2: Here we use the same diagram but show what happens when the demand curve becomes more inelastic. To make the illustration we zoom in on the interesting area around the equilibrium. One of the

Figure 7: Elasticity and the subsidy in the double-glazing market


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great features of the diagrams is that they can be drawn with no intercepts so there is no need to worry about scale relative to zero.

Figure 7 shows the results as demand becomes increasingly inelastic the reduction in price becomes larger, but the gain of quantity becomes smaller. However, in all cases the subsidy is effective at increasing the quantity.

Question 3: For this question we just use the information to calculate that:

Question 4: Products with elastic demand are those where a small increase in price will lead to a large reduction in demand. This will be true of things like holidays, as discussed in earlier examples. For these three it is harder to decide which one would have the largest elasticity. It can be argued that people need their homes insulating, and double glazing has a lot of uses in a cold country like the United Kingdom. With a shortage of sunshine there is also likely to be a lack of demand for solar panels when the price rises. However, if you are in a warmer country then the answer would soon change. It is important to think about context.

Activity 4.4

This relates to the Harvard Business Review article ‘The 3D Printing Revolution’. This considers the effect 3D printing is having on markets.

Question 1: 3D printing allows firms to reduce their fixed costs as it is more flexible than the traditional injection moulding technique; the same printer can make any number of products while moulds must be tailored for the precise details of the product. There is also a slower printing process to consider, and this will also raise the cost of each unit. Overall variable costs rise and the supply curve will shift to the left. Prices will rise and the quantity will fall. This corresponds to Figure 4.5 in the main text.

Question 2: 3D printing is heralded for its ability to create a product that can be easily tailored to customers’ needs. As a result demand is likely to rise as the product will make each customer happier, and therefore willing

to pay more. An increase in demand will cause the quantity to go up, as well as the price. Whether the increased quantity is enough to cancel out the lower quantity from the supply shift is questionable, and is something that any good answer should discuss. Ultimately it will depend on the size of the shifts and the elasticities of the curves.

Question 3: As supply becomes more inelastic the change in price becomes smaller for any given vertical shift of the curve.


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Unit 5

Activity 5.1

The firm is making a loss since D = MR = AR is below AC when MC = MR. Firms will move out of the industry and so the supply curve S2 will shift to the left. This will cause an increase in market price and the price will increase until the surviving firms are making normal profit.

Activity 5.2

Perfect competition is not very realistic. The problem with the assumptions is that they all need to be true at the same time for a market to be perfectly competitive. Clearly, consumers don’t have perfect knowledge and freedom of movement from seller to seller is not as straightforward as it might sound. However, the theory is still extremely useful because it allows an economist to compare other kinds of market structure with a market operating free of imperfections. We are able to make meaningful comments about monopoly power, pricing and output decisions, efficiency and profit, if we have a yardstick to compare them with.

Activity 5.3

The monopolist is neither productively or allocatively efficient. The abnormal profit earned by the monopolist in both the short and long run is paid for by the consumer.

Activity 5.4

In this activity you are expected to discuss the issues surrounding the Eurostar investment by the United Kingdom, French and Belgian governments.

This was a large investment in a market of which no one truly knew the size. Competing with airlines and cross channel ferries meant that rail

would have a battle to establish itself. Eurostar invested heavily in promotion as well as helping the governments pay back the initial infrastructure investment. By enabling an operating profit there was money available to pay back these fixed costs.

Had the governments permitted competition then no company may have been able to get past the short-run shutdown point and then there would have been no return on the significant investment of building the tunnel.


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It should also be remembered that the initial ownership of Eurostar was largely by the state and therefore the governments were keen to obtain monies for themselves. The company also made large losses in early years.

Activity 5.5

There are many ways of competing on a non-price basis: location, sidelines, advertising, free gifts, special offers, happy hours, opening hours, loyalty cards, product range, diversify product into top, mid, bottom of range, etc.

Activity 5.6

Question 1: Supermarkets have power in the market when dealing with suppliers, indeed this has caused a large amount of concern around the world because many believe that this power is wielded too much. However from the perspective of the consumer being able to obtain lower prices, and impose standards, it is welcome.

Supermarkets also need to compete with each other and attract customers to their marketplace. This means they offer low prices and better facilities to make shopping easier. By contrast perfectly competitive stores are compelled to take market size as given and so will not try to attract consumers. This is something which is the subject of a large literature, including Rudkin (2014) amongst others.

A wide academic literature studies supermarket competition both theoretically and empirically, with supermarkets often shown to offer higher utility to their shoppers than other retail formats. An empirical set of papers consider these results and what they mean for health, access to fruit and vegetables.

Question 2: Clearly the public in the article like supermarkets, but there are many consequences of allowing supermarkets to grow unchecked. Easier access to imports might make shoppers happy, but there are knock-on effects for domestic suppliers that lose market share and for the employees who work at those firms. Cheaper goods can mean people consume more of what they like, this can just as easily be high fat snacks as fruit.

In the developed world there was often a two-tier system in which the more wealthy had access to the big format stores, while the poorer neighbourhoods were left with no real access to supermarkets. This has been addressed in the latest wave of development, but is something which can have lessons for the developing nations.


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Again there is a large literature for those who are interested, but certainly we should not just look at prices and product ranges when deciding if a retail format is good, or whether market growth should be encouraged.

Review activity 5.7

Question 1: The firm will increase output and gain extra profits. As it does, this marginal cost will rise and output will be held constant once marginal cost equals £10.

Question 2: Managers may not wish to maximise profits. Measuring cost and revenues is not costless and so profits may actually fall.

Reference

Rudkin, S. (2014) Supermarkets versus local shopping: Welfare implications of provision mode. Economics Letters, 124(3): 396–398.


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Unit 6

Activity 6.1

Where does the money come from that is injected into the economy? What if the increase in spending is on imported goods? What if supply cannot keep up with the increased demand in the economy?

Activity 6.2

A low exchange rate increases the price of imports and reduces the price of exports. Exporters are pleased because they find it easier to compete in the world marketplace. Domestic producers are happy in that they can now compete more favourably with imported substitute goods. But, the firms that rely on imported raw materials face an increase in their costs and this could fuel inflation. In addition, there will be an increase in the price of imported food and this would add to inflationary pressure. Generally, however, the low exchange rate should move the balance of payments towards a surplus.

Activity 6.3

Question 1: A country enjoying economic growth has several advantages:

firms are doing well from high consumer spending, giving them the profitability to carry out future investment

high consumer spending and good profitability provides the government with increased tax revenues that can be used for infrastructure spending to make for a more efficient economy in the future.

Underdeveloped countries feel that no matter how quickly they grow, they only fall further and further behind in comparative living standards. This can be explained using a numerical example.

Country A: National income = $100 billion Country B: National income = $5 billion

Country A: Economic growth = 2% 2% of $100 billion = extra $2 billion increase in national income

Country B: Economic growth = 10% 10% of $5 billion = extra $500 million increase in national income


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Question 2: In the first part of the essay, briefly outline the main economic objectives and briefly explain why each is important. For the second part of the essay, take a scenario such as high unemployment and outline how tackling this problem may lead to other problems, such as inflation and the balance of payments imbalances.

Activity 6.4

Question 1: By helping its domestic firms to export more China is increasing the amount of funds flowing into the economy. Also by devaluing its currency, the renminbi (RMB) will buy less units of other currencies. For example Burberry has reacted to the news by reducing the size of its Chinese operation, noting that the same RMB price now means it is selling for fewer pounds. This means fewer imports. Exports are injections into the flow and imports are withdrawals. Increasing the former and reducing the latter mean there will be more funds circulating in the Chinese economy.

Question 2: Injections into the circular flow can also be achieved through promoting investment and government spending. China has long had policies to achieve both of these, with infrastructure to reduce the cost of business being a major focus of policy. Withdrawals also include taxation and savings, so a similar effect to reduced imports could be achieved by reducing taxation or reducing the incentive to save.

Review activity 6.5

Output method, add up all the output being careful not to double count: £240,000

Income method, remember both wages and profit are incomes: £240,000

Expenditure method, final spending on bread and ovens: £240,000


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Unit 7

Activity 7.1

If you can answer these three questions, then you are already some way towards understanding the next part of the Keynesian model. At yy the planned injections exceed the planned leakages in the economy. Spending increases, firms find their stocks become depleted so they take on more workers to increase production. National income increases and so does the ability to save, pay tax and buy imports. National income will increase until the planned leakages are equal to planned injections and the

economy is back in equilibrium at yx.

If unemployment exists at yx and we want it to fall, then the government should increase autonomous injections until we have full employment equilibrium at yfe. This is demonstrated in Figure 8.

Figure 8: Keynesian model

Activity 7.2

The UK government has no problem financing the injections into the economy because it discovers a massive gold mine underneath Wembley football stadium, which generates massive revenue for the government. UK firms have substantial spare capacity and extra consumer spending goes on British produced goods and services. The UK’s international competitors are supportive in their economic policies, and the computer revolution allows quick and accurate up-to-date statistics on the UK’s economic performance. Not a lot to ask for!


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Activity 7.3

Expansionary policy is more popular. It is easier to find ways of increasing spending on worthwhile projects. It is harder to find ways of making cutbacks.

Activity 7.4

Question 1: Independence was championed as a way to take control of the economy out of the hands of politicians and place it with experts. When there are elections coming governments will be tempted to buy votes, while immediately after an election they will take the chance to

recoup the give-aways. By handing control over to the Bank of England the UK government led by Tony Blair sought to establish greater economic credibility and ensure that future interest rate decisions would be made based on economic fundamentals. Of course, the MPC must still react to the economy, which can be shaped by any number of government policies.

Question 2: Demand is rising as the economy recovers and real wages start to go up. This will inevitably bring about inflation and the MPC will be keen to use interest rates to control any increase. Interest rate rises do risk slowing the recovery however, and so far most developed nations have avoided implementing rate rises for many years.

Activity 7.5

A balanced budget is one in which tax income is equal to government expenditure.

A budget surplus refers to a situation in which generated tax income exceeds government expenditure.

A budget deficit is a more familiar situation in which government expenditure exceeds tax income.

The national debt is the accumulation of past budget deficits and is the money that is owed to creditors by the government.

The PSNCR is the sum of central government borrowing (CGBR), local authority borrowing (LABR) and the nationalised industries borrowing (NIBR). National debt is accumulated central government borrowing over the years. In the UK the PSNCR has replaced the PSBR as the main measure. The PSBR was the same thing but had a slightly different method of calculation (you do not need to know the intricacies of this).


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Activity 7.6

Reducing government expenditure would be very difficult. More realistically the expenditure growth should be reduced. Taxation should be increased but this is both unpopular and it can affect incentives to work. Increasing interest rates would cut down consumer spending financed from credit and cut back investment expenditure. The reduction in investment may very well be counterproductive. In any case, increased interest rates should only be used in a supporting capacity since some firms will continue to invest even if interest rates are high as their expectations of future demand and profitability are more important.

Activity 7.7

Question 1: Keynesian influence of the Obama government. Price stability follows from the monetarist position that inflation is the real enemy and the thing that must be controlled. However the link between inflation and unemployment means that the Federal Reserve might not look at unemployment being created if a reduction in inflation was possible. The dual mandate ensures that a balance is struck.

Question 2: Should interest rates rise then people will borrow less and therefore have less money to invest in new projects that would generate flow around the economy. This would lead to reduced incomes for others and hence reduced consumer confidence. Further the reduced investment limits the expansion of the production possibility frontier and slows economic growth as a result.

Question 3: Productivity pushes out the PPF, and does so without requiring any additional inputs to the production function. As such, an economy can grow with a given level of unemployment provided it can increase its productivity. Productivity also helps make exports more competitive. Many of the developed economies are now experiencing a period where unemployment has become static and policies to promote productivity are being implemented. Naturally this coming before unemployment has been eliminated is causing some concern amongst certain commentators and is part of a wider debate about whether growth, or full employment, should be the goal.

Review activity 7.8

Question 1: The monetarist theory of inflation is built upon the quantity theory where MV = PY. You should explain the assumptions behind the way in which this works. V and Y are constant, or at least easily predictable so a relationship is left between M and P. For monetarists, it is an increase in M that leads to an increase in P. Keynesians criticise the


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assumptions. They state that V is not constant, it can change due to the speculative demand for money. In addition, Keynesians suggest that monetarists have got the direction of causation the wrong way around, rather than M determining P, it is changes in PY that cause the M to change to accommodate the level of spending taking place in the economy. Furthermore, even if the M could cause an increase in PY then the effect on P could be marginal if Y changed. In short, Keynesians argue that the simple relationship between M and P identified by monetarists needs to be replaced by a more realistic, and more complicated, relationship.

Keynesians believe inflation is caused by cost-push and demand-pull factors. Modern government is best advised to consider that inflation can be caused by a variety of factors all of which vary in importance at different times and,

therefore, the solution to inflationary pressure should include a combination of approaches as part of an integrated anti-inflationary policy.

Question 2: Start by outlining the Keynesian view on what causes unemployment. Before explaining how the Keynesian solution would work, you need to explain how it is possible to have equilibrium and unemployment. Having explained the Keynesian solution to unemployment, you should outline the difficulties with this solution. Then update the Keynesian solution by examining demand and supply side policies together.


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Unit 8

Activity 8.2

Question 1: European Union members benefit from removal of barriers to trade, enshrined in the notion of freedom of movement of goods and labour. Since the founding days the growth of the finance sector has added freedom of capital movement and therefore access to some of the world’s largest financial centres in London and Frankfurt. The European Union also generates a large amount of legislation designed to break down barriers to trade and open up markets for competition.

Question 2: Trading into the European Union (EU) from outside is very difficult as there are many barriers imposed in the form of tarrifs and market size limitations. Perhaps the most well known is the limit that the EU places on imports of cars, particularly from Japan. By restricting Japanese firms to just 10% of the market, the EU has encouraged these firms to locate within Europe, the UK being a large beneficiary from this, such that the cars are European made and not imported. The EU also legislates to protect local specialties, which helps producers win export orders and fight competition from imports. Examples of protected goods include Champagne, Stilton cheese and the Melton Mowbray pork pie.

Activity 8.3

The US consumers demand less pounds. The demand curve for pounds shifts to the left. This reduces the exchange rate of the pound and the price of pounds decreases from p1 to p2 as shown in Figure 9.

Figure 9: Decrease in demand


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Activity 8.4

If the UK decreases its demand for US goods, that will decrease the supply of pounds to the foreign exchange market. This has the effect of increasing the exchange rate of the pound.

Activity 8.5

If there is increased demand from the US for UK products, the demand for pounds will increase. This will cause the exchange rate of the pound to increase. As the exchange rate increases UK exports become more expensive and imports become cheaper. If UK exports become more

expensive then the world demand for UK products will start to fall. The demand for pounds will shift to the left causing downwards pressure on the exchange rate of the pound. The exchange rate is self-equilibrating in a floating exchange rate system.

Activity 8.6

Question 1: Quantitative easing involves buying government bonds; with Greek bonds being very low rated selling any is good. There will also be benefits from improved spending that follows. Should the easing not include Greek bonds, it will still generate funds that can be used for Greek benefit.

Question 2: Banks need cash to repay depositors, but often most of their money is lent out to borrowers; therefore, bank liquidity when things go wrong is a real issue. When the government provides assistance to banks to help them function then this is known as emergency liquidity assistance (ELA. This became really important for Greece as people tried hard to get their money out of the banks as collapse loomed. Thanks to the ELA, banks were able to resume trading after a shutdown period, but with heavy caps on the amount of each withdrawal.

Question 3: A single currency operates with a single central bank and at a value which all national members understand. It should therefore bring these benefits.

Stability – no exchange rate means no risk and good times in one nation will most likely be tempered by problems elsewhere meaning large fluctuations get averaged out.

Trading block – no transaction costs of doing business as there are no currencies to convert. The block also makes trading with the world easier as there is a powerful group to achieve good terms of trade with other nations.


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Reputation – the combined currency will benefit from the economic management record of the best nations in the group (provided it broadly follows their system). This is something the EU has aimed to do by borrowing Germany’s record as being a successful stable economy.

Question 4: Greece is being forced into a series of humiliating actions by lending governments trying to get as much collateral for their loans as possible. As a result there is less and less under Greek government control, making it harder to feel the benefits of quantitative easing or to gain from improved currency credibility. Continuing to engage with the process means that the people must believe that the future will be better and that the access to European markets and funds are worth the pain in the medium term.

Activity 8.7

Question 1: Expenditure by UK households would increase. Some of this increase would be spent on imported goods. The effect on foreign firms producing these products would depend upon the level of spare capacity that exists.

Question 2: Increasing taxation would reduce expenditure and so foreign firms would sell less in the UK and this could lead to unemployment.

Question 3: Increasing interest rates would reduce expenditure in the UK and this would have an adverse affect on foreign firms. But, higher interest rates can lead to a higher exchange rate, and this makes imports into the UK cheaper and hence more attractive.

Activity 8.8

This section of the textbook considers the geography of international trade and highlights the trading blocs that have formed, such as the North American Free Trade Area (NAFTA) and the European Union (EU). Trade is overseen by a range of bodies, such as the World Trade Organisation (WTO) and the General Agreement on Tariffs and Trade (GATT). Section 16.3 presents a review of the EU seeking to highlight how countries have gained from membership and being able to specialise according to comparative advantage. For example it suggests the Greek benefit is between 9% and 16% of GDP. Looking beyond the EU it is shown that the collective bloc becomes the biggest single trading entity in the world, with a share of 15.1% putting it ahead of China (13.3%) and the United States (10.8%). These figures are though from 2011 and the picture continues to change.


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Activity 8.9

Question 1: The advantages for the UK of having a large multinational sector are that it provides investment, employment and growth, and, given that many multinationals export, it contributes to the balance of payments. A disadvantage of having a large multinational sector is that the economy is vulnerable to these businesses deciding to leave. The recent debate about EU membership and the benefits to MNCs of the UK as a member has raised the spectre of such an event occurring. In addition, by having a large multinational sector within the economy, and with multinationals being such significant employers and investors, they may be able to exert control over the host state. Such control might, for example, take the form of requesting additional subsidies to help with expansion, otherwise businesses will look to expand elsewhere. Finally, much of the profit earned by multinationals does not remain in the country but flows back to the multinational’s country of origin.

Question 2: If the multinational was looking to expand overseas to reduce costs, then it would be more likely to consider a vertically integrated structure. If the multinational was looking to expand overseas to grow, then it would probably be considering a horizontally integrated structure.

Question 3: The location of multinational corporations (MNCs) in developed rather than developing economies, even when they are pursuing low costs, is due to the fact that many MNCs are seeking workers with skills, which they are more likely to find in developed markets. Hence it is cheap skilled workers, which are the target of the MNC. Also developed countries are more likely to offer a better transport, communications and financial infrastructure.

Question 4: When the product reaches its mature phase, that is, the phase when cost considerations become more important and the domestic market becomes saturated with competition, then the business will have to consider how to reduce costs to maintain profits, and how to continue to sell more of the product. An answer to both of these questions might be to locate production overseas in lower-cost production sites that give access to new consumers.

Question 5: As considered in the answer to question 1, the main advantages are to employment, growth, investment and the balance of payments. In addition, a further advantage, especially to less developed economies, might be the possibility of some technology transfer from the MNC to the host state. The disadvantages could include the uncertainty of MNC investment, the control and influence of the MNC over the host state, as well as the environmental and social impacts that an MNC might have. These problems might be significant in developing economies, where the MNC is less restricted by environmental regulations and social restrictions, such as worker rights.


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Question 6: Many of the arguments made above might be included in this debate. For countries that are desperately short of capital, MNCs provide an obvious source of investment. They often stimulate employment in local industries that provide components and services to the MNC. On the other hand, they may exacerbate the problem of poverty, and the uneven pattern of development experienced by many developing countries. Many MNCs are based in large cities. They act as a magnet to poor people, who flock in from the countryside in numbers greatly in excess of the jobs available. They contribute to the rapid pace of change in developing countries, where traditional values are often displaced by the consumerist values of the rich world. But the wants generated cannot be satisfied for vast numbers of poor people.

Review activity 8.10

Question 1: The alliance of convenience refers to the fact that economists believe that trade should be free to allow allocation of resources in the most efficient possible way. Over time, the definition of efficiency has been changed to incorporate social and environmental costs as well as the financial cost of trade. However, the basic principle is that any transaction costs and limitations prevent the most efficient outcome from being achieved. Anything that breaks down barriers, such as the TPP is a good idea. Business wants markets for its products, so anything that opens up a new market is good for them. For this reason trade partnerships giving better access are much better prospects.

Question 2: These partnerships work to break down barriers within the group, but much like the European Union they serve to then put up barriers to those nations that are not members. Whether explicitly, or because others simply struggle to gain market access, it is not the free trade playing field that economists espouse.

Question 3: Joining the TPP will give smaller economies access to markets, particularly the valuable USA market. This will allow greater specialisation. All of the benefits of free trade, lower transaction costs and easier business conditions will come when dealing with members.

However, there are also many disadvantages as the set of nations with whom free trade can be done is affected by the members of the partnership. It also opens up competition among similar members for the same benefits. There are also many other potential large markets, such as Europe and China, which may react less favourably to tie up deals with the USA – especially if the TPP includes any measures that count against those big markets.

There are many other advantages and disadvantages, but the main ones are those summarised here.

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